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Recognizing Limits of Markets, Rediscovering Public Interest in Utilities

This is a preprint of chapter in

NATURAL GAS AND ELECTRIC POWER INDUSTRY ANALYSIS (2003)

Robert E. Willett, Ed.

© Financial Communications Company, Houston, (financialcomms.com)series can be ordered through 1800 BOOKLOG.

Chapter 21

Recognizing Limits of Markets, Rediscovering Public Interest in Utilities

Mark Cooper

A

s evidence of manipulation and cheating in the West Coast electricity market mounted higher and higher in the winter of 2001–02, advocates of deregulation dismissedit as a bunch of crooks who had taken advantage of not-so-bright, tree hugging policy makers who did not really believe in the market.[1] With the spread of accounting and management scandals beyond the electricity industry and beyond the issue of commodity trading, which is notoriously raucous, to a wide range of business practices, they continue to labor to define the problem narrowly.[2] Confining the problem to the level of individuals allows deregulation advocates to offer solutions that focus on catching and dissuading criminals, rather than considering major institutional reforms.[3] Nevertheless, in the past year the failure of restructured energy markets has caused a growing number of analysts and public policy officials to question whether the electricity market can be organized on the basis of pure market transactions.[4]

This paper shows that lawlessness driven by a short-term mentality is symptomatic of a deeper problem and the struggles of electricity restructuring have a much larger message. In the last two decades of the Twentieth Century, policy makers forgot that the public good is more than the sum of private interests, destroying the special balance that U.S. capitalism had struck between private incentives and public responsibilities. The crisis came first and worst in the competitive electricity and telecommunications sectors because these utilities require long-term perspective and public obligations that are not well suited to the “one-size-fits-none” deregulation that was imposed on them.[5]

Five Public Values that Affect
the Electricity Industry

The institutions under which goods and services are delivered should reflect an empirical assessment of their fundamental economic conditions and a real-world understanding of their social and political significance. Because public policy had recognized that the electricity industry is “affected with the public interest” almost from its inception a century ago, the United States developed a uniquely pragmatic approach that blended private and public interests.[6]

Public Infrastructure

Communications, transportation, and transmission facilities, available to all on a nondiscriminatory basis, support highly complex and interconnected activities of our postindustrial economy.[7] Adequate and open infrastructure creates great fluidity and opportunities (positive externalities) in an information-based economy that individuals and businesses cannot capture directly through private actions. Economists fret about a free-rider problem when people use a network without accounting for every jot and twiddle of costs, but it is just as likely that the network can be creating shared user-benefits.

Electricity facilities are quintessential infrastructure. Capital-intensive assets are long-lived, sunk, and inflexible parts of an integrated network. Their value is to the network as a whole and not easily allocated. Long-term, public commitments are needed to support these infrastructure projects but that perspective is not promoted by the commodity-market mentality.

The challenge of meeting peak load demand and the externality nature of reliability render peaking facilities—power generating facilities that are able to quickly start and stop in order to meet short-term increases in demand—are extremely important, but financially risky in a market environment.

Public Resources

Certain resources, like pastures, fisheries, the air and airwaves (the radio spectrum) occur “freely” in nature. These generally need to be “managed” to preserve their value, prevent overuse, and for other considerations. While they can be enclosed or privatized, sharing common resources may be more equitable and efficient from a societal point of view.[8]

Environmental impacts, including pollution, carbon emissions, and nuclear waste and vulnerabilities, are a major concern in the electricity industry, and they deeply affect the deployment of its facilities and operations. The industry consumes large quantities of water and emits large quantities of pollutants. It is difficult to attribute a value or cost to these factors and incorporate that figure into the cost of a particular transaction. The market for pollution cleanup is established by a fundamentally nonmarket transaction, a political decision about what is or is not a pollutant and how much should be tolerated in public space. These environmental concerns result from fundamental decisions by society about how it values the environment and place significant constraints on the deployment and operation of facilities. They are noneconomic constraints on its operation.

Public resources are deeply embedded in the electricity industry in additional ways. As a wires industry, use of public rights-of-way is at the core of transmission and distribution. With the grid moving close to capacity, transmission has become a fundamental constraint in the industry and it captures the direct and indirect ways in which the industry burdens public resources.

Public Participation and Cooperation

In the past half-century, U.S. capitalism has drawn U.S. citizens into deeper participation in the economic system by spreading the base of private ownership of publicly traded corporations. Spreading corporate ownership makes large amounts of capital available for investment. As modern enterprises become larger and larger due to economies of scale and scope, raising this capital becomes critical.

Perhaps even more importantly, this spread of ownership creates a personal commitment of employees to their enterprises. This is a critical ingredient for economic success in the information age, where human capital is the most important factor of production. Having created a variety of investment vehicles for average people, we have allowed them to be abused by management that treats corporations as private preserves, rather than publicly traded companies. The resulting withdrawal of commitment makes financing more difficult, but capital markets will eventually adjust. However, recapturing intellectual commitments may prove to be more complex.

Because of the nature of the electricity industry, the cooperation of all entities participating in the industry is critical to its smooth operation. The competitive ethic that pervades markets frustrates the achievement of the necessary cooperation, increases costscosts, and weakens the base for coordination and integration of supply and demand.

Public Responsibility

While there is a growing distrust of management and the harm it has caused to employees, stockholders and the public, policy makers in Washington hesitate to impose obligations that would make corporate management accountable to the public. Accountability is only part of the problem. Responsibility is even more important. The financial darlings of the dot.com nineties (stock options and IPOs) were quintessential schemes to take the public’s money and run. Once CEOs and entrepreneurs cashed in, responsibility for the continuing viability of the enterprise was weakened.[9] It is hard to convince the public to invest in companies for the long term when management is not. Public officials fueled this attitude with their resistance to vigorous oversight of abusive practices. A remarkable unwillingness to infringe on management prerogatives created a public perception of indifference.

Public responsibility has a uniquely powerful expression in the electric utility industry. For all the focus on market efficiency, the ultimate test of electricity service is keeping the lights on. Some load-serving entities still have the obligation to ensure that they do so. However, in a deregulated market for supply, there are adverse consequences of this obligation. It is difficult for utilities to exercise restraint as supplies become tight. Merchants can withhold supply and “only” suffer a financial loss; utilities cannot let the lights go out.

Public Information and Knowledge[10]

Thomas Jefferson wrote in 1813, “Ideas should freely spread from one to another over the globe, for the moral and mutual instruction of man, and improvement of his condition.” Today ideas circulate effortlessly on the Internet, providing fuel for experimentation and creative thinking from unexpected and nontraditional sources. Pressures to patent and copyright everything for what is an eternity in cyberspace build controls into hardware in order that the equipment dictates how information can be used or lock information behind walls of commercial secrecy, threaten to destroy the transparency of markets and our open economy. This drains away resources from the next generation of inventions, creating a fear of infringement claims that chills creative endeavors, and forecloses consumers as a source of innovation.

One of the most important requirements for coping with electricity markets would be good information. Unfortunately, such information was not available. There is simply no centralized, reliable source of information. Information is much more difficult to gather for system aggregators. Moreover, the brokers who were the sources of information may well have had interests that would be served by skewing information in one direction or another.

Pragmatic Approaches Centered
on Core Public Values

Public policy recognized that electricity is deeply affected with the public interest. However, unlike most other capitalist countries where state monopolies provided these services, we relied primarily on private capital that was subject to direct oversight by state utility commissions. Utilities were granted franchises to serve in specific areas, which allowed them to finance projects with a low-cost, long-term mix of debt and equity. In exchange, they shouldered public responsibilities like the obligation to serve all comers on demand, a commitment to “keep the lights” on by building capacity, and a duty to interconnect on “just, reasonable and nondiscriminatory rates, terms and conditions.”

“Public ownership” was used to meet specific needs in parts of the country where private capital would not go and to provide a benchmark comparison between service areas. It was kept close to the people through municipal or direct consumer ownership, which prevented the growth of entrenched national bureaucracies. These segments of the industry, which avoided being swept up in the deregulation frenzy, have fared much better than the rest of the industry.[11]

This pragmatic, diverse approach to electricity service exhibited inefficiencies, but the balance between public and private was critical to ubiquitous, affordable, and reliable service. The result was the best utility sector in human history.

While economic theory could find ways to make these utilities better, economic reality proves that the core characteristics are too powerful and important to fool with. Deregulation did just that, imposing market transactions and encouraging competition where vertical integration and cooperation are critically important. Policy makers tried to force people to shop in the market for innovative utility products, when reliable service was all they wanted and really needed. “Deintegration” quickly turned into disintegration because capital and commodity markets would not support the public functions served by these industries.

In fact, consumers raised many questions about restructuring before it was undertaken,[12] and have charted its failures throughout the process.[13] This does not mean that efficiency could not be improved in the industry with reliance on greater incentives and competition in certain activities. For example, incentives to increase demand responsiveness can reduce peak requirements and lower costs. Competitive bidding for construction of power plants is a promising way to discipline cost overruns. However, these market-based principles need to be applied within an institutional framework that recognizes the structural limitations for reliance on markets created by the fundamental economic characteristics of the industry. The core of the industry requires that it be operated in the public interest.

This complex reality poses a problem for policy makers who are confronted with a political process that demands simplicity and is driven by ideological extremes. The lessons of deregulation in other industries with very different characteristics were misapplied to the electricity industry in the 1990s. The analogies simply do not fit. In July 1998, as the deregulation experiments were swinging into full gear, we called attention to this dilemma and cautioned policy makers against misapplying experiences across industries that were dissimilar. The warning bears repeating.

At one end of the spectrum, advocates of deregulation refuse to accept the fact that problems do arise, for fear that such an admission will be used to convince policy makers that reregulation should be tried. At the other end of the spectrum, the advocates of regulation refuse to acknowledge that efficiency improvements flow from deregulation, for fear that such an admission will be used to prevent policy makers from addressing the specific problems that arise.

The purpose of this paper is to make the point, with reference to the actual experience and rigorous analysis of the electric utility and other industries, that the reality tends to lay between the two extremes. Recognizing this before the fact of deregulation should enable policy makers to craft policies that capture the positives of competitive restructuring, while minimizing the negatives.

Compared to other industries, the prospect of electric utility restructuring is probably more complex and more problematic from the residential rate-payer point of view on several counts.

  • Elasticities of demand are lower, conveying greater market power to suppliers and a greater ability to price discriminate.
  • Transmission constraints may create severe bottlenecks (known as load pockets).
  • Distribution is an even more entrenched bottleneck than telephone wires or airport slots and gates thus the residual monopoly status of distribution creates severe problems of nondiscriminatory access to bottleneck facilities for potential entrants.
  • The electric industry is already characterized by increased concentration of ownership.
  • The incumbent electric utilities are vertically integrated (owning distribution, transmission, and generation) which is akin to cable operators controlling both programming and distribution systems.

Restructuring that cannot ensure competition can unleash market power that is disciplined by neither regulation nor competition. Thus, the actual problems experienced in other industries may be magnified in the electric utility industry. Moreover, the industry is much larger than any that has been restructured and much more central to economic activity and daily life. The fact that potential problems are at least as large as potential benefits only underscores the importance of requiring public policy to specifically address these problems and prevent them from afflicting residential rate-payers.[14]

The warning was not heeded and the mistakes have cost consumers and the industry tens, if not hundreds, of billions of dollars.[15] It is time to rebuild these utility industries for the Twenty-First Century on the basis of the public interest principles that served the nation so well in the Twentieth Century.

The Incredible Shrinking Benefits of Restructuring and Deregulation

The abuse in the economic marketplace has been equaled or exceeded by the abuse in the public policy arena. When the debate over restructuring of electric utilities began, proponents made a number of claims predicting that restructuring and deregulation of the retail electric market would bring both price and service benefits to consumers.[16] Projected price reductions were placed in the range of 40 percent. Without close scrutiny, these claims gained considerable prominence. As the debate has unfolded, however, it has become clear that the initial claims and promises are likely to far exceed the reality.[17] It is now clear that early analyses, which claimed so much benefit for consumers, had little basis in reality because:

  • They were primarily theoretical discussions of the benefits of competition without thorough analysis of the economics of the electric utility industry.;
  • Their projections were based on unrealistic assumptions about economic and political behavior; and.
  • The analogies that they drew between electricity and other industries ignored the fate of captive customers.

Once public scrutiny was brought to bear on these unsubstantiated claims, official estimates became much more subdued (see Table 21.1). In the late 1990s the Energy Information Administration (EIA) estimated short-term price declines in a competitive electric market in the range of 6 to 13 percent, before stranded cost recovery is added back in. EIA did not believe that even a 20 percent reduction was sustainable.[18] Not only did these estimates exclude stranded costs, but they also did not allow for transaction costs, cost shifting, or the exercise of market power. The EIA also recognized that the actual price declines would vary by region.