While rate of return regulation served the electricity industry and consumers well for many decades, it had embedded in it a number of incentive problems that made for inefficient operation of electric utilities and some behavior by regulators that was not always in the public interest. In particular, rate of return regulation gave electric utilities incentives to over-invest in capital - the so-called "Averch Johnson" effect. Regulators, in turn, labored under incomplete information regarding the state of the utilities that they were supposed to regulate. Even on their best day, the utilities knew more about the power grid than their regulators, so utilities could more easily get regulators to approve investments. Public utility commissioners are aided by large technical staffs, but at the end of the day, these staff members had expert knowledge but still had less data and system information than the utilities.
Recognizing that generation could be competitive over large regional areas, and that transmission and distribution needed to retain some form of regulation, the restructuring of the electricity industry consisted of the following fundamental changes:
- Dis-integration (or "vertical unbundling") of the regulated electric utility; or privatization of the national electric company in countries that had formerly known governmental control over electricity.
- A shift in transmission regulation away from state or local control and towards federal control. Federal policy encouraged the establishment of Regional Transmission Organizations (RTOs), which would manage electric grids over wide geographic areas.
- Establishment of competitive electricity markets for power generation, run by the RTOs. Generation companies would no longer enjoy a guaranteed rate of return, but would need to earn profits by providing services to RTOs at a lower price than their competitors.
- At the state level, establishment of retail competition for generation services.
In the United States in particular, restructuring has proceeded unevenly. Around half of U.S. states now have a power sector that has been restructured in some way. The other half still operate following the regulated utility structure that we discussed in Lesson 5.
Reminder - Complete all of the Lesson 6 tasks!
You have reached the end of Lesson 6! Double check the What is Due for Lesson 6? list on the first page of this lesson to make sure you have completed all of the activities listed there before you begin Lesson 7. Note: The Lesson 7 material will open Monday after we finish Lesson 6.
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