Energy Markets:

Cato's Taylor, Public Citizen's Slocum debate utility restructuring, attack FERC

What role should federal regulators have in the restructuring of electric power markets? How do mergers affect those markets? Are customers well-served by these changes? Joining OnPoint to discuss these and other power market and consumer issues are Jerry Taylor, director of natural resource studies for the Cato Institute, and Tyson Slocum, research director of Public Citizen's Critical Mass Energy and Environment Program.

Transcript

Mary O'Driscoll: Welcome to OnPoint. I'm Mary O'Driscoll. Today's topic is restructuring of the electric power industry and our guests are Jerry Taylor, director of natural resource studies for the Cato Institute, and Tyson Slocum, research director for Public Citizen's energy program. Thank you for joining us today. Both of you have been critical of the way that federal regulators are restructuring the electric power industry, and you're coming at it from a little bit of the different background. Jerry you talk about the need to pretty much scrap the entire process and focus on a wholesale embrace of markets, and Tyson you're talking about the need to protect consumers because consumers are being affected much more by what federal regulators are doing. Now granted, things are going to be changing a little bit with FERC Chairman Pat Wood stepping down at the end of next month, so that there's some expectation that the focus is going to change a little bit. But all that is just a beginning to talk about, I wanted to talk about first the latest debate in the electric restructuring issue, which is mergers. We saw mergers in the 1990s, and they were on the wane after the Enron problems, but now they're back. We've seen two really big mergers. The most recent of which was the Duke-Cinergy merger that was just announced this week. I wanted to ask Jerry, just broadly, what is your view of these deals? I mean it seems like these companies are getting bigger and bigger. We're talking about 5 million customers, 9 million customers. It almost seems like we're kind of doing what the telecom industry did, where we broke up the Baby Bells and now they're kind of morphing into something that's a little bit different shapes, but kind of what they were before. I'm just wondering, is this a good thing for restructuring? This is good thing for competition in the markets?

Jerry Taylor: Well I think you have to back up and ask yourself whether any of us knows the best size of power companies, the most efficient industrial arrangements and the optimal structure of the industry. My answer is that we don't know these things. Markets discover how best to organize business lines and how efficient different organizational structures might be and we simply can't know a priory that an industry that looks like this, that or the other is necessarily the best structure for this industrial sector, which is one of the reasons I'm fairly skeptical about restructuring as we've pursued it. It presupposes that regulators and politicians know beforehand exactly how to best organize this industry, and I just don't think that's true. I think that's what markets sort out for us. Markets are discovery processes. That's their main benefit, and we need to let these things sort out. Maybe these sorts of mergers make economic sense, obviously the people engaged in them do, but people have merged and regretted it in the course of time. So we'll soon see.

Mary O'Driscoll: OK. Tyson what's your view of these mergers? I mean is this something that consumers should be concerned about? You know it always seems like they're always talking about all these billions and billions of dollars and millions of customers that really don't make any sense to the average person, but your organization, Public Citizen, has been critical of these things. Why should consumers be worried about this?

Tyson Slocum: Well first of all there's nothing in these mergers statements that indicate there's going to be any benefit to consumers whatsoever. Public Citizen led the way with a broad based coalition to oppose the Exelon PSEG merger and that was because Exelon and PSEG were unable to demonstrate in their hundreds of pages of documents and filings that the merger was going to result in direct benefits to consumers. So unless there's a benefit to consumers the merger should not be approved and the main reason why the Exelon-PSEG merger raises so many problems is because of concentration of market power. It's very clear that there's already problems in the PJM marketplace. A merger of that magnitude this is just going to increase those problems in market power, making those markets less competitive and that means higher prices for consumers. As far as the Duke-Cinergy merger we see some of the similar problems. We also see a continuing problem of the erosion of the authority of state regulators and that's a significant problem. Particularly if we are going to try to back our way out of this whole restructuring experiment, which so far hasn't delivered on a single promise that it made.

Jerry Taylor: I think that's actually, it gets to kind of the nub of the disagreement and the difference of opinion between Tyson and myself. I would be perfectly happy to see mergers whether they benefit consumers directly or not. Let's assume that under a world in which this merger goes forward prices to consumers don't change very much. Prices after all are primarily regulated by states, even to this day, even in restructured states. So let's assume nothing really changes. Is that a reason to oppose the merger? I don't see why that would necessarily be a reason to oppose it. It might very well be that the merger increased the profitability of the company by enhancing efficiency of service. Why we're necessarily against that is sort of beyond me. We should allow market forces to operate at their will if it's an inefficient enterprise, if it's one that doesn't make economic sense, then it won't survive.

Mary O'Driscoll: Well, this kind of gets to, gets also to the question of oversight of mergers. I know Senator Burr from North Carolina has introduced a bill in Congress that would take FERC out of the merger review process altogether. Once again, it's a regulatory process, but why does, is that important that FERC stay in the regulatory process? Is it important that it get out of the regulatory process, that these utilities just be able to merge on their own? I'd like to get kind of some thoughts about this because there seems to be some discussion on Capitol Hill about the need for or the less of a need for FERC to be able to oversee the kinds of things.

Tyson Slocum: Well, I mean first of all there'd be some that would argue that FERC isn't even regulating the markets right now. I mean we've got companies that are supposed to, every three years, file their justification for market-based rates and FERC admits that lots of these companies haven't even bothered to do that. FERC has been forced to admit that they don't even know which power marketing subsidiaries of these companies are active or inactive. Fact is, FERC presides over a huge marketplace that they are structurally unable to adequately monitor. So if anything we need to be enhancing their power, but at the same time protecting the rights of states to adequately protect consumers. Remember this was a grand experiment and so far this restructuring experiment hasn't delivered on any of the promises and we need to think about going back to a state-based regulatory model.

Jerry Taylor: Well, to the extent to which you enhance FERC's power you're obviously taking it from somewhere else. There's only a fixed pie of power out there. You enhance FERC's power you take it from somewhere else, that's primarily state and local regulators. So you can't have it both ways. I'm with the Cato Institute so of course I'm going to tell you I don't think we need a FERC and I'd abolish it and I'd get rid of it and I'd take away not only the regulatory oversight authority over mergers, but over everything else as well. Of course that's not going to happen tomorrow, so what should FERC's role be? In my mind, FERC's role, if we're going to have to suffer under a Federal Energy Regulatory Commission, should be to basically oversee the interstate transactions of electricity. I think the idea that this is primarily a matter of interstate commerce is somewhat of a myth. The transmission system is regional in nature and if we're going to have a FERC that's probably it's most constructive role. Everything else should stay out.

Mary O'Driscoll: But then isn't that what FERC is trying to do with these regional markets that they're establishing or that they have established, New England, the mid-Atlantic region, the Midwest, they're trying to put one in the Pacific Northwest. They're trying to take this regional approach and as you said, that if there's a role for FERC, that's where it is. I mean has FERC overstepped its role as it were?

Jerry Taylor: Well, that's the theoretical role for the FERC, but it's, it hasn't done any of this very satisfactorily. I mean after all the FERC-approved California's regulatory design when it went in place after AD1899 was passed and it was a fiasco. FERC, in my opinion, is no better informed about how best to structure this industry than my dog. That's not to necessarily say anything bad about FERC or my dog, but it is to say that nobody, FERC, consultant, lawyer, doctor, lawyer or Indian chief has the faintest idea how this industry can best be regulated and structured. And anyone who says differently either doesn't know how much they don't know or they're throwing flimflam. So what I would propose is that FERC, for the most part, stay out of the business of standard market designs and things of that nature and primarily restrain itself to ensuring that there are no barriers to interstate competition to the extent to which it can do that.

Mary O'Driscoll: OK. I wanted to ask you one more question, just on mergers, where FERC is, has required utilities to join these regional markets that they've set up in order to get their mergers passed and it looks like that they're going to put that requirement on the Cinergy-Duke deal. But FERC also has a history of not exactly following up on that. It took, what four years for them to be able to get American Electric Power into a regional market after it merged with Central and Southwest in Dallas and then we're finding out that, realizing now, that Progress Energy, which is the big Southeastern utility based in Florida and South Carolina, also hasn't formed an RTO the way that it said it would when it merged, what, five years ago. So I mean are you seeing any ability of FERC to be able to really put any teeth behind this kind of thing?

Tyson Slocum: I mean FERC has a poor track record. They've got a poor track record on nearly everything that they do and that is a very good reason why we need to move away from these FERC-initiated proceedings. That's also why Public Citizen joined with a series of state attorneys general and other consumer groups calling the whole market-based rate authority that FERC is trying to shove down states throats illegal. There's nothing in the Federal Power Act that allows FERC to do this, and we're very confident that the federal courts will agree with us because FERC has shown that it is unable to adequately regulate this market-based rate authority. What the market-based rate authority has too often meant is charge whatever prices producers want at the expense of consumers. It hasn't been leading to efficiencies. It hasn't been leading to better competition. It's just led to a lot of price gouging.

Mary O'Driscoll: OK. Well that kind of gives us a segue then into talking about the report that you released last year, late last year, regarding the structure of the industry where you said that FERC should either have a thoroughgoing embrace, I think that was a direct quote, of markets or the industries should just go back to its vertically integrated self, because that's what they seem to be wanting to do anyway. You did note that the, in your view of what the industry could become was that markets would kind of settle themselves out. That consumers would be able to just pay whatever, you know, that they would pay no more than the marginal costs under this market structure where they have long term contracts between the companies. That this is a way that it would kind of settle out, but you noted that politically that's going to be almost impossible to be able to happen.

Jerry Taylor: Well to be specific, what we argued was that there is very good reason to think that in a laissez-faire world in which government regulators were kept away from this industry that you might very well see the sorts of industrial structure that you saw under regulation. You would see lots of long-term contracts. You might even see guarantees for investment in power supply. You might very well see contracts that would refrain industry from fully exercising its extensive market power. In other words, it's very easy to imagine how private contract, given this industry, would look a lot like the old regime looked under regulatory body. That's not to say we embraced that regulatory superstructure because after all, we could be wrong. Markets may go off in directions we hadn't anticipated, but the gist of what we tried to say in our study was less that than to remind people that we initially undertook restructuring because we thought it would save money, be more efficient. Where were those dollar savings supposed to come from? Academics said the first place would be the loss of guaranteed rate of return would remove the artificial incentive to invest in heavy capital intensive facilities and one of the main reasons we had very high electricity prices in some states, like California, New York, is because utilities had overindulged in capital intensive facilities. Largely as an artificial reaction to these guaranteed rates of return and that if we were to get rid of those guaranteed rates of return we would see less inefficient expenditure in place. That's the first thing economists said. The second thing they said is if we restructured you'd see more real-time pricing. You'd see more efficient pricing practices and that would save tremendous amounts of money. In fact, if you look at the studies, a vast majority of the savings that we were supposed earned through restructuring would come through real-time pricing. Now a fellow I know in academia looked at the studies and said, well if real-time pricing is so hot and that's where all the savings are, why don't we just mandate real-time pricing with the old regime? But be that as it may, that was the second benefit. And those essentially were the only two. There was a third that we talked about politically, which was the idea that if we restructured we would allow low-cost power in states like Kentucky to go to high-cost states like New York and that way we'd have interstate commerce, but what people forget is that there's a limited supply of that low-cost power. Those are essentially old coal-fired generators that don't face the same regulatory stipulations other generators face because of the Clean Air Act and their ability to expand production is very limited, so what that really it is a wealth fight. Who's going to get the low-cost power? Should it be entirely captured by people in Kentucky? Should it be spread around a little bit? Should it go to New York? However you allocate it there are going to be winners and losers. So to us that's a wealth fight, that's not an efficiency fight. It's not going to improve the industry any. It's only going to reallocate who wins and who loses and who gets the benefits from the low coal. So if you look at it, what happened under restructuring is that none of those things came about. We are now going back to I-cap rules, which mandate that certain reserve capacity be guaranteed by the state. That's like the old regime where we guarantee, where we told market investors that they had to have excess capacity. We artificially incentivized in the old regime. Now we're just going to order it, so there goes one sack of benefits. Real-time pricing? Never happened. Not in any significant way. So real-time pricing never happened and these wealth fights continue between Kentucky and New York and whatnot, but they haven't resolved themselves in any positive way. The only place now, if you pin a guy who's in favor of restructuring against the wall and you say, "Well where are these benefits coming from?" They'd tell you, "Well coal sale competitions will benefit because now we have people bidding to supply power to the utility companies." Well that might very well be and there's certainly evidence to suggest that there have been efficiencies gained through this kind of wholesale competition. But I would ask, if it makes, if a utility company can get lower cost power by contacting out through a third party, than by generating it himself, why wouldn't he do that voluntarily as long as regulators allowed him to keep the profits, right? No reason I can think of. In other words you don't need government to put a gun to people's head and tell them to be efficient and save money. I don't see what regulation necessarily has to mandate that arrangement. So what we're saying is that wherever we look we don't find any real savings from restructuring, theoretically. We don't find them on the ground, but we do see costs and the costs involved are essentially taking what used to be a vertically integrated industry that was vertically integrated for some very good reasons and breaking it up into constituent parts, in ways that we think are very problematic for the industry and actually make things less, not more efficient.

Mary O'Driscoll: OK, well that gets back to my original point about the mergers. Is that, you know, you want to break them up like the Baby Bells, but they are finding their own kind of natural forum I guess.

Jerry Taylor: Sort of. I mean for Duke to acquire this energy company doesn't necessarily reinstitute vertical integration. They're still separate operations and whatnot. We think there are very good reasons why companies vertically integrate. There are very good industrial organizational reasons for it. The transaction costs are lower, it allows for better incentives on the grid. It just seems to make a lot more sense anyway you cut it. Now of course, we could be wrong. In a laissez-faire world maybe industrial organization would take us in different directions. We wouldn't see so much vertical integration. But I will tell you that the ability of politicians and regulators to just simply know because they woke up one morning and had a dream and that dream told them that vertical integration is evil, bad, not economically efficient, makes no sense or what have you, is simply wrong. It makes a lot of sense in many cases and there are a lot of reasons why, which we list in our study, to suggest that vertical integration might make a lot of sense for this sector. Then the question becomes, what do you do about it? Of course, Public Citizen would react to vertical integration by saying, "That's why we need regulation because otherwise these vertically integrated companies would have too much market power." People like me at the Cato Institute would wonder whether that's certainly true. We think the economics literature on this subject is rather clear that to the extent to which market power exists, it's not really an efficiency problem, it's a wealth problem. In other words, it doesn't make markets less efficient, it simply gives, it might very well have overall effects regarding distribution of wealth and if that's your concern, I'm not sure that regulation has a role. Maybe the way you remedy that is to hike tax rates on power companies. Maybe you go with what Harold Demset at the University of Chicago talked about, which was competitive bidding for the right to be that monopolist. There are all sorts of possibilities.

Mary O'Driscoll: OK. Well Tyson what do you think?

Tyson Slocum: I mean there's no question that we've got new inefficiencies with breaking up these vertically integrated monopolies. For example, the Wall Street investment bank Morgan Stanley is now the second largest electricity trader in United States. It literally conducts thousands of transactions a day. FERC can't keep up with it. Nobody can keep up with it.

Mary O'Driscoll: But what's wrong with that?

Tyson Slocum: Because it's adding tremendous amounts of costs. It's inflating the bottom line for Morgan Stanley, but they are not delivering an improved product to consumers. All they are is stepping in as a middleman and increasing the costs down the road for consumers. It isn't efficient because it's not transparent. Returning to a vertically integrated system, in an economic model like electricity, which is very unique from the rest of the American economy, you need that kind of transparency and just because some states didn't do a very good job regulating in the 1970s and 1980s, that didn't mean that we needed to throw that whole model away. What we need to do is to improve state based regulation because what we've seen on the federal side, FERC is far worse than even the worst states were as far as its inability to effectively monitor these very important markets.

Jerry Taylor: OK, if you don't mind, I don't see any reason to think that vertical integration makes transactions more transparent. In fact the economics literature is fairly clear here, the fundamental problem with public regulation of vertically integrated companies is that the only information the regulators have to go on is the information coughed up by the companies. And there's a lot of evidence to suggest that companies selectively release information and put information in the public realm and provide it to utility companies in order to massage rates the way they want. In other words, it seems to me that if transparency is your goal, you would have a more transparent system by breaking up vertically integrated companies than you would by embracing them. Now I don't think that's a good criteria, so that's not what I'm going to advocate. But the idea that things are more transparent when you got a vertically integrated company I think is belied by experience.

Mary O'Driscoll: Tyson, you get the last word.

Tyson Slocum: Well first of all, we have seen some experience lately with state commissions ordering their vertically integrated utilities to start contracting out to add new generation or some other services through competitive bidding. So there is potential to put a new twist on the old vertical integration regulation, but there's no question that we've made a big mistake in moving towards restructuring. The cost to the economy and consumers has been huge. We need to return to a better regulated system.

Mary O'Driscoll: OK. Well unfortunately that's all we're going to time for today. I'd like to thank our guest Jerry Taylor of the Cato Institute and Tyson Slocum of Public Citizen. I'm Mary O'Driscoll. We'll see you next time on another edition of OnPoint.

[End of Audio]