Rethinking Vertical Integration in Electricity Markets: Insights and Implications

1. Rethinking Vertical Integrationin Electricity Robert J. Michaels California State University, Fullerton rmichaels@fullerton.edu 18th Annual Western Conference Center for Research in Regulated Industries San Diego, California June 24, 2005

2. The Economics that Electricity Forgot • Restructuring is about replacing vertical with market relationships • Most traditional reasons for vertical integration continue in force • Disregard of large literature on economies of integration • And inadequate studies of benefits of markets • Restructuring history almost entirely about vertical abuses, not benefits • With permanent institutional consequences

3. The Old Economics of Vertically Integrated Utilities • Interdependence of generation, transmission, distribution as rationales • Second-by-second coordination for efficiency • Responses to system stress, risk management • Rationalizes investment planning • Regulation and generator market power • Implicitly, markets are unnecessary or pernicious • In 1970s and 1980s utilities show that market transactions possible • And then PURPA, EPAct, Order 888, Blue Book, etc.

4. Some Intellectual History of Restructuring • 1970s – Lawyers assume no reason for vertical integration without evidence • Otter Tail finds vertically integrated utility can use transmission to harm competition for distribution franchises • 1980s – Continued emphasis on franchise competition without efficiency considerations

5. What Economists Know about Vertical Integration • Econometric work between 1985 and present, various samples back to 1970, U.S, Japan, Italy • Near 20 studies, methods usually • Testing separability of translog or quadratic cost functions for utilities • Estimating production functions for stages and seeing if integration with earlier stage cuts cost of later stage. • Other studies of integration into fuel supplies, generator maintenance

6. Vertical Integration and Reliability • No public studies re vertical integration and reliability • NERC and FERC concerns: • Grid design and generator locations not coordinated, underinvestment in grid • Market-induced variability in flow patterns may cause operating problems • Increase in transmission loading relief calls may reflect competitive and reliability concerns • Participant funding of transmission as solution or worsening of the problem?

7. Vertical Integration and Restructuring • California 1994: Regulators and experts say vertical integration unnecessary, makes competition impossible • Minimal discussion of efficiency aspects of integration • State law and FERC market power standards for PX and ISO call for divestiture of generation

8. California and After • Pre-2001 prices in state’s markets usually track cost fairly closely • Utility generation divestitures held as partial causes of market collapse • New economic models claim that vertical integration can constrain generator market power • Utilities taking advantage of transition to attempt vertical re-integration • IPP overbuild adds to their incentives

9. What Did We Learn About Integration? • Few studies of operating efficiency under RTOs as alternatives to integration • Other state’s transitions handled stranded cost and divestiture differently, generalization hard • View growing that partial integration is appropriate for utilities with POLR obligations under retail choice • Vertical market power now conspicuous by absence from the discussion

10. Estimating the Benefits of Markets and RTOs • Verified economies of integration and scope, but little on markets • Numerous studies claim benefits for RTO-based markets • Mostly just efficient dispatch models and not analyses of new institutions • Most of projected long-term savings comes from technological progress • Most do not net out lower consumer bills against decreased generator wealth to get welfare gain • Remarkable cost increases in most RTOs finally coming to light