Chapter 1
This is a preprint of chapter in
NATURAL GAS AND ELECTRIC POWER INDUSTRY ANALYSIS (2003)
Robert E. Willett, Ed.
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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 dismissed it 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 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.
In the most recent effort to estimate potential efficiency gains, the projections have shrunk yet again. The FERC’s analysis projects a base case efficiency gain of about 4 percent over almost two years.[19] Once again, transaction costs, market imperfections and market power are not taken into account. Even these small gains have been challenged as being too large.[20] In the United Kingdom, which has over a decade of experience with deregulation, the efficiency gains are 5 percent, and most of those were likely associated with privatization of the national monopoly.[21] Residential consumers did not enjoy any of the benefits of efficiency reductions.
TABLE 21.1: Declining Projections of Efficiency Gains from Restructuring and Deregulation
DATE OF CLAIM PERCENTAGE PRICE
REDUCTION PROJECTED
a/1995 40+
b/1998 6 < 20
c/2002 3-5
a/ See, for example, Maloney, Michael, et al, Customer Choice, Consumer Value: An Analysis of Retail Competition in America’s Electric Industry (Washington: Citizens for a Sound Economy, 1996); Maloney, Michael T., Robert E. McCormick and Robert D. Sauer, and Jerry Ellig, Economic Deregulation and Customer Choice: Lessons for the Electric Utility Industry (Arlington, VA: Center for Market Process, 1999)
b/ EIA, Electricity Prices in a Competitive Environment: Marginal Cost Pricing of Generation Services and Financial Status of Electric Utilities, A Preliminary Analysis Through 2015, (Washington: U.S. Department of Energy, August 1997).
c/ ICF Consulting, Economic Assessment of RTO Policy, Prepared for the Federal Energy Regulatory Commission, February 26, 2002, Tables ES-1, ES-2. Casazza, John, A., “Electricity Choice: Pick Your Poison: A. Errant Economics? B. Lousy Law? C. Market Manipulation? D. All Three?,” Public Utilities Fortnightly, March 1, 2001, identifies efficiency gains in generation of 3 percent. Newbery, David M. And Michael G. Pollitt, “The Restructuring and Privatisation of Britain’s CEBG—Was It Worth It?” The Journal of Industrial Economics 45:3 (1997) pp. 297-298, places pure efficiency gains at the 5 percent level for the United Kingdom.
The bogus claims that were made for restructuring before the experiment was attempted have been matched by equally bogus attempts to claim that the market is working for the benefit of consumers.[22] In virtually every state that has opened its market, competition is almost entirely lacking, especially for residential customers.[23] To the extent that there have been price decreases, they have been ordered by regulators, not created by market forces. Price caps, which advocates of restructuring and deregulation decry, have protected consumers from dramatic price increases in other states.
The political process through which restructuring was adopted in the states and regulatory oversight rendered ineffective at the federal level also call the legitimacy of restructuring into question. We hear a great deal about transparency of prices in electricity markets, but we also need transparency in the policy process. Policy makers need to exercise a great deal more skepticism about the self-interested claims of large corporations, even if they are large home-state entities. Episodes of Enron’s leveraging of the political process from Texas to Pennsylvania[24] to California[25] to Washington, D.C.[26] underscore the need for policy makers to keep their distance.
TABLE 21.1: Declining Projections of Efficiency Gains from Restructuring and Deregulation
DATE OF CLAIM PERCENTAGE PRICE
REDUCTION PROJECTED
a/1995 40+
b/1998 6 < 20
c/2002 3-5
a/ See, for example, Maloney, Michael, et al, Customer Choice, Consumer Value: An Analysis of Retail Competition in America’s Electric Industry (Washington: Citizens for a Sound Economy, 1996); Maloney, Michael T., Robert E. McCormick and Robert D. Sauer, and Jerry Ellig, Economic Deregulation and Customer Choice: Lessons for the Electric Utility Industry (Arlington, VA: Center for Market Process, 1999)
b/ EIA, Electricity Prices in a Competitive Environment: Marginal Cost Pricing of Generation Services and Financial Status of Electric Utilities, A Preliminary Analysis Through 2015, (Washington: U.S. Department of Energy, August 1997).
c/ ICF Consulting, Economic Assessment of RTO Policy, Prepared for the Federal Energy Regulatory Commission, February 26, 2002, Tables ES-1, ES-2. Casazza, John, A., “Electricity Choice: Pick Your Poison: A. Errant Economics? B. Lousy Law? C. Market Manipulation? D. All Three?,” Public Utilities Fortnightly, March 1, 2001, identifies efficiency gains in generation of 3 percent. Newbery, David M. And Michael G. Pollitt, “The Restructuring and Privatisation of Britain’s CEBG—Was It Worth It?” The Journal of Industrial Economics 45:3 (1997) pp. 297-298, places pure efficiency gains at the 5 percent level for the United Kingdom.
There is simply no credible, real-world evidence that the leap to markets in electricity services is good for consumers, even where circumstances are ideal. There is also a very strong probability that further deregulation of electric markets could be very bad for consumers. While deregulation will force consumers to bear the risk of increasing costs, there is little potential gain from the radical restructuring and deregulation of the industry.
Outline of the Paper
This paper presents the analytic framework and empirical evidence that lead us to this conclusion. The next section discusses economic fundamentals and the broad range of experiences with restructuring. Next, the paper discusses the political economy of California’s electricity crisis. Finally, the paper describes the diversity of supply, demand and regulatory circumstances throughout the country.
A Vital, Inherently Volatile Commodity
Advocates of electricity restructuring and deregulation should be truly embarrassed by the very small efficiency gains to be had. How could slovenly monopolists and the cost-based regulation they revile have managed to produce a system that achieves between 95 and 99 percent of the efficiency a market would? The answer is simple: electricity is different. Its economic fundamentals are severe and make for very weak market forces. Its physics are demanding, so that many decision are dictated by engineering and demand coordination and cooperation, which is better supplied in centralized, integrated institutions. In order to make a market, there must be a competitive supply side, demand side and a highway of commerce in between. In electricity, we have none of the above (see Appendix 21.1).
Demand
Electricity is a necessity that has no substitute on the demand side in the short-term. Electricity is like oxygen to the Twenty-First-Century economy and way of life. Denial of access to this service results in deprivation; access based only on price and the ability to pay results in discrimination.
Demand is highly sensitive to weather, which can create severe peaks in demand. Demand is not only driven by weather, it is also geographically focused. Typically, many consumers can be affected by the same factors that increase demand at the same time. This makes the demand on local and regional networks and commodity markets subject to extreme peaks and valleys.
Moreover, for the vast majority of consumers and over the relevant range of economic values, reliability is an externality. This is a network industry in which the fate of each depends upon the actions of all. Individuals cannot create their own reliability or capture its full value in private transactions.[27] Economic and institutional barriers make it difficult for small consumers to freely self-supply or to bargain effectively for supplies. Allocation of costs and benefits in this shared network is a difficult and ultimately arbitrary task.
In sum, the price elasticity of market demand is very low in the short-term and low in the long-term. The demand side cannot be counted on to discipline abusive pricing behavior. Inflexibility of demand and its sensitivity to weather renders the market volatile and vulnerable to abuse.[28]
One of the key factors that drive prices up is the need of utilities to ensure the physical availability of supply. Imposing an obligation on utilities to serve creates an uneven bargaining context. Entities with the obligation to serve are at a disadvantage to those who simply produce or transport electricity. Consumers have generally supported this fundamental principle of utility service because electricity service is just too important to be unreliable.
The best evidence from electricity markets is that the short-run elasticity of demand is considerably less than -.1. In other words, a 10 percent increase in price results in less than a 1 percent decrease in demand. In San Diego, where prices doubled during the summer of 2000, the elasticity of demand was less than .03.[29] A recent study finds that elasticities of demand exhibited in programs targeted at demand reduction are quite low.[30] The model programs achieve elasticities in the range of .03 to .1.[31] Long-run elasticities may be somewhat higher, but they are generally considered to be considerably less than 1.[32]
The low elasticity of demand is now recognized as the most critical factor in rendering the market volatile and vulnerable to abuse. When demand is inelastic, consumers are vulnerable to price increases, because they cannot cut back or find substitutes for their use of the commodity. When the most important market force in disciplining market power, demand elasticity, is as low as observed for electricity, there are many opportunities to exercise market power.
Supply
Electrons are among the most demanding, ornery little beings in nature. They go where they want and if they arrive under the wrong circumstances, they can do serious harm. The physical system demands perfect balance on a real-time basis.
Because of the basic physics of electricity, the production, transportation and distribution networks are extremely demanding, real-time systems. Electricity cannot be stored economically. The system requires perfect integrity and real-time balancing much more than other services and commodity systems do. The infrastructure to produce, transport, and deliver electricity is extremely capital-intensive and inflexible. [33] It takes a long time to build and bring power plants and transmission lines into service, and they last a long time. Thus, the ability to expand supply in the short and medium term is severely limited.[34] This is the critical factor that creates volatility and vulnerability to the abuse of market power on the supply side.[35]
Empirical studies show that strong economies are achieved by coordinating electricity supply and demand.[36] Before restructuring, the electricity industry was a reasonably well-run, complex, integrated network that was under some stress.[37] Creation of markets for electricity services leads to a huge growth in the number of transactions conducted every day and creates heavy administrative requirements. An entity that once maintained real-time balance as an insulated operation that could oversee its own supply, demand, and delivery, must now contract to achieve real-time balance simultaneously in five, six, or seven different markets over broad geographic areas.[38] This has proven a daunting task[39] that consumes substantial resources.[40]
Accidents have a special role in market networks such as these. Because of the demanding physical nature of the network, accidents are prone to happen. Because of the volatile nature of the commodity, accidents tend to be severe. Because of the integrated nature of the network and demanding real-time performance, accidents are highly disruptive and difficult to fix. To keep things in balance, the system needs either plentiful reserves close at hand, ample amounts of transmission capacity readily available to move abundant supplies from far away, or a great deal of load that can be quickly shed. Most electricity markets do not have those luxuries today,[41] or any chance of acquiring them any time soon.
The interstate highway system for the movement of electrons is inadequate and was not designed to handle market transactions. [42] Transmission capacity is constrained and extremely difficult to expand for environmental and social, not economic, reasons.[43] Getting approval to site new transmission lines is extremely difficult because of the negative impact on public spaces and concerns about public health. Similar constraints on the availability of distribution exist.[44] Wires are difficult to repair or replace in response to outages.[45] This places a premium on flexibility of supply and reserve margins, but neither of these is well-accommodated in the industry.[46]
The failure to recognize the important role of the continuing monopoly in transmission resulted in the underregulation of the wires segments of the industry. This is a highway system, not a market. It constitutes an essential, bottleneck facility with virtually no redundancy and is never likely to support head-to-head competition. Proposals to let the marketplace solve the wires problem will not succeed, given the market power that the wire “owner” would possess and the nonmarket barriers to expanding capacity. Profit maximization on the transmission system would only result in the abuse of market power and the creation of artificial scarcity rents. “Getting the prices right” from a monopolist’s point of view for a bottleneck resource like transmission in a critical infrastructure network industry like electricity is not the answer to the problem of maximizing societal welfare.
In sum, the elasticity of supply is low. Short-term supply responses are constrained by the difficulty of storing electricity. Provision for reserve margins is uncertain in a competitive market because the provision of reserves is unattractive to business interests, unless peak prices are extremely high. Consequently, electricity markets free of reserve planning and coordination may be chronically tight or subject to extreme price instability.
The best evidence from California is that the short-run supply elasticity is considerably less than 1. In fact, the supply elasticity is probably less than .2 on the basis of 1999 prices.[47] This is probably a higher price elasticity than observed in 2000–2001, which suggests a supply elasticity considerably less than .1 for the peak of 2000.[48]
Weak Market Forces Make for Bad Markets
The most important market forces are demand and supply elasticities—the ability of consumers to cut back or shift their demand for something and the ability of producers to increase their outputs in response to price increases. If these elasticities are too small, market forces are weak and the exercise of market power becomes more likely. Firms raise prices to increase their profits because they do not lose many sales to competitors, or because consumers lack alternatives. This is the reality of the electricity industry. As a result, deregulation or restructuring turns supply into a strategic variable.[49] Table 21.2 presents the key arguments in terms of the Lerner index..
TABLE 21.2: Transformed Lerner Index Analysis of Market Power
L= (P – C) 1 Sd (1-k)
______ = ___ = ____________________
P E edi + esj (1 – sn )
where:
Sd = the market share of the dominant firm
E = elasticity of demand in the market
edi = elasticity of supply of supply of the firm
esj = elasticity of supply of the competitive fringe
sn = market share of the fringe.
K = strategic interaction term
Sources: Landes, W. M. and R. A. Posner, “Market Power in Antitrust Cases,” Harvard Law Review, 19: 1981; Ordover, J.A. and R. D. Willig, “Herfindahl Concentration, Rivalry, and Mergers,” Harvard Law Review, 95: 1982
The exercise of market power allows suppliers to set prices above their costs and achieve above normal profits. Leading liberal[50] and conservative[51] economists describe this concept in precisely the same terms. Figure 21.1 shows the classic economic depiction of monopoly rents resulting from the exercise of market power.
[pic]
FIGURE 21.1: Landes and Posner Market Power
Landes and Posner present the discussion of market power in terms of the elasticity of demand and supply that is ideally suited for understanding the problem in electricity markets. The intuitive point is straightforward. A firm will raise its price if it does not lose too many sales. The elasticity of demand determines how much business will be lost. Consumers can react to price increases in two ways. They can buy less (the market elasticity of demand) or they can switch to the output of another firm, as long as it can expand its output and does not raise its price (the elasticity of supply of the competitive fringe).
Interestingly, the point of the Landes and Posner article was to argue against the simplistic use of market shares in market power analysis. This has long been a major focal point of debate in the electric utility industry.[52] Two aspects of particular concern to Landes and Posner are also critically important in the electric industry, the elasticities of supply and demand.[53]
Once one brings these elasticities into play in an industry like electricity, the analysis becomes extremely troubling.[54] Landes and Posner point out that when demand elasticities are low, market power becomes a substantial problem. By low they mean close to –1. As noted, the elasticities of supply and demand observed for electricity are extremely low, certainly not more than .1 or .2 in the short term and considerably less than 1 in the long term. In other words, given the weakness of market forces in the industry, a market power problem is inevitable.
The inelasticity of supply gives rise to a second deviation from a typical competitive market, excessive scarcity rents. An economic rent is “a payment to a factor in excess of what is necessary to keep it at its present occupation.”[55] More importantly, “in perfect competition, no rents are made by any factor, because changes in supply bid prices of inputs and labor down to the level just necessary to keep them employed.”[56]
In economic theory, these sources of overcharges could be competed away if supply and demand elasticities are high and electricity markets worked well. In reality, because of the economic characteristics and social impacts of the electricity industry, supply and demand do not respond. The results are elevated prices and a transfer of wealth from consumers to producers that achieves little or no real costs savings or efficiency gains. Excessive scarcity rents accrue where changes in supply are slow or nonexistent,[57] exactly the circumstances that apply to electricity markets. The supply curve is so steep (supply is so inelastic) that the scarcity rents make up the vast majority of the market price, as demand moves toward the peak. (see Figure 21.2, which uses the actual supply curve for Florida). Supply cannot respond to price signals, thus the owners of existing facilities just collect windfall profits.
Scarcity rents also pose a transitional problem in electricity markets. Existing facilities have proven to be far more valuable than their book costs, which are all that can be reflected in regulated rates. If utilities capture those plants at book value, but can price them at market in the future, the cost of electricity increases. The assets that would earn these rents have gained their advantage from historic utility financing. Unless the market windfall is passed back to consumers, electricity prices increase. If they are not passed back to consumers, they can be used by incumbents, as a cross-subsidy, to frustrate competition. Scarcity rents can be eliminated (e.g. taxed away or passed back to consumers) without harming economic efficiency.[58]
Market power is a separate problem (see Figure 21.3). The ability of producers to withhold supply or to hold out for high prices gives them an incentive to drive prices as far above costs as possible, and to keep them there in order to maximize profits. Distinguishing between real and artificial scarcity becomes difficult. The withholding problem was identified early on in the analysis of electricity markets. The markup of price over cost increases in lock step with the reduction of available plant, even in systems with excess capacity.[59]
[pic]
Figure 21.2: Scarcity Rents
[pic]
Figure 21.3: Monopoly Rent on Top of Capacity Rents
Empirical Elements of Classic Rents
Table 21.3 shows the results of a number of analyses of markets. It includes simulations and actual results. The most extensive problem occurred in California, [60] but virtually all markets, even those like PJM and the upper Mid-west that are well endowed with transmission capacity and excess generation, have been beset by the problem.
TABLE 21.3: Market Power Indicator Characteristics (Sources, see list at end of chapter.)
STATE CONCENTRATION ESTIMATED MARK-UP
HHI LEADING LERNER MODEL YEAR
FIRM INDEX
HARE
COLORADO 2813 38 52 DOMINANT 2002
FIRM
WISCONSIN 2761 47 300+ COURNOT 2000
PENNSYLVANIA 2000 20 9 - 19 COURNOT 1995
PJM 1150 16 29 ACTUAL
U. K. 1962 31 21 ACTUAL 1994
FLORIDA 1940 38 80 DOMINANT 1997
FIRM
1000+ CARTEL
CALIFORNIA 1537 10 22-29 COURNOT 1998
30 ACTUAL 2000
NEW ENGLAND 4-11 ACTUAL
(MARKET POWER
CONSTRAINED)
For the first year of the reliance on the spot market in California, the exercise of market power has been estimated to have increased costs by 22 to 30 percent, driving prices up by $400 million to $600 million.[61] From 1998 to the summer of 2000, well over a billion dollars of rents was collected in California.[62] In California in 2000, excessive rents were in the range of 40 to 50 percent.[63] The CAL-ISO analysis shows that by February 2001, the costs of a new plant brought on line in California when the restructured market commenced in May 1998 would have been fully recovered in just three years.[64]
Policy makers are struggling to avoid a similar problem in Montana.[65] As recently as April 2000, Montana was a very low-cost state, with the price of electricity 40 percent below the national average. Its power plants were divested, including very low cost hydro facilities. Industrial customer prices went “to market” very quickly and their rates almost quadrupled, driving the statewide average price above the national average.[66] The legislature made a deal with the merchant generator who bought most of the capacity in the state to keep residential rate increases “down” to only 50 percent when they “go to market.”[67] However, the public utility commission battled to keep prices at just and reasonable levels,[68] and a referendum to reclaim the resources and recapture the scarcity rents for consumers is underway.
The abuse of market power and the impact of tight markets that have been so much in evidence in California are not limited to that market. PJM, the poster child for deregulation, has suffered similarly near-vertical supply and the exercise of market power that parallels the problem in California in its early days.[69] In the PJM pool, the markup in the first year was estimated at 29 percent, increasing prices by $400 to $600 million.[70] In one week in 1998 in the Midwest, $500 million changed hands;[71] $70 million was collected in New York in one day.[72] The New England power pool experienced price run-ups.[73] In the United Kingdom, the markup of price over cost has been sustained at the 25 percent level over a long period of time.[74]
Market Transactions Raise the Cost of Utility Services
There is a third form of rent that restructuring creates, which I call “stupidity rents" (see Figure 21.4). These are rents that arise because reliance on market raises transaction costs.
Figure 21.4: Stupidity Rents
Merchant Generators and Transmission Raising the Cost of Capital
The merchant generators and transmission owners claim that they must be compensated for the risk of development in an uncertain market, but that comes at the price of a much higher capital costs. Under market conditions there is no long-term security of demand, thus merchant generators demand higher rates of return and seek to recover their capital as quickly as possible. The result is to raise capital costs in the near term.
A regulated utility approach to supplying electricity lowers the cost of capital. It lengthens the time horizon for investment, to match the lives of the assets. It brokers the relationship between the supply and demand sides to lower risk.
The implications of the increase in the cost of capital are striking. In analyzing “cost-plus” regulation for peaking facilities, the DOE (U.S. Department of Energy) focused its attention on a financial scenario in which merchant generators insisted on a 16 percent return on investment and a three-year cost recovery period (even though the facilities last twenty or thirty years).[75] In that analysis, a ten-year recovery results in a revenue requirement that is about half as large. The discussion shows clearly that very short cost recovery periods are driving industry behavior in critical areas, like bidding strategies and investment decisions.[76]
As remarkable as this analysis is, in 1998, the merchant generators actually proposed even more extreme analyses in reaction to the price spikes in the Midwest. To defend huge price spikes, Enron sought to justify astronomical prices for power by putting forward an analysis that involved the concept of essentially disposable power plants—capital-intensive facilities with twenty- to thirty-year lives—that were used for a few hours and then abandoned. Enron and other merchant generators argued that it was reasonable to build power plants that would be expected to run just ten hours of their useful life.[77] In order to justify building such a power plant, investors would have to project market prices for those very short periods of $10,000 to $25,000 per megawatt.
Regulated cost of capital results in lower costs for electricity.[78] Although the DOE analysis does not state enough of its assumption to consider the cost structure of a “utility” building peak plant, a financial analysis prepared by the California Energy Commission does.[79] Merchant finance raises the cost of capital by between 25 and 50 percent in these analyses. Merchant finance raises the costs of capital by almost 25 percent in the California Energy Commission view, because of a higher cost of equity. Shortening the cost recovery period, as the DOE does, drives capital costs up by another 20 percent. Reliance on more expensive equity (or more expensive debt) as is likely to be necessary for merchant plants, would drive the cost of capital even higher. Thus, the cost of capital for merchants is likely to be 50 percent higher than utility financed projects.
Contrary to the claims of some,[80] utility finance did not produce inadequate supply. In fact, if anything, the primary complaint against regulation was not that it resulted in too little capacity, but that it resulted in too much.[81] Regulators, who took the job of keeping the lights on very seriously, tended to authorize the building of too much capacity.[82] Primarily concerned with profit and not caring whether the lights go on, merchant generators are likely to build too little and charge much more for what they do build.
Ironically, while restructuring promised to shield consumers from capital cost risk, restructuring has exposed them to a great deal of fuel price risk. Although fuel adjustment clauses had already shifted some of that risk to rate-payers, the restructured energy market has compounded the problem for several reasons. Purchased power, especially in spot markets, has exhibited much greater price volatility than input fuel costs. Utilities have been foreclosed in some cases and been discouraged in others from owning generation assets, which denies them one of the most effective means of mitigating risk: physical hedges.
De-integration Increases Transaction Costs
Reform in the electric utility industry had its roots in the fact that regulators in several states had done very badly in overseeing one type of generation plant (nuclear power). These were the high-cost states that restructured first. In the late 1980s and early 1990s, the response to that problem was to require competitive bidding for new plants and open the wholesale market to competition. Electricity restructuring as practiced in the late 1990s went much farther. Seeking to introduce competition into retail transactions, it threatens the economic fabric of the industry. Not only does retail competition undermine the base for long-term utility financing, but it also weakens the base for coordination and integration of supply and demand.
Contracting to achieve real-time balance simultaneously in five, six, or seven different markets over broad geographic areas has proven a daunting task[83] that consumes substantial resources and may undermine economies of coordination, while it imposes many new administrative and transaction costs to support the new commerce. Prior to the price spikes of 1998, the number of traders increased by over fifty-fold; the quantity traded increased several hundred times.[84] It is clear that the introduction of competition has put a strain on an already stressed asset.[85]
Directly related to these transactions and managerial functions are facilities costs. Demands on network facilities are likely to increase as a result of the wide range of new transactions taking place. The physical facilities to support these transactions will have to be constructed and maintained. An increase in the number of transactions may require costly improvements to the transmission system in order to ensure reliability. The problem is not simply the number of transactions; it is also the nature of interactions. Complications of financial and ownership relationships between entities emerge when they share an integrated system. Changes in behavior reduce the ability of system managers to coordinate and run the transmission system. The problem stems both from complexity and from a lack of cooperation. Market participants do not have an incentive to cooperate. To make matters worse, the interstate highway system for the movement of electrons is inadequate and was not designed to handle these transactions. [86]
It may well be that inefficiencies introduced into what had been a reasonably well-managed network have increased costs by over 10 percent. In 1998, just as restructuring was being implemented in California, two consumer groups argued that based on econometric studies of the economies of integration, restructuring could raise prices by 12 to 22 percent.[87] A recent estimate has placed the increase in transaction and capital costs at 15 percent.[88]
Inadequate Reserves
The experience with restructuring underscores the need for large reserve margins. Operational reserves that have been required in this very demanding real-time system to simply to keep the lights on are not sufficient to also prevent the abuse of market power.[89] Additional reserves are needed. Merchant generators are primarily concerned with profit and do not care whether the lights go on. As if to prove the point, the merchant sector has collapsed and projects are being cancelled at a furious pace because of a perceived glut.[90] Some see a brutal “boom and bust” cycle developing.[91]
Operational reserves that have been required to simply keep the lights on in a vertically integrated, regulated sector are not sufficient to also prevent the abuse of market power.[92] Without much larger reserves, suppliers simply will not face sufficient uncertainty about their plants being called upon to run.[93] The problem is acute in electricity supply markets where participants enter repeatedly into auctions with multiple units and can easily game the bidding process.[94] Deregulated markets require much larger reserves to prevent manipulation,[95] but reserves cost money, especially at the merchant’s required rates of return.
The abuse of market power in the United Kingdom was taking place with reserve margins of over 20 percent.[96] Simulations based on U.S. cost and demand data, for systems with 20 percent excess capacity, lead to a similar conclusion.[97] In analyzing the California market, even at moderate levels of demand, a substantial market power threat exists.[98] These results demonstrate the need for substantial reserve capacity to prevent the abuse of market power.[99] In Australia, where market power problems did not occur early in the process, the primary reason appears to have been the existence of excess capacity of 40 percent.[100]
The problem is acute in electricity markets where participants enter repeatedly into auctions with multiple units and can easily game the bidding process. Without these much larger reserves, suppliers simply will not face sufficient uncertainty about their plants being called upon to run. The empirical evidence on the United Kingdom and California leads to the conclusion that the one-price spot auction is particularly vulnerable to the abuse of market power and that having numerous bidders is not enough to solve the problem. Demand must also be uncertain.[101]
CALIFORNIA’S WILD ride
No discussion of electricity restructuring would be complete without a short foray into California. California was a perfect storm of greed, irresponsibility and mismanagement in a volatile market for a vulnerable commodity. The result was a volatile run-up in prices[102] and a massive, inefficient, and unjustified transfer of wealth from consumers to producers.[103]
Racing To Disaster
As the crisis in California has unfolded and detailed analysis comes available, it becomes more and more evident that residential rate-payers have good reason to be mad as hell and every right to declare they will not take it any more. They have been the victims of greed exploiting a vulnerable market.
The fact that not much capacity was added in California is well known, but substantially over-stated compared to the rest of the nation.[104] Tight supply-demand developments in California are not that different from the rest of the country.[105] What receive less attention are all the other things that did or did not happen in California to make the market tight. Here I do not mean the hot weather and lack of rain, about which we hear so much. Responsible public policy cannot allow the health and welfare of its citizens to rely on the luck of weather. What I mean are the things that market participants did and policy makers let them do to protect their private interests at the expense of the public interest.[106]
Greed
Not only did utilities refuse to build power plants, they also actively prevented as much as 4,000 megawatts of long-term resources from entering the system and failed to provide an equal amount of short-term resources.[107] Utilities cut back on their spending on conservation, which led to a shortfall in demand reduction of a couple of thousand megawatts. In defense of the utilities assets distribution, the utilities also fought steadfastly against distributed generation, which could be bringing substantial capacity on line, in addition to relieving demands on transmission assets.[108] Citing the impending competitive market, utilities refused to buy about a thousand megawatts of renewable energy that they were supposed to. They failed to produce spot and interruptible contracts for large quantities of additional capacity to which they were committed.[109] When they were given the opportunity to enter into long-term contracts, they failed to fully avail themselves of the hedging opportunities to mitigate the exposure to price run-ups.[110]
The independent power producers also did not build any power plants. Instead, they bought the existing ones. They immediately began running plants less than the previous owners had.[111] In fact, producers do not even have an interest in delivering existing capacity.[112] On any given day during the recent price spikes these plants were producing between 2,000 and 6,000 megawatts less than their historic average.[113] The same independent generators also opposed long-term contracts, which would have kept utilities out of the volatile spot market.[114]
The events in California have popularized a whole new vocabulary of market abuses including “hockey stick bidding,”[115] “megawatt laundering,”[116] and wash-trades,[117] not to mention Enron’s colorful code words [See Santa’s chapter for a list, which FERC used on a hunt for further malfeasants—Ed.].[118] The analysis of bidding behavior outside of California indicates that these and other problems are not unique to that market.[119] The problem of manipulation of bidding is not one that is likely to just go away; nor is it limited to conditions where markets are extremely tight.[120]
Having learned how to manipulate the market, the primary interest of producers is to keep the market tight.[121] Exorbitant prices do not elicit efficient supply responses in such a market. They reward and create an incentive for more effective gaming.[122] To state the concept in layman’s terms, you make so much money by running the price up that you are made much better off by cutting back production than by increasing output, which would lower the price. You can only get away with this when demand is inelastic (because that creates huge economic rents) and the supply beyond your control cannot be easily expanded in the short-term (because competition would dissipate the rents).[123]
This is the greed part of the story.
Regulatory Irresponsibility That Harms The Public
For its part the Federal Energy Regulatory Commission (FERC) prematurely deregulated price over the objection of many in California. In fact, FERC fought California authorities to assert control over the Independent System Operator (ISO) and then deregulated the price of energy in the California wholesale market, even though its market analysis was fundamentally flawed. This enabled private interests to take advantage of the bad situation that they had helped to create.
FERC failed to reasonably analyze the market before it deregulated. It treated the state as one big market, when it is evident that there are distinct and separate north-south markets because of a capacity constraint.[124] It failed to identify load pockets that would be constrained at peak times.[125] It deregulated ancillary services, even though it was told market power existed in these markets.[126] It accepted on faith that “must-run” plants would mitigate market power, without any concrete plan to do thus.[127]
Generally, FERC has rubber stamped industry rules on transmission capacity availability and transmission load relief that simply cannot ensure open transmission networks or prevent manipulation of transmission capacity availability.[128] It has wasted years on voluntary approaches to forming independent, responsible transmission organizations that must be a cornerstone of the interstate market.[129]
The FERC has also pursued a remarkably permissive merger policy.[130] As a result, national and regional markets have become much more concentrated.[131]
FERC refuses to responsibly police the markets it has irresponsibly deregulated.[132] It has defended the secrecy of spot-market bidding, which appears to have the effect of allowing tight oligopolies of bidders to play their games behind closed doors.[133] It refused to requisition and study bidding records for abusive patterns after the first price spikes in 1998,[134] and the second price spikes in 1999,[135] which emboldened strategic bidders for the really big killing of 2000.
FERC approves rates without subjecting them to refund, in order that market manipulators know they will never have to disgorge their ill-gotten gains.[136] It even rushed in to allow a hasty reorganization of one of the California utilities to shield its assets from its creditors.[137] As the only dissenting commissioner put it, if the FERC had exercised more responsibility earlier, “capping spot market prices at variable operating costs plus a capacity adder… there is reason to believe that applicants would not be in such dire straits now.”[138]
This is the irresponsibility part of the story.
Regulatory Mismanagement Makes Matters Worse
Things would have been bad no matter what the California market institutions looked like, but the institutions certainly did not help matters and made them worse in a number of ways.[139] The ISO (California Independent System Operator) adopted a one-price auction,[140] which pays the highest price to everyone in an industry that is just dripping with scarcity rents.[141] It failed to impose a reserve requirement.[142] Different rules between the PX (California Power Exchange) and the ISO resulted in considerable underscheduling and drove up prices.[143] The CAL-ISO Market Surveillance Committee immediately and repeatedly found market power in its general studies,[144] but the ISO never sought to discipline those responsible.[145]
The CPUC (California Public Utilities Commission) adopted a prohibition on long-term contracts, which forced utilities into spot markets.[146] The ISO suggests that a large part of the responsibility for the failure of the demand side to respond in the short and long term rests with the CPUC and/or the legislature.[147]
To push through restructuring, the legislature bought the utilities off by paying them at least 100 percent of their stranded costs and letting them sell the wrong assets, while it put no restraints on how the gains of asset sales would be disposed of. As a result, the utilities put over $10 billion of net stranded cost,[148] over $10 billion of asset sales and $3 billion of excess deferred taxes in their pockets, which they claim are empty when it comes to spot-market purchases.[149] In total, over $25 billion of capital was transferred to the parent holding companies of the utilities, with no obligation to invest any of it in California electricity markets.
Remarkably, we can find a similar scenario simultaneously unfolding in natural gas, although that is the topic for another paper. The CPUC let the electric utilities out of natural gas storage requirements because they are noncore customers,[150] which is an absurd misdefinition of “core” and “noncore” that exacerbated the problem. [151] Large corporate consumers got out from under their obligations to keep fuel in storage (including electric utilities) and the obligation to have alternative fuel capacity because all these contingencies cost too much in a competitive market. [152] Simultaneously, utilities fought against increasing pipeline capacity into the state. Firm transmission rights and gas brokering functions were transferred to unregulated affiliates, who have every interest in charging the utility sister companies the highest price possible. FERC deregulated a capacity constrained market with storage at unprecedentedly low levels. Then the inevitable accident takes place. Prices go through the roof, abetted by manipulation.
This “perfect storm” quadrupled the average wholesale price of electricity from 1999 to 2000, with expectations that it would double again in 2001.[153] The eye of the storm was the abuse of market power in both the electricity and natural gas markets. The California ISO has documented price gouging (economic withholding) or hoarding (physical withholding) in virtually every hour of every day for almost a year.[154] Well over half of the increase in electricity prices may be attributed to this abuse in both the electricity and natural gas transportation markets.[155]
For a substantial part of the year, the higher prices got, the less supply was offered. In the slack months of winter and spring, prices were as much as ten times the previous year, while as much as one-third of total capacity was unavailable.[156]
Breaking the Market Power of the Merchant-Generators
Just as it took a powerful combination of events to create the storm, it took a combination to break up its eye. The key factor was a combination of good management, responsible exercise of authority, and good luck that undermined the ability of the merchant generators to abuse their market power.
California took the state out of the spot market. In the colorful language that has developed in the electricity literature of spot markets, it drained the (power) pool.[157]
• It signed more long-term contracts than anticipated.[158]
• The state brought other source of electricity on line more quickly than expected including qualifying facilities and generators that had been restricted by environmental constraints.[159] These generally small electricity producers were important because they are likely not as able to game the market, as the large merchant generators tend to.
• The combination of a public-spirited conservation campaign and a recession reduced demand.[160]
With weak demand and a “flood” of supply, the state created demand uncertainty for the merchant-generators. Uncertainty is critically necessary to make bidders behave honestly in these markets, because it undermines the ability of merchant generators to withhold capacity or demand high prices that drives the spot market to higher levels.[161]
The FERC finally accepted some responsibility by sending a signal that there might actually be negative consequences for the abuse of market power. [162]
• It imposed some price controls and opened a serious investigation into past overcharges.
• It created an obligation to sell electricity, shifting the responsibility for offering power into the market onto the generators, and gave the ISO more authority to enforce this obligation.
• It banned the practice of megawatt laundering, which transferred ownership of electricity to out-of-state brokers who would then sell the power back into the state at inflated prices.
• It got serious about tackling the abuse of market power in the natural gas transportation market.[163]
Luck helped too. The weather was cool.
The contract that El Paso Corporation used to control a large part of pipeline capacity coming into the state expired.[164]
Consumers appear to have lost faith in the process and structure of utility markets for good reason. Until utility industry institutions demonstrate that they have wrung the stupidity, excess scarcity, and monopoly rents out of the system, consumers are unwilling to bear the burden of dealing with legitimate scarcity problems and rightly so. Consumers insist that utilities, independent generators, and regulators accept their fair share of the responsibility. Having watched utilities take tens of billions of dollars out of consumer pockets for asset transfers, consumers in California are resisting the demands for another $12 billion to be paid to independent generators in uneconomic spot costs.
What has vanished entirely from the deregulation discussion are all the promises of efficiency gains and consumer savings. Gone are the fanciful claims of 40 percent savings. Instead, consumers in California, who pay among the highest rates in the country,[165] are told that “California froze retail rates at low levels.”[166]
Why West and South Want to Avoid FERC’s SMD, AND WHY NORTHEAST DOES NOT CARE
Utilities are leery for good reasons.
Deregulation: A Solution In Search Of A Problem
Scarcity rents can be taxed away without harming economic efficiency.[167] Monopoly rents should be eliminated to promote economic efficiency.[168] Stupidity rents, which are the most insidious of all, because they turn the fundamental market processes upside down,[169] should be prevented. However, when there are few if any efficiency gains to be had, why bother?
Policy makers across the country, who are closest to the people who pay the bills, quickly recognized the fatal flaws of electricity deregulation. They stepped back from the deregulation experiment, slowing it down in many cases and reversing it entirely in several other cases.[170] However, in a remarkable example of government policy-makers in Washington losing touch with the reality of the rest of the country, Congress and the FERC would like to steam ahead toward more radical restructuring and deregulation of the electricity industry.
The deregulation advocates insist that they can design markets to do the job. The result is a highly complex scheme in which six or seven markets are to be built by entirely new organizations, backed up by an army of accountants and auditors. The proposition being offered is that this scheme can do a better job of protecting the public interest than the simple scheme of cost-based regulation did. It certainly had stupidity rents, but it controlled the other rents much more effectively.
The Electricity Title of the Energy Act that did not die until the last days of the lame duck session and the Standard Market Design rules pushed by the FERC were conceived long before the meltdown in the competitive electricity sector. Neither were revised to reflect an understanding of the magnitude of the financial crisis that has hit the industry nor of the profound implications that recently revealed massive fraud and abuse have on the electricity market and consumers.
As the Wall Street Journal noted on September 16, 2002,
Even though the California power crisis clearly ranks as a watershed event in U.S. business history, many of the details remain murky. For instance, regulators have yet to sort out what portion of corporate profits generated during the year-long crisis were due to outright manipulation. Nor is it clear the extent to which suppliers conspired to rig the market.[171]
Repeal of the Public Utility Holding Company Act (PUHCA) remains high on the congressional agenda. PUHCA was designed to oversee the structure, financing, and operations of utility holding companies. A cornerstone of the electric utility industry under PUHCA was a desire to simplify the ownership structure and to ensure a direct operational or functional relationship between subsidiaries of a holding company. Over the course of the 1990s, deregulation moved the industry structure away from those principles. Many of the systemic abuses that have afflicted the electricity market since restructuring began in the late 1990s would have been prevented if PUHCA had been vigorously enforced.[172] Instead of repealing PUHCA, Congress should modernize and invigorate it.
Properly implemented PUHCA would require simplified structures, examine accounting practices, review affiliate transactions, and restrict diversification by requiring direct functional relationships between activities.[173] PUHCA was designed to prevent all of the abuses in which Enron and the other merchant generators engaged. In fact, a moment’s review of the origins of PUHCA shows that it was enacted as a reaction to gross abuse of electricity consumers in the early days of the industry. The assumption so widely bandied about in the 1990s that other institutions had grown strong enough to protect consumers and investors from these abuses is simply wrong.[174]
FERC’s plan, known as the Standard Market Design (SMD), is to force all regions of the country to implement extremely complex, short-term, dynamic markets for electricity, transmission, and related services, even though most of the country has absolutely no experience with such markets. In so doing, FERC has decided that the new regional transmission organizations must price newly defined transmission and energy products in single price spot markets that will ensure consumers pay the highest price the market will bear for their electricity.
This is a radical deregulation of interstate markets. In the sixty years between the passage of the Federal Power Act (1934) and the implementation of electricity restructuring (1996 in California), federal and state regulators have based electricity prices on the cost of service. FERC now proposes to base electricity prices on the scarcity value of electricity, regardless of what it actually costs to produce and deliver. FERC has imported some high-sounding language from economic theory, but the centerpiece of the strategy is to first extend FERC’s jurisdiction over transmission capacity and then to allow transmission capacity to be bid up to the highest price the market will bear, or, as FERC euphemizes,
the adoption of a market-based locational marginal pricing (LMP) transmission congestion management system designed to provide a mechanism for allocating transmission capacity to those who value it most.[175]
In response to the deepening crisis of fraud and market manipulation, the FERC was forced to devote an immense amount of attention to market power mitigation and market monitoring in proposing a SMD. The effort was to no avail. The SMD, which required spot-market transactions and auctions in six energy markets and two transmission markets, unleashed a storm of criticism from members of congress, state regulators, consumer representatives, prominent conservatives, and large industrial consumers. Much of this criticism has come from the states of the South and West. Although these states represent about two-thirds of the jurisdictions that are affected by the FERC order, some dismiss this opposition as an effort to horde low cost power for themselves, shield local monopoly utilities, or protect native load customers at the expense of interstate commerce.
It is certainly true that the states that have chosen not to restructure their markets for electricity have lower rates and have done a much better job of protecting the interests of their citizens (see Figure 21.5). However, the resistance in the South and West to FERC’s efforts to force their utilities into generation and transmission markets should not be seen as an antisocial exercise of parochial self-interests; it can and should be recognized as a rational assessment of the risks and rewards of relying on markets for electricity services.
In these states, markets are most likely to fail or shift substantial resources from consumers to facility owners even where they succeed. Monopoly rents and scarcity rents are likely to be largest in these states and policy makers have chosen to leave them in consumers’ pockets. FERC’s own studies show that there is little to be gained from reliance on market-based regional transmission organizations.[176]
South—Inelasticity of Supply Creates Excess Scarcity Rents and Threat of Abuse
There are two sources of concern to consumer advocates and policy makers charged with protecting the public interest from unjust and unreasonable rates: excessive scarcity rents and abuse of market power, which creates monopoly rents. A policy maker evaluating the option of relying on the market might reasonably enquire into how risky it is that consumers will be caught on the problematic portion of the supply curve.
[pic]
Figure 21.5: Restructuring and Residential Price Levels (Sources: Energy Information Administration, Electric Power Monthly: March 2002, Table 53; Center for the Advancement of Energy Markets, RED Index)
It turns out, largely because of climate and resource differences, that the risk is small in the Northeast. In that region, the supply curve becomes problematic at 110 to 115 percent of the peak. This does not mean that there have not been problems in this region. There certainly have been, especially in load pockets like New York City. Nevertheless, on average, and given the load curves, the amount of time consumers are forced to live on the problematic section of the supply curve is relatively limited. As one moves south, the supply curve becomes problematic at a much lower level of supply relative to peak. In Florida, the supply curve becomes problematic at 85 percent of the peak. Consumers in Florida are likely to be at risk a lot more.
Analysis of the Florida market shows that both scarcity rents and monopoly rents are a severe problem, that the supply curve becomes problematic at a much lower level of supply relative to peak.[177] If the market in Florida cleared in a “perfect” fashion under the FERC model (i.e. at the marginal cost without any exercise of market power) in every hour of every day the price of wholesale electricity would rise by 50 percent. The sum would be $2 billion. This huge sum of excess scarcity rents is created in just 10 percent of the hours. Florida is the extreme, but the rest of the south would suffer large increases as well.
This sum does not include any impacts resulting from market power. Any withholding would drive prices much higher. Monopoly rents in California were several times the size of scarcity rents. Moreover, in Florida, the largest supplier controls almost 40 percent of generation capacity. This means that the threat of withholding is present for a very significant part of the time. In the SERC region, the pivotal supplier has about a 20 percent share of capacity. In the South, consumers are likely to be at risk a substantial part of the time, as much as 30 to 50 percent.
The exercise of market power would drive prices even higher. Our simulation of the Florida market shows that a single firm, acting alone but knowing that a substantial part of its capacity will be needed in many hours of the year, would have the ability to raise prices substantially. Substantial markups can be expected in virtually every hour in which the pivotal supplier is called upon. In the dominant firm case, prices would rise to in excess of $500 a megawatt-hour for a few hours and would be above $100 a megawatt-hour for about 2 percent of the hours. In the dominant firm case, the average price would rise to almost $46 a megawatt-hour from the regulated price of $25.50 and the competitive price of $39. In the cartel case, prices would hit the $1,000 cap almost 10 percent of the time and prices would be above $100 about a third of the time. The average price would rise to over $370 a megawatt-hour. Before the meltdown in California, we would never have considered such a possibility, but that is the price that was sustained in California for almost half a year, during the off-peak period. The result of withholding and excessive scarcity rents to drive prices far above costs is supranormal profits. The $1,000 price cap used in this analysis is the cap FERC relies on in its SMD proposal. These results do not give us great confidence that the cap will do consumers much good.
Under the FERC scheme, consumers and regulators are forced to continually struggle to prevent the transfer of billions of dollars of scarcity rents and monopoly rents from consumers to generators and transmission owners. FERC invites utilities to try to avoid these price increases by entering into bilateral contracts, but there is no reason to believe that sellers in these contracts would not be able to capture at least part of these rents and consumers will end up worse off. FERC offers a series of complex allocations and auctions of rights and market monitoring to help consumers, but they will be vastly inferior to the approach taken by policy makers in these states, simply prevent the rents from being generated in the first place.
Interestingly, if we correlate the level of risk and the extent of restructuring, we find a pretty strong relationship between the risk of abuse and rent transfers and the refusal to restructure electricity markets (see Figure 21.6). Almost all of the states in the Northeast and near Midwest have restructured; virtually none in the South have. Ironically, the states that should have had the easiest task of protecting consumers did the worst job.
One final and obvious point that distinguishes the South from the rest of the nation is that it has a great deal more at stake on the demand side from the consumer point of view (see Figure 21.7). The average household in the South consumes about 35 percent more electricity than the national average, 60 percent more for air conditioning. The average household in the South spends about 25 percent more on electricity, about 40 percent more on air conditioning.
The West is an anomaly in this analysis, but that is easily explained by an examination of the nature of its dominant source of electricity and its geography. Indeed, California is a particular anomaly. It had the characteristics of a state that would be expected to be in the restructured group and it was. After the meltdown, it switched.
West—Reliance on Hydro, Long-Distance Transmission Cause Risks Under the SMD
The SMD Notice of Proposed Rulemaking recognizes that hydro does not fit well within its regulatory framework. The problem is partly that hydro has virtually zero running costs (i.e. a horizontal supply curve), which means it will be a voracious rent collector in any single-price auction. More important for FERC’s scheme, is that most hydro is a multipurpose undertaking. Hydro is not, and cannot be operated to maximize profits from the sale of electrons. Irrigation, flood control, and wildlife concerns dictate when the water and the electrons flow. This “irrational” economic actor mucks up FERC’s pretty theoretical scheme.)
The other key problem with hydropower is that rain does not respond to price signals. A drought can send hydropower generation into a tailspin and markets that are dependent on it into a panic. If the amount of electricity from this resource is small, one could probably ignore it, but in the West it accounts for over one-third of the total capacity (Figure 21.8). The Bonneville Power Administration is the largest pivotal supplier in the region and the nation. Fossil fuel plants that cannot run at full capacity because of environmental concerns are a similar anomaly. Thus, about 40 percent of the power in the West does not fit easily into the FERC scheme. FERC throws it hands in the air with respect to these resources.
[pic]
Figure 21.6: Correlation between Restructuring and Peak Load
(by NERC Regions) (Sources: Supply curves from CERA, Electric Power Trends: 2001 (Cambridge Energy Research Associates, 2001). Residential retail competition from Center for the Advancement of Energy Markets, RED Index)
The nature of hydro and the geography of the West interact to compound the problem. Dams can only be built on streams and rivers and transmission lines must run to the load. Similarly, it is economical to do the same with mine-mouth, coal-fired plants in the West. Because distances are extremely long in the West, transmission plays a much larger role there than in the rest of the nation. Hydro and mine-mouth coal plants were optimized with transmission. Separation of transmission and generation and forcing them into separate markets threaten to do a great deal of damage to the underlying economics of the way the network was built in the West. Scarcity pricing of transmission in the West could have severe and disruptive effects on consumers.
[pic]
Figure 21.7: Household Electricity Consumption across Regions
Thus, although the supply curve in the West may look friendly in terms of when consumers are at risk of being caught on the problematic portion of the supply curve, a couple of dry years can dramatically change the situation. The lack of rain certainly played a part in the California crisis. It should not come as a surprise that policy makers in the West are risk-averse, when the only two states that tried to rely on the market, Montana and California, have been badly burned. This risk-aversion is perfectly rational, from the consumer point of view. The fact that every state in the West that tried restructuring is slowing down or turning back reflects this rational choice.[178]
[pic]
Figure 21.8: Unique Western Dependence on Hydro and Transmission (by NERC Regions) (Sources: Transmission from Eric Hirst and Brendan Kirby, Transmission Planning for a Restructuring U.S. Electricity Industry, June 2001. Generation capacity from CERA, Electric Power Trends: 2001 (Cambridge, Mass.: Cambridge Energy Research Associates, 2001)).
Pennsylvania: Muddling To Nowhere
The above analysis explains why the West and South would not be in favor of restructuring. It also suggests why there is less concern about restructuring in the Northeast. A quick look at the poster child for restructuring, Pennsylvania, suggests why the deregulation train has run out of steam.
Consumer advocates found themselves in a dilemma in Pennsylvania.[179] Utilities and regulators had saddled many Pennsylvania consumers with some of the highest rates in the nation, while utilities like PECO had excess power that they were selling at bargain-basement rates outside of the state. The legislature mandated restructuring and consumer advocates did the best they could to protect the interest of their constituents.[180]
In simple terms, those who wish to import the Pennsylvania model should recognize that it started from very high rates in a situation with excess capacity and lots of transmission resources operated by an existing power pool. It ordered rate reductions and price caps that are still in place. Nevertheless, it now suffers from dramatically rising wholesale prices, a volatile spot market, and the abuse of market power. Responding to this tightening situation one utility has been badly burned in the spot market and independent generators are exiting the market, while customers flock back to the incumbent utilities.
Is this situation better than California? Certainly it is. Is it the outcome that policy makers in other states could or should aspire to? Probably not. To say that consumers have been well-treated or that other states should do the same is irresponsible. Only states that start from a condition this bad or worse and have assets this good or better could benefit from importing its model. The number of such situations is near zero. Even if there are some, for a number of reasons it is vastly premature to declare Pennsylvania a success. To the extent that there has been success to date in Pennsylvania, it has little to do with the market.
Only one state that has not restructured has residential rates higher than Pennsylvania. Residential rates in Pennsylvania are now just below the average for all restructured states, but remain about 25 percent above the states that have not restructured.[181]
Before restructuring, rates in Pennsylvania were about tenth-highest in the nation for residential rate-payers on a statewide basis.[182] Its relative position has not changed. Residential rate-payer savings in Pennsylvania are overwhelmingly the result of rate reductions mandated by regulators, not created by the market.[183] Regulators set the target rate by ordering reductions, and, in the residential class, competitors have just matched it, for now.[184] Industrial rate-payers enjoyed much larger rate reductions than residential consumers. In other words, the market facilitated price discrimination by allowing industrial customers to find lower-priced supplies, at least temporarily, while the residential market did not have similar opportunities.[185] However, data for more recent months suggest that rising capacity costs and natural gas prices have pushed the market price up and these opportunities are disappearing.[186]
High rates were concentrated in a few utilities in the eastern part of the state. The vast majority of those consumers who switched to alternative suppliers were customers of those utilities.[187] That is obvious. Rates were so high that it was easy to set a price to beat that would be attractive to competitors. What is not so obvious is that many of these consumers switched to utility affiliates.[188] This is hardly competition; it is just a shell game in which regulators were making up for the past bad treatment of consumers.
The growth of competition has slowed dramatically.[189] In the first two months of 2001, companies serving almost 10 percent of the customers who had switched exited the market.[190] Approximately three-quarters of the firms offering service have exited the market.[191]
Price caps on residential rates remain in place for consumers (just as they did in most of California), thus it is hard to say what will happen when they are removed.[192] The crisis did not hit in California until the price cap came off in San Diego. In fact, one Pennsylvania utility has gotten itself into a California-style problem with high-cost spot-market purchases, which have driven its costs above the cap.[193] It is seeking to break the cap to the tune of hundreds of millions of dollars.[194] Ironically, this utility has gotten itself into trouble even though Pennsylvania is a net exporter of electricity, it is located in the middle of the grid with lots of generation resources close by, it is in an area with a relative abundance of transmission capacity, and it is in a power pool that has a reserve margin requirement.[195]
The difficulties that both incumbents and entrants in Pennsylvania have gotten into underscore a fundamental question that hangs over the restructured-market overdependence on cheap natural gas. Rather than bring dramatic new efficiency to the market, many of the entrants seem to have based their business models—and regulators based their projections of consumer savings on—the ability to sell electricity powered by cheap natural gas. There was little real innovation underlying the move to deregulate, just the prospect that cheap gas would wring out some of the stupidity rents of the old system (expensive nuclear plants).
The power pool/transmission organization for the part of Pennsylvania where the benefits of deregulation are claimed, PJM, and its neighbors are relatively well-endowed in generation and transmission resources.[196] It was a long-standing pool that has tried to evolve to a wholesale market. PJM imposes critical restraints on “pure” market transactions, like a reserve requirement,[197] and protects its native load customers by shutting down flows when things get tight.[198] States at the end of the line or lacking these resources do not have this luxury and beggar-thy-neighbor policies are not sound national policies (unless the Canadians and Mexicans can be induced to get caught holding the bag). The spot market exhibits the same volatility in the East as it does in the West. [199] This market is plagued with the same complaints about the exercise of market power [200] and outages.[201]
PJM also uses a form of transmission pricing, locational marginal pricing (LMP), which lets transmission owners capture the scarcity rents associated with load imbalances.[202] In the tight geographical area with relatively short distances, this burden may be bearable, but in the West and Southwest, this approach would be murder on consumers. [203]
A debate is now brewing about the bottom line for consumers. A good case can be made that, given the market conditions that developed, consumers would have saved as much or more under effective regulation, without exposing consumers to this risk.[204] The primary cause of high costs for Pennsylvania utilities (as elsewhere) was primarily nuclear power plants, and the solution did not have to be deregulation.[205]
First, the high-cost Pennsylvania utilities had substantial excess capacity that they were selling “off-system” at very low rates. As the market tightened, and certainly as natural gas prices rise, it was clear that excess capacity would have fetched a higher price. Captive rate-payers, saddled with high costs, should have benefited as increased revenues lowered their burden.
Second, by writing off some of the stranded costs, immediate rate reductions were granted and used to jump-start competition. Of course, as these plants depreciated, those costs would have declined anyway.[206] Regulators allowed utilities to pump up their claims of stranded costs by using ridiculously low estimates of the market-clearing price of electricity, then wrote off fictitious stranded costs. Consumers enjoyed the time value of money, but because it has taken less than two years for utilities to start breaking the cap, there is not much gain here.
Consumers now face claims that larger reserve margins, higher capital costs, and faster depreciation are necessary to make the market work, plus additional transaction costs that have been incurred as a result of the creation of new institutions and markets. Promises of efficiency gains to offset these costs have vanished.
Consumers in California and Pennsylvania paid utilities over $2,500 per end-use customer in stupidity rents of the old system as the price for transitioning to the new restructured environment.[207] These had built up over decades. Pennsylvania has muddled through with vigorous regulation, not price cutting competition, but where it will end up remains murky. Under the best of circumstances for residential consumers, electricity restructuring was a solution to a high-cost problem that has not worked very well; under the worst of circumstances it threatens to make them much worse off.
CONCLUSION: when the solution becomes the problem
For the residential rate-payer in most states, the choice is clear. Their interests are better served by cost-based regulation. The best long-term hedge is a utility-financed, franchise-based power plant subject to aggressive least-cost planning and competitive bidding.
The evidence that radical restructuring and deregulation will result in higher costs has become overwhelming. Because of the nature of electricity service, eliminating the critical public interest obligations and values to rely on weak market forces results in manipulation, abuse, and inefficiency. Given the current status of the physical and institutional infrastructure, as well as the fundamental economic characteristics of the electric utility industry, there are four large sources of costs that can be imposed on the public with very few offsetting benefits (see Table 21.4).
• Monopoly Overcharges: Market power drives the price of electricity up because generators and transmission owners can overprice their product or withhold supplies. Analyses of actual markets indicate increases in prices from 20 to several hundred percent.
• Excess Scarcity Overcharges: Allowing generators and transmission owners to control/create scarcity and then capture the value of scarcity by pricing goods and services far above their costs. Analyses indicate these could range from 20 percent to 50 percent.
• Stupidity Costs: Administrative inefficiencies of imposing markets on complex services that require close coordination and cooperation results in substantial increases in transaction and administrative costs. Analyses indicate these costs are in the range of 10 to 20 percent.
• Cost of Capital: A competitive market raises the cost of capital sharply for this industry, which is very capital-intensive, as deregulated generators and transmission owners seek quicker paybacks with less-certain revenues. Analyses indicate these increases could range between 5 and 15 percent.
Table 21.4: Sources of Price Increases in Restructured, Deregulated Electricity Markets (sources, see list at end of chapter.)
SOURCE OF INCREASE PERCENT INCREASE
LOW HIGH
Market Power a/ 20 400
Scarcity Pricing b/ 20 50
Administrative/ 10 20
Operating Inefficiency c/
Cost Of Capital d/ 5 15
In a few instances, where prices were very high, primarily as a result of excess capacity and price caps remain in place, consumers have not suffered price increases in the near term. Market power transfers resources between producers, while regulation prevents price increases. Little competition exists for retail customers and efficiency gains are small or nonexistent.
The current map of electricity restructuring presents a stark picture. High cost states in the Northeast have moved down the path of restructuring. A few low cost states in the West started, but stopped. Vast differences between regions in population densities, weather conditions, resource mix, consumptions patterns and institutional make-up must be reflected in the delivery of a vital service like electricity.
When public functions and values become so dense in a sector, it becomes “affected with the public interest.” Recognizing that the “e” in “e-commerce” stands for electronic, which means that both the electrons and the bits must flow smoothly as the foundational activity of our twenty-first century digital economy, this paper argues that the loss of a public perspective has hurt the economy. Moreover, weakness in this sector has broad implications for the economy.[208] Virtually all households and businesses use these two services in substantial quantities on a daily basis. The loss of stock market value in the utility sectors (electricity and telecommunications) sectors swamps the highly touted problem.
The broader implications have become a frequent topic of public discussion. For example, the Wall Street Journal invited comparisons to the New Deal when it asked in a front-page story headlined, “Rising Anxiety: What Could Bring 1930s-Style Reform of U.S. Business?” [209] Ironically, the lead story on the very same page was headlined “Jolt of Reality: Amid Collapsing Power Market, Energy Companies are Reeling.”[210]
The New Deal laws that governed electric utilities for sixty years (the Public Utility Holding Company Act and the Federal Power Act) were heavily criticized as outdated in the 1980s and 1990s. They sought to simplify ownership structures and keep them focused on functional efficiency, while controlling the monopolistic tendencies in the industry through cost-based regulation. Recent events make these laws look far more reasonable. Misled by the effectiveness of this legislation in suppressing abuse, creating stability, and sustaining investment over decades, deregulation undervalued consumer and investor protections as well as the importance of smoothing out boom-and-bust cycles. The radical deregulators assumed that the correlation between the sharp increase in the public interest obligations at the core of these sectors codified by the New Deal legislation and the subsequent growth was just a coincidence. However, there is growing evidence that they are wrong.
During the 1990s, stodgy “old economy” utilities, with their slow growing but secure, dividend-paying stocks, were reviled on Wall Street in comparison to the “sexy” paper returns of the dot-coms. Utility stocks reflected the economic environment that public policy had created for them, one founded on the principle that the infrastructure building blocks for the rest of the economy need stability and long-term commitments. Now that the bubble has burst, investors will flock back to a dull sector that offers a solid and stable total return provided that public policy rediscovers the principle that electricity and telecommunications are deeply “affected with the public interest” and restores the balance between private incentives and public interest in these industries. This analysis suggests that we need an explicit reorientation to public values, not a tweaking of rules governing private behavior in these sectors.
Sources for Tables 21.3 and 21.4
Table 21.3
SOURCE: Market shares of Generation = Energy Information Administration, State Electricity Profiles (U.S. Department of Energy, March 1999); Import capacity for HHI calculation = Cambridge Energy Research Associates (CERA), Electric Power Trends: 2001 (2000); High Tension: The Future of Power Transmission in North America (August 2000) (hereafter, CERA, High Tension); U.S. Census Bureau, Statistical Abstract of the United States: 2000 (U.S. Department of Commerce), Population growth =Table 20, Cooling degree days and urban population = Table 39, 414: HHI and markups = Wisconsin = Bushnell, James, Christopher Knittel and Frank Wolak, Estimating the Opportunities for Market Power in Deregulated Wisconsin Electricity Market (Consumers First, ND); Colorado = Sweetser, Al, An Empirical Analysis of a Dominant Firm’s Market Power in a Restructured Electricity Market: A Case Study of Colorado (April 1, 1998); Pennsylvania = Rudkevich, Alesandr, Max Duckworth, and Richard Rosen, “Modeling Electricity Pricing in a Deregulated Generation Industry: The Potential for Oligopoly Pricing in a Poolco,” The Energy Journal, 1998 (19); PJM = .Mansur, Erin, T., Pricing Behavior in the Initial Summer of the Restructured PJM Wholesale Electricity Market (University of California Energy Institute, Program on Workable Energy Regulation, April 2001; UK = Wolak, Frank A. and Robert H. Patrick, Impact of Market Rules and Market Structure on the Price Determination Process in the England and Wales Electricity Market (POWER, February 1997), Wolfram, Catherine, “Measuring Duopoly Power in the British Spot Market,” American Economic Review, 89: 1999, p. 812, California = );.Hildebrandt, Eric, Impacts of Market Power in California’s Wholesale Energy Market: More Detailed Analysis Based on Individual Seller Schedules and Transactions in the ISO and PX Markets (Department of Market Analysis, California Independent System Operator, April 9, 2001), Klein, Michael and Loretta Lynch, California’s Electricity Options and Challenges (August, 2000).
Table 21.4
a/ See Table 21.3.
b/ See below based on the analysis of the supply curve in Florida that indicates scarcity rents equal to 50% of regulated costs (see Florida Municipal Electric Association, Energy 2020 Study Commission Wholesale Deregulation Proposal Will Raise Electricity Prices and Maximize Profits of Private Utility Shareholders, January 29, 2001) as does analysis of the California market in 1999 and 2000 (see Borenstein, Severin, James Bushnell and Frank Wolak, Measuring Market Inefficiencies in California’s Restructured Wholesale Electricity Market (Center for the Study of Energy markets, June 2002).
c/ Estimates are equal to the economies of integration, since deintegration would jeopardize these. Lower estimates are found in Hayashi, Paul M., James Yeoung-JLA Goo and William Cliff Chamberlain, “Vertical Economies: the Case of U.S. Electric Utility Industry, 1983-1987” and Kaserman, David L. and John W. Mayo, "The Measurement of Vertical Economies and the Efficient Structure of the Electric Utility Industry," Journal of Industrial Economics, 29:5, 1991. Higher estimates are found in Kwoka, John E. Jr., Power Structure: Ownership, Integration, and Competition in the U.S. electricity Industry (Dordrecht, Boston: 1996).
d/ See below pp. 29-30 and Staff Report, Market Clearing Prices Under Alternative Resource Scenarios: 2000 –2010 (California Energy Commission, February 2000). U.S. Department of Energy, Office of Economic, Electricity an Natural Gas Analysis, The Impact of Wholesale Electricity Price Controls on California Summer Reliability (June 2001)
Appendix 21.1: CAUSES OF ELECTRIC UTILITY INDUSTRY MARKET FAILURE DEMONSTRATED BY THE from FIRST THREE YEARS OF U.S. DEREGULATION[211]
BASIC CONDITIONS: SUPPLY
Technology Long lead times 5(7) 6(1),Delayed replacement 6(16) 11(2)
Inability to store electricity 5
Product durability Generation Outages 1(2-11, 4-6) 3(15) 5(40) 10(1-2),
Transmission shutdowns 1(4-10),
Failures take time to repair 6(9)
Summer impairment of performance 6(7, 18, 22)
BASIC CONDITIONS: DEMAND
Price elasticity Extremely low short-run 2(24) 5(39) 11(2)
Limited conservation 6(2,19, 23)
Substitutes Lack of substitutes, Restriction on self-supply 8
Cyclical/seasonal Weather-related demand 1(4-6) 2(37) 10(1-2),
Inadequate reliability criteria 6(21)
Purchase method Obligation to serve 1 (4-1) 2(25),
Lack of incentive to cut back 1(4-4) 4(46)6(2, 19)
MARKET STRUCTURE
Number of sellers Few sellers 2(ii) 3(21) 4(49-56) 5(6,7) 7
Number of buyers Constrained demand by utilities 1(4-1) 2(25) 5(30,31),
Constrained distribution 6(30)
Limited end-user choice 5(42,57)
Barriers to entry Transmission constraints 1(2-15,5-7)5 (11,12)
Load pockets, inadequate system 6(10,32)
Self-supply blocked 8()Emergencies 1(2-15), Substation inflexible 6(31)
Cost structures High fixed
Vertical integration Affiliate relations distort market 2(38) 6(38),
Integration restricts entry 11(3)
Diversification Utilities Add Brokerage 2(24,28) Inadequate Planning/Spending
for maintenance 6(29,34 - 37)
Inadequate Market Lack of timely, objective 1(5-3) 2(ii), Load projections 6(8),
Unit ratings 6(11)
Information Planning tools 6(13), Cable condition, incipient failure 6(5,14)
Refusal to share best practices 6(15), Forecasting 6(17, 28)
Inadequate notice 6(20) Dispatch software 6(27)
Inadequate coordination Breakdown of coordination 1(2-37, 3-3), ISO lacks authority 6(4), Lack of data 6(6)
CONDUCT
Pricing behavior Hoarding, gouging 4(65) 5(3,38) Above cost 10(1-4) 11(17)
Reliance on nonfirm power 6(24) 10(2-1) 11(3)
Legal tactics Defaults, abrogation of contracts, daisy chains, two-way deals1
(4-10, 5-2) 2(4)
Refusal to provide market monitoring information 5(4)
Inefficient short term sales 6(25), Records not preserved 6(33)
Regulation Transmission rules create problems 1(4-40) 2(20) 11(3)
Market rules not developed 6(3)
SOURCES:
The analytic categories are from Scherer, F. M. and David Ross. Industrial Market Structure and Economic Performance (Boston, Houghton Mifflin: 1990).
The substantive references are as follows:
1 = FERC. Staff Report to the Federal Energy Regulatory Commission on the Causes of the Pricing Abnormalities in the Midwest During June 199. Washington: 1998.
2 = Public Utilities Commission of Ohio. Report: Ohio’s Electric Market: June 22-26, 1998, What Happened and Why: A Report to the Ohio General Assembly. Columbus: 1998.
3 = Bohn, Roger E., Alvin K. Klevorick, and Charles G. Stalon. Report on Market Issues in the California Power Exchange Energy Markets. Market Monitoring Committee of the California Power Exchange.August 17, 1998.
4 = Bohn, Roger E., Alvin K. Klevorick and Charles G. Stalon. Market Monitoring Committee of the California Power Exchange, Second Report on Market Issues in the California Power Exchange Energy Markets. March 9, 1999.
5 = Klein, Michael and Loretta Lynch. California’s Electricity Options and Challenges. August, 2000.
6= DOE. Interim Report of the U.S. Department of Energy’s Power Outage Supply Study Team. January 1999; id. Horizontal Market Power in Restructured Electricity Markets. March 2000.
7 = DOE. Horizontal Market Power in Restructured Electricity Markets. March 2000.
8= Alderfer, R. Brent, et al. Making Connections: Case Studies of Interconnection Barriers and their Impact on Distributed Power Projects. National Renewable Energy Laboratory. May 2000.
9 = EIA. The Changing Structure of the Electric Power Industry 1999: Mergers and Other Corporate Combinations. December 1999
10 = Staff Report of the Federal Energy Regulatory Commission on Western Markets and the Causes of the Summer 2000 Price Abnormalities. November 1, 2000.
11= Wolak, Frank A., et al. “An Analysis of the June 2000 Price Spike in California ISO’s Energy and Ancillary Service Market.” Market Surveillance Committee of the California ISO. September 6, 2000.
-----------------------
[1] Taylor, Jerry and Peter VanDoren, California’s Electricity Crisis: What’s Going On, Who’s to Blame and What to Do (Washington: Cato Institute, 2001); Duane, Timothy P., “Regulation’s Rationale: Learning from the California Energy Crisis,” Yale Journal on Regulation, 19 (2002), notes that Larry Lindsey, the chief economic advisor to President Bush, claims that the Enron bankruptcy is “a “tribute to American capitalism.” At the extreme, the Wall Street Journal editorialized that the trading practices that had been used to manipulate the California market were not even disturbing (“Those Hideous, Awful Enron Memos: California’s Governor Uses a Disgraced Company as Scapegoat,” May 16, 2002).
[2] Uchitelle, Louis, “Broken System? Tweak It, They Say,” New York Times, July 23, 2002, covers five industries including electricity and telecommunications.
[3] Duane, p. 536.
[4] For example, California Public Utility Commissioner Carl Wood (Talk of the Nation, August 9, 2000) has suggested that some policy makers are exhibiting a “theological devotion to deregulation at any price.” Paul Krugman (“The Unreal Thing,” New York Times, February 18, 2001), hardly a wild-eyed consumer advocate, challenged deregulation “mythology” in the New York Times, stating that “the defenders of deregulation should stop making excuses and look seriously at what went wrong.”
[5] Cooper, Mark, Electricity Restructuring and the Price Spikes of 1998 (Washington: Consumer Federation of America and Consumers Union, 1999)(hereafter, Cooper Restructuring); id., “Back To Basics In Analyzing The Failure Of Electricity Restructuring: Accepting The Limits Of Markets,” paper presented at Energy Markets in Turmoil, Institute for Regulatory Policy Studies Illinois State University, Normal, Ill., May 17, 2001; id., Behind The Headlines Of Electricity Restructuring (Washington: Consumer Federation of America, 2001; id., Reconsidering Electricity Restructuring (Washington: Consumer Federation and Consumers Union, 2000); id., Electricity Deregulation And Consumers: Lessons From A Hot Spring And A Cool Summer (Washington: Consumer Federation of America, 2001).
[6] Hirsh, Richard, F., Power Loss: the Origins of Deregulation and Restructuring in the American Electric Utility System (Cambridge, Mass.: MIT Press, 1999); Stone, Alan, Public Service Liberalism: Telecommunications and Transitions in Public Policy (Princeton: Princeton University Press, 1991); Duane recounts the history and calls for a recognition of the reason the electric utility industry was regulated, but does not provide a detailed discussion of the underlying economics.
[7] Traditional economic discussions identify public goods and public infrastructure driven primarily by externalities (see for example John Taylor, Chapter 15, Economics (Boston: Houghton Mifflin, 1998) but the discussion inevitably leads to consideration of regulation of natural monopolies wherein public policy seeks to impose socially responsible behavior on private firms (see id., Chapter 16; Viscusi, W. Kip, John M. Vernon, and Joseph E. Harrington, Jr., Chapters 11-14, Economics of Regulation and Antitrust (Cambridge, Mass.: MIT Press, 2001).
[8] Bollier, David, Silent Theft: The Private Plunder of Our Common Wealth (New York: Routeledge, 2002).
[9] Mayer, Martin, “Banking’s Future Lies in its Past,” New York Times, August 25, 2002.
[10] Lessig, Lawrence, The Future of Idea (New York: Random House, 2001)
[11] “S&P Sees Negative Rating Trend Continuing: Deteriorating Picture,” Wall Street Journal, August 12, 2002,
The one bright spot S&P found has been the relative stability of the public power cooperatives sector, where ratings actions have been “considerably more measured.” It attributes much of that stability to the fact that public power agencies in deregulated states have remained vertically integrated and stay outside of deregulation.
[12] Cooper, Mark, Industrial Organization and Market Performance in the Transportation and Communications Industries: A Review of Current Theories and Empirical Applications to the Railroad, Electric Utility, Airline, Telecommunications and Oil Pipeline Industries with Hypotheses about Natural Gas Pipelines (Washington: Consumer Federation of America, January 1986) (hereafter, Cooper, Organization), identified basic economic conditions in the electricity industry that raise doubts about the prospects for deregulation as the debate was beginning (see also id., “Theory vs. Reality,” paper presented at the Consumer Federation of America Utilities Conference, Washington, April 6, 1987). Id., "Protecting the Public Interest in the Transition to Competition in New York Industries,” The Electric Utility Industry in Transition (New York: Public Utilities Reports, Inc. & the New York State Energy Research and Development Authority, 1994), stated the concerns as the policy of restructuring was being formulated. Id., Residential Consumer Economics of Electric Utility Restructuring (Washington: Consumer Federation of America and Consumers Union, July 1998) (hereafter, Cooper, Residential Consumer Economics), identified specific flaws in the restructuring policies that had been adopted.
[13] Cooper, Electricity Restructuring. Earlier analysis has reviewed conceptual, simulation, and foreign evidence. This paper relies solely on the domestic, U.S. experience to date. These concerns have been expressed in presentations to state policy makers including the Arizona Public Service Commission (April 17, 2000), the Wisconsin Public Power Association (June 28, 2000) Nevada Energy Policy Committee (November 30, 2000) Florida Public Utility Commission (January 13, 2001) and the Consumer Affairs Committee of the National Association of Regulatory Utility Commissioners (February 25, 2001). A videotape of the Nevada presentation is available, as is a written transcript of the presentation in Florida.
[14] Cooper, Residential Consumer Economics, pp. 35-36.
[15] David Armstrong and Andrew Caffrey (in “Amid Collapsing Power Market, Energy Companies Are Reeling,” Wall Street Journal, July 24, 2002) show a quarter of trillion lost market capitalization from the year-end 2000 to the end of July 2002. Asset values would be about twice as high and peak to current value calculations would be even higher. A figure of $2 trillion is given for the telecommunications sector (see for example, Yang, Catherine, “Powell of the FCC: Fiddling While Telecom Melts?” Business Week, August 26, 2002).
[16] See, for example, Maloney, Michael, et. al, Customer Choice, Consumer Value: An Analysis of Retail Competition in America’s Electric Industry (Washington: Citizens for a Sound Economy, 1996); Maloney, Michael T., et al., Economic Deregulation and Customer Choice: Lessons for the Electric Utility Industry (Arlington, VA: Center for Market Process, 1999).
[17] Pharris, Dale, Who Really Benefits From Retail Competition? (Washington: National Rural Electric Cooperative Association, September 1996). Kahal, Matthew I., The CSEF Electric Deregulation Study: Economic Miracle or the Economists’ Cold Fusion (Washington: Electric Consumers’ Alliance, December 1996). Binz, Ronald J., Thomas Feiler and Michael J. McFadden, Navigating A Course to Competition: A Consumer Perspective on Electric Restructuring (Washington: Competition Policy Institute, 1997)
[18] EIA, Electricity Prices in a Competitive Environment: Marginal Cost Pricing of Generation Services and Financial Status of Electric utilities, A Preliminary Analysis Through 2015, (Washington: EIA, 1997).
[19] ICF Consulting, Economic Assessment of RTO Policy, Prepared for the FERC, February 26, 2002, Tables ES-1, ES-2. Casazza, John, A., “Electricity Choice: Pick Your Poison: A. Errant Economics? B. Lousy Law? C. Market Manipulation? D. All Three?,” Public Utilities Fortnightly, March 1, 2001, identifies efficiency gains in generation of 3 percent. This latter figure is consistent with the actual experience in the United Kingdom, which began phasing in a competitive retail electric market in 1990. The figure suggests caution is necessary in the estimation of benefits (Newberry, David M. And Michael G. Pollitt, “The Restructuring and Privatisation of Britain's CEBG—Was It Worth It?” The Journal of Industrial Economics, 45 no. 3 (1997) pp. 297-298). Efficiency gains have not been very large and the exercise of market power and price discrimination are a constant threat to consumer benefits from restructuring, resulting in the efficiency gains not being passed through to consumers.
[20] “Comments on the RTO Cost Benefit Analysis Report by the New Mexico and Rhode Island Offices of Attorney General, The Rhode Island Division of Public Utilities and Carriers, the Public Advocate for the State of Maine and the Colorado Office of Consumer Counsel,” before the FERC, Electricity Market Design Structure, Docket Nos. RM01-12-000, etc., May 3, 2002.
[21] Newbery, David M. And Michael G. Pollitt, “The Restructuring and Privatisation of Britain’s CEBG—Was It Worth It?” The Journal of Industrial Economics 45:3 (1997) pp. 297-298.
[22] Cooper, Behind the Headlines.
[23] Oppenheim, Jerrold, “Assuring Electricity Service for All Residential Customers, Especially Low Income, Customers after Electricity Industry Restructuring,” Electricity: Too Important to Leave to the Market (Washington: September 2002); National Center on Alternative Technology, An Analysis of Residential Energy Markets in Georgia, Massachusetts, Ohio, New York, and Texas (Butte, MT: National Center for Alternative Technologies: 2002).
[24] An incident from Pennsylvania helps to make the point, as detailed in Dekok, David, “Bush Sought Ridge’s Support for Texas Utility Enron Corp.,” Patriot News, July 2, 2000; Oppel, Richard A., “The 2000 Campaign. The Donor: For A Generous Donor and Bush, The Support is a Two Way Street,” New York Times, June 29, 2000. As electricity restructuring was being implemented in Pennsylvania in 1997, Enron was having trouble getting its way. Although the legislature had required restructuring, it had given considerable flexibility to the Public Utility Commission to define how it would work. While consumer advocates were not thrilled with the legislation, they worked hard to get some basic consumer protections. A settlement was worked out that guaranteed a couple of years of rate cuts and price caps for almost a decade. Enron refused to participate in the settlement and proposed an alternative that was much less consumer friendly. To try to overcome this resistance, Enron turned to an all-too-frequent tactic. Enron CEO Ken Lay contacted his friend, Texas Governor George W. Bush, and asked him to contact the governor of Pennsylvania, Tom Ridge, to vouch for Enron. As Lay recalls it, he asked Bush to assure Ridge that Enron was “a good company, a serious company, a professional company.” There is direct confirmation that Governor Bush delivered that message.
[25] Wayne, Leslie, “Enron, Preaching Deregulation, Worked the Statehouse Circuit,” New York Times, February 9, 2002.
[26] The exploitation of access to policy makers by Enron is at the heart of the dispute over Vice President Dick Cheney’s meeting calendar and notes as head of the National Energy Policy Task Force. See for example, Zaldivar, Ricardo Alanso, “Dcouments Reveal Enron’s Clout on Energy Agenda,” Los Angeles Times, November 13, 2002; Milbank, Dana, “Enron’s Influence Reached Deep Into Administration,” Washington Post, January 18, 2002; Bumiller, Elisabeth, “Cheney is Set to Battle Congress to Keep His Enron Talks Secret,” New York Times, January 28, 2002; Holly, Chris, “Federal Judge Chastises Administration in Ruling On Cheney Task Force,” Energy Daily, July 16, 2002. Congress was not immune, as the battle over oversight of commodity markets shows, see for example, Blind Faith: How Deregulation and Enron’s Influence Over Government Looted Billions from Americans: Sen. Graham, White House Must Be Investigated for Role in Enron’s Fraud of Consumers and Shareholders (Washington: Public Citizen, December 2001); Gerth, Jeff and Richard A. Oppel, Jr., “Senate Bill Showed Complexities of Power Couple’s Ties to Enron,” New York Times, January 18, 2002.
[27] It has now become apparent that the value of peak load reduction is far higher than the market clearing price at the peak. Marcus, William B., and Greg Russzon, Cost Curve Analysis of the California Power Markets, (Sacramento: JBS Energy, Inc., 2000), estimates the value of peak shaving at between 5 and 10 times the market clearing price. Borenstein, Severin, The Trouble With Electricity Markets (University of California Energy Institute, Program on Workable Energy Regulation, January 2001) (hereafter, Borenstein, Trouble), uses an example in which the value of reduced demand is just under four times the market price. He argues that the ISO should capture this externality. The point is that it is highly unlikely that this externality will be internalized in direct, bilateral market transactions.
[28] Phillipovic, Dragana, Energy Risk: Valuing and Managing Energy Derivates (New York: McGraw-Hill, 1998), p. 3, cites a number of factors that distinguish energy from other commodities, but makes it quite evident that the need to physically consume the product on a real-time basis is the central factor.
[29] Bushnell, James and Erin Mansur, The Impact of Retail Rate Deregulation on Electricity Consumption in San Diego (Berkeley, CA: University of California Energy Institute, Program on Workable Energy, 2001).
[30] Hirst, Eric, and Brendan Kirby, Retail-Load Participation in Competitive Wholesale Electricity Markets (Washington: Edison Electric Institute and the Project for Sustainable FERC Energy Policy, 2000).
[31] Ibid., citing Braithwaite, S., “Customer Response to Market Prices—How Much Can You Get When You Need it Most?” paper read at the EPRI International Energy Conference, Washington, July 2000; and Schwarz, et al., Industrial Response to Real-Time Prices for Electricity: Short-Run and Long-Run (Raleigh: University of North Carolina, 2000).
[32]Reviews of dozens of studies can be found in Bohi, Douglas, Analyzing Demand Behavior: A Study of Energy Elasticities (Baltimore: Resources for the Future/Johns Hopkins, 1981) and Pyndyck, Robert, S., The Structure of World Energy Demand (Cambridge: MIT Press, 1979). Joskow, Paul and Richard Schmalensee, Markets For Power: An Analysis of Electric Utility Deregulation (Cambridge: MIT Press, 1984), concluded that many geographic markets would exhibit market power problems, in large part because the empirical evidence dictated the use of low elasticities of demand, in the range of .1 to .5. A decade-and-a-half later, Rose, Kenneth, Electric Restructuring Issue for Residential and Small Business Customers (Columbus, OH: National Regulatory Research Institute, 2000), reviewed more recent literatures and found short-run elasticities in the range of .2 (citing Branch, E. Ralph, “Short Run Income Elasticity of Residential Electricity Using Consumer Expenditure Survey Data,” Energy Journal, 14, no. 4 (1993)) and long-run elasticities of about 1.0 (citing Hyman, Leonard, S. America Electric Utilities: Past, Present and Future (Arlington, VA: Public Utilities Reports, 1988)). In analyzing the California market, Borenstein, Severin and James Bushnell, “An Empirical Analysis of the Potential for Market Power in California’s Electricity Industry,” Journal of Industrial Economics, 47 no. 3 (September 1999) states that “We have run simulations for elasticities 0.1, 0.4, and 1.0, a range covering most current estimates of short-run and long-run price elasticity.”
[33] Gegaux, Douglas and Kenneth Nowotny, “Competition and the Electric Utility Industry,” Yale Journal on Regulation, 10 no. 63, 1997; Gilsdorf, Keith, “Testing for Subadditivity of Vertically-Integrated Electric Utilities,” Southern Economic Journal, 18 no. 12 (1995): Henderson, J. Stephen, “Cost Estimation for Vertically Integrated Firms: the Cost of Electricity,” in M. A. Crew (Ed.), Analyzing the Impact of Regulatory Change in Public Utilities (Lexington, Mass., Lexington Books, 1985); Hirst, Erick and Brenda Kirby, “Dynamic Scheduling: The Forgotten Issue,” Public Utilities Fortnightly, April 15, 1997; Kaserman, David L. and John W. Mayo, “The Measurement of Vertical Economies and the Efficient Structure of the Electric Utility Industry,” Journal of Industrial Economics, 29 no. 5 (1991); Kwoka, John E. Jr., Power Structure: Ownership, Integration, and Competition in the U.S. Electricity Industry (Dordrecht, Boston: 1996); Roberts, Mark J., “Economies of Density and Size in the Production and Delivery of Electric Power,” Land Economics, 62 no. 4 (1986).
[34] Hirst, Eric and Stand Hadley, “Generation Adequacy: Who Decides,” Electricity Journal (October 1999) and Borenstein, Trouble, argue for market-based solutions to ensure capacity sufficiency on the basis of demand side responsiveness, not supply-side construction of reserves.
[35] Pirrong, Stephen Craig, The Economics, Law and Public Policy of Market Power Manipulation (Boston: Kluwer, 1996), pp. 10, 24, 59, 70, identifies storage and transportation costs, as well as low elasticities of demand as critical factors making market manipulation more likely.
[36] See note 32.
[37] Mistr, Alfred E. Jr., “Incremental-Cost Pricing: What Efficiency Requires,” Public Utilities Fortnightly, January 1, 1996; Oren, Samuel S., “Economic Inefficiency of Passive Transmission Rights in Congested Electricity Systems with Competitive Generation,” The Energy Journal, 18 no. 1 (1997), “Passive Transmission Rights Will Not Do the Job,” The Electricity Journal, 10 no. 5 (1997); Ostroski, Gerald B., “Embedded-Cost Pricing: What Fairness Demands,” Public Utilities Fortnightly, January 1, 1996; Radford, Bruce W., “Electric Transmission: An Overview, Public Utilities Fortnightly, January 1, 1996; Volpe, Mark J., “Let’s Not Socialize Transmission Rates,” Public Utility Fortnightly, February 15, 1997; Bohi, Douglas and Karen Palmer, “The Efficiency of Wholesale vs. Retail Competition in Electricity, The Electricity Journal, October 1996; Cornelli, Steve, “Will Customer Choice Always Lower Costs?” The Electricity Journal, October, 1996.
[38]Geographic scope is needed to achieve what network economists call “pool effects” in network industries. Stabell, Charles B. and Oysteing D. Fjeldstad, “Configuring Value Chains for Competitive Advantage: On Chains, Shops and Networks,” Strategic Management Journal, 19 (1998); or load balancing in the electric utility industry, Cooper, Residential Consumer Economics.
[39] Earle, Robert L, Phillip Q. Hanser, Weldon C. Johnson, and James D. Reitzes, “Lessons from the First Year of Competition in the California Electricity Market,” The Electricity Journal (October 1999), describe the process in a context that finds the potential for market power and inefficiency.
[40] FERC, Staff Report to the Federal Energy Regulatory Commission on the Causes of the Pricing Abnormalities in the Midwest during June 1998 (Washington, D.C., 1998) (hereafter, FERC, Staff Report), p. 3-2; Public Utilities Commission of Ohio, Report; Kiah, E., Thoughts on Wild Prices, July 1998; Department of Energy, Interim Report of the U.S. Department of Energy’s Power Outage Supply Study Team, (Washington, January 1999) (hereafter DOE, Outages).
[41] Cambridge Energy Research Associates (CERA), Electric Power Trends: 2001 (Cambridge, Mass.: 2000); High Tension: The Future of Power Transmission in North America (Cambridge, Mass.: August 2000) (hereafter, CERA, High Tension); Stipp, David, “The Real Threat to America’s Power,” Fortune, March 5, 2001.
[42]CERA, High Tension.
[43] Brendan, Kirby and Eric Hirst, “Maintaining Transmission Adequacy in the Future,” Electricity Journal (1999), acknowledge the primary importance of noneconomic factors.
[44] DOE, Outages, Finding, 30.
[45] Ibid., 9, 31.
[46] Ibid., 1, 16.
[47] Puller, Steven L., “Pricing and Firm Conduct in California’s Deregulated Electricity Market,” (University of California Energy Institute, Program on Workable Energy Regulation, November 2000).
[48] Marcus and Russzon.
[49] Even introductory economics texts now contain long discussions of strategic behavior and game theory [see, for example, Taylor, Economics, Chapter 11] and it has become a routine part of applied policy analysis [Hasting, Justine, “Factors that Affect Prices of Refined Petroleum Products” (Washington, D.C. Federal Trade Commission Public Conference, August 2, 2001)].
[50] Scherer, F. M. and David Ross, Industrial Market Structure and Economic Performance Third edition (Boston: Houghton Mifflin, 1990), p. 21–2. The profit-maximizing firm with monopoly power will expand its output only as long as the net addition to revenue from selling an additional unit (the marginal revenue) exceeds the addition to cost from producing that unit (the marginal cost). At the monopolist’s profit-maximizing output, marginal revenue equals marginal cost. However, with positive output, marginal revenue is less than price, and thus the monopolist’s price exceeds marginal cost. This equilibrium condition for firms with monopoly power differs from that of the competitive firm. For the competitor, price equals marginal cost; for the monopolist, price exceeds marginal cost.
[51] Interestingly, the first economic text cited by Landes, W. M. and R. A. Posner, “Market Power in Antitrust Cases,” Harvard Law Review, vol. 19 (1981) was the 1980 edition of Scherer and Ross. Landes and Posner (p. 937) offer a similar concept
Our concept of market power is illustrated… where a monopolist is shown setting price at the point on his demand curve where marginal cost equals marginal revenue rather than, as under competition, taking the market price as given. At the profit-maximizing monopoly price, Pm, price exceeds marginal cost, C’, by the vertical distance between the demand and marginal cost curves at the monopolist's output.
[52] Rosen, Richard, et al., Can Electric Utility Restructuring Meet the Challenges It Has Created (Boston: Tellus Institute, 2000), Bushnell, James, Christopher Knittel and Frank Wolak, Estimating the Opportunities for Market Power in Deregulated Wisconsin Electricity Market (Consumers First, ND), pp. 10–3.
[53] Landes and Posner, 947. “Since market share is only one of three factors in equation (2) that determine market power, inferences of power from share alone can be misleading… The proper measure will attempt to capture the influence of market demand and supply elasticity on market power.”
[54]Ibid., at 942:
[T]he formula "comes apart" when the elasticity of demand is 1 or less. The intuitive reason is that a profit-maximizing firm would not sell in the inelastic region of its demand curve, because it could increase its revenues by raising price and reducing quantity…
If the formula comes apart when the elasticity of demand facing the firm is l or less, it yields surprising results when the elasticity of demand is just a little greater than 1. For example, if the elasticity of demand is 1.01, equation (la) implies that the firm's price will be 101 times its marginal cost. There is a simple explanation: a firm will produce where its demand elasticity is close to one only if its marginal cost is close to zero, and hence a relatively low price will generate a large proportional deviation of price from marginal cost.
[55] Pearce, George, The Dictionary of Modern Economics (Cambridge, Mass.: MIT Press, 1984), p. 124.
[56] Bannock, Graham, R.E. Banock and Evan Davis, Dictionary of Economics (London: Penguin, 1987), p. 128.
[57] The origin of the concept has been associated with land, hence it is occasionally referred to as ground rents (Rutherford, Donald, Dictionary of Economics (London: Routledge, 1992), p. 137).
As land was regarded in classic economics as the only fixed factor of production, it alone earned rent. However, as any factor of production can be fixed in supply, “rent” can be earned by any factor of production. Popular examples of factors with an inelasticity of supply abound; labor can earn economic rent as persons with rare talents (e.g. opera singers and top sports players) have high earnings largely consisting of economic rent.
Teece, David, J. and Mary Coleman, “The Meaning of Monopoly: Antitrust Analysis in High-Technology Industries,” The Antitrust Bulletin (Winter 1998), p. 819, define scarcity rents as:
In many contexts where knowledge and other assets underpin a firm’s competitive advantage, additional inputs cannot simply be purchased on the market to expand output… historically at least, economists have associated Ricardian rents with scarce natural resources like land or iron ore.
[58] Because supply of a fixed asset does not respond to price changes, there is little or no dead weight loss, as Taylor, Economics, p. 350, puts it,
Economic rent is the price of anything that has a fixed supply. Economic rent is also sometimes called pure rent. Economic rent is a significant concept in economics precisely because the quantity supplied does not depend on the price. Thus, a tax on economic rents would not change the amount supplied; it would not affect economic efficiency or cause a deadweight loss.
[59] Rosen, et al.
[60] Hildebrandt, Eric, “Further Analysis of the Exercise and Cost Impacts of Market Power in California’s Wholesale Energy Markets,” (Folsom, CA: Department of Market Analysis, California Independent System Operator (ISO), March 2001); Id., “Impacts of Market Power in California’s Wholesale Energy Market: More Detailed Analysis Based on Individual Seller Schedules and Transactions in the ISO and PX Markets,” (Folsom, CA: Department of Market Analysis, California ISO, April 9, 2001); Sheffrin, Anjali, "Empirical Evidence of Strategic Bidding in California ISO Real Time Market,” (Folsom, CA: Department of Market Analysis, California ISO, March 21, 2001).
[61]Borenstein, Severin, James Bushnell and Frank A. Wolak, Diagnosing Market Power in California’s Restructured Electricity Market (University of California Energy Institute, Program on Workable Energy Regulation, August 2000), pp. 32-33.
[62] Cooper, Reconsidering.
[63] Bornstein, Bushnell and Wolak.
[64] Combining the results of Hildebrandt, Further Analysis, Tables 3-1, B-1 and B-2, we calculate annual recovery of capital costs under actual prices in effect in California in 1999-2001 as follows:
ANNUALS RETURN ON INVESTMENT
NP15 SP15
Low Cost plant ($500/MWh@ 14%ROI) 46 32
High cost plant ($600/MWH@16%ROI) 39 26
[65] National Rural Electric Cooperatives Association (NRECA) Energy Policy Department, Retail Wheeling Report (Washington, July 2001).
[66] EIA, Electricity Average Revenue April 2001 (Washington, various).
[67] Ochenski, George, “Power Play,” Missoula Independent, April 26, 2001; NRECA, Retail Wheeling, p. 33.
[68] Davis, Tina, “PPL Challenges Montana Limits on Power Rates,” The Energy Daily, July 11, 2001.
[69] Bowring, Joseph, et al., Monitoring the PJM Market: Summer 1999, Berkeley, CA, UCEI Power Conference, March 17, 2000), Rose, Other States; Stoft, Steven, PJM’s Capacity Market in a Price-Spike World (University of California Energy Institute, Program on Workable Energy Regulation, May 2000); Rosen, et al.
[70] Mansur, Erin, T., Pricing Behavior in the Initial Summer of the Restructured PJM Wholesale Electricity Market (University of California Energy Institute, Program on Workable Energy Regulation, April 2001).
[71] Cooper, Spike; Earle, Robert L, et al., “Lessons from the First Year of Competition in the California Electricity Market,” The Electricity Journal (October 1999).
[72] Rosen, et al.
[73] Dowden, Lisa G, Robert C. McDiarmid and Will S. Huang, Market Power: Will We Know it When We See It?: The California Experience, American Public Power Association (December 2000); Allen, Daniel, Bruce Biewald and David Schlissel, Generator Outage Increases: A Preliminary Analysis of Outage Trends in the New England Electricity Market (Union of Concerned Scientists, January 7, 2001); Rosen, et al.
[74] Wolfram, Catherine D., “Electricity Markets: Should the Rest of the World Adopt the United Kingdom’s Reforms?,” Regulation, 1999 (22) (hereafter Reform),
From 1992 to 1994, on average prices were 25 percent above the cost of the last plant needed to generate electricity in a given period. That suggests prices would have been substantially lower had they been set competitively. Since 1994, fuel prices have come down but electricity prices have not fallen accordingly. That suggests profits have risen and provides further evidence that prices are not responding to competitive forces.
Wolak, Frank A. and Robert H. Patrick, Impact of Market Rules and Market Structure on the Price Determination Process in the England and Wales Electricity Market (University of California Energy Institute, Program on Workable Energy Regulation, February 1997.
[75]U.S. DOE, Office of Economic, Electricity an Natural Gas Analysis, The Impact of Wholesale Electricity Price Controls on California Summer Reliability (Washington, June 2001).
[76] Ibid., p. 13.
Thus, a new combustion turbine would have to operate for more than 55 percent of the hours in a year in order to recover its fixed costs over a 3-year period if it were paid only $25/megawatt hour above its operating costs…
Because combustion turbines have high operating costs and are built to meet peak demand, developers generally expect that they will have relatively low capacity factors, ranging from 10 percent to 30 percent, significantly less than would be required to recover capital costs in 3 years under the cost-plus proposal. Although capacity factors for new combustion turbines in California are likely to be above average for the next year, the projected break-even point of more than 55 percent represents a considerable risk for developers, which many will be unwilling to bear. Even if a developer expected to spread the plant’s fixed costs over a 10-year period, the risk would still be high at a projected capacity factor of nearly 30 percent every year for 10 years.
[77] Enron Power Marketing, Inc., Analysis of the Midwestern Electricity Price Spikes of Late June 1998; Michaels, Robert J. and Jerry Ellig, Electricity Passes the Market Test (Arlington, VA: Mercatus Center, October 19, 1998); an analogous response for the summer 2000 problems in California can be found in Electric Power Supply Association, California: The Real Story, September 11, 2000; Enron, p. 7.
[78]Watts, Price C., “Heresy? The Case Against Deregulation of Electricity Generation,” The Electricity Journal, 2001 (March 3).
[79] Staff Report, Market Clearing Prices Under Alternative Resource Scenarios: 2000–2010 (Sacramento: California Energy Commission, February 2000). The alternative analyses focus on a combined-cycle plant, but the only difference in the financial assumptions is to increase the fixed charge factor for combustion turbines by assuming a higher rate of return on equity.
[80] Lawrence B. Lindsey, identified as “Mr. Bush’s chief economic advisor,” (“A Triumph of Politics,” Washington Post, June 20, 2001, p. A-14), stated the claim as follows in describing the FERC decision to impose price mitigation measures in California and the West “What they are trying to do is achieve two incompatible missions, preserving what is called ‘just and reasonable pricing’ and assuring an adequate supply of electricity.”
[81] Watts.
[82] Vasapoli, Joe, “Cost-Based Electricity Rates: Do They Cause Over- or Under-Supply?” Energy Daily, July 5, 2001, makes the obvious point that the long-term commitment to buy power is the key to inducing construction under cost-based rates.
[83] Rosen, et al., raise questions about the ability of any set of institutions to run the industry based primarily on external market transactions. Earle, et al., describe the process in a context that finds the potential for market power and inefficiency.
[84] FERC, Staff Report, 3-1, 3-2.
[85] Ohio Report, pp. 20–21.
[86] Ibid., p. 19; CERA, High Tension; Harris, Kiah, E., Thoughts on Wild Prices, July 1998.
[87] Cooper, Restructuring.
[88] Casazza, J. A., Errant Economics? Lousy Law? Market Manipulation? All Three!!, 2001. A guest editorial, a decade earlier by the same author, just as the United Kingdom was implementing restructuring, raised doubts about the economic benefits of restructuring (see Casazza, John A., Allan J. Schultz and Joseph C. Swidler, “A Brave New World: Let’s Look Before we Leap,” Electricity Journal, 1990 (November)).
[89] Karier, Tom, “Keeping the Lights on: A Banking Industry Model to Avoid Shortages,” Public Utilities Fortnightly, July 1, 2002, and Liveley, Mark B., “Keeping the Light on: An Insurance Industry Model to Stop Manipulation,” both argue that there is little responsibility for reserves in the current system, although they offer different regulatory solutions.
[90] Sansom, Robert L. and A. Michale Schall, “The Merchant Power Plant Shakeout,” Public Utility Fortnightly, June 15, 2002; Benson, Michael, Chip Cummins and Jathon Sapsford, “Trade Disclosures Shake Faith in Damaged Electricity Market,” Wall Street Journal, May 13, 2002; Lobensz, George, “Big Trading Losses Wilt Williams’ Stock, Trigger Downgrade,” Energy Daily, July 23, 2002; Davis, Tina, “Dynegy Ripples Rock Sithe, Chevron Texaco,” Energy Daily, July 31, 2002, “Duke Admits to ICE ‘Round-Trip’ Trades, Energy Daily, July 17, 2002.
[91] Holly, Chris, “Wall Street Analysis Finds Nation Faces Big Electricity Shortage,” Energy Daily, September 12, 2001; Davis, Tina, “Au Revoir, IPPs?” Energy Daily, July 9, 2002.
[92] The abuse of market power in the United Kingdom was taking place with reserve margins of over 20 percent (Wolak, Frank A. and Robert H. Patrick, Impact of Market Rules and Market Structure on the Price Determination Process in the England and Wales Electricity Market (University of California Energy Institute, Program on Workable Energy Regulation, February 1997) p. 30.
[93] Klemperer, Paul, The Economic Theory of Auction (Oxford: Nuffield College, July 2000), p. 30, stresses the important of uncertainty in avoiding tacit collusion, which is a particular problem in electricity markets, with cites to general auction literature.
[94] Klemperer, Economic Theory, at 30–31 (citing Newberry, David M., “Competition, Contracts, and Entry in the Electricity Spot Market,” Rand Journal of Economics, 29 no. 4, 1998; Wolfram, Catherine, D. “Strategic Bidding in a Multi-unit Auction: An Empirical Analysis of Bids to Supply Electricity in England and Wales,” Rand Journal of Economics, 29, 1998), identifies four characteristics of the electricity market that lead to concerns about “implicitly collusive bidding schedules,” a small number of bidders, capacity constraints, frequent repetition of auctions, and difficulty of entry.
[95] Wolak, Frank A., “An Empirical Analysis of the Impact of Hedge Contracts on Bidding Behavior in a Competitive Electricity Market,” International Economic Journal, 2000 (14), p. 34, analyzed the early pricing behavior in the market and found that excess capacity was a central driver of bidding behavior.
[96] Wolak and Patrick, p. 30.
[97] Bushnell, Knittel and Wolak; Sweetser, Al, An Empirical Analysis of a Dominant Firm’s Market Power in a Restructured Electricity Market: A Case Study of Colorado (April 1, 1998); Rudkevich, Aleksander, Max Duckworth and Richard Rosen, Modeling Electricity Pricing in a Deregulated Generation Industry: The Potential for Oligopoly Pricing in a Poolco (Boston, Mass.: Tellus Institute, February 24, 1997, review data from Pennsylvania, Borenstein and Bushnell, “An Empirical Analysis,” apply the approach to California.
[98] Borenstein and Bushnell, “An Empirical Analysis.”
[99] Ibid., finds that market power disappears at just 33,000 MW of demand. With a maximum peak demand in the month of just over 41,000 MW this implies a peak capacity for the month of 44,000 MW. In other words, at the 300th hour where market power is eliminated, excess capacity is at least 29 percent.
[100] Simulations in advance of the opening of the Australian market identified both highly competitive outcomesand the possibility of strategic bidding, but excess capacity loomed large in the market (Brennan, Donna and Jane Melanie, “Market Power in the Australian Power Market,” Energy Economics, 1998).
[101] Further insight into the reserve margin requirement can be gained from considering simulation of markets at different levels of demand elasticity. A good example is a simulation for Wisconsin (Bushnell, Knittel, and Wolak) similar to those done in a number of other states. Oligopoly pricing would result in huge markups of price over cost in about half the hours of the year, i.e. above 6,000 MW on a system with about 14,000 MW of capacity. This simulation is quite similar to the observed pattern in California in mid-2000, before the severe market problems of the winter 2000–spring 2001 period. The deviation of bids from prices takes place at about the same relative level of demand (about half way up the supply curve). Expanding transmission would restrain prices up to 8,000 MW, but then the supply side becomes too tight to prevent the exercise of market power. When one assumes a demand elasticity of -.4, four times the “normal” elasticity, however, market power is substantially controlled at all levels of demand. The authors of this simulation pause to consider the implications of such a huge increase in demand elasticity. In order to have the price disciplining effect, the demand elasticity must reduce demand by 20 to 30 percent as the system moves toward the peak. As the authors point out, this is a massive reduction in demand.
[102] Siddiqui, Afzal S., Chris Mornay and Karl Khavkin, “Excessive Price Volatility in the California Ancillary Services Markets: Causes, Effects and Solutions,” Electricity Journal, 6.
[103] Sheffri, Anjali, Comprehensive Market Redesign: Options, Mitigation (Folsom, CA: October 4, 2000).
[104] Klein, Michael and Loretta Lynch. California’s Electricity Options and Challenges (San Francisco: Public Utility Commission, August, 2000), p. 36, give an estimate of approximately 672 MW added capacity, or 2 percent, for 1996 to 1999. This is compared to a growth in peak demand of 5,522 MW over the period. In contrast, nationwide generating capacity has declined by about 10 percent, while noncoincident peak increased by 10 percent (EIA, Electric Power Annual 1999, December 2000, Tables 34, 35). Harvey, Hal et al., “California and the Energy Crisis: Diagnosis and Cure,” Energy Foundation, March 8, 2001, look at the decade of the 1990s and show substantial additions to capacity, particularly smaller scale units.
[105] In addition to the price spikes of 1998 (see FERC Staff Report, PUCO); the summer of 1999 experienced price spikes (see Rose, Kenneth, The California Electric Restructuring Meltdown and the Fallout in Other States, paper presented at National Conference of State Legislatures, AFI/ASI Joint Winter Meeting, AFI Energy and Transportation Committee (December 13, 2000) (hereafter Other States); id., The California Electric Meltdown, presentation to the NRRI Board of Directors Meeting, September 14, 2000, (hereafter, Rose, Meltdown); Bowring, Joseph, et al.,) and supply outages (DOE, Outages); and the summer of 2000 also exhibited sharp run-ups in New York and New England (see Rose, Meltdown, Rosen, et al.).
[106] An account of the immense sums spent in opposing vigorous competition at the federal level can be found in Benton, James C., “Money and Power: The Fight Over Electricity Deregulation,” CQ Weekly, August 12, 2000.
[107] The key elements of this scenario were laid out in Kahn and Lynch, Options. An interesting perspective on perceptions about the crisis that tracks many of the arguments made below can be found in “Roundtable Dialogue on California Energy Crisis,” Sacramento Bee (December 24, 2000). Marcus, Crisis, provides specific estimates of the size of each of the factors, as do Harvey, et al.
[108] See Marcus, Crisis. The DOE documented the difficulties that utilities created for the expansion of supply through distributed generation, see Alderfer, R. Brent, M. Monika Eldridge, and Thomas J. Starrs, Making Connections: Case Studies of Interconnection Barriers and their Impact on Distributed Power Projects (National Renewable Energy Laboratory, May 2000).
[109] Marcus, Crisis, gives the following figures for long term resources: 1,400 MW renewables and cogeneration and 2,000 MW of efficiency—and for short term resources, 2,300 MW of uncontracted spot capacity and 2,500 MW of bogus interruptible contracts (see also Harvey, et al.) The California Energy Commission put distributed generation as high as 20 percent, or as much as 10,000 MW, by 2010, which alarmed PG&E, see Pacific Gas and Electric Company’s Position on Distribution Competition, Distributed Generation and the Role of the Distribution Company, p. 27.
[110] Wolak, Analysis, and Kahn, Alfred, et al., Pricing in the California Power Exchange Electricity Market: Should California Switch from Uniform Pricing to Pay-as-Bid Pricing (California Power Exchange, January 23, 2001) also recognize that utilities did not take these opportunities, but excuse it by suggesting they did not trust regulators.
[111] Puller shows an immediate reduction in utilization after deregulation and divestiture.Marcus, Crisis, states, “Forced outage rates for California natural gas plants over the past five years have gone from the traditional 5-10 percent per year outage rate to an average of almost 50 percent.”
[112] Kwoka, John, E. Jr., Unilateral Withholding: Market Power and California’s Electricity Crisis, Discussion Paper No. 01-03 (Washington: Center for Economic Research, 2001).
[113] Rose, Other States, shows an increase in unplanned outages between 1999 and 2000 of about 1,000 MW in June, 1,600 MW in July, and 2,500 MW in August.
[114] Krugman, Paul, “Turning California On,” New York Times, June 27, 2001, A-25.
[115] Rothkopf; FERC, June 19th Order.
[116] Ibid.
[117] Davis, Tina, “Reliant Admits ‘Round-Trip Trading to Boost Revenues,” Energy Daily, May 14, 2002, “Duke Admits to ICS ‘Round-Trip’ Trades,” Energy Daily, July 17, 2002.
[118] “Those Hideous, Awful Enron Memos,” Wall Street Journal, May 16, 2002.
[119] Harris, p. 4.; Cal, First Report, p. 21; FERC, Staff Report, pp. 3-2, 4-10.
[120] Newberry, David, “Viewpoint: Freer Electricity Markets in the UK: A Progress Report,” Energy Policy, 26 no. 10 (1998) pp. 746-7; “Interview—UK Power Pool Says Reduces Price Surges,” Reuters, April 16, 1999.
[121] Puller finds strong evidence of static market power and weak evidence of dynamic gaming in the first year of the market. There is a general consensus that gaming increased in subsequent years, Kahn and Lynch, Options, Chapter III; Marcus, Crisis.
[122] There is a formal theory of this in economics, called a backward bending supply curve. It has been extensively applied to labor markets. That the concept is routine is attested to by its inclusion in introductory texts, see for example, Taylor, John, B., Economics (Boston: Houghton Mifflin, 1998), pp. 327-329. The most directly analogous situation is behavior of the OPEC cartel (see Adelman, Morris, “OPEC the Clumsy Cartel,” The Energy Journal, 1:1980; Bohi, Douglas and W. David Montgomery, Oil Prices, Energy Security and Import Policy (Washington: Resources for the Future, 1982); Aperjis, Dimitri, The Oil Market in the 1980s: OPEC Oil Policy and Economic Development (Cambridge, Mass.: Ballinger, 1982); Teece, David, “OPEC Behavior: An Alternative View,” in James M. Griffin and David J. Teece (Eds.), OPEC Behavior and World Oil Prices (London: George Allen and Unwin, 1982); Adelman, Morris, “OPEC as a Cartel,” in James M. Griffin and David J. Teece (Eds.), OPEC Behavior and World Oil Prices (London: George Allen and Unwin, 1982).
[123] Wolak, “An Analysis of the June 2000 Price,” p. 14.
[124] Borenstein, Severin, James Bushnell and Steven Stoft, “The Competitive Effects of Transmission Capacity in a Deregulated Electricity Market,” Rand Journal of Economics, 31 no. 2 (2000) p. 318, state, matter of factly, “Congestion on the north-south transmission lines often divides the state into at least two distinct geographic markets.” See also Dowden, McDiarmid Huang, Market Power: Will We Know it When We See It?: The California Experience, American Public Power Association (Washington: December 2000); Marcus, Crisis.
[125] Bushnell, James and Frank A. Wolak, “Regulation and the Leverage of Local Market Power in California’s Electricity Market” (University of California Energy Institute, Program on Workable Energy Regulation, September, 1999).
[126] Dowden, McDiarmid, and Huang: Marcus, Crisis.
[127] Ibid.
[128] Rao, Narasimha, and Richard D. Tabors, Transmission Markets: Stretching the Rules for Fun and Profit, TCA Working Paper, No. 327-0400 (April 2000). The importance of transmission is underscored in Borenstein, Bushnell and Stoft.
[129] Consumer Federation of America, “Request for Reconsideration,” Regional Transmission Organizations, United States of America, FERC, Docket RM99–2-000; Order 2000, Session (January 20, 1999).
[130]Cooper, Mark, Mergers and Open Access to Transmission in the Restructuring Electric Industry: Analytic Tools, Empirical Evidence and Policies to Build Effective Market Structures, (Washington: Consumer Federation of America, 2000).
[131] EIA, The Changing Structure of the Electric Power Industry 1999: Mergers and Other Corporate Combinations (Washington: December 1999).
[132] Dowden, McDiarmid, and Huang, recounts the evidence presented to FERC on market power and FERC’s seeming inaction; Cooper, Spikes, discusses the failure of FERC to react vigorously to complaints of market power in response to the 1998 price spikes.
[133] Dowden, McDiarmid and Huang.
[134] Cooper, Spikes.
[135] A frustrated FERC staff member wrote a blistering critique of FERC’s unwillingness to investigate transaction data in 1998 and 1999, just prior to the onset of the big problems in the California market in 2000. See Open Memorandum, From: Ron Rattey, OMTR, To: FERC Staff (June 2, 2000).
[136] Dowden, McDiarmid, and Huang.
[137] Order Authorizing Disposition of Jurisdictional Facilities, PGE National Energy Group, Inc., PG&E Enterprises and PG&E Shareholdings, Inc, FERC (January 12, 2001).
[138] Commissioner Massey, dissenting, Order Authorizing Disposition of Jurisdictional Facilities, PGE National Energy Group, Inc., PG&E Enterprises and PG&E Shareholdings, Inc, FERC (January 12, 2001).
[139] Some analysts emphasize the problem of imperfect institutions interacting with market power (Eric Charles Woychik, Nine Lessons From California’s Energy Blunderland? Don’t Markets Provide Infrastructure? (Oakland: Strategy Integration Inc., June 26, 2001); “Testimony of Eric Charles Woychik, on behalf of TURN and UCAN, San Diego Gas & Electric, et al., Docket No. EL00-95-000, November 22, 2000 (hereafter Turn). This view should be distinguished from those who argue that market imperfections are the primary, if not sole cause of the problems (see Chandley, John D., Scott Harvey and William Hogan, Electricity Market Reform in California, November 22, 2000; and id. Issues in the Analysis of Market Power in California, (Cambridge, Mass.: October 27, 2000)).
[140] McDiarmid, Robert C., Lisa G. Dowden, and Daniel I. Davidson, “A Modest Proposal: Revoke the Nobel Price? Recognize the Limitations of Theory? Or Grant a License to Steal?,” Electricity Journal, January/February 2001. Kahn, Alfred, et al., Pricing in the California Power Exchange Electricity Market: Should California Switch from Uniform Pricing to Pay-as-Bid Pricing (California Power Exchange, January 23, 2001, argue, based primarily on experimental results, that the bidding system does not matter much, compared to the problems of market power, tight supplies, and inelastic demand, and given the ability of those with market power to adapt their bidding strategies to any system. To the extent that the purpose is to prevent attention from being directed away from the important issues, this is a useful analysis, but the arguments miss the fundamental problem identified by other analysts and the victims of the one-price system. The critics of the one-price system focus on the massive economic rents and the lottery nature of the one-price system, which exposes a few very high price offers to little risk, a bidding strategy that is consistent with the backward-bending supply curve (see the sources cited at notes 12 and 13 in Kahn, et al.).
McDiarmid, et al., Modest Proposal, summarizes the lottery nature of this type of auction as follows:
I know that a simple bidding strategy of bidding very high on the last few MW will be extremely profitable for everyone, including me, if I have enough MW already running at the time, and so I will follow that strategy and I expect anyone else in the business to have enough brains to see the same advantage.
They describe the huge rents as follows (p. 16):
the cost difference from a market clearing price of $75 or one of $1,075 is $50 million per hour, or $500 million per 10-hour peak period. If the bidding behavior of one of the last few suppliers were rational then, the failure of a 100 MW unit to be dispatched would mean that the last supplier would lose $75,000 (gross revenue, which would translate into significantly less on lost profits after reduction of the out-of-pocket costs) for a 10-hour period; but if that supplier had 4,000 MW already in the market dispatched based on bids that would be rational for the second-price theory, the additional amount that it would gain for the output of those units already running if a market-clearing pride at the $1,075 level were established would be $4 million per hour, or $40, million for the 10-hour period.
Roundtable participants clearly care a great deal about the average price and believe that the very high rents available on all sales at peak times has dissuaded sellers from offering reasonable prices for longer terms. Similarly, Florida Municipal Electric Association, which represents consumers, show substantial rents, see Energy 2020 Study Commission Wholesale Deregulation Proposal Will Raise Electric Rates and Maximize Profits of Private Utility Shareholders. TURN and Woychik do not accept this point of view.
[141] Rosen, et al., stress the importance of rents in the industry.
[142] Wolak, et. al.; TURN; and Woychik stress this problem.
[143] Wolak, et. al.
[144] See, Market Surveillance Committee, “Analysis of Order Proposing Remedies for California Wholesale Electric Markets,” FERC, Dockets ER00-95-000, et. Al., (Folsom, CA: December 4, 2000), as well as Wolak, et al., Bushnell, and Wolak; Borenstein, Bushnell and Wolak, and Bohn, Klevorick and Stalon.
[145]Two and a-half years after first noting the market power problem, the California ISO finally did take action under FERC’s soft cap regime, requesting refunds of over $.5 billion of unjust and unreasonable charges for two months (see “Motion for Issuance of Refund Notice to Sellers, Request for Data, Request for Hearing, and Request for Expedited Action of the California Independent System Operator Corporation and the California Electricity Oversight Board,” before the FERC, San Diego Gas & Electric Company, docket Nos. EL00-95-000, EL00-98-000 and ER01-607-000, March 1, 2001.
[146] ISO Response to Selected Portions of the Summer 2000 Report to the Governor (Folsom, CA: August 8, 2000)[hereafter, ISO Response]; Wolak, et al., TURN and Woychik, question the importance of the lack of long term contracts (see also Harvey, Scott M. and William Hogan, California Electricity Prices and Forward Market Hedging, October 17, 2000).
[147] ISO Response, p. 5.
Indeed, planners of deregulation recognized that much of the success of the markets depend on work to be implemented and/or regulated by state policy makers. This work included development of demand responsiveness products, implementation of hedging instruments for entities that serve load, development of real-time rates and installation of real-time meters, promotion of consumer education on issues of price responsiveness and conservation, and facilitation of review of transmission lines and/or substations at critical junctions in the transmission system. Most of this work remains to be done.
[148] Kaloko, Ahmed, “California & Pennsylvania Retail Market Development,” (Pennsylvania Public Utility Commission, 1999).
[149] TURN, Memo to Legislators on Audits of Pacific Gas and Electric and Southern California Edison (San Francisco: January 31, 2001);
[150] Wolak et al.
[151] Marcus, Crisis.
[152] Ibid.
[153]Projections from the early part of the year put the 2001 bill at over $50 billion, up from $28 billion in 2000 and just $7 billion in 1999. “The Pros and Cons of Power Price Caps,” Wall Street Journal, June 4, 2001, gives figures of $7.4 billion for 1999, $27 billion for 2000, and an expected $50 billion for 2001. Woychik, Charles, Nine Lessons, p. 6, asks the question “2001 CA wholesale cost: $60 B or more?”
[154] After the CAL-ISO was reconstituted, efforts to demonstrate market failure increased, see Report on Real Time Supply Costs Above Single Price Auction Threshold: December 8, 2000–January 31, 2001 (Folsom, CA: February 28, 2001); Sheffrin, Anjali, Market Analysis Report (Folsom, CA: Memorandum to ISO Board of Directors, March 23, 2001); Hildebrandt, Eric, Further Analysis of the Exercise and Cost Impacts of Market Power in California’s Wholesale Energy Markets (Department of Market Analysis California ISO, March 2001), Impacts of Market Power in California’s Wholesale Energy Market: More Detailed Analysis Based on Individual Seller Schedules and Transactions in the ISO and PX Markets (Folsom, CA: Department of Market Analysis, California ISO, April 9, 2001); Sheffrin, Anjali, Empirical Evidence of Strategic Bidding in California ISO Real Time Market (Department of Market Analysis, California ISO, March 21, 2001); Hildebrandt, Eric, “Analysis of Payments in Excess of Competitive Market Levels in California’s Wholesale Energy Market: May 2000–2001,” FERC Settlement Conference, July 9, 2001. As if to underscore the determination of power suppliers to squeeze every penny out of the market, the ISO found thousands of above market transactions on May 30 and 31, just before the price mitigation measures went into effect (San Jose Mercury News, August 8, 2001).
[155] Consumer Federation of America, et al., “Motion To Intervene And Request For Rehearing,” “Reply Comments,” San Diego Gas & Electric Company, Complainant, v. Sellers of Energy and Ancillary Service Into Markets Operated by the California Independent System Operator and the California Power Exchange, Respondents Investigation of Practices of the California Independent System Operator and the California Power Exchange California Independent System Operator Corporation Investigation of Wholesale Rates of Public Utility Sellers of Energy and Ancillary Services in the Western Systems Coordinating Council, FERC, Docket Nos. EL00-95-012, EL00-98-000, RT01-85-000, EL01-68-000, demonstrates that price ceilings in California would be cut in half if high spot-market prices are not used. The implications are that abuse pricing of natural gas doubled the cost of electricity. The implication is that as much as three quarters of the increase in electricity costs could be the result of abuse.
[156] Krugman, California, uses this figure.
[157] Green, Richard, “Draining the Pool: The Reform of Electricity Trading in England and Wales,” Energy Journal, 2000; Rothkopf.
[158] Between April and June, 2001, the state added approximately 1,200 MW to its long term contract portfolio (see “California Agency’s Power Costs to Drop Sharply,” Energy Daily, June 13, 2001).
[159] San Jose Mercury News, June 11, 2001, puts the capacity made available at 1,200 MW as a result of the easing of air quality restrictions. The CPUC simultaneously ordered payment to small generators, (Reuters, June 13), making another 1,500 MW of capacity available.
[160] Conservation, adjusted for weather, has been put at 5 to 10 percent (see Sanchez, Rene, “California Residents Answer State’s Call to Cut Power Use,” Washington Post, June 5, 2001; Sheffrin, Anjali, Market Analysis Report for May 2001 (Folsom, CA: California ISO, June 15, 2001)). The reduction in peak use is between 2,000 and 4,000 MW.
[161] Summing up the “unexpected” shift in the supply demand balance we find 7,000 MW more resources available in a system that typically peaks at around 48,000 MW.
[162] FERC, Order Directing Remedies for California Wholesale Electric Markets, 93 FERC, ¶61,294 (December 15, 2000); Order Directing Seller to Provide Refunds of Excess Amounts Charged for Certain Electric Energy Sales During January 2001 or, Alternatively, to Provide Further Cost or Other Justification for Such Charges, 94 FERC ¶61,245 (March 9, 2001); Order Establishing Prospective Mitigation and Monitoring Plan for the California Wholesale Electric Markets and Establishing an Investigation of Public Utility Rates in Wholesale Energy Markets, 95 F.E.R.C. ¶ 61,115 (April 26, 2001); June 19th Order.
[163] Beattie, Jeff, “FERC Judge Takes Swing at El Paso on California Gas Market Manipulation,” Energy Daily, August 7, 2001; “FERC to Investigate Enron California Pipeline Deals,” Energy Daily, July 26, 2001.
[164] Opel, Richard, A. “California Gets a Reprieve as Natural Gas Prices Drop,” New York Times, June 11, 2001.
[165] EIA, Electricity $Sales and Revenue 2000, shows that California has the third-highest residential rates in the nation on a statewide average basis.
[166] Robert Solow, et al., Manifesto on the California Electricity Crisis, January 26, 2001, cited in William Hogan, California Electricity Market: Policy Meltdown, (paper presented at KSG Faculty Seminar, [Cambridge, Mass.: February 14, 2001]. .
[167] Taylor, Economics, p. 350.
[168] Scherer and Ross, pp. 15-29. Abuse of monopoly power imposes static, deadweight loss (see Asch, Peter, Industrial Organization and Antitrust Policy (New York: John Wiley and Sons, 1983) p. 83) and may impose dynamic x-efficiency losses (p. 97).
[169] They not only facilitate the abuse of monopoly power, they create substantial x-efficiency losses, by fostering the disincentive to produce (Ibid., p. 97).
[170] Davis, Tina, “Arizona Steps Back From Deregulation,” Energy Daily, August 20, 2002, notes the most recent reversal and points out that the failure to deal with market disruptions is a primary source of concern. Other states that have slowed down or changed course include Nevada, Oklahoma, Arkansas, and Virginia (Fialka, John, “Regulator Finds Himself Encircled in Enron Headhunting,” Wall Street Journal, Feb. 22, 2002).
[171] Thurm, Scott, Robert Gavin and Mitchel Benson, “As California Starved for Energy, U.S. Businesses Had a Feast,” Wall Street Journal, September 16, 2002, p. A-8.
[172] Although the agency has let many of the PUHCA powers atrophy, it can still be binding (see “AEP/CSW Merger Rejected by Court,” ELCON Report, No. 2, 2002) and a range of abuses that have afflicted the electricity market would have been prevented by aggressive implementation of PUHCA (see “PUHCA Repeal: A Catalyst to Corporate Raiders: Absence of PUHCA Aids Regulatory Chaos, not Competition,” TVPPA News, March-April, 2002).
[173] U.S. Senate Committee on Energy and Natural Resources, “Testimony of Scott Hempling,” The Public Utility Holding Company Act of 1935 and S. 1766, 107th Congress, pp. 30–32.
[174] United States Senate Committee on Banking, Housing, and Urban Affairs, “Testimony of Dr. Mark N. Cooper on the Regulation of Public Utility Holding Companies,” April 29, 1997. U.S. House Committee on Energy and Commerce, “Testimony of Dr. Mark N. Cooper on Behalf of the Consumer Federation of America and the Environmental Action Foundation on Exempting Registered Holding Companies from the Public Utility Holding Company Act for Diversification into Telecommunications,” July 29, 1994; Committees on Finance and Technology and Electricity, National Association of Regulatory Utility Commissioners, “Statement of Dr. Mark N. Cooper, Joint Hearing on the Public Utility Holding Company Act of 1935,” February 28, 1989; U.S. House Subcommittee on Energy and Power of the Energy and Commerce Committee, “Independent Power Producers and the Public Utility Holding Company Act of 1935,” September 14, 1988.
[175] “Commission Proposed New Foundation for Bulk Power Markets with Clear, Standardized Rules and Vigilant Oversight,” FERC, Docket RM01-12-000, Press Release, July 31, 2002, p. 2.
[176] Cooper, Market, All Pain, No Gain (Washington: Consumer Federation of America, 2002). The broader analysis of risks and rewards certainly applies to retail restructuring for residential customers throughout the nation.
[177] The model is based on the following assumptions and techniques
A constant elasticity of demand of -.1 is assumed in the form of Q = kPe.
Where:
Q = quantity
k = is a constant
p = price
e = market elasticity of demand
Demand is anchored in 1,000 MW increments assuming the average cost of production of $25.5/MWh by adjusting k.
All fringe supply is utilized first and the dominant firm/cartel face the residual for their demand curve.
Total nameplate capacity is 40,000 MW; import capacity is 4,000 MW.
Demand ranges from 8,000 MW to 36,000 MW per hour.
Fringe supply is 24,000 MW in the dominant firm case, 16,000 MW in the cartel case.
Given spinning reserves and outages, at 36,000 MW of load, the residual demand in the dominant firm case is 12,000 MW and in the cartel case it is 20,000 MW.
A price cap of $1,000 is assumed.
Cost data and net generation are taken from the FEMA study.
[178] There is one characteristic that the South and West share that should heighten their concerns about the SMD. They are both rapidly growing regions. The handling of growth in the SMD is ill-defined. The new, untried transmission organizations have responsibility for planning and ensuring expansion of the grid. New load is likely to be forced into the market for transmission services. Bargaining for power in markets where rents are rampant threatens to increase prices.
[179]These observations are based on direct participation in the Pennsylvania proceedings, see “Direct Testimony of Dr. Mark N. Cooper in Response to the Petition of Enron Energy Services Power, Inc., for Approval of an Electric Competition and Customer Choice Plan and for Authority Pursuant to Section 2801 E3 of the Public Utility Code to Service as the Provider of Last Resort in the Service Territory of PECO Energy Company on Behalf of the American Association of Retired Persons,” Pennsylvania Public Utility Commission v. PECO, Docket R-00973953 November 7, 1997; Pennsylvania Public Utility Commission, “Testimony of Dr. Mark N. Cooper on Behalf of the American Association of Retired Persons,” Application of Pennsylvania Power and Light Company for Approval of its Restructuring Plan Under Section 2806 of the Public Utility Code, Docket R-00973954 July 2, 1997; Pennsylvania Public Utility Commission, “Testimony of Dr. Mark N. Cooper on Behalf of the American Association of Retired Persons,” Application of PECO Company for Approval of its Restructuring Plan Under Section 2806 of the Public Utility Code, June 20, 1997; as well as participation in other state proceedings, see Arizona Corporation Commission, “Testimony of Dr. Mark N. Cooper on Behalf of the Arizona Consumers Council,” In the Matter of the Competition in the Provision of Electric Services Throughout the State of Arizona, January 21, 1998; State Corporation Commission of Virginia, “Direct Testimony of Dr. Mark N. Cooper on Behalf of the Virginia Citizens Consumers Council,” Virginia Electric Power Company, Application of Approval of Alternative Regulatory Plan, December 15, 1997; “Electric Industry Restructuring: Who Wins? Who Loses? Who Cares?” Hearing on Electric Utility Deregulation, National Association of Attorneys General November 18, 1997; “Direct Testimony of Dr. Mark N. Cooper Submitted on behalf of The American Association of Retired Persons,” before the Public Service Commission, State of New York, In the Matter of Competitive Opportunities Case 94-E-0952 New York State Electric and Gas Co. 96-E-0891; Rochester Gas and Electric Corp. 96-E-0898 Consolidated Edison Company of New York, Inc. 96-E-0897; Public Utility Commission of Texas, “Statement of Dr. Mark N. Cooper to the System Benefits Workshop,” Project on Industry Restructuring, Project No. 15000 May 28, 1996.
[180] Office of Consumer Advocate (OCA), Annual Report, 1998-1999, 1999–2000 (Harrisburg: various issues).
[181] These estimates are based on the figures available for June 2002.
[182] EIA, Electric Sales and Revenues, various issues. I use 1995 because restructuring was enacted in both California and Pennsylvania in 1996 (see EIA, Changing Structure, December 1999, Table 11).
[183] OCA, Annual Report, 1998-1999, 1999–2000, describes the regulated rate reductions. The shopping guide shows that competitors generally offer prices above the regulated rate.
[184] About one-fifth of residential consumers have switched to high-cost green power, a laudable outcome, but one that can be accomplished with much less disruptive policies (Statement of Representative Frank Tulli, January16, 2001, gives the numbers for green power).
[185] As described in Cooper, Economics, and Coyle, Eugene, Price Discrimination, Electronic Redlining, and Price Fixing in Deregulated Electric Power (Washington: American Public Power Association, 2000), price discrimination has traditionally been a concern in this industry because of its cost characteristics.
[186] EIA data for October 2000, show almost a 30 percent increase in industrial rates and a 3 percent increase in residential rates. This resulted from including nonutility prices in the index for the first time.
[187] Office of Consumer Advocate, Pennsylvania Shopping Statistics, January 2001.
[188] At least one-fifth of the consumers who had switched signed with a utility affiliate, since Exelon’s 10-Q claimed 99,000 customers in September 2000.
[189] Pennsylvania Shopping statistics shows the addition of residential customers who are switching dropped from ten thousand a month in 1999 to five thousand in 2000,
[190] Reeves, Frank, “ Turning Off 30,000 Pennsylvania Customers,” Post-Gazette (January 24, 2001); Turfa, Pam, “PG Energy Announces an End to Its Electricity Service,” Wilkes Barre Times Leader (February 7, 2001).
[191] Collins, Donnie, “Few Exercising Choice,” Scranton Times, January 29, 2001.
[192] OCA, Annual Report, 1999–2000, properly counts as one of its successes the ability to extend the caps or to wring out additional regulated rate reductions.
[193] Petition of Metropolitan Edison Company and Pennsylvania Electric Company for Interim Relief Pursuant to Section F.2 of Their Approved Approved Restructuring Plan, before The Pennsylvania Public Utility Commission Docket No.’s P-00001860, P-00001861.
[194] Supplemental Petition, before the Pennsylvania Public Utilities Commission, Petition of Metropolitan Edison Company and Pennsylvania Electric Company for Relief Under Their Approved Restructuring Plan and the electricity Generation Customer Choice and Competition Act Docket No.’s P-00001860, P-00001861, November 20, 2000.
[195] “Pennsylvania PUC Blasts GPU for Comparison to California,” press release (Harrisburg: Pennsylvania Public Utility Commission, January 19, 2001).
[196] Hirst, Erik, Expanding U.S. Transmission Capacity (Washington: Edison Electric Institute, 2000) shows that PJM has the smallest number of miles of transmission lines per megawatt of peak demand.
[197] Storm Warning (Harrisburg: PennFuture’s E-Cubed, February 20, 2001).
[198] NERC statistics for 1998 show substantial interruptions in 1998.
[199] Bowring, et al., Rose, Other States; Stoft, Steven, PJM’s Capacity Market.
[200] Storm Warning
[201] DOE, outages.
[202] For a critique Tabors, Richard D. and Luis Paz Galindo, Transmission Pricing in PJM: Allowing the Economics of the Market to Work (May 12, 1999).
[203] The population density of the PJM region is four hundred people per square mile of land. In the rest of the country, the population density is about seventy. Similarly, in New York where LMP has been applied, the population density is just under four hundred. The economic costs of low-density markets are a fact of life that cannot be avoided, but locational marginal pricing does not use the economic cost of transmission, it charges the opportunity or scarcity costs. As a result, severe efficiency and equity problems arise. In fact, LMP should really be referred to as LMR (locational marginal rents). Because transmission is a virtually fixed asset in the short- and mid-term, LMP creates massive transfers of inframarginal rents from consumers to transmission owners. Because these are scarcity rents, they do not contribute to economic efficiency. Even the defenders of locational marginal pricing grudgingly admit that the rents could be taxed away (Hogan, William W., Coordination for Competition: Electricity Market Design Principles (February 15, 2001)).
[204]Rosen, et al., lay out this argument. Consumer advocates argued that declining nuclear costs and expiring Standard Offer contracts in California would have produced savings as large as legislators ordered as part of restructuring (Cooper, Economics).
[205] Cooper, Economics, pointed out that a similar argument was made with respect to standard offer PURPA contracts in California.
[206] In California, a combination of depreciation of nuclear power plants and expiration of standard offer PURPA contracts would have had the same effect, as many consumer advocates argued before restructuring (see Cooper, Balancing).
[207]Kaloko identifies California stranded costs at $28.5 billion and Pennsylvania at $12.2 billion; while California had 10 million customers of investor owned utilities and Pennsylvania had 4.8 million (EIA, Electric Sales and Revenues: 1999, Table, 9).
[208] The connection between the two became immediately apparent, see for example Leonhardt, David, “How Will Washington Read the Signs: The Race is On For Tougher Regulation,” New York Times, February 10, 2002; Beerenson, Alex, “The Biggest Casualty of Enron’s Collapse: Confidence,” New York Times, February 10, 2002. If investors don’t believe the numbers that public companies put out, they’ll be less willing to take risks. Accounting, ordinarily a pillar of capitalism, was misused to prop up profits.
[209] Seib, Gerald F., “What Could Bring 1930s-Style Reform of U.S. Business?”, Wall Street Journal, July 24, 2002.
[210]Armstrong and Caffrey.
[211] Numerals are source numbers on the list accompanying the index; those in parentheses are page numbers for that reference.
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