Can You Profit Under Electric Deregulation?
 
October 1, 1999
 

Quietly, with little fanfare, a deregulation revolution is sweeping across America's electric industry. This revolution can mean big bucks and bigger opportunities for hotel owners who can profit from their size and real estate portfolio. Nearly half of the states have already passed legislation that will allow consumers to choose their electricity provider, and the list grows monthly. If the current trend continues, it will not be long before choosing an electricity provider is as routine as choosing a company to handle your long-distance phone calls for your hotel or franchise system.

It is difficult to overstate the size and importance of America's electric industry. Nationwide, the industry generates yearly sales in excess of 215 billion dollars by selling to virtually every home and business in this country. The deregulation of the industry will forever change the nature of the relationship between the electric utilities and their customers, and will bring about a new age of competition, with its attendant risks and rewards.

Background

In the United States, electric power has long been treated as a natural monopoly: a market failure in which competition does not serve to decrease prices. Under this monopoly system, a series of regional electric utilities have been established to generate, transmit and distribute electricity to individual homes and businesses. Competition between regional electric utilities is forbidden, and consumers may not purchase electricity from any source other than their local electric provider.

To prevent the regional utilities from taking advantage of their monopoly status, local Public Service Commissions (PSC) tightly regulate the electric market. PSCs set electric rates, review and approve utility budgets and new construction, and require that utilities subsidize low-income and rural residential consumers in so-called "universal service" programs.

In exchange for this high level of regulation, regional utilities are insulated from the turbulence and competition of the marketplace. PSCs ensure that electricity rates are set high enough to enable the regional utilities to turn a reasonable profit, and to service the debt from the large capital investments required to operate an electric utility. This symbiotic relationship between the PSCs and the regional utilities has remained unquestioned for the better part of this century, but has now started to crumble.

The Move Towards Deregulation

While the monopoly market for electricity has proven effective at providing reliable electric service accessible to people of all levels of income, many have come to doubt the system's efficiency. A review of electric prices across the United States shows wide disparities in rates between regions, a situation that has led many to conclude that the market for electricity is not operating efficiently. For example, in 1995 (before electric deregulation took hold) residents of Oregon paid 4.7 cents/kilowatt hour for electricity, while those just across the border in Northern California paid 9.9 cents/kilowatt hour, more than twice as much.

In an effort to reduce these high costs, many states have moved away from tightly managed electric markets and have embraced deregulation. In the deregulated market, the regional utilities maintain control over the distribution network, but are forced to sell off their electric generation assets. The outside companies that purchase the generators are then placed in competition with each other, and must develop their own customer base to survive. Theoretically, this process should drive down the cost of electricity, as consumers select the electricity providers that offer the best value, and force inefficient, high-cost producers to cut prices or leave the market.

Current Status Of Deregulation

Currently, almost half the states have either passed legislation or adopted regulations that will deregulate their electric industry. There has also been movement on the federal level, although all comprehensive deregulation proposals have thus far died in Congress.

A review of the states that have moved toward deregulation shows a strong correlation between high electricity rates and the implementation of deregulation. The pattern is particularly evident in the Northeast and Southwest, where electricity costs far outpace the rest of the country.

Hurdles To Deregulation

While the economic theory behind electric deregulation seems solid, a series of issues have emerged as deregulation has moved from theory to reality.

First is the issue of stranded costs. The debate over stranded costs is so contentious that even the definition of the term is up for debate. For those in favor of recovery, stranded costs are those investments made by electric utilities under the old regulatory regime that cannot be recovered in the new competitive market, and therefore must be paid by consumers. For opponents of recovery, stranded costs are the result of poor business planning by the electric utilities, and not the customer's responsibility.

The decision whether to pay stranded costs to the utilities is a difficult one, with the potential to seriously impact the newly deregulated market. If stranded costs are allowed to be recovered, consumers would pay a surcharge to the regional utility, which could at least partially offset the savings from deregulation. On the other hand, if stranded costs are not paid, the regional utilities would face a large liability they may not be able to pay off, which could result in bankruptcy. Because the regional utilities are needed to maintain the electric distribution system, any regional utility bankruptcy would seriously jeopardize the survival of the deregulated market.

The second issue that has arisen as electric deregulation has become a reality is the danger of the current monopoly system being replaced by an equally inefficient oligopoly of electric providers. Electric generation plants represent a huge capital investment that few firms are capable of making. If only a small number of companies are interested in purchasing these generating assets, the envisioned fervent competition between electric providers may not materialize, and the resulting cartel of electric producers would be free to set prices at any level, which could quickly doom deregulation.

Deregulaton and the Hospitality Industry

So what does all of this mean for the hospitality industry? As a large consumer of electricity, the industry will see potentially substantial benefits from deregulation. If estimates by the United States Department of Energy's Energy Information Agency are correct, retail prices for electricity will fall between 6 and 13 percent within two years of deregulation, and could drop by as much as 24 percent in intensely competitive markets. However, to enjoy the full benefits of these price drops, the hospitality industry must start preparing now for the new world of deregulated electric power.

The most important decision that must be made in the deregulated electric market is the choice of which aggregation group to join. Aggregation is the process by which many electricity consumers band together to purchase electricity in bulk. Because electric providers offer discounts based on the amount of electricity purchased, aggregation will make sense for all but the very largest of electricity consumers.

Currently, aggregation policies vary widely by state. For instance, in Massachusetts, cities and towns are empowered to automatically include every residential and small commercial customer in their aggregation group unless individual consumers elect to opt-out. While in Pennsylvania and California, cities and towns must get opt-in approval from each customer before they can negotiate rates on their behalf.

The diversity of aggregation rules between states requires that customers educate themselves on the law in their jurisdiction. Upon understanding the aggregation rules, consumers then must investigate the various aggregation groups, and attempt to find the organization that can negotiate the best deal. Although this research can be time consuming, the resulting energy savings make it well worth while. In the hospitality industry there is also the potential for aggregation by just one or two companies that own or control significant assets. Economies of scale are already well recognized in many aspects of the industry. Electricity purchasing power might be the next addition to the list.

For More Information

Because information about electric deregulation changes on a monthly or even daily basis, the rapidly updated Internet is among the most effective ways to gather additional information. You will find the following sites particularly useful:

To Follow Federal Action On Electric Deregulation, Visit:

http://www.house.gov/commerce (House Commerce Committee)

http://www.senate.gov/~energy (Senate Energy and Natural Resources Committee)

To Obtain The Status Of Electric Deregulation In Your State:

http://www.eia.doe.gov/cneaf/electricity/chg_str/regmap.html

For more detailed information about how electric deregulation will affect your state, visit the Web site of your public utility commission. All 50 commissions are listed at: http://www.naruc.org/Stateweb.htm

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Mr. Migdal is a member of the Hospitality Group and practices in the Washington, D.C., office He can be reached at 202-457-5925 and at nmigdal@hklaw.com. Mr. Arenson was a 1999 Summer Associate in the Washington, D.C., office.