Thursday, November 04, 2004

Some observations on the Power industry

This is from a paper I did on the Springfield Power company. Depending on what is talked about tomorrow in class when we have Mr. Anthony Annunziato speak, this may or may not be useful.

However, even if it he does not speak on this, I think the recent history of the utility industry is really something everyone (and not just finance majors) should know about to uderstand some of the controversy about power shortages, outages, and regulation.

Sorry it is a bit long:


The electrical utility industry traditionally has been seen as a natural monopoly where high fixed costs serve as an economic barrier-to-entry that prevents more than one firm from being able to survive economically in any given market. Because monopolies have the ability to use their market power to earn abnormally high returns at the expense of their customers, utilities in many countries have been highly regulated. In the United States, this regulation was done on a state-by-state basis. Typically, it involved a regulatory board, which in consultation with the firm, users, and other citizen groups, set rates and approved large expenditures.
To avoid the restrictive, low-return environment of the regulated power business, many utility firms created unregulated subsidiaries through which the firm could run businesses outside the reach of state regulators. However, this type of organization occasionally proved problematic for shareholders. If the unregulated business did well, regulators might expect the earnings to be used in the regulated utility and thus reduce allowed rates in the regulated business. On the other hand, if the unregulated business did poorly, the regulators would not allow these costs to increase the utility rates. Thus, some analysts argued that shareholders were doomed to a “lose, lose” situation whenever regulated utilities diversified. Springfield Power was well acquainted with this cross subsidization problem. The firm had recently won a 3-2 decision whereby state regulators had ruled that the VirtualAmerica subsidiary was able to keep separate from the regulated SPU utility business the money it received from AT&T for allowing the use of its transmission towers.
To prevent this negative cross-subsidization problem, most utility industry officials favored ending regulation. In return for this concession, the utilities would end their monopolistic position and allow the free market to decide prices and dictate winners and losers. Starting in 1980, much of the global business world went through a U.S.-led deregulation wave that was built on the theory that allowing market forces to act would give market participants incentives to find better ways to lower costs and improve efficiency.
In the United States, utility deregulation was made possible by the Federal Energy Policy Act, a 1992 Federal law that forced utility companies to allow energy created by other firms to travel through each other’s distribution channels. This, in effect, created a national power grid that enabled the delivery of electrical energy across markets, and made possible the separation of energy creation and energy distribution. This separation ended the monopoly situation and, consequentially, the need for regulators to set prices. Once the infrastructure was in place, utility deregulation spread across the US.
While each state adopted its own rules governing deregulation, the general framework was that utility companies and state regulators would allow customers (first industrial customers and later retail customers) to shop around for power just as they did for long distance or other products or services. It was expected that this competition would improve incentives, lead to greater efficiencies, and lower costs. While many of the benefits of deregulation would take years to develop, a predictable short-run consequence of national deregulation would be more standardized prices. Additionally many environmental groups feared that price competition could lead to environmentally destructive behavior. As a result, consumer groups and environmental groups lined up to oppose the deregulation.
On the other hand, utility executives, large power users, and shareholders generally supported deregulation. The reasons varied, but each group felt that deregulation would improve its own position. For example, large users expected they would be able to negotiate better rates if there were multiple energy providers. Many executives reasoned that their importance would grow with the greater discretion that would come after deregulation. With this increased importance, managerial pay was expected to increase. Similarly, because of the increased flexibility, deregulation was seen as increasing firms’ cash flows and hence shareholder returns.
In 1997, the utility deregulation debate came to Springfield. Not surprisingly, SPU officials and large power users were the chief advocates while opposition consisted of grass-root groups who feared rising prices, environmental damages, possible employee job losses, and increased volatility of energy costs. After much last minute lobbying, Springfield’s pro-deregulation camp prevailed and the Electric Utility Customer Choice Act (Bill BS390) was pushed through both houses of the legislature in late April and signed by Governor Quimby in early May 1997. Under this new law, industry regulation would be phased out over the next 5 years with regulations on the residential market being the last to be dropped.

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