Scott and Berger Respond

By Frank A. Scott and Mark C. Berger

The production and consumption of electric power is a critical part of the state’s and the nation’s economy. Driven by technological advances, the electric utility industry is changing all over the world. The generation of electric power is no longer a natural monopoly, but is becoming inherently more and more competitive. As economists, we are well equipped to analyze and understand how these changes will occur and what the effects will be. As academics, our role is to shed light and not to blow smoke. We hope that our earlier report and the above article embody both of these notions.

No Utility is an Island. Freshwater and Goetz make three main points in their response to our article and then offer several additional comments. Let us first address each of their three points. Regarding their first point, it is mistaken to think of each power company as an island. Electric utilities have clearly defined distribution territories, but their transmission lines are all interconnected and they buy and sell power continuously. A visit to the power marketing operations at LG&E or Cinergy would be very educational for Freshwater and Goetz. There they would see how active the market for wholesale electric power is. Power is bought and sold for the next half hour, and for six months from now. These wholesale exchanges of power occur in unregulated markets and prices are determined by market supply and demand. Freshwater and Goetz at least are aware that power sales occur between the upper Midwest and Florida, and between buyers and sellers in lots of other locations as well. These sales occur at prices that average less than two cents per kilowatthour, however, and not at five cents per kilowatthour as Freshwater and Goetz apparently believe.

Choosing the Number that Suits You. Freshwater and Goetz base their entire analysis upon one number, 6.5 cents per kilowatthour, that they lifted without explanation from an EIA report. This report has a table of estimated national average prices under competition. Five different scenarios for deregulation are presented for five different time horizons. The estimated competitive prices range from 5.3 to 6.5 cents per kilowatthour. The EIA also has projected prices for each region. For Kentucky’s region, the projected prices for the year 2000 are between 5.0 and 5.2 cents per kilowatthour. The most favorable interpretation that we can give to Freshwater and Goetz’s assertion that the price of electricity will rise to 6.5 cents per kilowatthour for all Kentuckians is that they have been very sloppy in their research, by ignoring available regional price projections and by choosing an extreme value for national price rather than a mid-range value.

Airplanes or Telephones? The second point that Freshwater and Goetz make is that rural customers participate in thinner markets than urban customers, and that deregulation of certain industries may not hold as much promise for rural residents as a result. That point has some relevance for certain industries such as air transportation, but has no relevance for electricity deregulation. As we continue to emphasize, it is the electric power component of customers’ monthly bills that will be subject to competition, and not the transmission, distribution, administration, or tax expense components. The appropriate deregulation analogy is to long-distance telephone service. Competition and customer choice have led to lower long-distance telephone rates for rural and urban customers. AT&T, MCI, and GTE Sprint compete for the patronage of anyone connected to the telephone grid, regardless of location. The same will be true for electricity. Enron, Entergy, LG&E/KU, Cinergy, AEP, and others will aggressively seek the business of customers in Hancock, Pike, Pulaski, and Trigg counties, and in Lexington and Louisville as well.

One Thing that We Agree on. The third point made by Freshwater and Goetz is that different households will be affected differently by electricity deregulation. We agree. Low-income households tend to spend a greater proportion of their income on electricity than middle and upper-income households. Thus they stand to gain relatively more if electricity prices fall, and to lose relatively more if electricity prices rise.

The Fallacy of Sunk Costs. Freshwater and Goetz make several additional points in their response, two of which we find particularly disturbing because they indicate a basic ignorance of economic theory and logic. Let us respond to each of the additional points in turn. First, we did not argue nor have we ever argued that "all the fixed costs in the industry will be ignored." Instead, we have argued that firms will ignore their historical or "sunk" costs when making current production decisions. If Freshwater and Goetz can find a single colleague in the Agricultural Economics Department at UK who agrees with them that sunk costs are relevant to current production decisions, then Professors Scott and Berger will publicly eat a copy of this issue of Foresight. To make sure that there is no confusion about sunk costs and fixed costs, let us be clear. Fixed costs are forward-looking in nature. Firms pondering an investment will proceed only if they can reasonably expect the revenues generated to cover both the fixed and variable costs associated with the investment project. After the investment is undertaken, only the variable expenses will affect the firm’s production decisions. So, fixed costs will definitely not be ignored. Utilities will not build new generating units unless they can anticipate that both fixed and variable costs will be covered. In deciding whether to use an existing unit to generate electricity, however, utilities do not look backward at what it cost to build the unit in the first place. These costs are sunk and irrecoverable. This concept is a basic tenet of production and cost theory that Professor Scott teaches to first-year graduate students in economics and agricultural economics. Most of them have no trouble grasping it.

What an Upward-Sloping Supply Curve Means. Freshwater and Goetz also assert that our model assumes that "following deregulation and the drop in prices there is no decline in power production—that is, supply is invariant with price." This statement is even more shocking than the sunk cost fallacy. Sophomores taking principles of microeconomics at the University of Kentucky learn in the third or fourth week of the semester that more of a commodity will be supplied at higher prices than at lower prices. This relationship between supply and product price is illustrated by an upward-sloping market supply curve. Both Figures 2 and 3  contain upward-sloping supply curves for electricity. The accompanying text carefully explains that more power will be supplied as the market price of electricity rises. We could not in good conscience give a passing grade to a sophomore student who read our article, looked at the figures, and concluded that "supply is invariant with price."

Long-Run Adjustments. Freshwater and Goetz assert that our analysis has not taken into account the dynamic adjustment process that will occur in the electric utility industry. We beg to differ. We explicitly discuss the role that new generating capacity will play in the long run, not the short run. We repeatedly emphasize that the time horizon for long-run adjustments in the industry has shortened considerably, because utilities can bring a new generating unit on line much more quickly than they could a decade ago. These are not our original ideas, instead they come from articles written by electric power engineers and planners in trade journals that are cited in our original report.

A Primer on Academic Research. Finally, Freshwater and Goetz point out that the four investor-owned utilities who sponsored our original research project were not all completely pleased by everything contained in our research report. That is true. We suggest that this confirms the objectivity and dispassion of our research. A little background is in order here. In late 1996 and 1997 we were approached separately by the four investor-owned utilities, by representatives of the National Rural Electric Cooperative Association, and by one of the electric cooperatives in the state. Each group wanted to discuss the possibility of our conducting an analysis of the effects of deregulation on the electric utility industry. We described to each group how such a study should be conducted. In each case we explained how we would proceed, but could not provide any guarantees about what we would find. Only the four investor-owned utilities were comfortable funding a research project on that basis. Along the way we had many spirited discussions with economists and other experts employed by the utilities. We considered their many suggestions and criticisms, and incorporated the ones that we agreed with and rejected the ones that we disagreed with. The National Rural Electric Cooperative Association ultimately found its way to Professor Freshwater, who is Program Manager for the TVA Rural Studies Center, funded by the same TVA that under the existing regime charges Pennyrile RECC more for wholesale power than Kentucky Power charges retail residential customers in Pike County.