During the more than 100 years from the inception of the electric utility industry in the latter part of the 19th century through 1995, the inflation-adjusted price of electricity in the United States dropped by about 85 percent, the U.S. power grid enjoyed a reliability record second to none, and the industry achieved the world's highest output per employee. Every year, customers consistently ranked their local utilities among the one or two most respected institutions in their communities. All this was achieved under a system where most utilities owned all their own generators, high-voltage transmission lines, and local distribution systems in one vertically integrated, regulated (or government-owned) company.

Given all of this, one might wonder why states across the country embarked several years ago on ambitious plans to unleash the forces of competition on their electric power industries. Most industry observers believe that the transmission and distribution functions are natural monopolies that must have their prices regulated. Electricity generation, on the other hand, is a distributed activity that allows for many independent participants and thus could operate more effectively in a deregulated environment. For example, deregulated industries are generally better at realizing the full benefits of certain efficiencies and cost savings in the way a product is made and sold. Since 1978, when the Public Utilities Regulatory Policies Act (PURPA) began the process of deregulating electricity generation by requiring utilities to purchase power from some independent generators, nonutility and utility companies alike have been able to build power plants more quickly and operate them more cheaply by using standardized designs and outsourcing some functions.

Another theoretical benefit of a deregulated market is its ability to distribute gains and losses that result from good and bad investment decisions in a less political way. In the late 1970s and early 1980s, the regulated industry constructed a number of power plants for which consumers paid too much either because of cost overruns (nuclear power being the best example) or because the plants were built when they weren't really needed. This seems to be happening less often now that wholesale and in some cases retail competition have been introduced, though any competitive industry makes investment mistakes too. In those cases, however, it is the market that disciplines management and determines the long-term allocation of the costs of unsuccessful investments between shareholders and customers. One of the factors contributing to the California crisis was the presence of retail price caps that prevented a market-based allocation of risks and costs.

The enhanced customer choice provided by power deregulation also is expected to yield a broader array of new products and services and alternative pricing plans. Just consider how innovative the telecommunications industry has been in the 15 to 20 years since it was deregulated, and the possibilities in the electric power industry are clear. Bundled electric and Internet service or electric and long-distance phone service are perfect examples. Down the road we can expect a new emphasis on alternative sources of energy and "distributed generation" through micro-power plants owned and operated by individual companies and institutions.

These arguments, a perception of success in other deregulated utility sectors, and a desire to diversify energy sources led the federal government to start the process of deregulation at the wholesale level of the generation business with passage of the National Energy Policy Act of 1992, which went far beyond PURPA in allowing for independent power generation. States began to take the next logical step--deregulation at the retail level--when California became the first to pass a deregulation bill in 1996. Dozens of states followed California's lead, particularly in the Northeast, where relatively high prices for electricity also drove policymakers to embrace deregulation as a boon to economic development. …