Ownership Change, Incentives and Plant Efficiency:

1. Ownership Change, Incentives and Plant Efficiency: The Divestiture of U.S. Electric Generation Plants James Bushnell UC Energy Institute Catherine Wolfram UC Berkeley The Economics of Electricity Markets June 2-3, 2005  Toulouse, France

2. Electric generating plant divestitures in the U.S. • The ownership of electric generating plants in the U.S. changed dramatically between 1998 and 2001. • Over 300 plants, representing nearly 20% of U.S. installed generating capacity, changed ownership. • Divestitures were encouraged by state regulators as part of the industry restructuring. • Easy measure of stranded costs. • Addressed concerns about the ability of a firm that was vertically integrated into transmission to exercise market power. • Old owners (investor owned utilities) faced cost-of-service regulation; new owners face market incentives.

3. Electricity industry restructuring and economic efficiency • There is heated debate in academic and policy circles about how to design restructured markets. • All of this should be moot if restructuring doesn’t improve economic efficiency. • Several academic and policy studies have examined the effects of restructuring on cost efficiencies: • Top down: DOE (2003), SEARUC (2003), CAEM (2004). • Bottom up: Markiewicz, Rose and Wolfram (2004) looks at changes in operating efficiency at IOU plants facing new incentives; Kleit and Reitzes (2005) looks at dispatch efficiency.

4. Measuring the effects of divestitures on plant efficiency • Ideally, we would like to evaluate changes in each plant’s total factor productivity after divestiture. • Unfortunately, data on employment, maintenance and capital inputs is not publicly available after divestiture. • We’re exploring data availability from various sources. • For now, we’re analyzing whether fuel efficiency changed at plants that were divested. • Rich data are available from the Environmental Protection Agency. • Implicit assumption that production is Leontief in fuel and other inputs.

5. There may be no effect of divestiture on fuel efficiency, • A generating unit’s fuel efficiency is an immutable technological characteristic. • IOUs may have made poor investment decisions, but at least they knew how to operate their own plants.

6. …or there may be either positive or negative net effects. • Heat rates could go up following divestiture. • It will take the new owners some time to master the idiosyncrasies of the plant. • New owners may cycle the plants more (e.g. to exercise market power) at the cost of higher heat rates. • Heat rates could go down following divestiture. • IOUs had fuel adjustment clauses, so they didn’t do everything possible to minimize heat rates. • New owners might be able to renegotiate union contracts so they can promote good operators.

7. Data set • We are analyzing electric generating units that are: • Fossil-fuel fired (i.e. not nuclear or hydroelectric). • Included in the EPA Continuous Emissions Monitoring System data base. • In regions where divestitures were prominent (this excludes, for instance, all the plants in Florida). • We have hourly fuel input and output data on ~1000 generating units for 7 years (1997-2003).

8. We analyze plants in the shaded states.

9. Empirical specification • To analyze divestitures, we estimate versions of the following equation: • for unit i in time period t, where • HR is the unit’s heat rate (inverse of fuel efficiency), • t is either monthly or hourly, • Divestiture = 1 after divestiture (if applicable), • t are month dummies, θi are unit dummies, and • we specify the relationship between HR and Gross Load with care.

10. Example of what we’re labeling a Divestiture effect. Average Heat Rates for 2 units across 2 years Our Divestiture effect: (12-14) – (10 -11) = -1 Our Divestiture effect in logs: (ln(12)-ln(14)) – (ln(10) –ln(11))  -.05 Our estimates control for: - differences in average heat rate levels across divested and not-divested units. - general trends in heat rates.

11. The basic Divestiture effect: 2% reduction in Heat Rate See Table 4 in the paper.

12. Why do we see lower heat rates after divestitures? • Utilities only sold plants that were ripe for improvements. • Utilities deferred maintenance before they sold the plants; merchant firms have been regaining lost ground. • Merchant firms faced new incentives—incentive effect. • New owners shook things up—ownership effect.

13. In states with major divestitures, IOUs sold nearly all their thermal capacity.

14. Table 7: evidence on incentive and ownership effects IOU plants showed improvements in states with rate freezes, suggesting incentives matter. Evidence on effects of ownership transfers less clear.

15. What is being done differently at divested plants? • Are merchant firms operating at the “sweet spot” more? • Are merchant firms changing other aspects of operations (combustion optimization software, fuel switching, etc.)?

16. Unit heat rate profiles

17. Implied magnitude • Our estimates suggest that plants have ~2% lower heat rates after the divestiture. • At current fuel prices, this amounts to about $0.6/MWh. • At the plants that were divested, this adds up to savings of nearly $500 million per year. • Scaling this up to all thermal plants nationwide, this could add up to almost $1.5 billion per year. • Improving fuel efficiency helps achieve environmental goals, especially with respect to CO2.

18. Conclusions • In light of the California electricity crisis, it is useful to remind ourselves about the potential efficiency gains of restructuring. • This paper focuses on fuel efficiency at existing generating plants. • Evidence is positive—owners respond to incentives. • Additional efficiency gains possible through: • More efficient long-term (capital) investment. • Incentive regulation for transmission and distribution. • Reallocating output across plants.