Legislation altering the pricing structure of electricity took effect in Illinois on August 28, creating an uncertain future for electricity prices in the state. My take as an energy economist on this agreement between electric utilities and the political establishment is that wholesale prices of power will still return to something close to market levels, albeit not until 2009.
‘Just and Reasonable’ Past
A decade ago the Illinois Commerce Commission established a set of electricity prices that was deemed “just and reasonable.”
At the time, the state legislature, with the endorsement of the Commonwealth Edison electricity company and the Citizens Utility Board, rolled back those rates 20 percent in exchange for allowing the wholesale price of power to go to market levels at the end of 10 years. This was an alternative to the system of setting rates based on historic cost.
We are now at the end of the decade, and wholesale electricity prices have returned to the “just and reasonable” levels that prevailed before the deregulation process began. However, the state’s political establishment wants to give residential consumers a discount from market rates.
New Pricing Structure
The state’s politicians have strong-armed electricity suppliers Ameren and ComEd into giving refunds and drawing out the return to market rates. The legislation that came into force on August 28, 2007 also eliminated the reverse auction of power and created a new Illinois Power Agency to take over the buying of electricity from generators.
It is conceivable that a single government purchasing agency might exercise monopoly power. However, experience with a similar agency in California after the power market was reregulated there in 2001 indicates such an institution might very well lock in prices that are above market levels.
Moreover, generators in Illinois will no longer be locked into the Illinois market. If in-state generators do not receive near-market prices, they will be led to sell power to neighboring states where market prices prevail.
Increased Investment Incentives
The substance of the change will be about the same under either regime. Namely, the prices paid to generators will be influenced by market forces rather than by historic cost as they were under regulation. This in turn means increased value of electricity from coal-generating plants and, more importantly, power from nuclear plants operated by Exelon, the unregulated corporate parent of ComEd.
While this means somewhat higher prices to residential consumers, it will also create investment incentives to build new plants and expand old ones, which will moderate rate increases in the future.
The regime of rates determined by historic costs worked tolerably in the period of stable energy prices. Cost-plus regulation served to create an extra margin of generation (and distribution) that came in handy when there was a surge in demand or a power plant had to be shut down for maintenance or for other reasons. Since generation and distribution were vertically integrated within the same corporate structure, a surge could be handled at either stage of production.
The point here is that vertical integration is a hedge.
The effect of this new regime on the distribution and transmission grids is not so clear. As time goes on, power will increasingly flow across state lines. That means transmission lines under the regulation of the Federal Energy Regulatory Commission will require expansion and improved maintenance to meet the new demands, including surges.
It is not certain that regional service organizations, which manage the grid but don’t own it, will be able to coax the proper investment from the incumbent utilities.
The generators and their large industrial customers that will make up the new interstate market ought to supply the capital for the enhanced grid. These are not necessarily the present grid owners. Unless the transmission grids are reorganized into joint ventures, like interstate oil pipelines and intrastate gas pipelines in Texas, the quality of the grid will deteriorate over time.
A grid that is not a joint venture by users will also be vulnerable to the gaming of capacity reservations like what happened during the California electricity crisis.
James L. Johnston ([email protected]) is an economist retired from Amoco Corporation and a policy advisor to The Heartland Institute.