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<td width="75%" valign="top"><p ALIGN="left"><big><b><big><strong>Impacts of Utility Entry
Into Air Conditioning Installation and Maintenance for Air Conditioning Contractors of
America</strong></big></b></big></p>
<font SIZE="2"><p></font><font size="4"><font face="Arial"><strong>BY<br>
RICHARD C. CARLSON<br>
CHAIRMAN, SPECTRUM ECONOMICS<br>
MAY 6, 1998</strong></font></p>
</font><p ALIGN="left"><small>(<em>originally published by PMA OnLine Magazine: 07/98</em>)</small></p>
<font face="Arial"><p align="left"> </p>
<b><font SIZE="2"><p ALIGN="left"></font>EXECUTIVE SUMMARY</b></font></p>
<p><font face="Arial">If done properly, electric deregulation promises to create a
competitive market for retail sales of electricity which should lead to substantial energy
cost savings for most consumers. However, early experience with deregulation has
demonstrated that there are several substantial, unexpected problems. One such problem is
the cross-subsidization of utility affiliates in unregulated service industries which
threatens to undermine competition in these service industries as well as to reduce cost
savings to consumers of electricity. The current pattern of electric deregulation creates
strong economic incentives for such cross-subsidized market entry.</font></p>
<p><font face="Arial">The most obvious example of cross-subsidized utility entry into new
markets is the move of several utilities into the heating, ventilation, air-conditioning
and refrigeration (HVACR) market. Members of the HVACR service industry have witnessed an
unprecedented and growing incursion into the HVACR service market by utility affiliates in
recent years. In a few states, such as Delaware and Maryland, utility affiliates have used
their market power and cross-subsidies to suddenly gain over a 20% share of the HVACR
market. These affiliates have enjoyed substantial cross-subsidies from their related
utilities in the form of free advertising, free marketing, free customer information, free
or reduced cost employees and free equipment. These cross-subsidies impose costs on the
electric consumer and are contrary to the goals of open competition on which deregulation
is premised.</font></p>
<p><font face="Arial">This report, prepared by Spectrum Economics of Palo Alto, California
examines the issue of cross-subsidization of utility affiliates in the HVACR market and
its potential implications for deregulation of the electric power industry. The key issues
explored and conclusions reached are as follows:</font><ul>
<li><font face="Arial"><b>Deregulation and Cross-Subsidization:</b> This section reviews the
long history of the problems of cross-subsidization created by earlier deregulation of
other industries such as natural gas and long-distance service. In all of these
industries, strict safeguards against cross-subsidization were required.</font></li>
</ul>
<ul>
<li><font face="Arial"><b>Cross-Subsidization Defined:</b> The National Regulatory Research
Institute has defined cross-subsidization and demonstrated how regulation creates
incentives for cross-subsidization.</font></li>
</ul>
<ul>
<li><font face="Arial"><b>Utility Cross-Subsidization of HVACR Affiliates and Its Public
Policy Implications:</b> Examines why deregulation creates incentives to cross-subsidize
unregulated affiliates and the forms of cross-subsidization. Partial deregulation
encourages cross-subsidization because subsidy costs can be hidden in regulated operations
and passed on to consumers. Such subsidies both increase costs to electric consumers and
in the long run would lead to high price monopolies in the unregulated HVACR business.</font></li>
</ul>
<ul>
<li><font face="Arial"><b>Utility Entrants into HVACR Markets and Regulatory Responses:</b>
Surveys the entry of utility affiliates into the HVACR market as well as regulatory
responses in seven key states: New York, Nevada, Colorado, Maryland, Virginia, Ohio and
Michigan. Among these states, the strongest utility HVACR programs are in Maryland and
Ohio. Many states are considering tough rules to prohibit cross-subsidies, but Minnesota
has enacted the toughest regulations. </font></li>
</ul>
<ul>
<li><font face="Arial"><b>Impacts of Cross-Subsidization on Competition:</b> The California
PUC has found that cross-subsidies in California alone are approaching over $100 million
per year. This would translate into a national consumer loss of over $2 billion per year.
Short term job loss to existing workers could reach 60,000.</font></li>
</ul>
<p><font face="Arial">The report concludes that legislation to deregulate electric
generation must address the issue of cross-subsidization in order to avoid substantial
harm to competition and consumers.</font></p>
<b><p><font face="Arial">I. INTRODUCTION</font></b></p>
<p><a name="12345"></a><a name="B12345"></a><font face="Arial">The U.S. heating,
ventilation, air conditioning and refrigeration (HVACR) industry has revenues of over $67
billion per year and employs over 530,000 people<a href="#1,2"><sup>1,2</sup></a>.
About 70% of the employees work for small contractors who employ less than 50 people, and
almost half work for employers with less than 10 employees<a href="#3"><sup>3</sup></a>.
The industry pays high wages to its employees, who average about $17 per hour and provides
independent livelihood to over 53,000 small business owners and their families.<a href="#4,5"><sup>4,5</sup></a></font></p>
<p><a name="B6"></a><font face="Arial">Increasingly, the future of these independent
contractors is threatened by anticompetitive practices associated with the entry of large
electric and gas utilities into the HVACR industry through unregulated affiliates. About
42% of utilities are now active in the HVACR business, but most of their activity is
recent.<a href="#6"><sup>6</sup></a> In the early 1990s only two major utilities,
Consumer’s Power of Michigan and Public Service of Colorado, had major HVACR
businesses. By 1997, the number of utilities in the HVACR market had grown to over 50. The
change in utility participation in the HVACR business is shown in <a href="#Chart1" name="C1">Chart 1</a>. This report examines some of the reasons for utility entry into the
HVACR market, the potential for cross-subsidization of unregulated affiliates in the HVACR
market, how this development threatens to reduce consumer savings in the soon-to-be
deregulated electric power market, and utility actions and regulatory responses in seven
states: Nevada, Colorado, Ohio, Michigan, New York, Maryland and Virginia.</font></p>
<b><p><font face="Arial">II. DEREGULATION AND CROSS-SUBSIDIZATION</font></b></p>
<p><font face="Arial">Recent U.S. efforts to deregulate major industries such as airlines,
trucking, railroads and natural gas have by and large led to more competition and lower
prices for most consumers. It is anticipated that deregulation of electric generation will
produce many of the same benefits for consumers of electric power. However, if the
transition to competition is not properly handled, deregulation could result in new
economic inefficiencies both in the market for electric power and in related markets such
as HVACR services. The recent and sudden expansion of electric utilities into the HVACR
business is the leading edge of the potential for large energy supply and service
conglomerates that could achieve near monopoly status in some industries. While integrated
conglomerates are not in themselves problematic, the potential for anticompetitive impacts
contrary to the intent of deregulation arises from the potential for utilities to use
cross-subsidies from their regulated business to enter into and unfairly dominate other
related but unregulated industries.</font></p>
<p><font face="Arial">In contrast to European and Asian encouragement of industrial
consolidation, the United States has historically sought to prevent monopolies. When
industrial consolidation went too far, the government broke up such near monopolies as
Standard Oil, IBM and AT&T. Today Microsoft has come under increasing government
scrutiny for allegedly monopolistic actions. Active U.S. enforcement of antitrust laws, in
contrast to European and Asian protection of inefficient industrial giants, is one of
several reasons for the relatively greater economic success of the United States. Where
monopoly was thought to be inevitable, the U.S. has traditionally regulated such
"natural monopolies" as water, electricity, gas and communications. Through
regulation, monopolies prices were constrained, but they were also protected against
competition. Thus regulated monopolies were both restricted and protected by their
regulators.</font></p>
<p><font face="Arial">Regulated firms generally were subject to another restriction: they
were rarely allowed to enter unregulated businesses. This restriction was put in place to
prevent these regulated monopolies from subsidizing their entry into new businesses using
assets paid for by the ratepayers or from shifting part of that cost to consumers in the
regulated industry. However, changing telecommunications and energy markets have led to
partial deregulation first of natural gas and long-distance service, then of electricity
generation. Partial deregulation of these industries has led to a "mixed-market"
environment in which portions of the industry have been opened to competition while other
portions have remained subject to regulation.</font></p>
<p><a name="B78"></a><font face="Arial">As part of this deregulation process, utilities
have been allowed to establish unregulated subsidiaries, but initially only under
carefully controlled conditions. The first major utility deregulation effort, that of
long-distance rates, required AT&T to divest its regulated regional Bell operating
companies (RBOC’s) and limited its entry into a variety of information publishing
sectors.<a href="#7,8"><sup>7, 8</sup></a></font></p>
<b><p><font face="Arial">III. WHAT IS CROSS-SUBSIDIZATION?</font></b></p>
<p><font face="Arial">Cross-subsidization is one of the key problems created by a mixed
market environment. Concern about the potential for cross-subsidization prompted many of
the restrictions described above and has posed a persistent problem for regulators.
Cross-subsidization occurs when an affiliate in an unregulated market is able to price its
product or services below cost due to its relationship with a regulated entity. Whether
this cross-subsidy takes the form of covering the affiliates losses with revenues from the
regulated utility or arises from the use of assets of the regulated entity to reduce the
cost of providing service, the unregulated affiliate enjoys a competitive advantage due to
its relationship with the regulated monopoly. This internal subsidy is borne, directly or
indirectly, by the consumers of the regulated entity.</font></p>
<p><font face="Arial">The result of this cross-subsidy is both inefficiency in the
regulated market and a skewing of competition in the unregulated market as the affiliate
is able to drive out otherwise efficient rivals through below cost pricing. The
cross-subsidy enjoyed by the affiliate may allow the affiliate to offer prices far enough
below its cost to allow it not only to drive out competitors but to prevent new entrants
into the market. Once competition is eliminated, prices in the unregulated market will
rise and the threat of predatory pricing will be sufficient to dissuade potential new
entrants. Obviously, cross-subsidies pose adverse consequences for consumers and
competitors alike.</font></p>
<p><b><font face="Arial">IV. UTILITY CROSS-SUBSIDIZATION OF HVACR AFFILIATES AND ITS
PUBLIC POLICY IMPLICATIONS</font></b></p>
<b><p><font face="Arial">A. Why Deregulation Creates Incentives For Utilities To
Cross-Subsidize Their Entry Into The Market for HVACR Services</font></p>
</b><p><a name="B9"></a><font face="Arial">The utility industry is a huge industry
undergoing the stress of market change and deregulation. The $213 billion electric utility
industry dwarfs the $67 billion air conditioning installation and maintenance business<a href="#9"><sup>9</sup></a>. Several individual electric utilities are larger than an
entire state’s HVACR industry. Natural gas utilities are "only" a $60
billion industry. The relative sizes of the HVACR, Electric Utility and Gas Utility
industries are shown in <a href="#Chart2" name="C2">Chart 2</a>.</font></p>
<p><a name="B10"></a><font face="Arial">Deregulation creates powerful incentives for gas
and electric utilities to move into HVACR installation and service. The key incentive
shared by all utilities and created by deregulation is the search for long-range profits.
By hiding part of the costs of establishing themselves in the unregulated HVACR business,
utilities can force their electric customers to help finance corporate expansion. In the
long-run, after competitors are driven out by predatory pricing unregulated monopoly
profits can be earned in the new business<a href="#10"><sup>10</sup></a>.</font></p>
<p><font face="Arial">The second reason is bundling: using service contracts bundled with
gas or electric purchases to encourage customers not to shift to new, more
cost-competitive energy supplies. Fearful that they will be unable to compete on price
alone due to stranded costs and other factors, utilities are hoping to retain customers by
offering services like HVACR installation and service along with the base gas or electric
service as a single package. Alternate suppliers of cheap gas and electricity can compete
on price more easily than they can compete on service. Many utilities believe that they
have a better chance of retaining consumer loyalty for their base electric and gas
products by providing a bundle of energy services, including HVACR and appliance services,
at a single package price. These utilities are deliberately under-pricing service
contracts as loss leaders, to convince customers to accept long-term electric or gas
purchase contracts. The main incentive to do this is that many utility costs are largely
fixed, so that the loss of a small number of customers can significantly reduce profits.</font></p>
<p><a name="B11"></a><font face="Arial">Under deregulation both electric and gas utilities
share another powerful reason for diversifying into HVACR installation and service:
institutional survival. Their existing businesses are slow growing, and new competitors
will almost surely take some of that current business. Established organizations generally
try to avoid staff cuts. Most utilities must cut staff to remain competitive in their core
business, but they are desperate to shift these workers to new business to avoid the
organizational morale and political problems of significant layoffs. Many utilities will
grasp at any possibility to maintain the size of the organization, even if it will not be
immediately profitable. Regulatory politics encourages such investments. Electric
deregulation and general rate freezes are occurring at a time of declining interest rates
and declining fuel prices. These fortuitous circumstances make many utilities potentially
so profitable that they risk a political backlash against deregulation. After languishing
for most of the last five years, utility earnings per share growth rates are expected to
more than double from 2.5% per year to almost 6% per year in the next five years under
deregulation<a href="#11"><sup>11</sup></a>. The decision facing utility executives is
simple: If they don’t take the diversification risk, their own jobs are at risk, and
the profits saved from utility staff cuts may be recaptured by regulators in any case. If
utility executives do invest in risky, initially money losing diversification, their jobs
are saved and they are effectively risking the money of their regulated customers, not
their shareholders. </font></p>
<p><font face="Arial">Avoiding layoffs through diversification only works if the utility
can be cost competitive in the new business or if it can use cross-subsidization to kill
competitors. Utilities cannot be cost competitive in the HVACR business with their
existing staff -- their wages are too high. Thus, utilities must either cross-subsidize or
use non-union contractor personnel in the new HVACR enterprises: They must choose between
an economic problem and a political one. </font></p>
<p><font face="Arial">However, many utilities are doing so by utilizing their
ratepayer-based assets to cross-subsidize their entry into the market for HVACR services.
Through cross-subsidization, the affiliate’s costs are lower than other participants
in the market for HVACR services and are able to use their cost difference to force out
current HVACR service providers and discourage new market entrants. Thus, while the
initial result of cross-subsidization may be to lower the cost of HVACR services, these
prices will surely rise as competition is eliminated. In addition, the cost of providing
these below-cost services is actually being paid by the customers of the regulated part of
the utility. </font></p>
<b><p><font face="Arial">B. Utility Cross-Subsidization and Public Policy</font></b></p>
<p><font face="Arial">Both gas and electric utilities have many ways to cross-subsidize
their HVACR affiliates. Some key cross-subsidies include providing the following services
to unregulated affiliates at low or no cost:</font><ul>
<li><font face="Arial"><b>Customer Data:</b> Utilities have amassed large volumes of
information on their customers and those customers’ usage patterns during their
tenure as monopoly utility service providers. Obviously, this type of information becomes
extremely valuable in a competitive marketplace. By sharing this data with its unregulated
affiliate, the utility provides the affiliate with a substantial competitive advantage.</font></li>
</ul>
<ul>
<li><font face="Arial"><b>Employees and Employee Benefits:</b> Costs associated with
employees and employee benefits are substantial, and the potential for cross-subsidization
arises when employees are shared between the utility and its affiliate.</font></li>
</ul>
<ul>
<li><font face="Arial"><b>Finance:</b> Regulated entities generally receive a lower costs of
capital than firms in competitive markets. If this advantage is passed on to the
unregulated affiliate, that entity enjoys lower costs of capital than similarly placed
independent firms solely by virtue of its relationship with the utility. Borrowing for
these unregulated subsidiaries raises interest costs paid by general utility customers.</font></li>
</ul>
<ul>
<li><font face="Arial"><b>Shared Logos or Trademarks:</b> The "name brand"
recognition possessed by utility logos and trademarks is the result of their monopoly
status and should be considered to be a ratepayer asset in a competitive environment.
Allowing unregulated affiliates to advertise, trade upon, or promote their affiliation
with the utility through the use of shared logos or trademarks results in a ratepayer
asset being used to create an unfair competitive advantage in the market for HVACR
services.</font></li>
</ul>
<ul>
<li><font face="Arial"><b>Bill Inserts:</b> Direct mail advertising is expensive. Many
utilities provide free advertising to their affiliates by allowing them to insert
advertising in the utility’s monthly billings.</font></li>
</ul>
<ul>
<li><font face="Arial"><b>Preferential Referrals:</b> Many consumers call their utility when
they experience problems with major appliances or HVACR systems. Often utilities refer
these callers only to their unregulated affiliate rather than informing them of the
existence of numerous qualified service providers.</font></li>
</ul>
<p><font face="Arial">While requesting the freedom to subsidize their own entry into the
HVACR business through their affiliates, electric utilities have at the same time opposed
subsidies to their competitors. Investor owned utilities have spent over 50 years fighting
subsidized public power projects. They objected to the public power industry receiving
subsidies from taxpayers in form of below market interest rates, low or no taxes and free
administrative support. The Edison Electric Institute, a coalition of investor-owned
utilities, was formed over 50 years ago to fight public power subsidies. These public
power subsidies are similar to the utility’s cross-subsidies of their unregulated
affiliates.</font></p>
<p><a name="B12"></a><font face="Arial">Many of these same utilities are currently
proposing new subsidies to themselves. These proposed subsidies would require customer
payment for so-called "stranded costs" (e.g., unsuccessful past investments
which firms in normal competitive industries would be forced to write off). These proposed
stranded cost assessments amount to a subsidy to electric utilities of between $100 and
$160 billion<a href="#12"><sup>12</sup></a>. While the utilities plead financial necessity
to obtain stranded cost recovery, many of these same utilities are pouring tens of
millions of dollars into entering the HVACR business.</font></p>
<p><a name="B13"></a><font face="Arial">The economic and public policy reasons for
limiting cross-subsidization of unregulated affiliates in the HVACR industry are well
described in a recent report issued by the National Regulatory Research Institute
entitled, "The Problem of Regulating Utility Affiliate Interactions in a Mixed Market
Environment" by Kenneth Costello and Robert Graniere<a href="#13"><sup>13</sup></a>.
The Institute is supported by the National Association of Regulatory Utility Commissioners
(NARUC). The report makes the following key points:</font><ul>
<li><font face="Arial">Cost shifting from unregulated affiliate to regulated utility can be
accomplished in myriad ways;</font></li>
</ul>
<ul>
<li><font face="Arial">Cost based regulation provides a substantial economic incentive for
such cost shifting;</font></li>
</ul>
<ul>
<li><font face="Arial">The regulatory challenge of reviewing such cost shifting is
difficult, if not impossible;</font></li>
</ul>
<ul>
<li><font face="Arial">Cost shifting is economically inefficient: it taxes utility customers
to finance unfair competition by the unregulated affiliate; and</font></li>
</ul>
<ul>
<li><font face="Arial">In the long run, the potential for cost-shifting limits competition
in the industry entered by the utility’s unregulated affiliate.</font></li>
</ul>
<p><a name="B14"></a><font face="Arial">The ability of regulated utilities to leverage
their market power into closely related sectors such as HVACR service through
cross-subsidization of unregulated affiliates presents significant problems for both
regulators and competitors in these unregulated industries. Even Robert Pitofsky, Chairman
of the Federal Trade Commission and one of the top government officials charged with
enforcing the antitrust laws, concedes: "[cross-subsidization] is one of the most
difficult issues to deal with in antitrust enforcement, because the books are in the hands
of the person who is doing the cross-subsidizing, and the allocation problems are
enormously difficult."<sup><a href="#14">14</a> </sup>Even where regulators have
attempted to maintain effective regulations against subsidized utility entry into new
market, detailed controls against cross-subsidies have been difficult to implement.
California has imposed stringent controls on utilities’ affiliate transactions,
including corporate separation, and has tried to closely monitor these relationships for
such giant utilities as Pacific Gas and Electric. Nevertheless, a late 1997 audit of
PG&E’s subsidiaries found cross-subsidiaries amounting to $33.7 million dollars.
California PUC staff projected that PG&E subsidies to its unregulated subsidiaries
were growing at such a rate that they could amount to $300 million over the next three
years. Unfortunately, no other PUC has completed such a study of the actual costs of
cross-subsidies. Projecting the California PUC results for PG&E to a national level,
however, the annual national cost for these cross-subsidies would amount to approximately
$2 billion per year. The estimated cross-subsidy cost to utility consumers by state is
shown in <a href="#Table1" name="T1">Table 1</a>.</font></p>
<b><p><font face="Arial">V. A SAMPLING OF UTILITY ENTRANTS INTO THE HVACR MARKET AND
REGULATORY RESPONSES IN MAJOR STATES</font></p>
<p><font face="Arial">A. Overview</font></b></p>
<p><font face="Arial">Utility participation in the HVACR market has taken a variety of
forms, including:</font><ul>
<li><font face="Arial">contractor certification programs;</font></li>
<li><font face="Arial">sales of referrals for customers seeking HVACR service;</font></li>
<li><font face="Arial">sales of HVACR maintenance plans (either directly or through an
affiliate); and </font></li>
<li><font face="Arial">general HVACR maintenance and contracting.</font></li>
</ul>
<p><font face="Arial">In response to this development, many state regulatory commissions
have begun crafting standards of conduct to govern utility affiliate transactions,
particularly those states moving towards a deregulated market. Among these states, many
are moving towards stricter requirements of physical and financial separation for electric
utilities and their non-regulated affiliates. New Hampshire and California have required
that the utilities and their affiliates be separate corporate entities. Iowa, while not
requiring complete separation, has prohibited the sharing of vehicles, service tools and
other assets between the utility and its unregulated affiliates. Minnesota probably
enacted the strictest rules: it required that unregulated affiliates pay a 1% of revenues
franchise fee to the regulated utility. (This was later overturned by state courts.) Many
other states are currently considering similar rules including charges for shared data
processing and administrative support, permitting sharing of marketing and other data only
if it is available to all competitors on a nondiscriminatory basis, and other rules to
prevent abuse of utility market power. The degree to which such rules are enacted and
effectively enforced will determine whether HVACR service remains a bastion of small
business.</font></p>
<b><p><font face="Arial">B. Status In Key States</font></b></p>
<p><font face="Arial">The nation’s most aggressive utility moves into
air-conditioning installation and maintenance are in Maryland, Virginia, and Colorado.</font></p>
<p><font face="Arial"><b>Maryland</b> -- Baltimore Gas and Electric is moving aggressively
into the HVACR business. Through their Home Products and Services division , formed in
1994, BG&E sells HVACR and appliance service contracts, repairs and installs HVACR
systems, and sells appliances. BG&E’s Commercial Building Systems division
designs, finances and supervises the installation of commercial HVACR systems. BG&E
clearly cross-subsidizes its affiliates, which pay nothing for such vital services as
advertising, data or customer referrals from the regulated utility. </font></p>
<p><font face="Arial">Delmarva Power (recently renamed Connectiv), which supplies
electricity to Delaware and Eastern Maryland, has been even more aggressive in the HVACR
area. Delmarva/Connectiv has purchased several electrical contractors and now sells,
finances and installs residential and commercial central air conditioning systems.
Connectiv recently announced that its HVACR business tripled to $95 million in 1997. This
amounts to a market share of over 20% in Connectiv’s territory. </font></p>
<p><font face="Arial">The Washington, D.C., area gas utility, Washington Gas, is also
aggressively selling HVACR services. Its HVACR service programs go back at least to the
early 1980's. They sell appliance and HVACR service contracts and finance purchases
through a "Thrift Purchase Plan". The actual service work is done by a
combination of Washington Gas staff and "Trade Associate" contractors.
Washington Gas also operates a contractor referral program.</font></p>
<p><font face="Arial">Several Maryland area utilities are not entering the HVACR business,
as of late 1997. Allegheny Power, which services western Maryland, is not pursuing air
conditioning installation and maintenance. Columbia Gas also has no major programs. </font></p>
<p><font face="Arial">Maryland regulators and the Maryland legislature are currently
debating how to regulate these utility programs. The staff of the Maryland PSC has
recommended strict separation between BG&E and its affiliates, including competitive
bidding for all utility contracts and open purchase of all utility services such as
customer data. The legislature passed tight cost allocation rules for utility
subsidiaries.</font></p>
<p><a name="B15"></a><font face="Arial">In nearby Delaware, the State Legislature passed a
Joint Resolution establishing Fair Conduct rules for utility subsidiaries. Delmarva Power
had bought several HVACR contractors and the utility was referring customers to these
unregulated subsidiaries without informing the customers of the corporate relationship.
The Delaware Public Service Commission examiner found Delmarva Power’s actions to be
in clear violation of the Code Of Conduct.<a href="#15"><sup>15</sup></a></font></p>
<p><a name="B16"></a><font face="Arial"><b>Virginia</b> -- Virginia Power (VEPCO) had an
aggressive HVACR program but is pulling back from this business as of late 1997. VEPCO
designs, builds and manages commercial HVACR systems. It created a "Comfort
Assured" Preferred Dealer Network to install and service residential heat pump
systems and provides low interest loans through these contractors. VEPCO also bought an
appliance and HVACR service contract and warranty business. Under significant legal and
political pressure, VEPCO is now selling the warranty business and is reducing its other
HVACR service business. Under intense pressure, VEPCO signed an agreement with the
Virginia Coalition for Fair Competition to follow strict "standards of Conduct."<a href="#16"><sup>16</sup></a></font></p>
<p><font face="Arial"><b>Colorado</b> -- Public Service of Colorado both services air
conditioning systems and appliances and is constructing a large chilled water plant to
provide cooling to downtown Denver. The plant will use off-peak power in the evening to
chill water for day time use. PSC has reduced its once aggressive appliance service
business to cover the Denver area only.</font></p>
<p><font face="Arial">The most aggressive utility provider of HVACR services in Colorado
and several nearby states is KN Energy, once mainly a gas transmission and distribution
company. KN Energy provides appliance service (including HVACR), and appliance warranties
along with a wide variety of gas and telecommunications services. </font></p>
<p><font face="Arial">A nearby utility, NorAmEnergy, now part of Houston Industries, is
aggressively expanding its appliance and air conditioning service business in Texas,
Oklahoma, Arkansas, Louisiana and Minnesota and may soon enter the Colorado market.</font></p>
<p><font face="Arial">Colorado’s Public Utilities Commission is finalizing a modestly
strict code of conduct rules for unregulated affiliates which require full payment to the
utility for all data and other services. </font></p>
<p><font face="Arial"><b>New York</b> -- New York utilities are discussing providing a
variety of HVACR services but relatively few programs are being implemented as of late
1997. The most active program is that of Brooklyn Union Gas and their merger partner Long
Island Lighting (LILCO) -- now Keyspan Energy. Brooklyn Union sells and installs gas air
conditioning and sells gas appliance maintenance contracts. Any further Keyspan entry into
the HVACR business is being held up by negotiations surrounding the merger.</font></p>
<p><font face="Arial">The other major New York utilities, Niagra Mohawk, Consolidated
Edison, Rochester Gas and Electric and New York State Electric and Gas are not
aggressively pursuing the HVACR business. </font></p>
<p><font face="Arial">The New York PUC has ordered all state utilities, including Brooklyn
Union/Keyspan out of the HVACR business by 2000, unless the utilities can prove they are
not cross-subsidizing. The April 4, 1997 PSC order requires that all utility HVACR
services be provided by separate subsidiaries, that past expenditures be refunded to
customers and that HVACR service prices be immediately raised to unsubsidized levels. </font></p>
<p><font face="Arial"><b>Michigan</b> -- Consumers Power has been aggressively trying to
enter the HVACR business for 15 years, but they have been held up by litigation and the
Michigan Coalition for Fair Competition has continued to fight these utility HVACR
programs. Consumers Power sells appliance and HVACR service contracts for residences and
is discussing broader HVACR services. Consumers Power also has a referral program which
includes a 10% kickback from the contractor. </font></p>
<p><font face="Arial">Detroit Edison sells appliance and HVACR service contracts. Detroit
Edison is also installing its Liquid Pressure Amplification Pump as part of commercial
refrigeration and air conditioning systems. </font></p>
<p><font face="Arial">Michigan Consolidated Gas (part of MCN Energy) has expanded from
servicing gas appliances to selling service contracts for central air conditioning systems
in the Detroit and Grand Rapids areas. Michigan Consolidated advertises its"100 years
of gas appliance service experience." </font></p>
<p><font face="Arial">These utility programs and potential cross-subsidy problems would be
severely limited, if not killed by pending Michigan legislation enacting utility standards
of conduct. The proposed Michigan standards would prohibit unregulated subsidiaries using
the utility’s name, staff or data bases. The Michigan Alliance for Fair Competition
has repeatedly sued successfully to limit regulated utility provision of HVACR services.</font></p>
<p><font face="Arial"><b>Ohio</b> -- Ohio utilities are discussing entering many aspects
of the HVACR business, but no programs were actively implemented until 1997. In 1997, Ohio
Edison (now part of First Energy which includes Toledo Edison and Cleveland Electric
Illuminating) bought two of the nation’s largest mechanical contractors, Roth
Brothers and RPC Mechanical, with combined revenues of over $90 million. Ohio Edison has
announced that through these contractors it will supply the full spectrum of HVACR,
roofing, and building services primarily to commercial and industrial customers. They are
also starting a "one call" appliance service program. This dramatic move makes
Ohio Edison/First Energy a major HVACR player. </font></p>
<p><font face="Arial">American Electric Power is indirectly entering the HVACR business
through its proposed 10 year guaranteed savings programs. For large customers willing to
contract for buying electricity for 10 years, AEP guarantees cost savings and installs
energy saving equipment, including HVACR equipment, for free. It is unclear how extensive
these new power contracts will be and what their impacts will be on existing HVACR
contractors.</font></p>
<p><font face="Arial">Columbia Gas has an appliance warranty program in Ohio. Consolidated
Natural Gas is experimenting with an appliance warranty program in nearby Pennsylvania,
which may be extended to the territory of CNG’s East Ohio Gas.</font></p>
<p><font face="Arial">Neither of Ohio’s other major electric utilities, Cincinnati
Gas and Electric (now Cinergy) and Dayton Power and Light, are actively pushing air
conditioning installation and maintenance programs. </font></p>
<p><font face="Arial">The Ohio legislature is considering utility standards of conduct
which would control these programs, but passage is uncertain.</font></p>
<p><font face="Arial"><b>Nevada</b> -- Nevada Power proposed a preferred dealer network
where it would sell referrals to selected contractors, but this program was effectively
killed by PSC action. They are also planning a central chilled water cooling system for
the Las Vegas "Strip." Having lost the dealer referral battle, Nevada Power is
now entering the home and appliance warranty business (including HVACR) through an
insurance affiliate, First Choice Insurance. This program is running into problems with
the contractor’s licensing board, as is a similar insurance program run by Old
Republic. Sierra Pacific has no similar programs. </font></p>
<p><font face="Arial">Southwest Gas has some contractor referral programs, but these are
operated in cooperation with existing contractor organizations. </font></p>
<p><font face="Arial">The Nevada Legislature passed a new law requiring that all
unregulated work be run through separate affiliates, but the standards of conduct for
these affiliates will be established as part of complex new laws and new rules for
de-regulating electric power generation.</font></p>
<b><p><font face="Arial">VI. POTENTIAL IMPACTS OF CROSS-SUBSIDIZATION ON LONG-TERM
COMPETITION</font></p>
</b><p><font face="Arial">Since electric and gas markets will continue to be partially
regulated, the opportunities and incentives for cross-subsidization will also continue.
The market power of existing regulated electric and gas monopolies may decline, but will
not disappear. Therefore, careful regulation to prevent unfair cross-subsidization will
continue to be necessary in order to prevent diverting consumer savings from the
electricity markets and causing substantial disruptions in unregulated markets such as
HVACR services.</font></p>
<p><font face="Arial">Consumers are harmed by cross-subsidization both in the market for
electricity and in markets served by unregulated utility affiliates. The harm to the
utility’s customers lies in the fact that they bear, whether directly or indirectly,
the cost of the internal subsidy to the utility’s unregulated affiliate. The harm to
consumers in the market for HVACR services arises from the inefficient skewing of that
market caused by the cross-subsidy. Again, the utility affiliate’s ability to price
its services at below cost in order to gain market share allows it to drive other
competitors from the market. New competitors will be discouraged from entry by the
affiliate’s ability to incur short-term losses to eliminate competition. Therefore,
while consumers may initially benefit from lower prices, these prices will rise rapidly
once long term competition has been reduced.</font></p>
<p><font face="Arial">Utility takeover of the HVACR business would be disruptive to the
lives of both existing contractors and their workers. Delmarva/Connectiv’s gaining of
over a 20% market share in less than five years demonstrates how a large utility with
unlimited funds can quickly dominate the HVACR industry. If utilities takeover only 10% of
the existing market, total national job loss among existing workers would be 60,000 jobs.
About 5,000 existing contractors would close down at this level of utility expansion. </font></p>
<p><font face="Arial">Utilities have argued against restrictions on affiliate
cross-subsidies on the grounds that they should be allowed to achieve economies of scale
like other large integrated entities. There is inevitably a tension in deregulating
monopolies between allowing realization of the benefits of economies of scale and creating
an environment in which the benefits of market competition can be fully realized. However,
past deregulation efforts demonstrate that legislators and regulators have seen fit to
balance these interests by imposing at least some restrictions on the incumbent
monopolists’ ability to utilize their accumulated market power. These restrictions
are necessary in order to create a marketplace in which open competition can flourish. </font></p>
<p><font face="Arial">In the long run, without restrictions, energy utilities will be able
to gain monopoly level profits in related, unregulated service industries. Once
cross-subsidies have been used to drive out existing competitors, prices can be raised to
high levels, generating monopoly profits for the unregulated subsidiaries of the
utilities. These high prices and profits can be maintained because potential new entrants
will be frightened off by the risk of predatory low prices charged by the utilities. </font></p>
<p><font face="Arial">Finally, allowing cross-subsidization of utility affiliates
represents an unwise investment for utilities themselves. Utilities will face extremely
difficult competitive forces in their core business in the coming years.
Cross-subsidization diverts needed resources, that could be devoted to providing core
utility services in the new competitive environment, to side ventures subsidized by the
utility’s customers.<font SIZE="2"></p>
</font><hr>
<a name="Chart1"><p align="center"><img src="../images/carlcht1.jpg" alt="wpe3.jpg (7100 bytes)" WIDTH="288" HEIGHT="193"></a></p>
<p align="center"><strong><small>Spectrum Economics, Inc.<small><br>
</small>550 Hamilton Avenue, Ste. 307, Palo Alto, CA 94301</small><br>
</strong><a href="#C1"><small>Return</small></a></p>
<hr>
<p align="center"><strong><a name="Table1">Table 1</a><br>
Potential Annual Cross-Subsidies By State<br>
<small>($ IN MILLIONS)</small></strong></p>
<div align="center"><center><table border="5" width="34%">
<tr>
</font><td width="50%"><font face="Arial" size="2">COLORADO</font></td>
<td width="50%"><font face="Arial" size="2">$ 28.7</font></td>
<font face="Arial">
</tr>
<tr>
</font><td width="50%"><font face="Arial" size="2">MARYLAND</font></td>
<td width="50%"><font face="Arial" size="2">$ 38.5</font></td>
<font face="Arial">
</tr>
<tr>
</font><td width="50%"><font face="Arial" size="2">MICHIGAN</font></td>
<td width="50%"><font face="Arial" size="2">$ 72.5</font></td>
<font face="Arial">
</tr>
<tr>
</font><td width="50%"><font face="Arial" size="2">OHIO</font></td>
<td width="50%"><font face="Arial" size="2">$ 84.5</font></td>
<font face="Arial">
</tr>
<tr>
</font><td width="50%"><font face="Arial" size="2">NEW YORK</font></td>
<td width="50%"><font face="Arial" size="2">$ 137.4</font></td>
<font face="Arial">
</tr>
<tr>
</font><td width="50%"><font face="Arial" size="2">VIRGINIA</font></td>
<td width="50%"><font face="Arial" size="2">$ 50.6</font></td>
<font face="Arial">
</tr>
<tr>
</font><td width="50%"> </td>
<td width="50%"> </td>
<font face="Arial">
</tr>
<tr>
</font><td width="50%"><font face="Arial" size="2">U.S. TOTAL</font></td>
<td width="50%"><font face="Arial" size="2">$1,000.0</font></td>
<font face="Arial">
</tr>
</table>
</center></div><p align="center"><small><a href="#T1">Return</a></small></p>
<hr>
<p align="center"><a name="Chart2"></a><strong>Chart 2<br>
Relative Size 1997</strong></p>
<font SIZE="3"><p align="center"></font><img src="../images/carlcht2.gif" alt="carlcht2.gif (3388 bytes)" WIDTH="288" HEIGHT="192"></p>
<p align="center"><strong><small>Spectrum Economics, Inc.<small><br>
</small>550 Hamilton Avenue, Ste. 307, Palo Alto, CA 94301</small><br>
</strong><a href="#C2"><small>Return</small></a></p>
<hr>
<p><big><strong>Footnotes</strong></big></p>
<font SIZE="2"><p></font></font><a name="1,2"></a><font face="Arial" size="2"><sup>1</sup>Projected
from 1992 Census of Construction Industries output of $41 billion, based on recently
released 6 digit SIC detail. HVACR includes SIC 17111, SIC 171116 (mechanical), SIC 171118
(Refrigeration), SIC 171122 (Combination), and N.S.K (Other). Projection based on growth
in earnings and employment through 1997. <a href="#12345">Return</a></p>
<p><sup>2</sup>Employment and Earnings, Nov. 1997, Table B-12, HVACR is 66% of SIC 171,
Plumbing, Heating and air-conditioning. <a href="#12345">Return</a></p>
<p><a name="3"></a><sup>3</sup>U.S. Bureau of the Census, County Business Patterns, U.S.
Summary, 1995, p.7. <a href="#12345">Return</a></p>
<p><a name="4"></a><a name="4,5"></a><sup>4</sup>Employment and Earnings, Nov. 1997, Table
B-15, data is for SIC 171. <a href="#12345">Return</a></p>
<p><sup>5</sup>Op.cit.., County Business Patterns, p.7. <a href="#12345">Return</a></p>
<p><a name="6"></a><sup>6</sup>1996 data from Energy Users News, July 1997. <a href="#B6">Return</a></p>
<p><a name="7,8"></a><sup>7</sup>See 47 U.S.C., Sections 272 (separate affiliates for
competitive activities, 274 (separate affiliate for electronic publishing), 275 (delayed
entry into alarm monitoring services). <a href="#B78">Return</a></p>
<p><sup>8</sup>For an excellent discussion of the economic theory of why regulated firms
should be kept out of unregulated markets, see Timothy Brennan, "Why Regulated Firms
should be Kept Out of Unregulated Markets: Understanding the Divestiture in United States
v. AT&T, The Antitrust Bulletin, Fall 1987, P. 741 to 793. <a href="#B78">Return</a></p>
<p><a name="9"></a><sup>9</sup>Monthly energy review, December 1997, KWH sales times
average price. <a href="#B9">Return</a></p>
<p><a name="10"></a><sup>10</sup>For an analysis of the economic and regulatory incentives
for cross-subsidies see Jaison Abel, An Economic Analysis of Marketing Affiliates in a
Deregulated Electric Power Industry, National Regulatory Research Institute, Ohio State
University, Feb. 1998. <a href="#B10">Return</a></p>
<p><a name="11"></a><sup>11</sup>Zack’s Earnings forecasts, April 24, 1998. <a href="#B11">Return</a></p>
<p><a name="12"></a><sup>12</sup>A. Thierer, "Electricity Deregulation: Separating
Fact From Fiction in the Debate Over Stranded Cost Recovery", March 1997, The
Heritage Foundation, Washington D. C. <a href="#B12">Return</a></p>
<p><a name="13"></a><sup>13</sup>For a detailed review of how utilities can cross
subsidize, see Costello and Graniere, "The Problem of Regulating Utility-Affiliate
Interactions in a Mixed Market Environment, National Regulatory Research Institute, April
1997. <a href="#B13">Return</a></p>
<p><a name="14"></a><sup>14</sup>Antitrust Aspects of Electricity Deregulation before the
House Committee on the Judiciary, 105th Congress, 1st Session, at 68 (1997) (statement of
the Honorable Robert Pitofsky, Chairman, Federal Trade Commission). <a href="#B14">Return</a></p>
<p><a name="15"></a><sup>15</sup>State News, October 19,1997. <a href="#B15">Return</a></p>
<p></font><a name="16"></a><font face="Arial" size="2"><sup>16</sup>Lawrence DeSimone,
Senior Vice President of Virginia Power, letter of Nov. 4, 1997 <a href="#B16">Return</a></font></td>
</tr>
</table>
</center></div>
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