FTC Staff Comment Before the Alabama Public Service Commission Concerning Restructuring in the Electric Utility Industry

* This comment represents the views of the staff of the Bureau of Economics of the
Federal Trade Commission. They are not necessarily the views of the Federal Trade
Commission or any individual Commissioner.
Before the Alabama Public Service Commission
Docket No. 26427
Restructuring in the Electric Utility Industry
Comment of the Staff of the
Bureau of Economics
of the Federal Trade Commission*
January 8, 1999

TABLE OF CONTENTS
I. Introduction and Summary 1
II. Public Interest and Regulation 4
III. Stranded Cost and Benefit Recovery: Potential Distortions 10
A. A Possible Unintended Consequence: Stranded Cost Recovery
May Create Artificial Incentives to Deter Entry 11
B. Why Vertically-Integrated Incumbents May Wish to Deter Entry 15
C. Possible Remedies to Prevent Consumer Harm if Stranded Cost
Recovery Is Allowed 16
D. Potential Inefficiencies and Distortions from Stranded Cost
and Benefit Recovery 19
E. Incentives to Mitigate Stranded Costs 20
IV. Market Structure: Functions that Can Be Competitively Supplied 21
V. Market Power 22
A. Both Horizontal Market Power and Discriminatory Access to
Transmission May Be of Concern in the Electric Industry 22
B. Several Factors Are Important in Evaluating Horizontal Market
Power Issues 24
1. The APSC May Wish to Use Computer Simulation
Models to Help It Assess Horizontal Market Power and
Structural Remedies for Market Power 24
2. The APSC May Wish to Examine the Sensitivity of
Market Power Analysis to Prospective Technical Changes 25
C. If the APSC 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 27
D. ISOs Are Potentially Attractive Institutions for Addressing
Many Market Power Issues in the Electric Industry 29
E. Rules Governing Transactions Between Utilities and Their
Affiliates 34
1. Initial Assessment of Vertical Efficiencies 37
2. Limits on Transactions Between Utilities and Their
Affiliates 37
3. Benefits and Costs of Allowing Affiliates to Use the Parent
Distribution Firm’s Logo 40
F. State Roles in Mergers and Existing Market Power 46
VI. Properly Developed and Operated ISOs May Also Help Address
Reliability Concerns 48
VII. Conclusion 48

1 This comment represents the views of the staff of the Bureau of Economics of the
Federal Trade Commission. They are not necessarily the views of the Federal Trade
Commission or any individual Commissioner. Inquiries regarding this comment should
be directed to John C. Hilke (303-844-3565).
Before the Alabama Public Service Commission
Docket No. 26427
Restructuring in the Electric Utility Industry
Comment of the Staff of the
Bureau of Economics
of the Federal Trade Commission1
I. Introduction and Summary
The staff of the Bureau of Economics of the Federal Trade Commission (FTC)
appreciates this opportunity to present its views to the Alabama Public Service
Commission (APSC) concerning restructuring in the electric utility industry. Alabama
is among a large number of states considering regulatory reforms to bring more of the
benefits of competition (lower prices, improved service, and innovation) in the electric
industry to its citizens and businesses.
The FTC is an independent administrative agency responsible for maintaining
competition and safeguarding the interests of consumers. The staff of the FTC often
analyzes regulatory or legislative proposals that may affect competition or the
efficiency of the economy. In the course of this work, as well as in antitrust research,
investigation, and litigation, the staff applies established principles and recent
developments in economic theory and empirical analysis to competition issues.
The staff of the FTC has a longstanding interest in regulation and competition in
energy markets, including proposals to reform regulation of the electric power and
natural gas industries. The staff has submitted numerous comments concerning these

2 The staff of the FTC has commented to the Federal Energy Regulatory Commission
(FERC) on electric power regulation in Docket RM98-4-000 (Sept. 11, 1998); Docket No.
PL98-5-000 (May 1, 1998); Docket Nos. ER97-237-000 and ER97-1079-000 (Feb. 6, 1998)
(NEPOOL Comment); Docket No. RM96-6-000 (May 7, 1996); Docket Nos. RM95-8-000 and
RM94-7-001 (Aug. 7, 1995) (Open Access Comment). The staff of the FTC also has
submitted comments to various state agencies, which are included on the FTC’s website
<www.ftc.gov/be/ advofile.htm>, including the Louisiana Public Service Commission,
Docket No. U-21453 (affiliate transactions) (Oct. 30, 1998); Public Utility Commission of
Nevada, PUCN Docket No. 97-5034 (affiliate transactions) (Sept. 22, 1998); Mississippi
Public Service Commission, Docket No. 96-UA-389 (Transco proposal) (Aug. 28, 1998);
Louisiana Public Service Commission, Docket No. U-21453 (stranded costs) (Aug. 7, 1998);
Michigan Public Service Commission, Case No. U-11290 (electric restructuring) (Aug. 7,
1998); West Virginia Public Service Commission, Case No. 98-0452-E-GI (electric
restructuring) (July 15, 1998); Commonwealth of Virginia, Joint Subcommittee Studying
Electric Industry Restructuring, SJR-91 (July 9, 1998); Public Utility Commission of Texas,
Project Number 17549 (affiliate transactions) (June 19, 1998); Maine Department of the
Attorney General and Public Utilities Commission, “Interim Report on Market Power in
Electricity” (May 29, 1998); Louisiana Public Service Commission, Docket No. U-21453
(market power) (May 15, 1998); California Public Utilities Commission, Docket Nos. R.94-
04-031 and I.94-04-032 (electric industry restructuring) (Aug. 23, 1995); and South Carolina
Legislative Audit Council (section on foreign experience in electric industry restructuring)
(Feb. 28, 1994).
2
issues at both the federal and state levels.2 Moreover, the FTC has reviewed proposed
mergers involving electric and gas utility companies.
The APSC requests comment on a wide range of competition issues grouped
under twelve categories. This comment focuses on the first six of these categories: "(A)
Public Interest," "(B) Regulation," "(C) Stranded Costs," "(D) Market Structure"
(including affiliated relationships) , "(E) Market Power" (including horizontal market
power, discrimination in access to transmission, and independent regional transmission
entities), and "(F) Reliability."
In Section II, we discuss a cost/benefit framework for analyzing the public
interest in regulatory reform in the electric industry and note that previous regulatory

3
reforms in the United States and abroad often have provided substantial net benefits.
These benefits have gone beyond lower prices and lower costs to include technological
advances and increased variety of products and services. In this section we also discuss
how a state with low-cost generation may preserve low prices for its electricity
customers during the transition to competition.
Section III of the comment addresses the narrow issue of how to avoid a possible
unintended anticompetitive consequence that could flow from certain methods of
stranded cost recovery. If the APSC chooses to implement stranded cost recovery, the
staff recommends that it do so in a way that discourages anticompetitive conduct by
vertically-integrated incumbent electric utilities and reduces distortions in future
electricity purchase decisions of consumers and businesses.
The comment focuses on market structure in Section IV. We observe that
traditional regulation may remain appropriate for transmission and distribution assets,
while most other aspects of the industry should be candidates for competition.
Section V defines the term market power and presents costs and benefits of
open-access rules and independent systems operators (ISOs). This section also
provides economic insights on utility affiliate rules and compares the role of states in
evaluating and remedying market power in the retail competition and merger contexts.
In Section VI, we observe that large, regional ISOs or other independent
transmission entities may be attractive from a reliability perspective as well as from a
competitive perspective.
II. Public Interest and Regulation

3 APSC, Scheduling Order, Docket 26427 at 3 (June 16, 1998). We have not attempted
to identify sources of Alabama’s relatively low electricity prices compared to nearby areas
of Florida and Arkansas. We note that lower rates prevail in sections of other states
within the South and South Central regions, including Mississippi, Kentucky, Virginia, and
Oklahoma. Ronald J. Binz, Thomas Feiler, and Michael J. McFadden, Navigating a Course
to Competition: A Consumer Perspective on Electric Restructuring 36-39 (1997).
4 Exports of electric power from generators located in Alabama would compete on the
basis of the net delivered price that would include transmission use, transmission
congestion, and distribution charges. Consequently, even with increased exports of
electric power from Alabama, electricity prices in Alabama would likely remain below
those in areas with higher-cost generation for some time to come. See, e.g., Frank Felder,
Greg Hopper, and Jay Lukens, Benefits of Retail Electricity Competition in Low-Cost
States: Expectations for an Evolving Industry 11 Elect. J. 75-81 (Aug./Sept. 1998). Only
in the longer run, with relaxed state and local transmission siting rules and extensive
transmission investment, would electricity prices (energy charges plus transmission and
distribution charges) be expected to equalize across areas. Major new transmission lines
have been subject to extended delays or cancellations in many areas of the country due to
environmental, safety, and aesthetic concerns.
4
From an economic perspective, evaluation of the public interest in prospective
electric industry regulatory reform is best carried out through an assessment of the
costs and benefits relative to what the APSC calls “our current low cost status under a
regulated environment.”3 The concern is that competition at the wholesale and retail
levels could result in high electricity prices in Alabama. As Alabama producers divert
low-cost power produced in Alabama to sell it in higher-price areas, prices for electric
power may equilibrate across several southern states at a higher level than presently
prevails in Alabama. In reality, transmission costs and constraints are likely to
preserve lower prices in low-cost areas such as Alabama, although the degree of
advantage may narrow in the future if state and local transmission siting rules are
relaxed or existing transmission lines are upgraded to handle additional capacity.4

5 Economies of scale are present if, when all inputs are adjusted optimally, average
costs decline as output increases within a firm. Economies of vertical integration occur
when a single firm’s performance of activities at two or more stages of production yields
lower average costs. See Jean Tirole, The Theory of Industrial Organization 16-21, 288
(1989).
6 See, e.g., John E. Kwoka, Power Structure: Ownership, Integration, and Competition
in the U.S. Electric Industry (1996); Paul L. Joskow and Richard Schmalensee, Markets for
Power, An Analysis of Electric Utility Deregulation (1983).
5
In light of this concern about the price effects of diversion, the experience in
other industries undergoing deregulation may be instructive. In many of these
industries a major portion of the benefits has come from new products and services. In
the telecommunications industry, for example, local telephone companies undergoing
deregulation have begun to offer a range of new products, including voice mail, caller
identification, call forwarding, and many others. Similarly, recent technological and
organizational changes may have a large impact on projections of future price levels for
electricity. Until recently, two historical characteristics of electric industry technology
provided justification for treating the industry as a natural monopoly: economies of
scale and economies of vertical integration.5
Until the 1980s, both scale economies and economies of vertical integration were
seen as characteristic of the entire industry.6 Recent technological advances, however,
have undermined the natural monopoly rationale for regulation, 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,

7 See Timothy Brennan et al., A Shock to the System 16-19 (1996); FERC Order No. 888
(Promoting Wholesale Competition Through Open Access Non-Discriminatory
Transmission Services by Public Utilities; Recovery of Stranded Costs by Public Utilities
and Transmitting Utilities), 61 Fed. Reg. 21539, 21544 (May 10, 1996) (Order No. 888).
Advances in microturbine and other distributed generation technologies may further
extend this trend in the future. See, e.g., Brian O’Reilly, Transforming the Power Business,
Fortune (May 11, 1998); Joanne Von Alroth, Generating Interest, Current Events:
Microturbines Tout Cheaper, More Reliable Power, Crain’s Chicago Business (Apr. 13,
1998); Thomas R. Casten, Electricity Generation: Smaller Is Better, 8 Elect. J. 65-72 (1995);
Clyde Wayne Crews, Jr., Electric Utility Reform: The Free Market Alternative to
Mandatory Open Access, Competitive Enterprise Institute <www.electricity-
online.com/crews.html (1998)>.
8 One potential difficulty with the nonprofit status of ISOs is the lack of incentives to
operate efficiently and make economically appropriate investment decisions regarding
expansion of the transmission grid. ISO governing bodies typically provide incentives for
managers to operate the grid efficiently and to diminish transmission bottlenecks by
arranging for appropriate additions to transmission capacity.
6
combined-cycle gas plants may be less than one quarter the size of efficient coal or
nuclear plants.7 Deregulation of natural gas and the resulting decline in natural gas
prices relative to other fuels has spurred this new technology. At the same time, new
institutional arrangements, particularly ISOs, are expected to be able to capture many
of the benefits of vertical integration without many of the costs.8 Thus, much of the
genesis of regulatory reform in the electric industry has been technological innovation
in generation and organizational innovation in transmission.
In a variety of industries, extensive economic research on the actual effects of
regulatory reform has revealed a general pattern of strong net benefits of several types,
including cost savings, technological advancements, and increased variety of products

9 Surveys of this literature include: Clifford Winston, U.S. Industry Adjustment to
Economic Deregulation, 12 J. Econ. Persp. 89-110 (Summer 1998), and Economic
Deregulation: Days of Reckoning for Micro-economists, 31 J. Econ. Lit. 1263-1289 (Sept.
1993); John C. Hilke, Competition in Government-Financed Services (1992); Paul L. Joskow
and Nancy L. Rose, The Effects of Economic Regulation, in Richard Schmalensee and
Robert D. Willig (eds.), Handbook of Industrial Organization Vol. II (1989).
10 To the extent that low prices in Alabama stem from access to federal electric
generating facilities such as those of Tennessee Valley Authority, which may be subsidized
by the federal government, the APSC may wish to include in its deliberations the
possibility that such subsidies, if any, may be reduced or terminated in the future
regardless of whether the APSC deregulates its electricity. For related discussion, see
Matthew C. Cordaro, What Future for Public Power?, 10 Elect. J. 72-77 (Nov. 1997).
7
and services.9 The gains typically take several years to be realized. Importantly, these
likely benefits are realized by all consumers even if some buyers benefit more than
other buyers from regulation. Alabama may find significant benefits from increased
competition, even if relatively low-cost producers presently serve its consumers.10
Innovation effects at the generation and distribution levels may be particularly
important.
For example, increased availability of time-of-day metering for residential
customers may result from regulatory reform. With retail competition, some suppliers
may elect to compete by offering time-of-day metering. Consumers may be attracted to
such metering because it offers them an opportunity to reduce their electric bills by

11 Some shifts in demand away from peak periods may be easy to accommodate
without any incremental investment on the part of customers (i.e., operating household
appliances during off-peak hours). Other shifts may be facilitated by investments in
computer technology (e.g., "smart" metering that automatically adjusts energy usage in
response to price changes), energy storage devices (e.g., air conditioning systems that chill
water in off-peak periods to use for cooling during peak electricity demand periods), use
of alternative energy sources (e.g., use of gas heat rather than electric heat during peaks
in electricity demand), or distributed generation (e.g., microturbines).
12 In addition to being economically attractive to some consumers, time-of-day metering
may have very attractive efficiency effects on the electric system generally. For example,
when consumers face higher prices during peak demand periods, they are likely to reduce
their demand. (With present pricing systems, consumers receive no incentive to use less
during high-cost periods.) Reducing demand peaks can reduce generation costs and
reduce the need to invest in high-cost peaking units. Reducing peak demand through
pricing also can relieve transmission congestion (a condition in which transmission lines
are being used to full capacity and additional transmission efforts between a generator and
load reduce the efficiency of other transmissions on the transmission grid), thereby
reducing load pockets (demand that can only be satisfied by generation in that area
because of transmission congestion) and the corresponding risks of generation market
power.
13 In this discussion, we assume that Alabama’s lower electricity rates do not stem from
the APSC’s suppression of rates below those required for long-term viability of suppliers.
14 In some states, the expected revenue stream under regulation may be smaller than
the revenue stream under competition. If so, the difference is termed a “stranded benefit.”
Typically, stranded benefits and stranded costs are combined to create a net total. When
there are net stranded benefits, the market value of a utility’s generation assets is likely to
be greater than the book value of those assets. A 1996 state-by-state estimate lists net
stranded costs of $735 million in Alabama. See Ronald J. Binz, Thomas Feiler, and Michael
J. McFadden, Navigating a Course to Competition: A Consumer Perspective on Electric
(continued...)
8
shifting their use of electricity to off-peak periods,11 when electricity is likely to cost less
to produce and, therefore, can be priced at a lower level.12
Finally, Alabama, like other states with low-cost generation,13 may find it
possible to preserve lower electric bills for consumers in the state as part of an
assessment and recovery of stranded costs and stranded benefits.14 In a low-cost state,

14(...continued)
Restructuring 38-39 (1997). Since these estimates were made, estimates of net stranded
costs have generally declined because auctions of generating assets in various parts of the
country have generally received bids considerably in excess of the book value of the assets.
If this pattern holds true for Alabama, part or all of the state may well have net stranded
benefits.
15 Some states also have relied on rate caps to assure that consumers not pay higher
prices during the transition to competition.
16 Presentation of Commissioner Richard H. Cowart, Chair, Vermont Public Service
Board, Sixth DOE-NARUC National Electricity Forum, Houston, Texas, Sept. 17, 1998. To
avoid distorting consumption decisions between electricity and other forms of energy, the
APSC may wish to avoid using net stranded benefits to directly reduce generation charges.
As discussed in Section III.D., a lump sum, fixed payment based on past electricity use
may be more attractive.
9
stranded benefits may exceed stranded costs because the market price of electric power
may be higher than the regulated price, even if potential market power problems in
generation have been addressed. The APSC may wish to consider requiring that
incumbent suppliers return net stranded benefits to customers, just as customers would
have been responsible for paying net stranded costs had stranded costs exceeded
stranded benefits.15 For example, the APSC could require that net stranded benefits be
returned to customers in proportion to historic electricity use, effectively reducing
electricity bills for customers.16
In summary, low-cost states may be concerned that retail competition will create
incentives for Alabama producers to divert electricity to areas with higher prices. This
concern may be overstated in that transmission conditions are likely to preserve a cost
advantage for power produced and consumed in Alabama. Further, the APSC may
recapture some of the benefits of diversion for Alabama customers through recovery of

10
net stranded benefits. Finally, retail competition is likely to provide other benefits in
the form of new services and lower costs that will offset any price effects of diversion.
III. Stranded Cost and Benefit Recovery: Potential Distortions
Alabama is among a number of states examining public interest issues
surrounding recovery of stranded electric utility costs and benefits. The staff takes no
position as to whether stranded cost and benefit recovery is in the public interest -- a
determination best made by state and local regulators with knowledge of unique local
circumstances. Whether and how to implement stranded cost and benefit recovery
raises many complex policy issues that reach far beyond the scope of this comment.
Instead, we address the narrow issue of how to remedy an unintended anticompetitive
consequence that could flow from certain methods of stranded cost or benefit recovery
in the event the APSC decides to permit vertically-integrated, incumbent electric
utilities to recover net stranded costs or to permit customers to recover net stranded
benefits.
Certain net stranded cost recovery systems may create artificial incentives for
incumbent utilities to set prices that deter entry and harm competition. If the APSC
finds that there are net stranded costs in an area and chooses to implement stranded
cost recovery, we recommend that it do so in a way that discourages such
anticompetitive conduct by incumbent firms.
In addition, we briefly discuss (1) potential market distortions and inefficiencies
that may accompany stranded cost and benefit recovery and ways to minimize such
inefficiencies, and (2) mitigation of the level of stranded costs. These two issues were

17 Entry in generation could take the form of new generation facilities, or it could
consist of improved transmission capacity that makes distant generation sources more
effective competitors to local generation sources.
18 This discussion is developed in the context of retail competition and retail stranded
costs. Similar concerns may arise concerning wholesale competition and stranded costs.
11
examined in the attached Open Access Comment to the Federal Energy Regulatory
Commission.
A. A Possible Unintended Consequence: Stranded Cost Recovery May
Create Artificial Incentives to Deter Entry
One potential unintended consequence of stranded cost recovery is that
incumbent firms may be able to use the stranded cost recovery system to deter
potentially more efficient and innovative entry17 and thereby delay or harm
competition.18 If that occurred, electricity customers (municipalities, businesses, and
consumers) would lose not only the benefits of price competition but also those flowing
from the product and service improvements and increased product variety that
competition brings. They would likely pay more than they otherwise would during the
period after the stranded cost recovery period ended. The APSC could safeguard
against these unintended consequences, however, by adopting, in conjunction with any
stranded cost recovery system, one of three possible remedies discussed in Section
III.C, infra.
Consumers could be harmed by the exclusion of efficient entrants during the
stranded cost recovery period. The harm could result because of a connection between
the way stranded costs are defined and a decision by state regulators to provide

19 Recent publications that discuss specific instances and present a similar discussion
of the issues include Richard Pierce, Conceptual Issues Raised by the PECO/Enron
Dispute, 11 Elect. J. 26-38 (Apr. 1998); and Jeffrey D. Watkiss, Retail Competition:
Preliminary Results, Electric Utility Consultants’ Transmission Pricing Conference,
Denver, Colorado (June 26-27, 1998).
20 Under traditional regulation, the price of electricity is a bundled price that includes
generation and transmission/distribution components blended together. Under most
competitive scenarios, the individual components are unbundled and reported separately.
Here we refer to the generation component of traditional rates as the "energy charge" and
the transmission/distribution components as the "lines charge."
12
incumbent utilities with recovery of most or all of their stranded costs through
surcharges on electricity use.19 Stranded costs are often defined by calculating the
difference between the (larger) net present value of future income under traditional
regulation using a rate-of-return concept and the (smaller) net present value of future
income under regulatory reform. That is, the net present value of the income from a
particular generation asset in a competitive environment is expected to be less than the
income regulators would allow from a particular asset in a regulated environment.
When stranded costs are defined in this manner, the level of stranded cost
recovery is inversely related to how far prices for electric power (energy charges) fall as
the result of competition.20 From the incumbent’s perspective, there is an increase in
revenue from stranded cost recovery for every revenue decline due to lower energy
charges. With 100 percent stranded cost recovery, as some regulators have chosen, the
offset is dollar-for-dollar. By contrast, the potential generation entrant has no stranded
cost recovery revenue to offset lower energy charges. Thus, it could be disadvantaged

21 The level of the incumbent’s energy charge necessary to deter entry depends, in part,
on the costs faced by prospective entrants. Establishing a very low energy charge -- one
that is below the expected variable costs of potential entrants, for example -- is quite likely
to deter entry.
22 In theory, if a state determines not to permit 100 percent stranded cost recovery, the
utility’s incentive to engage in entry-deterring pricing of energy charges will be weakened,
depending upon the amount not recovered. Although the aggregate stranded cost
recovery amount is lower, which should result in a lower total price for electricity to
consumers and increased output by producers, the actual effect on output may be slight
because electricity demand is commonly thought to be relatively inelastic, at least in the
short run.
23 Although the new supplier would bill and collect these three charges, it would remit
the stranded cost recovery surcharge to the vertically-integrated incumbent.
13
by such a stranded cost recovery system because it may need to match the incumbent’s
lower energy charges in order to compete, but may lack the wherewithal to do so.
As competition in generation is about to begin, the vertically-integrated
incumbent must decide what price (energy charge) to set for the electricity it generates.
If it establishes an artificially low energy charge,21 entry would be less likely to take
place and competition from entrants may be less likely to reduce the incumbent’s future
profits.22 Stranded cost recovery revenue effectively could subsidize such artificially
low energy charges, without proportionately reducing the total charges to consumers.
Customers that leave a vertically-integrated incumbent and choose a new
electricity supplier will typically be required to pay an energy charge, a lines charge,
and a stranded cost recovery surcharge as part of their monthly electricity bill during
the stranded cost recovery period.23 Because many stranded cost recovery proposals
incorporate an equalization-type formula -- such that stranded cost is defined as the

14
remainder after subtracting energy and lines charges from the sum of the total charges
projected under traditional rate-of-return regulation -- a decrease in the energy charge
prompts an offsetting increase in the stranded cost surcharge. In this circumstance, a
decrease in energy charges may not be associated with any change in the total charges
(price) for consumers and, thus, would be unlikely to result in increased output. Such a
system also would provide less incentive for the incumbent firm to produce efficiently
or to mitigate stranded costs.
Under this scenario, stranded cost recovery might become a license to block or
eliminate entry, even if the entrants would be more efficient and innovative. As
addressed in Section III.C infra, however, at least three alternative remedies (including
a structural remedy) may be effective to prevent this from occurring.
B. Why Vertically-Integrated Incumbents May Wish to Deter Entry
From the incumbent firm’s perspective, deterring entry may be attractive if
delays in entry (1) increase costs for entrants, or (2) slow establishment of a competitive
market. An incentive to deter entry may arise, for example, if the initial opening of
competition by the state represents a unique window of opportunity for entrants to
attract attention from potential customers at lower marketing costs than they otherwise
would incur in a competitive market. In other words, the "kick-off" of retail
competition is likely to be accompanied by publicity (news coverage) and government-
authorized consumer education materials that are designed to raise consumer
awareness of the opportunity to “shop” for power. Later entrants may face higher
costs in establishing the same consumer awareness and interest in switching providers

24 If there is uncertainty about the viability and reliability of new suppliers, as is likely,
customers may be reluctant to undertake the costs of search and of switching to alternative
suppliers until such suppliers are operating.
15
because their efforts will receive no spillover benefits from government-financed
consumer information campaigns and publicity. In addition, a degree of consumer
inertia may make consumers less amenable to "power shopping." If such is the case,
the incumbent’s ability to deter entry during this critical period of consumer interest
and awareness may raise entrants’marketing costs above what they otherwise would
be, over both the short and the long run.
A second incentive to deter entry may arise if there are lags in undertaking new
generation and transmission investments that are needed to establish a competitive
market. Delays in new investment sufficient to create a gap between the end of the
stranded cost recovery period and establishment of a competitive market could stem
from matters such as higher marketing costs associated with inducing customers to
switch before the new supplier is ready to start supplying the market.24 By delaying
entry, the incumbent firm might slow the development of a competitive market, and
thus be able to exercise generation market power between the end of the stranded cost
recovery period and the birth of the competitive market. If entry can be timed

25 Similarly, if entry takes longer than the period allowed for stranded cost recovery,
artificially low energy charges during the recovery period may not affect the timing of
entry or the length of the transition between the end of the stranded cost recovery period
and entry. Assuming that entry is motivated by prospective profit at the time the entry
takes place, artificially low prices during the interim are unlikely to change the potential
entrant’s evaluation of the attractiveness of entry so long as entry takes longer than the
stranded cost recovery period.
26 A policy of fixing the level of stranded costs at the onset may solve the problem in
principle because it makes it impossible for the incumbent firm to influence the level of
stranded cost recovery by lowering the energy charge during the recovery period. This
may not be a sufficient remedy in practice, however, because it may motivate incumbent
firms to overstate stranded costs (understate the competitive level of energy charges) and
to understate their ability to reduce stranded costs, in ways that deter entry and are
difficult for regulators to detect.
16
perfectly, however, the transition period may be brief,25 and such competitive problems
would not arise due to this incentive.
C. Possible Remedies to Prevent Consumer Harm if Stranded Cost
Recovery Is Allowed
If the stranded cost recovery mechanism allowed incumbent firms to act in the
above-described manner, consumers could find total prices (including stranded cost
recovery) to be no lower in the short run and higher in the long run. In addition, other
benefits derived from early entry could be lost. These could include, for example,
product improvements from new technology, lower-cost production methods, service
innovations, and increased product variety. The APSC may consider the following
three policy alternatives to avoid this possible harm to consumers and competition if it
determines that stranded cost recovery is appropriate.26

27 Massachusetts, for example, has required that generation capacity be divested as a
condition for stranded cost recovery. Edison Electric Institute, Retail Wheeling &
Restructuring Report, A Quarterly Report 65 (Mar. 1998). New York State similarly has
required divestiture of most generating facilities. Edison Electric Institute, Retail Wheeling
& Restructuring Report, A Quarterly Report 91 (June 1998). This approach also provides
certainty about the magnitude of stranded costs by defining stranded costs as the gap, if
any, between the sale price of the plants and their regulated (book) value. California has
required divestiture of a large portion (50 percent) of generation assets. California,
Brubacker & Associates Electric Industry Restructuring Newsletter 1 (Oct. 1998). To date,
all divestiture sales have occurred at prices above the book value of the generating
facilities. The premiums over book values range from 19 percent to 253 percent for
completed transactions. One pending transaction involves a premium over book value of
485 percent. Electric Utility Plant Divestitures: Transaction Summary, Brubacker &
Associates’Electric Industry Restructuring Newsletter, insert (Oct. 1998). A variant on
divestiture is to require dominant firms to sell portions of their capacities as entitlement
contracts that buyers can bid into the market in competition with the incumbents. As
FERC’s recent order in the Duquesne/Allegheny merger indicates, such contractual
arrangements may not be a good substitute for divestiture, particularly when contracts are
of short duration, the incumbent makes facilities operations decisions "for" competitors,
and minimum prices for "successful" contract bids are set by the incumbent. Allegheny
Energy Inc. and DQE, Inc., FERC Docket Nos. EC97-46-000, ER97-4050-000, ER97-4051-000
(Sept. 16, 1998).
28 Vertical divestiture may also help address existing market power problems in
generation, but only if the divestiture is handled as an arm’s-length transaction in the
(continued...)
17
1) Require that incumbent, vertically-integrated firms sell (divest) their
generation capacity.27 Vertical divestiture is likely to eliminate the incentive and ability
to impose higher electricity prices after stranded costs are recovered, because the
incumbent firms will not be selling electricity at that time. Although vertical
divestiture could result in a loss of economies of vertical integration, institutions such
as an independent grid operator may preserve these economies if they precede or
accompany divestiture. This structural remedy may be attractive because it changes
the incentives of incumbent firms and should require no additional regulatory action.28

28(...continued)
event the seller’s affiliate(s) are allowed to bid. Divestiture to a single entity will not
generally address existing generation market power. Divestiture to more than one entity
is likely to increase competition in the relevant market(s).
29 Fuel costs (including transportation costs for fuel) typically represent a substantial
proportion of total generation costs, and differences in fuel costs typically represent a large
portion of the difference in the relative costs (both total and variable) of various generating
facilities. Hence, a minimum energy charge set at fuel costs represents both a substantial
difference from a near-zero energy charge, and a sufficient inducement to entrants to
invest either in new generation with low fuel costs or in new transmission providing access
to low-cost generation.
18
2) Establish minimum energy charges for the incumbent utility that reflect at
least its fuel costs. If the incumbent utility is required to set its energy charges at least
at the variable costs of fuel, alternative suppliers with lower fuel costs may find
sufficient incentives to enter. 29 The regulator’s tasks of collecting data, monitoring
compliance, and determining variable costs (assuming variable costs can even be
determined) under this type of rule, however, would require significant resources.
Although this approach may discourage entry-deterring prices, it also risks
discouraging competitive price reductions aimed at, for example, promoting the
sampling of new products, enhancing the demand for complementary products, or
learning more about demand elasticity.
3) Establish caps on electricity prices during a transition period that extends
for a fixed interval beyond the stranded cost recovery period. The price cap would
reduce the ability of the incumbent utility to take advantage of the lack of entry during
the recovery period by raising rates immediately thereafter. One drawback of this

30 Net stranded benefit recovery implemented with lower energy charges would have
the reverse effect, but would equally distort choices about electricity use. By contrast,
payments of net stranded benefits to customers based on past consumption would avoid
this type of distortion.
19
approach is that the long-term use of pricing caps may harm competition by muting
important economic signals for additional transmission or generation capacity.
D. Potential Inefficiencies and Distortions from Stranded Cost and Benefit
Recovery
Different methods of recovering net stranded costs or net stranded benefits
could have significantly different economic effects. The likely differences are explored
in the public finance literature about different forms of taxation and subsidization. For
example, a proposal to recover stranded costs through an additional charge on
transmission services for departing customers is analogous to a sales or excise tax, with
the charge paid varying in relation to the amount purchased in the future, thus possibly
distorting future electricity consumption decisions.30 Its effects can be contrasted with
the effects of a lump sum, fixed charge based on past electricity use, which would not
create the same possible distortions of future electricity consumption decisions. Section
V.A. of the attached Open Access Comment to FERC presents a discussion of these
aspects of stranded cost recovery.
E. Incentives to Mitigate Stranded Costs
Suppliers generally have strong incentives to respond to changing demands by
undertaking product and service innovations that make the best use of their capacity.
As regulation in the electric industry is reformed, suppliers of electric power could

31 In the case of net stranded benefits, full recovery for customers may similarly
discourage firms from obtaining such benefits by effectively taxing them at 100 percent.
32 Rate and service regulation of transmission and distribution assets can be consistent
with competition to supply energy conveyed over these lines by unbundling transmission
and distribution from energy sales.
20
have similar incentives to innovate in order to mitigate threatened losses, such as those
that are labeled here as “stranded costs.” But requiring that all mitigation savings be
passed through to the departing customers would effectively impose a 100 percent tax
on mitigation savings, thereby discouraging additional efforts to mitigate stranded
costs.31 Other treatments of mitigation savings may not discourage mitigation of
stranded costs to the same degree. Stranded cost mitigation incentives are discussed in
Section V.B. of our Open Access Comment.
IV. Market Structure: Functions that Can Be Competitively Supplied
To date, technological and organizational innovations allowing competition have
centered on generation and marketing of electric power. Additional opportunities for
unbundling, such as competition in metering and billing services, appear to warrant
serious consideration either as elements of marketing or as separate enterprises. At the
same time, there is a considerable degree of consensus that transmission and
distribution assets should remain under rate and service regulation for the present32
because economies of scale continue to be a primary consideration for investment in

33 Illustrative figures developed by Oak Ridge National Laboratory show that a 765 kV
transmission line costs at least 30 percent less than a 500 kV line and at least 85 percent less
than a 138 kV line, on a cost per MW-mile basis. FERC Transmission Task Force, Staff
Report, pp. 215-16 (1989). As indicated in note 7 supra, at some future date, various forms
of distributed generation (e.g., microturbines and fuel cells) may allow this element of rate
and service regulation to be relaxed as well.
21
these assets.33 The APSC may wish, therefore, to consider establishing competition in
all facets of the industry except control of transmission and distribution assets.
V. Market Power
A. Both Horizontal Market Power and Discriminatory Access to
Transmission May Be of Concern in the Electric 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 that may concern the APSC as it
contemplates moving to retail competition: 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

34 See Timothy Brennan, Why Regulated Firms Should Be Kept Out of Unregulated
Markets: Understanding the Divestiture in United States v. AT&T, 32 Antitrust Bull. 741
(1987), and Cross Subsidization and Cost Misallocation by Regulated Monopolists, 2 J. Reg.
Econ. 37 (1990).
35 See, e.g., "Petition for a Rulemaking on Electric Power Industry Structure and
Commercial Practices and Motion to Clarify and Reconsider Certain Open-Access
Commercial Practices," filed with FERC by Altra Energy Technologies, Inc. and others on
March 25, 1998. Aside from the question of compliance with FERC Order 888, there is a
question about the breadth of its application. While FERC orders generally apply broadly
to all energy sales involving interstate commerce, Order 888 does not apply to transmission
by traditional vertically integrated utilities to accommodate "native" load. Transmission
to accommodate native load accounts for a large portion of total transmission. Order No.
(continued...)
22
heightened by the pioneering British deregulatory experience. Following the
implementation of electric 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, the
APSC 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.34
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.35 The FTC staff’s

35(...continued)
888, 61 Fed. Reg. at 21552.
36 Otter Tail Power Co. v. United States, 410 U.S. 366 (1973).
37 Although the DOJ/FTC Merger Guidelines provide a firm foundation for analyzing
changes in prospective market power resulting from a proposed merger, the analysis does
not focus on detecting or measuring market power that may already exist in the market.
Further, antitrust enforcement is focused on anticompetitive mergers and unfair methods
of competition. From an antitrust perspective, a firm that lawfully acquired market
power does not commit an antitrust offense merely by exercising that power, unless it
engages in unfair methods of competition to protect that power. Consequently, antitrust
enforcement may not be able to reach such market power as may exist as a market moves
from local regulated monopolies to competition. Hence, if it finds that horizontal market
(continued...)
23
Open Access Comment to FERC in 1995 emphasized the limitations of behavioral rules
in addressing vertical discrimination in access to transmission. The comment discussed
continued incentives to discriminate under open access rules and difficulties in
detecting and documenting violations of such rules. Likewise, discriminatory
behavior is consistent with the evidence from the Supreme Court’s Otter Tail Power
decision.36 Although we have not performed an empirical study of the presence of
either horizontal market power or transmission discrimination in Alabama, we can
provide some insights into the process of making such an assessment and developing
remedies if market power is a concern.
B. Several Factors Are Important in Evaluating Horizontal Market Power
Issues
Economic analysis of market power includes five primary areas: market
definition, market structure, likely competitive effects of the structure or of changing
the structure, entry conditions, and efficiencies.37

37(...continued)
power problems exist in the generation market(s), the APSC may wish to look beyond
antitrust enforcement by considering structural relief (i.e., divestiture of generation assets
by a transmission monopolist). At the same time, however, if the APSC is contemplating
structural relief to correct an existing market power problem, an analysis using the factors
set forth in the DOJ/FTC Merger Guidelines may be helpful.
38 FERC’s Inquiry Concerning the Commission's Policy on the Use of Computer Models
in Merger Analysis; Notice of Request for Written Comments and Intent to Convene a
Technical Conference, 63 Fed. Reg. 20,392 (1998) ("The purpose of this inquiry is to gain
further input and insight into whether and how computer models should be used in the
analysis of mergers ...").
39 Federal Trade Commission, "Analysis of Proposed Consent Order to Aid Public
Comment In the Matter of PacifiCorp et al.," FTC File No. 971-0091, at 4 (Feb. 18, 1998).
The FTC withdrew from the proposed consent order as of June 30, 1998 because PacifiCorp
withdrew from the merger <www.ftc.gov/opa/9807/petapp39.98.htm>.
24
1. The APSC 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. The APSC may wish to consider employing such

40 The competition implications of market concentration are affected significantly by
entry conditions. If entry is likely, timely, and sufficient to undermine efforts to exercise
market power, then even high concentration may not have adverse implications for
consumers. (See the DOJ/FTC Merger Guidelines, Section 3, for a discussion.)
41 A "load pocket" refers to demand in an area that must be satisfied by generation in
that area because transmission congestion prevents utilization of supplies from outside the
area.
42 <www.ftc.gov/be/advofile.htm (V980011)>
25
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.
2. The APSC May Wish to Examine the Sensitivity of Market
Power
Analysis to Prospective Technical Changes
With rapid technical change, there is an important potential distinction between
current market power problems that are transitory and those that are likely to persist
despite new technology and new institutions. A good example is the effect of changing
technology on entry conditions.40 Technological and regulatory changes over the past
decade have tended to ease entry obstacles in electricity generation markets. In the
comment to the Maine Department of the Attorney General and the Public Utilities
Commission, the FTC staff observed that future entry conditions in possible load
pockets41 in Maine may be eased considerably by installation of new natural gas
pipelines that can supply fuel to new, smaller gas generators.42 New and existing
natural gas distribution lines may make entry of new, smaller-scale electric generators
quicker and easier in Alabama as well, particularly given the proximity of Alabama’s
load centers to extensive natural gas fields.

26
Entry analysis of electric generation markets considers two principal forms of
entry. The first is new or expanded generating capacity within the existing product
and geographic market. The second is enhanced access to existing generating capacity
by virtue of new or expanded transmission capacity. Increased transmission capacity
that permits additional suppliers to compete frequently enlarges the relevant
geographic market, and consequently tends to reduce concentration in the relevant
market(s), even if no additional generation capacity is installed. The APSC may wish to
distinguish in its analysis of market power between present market power and one or
more future market power scenarios.
In summary, if the APSC determines to perform an assessment of existing
market power, the DOJ/FTC Merger Guidelines provide an appropriate set of factors to
consider, and computer simulation models may facilitate a fuller understanding of
existing market power risks. Because the ability of incumbent generating firms to
exercise market power may well change over time, the APSC may wish to supplement
a market power analysis with an assessment of how likely technical changes will alter
the ability of firms to exercise market power in the future. Computer simulations may
materially assist in this effort as well. If present market power problems are likely to
differ significantly from future market power problems, the APSC may wish to design
its remedies to take account of these expected changes.
C. If the APSC 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

43 The concerns expressed in the NEPOOL Comment were generalized in our May 1,
1998 ISO Policy Comment to FERC. The NEPOOL Comment focused on potential
drawbacks to the market power mitigation proposals made by NEPOOL to FERC. It did
not address the empirical issue of the presence or magnitude of existing generation market
power in New England <www.ftc.gov/be/advofile.htm (V980007)>. For a review and
analysis of the ISO New England’s market rules, see Peter Cramton and Robert Wilson, A
Review of ISO New England’s Proposed Market Rules (Sept. 1998). The authors
recommend switching to a multi-settlement system, introducing demand-side bidding,
adopting location-based transmission congestion pricing, and fixing the pricing of ten-
minute spinning reserves.
27
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),43 Alabama 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

44 Potential structural reforms in the electric industry include a wide variety of
alternatives. For a review of alternative market designs for wholesale trades in electricity
markets, see Robert Wilson, Report to the Competition Bureau of Industry Canada,
Efficiency Considerations in Designing Electricity Markets (Mar. 30, 1998).
45 The APSC may also be asked to consider alternatives to a regional ISO, such as a
transmission company (a "Transco"). If so, the APSC may wish to consider potential
competition and efficiency issues related to Transcos that are identified in the recent FTC
staff comment to the Mississippi Public Service Commission <www.ftc.gov/be/advofile
(v980024)>.
46 Under authority granted to FERC by the Department of Energy, FERC is now
undertaking consultation with the states on establishing contours for transmission
reliability regions to cover the entire nation. FERC, News Release, Docket No. RM99-2-000
(Nov. 24, 1998). This is the next step in an on-going process at FERC to assess whether
independent regional transmission entities should be established in all areas of the country
to facilitate reliability, efficiency, and competition. Alleged deficiencies in the
implementation and scope of FERC Orders 888 and 889 have helped prompt this policy
review.
47 Under traditional FERC transmission tariffs, an additional charge is incurred any
time the contract transmission path involves more than one firm’s transmission system,
thus causing rates to be "pancaked."
28
potential to address market power with greater certainty and lower costs to consumers
(id. at 6). 44
D. ISOs Are Potentially Attractive Institutions for Addressing Many
Market Power Issues in the Electric Industry
Both horizontal market power and transmission discrimination concerns can be
addressed by ISOs45 or other regional transmission entities.46 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 rates47 and
embracing an enlarged geographic area, ISOs can broaden the effective geographic

48 One potential difficulty with the nonprofit status of ISOs is the lack of profit
incentives to operate efficiently and to make economically appropriate investment
decisions regarding expansion of the transmission grid to address transmission
bottlenecks. ISO governing bodies may be able to design the employment contracts of ISO
managers to provide such incentives.
49 FERC issued additional guidelines on formation of ISOs in Order No. 888 and Order
No. 889, FERC Stats. & Regs. (CCH) ¶31,594 (Apr. 24, 1996) (Open Access Same-Time
Information System and Standards of Conduct).
29
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 that arise during periods of transmission
congestion.48
If Alabama 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:49 (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.

50 Another disadvantage may be that it does not provide enough diversity in generation
(with respect to number and type of generators) to optimize system reliability. See Section
VI infra.
30
ISO Warning Sign Number One: The ISO is too small. One disadvantage of
an ISO with limited geographic scope is that it may not encompass enough generating
firms to mitigate generator market dominance problems. 50 With very few, if any,
exceptions, a single state is too small for an ISO. An ISO that includes only one utility’s
service territory warrants even closer scrutiny. In contrast, several participants at
FERC’s April 1998 ISO Policy Conference testified that reliability and competition
concerns might lead to consolidation into as few as three ISOs to cover all forty-eight
contiguous states.
ISO Warning Sign Number Two: There is no plan for generation
restructuring even when there is a potential generation market dominance problem.
As a general proposition, a market power monitoring office within the ISO may not be
a good substitute for up-front divestiture of generation capacity if market power is
present. Several states, including California, have confronted the generation market
dominance issue directly and required divestitures of key generation capacity in
conjunction with forming an ISO. Divestiture that simply replaces one dominant
generating firm with another is unlikely to address market power problems in
generation. Divestiture to multiple buyers is likely to be necessary. In evaluating
divestiture proposals, it is important to address potential biases in the divestiture
process as well as partial cross-ownerships of generating plants that may thwart

51 The Administration’s recent proposals respond to this concern by recommending that
Congress give FERC (in consultation with the FTC and DOJ) authority to require
divestiture of generation assets by generating firms that have market power in the context
of retail competition. "Comprehensive Electricity Competition Plan" (Mar. 26, 1998)
<www.hr.doe.gov/electric/plan.htm>.
52 See James Baker Jr., Bernard Tennebaum, and Fiona Wolf, Governance and
Regulation of Power Pools and System Operators: An International Comparison, 382
World Bank Technical Papers (1997) (a report on international comparisons of ISO
governance systems written in part by FERC staff); Alex Henley, Contrasts in
Restructuring Wholesale Electric Markets: England/Wales, California, and the PJM, 11
Elect. J. 24 (Aug./Sept. 1998).
53 "Transmission congestion" refers to conditions in which transmission lines are being
used to full capacity and additional transmission efforts between a generator and load
reduce the efficiency of other transmissions on the transmission grid. Transmission
congestion is most likely during peak demand (load) periods.
31
competition. As noted earlier, antitrust may not be an effective policy tool for
addressing existing market power created under past regulation. Hence, the APSC,
other state public utility commissions, and FERC may be in the best position to address
this aspect of restructuring as part of the ISO formation process.51
ISO Warning Sign Number Three: The "I" part of the ISO is missing or weak.
Independence is a keystone of successfully launching competition through an ISO. For
competition to develop, current and prospective industry participants need to have
trust in the objectivity of the ISO. If, for example, incumbent vertically integrated
utilities can veto expansions of the transmission grid, or limit who may use the grid, the
ISO’s independence is likely to be at risk.52
ISO Warning Sign Number Four: The ISO plan does not effectively deal with
transmission congestion.53 Failure to deal effectively with the transmission congestion

54 A variety of transmission congestion pricing systems have been approved by FERC
for use by ISOs, and the APSC may wish to compare the effects of the different systems as
more experience is gained. California, for example, opted for a "zonal transmission
pricing" approach, albeit with very large zones. The Pennsylvania, [New] Jersey,
Maryland (PJM) ISO has chosen to address transmission congestion problems with much
more narrowly defined pricing zones. PJM’s approach is termed "locational marginal
pricing" or "nodal pricing." Locational marginal pricing is a transmission pricing system
that attempts to take full account of transmission loop flows. Loop flows are a
complication of the physics of electricity (electricity follows the path of least resistance)
that results in transmission congestion arising in places and times that are counter to the
intuitive, traditional view of transmission as a point-to-point delivery of electric energy.
Locational marginal pricing assesses congestion charges based on the transmission
congestion caused throughout the transmission system by a particular transaction.
55 Public attention to this warning sign has been accentuated by the British experience.
The British government’s decision to privatize with only two major private suppliers
resulted in a market structure that fostered market power in generation. See Alex Henley,
supra n. 52..
56 Roger E. Bohn, Alvin K. Klevorick, Charles G. Stalon, Report on Market Issues in the
California Power Exchange Energy Markets (Aug. 17, 1998). Relaxing restrictions on
supply of such services by firms outside the ISO boundaries may help alleviate this market
power. Anjali Sheffrin, Review of Ancillary Service Market (Aug. 27, 1998).
32
problem can threaten system stability, present opportunities for generators to create or
protect generation market power, and reduce the overall efficiency of the transmission
grid. Other states that have considered this problem have included transmission
congestion pricing systems in their restructuring programs.54
In addition to these four warning signs,55 future ISO designs may be able to take
advantage of insights gained from experiences with existing ISOs. For example,
California has experienced significant price anomalies with its market for ancillary
services that may reflect market power.56 Similarly, the design of California’s power

57 Robert Wilson, PX Activity Rules (Feb. 1997) and Activity Rules for the Power
Exchange (Mar. 1997). For a more general discussion of market design considerations, see
Robert Wilson, Report to the Competition Bureau of Industry Canada: Efficiency
Considerations in Designing Electricity Markets (Mar. 1998).
58 Under fully implemented retail competition, it is expected that both generation and
final sales to end users (such as residential consumers, businesses, schools, etc.) will
operate competitively with no price regulation. Meanwhile, distribution and transmission
services are likely to remain regulated, given current technology. The formerly regulated
local monopoly suppliers generally will be required to unbundle their services when retail
competition is initiated. (An exception may occur if the state designates the traditional
vertically integrated utility as the "supplier of last resort" to serve customers who do not
select a competitive supplier.) To accomplish this unbundling, a traditional utility that is
allowed by law or regulation to retain ownership of all its previous assets could, for
example, elect to establish separate affiliates that would compete in (1) generating
electricity (competing with other generators) and (2) selling electricity to consumers
(competing with power marketers, independent power producers, utilities from nearby
geographic areas, or the electricity supply pool associated with an ISO). The utility also
could establish unregulated affiliates in other industries or in other geographic markets
in the electric industry.
33
pool arrangement (which operates in tandem with the ISO) might be improved to
encourage greater reliability in pricing offers earlier.57
E. Rules Governing Transactions Between Utilities and Their Affiliates
Formation of public policy concerning affiliate transactions involves many of the
same issues discussed above in Section V.A. concerning discrimination in access to
transmission.58 These concerns are increasing as states implement regulatory reform in
the electric industry by requiring vertically integrated monopolies to unbundle various
services. The basic policy issue concerns how to balance the expected benefits and costs
of separating regulated utilities from their unregulated affiliates. The Public Utility
Commission of Texas has noted that this tradeoff should be analyzed with a recognition
of utilities’continuing incentives:

59 Public Utility Commission of Texas, 23 Tex. Reg. 5294 (May 22, 1998).
34
[T]here is a strong likelihood that a utility will favor its
affiliates where these affiliates are providing services in
competition with other, non-affiliated entities. . . . [In
addition,] there is a strong incentive for regulated utilities or
their holding companies to subsidize their competitive
activity with revenues or intangible benefits derived from
their regulated monopoly businesses. . . . Finally, . . .
current regulations . . . are not adequate to prevent or
discourage [this] anticompetitive behavior. . . . However,
the Commission is aware that efficient competition is
fostered by encouraging the participation of many qualified
participants, including unregulated affiliates.59
The potential benefits to consumers from preventing discriminatory transactions
and cross-subsidization between regulated distribution utilities and their unregulated
affiliates can take several forms. First, discrimination and cross-subsidization may
artificially increase the costs of the regulated utility as costs incurred for the benefit of
the affiliate are shifted to the regulated firm. Under a rate-of-return regulatory regime,
higher costs will result in increased prices in the regulated market. Second, such
conduct may increase costs in unregulated markets by displacing innovative, lower-
cost suppliers and entrants with a higher-cost affiliate of the local regulated distribution
utility. Third, this displacement also may eliminate or reduce the process and product
innovations that the displaced firms would have provided to consumers.
On the other hand, unbundling can impose costs on consumers in the form of
lost economies of vertical integration and forgone economies of scale or scope. These
lost economies translate into higher costs and higher prices in either the regulated or

35
unregulated markets. In addition, participation by affiliates may in itself increase
competition in relevant markets.
In weighing the trade-offs between preventing discrimination and fostering
economies of vertical integration, it is important to keep in mind that these questions
arise in a broader context of introducing competition into a very large industry with
widespread effects on local economies as well as the national economy. For
competition to take hold quickly and effectively in these formerly regulated markets, it
may be particularly important to dispel potential entrants’perceptions that the
incumbent distribution firms will manipulate rules and mislead regulators to the
disadvantage of new competitors.
This perception issue gains urgency to the extent that entry may be less costly
when competition is initially being introduced in the electricity industry, when
consumers and businesses are likely to be more aware of and interested in new choices.
Conversely, entry may be more costly and less likely in the long run if an incumbent
retains incentives to increase the risks of entrants into markets served by the
incumbent’s affiliates. These broader concerns about entry are not as relevant to state
regulators when an affiliate is operating in competitive markets that are less closely
related to the markets supplied by the regulated incumbent. Accordingly, the need to
address (and reduce) the perception of potential discrimination and cross-subsidization
may be greatest when competition is just getting underway.
1. Initial Assessment of Vertical Efficiencies

60 See John E. Kwoka, Jr., Power Structure: Ownership, Integration, and Competition
in the U.S. Electricity Industry (1996).
36
The APSC 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, the APSC 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 industry may be
material, but that they vary considerably in different circumstances and may be
realized through alternative organizational arrangements.60 Given this evidence, it
seems reasonable to assume initially that vertical integration produces at least modest
economies.
2. Limits on Transactions Between Utilities and Their Affiliates
The APSC has questioned whether behavioral rules are sufficient to discourage
discrimination in transactions between regulated utilities and their unregulated
affiliates. As discussed above, we have significant reservations about the effectiveness
of relying exclusively on behavioral rules. If the scale, scope, or vertical integration
economies of affiliation are substantial and can be realized even in the presence of
functional unbundling, the APSC may wish to strengthen its approach by requiring the

61 For example, Phoenix, Arizona has implemented a system of competitive bidding in
which outside contractors compete against government departments for contracts to
provide various city services. Before a city agency can submit a bid, however, the Office
of the Comptroller, which is an independent entity, must certify that the bid is realistic.
John C. Hilke, Competition in Government-Financed Services 16, 67-68 (1992). The city
continues to save substantially through this bidding process. (Communication with Lera
Riley, Assistant Public Works Director, City of Phoenix, Oct. 1998.)
62 See e.g., Public Utilities Commission of Nevada, Proposed Regulations Governing
Affiliates of Distribution Companies, Sec. 22.
37
affiliates to operate independently, on a bid-based, arm’s-length basis. For example,
the APSC 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.61
In addition, the APSC 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.62 This proposal raises issues similar to
determining the value of assets in assessing stranded costs. Just as some states, such as

63 Edison Electric Institute, 4 Retail Wheeling & Restructuring Report 65 (March 1998).
64 One deficiency in sales of stranded assets may be the role of investment bankers and
affiliates in the sale. For example, if the sale is managed by an investment banker who
works for the selling utility, a serious principal-agent problem may be created because the
residual claimants for the revenue from the sale are the ratepayers, whereas the incentive
for the investment banker is to structure a deal that benefits the transacting parties
(possibly including a buyer who is the customer of the investment banker in other
jurisdictions). If the sale is managed by an investment banker working for the selling
utility and an affiliate is the prospective buyer, self-dealing may be an issue. Because
ratepayers are the residual claimants in sales of stranded assets, it is likely to be
appropriate for the investment banker handling the sale to be retained by state regulators
representing consumers (rather than having an investment banker that represents the
selling utility).
65 We use the term "logo" here to include the logo, name, and other elements used to
identify the regulated utility.
66 Initial evidence from the Pennsylvania retail competition experiment suggests that
consumers may rely on the use of the logo to select an electricity provider. Customers
(continued...)
38
Massachusetts, have determined that the market is the best gauge by which to
determine the value of generating assets in a stranded cost assessment,63 the APSC 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. Application of an arm’s-length bid process should help avoid bias both
in the one-time sale of generation assets64 and in repeated transactions between
regulated firms and their unregulated affiliates.
3. Benefits and Costs of Allowing Affiliates to Use the Parent
Distribution Firm’s Logo 65
The APSC may wish to compare the benefits and costs of allowing affiliates of
regulated distribution firms to use the corporate logo of the distribution firm.66 One

66(...continued)
reportedly favored an affiliate that used the logo of its parent distribution utility over an
affiliate of the same parent firm that did not use the logo. Energy Daily (June 23, 1998).
67 The incremental (marginal) cost of marketing to additional customers is likely to be
lower if consumers are already familiar with the logo employed in the marketing effort,
since little effort will be required to establish familiarity.
68 If the competing firms do not respond with lower prices, the affiliate likely will gain
market share. If so, the average price in the market will be lower, even if competitors do
not reduce their prices when the affiliate lowers prices, because of its lower marginal costs.
69 Consumers could view use of the parent utility’s logo as a guarantee that the affiliate
firm is not a fraudulent operator.
39
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 lower the
marketing costs that it passes along to consumers in a competitive market.67 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.68 If consumers’
perceptions of the implications of an affiliate’s use of the parent utility’s logo are
accurate,69 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: Alabama is concerned about the effects on consumers
and competition of unrestricted use by unregulated affiliates of the logo of the
regulated distribution firm. Harm to consumers and competition may occur if elements
of the reputation of the regulated firm are not applicable to the unregulated affiliate,
but consumers believe that they are applicable when the unregulated affiliate uses the

70 15 U.S.C. § 45.
71 See Federal Trade Commission’s Policy Statement on Deception, letter to Hon. John
D. Dingell, Chairman, Subcommittee on Oversight and Investigations, Committee on
Energy and Commerce, U.S. House of Representatives (Oct. 14, 1983), appended to
Cliffdale Associates, 103 F.T.C. 110 (1984).
40
parent utility’s logo. For example, an element of a parent firm’s reputation might be
the credibility of its pledges of high-quality service that are backed by the parent’s
financial stability as a government-franchised monopoly. If a consumer imputed this
same credibility to an affiliate’s promises of high-quality service because of its use of
the parent’s logo, when in fact the affiliate did not have access to the revenues of the
monopoly franchise, the consumer could be injured if the affiliate was unable to fulfill
its promises in the way the consumer expected. Under such circumstances, the use of
the logo by the unregulated affiliate could harm consumers and competition in much
the same way as deceptive advertising.
False or deceptive advertising is prohibited under Section 5 of the Federal Trade
Commission Act.70 In determining whether an advertising representation is deceptive,
the FTC generally 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.71
Thus, when considering the effect of an affiliate’s use of the parent utility’s logo,
the FTC would consider consumers’impressions about the relationship between the
utility and the affiliate and whether those impressions would be likely to affect
purchase decisions. If use of the utility’s logo implies to consumers that the

72 Harm to consumers or competition could arise if, for example, the affiliate failed to
provide the anticipated level of service reliability, forcing consumers to incur costs of
obtaining access to alternative sources of supply.
73 Transfer pricing rules typically forbid transactions between an unregulated affiliate
and its regulated parent utility at prices that fall outside of specified limits. Commonly
used boundaries include market prices, embedded costs, and book value.
41
relationship between the utility and the affiliate is different from what it really is -- an
attribute that consumers care about -- such use of the logo could be considered
deceptive. If this deception results in harm to consumers or competition, the APSC
may wish to restrict or regulate how the affiliate uses the parent’s logo.72
(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,73 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

74 If entry is difficult or delayed, market share gained through cross-subsidization also
(continued...)
42
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;74 and (3) discouragement of potential

74(...continued)
may have persistent effects even after the cross-subsidization has been discontinued.
75 Although use of a disclaimer may be a remedy worth considering, it may be difficult
to develop disclaimers that are simultaneously sufficient to avoid deception and succinct
enough to make affiliate use of the regulated parent utility’s logo practical.
76 Private parties may submit such evidence from privately funded research. The
APSC, however, should be wary of testing performed on behalf of special interests, and
should take steps to ensure that the results represent useful indications of likely consumer
impressions and behavior.
43
entry that likely would have occurred absent the cross-subsidization, including entry
involving innovative products and production processes.
If the APSC 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, the APSC 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. The APSC 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.75 Consumer research designed to investigate the effects
of several alternative policies on consumers may be the most effective approach.76 A
disclaimer that suffices to avoid consumer deception also may suffice to discourage
cross-subsidization in the form of excessive investment in reliability.

77 In some situations, firms may sell the right to use a logo to independent entities,
contingent upon conditions and restrictions placed on use of the logo.
78 Payments to the regulated distribution firm for use of its logo could reduce prices for
distribution services by substituting payments from an affiliate for what the firm otherwise
would be authorized by the APSC to collect through distribution charges.
79 The Maine Public Utilities Commission has established rules requiring affiliates to
pay the incumbent utility for use of the goodwill reflected in the utility’s name. The
payment is determined according to how soon the utility succeeds in earning its
authorized return on equity. Maine Public Utilities Commission, Docket No. 98-077 (July
7, 1998). The rules provide a three-year initial payment period followed by a reassessment,
with up to three additional years of payments if necessary to bring down the value of the
goodwill asset to zero. Corporate Goodwill, Public Utilities Fortnightly 16 (Oct. 15, 1998).
44
An alternative means of transferring 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 77) pay
the parent for the right to use the logo.78 Because the logo is an asset, use of the logo by
other firms, including affiliates, represents an asset transfer from the parent firm, and
the APSC may wish to treat it like other asset transfers. In order to avoid cross-
subsidization in such a transaction, the use of the parent logo must be fairly
evaluated.79

80 Federal antitrust review may consider the retail effects of electricity mergers, but
traditionally antitrust remedies do not focus on alleviating existing (i.e., premerger) market
power held by the merging parties.
81 FERC Order 888, 61 Fed. Reg. at 21555 (May 10, 1996).
82 For decades, mergers in the electric industry were permitted under the assumption
that rate-of-return regulation would continue indefinitely and eliminate antitrust concerns
about increased prices and decreased quality of service caused by increased market power.
83 The Comprehensive Electricity Competition Act (Section 403) proposed by the
Department of Energy contains provisions to give FERC authority (in consultation with the
Federal Trade Commission and the Antitrust Division of the Department of Justice) to
remedy existing generation market power at the retail level if a state requests that FERC
exercise this authority. Many state utility commissioners perceive that they lack authority
to order structural remedies to address existing generation market power. National
Association of Regulatory Utility Commissioners, Executive Dialogue on Market Power,
(continued...)
45
F. State Roles in Mergers and Existing Market Power
Assessment of market power is necessary both in the handling of mergers and in
the transition to retail competition. State review may be the only regulatory review in
two situations. First, while mergers between utilities may affect both wholesale and
retail competition,80 FERC presently focuses only on effects and remedies at the
wholesale level.81 States, therefore, have the primary responsibility for reviewing the
competitive effects of mergers at the retail level. Second, when a state allows retail
competition, there may or may not be existing market power in generation.82 Federal
antitrust laws, however, do not focus on existing market power revealed through
relaxation of rate regulation, unless the market power was gained or preserved by
means of unfair methods of competition. Similarly, FERC does not routinely assess
existing market power at the retail level.83 States, therefore, have the primary

83(...continued)
Minneapolis, Minnesota, July 8-9, 1998. Subsequent to this Executive Dialogue, NARUC
passed a resolution urging states that are considering retail competition to obtain authority
to remedy existing market power at the retail level. Despite the lack of restructuring
authority, some states (e.g., California) have induced divestiture of generation assets by
large franchised utilities by requiring such divestiture as a condition for recovery of
stranded costs.
84 Some states have determined to assess retail market power with the aid of computer
simulation models. The APSC may wish to consider this approach as well. Staff of the
Utah Public Service Commission released a draft Market Power Report to that state’s
Electrical Deregulation and Customer Choice Task Force on August 14, 1998. This report
contains an extensive section on computer simulation modeling. Computer simulation
modeling of retail market power in Colorado was performed for the Colorado Public
Utilities Commission and reported in an article entitled Measuring Market Power in a State
with a Dominant Supplier: A Case Study, 11 Elect. J. 61 (July 1998). Because subtle
modeling parameters may have very significant effects on results, the APSC may wish to
avoid relying exclusively on incumbent firms to perform this type of analysis.
46
responsibility for review of generation market power (if any) at the retail level. The
APSC may wish to focus its analytical resources on these two important situations
where it has the primary role in assessing market power and developing appropriate
remedies.84
VI. Properly Developed and Operated ISOs May Also Help Address Reliability
Concerns
Although the issues of competition and reliability are commonly discussed
separately, there is a major overlap between the two that relates to the appropriate size
of the ISO or other independent regional transmission entity. As discussed above, large

47
ISOs can alleviate generation market dominance concerns by broadening the relevant
geographic market and by providing unbiased incentives to add transmission capacity
to alleviate transmission bottlenecks. Large ISOs can have a similarly salutary effect on
reliability difficulties, by increasing the number and diversity of generation and
transmission reserves. A large ISO will have incentives to strengthen transmission
links throughout its operating area in order to avoid transmission bottlenecks. This,
coincidentally, will enhance the ISO’s ability to bring reserve capacity to bear from
different areas to meet reliability problems in a particular area.
VII. Conclusion
Public Interest and Regulation: In assessing the public interest regarding electric
industry regulatory reform, the APSC will be weighing the prospective benefits and
costs of moving toward competition primarily in generation and marketing. The effects
of regulatory reform on electricity prices may be overstated despite the fact that
Alabama already enjoys lower costs than many other states for electric power and
diversion of power to higher-cost states may follow retail competition. The APSC may
wish to take into consideration extensive evidence from other industries that increased
competition can benefit jurisdictions with relatively low costs by delivering additional
cost savings as well as technical innovation and a broader variety of products and
services.
Stranded Costs and Benefits: If the APSC determines that recovery of stranded
costs and benefits is appropriate, potential harm to consumers may be reduced by
designing a recovery method that avoids distorting future electricity purchases, by

48
including incentives to mitigate stranded costs (and increase benefits), and by taking
steps to avoid strategic use of stranded cost recovery revenues by traditional vertically-
integrated electric utilities to block or eliminate entry. If Alabama determines to allow
recovery of stranded costs and benefits, and if areas of Alabama have net stranded
benefits rather than net stranded costs, the APSC may wish to consider recovering these
benefits for electricity customers in these areas in a competitively neutral manner.
Market Structure, Market Power and Reliability: Horizontal market power and
transmission discrimination problems are real sources of concern for the APSC as it
considers retail competition. Use of the factors set forth in the DOJ/FTC Merger
Guidelines, together with computer models, may allow the APSC to draw appropriate
conclusions about the extent of generation market power facing Alabama customers. In
conducting such a market power analysis, the APSC may wish to make a distinction
between present market power and likely future market power, since technological and
institutional changes may materially alter generation market power (as they have in the
past).
A carefully formed ISO may be an attractive institution through which to
implement retail competition and enhance wholesale competition. One criterion for an
effective ISO is likely to be significant geographic size, with numerous generating
facilities and firms. A large ISO of this type is apt both to alleviate generation market
power and to enhance reliability. In addressing potential market power in transactions
between regulated utilities and their unregulated affiliates, it is necessary to strike a
balance between preventing discriminatory conduct by utilities and their affiliates and

49
preserving possible economies of vertical integration. Bidding rules and other policies
appear to constitute a reasonable initial approach to this trade-off. If such rules are
adopted, the APSC may wish to set a date to reevaluate the adequacy of the rules, with
a view to moving to full divestiture if the rules have not prevented discrimination or
have proven very costly to enforce. In the area of consumer protection, the APSC may
wish to adopt rules on advertising by affiliates that are consistent with FTC law on
deceptive advertising. Finally, the APSC may wish to maintain the confidentiality of
commercially sensitive information on winning bids in order to avoid aiding
coordinated interaction between competitors.

50
We again thank the APSC for inviting comments as part of its wide-ranging
inquiry concerning prospective electric industry regulatory reform and restructuring.
Respectfully submitted,
________________________
John C. Hilke, Electricity Project Coordinator
Bureau of Economics
Federal Trade Commission
600 Pennsylvania Ave., N.W.
` Washington, D.C. 20580
January 8, 1999