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Municipalization: Bypass and Opportunism in the U.S. Electric Utility Industry

Posted: 19 Nov 2008  

Date Written: 1997


As of April 1997, more than forty municipalization proposals have emerged in seventeen states as a means of evading competition transition charges for stranded costs proposed by state commissions. Stranded costs equal the difference between expected regulated net-revenues and the netrevenues obtained in competitive markets from formerly regulated assets.' Municipalities have attempted to bypass these charges through variousapproaches, including: (1) traditional municipalization through condernnation;(2) municipalization involving construction of duplicative or parallel facilities; (3) municipalization through annexation; and (4) municipalization through the provision of only minimal facilities, i.e., muni-lite. The municipalities allege that under the Federal Energy Regulatory Commission's (FERC) Order No. 88g2 they are not responsible for payments resulting from stranded costs because they could always have condemned the property. Thus, they claim that the utility could not have had a reasonable expectation of continuing to serve in the area. This article explores the municipalization bypass phenomenon and concludes that the FERC should adjust its policies to avoid this type of opportunistic behavior.

How do retail customers bypass the competition transition charge? FERC's Order No. 888 developed a "reasonable expectation" criterion for the recovery of stranded costs from retail-turned-wholesale customers. The reasonable expectation approach represents an efficient means of addressing contractual change in wholesale power markets that is consistent with common law remedies for breach of private contract that protect buyer and seller expectations. However, while the FERC proceeded with laudable intentions and applied the correct economic approach to contractual expectations, the reasonable expectation standard may be subject to legal interpretations that depart from the economic expectations of utilities. Further refinement of the reasonable expectation criterion directed against so-called "sham transactions" may be necessary to rule out bypass of transition charges.

Municipalities, representing retail customers within their boundaries, can become wholesale intermediaries. The municipalities purchase commodity power from a lower cost source and seek an order from the FERC that the incumbent utility "wheel" that power over its transmission facilities to the municipality. The municipalities then have an incentive to assert that the expectations of incumbent utilities should be substantially lower than the utilities claim, because the municipalities could have condemned the utility's distribution facilities for compensation equal to the book value of the facilities (rather than their market value). Thus, the retail customers avoid competition transition charges, and the municipality need only compensate the incumbent utility for the expected return that it would have obtained were its facilities to be condemned. Using this logic, any wholesale intermediary can enter to serve retail customers and propose that the utility's reasonable expectations should be lowered because retail customers could have bypassed the utility through cogeneration, self-generation, or the construction of new transmission inter-ties. Were such arguments to be upheld, the reasonable expectation standard would have little practical value in determining the incumbent utility's economic expectations.

Because transition charges are typically assessed as distribution surcharges, there are incentives to avoid the charges through bypassing not just the merchant function of the incumbent utility, but the distribution system as well. The potential inefficiencies created by such bypass are evident. Duplicative distribution facilities are created not because they can be operated at lower cost than the incumbent or because additional capacity is needed. Rather, the avoidance of distribution surcharges makes the creation of alternative facilities economically feasible. This is a potentially difficult problem that has prompted calls for exit charges or competitively neutral end-user charges imposed on wholesale intermediaries.

This article addresses the two means of avoiding competition transition charges: municipalization and transmission bypass. We begin, in Section 11, by reviewing some of the municipalization decisions. We consider proposals by municipalities to supply power with minimal facilities. We then review cases of municipalization with a duplicative distribution system or substation by examining opportunism and contract renegotiation. In Section 111, we consider the FERC's "reasonable expectation" criterion for stranded costs recovery and consider what impact the possibility of condemnation by municipalities has on the expectation interests of incumbent utilities. In Section IV, we examine the potential for uneconomic bypass in the context of the changing structure of the electric power industry. We present our conclusions in Section V.

Suggested Citation

Doane, Michael J. and Spulber, Daniel F., Municipalization: Bypass and Opportunism in the U.S. Electric Utility Industry (1997). Energy Law Journal, Vol. 18, No. 2, 1997. Available at SSRN:

Michael J. Doane (Contact Author)

Competition Economics LLC ( email )

2000 Powell Street
Suite 510
Emeryville, CA 94608
United States
510-655-7503 (Phone)

Daniel F. Spulber

Northwestern University - Kellogg School of Management ( email )

Kellogg Global Hub
2211 Campus Dr.
Evanston, IL 60208
United States
847-491-8675 (Phone)
847-467-1777 (Fax)

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