oEPA
United States
Environmental
Aoencv
ction
Municipal Environmental Research
Laboratory
iH 45268
Research and Development
Treated Water
Demand and the
Economics of
Regionalization
Volume 2
Economics of
Regionalization:
The Electric
Power Example
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RESEARCH REPORTING SERIES
Research reports of the Office of Research and Development, U.S. Environmental
Protection Agency, have been grouped into nine series. These nine'broad cate-
gories were established to facilitate further development and application of en-
vironmental technology. Elimination of traditional grouping was consciously
planned to foster technology transfer and a maximum interface in related fields.
The nine sertes are:
1 Environmental Health Effects Research
2. Environmental Protection Technology
3. Ecological Research
4 Environmental Monitoring
5. Socioeconomic Environmental Studies
6. Scientific and Technical Assessment Reports (STAR)
7 Interagency Energy-Environment Research and Development
8. "Special" Reports
9. Miscellaneous Reports
This report has been assigned to the ENVIRONMENTAL PROTECTION TECH-
NOLOGY series. This series describes research performed to develop and dem-
onstrate instrumentation, equipment, and methodology to repair or prevent en-
vironmental degradation from point and non-point sources of pollution. This work
provides the new or improved technology required for the control and treatment
of pollution-sources to meet environmental quality standards.
This document is available to the public through the National Technical Informa-
tion Service, Springfield, Virginia 22161.
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EPA-600/2-80-163
August 1980
TREATED WATER DEMAND AND THE
ECONOMICS OF REGIONALIZATION
Volume 2. Economics of Regionalization:
The Electric Power Example
by
Donald L. Hooks
University of Alabama
University, Alabama 35486
Grant No. R805617
Project Officer
Robert M. Clark
Drinking Water Research Division
Municipal Environmental Research Laboratory
Cincinnati, Ohio 45268
MUNICIPAL ENVIRONMENTAL RESEARCH LABORATORY
OFFICE OF RESEARCH AND DEVELOPMENT
U.S. ENVIRONMENTAL PROTECTION AGENCY
CINCINNATI, OHIO 45268
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DISCLAIMER
This report has been reviewed by the Municipal Environmental Research
Laboratory, U.S. Environmental Protection Agency, and approved for publica-
tion. Approval does not signify that the contents necessarily reflect the
views and policies of the U.S. Environmental Protection Agency, nor does
mention of trade names or commercial products constitute endorsement or
recommendation for use.
ii
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FOREWORD
The U.S. Environmental Protection Agency was created because of
increasing public and government concern about the dangers of pollution to
the health and welfare of the American people. Noxious air, foul water,
and spoiled land are tragic testimonies to the deterioration of our natural
environment. The complexity of that environment and the interplay of its
components require a concentrated and integrated attack on the problem.
Research and development is that necessary first step in problem
solution; it involves defining the problem, measuring its impact, and
searching for solutions. The Municipal Environmental Research Laboratory
develops new and improved ^technology and systems to prevent, treat, and
manage wastewater and solid and hazardous waste pollutant discharges from
municipal and community sources, to preserve and treat public drinking
water supplies, and to minimize the adverse economic, social, health, and
aesthetic effects of pollution. This publication is one of the products of
that research and provides a most vital communications link between the
researcher and the user community.
This report presents a data base and methodology for estimating the
determinants of residential demands for treated water.
Suggestions are also made regarding methodologies useful for future
research into the nature of water system costs by drawing upon the literature
on the electric power industry.
Francis T. Mayo, Director
Municipal Environmental
Research Laboratory
iii
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ABSTRACT
This two-volume report examines the present and future demands and costs
for residential water in view of the new requirements for water quality
standards under the Safe Drinking Water Act of 1974 (PL 92-523). Volume 1
investigates the determinants of residential water demand (including water
price, family income, and appliance ownership) and develops a methodology by
which utilties can determine future customer demand. A data base has been
developed, and results of the analysis are given. These data can be used to
test many hypotheses other than those examined in this study, and they could
be a valuable tool for further research into the household demand for water.
Methods are discussed sufficiently to provide a point of departure for water
utilities that may wish to analyze their own demand.
Volume 2 investigates consolidation in the electric power supply industry
as an example of a possible method for offsetting the increased costs of water
treatment that will be incurred under the new Federal regulations. The
structure of the power industry is examined and the history, advantages, and
cost benefits of coordination are evaluated. Several alternatives to the
present system are considered, including consolidation of existing systems,
encouragement of competitive markets, and public ownership of generation and
transmission facilities.
This report was submitted in fulfillment of Contract No. R805617-01-1 by
The University of Alabama under the sponsorship of the U.S. Environmental
Protection Agency. The report covers the period 4-1-78 to 12-31-79 and work
was completed as of 12-31-79.
iv
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CONTENTS
Foreword ill
Abstract iv
Figures vi
Tables vii
1. Introduction 1
2. Conclusions and Recommendations 3
3. Implications of the Power Industry Experience for
the Water Supply Industry 6
4. Evolution of the Electric Power Industry Structure 8
5. Coordination of Electric Power Supply: History, Advantages,
and Cost Benefits 16
6. Evaluation of Existing Coordination 21
7. Alternatives to the Present System 28
References 42
Appendix
Summary of Methodologies Used in Econometric Studies of Electric
Power Supply 47
Glossary 51
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FIGURES
Number Page
1 Economies of scale in the electric power industry, 1970 22
2 Suggested optimum system size as a result of scale economies . . 30
3 Alternative estimates of optimum system size by Huettner and
Landon (1978) and by Christensen and Greene (1976) 31
4 Cost reductions resulting from scale economies and technical
changes, 1955-70 32
5 The natural monopoly case 38
vi
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TABLES
Number Page
1 Number and Type of Electric Systems for Selected Years
From 1902 to 1932 9
2 Newly Incorporated Holding Companies 10
3 Market Shares of Electric Utilities, 1930 11
4 Number of Electric Supply Systems, 1937-65 14
5 Potential Cost Savings as a Result of Coordination, 1962-80 ... 19
vii
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SECTION 1
INTRODUCTION
The Safe Drinking Water Act of 1974 (Public Law 93-523), which requires
the U.S. Environmental Protection Agency (EPA) and State agencies to develop
and enforce water quality standards, will have a significant impact on the
cost of supplying treated water. One of the consequences of the Act has
been an emphasis on the possible benefits of consolidating water suppliers
into regional systems to offset some of the increased costs through scale
economies and other gains in economic efficiency. This volume investigates
consolidation in the electric power supply industry as an example of a
possible method for offsetting these new costs of water treatment. The
structure of the power industry is examined along with the history, potential
advantages, and costs and benefits of coordination. Alternatives to the
present power system are also considered.
PRESENT STATE OF THE WATER SUPPLY INDUSTRY
A recent study of treated water supplies in northeastern New Jersey
(Greenberg and Hordon, 1976) concluded that a century of evolution in this
field had resulted in many separate systems characterized by lack of long-
range planning, piecemeal and inequitable arrangements for solving local
differences in supply and demand, incomplete projects, and the need for
State intervention during emergencies to break institutional logjams. To
overcome this situation, Greenberg and Hordon proposed regional management
of the water systems. The potential for regional consolidation appears to
be great if we consider only the community public water systems (those
serving at least 15 permanent users or 25 nonresident users). More than
40,000 such systems are in existence, and more than 90 percent of them have
fewer than 10,000 customers (Clark and Stevie, 1978).
THE QUESTION OF MUNICIPAL CONTROL
Historically, treated water has been provided by municipal governments
in the United States. Clemens (1950) has suggested the following reasons for
this arrangement:
1. Water treatment and supply is a relatively simple operation
that can easily be carried out on a small scale.
2. Over the years, few changes have occurred in water treatment
technology to make the process more difficult or expensive
to provide on a local level.
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3. Treated water can be supplied by municipalities as a joint
service with fire protection.
4. Treated water supply involves the public health, and as
such it is generally viewed as the function of government.
5. Significant scale economies are lacking at the local level.
6. The private sector has failed to enter the market in many
cases.
To these arguments can be added the political and equity considerations often
used to explain public ownership and regulation of certain economic
activities.
Although these arguments may have helped to explain the history of
municipal water systems, it is not at all obvious that all of them hold
today. Increasing water quality standards and the investments in the
sophisticated technology that may be required to meet them certainly will
continue to modify the first two considerations. Furthermore, although it
may be generally accepted that public health is a proper function of govern-
ment, it does not necessarily follow that public provision of treated water
is the only way to enforce health standards. The regulation of private
suppliers (and those who produce their own water) is certainly a viable
alternative. (See Cowing and Holtman (1976) for a discussion of this
possibility in the context of solid waste collection.)
Factors 5 and 6 may be related in that private investors may not have
entered small markets because the system size would not have been economi-
cally efficient. But whether or not this was true in the past, the question
of optimal system size is relevant to the development of public policies
regarding the future of treated water supply systems.
POTENTIAL ADVANTAGES OF REGIONAL CONTROL
The potential advantages of large regional systems appear to result
from economies of scale and size that can partially offset rising consumer
costs with the declining unit costs that occur as system size increases
(Clark and Stevie, 1978). Another benefit of consolidation would be to
regulatory agencies, who would have fewer systems to monitor (as of 1975, an
estimated 240,000 public water systems existed in the United States) (Clark
and Stevie, 1978).
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SECTION 2
CONCLUSIONS AND RECOMMENDATIONS
The electric power industry has attained a high degree of interconnec-
tion and significant levels of coordination and/or consolidation on a
regional basis; yet the extent of coordination and consolidation has not
been as great as had earlier been predicted and advocated on grounds of
economic efficiency. The little evidence available to date indicates that
few economic benefits have actually been realized from coordination. More-
over, recent studies suggest that some power systems or functions—distribu-
tion, for example—are larger than the optimum size.
Because treated water and electric power systems appear to be closely
analogous, the evolution of the structure of the latter should provide
some guidance for the future development of water systems. This use of the
power industry case as a model should include more than just a recognition
of the potential benefits of scale economies and operating efficiencies that
can be achieved through consolidation and/or close coordination; it should
also provide examples of the costs that'can offset the benefits in many
cases. Perhaps more important, however, the studies cited in this report
demonstrate a methodology that is suitable for determining the optimum
organizational structure and size of treated water systems. The historical
cost data for existing water systems, under development by the EPA, should
provide a valuable base for testing hypotheses regarding the extent of
scale economies, optimum system size, organizational structure, public/pri-
vate ownership issues, and regionalization, as has been done in the power
industry.
Following Cowing and Smith (1978), particular attention should be
given to the following in making such determinations: (1) the level of
aggregation (unit, plant, firm, system, etc.), (2) ex ante versus ex post
modeling, (3) the behavioral objectives of the organization (i.e., do
managers attempt to minimize costs?), and (4) the costs of presumably
separable functions such as acquisition, treatment, transmission, and
distribution. Selecting the appropriate unit for observation is important
because of the possibility that inputs and outputs are not the same across
all units at the microeconomic level. Moreover, both technical and
behavioral characteristics will be reflected in the data, and these may vary
with the level of aggregation. Care must also be taken with behavioral
assumptions to avoid possible distortions and biases caused by regulation
itself. Thus estimates of cost and other functions derived from particular
assumptions about behavior allow more hypothesis testing and more confidence
in the results.
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Ex ante studies (which refers to estimates of cost behavior based on the
potential cost relationships dictated by the technology or production process
being used) are useful in the development of policy. These include simula-
tion studies of feasible alternatives (such as the one presented in Greenberg
and Hordon (1976))and the estimation of engineering or process production and
cost functions as exemplified by the work of Griffin (1972, 1977), Kirchmayer
(1955), Marsden et al. (1972), and Smith (1961). Perhaps more important,
however, are ex_ post studies using historical data to determine how costs
actually behaved with a given technology. Such studies are essential even
if the ex ante work was predicated upon efficient cost behavior. The ex post
studies should also attempt to examine alternative organizational forms,
system sizes, and other factors that could help determine costs. In addition,
the ex post approach is useful in comparing the optimum ex ante system with
what actually transpired, as in the electric power case, in which the extent
of actual voluntary coordination among independent systems and realized cost
savings appear to have been much less than anticipated, given the early
engineering-based estimates.
Only about 42 percent of the community water systems are privately
owned, and they supply only 12 percent of the treated water in the United
States. These figures suggest that the greatest potential gains from consol-
idation would be among private systems and/or between publicly owned and
private utilities. Although a partial explanation for the existence of many
small, systems could be the actual lack of scale and other economies usually
associated with large systems, their development may also be due to public
versus private ownership issues and the use of political boundaries to
define service areas. If greater regionalization is warranted on a cost
basis, the question of ownership may still have a bearing on the total
gains in economic efficiency that can be realized. A regulated, private,
regional utility that serves many government units could be a viable
alternative to a large public water system.
Finally, alternative ways to capture the potential economies of
regionalization may also be viable. These include pooling and/or coordina-
tion to the degree that the cost savings warrant, up to and including large
systems under common ownership. Moreover, it might be found that a small
number of large, integrated systems is not the best solution if the treatment,
acquisition, transportation, and distribution functions of treated water
systems all exhibit different cost behavior with respect to size. For
example, treatment and acquisition may show scale economies, but distribution
may not (see Clark and Stevie, 1978, pp. 48-53, on this point). Such results
would support the separation of some functions and the encouragement of
alternative market structures (see Section 7).
In conclusion, calls for the regionalization of treated water supply
systems such as those made by Greenberg and Hordon (1976) should first be
answered by studies to determine the optimum size for a system and the
extent to which vertical integration, horizontal integration or consolidation,
and coordination or pooling appear to be efficient. Recent literature sug-
gests that some electric power supply systems are already too large. Thus
it would be prudent to examine the present structure and performance of
treated water supply systems and to evaluate the alternatives before a policy
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is established on the presumption that greater centralization and consolida-
tion is the best course of action. The appendix to this report, which
summarizes several of the methodologies that have been used in many of the
econometric studies of electric power supply cited in the text, outlines
ways in which studies of treated water systems could be conducted to provide
policy and rulemaking guides.
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SECTION 3
IMPLICATIONS OF THE POWER INDUSTRY EXPERIENCE FOR THE WATER SUPPLY INDUSTRY
INTRODUCTION
The extent to which consolidation of the water supply industry should be
carried out depends partly on the determination of optimum size for a treated
water system. Few data are available on this point for the water supply in-
dustry, but they are available for the electric power industry. The economic
structure of the power industry has been studied in great detail over the
past 30 years, and arguments for regional coordination can be found in pre-
vious studies (U.S. Federal Power Commission, 1964). In addition, many
similarities exist between the two industries, so that a study of one may
provide valuable insights into the other. Specifically, a survey and eval-
uation of studies done on the power industry may provide important data on
the feasibility of greater consolidation and coordination of water supply
systems. Moreover, an analysis of the factors that led to changes in the
structure of the power industry over time may help put the regionalization
issue into historical perspective.
COMPARISON OF THE WATER AND POWER SUPPLY INDUSTRIES
Most of the characteristics of water supply systems appear to be very
similar to those of electric power systems, especially with regard to distri-
bution. The many close analogies between the two systems have been noted by
Vennard (1970) , and they appear to be close enough so that most of the argu-
ments regarding electric power consolidation, optimum system size, coordina-
tion, and form of ownership should be applicable to treated water systems.
In addition to the distribution functions, electric power transmission
is the counterpart to water transport, and the power generation function is
the counterpart to water acquisition, storage, and treatment. The use of
transformers to change voltage serves a function similar to the use of pumps
to maintain water pressure during transport and distribution. Both have pro-
blems of efficiency such as line loss (heat) for electricity and friction in
the case of water pipes. Maintenance of water quality may require filtering
and treatment, which is analogous to maintenance of a constant voltage with-
out interruption. Both types of systems are referred to as infrastructure,
which implies a network of fixed facilities (lines, pipes, reservoirs, etc.);
thus, fixed costs usually loom large in relation to variable, or operating,
costs and additional capacity usually involves long lead times, siting pro-
blems, and the need for public condemnation and other legal action to obtain
rights-of-way. Finally, hourly and seasonal variations in demand often pose
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significant problems of excess capacity, which emphasizes the need to manage
load factors (the ratio of actual usage in a given time period to total capa-
city of the system measured in kilowatt hours of electricity and gallons (or
cubic feet) of water.
There are some basic differences between the two systems; however, these
appear to be only a question of degree. A predominance of underground struc-
tures distinguishes water systems to some extent, but underground power lines
may be a growing trend. Power supply involves some problems that are pecu-
liar to the nature of alternating current generation and transmission. These
include the need to maintain synchronization among multiple generating units
and a balance between the load, or demand, and the energy being supplied by
the generator; moreover, system failures can induce a cascading effect of
power surges throughout the system. This necessitates elaborate mechanisms
and procedures to quickly remove generators from service and to isolate the
failed equipment or even portions of the system. Perhaps the greatest dif-
ference is the fact that treated water can be stored and electric power can-
not, given present technology.
Despite these possible differences between the system types, the
similarities suggest that the potential benefits and costs of regional con-
solidation in alternative forms may apply to water systems as well as to the
electric power industry. Economies of size and/or scale may result in de-
clining unit costs to at least partially offset other forces that may tend to
increase costs, such as mandated higher water quality standards.
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SECTION 4
EVOLUTION OF THE ELECTRIC POWER INDUSTRY STRUCTURE
The early evolution of the power industry's structure has been due
largely to advances in the technology of generation and transmission of elec-
tric power, which led to a rapid change from small plants with limited ser-
vice areas and relative cost inefficiencies to systems that could serve even
the largest cities. Thus, many of the original firms were absorbed into the
larger systems made possible by technological change. As Kahn (1971)
observed, technology has no respect for the ownership patterns that happen
to prevail in industry.
In addition to this technological imperative, however, purely financial
considerations began to explain the industry's structure by the 1920's.
Moreover, broader economic and political considerations appear to have placed
some restraints on the industry's responses to technological change.
ORIGINAL FORM OF THE INDUSTRY
The electric power industry began with Thomas Edison's Pearl Street
Station in New York City in 1882. The available technology of a recipro-
cating steam engine and the generation of direct current (DC) limited these
first markets to areas measured in city blocks, with transmission lines less
than a mile long because of power losses during transmission. The 560 kilo-
watt plant served 500 customers using more than 10,000 of Edison's incandes-
cent lamps. Earlier central stations at Cornell University (1875) and in
San Francisco (1879) provided electricity for arc lamps (Phillips, 1969).
In addition to the small firm size dictated by the technology, the
little regulation that existed took the form of city franchises that were
either granted to more than one firm as a deliberate competitive policy or
simply served as a general franchise to all applicants (Hellman, 1972).
Thus by 1905, Chicago had 29 firms in operation and surrounding cities
were served by 18 more utilities. The experience in other cities was similar
during this early period, with six firms in Salt Lake City, five in St. Louis
and Duluth, and six in New York City (Hellman, 1972). Overall, the existence
of as many as 28,000 private and 800 municipal systems serving primarily
urban markets by 1902 (see Table 1) strongly suggests that workable compe-
tition prevailed in many markets during these early years (Hellman, 1972, and
Newberg, 1976).
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TABLE 1. NUMBER AND TYPE OF ELECTRIC SYSTEMS FOR SELECTED
YEARS FROM 1902 TO 1932*
Number of systems
Year
Private Municipal Other public
1902 2805 815
1912 3659 1562
1922 3774 2581
1932 1627 1799
*Source: Phillips, 1969, pp. 544-45.
EARLY CONSOLIDATIONS
At least two technological innovations began to change the industry
structure before the turn of the century: . The transformer in 1886, and the
steam turbine generator in 1898. The transformer led to the shift away from
DC current, which had been pioneered by and favored by the Edison companies,
to the generation of alternating current (AC). This was particularly im-
portant because it allowed for more economical generation of current at low
voltages, which was then stepped up by the transformer to high voltages for
transmission to the customer, where it was stepped down to the lower voltages
required by the user. High voltage transmission meant lower line losses and
larger market areas that could be economically served by a single firm. DC
could not be stepped up in the same way (Phillips, 1969). AC is not without
its disadvantages, however, including instability under power surges, sus-
ceptibility to cascading blackouts when failure occurs in the system, and
its requirements for larger conductors, more insulation, and wider rights-of-
way for transmission lines. It is now feasible to convert AC to DC after it
is stepped up for transmission, and then to revert to AC before stepping down
the current. High voltage DC lines appear to be economical for above-ground
distances of over 500 miles and underground distances of 40 to 65 miles for
up to 600 kilovolts (kV) (Hingorani, 1978). These facts have implications
for system reliability and the coordination issues to be discussed in the
next section.
Advantages began to accrue to larger firms as smaller firms failed or
merged because of their inability to obtain adequate financing for expansion
and/or losses caused by destructive competition among rival firms. The term
"destructive competition" here refers to industries characterized by high
fixed costs, long periods of excess capacity, and inelastic or unresponsive
supply. When such conditions are extreme, most if not all firms face the
prospect of economic losses for prolonged periods unless they exit or merge.
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See Kahn (1971) for further discussion of cases of excessive competition in
the face of scale economies.
The following examples suggest the rapidity of the consolidation move-
ment: By 1897, 23 formerly independent firms had disappeared due to mergers
with surviving systems in Chicago; Detroit had only one supplier by 1900; and
98 percent of the New York City market was served by one firm in 1907
(Hellman, 1972).
Although increasing economies of scale relative to the size of the
market and financing constraints help to explain this early period of hori-
zontal integration (merger of electricity suppliers in the same market) other
economic incentives led to broader forms of consolidation, as the following
discussion from Clemens (1950) indicates. Many generating firms were ac-
quired by their suppliers of equipment or services. At first, equipment
manufacturers may have purchased the stock of electric companies as a means
of financing sales of generating equipment, but the advantages of vertical
integration soon became obvious when markets could be assured and prices made
certain through ownership and control of a firm's customers. By 1905, The
General Electric Company had taken the securities of enough generating com-
panies in payment for equipment to warrant formation of the Electric Bond and
Share Company to hold the operating company shares. Similar acquisitions
were made by companies selling management services, resulting in such con-
solidated systems as the Standard Gas and Electric Company, General Gas and
Electric, and Associated Gas and Electric. As in the case of the equipment
companies, this acquisition movement itself became competitive as the ser-
vice companies sought to prevent the loss of their customers to other systems.
This emerging holding company movement took on its classical form—the
creation of corporations to hold the equity (common stock) shares of other
firms—when the financial investment motive began to predominate after World
War I. Table 2 summarizes the early record of holding company growth. In
addition to the potential operating economies from horizontal and vertical
TABLE 2. NEWLY INCORPORATED HOLDING COMPANIES*
Period Number
Before 1900 5
1900-1909 11
1910-1919 7
1920-1929 46
1930 2
*Source: Clemens, 1950, p. 491.
10
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integration cited earlier, the incentives to form holding companies included
the introduction of better and more aggressive management, better access to
financial markets, risk reduction through geographic and/or product diversi-
fication (e.g., electricity, gas, and fuel oil suppliers), financial leverage,
and avoidance of legal restrictions that were specific to certain States or
industries.
The major criticism of the holding company in the 1920's emphasized the
financial incentive that had the potential for abuse through the pyramiding
of ownership by means of multiple layers of so-called paper corporations and
widespread speculative acquisition without regard for the physical integra-
tion of the system or for the potential instability of the resulting finan-
cial structure. Other public policy concerns included the potential for the
exercise of monopoly power in local markets and the concentration of broader
economic and political power at the national level. The latter problem is
suggested by the evidence in Table 3, where it can be seen that only 19 com-
panies accounted for 77 percent of U.S. power sales in 1930. The sheer size
of these firms led to fears of undue political influence at the State and
national levels.
STATE REGULATION ^
The first State regulatory agency, the Massachusetts Board of Gas
Commissioners, which was created in 1885 and was given jurisdiction over
electric companies two years later (Clemens, 1950) was created in response
to the power industry's request for the limitation of excessive competition
(which provides additional evidence that many markets were competitive during
the first two decades of the electric power industry). By 1907, however,
TABLE 3. MARKET SHARES OF ELECTRIC UTILITIES. 1930*
Percentage of total
Utility sales in U.S.
Electric Bond & Share Co. 12.3
Insull Group 12.3
Other large holding company groups (17) 52.4
Largest independent companies (6) 11.1
Other holding companies, independents, and
municipal utilities
*Source: Clemens, 1950, p. 499.
11
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consolidation and the resulting increase in local market concentration had
prompted State investigations into market structure and the conduct of
individual companies. These investigations led to the creation of commis-
sions in New York, Wisconsin, and Georgia in that year to regulate electric
power companies.
Within five years, electric utility regulation by commission had spread
to 25 other states. In most cases, it was a matter of extending the juris-
diction of previously created railroad commissioners (Clemens, 1950). Thus
continuous and direct regulation began to supplant the use of local fran-
chises that had relied on contractual obligations, to the extent that prices
and services were regulated at all.
PUBLIC OWNERSHIP
Public ownership, which also began in 1882 at the municipal level,
accounted for 22 percent of the suppliers but less than 0.5 percent of the
generating capacity and power production by 1902 (Phillips, 1969). As many
municipal plants originated in small communities not being served by private
firms, they do not appear to have had a significant regulatory influence on
electric power markets during that period. By 1907, however, the growing
concern over the actual and potential abuse of monopoly power led to consid-
eration of municipal ownership as an alternative to private monopoly, and
the numbers of publicly owned systems had more than tripled by 1912 (see
Table 1). Hellman (1972) notes that there is little evidence that the
economic concepts of efficiency and natural monopoly resulting from extreme
scale economies were part of the early discussions of public ownership,
although the Massachusetts commission did cite the role of the municipally
owned utility as an actual or potential competitor (Hellman, 1972). Some
examples did exist of successful duplication of service, in which private
firms survived and lower rates resulted (Hellman, 1972).
Table 1 indicates that consolidation activity and the attendant finan-
cial and economic forces also had an effect on independent municipal power
systems during the 1920's. Other forms of public power were negligible until
the late 1930's, and by that time, a resurgence of interest in municipal
ownership manifested itself in increases in the number of elections held on
the issue. Neither of these developments had the impact on the private sec-
tor that the general economic decline and subsequent Federal legislation did
during this period, however.
FEDERAL REGULATION
Earlier concern over pyramiding and other abuses of the holding company
organizational form was partially realized when more than 50 holding com-
panies, including some of the largest, with share par values of $1.7 billion,
failed and another 25 defaulted on interest payments during the first half of
the 1930's (Phillips, 1969). Congress responded with the Wheeler-Rayburn
Public Utility Act in 1935, which led to a restructuring of the industry and
an extension of Federal regulation. Title I of the act gave the newly
created Securities and Exchange Commission (SEC) greater jurisdiction over
utility holding companies, and Title II placed interstate transmission of
12
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electric power under the jurisdiction of the old Federal Power Commission
(FPC). This brought not only financial practices but also entry, rates, and
service under greater regulatory control, because State commissions had been
limited in their ability to deal with interstate transactions in general and
holding companies in particular.
Perhaps more important for the purposes of this report, however, this
legislation provided for the first Federal attempt to encourage a rational
economic structure for the power industry. This goal was implied by the
criteria to be used in dismantling the existing holding companies, as stated
in Section 11 (b) (1) of the Holding Company Act, in which the SEC was "to
limit the operations of [each] holding company system...to a single integra-
ted public utility system, and to such other businesses as are reasonably
incidental, or economically necessary or appropriate to the operations of
such integrated public utility system." (Other provisions included simplifi-
cation of corporate structure, stockholder rights and compensation, capital
structure, retention of non-electric businesses, and service company regula-
tion.) The emphasis in this Act was on the economic efficiency associated
with physical rather than merely financial integration of operating companies
horizontally and a recognition of the advantages of vertical integration.
The tests to be applied in the case of retention of isolated or nonintegrated
systems included: (a) Consideration of the economic viability of an inde-
pendent operation; (b) they must be located in the same or contiguous
States; and (c) consideration of possible impairment of efficient operation
and effective regulation. In general, gas systems could not be retained in
the same market unless it could be shown that such gas and electric combina-
tions produced substantial economies.
In its case by case examinations, the SEC interpreted integrated systems
as being those in which operations were actually coordinated and not merely
connected by transmission lines (Clemens, 1950). The potential benefits of
coordination will be discussed in the next section.
Of the 2,145 holding companies subject to SEC jurisdiction as defined
by the legislation, only 713 remained by 1948 after divestiture proceedings
(Clemens, 1950). Abolishment was automatic for all companies more than twice
removed from the operating subsidiaries (since many were literally paper
corporations), and the rest were subject to SEC scrutiny under the criteria
cited above. As Table 4 indicates, the declining number of independent pri-
vate firms resumed after this period, which suggests that mergers continued
to be approved even under the new rules affecting private firms, but the num-
ber of municipal systems remained relatively stable into the mid 1960fs.
COOPERATIVES AND FEDERAL PROJECTS
Other than the large multi-purpose Federal projects, the major event
during this period was the emergence of the cooperative power systems, which
were authorized by the 1936 Rural Electrification Act. Although their num-
ber stabilized after 1950, cooperatives seem to have had some pro-competitive
effects on electric rates and costs.
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TABLE 4. NUMBER OF ELECTRIC SUPPLY SYSTEMS. 1937-65*
Year Private Municipal Cooperative^
1937
1945
1950
1955
1960
1965
1407
1060
821
581
496
472
1877
2092
2077
1968
2026
2114
192
825
1054
1042
1072
986
*Source: Federal Power Commission.
^Cooperatives also include some special districts and State
projects, except for 1965, when these are included under municipal.
Hellman (1972) and Clemens (1950) have argued that although most
cooperatives purchased power for resale from private systems, they posed
the threat of potential competition by generating their own power or pur-
chasing from Federal projects. The merits of this argument will be discussed
later in more detail.
In a related policy measure, the Public Works Administration (1933)
allocated power from Federal projects to systems owned by State and local
governments, with about 30 percent of the allotments going to new or existing
municipal distribution systems that were in competition with private firms
(Hellman, 1972). The Tennessee Valley Authority (1933) and the New York '
Power Authority (1931) are other examples of government projects intended in
part to provide competition as well as cost, price, and service yardsticks
for private, regulated monopoly systems (Hellman, 1972).
THE ROLE OF SCALE ECONOMIES IN CONSOLIDATION
The multiple-tier holding company aside, it has generally been
accepted that the pattern of horizontal merger during the early period of the
industry can be attributed to the technological changes that gave rise to
increasing economies of scale relative to the size of the market. Small,
independent systems unwilling or unable to expand had merger as an alterna-
tive to failure, especially in the more competitive markets. The acquiring
system could take greater advantage of these economies by expanding capacity
at the same time its market expanded. However, scale economies are not
necessary to explain mergers that further enhance monopoly power in local
markets. Although the theory is sound, empirical evidence on the nature of
power industry costs for the United States was largely unavailable until the
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late 1930's. The first uniform data on power plant output, inputs, and costs
were not published by the Federal Power Commission until 1938, and few econo-
metric studies have examined the pre-World-War-II period. (It remains an
unfortunate irony that most uniform data required for research into industry
structure and performance have been byproducts of regulation; not only may
they have been collected for other purposes, but the regulation itself may
distort industry behavior and bias the findings.)
The fact that transmission of power as far as 25 miles was still con-
sidered exceptional in 1900 casts doubt on the significance of overall scale
economies in explaining the consolidation that took place in the early years;
moreover, a study of systems in England for 1928-47 reported that scale
economies were exhausted after relatively small plant sizes were attained
(Johnston, 1952). Still, studies of U.S. systems using data for years as
early as 1938 have found some evidence that significant scale economies
existed in the late 1930's and the 1940's (Komiya, 1962; Galatin, 1968;
Dhrymes and Kurtz, 1964). Similar results have been reported for the 1950's
and early 1960's, although the system size at which scale economies stop
increasing was not clearly determined. Some examples are, lulo (1961), Fuss
(1979), Nerlove (1965), Christensen and Green (1976), and Hughes (1971). By
the mid 1960's, several^related trends were evident, Horizontal merger
activity increased, with an average of 40 acquisitions per year of generally
small systems (less than 1000-MW capacity) during the decade (Breyer and
MacAvoy, 1974). At the same time, a number of voluntary formal and informal
intercompany power pools and coordination agreements developed within the
framework of a half dozen or so interconnected networks that allowed power
interchange among systems. The following section examines this development.
15
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SECTION 5
COORDINATION OF ELECTRIC POWER SUPPLY:
HISTORY, ADVANTAGES, AND COST BENEFITS
HISTORY OF COORDINATION
Voluntary interconnection and interchange of electric power had existed
long before the FPC involvement. Perhaps the earliest example of what is now
termed an interconnected grid was the Great Southern Grid, begun by the
Southern Power Company in 1905 to better serve the textile industry in the
Southeast. The grid had linked seven independent systems in four States by
1914 and allowed transfers of power between points as much as 1,000 miles
apart. By the late 1920's, interconnection was developing in the Northeast,
the Midwest, and in California (Electric Power Research Institute, 1979).
The creation of the TVA in the early 1930's marked a third major step in the
development of regional interconnection as part of a multipurpose project.
Although the potential for coordination existed once interconnection
had been accomplished, most of the early use of the grids was for the purpose
of evening out load diversity and for emergency access to power supply when
such disruptions as decreased hydroelectric generation during droughts
occurred. Vennard (1970) traces the beginnings of modern-day pooling to
World War II, when expansions in generating capacity were limited by the
diversion of resources to the war effort at the same time the defense
plants were demanding increasing electric power. For example, 12 companies
formed a pool to enable continued service to existing customers plus a new
factory complex in Arkansas (Vennard, 1970).
The industry's structure was relatively stable in the 1950's, with most
of the emphasis on coordination through pooling of reserve capacity and some
staggering of construction; during the next decade, however, the resurgence
of the consolidation movement resulted in more common ownership of capacity
and transmission lines (Hughes, 1971).
Section 202 (a) of the Federal Power Act of 1935 charged the Federal
Power Commission with promoting and encouraging voluntary interconnection and
coordination to assure an abundant supply of energy throughout the United
States with the greatest possible economy and with regard to the proper use
of resources. An outgrowth of that charge was the 1964 National Power Survey,
which developed an indicative plan intended to foster greater coordination
for meeting projected future power requirements. The United States was
divided by this survey into geographical areas at five levels ranging from
two zones to 48 power supply areas.
16
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Three interrelated concerns that prompted the survey and subsequent
studies and proposals were system reliability, operating economies with
existing capacity, and efficient additions to transmission and generating
capacity. It was generally accepted that greater coordination of operations
and investment planning in conjunction with planning at the national level by
the FPC could result in a more reliable and economical bulk power supply gen-
eration and transmission system. Furthermore, coordination could serve as an
alternative to the consolidation of inefficient smaller systems by merger.
The need for greater coordination was indicated by the 1964 survey, which
identified 3,190 small systems (less than 25 MW of electricity demanded at
their annual peak hour), only 899 of which had any generating capacity (U.S.
Federal Power Commission, 1970). By 1968, consolidation had reduced these
figures to 2,842 and 800, respectively; moreover, 243 of these small gener-
ating systems were isolated from large systems, which were defined as having
at least 500 MW of generating capacity (U.S. Federal Power Commission, 1970).
In addition to the higher costs of construction per kW and operation per kWh
attributed to systems of less than optimum size, the survey found that about
75 percent of the isolated systems had reserve generating capacity in excess
of 50 percent of their annual system peak loads (U.S. Federal Power Commis-
sion, 1970).
ADVANTAGES OF COORDINATION
The potential advantages of coordination include: (1) the attainment of
a system size large enough to justify installation of the optimum size gen-
erating plant; (2) the ability to stagger the timing of construction of
additions to capacity and the sharing of excess capacity; (3) the sharing of
reserve capacity, which otherwise should be at least equal to the capacity
of that of the largest plant in an individual system if service is not to be
interrupted by failure; (4) the sharing of risks and other costs of financing
system investment; (5) circumvention of the problem of a lack of suitable
sites for generating plants for environmental or other reasons; and (6) the
attainment of load balancing by internalizing demand diversity or differences
in seasonal peaks among systems in different regions (e.g., exchange of power
between two systems with peak demands in different months—February and
August, perhaps).
COMMON TYPES OF COORDINATION CONTRACTS
Although it might appear that the advantages of coordination could best
be obtained by interconnected systems under common ownership and management,
they are also possible under a variety of voluntary contractual arrangements
that existed even before the FPC interest in coordination. The most common
types of contracts include emergency power, standby power, supplemental
requirements, purchased or all requirements power, exchange of service or
economy energy, short-term service, transmission service or wheeling, dump
energy, and exchange of capability or unit sales. These contracts are
described as follows.
Emergency power is usually provided in the form of short-term purchases
on a standby basis with a reciprocal responsibility on the buyer's part and
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with payment in cash or in kind at the seller's option at prices equal to the
marginal or incremental cost plus, (e.g., 10 percent).
Standby power is similar to emergency power, but some plant capacity is
set aside for this purpose.
Supplemental requirements are purchases made to supplement a system's
own generating capacity on a short- or long-term basis.
Purchased or all requirements power includes sales to a distribution
system with no generating capacity on a wholesale or bulk basis with prices
that may include capacity, demand, and energy charges.
Exchange of service or economy energy involves delivery of power from
the least-cost source; as needed, on a continuous basis in a tight pool or
holding company system. The price (which may be a transfer price for regula-
tory and management accounting purposes only) is usually the seller's margin-
al cost plus half the difference between that and the buyer's own marginal
cost.
Short-term service also involves power transfers within pools, but for
periods of weeks at prices that may include demand and energy charges.
Transmission service or wheeling is power that is usually displaced
rather than transmitted through a complete system. Charges depend on the
nature of the transmission (emergency, etc.) and may include some construc-
tion cost allocation and adjustment for line losses.
Dump energy involves sales of surplus hydroelectric power on terms
similar to economy sales.
Exchange of capability or unit sales may involve power from jointly
owned plants, dedicated shares of capacity, or plants that are part of a
staggered construction agreement. Charges usually reflect an allocation of
fixed and variable costs.
COST BENEFITS OF COORDINATION
Estimates of potential cost savings have been made for three major cate-
gories of coordination: (1) evening out demand or peak-load diversity among
systems, (2) pooling of reserve generating capacity, and (3) installing opti-
mum-sized generating plants. Table 5 summarizes estimates by the FPC
(Breyer and MacAvoy, 1974) and by Hughes (1971) as to the possible gains from
such coordination. The $1.68-billion savings in annual operating costs
estimated by the FPC assumes effective coordination of systems within each of
16 regions as designed by the FPC.
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TABLE 5. POTENTIAL COST SAVINGS AS A RESULT OF COORDINATION, 1962-80
EPC estimates* Hughes (1971) estimates of
Category of Annual
Coordination •— Operating costs
Total capacity cost Annual operating costs ^in roill*-0115)
(in billions) (in millions)
M Demand diversity $1.5 to $ 4.0 $ 180 to $ 480 $ 210 to $ 420
Reserve pooling 4.7 to 6.5 564 to 780 600 to 1,200
Efficient plant 3.5 420 930
Total 9.7 to 14 1,164 to 1,680 1,740 to 2,550
*Breyer and MacAvoy, 1974.
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Given his own estimates that the elasticity* of total generation cost
with respect to unit size was equal to 0.9 during the 1960's, Hughes (1971)
recommended a restructuring of the electric power industry into approximately
30 planning and operating units by merger and/or close coordination of public
and private systems. Breyer and MacAvoy in 1974 estimated a potential $2-
billion annual cost saving by 1980 based on 5-percent reduction in new capa-
city costs resulting from efficient plant size and economic dispatch and
another saving of 6 percent in capacity as a result of reserve pooling. In
spite of the agreement of these studies, actual coordination has not devel-
oped to the extent projected (see Breyer and MacAvoy, 1974, for a determina-
tion of coordination as of 1970-71); thus not all of the cost savings have
been realized.
Breyer and MacAvoy (1974), citing several engineering studies in
addition to the economic evaluations, concluded that rationalization of bulk
electric power supply could be achieved by creating 10 to 15 closely coordin-
ated systems through merger. Of course, this proposal and the similar one by
Hughes raise the question of increased monopolization, which might be offset
to some extent by other measures (e.g., the dismantling of such vertically
integrated operations as generation and transmission). As an alternative,
they suggest public ownership of generation and/or transmission lines by a
government corporation that would sell to distribution systems. These issues
are discussed later in more detail.
*The elasticity is calculated as the percent of change in cost due to a
1 percent increase in the size of conventional generating plants. Hughes'
estimate for the 1950's was 0.8.
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SECTION 6
EVALUATION OF EXISTING COORDINATION
A recent study has estimated by econometric techniques the actual cost
reductions in the power industry resulting from coordination as of 1970
(Christensen and Greene, 1978). Coordination was defined as formal con-
tractual pooling arrangements, with or without central dispatch, among inde-
pendent systems or through common ownership by a holding company. Estimates
of total generating cost advantages for pool member firms of approximately
4 percent, with an additional 1.3 percent if central dispatch was used, were
not statistically significant for a sample of 138 firms. As in the earlier
studies, no attempt was made to identify the additional costs of forming a
pool, such as new transmission line construction, which biases the estimates
of cost savings upward. On the other hand, downward biases may have occurred
when possible gains were ignored in reliability and in the environmental
benefits of better locations for fewer plants in a larger region.
Although holding company affiliation appeared to result in a 7-percent
cost advantage over independent pool members, when regional location and firm
size were taken into account, the authors were forced to conclude that formal
power pools resulted in no systematic generating cost reductions for their
members in 1970. Moreover, this observation implies that any advantages in-
herent in close coordination could be achieved through informal, arms-length
relations among systems (Christensen and Greene, 1978).
In an earlier study by Christensen and Greene (1976), it was found that
most firms in 1970 were already operating in the flat or constant long-run
average cost (LRAC) range (fewer that 50 percent had unexploited scale eco-
nomies), and that a 3.2-percent cost reduction would have been obtained if all
firms in the sample had operated at minimum LRAC (see Figure 1). If each firm
had been of optimum size (output of approximately 32 billion kWh at a cost of
0.473(?/kWh in 1970), 30 percent fewer firms would have existed, a fact that
indicates that there would have been potential cost savings through additional
mergers among the smaller systems (Christensen and Greene, 1976). Both the
1976 and 1978 Christensen and Greene studies, taken together, suggest that
formal voluntary coordination and tight pools have not been a viable substi-
tute for selective mergers. Moreover, these studies help explain why the
extent of such coordination has fallen short of the potential cited by the
FPC and others. The cost savings apparently were not being realized by the
firms in practice. Other possible explanations for the lack of voluntary
coordination and/or the apparent lack of realized benefits to existing power
pools are worth exploring at this stage. The following discussion draws
heavily from Breyer and MacAvoy (1974), Kahn (1971), and Lindsay (1976).
21
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to
K)
CO
o
u
LLJ
CD
ce:
LU
LRAC
.473
32 BILLION KWH
OUTPUT CKWH)
Figure 1. Economies of scale in the electric power industry, 1970.
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COORDINATION INCENTIVES AND DETERRENTS
As most electric power is generated by investor-owned (IOU) utilities
subject to State and/or Federal regulation, this discussion is primarily con-
cerned with their incentives for and deterrents to coordinating short of
actual merger. Yet some of the arguments may also apply to public systems,
depending on their objectives as an economic organization. Moreover, the
objectives of the IOU and the nature and effects of regulatory constraints
are inextricably linked to the coordination issue. Thus, for example, if a
regulated franchise monopoly lacks the incentive to minimize costs and/or
improve the quality and reliability of its services (which are among the ex-
pected benefits of coordination), then the lack of voluntary full coordination
is understandable. Or the perceived cost of coordination agreements may ex-
ceed the perceived benefits to the individual firm, resulting in less than
optimal coordination from the point of view of society. One aspect of the
problem of costs and benefits as perceived by the decision maker has to do
with private versus social costs and benefits. For example, if the coincident
peak load of a coordinated system is less than the sum of the noncoincident
peak loads of the member firms, then coordination could benefit each firm (and
its customers) as well as society in general by allocating resources more
efficiently. On the other hand, if coordination provides a larger geographic
area in which to locate generating plants which minimum environmental costs,
but the firms and their customers do not recognize or pay such environmental
costs, then the incentive for voluntary action is reduced because the private
benefits are less than the social benefits.
Another aspect has to do with such added costs that may be associated
with coordination as the construction of :new transmission lines in order to
interconnect systems. Moreover, Breyer and MacAvoy (1974) have noted that the
rate of forced outage due to failure has increased with plant size and techno-
logical improvement; thus, the gain to individual systems in terms of reduced
reserve capacity requirements can be at least partially offset by the need for
reserve capacity for the pool if it has both larger and less reliable plants.
Finally, although the State commissions, the FPC, and its successor, the
Federal Energy Regulatory Commission (ERC), have long had the authority to
require and/or encourage efficient and reliable service, they may lack the
incentive to act or they may have conflicting objectives as an institution.
Corporate Behavior
The economic model of the competitive market can be used to explain why
an owner-managed firm is forced to attempt to maximize profits and, as a
necessary condition, minimize costs in order to survive in the long run. If
competition is lacking, if ownership and managerial control are separated, or
if a short run decision is involved, it can be argued that other objectives
of the firm's management may override efficiency considerations; i.e., it is
rational for the hired management to attempt to maximize their own welfare if
free to do so. As this would appear to be the environment in which corporate
management operates—and if regulation is ineffective—then part of the lack
of coordination may be due to the problem of management incentives to achieve
cost minimization.
23
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On the other hand, if the owners (stockholders) wish to maximize their
profit and if the capital markets are sufficiently competitive—as appears
to be the case—then the existence of a monopoly in the market for a firm's
product or service is not sufficient to allow this kind of managerial discre-
tion. Moreover, evaluation of managerial performance by the financial press
and the potential for corporate mergers and takeovers serve to provide disci-
pline for management to act in the interests of shareholders.
Federal and State Regulation
If the regulatory agencies provide the incentives and/or orders neces-
sary for efficient service, this discussion is irrelevant. But the evidence
on the effectiveness of regulation is mixed at best. The classic study by
Stigler and Friedland (1970) concluded that State regulation of electric
utilities had no effect on prices and returns, and Breyer and MacAvoy (1973,
1974) have concluded that the FPC failed to promote coordination to the ex-
tent possible. If regulation is effective to the extent that the allowed
rate of return on investment (ROR) is less than the ROR that could have been
earned by a profit-maximizing utility, then a distortion often referred to as
the A-J effect can arise that gives the firm the incentive to use more capi-
tal than would be optimal relative to labor, fuel, and other inputs.* Effec-
tive ROR regulation would create an incentive to increase the size of the
rate base (value of plant and equipment) to increase the total profit for a
given allowed ROR, which will result in a greater total cost than if the in-
put mix were optimal. Thus the utility would have less incentive to partic-
ipate in pooling and coordination arrangements that reduced rather than in-
creased its rate base (e.g., sharing reserve capacity rather than wholly
owning it). The A-J thesis and related distortions resulting from ROR regu-
lation have only recently been subjected to empirical tests, and although
there is some evidence to support the argument that this effect is a deter-
rent to coordination, the evidence is mixed. See, for example, Boyer (1976),
Courville (1974), and Spann (1974). The testing of this hypothesis Is
complicated by the necessity of assuming two other potentially testable hy-
potheses: That ROR regulation is effective and that utilities attempt to
maximize their ROR. Assuming that the theory has no logical inconsistencies,
failure to confirm the A-J thesis would cast doubt on one or both of these
assumptions. None of these studies has attempted to relate the A-J effect to
coordination.
State or Federal regulation could have retarded the coordination move-
ment in several other ways. Power pools that cover several States may en-
counter State laws and/or regulatory commission rules regarding reliability,
reserve capacity, or joint ventures in generating plants as part of capacity-
*The seminal work on the A-J effect is Averch and Johnson (1962). This
effect differs from the older "gold plating" argument (referring to the use
of nonproductive plant and equipment or to excessive reliability) and from
the inflation of the value of plant and equipment for rate-making purposes.
Although these may well be distortions resulting from regulation and have
long been the objective of regulatory scrutiny, they appear to be unrelated
to the coordination issue.
24
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sharing agreements. Moreover, State commissions may be opposed to having
plants that are financed by firms under their jurisdiction provide signifi-
cant long-term power to customers in other States. Finally, membership in an
interstate pool could have brought a utility under the unwanted jurisdiction
of the FPC and other Federal agencies, which would inhibit coordination with
intrastate systems. But this argument is weakened by the liberal court in-
terpretation of the Commerce Clause (Article I, Section 8) of the U. S.
Constitution. Furthermore, since the 1972 FPC versus Florida Power and Light
Company case (in which the court ruled that the FPC had jurisdiction over the
firm, even though it operated wholly within the State, because it was con-
nected to interstate transmission lines and its electricity was commingled
with that of interstate systems), it has been concluded that the FPC has the
authority to affect virtually any firm having generation and/or transmission
facilities (see Breyer and MacAvoy, 1974).
Competition
Another possible explanation for the less than enthusiastic embracing of
full coordination is that there exists present and future competition among
utilities that are usually considered to be natural monopolies.
i
In fact, there are a number of areas in which an electric power utility
may face present or potential competition despite its franchise monopoly
status: Alternative energy suppliers, self generation by the user, over-
lapping service areas by IOU, municipal, and cooperative systems, loss of
franchise, and competition for new customers, especially by attracting new
industries into the system's present service area. For example, a firm may
be willing to forego short-run profit increases resulting from cost reduc-
tions through coordination in the attempt to gain long-run profits (i.e., by
avoiding cooperation that could benefit potential competitors in the sale of
power or with systems that could be customers in the future).
POOL FORMATION AND MAINTENANCE
The difficulties in forming a power pool or in maintaining it once it
has been organized are similar to those inherent in the voluntary economic
associations known as interdependent oligopolies or cartels. They include
such issues as the allocation of the costs and benefits of coordination among
the members, the resolution of disputes, and control and enforcement of agree-
ments. Just as in the case of legal or illegal cartels, there is an inherent
instability problem in pool arrangements among independent systems. Indeed,
several closely coordinated pools have broken up because of their inability
to resolve such issues by committee management (Hughes, 1971). These problems
can become even more acute when central dispatch is considered by a formal
power pool. This degree of coordination will not be optimal unless the par-
ticular economic circumstances and objectives of each member and the pool as
a whole are compatible. Wide divergencies in the proportion of fixed (plant)
and variable (chiefly fuel) costs among members can make inter-system pricing
and cost sharing arrangements very difficult (Breyer and MacAvoy, 1974).
Size differences and the generation-distribution mix of systems can also
have an effect on pool formation. In general, smaller systems would have
25
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more to gain in the way of cost reductions than the larger firms, which could
also lose more to future competition than would be gained through coordi-
nation. This would be particularly true in the case of small distribution
systems that generate little or none of their power requirements. Thus vol-
untary coordination arrangements might be more attractive among large, inte-
grated systems.
Small, distribution-only systems can contribute to the overall gains
from coordination in some cases if they have peak demands that are not coin-
cident with the pool and/or if they have large off-peak base loads such as
street lighting. Or, they can form a subgroup large enough to enable them to
own jointly generating capacity of an economical size, which would allow them
to make a greater contribution to the pool. Even in these situations, how-
ever, members of a pool would have the incentive to protect themselves by
attempting to impose restrictions on each other. These restrictions might
concern the markets to be served by members, controls over resale of power
to nonmember systems or final users, pricing, and the exclusion of certain
systems from membership. Members of a pool who contribute little or nothing
would be benefiting from cross-subsidization if their charges did not reflect
the costs of servicing them. On the other hand, admitting a system to a pool
that was formerly a purchaser from its members could lessen actual or poten-
tial competition in wholesale and/or retail markets.
FPC AUTHORITY AND ANTITRUST SCRUTINY OF COORDINATION
For these reasons, the coordination movement in general and certain
practices of member systems have been the subject of antitrust scrutiny by
the Justice Department and the courts. The following discussion of this
subject is drawn from Jones (1976), Lindsay (1976), and Schwartz (1976). In
addition to the obvious concern over mergers and voluntary agreements among
lOU's to cooperate (which, of course, are agreements not to compete), the
courts have dealt with cases questioning FPC authority and jurisdiction under
its enabling legislation and the exemption of utilities from antitrust laws
because they came under FPC jurisdiction. Smaller, mostly public systems
sought rulings that would give them access to pools and relief from alleged
anticompetitive practices. In the 1952 Pennsylvania Water and Power Co.
versus FPC case, the court ruled that the FPC had jurisdiction over the coor-
dinated interstate system to which the Pennsylvania company belonged, and
that antitrust litigation was not material because the FPC had the authority
to order or sanction coordination. A year later (U. S. versus Public Utility
Commission of California), the court upheld the FPC's authority to regulate
wholesales from an IOU to a municipal system. A number of subsequent cases
have upheld the FPC's authority to order the granting to small public and
private systems of access to power supplies and/or pools. Moreover, certain
practices and terms of coordination contracts were found to be anticompeti-
tive. These included requirements that small systems maintain reserve capac-
ity equal to their own largest plant and the charging of wholesale rates
not reflective of costs in order to preclude resale of competitive rates. In
City of Paris (Kentucky) versus FPC (1968), the court held that the FPC could
order an IOU to wheel power, but only if interconnection already existed. In
1971, however, the court ruled that the FPC had the authority to order Florida
Power to connect with a municipal distribution system and to set the terms of
26
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the contract. The decision in Municipal Electric Association versus SEC
(1969) found that an IOU is subject to antitrust regulation if it forms or
buys into a company (e.g., a nuclear plant joint venture) and excludes others.
The results of more recent litigation (Otter Tail Power Co. versus U. S.
(1973); Gulf States versus FPC (1973); and Conway Corporation versus FPC)
have supported the contention by the Justice Department and the SEC that a
somewhat reluctant Federal commission must consider the broader competitive
issues when acting on complaints and issuing orders. Taken together, the
list of practices that are questionable now include restrictions on resale of
wholesale power, full requirements contract stipulations imposed on distri-
bution systems, wholesale rates so high as to prevent competitive retail
rates, market allocation by pool members, refusals to wheel power, and denial
of pool membership or equal access to power.
The apparent reluctance of the FPC to exercise fully its authority to
promote coordination has been attributed to the nature of institutions that
rely on case-by-case hearings, adversary proceedings, and piecemeal approaches
to complaints and problems (Kahn, 1971). This factor plus a perceived lack
of a mandate to consider the broader public interest has resulted in an
emergency or crisis approach to coordination rather than long-range planning
in which economic efficiency, reliability, and environmental costs are
treated as interrelated issues (Breyer and MacAvoy, 1974).
The 1978 Public Utility Regulatory Policies Act (Sections 202-205 and
209-210) gives the FPC's successor, the ERG, explicit criteria to be used in
the consideration of coordination, pooling, and wheeling arrangements, with
the emphasis on economic efficiency, reliability, and resource conservation.
The public interest and existing competitive relationships are to be consid-
ered in issuing orders, and benefit cost studies are called for in evaluating
alternative proposals for dealing with these and other issues, including the
structure of the power supply industry.
Thus, even though there are recognized potential benefits from consol-
idation and close coordination, it is also recognized that they are not always
realized and that they may not exceed the costs in all cases. Some alter-
native organizational structures should be discussed before any particular
system is suggested for treating water supply.
27
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SECTION 7
ALTERNATIVES TO THE PRESENT SYSTEM
The 1978 Public Utility Regulatory Policies Act requires the Department
of Energy to study the cost effectiveness of adding a number of small, decen-
tralized generating units rather than a small number of large generating
units of similar megawatt capacity for achieving the desired level of reli-
ability (Sec. 209 (2) (E)). This directive appears to question the earlier
arguments for greater coordination and larger plants to achieve reliability.
In view of the evidence already examined in this report, however, full
voluntary coordination of a few large systems and alternative industry
structures should be examined further.
The major alternatives that have been suggested in the literature
include: (a) consolidation of existing systems into a relatively few large,
closely cbordinated and integrated systems, either by merger or by the for-
mation of multisystem pools; (b) encouragement of workably competitive mar-
kets where possible, with greater reliance on antitrust regulation; and
(c) public construction and ownership of generation and transmission capacity
with public or private management.
CONSOLIDATION OF EXISTING SYSTEMS
The first alternative, of course, is a continuation of the past consoli-
dation and coordination trends, but with a policy choice between a few multi-
system holding companies versus a few pools made up of large independent
systems. This involves consideration of the relative abilities of a single
ownership unit or a committee of independent firms to efficiently manage the
coordination of a large system as well as the potential adverse effects of
greater market concentration in the power industry. In view of the discus-
sions presented earlier, increasing mergers among the large systems does not
appear to be the best policy, although a good case can be made for mergers
among the smallest systems to achieve a minimum efficient size. Moreover,
it has been argued that voluntary pools are easier to form and change or
dismantle than are mergers (U.S. Federal Power Commission; 1970, Weiss,
1975) . Hughes (1971) and Breyer and MacAvoy (1974) have emphasized the use
of a few large, voluntary planning units with a Federal plan as a guide to a
rational system. Despite the difficulties associated with achieving full
coordination that were discussed in Section 5, it is possible for greater
antitrust enforcement and reform of the regulatory institutions to make
pooling a viable way in which to attain scale economies and the benefits of
coordination. (See Breyer and MacAvoy, 1973 and 1974, for a critique of the
FPC's role in promoting coordination. For broader critiques of commission
regulation, see Phillips, 1969, and Trebing, 1976.)
28
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A more important question, however, may have to do with the extent of
consolidation rather than its form. That potential economic benefits of
economies of scale can be obtained through consolidation of services, espe-
cially those that constitute natural monopolies, is generally recognized
(see, for example, Cowing and Holtmann, 1976, Dajani, 1973, and Hirsch,
1968). It should be noted, however, that the natural monopoly criterion may
be a more subtle concept than has previously been thought (see Baumol, 1977).
To the extent that a monopoly is natural, the potential benefits accrue to
the firm unless effective regulation transfers at least part of them to con-
sumers and/or other parties. Primeaux (1975), among others, points out that
regulated monopoly utilities do not always have lower costs than those facing
competition. Thus the question of scale economies in electric power supply
is more a question of degree than of existence. Indeed, until very recently,
the econometric and engineering studies have been almost unanimous in their
finding that significant scale economies exist over the range of existing
system sizes. Barzel (1963, 1964), Cowing (1974), Dhrymes and Kurz (1964),
Fuss (1979), Galatin (1968), Griffin (1977), Hughes (1971), lulo (1961),
Johnston (1952), Kirchmayer (1955), Komiya (1962), Ling (1964), Lomax (1952),
McNulty (1956), Nerlove (1965), and Wilson and Uhler (1976) all report
essentially L-shaped LRAC curves or increasing returns to scale that imply
such cost behavior. Thus over the range of observations of these studies,
there would appear to be no limit on system size in terms of unit cost
declines. (See Cowing and Smith, 1978, for a review and critique of these
and other studies.) Several proponents of restructuring the industry have
assumed 5,000 MW to be the minimum efficient size for a system, and at least
one engineering estimate reported that 25,000 MW would not exhaust scale
economies (see Christensen and Greene, 1978, and Weiss, 1974). The LRAC
curves suggested by these studies are shown in Figure 2. Breyer and MacAvoy
(1974) used a system size range of 30,000 to 40,000 MW for their estimates
of potential gains from coordination. A recent study (Christensen and
Greene, 1976) using 1970 data that attempted to correct for the effects of
holding companies on costs has reported that scale economies were exhuasted
for firms generating in excess of 19.8 billion kWh annually, which implies a
minimum efficient firm size of approximately 4,000 MW.* This finding is
consistent with the results of a study (Huettner and Landon, 1978) using 1971
data and a different methodology. These investigators reported that minimum
LRAC's were reached at a firm size of about 2,000 MW for all functions and
for the generating function alone.t These findings are compared in Figures
3 and 4.
*Christensen and Greene (1976) also reported that most of the cost
reductions from 1955 (the year of Nerlove's study that they took as a point
of departure) and 1970 was due to technological advances that shifted the
long run average cost schedule downward but did not significantly change its
L-shape; thus, scale economies were not a major factor.
tThey also prepared benchmark estimates of potential unit costs from
engineering data at the generating unit level and reported a similar figure
for expected unit costs. This estimate is important due to the questions
raised by Cowing and Smith (1978) regarding the distinction between ex ante
and ex post; i.e., between input substitution choices made before technology
29
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co
o
CO
o
u
LU
(D
LU
LRAC
5,000
SYSTEM SIZE CMW)
M/
25,000
Figure 2. Suggested optimum system size as a result of scale economics.
-------
CO
o
(J
1*3
LU
LRAC
2,000 4/000
SYSTEM SIZE CMW)
Figure 3. Alternative estimates of optimum system size by Huettner and
Landon (1978) and by Christensen and Greene (1976).
-------
u>
NJ
CO
o
u
LU
o
LU
LR AC (1955)
LRAC (1970)
OUTPUT (KWH)
Figure 4. Cost reductions resulting from scale economies and technical changes, 1955-70.
(Source: Christensen and Greene, 1976.)
-------
The Huettner and Landon (1978) estimates, when combined with the
Christensen and Greene (1976) study of coordination cost savings provide
little support for the consolidation alternative. Indeed, the major dis-
agreement between the two on minimum efficient size may be due to the way in
which the effects of holding companies were accounted for. When members of
holding companies were treated as independent firms, Christensen and Greene
reported that unit costs in 1955 were minimized for the equivalent of a sys-
tem size of 1,700 MW (as compared to the 4,000 MW obtained when holding
companies were treated as a single unit). Unfortunately, Christensen and
Greene did not make the same comparison for 1970. But if Huettner and
Landon?s criticism of Christensen and Greene is accepted on this point, the
two studies are in even closer agreement. Furthermore, Huettner and Landon
found no significant holding company effect on generation or total system
costs.*
THE POTENTIAL FOR WORKABLE COMPETITION
The findings reported here do appear to support the alternative of
restructuring the industry into competing systems of at least the minimum
size necessary to exhaust scale economies, coupled with more reliance on
antitrust remedies and/or''a greater recognition of anticompetitive acts on
the part of State and Federal utility regulatory commissions. Although the
justification for the degree of horizontal integration that the largest sys-
tems have attained is called into question by the results cited above, the
issue of vertical integration remains more in doubt. The incentive for any
firm to integrate vertically involves a combination of potential reductions
in costs and risks. That is, to the extent that a firm can control the terms
and prices of its sales and purchases, it can reduce costs and insure markets
and sources of supply. (See Kahn, 1971, pp. 256-64, for a good discussion of
has been embodied in particular capital equipment and such choices after
equipment design is complete. If input choices are restricted in the ex post
situation, minimum cost solutions will differ from those obtained in the ex
flnte situation. It is also important to distinguish between what may be
feasible according to engineering cost and production estimates, and what
actually transpires for a variety of reasons having to do with managerial
incentives, regulatory constraints, and other behavioral and institutional
factors.
*Both studies have limitations, of course, but the "nontraditional" cost
functions used by Huettner and Landon have been viewed with some skepticism
by Cowing and Smith (1978) due to the lack of rigor with which they treated
system behavioral objectives and duality. The latter concept refers to the
correspondence between the estimated cost function and the underlying pro-
duction process. Although the translog functional form used by Christensen
and Greene appears to be more appropriate, Huettner and Landon maintain that
their approach is better suited for the analysis of the effect of holding
company membership on system costs. See the Appendix for more on alternative
functional forms.
33
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the economics of vertical integration.) Unless the firm is a monopoly, how-
ever, integration should benefit the consumer if the firm can produce a good
or service internally at a cost that is lower than the price at which it can
be purchased and if these cost reductions are reflected in prices. If a
monopoly acquires a monopoly, the controlling firm can appropriate the
profits of the other, which would not benefit the consumer. If the acquired
firm is in a competitive market, integration could result in less competition
to the extent that the other firms are excluded from buying from or selling
to the controlling firm. On the other hand, vertical integration could be
procompetitive if it improves the ability of the parent firm to compete, if
it adds another competitor to the market for the services of the function
being integrated, or if the mere threat of such an event affects the other
market.
Regulation can force the controlling firm to pass the benefits of ver-
tical integration on to the consumer. But the commission would have to
examine carefully the allocation of costs between functions, especially if
one is outside its jurisdiction, because the incentive exists to inflate
transfer prices in order to show higher costs for regulatory purposes. It
is also possible that the A-J effect under ROR regulation creates an incen-
tive for vertical integration in order to increase the rate base. If the
result was merely to raise costs without improving service, then integration
would be inefficient.
Because the electric power industry is highly vertically integrated,
especially with respect to generation, transmission, and distribution func-
tions, any policy of opening up competition must consider the benefits and
costs of divestiture and separation of these functions. If workable compe-
tition is to be fostered, vertical integration could be an impediment; on the
other hand, separating major functions could result in higher costs and
prices, albeit competitively determined.
Transmission as a Monopoly
General agreement seems to exist among those who have evaluated the com-
petitive alternative that transmission has the greatest claim to being a
natural monopoly. Thus proposals have been made (a) to regulate this func-
tion as a common carrier analogous to gas pipelines, or (b) to provide public
transmission services (Breyer and MacAvoy, 1974; Kahn, 1971; Trebing, 1976;
Weiss, 1975). Under either proposal, generation and distribution systems—
private and public—would be free to compete among themselves for markets
and for bulk power supplies.
The only econometric study to treat transmission as a separate function
found no evidence to support the natural monopoly argument (Huettner and
Landon, 1978). Indeed, the firms in the sample appeared to have diseconomies
of scale over a wide range of output with a positive relationship between
unit costs and miles of structure per customer. Moreover, holding company
membership had no effect on costs.
Several qualifying remarks about this study are in order, however, as
the authors point out. The capacity measure used was actually for generation,
34
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which could bias the results, but in an unpredictable direction. Line losses
could bias results based on generation capacity in favor of scale economies.
It is also possible that integrated systems view generation plant size and
location as a tradeoff with transmission costs. Thus when total system costs
are minimized, higher transmission costs may be more than offset by lower
generating costs. Finally, the allocation of costs to the transmission func-
tion may be overstated because they are inherently unallocable (and thus
arbitrary) and/or because of the regulatory distortions cited earlier
(Huettner and Landon, 1978, p. 907).
Distribution
The distribution function has been studied to a greater extent than
transmission, and there is some evidence to support exhaustion of scale
economies at relatively low system sizes. (See the studies by Hellman [1972,
p. 54], Huettner and Landon [1978], Meyer [1975], Neuberg [1976], Weiss
[1975], and Wilson and Uhler [1976].) Neuberg (1976, 1977) found that the
optimum size for distribution systems in his sample was between 85,000 and
230,000 customers, depending on the model used (the latter figure is for
operating costs only). Assuming a 60-percent load factor, these results
imply system sizes of approximately 370 MW and 1,300 MW, respectively. Most
of Neuberg1s estimates imply U-shaped LARC curves, leading him to conclude
that the largest systems in his sample were too large, and that many others
were too small. In terms of theoretical rigor, econometric technique, and
the attempt to capture the peculiar nature of a distribution network in which
geographic area and density of usage are cost determinants, this appears to
be the best study to date.
The most recent study tells a somewhat different story, however.
Huettner and Landon (1978) found that unit distribution costs follow an L
shape in which scale economies appear to be exhausted at a system size of
2,600 MW, which corresponds to a system serving over 500,000 customers under
the usual assumptions regarding load factors. These authors also reported a
weak holding company effect on distribution costs and noted that the declin-
ing unit costs seem to justify declining block retail rate structures.
Wilson and Uhler (1976), whose study was solely concerned with the cost
justification of block rate structures, reported similar results for total,
generating, and distribution costs.
As in the case of transmission, attempts to estimate distribution costs
may be biased by the allocation of costs reported by integrated systems and
by the technical question of the separability of functions. The latter has
to do with whether or not the distribution stage (however defined) should be
estimated as a separate function if vertical integration produces internal
economies. (See Neuberg, 1976, and Courville, 1974, for discussions of the
separability problem in this context.)
Still, both studies suggest that a policy of promoting competition among
distribution systems would not be at as great a cost in terms of foregoing
economies of scale as has been previously thought. Additional support for
alternatives to greater consolidation is given by the findings that scale
economies appear to be exhausted for system sizes of 2,500 MW for
35
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administrative costs and 1,700 MW for customer costs (Huettner and Landon,
1978). It was this last category of cost savings that Weiss (1975) suggested
might be lost if vertical integration was reduced or eliminated.
Among other possible consequences of dismantling integrated systems are
that single function systems may have greater risks in unregulated markets.
However, if transactions costs are not excessive, and if access to markets
and transmission lines is not blocked, the electric power industry should not
find competition to be uniquely risky. As for planning, integration does not
appear to be a necessary condition for increasing efficiency (Weiss, 1975).
Indeed, Weiss argues that integration can result in suboptimal plant size
and/or location decisions if firms attempt to serve captive distribution
systems.
Other than the possible loss of cost savings associated with horizontal
and vertical integration and pooling, the major impediments to a workable
policy of competition appear to be the traditional ones of market structure
and performance that concern the antitrust laws. Indeed, once the extent of
the naturalness of the monopoly in this industry has been shown to be lim-
ited, most of the present barriers to entry and anticompetitive practices
appear to be fostered by or sanctioned by regulatory authorities and/or
legislation.* In addition to the court rulings and antitrust remedies that
were discussed above (many of which were responses to the present system),
changes in existing legislation could remove other impediments to competi-
tion. These include repeal of State antipirating laws that limit competition
for customers in existing markets and laws that allocate exclusive service
territories (Weiss, 1975).
Areeda (1972) also discusses the relevance of antitrust law to regulated
utilities. Note that these recommendations would not necessitate complete
deregulation, but would require a change in the criteria used by State and
Federal commissions in regulating the industry. In any event, the antitrust
laws would be available under deregulation.
*Trebing (1976) cites three other separable arguments against competi-
tion: Systems too small to attract capital at reasonable costs or terms,
regulatory lag, and shortages of fuel and capital. None of these arguments
appear to be compelling or unique to this industry, however. For example,
the significant size of the Southern Company and its subsidiaries (especially
Alabama Power), has not insulated it from either capital attraction problems
or regulatory lag (see Scott, 1976, for an evaluation of the industry's
financing problems under the present industry structure). The last argument
is, of course, a classic economic fallacy when one considers that the allo-
cation of scarce resources is the economic problem that a competitive market
system solves. Unfortunately, in recent years, market intervention has not
only distorted efficient allocation of resources, but it has created short-
ages, which is not the same thing as scarcity.
36
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PUBLIC SYSTEMS
Several aspects of the role of public systems must be considered. If
transmission is indeed characterized by great economies of scale (which is
unclear at this point), or if environmental and related concerns dictate non-
duplication, then at least three alternatives suggest themselves: Unre-
stricted access to power supplies on economical terms, regulated common
carrier status, and public ownership. On the other hand, public power sub-
sidies should be eliminated if a competitive system is to be workable and
efficient, with all competitors on the same footing (Weiss, 1975).*
More public ownership is also an alternative at the generation and dis-
tribution stages, but the potential for it seems greater for distribution
systems through local option municipal franchise elections or the creation of
power districts. (Se.e Clemens, 1950, for a discussion of local, regional,
and national issues, and Shepherd, 1965, for an evaluation of public enter-
prise performance in general.) If economic efficiency is the objective and
if unit costs are decreasing over the relevant range of output (see Figure 5),
public ownership could be a viable alternative to a regulated private monop-
oly because of the necessity for subsidizing the latter if prices are to
equal the marginal or incremental costs of services.
Such a case is the classic natural monopoly (Figure 5), in which compe-
tition is thought to be unworkable. In this case, marginal cost pricing
results in long-run losses to the firm because marginal costs are lower than
average costs, which results in higher total costs than total revenue. The
usual regulatory solution is to sanction average cost pricing; thus although
monopoly profits are presumably avoided and output exceeds that of an unregu-
lated monopoly, the result is not economically efficient. The obvious
solution if efficient pricing is to be used is to subsidize the firms out of
general tax revenues or to provide the service publicly.
Note that pricing schemes can be developed based on marginal costs that
allow revenues to cover costs, but these have not been widely adopted. If a
system is operating in a constant LRAC range, marginal cost pricing could
allow normal profits, and public ownership would have to be justified on
other grounds.
Of course, attainment of broader social goals than economic efficiency
may be invoked to justify public ownership, which leads to equity versus
efficiency arguments. For the purposes of this report, however, the focus
will be on the relative efficiency of private versus public ownership and
operation of electric power supply.
*See Hellman (1972), Primeaux (1975), and Trebing (1976) for more on
the existing competition between public and private systems. Primeaux (1978)
has recently reported that he found no significant difference in the rate of
capacity utilization (i.e., excess capacity) in markets served by a single
utility and those served by two. .This finding casts doubt on the natural
monopoly argument used to justify monopoly franchises.
37
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LLJ
U
CL
LO
oo
CO
o
u
DEMAND
PRICED LRAC
> PRICED LRMC
LRAC
LR.MC
OUTPUT
Figure 5. The natural monopoly case.
-------
The logical reasons to expect differences in efficiency by ownership
category include: subsidy of the public systems, differences in the quality
of management and/or in managerial objectives and incentives, and the effects
of ROR regulation on idu systems. (See DeAlessi, 1974, for an evaluation of
some of these arguments.) Two recent econometric studies have tested the
hypothesis that type of ownership does explain cost differences among distri-
bution systems. Meyer (1975) found that IOU systems had higher rates (except
for larger industrial users) and higher costs than did municipals. The
relative cost efficiency he identified for municipal systems was confirmed
by the conceptually superior study of Neuberg (1976, 1977), who qualified his
conclusions somewhat by pointing out that possible regulatory distortions may
account for the difference rather than ownership effects (i.e., the A-J
effect could have biased IOU costs upward). Neuberg's other possible expla-
nations for municipal cost efficiency include IOU advertising and selling
costs, differences in quality of management, arbitrary cost allocation and/or
suboptimization with respect to the distribution stage by lOU's, and greater
pressure on municipals to prove themselves in a pro-IOU environment. Unfor-
tunately, the question of subsidy does not appear to have been adequately
considered by Neuberg because of his use of the same cost of capital for both
categories of ownership.
"i
The implications of Neuberg's observation that many distribution systems
are of less than optimal size are not clear. As the sample consisted only of
regulated firms and municipal systems, the source of this inefficiency may be
traced to one or more of the following: Regulatory distortions, deliberate
suboptimization by integrated lOU's, or those political and economic forces
that determine the geographic size of municipalities (which in turn dictates
the market size). If economic efficiency is the criterion, then it is not
apparent that public systems have a better record than private systems in the
attainment of optimum size. Indeed, the record on consolidation of govern-
ment services in general suggests that serious impediments to efficiency
exist in the government sector (Hirsch, 1968). But on the other hand, regu-
lation and public ownership (at least in practice) have the overt or covert
purpose of facilitating internal subsidization of consumer groups. This use
of price discrimination is difficult, if not impossible, to achieve in an
unregulated competitive market. Moreover, discriminatory pricing is gener-
ally illegal under the antitrust statutes.
A mix of public and private power systems is likely to continue even If
public policy is influenced by the emerging literature calling into question
the natural monopoly assumption. If the current deregulation trend is more
than the symptom of a short cycle in political economy, It is possible that
competition will continue to be introduced into electric power markets.
Such competition would require that consolidation be limited to the smallest
existing systems and that existing regulatory institutions be reformed or
replaced.*
*Note that deregulation coupled with a tax on monopoly profits would not
get at the problems of inefficient resource allocation and anticompetitive
practices unless antitrust remedies were also used. Demsetz (1968) has pro-
posed the alternative of competition for utility franchises by private firms,
39
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Competition in and for markets, in conjunction with spot and contract
purchases, could be a viable alternative, but it places a heavy burden on
recurrent contracting and, by implication, on the assumption that contract
law behaves as if it seeks to attain efficient resource allocation. (See the
works cited by Williamson, 1976, for the literature on the objectives of con-
tract law and its role in facilitating market transactions.) The major
objections to this approach appear to be concerns over price discrimination,
the creation of greater risks, the nature of managerial incentives, and
exceedingly complex contractual obligations. Furthermore, as Williamson
(1976) points out, it is these factors that provide the incentives for ver-
tical and, to some extent, horizontal integration, which could work against
competition.
Areeda (1972) has predicted that eventually the courts will face chal-
lenges to government-sanctioned or created cartels and monopolies on new
grounds. Previously, plaintiffs argued denial of due process or confiscation
of property as a result of economic regulation; however, Areeda suggests
success for the argument that such government actions constitute burdens on
interstate commerce without being necessary to achieve their stated objec-
tives. In view of the cases that have already touched on these issues, such
success seems very likely. Whether actions of government units themselves
(such as municipal power systems) will also be subject to this remedy is
another question.
Most of the evidence on total and generation costs is for conventional
fossil fuel plants. If nuclear generation continues to augment and/or dis-
place this technology, the optimum size for a plant and system may well
become larger than those reported in the recent literature; also, some of the
advantages of pooling and other forms of close coordination may become
greater. Joint ownership and staggered construction and plant location
decisions take on even greater significance when the very large capital
investment and the environmental and safety problems associated with nuclear
technology are considered. On the other hand, the unit cost advantage that
nuclear generation is now said to have over conventional plants could be
partly based on subsidies and on an understatement of the true economic
costs. The subsidies refer mostly to fuel fabrication, and the cost under-
statements have to do with environmental safety standards and the costs of
meeting them.
Clearly more attention needs to be given to these arguments when the
studies cited here are updated. Indeed, one of the reasons given for using
generation cost data from no years later than 1971 is to avoid the effects
that pollution control investments and mandatory conversion from coal may
have on the results. Other complicating factors include the OPEC embargo
and the resulting mandatory conversion from oil and gas. The present con-
version of boilers from petroleum fuels to coal for conservation reasons is
much costlier than the original conversion from coal to meet pollution stan-
dards.
which could also eliminate excess profits. But see Trebing (1976) and
Williamson (1976) for critiques of this proposal.
40
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The uncertain future role of nuclear power generation-aside, it appears
that a case can be made for a rational bulk power supply system with many
more than the 10 to 30 systems that have been suggested in the literature.
In addition, the degree and extent of voluntary coordination (which could be
a substitute for consolidation) necessary to facilitate scale economies may
be less than earlier proponents had suggested. The argument for coordination
may rest more on reliability and financing concerns than on the attainment of
the very large system sizes that have been presumed necessary.
If this assessment of the power industry situation is accurate, then the
transfer of the concept of a few large systems to the supply of treated water
should be examined much more closely. Reliability and financing problems
appear to be of a lower order of magnitude for water systems; thus the case
for large systems should rest primarily on the existence of increasing
economies of scale in the acquisition, treatment, and/or distribution of
water. Future research should include the estimation of the cost-output
relationships of treated water supply systems with respect to size and form
of ownership as well as technology.
41
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"^
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Griffin, J.M., 1972. "The Process Analysis Alternative to Statistical Cost
Functions: An Application to Petroleum Refining," American Economic
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Griffin, J.M., 1977. "Long-Run Production Modeling with Pseudo Data:
Electric Power Generation," The Bell Journal. Spring 1977, pp. 112-127.
43
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Hellman, R., 1972. Government Competition in the Electric Utilities
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Hingorani, N., 1978. "The Re-emergence of D.C. in Modern Power Systems,"
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Press, Baltimore, Maryland.
Huettner, D.A., and J.H. Landon, 1978. "Electric Utilities: Scale
Economies and Diseconomies," Southern Economic Journal. April 1978,
pp. 883-912.
Hughes, W.R., 1971. "Scale Frontiers in Electric Power," in Technological
Change in Regulated Industries. W.M. Capron, ed. Brookings
Institution, Washington, D.C.
lulo, W., 1961. Electric Utilities—Costs and Performance. Bureau of
Economic and Business Research Bulletin No. 34, Washington State
University, Pullman, Washington.
Johnston, J., 1952. "Statistical Cost Functions in Electricity Supply,"
Oxford Economics Papers, February 1952, pp. 68-105.
Jones, W.K., 1976. Regulated Industries. The Foundation Press, Mineola,
New York.
Kahn, A.E., 1971. The Economics of Regulation. John Wiley and Sons,
New York, New York.
Kirchmayer, L.K., et al., 1955. "An Investigation of the Economic Size
of Steam-Electric Generating Units," AIEE Transactions, Vol. 74,
pp. 600-609.
Komiya, R., 1962. "Technical Progress and the Production Function in the
United States Steam Power Industry," Review of Economics and Statistics.
May 1962, pp. 156-167.
Lindsay, W.W., 1976. "Pricing Intersystem Power Transfers in the United
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ed. Michigan State University Graduate School of Business Administra-
tion, East Lansing, Michigan.
Ling, S., 1964. Economies of Scale in the Steam Electric Power Generating
Industry. North-Holland, Amsterdam, the Netherlands.
Lomax, K.S., 1952. "Cost Curves for Electricity Generating," Economica,
New Series, 1952, pp. 193-197.
44
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Marsden, J.R., D.E. Plngry, and A. Whinston, 1972. "Production Function
Theory and the Optimal Design of Waste Treatment Facilities," Applied
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pp. 30-43.
Meyer, R.A., 1975. "Publicly Owned Versus Privately Owned Utilities,"
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Nerlove, M., 1965. Estimation and Identification of Cobb-Douglas Production
Functions. Rand McNally and Company, Chicago, Illinois.
Neuberg, L.G., 1976. Returns to Scale and Comparative Efficiency in
Investor- and Municipally-Owned Electric Power Distribution Systems;
An Application^ of Cost/Production Function Duality Theory. Ph.D.
Thesis, University of California Library, Berkeley, California.
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Power Distribution Systems." The Bell Journal, Spring 1977, pp. 303-323.
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Spann, R.M., 1974. "Rate of Return Regulation on Efficiency In Production:
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School of Business Administration, East Lansing, Michigan.
46
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APPENDIX
SUMMARY OF METHODOLOGIES USED IN ECONOMETRIC STUDIES OF ELECTRIC POWER SUPPLY
Most of the econometric studies cited in the text began with the
assumption (explicit or implicit) that a production process can be described
in general as
Q = f(Xi), i - 1, n (1)
where Q is output, the x. are inputs, and the functional form represents a
given technology. If input prices p. are given, the cost function can be
expressed as
n
C = Z P.X, (2)
i 1 1
with the Xj assumed to be endogenous decision variables. Assuming the
producer attempts to minimize equation (2) subject to (1), it is possible
to obtain a unique cost function
C = g(Q, P±) (3)
if the production function has certain properties (Shephard, 1953). This
duality between the production and cost functions allows inferences about one
to be made from estimates of the other. If a linear model is specified for
estimation purposes
n
C = a + OIQ + I ap + e (4)
1=2 1 i
the error term e is usually assumed to be randomly distributed, which implies
no systematic differences among the production technologies used by the pro-
ducers in the sample. Neuberg (1976) has argued that differences not cap-
tured in the inputs or their prices may be important cost determinants; thus
he added a set of systems variables (s.) to model (4)
n m
C = a + a,Q + I a.p + E 0.s, + e (5)
1-2 x -1 * 3
47
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where the s^ represent kWh sold (si) , miles of distribution line (82) , and
square miles of service area (so) , and where output (Q) is the number of
customers served. After evaluating a number of alternative families of
functional forms for the underlying production function in terms of (a)
their ability to approximate actual processes, (b) suitability for ordinary
least squares (OLS) estimation, and (c) their ability to provide a simple
test for returns to scale or scale economies, Neuberg selected the general-
ized Cobb-Douglas production function
Q = Q0 * X^i (6)
where returns to scale can be inferred from Z a. ^ 1. The dual to equation
(6) can be expressed for two inputs, capital (KJ and labor (L) ,
aK aL Bj 71
C = CQ PK PL (TT Yj ) e e (7)
where the Y^ are Q plus the s^ and I indicates an IOU or a municipal system.
For estimation purposes, a logarithmic transformation of the data gives
In C = In C0 + ctj. In pK +> o^ In pL + Z B. In Y . + yl + e (8)
Returns to scale are decreasing, constant, or increasing as Z B. ^ 1.
j J
To test for a U-shaped or L-shaped average cost curve, Neuberg estimated
In AC = In ACQ + c^ In PK + C^ In PL + Z Bj In (s . /Q) (9)
+ In Q. + p (InQ)2 + 7 I + e
and tested for p = o versus p > o. A point estimate of optimum system size,
Q = e"^'^ p, was obtained by differentiating (9) with respect to Q and
solving for Q.
A more general production function was used by Christensen and Greene
(1976, 1978). The translog function is
In Q = In a + I a. In x^ + 1/2 Z £ B-r, In Xi In X. (1°)
i x i j J J
If BJ^ = o, then In Q = In a0 + Z a . In x^» which is the Cobb-Douglas form.
1
If Z a± = 1 and Z BJJ = £ Bjj. = £ Z B-n = o, there are constant returns to
48
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scale. The translog cost function estimated by Christensen and Greene was
In C = In «0 + otQ ln Q + L/2 $QQ (InQ)2 + | &± In p± (11)
+ 1/2 Z I 3^ In p£ In PJ + Z BQ± In Q In p±
where the D^ are a set of dummy variables to control for organizational form,
regional effects, etc. A maximum likelihood procedure was used to estimate
equation (11) together with the cost share equations for each input
s± = a± + 3qi In Q + Z 6 In p.
(12)
in order to gain more degrees of freedom and avoid the multicollinearity
problems likely with OLS estimation of (11) alone. It was the latter prob-
lem that led Neuberg to prefer the Cobb-Douglas over the translog function.
The extent of scale economies depends on (1 - x •• •-) being greater than
9 In Q
(economies) or less than (diseconomies) zero.
The nontraditional approach taken by Huettner and Landon (1978) con-
sisted of OLS estimation of
AC = ct0 + a-L In K + a2 (InK)2 + a3 In U + a4 (InU)2 (13)
+ Z p1 DI + a5 PF + a6 PL + e,
where K is a measure of capacity, U is the capacity utilization rate, pF and
PL are prices of fuel and labor, respectively, and the D.^ are dummy variables
for the effects of region, organizational form, fuel mix, etc. The squared
terms were included as a test for the shape of the average cost curve, and
it was assumed that system output could be expressed as Q = KU.
REFERENCES
Christensen, L.R., and W.H. Greene, 1976. "Economies of Scale in U.S.
Electric Power Generation," Journal of Political Economy, August 1976,
pp. 655-676.
Christensen, L.R., and W.H. Greene, 1978. "An Econometric Assessment of Cost
Savings from Coordination in U.S. Electric Power Generation," Land
Economics, May 1978, pp. 139-155.
Huettner, D.A., and J.H. Landon, 1978. "Electric Utilities: Scale Economies
and Diseconomies," Southern Economic Journal. April 1978, pp. 883-912.
49
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Neuberg, L.G., 1976. Returns to Scale and Comparative Efficiency in Invest-
tor- and Municipally-Owned Electric Power Distribution Systems; An
Application of Cost/Production Function Duality Theory. Ph.D. Thesis,
University of California Library, Berkeley, California.
Shephard, R.W., 1953. Cost and Production Functions. Princeton University
Press, Princeton, New Jersey.
50
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GLOSSARY
Coordination or Pooling; The coordination of activities by power sys-
tems. This practice can range from the sharing of information on maintenance
schedules and capacity expansion plans by independent systems to the opera-
tion of systems under common holding company ownership with centralized man-
agement and dispatch of power from the least-cost plant in the system. The
latter is often termed a "tight pool," and pooling itself is usually asso-
ciated with attempts to reduce operating and investment costs through rela-
tively formal contractual arrangements. The less formal arrangements con-
stitute a broader aspect of coordination (e.g., the Electric Reliability
Councils or other area coordination organizations). The primary distinction
among these various categories of organizations is the extent of contractual
obligation of the member systems.
Interconnect ion; The physical connection of two or more systems by
transmission lines.
Interchange; The purchase and/or sale of electricity by two or more
systems, either on an emergency or a regular, contractual basis.
Reliability; The frequency and duration of service disruptions and
voltage fluctuations, often expressed in terms of probability of failure.
Wheeling; The transfer of electric power between two systems by way
of the transmission lines of one or more intermediate systems. This process
usually involved displacement, in which the intermediate system provides
power to the final user and replaces it with power from the originating
system.
51
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TECHNICAL REPORT DATA
(Please read Instructions on the reverse before completing)
1. REPORT NO.
EPA-600/2-80-163
3. RECIPIENT'S ACCESSION NO.
4. TITLE AND SUBTITLE
TREATED WATER DEMAND AND THE ECONOMICS OF
REGZONALIZATION
Volume 2. Economics of Regionalization:
The Electric Power Example
5. REPORT DATE
August 1980 (Issuing Date)
6. PERFORMING ORGANIZATION CODE
7. AUTHOR(S)
Donald L. Hooks
8. PERFORMING ORGANIZATION REPORT NO.
t. PERFORMING ORGANIZATION NAME AND ADDRESS
University of Alabama
University, Alabama 35486
10. PROGRAM ELEMENT NO.
C61C1C, SOS 91, Task 64
11. CONTRACT/GRANT NO.
R805617
12. SPONSORING AGENCY NAME AND ADDRESS
Municipal Environmental Research Laboratory - Gin., OH
Office of Research and Development
U.S. Environmental Protection Agency
OMn 4S268
13. TYPE OF REPORT AND PERIOD COVERED
Final Report 4/78-12/79
14. SPONSORING AGENCY CODE
EPA/600/14
15. SUPPLEMENTARY NOTES
See also Volume 1 (EPA-600/2-80-162)
Project Officer: Robert M. Clark (513) 684-7488
16. ABSTRACT
This two volume report examines the present and future demands and costs for
residential water in view of the new requirements for water quality standards under
the Safe Drinking Water Act of 1974 (PL92-523) Volume 2 (This volume) investigates
consolidation in the electric power supply industry as an example of a possible
method of offsetting the increased costs of water treatment that will be incurred
under the new Federal regulations. The structure of the power industry is examined
and the history advantages, and cost benefits of coordination are evaluated. Several
alternatives to the present system are considered, including consolidation of existing
systems, encouragement of competitive markets, and public ownership of generation and
transmission facilities.
The most significant product of this research effort is the analogies that can
be drawn between the history of regionalization in the electric power industries and
the future for Drinking Water supplies.
17.
KEY WORDS AND DOCUMENT ANALYSIS
DESCRIPTORS
b.lDENTIFIERS/OPEN ENDED TERMS C. COS AT I Field/Group
Consolidation
Economics
Electricity
Financing
Planning
Power Lines
Power Plants
Regional Planning
Urban Development
Urban Planning
Utilities
Water Consumption
Water Distribution
Water Supply
13B
18. DISTRIBUTION STATEMENT
Release to Public
19. SECURITY CLASS (THISReport}
Unclassified
21. NO. OF PAGES
60
20. SECURITY CLASS (Thitpage)
Unclas«?1f 1 f>A
22. PRICE
EPA Form 2220-1 <*•». 4-77)
52
U.S. GOVERNMENT PRINTING OFFICE: 1980--657-165/0108
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