Rethink the Natural Monopoly Justification of Electricity Regulation

Blackout shows need for change

Last week’s blackout shows that transmission investment has not evolved in keeping with the dynamics of growing wholesale electricity markets. The deregulation of wholesale prices and the removal of geographic restrictions on sales of generated electricity have unleashed dramatic changes in the industry and led to increasing efficiency. Currently, though, the antiquated transmission system and continuing retail and distribution regulation at the state level hamper growth and efficiency in the electricity industry. Backward-looking, static regulatory thinking about how benefits are generated through competition hampers the unleashing of possible benefits of competition in the electricity industry.

Both federal and state policymakers continue to treat transmission and distribution as natural monopolies, meaning they believe one firm could supply the entire demand at lower cost than multiple firms serving the relevant market. From this premise they conclude that transmission and distribution must continue to be regulated, because in the absence of regulation, transmission and distribution owners would not face sufficient competition to keep prices low to consumers and to achieve economic efficiency in transmitting and distributing electricity. Natural monopoly concerns also include wanting to avoid the “unnecessary duplication” of such expensive capital infrastructure as high-voltage wires and transformers. Thus even under current Federal Energy Regulatory Commission proposals to revise the regulation of electricity, both transmission and distribution would continue to be regulated.

Although regulators are considering ways to incorporate more performance-based rates to move away from rate-of-return regulation, the natural monopoly paradigm locks them into a regulatory framework that is becoming outmoded as a result of technological change. Overcoming the traditional regulatory mindsets is a crucial step in delivering a variety of benefits to consumers, the economy and the environment from competition in electricity. Current regulatory proposals (such as FERC’s Standard Market Design proposal) will lead to the construction of additional high-voltage transmission to create a unified transmission network across the country; while this proposal is sure to create some benefits by integrating separate geographic markets, it will also encourage more transmission construction than if regulators allowed for more flexible customer and supplier use of new technologies that will provide substitutes for long-distance transmission. Such substitutes would create competition for transmission, and would reign in a transmission owner’s ability to raise prices to consumers. Through such a process we could actually get closer to achieving economic efficiency in transmission, without running the risk of the regulatory mandate to build more grid that could lead to expensive overconstruction.

Many technological and market innovations have reduced the natural monopoly rationale for traditional electric industry regulation. For example, consider distributed generation. Distributed generation (DG) is the use of an energy source (gas turbines, gas engines, fuel cells, for example) to generate electricity close to where it will be used. Technological change in the past decade and deregulation in the natural gas industry have made DG an economically viable alternative to buying electricity from a monopoly utility and receiving it over the utility—s transmission and distribution grid. The potential for this competition to discipline a transmission owner—s prices for transmission services is immense, but it still faces some obstacles.

Some utilities are offering DG, particularly to large industrial consumers who require higher reliability than the standard offering. These systems, though, tend to serve primarily as backup, because the government-granted monopoly franchise still exists for all utilities. This franchise imposes a twofold legal obligation – an obligation on all utilities to serve, and an obligation on all customers to buy. This relic of monopoly regulation has stifled the spread of DG and its ability to inject competition into the transmission and distribution sectors of the industry. FERC has been working with state regulators to craft a consistent set of standards that would enable DG to interconnect with the grid, and to put any excess power generated onto the grid. This effort has met technical and political obstacles, although the political obstacles have been the more daunting. Utilities generally perceive DG as a threat to their revenue stream, because they still operate under the old regulated business model of “sell more power, make more profit.” But there are other value propositions out there – once utilities realize that they can make more profit by selling less power (e.g., through offering different contracts with market-based retail pricing), DG becomes much less of a threat to the utility business model. This change in mindset, and in business model, is impossible under the current regulatory environment that treats transmission and retail as a natural monopoly.

Such contestability of what was once thought to be a natural monopoly, and opting out of the use of that one-time natural monopoly, is occurring in other network industries, such as telecommunications. As wireless technology and services improve and digital networks expand, more customers are opting out of having a “land line” into their homes, choosing instead to rely entirely on their cellular telephones for service. Customers (specifically large industrial and commercial consumers right now, given existing technology) could reap similar benefits in electricity. However, policymakers are not yet considering the regulatory changes required to achieve those benefits.

Technological change and market dynamics have made the natural monopoly model of electricity regulation obsolete. While technological changes and market innovations that shape the electricity industry’s evolution have received some attention, their roles in making natural monopoly regulation of transmission and distribution obsolete have not received systematic treatment. For that reason, the policy debate has focused on creating regional transmission organizations to rationalize grid construction, but has not dug more deeply into the possible benefits of dramatically rethinking the foundations of natural monopoly regulation. Last week’s blackout suggests that this rethinking of natural monopoly is long overdue.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.