ACROSS North America, the electric utility industry is changing rapidly. Legislatures and regulators are beginning to embrace the forces of competition. Earlier this month on January 1, retail markets opened up to competition in California. In March 1998, markets will open in Massachusetts and soon, customers in these and other US states will be able to ‘shop’ for alternative energy suppliers, while using only the ‘wires’ services of their local electric utility.

Deregulation and restructuring are dramatically shaping today’s electric industry. Although complete restructuring is likely to take years, dramatic changes will occur in select markets within a shorter time frame.

Large industry

The electric power market is the largest American industry to be deregulated; annual revenues total more than US$200bn. This market is more than twice the size of the long-distance telecommunications market, and significantly larger than the natural gas, airline, trucking, and railroad industries. The potential for cost-savings in this vast market is the key driver in the efforts to deregulate the industry. Consequently, most activity is occurring in states or regions with higher than average energy costs. Regulators in these areas generally believe that energy industry deregulation will lead not only to lower electricity costs, but to greater overall economic growth and increased competition across all industries, as the effects of commercial and industrial energy cost-savings multiply throughout the economy.

Although legislation to establish a national requirement for electric deregulation has been proposed, regulators and stakeholders from individual states have successfully stalled such efforts. Consequently, the electric restructuring debate rages on within individual state legislatures or before state regulators. In spite of these disjointed initiatives, various regulatory and restructuring trends are emerging among the states that are actively working to deregulate their electricity industries. These trends include direct retail access, recovery of stranded costs, functional unbundling, generation divestiture, rate caps and rate reductions, and standard offer service.

The first of these restructuring trends is the promotion of a competitive market structure that accommodates direct retail access for energy supply services. While these new markets will probably incorporate a bid-based power exchange for the trading of energy, competition will extend beyond wholesale procurement to retail choice. Electricity consumers will have the ability to select their provider from existing utilities, energy marketers, power generators, or purchase energy directly from the power exchange. The reason for this dramatic structural change is simple: customer choice offers the primary means to achieve one of the most desired regulatory goals, long-term sustained rate reduction. Retail access ensures that the benefits of wholesale competition flow through to energy consumers.

Another trend emerging from the electric restructuring process is the treatment of stranded costs. In most jurisdictions, regulators are allowing a ‘reasonable’ opportunity to recover prudently incurred above-market generation costs. Stranded costs are defined as the difference between the costs of utility generation and the true value of such generation in a competitive market. Given that these generation investments have been approved for recovery, utilities argue that the ‘regulatory compact between the utility and its regulator stipulates continued recovery of these investments’. Consequently, in the interests of promoting an expedited move towards competition, regulators have allowed a stranded cost recovery contingent upon demonstration of cost mitigation, rate reduction, or, in some cases, upon generation asset divestiture. Net stranded costs after mitigation and/or divestiture would be recovered from customers through a non-bypassable surcharge for a period of four to 12 years.

In some states, regulators or legislatures are providing the opportunity for utilities to securitize their stranded costs in order to reduce the overall costs recovered by customers. ‘Securitization’ refers to a financial mechanism that allows a utility to recover its stranded costs up front in a single, lump sum payment. Stranded cost surcharges provide a relatively predictable, ensured revenue stream during the period of collection. Utilities can convert the present value of this revenue stream into marketable securities or ‘securitize’ these guaranteed receivables. Securitization may offer opportunities for additional stranded cost mitigation, but is considered con- troversial since future market prices, and the total expected stranded costs, are unknown.

The market structure emerging from the current restructuring initiatives consists of functionally disaggregated electric utilities. That is, entities with separate generation, transmission, and distribution business units. Functional unbundling may involve the formation of separate business units or operating divisions, or the financial divestiture of utility assets. Unbundling enables the separation of competitive services, such as generation, from monopoly services, such as transmission and distribution. The US Federal Energy Regulatory Commission, initiated this unbundling by mandating that utilities provide direct access to transmission services, thus initiating competition in wholesale markets. On many utility systems or in many regions, independent system operators (ISOs) are being established to ensure non-discriminatory open access to transmission services by means of an electronic open access same-time information system, commonly referred to as OASIS.

Restructuring process

In conjunction with the functional separation of services and to facilitate customer education, many utilities are providing unbundled energy bills. These bills provide a breakdown of the utility rates for generation, transmission, distribution, and other services and charges. These other unbundled charges may include taxes, conservation and load management services, and nuclear decommissioning costs. Some participants in the restructuring processes are asking utilities to unbundle all competitive services, not simply generation. Other utility services that arguably could be provided competitively include metering, billing, account maintenance, and customer service operations. Some restructuring stakeholders argue that regional and national suppliers can provide these services more efficiently at a lower cost. While the arguments for unbundling these services may be persuasive, the potential for adding additional stranded costs to this complex process decreases the likelihood that such services will be open to competition when generation is deregulated.

Although functional separation may be considered adequate to ensure fair competition in energy services, many legislatures and regulators are encouraging or requiring divestiture of generation assets to address concerns with affiliate relationships and vertical market power. In August 1997, the New England Electric System, a public utility holding company in Massachusetts, sold approximately 4000MW of fossil and hydroelectric generating stations in Massachusetts, Rhode Island, New Hampshire, and Vermont for more than 1.4 times their net book value to US Generating Company, an affiliate of an energy holding company. In late November 1997, Southern California Edison, a utility in California, announced the sale of ten gas-fired generating plants for more than 2.5 times their net book value to four separate energy companies. Currently, utilities in Massachusetts, Maine, and California have more than 10 000MW of combined generating capacity for sale. Many of these auctions were scheduled to be completed by the end of 1997. Other utilities in New York, Pennsylvania, and New Jersey are expected to divest their generating plants during the next 12 to 24 months.

Regulators are promoting generation divestiture for two primary reasons: to provide a value for purposes of determining stranded costs, and to eliminate concerns associated with the vertical market power of traditional electric utilities. The magnitude of stranded costs resulting from deregulation is a significant obstacle that can impede the restructuring process. Through a competitive auction process, divestiture provides a market-based valuation of a utility’s generation resources, thus eliminating contentious debates on the appropriate pricing measure to use in calculating stranded costs.

In addition to simplifying the stranded cost question, divestiture may hasten the development of a competitive generation market. Divestiture dissolves the vertical market power of the traditional electric utility and provides opportunities for market participants to gain access to valuable resources.

Another consistent trend developing out of the restructuring process is the requirement for rate reductions, or at a minimum, caps on existing rate levels. To ensure smaller customers obtain the benefits of competition, and as a condition for stranded cost recovery, regulators are requiring utilities to provide immediate rate reductions to customers. In California, retail customers will see a ten per cent rate reduction beginning in January 1998. Recently approved legislation provides Massachusetts customers with a ten to 15 per cent rate reduction upon the implementation of retail choice. In New Jersey, customers may see a five to ten per cent rate reduction initially, and further reductions after tax normalization measures commence.

‘Standard offer generation’

The final trend that is emerging is the establishment of default, basic generation service or ‘standard offer service’, offered by the utility to retail customers that have not yet selected an alternative supplier. This service will continue as a regulated, pass-through utility service, and utilities wishing to compete for generation service must do so through unregulated affiliate corporations. Standard offer generation service may be priced at a discount off the utility’s historic generation-related rates or priced, based on average market energy prices, as reported by the power exchange. For utilities planning to divest, the standard offer service must be procured through the power exchange or a bidding process.

Direct retail access, recovery of stranded costs, functional unbundling, generation divestiture, rate caps and rate reductions, and standard offer service are the characteristics of the newly emerging deregulated energy market. The success of deregulation in California, New York, and New England markets will determine the life of these trends in other regions and the pace of restructuring across North America.