Monday, March 30, 2009

Will Reregulation Work?

One of the biggest issues before the General Assembly at the moment is an effort to “re-regulate” electricity provided by new power plants. The bill, as amended, would grant the Public Service Commission the authority to force utilities to build new power plants and end retail competition for electricity. The bill’s supporters claim it will lead to lower electricity rates. Will it?

For the majority of the twentieth century, electric power was provided by regulated monopolies. In most local areas, one company generated the power, transmitted it to substations and distributed it directly to residential and industrial customers. State and local regulatory bodies decided on the rates that were charged to consumers. In 1996, the Federal Energy Regulatory Commission opened the door to electric power competition through its Order No. 888, which required owners of transmission lines to allow non-discriminatory access to other power providers. That kicked off a movement by 18 states plus the District of Columbia to set up competitive markets through which electric power could be bought or sold.

In Maryland, a 1999 bill required Pepco and Baltimore Gas & Electric (BG&E) to divest their in-state plants, freeze rates through 2006 and ultimately allow their customers to pick their energy suppliers. Pepco sold most of its plants to new merchant generator Mirant while BG&E formed a new parent company (Constellation) and transferred its plants to a different subsidiary. True competition never materialized in Maryland and electricity fuel input prices went up, so BG&E and Pepco sought colossal rate increases in 2006. Many politicians now describe deregulation as a failure and the issue has been a political football ever since.

SB 844 seeks to remedy the problem by giving the state’s Public Service Commission (PSC) the ability to force power suppliers to build new generating plants and directly regulate the rates those new plants can charge consumers. Will this bill lower electric prices over time? Probably not, for the following reasons:

1. Regulation does not automatically lower rates.

We obtained monthly year-on-year U.S. electricity retail price change data from the Bureau of Labor Statistics from 1953 through February 2009. We present the data in the graph below.

The biggest electricity price spikes since 1953 have occurred from December, 1972 through September, 1975 (when prices jumped by 42.5%) and December, 1978 through August, 1982 (when prices jumped by 65.2%). Those were periods in which almost all electric power in the U.S. was subject to regulation. The reason for electric power price increases was price hikes for fuel inputs, especially fossil fuels. Under cost-of-service regulations, the traditional method of price-setting used by regulating entities, utilities are allowed to charge rates that reflect their price of inputs along with a modest profit. Regulation may allow price increases to be spread out over time, but it does not shield consumers from input price hikes over the long term.

The data shows one additional fact. The greatest prolonged drops in retail electricity prices since 1953 occurred from July, 1997 through January, 1999 (down 13.0%) and July, 2001 through November, 2002 (down 11.3%). Both of those declines occurred during a time when many states were deregulating.

2. The bill does not address the root cause of rising electricity prices.

Below we illustrate the monthly levels of U.S. retail electricity prices and wholesale prices for crude petroleum, natural gas and coal from 1986 on from the Bureau of Labor Statistics. All price levels are indexes using 1984 as a base level of 100.

We ran a multiple regression predicting retail electricity prices on the basis of the above three fuel inputs. We found that 77% of the variation in retail electricity prices since 1986 was explained by variation in wholesale prices of crude petroleum, natural gas and coal. So for the most part, rising electric bills are a result of rising commodity prices.

The role of natural gas is especially crucial. Since 1998, 96% of all net generation capacity added in the U.S. has come from natural gas-fired plants. The reason for that is three-fold. First, natural gas is relatively abundant in North America and burns cleaner than coal, making it the fuel of choice for new plants in the 1990s and the early 2000s. Second, gas plants can be built quickly and relatively cheaply compared to new coal and nuclear facilities. For example, merchant generator Calpine used one plant design to build dozens of new facilities across the country. Third, gas plants can be quickly turned on and shut off, making them ideal for use during power spikes (like hot summer days) and in spot markets. But the sudden increase in demand for natural gas could not be met by existing exploration and the result was soaring, and volatile, natural gas prices. This pushed up retail electricity rates. Maryland’s reregulation bill does nothing about this.

3. The bill could have unintended consequences.

Astute utility managers hedge their exposure to commodity prices by diversifying their supplies among many fuel inputs, many suppliers and many contract intervals. But the reregulation bill could conceivably impede these strategies by emphasizing new construction over imports. Suppose PSC orders a Maryland generator to build a new natural gas plant and later the price of natural gas spikes. Under cost-of-service regulations (which are explicitly called for in the bill’s amendment), the plant owner would be entitled to call upon ratepayers to compensate it for the higher costs. That would mean that the bill might actually cause electric rates to increase.

4. Any positive impact will only affect a tiny share of the power market.

As of 2006, Maryland had 12,500 megawatts (MW) of generating capacity. (One MW is enough to power 600-1,000 single-family homes). The largest power plant in the state is Mirant’s Chalk Point coal plant, a 2,429-MW facility that produces about 19% of the state’s capacity. Coal plants produce a lot of energy but it is unlikely that PSC will permit any more of them. Gas-fired plants generate anywhere from a few dozen to a couple hundred megawatts each. So suppose PSC ordered a generator to build a 300-MW gas plant, a rather large facility for that fuel type. That plant would only account for 2% of the state’s capacity. Even if its rates were kept artificially low, they would have almost no impact on the rest of the market. Add to that the fact that new generating plants take many years to permit and build and – at its best – the reregulation bill offers almost no hope of any meaningful price relief.

Overall, the bill’s command-and-control approach to the dysfunction of the electricity market (a market that was created by the General Assembly) shows little promise of decreasing rates. That is why a giant coalition of industrial customers opposes it. But there are real steps the legislature can take to ease electricity rates over time. We will recommend three options in our next post on the issue.