Association for Public Policy Analysis & Management

U.S. policymakers are seeking to anticipate the potential market power of the investor-owned vertically integrated utilities that are natural monopolies. While some states continue to regulate their electricity industry, other states have undergone electricity market restructuring and deregulation in order to create competitive wholesale and retail markets for power. In these states, investor-owned utilities (IOUs) are required to divest the majority of their generation assets in order to purchase power from merchant generators, independent power producers, and power marketers competing in the new market. This paper examines the effect divestiture policy on the technical efficiency of IOUs during the post-divestiture period. It is particularly interested in the impact of the governance structures used to purchase power in the wholesale market, i.e. bilateral forward contracts and market transactions, on IOUs’ technical efficiency. Using a two-stage empirical strategy (the non-parametric data envelopment analysis and the difference-in-differences regression approach), I analyze the performance of 152 distribution utilities in the U.S. from 1994 to 2015. The results show that while the use of contracts has no significant effect, the use of market transactions after the divestiture has a significant negative effect on utilities’ technical efficiency. This suggests that trading arrangements in the competitive wholesale markets for power generates transaction costs that make it too costly for the utility to use market transactions. Thus, market transactions are not the efficient governance structure to facilitate power transactions in the policy-induced wholesale markets for power and the adverse effect of market transactions on IOUs’ efficiency persists until 20 years after the divestiture.