UNITED STATES
FEDERAL TRADE COMMISSION

Staff Report: Competition and Consumer Protection Perspectives on Electric Power Regulatory Reform

July 2000

Contributors to this Report

Bureau of Economics, Bureau of Consumer Protection, Bureau of Competition, and Policy Planning, Federal Trade Commission

This Report represents the views of the staff of the Federal Trade Commission. It does not necessarily represent the views of the Federal Trade Commission or any individual Commissioner.

Inquiries regarding this report should be directed to:

Michael S. Wroblewski, (202) 326-2155 (Policy Planning),
John C. Hilke, (303) 844-3565 (Bureau of Economics),
Mary K. Engle, (202) 326-3161 (Bureau of Consumer Protection), or David A. Balto, (202) 326-2881 (Bureau of Competition).

Table of Contents

Executive Summary

Foreword

Chapter I: Introduction

1. Underlying Technological Changes  
   
   
2. Underlying Regulatory Changes

Chapter II: Existing Market Power In Generation Services

1. Both Horizontal Market Power and Discriminatory Access to Transmission May Be of Concern in the Electric Power Industry
   
   
2. If [the State Commission] Determines That It Faces Likely Market Power Problems in Generation, Addressing Them Through Structural Remedies May Be Preferable to Relying Exclusively on Market Power Monitoring and Mitigation  
   
   
3. ISOs Are Potentially Attractive Institutions for Addressing Many Market Power Issues in the Electric Power Industry  
   
   
4. Entry Considerations  
   
   
   1. Context of Entry Considerations  
      
      
   2. Additional Consideration of the Evolution in Electric Industry Entry Conditions  
      
      
5. [A State] May Wish to Use Computer Simulation Models to Help It Assess Horizontal Market Power and Structural Remedies for Market Power

Chapter III: Vertical Discrimination In Transmission Access

1. Operational Unbundling Offers Significant Advantages Over FERC's Proposed Functional Unbundling Approach  
   
   
   1. Preventing Discrimination of Cost Shifting by a Regulated Monopolist is Difficult  
      
      
   2. Operational Unbundling is Likely to be More Effective And Less Costly Than Functional Unbundling in this Industry  
      
      
2. Independence Minimum Characteristic
   
   
3. Distributed Generation and Competition in Electric Distribution Service in California

Chapter IV: Affiliate Transactions

1. Initial Assessment of Vertical Efficiencies
   
   
2. Application to Transactions between Public Utilities and Their Unregulated Affiliates  
   
   
3. Limits on Transactions Between Regulated Utilities and Their Unregulated Affiliates  
   
   
4. Benefits and Costs of Allowing Unregulated Affiliates to Use the Parent, Regulated Distribution Firm's Logo

Chapter V: Horizontal Mergers

1. Introduction and Summary  
   
   
2. Expanded Data Requirements for Merger Analysis  
   
   
3. Alignment with the Horizontal Merger Guidelines Framework of Analysis  
   
   
4. Analysis of Alternative Scenarios

Chapter VI: Vertical And Convergence Mergers

1. Raising Rivals' Costs  
   
   
2. Abuse of Proprietary Information

Chapter VII: Particular Retail Competition Entry Considerations

1. A Possible Unintended Consequence: Stranded Cost Recovery May Create Artificial Incentives to Deter Entry  
   
   
2. Why Vertically Integrated Incumbents May Wish to Deter Entry  
   
   
3. Possible Remedies to Prevent Consumer Harm If Stranded Cost Recovery is Allowed  
   
   
4. Potential Inefficiencies and Distortions from Stranded Cost and Benefit Recovery

Chapter VIII: Consumer Protection

1. Advertising Claims  
   
   
   1. Voluntary Advertising Claims  
      
      
      1. Interpretation of Advertising Claims  
         
         
      2. Affiliate Use of Parent Name or Logo  
         
         
   2. Substantiation  
      
      
      1. Tracking of Electricity  
         
         
      2. Disclosures for Claims Substantiated Under a Tagging System  
         
         
      3. Claimed Versus Actual Production  
         
         
2. Uniform Labeling Requirements Are Likely to Assist Consumer Choice of Electric Power Suppliers  
   
   
3. Unfair or Deceptive Business Practices
   
   

EXECUTIVE SUMMARY

Electric power is the latest -- and largest -- industry in which advances in technology have made extensive regulation obsolete. In particular, it is now possible for customers (e.g., residential consumers and businesses) to select their own electric power supplier, while the transmission and distribution functions of electric power continue to be regulated.

Restructuring the electric power industry raises many competition and consumer protection issues concerning how to obtain lower prices, cost efficiencies, and innovations of a competitive market without creating new inefficiencies or penalizing incumbent utilities. Indeed, the benefits of deregulating the electric power industry may be deferred -- or may not materialize at all -- if existing monopoly utilities are left unchecked to exercise market power in a deregulated marketplace.

The Federal Trade Commission has articulated four principles for effective restructuring of electric power markets to ensure that the benefits of competition flow to consumers. Briefly, these principles include: (1) unburdening markets from substantial and durable horizontal market power; (2) removing incentives for vertically integrated firms to engage in undue discrimination and cross-subsidization; (3) fostering accurate, non-deceptive information disclosure to customers about price and service offerings; and (4) promoting uniform disclosure of the prices and other relevant attributes of offers to customers.(1) This Commission staff report, which stems from the Commission's unique role of studying competition and working with the business community to detect new market trends, suggests an analytical framework that federal and state policymakers may wish to employ to ensure that consumers and businesses benefit from electric power industry restructuring.

After describing briefly the technical advances in the electric power industry that have made restructuring possible (Chapter I), the report discusses how high concentrations in the ownership of existing generation assets (which remain from an era of regulated monopolies) may allow the exercise of market power, to the detriment of consumer welfare (Chapter II). The electric power industry's history of common control of generation assets and transmission lines may impede wholesale competition, largely because of a utility's ability to discriminate against competing generation sources in providing access to its wholesale transmission assets (Chapter III). A lack of wholesale competition is likely to harm retail competition as well. A utility's incentives and ability to discriminate and to cross-subsidize unregulated activities also arise in transactions between the regulated parent utility and its unregulated business units offering generation or other services at the retail level (Chapter IV). Moreover, the use of behavioral rules to control these incentives may be ineffective; remedies separating ownership of different assets may be more effective and less costly to enforce.

As the electric power industry is deregulated, the number of mergers is expected to increase as firms respond differently to new competitive opportunities. The staff report analyzes issues involved in, and presents an analytical approach to, horizontal and vertical/convergence mergers in the electric industry. This analysis may be useful to state regulators as they evaluate mergers in the energy industry, including mergers that involve other sectors of the industry (Chapters V and VI).

Whether and how consumers participate in competitive retail electric power markets will determine whether electric power industry restructuring is successful. The provision and pricing of "default service" (for consumers who fail to choose a new supplier) are likely to be critical determinants of whether consumers will participate in these markets (Chapter VII). Consumers in electric power markets are likely to be better able to promote their interests when a substantial portion of them can readily switch among several suppliers offering a variety of products and services and when they can easily compare prices and terms of competing offers. Consumers' ability to choose among newly offered options is likely to be enhanced if non-deceptive advertising claims are supplemented by uniform disclosures of terms of service, prices, and relevant attributes of electric power. In addition, vigilant enforcement against unfair or deceptive business practices, which may crop up in a newly deregulated electric power market, is critical to ensure that consumers obtain the benefits of competition (Chapter VIII).

FOREWORD(2)

Electric power is the latest and largest industry in which extensive regulation has been outmoded by technology. In particular, scale economies in generation have diminished, enabling entry of efficient small-scale generation sources so that electric utilities can meet demand through, and trade excess electric power in, more competitive wholesale markets. The Federal Energy Regulatory Commission (FERC) has initiated competition at the wholesale level, and nearly one-half of the States are implementing retail competition that allows customers to choose their electric power supplier, while the transmission and distribution functions of electric power continue to be regulated.

The stakes are high in the shift to a competitive environment for the electric power industry. Total industry revenues are estimated at $200 billion a year. Regulation has receded in industries such as airlines, telecommunications, railroads, trucking, banking and financial services, and the production and transmission of natural gas (which shares many of the same structural characteristics as the electric power industry). Extensive research on the actual effects of regulatory reform has revealed a pattern of substantial benefits, including cost savings, technological advancements, and increased variety of products and services.(3)

If the levels of cost savings and technological improvements in this industry approach those attained in previously deregulated industries, consumers will be substantially better off in terms of lower prices and increased choices.(4) The gains typically take several years to be realized and may be thwarted if incumbent monopolists are permitted to exercise market power to the detriment of a competitive market. Ensuring the benefits of competition will require vigorous antitrust and consumer protection law enforcement. If private market power is unleashed or accumulated following the withdrawal of regulatory constraints, consumers will likely lose potential benefits of regulatory reform and restructuring.

The starting point for thinking about regulatory reform of the electric power industry is not the level playing field characteristic of a newly developing market. Instead, vertically integrated, regulated monopolies have controlled the generation, transmission, and distribution of electric power in state-authorized geographic territories. In this context, as regulation is reduced and competition is encouraged, there is a significant potential that these utilities will use their existing market power in generation, transmission and distribution services to deter competition that could benefit consumers. In addition, consumers have not previously had choices of electric power suppliers, and thus consumer protection issues need particular attention.

The Commission has developed four principles that apply to the analysis of competition and consumer protection policies in a deregulated electric power industry. We have used these principles when asked to evaluate state and FERC proposals. The principles also have guided us when we have been requested to review federal restructuring legislation.

Principle 1: Assessing Horizontal Market Power: Traditional antitrust analysis recognizes that the benefits of competition are most likely to accrue to consumers when markets operate unburdened by substantial and durable market power. Outside the merger context, concerns with horizontal market power focus on the possibility that one or a few generating firms might obtain and be able to exploit market dominance in areas of the country where transmission congestion occasionally creates restricted geographic markets for electric energy (load pockets).

Current antitrust laws are not designed to address the mere possession of market power or the legitimate acquisition of or increase in market power through lawful regulatory processes. Instead, the antitrust laws are designed to address increases in market power brought about by mergers or unfair methods of competition, such as predation, discrimination, and raising rivals' costs. In light of this possible situation, tools to identify and remedy horizontal market power in generation are critical to increased competition in electric power markets.

Principle 2: Independence of the Transmission Grid: Market power at the transmission level is likely to give a vertically integrated firm the incentive to discriminate against its competitors. Vertically integrated utilities, even after functionally unbundling their generation assets from their transmission assets, have a continuing opportunity to engage in undue discrimination in providing access to their transmission facilities and thus to impede competitive markets. Vertically integrated firms also may exercise their market power through cross-subsidization in favor of their unregulated affiliates.

Both forms of behavior will likely reduce the degree of competition facing the integrated firm's generation assets. These two forms of anticompetitive behavior, plus the costs of regulation, may be significant enough in some circumstances that separating the operation (and/or ownership) of the transmission grid from the ownership of affiliated power marketing interests should be the preferred solution to address horizontal market power at the transmission level.

Principle 3: Non-Deceptive Advertising: The benefits to consumers of a competitive electricity market will be substantially reduced unless the information presented to consumers through advertising and other means is accurate and non-deceptive. In determining whether an advertising representation is deceptive, the Commission relies on the principle that if at least a substantial minority of consumers takes a particular message from an advertisement, and if that message is likely to mislead consumers to their detriment, then the advertisement is deceptive. Moreover, consumer confidence in any competitive market is based on informed choices. The information provided to consumers also must be substantiated using a reasonable basis, and the substantiation must be verifiable by third parties, including the government. As a practical matter, consumers cannot verify for themselves the attributes of the electric power they purchase (e.g., they cannot verify that the electricity they are purchasing is generated through wind power).

Principle 4: Uniform Disclosures: Uniform disclosure of terms, prices and relevant attributes of electric power also will help ensure that consumers are able to make well-informed choices and thereby reap the benefits of competition. Consumers have had no prior experience in choosing an electric service provider. A uniform disclosure containing standardized information that electric service providers would use to inform consumers in their advertising -- similar to what has been done with nutrition labeling on food or energy efficiency labels on appliances -- will help ensure that consumers are not misled or confused. It also would facilitate national marketing of electric power.

ORGANIZATION OF THE REPORT

This report summarizes various competition and consumer protection principles that are involved with regulatory reform and restructuring of the electric power industry. Discussions of these principles are excerpted from FTC staff comments to state regulatory commissions and to FERC. The staff comments are supplemented and updated with insights gained from the FTC's Public Workshop: Market Power and Consumer Protection Issues Involved with Encouraging Competition in the U.S. Electric Industry (Sept. 13-14, 1999) (Electricity Public Workshop). The intent is to provide policy makers and industry with analytical tools and supporting information on a wide range of competition and consumer protection issues to advance the emergence of effective competition in the electric power industry for the benefit of consumers.

The report is organized in the following manner:

• Chapter I reviews briefly the technical advances in the electric power industry and the regulatory reforms in other industries or in the electric power industry abroad that precipitated consideration of competition in generation of electric power in the U.S.

• Chapter II discusses existing horizontal market power issues in electric power generation. This issue has gained importance as dominant generating firms (or concentrated ownership of generation assets) remain in some areas despite open access to wholesale transmission services. High concentrations of generation ownership may allow the exercise of market power even after competition is introduced in wholesale and retail markets.
  
• Chapter III discusses how common control of power generation and transmission services holds risks for wholesale competition. Nondiscriminatory access to a utility's transmission facilities facilitates competition among wholesale electric power suppliers because transmission facilities are likely to remain regulated monopolies. Incumbent, vertically integrated firms have an incentive to exercise their market power at the transmission level by (1) discriminating against competing electric power suppliers in providing transmission facility access, and (2) engaging in cross-subsidization in favor of their unregulated power marketing affiliates.
• Chapter IV reviews various forms of vertical discrimination and cross-subsidization that can occur in transactions between regulated utilities and their unregulated affiliates at the retail level. As states implement retail competition (i.e., allowing customers to choose their electric power supplier), cost shifting and discrimination concerns have arisen concerning activities of a regulated utility that maintains a monopoly over local distribution lines and its unregulated affiliates engaging in competitive lines of business. The FTC staff has been skeptical of the effectiveness of an ongoing behavioral or regulatory approach to resolving these issues.

• Chapters V and VI analyze issues involved in, and present an analytical approach to, horizontal mergers and vertical/convergence mergers, respectively. With regulatory reform in both wholesale and retail electric markets, incentives to restructure the industry have arisen that may include mergers that threaten to create or perpetuate market power and, thereby, frustrate competition.

• Chapter VII analyzes particular issues that may affect entry into retail electric power markets, including the pricing of default service. In particular, the chapter discusses how to avoid forms of stranded cost recovery in retail electricity rates that will subsidize or penalize either incumbents or entrants and, thus, discourage entry.

• Chapter VIII identifies and discusses consumer protection issues that have arisen as retail competition is initiated in several states. The benefits of a competitive electricity market will be substantially reduced unless the information presented to consumers through advertising and other means is accurate and non-deceptive.

FTC INVOLVEMENT

The FTC's involvement with electric power industry regulatory reform, like its involvement in earlier regulatory reform efforts in several industries, stems from its missions to promote competition and consumer protection through law enforcement and advocacy activities.

1. Antitrust Enforcement The FTC has had substantial involvement in the electric power industry through the PacifiCorp/Peabody convergence merger(5) and in evaluating the competitive aspects of mergers between natural gas and electric power utilities.(6) The United States Department of Justice (DOJ) has taken the lead on most mergers that solely involve electric utilities.(7) In addition to merger matters, the Commission has responsibility to prevent unfair methods of competition, which may be especially acute as the electric power industry moves toward competition.

2. Consumer Protection With the sharp rise in interest in retail competition in the electric power industry, consumer protection issues have risen to prominence on state and federal agendas. The Commission's law enforcement powers in advertising and over unfair business practices are applicable to a restructured and less regulated electric power industry. In addition, several pending legislative bills would provide federal agencies with the authority to require disclosure of prices and environmental characteristics to consumers; certain proposed legislation designates the FTC as the enforcement agency for these disclosure requirements.

3. Competition Advocacy Staff of the FTC has provided comments to FERC and to various states on competition and consumer protection issues raised as the electric power industry experiences restructuring and regulatory reform.(8) In addition, the Commission has analyzed pending federal restructuring legislation and provided testimony to relevant Congressional committees.

4. Electricity Public Workshop The FTC conducted a workshop on market power and consumer protection considerations in the electric power industry to further assist states in examining these important issues. Workshop presenters emphasized many of the same issues addressed in FTC staff comments and highlighted two areas where policy discussions have focused most recently. These policy areas include state policies that may enhance or thwart (1) a vertically integrated utility's advantages with respect to default service obligations, consumer shopping credits, and its affiliate's use of the utility's name or logo, and (2) consumer awareness of and information about retail competition.

I. INTRODUCTION

The evolution of the technology of the electric power industry has motivated reconsideration of the organization and regulation of the industry. In particular, scale economies in generation have diminished, leading to interest in opening generation and sales of electricity to competition. Although regulatory reform of the electric power industry started abroad, interest in reform has spread across much of the U.S. as regulators and customers focus on the prospects for lower rates and more options in electric service through increased competition.

A. Underlying Technological Changes

The electric power industry consists of three stages of production: generation, transmission, and distribution.(9) Generation, at its most basic, entails rotating coils of copper wire through a magnetic field. Electricity suppliers typically utilize heat from combustion of coal, oil, or natural gas (or from a nuclear reactor) to create steam. Pressurized steam forces the blades attached to the turbine shaft to rotate. The rotation of the turbine shaft drives the generator to produce electric power. Alternatively, the turbine blades may be rotated directly by falling water or by wind. Transmission from the generator to local distribution is carried over high voltage transmission lines stretched between the familiar large towers that dot the countryside. The distribution stage occurs once the high-voltage electricity arrives close to the load centers. It begins when transformers step down the voltage to useable levels. The electricity then flows through the local, low-voltage distribution system to individual customers.

There are four aspects of electricity and its supply technology that give rise to unique characteristics of the electric power industry and, therefore, deserve special attention. First, electricity cannot be economically stored in large quantities. Consequently, demand and supply must be balanced continuously and instantaneously to maintain service reliability.(10) Second, generating costs, for an area's electric system as a whole, are generally minimized during low demand periods by operating a few generating plants near capacity while leaving others idle. Generating plants with a wide variety of marginal costs may coexist in serving customers in a given area. As a result, generating costs for an area's electrical system can vary a great deal across different times of the day and seasons of the year. Third, electricity follows the path of least resistance and does not generally follow the shortest route between two points, much less the assumed contract path(11) for the transmission. Hence, it can be difficult to accurately compensate transmission owners for transmission services and congestion effects (loop flows(12)) using conventional transmission rates. Fourth, all generators within an interconnected transmission network must be synchronized with respect to the alternating current cycle they produce. Generators not in synchrony will disrupt reliability and reduce net generation available to the system. Only relatively limited ties (or interconnected lines) are available between areas that are not synchronized.(13)

Two other important technological aspects of the industry have been economies of scale and economies of vertical integration. Until the 1980s, both scale economies and economies of vertical integration were seen as endemic to the entire industry. They were viewed as a sufficient justification for treating the whole industry as a natural monopoly.(14) Recent technological advances, however, have undermined this consensus, particularly with respect to generation. The most important of these developments has been the combined-cycle gas turbine. This technology can be competitive with coal and traditional natural gas generating plants, but at a much smaller scale. Efficient-scale, combined-cycle gas plants may be less than one quarter the size of efficient-scale coal or nuclear plants. Indeed, micro-generators, reflecting additional declines in minimum efficient scale generators, are now entering the marketplace and may open the option of onsite generation to a far broader proportion of customers than prior technologies allowed. Deregulation of natural gas and the resulting decline in natural gas prices relative to other fuels underlined the importance of this new technology. At the same time, new institutional arrangements, particularly regional transmission organizations (RTOs), are expected to be able to capture many of the benefits of vertical integration without many of the costs.(15)

B. Underlying Regulatory Changes

Until very recently, the electric power industry in the U.S. was treated as a series of local, vertically integrated natural monopolies subject to rate of return and quality of service regulation. States controlled retail rates while FERC controlled interstate transmission rates. Private utility firms accounted for about three quarters of industry capacity with the rest coming from various government-owned suppliers or cooperatives.(16) From the beginning of the century through the 1970s, the electric industry provided power at ever lower real prices by exploiting increasing economies of scale in both generation and transmission, and by incorporating other technological advances.

Several policy shocks hit the industry during the 1970s and 1980s. These shocks both motivated and facilitated the restructuring of the industry that is now taking place. The litany of disruptions is as familiar as "yesterday's" headlines: the OPEC energy crisis, nuclear safety, acid rain, blackouts and brownouts, and deregulation of natural gas prices.

Despite the shocks, new technologies, and disparities in prices between states, the U.S. regulatory system remained largely unchanged until the 1990s. In many ways, the U.S. electric power industry followed the restructuring developments in the United Kingdom.(17) In 1989-1990, the United Kingdom moved from a nationalized, vertically integrated monopoly to a privatized and vertically unbundled industry committed to gradually opening up competition even at the retail level for both businesses and consumers.

The new U.K. system featured 1) several independent local distribution firms that would serve businesses and consumers, 2) a regional transmission organization (a Gridco(18) in this instance to control the transmission grid and manage the dispatch of generation capacity to meet demand, and 3) independent generating firms. A tiered schedule was established for offering retail customers an opportunity to "shop" for their own electricity generator or power merchant (retail wheeling).(19) The results for the U.K. of this revolutionary change were generally positive. Prices fell for both large and small customers as efficiencies were realized in generation, transmission, and distribution. Reliability was maintained. New generating investments were attracted. Soon, talk of the successes of the U.K. model spread to the U.S.(20)

The main economic drawback in the U.K.'s new system proved to be a market power problem in generation. Initially, generation assets remained highly concentrated. This resulted in the exercise of market power at the generation level. Subsequently, the problem was addressed by requiring that the leading generating firms divest some of their facilities, and by new entry.(21)

The first major move toward regulatory reform and restructuring of the U.S. electric power industry was passage of the 1992 Energy Policy Act. It gave FERC authority to order open access to transmission lines and to encourage independent operation of the transmission grid. Shortly thereafter, California became the first state to contemplate retail wheeling. To date, states representing over 50% of the U.S. population have established target dates for initiating retail competition. Most recently, Congress and the Clinton administration have developed legislative proposals on electric power industry regulatory reform and restructuring.

II. EXISTING MARKET POWER IN GENERATION SERVICES

Concentrations of electric power generation may be high in some areas, in part because state and federal regulators assumed that rate and service regulation would remain in place indefinitely and thus may have assumed that there was no need for antitrust scrutiny to restrain prior growth of horizontal market power. As a result, one or a few generating firms might have obtained, and now be able to exploit, market dominance in areas of the country where transmission congestion creates restricted geographic markets for electric energy (load pockets). As regulations are relaxed to allow for retail trades of electricity, however, existing market power in generation may prevent consumers from realizing the full benefits of competition.

Current antitrust laws are not designed to address the mere possession of market power or the legitimate acquisition of or increase in market power through lawful regulatory processes. Instead, the antitrust laws are designed to address increases in market power brought about by mergers or unfair methods of competition, such as predation, discrimination, and raising rivals' costs.

Although individual states may be able to address these issues, the success of these efforts may be limited by the difficulty of identifying market power problems, distinguishing between predatory and vigorous competitive conduct, and tracing the effects of that conduct. This is especially true in markets where market power, conduct, and effects all tend to be interstate (regional) in nature. In addition, a state acting alone may not be able to implement the most effective remedies, which are likely to be regional.(22)

The DOJ/FTC Horizontal Merger Guidelines contain analytical principles that are appropriate to analyze existing market power. To the extent that market power already exists, state regulators and FERC have a variety of remedies from which to choose: implementation of regional transmission organizations (RTOs), easing of entry conditions for generation and transmission, facilitating new generation technologies, and divestiture to multiple parties of the generation assets of vertically integrated monopolies. Finally, the technological complexities of transmission flows and the non-storability of electricity make analysis of electricity market power potentially very difficult. Computer simulation modeling is a potentially attractive approach.

Sections A through C are excerpted from the January 1999 FTC Staff Comment to the Alabama Public Service Commission. These sections discuss how market power can be exercised and suggest using the framework in the DOJ/FTC Horizontal Merger Guidelines to assess existing market power. Section D, excerpted from the May 1998 FTC Staff Comment on the Maine Attorney General's "Interim Report on Market Power in Electricity," discusses the importance of unimpeded entry into electric power markets. Section E, which also is excerpted from the 1999 FTC Staff Comment to the Alabama Public Service Commission, discusses the potential for computer modeling in assessing existing market power.

A. Both Horizontal Market Power and Discriminatory Access to Transmission May Be of Concern in the Electric Power Industry

Market power is typically defined as the ability of a firm (or a coordinated group of firms) to profitably price above the competitive level for an extended period of time. There are two expressions of market power . . . : horizontal market power and discriminatory access to transmission. Horizontal market power in this context refers to the ability of one or more electric generating firms to raise prices above competitive levels for an extended period of time. Horizontal market power results in higher prices, inefficient allocations of scarce resources, and distortions of consumer choices. Concerns about horizontal market power in generation during deregulation have been heightened by the pioneering British deregulatory experience. Following the implementation of electric power industry restructuring in the United Kingdom, in 1989 and 1990, researchers determined that the two private generating firms that dominated the industry were exercising market power. These findings prompted subsequent orders for divestiture of generation capacity. In addition to horizontal market power, [state regulators] may want to examine closely the incentives and ability of a vertically integrated transmission monopolist, whose rate of return is regulated, to evade the regulatory constraint in order to earn a higher profit. Its participation in an unregulated market may give it the means to do so, either by discriminating against its competitors in the unregulated market or by shifting costs between the regulated and unregulated markets.(23)

Consistent with economic theory regarding potential competition concerns of this nature, numerous independent producers and large industrial users have alleged discriminatory conduct in the operation of transmission facilities.(24) Likewise, this behavior is consistent with the evidence from the Supreme Court's Otter Tail Power decision.(25)

B. If [the State Commission] Determines That It Faces Likely Market Power Problems in Generation, Addressing Them through Structural Remedies May Be Preferable to Relying Exclusively on Market Power Monitoring and Mitigation

Determining how to address an existing market power problem is potentially difficult. Opting to impose new rules and regulations to curtail market power is one potential solution. For reasons articulated in our February 1998 comment to FERC on market power monitoring and mitigation proposals from the New England Power Pool (NEPOOL),(26) [a state] may wish to avoid relying exclusively on such behavioral rules. We summarize the drawbacks to relying exclusively on a behavioral approach in four points: First, it is likely to be difficult to detect and document the exercise of market power in many instances (NEPOOL Comment at 5). The need to balance supply and demand in electricity markets continuously and precisely makes electricity trades vulnerable to subtle and short-lived anticompetitive actions that are likely to go undetected because monitoring is complex and costly. Second, behavioral rules for market power mitigation will not eliminate incentives to exercise market power (id. at 6). Third, market power monitoring and mitigation rules create a risk that competitive behavior will be misidentified as anticompetitive behavior, thus chilling competition and increasing administrative and litigation costs (id. at 5). Fourth, focusing on behavioral remedies may divert attention from structural remedies that have the potential to address market power with greater certainty and lower costs to consumers (id. at 6).

C. ISOs Are Potentially Attractive Institutions for Addressing Many Market Power Issues in the Electric Power Industry

Both horizontal market power and transmission discrimination concerns can be addressed by ISOs.(27) ISOs can be organized to reduce potential horizontal market power by including a broad geographic area with many separate generation firms. By eliminating pancaked transmission rates(28) and embracing an enlarged geographic area, ISOs can broaden the effective geographic market and thereby reduce market concentration in generation and consequently the likelihood of generation market power. A broader geographic market will not necessarily solve all the generation market power problems, but it can provide a major step in that direction.

If it is truly independent in its governance and operations, the ISO also eliminates transmission discrimination incentives by removing control of transmission assets from the hands of firms that own generation facilities. In addition, the ISO may have stronger incentives than traditional vertically integrated utilities to address generation market power in load pockets(29) that arise during periods of transmission congestion.(30)

If [a state] becomes involved in the formation of an ISO, it may wish to consider four danger signs warning of risks to competition in the ISO formation process:(31) (1) the ISO is too small; (2) there is no plan for generation restructuring; (3) the ISO is not sufficiently independent; and (4) the ISO plan does not effectively deal with transmission congestion.

D. Entry Considerations

1. Context of Entry Considerations

The implications of high market concentration may be affected by entry conditions. For example, the Department of Justice/Federal Trade Commission Horizontal Merger Guidelines (DOJ/FTC Merger Guidelines) describe these effects in the context of mergers.(32) In circumstances where entry is timely, likely, and sufficient to deter or counteract efforts to exercise market power, market concentration may not have adverse implications for consumers.(33) In our merger and competition advocacy work, we have found that full treatment of entry conditions, both present and future, is an important aspect of competition analysis.

2. Additional Consideration of the Evolution in Electric Industry Entry Conditions

Technological and regulatory changes over the past decade have tended to ease entry obstacles in the electric power industry and may continue to do so. [There are two] possible forms of entry in the electric power industry.

The first form of entry is new or expanded generating capacity within the existing product and geographic market. The second form of entry is enhanced access to existing, but distant or isolated, generating capacity by virtue of new or expanded transmission capacity. Effective entry into an electricity generation market in some circumstances may be accomplished by increased transmission capacity even if new generation capacity is not installed. Entry through increased transmission capacity frequently broadens the relevant geographic market. Because a broader geographic market is likely to include more suppliers, increased transmission capacity may also reduce market concentration.

Both forms of entry have been affected by technological advances in the past few years. First, new combined-cycle, gas-turbine technology, in conjunction with deregulation of natural gas prices, has significantly reduced scale economies in electric generation and made such facilities far more competitive with coal-based generating plants.(34) Because the new natural gas generating facilities can be economical at a smaller scale, combined-cycle, natural-gas generating facilities take less time to design and build, have less lumpy effects on supply conditions, and involve fewer sunk costs. In short, the advances in generation fueled by natural gas may make entry more timely and likely. . . .

Second, improved electric transmission technology makes expanded transmission capacity a more viable and better understood substitute for new generating capacity.(35) Improved understanding of the origins of and remedies for transmission congestion may aid in making transmission a more effective constraint on market power in electricity markets.(36) Further, eased health concerns about high voltage transmission lines may help make expansions of the transmission grid more acceptable to those living and working near these facilities.(37)

E. [A State] May Wish to Use Computer Simulation Models to Help It Assess Horizontal Market Power and Structural Remedies for Market Power

Recently, computer simulation models of generation and transmission that may facilitate analysis of market power issues have become more widely recognized and tractable.(38) Our experience in evaluating the PacifiCorp/Peabody merger evidences the potential usefulness of computer simulation models for the analysis of market power and potential structural remedies.(39) For example, by simulating various price increases and their effect on pricing in the relevant market(s), computer models can be used to determine relevant geographic markets in a merger analysis or to ascertain whether an entity is engaging in anticompetitive behavior. Various state regulatory agencies and reliability councils also incorporate computer simulation models in their long-range planning efforts. [A state] may wish to consider making use of such computer simulation models, if it has not already done so, to help it assess existing generation market power and potential structural remedies for such market power.

III. VERTICAL DISCRIMINATION IN TRANSMISSION ACCESS

FERC recently promulgated rules encouraging the voluntary formation of regional transmission organizations (RTOs) across the Nation. In doing so, FERC noted that its current behavioral rules for open transmission access (FERC Order Nos. 888 and 889) have not solved the vertical transmission discrimination problem in the electric power industry. Even under open access, vertically-integrated firms have a continuing opportunity to engage in undue discrimination in providing access to their transmission facilities and thus to impede competitive markets.(40) Without nondiscriminatory access to transmission, competition among generation suppliers is unlikely to be effective at the wholesale or retail level.

In comments to FERC prior to adoption of Orders 888 and 889, the FTC staff expressed concern that behavioral rules alone are unlikely to work very well in this industry because (1) they leave anticompetitive incentives to discriminate in place and (2) enforcement of antidiscrimination rules is likely to be particularly problematic. Since then, the FTC has recognized that vertically integrated firms have an incentive to exercise their market power at the transmission level both by discriminating against electric power suppliers in providing transmission facility access and by engaging in cross-subsidization in favor of their unregulated power marketing affiliates. These two forms of anticompetitive behavior, plus the cost of regulation, may be significant enough in some circumstances that separating the operation (and/or ownership) of the transmission grid from the ownership of affiliated power marketing interests should be the preferred solution to address market power at the transmission level. The text in Section A, presenting this argument, is adapted from the August 1995 FTC Staff Comment to FERC.

At the Electricity Public Workshop, presenters from several states and organizations emphasized why wholesale and retail levels of competition among generation suppliers should be considered together. In particular, presenters were concerned that retail competition would be less robust without effective wholesale competition. Presenters argued that unless open access policies are applied to a traditional utility's captive retail customers (i.e., its "native load" requirements), the utility will continue to have the incentive and ability to discriminate in providing access to its monopoly transmission and distribution assets.(41)

Other participants noted that the effectiveness of wholesale and retail competition depends on the physical transmission capacity serving the area and that expansion of wholesale transmission facilities may be a prerequisite for moving toward retail competition. These Workshop presentations underscored the importance of the maximum-geographic-scope element and the grid-expansion element in formation of RTOs. Effective RTOs can help broaden the geographic market (increase the number of generators) serving a state that implements retail competition. At the same time, it is important that customers be provided with price signals that accurately reflect transmission constraints and generation costs in peak and off-peak periods. In particular, the average pricing faced by many customers in peak periods understates the costs involved and, conversely, average pricing overstates the costs involved to supply and deliver electric power during off-peak periods. Accurate price signals not only will increase the elasticity of demand at the wholesale level, but they can potentially curtail market power and reduce average costs facing all customers.

Section B, which is excerpted from the August 1999 Staff Comment to FERC on Regional Transmission Organizations, discusses the importance of ensuring that an RTO is independent from owners of electric power suppliers.(42)

Recent technological developments favoring the commercial viability of very small-scale generation units (microturbines and fuel cells), termed "distributed generation" or "DG," have added to concerns about discrimination in transmission access and have extended the policy discussion to distribution as well as transmission. DG may represent an emerging close substitute for transmission and distribution services because, as a form of generation, it can be located at, or very close to, load centers. If so, owners of transmission, distribution, and existing (but more distant) generation are likely to have incentives to impede the entry and spread of DG. DG is likely to be most economically viable, at least initially, as a method for customers to reduce peak-load demand on the power grid and improve reliability while continuing to be connected to the grid. Consequently, the most likely avenue for impeding the spread of this new technology is discrimination in connecting DG units to the transmission and distribution system. To the extent that DG connections to the grid are denied, delayed, or made more costly, incumbent transmission, distribution, and generation owners may realize greater profits while consumers may face higher prices and lower reliability. Section C, discussing DG, is adapted from the March 1999 FTC Staff Comment to the California Public Utilities Commission.

A. Operational Unbundling Offers Significant Advantages Over FERC's Proposed Functional Unbundling Approach.

1. Preventing Discrimination or Cost Shifting by a Regulated Monopolist Is Difficult.

A monopolist whose rate of return is regulated has an incentive to evade the regulatory constraint in order to earn a higher profit. Its participation in an unregulated market may give it the means to do so, either by discriminating against its competitors in the unregulated market or by shifting costs between the regulated and unregulated markets.(43)

The discrimination strategy involves complementary products. The monopolist controls others' access to its regulated product in ways that permit it to earn supra competitive returns in its own operations involving the unregulated complement. Discrimination could appear as a subtle reduction in quality of service, whose effects would be more difficult to identify and measure than outright denial of access. An integrated transmission monopolist might afford other generation sources access to its transmission services only on terms that raise others' costs and permit the monopolist to make supra competitive profits in the generation market.

The cross subsidization or cost shifting strategy involves inputs used for both regulated and unregulated products. Costs of the shared inputs, which in the electric power industry might include scheduling and general overhead, are assigned to the regulated business to justify higher cost-based rates there. This shifting distorts competition and produces inefficiencies in the unregulated business as well. Controlling the discrimination and cost-shifting strategies with monitoring and regulation is difficult. They can be defeated most effectively by preventing the regulated monopolist from entering the unregulated business, thus eliminating its ability to distort competition in the unregulated market.

2. Operational Unbundling Is Likely to be More Effective And Less Costly Than Functional Unbundling in this Industry.

[F]unctional unbundling . . . stops short of structural separation and thus leaves in place the anticompetitive opportunities and the monitoring and enforcement difficulties that are inherent in vertical integration between regulated and unregulated markets. Electric utilities that own or control transmission facilities would be required to offer an open-access tariff to other parties and to take transmission services for their own wholesale purchases or sales under that same tariff. Thus, the rules would require the utility to charge itself the same price, under the same terms, that it charges others for the same transmission service. . . . [R]etaining integrated ownership and control of transmission and generation services . . . could leave the integrated utilities with the incentive and opportunity to find ways to evade regulatory constraints. One way could be to manipulate the sensitivity of short-run transmission services to the risk of delay and uncertainty, which is inherent for this non-storable product. A transmission owner may be able to favor its own generating plants materially with subtle delays or complications in the transmission approval process.

Rules mandating open access and comparable treatment would be particularly difficult to monitor and enforce in this industry, because, to succeed, the rules must constrain transmission owners to ignore their economic interests. Ensuring that the services and prices the integrated utility provides to and charges its competitors are equivalent to what it provides to and charges itself could require virtually transaction-by-transaction regulatory oversight. Monitoring and enforcing compliance with regulations against discrimination may be particularly difficult when quality of service is time sensitive, as it is in electric power. Because power is sold on an hourly basis, market dynamics -- and thus the incentive and ability to exploit market power -- can shift over the course of each day, making it virtually impossible to intervene before conditions have changed. Hemming in transmission owners' behavior, although perhaps possible in theory, will be difficult to maintain in practice. Successfully containing their behavior at one time and place may provide little assurance of containing it later or elsewhere.

Complete divestiture would resolve the competition problem better than regulation of behavior. Complete separation of both ownership and control can provide the best assurance against the anticompetitive incentives and capabilities of combined operations. Divestiture also avoids the expense and intrusiveness -- and perhaps futility -- of monitoring and controlling a firm's day-to-day behavior.

On the other hand, complete divestiture, curtailing vertical integration to prevent anticompetitive behavior, may sacrifice economies of scope between the regulated and unregulated markets. A regulated monopolist's participation in the unregulated market might be desirable if it would realize scope economies that outweigh the anticompetitive distortions.(44) In the electric power industry, there may be economies of scope in coordination between output and transmission and in planning, or in lower average inventory, personnel, or reserve requirements.(45)

In antitrust enforcement, divestiture is the remedy most commonly sought for anticompetitive mergers or monopolization. In some cases, remedies short of full divestiture have been applied, to preserve the efficiency benefits of a combination while addressing its competitive problems. A constant concern in devising orders short of full divestiture is how to monitor compliance to prevent competitive abuse. The only compliance oversight required for divestiture is ensuring that the divestiture takes place. By contrast, continued monitoring is required to assure compliance with behavioral or intra-firm structural orders. Ordering a firm to afford access is futile if the price it charges or the cost of monitoring its compliance are too high. . . .

Because functional unbundling alone may not be effective, and both it and complete divestiture may be more costly to implement, a middle-way "operational unbundling" approach should be favorably considered. By operational unbundling, we mean structural institutional arrangements, short of divestiture, that would separate operation of the transmission grid and access to it from economic interests in generation.(46) The purpose would be to prevent the regulated transmission monopolist from influencing the potentially competitive wholesale generation market. Separating ownership of generating facilities from control of transmission would reduce the incentives and ability to exercise transmission market power.(47) By separating ownership from control, operational unbundling captures a primary advantage of divestiture by affording a high level of assurance -- at least as high as functional unbundling, if not higher -- that nondiscriminatory practices and rates will prevail.(48) Operational unbundling would not incur the costs of enforcing behavioral rules, because the firms would have less incentive and ability to discriminate. It should be at least as effective as functional unbundling in ensuring against discrimination, and it would be much less costly to implement than divestiture, because only operation, not ownership, would be structurally separated.(49)

B. Independence Minimum Characteristic

The basic issue underlying why transmission should be independent of generation in a qualified RTO is the threat of vertical discrimination in access to transmission services. Vertical discrimination in transmission is a serious concern because transmission technology continues to exhibit major economies of scale that often preclude effective competition in providing alternative transmission services between generation sources and loads.(50) The perceived threat of vertical discrimination in transmission raises the risks associated with investments in both generation and obtaining electricity trading skills (training and experience) in order to compete with generation assets owned by the operators of transmission assets. This perceived risk discourages entry by generating firms and traders, making effective competition in generation less likely. Reduced supply (less generation entry) and thinner markets (less trading) are likely to result in higher prices for consumers than would exist absent such potential transmission discrimination.

Concerns about vertical discrimination in transmission access are not limited to existing transmission and generation assets, but rather apply to expansions of generation and transmission as well. Transmission owners could discriminate in providing grid connections to new generators and in selecting transmission expansion projects. Discrimination or uncertainty about the terms and conditions for obtaining connections to the grid will raise the risk of new generation investments with respect to their commercial viability and timing. Discrimination in the selection of future grid expansion projects may disrupt such project[s] by similarly increasing uncertainty about future revenues of entrants (for example, discriminatory positioning of a new transmission line may disproportionately reduce demand for power from the entrant). By eliminating or delaying generation entry, or deflecting it to a different site, a transmission owner may reduce the competitive pressure on its own generation assets, particularly if the prospective entrant's assets are likely to be more efficient.(51) As a result of such discrimination, consumers are likely to face higher electricity prices because more efficient generators fail to enter to displace less efficient generators.

In addition, we concur with the assessment in the Notice that affiliated transmission companies . . . may not be trusted by market participants even with elaborate protections. . . . We believe that market participants are likely to suspect that the safeguards will be gamed. This, in turn, could affect investment behavior. In particular, market participants may be reluctant to make needed investments in generation or marketing of electricity if they believe that the RTO is likely to give favored treatment to its affiliates.(52)

We also agree that behavioral codes of conduct are unlikely to solve this problem because of enforcement costs and uncertainties.(53) . . .

In order for an RTO to be independent, [it may be necessary] to distinguish between voting interests and passive investment interests . . . . To the extent a non-voting, passive investment interest insulates this type of investor from the RTO's decisions regarding operations, planning, and expansions, a non-voting interest is less likely to undermine the independence minimum characteristic. Although we are reluctant to advocate an inflexible prohibition on voting rights for owners of generation assets located within the RTO, we note that exceptions to any rule may grow into a serious breach over time.(54) In order to provide . . . a benchmark for [the] independence criteria, we provide here a brief review of such criteria in the antitrust enforcement context. We do not view this as definitive with respect to FERC's consideration of an appropriate de minimis standard, but merely as informational.

The loss of independent decision-making - whether sacrificed in a collusive arrangement or destroyed by the anticompetitive unilateral exercise of market power - is an overarching concern of antitrust enforcement. Two areas in which antitrust law attempts to guard against this loss of independence may offer FERC useful perspectives.

First, Section 8 of the Clayton Act(55) prohibits interlocking directorates among competing firms. No person may serve as a director or officer of competing corporations if each firm has an aggregate total of capital, surplus and undivided profits exceeding $10,000,000.(56) Although FERC's Notice incorporates a similar provision based on share of control, FERC may also find it useful to consider whether common directorships in third parties may be used to circumvent the basic prohibition.

Second, the FTC sometimes permits firms to merge provisionally, subject to a "hold separate" agreement that maintains each firm's structural and operational independence while the FTC completes its review of the transaction. Such temporary hold separate agreements frequently prohibit the merger partners from mingling the firms' assets or operations; having common directors, officers or employees; exercising voting rights in each other (other than a de minimis exercise that may be necessary for tax purposes); attempting to influence each other's voting shareholders; and communicating with each other.(57) Prohibitions such as these may be adapted to the electricity market to secure both the complete independence, and the appearance of independence, of RTOs and market participants.

Even if FERC adopts a specific de minimis standard, it must be alert for potential coalitions of common interest -- for example, a group of generation owners with similar incentives and RTO ownership interests that could undermine the independence of an RTO. With an ownership de minimis standard applied only against individual ownership interests, such a coalition could make possible the type of vertical discrimination of concern in electric power markets.(58)

In addition, even with a low de minimis standard, we alert FERC to possible conduct that antitrust enforcers confront. Although operational unbundling or divestiture minimizes the likelihood of discriminatory access to transmission, there are less direct ways in which anticompetitive influence can be used to foster discrimination. Important antitrust cases have been decided where indirect pressure or influence has been applied to advance common ownership interests against structurally independent firms.(59) We invite FERC to be alert to this type of anticompetitive behavior as well.

C. Distributed Generation and Competition in Electric Distribution Service in California

Over the past several decades, generation has been highly centralized in large generation facilities. Customers are served primarily by utility distribution companies (UDCs) that have connections to large generation facilities using high voltage transmission lines and connections to customers through their lower voltage distribution lines. This grid system is referred to as the transmission and distribution (T&D) system. In an electrical system with DG, smaller, widely-dispersed generation units would supply electric power in additional to (or instead of) centralized facilities. . . .

In general, advances in DG technology offer substantial potential benefits to consumers, but the rate and extent of DG implementation have yet to be determined and there are some potential costs of DG use as well. DG also faces potential discrimination in connecting to the grid from vertically integrated, incumbent suppliers in light of DG's potential to increase competition in generation, transmission, and distribution. Realizing these potential benefits may depend upon [a state] affording DG units a fair market test. A fair market test requires technical interconnection rules allowing DG units to connect to the T&D system without undue discrimination and unnecessary technical requirements left to the discretion of incumbent generation and T&D suppliers. [A state] is likely to benefit consumers by first addressing the conditions necessary for a fair market test of DG and then addressing the broader, longer-term questions of distribution competition. The results of a fair market test in terms of DG's market acceptance might provide additional guidance to [a state commission] as it examines the issue implicated by increased competition in generation, transmission, and distribution.

IV. AFFILIATE TRANSACTIONS

The risk of vertical discrimination in transactions between regulated utilities and their unregulated affiliates (which may be engaged in supply of generation or metering and billing services, etc.) arises in many contexts as states allow consumers to choose their electric power supplier. In Chapter III, vertical discrimination regarding access to transmission was discussed. The concern in that discussion was that incumbent transmission owners may raise the costs of actual and potential generation and marketing for competitors by charging higher prices, providing inferior service, or denying access to important transmission facilities. In doing so they would advantage their own affiliates engaging in the same unregulated businesses.

The chief concerns in the context of affiliate transactions in retail competition typically include discrimination as well as cross-subsidization or cost-shifting that favors the unregulated affiliate relative to its competitors. Consumers are harmed because discrimination and cross-subsidization may displace more efficient and innovative competitors and shift production to less efficient suppliers.

Most states have rules or codes of conduct against cost shifts and cross-subsidization already in place because of the traditional concern about burdening ratepayers with unrelated costs.(60) Retail competition and the associated unbundling of services, however, have raised the importance of these rules. Participants in the FTC Electricity Public Workshop confirmed that these issues continue to be difficult and contentious for state regulators. For example, some participants noted that traditional utilities control the cost of inputs of their retail competitors because the utility has full access to customer consumption or load profile information (which is necessary for a utility's competitors to prepare price offers to potential customers) as a result of the utility's continued monopoly control over distribution services. As a result, the utility has the incentive to discriminate in providing access to this information to increase its competitors' costs to serve retail customers.

The FTC staff has addressed both the general question of the effectiveness of codes of conduct that govern the relationship between a utility and its unregulated affiliate(s) and the specific question of what types of provisions should be included in a code of conduct. The staff also has suggested that states periodically reexamine the effectiveness of their code(s) of conduct to determine whether a structural approach, rather than a behavioral approach, would be more effective in promoting effective competition. Sections A and C are excerpted from the January 1999 FTC Staff Comment to the Alabama Public Service Commission regarding codes of conduct. Section A examines alternative ways of structuring affiliate rules in the context of a cost/benefit framework in which the state has already determined that there are substantial, but not overwhelming, economies of vertical integration. Section B is adapted from the December 1999 Comment to the New Mexico Public Regulation Commission and describes how concepts from antitrust analysis can be used to assess efficiencies of vertical integration. Section C discusses why codes of conduct that include market-like mechanisms, which govern transactions between a regulated parent and an unregulated affiliate, are likely to reduce the ability of the regulated parent to favor its unregulated affiliate in an anticompetitive manner.

During the FTC Electricity Public Workshop, presenters discussed another difficult issue regarding the relationship between the incumbent and its affiliates, namely, incumbency advantages -- such as name recognition and customer inertia --that accrue to unregulated affiliates.(61) Because the growth of competition in telecommunications has been reported to be slow, some participants expressed the view that steps need to be taken to speed the transition to competition in the electric power industry. Others expressed concern that steps to speed the transition to competition might unfairly favor entrants over incumbents, with a resulting loss of efficiencies. The excerpt in Section D from the January 1999 FTC Staff Comment to the Alabama Public Service Commission describes a cost/benefit approach that state utility commissions may want to use to assess these incumbency advantages.

Because the costs and benefits of alternative approaches to this issue are unlikely to be uniform across jurisdictions or across specific policy options, a case-by-case cost/benefit analysis appears to be the best approach. In such an assessment, it is important to distinguish incumbency advantages based on accurate consumer perceptions from those that may be based on misperceptions. For example, in developing default service policies, some consumers may elect not to choose because they believe that they will maintain the status quo by not choosing. However, the state's decision to implement retail competition arguably means that the status quo no longer exists as an option. Similar issues of consumer perception are featured in the section below on use of the regulated distribution firm's name and logo by its unregulated affiliates. Indeed, evidence presented during the FTC Electricity Public Workshop indicated that consumers may be confused when an affiliate uses a name or logo similar to that of its completely separate parent.(62)

A. Initial Assessment of Vertical Efficiencies

[A state commission] may wish to assess whether significant existing or prospective economies of vertical integration will be lost if it allows incumbent utilities to establish affiliates to offer unregulated services. Such an assessment could alleviate some uncertainty about the costs and benefits of different policy options. If economies of vertical integration are minimal, divestiture at the outset of regulatory reform may be more appropriate than the proposed behavioral rules. Conversely, if economies of vertical integration are substantial, [a state commission] may wish to consider whether any type of separation of a utility from its affiliates is likely to yield net benefits. Recent empirical evidence suggests that economies of vertical integration in the electric power industry may be material, but that they vary considerably in different circumstances and may be realized through alternative organizational arrangements.(63) Given this evidence, it seems reasonable to assume initially that vertical integration produces at least modest economies.

An initial assessment of the relative magnitudes of likely costs and benefits is often an appropriate step in policy analysis because it allows the inquiry to be terminated or focused on critical issues at an early stage before extensive resources and time have been consumed on detailed investigation of facts that are unlikely to materially address the balance of costs and benefits.

B. Application to Transactions between Public Utilities and Their Unregulated Affiliates

The most difficult application of an affiliate code of conduct is likely to occur when a proposed transaction between the regulated utility and its unregulated affiliate substantially increases the likelihood of both anticompetitive effects and of efficiency gains. A similar policy balance of competitive concerns and efficiency opportunities lies at the core of antitrust policy toward mergers and joint ventures. [A state commission] may be able to benefit consumers by applying the insights from antitrust policy regarding these potentially offsetting effects to the context of the proposed affiliate code of conduct.

Within antitrust analysis, only efficiencies that are specific to a proposed transaction are relevant to the competition/efficiency policy assessment. Other efficiencies may be obtained without an accompanying threat of diminished competition. For example, economies of scale may be realized when a regulated utility and one of its unregulated affiliates jointly operate a single billing organization. Such economies are not, however, specific to this transaction, if similar economies practically can be realized by the regulated utility and the unregulated affiliate if they partner instead through a joint production venture with one or more unaffiliated firms, or by contracting for the service through an independent provider.

In the merger context, the antitrust agencies have adopted guidelines that explain how the agencies consider efficiencies when considering the competitive impact of a merger.(64) In particular, the agencies only consider those merger-specific efficiencies that offset competitive concerns. Although the following excerpt from the Horizontal Merger Guidelines discusses horizontal mergers, the same analysis is appropriate to evaluate efficiency claims when examining the competitive effects of vertical transactions, because significant competitive problems can arise in either context.

The Agency will consider only those efficiencies likely to be accomplished with the proposed merger and unlikely to be accomplished in the absence of either the proposed merger or another means having comparable anticompetitive effects. These are termed 'merger-specific efficiencies.' Only alternatives that are practical in the business situation faced by the merging firms will be considered in making this determination; the Agency will not insist upon a less restrictive alternative that is merely theoretical.

Efficiencies are difficult to verify and quantify, in part because much of the information relating to efficiencies is uniquely in the possession of the merging firms. Moreover, efficiencies projected reasonably and in good faith by merging firms may not be realized. Therefore, the merging firms must substantiate efficiency claims so that the Agency can verify by reasonable means the likelihood and magnitude of each asserted efficiency, how and when each would be achieved (and any costs of doing so), how each would enhance the merged firm's ability and incentive to compete, and why each would be merger-specific. Efficiency claims will not be considered if they are vague or speculative or otherwise cannot be verified by reasonable means.

'Cognizable efficiencies' are merger-specific efficiencies that have been verified and do not arise from anticompetitive reductions in output or service. Cognizable efficiencies are assessed net of costs produced by the merger or incurred in achieving those efficiencies.

The Agency will not challenge a merger if cognizable efficiencies are of a character and magnitude such that the merger is not likely to be anticompetitive in any relevant market. To make the requisite determination, the Agency considers whether cognizable efficiencies likely would be sufficient to reverse the merger's potential to harm consumers in the relevant market, e.g., by preventing price increases in that market...(65)

[A state commission] may wish to use this efficiency analysis analytical framework in making the preliminary assessment of whether to require vertical separation between a public utility and its unregulated affiliates.

In addition, the framework may be applicable as well in assessing the efficiency benefits of a particular joint activity between the public utility and its unregulated affiliate(s).(66) Given widespread evidence of continued vertical discrimination concerns in the operation of the transmission grid(67) and similar incentives that regulated utilities have to favor their unregulated affiliates in other aspects of their operations, [a state commission] may wish to take into account the strong likelihood that certain joint activities or substantial transactions(68) between a regulated utility and one of its unregulated affiliates, other than an arms-length purchase in an open market, represent a potential threat to competition. If so, [a state commission] may wish to consider requiring that the regulated utility demonstrate strong cognizable efficiencies sufficient to offset potential anticompetitive effects before the regulated utility engages in a particular joint activity or consummates a substantial transaction with one of its unregulated affiliates.(69)

C. Limits on Transactions Between Regulated Utilities and Their Unregulated Affiliates

As discussed above, we have significant reservations about the effectiveness of relying exclusively on behavioral rules [to discourage discrimination in transactions between regulated utilities and their unregulated affiliates]. If the scale, scope, or vertical integration economies of affiliation are substantial and can be realized even in the presence of functional unbundling, [a state commission] may wish to strengthen its approach by requiring the affiliates to operate independently, on a bid-based, arm's-length basis. For example, [a state commission] may wish to require that the bulk of regulated utility purchases from unregulated affiliates be restricted to contracts won through an objective bidding process in which a third party evaluates the bids.

A critical element of workable bidding systems is the perceived and actual objectivity of the bid evaluation process. The system must be perceived as objective in order to attract bidders. Potential bidders, other than affiliates, may be unwilling to incur the costs of making a bid if the system is perceived as biased in favor of affiliates. The system must also be objective in fact in order to avoid raising costs for customers of the regulated utility. The use of third-party evaluations of the bids is one technique for achieving such objectivity.(70)

In addition, [a state commission] may wish to consider restrictions on asset transfers from the parent distribution utility to an affiliate. Some states are considering making such transfers subject to particular price bounds to assure that ratepayers do not unfairly subsidize the activities of the affiliate.(71) This proposal raises issues similar to determining the value of assets in assessing stranded costs. Just as some states, such as Massachusetts, have determined that the market is the best gauge of value to determine the value of generating assets in a stranded cost assessment,(72) [a state commission] may wish to use actual market values, rather than a band of prices, for asset transfers. The arm's-length bid process discussed above is an example of a method to establish actual market values.

D. Benefits and Costs of Allowing Unregulated Affiliates to Use the Parent, Regulated Distribution Firm's Logo

[A state commission] may wish to compare the benefits and costs of allowing affiliates of regulated distribution firms to use the corporate logo of the distribution firm.(73) One benefit of such use may be to reduce prices in the competitive markets served by affiliates. With access to the parent company's logo, the affiliate is likely to have lower marketing costs that may be passed along to consumers in a competitive market.(74) The lower prices of the affiliate may encourage other firms serving this market to charge lower prices as well, resulting in lower prices for the market as a whole.(75) If consumers' perceptions of the implications of an affiliate's use of the parent utility's logo are accurate,(76) a second prospective benefit may be reduced search costs for consumers.

On the cost side, we have identified two potential concerns about the use of logos by affiliates: deception of consumers and cross-subsidization.

(1) Potential Deception: [This is discussed in Chapter VIII.]

(2) Potential Cross-subsidization and the Use of the Parent Utility's Logo: Although some forms of cross-subsidization may be effectively addressed by transfer pricing rules,(77) other forms may be more difficult to assess. Cross-subsidization could take the form of cost-shifting among inputs used for both regulated and unregulated products, such as the use of a corporate logo in marketing the affiliate's products and services as well as the regulated parent utility's products and services. Costs of shared inputs could be assigned in a biased manner (i.e., with additional costs assigned to the regulated side of the business) so that the regulated entity can justify higher rates. This biased assignment of costs, which is often difficult for regulators to detect and remedy, distorts competition and produces inefficiencies in the unregulated business as well.

The risk of failing to detect anticompetitive cross-subsidization is heightened if (1) the reputation of the regulated parent utility is effectively embodied or represented by its logo; (2) the regulated parent firm can improve its reputation by incurring costs of the type that regulators would traditionally include in the rate base of the regulated firm; and (3) the unregulated affiliate can enhance its own reputation among consumers by using the logo of the regulated parent firm, even if elements of the regulated firm's reputation do not apply to the affiliate. When these factors are present, a regulated incumbent will have a heightened incentive to overinvest in reputation-building because it can expect to incorporate a greater share of these investments into its rate base than if the assets were not shared with the affiliate. Moreover, the affiliate would realize additional profits from its increased sales in the unregulated market. The principal obstacle to deterring this conduct is that it may be extraordinarily difficult to distinguish competitive from anticompetitive levels of investment in reputation-building. Harm to competition and consumers may result from such overinvestment and subsequent cross-subsidization.

Harm to competition may occur because the unregulated affiliate's access to the logo of its regulated parent gives it a cost advantage through potential cross-subsidization that otherwise equally efficient competitors cannot match. The anticompetitive results may include (1) higher-than-necessary average operating (i.e., non-logo-related) costs for the industry and higher prices for consumers due to the continued operation of the affiliate, which can survive with higher-than-necessary costs due to the cross-subsidization; (2) greater market concentration and less competition than would occur absent the cross-subsidization;(78) and (3) discouragement of potential entry that likely would have occurred absent the cross-subsidization, including entry involving innovative products and production processes.

If [a state commission] upon more detailed study determines that there are substantial economies of vertical integration that cannot be realized without allowing affiliates to use the logos of their respective regulated parent utilities, [a state commission] may wish to consider two policy alternatives that are designed to obtain some of the potential benefits of affiliate use of the parent distribution firm's logo without incurring the costs. First, some states are considering allowing the use of the logo by affiliates, contingent upon use of a disclaimer that avoids consumer deception. [A state commission] may wish to evaluate this alternative by examining the impression that consumers are likely to have with the use of the logo accompanied by a disclaimer, and whether that impression would be accurate.(79) Consumer research designed to investigate the effects of several alternative policies on consumers may be the most effective approach.(80) A disclaimer that suffices to avoid consumer deception also may suffice to discourage cross-subsidization in the form of excessive investment in reliability.

Another alternative for transfer of the rights to use the parent firm's logo is to require that the affiliate (and any other firms granted the right to use the logo) pay the parent for the right to use the logo.(81) Because the logo is an asset, use of the logo by other firms, including affiliates, represents an asset transfer from the parent firm, and [a state commission] may wish to treat it like other asset transfers.(82) In order to avoid cross-subsidization in such a transaction, the use of the parent logo must be fairly evaluated.(83)

V. HORIZONTAL MERGERS

Competition reviews of horizontal mergers in the electric power industry are conducted by FERC, the FTC, and the United States Department of Justice (DOJ) using the framework of the Horizontal Merger Guidelines. The Horizontal Merger Guidelines were developed by DOJ and FTC and subsequently adopted by FERC as the conceptual framework for its merger reviews. FTC staff has commented to FERC on the evidentiary difficulties of conducting an effective merger review in the electric power industry. The same concerns about access to information and appropriate methods for assessing market definition, market structure, competitive effects, entry conditions, and failing assets are likely to apply to state reviews of retail competition in the electric power industry. Because of the large number of relevant scenarios for assessing the effects of mergers in the electric power industry and because of the technical complexities of this industry (e.g., loop flows and hourly markets), the FTC staff has recommended that both FERC and the states consider using computer simulation modeling to aid the analysis of the market power effects of mergers in the electric power industry. The text below is excerpted from the September 1998 FTC Staff Comment to FERC in a proceeding designed to determine whether to revise the information filing requirements that electric utilities must provide to FERC with their merger approval application. These same recommendations are applicable to state reviews of electric utility mergers as well.

A. Introduction and Summary

The primary theme of our comment is that an analysis of market share information is often the ramp that leads antitrust agencies to a more sophisticated merger analysis. In light of this, FERC, where appropriate, may wish to expand its merger analysis beyond its current strong emphasis on market share information. Such an expansion has implications both for the information FERC collects and for the analysis it conducts. As part of an expanded analysis, computer simulation modeling may be a particularly promising development that may make it more feasible for FERC to consider alternative scenarios about future technical, economic, and regulatory conditions in its electricity industry merger reviews. We recognize that expanding FERC's merger analysis may entail significant costs to the agency, to the merging parties, and to interested third parties. Such costs, however, may be a necessary prerequisite to a complete and more accurate assessment of the likely competitive effects of proposed mergers.

B. Expanded Data Requirements for Merger Analysis

Merger analysis under the Horizontal Merger Guidelines is by its nature an information-intensive task once a preliminary analysis reveals a potential for anticompetitive effects. Many important questions about the competitive effects of mergers are best answered with documents, interviews, and data from many sources.(84) The evolution of our Horizontal Merger Guidelines reflects an expanded consideration of facts and approaches. FERC may be better able to protect the public interest as it reviews proposed mergers in the rapidly changing electric power industry by revising its information-gathering process to more closely match the information requirements of the Horizontal Merger Guidelines and to improve understanding of vertical competition issues.

To analyze prospective competitive effects of a proposed merger beyond reviewing market share statistics submitted by the merging parties, as well as to assure the accuracy of market share statistics, we have found various sources of data to be important in our merger investigations. Although only some of these sources are likely to be relevant in any individual investigation, FERC may wish to obtain each where appropriate and cost-effective. Sources used in our merger investigations often include, for example, the following:

• internal documents of the merging parties (including, for example, planning and marketing documents; merger assessments; evaluations of current and projected technology; cost, quality, and reliability comparisons of firms and their individual production facilities; and joint venture documentation);

• third-party documents, including documents from industry trade associations;

• depositions of party and third-party executives and consultants;

• history of previous antitrust cases (including collusion cases involving the same companies or the same industry);

• financial analysts' reports;

• employee notes concerning contacts with competitors;

• consultants' reports on competitive conditions in the industry;

• documents and interviews with executives of failed entrants, prospective entrants, and fringe firms;

• filings about competitive conditions made with other government agencies;

• documents and interviews with suppliers; and

• documents and interviews with a variety of customers. . . .

C. Alignment with the Horizontal Merger Guidelines Framework of Analysis

We have identified seven aspects of electricity merger analysis covered by the Notice that FERC may wish to consider from this perspective. On the basis of our experience, each of these aspects may be significant in determining the prospective effects of a merger on competition and consumers. Accordingly, FERC may wish to revise both its information-gathering procedures and the types of information it gathers in screening mergers to enhance its merger analysis.

(1) Hypothetical Price Increases in the Presence of Elevated Pre-Merger Prices(85) -- A key element in merger reviews is determining the economic arena in which the competitive effects of a merger are likely to take place. The economic arena is defined geographically as well as with respect to the product or service likely to be affected. Both product and geographic market assessments under the Horizontal Merger Guidelines are carried out by asking whether a hypothetical monopolist would profitably impose a small but significant and nontransitory price increase.(86) Typically, the price increase is applied to pre-merger prices to conduct the analysis. Thus, in defining the market, the Horizontal Merger Guidelines generally focus on the possibility of incremental market power due to a merger.

This approach may not be appropriate in a newly deregulating industry, such as the electric power industry, where pre-merger market power may have been created or protected by regulations that are no longer in place or are likely to be relaxed. The Horizontal Merger Guidelines recognize this possibility in Section 1.11, where they specify that "the Agency may use likely future prices, absent the merger, when changes in the prevailing prices can be predicted with reasonable reliability." Changes in price may be predicted on the basis of, for example, changes in regulation which affect price either directly or indirectly by affecting costs or demand.(87) FERC may wish to recognize explicitly that this alternative definition of price may be particularly relevant in the electric power industry, where past restrictions on entry, regulatory limitations on the variety of services offered, and reduced incentives to operate efficiently and competitively (associated with rate-of-return regulation) may have elevated prices above competitive levels.

(2) Duration of Anticompetitive Effects(88) -- FERC asks how long a binding transmission constraint must persist to be deemed significant. This problem commonly arises in electricity markets where peak demand periods, with binding transmission constraints, are likely to be limited to certain hours of the day during certain seasons of the year. A typical example would be weekday afternoons during the summer months. Because electricity cannot be economically stored in large quantities,(89) electricity supply and demand must be continuously balanced. Consequently, supply and demand conditions within short time intervals may be independent of each other in most respects. This may require defining electricity sales during, for example, individual hours as separate product markets, each of which may have a different geographic market associated with it. The relevant geographic market during peak demand periods is likely to be smaller than during off-peak periods because transmission congestion during peak periods may reduce or eliminate the ability of distant generators to compete. In examining the importance of a transmission constraint of short duration, FERC may wish to consider that although a transmission constraint may be of short duration, it may have large price effects(90) in a large area.(91) Such conditions (and effects) are likely to recur.

The likelihood that product markets may be defined on an hourly basis in the electric power industry raises another potential complication in analyzing mergers in this industry. During some hourly periods (product markets), a proposed merger may increase the likelihood of higher prices or other competitive harm. For example, during peak load periods when transmission is constrained, the proposed merger might give rise to market power in the generation of electricity. During other hourly periods (product markets), the same proposed merger may provide merger-specific, cognizable efficiencies. For example, the merger might provide merger-specific generation efficiencies through reduced reserve requirements that allow plants with lower marginal costs to be used for reserves.(92) In such circumstances, FERC may be faced with the necessity of balancing anticompetitive effects in some product markets against efficiencies in other product markets that are served by the same assets, and that have substantially overlapping relevant geographic markets.

Under the Horizontal Merger Guidelines, such tradeoffs may be considered only where efficiencies in different markets are inextricably linked to the relevant market, as they are likely to be in the example above.(93) FERC may thus wish to consider techniques for examining the degree of linkage between efficiencies in different electricity product markets (e.g., electricity sold on an hourly basis), and whether to seek remedies that affect the same generation assets differently in different time periods.

(3) Potential Competition Concerns(94) -- Because competition may be harmed by mergers that stifle potential competition as well as by those that harm actual competition, antitrust agencies examine mergers for effects on potential competition, even if they appear to present little threat to existing competition. Potential competition issues may be important in formerly regulated industries where restraints on potential entrants may have been in place. The FTC's recent Questar/Kern River case presented such an issue in the natural gas pipeline industry.(95) Similar situations may arise in the electric power industry.

FERC may wish to acknowledge that its analysis of electric power industry mergers under the Horizontal Merger Guidelines will cover potential competition effects and that FERC will incorporate this concern into its analysis generally.(96) Accordingly, FERC may wish to remove or restrict its proposed de minimis exception to the filing requirements for geographically discontiguous operations. This would allow FERC to take into account the possibility that mergers of geographically discontiguous operations(97) may nonetheless involve potential competition issues.

(4) Rate Cap Effects Compared to Competitive Markets(98) -- FERC may find situations in which behavioral remedies, such as rate caps, are appropriate, although structural remedies are generally more effective and less costly to enforce. A rate cap is often intended to replicate the constraint on prices that competition would impose. Often a rate cap takes the specific form of a freeze on current rates. Like competition, a rate freeze operates to prevent prices from going higher due to market power; unlike competition, however, it does not take into consideration the downward pressure on prices in competitive markets from technological advances in production techniques and product design.(99) Thus, a rate cap that does not include consideration of technological advances may allow suppliers to exercise market power by charging higher prices than they would under competition. To help ensure that a rate cap effectively reduces the exercise of market power, FERC may wish to consider requiring adjustments in such rate caps over time to reflect anticipated changes in costs due to technological and organizational advances.(100) We note that the rate caps adopted in the electricity reforms in the U.K. included a downward adjustment to account for technical progress.(101) As an alternative, FERC may wish to establish a lower fixed rate cap initially, to create an expected stream of income equivalent to the technological adjustment approach.

(5) Entry and Efficiency Considerations in Merger Screening Analysis(102) -- The Horizontal Merger Guidelines include consideration of entry conditions and efficiencies,(103) and such factors sometimes reveal that market share concentration statistics overstate the degree of competitive concern associated with a proposed merger. For example, consideration of entry conditions may become more important in markets for electric power as costs for smaller-scale generation facilities, with shorter construction periods and fewer siting problems, fall relative to those of large-scale generation facilities. We have in some instances extended our merger screening analysis to include evidence of likely, timely, and sufficient entry and substantial, verifiable, merger-specific, and cognizable efficiencies. FERC may wish to consider explicitly allowing its merger screening process to include these elements as well.

(6) Product Differentiation -- Although electricity is homogeneous in a physical sense, it is subject to differentiation as a product or service. Such differentiation is likely to increase over time as suppliers pursue incentives to respond to variations in customers' demands for electricity.(104) For example, as retail competition is introduced in various states, consumers will be able to express a preference for power from different fuel sources. Firms also could be differentiated by different brand names or levels of service quality. Statutory requirements also may differentiate suppliers.(105) FERC may wish to acknowledge that differentiation may alter the degree of substitutability between electricity from different sources and may thereby affect the assessment of product markets, geographic markets, and competitive effects.(106)

Information on differentiation is critical in the evaluation of competitive effects under a unilateral market power theory. "A merger between firms in a market for differentiated products may diminish competition by enabling the merged firm to profit by unilaterally raising the price of one or both products above the premerger level. Some of the sales loss due to the price rise merely will be diverted to the product of the merger partner and, depending on relative margins, capturing such sales loss through merger may make the price increase profitable even though it would not have been profitable premerger."(107) Accordingly, FERC may wish to amend its filing requirements to include information sufficient to examine this possibility, including marketing plans, analysis of generation capacity, and quality of service assessments.

(7) Economic Performance Measures(108) -- FERC states that its concerns in reviewing mergers are price increases and output decreases. These economic performance measures are employed by the antitrust agencies as well, but merger analysis under the Horizontal Merger Guidelines also refers to the effects of mergers on quality, innovation, and customer choice among product designs.(109) Given ongoing regulatory and institutional changes in the North American Electric Reliability Council, FERC may wish to indicate that it will consider effects on reliability (quality) in analyzing electricity industry mergers (because quality decreases are equivalent to price increases). More generally, FERC may wish to acknowledge that its merger analysis and merger screening will consider effects on these additional forms of economic performance that are likely to affect consumers.

D. Analysis of Alternative Scenarios

FERC may wish to take advantage of advances in computer simulation modeling techniques to examine more alternative scenarios about future technical, economic, and regulatory conditions in its merger evaluations. FERC's merger analysis is likely to confront numerous technical and factual issues that can significantly influence the conclusions reached. Analysis of alternative scenarios is likely to be particularly useful with respect to defining relevant product and geographic markets and estimating market concentration. Broadly speaking, analysis of alternative scenarios allows FERC to consider various conditions that are critical in assessing the likely competitive effects of a proposed merger. We identify four areas for analysis of alternative scenarios that FERC may wish to consider.

(1) Variations in Underlying Parameters for Geographic Market Analysis -- The Notice recognizes that applicants may face choices among sources and methods for calculating pre-merger prices in the destination markets that are relevant to FERC's proposed horizontal and vertical merger screens.(110) This discretion can affect the values of the parties' pre-merger price estimates. In turn, these estimates can affect whether the applicants will be required to file a horizontal or vertical competitive analysis and whether the merger will ultimately be set for hearing.(111)

Under FERC's proposed filing requirements, merger applicants would be asked to make their best efforts to provide or estimate data that they may not possess. As a result, important data might well contain errors. When there is uncertainty about the data, parties also would have incentives to bias the data in favor of the acquisition. Analysis using different scenarios about the nature and extent of errors could reveal the degree to which results would be robust against errors or bias in data or in any surrogate data submitted by applicants.

(2) Native Load -- The Notice raises questions regarding the treatment of native load in merger analysis. In simple terms, native load encompasses certain contractual and regulatory obligations of electric utilities to serve existing customers. These obligations may dissipate over time because of, for example, retail deregulation or the expiration of contracts. For instance, if most of the capacities of the merging parties are committed under current state regulations to serve native load customers, a merger might have little effect on concentration and competition in wholesale electricity markets in the near term. In the longer term, however, when retail competition is introduced and native load obligations are relaxed in one or more states, the same merger might have a significant effect on concentration in wholesale electricity sales.

FERC may wish to examine two scenarios: (1) relevant suppliers constrained by obligations to serve present native load and (2) relevant suppliers unconstrained by such obligations. The former assumption often would describe competition over the near term, with no expiration of contracts and no retail (or other) deregulation. The latter assumption often would describe longer-run competition that might occur as contractual obligations expire or as retail competition is implemented by individual states. It may be appropriate to challenge the acquisition if threats to competition are found under either scenario.

(3) Transmission Pricing Regimes -- Transmission pricing regimes can strongly affect the scope of geographic markets. In addition, transmission pricing regimes may be subject to changes in regulation and in the scope and nature of regional transmission agreements. For these reasons, analyses of different scenarios can usefully identify to what degree merger evaluations depend upon the transmission pricing regime(s). Differences in transmission pricing regimes may affect suppliers' access to customers within the relevant geographic markets (due, for example, to the pancaking of transmission tariffs, the availability of discounted tariff rates, and the presence of tariff regimes such as Independent System Operators (ISOs)). FERC may wish to include in its analysis a separate scenario for each reasonably foreseeable and substantial change in transmission pricing regime.

(4) ISOs and Other Potential Mitigation Measures -- Analysis of alternative scenarios can provide a useful means of evaluating the likely effects of potential measures to mitigate market power. FERC may wish to use computer simulation modeling with alternative scenarios to evaluate the likely effects of ISOs, structural divestitures, and other potential mitigation measures. For example, a structural divestiture of generation capacity by applicants would most directly affect market concentration, and an ISO would most directly affect the transmission prices (or access) that potential suppliers must face.

VI. VERTICAL AND CONVERGENCE MERGERS

Just as vertical discrimination in transmission access and cross-subsidization concerns arise from the traditional vertical integration in the electric power industry, so too do these concerns arise from mergers that create vertical integration. Of particular interest are convergence mergers in which electric generating companies seek to acquire fuel suppliers that serve the acquiring firm's current or future competitors. In such cases, the concern arises that the acquirer will raise the costs of its competitors, thereby raising electricity prices, which will in turn increase the profits of the acquirer's generation assets. In the PacifiCorp/Peabody merger case, in which PacifiCorp sought to acquire Peabody Coal Company, the FTC published an analysis of a proposed settlement that highlighted how these competitive concerns can fit into a particular fact situation.(112) The text in Sections A and B is adapted from the February 1998 Analysis of Proposed Consent Order to Aid Public Comment in that case.

A. Raising Rivals' Costs

Navajo Generating Station (Navajo) is a 2,250-megawatt coal-fired power plant located in the north-central section of Arizona. Navajo is supplied exclusively from Peabody's Kayenta mine via an 80-mile dedicated rail line. Mohave Generating Station (Mohave) is a 1,580- megawatt coal-fired power plant located in southern Nevada. Mohave is supplied exclusively from Peabody's Black Mesa Mine through a 275-mile coal slurry pipeline. Long-term contracts govern the terms on which Peabody supplies Navajo and Mohave.

Navajo and Mohave are absolutely dependent upon the Kayenta and Black Mesa coal mines for their fuel supply because of their extreme isolation relative to rail lines and other coal mines. There are no other economic sources of fuel, coal or otherwise, for these two large power plants.

PacifiCorp owns roughly 9,000 megawatts of generating capacity in the Western Systems Coordinating Council (WSCC), an organization of electric utilities and power marketers organized to improve the reliability of power transmission and delivery in the western United States and parts of southwestern Canada and northwestern Mexico. The WSCC represents a geographic market since transmission constraints severely limit imports. Sub-regions within the WSCC may also represent geographic markets, at certain times, given that the transmission capacity connecting subregions is limited and may be inadequate to balance supply and demand across the subregions.

A firm can sell its product at a higher price if its rivals charge higher prices. Thus, a firm can profitably increase its own price if it can take actions at low cost to itself that raise the costs, and subsequently the price, of its rivals. By vertically integrating with suppliers of a large share of some key input, a firm may be able to increase its rivals' costs. Given this, PacifiCorp's acquisition of Peabody, which is the exclusive supplier of coal to certain power plants that compete with PacifiCorp's own power plants, raises antitrust concern. Specifically, PacifiCorp would have an incentive to increase fuel costs at Navajo and Mohave in order to drive up the market price of electricity in the western United States. In the near term, PacifiCorp would be able to realize this higher price on its net wholesale electricity sales. In the long-term, assuming deregulation, PacifiCorp might also be able to realize this higher price on some of its retail electricity sales.

The extent of the anticompetitive harm caused by PacifiCorp's acquisition of Peabody depends on two factors: First, how much discretion does the mine owner have to affect the fuel costs at Navajo and Mohave given the long-term contracts between Peabody and the plant owners? Second, over what periods, if any, and to what extent will changing the costs of Navajo and Mohave affect the market price of electricity?

The long-term contracts that govern the supply of coal to Navajo and Mohave have a modified cost-plus format that makes them vulnerable to cost manipulation. A long history of cost disputes between the parties underlines the supplier's discretion to determine cost levels at the power plants. Consequently, post-merger, PacifiCorp could increase Navajo and Mohave's costs. Alternatively, an independent, profit-maximizing Peabody might find it in its interests to grant the power plants a discount on coal pricing. A merged PacifiCorp/Peabody, however, might decline to grant such discounts because increased output at Navajo and Mohave might decrease wholesale electricity prices in the WSCC and cause PacifiCorp/Peabody to earn less on its electricity sales. In this context, failure to grant a price concession amounts to a price increase.

Peabody documents reveal that price concessions in the near future for both Navajo and Mohave are a real possibility. Peabody documents show that the company has considered granting Navajo price discounts, because the plant has been underutilized during off-peak hours in the recent past. Moreover, Peabody documents also reveal that it expects the coming deregulation of the electricity industry will intensify competitive pressures on both coal-fired power plants and their coal supplier