Academic journal article Independent Review

Incumbent Vertical Market Power, Experimentation, and Institutional Design in the Deregulating Electricity Industry

Academic journal article Independent Review

Incumbent Vertical Market Power, Experimentation, and Institutional Design in the Deregulating Electricity Industry

Article excerpt

Vertical market power has been an essential characteristic of the regulated electricity industry for the past century. A vertically integrated, regulated utility has complete downstream market power; this vertical monopoly power is subsumed within the business model because regulation erects legal entry barriers and regulated electric utilities have been vertically integrated. Unfortunately, regulation can enable such market power to persist even when economic dynamism and technological change might otherwise erode it.

This regulation-reinforced vertical integration in the electricity industry has broken down to some extent over the past three decades, with some liberalization and regulatory restructuring in the 1990s due primarily to the dynamic effects of innovations in electricity generation that have reduced economies of scale. But despite some statutory changes in regulatory institutions in some states, retail competition for residential customers remains sluggish, and little innovation in products, services, or pricing has occurred in those markets. Regulatory restructuring has nominally reduced legal entry barriers in retail markets in fifteen states and the District of Columbia, but in most states entry has been small, and few innovations in products, services, or pricing have occurred.

Regulation-enabled incumbent vertical market power reduces experimentation by both producers and consumers in these restructured states. Such experimentation is the essence of the entrepreneurial market process. An incumbent's presence in a downstream market can act as an entry barrier, undermining producer and consumer ability to experiment by raising costs and reducing variety. In regulated industries such as electricity, the kind of economic experimentation that has become common in our digital society cannot occur because legal rules erect entry barriers and define market boundaries that reinforce the vertically integrated organizational structure of regulated monopolists. Yet technological change occurs outside the industry, putting external pressure on those boundaries and business models. By so doing, it also affects how competitive markets that were previously subject to stringent economic regulation, such as retail electricity markets, can be.

Innovation in retail residential energy products, services, and pricing are increasingly feasible due to innovations in digital communication technology happening outside the industry. Digital innovation has happened at a rapid pace and has become a driver of new value creation and economic growth. Vint Cerf, one of the original creators of the Internet, attributes this pace and impact to its bottom-up, distributed creation and its nature as a platform for "permissionless innovation": "When I helped to develop the open standards that computers use to communicate with one another across the Net, I hoped for but could not predict how it would blossom and how much human ingenuity it would unleash. What secret sauce powered its success? The Net prospered precisely because governments-for the most part-allowed the Internet to grow organically, with civil society, academia, private sector and voluntary standards bodies collaborating on development, operation and governance" (2012).

One project that tested the individual and system effects of the combination of digital, transactive technology with dynamic pricing was the GridWise(TM) Olympic Peninsula Testbed project in 2005-2006 (Chassin and Kiesling 2008; Chassin 2010).1 In this project, each household had a price-responsive thermostat that the customer could program to respond autonomously to changes in electricity prices over the course of the day, without any further homeowner intervention or manual control; this capability is also known as "transactive control." Homeowners could also choose a retail contract from a portfolio of contracts comprising a fixed retail price, a time-of-use retail price with two peak periods per day, and a real-time retail price that reflected wholesale prices in five-minute market intervals. …

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