EHIND THE NEW WORLD OF COMPETITION and choice

in electricity is a single big idea: that it is possible and desir-

able to separate the transportation from the thing trans-
ported. In other words, electric energy can be separated commer-
cially as a product from transmission as a service.
In the past, electricity has been viewed as a product used only
at the point of delivery and paid for in a single delivered tariff T h e
question now is, could the bill be "unbundled into an electricity
and a delivery charge? Even i f the delivery service remained a
monopoly, could the customer choose who would supply the
electricity over the wires? Could the wires be "common carriers,"
even though the physics of the system dictate that the product is
fully intermingled and indistinguishable?
This last, seemingly simple question is central to understand-
ing what is going on in the electric industry today. For 100 years,
it has been assumed that electricity and its delivery were
inevitably intertwined, like an egg baked into a cake, which, once
the cake is mixed, cannot be reconstituted. But if it is possible to
define and separate the transport service, so that it can be pro-
vided separately from the electricity itself, electricity becomes a
product that can be bought and sold and transported from place
to place, much like any other product. Electricity markets are
opened to alternative producers and alternative purchasers. T h e
economic analysis required for this type of world is the analysis
of transactions-what is the Droduct being bought
sALLVH
v v
The electricity grid resembles an
unswitched network, on which message:
are broadcast without addresses; how so
can consumers choose suppliers?
Perhaps the need to separate the transport from the product
would not have arisen but for the realization that generation was
n o longer a natural monopoly. This in turn was due to the
changes in generating costs that characterized the 1980s. T h e
generating portion of the industry had been thought of as a nat-
ural monopoly because of the economies of scale that could be
obtained by purchasing large and more efficient plant. These
plants were large with respect to the size of the market. Even as
markets got larger, and the use of electricity increased, so did the
optimal size of plant.
Then things began to turn around. Technology imported
from materials science and the space program made turbines
much more efficient than they had ever been. At the same time,
the price of gas declined, and the prohibitions on gas burning
that the western countries had imposed were repealed.
T h e way was then clear for smaller and cheaper generating
units to be built economically. They were the

and sold, at what time, in what place, who is the U NT cheapest form of new construction but, more
buyer, who is the seller, what is the price, how is & GRAHAM SHUTTLEWORTH important, in many cases the all-in cost of a new
it determined, and what are the conditions of the National Economic Research plant was less than the customers were paying
sale? This is the world of markets and contracts. Associates Inc. for the sunk costs of old plant. These sunk costs

20 001 8 - 9 2 3 5 / 9 6 / $ 5 000 1996 lLciI IEEE SPECTRUM JULY 1996

in turn had been magnified by very expensive retrofits to nucle-
ar plants, and by excessively generous contracts with suppliers
of such renewable energy as wind and solar.
Customers began to think about building their own plant, and
wanted to know why they could not change suppliers to get
cheaper power. T h e main impediment seemed to be the more
numerous transactions and hence higher transactions costs that
would be associated with a more diverse and competitive sys-
tems of electricity supply. But with computers becoming ever
more capable, those costs might be contained.
Four issues are integral to the restructuring of the electricity
industry. T h e first is the question of who can sell what to whom,
or, to put it a little differently, how much competition is neces-
sary to ensure that the competitive market benefits the electric
power sector as a whole.
Second, what rules should govern the wholesale power mar-
ket and bilateral trades? H o w should the transmission system be
controlled and priced?
Third is the issue of ownership. Decisions need to be made as
to which functions must be operated separately because of mar-
ket power concerns or conflicts of interest.
Fourth is managing the transition. How should provision be
made for the regulation of setvices not joining the new competitive
regime?A new look would be needed at the way in which environ-
mental issues are addressed; at obligations to provide service; at the
measurement and recovery of what are called stranded costs, and at
the potential termination of social programs attached in the past to
utility programs.
How much competition?
From the point of view of competition in the product market,
there are really only four fundamentally different ways or models
of structuring the industry [see table], although there are many
possible variations on each. The models are defined on the basis
of the extent of monopoly permitted or required in the industry.
The first task in restructuring is to decide which model to follow.
T h e four models correspond to varying degrees of monopoly,
competition, and choice in the industry. They are abstractions
and do not describe particular systems. Although they corre-
spond broadly to real electric systems, particular systems may
vary in their actual arrangements.
Model 1: monopoly at all levels.
Generation is not subject to competition, and no one has any
choice of supplier. A single company has the monopoly of pro-
ducing electricity and delivering it over the transmission net-
work to distribution companies a n d o r final consumers or, if a
separate distribution company exists, it is tied to only one sup-
plier. This model prevailed almost universally until quite
recently.
Model 2: purchasing agency.
Here, a single buyer, the purchasing agency, chooses
from a number of different generators to encourage
competition in generation. Access to the transmission
wires is not permitted for sales to final consumers. The
purchasing agency has a monopoly on transmission net-
works and on sales to final consumers.
Model 3: wholesale competition.
Distribution or retail companies buy electricity directly
from a producer and deliver it over a transmission net-
work. But the distributionhetail companies still have a
monopoly over final consumers. There is open access to
transmission wires.
Model 4:retail competition or direct access.
In this case, all customers choose their supplier. There is
open access to transmission and distribution wires. T h e
distribution is separate from the retail activity, and the
latter is competitive. This, in broad outline, is the pro-
HUNT & SHUTTLEWORTH - UNLOCKING THE GRID
posed California model [see "Charting a new course in Califor-
nia," pp. 26-3 11.
T h e models have quite different types of trading arrange-
ments. They require distinct sorts of contracting arrangements
and have dissimilar regulatory requirements. They may require
different ownership arrangements for the companies operating
in the sector.
Monopoly, monopsony
n a Model 1 system, no one may buy frorn an independent
generator, so none exists. All final consumers are supplied by
the incumbent utility. Model 1 has been the paradigm for a
century, for good reason. This form of vertically integrated orga-
nization has enabled the development of large-scale transmission
systems and the introduction of larger plants. These economy-
of-scale arguments, which were persuasive for many years, and
still apply in some developing countries, justified monopoly
arrangements. The total monopoly has also allowed governments
to pursue public objectives, such as subsidies for poor areas, rural
electrification, and development of indigenous fuels.
Model 2 is sometimes called the single-buyer model, and
would be described by economists as a monopsonistic system.
Here, only a designated purchasing agency-typically the local
utility-is allowed to buy from independent power producers. In
the United States, the Public Utility Regulatory Policy Act of
1978 (Purpa) introduced this idea of electric utilities being
exclusively authorized to buy from the independents.
T h e single-buyer model introduces competition in power gen-
eration-arguably where competitive pressures can do the most
good in reducing costs. T h e model may also make it easier for
governments to continue to advance policy objectives, including,
besides those mentioned already, diversity of generating plant,
demand-side management, and environmental amelioration. At
the same time, this type of system avoids somie costs of a more
thoroughly deregulated system-namely, the transaction costs of
spot markets and transmission access, and an increased cost of
capital that arises when generators bear technology risk.
A single-buyer system usually requires long-term contracts
between the buyer and the independent power producers. The
independent generators are in this way insured against market
risk, which makes it easier to raise capital. These contracts are
based on cost. T h e independents compete to the extent of com-
mitting a plant, but their revenues are guaranteed so long as the
plant runs, even if later entrants are cheaper. With these guaran-
tees, they can finance with a very high proportion of debt,
which reduces the prices they have to charge. T h e market and
technology risk is passed, through the purchasing agency, to the
21
captive customers. By insulating the owners of the plant from
the effectsof technical change and market forces, Model 2 does
blunt the dynamic benefits of competition, leaving many aspects
of the choice of when and what to build in the hands of central
planners rather than of entrepreneurs.
Wholesale, retail competition
In the Model 3 system, distribution or retail companies (that
is, the traditional utilities) are authorized to buy directly from
competing generators (includingutilities), but they retain a local
franchise over retail customers. The generators must have access
to the transmission network, and there need to be trading
arrangements for the network. Model 3 is close to the British
system as it operated immediately after being privatized in 1990
[see Richard Tabor's article in the next issue]. It is also the mod-
el envisaged in the Energy Policy Act of 1992 in the United
States [see p. 241.
In the wholesale-access system, competition is expanded in
that all generators can now sell to many customers rather than
to just one. More buyers make the market more competitive and
more dynamic. And, the benefits of competition in generation
are enhanced by pushing the market risk and the technology risk
back to the generators.
Arguably, generators are in a better position to judge the ben-
efits of new technology than a regulator. When their own cash
is at risk, they are likely to give new investments more careful
thought. By the same token, however, making generators re-
sponsible for risk also increases their cost of capital. Wholesale
competition also increases transactions costs by requiring mar-
kets and network agreements. And it eliminates the ability of
governments to direct the choice of new generation technology,
other than by direct subsidies or directives.
Despite its many virtues, there are many reasons to think that
generally wholesale competition will be merely a way-station
and testing ground for full-fledged retail competition. Probably
the main reason is that both in the United Kingdom and in the
United States, when authorities have tried to grant some types
of customers open access to sellers while excluding others, the
problems of definition have become acute.
In the UK, the bulk of the regulators' work for an entire year
went into defining exclusions. In the United States, when large
power customers have been denied direct access to sellers, they
have threatened to "municipalize the hell out of the countV"--
that is, to persuade friendly municipalities to declare themselves
independent retailers and so become eligible to buy and resell (to
the large industrial customers, of course) and by implication avoid
paying for the sunk costs of their suppliers.
This is a key problem in moving from a cost-of-service regime
to competitive arrangements. If the regulators are not careful, they
may bankrupt the companies in their charge and encourage waste-
ful excess capacity, compounding rather than solving problems.
The situation may be best grasped by means of a simple
example. Suppose the sunk costs of generation are 6 cents per
kilowatthour-what customers on average are now paying.
Suppose that, because there is excess capacity, marginal costs
(the cost of adding a customer or the savings from losing one)
are 2 QikWh.Suppose also that the cost of self-generating comes
to 3.5 &Wh. The customer who chooses to self-generate is
making an economic choice from his own perspective: he saves
2.5 cents. But from the perspective of society at large, the pub-
lic has spent 3.5 cents and only saved 2 cents for a net loss of
1.5 cents-and it is saddled with even more excess capacity than
before. (In the jargon of the trade, this is called "uneconomic
bypass" and "uneconomic self-generation.")
Most likely, the Model 4 system-generally dubbed "retail
wheeling"-is the world of the future. Britain, N o w a y , Chile,
and Victoria, Australia, have systems that approximate this sys-
22
tem or are in phased transition to it, and the California Public
Utilities Commission has this model in mind. In every case so
far, the transmission system is owned separately, and in none
have the low-voltage wires been separated from the retailing
function, although separate accounting is always required.
Retail competition makes the most of competitive forces by,
in principle, bringing all final consumers into the market. But it
also greatly increases transactions costs by requiring more com-
plex trade arrangements and metering. For small users, the costs
may easily outweigh the benefits. Not only are metering costs
comparatively higher for small customers, but the benefits of
one-stop shopping are lost-a problem that has also arisen in
the telephone industry. Precise responsibility for poor service
may be difficult to pinpoint when the local distribution compa-
ny is not also the retailer.
Movement to competition
lectric power restructuring began in the United States
with the enactment in 1978 of Purpa, which introduced
the idea of competition in generation. Established utilities
had to purchase power from independent generators at prices
that equaled their "avoided costs."
Despite initial skirmishes, independent power producers soon
thrived. But some states, particularly New York and California,
overestimated "avoided costs" so badly that they induced exces-
sive amounts of new independent capacity. As a corrective mea-
sure, during the 1 9 8 0 ~it ~became standard procedure in many
states to require competitive bidding to build new plants and
operate capacity, as well as contracts for the output of the plants.
The growth of the independents demonstrated forcefully that
economies of scale in generation no longer justified viewing
generation as a natural monopoly. By 1993, some 50 percent of
new capacity in the United States was being constmcted by
independents. Competition in generation was possible and the
utility had become a sort of purchasing agency for generation.
But there was still no question of giving the U.S. electricity cus-
tomers a choice of who would supply them.
Purpa was motivated primarily by a desire to encourage new
and alternative energy-saving means of generation, not by a
commitment to deregulation or restructuring. Conventional wis-
dom remained much on the side of vertical integration in the
power sector. But that wisdom got a sharp jolt in 1988, when the
British government proposed that the electricity privatization
should include breaking up the Central Electricity Generating
Board (CEGB),the nationalized industry that owned all the gen-
erating plants and the transmission system.
After two years of negotiations, false starts, massive comput-
er programs commissioned and abandoned, what has turned out
to be the current UK market structure took form in early 1990.
The new structure, which separates the product from the trans-
portation at all levels, consists of competing generators, regulat-
ed transport companies at two levels (transmission and distribu-
tion), and competing retailers Complaints about the UK system
[see next issue] relate to the winners and losen as changes have been
introduced, and to the small number of competitors in the system.
None relates to the feasibility of setting up a disaggregated com-
mercial system, as such. The effect of the technical success of this
operation is hard to overestimate.
The United States began to follow suit with the Energy Policy
Act of 1992, which permits wholesale customers a choice of sup-
plier and obliges utilities to "wheel" power across their territory
to accomplish this. However, the legislation prohibited Federal
authorities from mandating retail wheeling, although individual
states may permit it and many are now considering doing so.
California announced in April 1994, that it intended to go to
"direct access" or competitive markets for all consumers a move
that has been likened to an earthquake in electricity regulation.
IEEE SPECTRUM JULY 1996
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HUNT g SHUTTLEWORTH ~ U N L O C K I N G THE GRID 23

The national picture the utilities' investors a n d o r customers) to absorb sunk costs.
The multiplicity of jurisdictions in the United States makes it The commission is now tackling the issues of independent sys-
much harder to bring about radical change than in a much small- tem operators, real-time information networks, and the changes
er and simpler system such as Britain's. needed in its merger policy to reflect the changing shape of the
About 70 percent of the power sold in the United States is electric industry.
provided by some 200 investor-owned utilities whose prices are
regulated by a public utility commission in each state. There are Mergers and market power
also about 3000 municipal utilities that purchase power whole- In the Model 3 and Model 4 worlds of wholesale and retail
sale, the largest of these also own generating plants. In addition, wheeling, electric-power functions that traditionally were per-
the federal government owns several large generating and trans- formed by a single monopolistic entity will be separated or "unbun-
mission companies, notably the Tennessee Valley Authority and dled," and some of them may have to be provided by different enti-
the Bonneville Power Authority. The Federal Energy Regulatory ties to avoid conflict of interest and self-dealing. The main issues
Commission has jurisdiction over interstate matters such as here have to do with questions of market power and cross-owner-
transmission access and pricing, and sales for resale. ship of the regulated and competitive parts of the business.
Each state is following its own restructuring agenda, and is Generally, the competitive parts of the newly restructured sys-
doing so at its own pace [see "Electricity restructuring, state by tems are generation and retailing, while the regulated parts are dis-
state," pp. 231. Introducing competition into the industry, wher- tribution and transmission. In principle, in the new world, there
ever it may occur, is now provoking many questions, controver- should be no need to regulate power prices, unless there are too
sies and inevitably, debates about the merits of such change- few competing players to eliminate or at least minimize monopo-
not to mention its implementation. listic pricing. But if a single utility controls too much of the mar-
States such as California, Massachusetts, New York, and New ket, divestiture may be ordered or encouraged.
Hampshire have taken a strong and forward-looking stance. Clearly, the control of transmission has to be separated from
They are actively putting programs in place to restructure the generation as well as from the retailing function. This is neces-
electric industry. But in many states, little movement has been sary to avoid conflict of interest in the dispatching process, and
made toward deregulation or restructuring. to avoid the appearance of self-dealing. It can be done through
the use of an independent system operator (ISO), which can
Managing transitions neutrally administer the processes of scheduling and dispatching
T h e question of "stranded costs'' and who should pay for them plants, subject to protocols established for system security and
has become a major issue in the United States during the past the tariffs for the use of the system.
three or four years. Stranded costs are those costs that have T h e operator (or maybe a separate power exchange) would
already been incurred by the utility, and are already being paid
by the customers, but which would not be recoverable in a com-
petitive market. They include:
T h e cost of some utility generating plant, particularly nuclear
facilities, which often have tremendous fixed costs not yet
recovered or depreciated.
T h e cost of power contracts with independents, locked in at
higher-than-current market prices.
Some regulatory assets (such as deferred taxes) representing
liabilities for which customers have not yet paid.
None of these costs is new. All are included in the utility's cur-
rent prices, and all were approved by the regulators on behalf of
the customers.
Besides pitting customers against utilities and the general
public against investors, the stranded cost issue has divided even
utilities among themselves. High-cost utilities can be saddled
with stranded costs of a size that could wipe out their equity.
Low-cost utilities, on the other hand, see no reason why they
should be burdened with the cost of regulations crafted to pro-
tect high-cost competitors.
To the surprise of many people in the industry, in March 1995
the Federal Energy Regulatory Commission (FERC)took the
lead on this issue with its Notice of Proposed Rulemaking on
open access (its so-called Mega-NOPR) It approved stranded-
cost recovery in principle for those transactions that it regulates,
namely, transmission and wholesale transactions. Other regula-
tory commissions have followed suit, approving recovery subject
to mitigation measures. Nonetheless, the issue is far from set-
tled, nationwide.
FERC has also played a central role in other aspects of the
transition to competition. For some years, the commission has
wanted utilities to provide access to their transmission wires.
T h e utilities saw this as granting their competitors access to
their customers, and understandably refused. T h e customers,
mainly the large industrial buyers and wholesalers, wanted low-
er prices, to be sure, but mostly they wanted to take advantage
of the latest (low) market prices while leaving utilities (that is,

24 IEEE SPECTRUM JULY 1996

run a spot market and establish a market price. If
all customers can choose among generators, as in
Model 4, the self-dealing problem does not
arise-the problem of having a company with a
retail monopoly being one of the competing sup-
pliers of generation to itself. But in the typical
transition from wholesale to retail wheeling, not
all customers will be able to choose their suppliers,
and those who have no choice will want to ensure
that their supplier is getting the best deal for them.
If the retailer is also the generator, it will be tempt-
ed to buy from itself, even at above-market prices.
Trading arrangements, transaction costs
T h e industry structures under Models 3 and 4
require trading across a transmission grid that nei-
ther knows nor cares who owns the power, but
which requires split-second timing to control the
flows [see "Settlement on the spot"]. It is essential that the system
operator retain control of the transmission system, and be
responsible for the grid's reliable operation. The new world
should allow for, and indeed support, bilateral sales arranged
between buyers and sellers. It is also useful-some would say
essential-to have a spot market where traders can buy and sell
what they need to make up their contracts in real time.
Both spot markets and scheduled bilateral trades are currently
accommodated within the existing inter-utility pooling arrange-
ments in the Northeast. These pooling arrangements can be
modified to accept more participants, although some of the
rules, which envisaged voluntary sharing and reciprocal services,
will have to be changed.
Most of the changes will involve defining contractual ar-
rangements among various parties, and putting prices on services
previously provided on a "fair share" basis. T h e pooling arrange-
ment will also need to become independent of the existing util-
ities. In other words, there will need to be an independent sys-
tem operator to operate the electricity market or pool. All traders
of electricity will pay for transmission and for ancillary services
such as reserves, which the independent system operator needs
to maintain a stable system.
Too much of a good thing?
As early as 1983, Paul Joskow and Richard Schmalensee, both
of the Massachusetts Institute of Technology, pointed out in their
influential book, Marketsfor Power, that it is theoretically possible
to replace command-and-control relationships (within a firm)
with "contractual" relationships (between firms). Contractual
relationships in this context may mean any agreement about the
terms on which transactions take place between the separate
firms. They also pointed out, however, the difficulty of fully spec-
ifying all the terms of the contract necessary to cover all possible
situations, and said the task may be so great, and so expensive to
negotiate, execute, and litigate, that it is not worth attempting. In
this case, it is more efficient to keep the activities with a single
firm where one manager manages both activities.
Joskow and Schmalensee spelled out the difficulties to which
transaction costs give rise in the institutional and technical con-
text of the electric industry. They noted that free entry would re-
quire, among other things, a regional transmission-coordination
system with interconnected generating plants, plus a mechanism
for dispatching generating plant that recognizes the need for
physical control second by second, but permits and encourages
economic (least-cost) dispatch. Other requirements are methods
for coordinating unit commitment and maintenance, for ensuring
that adequate generating capacity is built, for minimizing cost
investment systemwide, and for dealing with emergencies.
When MdrketsforPower appeared, it was widely agreed that these
HUNT L SHUTTLEWOKTH - UNLOCKING THE GRID
requirements were correct, but that the difficulties were insupera-
ble. Now, with the development of methods of handling transac-
tions, it seems inevitable that open access at the wholesale level will
be introduced everywhere in the United States--FERC will insist
on it. Industrial customers will push for direct retail access in areas
where prices are high, unless they can get regulators to approve
special and advantageous tariffs.
Meanwhile, the threat of municipalization or self-generation
will force utilities to cooperate with regulator:;. There will be a
spate of utility mergers intended to reduce costs and gain strategic
advantage. But there is a major obstacle: the high cost of installing
digital meters at the residential level to providle the basic infra-
structure for wide consumer choice. Consequently, universal retail
wheeling probably will be delayed for many years, especially
where prices are already low. +
To probe further
Some of the early thinking about electricity restructuring can be prof-
itably explored in F.C. Schweppe, "Power Systems '2000': Hierar-
chical Control Strategies," /€€€Spectrum, July 1!378, pp. 42-47; and
P.L. Joskow and R. Schmalensee, Markets for Power: A n Analysis o f
Nectric Utility Deregulation (MIT Press, Cambridge, Mass., 1983).
Regulating Regional Power Systems: Case Studies and Perspectives o n
Emerging Competition (IEEE Press, Piscataway, N.J., 1995). edited
by Clinton J. Andrews, provides a useful and relatively up-to-date
survey of the current scene.
A sampling of recent views from some of the most influential parties
t o the debate over restructuring can be gleaned from recent arti-
cles in The ElectricityJournal, for example: "It's All in the Structure:
A Conversation with William Hogan," November 1995, pp. 50-60,
p. 75; "What Model for Restructuring? The Debate in the
Competitive Power Market Working Group," by Charles G. Stalon
and Eric C. Woychik, July 1995, pp. 63-73; and "How Will It All End?
The Electric Utility Industry in 2005," by Paul Jo!,kow, January-Feb-
ruary 1996, pp. 67-73.
About the authors
Sally Hunt and Graham Shuttleworth are economists at the National
Economic Research Associates Inc. (NERA), White Plains, N.Y. As
advisers t o British regulatory authorities, they helped design the
United Kingdom's power pool, the linchpin of its competitive mar-
ket. Since then they have advised on many aspects of restructuring
in both the electricity and gas industries on five continents. Hunt,
based in New York City, was educated at the University of Oxford.
Shuttleworth, based in London, was educated at Oxford and the
University of Cambridge. Their book, Competition and Choice in
Hectricity, has just been published by John Wiley & Sons.
Spectrum editor: William Sweet
25