The Public Utility Regulatory Policies Act

Government Involvement to Remedy Energy Crisis: PURPA

President Carter's Philosophy about Conservation

When he moved into the White House in January 1977, after presidents Nixon and Ford found it impossible to make much headway on energy "independence," Jimmy Carter vowed to be different. Making energy matters a top priority, he went before the American public in April and announced the outlines of a bold new plan. Equating the energy crisis with the "moral equivalent of war," he chastised Americans for being the biggest wastrels of energy in the world. He further reflected the influence of energy-efficiency advocates, such as S. David Freeman and Amory Lovins, who pointed out that much of America's energy needs could be found by developing and using appliances and manufacturing equipment that used less energy to do the same tasks as more inefficient devices. Carter pointed out that conservation was the "quickest, cheapest, most practical source of energy," and he made it the cornerstone of his new policy.

Encouraging Conservation

To encourage conservation, the President advocated the use of carrots and sticks: he sought tax credits to spur individuals and businesses to insulate their homes, stores, and factories, thus reducing energy use. He also lobbied for acceptance of a tax on gasoline--rising to 50 cents a gallon--if consumption did not decline as mandated, as well as a tax on "gas guzzler" cars.

Exploiting Other Energy Resources

While conservation may have been the cornerstone of his new policy, Carter also sought development and exploitation of other energy resources. He sought greater production of coal and oil and further use of nuclear power plants, for example, though he hoped the extra production could be achieved without adversely affecting the environment. And he hoped that alternative energy devises, such as solar cells, geothermal energy, and wind turbines, would receive federal funding and other incentives so they could produce power without being dependent on fickle foreign suppliers of petroleum.

Managing Supply and Demand

Many of these goals had been sought by previous presidents. But President Carter seems to have been the first to understand clearly that the energy crisis had two elements. The most public element consisted of the apparent shortage of energy supplies. Consumption patterns of the recent past meant that Americans would need ever-increasing supplies of energy. But the country could no longer produce all the energy it needed domestically. America simply did not have enough energy to go around. So it now was forced to draw on supplies from abroad, which incurred high political, military, and economic costs.

The less public element of the energy crisis focused on the demand side. Americans had become accustomed to the ability to secure inexpensive energy, and they neglected energy efficiency in favor of convenience and pleasure. Why ride the bus to work when driving a powerful car to work was more convenient and when gasoline cost less than 30 cents per gallon? Why insulate your house when oil and electricity prices hit record lows? As a result, energy demand grew exponentially, though supply did not. Carter realized that if the growth in energy demand could be slowed, or even reduced, then the effects of the energy crisis could be mitigated. In short, he made energy conservation the cornerstone of his new policy and the basis of long-term energy independence rather than just a short-term fix to current woes.

PURPA's Terms

End of Promotional Rate Structures

As one part of his National Energy Plan, debated by Congress in 1977 and 1978, President Carter suggested changes to the way power companies charged for electricity. Typically, utilities offered customers a "rate structure" that encouraged them to use increasing amounts of electricity. It did this by charging higher prices for the first increments of electricity used by customers--for example the first 50 kWh--with subsequent increments costing less per unit. One New York utility in 1973, for example, charged 4.4 cents per kWh for each of the first 50 kWh of use, but only 3.9 cents for the next 60 kWh, 3.4 cents for the subsequent 120 kWh, and only 2.8 cents for each unit greater than 240 kWh.

During the golden years of the utility industry, this "promotional" rate structure made sense, as utility costs continuously declined and as growing demand pushed costs still lower. But with technological progress limited and energy costs climbing, power companies no longer could achieve lower costs. Moreover, the rate structure encouraged people to use more electricity at a time when conservation was becoming the nation's watchword.

Signed into law in November 1978, the Public Utility Regulatory Policies Act (PURPA) focused on eliminating promotional rate structures except when they could be justified by the cost structure of utility companies. In most cases, they could not be so justified, so the law required state commissions to order utilities to develop new rate structures. Most utility managers did not worry too much about the law, and they were able to comply with it. In fact, some utility companies executives thought they got off fairly easily with this provision, being more worried about other terms of Carter's energy plan that required them to convert from burning oil to coal and prohibitions against the use of natural gas.

Cogeneration Incentives

But one minor portion of PURPA mostly escaped the attention of utility managers. It required utility companies to purchase power from industrial companies that produced electricity as a by-product of other activities. In other words, a paper company that needed steam would boil water and first send the steam through a turbine-generator and produce some electricity for use in the factory. The waste steam would be used for industrial processes. In this way, usually more than 45% of the energy content in the raw fuel would be used for productive purposes--several percentage points better than the best utility power plant. Unfortunately for a company that used this "cogeneration" process, it usually could not find a market for electricity it produced in excess of what it used internally.

President Carter and his staff saw this situation as a lost opportunity to improve the energy efficiency of producing power, and PURPA contained a provision that required local utilities to buy excess power from these so-called "qualifying facilities" (or "QFs") at very favorable rates--rates equivalent to their cost of producing power by conventional means. Often, this "avoided cost" was higher than the price companies paid for purchasing electricity from the utility. But in most cases, cogenerated power was cheaper than utility-generated electricity, despite the lack of scale economies, because the fuel was used to perform double-duty: it produced steam for industrial activities and electricity for internal use and sale to the electrical grid. Moreover, the company could produce and sell power without being subject to the regulations dealing with security registration or prices that utilities were forced to endure.

Gas Turbine Technology

Developments in gas-turbine technology helped make cogenerated power especially attractive. In essence, a gas turbine is an aircraft engine, powered by natural gas, that is attached to a generator. Much electricity is produced directly from the generator, but in a cogeneration scheme, the waste heat from the engine's exhaust is used for industrial purposes or to heat water and send the steam through a more traditional steam turbine generator. Again, the raw fuel gets used to make two products, thus enhancing overall thermal efficiency. Moreover, during the military buildup of the Reagan presidency, manufacturers of jet engines received government funding for research and development to advance the efficiency and reliability of the technology. Seeing another market for similar equipment, manufacturers modified the jet engines for use in electricity production. By the early 1990s, gas turbine cogeneration units could be installed quickly and obtain thermal efficiencies in the 50% range--well above that achieved by central station utility plants.

Alternative Energy

PURPA provided similarly favorable terms to entrepreneurial companies that produced electricity from solar cells, wind turbines, and other renewable (i.e., non-fossil-fuel) resources. In some states, such as California, where the regulatory commission established favorable terms for the new power producers, alternative energy flourished. Dozens of companies sporting various types of wind turbines, for example, set up shop, and technological innovation in the technology advanced rapidly. By 1990, the price of wind-generated electricity dropped about 80% (compared to 1980), making it competitive with utility-generated power, especially power produced by expensive nuclear plants. Cost reductions of the same magnitude occurred for making electricity from the sun, though it still did not compare to utility costs. But California's commission still provided incentives for its production as a way to continue the downward trend in costs. As a result, by 1990, California had become the home of 85% of the world's capacity of electricity powered by the wind and 95% of the world's solar-powered electricity.

PURPA'S Effect on Technological Innovation

Overall, PURPA provided a tremendous--and unanticipated--spur to technological innovation on numerous non-traditional technologies for producing electricity. From gas turbines to wind turbines, from solar cells to geothermal generators, PURPA enabled small, start-up entrepreneurial firms and larger, established companies to enter the generation business. Of course, this goal was anticipated by President Carter and his staff. They hoped that, given the proper incentives, a useful source of domestic energy production could be marshaled to stave off demand for petroleum and other resources from abroad. By 1995, about 9% of all electricity produced in the United States came from PURPA QFs, up from about 2.5% in 1985.

PURPA's Consequences

Utilities as Vertically Integrated Companies

While hoping for non-conventional sources of power to come on line as a result of PURPA, no one anticipated the changes that the law would have on the regulation of electric power and the overall structure of the electric utility system. Even before utility companies won designation as natural monopolies, they had established themselves as vertically integrated firms. In other words, they undertook all the functions of generating, transmitting, and distributing electricity to the ultimate customer. Conceivably, one can imagine any of these three functions being performed by different companies, but early utilities became protected as regulated monopolies partly on the assumption that one company could produce power more efficiently and economically as one company than as several. Since utility companies had already been vertically integrated by the time regulation became imposed, they remained so structured thereafter. Few people thought to question an alternate arrangement, and utility managers, who sought to maintain control over as much of their business as possible, certainly would not offer to divest their existing companies.

Challenging the Monopoly in Generation

But unintentionally, PURPA started that questioning process because it enabled non-utility generators (sometimes called "NUGs") to produce power for use by customers attached to a utility's grid. In other words, the law broke the stranglehold on power companies' previous monopoly in the generation function. Now, any unregulated cogenerator or renewable energy producer could sell electricity into the power grid, with regulated utilities helpless to dictate terms.

In a sense, however, PURPA did not create a competitive market for power yet. After all, the PURPA QFs did not literally compete with regulated utilities since those companies were required by law to purchase whatever power came their way from the cogenerators and alternative power generators. Still, the PURPA producers caused real grief to many utility managers, since the new players represented a source of power they could not control. The QFs sold power into the grid whenever they wanted, or whenever they had excess power remaining in a cogeneration plant, and utility managers had to find ways to limit their own production, or boost it, to ensure that customers obtained the power they needed without interruption.

In another sense, however, the PURPA producers constituted a definite competitive threat. Because the QFs usually obtained a price equivalent to the cost utilities would incur when they generated power, the independents by definition could produce power as cheaply or cheaper than could utilities. Though cogenerating equipment cost more than hardware that only produced only electricity, the salability of steam, which had a value of between 1 and 2 cents per kilowatt-hour, allowed cogenerated electricity to be less expensive than that produced by many utility companies. The competitive pricing situation would not have existed in the 1940s or 1950s, however, since utility companies could still exploit economies of scale and increasing thermal efficiencies. But when utilities ran into technological limits to traditional progress, unconventional power production techniques proved cost effective. In a similar vein, electricity produced from natural gas turbines owned by PURPA entrepreneurs became increasingly attractive, as the price of natural gas fell from a peak in the mid-1980s, and as the technology became more efficient. Again, economies of scale meant less than economies involved in mass producing small (approximately 100 MW) gas turbines.

Questioning the Rationale of Natural Monopoly for Regulation

These realities of electricity production made many people within and outside the industry question one of the rationales for acceptance of utilities at natural monopolies and, consequently, the justification for regulation. In the theory accepted early in the 20th century, electric power production and distribution constituted a natural monopoly because, by dint of huge capital investment in expensive generating equipment and associated facilities, one company could produce power more economically than could competitive firms. Many companies in the same market would not enjoy the large market of diverse customers, and they would be limited to using smaller and less-efficient equipment. All customers, therefore, would be deprived of the benefits that could be accrued if only one company produced power for an entire market.

But the end of technological progress combined with the economic woes of the 1970s and 1980s turned this argument upside down. It now appeared, thanks to incentives provided by PURPA and innovation in small-scale technologies, such as gas turbines, that non-utility companies could produce power as cheaply or more so than could regulated firms. As a result, many people began suggesting that the fundamentals of the power industry needed to be re-evaluated. In 1983, William Berry, president of the Virginia Electric and Power Company, realized earlier than most of his utility colleagues that "[a]s in so many other regulated monopolies, technological developments have overtaken and destroyed the rationale for regulation. Electricity generation is no longer a natural monopoly." Congressmen and members of the Federal Energy Regulatory Commission, the body that has authority over interstate transactions of electricity, reflected similar sentiments in the 1980s. In short, the existence and success of PURPA QFs appeared to destroy one important justification for regulation of utilities.