On Electrical Deregulation
Last weekÂ’s blackout seems to have inspired more serious discussion of how America should structure its energy industry than the entire California electrical crisis did. I am not too sure why that is, and much of the discussions application to the events at hand was certainly premature, but I am still grateful for it. There seem to be too central questions in this discussion: should electrical grids be managed at the federal or state levels, and should they be organized into regulated monopolies or competitive markets.
On the first of these questions, there is a shocking amount of consensus that it is in the nations interest to have the federal government take responsibility for establishing the ‘rules of the road’ for our electrical grid, even from big-government-hating conservatives. This doesn’t mean that the states are going to be in any hurry to give up their influence, or the federal government is going to be ready to assert itself until there is a broader consensus on how to organize the grid.
The second question ignites the usual discord about the values of deregulation. (As an aside, does anyone else think that the proponents of ‘deregulation’ did themselves a disservice in picking that term? It did a good job of defining them in contrast to the everything-is-regulated 70s, but it emphasizes controversial the means of eliminating traditional regulation rather than the end of creating competitive markets. I wonder if they would have done better with a term like ‘marketize’.) An excellent (and by excellent, I mean worth my taking the time to pick on) attack on deregulation in electricity markets by Robert Kuttner appeared in the New York Times recently. Kuttner is clearly knows something about markets in general and electrical markets in particular, which is why his piece stands above most of the anti-corporate or anti-government blather that passes for a public dialog on the effectiveness and limits of markets.
Kuttner avoids the usual complaints about how supplying electricity is too ‘important’ a task to be left to markets. Instead he focuses on the logistics of organizing an electrical market. His first objection is as follows:
First, there is a fairly fixed demand for electricity and generating capacity is tight, so companies that produce it enjoy a good deal of power to manipulate prices. The Enron scandal, which soaked Californians for tens of billions of dollars, was only the most extreme example. California authorities calculated that a generating company needed to control just 3 percent of the state’s supply to set a monopoly price.
Presumably, when Kuttner suggests that demand is ‘fixed’, he means that it is inelastic, and therefore that consumption will be unaffected by electrical prices. This seems contrary to the experience in California where both individuals and businesses took drastic measures to reduce their use of electricity in the face of expensive power. This is an area of fact in which I am not an expert. It is more informative to examing Kuttner’s assertion that electrical generating capacity is ‘tight’ (which implies that supply of electricity is inelastic). We can reasonably assume this means that there is little slack generating capacity, and that it is not easy to bring new capacity online. The question at hand then becomes what about the structure of the electrical generation market ensures that there is such limited productive capacity.
I can think of two reasons for this. The first is that perhaps the fixed costs of building electrical plants is so exorbitant, that it is simply not cost-effective to build any capacity that is going to go unused. This explanation makes some intuitive sense, because we all know that electrical plants are massive endeavors involving lots of machines made by GE that few of us understand. However, this would imply that electrical suppliers would have to be price-takers, because keeping their capacity online is worth it at any price. That is not consistent with the portrayal of producers using the tight supply to keep prices high. A more fitting explanation is that there are significant barriers to entry in the power business. Indeed, CaliforniaÂ’s deregulation laws forced any new suppliers of power to take on portions of the debt of existing suppliers. Barriers to entry are an impediment to markets working efficiently (and helping consumers). CaliforniaÂ’s deregulation statutes were decried from the beginning asdiscouraging competition and being rigged against consumers (although few pundits had the foresight to see how dire their implications would be). I would like to write more about the political environment that led to these mistakes, but I think I will do it another time.
This description of tight capacity is clearly influenced more by the California experience, rather than that of a functioning market where competitive forces dictate that capacity doesnÂ’t stay tight in the face of unmet (and inelastic) demand. By extension, his questionable statistic that three percent of the suppliers can set prices is further evidence at the dysfunction of what happened in California.
(A little Googling turns up a nice three-year-old piece by the eminent Carl Shapiro, where he explains that functioning markets have a fantastic mechanism for ensuring price stability in markets with inelastic supply and demand and non-storable goods: the forward contract. By arranging their purchase well in advance, buyers can lock in reasonable prices and sellers know how much demand to expect. He considers the absence of these mechanisms good evidence of the poor functioning of the California electricity markets.)
KuttnerÂ’s next argument is his most specific to the electrical industry. He asserts the following:
Second, the idea of creating large national markets to buy and sell electricity makes more sense as economic theory than as physics, because it consumes power to transmit power. “It’s only efficient to transmit electricity for a few hundred miles at most,” says Dr. Richard Rosen, a physicist at the Tellus Institute, a nonprofit research group.
I cannot dispute the expertise of either Kuttner or his expert in the efficiency of electrical transport. But it seems evident that their analysis is based on how electricity is generated today (big centralized plants dedicated to serving large regions), rather than how it might be in a competitive market (with regional capacity spread over multiple plants). This argument also seems contrary to our experience. The existence of continent-spanning electrical grids indicates that there is a way for plants in one region to ‘contribute’ electricity to another. A consumer does not need access to every supplier to benefit from competition. Rather, a small oligopoly of players in their region should be sufficient to guarantee them a reasonable price.
Lastly, Kuttner asserts that:
Third, under deregulation the local utilities no longer have an economic incentive to invest in keeping up transmission lines. Antiquated power lines are operating too close to their capacity. The more power that is shipped long distances in the new deregulated markets, the more power those lines must carry.
This is a timely argument, and indeed it did not take long for deregulations opponents to blame it for the sorry state of our electrical grid. However, this argument is not well served by the degeneration of the grid in recent years under the watch of regulated monopolies. The fact is that both regulated and deregulated electric companies respond to economic incentives, and neither has been incented to invest in transmission systems. There is some logic to this. Prestige aside, what did energy companies lose by shutting off the power for the day? Not much beyond one 365th of their annual revenue. Given that this sort of blackout is a decadely event one can see why the utilities are in no hurry to prevent it. However, this blackout imposed costs on society that dwarf the suppliersÂ’ losses. So the only way to ensure they invest appropriately in the grid is to share the true costs of a blackout.
I see two mechanisms for this. The heavy-handed would be a law which heavily fines utilities for allowing the lights to go out. This would work, but it presents regulators with the difficulty of estimating the true costs of a blackout, so as not to induce the utilities to overinvest or underinvest. An alternative would be to give consumers the ability to contract directly with their electric company to ensure that they are appropriately compensated for a blackout. Because most consumers aren’t negotiating electricity contracts directly with their provider, a convenient mechanism to allow this contracting would be to force electric companies to sell ‘blackout insurance’. Consumers could then buy a policy covering their hourly losses in the event of an electrical failure, and the electric company would compensate them in the case of a blackout. These could be purchased by individuals, but I imagine the biggest consumers will be those who take the hardest economic hit in the case of a blackout. This includes businesses who cannot function, police and hospitals who are forced to work overtime, and insurance companies who will probably end up picking up some of this tab. It is estimated that the recent blackout had economic costs approaching $5 billion. If the grid operators were faced with these costs, they (and their insurers) would certainly have good reason to keep this from happening again.
But more importantly, the grid seems like the last part of the electric system that one would want to deregulate. There is an analogy here to the long-distance market in the 80s, where we decided to keep the lines running into peopleÂ’s homes as a regulated monopoly, but to allow providers to compete on the services they offer over those lines. Technology enabled the resource that produced the natural monopoly (the telephone network) to be detached from the goods it enables. There is no sense in having competitors try to build new electric grids our telephone networks. But by forcing the owners of these networks to deliver many suppliersÂ’ products, we can free consumers from monopoly prices. Again, KuttnerÂ’s case against deregulation ends up being against thoughtless deregulation.
Kuttner fails to address what reasons people might have for favoring electrical deregulation. (In fairness, he was writing a 600-word editorial, and I have the luxury of a 2,000-word response. I would like to know more about his thoughts, and may purchase his book.) As usual, the proponents of deregulation do a poor job of articulating its benefits. In a regulated monopoly, all decisions about what capabilities and technologies to invest in are made by the monopolist and its governmental regulators, and the costs of these decisions are born by consumers. This combined entity has little or no incentive to invest in new technologies which promise to lower the cost (direct and social) or improve the quality of electricity production. The monopoly has a great deal invested in the status quo, and its regulator is usually subject to lobbying to protect existing businesses. Because the costs of these decisions are born by risk-averse consumers, both sides have little incentive to take any chances. And most importantly, because the monopolist has a captive market, fairly inelastic demand, and a guaranteed return on their investments, they have no reason to invest in any technology which reduces their costs.
A couple of decades ago this was an unfortunate situation, but one that was bearable and difficult to correct. Three things have changed since then. First of all, our consumption of power has continued to increase. Not only do consumers use more power, but electric power is an important input to all of the goods and services the US produces, so the cost of power directly affects the health of the economy and our economic competitiveness more than ever. Secondly, improvements in information technology have made it viable to have markets in goods as ephemeral as electrical power. Third, a variety of new power-generation technologies, both progressive and disruptive, have become available. Even without the perverse incentives present here, the decision of which new resources are worth investing capital in is the sort that beauracracies are famously bad at and that markets seem uniquely good at. Consider KuttnerÂ’s sentimental recollection of regulation:
In addition, in the old days of regulation, a utility like Con Ed would be required to regularly submit a resource plan to a state’s public service commission. The two organizations would forecast demand and decide how much money should be invested in power plants and transmission lines. Rates would be adjusted to cover costs. Under deregulation, however, nobody plays that crucial planning role.
Exactly. No one makes all the choices. And, as a Scott pointed out two-hundred years ago, that is the only way good choices get made.