Is the Price of Deregulation More and More Blackouts?

The power may be back on, but the multi-state blackout last weekend raises a large cloud over deregulation of the electric-utility industry in California and nationwide. At the heart of the problem is a fundamental conflict between the utility industry’s historical “obligation to serve” and the cost-cutting pressures being ushered in by deregulation. These pressures contributed to the outage. Accordingly, those guiding the far-reaching changes transforming the industry should heed the warnings sent by the blackout if worse problems are to be avoided.

Veteran utility officials will tell you the multi-state outage should not have occurred. Without second-guessing investigators, one of the key questions is: Would the blackout have occurred as recently as a few years ago, before all the changes sweeping the industry today? The answer is probably no.

Historically, electric utilities accepted the responsibility to provide a highly reliable supply of electricity in exchange for a certain return on their investment and a service area free of competition. This responsibility had two elements. One was a long-term obligation to plan, design and build major generation, transmission and distribution facilities of sufficient capacity to ensure a reliable supply of power to their customers. The other covered daily operation of these facilities, which included running adequate backup generation and transmission in case of unexpected outages.

The blackout appears to have resulted from a shortage of such backup, or “spinning reserve”--generators spinning in place so they can be instantly tapped. When several transmission lines shorted out as they sagged in Oregon’s withering heat, coming into contact with overgrown trees below, there wasn’t enough generation to pick up the load.

In the new age of competition, utility managers are being driven to cut costs to survive. “Spinning reserves” and tree trimming are among the expenses being targeted for reductions. Since utilities will no longer be guaranteed a fair rate of return or an exclusive service territory, many consider cost per kilowatt hour as the ultimate determinant of success in the marketplace. The lower the cost, the greater the profit. The problem is that there are significant cost trade-offs associated with various levels of reliability.

As part of its deregulation program, the California Public Utility Commission split the vertically integrated electric-power industry into its generation, transmission and distribution components. In addition to creating a major new role for independent power producers, it added many nonregulated players to the game, such as power brokers and Wall Street commodity traders. This has raised questions within the industry about who will assume its historical obligation to serve and whether responsibility is too diffused.

The CPUC’s new Power Exchange will be responsible for providing an hourly market for generation and will fall under the jurisdiction of the Federal Energy Regulatory Commission. Ultimately, the exchange will be able to ensure that at least California utilities provide adequate “spinning reserve” for daily operations, in compliance with reliability standards.

The utility industry’s Western Systems Coordinating Council, under the guidance of the National Electric Reliability Council, sets these standards. The blackout demonstrates these two organizations need a lot more clout to make sure all utilities in the West adhere to their standards. Otherwise, the federal commission will have to enforce the standards to ensure that all utilities play by the rules and the public is protected.

It is unclear whether we can count on the market to reward utilities that embark on multi-year projects to add power sources to meet growth requirements. In much of the West, there is currently a surplus of generation capacity, which is expected to last into the next century. Consequently, existing owners of generation will probably sell their surplus electricity at only slightly above their marginal costs, because they have idle capacity. For them, any price that exceeds fuel costs helps offset any remaining capital costs.

But these prices probably won’t entice many new entrants into the generation market unless they can build plants that generate electricity more cheaply, including capital, than the marginal cost of existing ones. The return necessary to attract capital to a relatively risky, long-term investment must be factored in. As a result, many question whether investments will be made in time to provide a reliable supply in the future.

The market works reasonably well in other capital-intensive industries, but customers of electric utilities have few options should it fail them. The California and federal commissions should recognize this and put in place safeguards or procedures that would monitor long-term capacity additions. They should also set forth alternative approaches if the market risk proves too great.

Transmission facilities link California utilities with numerous power sources beyond its borders. But responsibility for transmission planning and funding remains murky under the CPUC’s plan for an Independent System Operator, which would also fall under the federal commission’s jurisdiction.

Until now, individual utilities accepted responsibility for both generation and transmission, often in cooperation with neighboring utilities. Under the CPUC’s plan, individual utilities will own and maintain transmission lines but the Independent System Operator will have exclusive authority to operate them. These split assignments do not adequately fix responsibility for adding capacity to these lifelines.

Over the long term, deregulation should lower electric-utility costs to consumers. But it has taken 100 years for the industry to evolve into one of the nation’s most reliable infrastructures. The task of restructuring it should thus be undertaken with great caution. Last week’s blackout offered a vivid warning that consumers should not be put at any greater risk.