By David Freshwater, Stephan Goetz and Scott Samson
From Foresight, Vol. 5, No. 1
published 1998
Experience suggests that, for the nation as a whole, significant increases in efficiency do occur with less direct regulation. However, experience also suggests that the benefits are not uniformly distributed, and while the aggregate gains exceed the losses, there will be losers.
Rural people have been among the most vulnerable to losses from other efforts to reduce regulation. Because they were intentionally assisted under the old rules and because the benefits of competition under the new rules often do not fully flow to small and remote places, rural areas are adversely affected by deregulation. Here, we provide a general analysis of how changing electricity regulations could affect rural areas in the state and a more specific assessment of the potential impacts on four counties: Hancock, Pike, Pulaski and Trigg. These counties were chosen to provide a cross section of a diverse rural Kentucky; they obtain power from different sources, they vary in size, their economies differ, and they are in different regions of the state. Yet it would appear that in all four of these counties, regulatory change is unlikely to improve circumstances for people.
Tighter integration into a larger market can benefit rural areas. In more remote areas where local monopolies have contributed to higher costs or failed to provide modern technologies, deregulation may be beneficial. But in those areas where the local market has operated at a low price or provided services that are not supported in the larger national market, painful adjustments may lie ahead. For example, the Pennyrile RECC makes three-phase power available throughout much of its service area as a service to farmers rather than providing it strictly on demand. In a market-priced system, a less costly distribution system would be employed and each farmer requiring three-phase power would likely face an incremental charge for the service.
While the potential rural outcomes of deregulation are receiving little consideration, significant discussion of rural areas is warranted. The source of electricity in rural areas differs significantly from that in most urban places. Investor-owned utilities have a much smaller share of the market because cooperatives and federal power agencies are large enough to have a substantial impact at the margin on regional power production and flows. Because they are not investor-owned, it cannot be assumed that coops and federal agencies will react to regulatory change in the same way as investor-owned utilities. Nor will the usual regulatory authorities have the same influence over these institutions.
Further, because of low density population and often more difficult terrain, rural service exacts higher costs. In addition, the high incidence of low-income families and individuals and the absence of alternatives to electric heat in many rural homes may make any increase in electricity rates particularly burdensome.
Past cross-subsidy decisions are also important to understanding rural power systems. To assure the availability of electricity in rural areas that investor-owned firms were unwilling to serve, the federal government fostered the development of cooperatives, provided subsidized loans, and allowed preferential access to power from federal facilities. Another important form of subsidy in rural areas comes from the beneficial effects of a single price within a rate class, which assures customers in remote parts of a service area electricity at the same price as those in more urbanized locations.
Rural areas also support generation and transmission activities. Consequently, rural residents are most exposed to the negative consequences of the construction and operation of these systems. Since the current pattern of generation and transmission facilities is likely to be inappropriate for a deregulated environment, significant investments will have to be made to reduce generation and transmission costs. If rural residents receive few benefits from deregulation, they will have little reason to cooperate in siting new facilities.
Kentucky’s remarkable diversity is also evident in its electricity sector. Unlike most states, electric power in Kentucky comes from investor-owned utilities (IOUs), electric cooperatives and federal agencies. And demand for electricity in Kentucky has outpaced the national demand. While national demand has risen steadily over this decade, growth in sales of Kentucky’s inexpensive electricity has been much stronger, rising 6 percent in 1992 and almost 20 percent in 1995 (see Figure 1).
Figure 1: Growth in Electricity Demand, U.S. vs. Kentucky, 1991-95
Because electricity in Kentucky is now cheap by national standards, any movement to a national market-based pricing structure with less price variability among the regions of the nation will increase the price paid by most Kentuckians. Electricity, like money, is a standardized commodity and the economic characteristics of power markets have strong similarities to those of financial markets where arbitrage equalizes prices. Just as with financial markets, competitive power markets need not require major increases in the amount of power flowing from one geographic area to another, but they do require that prices in all areas adjust in response to marginal flows of power. For electricity markets to become more competitive, it will be necessary for rates everywhere to reflect these marginal flows of power.
A major objective of the changes in federal regulations is to facilitate the flow of electricity from low-cost regions to high-cost regions and stimulate competition. Since the regulatory changes, one of the main activities in the industry has been a search for mechanisms to facilitate this flow of power. Efforts to create futures markets for electricity and develop new ways to manage the power grid, such as the creation of Independent System Operators to minimize transmission costs, are central to the success of the deregulation scheme. Given the complexity of the changes, there is no consensus on the magnitude of price changes in various places, but computer models that forecast price convergence project higher prices and increased conservation by consumers in regions where prices are now low, and increased use and less generation in regions where prices are now high. Our analysis uses a national equilibrium price of 6.5 cents per kilowatt-hour (kwh) as an estimate of how prices may change. By comparison, the present national average price is about 8.4 cents, so for the nation deregulation is likely to result in a drop in the average price.
Logically, in Kentucky, where average rates are now well below the national average, the general direction of price changes will be up, if markets work and convergence occurs. However, even in Kentucky, some areas may see a price decrease if increased competition results from deregulation. In some parts of the state, present rates are above 6.5 cents per kwh, so prices may drop for these areas.
There are clear limits in making comparisons of the electricity industry to regulatory changes in other sectors. As well as banking, other typical comparisons have been to the natural gas, airlines, and long distance telephone industries. However, all such comparisons are carefully qualified by the fact that there are unique aspects to the electricity industry that limit direct comparisons to the outcomes from these other changes in regulatory environment.
Most importantly, electricity markets remain subject to laws of physics that can significantly constrain efficient market outcomes. Perhaps the three most important points to keep in mind from our experience with other sectors that have undergone major changes in regulatory structure are:
Ultimately, these are changes in regulatory systems, not pure deregulation.
The impacts of changes were not equal across the nation and in particular, rural areas experienced different impacts than urban places.
An ideal competitive situation did not materialize across a single national market.
In each earlier case, (1) additional regulations were required to provide a framework for price-driven transactions to develop; (2) rural areas often experienced fewer benefits of competition than urban places, where volume was large enough to bring about workable competition; and (3) firms found ways to exploit monopoly power, either by consolidating or by creating entry barriers. As a result, while the change in regulatory structure may have been beneficial for the nation, the magnitude and distribution of the benefits did not match the ideals that were often promised. Electricity deregulation may repeat this pattern.
To examine the effects of changes in regulations on the four counties, we followed two approaches. The first, a county-level input-output model, IMPLAN, shows how changes in electricity prices pass through to the local economy. Input-output models capture the links among various sectors of the economy. A change in the price of electricity affects the production costs for industry, as well as income, employment and household consumption.
In the first scenario, we changed residential rates in all four counties to 6.5 cents per kilowatt, the U.S. Department of Energy estimate of the average national price under their base deregulation scenario. For the nation, it represents a decline of roughly 2 cents from the current average price, but for Kentucky, this new price raises rates in two of the counties studied, is identical to the current rate in one, and lowers the rate in the fourth. Under the change in residential rates, the impacts on the four counties are modest, despite the fact that the price increases are large in percentage terms in the two counties where prices increase (see Table 1).
Table 1: Results from IMPLAN Scenarios
The model produces relatively small effects because, on average, households do not alter their consumption pattern by much, and the model treats the rest of the national economy as experiencing no price change. Since we cannot determine what share of county exports and imports go to regions of the country where electricity will go up in price and what share goes to regions where it will fall, we did not change the levels of county imports and exports. The model captures only pure local effects of price changes. The best way to interpret the results is in terms of magnitudes of changes between counties under different scenarios.
In the second scenario, we alter the price of electricity to manufacturers to 5 cents per kilowatt-hour, which preserves much of the existing gap between industrial use rates and household rates while keeping residential rates at 6.5 cents. Higher industrial rates are predicted because one of the functions of a market-based system should be to equalize rates among types of use as well as regions. If a Kentucky generator can consistently sell power to New York for 6.5 cents, it will not likely sell it locally for 3 cents.
The resulting price impacts on the four county economies increase, but not by a large amount. While Hancock County was relatively unaffected by the change in residential rates, it is now the most affected because it has a large energy-consuming aluminum industry. Pike County, which has an increase in electricity rates of roughly the same degree, has a much smaller effect; there is almost no change from the first scenario. The other two counties started with significantly higher industrial electricity rates and also have few energy-intensive industries, so price changes have a smaller effect. Only Trigg County experiences a decline in industrial rates under this scenario and creates small increases in output, employment and income.
In the third scenario, we increase county prices by 20 percent above the new prevailing national price of 6.5 cents for residential rates (see Table 1). This scenario captures the likely effect of higher transmission and distribution costs in remote, sparsely settled areas. If generators can sell power in areas easier to serve, they will demand that customers absorb the higher costs for delivering power in rural places. In this scenario, all four counties experience a price increase, with consequent negative effects on output, income and employment. Hancock County experiences larger effects than those of the other three counties, but the effects in Pulaski County are the second most pronounced despite the fact that the price increases are higher in Pike County.
In the fourth scenario, we look at impacts on different types of residential customers. The analysis looks at some key indicators: median household income, percent of homes using electric heat, median age of housing, percent of mobile homes, percent of persons below the poverty level, and population density. The data show, at the block level, a strong positive correlation among a higher incidence of poverty, lower median household income, older housing, and the prevalence of mobile homes. Because electricity has been relatively cheap in Kentucky, a uniformly high incidence of electric heat is found in all block groups.
Low-income households spend a higher share of their income on electricity than wealthier households. Thus, an increase in electricity rates has a proportionately larger effect on the poor than the wealthy. Based upon data from Pulaski County, Table 2 shows some estimates of the impact of changes in electricity rates on households with different levels of income and different types of homes. Clearly, those with lower incomes who use electric heat are most adversely affected by rate increases. Not only is the expenditure share greater, but the ability to adapt is more limited because the poor have little or no discretionary income. If the poor are housed in older homes with substandard insulation or in mobile homes with similarly poor insulation, the effects are more pronounced. When the high incidence of electric heat is considered, it is clear that the potential for major adverse consequences for a specific subpopulation of the county exist.
Poverty is an endemic problem throughout Kentucky. None of the four counties examined is among the most disadvantaged in the state, so the potential exists for more extreme impacts. Most rural areas may also experience additional consequences from regulatory change. If retail pricing systems allow price differentials within the residential rate classes to eliminate cross-subsidies, then those in low density areas remote from substations will experience significant price increases due to the higher cost of providing them electric service. Since the block group data for the four counties suggest that the poor are concentrated in just these areas, the adverse distributional consequences are even harsher. The analysis suggests that for the county as a unit, the local economic impacts of the new regulations will be small because rural counties are far more dependent on external economic conditions than their internal dynamics. However, within a county the effects on individual households can differ widely.
Perhaps the greatest issue for rural Kentucky as a whole is the impact of changes in residential rates. Much of rural Kentucky has both a high incidence of electric heat use and a high incidence of poverty. While a modest increase in electricity rates may not be painful for those at or above the median income, those living in poverty, particularly in substandard housing heated by electricity, will be adversely affected. For these people, the absence of discretionary income may mean choices about food versus heat if rates increase by even a modest amount. The fact that Kentucky has historically had relatively low electricity rates has led large numbers of people to adopt electric heat. At the time of construction, there is usually only a small difference in costs among alternative heat sources, but changing a heating system requires a large investment. Past price patterns have locked a large number of Kentuckians into reliance on electricity for heat. If rates increase, the option of changing heating systems will be lost to many.
Historically, electric utilities have been one of the strongest advocates of local economic development because it offered a logical way to build load and shape it so that peaks and troughs were reduced. Deregulation will reduce much of this incentive. Companies may be able to sell power to other areas instead of relying on native load, and if customers can buy power from other sources, they will have little incentive to locate in a particular area.
For rural areas this could have a major impact. Not only has cheap power been one of the few attractions of some rural places, but the expertise of the power company has been a critical factor in defining and executing local development strategies. Without the local power company’s support, many rural places will be pressed to maintain their development efforts at a time when other changes demand that a coherent development strategy be in place.
While the analysis conducted in this study provides some additional information on the consequences of regulatory change on rural areas in Kentucky, far too many important questions remain unanswered for a full understanding of the outcomes to be developed. At a minimum, policymakers need a clearer understanding of the following issues to develop new regulatory policy for the electricity industry that will result in market forces that will not further disadvantage the development of rural areas.
To what extent will competition occur in rural areas and to what extent will it lead to a convergence of electricity rates among regions to a narrower range of values?
How will rural areas served by cooperatives fare relative to areas served by investor-owned or municipal systems?
What is the magnitude of the average price increase that Kentucky will face as more power is moved from region to region? How high will charges for shifting power be and will transmission constraints limit the flow of power? How will policies on lost pass-through costs in other regions affect the demand for power from Kentucky?
To what extent will rate differentials be preserved to allow manufacturers in Kentucky to retain access to low-cost power? If they narrow, how will Kentucky’s economic development strategy and prospects be affected?
To what extent will the changes in electricity regulation benefit the national economy and will improvements in the national economy offset the negative effects within Kentucky?
None of these questions have easy answers and many cannot be resolved until regulatory changes unfold. While policy development cannot be deferred until all questions are answered, concern about these issues should be present in the discussion of regulatory change. Otherwise, it will be tempting to assume that these changes will create no losers, and that all will benefit equally from deregulation.
The final and most striking conclusion that emerges from the work is that much of the current discussion of outcomes of electricity deregulation is not applicable to rural areas in Kentucky. Instead, the debate has focused principally on the effects on generators of power and on customers who will likely benefit from lower rates. Little attention has been given to those customers who will likely pay more.
Expectations of deregulation are high. Current customers of high-cost providers of power expect deregulation to result in lower rates. Low-cost providers support deregulation in expectation of higher revenue from sales to other regions. Owners of high-cost generating facilities such as nuclear power plants have argued for payments to cover the anticipated losses of pass-through costs. None of these groups has an incentive to discuss prospects for the current customers of low-cost generating facilities. But if the owners of high-cost generating capacity in the Northeast and elsewhere are entitled to adjustment compensation for lost pass-through costs, then similar consideration should be given to residential and industrial customers who will see their rates rise with regulatory change.
David Freshwater and Stephan Goetz are, respectively, professor and associate professor of Agricultural Economics, and Scott Samson is assistant extension professor in Rural Sociology at the University of Kentucky. Dr. Freshwater is Program Manager of TVA Rural Studies. This work was sponsored by the National Rural Electric Cooperative Association.