Electricity Prices in a Competitive Environment: Marginal Cost Pricing of Generation Services and Financial Status of Electric Utilities A Preliminary Analysis Through 2015
Release date: August 1997
This report presents some of the potential impacts of the competitive pricing of electricity in the United States, based on widely accepted principles of economic theory. The assumptions that form the basis of the analysis may or may not reflect actual developments resulting from the emergence of fully competitive electricity markets.
One important assumption in this analysis is that there will be an absence of market power in the coming competitive market for electric power. “Market power” means that a supplier or consumer has the ability independently to influence prices by virtue of size or control over an important aspect of the market, such as access to transmission lines. If there is no market power, then economic theory suggests that prices will fall to the marginal costs of production, and the cost of operating the most expensive generating plant in operation at any point in time will set the price for electricity.
Given this assumption, the cases considered in the analysis, and the assumption that full-scale competition in generation services begins on January 1, 1998, retail prices for electricity could be lower on average by as much as 6 to 13 percent within 2 years, compared with prices under current laws and regulations. This is in addition to the price reductions already taking place as a result of limited wholesale competition, producers’ preparation for retail competition, and incentive regulations implemented by State regulators. If the price reductions already occurring were added to those resulting from full-scale competition in generation services, prices by 2000 could be 8 to 15 percent below where they would have been in the absence of competition and incentive regulations. The price changes would vary from region to region, and some regions could even see price increases.
Under conditions of intense competition, where many producers have access to customers and engage in price cutting strategies to win market share, prices could fall by as much as 24 percent instead of the 8 to 15 percent cited above. However, a price decline of this magnitude will not be achieved unless utilities are able to reduce their costs substantially from current levels and maintain those cost reductions.
Uneconomic costs, also called “stranded costs,” are costs incurred under regulation that cannot be recovered through lower competitive prices. Such costs include investments in expensive generating plants and high-cost contracts for fuel and wholesale electric power. Unless policymakers mandate stranded cost recovery through regulatory means, U.S. suppliers could experience a total reduction in market value (stranded assets) of as much as $72 to $169 billion, and there could be a number of bankruptcies. Over the 2-year period from January 1, 1998, to January 1, 2000, the stranded assets faced by utilities could be reduced by as much as $30 or $40 billion as utility customers pay down uneconomic costs through regulated electricity prices.
In the intense competition case cited above, severe stranded costs could erode the entire $400 billion book value of the industry in the absence of successful costcutting measures. However, price decreases of this magnitude would likely be accompanied by intensive cost cutting and efficiency improvements, which could reduce a significant portion of the $25 to $30 billion that electricity suppliers incur each year in nonfuel, non-capital-related costs. These estimates of stranded costs are net of any benefits accruing to low-cost suppliers; if such benefits are excluded from the calculation, the stranded costs for high-cost suppliers could be as much as 20 percent higher than those stated above
If policymakers mandate full recovery of stranded costs, there will be little difference between competitive and regulated prices in the short term, and little change in tax revenues (although there could be substantial benefits over the longer term). If policymakers do not mandate any stranded cost recovery, Federal tax revenues from utilities could be reduced by $2.5 billion per year on average under the assumptions of the most likely range of cases in this report. (At the same time, Government expenditures on electricity would fall, and there could be macroeconomic effects resulting from lower electricity prices—both of which would at least partially offset some of the reduction in Federal tax revenues.) Most restructuring plans to date at the State and Federal levels allow for at least some recovery of stranded costs through prices
Most analysts and policymakers believe that the benefits from competition in the long run will result from efficiency gains and cost reductions due to competitive pressures. That is, over the longer term, with efficiency improvements under competition and the absence of further uneconomic costs under regulation, electricity prices will fall relative to where they would have been under regulation. This analysis does not assess the extent to which competitive pressures could reduce costs and prices over the long term, but a sensitivity analysis examines the effects of greater efficiency improvements