Electricity Regulation and Market Power, from the May, 1999 Issue of Electricity Journal, with permission

May 18 1999

"Published in May, 1999, Electricity Journal (with permission)

Institutional Contexts of Market Power in the Electricity Industry

Albert A. Foer1

Market power is widely recognized as one of the principal issues that must be dealt with if the electricity industry is to make the transition from regulation to competition.2 In this essay, I provide a legal and economic introduction to what the antitrust community3 means by "market power" and explain why market power is so central an issue in the electricity industry. Finally and most importantly, I offer comments on the institutional contexts of market power, exploring the process which I call "Shermanization"- institutional aspects of moving from regulation to competition.

I. What is Market Power?

In the economists' model of a perfectly competitive market, all competitors (both sellers and buyers) are PRICE TAKERS. No competitor has the individual power to set prices.

At the other extreme is monopoly. A monopolist or dominant competitor has power to set the market price by unilaterally limiting output. The objective may be, but doesn't have to be, to maximize profit. (E.g., a monopolist could limit prices in order to discourage new entrants, in the interest of long-term rather than more immediate profit or could lead the easy life of eating up possible profits by high costs. Further, a monopolist may choose not to limit output to increase price, if it can price discriminate.)

Between competition and monopoly is oligopoly, a market structure dominated by the "few". Working jointly or by implicit parallel behavior, oligopolists may have the same power as monopolist to control prices. Oligopolies may be tighter or looser, depending on the number of oligopolists and the nature of their interactions.

"Market power" is the term applied wherever a supplier has the ability to raise its prices above the purely competitive level on a sustained basis, i.e., to set price above marginal cost (after including a reasonable return on investment). Where there is a PRICE MAKER, there is some degree of market power. Market power does not require monopoly or oligopoly power over a full market, but requires consumers to perceive that there are no exact substitutes for the product or service, or that such substitutes are in short supply. Thus, differentiating a product through advertising may create a niche in which there is market power.

Short-term market power in this sense is not at all uncommon and may be necessary to induce technical innovation and improved quality. Antitrust law generally requires "substantial" market power before there is an illegal restraint on trade or other legal problem.

Note that while market power is usually thought of in terms of higher prices, it can be manifest as lower quality of products or services, less innovation, and less variety of products or services-compared to what would be found in a more competitive market. Finally, market power is not limited to sellers. Buyers can also have market power. For example, large industrial customers of electricity have far more ability to affect pricing than residential customers.

II. How is Market Power Created and Sustained?

Market power can be created and sustained in a variety of ways. A "natural monopoly" is said to exist where the nature of the particular market is such that it is noticeably inefficient to have more than one supplier. A prime example is the transmission of electricity.4 Typically, once a substantial market is recognized as a natural monopoly, the public builds protection against market power through regulation, government ownership, or cooperative ownership.

Market power can be created by the elimination of competitors and potential competitors through horizontal mergers or by the foreclosing of competitors through vertical mergers. This is generally subject to Section 7 of the Clayton Act.

Collusion, where two or more firms can conspire to act more or less like a monopolist, is a method for competitors to gain market power. Once this is recognized, the public protects itself through antitrust enforcement. Horizontal price fixing is per se illegal and punished severely under Section 1 of the Sherman Act.

Unilateral anticompetitive behavior can also achieve market power. While we want firms to engage in aggressive competitive behavior, we do not want them to cross the line into what is actionable as unfair competition, an unreasonable restraint of trade, or monopolization. Unfair methods of competition are illegal under Section 5 of the Federal Trade Commission Act and "Little FTC Acts" at the state level. Section 2 of the Sherman Act makes it illegal to maintain or attempt to gain a monopoly.

Finally, there are many different ways in which governments help establish or maintain market power, sometimes directly, sometimes indirectly. Electric utilities, both privately-owned and publicly-owned, have traditionally been heavily regulated monopolies. On the one hand, price regulation by government usually prevents or reduces the profitable exercise of market power by the monopolist; on the other, it is usually coupled with a government-granted retail territorial franchise that prevents entry of new competitors and may even include quasi-governmental authority to build new facilities using eminent domain.5

To complete this brief overview, we need to make reference to three frequently encountered terms: barriers to entry, price discrimination, and vertical integration.

Imagine a market as a bounded physical space having competitors inside. These competitors naturally don't want new ones to come into their space. Barriers to entry are what make it difficult for new competitors to participate. The ultimate tactic for maintaining market power is to locate oneself behind entry barriers (such as economies of scale or know-how) or to construct barriers around your market, so that competitors can enter, if at all, only on disadvantageous terms.

In a purely competitive market, there is only one market price. From a supplier's perspective, it may be desirable to break customers into various categories, charging consumers in each category as much as they are willing to pay. This strategy is called "price discrimination": with market power, a seller may maximize profits by charging different prices to different consumers for the same product.

Vertical integration (e.g., owing both generation and transmission facilities) can also be a strategy for gaining or taking advantage of market power. Economists have developed fairly sophisticated theories about the potential negative effects of vertical integration:

(i) Vertical integration can force two-level entry, which may make entry more difficult.

(ii) Vertical integration can allow price discrimination.

(iii) If there are customers in market B that do not buy the product in market A in fixed proportions (or at all), vertical foreclosure may allow the monopolist in market A to leverage its power into B by either controlling some of the implicit substitution of B for A or by extracting monopoly rents from B purchasers that were beyond the reach of the monopolist when it only sold product A.

(iv) By tying two products together and forcing others to exit the related market, the monopolist may be able to reduce research and development competition in the related market, which may increase a monopolist's profits.6

Enough! What does all this have to do with electricity restructuring?

III. Market Power and Electricity Restructuring

Electricity restructuring can be described as the movement from a mature vertically integrated governmentally-regulated monopoly to a functionally unbundled framework supported by some measure of regulation at the federal and state levels.

The electricity restructuring movement is motivated primarily by (a) the desire to bring choice to consumers and to open the market to competition, with all of competition's pricing and efficiency benefits, and (b) the desire to take advantage of innovative technologies that have changed the economies of scale in the generation sector. The new technology arguably takes the generation of electricity out from its historic natural monopoly shelter, making the generation level, at least, "safe" for competition.

In explaining why things are now changing, it is also important to observe that ideologically, the public and opinion leaders today generally have more confidence in markets and less confidence in the ability of governments to act as a surrogate for the market.7 We are developing new institutions (like open access tariffs and ISO's) to replace the vertically integrated geographic monopoly, in order to take advantage of potential efficiencies. Additional institutional changes will be required.

The benefits of changing over from a regulated electricity industry to a competitive industry sound terrific in the abstract. But the transition will not be easy and if not undertaken with extreme care, may not lead to the desired outcomes. The potential for market power abuse in the restructuring of the electric industry appears in several forms, to which we now turn.

Assuring that the generation level of the industry will be workably competitive is the key to successful restructuring. Whether it will be depends on (a) aggressive merger controls and (b) vertical relationships in the industry.

Horizontal concentration in generation at either the wholesale or retail level.

Where concentration is high, collusion and parallel behavior become more likely. The level of concentration may depend on the geographic size of a market (i.e., the larger the geographic market, the more competitors are likely to be present) and this may depend on transmission facilities being available on competitive terms to generating companies as well as entry conditions in generation and transmission. The on-going wave of utility mergers, apparently in strategic preparation for restructuring, has the potential for nullifying the objective of opening up markets.8 Many mergers involving adjacent geographic markets appear to be aimed at expanding the incumbency advantages prior to the restructuring.

Vertical relationships.

While vertical integration is well-established in the electricity industry, primarily through the peaceful coexistence of transmission, generation, and distribution under one roof, continued vertical integration represents the largest threat to a horizontally competitive generation market.

As we observed, vertical integration can give an inherent advantage to the incumbent, creating an entry barrier to potential entrant generators. More specifically, the vertically integrated utility can use the transmission and distribution monopoly to provide its vertical affiliate various advantages over other retail electricity suppliers or generating companies that have no alternative ways to move their output to market. Potential abuses include: price discrimination, pricing collusion, cross subsidization, abusive affiliate relationships, control of bottleneck or essential facilities, and access to the books and records of competitors or of an affiliated company.

The antitrust community is well-aware of these possibilities and has given much attention to the question of how to avoid competitive problems. Because electricity cannot be stored, electricity trades are particularly vulnerable to subtle discriminations-which are extremely difficult to identify and document. For this reason, the federal antitrust agencies generally favor structural remedies rather than behavioral rules.

FERC's Open Access Rule9 is a behavioral approach to tempering the vertical integration problem. There remains much skepticism as to whether this goes far enough. The Department of Justice Antitrust Division and the Federal Trade Commission, worried about the difficulty of detecting behavioral abuses and dealing with them in a timely way, have favored divestiture-type restructuring, which goes much further in separating transmission and distribution from generation.

Various forms of stand-alone transmission organizations have come into existence and others are being planned. The devil will be in the details: since these will still be monopolistic after restructuring, how best to assure that their market power is not abused? FERC's Chairman recently acknowledged that Order 888 has serious deficiencies and has proposed establishing a generic NOPR or policy statement on regional transmission organizations as a potential remedy for these problems.

Regulated utilities have entered many other product markets (e.g., heating, ventilation and air conditioning) which have traditionally been supplied by unregulated, non-utility contractors. A competitive problem arises when the utility is able to use its regulated assets (such as trucks, staff, mailing lists, logo) to cross-subsidize its competition against non-utility businesses. These problems represent yet another indication of the need for a government (or governments) committed to market solutions to play an active role in the transition to competition.

IV. "Shermanization": Institutional Issues in the Control of Market Power

I offer a new word and its definition: Shermanization: the overlaying of the institutions and mindset of rate regulation by the institutions and mindset of antitrust, appropriate to the process of an industry's deregulation.

Experience with examples of deregulation teaches that competitive markets do not materialize just because theoreticians believe they are good or because there are basic economic characteristics of a market that make it possible to perform more efficiently. Rather, competitive markets are deeply imbedded in social, intellectual, legal, and political institutions.10 Transitions from regulation to competition, therefore, are not likely to work out very well unless the institutional framework is also being changed in parallel ways.11 Transitional problems must not be dismissed as if they don't affect future institutional relationships. The transition can create a life of its own, leading to outcomes that were never envisioned.12

Because of natural monopoly problems and the supreme importance of electricity to our economy and to human lives, it is easy to predict that regulation will not disappear. But the regulatory mission will certainly continue to change. In important arenas, antitrust-type thinking will have to replace rate-regulation thinking. Can this be done without addressing, for example, who regulates what and how such regulators are trained?

The electricity industry is inordinately complex. It is regulated at different levels of government and by a variety of agencies at each level. Because it is of concern to so many different constituencies, we can predict that the multiplicity of regulators won't simply go away. The implication is that we need ways to harmonize and streamline the various parts of the regulatory puzzle. This probably requires federal legislation but a lot can be negotiated among governmental units.

Comparing the FTC, Antitrust Division, and FERC.

At the Federal level, three agencies are particularly involved with market power, FERC, the Antitrust Division, and the FTC. Each agency has advantages and disadvantages for taking the lead in assuring workable markets within a restructured electricity industry, and it is worthwhile to compare these, because of the potential need for re-arranging these relationships in the course of restructuring.

The Antitrust Division and FTC each have substantial legal and economic expertise. Neither has a great depth of electrical industry expertise. FERC has deep industry expertise, but very limited antitrust expertise and indeed an occupational and institutional bias toward regulatory rather than market solutions. Thus we have the possibility of two different mindsets at work. Transition is not just a matter of teaching someone facts; the orientation of a whole career experience is involved.13

The FTC, an independent commission, has focused its electricity industry efforts on advising states on competitive and consumer protection issues.14 While the FTC's statutory mission is somewhat more flexible than the Antitrust Division's, the Division, as an executive agency, has focused more on federal issues. Both antitrust agencies are likely to continue to play roles in finding and remedying generation market power. It would be theoretically open to Congress to re-arrange the various functions and priorities of these agencies and the FERC, if it concluded that adjustments should be part of electricity restructuring.

The antitrust laws generally require the Antitrust Division and the FTC to react after a competitive problem has been identified. One exception is the Hart-Scott-Rodino Pre-Merger Notification Act15, which requires merging utilities to notify and provide information, subject to possible preliminary injunction. The agencies are free, however, to give forward-looking advice to private parties and to governmental units. FERC has on-going oversight and ability to set rules and guidelines in advance of a problem.

The Antitrust Division's jurisdiction is both criminal and civil, the FTC's only civil. In litigation, they must carry the burden of proof. Their standards under the antitrust laws, exclusively involve competition. FERC, with civil authority only, has a public interest standard16 and a utility-applicant has the burden of proof.

The Antitrust Division investigates through its Civil Investigative Demand authority and procedures, allowing it to collect and keep confidential much proprietary information. The FTC issues subpoenas and also is bound by strict confidentiality requirements. FERC, on the other hand, operates in a public fishbowl, with open hearings. Because of this, it has difficulty with confidential information. As a generalization, highly confidential internal strategic planning documents and other proprietary data that help an investigator understand what is happening are more important in antitrust decision-making than in rate-making. One of the institutional changes that is needed, therefore, as antitrust takes on more importance, is a transition from FERC's fishbowl procedures to more confidential investigatory procedures. The magnitude of this change should not be underestimated. It would dramatically affect how much the public (and particularly interested private companies) would know about a transaction and hence would reduce the role of competitors in the agency decision-making process.

Another important difference between the agencies flows from mindset. FERC's approach to competitive issues has tended to focus on behavioral remedies. The antitrust agencies' approach more often tends to focus on structural remedies.

Any decision on the roles of various agencies in overseeing electricity restructuring will necessarily include important political considerations. The Antitrust Division, while its appointed leadership is political, is not subject to capture by one or two industries.17 The FTC, headed by an independent commission and dealing with a multitude of industries, is also unlikely to be captured. FERC is theoretically more subject to the possibility of capture. If FERC is to retain the major responsibility for keeping the generation market competitive, then the majority of its Commissioners and staff must have a strong antitrust orientation. They must be captured not by an industry but, like the Antitrust Division, by an intellectual commitment to the antitrust mindset. This will require a different attitude in the White House before there is a notably different attitude at FERC.

For those pro-competition forces which would prefer to see the electricity industry come more under one of the antitrust agencies, it must be observed that, apart from limited industry expertise, they would always have limited resources to throw at electricity, and might find themselves tied up in a few really large cases (e.g., the Antitrust Division's Microsoft case) at a time when electricity cases could be critical.

On balance, my current view is that it is probably best to keep the principal oversight of electricity in FERC, because competitive issues will continue to be worked out in the context of regulatory decision-making, with industry expertise extremely important. But, it will be necessary to assure that FERC has appropriately trained and competition-oriented personnel, with appropriate changes in investigative procedures to assure the agency's ability to obtain and utilize highly proprietary information without unduly compromising it.

A Special Look at Public Utility Mergers.

Having said that, I want to put on the table consideration of a reversal of roles in the public utility merger area. Today, although FERC approval does not immunize electric utility mergers from the federal antitrust laws, the Antitrust Division gives advice, but FERC makes the decision. Suppose FERC and DOJ negotiated (or Congress required) a new working arrangement that shifts to the Division the primary jurisdiction over competition aspects of utility mergers, using confidential Hart-Scott-Rodino information, while FERC gives advice and also goes forward with all other aspects of its own merger review.

Under this procedure, if the Division does not seek a preliminary injunction, FERC would still be free to make its own decision, using its broader public interest standard. In practice, if the Division sees a problem, there would be negotiations with the merging utilities and with FERC, often resulting in a compromise. The benefit of this arrangement would be to get the Division's competition expertise into merger analysis, with their clout and their stronger investigative process, early on. This should not slow the overall decision-making process but should expand antitrust's role in restructuring. The subtext of this proposal is that the federal government would take a tougher stance toward utility mergers in the transitional period.

The Challenge to FERC.

Among the institutional questions that come up in the transitional context, is how to instill more of an antitrust mentality into FERC. For instance, should the individuals who have antitrust expertise be bureaucratically integrated with others (who focus on rate and tariff issues, for example) or be kept separate within the agency? Sub-organizational separation may be a better way to assure that competition advocates inside the agency get a full hearing. As the agency becomes more Shermanized, separation should be less necessary.

Institutionally, FERC must move from a case-specific orientation, under which each filing is evaluated on its own merits, to an overwhelming concern for creating a competitive market system. Decisions must now be made in a context of whether a regulatory decision will contribute to the longer-range desired end. E.g., a merger which would have been acceptable on a stand-alone basis in the past must now be considered under the federal merger analysis standards, with great concern for the envisioned future of vigorous competition. It is not enough to keep the existing market from becoming less competitive in the near term. Now it is necessary to work from a vision of making a future market more competitive. FERC has the authority to work out the "incipiency" nature of the Clayton Act18 within the peculiar context of a deregulating industry.

Thinking about electricity restructuring requires a separation between the transitional phase we have entered and the free market fulfillment phase that is envisioned to lie somewhere in the future. During transition, FERC and other regulatory agencies will have to engage in both old types of regulation and new. A credible program of market oversight (with governmental market data collection and analysis), coupled with enforcement of behavior rules, is essential. A philosophy of transition should try to keep the industry's structure from changing dramatically until institutions for free markets are more in place. A moratorium on large utility mergers would be appropriate. The "public interest" standard should be employed with the future in mind, a tool for affirmatively building a competitive regime. The institutional conditions for a competitive industry must be identified and constructed before competition can be counted on to displace regulation.

Some Useful References:

An introduction to antitrust law: Shenefield & Stelzer, The Antitrust Laws, A Primer, (Washington: AEI Press, 1993).

The economics of antitrust: Scherer & Ross, Industrial Market Structure and Economic Performance (Boston: Houghton Mifflin Co., 1990).

Regulatory economics: Kahn, The Economics of Regulation, Principles and Institutions (Cambridge: MIT Press,1995).

Introduction to electricity restructuring: Brennan, Palmer et al., A Shock to the System, Restructuring America's Electricity Industry (Washington, DC: Resources for the Future, 1996).

Market power and electricity: Frankena & Owen, Electric Utility Mergers: Principles of Antitrust Analysis (Westport, Conn: Praeger, 1994).

1The author is President of the American Antitrust Institute. This paper is an expansion of a lecture originally prepared for the National Rural Electric Cooperative Association. The author expresses his gratitude for many discussions that affected his views, with: Roger Boner, Charles Higley, John Hilke, Robert Lande, Lara Leibman, Richard Meyer, David Mohre, Allen Mosher, Philip Nelson, David Penn, Wallace Tillman, among others. 2See, for example, Restructuring the Electric Utility Industry: A Consumer Perspective, A Report of the Consumer Energy Council of America Research Foundation's Electric Utility Restructuring Forum, Mar. 1998, pp. 28-37; Alliance to Protect Electricity Consumers, Statement of Principles Regarding Electric Industry Deregulation, Feb. 12, 1998, pp. 7-8. 3By antitrust community, I refer to regulators, lawyers, economists, professors and others who are expert in the antitrust laws. By antitrust laws, I refer to the Sherman Act of 1890, 15 U.S.C. sec. 1,et seq.; the Clayton Act of 1914, 15 U.S.C. sec. 13 et seq.; and the Federal Trade Commission Act of 1914, 15 U.S.C. sec. 45 et seq. 4See Timothy J. Brennan, et al, A Shock to the System, Restructuring America's Electricity Industry (Washington, D.C.: Resources for the Future) pp. 61-80. 5On the relationship between antitrust law and government actions that make anticompetitive behavior possible, see Shapiro and Leibman, Antitrust and Anticompetitive Conduct: the Role of the State Action Doctrine during the Transition to Retail Electric Competition, FTC:WATCH, Jan. 18, 1999, available at www.antitrustinstitute.org . 6On the other side of the scale, vertical integration by a monopolist can be efficiency-enhancing by promoting synergies or eliminating a double monopoly rent that leads to more social loss than the operation of two previously separate monopolies by a single firm. 7There remains a substantial skepticism in many quarters about whether competition will bring advantages to residential consumers and whether the price will be too high in terms of environmental and reliability concerns. See, e.g., Wallace Roberts, "Power Play," in The American Prospect, Jan.-Feb., 1999, pp. 71 et seq. 8The American Antitrust Institute has endorsed the concept of a moratorium on large public utility mergers, initially put forth by the American Public Power Association and the National Rural Electric Cooperative Association in FERC Docket No. RM98-6-000 (1998). See Comments of the American Antitrust Institute Regarding Filing Requirements for Public Utility Mergers, FERC Docket No. RM98-400, Aug. 24, 1998, available at www.antitrustinstitute.org . 9FERC Order 888. 10See, e.g., Sunstein, Free Markets and Social Justice (NY: Oxford Univ. Press, 1997), introduction. 11An expanding literature studies the conditions of transitions from regulation to competition on an international basis, e.g., Kovacic, "Getting Started: Creating New Competition Policy Institutions in Transition Economies," 23 Brooklyn J. of Int. Law 403 (1997). 12When air transportation was being deregulated, no one predicted we'd end up with fortress hubs dominated by monopolistic carriers. 13On the importance of occupational background of regulators, see two works by political scientist Marc Allen Eisner, Regulatory Politics in Transition (Baltimore: Johns Hopkins University Press, 1993) and Antitrust and the Triumph of Economics: Institutions, Expertise, & Policy Change (University of North Carolina Press,1991). 14See Stephen Calkins, Energy Deregulation: A Special Role for FTC's Unique Mix of authority, FTC:WATCH, December 21, 1998, available at the American Antitrust Institute's website, www.antitrustinstitute.org. 1515 U.S.C. sec. 1311, et seq. 16Section 203(a) of the Federal Power Act. 17For a brief review of the "capture" literature, see Walters, Enterprise, Government, and the Public (N.Y.:McGraw Hill 1993), ch. 4. 18The Clayton Act makes illegal mergers that "may substantially lessen competition," which means taking action long before a dramatic level of market power has been achieved.