Restructuring the U.S. Electric Power Sector: A Review of Recent Studies

1. Restructuring the U.S. Electric Power Sector:A Review of Recent Studies John Kwoka

2. introduction • U.S electricity sector was naturally monopolistic. • Throughout 20th century there was state and federal regulation of investor owned utilities and public ownership. • By 1978,reforms started taking place and by 1990s total transformation characterized by substantial de-integration, significantly looser regulation, and more market-oriented operation • Changes were intended to bring competition to wholesale and retail customers to lower wholesale costs and thus lower retail prices. • By the year 2000, about half the states either had restructured their electricity sectors or were planning to do so.

3. INTRODUCTION • Electricity restructuring is substantially complete in some regions of the country, although other regions are much less affected. • Hence comparison of costs and prices between states would permit an economic assessment of the actual impact of reforms and determine whether expectations about cost and price effects are being met. • This review discusses ten of the major quantitative studies.

4. structure • This review begins with a discussion of various methodologies that are commonly used in economic evaluations of policies like restructuring or deregulation. • That is followed by an analysis of three significant methodological deficiencies that characterize many of these studies. • The individual studies are then assessed to illustrate major methodological issues. • The final section raises some additional effects of electricity restructuring that are relevant to a comprehensive assessment but are either not addressed or receive inadequate attention in these studies.

5. Assessing Deregulation: Procedures and Pitfalls EMPIRICAL METHODOLOGIES 1. Direct comparison of regulated and unregulated firms and markets. Cross sectional or time series. Need to pay attention to: • what constitutes the regulatory difference or change that arguably affects performance. • the exact date of change in regulation or deregulation. • any non-policy factors that need to be controlled for. • The possibility that those states that choose to deregulate differ in some way that alters the effects of the policy.

6. Assessing Deregulation: Procedures and Pitfalls • to examine the effects of variations in the intensity of regulation across time and place • This approach is particularly well suited to the circumstance where complete deregulation may not have occurred but regulation varies in its stringency across firms or markets. • With proper modeling and attention to all of the above considerations, one can measure the effects of the degree of change or the difference in regulation that is observed.

7. Assessing Deregulation: Procedures and Pitfalls 3. where actual data are unavailable, inadequate, or otherwise compromised, a controlled experiment is a possible means of predicting the effects of deregulation. • Such an experiment in principle might be a field experiment or a laboratory experiment 4. one might estimate an industry model based on underlying demand, costs, and other relevant behavioral relationships. • A well-specified and well estimated econometric model may provide the basis for predicting the effects of deregulation; but is dependent on the availability of good data, correct model specification, and the resolution of any econometric issues. • Simulation of a well-specified model with correct parameters is an accepted, although less commonly employed, approach to measuring likely regulatory effects.

8. Assessing Deregulation: Procedures and Pitfalls • PITFALL # 1: Defining Electricity Restructuring • PITFALL # 2: Post-Reform Price • rate reductions and freezes, • stranded costs, • excess capacity • PITFALL # 3: Causation • Controls for Other Factors • Projection and Prediction • Selection Bias and Endogeneity

9. OBSERVATIONS ON METHODOLOGY • The studies reviewed in this report illustrate the wide variety of standard methodological approaches to evaluating regulatory reforms. • Three pitfalls in the methodologies discussed are • the failure to be precise about the reforms being evaluated. • the use of a post reform comparison price that is itself distorted, • an inadequate specification of causation.

10. Five econometric studies of price • Cambridge Energy Research Associates Study (2005) • attempts to measure the effects of electricity deregulation on the trend of power prices. • involves estimating what the price would have been with continued regulation for the period 1998-2004 and comparing it to the actual “deregulated” price during that period. (1997 break point). problems • The study develops an econometric model to establish the relationship between fuel and financing costs and electricity price under regulation. • the model explaining price is fairly rudimentary • the study uses a model estimated for 1990-97 to predict 1998-2004 prices .out of sample prediction is statistically inferior.

11. Five econometric studies of price 2. Joskow Study (2006) • Joskow offers an analysis of retail prices after reform. He notes the difficulties of determining the counterfactual price and then proceeds with three approaches to the problem: an analysis of time series data on prices, a comparison of price trends in states with and without retail competition,anda regression analysis. • uses the full sample in order to maximize reliability of coefficient estimates, incorporates a number of control factors which prove significant, and controls for both state-specific and time-specific errors. problems • no correction for price reductions and freezes in the deregulation period. • retail restructuring enters as a zero-one dummy variable.

12. Five econometric studies of price 3. Taber, Chapman, and Mount Study (2006) • The paper Examining the Effects of Deregulation on Retail Electricity Prices, notes that the purpose of electricity deregulation was to reduce the retail price of electricity. • This empirical study compares prices for utilities in deregulated states with prices in regulated states between 1990 and 2003. problems • Problems with definition • Use of gap variables • Inclusion of prices of public and privately owned utilities. • Arithmetic averages not valid for drawing conclusions. • Does not reflect what the post structuring price reflects.

13. Five econometric studies of price 4. Fagan Study (2006) • The study Measuring and Explaining Electricity Price Changes in Restructured States, focuses on industrial prices. • Fagan develops a counterfactual model of price differences between restructuring and non-restructuring states over the period 2001-2003. problems • Counterfactual model too simplistic. • Crucial explanatory variable (fuel price) statistically insignificant. • Make unrealistic assumptions. • Estimations made for individual state instead of all states together. • Various causal factors should have been included in the regression.

14. Five econometric studies of price 5. Law and Economics Consulting Group (2006) • The Analysis of the Impact of Coordinated Electricity Markets on Consumer Electricity Charges acknowledges problems with many common approaches to assessing restructuring. • It concludes that a new approach is necessary. problems • Study not precise about what it is evaluating. • The study excludes most states and regions. • Model specification issues. • estimated coefficients that fall short of conventional levels of statistical significance • Unsupported presumptions.

15. summary

16. FIVE COMPARATIVE STUDIES OF PRICE AND COST • CAEM Study (2003) • The study Estimating the Benefits of Restructuring Electricity Markets: An Application to the PJM Region, calculates the benefits from restructuring the PJM market. • It is based on the working assumption that “restructuring redistributes producer surplus [the profit gain] from regulated utilities to competitive suppliers, but produces no net change” problems • the inadequacy of comparing PJM prices in 2002 with prices in 1997, with the difference (adjusted for inflation) attributed to restructuring. • the study does not state precisely what “restructuring” means • the study fails to correct for the distorting effect of rate reductions and freezes and of excess capacity

17. FIVE COMPARATIVE STUDIES OF PRICE AND COST 2. Apt Study (2005) • The study Competition Has Not Lowered U.S. Industrial Electricity Prices also focuses on industrial prices. problems: • the annual rate of price change is not a well-chosen criterion for measuring the performance effects of electricity reforms. • the study’s method for calculating the annual rate of price change is likely to introduce errors in variables. • by annualizing the rate of change, Apt overlooks possibly relevant differences in the rate of price change in certain years • the study chooses to address industrial prices in order to avoid issues such as price freezes, stranded costs, etc., but such issues were true for industrial prices.

18. FIVE COMPARATIVE STUDIES OF PRICE AND COST 3. Synapse Energy Economics Study (2004) • The study Electricity Prices in PJM: A Comparison of Wholesale Power Costs in the PJM Market to Indexed Generation Service Costs analyzes electricity generation costs before and after two changes: (1) the retail restructuring in states within the PJM region, and (2) the restructuring of the wholesale markets in PJM with the introduction of markets for energy, capacity, and other services, beginning in 1998. problems • Results rely on simplified assumptions. • The wholesale power costs include some congestion-related transmission cost • WPCs do not necessarily translate into actual prices to customers, • WPCs in these years have been unusually low due to capacity surpluses in the PJM region.

19. FIVE COMPARATIVE STUDIES OF PRICE AND COST 4. Global Energy Decisions Study (2005) • Putting Competitive Power Markets to the Test: The Benefits of Competition in America’s Electric Grid–Cost Savings and Operating Efficiencies, Global Energy Decisions (GED) analyzes three aspects of wholesale electric market restructuring in the PJM Eastern Interconnection region • comparing costs under two scenarios , “With Wholesale Competition” and “Without Wholesale Competition,” problems • Assume that “without competition” means that no reforms • the study’s assumption of no transmission constraints • Capital costs remain the same.

20. FIVE COMPARATIVE STUDIES OF PRICE AND COST 5. Energy Security Analysis, Inc. Study (2005) • The study Impacts of the PJM RTO Market Expansion by Energy Security Analysis, Inc. (ESAI) (commissioned by PJM itself) evaluates the impact of PJM’s expansion both on its original service territory and on its expanded territory following the addition of member utilities starting in 2002. • The study states that PJM expansion has had various important consequences than a simple reduction in energy price, including the degree of liquidity in the market for power contracts. problems: • With the design of the energy cost estimation technique, • With the methodology, • Results based on unfounded assumptions.

21. SUMMARY

22. Other Issues in Electricity Restructuring • Market Structure, Market Power, and Mergers • RTO Costs, Governance, and Effectiveness • Service Quality and Reliability

23. CONCLUSIONS • The focus of this review has been on the strengths and limitations of the specific methodologies used in these studies. • this review has noted several important aspects of restructuring that should receive more attention. • These studies are important since they represent the first wave of evaluations of electricity restructuring up to this point in time, and also provide guidance on further possible reforms.