EME 801
Energy Markets, Policy, and Regulation

Electricity Industry Structure and Regulation

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For nearly one hundred years, the fundamental building block of the electric power sector was the vertically-integrated utility, regulated by the public utility commission in the state(s) in which the utility operated. Roughly speaking, the electric power supply chain has three links (shown in Figure 5.4): generation, transmission, and distribution. Generators are electric power stations that produce electricity by various means, including the burning of fossil fuels or waste products, harnessing kinetic energy of water and wind, and nuclear fission. The various generators, which are often located large distances from consumption centers, connect to a high-voltage transmission network. Closer to the point of consumption, the transmission network is connected (through a series of step-down transformers) to a lower-voltage distribution network. A second series of transformers connects individual customers to the distribution network.

 Links in the Electricity Supply Chain showing movement from generation to transmission to distribution to the consumer.
Figure 5.4: Links in the Electricity Supply Chain

The electric power sector has long been viewed as having economies of scale and of scope. The term "economies of scale" means that average and marginal costs of production decline as the output of firms increases - in other words, situations where larger firms are more efficient than smaller firms. Firms that exhibit economies of scale, no matter how much they produce, are often termed "natural monopolies." The term "economies of scope" in this case means that one firm can provide generation, transmission, and distribution service more efficiently than separate firms providing each type of service. Such a type of firm is referred to as a "vertically integrated" firm. Economies of scale were the justification for granting electric utilities franchise monopolies, while economies of scope were the justification for the continued vertical integration of firms in the industry. With electric-sector reform in the U.S., the assumption ,of economies of scale has been questioned in the generation business, but the "wires" segments of the supply chain (transmission and distribution) are still considered to exhibit economies of scale and are thus still tightly regulated.

The emergence of economically viable small-scale or "distributed" generation has, in some places, begun to upend traditional assumptions regarding economies of scale in generation and also the extent to which distribution of electricity could be a competitive business. We won't discuss those issues as much in this course, but if you are interested in learning about these types of disruptive technologies, AE 862 devotes an entire semester to this topic.

Electric energy is currently generated by two types of firms. The first type is the traditional vertically-integrated utility. These firms generate power to sell to their customers or to sell on the open market. The second type is the non-utility generator, also called an independent power producer (IPP) or merchant generator. These firms typically do not have any customers who consume electricity; they simply generate power and sell it to utilities that do have customers. In a competitive market for electricity, IPPs are likely to be financially successful only if they can produce power at costs lower than prevailing market prices, or below the cost that the utility charges.

Electricity restructuring has changed the utility business model substantially in areas of the U.S. where it has been enacted. The details of restructuring are left to the next lesson, but the map in Figure 5.5 will give you some idea of areas of North America that have actively engaged in electricity restructuring versus those that have resisted restructuring and competition in favor of the traditional model of the regulated and vertically-integrated electric utility. Areas that have established "Regional Transmission Organizations" as shown in the map are considered to have engaged in some degree of electric industry restructuring.

See caption. Shaded regions are California, the Midwest and south west, and states including and above Kentucky and Virginia
Figure 5.5: The colored regions on the map represent portions of North America that have engaged in some form of electricity restructuring through the establishment of "Regional Transmission Organizations" that manage competition between power generators on a regional basis. Unshaded areas have retained the traditional structure of the regulated vertically-integrated electric utility.

Although the electricity industry was dominated by the vertically-integrated utility for nearly a century, the beginnings of the industry were very different. After the opening of Edison's 1882 Pearl Street generation station in New York City's financial district, the industry emerged in an era characterized by intense competition between Edison, his rivals, and municipal cooperatives. Edison's direct current (DC) power required generation stations to be located within a mile of the electric lights. A decade later, Edison merged his company with a firm expert in alternating current (AC) technology to form General Electric. AC power was both more efficient for powering motors than DC and could be shipped long distances, allowing large central generation stations to supply many customers.

By 1910, a consensus emerged that vertically-integrated companies should be granted monopoly status within a geographical area in exchange for regulation that obliged them to serve consumers at prices and terms that were regulated by the respective states in which these companies operated, but gave them essentially guaranteed rates of return that could attract capital. Power companies supported state regulation as a barrier to entry of potential competitors and as a way to reduce the high costs of managing a patchwork of local regulation bulwark against a patchwork of local regulation. This ushered in a decades-long era that has come to be known as the "utility consensus."

Most utility regulation occurs through a process known as "cost-based ratemaking" or "rate of return regulation." Under rate of return regulation, the utility sets prices (rates that are paid by retail customers) to recover the costs associated with providing service, plus a level of profit determined by the state public utility commission. It is important to remember that this regulation in the United States occurred at the state level, not the federal level. For many decades, the federal government played a relatively minor role in the regulation of specific utility companies. The federal government did play a major role in the widespread electrification of the American countryside, in part through the establishment of federal policies such as the Rural Electrification Act and federal power projects such as those managed by the Tennessee Valley Authority and the Bonneville Power Administration. As we will find out in Lesson 6, the process of "deregulation" has actually involved a substantial shift in electricity regulatory authority from the states to the federal government.

The following short videos provide some more explanation on rate of return regulation.

Video: Grid Regulation - Part A (4:35)

Video 5.3: Grid Regulation - Part A.
Click for transcript of Grid Regulation - Part A.

So, this public utility operated under what we call the regulated monopoly or regulated franchise model. the regulated monopoly or regulated franchise model was granted by the state, a geographic territory over which it had a monopoly to produce electricity, to transmit electricity, and to sell electricity. So, not only was this utility a vertically integrated firm, it was a vertically integrated monopoly. So, for seven decades, the utility could not have any competition for any part of its business. And, in exchange for that, in exchange for being given this state-sanctioned monopoly, the utilities agreed to have their prices and their profits regulated by a state-level entity called a public utility commission. So, the public utility commission effectively set the price that the utility could charge for electricity. It also set the price that the utility could charge to different types of customers. So, Penn State had a different price than Seth Blumsak. And the public utility commission was ultimately the entity that set those prices. The public utility commission also decided what investments the utility would be allowed to make. Or not really make, but what investments the utilities could force their customers to pay for. And so, the utilities basically had this monopoly. And they were very highly regulated, and their operations were very highly regulated. And basically, they had one job, sort of two jobs. The first job was that they had to supply whatever electricity was different. So, they couldn't tell people, I will not supply you with electricity. And the other thing was that they basically had to operate the system reliably. So, they had to operate the system in a way that you wouldn't have a lot of blackouts. So, their responsibility was, basically, serve all the customers and don't break the system.

[Question] That's all utilities?

So you can see how the system had its ups and downs. It created a very stable economic climate for the utility business. And it was able to borrow money and attract investment at very attractive rates of return. Because if the utility has a guaranteed profit margin of 10% and there's basically no risk to that, if you're a potential investor who's going to lend the utility money, all of a sudden, this looks like manna from heaven. And so it created a very stable economic climate for the utilities. And it allowed, basically, a fairly rapid electrification of the US.

Credit: Seth Blumsack

Video: Grid Regulation - Part B (3:42)

Video 5.4: Grid Regulation - Part B.
Click for transcript of Grid Regulation - Part B.

So, variation in fuel costs, those variations were generally allowed to be passed on directly to the consumers. So, if the price of all the fuel the utility had to buy doubled, then the generation portion of your electricity bill would double. So, utilities were generally allowed to do that. Most state regulators broke up the utilities costs into capital investments--in wires, and substations, and power plants, and things like that--and operational costs, which were things like labor costs and fuel. And basically the deal that the utilities had with the public utility commission was that they could pass through all of their operational costs to consumers. So if fuel prices increased, electricity prices would go up. But they weren't allowed earn any profit on fuel. But they were allowed to earn profit on stuff that they had built. This was called rate based. So, every time the utility built a new power plant, or it build a new transmission line, then it would get to earn a profit off of that investment.

So, this regulation created a very stable climate for a long time. You could see where we might start to have some problems. One, if the utility's profits went up every time it built something, then the utilities got in this mindset where their business model was building stuff. Second, when you're spending other people's money, then you're maybe not necessarily as careful with it as you might be otherwise. But what economists would call incentive problems existed for a long time. But they really didn't manifest themselves until the 1970s, when we basically had two things happen at the same. One, we had the energy crisis of the 1970s. And fuel prices increased dramatically. At the time, 20% of US electricity was generated with oil. So, when oil prices went up dramatically, that impacted the cost of generating electricity. The second thing that happened was for environmental and other reasons, the utilities in many states were halfway forced and halfway decided to make large investments in nuclear power plants. And as it turned out, the utilities did not know how to build or operate nuclear power plants terribly well. And so, there were all sorts of delays, and cost overruns, and cost escalations with nuclear power plants. And because of this deal that the utilities had with their regulators, all or most of those costs ultimately had to be paid by utilities customers.

Credit: Seth Blumsack