Disappointing Results from Deregulation

The deregulation of electricity generation has been problematic:

Competitive Era Fails to Shrink Electric Bills, by David Cay Johnston, NY Times: A decade after competition was introduced in their industries, long-distance phone rates had fallen by half, air fares by more than a fourth and trucking rates by a fourth. But a decade after the federal government opened the business of generating electricity to competition, the market has produced no such decline. Instead, more rate increase requests are pending now than ever before...

The disappointing results stem in good part from the fact that a genuinely competitive market for electricity production has not developed. ... The Federal Energy Regulatory Commission and five other agencies, in the draft of the report to Congress, are unable to specify any overall savings. “It has been difficult,” the report states, “to determine whether retail prices” in the states that opened to competition “are higher or lower than they otherwise would have been” under the old system. ...

Under the old system, regulated utilities generated electricity and distributed it to customers. Under the new system, many regulated utilities only deliver power, which they buy from competing producers whose prices are not regulated. For example, Consolidated Edison, which serves the New York City area, once produced almost all the power it delivered; now it must buy virtually all its electricity from companies that bought its power plants and from other independent generators. The goal is for producers to compete to offer electricity at the lowest price, savings customers money.

Independent power producers, free-market economists and the Clinton Administration cheered in 1996 when the federal government allowed states to adopt the new system. ... But ... A truly competitive market has never developed, and, in most areas, the number of power producers is small. ...

[C]ritics say that, as in California five years ago in a scandal that enveloped Enron, the auction system can be manipulated to drive up prices, with the increases passed on to customers. What is more, companies that produce electricity can withhold it or limit production even when demand is at its highest, lifting prices. This happened in California, and the federal commission has found that it occurred in a few more instances since then. Critics say that more subtle techniques to reduce the supply of power are common ...

Richard Blumenthal, the Connecticut attorney general, said the supposedly competitive market has been “a complete failure and colossal waste of time and money.” He asked the federal commission to revoke competitive pricing in his state, but the commission dismissed the complaint last Wednesday, saying the state had not proved its case.

Advocates of moving to the new system say that, in time, the discipline of the competitive market will mean the best possible prices for customers. Alfred E. Kahn, the Cornell University economist who led the fight to deregulate airlines and who, as New York’s chief utility regulator in the 1970’s, nudged electric utilities toward the new system, said that he was not troubled by the uneven results so far.

“Change,” Professor Kahn said, “is always messy.” ...

Stubborn adherence to a policy that isn't working can be even messier. Free, unregulated markets are best when it results in an efficient outcome, but the necessary conditions for competition are not met in these markets and oversight is needed to prevent and penalize price manipulation.

Comments

[DRR]

These guys just seem to think that all you have to do is untie the regulation knot and presto! the market will carry us to utopia. They think the absence of a market is but only due to regulation preventing it from flourishing, ignorant that even under deregulation there is no guarantee of a functioning market. The market will either act perversely or not at all. Deregulation & privatization, wherein efficiency & growth can be gained is just fine. Deregulation & privatization always, at all costs, in everything, no matter how unpractical or unlikely it is to yield the results the charlatans claim it will is perverse.

[Laurent GUERBY]

You'll find an analysis on the "free energy market" push in Europe on the European Tribune site, PDFs:

http://www.eurotrib.com/site-files/Open_Letter_EuroTrib_en.pdf

http://www.eurotrib.com/site-files/060927_GP_Energy_Consultation_ET_final.pdf

Discussions

http://www.eurotrib.com/

For example EDF, Gazprom and the FT:

http://www.eurotrib.com/story/2006/7/24/54617/7727

[anne]

Laurent, can you reference any other easier to use European articles on the efficacy of free energy markets?

[lonesome moderate]

Even the Cato Institute has essentially concluded that effective deregulation of electricity is impossible and a return to the old system is the best that can be hoped for right now: http://www.cato.org/pubs/pas/pa530.pdf.

[lonesome moderate]

Doesn't every successful free market model for electricity depend on a robust network of "backbone" power lines for routing power back and forth between markets. And aren't these kinds of super high-voltage lines dangerous? I sure wouldn't want one near my own house.

[true dough]

This happened to Ontario and Alberta, too. But can a case be made for pre-deregulatory transition mechanisms?

“To save political reputations, a pre-deregulatory transition period may allow new unregulated, small-site power producers to supply a variety of local markets. Unregulated CHP power stations, serving industrial and commercial customers in industrial areas, would allow new players to increase the power supply. Such power stations could also serve new rental residential developments and new housing subdivisions. Homeowners generating power need to be free to connect power lines across residential property lines, to supply power to their neighbours. Large number of unregulated, competitively-priced, small-site power producers entering the market prior to total market deregulation, could sufficiently increase the supply of electricity so as to moderate post-deregulatory power price upheavals.”

“Ontario has recently shown that cancelling electric power deregulation will still involve power price increases, possible future power shortages and a potential loss of future economic development. Unless a sensible transition is made into a regulation-free electric power regime, Alberta, Saskatchewan, New Brunswick, Nova Scotia and Ontario will likely experience drastic future power shortages.”

That's from: http://www.quebecoislibre.org/04/040117-7.htm

[Bruce Webb]

Utility managers have a fiduciary responsibility to stockholders. Fine, that is capitalism. In a regulated utility environment you maximize return by increasing efficiency, your price per unit is fixed, and you make your money by reducing your unit cost. In a deregulated utility environment you maximize return by getting your price per unit as high as you can without serious offsets in demand. And given that the demand for water or electricity is not totally elastic, that generally you only have one supplier, and relatively few opportunities for substitution the result is going to be higher prices. Otherwise the managers are not doing their job.

During the electricity crisis Public Utility customers did not experience as serious of rate hikes. Both LA and San Francisco have their own public utility companies. As such they had a fiduciary responsibility to their stockholders, which in this case was the public. Keeping rates down was in this case their job.

To believe that deregulation of electricity would simply result in lower prices to consumers is to ignore fiduciarity altogether.

I now work in real estate in acquisitions. My niche is to identify properties that have locked up values that may be invisible to the current owner. Do I have a responsibility to tell that owner that after an inspection of public records I have determined he has a property right he is not exploiting at its highest and best use? No, and it wouldn't matter if the owner was named Grandma Millie. Do I have the right to lie to Grandma Millie or to coerce her into selling? No, that would be fraud or extortion. Those Enron traders simply stepped over the line from maximizing return to criminal fraud, but anyone who doesn't understand that an energy trader's job or any agent to any principal's responsibiliy is to maximize returns within the scope of the law kind of failed Capitalism 1.

[anne]

True:

"Homeowners generating power need to be free to connect power lines across residential property lines, to supply power to their neighbours."

Thank you for the article, for surely this sentence is dark comedy. Like the idea in a former Great Leap Forward of backyard steel production. Imagine me connecting power lines from my home generating station to my neighbors. This is really nuttiness.

[true dough]

Anne, excuse me. I somehow overlooked that very odd line.
Still, I'm interested in exploring the idea that there could be a case made for a well-designed transition into deregulation.

[dWj]

What was called deregulation in Pennsylvania worked much better than what was called deregulation in California -- and they were quite different things. (In fact, the Pennsylvania variant was more thorough than the California variant, in which the biggest problems seem to have originated at those junctures between parts of the market that were relatively deregulated and those that weren't.) It has even been suggested that Pennsylvania served as a bulwark in the blackout of 2003, preventing it from spreading south, because of some of the changes made when Pennsylvania deregulated.

There is a natural monopoly in electricity distribution, and there will thus necessarily be a place in designing sensible market rules, even where these should be as free as possible.

[anne]

True, thank you for the article and I agree that preparation for and supervision of deregulation may be significant factors but deregulating necessary infrastructure is at the least tricky. And, given my sense of humor, the thought of me power wiring the neighborhood was too much to resist.

[Bruce Wilder]

I live California, and followed the electricity deregulation debacle closely. I live in Los Angeles, and am served by the municipal Department of Water and Power, which has highly efficient power generation of its own, and actually profited from that disaster. The failure of politics and the news media to respond intelligently distresses me to this day. The fact that Republicans cynically transferred billions from Democratic California to Republican Texas, and all the while pundits confidently opined that the crisis was a product of under-building of power capacity due to environmental concerns, with the final result that a hapless Democratic governor was replaced by the Arnold, has been a major contributor to my expectation that the Democrats will be manipulated into accepting blame for all the consequences of Bush's insane policies during their brief sojurn in partial power, beginning in a few weeks. (And, my paranoia was not aided by the fact that Arnold immediately replaced the elected Secretary of State with a Republican devotee of Diebold; did anyone notice that practically the only race still being funded by national Republicans in Ohio is Secretary of State? -- grab a clue people)

There are all sorts of issues involved in the insanity of debates over California power regulation and the quite successful campaign of the power generators to realize favorable rates, as well as the Bush Administration's kleptocratic complicity in market manipulation transferring billions to Bush's supporters. The abject failure of the pundits bugs me, of course, as does the insistence of ideologues on their stupidity.

The positions taken by policy brothels like Cato, the Hoover Institution, or AEI, let alone the fax mills like Heritage really do not surprise me. You get what you pay for, after all.

This being an economics blog, though, I would like to complain about the underlying quality of economic analysis.

I find myself disgusted by the whole history of "economic analysis", which accompanied the policy of deregulation. In no case that I know of, was deregulation guided on any level by an economic analysis, which deserved better than a "B" in an intermediate college economics course.

The Chicago School laid down the intellectual foundation for deregulation, beginning, I believe, with some classic papers by George Stigler circa 1971, followed by stuff from Demsetz, Posner, and on and on. Some of this was of very high quality. Demsetz, whose political attitudes place him to the right of Attila the Hun, laid out some of the best arguments for utility regulation ever made.

But, the grip of even these (relative) intellectual giants on reality was slippery. Idealism was the guiding light, and the ideals were the classic price theory models of monopoly and perfect competition. Modeling an actual situation was never allowed to interfere with or contradict the basic "results" derived from those idealized types.

Most importantly, though critical issues relating to rents (including quasi-rents) and increasing returns due to economies of scale could not be ignored entirely, and are acknowledged, but, over and over again, the implications are minimized, swept under a rug, or skirted.

(Since international trade is so often a topic here, I cannot help but notice the parallels. In international trade theory no matter how many times Heckscher-Ohlin models explaining trade in terms of factor proportions in good Ricardian fashion, are shown to fail, no feedback from those failures are ever allowed to touch the theory. Ricardian comparative advantage is absolute truth, even when grudging acknowledgment of "exceptions" derived from increasing returns or external economies of co-location or the like are made.)

Alfred Kahn, of course, is no Stigler, and he was tackling the airlines and regulation under the Civil Aeronautics Board, which was surely a rich target for ridicule. But, ridicule is no substitute for sound economic analysis in support of sensible policy-making.

The basic economics of running an airline do not fit well with the basic assumptions of either monopoly or perfect competition. Unrealized economies of scale in the choice of planes exist across most of the spectrum of routes, which implies, according to orthodox price theory, that there can be no market equilibrium; a profit-maximizing airline in a competitive market without some significant cost advantage, will tend to make choices, which will result in chronic financial loss. This is not exactly rocket science; it is economic reality. I have had occasion to question a few of the economists and lawyers involved in airline regulation before and after "deregulation" and, mostly, I have found them unfamiliar with even this most basic analysis, and even those, who would acknowledge it, dismissed it out of hand. Dismissal I understand, as there is no advantage to the individual in actual policymaking of embracing a theoretical analysis without a compelling narrative; much of policy debate is an exchange between the willfully blind and the willfully deaf, in the best of circumstances; bullies prosper. Where I find fault is the intellectual foundation laid down in the universities, which makes it OK to not know even basic stuff at the outset. (Keynes said something about politicians being the slaves of dead economists, and having seen policymaking up close and personal, I'm not sure that that is a bad thing; but, I do think we need to find a better class of dead economists to be the masters.)

The basic economics of scheduled, small unit transportation is, admittedly, somewhat obscure. Why it doesn't make it into the elementary textbooks is open to debate. I, personally, think case study is essential. But, economics as an academic discipline has never been happy about the prospect of reality impinging on theory. (Lord knows, the great Stigler was a classic example of never wanting facts to soil theory; for that, he would say, you would need a theory of error. Duh.)

I would not think the economics of power generation would be anywhere near as obscure, but I guess it is. Economies of scale in power generation and the economics of managing distribution nets is not that difficult. One thing it shares with airlines is that there is no necessary, determinant equilibrium, or equilibrium unit price equal to unit marginal cost. Equilibrium models of either monopoly or perfect competition do not apply, even as analogies, but that doesn't seem to make even the professionals hesitate to pontificate as if they do.

None of which is to say that the fact that the kleptocrats Bush put in charge of electricity regulation are not in jail, is not more important than what Professor Mancow puts in his textbook. But, somehow, I suspect that the two are related. If the professional standards of academic economists allow the outright theft of billions, without much comment or protest, it becomes a matter of a tree falling in the forest with no one to hear it. It is part of the foundation upon which pundits and policy brothels obscure what has happened.

[anne]

Bruce Wilder:

"I live in California, and followed the electricity deregulation debacle closely. I live in Los Angeles, and am served by the municipal Department of Water and Power, which has highly efficient power generation of its own, and actually profited from that disaster. The failure of politics and the news media to respond intelligently distresses me to this day."

Frank Wolak at Stanford understood at once that the deregulated electricity market was being played in
California, but Paul Krugman seemed to be alone in paying attention to Wolak and writing of the game playing from the beginning. Krugman was ridiculed for dismissing the reality of an energy crisis, only to turn at right since Wolak was right. There was never a doubt in my mind as to what was happening, simply by considering a probability analysis of the day to day energy price swings.

[Laurent GUERBY]

anne, Jerome a Paris is an energy banker. He often posts when idiotic things about energy "liberalization" are said by various serious journals and people. He cross posts at Daily Kos and is part of the "Energize America" movement there.

The PDFs are a good summary. He also writes a "countdown to $100 oil" serie, here is a link:

http://www.eurotrib.com/story/2006/10/5/10389/0607

I'm not sure what kind of articles you want? For a list of articles about energy you can use the following URLs:

http://www.eurotrib.com/search?topic=energy

If you're interested in interview / media material, feel free to contact him directly, his email is given here:

http://www.eurotrib.com/user/Jerome%20a%20Paris

[TDM]

Energy input prices have only been increasing recently so that without deregulation we would be paying even higher electricity prices.

When California deregulated wholesale prices dropped and producers immediately started building new generation capacity. The new supply was not completed before the shortages so we had one year of blackouts. Without deregulation we would have had the same brain-dead regulators and would not have started building new capacity until after the blackouts, and would have had several years of blackouts. Because the regulators keep unreasonably low rates during a shortage, consumers are still paying higher prices to pay for electricity consumed during the shortage. If prices had been raised to reasonable levels during the shortage prices would be much lower today.

[anne]

Ah, thank you, Laurent, I understand. Tomorrow I will go through each of your references, even the PDFs which I always try to avoid for I find them to slow in reading unless I print them. Eurotrib will be useful as I get to know the site.

[Laurent GUERBY]

anne, yes the site can be a bit confusing :). Feel free to post questions or comments on European Tribune.

[Bruce Wilder]

TDM, you are misinformed.

[reason]

Bruce,
I for your comment both fascinating and distressing.

Distressing because I have an economics degree but are not aware of theory proving the tendency of oligopoly combined with increasing returns to result in chronic losses. Do you have a good reference for this? Perhaps the relevant research post-dated my degree? I don't doubt your veracity here by the way.

Interesting because this surely applies to the car industry as well as the cases you cite.

[fiskhus jim]

The essential lie behind "Deregulation" and/or "Privatization" is laid bare, exposed to the withering stare of the exploited. As is the fundamental inability of the GOP to understand Microeconomics.

See, until there is a viable MultiPoint, MultiChannel Distribution System for electric power generation AND provision, the principles of economies of scale still apply. And, in a universe where economies of scale apply, increasing competition actually increases inefficiency and, thereby, the cost to the exploited consumer.

[anne]

Worth careful attention:

http://www.nytimes.com/2005/11/23/business/23place.html?ex=1290402000&en=af94e061d03d0756&ei=5090&partner=rssuserland&emc=rss

November 23, 2005

The Deal That Even Awed Them in Houston
By SIMON ROMERO

HOUSTON - Texas Genco might lack the flash and fame of Enron, but its low-profile owners have managed to accomplish something rare in this swaggering city: a deal so ambitious in its scale that it has caused jaws to drop in Houston's energy circles while angering and perplexing people who are feeling the sting of surging electricity prices.

The buzz in Houston these days is over the $4.9 billion in profit that four elite private equity firms - the Texas Pacific Group, the Blackstone Group, Kohlberg Kravis Roberts and Hellman & Friedman - stand to make from selling an electricity company for $5.8 billion.

Lured by deregulation of the electricity industry in Texas, the investors acquired the electricity company Texas Genco, which owns several power plants in the Houston area, just last year with $900 million in cash. Now, they are selling it to NRG Energy of Princeton, N.J., for a gain of $5 billion, a flip that will be one of the most lucrative private equity investments in recent memory.

"This part of the deregulation process has transferred billions from ratepayers to investors," said Clarence L. Johnson, director of regulatory analysis at the Office of Public Utility Counsel, a state agency in Texas created to represent the interests of homeowners and small businesses on utility issues. "It seems extraordinary, doesn't it?"

The investors profited largely by exploiting an obscure part of electricity deregulation here that pegs electricity prices to the price of natural gas. Because Texas Genco fuels some of its plants with relatively cheap coal and nuclear power, its operations become much more lucrative in times of high natural gas prices, like now. The profit from the deal is about half the $9.9 billion that Exxon Mobil, the nation's largest energy company, with 86,000 employees, made in the most recent quarter. Such an outcome from deregulation, which made it perfectly legal for a handful of investors to reap fortunes from their control of Texas Genco, a little-known electricity company with 1,200 employees, has stunned some people in Houston, which has some of the most expensive electricity prices in the country.

"The entire situation is terrible, but this one chapter is obscene," said Jayne Junkin, an organizer with Houston Acorn, a community group that has criticized the impact of rising electricity prices on low-income families....

[what]

TDM you need to keep informed. The blackouts where becuase Enron was shutting down power to boost profit. There was plenty of power but it just wasn't being used. Go to google and search Enron and read up on Why those blackouts came right after deregulation.

why hasn't anyone talked about what happened to workers in states that deregulated. Since the company now just want to make a profit for share holders they are taking as much away from there workers as possible. Not to mention eleminating jobs and over working the people left behind.