9/20/2016 1997 energy issue paper: Why separate utilities' distribution functions from generation/energy

http://www.nwcouncil.org:81/library/1997/distsep2.htm 1/3

Reports & papers 1997 energy issue papers

Why separate utilities? distribution functions from

their generation and energy service functions in a

competitive retail electricity market?

One of the most basic requirements for a competitive retail market for electricity is

participants? access to the wires, transmission and distribution, that move electricity

from generating plants to consumers. Physical connection to the wires is not enough ­­

the terms and conditions of access cannot discriminate between competitors if full and

open competition is to develop. Some of the more difficult issues that have been raised

in debates about restructuring the industry have been questions about how best to

assure nondiscriminatory access to the wires.

One such issue has been the notion that it is important to separate, at least in a

functional sense, the distribution part of the utility ­­ the wires and equipment that

connect the utility to its retail customers ­­ from the generation and energy services

parts of the utility. In general, distribution is expected to remain a monopoly function

because it would be impractical and wasteful to have several sets of wires delivering

electricity to the same areas. Because it is likely to remain a monopoly, it will probably

continue to be regulated.

In contrast, generation and energy services ­­ the businesses of producing, acquiring

and selling the electricity commodity ­­ are the parts of the utility business that are

becoming competitive. It is no longer impractical for different generators or marketers

to compete to provide the electricity itself to retail customers. Generators are already

competing in the wholesale market. The provision of energy services (which include the

consolidation of customers into groups, packaging of energy with various levels of

reliability and other services) is expected to develop into a competitive activity as

competition is allowed at the retail level.

The case of generation and transmission

Transmission can be defined as the wire and equipment that is used to move electricity

between utilities and over long distances. Transmission is similar to distribution in that

it is likely to remain a monopoly function. Transmission owners are now required to

provide transmission access to other generators, but simple access is not sufficient to

ensure effective competition among generators. As competition has developed in the

wholesale market for power, it has been widely appreciated that transmission needs to

be separated from generation to prevent "self­dealing". For example, if a company is

allowed to mix its generation and transmission costs, it can raise the price of
9/20/2016 1997 energy issue paper: Why separate utilities' distribution functions from generation/energy

http://www.nwcouncil.org:81/library/1997/distsep2.htm 2/3

transmission to cover some of its generation costs. This enables the company to charge

less than its full cost to generate the electricity commodity.

The practice has four effects: First, transmission is overpriced, so the transmission

system may be underutilized. Second, generation is underpriced, leading to greater use

of the company?s generators than is economically efficient. Third, competition is stifled

by allowing the company to compete unfairly against generators who must cover all

their generation costs from their generation revenues. Fourth, there may be temptations

for the utility to cut its transmission system maintenance costs to the bone to

compensate for higher generation costs. This can result in reduced reliability of the

power system.

The Federal Energy Regulatory Commission recognized the importance of separating

the costs of transmission and generation. To encourage a competitive wholesale

generation market, the Commission established regulations that require such

separation. How these functions might ultimately be separated has not been

determined. One alternative would be divestiture into separate companies. Utilities in

the Northwest and elsewhere are exploring another arrangement in which control of

transmission equipment is turned over to an independent grid operator (IndeGO is the

Northwest example).

The case of energy services and distribution

While the desirability of separating generation and transmission has been widely

discussed, the similar relationship between energy services and distribution wires has

received less attention. Mixing these two activities? costs in a single company would

create the same opportunity for price distortions and unfair competition as described

for generation and transmission above. The company could charge expenses incurred in

the energy services activity to customers of the distribution wires, with the result that

energy services are underpriced, distribution is overpriced, and competition with other

energy services businesses is unfair. In a world moving toward retail competition, the

pressure to subsidize the competitive activity with revenue from the monopoly activity

becomes more intense. Separation of the two activities removes the pressure and

prevents the potential unfair and inefficient results.

There are other concerns about retail competition?s potential impact on retail

customers. One is a concern about quality of service. For example, suppose customers

select an energy service provider other than their current utility. If there is a power

outage, would the utility that controls their distribution wires ­­ the utility they left for

the new provider ­­ place the same priority on restoring their power as for customers

whose energy services are still provided by the distribution utility? A similar concern is

whether, under competitive pressures in its competitive activities, a utility would

sacrifice the maintenance of the distribution system and thus affect system reliability.
9/20/2016 1997 energy issue paper: Why separate utilities' distribution functions from generation/energy

http://www.nwcouncil.org:81/library/1997/distsep2.htm 3/3

These are valid concerns if the distribution system is run by the same company that is

selling the energy services. Separation of the distribution and energy services activities

solves this problem.

Forms of separation ? functional vs. divestiture

Separation can be accomplished in a variety of ways, but the possibilities generally fall

into two categories: functional separation or divestiture. Functional separation

ordinarily requires separate accounting and employee organization for the separated

activities, but allows ownership of both activities by the same owner(s). Divestiture

requires that ownership be separated.

Functional separation has the advantage of being relatively easy to accomplish ­­ the

utility can set up separate divisions within the company, with the activities under

separate management, with costs and revenues kept in separated activity accounts. The

main disadvantage of functional separation is that even with regulatory scrutiny it is

difficult or impossible to be certain that costs are not being mixed, or that the monopoly

activity is not being managed to advantage the competitive activity in some way. As long

as ownership is common to both activities, there will be incentive to manage the

monopoly activity to favor the competitive activity.

Divestiture has the advantage of a complete separation of activities. With separate

ownership, incentive for the monopoly business to favor the competitive business is

gone. The main disadvantage of divestiture is the difficulty and complication of carrying

it out. There may be tax consequences for investor owned utilities. Regulatory concerns

will arise in assigning the assets and liabilities of the current company to the separated

businesses, especially if collection of stranded costs is an issue. If one of the businesses

is to be sold, there will be concern about whether the pool of interested buyers is large

enough to ensure a reasonable price for the business.

Since each approach has its advantages and disadvantages, utilities and regulators have

been slow to settle on a preferred alternative. The general approach has been to attempt

functional separation while monitoring results to see whether functionally separated

companies can participate in competitive markets on equal terms. If not, full divestiture

is likely to be necessary for fair and efficient competition in the deregulated activities.

^ top