ELECTRIC DEREGULATION CAN SUCCEED - IF IT FOLLOWS MARKET RULES

FAYETTEVILLE, Ark. - Electric utility deregulation has been a disaster in California because the new rules imposed by legislators violate the basic supply and demand tenets of the free market, according to University of Arkansas researcher Tomas Jandik.

Jandik’s study of the diversification of electric utilities, co-authored with Anil Makhija of Ohio State University, appears in the current issue of the National Regulatory Research Institute Quarterly Bulletin.

"California’s problems are caused by unusually structured deregulation," explained Jandik , assistant professor of finance. "The utilities in California still have very limited opportunities to rely on free market forces. For example, electricity prices are allowed to move in the wholesale market, but the utility distributors are still subject to relatively strict price controls when they sell to the consumer."

In fact, Jandik does not believe that the California situation actually qualifies as deregulation. "The new California laws should have been referred to as 'restructuring’ instead of 'deregulation.’ Sadly, because of the subsequent events that have led to blackouts and bankruptcy in the utilities industry, the whole process of deregulation got an undeserved bad reputation," said Jandik.

Requiring utility distributors to buy all of their power from generators in one centralized market also weakens the power of competition in California. Prohibiting outside contracts puts the distributors in an extremely disadvantageous position, according to Jandik.

"Not only are the distributors forced to absorb all of the price shocks from the wholesale markets without the opportunity to pass them on to customers, but they are not allowed to hedge against adverse price movements," Jandik explained.

Worst of all, new laws forced power distributors to divest their power generating facilities. According to Jandik, "if the goal is to become more competitive, it is not necessary to force divestment of generation facilities."

An integrated company, which both produces and sells power, can spread costs more easily and foresee demand, according to Jandik. It has the resources to do market research and the incentive to meet demand. Without both components, supply and demand communication breaks down.

In fact, Jandik believes that it was counter-productive. By separating supply from demand, the legislature created a communication gap that prevented the market from being fully informed.

"Companies that just generate electricity have no incentive to build new facilities," Jandik explained. "It will cost them money to build the facilities, and then their profits will fall as more power becomes available and prices drop."

However Jandik’s research indicates that, if done correctly, deregulation actually can benefit both utility companies and the general public. By examining the history of electric utility regulation he found that previous regulatory policies have actually created the very situation they were designed to prevent.

When Congress passed the Public Utility Holding Company Act (PUHCA) in 1935, it intended to prevent electric utilities from diversifying into non-utility industries and passing along costs and losses to utility customers. Because the utilities were regulated monopolies, their profits were easy to attack and regulations made it difficult to return money to the shareholders.

"With all of the explicit and implicit restrictions on dividend payments, utilities reinvested, perhaps even over-invested in the company," Jandik explained. "By the 1980s there was plenty of power."

Companies at peak generation, with demand under control, sought new ways to invest to add value to the company. Many electric utilities sought, and were granted, permission to diversify. By 1992, 54 percent of public utilities had diversified into non-electric divisions. In 1992 the Energy Policies Act further eroded PUHCA and granted utilities many avenues to enter competitive business.

States still had regulatory control, but implementation varied widely. Exempt holding companies invested in areas ranging from venture capital and savings and loan associations to leasing satellites and airplanes.

"This is in absolute contrast to the trend pursued by most other industries, where focused firms are stronger," said Jandik. "Diversification from the core industry is usually considered bad. Rather than creating value, it results in a drop in value. To put it simply, every new division may add further distraction for managers in company headquarters."

Jandik found that diversified utilities "may have actually created value, opposite to substantial losses associated with diversification of other, non-utility firms." He found that diversified firms made smaller investments in their electrical divisions and showed higher returns on assets than single-segment firms.

However, Jandik also fount that, contrary to the intent of PUHCA, these firms were passing along losses from non-utility divisions to the utility division. "Our findings suggest that despite attempts by regulators to erect 'Chinese walls,’ cross-subsidization was not eliminated and utilities were at least partially successful in shifting costs and risks from non-utility divisions on to the regulated electricity business," he added.

Since regulators generally allow utilities to set higher prices if the process of electricity generation is costlier and riskier, it could have been the customer who paid higher prices and picked up the tab for past diversification efforts of utility companies. Jandik concludes that "ultimately it is questionable whether the process of diversification actually benefited the general public."

Jandik thinks that after deregulation, utilities will begin to behave more like regular industries, because they will no longer have a reason to diversify into non-utility areas.

"Under regulation, diversification was just a convenient way to 'park’ the abundant profits that, on average, utilities created. It is better to put your money into anything rather than to signal to regulators that you may have too much money and risk rate cuts," Jandik added. "With deregulation, utilities will behave more like regular companies. Their profits being determined by the free market, utilities will have no reasons to spend money to buy new businesses 'just to invest.’ Diversification should be more meaningful and actually create value."