A Five Point Checklist For Successful Electricity DeregulationLegislation

After dozens of hearings and years of intense public debate, both houses of Congress appear ready to move electricity legislation to the floor for a vote in upcoming months. The debate up to this point has been contentious, and it promises to become even more acrimonious as legislation to deregulate the electricity industry takes center stage. Although the chances of passage are not certain, several Members of Congress are showing an interest in advancing this legislation, and a consensus supporting the rapid opening of the electricity market appears to be forming. Federal policy makers should use this new window of opportunity to establish nationwide competition and consumer choice in the electricity market.

Not all market liberalization efforts will be equal, however. Of the countless electricity deregulation or restructuring efforts introduced over the past few years, few proposed all the reforms that would be necessary to deregulate the electricity sector successfully and enhance consumer choice and competition. To be successful, initiatives to deregulate the electricity market should incorporate five simple steps:

1. Eliminate, reform, or phase out federal electricity laws and programs.

2. Mandate the implementation of pro-competition, open-access policies at the state level by a specific date.

3. Restrict utility bailouts that could strangle competition at the outset and unconstitutionally burden interstate commerce.

4. Privatize federal public power entities immediately to level the
   playing field.

5. Refrain from imposing any new environmental mandates.

Congress must follow this five-point strategy to establish a firm foundation for the developing free market in electricity. If any of these elements is disregarded, the most likely effect will be to postpone indefinitely the development of competition and consumer choice in the industry or, at a minimum, to diminish the gains that could accrue to consumers in the short term.

A FIVE-POINT STRATEGY FOR ELECTRICITY DEREGULATION

Eliminate Federal Electricity Laws and Programs

The first step toward creating a free market in electricity is to repeal the federal statutes and regulations that hinder electricity competition and consumer choice. The following steps should be taken:

• Repeal the Public Utility Holding Company Act of 1935, which regulates the practices of multi-state utility holding companies, unnecessarily restricting their business operations.

• Repeal the Public Utility Regulatory Policies Act of 1978, passed during the energy crisis of the 1970s to encourage the use of alternative energies and conservation techniques. The law imposes burdensome purchasing requirements on utilities, forcing them to enter expensive long-term contracts with independent power producers.

• Repeal the Energy Policy Act of 1992, which allows the Federal Energy Regulatory Commission (FERC) to introduce elements of competition in the wholesale end of the electric generation marketplace. The law does not cover retail transactions, however.

• Repeal most previous FERC orders.

• Repeal other Department of Energy rules related to the electricity industry. A plan to reform, downsize, and eventually abolish the Department of Energy should be formulated.

• Reform Nuclear Regulatory Commission rules to allow for a more viable nuclear industry in the future.

• Abolish the Low-Income Home Energy Assistance Program, which provides $1.2 billion in federal funding to reduce residential energy bills for some low-income Americans. State and local officials are better able to target and administer such low-income assistance programs.¹

These federal laws, regulations, and programs should be superseded by a single electricity law that is deregulatory (instead of regulatory) in nature and promotes competition.

Mandate the Implementation of a Pro-Competition, Open-Access Policy at the State Level by a Specific Date

As the states pursue plans to open their markets to competition, Congress should provide minimal backstop measures to insure that the electricity market--increasingly national in scope--continues to grow unencumbered by restrictive burdens imposed at the federal, state, or local level. Among the reforms that would insure open access and true competition are:

• Elimination of the exclusive state franchising of electric company monopolies. No state should be permitted to impose random, geographically defined walls that would disallow interaction between producers and consumers in the interstate electricity market. Such state-based laws should be prohibited outright as unconstitutional restraints of interstate commerce.

• Open-access plans. To promote nationwide competition and to guarantee efficient, constant, and reliable service, states should proceed on a relatively similar schedule. A congressional backstop to allow a state to open its electricity market by an established date, or after a certain number of other states have acted, would facilitate state efforts to establish a competitive market quickly and would help to solve any reciprocity concerns that arise.

• Voluntary interconnection negotiations among competitors who seek access to new markets. Policymakers should not attempt to impose overly complex interconnection arrangements on carriers. Instead, they should establish simple guidelines to require interconnection and then allow the companies involved to negotiate the access rules. If problems arise and mediation is needed, state officials or private parties can serve as arbitrators, similar to those required in telecommunications interconnection negotiations.

• No specific mandates on grid management that would box the industry into centrally organized and inefficient transmission and distribution systems. Efforts should be undertaken as quickly as possible to deregulate the transmission and distribution segments of the industry. Voluntary industry-led agreements can solve grid management issues, insure superior coordination of power flows, and guarantee service reliability.

• The sunset of new access rules by a specific date. Transitional access rules could grow to become perpetual impediments to further deregulation. Ideally, a transition period should not last longer than five years, at which time a "cold turkey" deregulatory approach should be adopted for the entire industry.

Restrict Utility Bailouts That Could Strangle Competition at the Outset and Unconstitutionally Burden Interstate Commerce

Congress should take a firm stand against industry-led proposals to hand inefficient, debt-ridden, investor-owned utilities a multibillion-dollar bailout of their so-called stranded costs. In essence, stranded costs are economic losses that some utilities incur in a deregulated market because of bad investment decisions in the past. Many utilities hope to convince policymakers and the public that, because the government forced these costs on them, they should not be held responsible for absorbing them. In reality, government regulation played only a small part in determining how utilities incurred the largest portion of these costs.

Moreover, even if regulatory activity had forced utilities to incur these costs, the industry would not be justified in asking the taxpayer to fund its requested quarter-trillion-dollar bailout. Nor would the industry be justified in passing the stranded costs along to unknowing consumers or potential competitors, because they had no voice in how the past investment decisions were made and would receive no future benefits from the utilities showered with the bailout. As The Economist recently noted, for example,

Where utilities are allowed to recover stranded costs for nuclear power and other dud investments, real competition may be delayed for years.²

It now appears that proponents of a multibillion-dollar bailout greatly exaggerated the potential magnitude of industry losses from deregulation. In a recent analysis of auctions of five major utility asset sales since mid-1997, Kenneth Skilling of the BNA Daily Report for Executives finds that "Most of the sales have been at substantial premiums over book values."³ For example, New England Electric System's recent sale of generation assets to the U.S. Generating Company raised $1.59 billion, 45 percent more than book value. And last fall, the California-based utility Edison International sold nine of its gas-fired plants--with a book value of $421 million--for $1.1 billion, 2.65 times their book value. Industry claims that consumers should fork over billions to pay off their debts are difficult to justify when their assets actually may turn a handsome profit on the auction block.

In light of the claims being advanced by bailout proponents, minimal federal guidelines will be necessary to insure that the stranded cost bailout process does not spiral out of control.⁴ Congress should consider two sound approaches:

1. Create guidelines for state-imposed stranded cost recovery plans. Although federal policy makers can grant the states broad discretion in determining how much, if any, compensation the utilities should receive to bail out their old debts, Congress should craft specific guidelines to make sure that the recovery process does not impede the development of interstate competition. Federal and state regulators could design a "federal-state competitive compact" to delineate the rights and responsibilities of federal and state officials in the recovery process. Federal policy makers would work with state officials to establish competitive cost recovery guidelines to outline "ceilings" and "floors" for assets or investments that all policymakers collectively would regard as "clearly unrecoverable" or "potentially recoverable."

Federal policy makers also could develop guidelines regarding what recovery mechanisms are most suitable in the state legislators deem event compensation appropriate. For example, excessive or discriminatory entry or exit fees that would prevent the development of interstate competition should be discouraged. If state policy makers determine that they indeed had forced certain companies to incur costs against their will and, therefore, that some compensation is justified, federal policy makers should recommend that states use general treasury funds to compensate those utilities. Such a compensatory system would be more fair than the imposition of hidden taxes on consumers and competitors; it also would discourage state policy makers from granting excessive compensation to specific companies.

2. Impose a strict quarantine for utilities that accept state-sanctioned bailouts. A simpler, more practical alternative might be to limit or contain an "S&L-style" multibillion-dollar industry bailout by barring firms that accept state-granted bailouts from entering the interstate electricity market. Excessive state-based efforts to recover stranded costs already have contributed to an economic trade war between the states. In some states, legislators and regulators shower their in-state utilities with more money than neighboring states do in order to keep ahead of the competition. As a result, the price tag associated with the overall industry bailout is escalating rapidly, and discriminatory and protectionist mechanisms to recover stranded costs are being concocted to skew the rules of the game squarely in favor of the largest, most inefficient high-debt companies.

If poorly managed utilities convince state legislators to support schemes that would force consumers and competitors to shoulder the burden of the multibillion-dollar bailouts, it is highly unlikely that real electricity competition will develop in the near term. Moreover, such state-crafted bailouts raise two troubling questions:

Congress must assume the role of referee to guarantee that a state-by-state electricity bailout war does not spin out of control. The most logical way to do this without trampling the rights of the states to make certain compensatory determinations is simply to forbid firms that accept such state-granted bailouts from entering the interstate electricity market. In other words, any electrical utility that applies for and receives a multibillion-dollar bailout of past or future economic losses would be quarantined within its current service jurisdiction. This would contain the anti-competitive effects of such bailouts so that they do not spill over into interstate markets. Firms that may have accepted some form of bailout already should be allowed to compete in interstate markets if they agree to refund any bailout funds they may have confiscated from consumers on current billing statements.

This sensible compromise may be the best way to balance the right of states to make stranded cost bailout determinations with the right of the federal government to protect the free flow of interstate commerce. Congress should not shrink from its constitutional role as protector of the national marketplace from barriers to interstate competition.

Privatize Federal Public Power Entities Immediately to Level the Playing Field

There is no justification for continuing to promote government ownership of electricity companies or resources. The immunity to the discipline of market forces that government-owned power entities enjoy has caused both the squandering of taxpayer resources and the disappointing performance of entities that are supposed to serve the "public interest."

The lesson of this decades-long experiment is simple: The public interest cannot be served unless the public has a direct voice in how it is served. The following reforms must be undertaken immediately to bring market discipline to the noncompetitive world of public power generation and supply:

• Privatize the Tennessee Valley Authority (TVA) by breaking it into three to five geographic units and selling the new, distinct companies to private utilities. These sales would help pay off the TVA's remaining debts and raise revenue for the federal Treasury.⁵

• Privatize the Power Marketing Administrations (PMAs), including the Bonneville, Southeastern, Southwestern, and Western Area PMAs.⁶

• Abolish the Rural Utilities Service, because the job of wiring rural areas of the United States for utility service was accomplished long ago.⁷

• Reform federal tax laws that grant unfair advantages to municipally owned or cooperatively owned utilities. In terms of leveling the competitive playing field, few actions would be more beneficial than reforming the tax code and eliminating the distinction between private and public power entities. Municipally owned and cooperatively owned utilities, for example, benefit from generous tax breaks and preferences that will give them an unfair advantage over private competitors in the future. Either these distinctions must be eliminated or these power companies must be quarantined within their existing service territories to prevent them from adversely affecting competition in the electricity market.

If Congress does not undertake such public power reforms, the job of electricity restructuring will be incomplete and private investor-owned utilities will assert correctly that they are being forced to compete on unequal terms with subsidized, government-owned entities.

Refrain from Imposing Any New Environmental Mandates

Reformers must not succumb to pressure to include an expansive environmental agenda in their electricity deregulation efforts. If policymakers determine that regulatory environmental mandates are necessary to bring comprehensive restructuring legislation to the floor, they should delay their deregulatory efforts. To promote competition on a rapid timetable, policymakers must exercise caution so that they:

• Do not force new renewable energy mandates on consumers or the electricity industry. If solar, wind, hydrothermal, or other alternative power production proves to be sustainable in an open market, then the utility companies will adopt those alternative power sources on their own. Prematurely mandating their use, however, could prove costly to companies struggling to compete in newly liberalized markets and drive consumer prices significantly higher just as the benefits of competition take hold. It makes no sense for policymakers to argue on the one hand that they trust the market to provide better service and prices and to contend on the other that they do not trust the same market to pursue safe, environmentally friendly, and sustainable energy alternatives.⁸

• Separate the debate over clean air rules from the debate over electricity deregulation. Efforts to promote competition should not be derailed by the attachment of expensive and unnecessary new mandates. Anything that delays the advent of consumer choice also will diminish industry efforts to offer environmentally concerned consumers service that is more energy-efficient. In other words, competition and consumer choice will do much to insure the overall improvement in clean air quality without the imposition of new regulatory mandates.

• Do not allow efforts to pass a global warming treaty to piggyback on electricity reform. Such an approach likewise would derail any consumer choice legislation.⁹

CONCLUSION

The window of opportunity to bring about successful electricity deregulation may close soon. Legislative or regulatory efforts are under way in every state, and these efforts could become the de facto deregulatory policy for the United States if the federal government does not take appropriate action. Although such state-by-state experimentation in this arena has some advantages, it is unlikely that the patchwork quilt of electricity laws and policies that would spread across the country would guarantee the total deregulation of this market. For many states, the overriding objective lies not in the enhancement and enlargement of a vigorously competitive national marketplace, but in the preservation and protection of parochial industry interests. Such actions are not beneficial to consumers or companies operating in the national marketplace.

Historically, deregulating other large national industries has required some form of minimal federal oversight. In most of these cases, state officials either were held captive by parochial special interests or lacked jurisdictional authority to deal with issues that were national in scope. Federal policy makers were responsible for moving the bulk of the deregulatory efforts forward. And even though previous efforts to deregulate the telecommunications, financial services, aviation, railroads, and banking industries have not always been perfect, almost all economists will agree that they led to overall improvements in service quality, safety, industry innovation, and prices for consumers.¹⁰

Federal efforts were needed to insure that a national competitive framework was established in these sectors and honored by the states and localities. Likewise, federal effort is essential in the electricity sector to promote nationwide consumer choice and vigorous rivalry between industry competitors. To achieve these objectives, however, the federal government must get its own regulatory house in order. Numerous federal laws, regulations, and programs will need to be eliminated as soon as possible.

Federal policy makers must not allow this window of opportunity to close without developing a clear framework for establishing nationwide competition and consumer choice in the electricity sector. They must act soon if the promise of electricity deregulation is to generate rewards for Americans in the near future.

Adam D. Thierer is former Alex C. Walker Fellow in Economic Policy at The Heritage Foundation.

Endnotes

1 See Robert Rector and Dorothy Hanks, "Low-Income Home Energy Assistance," in Scott A. Hodge, ed., Balancing America's Budget: Ending the Era of Big Government (Washington, DC: The Heritage Foundation, 1997), pp. 368-369.

2 "Electric Avenues," The Economist, February 28, 1998, p. 70.

3 Kenneth Skilling, "Power Plant Sales Raise Questions About Stranded Costs, Consumers' Bills," BNA Daily Report for Executives, February 6, 1998, p. C1.

4 For more details, see Adam D. Thierer, "Electricity Deregulation: Separating Fact from Fiction in the Debate Over Stranded Cost Recovery," Heritage Foundation Talking Points No. 20, March 11, 1997.

5 See Adam D. Thierer, "Five Good Reasons to Force the TVA into Mandatory Retirement," Heritage Foundation F.Y.I. No. 144, June 3, 1997.

6 See Adam D. Thierer, "Power Marketing Administrations," in Hodge, ed., Balancing America's Budget, pp. 113-115.

7 See Adam D. Thierer, "Rural Utilities Service (Rural Electrification Administration)," in Hodge, ed., Balancing America's Budget, pp. 107-108.

8 For more information, see Robert L. Bradley, Jr., "Renewable Energy: Not Cheap, Not 'Green,'" Cato Institute Policy Analysis No. 280, August 27, 1997.

9 See Angela Antonelli, Brett D. Schaefer, and Alex Annett, "The Road to Kyoto: How the Global Climate Treaty Fosters Economic Impoverishment and Endangers U.S. Sovereignty," Heritage Foundation Backgrounder No. 1143, October 6, 1997.

10 See Robert Crandall and Jerry Ellig, Economic Deregulation and Customer Choice: Lesson for the Electric Industry (Fairfax, VA: Center for Market Processes, 1997), and Adam D. Thierer, "History Shows Deregulation Will Benefit Electricity Consumers," Heritage Foundation F.Y.I. No. 140, April 24, 1997.