5.4: Electricity Industry Structure and Regulation

Electricity Industry Structure and Regulation

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 \(Figure \text { } 5.4\)): 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.

\(Figure \text { } 5.4\): 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 \(Figure \text { } 5.5\) 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.

\(Figure \text { } 5.5\): The colored regions on the map represent portions of North America that have engaged in some form of electricity restructuring thorugh 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: Grid Regulation - Part B (3:42)