Per introductory economics theory, in a perfectly competitive market, supply and demand dictate price. At this equilibrium in a functioning market, we expect producers and consumers to agree upon a price for transaction in their own self-interest. After all, “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest[,]” as Adam Smith so wisely put. A perfectly competitive market, with both consumers and producers have minimal information asymmetry, reveals preferences otherwise not stated.
But how does this comport with the idea of a natural monopoly, wherein you have high land or capital constraints such that competition becomes inherently redundant, unfeasible, and uneconomical? How many pipes, wires, and roads can we run to one building before each individual competitor becomes bankrupt? What is the economic efficiency to gain from them?
Wireline History
Here lies the problem with the electric grid. Understandably across much of the United States, electric grids were built as a monopoly. The exception was in the beginning: efforts in Manhattan to wire up competing systems to buildings nearly blotted out the sun from the copper hanging on electric poles. This also coincided with telegraphy and telephony, also suffering from a similar experience. Surely Manhattan’s density could ensure a competitive market, but it was not economical to maintain, nor could it be replicated outside of such a dense environment. Governments, rather, chose to regulate monopoly utilities and ensure universal service.
As the grid slowly expanded, it inherently, due to engineering constraints, assumed a tree branch design where power flowed from generation stations, to high-voltage transmission lines, to substations, then finally to distribution transformers before entering a home or business. A one-way flow that would last for over a century. Due to this nature, utilities and governments agreed upon a reimbursement system: regulated rates for consumers, variable rates for industry and commercial, and rate-of-return guarantees for long-term investment in generation and transmission. Investing in the system was a ticket to print money.
Unbundle, Deregulate, Invest
During the neoliberal wave of deregulation, after the success of airline deregulation, governments and economist sought the next big relief valve for consumers where they could stimulate competition. This structure of guaranteed payment for building power plants, many of which sit idle or as reserve capacity, seemed wasteful. Recognizing that distribution of electricity itself might be constrained, but generation of it might not, they conducted a new experiment: deregulate generation. Utilities would no longer be paid for building power plants. Rather, they would be middle-men: connecting generators to consumers, coordinating who to buy power from.
The idea is deceptive simple: building more generators, each of whom wants to sell power at a high price, to a utility that wants to buy it at a low price, would mimic supply and demand, and competition would lower prices. Theoretically, anyone can now apply to become a generator and sell power on the grid, and the abundance of choice will drive down prices.
That is the theory. It’s sound. And it’s what many states adopted. Utility unbundling was now law.
States deregulated the utility industry, and set up independent system operators, or ISOs, to manage the grid. You may have heard of a few: CAISO, ERCOT, PJM, NYISO, MISO, and SPP. They act as airport traffic controllers. They tell generators and utilities what the market rate is, and direct power sales through least marginal pricing, projecting demand up to a week in advance, have day-ahead markets, and spot markets.
Technology Constraints
So far we have been discussing the economics of the utility market. But what makes this market a bit different from most other luxury goods is the nature of alternating current (AC). Alternating current must be balanced between supply and demand instantaneously. Stray too far from the generation setpoint of 60Hz (chosen for historical reasons, baked in as a technical requirement today in North America) and generation slows down or speeds up too much, you risk catastrophic damage to the massive (in order of tens of tonnes) generators. Too little power and too much demand will burn out generators, and to protect them, you must increase generation, shut generators down or turn off customers.
Gold Rush
The rush to deregulate led to some initial less than ideal outcomes. Many Californians, and Governor Gray Davis, will recall the time vividly. Hot summer days stress the grid out quite a bit. In 2001, California utility customers under PG&E, SCE, and SDGE had their power cut. Too much demand, it seemed, for too little supply. Yet, a curious thing was happening on the generation market. The payrate for a kilowatt-hour (kWh) had hit up to 50 cents, when it would normally be around 3 cents. Yet, generators were going offline for scheduled or “unscheduled” maintenance right before this, or power from them was being sold out of state first at a low bid before being bought back in-state at high rate.
The electric utilities, unable to raise rates by law, and unable to secure long-term generation contracts with generators, had to buy electricity on the spot market. They could charge 6c /kWh, but had to pay 50c /kWh. The utilities went bankrupt. The state had to bail them out. Behind the scenes, the Enron Corporation had been coordinating with generators to strategically hold the grid hostage to extract rents. The Federal Energy Regulatory Commission eventually sought settlements with various power producers to the tune of $6 Billion.
This type of market manipulation is now closely monitored, and deregulated energy markets have been corrected. So how have prices fared?
The Free Market Decides
If the theory holds, we should see a lowering in costs to the ratepayers. Electricity generation should be facing fierce competition at this point. So what has the data shown?
An initial 2007 study using data gathered from the Energy Information Administration showed that deregulated markets cost ratepayers up to 25 to 49 percentage points more than regulated markets. This might have been an initial cost-shock due to subsidized electricity rates expiring, and passthrough rates being applied. (Competitively Priced Electricity Costs More, Studies Show – The New York Times)
A follow-up study conducted in 2026 examined long-term impacts of deregulation, and found, “Consistent with earlier studies, we find that marginal generation costs fell in deregulated markets. However, despite lower generation costs, wholesale prices increased along with utilities’ overall expenses on energy. The resulting increase in utility energy costs can explain a substantial portion of the increase in downstream retail prices. Overall, we estimate that the increase in wholesale margins more than offset the efficiency gains, which can occur when markets are not perfectly competitive.” (Do Markets Reduce Prices – Evidence from the U.S. Electricity Sector.pdf)
This creates an effect known as double marginalization. Generators seek a profit margin. Utilities also seek a profit margin. Rather than reducing costs, these margins compound as they flow down. As generation costs reduce, the margins increase for generators, who thus have less incentive to compete on price. Utilities, passing the cost on to ratepayers, will also protect their margins first.
Uncapped Savings / Uncapped Costs
But what if we let customers buy wholesale, rather than pay retail rates? That’s exactly what the Electric Reliability Council of Texas (ERCOT) sought to do. The deregulation of generation was paired with utility deregulation, where ratepayers could choose the company they wanted to buy electricity from, while the local utility handled the transmission maintenance, a form of local loop unbundling (LLU).
The system provided immense savings to those who wanted to buy at the (often very) cheap power from generators, often single-digit kWh to near pennies on the dollar at very low times of demand. Transmission costs were fixed, but generation costs weren’t. The system worked. But it also broke, gradually, then suddenly.
Customers on Griddy, the utility that sold wholesale power, found themselves in a shock after surviving the immense cold of the 2021 Texas Winter Storm, if they were lucky enough to keep their lights on. Power rates that were normally in the single cents from $0.05/kWh had jumped to $9.00/kWh. A single plug-in electric heater would cost $1000 to run for five days. (His Lights Stayed on During Texas’ Storm. Now He Owes $16,752. – The New York Times)
Customers were outraged for feeling extorted to survive, and most couldn’t afford their bills. Griddy went bankrupt. The state banned wholesale electric sales.
The lack of winterization ultimately caused the Texas grid to nearly fail due to generators natural gas pipes freezing and fuel going offline as the storm got worse, but customers, who were used to nominally cheap power and normally only cut back usage on hot days, did not know this.
As close to a competitive electric market one could make, with inelastic demand, had arrived to encourage usage to go to those who might need it more, at a time when everyone did.
It did not survive the deep freeze.
Economies of Scale and High Barriers to Entry
Between the effects of double marginalization, high capital costs, and high barriers to entry, it might be best to consider utilities a natural monopoly, one best subjected to oversight and regulation rather than pure market forces.
In California alone, customers on investor-owned utilities SCE pay an average of $0.35/kWh, while customers on municipal utilities like LADWP pay an average of $0.19/kWh, nearly half.
Deregulation Moving Forward
In pursuit of revenue maximization, you can destabilize the very society that enables your maximization in the first place.
Electricity is not an elastic market. It faces real-world constraints that must be accounted for in designs across decades. As the world changes, in both supply generation mix and demand mix, the grid must be updated to reflect that.
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