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Traditionally, the electric utility industry has been structured as a vertically integrated regulated monopoly. This began to change in the 1980s with the privatization of the industry in the United Kingdom. One important aim of the U.K. privatization was to introduce competition into an industry that previously had been a publicly owned monopoly. A similar process of attempting to open up the industry to competition was set in motion in the United States with the Energy Policy Act of 1992. However, the process is far from complete and agreement as to the structure of the industry currently does not exist. This is nowhere more apparent than in the problem of the organization and ownership of the transmission function, which plays a critical role in enabling competition to take place. Thus, this paper is concerned with governance of transmission networks.

This paper examines the problems associated with the application of traditional capital budgeting practices to the valuation of radically new processes and technologies in an environment of rapid technological change. It focuses on a restructured utility industry, and the possible emergence of the Virtual Utility.

The Context: What Is the Virtual Utility? The current transformation of the US electric utility industry is not dissimilar to the significant changes undergone by US manufacturers over the last two decades. During this period the industry has changed radically by abandoning previous mass-production protocols and adopting flexible, computer-integrated or “just in time” manufacturing.1 A considerable body of literature has investigated this transformation. The virtual utility (VU) is a flexible collaboration of independent, market-driven entities that provide efficient energy service demanded by consumers without necessarily owning the corresponding assets. The VU becomes a metaphor for lean, flexible electricity production/delivery and flexible, customer-oriented energy service provision. The VU construct provides a context for examining the issues surrounding the current transformation of the industry in part by adapting and using important concepts developed in the “new manufacturing.”

Utility company managers (and most business people) are often surprised to learn that accounting income and rate-of-return measures have little economic significance and do not offer much insight into the profitability of a venture or firm. Why the serious shortcomings of the accounting earnings measure are not more widely recognized is quite puzzling in view of the fact that the academic literature has been dealing with this problem for at least 25 years.1 So significant are the errors associated with the accounting rate of return (ARR), according to some researchers, that it “provide[s] almost no information about the [true] economic rates of return” of American corporations (Fisher and McGowan 1983, 82). Nonetheless, the ARR continues to be widely followed, and, in the regulatory context, forms the basis for ratemaking, a role for which it was certainly never intended and for which it is poorly suited (Awerbuch 1986, 20–21).