Vertical disintegration for electric utilities: A half-serious proposal

At Utility Dive Ari Peskoe tries answering the question, “Can FERC convince utilities to build modern transmission systems?” Peskoe directs Harvard Law School’s Electricity Law Initiative. The summary up front succinctly states the problem.

For FERC’s rules to be successful, they must overcome utility incentives to overlook cost-saving technologies, prioritize local projects over regional investments, and thwart development of projects that might threaten their generation interests.

Notice that the incentive problem is inherent to the nature of vertically-integrated electric utilities. If a company owns transmission assets and generation assets in the same region, then decisions about transmission assets affect payoffs expected by generation assets. Similarly, decisions about generation assets affect payoffs expected from transmission.

A company board and management cannot be made to be ignorant of the interactions. The board and management of vertically integrated utilities have inherent incentives to invest in transmission assets in ways that do not detract from the value of their generation assets. No code of conduct erases the incentives. Executives may be prohibited from stating the obvious, but they cannot be prohibited from thinking the obvious.

Peskoe said, “Rather than expanding transmission to increase interconnectedness, utilities have recently been mired in small-scale projects that often simply rebuild last century’s grid.”

Not too surprising, right?

The grid built up last century primarily served to connect a monopolist’s generation to the monopolist’s locked-in customer base. That grid and the companies generation fleet were developed together in ways that made sense to utility shareholders last century. That grid enhances the value of old generation assets to utility shareholders even while it may reduce the overall value of the grid to society.

One possible fix is an old idea that was mostly ignored in the US: the transco.

The federal government should prohibit ownership ties between transmission and generation. (Ownership ties between transmission/distribution and retailing are also suspect, but that is less of a federal issue.) Spin off all transmission in an RTO to a single transmission owner with no financial ties to generation or retailing companies. That transco would remain a FERC-regulated public utility. Competition among generation is heightened when the bias created by vertical integration is removed.

So, half seriously, I’m proposing a ban on vertical integration in the electric power industry.

Only half seriously because it would be a fairly heavy handed regulation. Vertical integration often provides economies that dis-integration would eliminate. But here it seems that vertical integration of transmission and generation assets is driving anti-competitive behavior that itself has high costs. Two decades ago FERC and most utilities involved in the formation dismissed the transco idea. Might have been a mistake, as two decades of FERC frustration around transmission investment suggests.

Virtical disintegration. It’s a half serious proposal that requires serious consideration.