Regional Transmission Organizations as Market Platforms V
Would quarantining the monopoly and competitive joint ventures improve power systems?
Photo by Anders Norrback Bornholm on Unsplash
In this RTO series, I've been exploring the decision-making processes and corporate governance structures within Regional Transmission Organizations (RTOs), highlighting how these institutions perpetuate the control and decision-making power of incumbent investor-owned utilities (IOUs). Today, we'll delve deeper by examining two critical, complementary insights: first, how monopoly regulation dilutes corporate governance incentives for IOUs, and second, how continued vertical integration and significant entry barriers distort transmission investment incentives. I'll draw on three published papers to recommend some reforms to RTO governance.
Monopoly Regulation and the Dilution of Corporate Governance Incentives
Kovvali and Macey (Yale Journal on Regulation 2023) propose the provocative idea that shareholders in rate-regulated utilities essentially act as creditors rather than true residual claimants. Traditional corporate governance literature, building on foundational work by Jensen and Meckling (1976), emphasizes the role of shareholders as residual claimants who internalize both the risks and rewards of corporate decisions. This alignment creates a robust incentive structure whereby shareholders actively discipline management through mechanisms like the market for corporate control, ensuring that executives make decisions that maximize overall firm value.
The regulatory structure of monopoly utilities fundamentally alters this alignment. Regulation guarantees utilities a rate of return based largely on their invested capital, effectively shielding shareholders from the direct risks and rewards that characterize typical corporate governance dynamics. Kovvali and Macey argue that this guarantee transforms shareholders into quasi-fixed claimants, akin to bondholders rather than true equity owners. With returns virtually assured through regulation, shareholders lose the incentive and the ability to monitor and discipline management behavior rigorously.
This weakened market for corporate control creates a distorted governance environment in monopoly utilities. Executives lack accountability to the traditional disciplinary mechanisms because their decisions generally don't affect shareholders' returns significantly because of the regulatory revenue guarantee. Instead, ratepayers, who ultimately bear the risks and residual costs, become the true residual claimants. Yet ratepayers possess no direct governance mechanisms to influence management decisions or discipline executives, creating a fundamental misalignment between corporate interests and customer welfare.
Misaligned Incentives in Transmission Investment
This dilution of corporate governance incentives has especially detrimental effects on investment in transmission infrastructure. Transmission and distribution networks, due to their natural monopoly characteristics, remain tightly regulated. Yet incumbent IOUs continue to exercise considerable vertical market power through integrated operations in both transmission and generation segments. This vertical integration generates perverse incentives that further undermine efficient investment and innovation in transmission infrastructure.
RTO governance structures, often dominated by transmission-owning IOUs, institutionalize incentives that prioritize incumbent utility interests over broader market efficiency, reliability, and innovation. These IOUs exploit their dual roles, as both market participants and grid operators, to engage in strategic behaviors that protect their legacy generation assets (as discussed in part IV). For example, utilities frequently delay or underinvest in transmission upgrades necessary for integrating renewable resources or facilitating market competition. Such behavior shields their aging fossil-fuel generation from competitive pressures, thereby preserving their market dominance and profit margins at the expense of efficiency, innovation, and consumer benefit.
Moreover, the existing regulatory environment enables utilities to lobby strategically for state-level rights of first refusal (ROFRs, as discussed in parts II and III), significantly raising entry barriers to independent, competitive transmission developers. These ROFRs effectively grant incumbent utilities monopoly rights over new transmission projects within their state boundaries, discouraging cost-effective regional transmission investments that would improve grid reliability, lower electricity costs, and accelerate decarbonization. Instead, IOUs have strong incentives to pursue smaller-scale intrastate transmission projects that maximize their regulated returns without adequately addressing regional transmission needs or facilitating competitive market entry.
Competitive Joint Ventures: A Novel Institutional Approach
One alternative to this distorted investment environment is the competitive joint venture (CJV) model introduced in my previous work with Federico Boffa. In that paper we focused on the distribution wires network, not transmission, using prior work that Vernon Smith did relating to his experimental economics work in the New Zealand electricity reforms in the 1980s (here's a 1987 Regulation magazine article from Vernon on the CJV design).
The CJV approach envisions shared ownership of network infrastructure by independent downstream retailers, with each firm's ownership stake in the wires network directly proportional to its downstream market share. This ownership structure aligns incentives robustly, as each retailer simultaneously serves as a network owner and customer. Retailers thus internalize both the costs and benefits of efficient network operation and expansion, incentivizing them to minimize infrastructure costs while maximizing quality, reliability, and innovation. In this institution, firms are also not allowed to block any entry or investment in the wires network by other co-owners. We spent some time in the paper showing how in our model, this combination of (1) market shared-based co-ownership and (2) no veto on investment yields the best feasible outcome (i.e., second best since first best is impossible due to the high fixed costs).
Applying the CJV concept to RTOs, consider a scenario where transmission-owning utilities, generation developers, and retail service providers collectively own and manage transmission infrastructure through clearly defined governance mechanisms. Unlike current RTO governance, dominated by incumbent IOUs with conflicting incentives, a CJV-inspired structure would harness competitive tensions among participants to achieve more efficient investment outcomes. Retailers and generators, as owners of the transmission infrastructure, would strongly advocate for timely investments that reduce congestion, enhance grid resilience, and support the integration of innovative technologies and renewable resources, instead of the existing RTO structure in which vertically-integrated TOs block new transmission and technology investments to favor their affiliated generation. It would require more thinking about how to define ownership shares, since the retail market share → ownership share connection isn’t as tight at transmission level as it would be at the distribution level. But that’s not a reason to dismiss the idea.
Recommendation: Quarantine the Monopoly and Reform RTO Governance
This thought experiment shines a light on the incentive problems that arise from transmission owners vertically integrated with affiliated generation. Moving to a CJV governance structure would require institutional reforms to "quarantine the monopoly" structurally, isolating the natural monopoly transmission and distribution components clearly from competitive generation and retail activities. This quarantine aligns with insights Kovvali and Macey (2023) from my earlier analysis on incumbent vertical market power and market experimentation (2014). Drawing parallels to the telecommunications industry’s successful "Bell Doctrine," structural separation of monopoly infrastructure from competitive markets limits incumbents' ability to exploit market power and erect anti-competitive barriers. Early on in this Substack I also reposted an old 2011 Knowledge Problem post on the Bell Doctrine and our failure to use it in electricity (except for Texas).
These CJV principles provide some suggestions for RTO governance reform. Governance reforms should ensure proportional representation and decision-making power for independent transmission developers, generators, retailers, and consumer representatives, rather than maintaining disproportionate influence for incumbent IOUs and the distortions introduced by existing models of share-weighted voting in some RTOs (as discussed in part II). Regulatory frameworks should facilitate transparent, competitive bidding and financing requirements for transmission infrastructure projects, eliminating anti-competitive ROFRs and promoting regional cooperation and integration.
By quarantining the monopoly and redesigning RTO governance along CJV lines, we can enhance market efficiency, innovation, and consumer welfare. Such structural and institutional reforms will realign incentives, facilitating timely, cost-effective transmission investments that accelerate decarbonization and reduce electricity costs for ratepayers.
Conclusion
Monopoly utility regulation undermines corporate governance incentives, leading to significant misalignments in transmission investment decisions and stifling innovation. By understanding shareholders as creditors rather than true residual claimants under monopoly regulation, we recognize the need for radical institutional changes to restore proper incentive alignment.
Competitive joint ventures, combined with structural quarantining of monopoly infrastructure and comprehensive governance reforms within RTOs, offer a promising path forward. These reforms would enhance accountability, transparency, and efficiency, ensuring that transmission investment decisions genuinely reflect broader interests than just narrow incumbent IOU interests. Such reforms would not be easy, but nothing worth doing every really is.
In addition to the governance changes Lynne suggests, wouldn't IOU RTO membership also need to be mandatory in order to "quarantine the monopoly"? Haven't there have been instances where simply by an IOU proposing to leave an RTO, new transmission lines have been prevented from being built?