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Impacts of Utility Entry Into Air Conditioning Installation and Maintenance for Air Conditioning Contractors of America

MAY 6, 1998

(originally published by PMA OnLine Magazine: 07/98)



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.

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.

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:

  • Deregulation and Cross-Subsidization: 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.
  • Cross-Subsidization Defined: The National Regulatory Research Institute has defined cross-subsidization and demonstrated how regulation creates incentives for cross-subsidization.
  • Utility Cross-Subsidization of HVACR Affiliates and Its Public Policy Implications: 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.
  • Utility Entrants into HVACR Markets and Regulatory Responses: 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.
  • Impacts of Cross-Subsidization on Competition: 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.

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.


The U.S. heating, ventilation, air conditioning and refrigeration (HVACR) industry has revenues of over $67 billion per year and employs over 530,000 people1,2.  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 employees3. 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.4,5

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.6 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 Chart 1. 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.


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.

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.

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.

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.7, 8


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.

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.


A. Why Deregulation Creates Incentives For Utilities To Cross-Subsidize Their Entry Into The Market for HVACR Services

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 business9. 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 Chart 2.

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 business10.

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.

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 deregulation11. 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.

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.

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.

B. Utility Cross-Subsidization and Public Policy

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:

  • Customer Data: 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.
  • Employees and Employee Benefits: 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.
  • Finance: 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.
  • Shared Logos or Trademarks: 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.
  • Bill Inserts: 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.
  • Preferential Referrals: 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.

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.

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 billion12. 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.

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 Graniere13. The Institute is supported by the National Association of Regulatory Utility Commissioners (NARUC). The report makes the following key points:

  • Cost shifting from unregulated affiliate to regulated utility can be accomplished in myriad ways;
  • Cost based regulation provides a substantial economic incentive for such cost shifting;
  • The regulatory challenge of reviewing such cost shifting is difficult, if not impossible;
  • Cost shifting is economically inefficient: it taxes utility customers to finance unfair competition by the unregulated affiliate; and
  • In the long run, the potential for cost-shifting limits competition in the industry entered by the utility’s unregulated affiliate.

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."14 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 Table 1.


A. Overview

Utility participation in the HVACR market has taken a variety of forms, including:

  • contractor certification programs;
  • sales of referrals for customers seeking HVACR service;
  • sales of HVACR maintenance plans (either directly or through an affiliate); and
  • general HVACR maintenance and contracting.

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.

B. Status In Key States

The nation’s most aggressive utility moves into air-conditioning installation and maintenance are in Maryland, Virginia, and Colorado.

Maryland -- 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.

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.

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.

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.

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.

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.15

Virginia -- 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."16

Colorado -- 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.

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.

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.

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.

New York -- 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.

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.

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.

Michigan -- 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.

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.

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."

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.

Ohio -- 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.

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.

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.

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.

The Ohio legislature is considering utility standards of conduct which would control these programs, but passage is uncertain.

Nevada -- 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.

Southwest Gas has some contractor referral programs, but these are operated in cooperation with existing contractor organizations.

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.


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.

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.

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.

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.

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.

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.

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Spectrum Economics, Inc.
550 Hamilton Avenue, Ste. 307, Palo Alto, CA  94301


Table 1
Potential Annual Cross-Subsidies By State

COLORADO $     28.7
MARYLAND $     38.5
MICHIGAN $     72.5
OHIO $     84.5
NEW YORK $    137.4
VIRGINIA $      50.6
U.S. TOTAL $1,000.0


Chart 2
Relative Size 1997

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Spectrum Economics, Inc.
550 Hamilton Avenue, Ste. 307, Palo Alto, CA  94301



1Projected 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. Return

2Employment and Earnings, Nov. 1997, Table B-12, HVACR is 66% of SIC 171, Plumbing, Heating and air-conditioning. Return

3U.S. Bureau of the Census, County Business Patterns, U.S. Summary, 1995, p.7. Return

4Employment and Earnings, Nov. 1997, Table B-15, data is for SIC 171. Return

5Op.cit.., County Business Patterns, p.7. Return

61996 data from Energy Users News, July 1997. Return

7See 47 U.S.C., Sections 272 (separate affiliates for competitive activities, 274 (separate affiliate for electronic publishing), 275 (delayed entry into alarm monitoring services). Return

8For 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. Return

9Monthly energy review, December 1997, KWH sales times average price. Return

10For 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. Return

11Zack’s Earnings forecasts, April 24, 1998. Return

12A. Thierer, "Electricity Deregulation: Separating Fact From Fiction in the Debate Over Stranded Cost Recovery", March 1997, The Heritage Foundation, Washington D. C. Return

13For 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. Return

14Antitrust 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). Return

15State News, October 19,1997. Return

16Lawrence DeSimone, Senior Vice President of Virginia Power, letter of Nov. 4, 1997 Return

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