Do Markets Reduce Costs?
Assessing the Impact of Regulatory
Restructuring on the Efficiency of
Electricity Generation
Nancy L. Rose
MIT and NBER
COMPETE Forum
November 5, 2007 Washington, DC
Electricity markets in historical perspective

Early industry evolution led to monopoly concerns

Government ownership or regulation arose to limit firms’
exercise of pricing power

“Traditional” rate-of-return regulation of investor-owned
utilities (IOUs) dominated in US

Worked well to keep prices close to costs

But provided limited incentives to keep costs low

Higher costs generally flowed through to ratepayers

Distortion of investment incentives

Insulation from competition reduces feedback and cost
pressure
Restructuring has recently replaced traditional
cost-plus regulation in many jurisdictions

Institutional choices balance costs/benefits of imperfect
markets vs. imperfect regulation

Generation and Retail Services: Vertically disintegrate,
move to markets


“Natural monopoly” not relevant to current technologies, scale of
markets in generation and retailing

Recognition that cost inefficiencies entail first-order welfare loss
Transmission and Distribution: Incentive regulation

Trade-off market power (potentially substantial in these sectors)
and efficiency concerns

“Natural monopoly”/ Network domains benefit from “smarter”
regulation
Does restructuring improve efficiency?
This is the billion dollar question

Theory: Changes in incentives can
change behavior

Empirical evidence: What happens?
Focus on electricity generation
What does restructuring do to
generation?


US: 1,000+ interconnected generating
plants built and operated mainly by
investor-owned utilities (IOUs).
What changes in restructured regimes?
New incentives for operation by existing
owners (anticipatory, short- to medium-run)
 Divestitures/new owners of existing plants
(short- to medium-run)
 Investment in new plants (long-run)

What choices might restructuring affect?



Start with a stylized description of what
plants do
To produce electricity (MWhs), plants
combine fuel, labor, materials and capital
This process can be described by a
production function:
y = f(F,L,M,K)
A one-input production function
Electricity (MWh)
y = f(F)
Efficient plant
“Lost” MWhs
Inefficient plant
Excess fuel
Fuel (Btu)
What might change: plant level




Technical efficiency (e.g. improved heat
rates)
Input mix (e.g. substitute away from fuel)
Cost of inputs (e.g. fuel procurement
practices change)
Balance between expense of preventative
maintenance and cost of forced outages
What might change: dispatch level

Mix of plants included in the dispatch improves
due to expanded coordination areas (+)


Mix of plants included in the dispatch worsens
due to dispatch on price (bids) not costs (-)


Regional trading organizations may improve interregional trade and congestion management
If some firms withhold capacity from the market to
exercise market power, it will be replaced by power
from plants that otherwise would have been too
expensive to run.
Mix of plants brought online improves (+)
Empirical assessment: Measuring the
effects of restructuring

We can’t simply compare prices, costs or
efficiency measures across restructured v.
traditional regulatory environments




Restructured states tended to have higher electricity
prices before restructuring
Input shocks, especially fuel prices, change costs
over time even without restructuring
Plant mix is different in states that have restructured
We need a counterfactual: What would have
happened without restructuring?
Empirical assessment: The importance
of the counterfactual


To measure empirical effects of restructuring,
consider a set of efficiency measures
 X  {investment, fuel use, staffing levels, etc.}
Some candidate counterfactuals: Restructuring Effect:
X2000 – X1990
 X before restructuring
“difference in differences”
 X in other parts of the world.
(X2000, CA – X1990,CA)  X in states that aren’t progressing
(X2000,KY –X1990,KY)
with restructuring quickly.
Restructuring effects on generation
efficiency

Fabrizio, Rose and Wolfram (2007) explore
whether impending restructuring caused existing
owners (IOUs) to operate their plants differently.

Difference in difference analysis:

Compare changes at large fossil IOU plants in
restructuring states over 1980-1999 to two “control
groups”



Similar IOU plants in non-restructuring states
Cooperatively- and publicly-owned plants
Restructuring states are those that passed
restructuring legislation by 2001.
See K. Fabrizio, N.L. Rose and C.D. Wolfram, “Do Markets Reduce Costs? Assessing the Impact of
Regulatory Restructuring on US Electric Generation Efficiency,” American Economic Review, (2007)
97:1250-1277.
Employment Growth Relative to 1981
Figure 1: Employment Trends by Company Type and Restructuring Status
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
MUNI
Year
IOU: Non-restructured States
IOU: Restructured States
Nonfuel Expense Growth Relative to 1981
Figure 2: Nonfuel Expense Trends by Company Type and Restructuring Status
0.2
0.1
0
-0.1
-0.2
-0.3
-0.4
-0.5
-0.6
MUNI Plants
IOU: Non-restructured States
IOU: Restructured States
Divestiture and Efficiency

Bushnell and Wolfram (2006) estimate that fossil plants
have ~2% lower heat rates after divestitures

At current fuel prices, this amounts to $1/MWh or more

At the plants that were divested, this adds up to savings of
roughly $1 billion per year

Barmack, Kahn, & Tierney (2007) estimate nuclear plant
capacity factors increase about 10% post-divestiture

Improving efficiency helps achieve environmental goals,
especially with respect to CO2
J. Bushnell and C.D. Wolfram, “Ownership Change, Incentives and Plant Efficiency: The
Divestiture of U.S. Electric Generation Plants,” UCEI CSEM Working Paper 140.
M. Barmack, E. Kahn and S. Tierney, “A cost-benefit assessment of wholesale electricity
restructuring and competition in New England,” Journal of Regulatory Economics, (2007)
31:151–184.
Markets improve the mix of plants in dispatch




Mansur and White (2007) examine effects of
PJM market expansion
Centralized market replaced bilateral trading
between PJM East and the Midwest
Dramatic increase in volumes that flowed from
inexpensive coal plants in the Midwest to
Pennsylvania, New Jersey and Maryland.
Estimated savings on the order of $180m/year
E. Mansur and M. White, “Market Organization and Market Efficiency in Electricity Markets,”
Yale School of Management Working Paper.
Quantities traded: Day-ahead net exports,
Midwest  East
What’s the bottom line on restructuring?

Remind ourselves about the source of potential gains
from restructured electricity markets:
 It’s not about short-term price effects
 That
may be due to temporal shifts (from differences in plant
age, regulatory rate base accounting, treatment of “stranded
costs,” ), or changing input prices, especially fuel
Real benefits arise from lower costs due to increased
efficiency (short- to medium-run) and better
investment decisions (long-run)
Evidence on operating efficiency at existing generating
plants is positive.
Additional efficiency gains possible through:



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More efficient long-term (capital) investment.
Incentive regulation for transmission and distribution.