For eight decades, the electricity supply industry and its customers
enjoyed the benefits of increasing economies of scale. Electric utilities,
people reasoned, were natural monopolies because they enjoyed economies
of scale. In other words, the larger the generating station, the lower
the cost per unit of output. In order to assure that the utility could
install the largest possible unit and operate it at maximum output, the
state would prevent others from selling in that market. (Many small generators
would produce electricity at a higher cost than one large generator.)
Then, in order to assure that consumers would capture the benefits of
the lower costs, rather than the monopolist, the state regulated the price
charged by the monopolist, limiting the price to costs incurred, plus
a fair profit for the capital employed.

As the industry installed larger generating stations, the cost per unit
of output declined. Thanks to the regulatory system in place, the utility
had to pass on to customers those cost reductions in the form of lower
prices. Customers took more electricity because of lower prices and a
plethora of new uses. Higher sales volume enabled the utilities to install
even larger generators. That reduced costs and prices even more, and the
cycle continued, until the 1960s, when conventional steam generating stations
ran up against the efficiency limits inherent in the Rankine Cycle. From
that point forward, electricity suppliers could eke only minimal additional
efficiencies from the system, not enough to overcome the inflation in
other costs.

Solving the Problem

Electric utility executives did not rest on their laurels. They embraced
a technology that they knew would bring about an unprecedented new age
of abundant and cheap electricity – nuclear power. Unfortunately, nuclear
power raised rather than lowered costs, and the financial stress of financing
the long-drawn-out construction processes pushed many utilities to the
brink of, or into, bankruptcy.

Ironically, during the 1960s, equipment manufacturers introduced the
stationary gas turbine, a derivative of the aircraft jet engine, as a
power generator. Utilities must have viewed these little devices with
as much disdain as did the American automobile manufacturers when they
saw those first, tinny, little Japanese imports. “Gas turbines? They’re
okay for peaking,” they said. Over the coming decades, though, manufacturers
perfected the gas turbine, raising it to unprecedented levels of efficiency
and reliability, while the conventional, huge power station favored by
the utilities showed minimal improvement. The electric utility industry
had bet on the wrong horse. Or better still, at a key point in the industry’s
evolution, the industry bet on the dinosaur instead of the rat.

Figure 1

The evolution of electricity pricing and the power plant (Source: Leonard
S. Hyman, Andrew S. Hyman, and Robert C. Hyman, “America’s Electric Utilities:
Past, Present and Future” (7th Edition) Vienna, VA: Public Utilities Reports,
scheduled for 2000 publication).

Technological change will not take hold if the only possible users of
it resolutely decide to ignore it. The utilities, after all, did have
a monopoly on electric generation, unless you planned to do it yourself
off the grid. Congress changed that stranglehold on generation when, in
1978, it passed the Public Utility Regulatory Policies Act (PURPA), whose
Title II established a special type of generator that could sell its output
to utilities. Those qualifying facilities (QFs), in the main, employed
gas turbines to produce electricity. The independent power producers,
over the next decade, demonstrated that they could efficiently and reliably
build and operate the new power stations.

The electric industry pushed up prices to reflect higher costs due to
nuclear cost overruns, environmental controls, and higher fuel costs.
Industrial customers began to notice that the independent power producers,
without the baggage that the utilities carried, could produce electricity
for less. Some industrial customers realized that they could put in their
own generation and produce power for less than the local utility charged.
Small, modern gas turbines produced electricity at costs competitive with
those of large electric utility generators. Electric utility generators
no longer had a natural monopoly. Regulation now protected the utility
against competition rather than the consumer against exploitation by the
monopolistic utility.

Industrial customers first noticed the increasing gap between price and
marginal cost. They began to demand lower prices, threatening to move,
close up, divert production to other places, or self generate unless the
electric utility reduced prices to them. The utilities or the state regulators
usually caved in to the pressure. Industrial customers gained the benefits
of competitive pricing despite the lack of competitors.

In 1992, Congress passed the Energy Policy Act, which removed restrictions
on independent power producers and enjoined the transmission-owning utilities
to open their lines to all comers, including competitors that needed the
utilities’ lines to transport power to the utilities’ own customers. The
industry paid little attention to the change. The Federal government moved
slowly and had jurisdiction over only a small part of the industry’s sales.
Then regulators in California decided to ask why Californians paid such
high prices for electricity, and other high-cost states quickly began
their own inquiries. By the end of 1996, 14 states had either enacted
new regulations or had investigations underway with action likely to open
up the electricity market to competition at the retail level. The old
state-protected monopoly seemed on the way out.

The Reaction

Utilities reacted to the changes in law and the threat of competition.
They decided to invest in utility properties abroad, because of greater
opportunities for growth. They put money into unregulated generation in
the United States, figuring that they understood that business. Many utilities
decided to get out of the regulated generating business, and some decided
to get out of the generating business altogether. Success in the commodity
generating market required expertise and scale that the exiting utilities
believed they did not possess.

For that matter, the utilities believed that they had to achieve greater
scale in their overall operations in order to efficiently serve consumers.
They had to offer consumers a greater choice of energy services in order
to remain competitive. They required a wider range of skills, too, in
order to succeed in rapidly changing businesses. Rather than attempt to
develop scale, scope, and expertise internally, the utilities launched
into a wave of mergers probably unprecedented since the 1920s. They bought
or merged with neighboring electric and gas utilities, natural gas pipelines,
energy traders, telecommunications firms, and even water utilities. Meanwhile,
foreign utilities eyed the U.S. market, plunged into generation and power
trading here, and then purchased two large utilities.

Utility managements know best how to manage regulation. They proved that
during the restructuring process. In almost every jurisdiction, they convinced
regulators of the need to allow the utilities to recover the costs that
were supposedly “stranded” by the introduction of competition – that is,
the costs above the competitive level that they could not charge customers
in a competitive environment.

The states, however, wanted something in return. They introduced competitive
choice for retail customers, demanded immediate price reductions from
the utilities, and in order to create competitive markets, many states
insisted that the local utilities sell off their generating plants, so
they could no longer exercise local monopoly power over both generation
and distribution of electricity. Meanwhile, Federal regulators worried
that the utilities, as owners of generation and transmission assets, would
operate their transmission lines in a manner that would disadvantage competitive
generators seeking to reach the market. Therefore, late in 1999, the Federal
Energy Regulatory Commission told the utilities to put their transmission
lines under the supervision of independent regional transmission organizations.
That order could encourage some utilities to get out of the transmission
business altogether.

Neither the shareholders nor the managers of the investor-owned utilities
seemed to know how to react. Despite regulatory settlements, sale of power
plants at high prices, and the recovery of stranded costs through securitization,
utility stocks performed poorly. Perhaps the old utility investor, who
sought high dividends and steady income, no longer approved the new mix
of foreign investments, domestic competition, and uncertain dividends.
The utility companies, despite the dramatic changes in the business, not
only maintained the old financial policies, appropriate for the regulated
monopoly, but they actually put on more debt than before, acting as if
the business had gotten safer than when they had the monopoly. No wonder
investors were confused.

As illustrated in Figure 2, the business turned upside down within a
few years, but some folks did not seem to notice.

Figure 2
Trends in the utilities industry (Source: See Figure 1.)

What Next?

The electricity supply sector barely has moved into the competitive era.
The same managements run the same corporations with the same financial
structure and shareholder base as before. Consumers have limited choices
determined by regulators, who (in conjunction with state legislatures)
continue to set prices for much of the business. Transition periods stretch
on for years, with different terms for each state, thereby balkanizing
the market in a way that discourages the formation of nationwide competitors.

But, if a revolution in generating technology, aided by a worldwide retreat
from government regulation of the economy, could upset a well entrenched
industry over a 30-year period, how long will it take for the next technological
revolutions – encompassing distributed generation, time-of-day metering,
a more efficient transmission network, and the Internet – to shake up
a market that has not even completed the restructuring prompted by the
last revolution?

Major industrial corporations have launched programs to develop and market
small generators. Both microturbines and fuel cells could go on sale in
volume within two or three years. Those small generators could enable
consumers to either bypass the electric grid altogether or to limit their
use of grid electricity when price rises too much. Obviously, that distributed
technology could threaten the monopolistic position of the distribution
network and the profitability of power stations that make their profits
during peak periods.

Customers, of course, need real-time metering that allows them to make
decisions. Right now, the market does not take into account consumer reaction
to price, because most consumers do not see price until months later,
when the electric bill arrives, or maybe not at all. Competition will
not work until customers see prices. When they do, their reactions could
upset many a plan devised by aggressive electricity suppliers whose profitability
depends on shortages that might melt away when price rises in a visible,
real-time manner. Thus, real-time metering could have a profound influence
on the industry.

Generators today seem to assume that the transmission network remains
in its strangled state, with no improvements possible due to lack of financial
incentives. Even regulators will wake up to the possibilities, after a
few scary summers of shortages. Yet means do exist to improve the operation
of the network, without stringing new lines, and the introduction of more
economical DC technology and, later, superconducting cable, could transform
the network over the coming decade. Imagine the possibility of a deadly
price war that pits local central station generators against distributed
generation on one side and distant central stations that can now reach
the market, thanks to improved transmission, on the other. Then, consider
that Internet suppliers can cut out middlemen and achieve direct access
to the utility’s customers. They can run virtual utilities, relegating
the old utility to the position of supplier to the virtual utility, which
has the all-important contact with the consumer. Internet markets can
replace vast trading floors and reduce the value of expensively acquired
trading operations.

Is that all? The next revolutions, the third wave, could encompass decarbonization,
the hydrogen economy, and interactive markets between consumers and producers
that do away with the intermediary organizations that the regulators,
utilities, and marketers have worked so hard to erect. This will no longer
be the “old utility business.”