The Electricity Blame Game

December 28, 2000 • Commentary

Confronted with economic problems, politicians always blame the private sector first. The effort to accuse deregulation of causing local electricity‐​supply problems, such as we are seeing in California at the moment, is but the latest example.

At a minimum the attack is off base for blaming the problem on the solution. Two decades ago, while teaching at Pennsylvania State University, I noticed that the then well‐​publicized cancellations of nuclear power plants were followed by generally overlooked cancellations of coal‐​fired plants. I subsequently arranged to visit many of the country’s leading electric utilities. Everywhere the story was the same: Regulatory policies adopted as a response to the 1970s energy crisis made capacity expansion unprofitable.

After the plants already in the construction pipeline were completed in the mid‐​1980s, utility investment in additional capacity predictably declined. Smaller, gas‐​fired units were built in lieu of the conventional large baseload facilities, and an increasing proportion of that new capacity‐​80 percent in 1998, the most recently reported year‐​was provided by companies independent from the established electric utilities. Unfortunately, those third‐​party investments were not large enough to keep up with demand.

Regulatory reforms in the 1990s were undertaken in part to overcome those disincentives to invest. Given that those reforms have only been put in place over the last four years and that conventional power plants can take a decade to build, however, it is too soon for those regulatory changes significantly to affect capacity additions. Thus, the cure (deregulation) is now being blamed for the disease (energy shortfalls). In fact, one could argue that the slow pace of reform has added to capacity problems.

Then there is the problem of the regulatory reforms themselves. Instead of the sweeping (but still incomplete) deregulation that was applied to the transportation industry, reformers are applying to electricity the far less successful telecommunications model of government‐​directed industrial reorganization. Utilities are treated like phone companies, receiving greater pricing flexibility in return for allowing non‐​utility power generators access to their transmission and distribution grid. Many states have in fact gone further, requiring that utility companies sell all their power plants to independent entities to promote further competition and to constrain any latent utility monopoly power.

Yet there is no proof that utility plant ownership has distorted markets. As any competent economist could tell you, unified ownership of facilitates often improves coordination and enhances overall efficiency. Should important coordination benefits exist in the utility industry, the forced breakup would prove harmful‐​not just to the companies, but to consumers as well.

Another problem reformers faced is how best to coordinate generation and transmission among companies. Historically, only three “tight” power pools operated in the United States, all located in the Northeast. In a tight pool, member utilities maintain a continuously operating central dispatch authority to optimize capacity utilization. Elsewhere, the interactions among companies were direct. While many of the companies in the “loose” pools generated far more electricity on average than the members of the tight pools and were thus less dependent on others, many have deemed this inefficient. What is critical, however, is that those looser arrangements were at least as effective at coordinating capacity utilization (and less prone to capacity shortfalls) as the more formal ones.

To be sure, many considerations other than the choice of coordination mechanisms affect electricity prices. The areas that use tight pooling, for instance, have special problems, such as long distances from coal fields and urbanized service territories, which greatly affect supply and demand patterns. Nevertheless, some states have concluded that tight pooling is desirable despite precious little evidence to that effect.

The bottom line is that restructuring proponents are shooting in the dark. Instead of relying on market forces to discover the best forms of industrial organization, they are imposing organizational structures that may or may not enhance efficiency. Doubts also arise about whether regulated restructuring has promoted promised claims of more flexible and, on average, lower prices.

We are still a long way away from having a free market in electricity. We are also still a long way from having a deregulatory agenda. It is perhaps too early to tell whether restructuring will remedy the capacity shortfall that is helping to drive up prices, or whether reforms will enhance the overall efficiency of the industry. However, it is not too early to point out that the government, not the market, is currently in charge.

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