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A Plea for Power by John O. Sillin Barron's - October 13, 2003

Electricity reform should be grounded in profit and efficiency

The Aug. 14 blackout was the piece de resistance in the national need for major reform of how the electric power industry is regulated and managed. It comes on the heels of the California electricity crisis, other service interruptions, the bankruptcy of major generating companies, the electricity-trading debacle, the loss of billions in international power investments, and the financial decline of major segments of the electric power business.

Earlier this year, the Senate and House passed comprehensive energy legislation, and the final version is now being negotiated in conference. While the conferees are making some effort to address oil and natural-gas supply issues (opening the Alaskan National Wildlife Refuge and providing incentives to build the Alaska natural-gas pipeline are still part of the bill) it appears nothing of consequence has yet been done on electricity, despite a high profile hearing by the House Committee on Energy and Commerce in September.

Electricity reform provisions in the bill include building more windmills, researching "clean coal," researching the "hydrogen economy" and increasing appliance energy-efficiency standards.

While most of this stuff is well-meaning, and by Washington standards inexpensive, it all fails to address the root issue facing the power industry: How to accomplish its fundamental mission of producing and delivering electricity reliably and economically. The Blackout and Hurricane Isabel again demonstrated that reliable, economic electric service are absolutely necessary in a modern economy.

We used to know this, but the purpose of the electric power industry has been diluted, if not lost. Now its function is to deliver politically correct "green power" and energy conservation, and do whatever else politicians and regulators want. To the extent electricity can be generated from new sources, the prevailing political preference is to use "clean" natural gas, and other "small-is-beautiful" technologies. Trouble is, neither the color nor the source nor the size of the generating facility has much to do with whether we will have an economical, reliable electricity supply.

Inefficiency by Rule

The 1992 Energy Policy Act was supposed to assure that investment decisions were based on economics not politics, at least with regard to generation. But the fundamental issue of how to deal with state regulators, often vulnerable to political pressures, was left unresolved. They set the rates that utilities can charge, thus they control utility company behavior and have veto power over any significant investment decisions.

When the relationship between capacity and demand dropped to dangerously narrow margins in the mid- and late-1990s, there was a rush to install natural- gas power plants, which were perceived to be cheap to build and operate. This was the way chosen to provide rate freezes and similar moves aimed at keeping voters happy. Over $100 billion was invested in these plants.

Well, the cost of construction may still be reasonable, but few if any of these plants will operate for long, as gas prices approach $5 per million BTUs. Generating companies that invested heavily in this technology are suffering huge losses or going bankrupt. And utility distribution companies are now left with worthless contracts, and perhaps not enough power to keep the lights on.

The 1992 Energy Policy Act also failed to address the utilities' loss of eminent domain authority -- an authority which would enable them to upgrade and extend capabilities by acquiring public or privately held land. New facilities are contested at all local, state and federal levels. This opposition and not-in-my-backyard state regulation have caused transmission investment to lag behind need. In the 1990s alone, electricity demand increased by 35% while transmission investment increased by only 10%. The August blackout and a general deterioration in system reliability are direct consequences of this under-investment.

Distribution investment has also lagged. Overall, investment as a percent of the power-industry revenue dollar is near an all-time low.

Inefficiency by Design

Not only did essential electric infrastructure not get built, but many electric companies lost billions in pursuing profits they thought they could no longer earn in the core utility business.

Merchant power plants, plants fueled by natural gas that were built to serve the wholesale market, have led companies up an expensive blind alley, leaving them either bankrupt or with single-digit share prices.

There was more hype than reality to electricity trading. "Roundtrip ticketing" and other shady practices were part of the hype used to sustain this business. Those that led the hype, such as Enron and Dynegy, ultimately lost billions.

There was more self-congratulation than reality in the belief that domestic management skills were going to be transferable to international utility acquisitions. International power plant and distribution company investments have been huge losers, costing U.S. power companies and their investors billions.

The California energy crisis, the August Blackout, efforts to abrogate wholesale power agreements, the decline in reliability, the exposure to rising natural-gas prices, and the decline of the Dow Jones electric utility share price index -- from over 170 in December 2001 to 111 as of this writing -- are the most obvious consequences of more than 30 years of politically influenced regulation and legislation.

The energy bill now in conference could provide an opportunity to begin reversing this trend. What should be in it? Here are the principles that should guide the lawmakers.

The underlying mission of the electric power industry is to deliver electricity reliably and safely at as economical a price as possible. Power companies are not social-service-delivery organizations.

Expanding and upgrading the electric transmission system is critical. To accomplish this, investment incentives and the power of eminent domain are required to make the investments feasible.

Generation diversity should be an option, and tax and regulatory policies should be technology-neutral. Relying on a single fuel form, such as natural gas or renewables, is dangerous to electric-system economics and stability.

Electric-industry barriers to entry should be lowered. If utilities can squander investment in unregulated activities, fairness requires that new entrants be allowed to replace them.

Several elements of the electricity industry, such as transmission and distribution, are monopolistic in nature. Some public entities need to oversee these elements of the business. But regulators, particularly at the state level, should be limited to enforcing system operating rules and encouraging investments that strengthen the electric grid. Otherwise management should be in charge of companies -- including having the freedom to earn high rates of return in the core electric-power business.

Efficiency Through Profit

The Balkanized regulatory structure of the power industry needs reform. The Federal Power Act establishing this structure dates back to the 1930s. Everything else has changed except the law. With nearly all utilities having interstate operations, there are frequent conflicts between federal and state regulators.

It is possible to make money in the electric-power business as companies such as Entergy, Southern and Exelon demonstrate. These companies, either through accident or design, have avoided the most common mistakes (Southern, for example, divested its merchant power plant subsidiary just before natural-gas prices began their inexorable climb), and appear to be producing electricity reliably and delivering it an economical price. At the same time, their share price has outperformed both that of other utilities and the S&P 500 over the past three years, and managed to realize share-price increases in a down market.

Energy legislation can encourage and reward other companies in the electric-power sector to follow similar strategies -- to build reliable electric grids with generating facilities that have stable, relatively low operating costs.

Somehow, Congress must provide the leadership that is needed. Electricity is an absolute necessity to the functioning of a modern nation, and the time for allowing politics to control its development must be at an end.