Reason Foundation - Policy Areas > Electricity

The Real Climate Change Deniers

shikha.dalmia@reason.org (Shikha Dalmia) — Thu, 25 Jun 2009 23:39:00 EDT

The U.S. House is a cat's whisker away from passing a cap-and-trade climate change bill tomorrow that will effectively impose a $1,600 carbon tax on an average household in the name of fighting global warming. (For context, consider this: A typical family of four earning $50,000 a year pays $3,000 in income taxes).

But the irony is that the bill comes precisely when the rest of the world is experiencing fresh doubts about the science of manmade global warming. Wall Street Journal editorial writer Kimberly Strassel reports that New Zealand's new government last year immediately suspended the country's weeks-old cap-and-trade program. In France, President Nicolas Sarkozy wants to tap Claude Allegre to lead the country's new ministry of industry and innovation. Twenty years ago Mr. Allegre was among the first to trill about man-made global warming, but the geochemist has since recanted.

"The number of skeptics, far from shrinking, is swelling. Oklahoma Sen. Jim Inhofe now counts more than 700 scientists who disagree with the U.N. -- 13 times the number who authored the U.N.'s 2007 climate summary for policymakers. Joanne Simpson, the world's first woman to receive a Ph.D. in meteorology, expressed relief upon her retirement last year that she was finally free to speak 'frankly' of her nonbelief. Dr. Kiminori Itoh, a Japanese environmental physical chemist who contributed to a U.N. climate report, dubs man-made warming 'the worst scientific scandal in history.' Norway's Ivar Giaever, Nobel Prize winner for physics, decries it as the 'new religion.' A group of 54 noted physicists, led by Princeton's Will Happer, is demanding the American Physical Society revise its position that the science is settled. (Both Nature and Science magazines have refused to run the physicists' open letter.)," writes Strassel.

Why this turn around? Because for the last 10 years, the earth's temperatures have remained essentially flat. And over the next 10, some credible studies have actually predicted a cooling.

One does not have to believe that global warming is a total hoax to concede that its claims need further investigation before action. Denying dissenters a voice never serves the cause of science. Ask Galilelio.

President Obama's Energy Plans Have a History of Failure

rbailey@reason.com (Ronald Bailey) — Wed, 20 May 2009 10:43:00 EDT

“Voters want action on energy,” one congresswoman told The Washington Post. “They don’t really care how much it costs.” A Democratic president was on the verge of signing “the most important energy legislation in a decade,” with tens of billions of dollars dedicated to jump-starting a cleaner alternative to fossil fuels and helping the United States achieve “energy independence.” For too long, most analysts agreed, America had put off the hard choices necessary to prevent the next oil shock and wean the country from petrodictators in the Middle East. Now was the time for bold investment and leadership from Washington.

The year was 1979. At the time I was a low-level regulator in President Jimmy Carter’s Federal Energy Regulatory Commission. It was a boring agency, but I got to work in its most exciting division: the special cases branch dealing with exotic new sources of power. From that perch I witnessed firsthand the sad, expensive, and now-forgotten saga of the Great Plains Coal Gasification Plant in Beulah, North Dakota. Like many projects being discussed in Washington today, Great Plains was hailed as the vanguard of a new domestic alternative to foreign oil.

In 1979, as lines at gas stations snaked for blocks, the House of Representatives, by a vote of 368 to 25, created the U.S. Synthetic Fuels Corporation, an “independent” federal entity charged with creating new fuel sources by spending $20 billion in seed money ($57 billion in 2009 dollars) during its first five years. Originally, the Synfuels Corporation was projected to spend $88 billion ($250 billion in today’s dollars) over 12 years to build the capacity to produce the equivalent of 1.5 million barrels of oil per day from coal.

That was just one element of Carter’s ambitious energy plans. In July 1979 he announced, “I will soon submit legislation to Congress calling for the creation of this nation’s first solar bank, which will help us achieve the crucial goal of 20 percent of our energy coming from solar power by the year 2000.” In 1980 Congress authorized the Department of Energy to spend $1.3 billion on ethanol research and loans to produce fuel for automobiles. In May of that year, Carter declared, “For the first time in our nation’s history, we will have a national energy program to put us on the road to energy security. It’s more ambitious than the space program, the Marshall plan, and the Interstate Highway System combined.”

Sound familiar? During the 2008 presidential campaign, Democratic candidate Barack Obama declared almost daily that developing new energy sources and breaking our addiction to foreign oil would “take nothing less than a complete transformation of our economy.” He explicitly compared his plan to putting a man on the moon and building the Interstate Highway System.

President Obama has not forgotten candidate Obama’s promises. In a February address to a joint session of Congress, the president boasted: “Thanks to our recovery plan, we will double this nation’s supply of renewable energy in the next three years. We have also made the largest investment in basic research funding in American history.” Obama promises to create 5 million new jobs by investing $150 billion in clean energy technologies during the next 10 years. He also aims to put 1 million plug-in hybrid electric vehicles on America’s roads by 2015, promising buyers a $7,500 tax credit. Even more ambitiously, 25 percent of our electricity supposedly will come from renewable sources such as wind, solar, geothermal, and biomass by 2025. To tie a ribbon on the alternative energy package, the president asked Congress to impose a cap-andauction scheme to reduce greenhouse gas emissions 80 percent by 2050.

Will such policies produce the promised results? They didn’t three decades ago.

After Carter’s equally ambitious moves, global oil prices dropped like a rock. The deregulation of natural gas led to vast new fossil fuel supplies, and abundant stocks of cheap coal kept electricity humming down transmission lines. Meanwhile, the federally funded Great Plains Coal Gasification Plant, on which I worked, became the largest construction project in the United States, costing $2.1 billion ($5.3 billion in today’s dollars) to build. The plant was supposed to convert coal into 125 million cubic feet of natural gas per day, an amount equal to about 20,000 barrels of oil. Instead, by 1984, as the price of natural gas continued to fall, Great Plains went into bankruptcy. It was eventually sold in 1988 to a local electric cooperative for $85 million—a little more than 4 cents on the dollar. The $2.1 billion the plant cost to build, if invested in bonds, would have grown to about $8.4 billion by 2009. Instead, Congress disbanded the Synthetic Fuels Corporation in 1986, the money irretrievably lost.

History teaches us that the government is not very good at getting the results it intends when it intervenes in complex markets subject to violent price fluctuations. And unfortunately for Obama’s Carteresque agenda, Washington also has a poor track record when it comes to alternative energy research and development.

Whistling Past the R&D Graveyard

Obama has promised to “invest” $150 billion in new energy research and development during the next 10 years. “To truly transform our economy, protect our security, and save our planet from the ravages of climate change,” the new president declared in his February address to Congress, “we need to ultimately make clean, renewable energy the profitable kind of energy.” What he presented as bold new policy has a long and decidedly untransformative track record. The main difference in 2009 is that an unfounded fear of depleting global resources has been replaced with an exaggerated fear of global warming.

Since 1961 the federal government has spent nearly $187 billion (in current dollars) for the development of advanced energy technologies and basic energy science research. About a quarter of the funds were spent during the oil crisis of the 1970s. According to an October 2008 report by the Department of Energy’s Pacific Northwest National Laboratory, $66 billion of that $187 billion has been spent researching nuclear energy, $65 billion on basic energy science, $28 billion on fossil fuel research and development, and $28 billion on renewables and conservation.

A comprehensive September 2008 report by the economic research firm Management Information Services, commissioned by the pro–atomic power Nuclear Energy Institute, slices the government’s energy-spending pie into slightly different portions. In addition to direct research and development spending, the report documents how the feds have used tax incentives, mandates, and regulations to steer energy production since 1950. During those six decades, the paper’s authors found, the oil industry received federal incentives worth $352 billion in current dollars, mostly in the form of tax breaks and regulatory relief (e.g., exemptions from price controls). Natural gas got about $105 billion, coal $99 billion, hydroelectric $84 billion, nuclear $68 billion (minus $15 billion assessed for nuclear waste storage), and renewables $47 billion.

Did all this “investment” in energy pay off? Not according to Robert Fri, a former deputy administrator of both the Environmental Protection Agency and the Energy Research and Development Administration. In the Fall 2006 Issues in Science and Technology, Fri, now a visiting scholar at the D.C.-based think tank Resources for the Future, noted that a “mere 0.1 percent of the expenditure accounted for three-quarters of the benefit.” Three unsexy programs—developing energy-efficient windows, electronic ballasts for fluorescent lighting, and better refrigerators—converted $13 million in spending into $30 billion in benefits, according to a National Research Council study cited by Fri. “Threequarters of the expenditure—a little over $9 billion—produced no quantifiable economic benefit,” he concluded. “Half of this money was applied to synthetic fuel projects that turned out to be at least a couple of decades premature.” As Fri told Chemical & Engineering News last year, “The government is very good at starting energy projects that it believes will solve energy problems, but it is not very good at generating the intended results.”

Yet Washington has gone on an energy project binge. In December 2007, Congress passed and President George W. Bush signed the Energy Independence and Security Act, which raises corporate average fuel economy standards from 27.5 miles per gallon to 35 miles per gallon by 2020, mandates that the U.S. produce 36 billion gallons of conventional and “advanced” biofuels by 2022, bans most incandescent light bulbs by 2014, and establishes the $25 billion Advanced Technology Vehicles Manufacturing Incentive Program to help retool legacy U.S. auto companies to manufacture more-fuel-efficient cars.

In February, Obama upped the ante with his $787 billion American Recovery and Reinvestment Act, which allocated $11 billion to smart grid initiatives (see “Electric Intelligence,” page 26), $2 billion to advanced battery manufacturing grants, $500 million to job training in renewable energy fields, and a plethora of tax benefits to renewable energy producers. In addition, Congress revived FuturGen, a carbon dioxide capture and sequestration project that the Bush administration had canceled when its costs escalated.

Nearly all of the $3.4 billion in stimulus money for fossil fuel research is expected to be spent on carbon capture and sequestration projects, which are intended to demonstrate the feasibility of capturing carbon dioxide produced by power plants and injecting it underground, thus preventing the gas from entering the atmosphere and contributing to global warming.

If climate change were not a concern, humanity could easily power its economic development using abundant coal and natural gas supplies for decades to come. But in December 2007, at the United Nations climate change conference in Indonesia, the nations of the world, including the U.S., promised to adopt binding greenhouse gas emission limits at another climate change conference at the end of this year. In February, Obama asked Congress to impose a cap on carbon emissions as a way of boosting the production of renewable energy in America. “To support that innovation,” he said, “we will invest $15 billion a year to develop technologies like wind power and solar power, advanced biofuels, clean coal, and more fuel-efficient cars and trucks built right here in America.”

It’s been tried before. Obama apparently believes he’ll be more successful than past politicians in picking the best energy technologies.

How Much for That Kilowatt-Hour?

A kilowatt-hour of electricity is the amount it takes to run 10 light bulbs of 100 watts for one hour. In 2007, according to the Energy Information Administration, monthly residential electricity consumption averaged 936 kilowatt-hours per household. The average price of a kilowatt- hour, adjusted to 2009 dollars, has fluctuated over the years, ranging from about nine cents in the 1970s up to 13 cents in the 1980s; it was 9.6 cents in December 2008, the latest date for which we have data. Prices vary considerably by state, depending on the local regulations and sources of supply. Residents of Connecticut pay nearly 20 cents per kilowatt-hour, for example, while Idahoans pay only 7.5 cents.

On the power generation side, a November 2008 report by the electricity industry’s Electric Power Research Institute provides the best up-to-date comparison of plausible energy technologies. From those numbers and other sources, I have taken a comparative look at the past, present, and future of nine promising energy sources. (See “Energy Futures,” page 29.) Capital costs for each vary considerably; to make a rough comparison, I have standardized capital costs to a 1,000-megawatt nuclear power plant operating 90 percent of the time, which would produce enough electricity for between 700,000 and 800,000 homes.

In addition to those power generation methods, a handful of other once-and-future technologies have come up for discussion. Two in particular deserve extra attention:

The electric car. Who killed the electric car? The batteries did. Back in 1996—when a share of General Motors stock sold for $40, not less than $3—the company introduced its all-electric two-seater EV1 automobile. The EV1’s 1,200-pound battery could power the car for 75 to 100 miles, and fully recharging it took eight hours. G.M. produced only 1,100 cars total and ended the program in 2003, a move that has sparked a cottage industry of conspiracy theories.

A chastened G.M., its CEO defenestrated by President Obama himself, has developed plans to introduce the plug-in hybrid Chevy Volt in 2010. The Volt will be driven by an electric motor powered by a 400-pound lithium-ion battery, supplemented by a range-extending gasoline engine that will produce electricity to keep the battery charged. The Volt will be able to travel in all-electric mode for 40 miles on a single charge.

Obama sees plug-in hybrid electric vehicles (PHEVs) like the Volt as a key step in weaning America off foreign oil. Initially this may sound like a terrific idea. A 2007 study by the Department of Energy’s Pacific Northwest National Laboratory estimated that the country would reduce oil consumption by 6.5 million barrels per day, equivalent to 52 percent of current petroleum imports, if 84 percent of cars, light trucks, and SUVs were PHEVs, traveling an average of 33 miles per day on electric power. Greenhouse gas emissions would be cut by as much as 27 percent.

But the Energy Department study also found that when compared to the 27.5 miles per gallon that internal combustion vehicles get, the breakeven premium for a plug-in hybrid—that is, the extra amount a driver would be willing to pay for the car due to how much he would save in gasoline costs—is $3,500 when gasoline costs $2.50 a gallon and electricity costs $0.12 per kilowatthour. At $3.50 per gallon, the premium rises to more than $6,500. Since batteries are expected to boost the average cost of each vehicle by as much $10,000, gasoline will have to cost more than $5 per gallon before PHEVs make economic sense to most drivers. Of course, federal intervention can help overcome this financial disincentive and the $787 billion stimulus package offers just such an incentive in the form of a $7,500 tax credit. Washington also could double or triple gasoline prices by dramatically raising taxes, though that would be politically unpopular.

President Obama promised to put 1 million PHEVs on America’s roads by 2015. That sounds impressive—until you remember that Americans currently drive 240 million conventional vehicles.

Corn ethanol. The Energy Independence and Security Act of 2007 established a misbegotten national renewable fuels standard requiring transport fuel refiners to use at least 36 billion gallons of biofuels by 2022. That’s equal to about 27 percent of the gasoline Americans use each year. The idea is that biofuels are a way to recycle carbon dioxide without adding any more to the atmosphere. Ethanol is also supposed to further the fanciful goal of “energy independence,” since the raw materials are produced on America’s farms.

Worldwide in 2007, 100 million tons of grain were turned into biofuels. That’s enough grain to feed 450 million people for a year. In January 2005, the American landscape was dotted with 81 ethanol plants with a combined capacity to produce 3.6 billion gallons a year; by January 2009, the number of ethanol distilleries had grown to 172 with a total capacity of 10.5 billion gallons. According to the Global Subsidies Initiative, a Geneva-based nonprofit that spotlights transfers of public money to private interests, this boom was fueled by $7 billion in federal and state subsidies in 2008. Converting low-priced food into higher-priced fuel was a key factor in the sharp increase in global food prices during the last couple of years. As for the alleged climate change benefits, some researchers argue that the pressure to produce ethanol causes farmers in developing countries to chop down forests. A study in the January 2008 Science calculated that such deforestation releases more carbon dioxide into the atmosphere than growing biofuel crops on the land can replace in 86 years.

Congress engineered a similar ethanol boom in the 1970s and early ’80s by reducing the federal excise tax on ethanol by 40 cents per gallon. The result was a 10-fold increase in the number of ethanol plants, which reached 163 in 1984. Then the price of oil collapsed, and with it fell the artificially stimulated ethanol industry. This pattern is now repeating. As the price of oil has fallen since July 2008, so too has the price of gasoline. Without subsidies, ethanol cannot compete with gasoline unless oil prices are over $80 per barrel. Consequently, the boom has gone bust. In October the country’s second largest ethanol producer, the South Dakota–based VeraSun, filed for Chapter 11 bankruptcy. By some estimates as many as 40 ethanol plants could follow this year.

Naturally, an industry that was conjured into existence by Congress has come calling to the Capitol begging for yet more help. Specifically, ethanol producers now want Congress to mandate that fuel refiners increase their ethanol content from 10 percent to 15 percent. (According to a 2008 report by researchers at Iowa State University, more than 70 percent of U.S. gasoline contains ethanol.) Bob Dinneen, president of the Renewable Fuels Association, a trade group, says “approving the use of ethanol blends up to 15 percent is a necessary and positive step to ensure the full potential of a robust domestic ethanol industry.” And not incidentally, to save his members from bankruptcy.

Wild Cards

Amid these erratic shifts in federal policy, American researchers and innovators are in hot pursuit of the next energy technology. Despite the ongoing economic turbulence, global venture investing in clean technologies was $8.4 billion in 2008, up from $6 billion in 2007 and $4.5 billion in 2006, according to the Cleantech Group consulting partnership. Solar power start-ups garnered the lion’s share of venture capital at $3.3 billion, followed by biofuels at $1 billion and companies focused on alternative transportation (batteries and fuel cells) at $800 million.

Given human creativity and the lure of fabulous profits, it is entirely possible that some nanotechnologist might find a dramatic new battery chemistry or a way to paint solar cells onto the sides of houses to produce electricity. Disruptive technologies are disruptive in large part because nobody can see them coming or foresee their ultimate economic elaboration. When the laser debuted in 1960, it was called “an invention looking for a job.” Since then, it has been applied to everything from compact discs to eye surgery. So what future breakthroughs in energy might occur?

Biocrude. In addition to the problems I’ve mentioned, ethanol has a major drawback: It corrodes pipes and picks up water, so it cannot be transported through pipelines. Wouldn’t it be better if biofuels were more like gasoline and diesel? Then there would be no need to transform our vehicles or our fuel distribution systems.

Based on this insight, several start-ups are trying to engineer microbes to make such fuels. LS9, a privately held San Francisco start-up that calls itself the “renewable petroleum company,” has modified bacterial metabolic pathways so that E. coli can eat cellulose and excrete hydrocarbons almost indistinguishable from diesel. In October the company hired a veteran oilman as CEO, and it is now seeking $100 million to build a pilot plant. The facility aims to produce 2.5 million barrels per year by the end of 2010. Its break-even oil price is $50 a barrel.

Several other companies are pursuing a similar strategy of tweaking microbes to make oil. Amyris, based in Emeryville, California, has engineered yeast that can eat hydrocarbons and secrete diesel. The company opened a pilot plant last fall and claims it will produce 200 million gallons of diesel a year by 2011. Of course, these strategies mean growing feedstock such as sugar cane, which means more land competition between food and fuel.

Ultracapacitors. Like batteries, ultracapacitors are energy storage devices, but they store electrical charges instead of batteries’ chemical charges. The secretive company EEStor, headquartered in Cedar Park, Texas, claims its ultracapacitor weighs just under 300 pounds, charges in minutes, and can propel an automobile 250 miles. If true, this would be a revolutionary technological breakthrough. Such ultracapacitors could power cars and store energy produced by renewable sources such as wind and solar power. The company has contracts with the small Canadian electric car company Zenn Motors and the huge American defense contractor Lockheed Martin. Considerable skepticism is warranted, since nobody outside of the company has seen a working version of the device.

New approaches to nuclear power. In March, Obama shut down work on the Yucca Mountain nuclear waste facility in Nevada. That left the country without a national storage option for the copious amounts of highly radioactive and long-lived waste produced by light-water nuclear reactors, the only kind of fission plants currently functioning in America. Aside from the waste issue, light-water reactors produce plutonium, which can be used to make nuclear bombs. Shutting Yucca Mountain may provide the impetus for building new types of nuclear reactors that can burn up radioactive waste to produce still more electricity.

For instance, the Argonne National Laboratory has developed a technology it calls the integrated fast reactor (IFR). The IFR, which is cooled by liquid sodium rather than water, is called a “fast” reactor because it uses fast neutrons instead of slow ones in its nuclear chain reaction. In addition to consuming nuclear waste and plutonium from nuclear stockpiles to produce electricity, the IFR uses uranium with 100 to 300 times the efficiency of light-water reactors.

Backers of the technology argue that fast reactors could provide all the electricity the country needs for centuries, using only uranium that has already been mined. So far no such plants have been proposed for construction in the U.S.

Another alternative is the thorium reactor. Thorium, a slightly radioactive metal, is three times more abundant than uranium. It cannot sustain a nuclear chain reaction by itself but can function with neutrons provided by outside sources, such as fissile isotopes of uranium. Thorium reactors also burn waste and plutonium, although less efficiently than IFRs. The McLean, Virginia–based Thorium Power is working with the Indian and Russian governments to build commercial thorium reactors. In December 2008, three Scandinavian companies submitted a proposal to build a 1,500-megawatt thorium reactor in Finland. The estimated cost is $2.3 billion, and it would take five to eight years to build.

Innovators, Not Planners

Such leapfrog jumps in technology, including processes undreamt-of today, are surely where our energy solutions will come from. Instead of creating artificial alternative energy markets that depend on government support and the high price of oil, policy makers should be focusing on removing barriers to the creation of revolutionary new technologies. In their 2008 book Earth: The Sequel, the environmentalists Miriam Horn and Fred Krupp write: “Mandates presume that the government already knows the best way to proceed on energy. But the government doesn’t know any better than anyone else. The best thing to do is to level the playing field…and then let the market sort things out.”

While Horn and Krupp were specifically addressing the problem of climate change, the point applies to all sorts of energy innovation. During the last half-century, both federal and state governments have intervened repeatedly in energy markets and tried many times to steer the evolution of technologies via research and development subsidies. Far more often than not, this activity has turned out to be a colossal waste of taxpayer dollars, resulting in expensive failures like the Great Plains Coal Gasification Plant. Thirty years ago, as a young energy regulator, I had a front-row seat as another president’s ambitious plans to transform America’s energy economy crashed and burned. I suspect that today’s eager young bureaucrats will witness a similar debacle.

Ronald Bailey Reason magazine's science correspondent.This article first appeared in the June 2009 issue of Reason magazine.

First They Came For The Light Bulbs

steven.titch@reason.org (Steven Titch) — Mon, 23 Mar 2009 15:51:00 EDT

Now, if you live in California, they are coming for your big screen TV.

In a move that is so wrong-headed on so many levels, the California Energy Commission wants to ban large-screen TVs because they allegedly contribute to (alleged) global warming.The wording is parsed to suggest "complaint" models will still be permitted, but it's unclear what the requirements will be.

The OC Register reckons that the CEC proposal would likely remove most models over 40 inches from the market. The agency wants to put the new rules into affect by 2011.

Here we have more enviro-puritanism running amok. After all, people like watching big screen high-def TV, especially when the current economy makes home entertainment an economic option. There’s indication how this might be enforced. You can mail-order big screen TVs from Amazon.com (like I did) and other outlets. Californians can also drive to Arizona, Nevada or Oregon to buy one.

Let’s also mention the cockamamie idea of taking products off the shelves during a recession in a state where a good chunk of the population makes a living producing TV and movies and video games – you know, the stuff that plays well on big screen TVs.

The CEC itself says its goal is to avoid the necessity of building more power plants—a questionable priority to say the least. Instead it has declared of war on plug-in appliances and anyone who dares to use them.

What's So Smart About Investing in the Smart Grid?

rbailey@reason.com (Ronald Bailey) — Fri, 06 Feb 2009 00:00:00 EST

Reason.com

Smart grid technology is all the rage. General Electric just paid $2.4 million for a Superbowl ad featuring an animated scarecrow singing "If I Only Had a Brain" to promote its smart grid initiatives. IBM, meanwhile, is running full page "Smarter power for a smarter planet" ads in major newspapers like the New York Times. These corporations are in perfect sync with the new administration in Washington.

Earlier this month, President Barack Obama promised to retrofit America by "updating the way we get our electricity, by starting to build a new smart grid that will save us money, protect our power sources from blackout or attack, and deliver clean, alternative forms of energy to every corner of our nation." To that end, the House version of the American Recovery and Reinvestment Act authorizes the Department of Energy to spend $4.5 billion dollars to stimulate the deployment of smart grid technologies.

The Energy Information Administration (EIA) describes the current national power grid as the "largest interconnected machine on earth." The U.S. electric power infrastructure is worth over $1 trillion. It consists of more than 9,200 electric generating units with more than 1 million megawatts of generating capacity connected to more than 300,000 miles of high voltage transmission lines and 5.5 million miles of distribution lines. Utility companies have only the most rudimentary ability to monitor this vast grid. More often than not, utility companies only learn about a local power outage when customers call to complain.

Creating a smart grid means computerizing the current electric grid using advanced wireless two-way information and communications equipment, deploying an array of sensors to monitor activity, and developing the software to control and track in real time all aspects of electricity generation, transmission, and consumption. The smart grid would also more easily integrate supplies from decentralized renewable energy suppliers and enable consumers to better manage their energy consumption.

Modernization would certainly help the current transmission network, which is so overburdened that blackouts are now bigger, lengthier, and more common. The EIA estimates that outages currently cost the economy as much as $150 billion per year. Even as demand for electricity has grown, transmission capacity has been lagging. In addition, Americans are projected to use about 30 percent more electricity by 2030. The Electric Power Research Institute (EPRI), the think tank of the utility industry, estimates that smart grid technologies could potentially lower projected annual energy consumption in 2030 by 1.2 to 4.3 percent. This would mean that fewer power plants and transmission lines would need to be built in the future.

For many proponents, however, the chief reason to create a smart grid is that it promotes energy conservation. For example, the smart grid concept envisions smart meters in homes or businesses allowing consumers to fine tune their energy consumption, such as setting dishwashers or washing machines to turn on at night when electric power is relatively cheap and more plentiful. And consumers could also grant utility companies permission to send signals that lower the temperatures on residential hot water heaters or reduce air conditioning when the grid is threatened with an overload on hot summer days. Some pilot projects report that consumers using this technology have cut their energy bills by an average of 10 percent.

But why is there such a push to conserve energy, especially electricity? After all, the U.S. has plenty of coal, natural gas, and uranium to generate power and, if promoters of renewable fuels are right, there'll be plenty of those, too. The answer, of course, centers on concerns about man-made global warming. About 50 percent of our electricity is produced using coal and 20 percent more is generated by burning natural gas, both of which emit carbon dioxide that contributes to raising the earth's average temperature.

If the goal is reducing carbon dioxide emissions rather than achieving energy efficiency for its own sake, then the simplest and most effective policy would be to place a price on carbon dioxide emissions. Pricing carbon would push generators and consumers to switch to low and no-carbon fuels while encouraging innovators to develop such fuels. Proponents of the smart grid often liken it to the Internet. And that's actually a pretty good analogy. No central computer distribution company created the Internet by installing a desktop in every home, after all. So why should we jigger electricity rate regimes in order to push utility companies to install smart meters or appliances? As higher carbon prices cause electric bills to increase, consumers themselves will start installing smart meters and appliances while seeking out relatively cheaper low-carbon power.

Here's another question: Why haven't utility companies and electric generation companies already started invested in a smart grid? One word: incentives. The chief problem is that power companies make more money when they sell more electricity to consumers. Building a smart grid means utilities would pay for infrastructure that could reduce the amount of electricity they sell. In other words, given the current regulatory system, utilities would be spending money so that they would make even less money. Obviously, this incentive scheme won't work.

The leading proposal to change the incentive structure is called decoupling. Instead of earning money by selling more electricity, a utility's profits are decoupled from the amount of electricity it sells. Regulators guarantee that a utility's fixed costs, including a profit margin, can be recovered no matter how much energy it sells through a rate adjustment formula. So if a utility sells less than was forecasted, the rates to consumers are adjusted to make up the difference. Generally speaking, such adjustments have amounted to an additional 2 to 3 percent on consumers' bills.

The House stimulus bill contains provisions that require states to consider decoupling as a condition for applying for $3.4 billion in energy efficiency grants. Some free marketers dislike decoupling because consumers could perversely see their energy use go down while their bills remain the same or even go up. Some progressives also reject decoupling on the grounds that it provides windfall profits to utilities.

While decoupling removes the incentive for utilities to sell more power, it doesn't provide much impetus for utilities to boost energy efficiency. One proposed fix for this problem is shared savings. If a utility invests in some type of energy efficiency—say the installation of smart meters or better insulation in houses—the utility shares the energy savings with the consumers. How? Consumers get lower utility bills because they use less energy and regulators award the utility with higher rates to pay back its investment in energy efficiency. For example, California utilities get rate hikes that amount to between 9 and 12 percent of the energy efficiency savings. But again, why rig electricity markets so that utility companies end up in charge of insulating houses, paying for energy efficient appliances, and installing energy management systems? Instead, utilities need to create an open information exchange network that both consumers and power generators can tap into.

In 2004, the Electric Power Research Institute calculated that it would cost $165 billion over the next 20 years—about $8 billion per year—to build out the smart grid. And one of the first challenges is mobilizing sufficient investment. But that problem won't be solved by throwing $4.5 billion at the electric grid as a sop to the environmental lobby—even if it does stimulate the bottom lines of favored corporations.

Ronald Bailey is Reason magazine's science correspondent. His book Liberation Biology: The Scientific and Moral Case for the Biotech Revolution is now available from Prometheus Books.

This column first appeared at Reason.com.

The Myth of Energy Deregulation

adam.summers@reason.org (Adam Summers) — Mon, 07 Nov 2005 00:00:00 EST

While the initiatives on the upcoming November 8 California special election ballot backed by Governor Arnold Schwarzenegger have been receiving all of the media attention, another initiative that addresses an important issue is being overlooked. Proposition 80, the so-called "Repeal of Electricity Deregulation and Blackout Prevention" initiative, would make some significant — and detrimental — changes in the state's energy policy.

The fact that even a government regulatory body such as the California Public Utilities Commission (PUC) is actually against a measure that would increase its regulatory powers should tell you something right off the bat about the merits of Prop. 80.

California energy consumers are currently served by one of three types of providers: investor-owned utilities (IOUs), local publicly-owned electric utilities, and independent electric service providers (ESPs). Before the state's "deregulation" experiment of the 1990s was suspended in 2001 during California's energy crisis, customers could choose to purchase their electricity services directly from ESPs through "direct access" contracts, rather than through an intermediary such as the local IOU or public utility.

Proposition 80 Would Reduce Consumer Choice and Increase Costs

Proposition 80 would permanently prevent all customers receiving electricity services from an IOU from switching to an ESP, effectively eliminating any new direct access (existing direct access contracts would be grandfathered in).[1] Thus, under Prop. 80, instead of having the option to buy electricity directly from independent producers, consumers would have no choice but to buy their electricity from utilities. By effectively eliminating an entire class of providers, the state has stifled competition (and would continue to do so), thereby leading to higher prices and, likely, lower-quality service.

The effect of this provision on prices would be significant. ESP customers include hospitals, local governments, the California State University system, several University of California campuses, community college districts, and local school districts. The nonpartisan Legislative Analyst's Office (LAO) estimates that the UC system alone saves about $12 million per year by purchasing its electricity from a lower-cost independent provider.

According to Mike Florio, an attorney for The Utility Reform Network (TURN, one of the chief proponents of Prop. 80 that helped craft the measure), the ability of consumers to purchase electricity directly from independent service providers "destabilizes the whole business � and we'll truly be at the mercy of the gods of the free market."[2] How dare people be able to choose whom they want to do business with! I suppose TURN hired Mr. Florio not for his legal expertise, but rather by the sheer providence of the "free-market gods."

Proposition 80 Would Impede Innovation and Efficiency

Another provision of Prop. 80 would prohibit the broader implementation of "dynamic pricing" of electricity without the consent of the consumer. Currently, all but the largest energy consumers pay a flat rate for electricity that does not vary by the time of day. Clearly, energy use is not constant throughout the day, however. There are certain "peak" hours of the day when consumers use lots of electricity, and "non-peak" hours when they use very little. The costs of providing electricity vary accordingly. As such, the IOUs have submitted proposals to the PUC to charge all consumers higher rates during peak hours and lower rates during non-peak hours. This price discrimination would be accomplished through the use of high-tech "smart" meters.

In addition to making good sense — one should pay more for something when it is in higher demand — dynamic pricing would encourage conservation via the pricing mechanism. Dynamic pricing would be a more efficient system because higher prices would discourage some from consuming such a scarce resource while ensuring that those who place the highest value on energy use are still able to consume it. Similarly, those who have some flexibility over when they consume their energy would be encouraged to utilize it during non-peak hours, thus placing less strain on the system.

Allowing the consumer to opt out of a dynamic pricing model would be like forcing a hotel owner to offer customers the choice of the nightly room rate or an average of the nightly room rates throughout the week. Since significantly more people stay at hotels during the weekend, rates are much higher on Friday and Saturday nights. The average weekly rate, however, would be higher than normal weekday rates but lower than normal weekend rates. The cheaper "opt-out" weekend rates and higher weekday rates would encourage even more people to stay during the weekend and fewer to stay during the week. The result would be a shortage of hotel rooms during the weekend and a loss of revenue for the hotel owner. No wonder demand strains the electrical grids during hot summer days.

Environmental Issues

Under current regulations, energy producers must increase the portion of energy derived from renewable energy sources — such as solar, wind, and hydroelectric � by one percent per year until 2017, when 20 percent of the energy produced must come from these sources. Proposition 80 would accelerate this deadline to 2010. Interestingly, some environmentalists oppose Prop. 80 because a provision requiring a two-thirds vote of the Legislature to amend the measure could make it more difficult to increase the renewable energy standard in the future.

According to the LAO's analysis, Prop. 80 would also require that "the first priority for IOUs in procuring new electricity is to be from 'cost-effective' energy efficiency and conservation programs, followed by 'cost-effective' renewable resources, and then from traditional sources such as fossil fuel burning power plants."[3] Of course, if renewable energy sources and energy efficiency and conservation programs were truly "cost effective," producers would already be utilizing them in higher numbers because it would make them more profitable. This clearly is not the case. Forcing companies to invest significant amounts of their scarce resources on more costly energy-production methods, which make up a relatively small share of total energy production (for good reason), will only ensure that costs — and, ultimately, consumers' electricity bills � remain higher than necessary.

As new technologies and energy-production methods are developed, this may change, but for now, it is best for both producers and consumers to focus on the most efficient means of producing energy. Of course, if consumers demand "cleaner" energy, in a truly free market, producers will have an incentive to provide it. Indeed, after Pennsylvania successfully implemented its electricity deregulation effort in 1999 (without the pitfalls experienced by California), 20 percent of consumers chose to switch to suppliers of "green power," despite the fact that they had to pay a small premium to do so. Proposition 80 eliminates this choice, instead demanding that all consumers support the higher cost of investing more in renewable energy — whether they want to or not.

Misconceptions Over Electricity "Deregulation" in California

Some blame deregulation for the rolling blackouts, soaring spot market prices, and utility bankruptcies that sprang from the energy crisis of 2000 and 2001. But this anger is misplaced. California has never experienced true deregulation. The "deregulation" implemented in 1996 left price controls in place and created "artificial" markets ripe for manipulation and disparities between supply and demand.

By setting price caps below market prices, California limited the profitability of the industry. When wholesale energy costs increased, the price caps prevented energy producers from passing them on to consumers. Wholesale prices rose dramatically for a number of reasons: natural gas prices rose, hot weather in the Southwest increased demand, a relative lack of water in the Northwest minimized the production of hydroelectric energy, and pollution-control permits, which allow industrial companies that produce less pollution than allowed by regulations to sell the difference as "credits" to higher-pollution-producing companies, rose ten-fold, from $4 to $40.

The price caps additionally discouraged potential producers from entering the market and increasing competition, and they discouraged existing producers from investing profits in adding capacity, of which Californians were (and continue to be) in dire need. As a result of the price caps and pressure from politicians and environmentalists, the building of plants and transmission lines slowed dramatically and energy producers were not able to keep up with demand, particularly in the Silicon Valley, where the booming computer and "dot-com" industries led to even sharper increases in electricity demand.

After the big three investor-owned utilities — Pacific Gas & Electric, Southern California Edison, and SEMPRA (San Diego Gas & Electric) — were forced to sell many of their fossil-fuel-burning generators to private firms, regulators prohibited them from entering into long-term contracts with these firms, forcing them to rely upon the much more volatile short-term and spot markets. In addition, California forced generators and utilities to trade power through the Power Exchange, a state-run pool.

While that requirement was designed to give every company the same wholesale price for power, it also guaranteed that they would be unable to negotiate lower-priced power on their own. The California rules essentially barred utilities from buying power on the futures market, meaning they were unable to lock in supplies and prices.[4]

This is as if Wal-Mart and Marshall Field's were forced to acquire their goods from a non-profit, state-run pool that would guarantee that they would acquire the goods for the same price. Wal-Mart never would have been able to develop its efficient and innovative purchasing and distribution system, meaning it could not generate savings to pass on to customers in the form of lower prices.

At the time of the increase in wholesale prices, PG&E and Edison were still in the deregulation "transition" period, and thus still subject to PUC rate regulations. As a result, PG&E went bankrupt and Edison teetered on the edge of insolvency. To add insult to injury, when the government stepped in to purchase electricity on behalf of the struggling IOUs to try to quell the crisis, not only did it do so at the height of the emergency, when energy prices were highest, it locked in these prices with long-term contracts costing billions of dollars.

The Natural Monopoly Justification for Regulation

The main argument against the full privatization of public utilities such as electricity and water service is that such industries are "natural monopolies." That is, they require such high fixed costs (it is easier to start a new restaurant than to invest in the infrastructure for a new electric grid) that it is inefficient for there to exist more than one producer in a particular location. This, it is feared, will lead the producer to engage in price gouging.

There are several problems with this rationale, not the least of which is the notion that "public utilities" somehow constitute a unique set of goods that must be "protected" by government intervention. As economist Murray Rothbard noted in Power and Market:

The very term "public utility" — is an absurd one. Every good is useful "to the public," and almost every good � may be considered "necessary." Any designation of a few industries as "public utilities" is completely arbitrary and unjustified.[5]

High capital costs certainly will limit the number of actual and potential providers, but there is still a profit motive in a free market that creates opportunities for lower-cost producers. In addition, it is important to note that markets are not static; technological innovations may allow for additional competition in the future.

Another misconception opponents of free markets have concerns the very understanding of the nature of competition. Even if there is only one producer of a certain good or service in town, this does not mean that the producer is "gouging" customers through monopolistic practices. Indeed, just because he is the sole supplier today does not mean he will be the sole supplier tomorrow. As economist Thomas J. DiLorenzo explains:

If competition is viewed as a dynamic, rivalrous process of entrepreneurship, then the fact that a single producer happens to have the lowest costs at any one point in time is of little or no consequence. The enduring forces of competition — including potential competition — will render free-market monopoly an impossibility.[6]

In other words, even if there happens to be only one current provider of a particular good or service, in a free market that provider is held in check by the mere threat of competition — if he charges prices that are too high or provides poor service, there will be an incentive for a competitor to come in and take market share from him by offering lower prices or better service.

The rules change, however, when government regulation erects barriers to entry or otherwise suppresses competition. In addition to the many government regulations purportedly enacted in the "public interest," there are numerous instances where private-sector businesses have been able to successfully lobby policymakers to use the power of government to establish barriers to competition and protect them from existing or potential rivals. Unlike the free-market case, there is no possibility of these monopolists losing out to lower-cost providers (barring the elimination of the regulations), and they are able to "exploit" consumers. These are the truly harmful monopolies. Thus, the only "bad" monopoly is a government-created or government-preserved monopoly.

Conclusions

Proposition 80 would be a step backward for California. It would restrict consumer choice, discourage competition, and impose more of the kinds of regulations that got the California power industry into trouble in the first place.

As awful as Proposition 80 is, however, there is good news. It is trailing in recent public opinion polls, and even if it should end up passing it is likely to be discarded by the courts. It was removed from the ballot on July 22 by the Court of Appeals in Sacramento because the court found that, according to the state constitution, the PUC's authority can only be increased by the Legislature, not by initiative. The initiative was restored a few days later by the California Supreme Court, which did not offer an opinion on the merits of the case but felt that the public should have the chance to vote on the initiative before the legal challenge is heard. (Of course, if voters reject the measure, this will be a moot point and the courts will not have to waste their time on it — a fact that surely was not lost on the Supreme Court.)

Politicians and regulators forced a sham of a "deregulation" scheme upon the energy industry in California, and then blamed the free market when it inevitably failed! The problem was not too much free-market competition; it was too much regulation (despite the "deregulation" doublespeak). The real solution to California's energy problem is to eliminate price caps and all government regulation, thereby removing barriers to entry, fostering competition, offering consumers maximum choice, and affording providers the greatest incentives to increase capacity and best serve their customers.

Adam Summers is a policy analyst at Reason Foundation. A version of this article was originally published by the Ludwig von Mises Institute.

Endnotes

[1] This option was suspended during the electricity crisis of 2000 and 2001, but is scheduled to be reinstated when the last of the power contracts signed on behalf of the IOUs by the Department of Water Resources expires in 2015.

[2] Carrie Peyton Dahlberg, "Electricity proposition crackles: Will prices go up? Will it avert an energy crisis? It all depends on who's talking," Sacramento Bee, October 15, 2005, http://www.sacbee.com/content/politics/story/13717834p-14560232c.html (free registration required).

[3] California Secretary of State, Official Voter Information Guide, Statewide Special Election, November 8, 2005, p. 52, http://www.ss.ca.gov/elections/bp_nov05/voter_info_pdf/entire80.pdf.

[4] Terry Maxon, "Power Woes Unlikely in Texas, Officials Say," Dallas Morning News, January 19, 2001, cited in Lynne Kiesling, "Getting Electricity Deregulation Right: How Other States and Nations Have Avoided California's Mistakes," Reason Foundation Policy Study No. 281, April 2001, p. 18, http://www.reason.org/ps281.pdf.

[5] Murray N. Rothbard, Power and Market: Government and the Economy, (Kansas City: Sheed Andrews and McMeel, 1977), p. 76, http://www.mises.org/rothbard/power&market.pdf. Now integrated into Man, Economy, and State.

[6]Thomas J. DiLorenzo, "The Myth of Natural Monopoly," The Review of Austrian Economics, Vol. 9, No. 2 (1996), p. 44, http://www.mises.org/journals/rae/pdf/rae9_2_3.pdf.

Call for Real Electricity Deregulation

adam.summers@reason.org (Adam Summers) — Tue, 25 Oct 2005 00:00:00 EDT

Ventura County Star

NO: Proposition 80 would make some significant — and detrimental — changes in the state's energy policy, proving that we haven't learned the lessons of the so-called "deregulation" of the 1990s.

Before the state's "deregulation" experiment was suspended in 2001 during California's energy crisis, large energy users could choose to purchase their electricity services directly from independent electric service providers, rather than through an intermediary such as the local investor-owned utility or public utility. ESP customers include hospitals, local governments, and schools. Proposition 80 would permanently prevent customers switching from an IOU to an ESP, thus reducing choice and forcing consumers to buy their electricity from (often higher-priced) utilities.

Another provision of Proposition 80 would effectively prohibit the broader implementation of "dynamic pricing" of electricity without the consent of the consumer. Currently, all but the largest energy consumers pay a flat rate for electricity. However, the IOUs have submitted proposals to the Public Utilities Commission to charge residential and small commercial customers higher rates during peak hours and lower rates during nonpeak hours.

In addition to making good economic sense, dynamic pricing encourages conservation. Higher prices discourage some from consuming such a scarce resource, and those who have some flexibility over when they consume their energy are encouraged to utilize it for cheaper during nonpeak hours.

Proposition 80 also promotes investment in inefficient "green" energy sources. Under current regulations, energy producers must increase the portion of energy derived from renewable energy sources — such as solar, wind, and hydroelectric — to 20 percent by 2017. Proposition 80 would accelerate this deadline to 2010.

According to the Legislative Analyst's Office ballot analysis, Proposition 80 would also require that IOUs place a higher priority on cost-effective renewable resources than on "traditional sources such as fossil fuel burning power plants." Of course, if renewable energy sources were truly "cost effective," producers would already be utilizing them in greater numbers.

Some blame "deregulation" for the rolling blackouts, soaring spot market prices and utility bankruptcies that sprang from the energy crisis of 2000 and 2001, but this anger is misplaced. California has never experienced true energy deregulation. The "deregulation" implemented in 1996 left price controls in place and created "artificial" markets ripe for manipulation and mismatches between supply and demand. By setting price caps below market prices, California limited the profitability of the industry. When wholesale energy costs increased, the price caps prevented energy producers from passing the increases on to consumers, resulting in the bankruptcy of PG&E and the near-insolvency of Edison.

The price caps additionally discouraged potential producers from entering the market and increasing competition, and they discouraged existing producers from investing profits in added capacity, of which the state was (and continues to be) in dire need. Furthermore, after the IOUs were compelled to divest many of their fossil-fuel-burning generators to private firms, regulators prohibited them from better managing risk through long-term contracts with these firms, forcing them instead to rely on the much more volatile short-term and spot markets.

Politicians and regulators forced a sham of a "deregulation" scheme on the energy industry in California during the 1990s, and then blamed the free market when it inevitably failed! The problem was not too much free-market competition; it was too much regulation. Quite simply, it was a government regulation failure, not a market failure.

Proposition 80 supporters apparently failed to learn this lesson. Proposition 80 would represent a huge step backward, toward stifling regulation and decisions based on politics, not economic realities.

The real solution to California's energy problem is to eliminate price caps and all government regulation, thereby removing barriers to entry, fostering competition, offering consumers maximum choice, and affording providers the greatest incentives to increase capacity and best serve their customers.

Adam B. Summers is a policy analyst at the Reason Foundation, a free-market think tank.

Bureaucracy, Lack of Innovation Led to LA Blackout

adrian.moore@reason.org (Adrian Moore) — Wed, 14 Sep 2005 00:00:00 EDT

Los Angeles Daily News

You'd think we would have learned something from the gigantic Northeast blackout that left 50 million Americans without electricity in 2003. But Monday's blackouts that left up to 2 million people around the Valley and Los Angeles without power shows just how archaic and inept the city-owned utility, the Los Angeles Department of Water and Power, has become.

The DWP is a relic, a remnant of many public utility dinosaurs created two centuries ago that came to their full during the Great Depression. What was "modern thinking" back then is now a bureaucracy built extensively on outdated, burdensome rules and regulations. Pick an adjective to describe a poorly functioning agency — politicized, inefficient, unresponsive — and you've described the DWP.

The city's municipal enterprise has shown a stunning lack of innovation and, even more worrisome, an inability to keep up with the industry's best and latest practices. Some leaders would say budgets are too tight - as if Californians and Angelenos don't pay enough taxes to enjoy modern electrical systems - or that the accidental cutting of power lines while attempting to upgrade the system is actually, somehow, a sign that the DWP is heading in the right direction because the blackouts didn't spread even further.

Wrong.

The DWP's absurd oversight system stifles innovation and lends itself to backroom deals and power plays that have long left city residents holding the bag.

The rest of the world has moved on from this outdated model of a power utility, and it is time that Los Angeles did, too. Most of the power in the United States is provided by private, investor-owned utilities, a model that has proven to be cost-effective and responsive to consumers. It is time to "corporatize" the DWP.

Corporatization - a model that has worked all over the world with national electric utilities, from Argentina to Australia and from Great Britain to New Zealand.

Corporatization means shifting the DWP from being a government department to an incorporated, for-profit business owned by the government. The city would set rules guarding against monopoly pricing and to ensure compliance with environmental mandates.

The new DWP would have a board of directors run by a strong chairman. Instead of living in the government's world of red tape, the new DWP would work and function under ordinary corporate law. It would pay the same taxes as any other business, including local property taxes to the municipalities where it has facilities. And, if it turned a profit, it would pay dividends to its shareholder, the city of Los Angeles.

But here's the key for taxpayers: If the DWP were operating as a business, management, budget and operating decisions would be based on serving customer needs directly, not serving political or special-interest needs. That means a new focus on reliability and quality.

Of course, as the owners of the DWP, the city needs, and would have, some ultimate means of accountability and oversight. The city would negotiate an annual policy statement with the board detailing specific performance measures that must be met. The CEO, in turn, would work out performance agreements for his management team, and so on, down the line. Everyone would be accountable and required to meet their goals - unlike in today's DWP.

What would taxpayers get from a shift to corporatization? Better service, modernized equipment and lower costs - thanks to streamlined operations and a changed corporate culture that comes with shedding bureaucracy.

We'd also get a DWP with greater overall productivity, a more predictable revenue stream for the city from annual property taxes and business taxes paid by the DWP, and dividends paid in profitable years.

Los Angeles should learn from this blackout. The writing is on the wall, and since the lights are back on, let's hope city officials can see that it is time to reform DWP.

Adrian Moore, Ph. D., is vice president of research at Reason Foundation.

Give Consumers Choice on Utilities

info@reason.org (Vernon Smith) info@reason.org (Lynne Kiesling) — Fri, 27 Aug 2004 00:00:00 EDT

San Diego Union-Tribune

Some California utilities are working to turn the clock back to the "good ol' days" of regulation and guaranteed profits. A bill currently before the Legislature would take hard-won economic power from consumers and return it to monopoly utilities, in the name of increasing investment in the electric power system. This should cause all ratepayers concern.

Eighty-odd years ago a bargain between state legislatures and utilities was struck: provide ample, reliable power to customers, and regulators would guarantee a reasonable profit to the utility. While this guaranteed profit incentive structure funded the industry's growth it also provided disincentives to innovate. This model has left California — and other states — with a technologically backward energy system, ironically co-existing with the high-tech mecca of Silicon Valley in the age of sophisticated monitoring, switching and control devices.

California can better meet its goal of attracting capital investment by empowering consumers. While utilities have sought rate increases through the regulatory process, entrepreneurs have risked their own capital to create innovative solutions that provide a portfolio of choices to consumers, increasing economic and grid flexibility at the same time. However these innovations remain shackled by regulatory fiat, and blocked by utilities' control of access.

Regulatory efforts have focused exclusively on the supply side of energy. Noticeably absent from the state's electricity strategies have been aggressive proposals to empower consumer demand and choice.

Even though the cost of producing and transmitting electricity fluctuates by the hour, and the seasons, almost all consumers pay the same price for electricity every hour, year-round. But electricity used on hot summer days costs much more to generate and transmit. In effect, consumers overpay most of the time — when prices are low — and underpay when prices spike.

By ignoring the basic laws of supply and demand, California's inefficiencies are perpetuated and consumers lose the ability to benefit from the cost differences — shifting their energy use to less-costly periods, late at night for example, and away from demand peaks. As an end result of the current price structure, off-peak power users unfairly subsidize consumers of costly peak power, creating great strain on the state's energy supply.

One simple and straightforward improvement that California lawmakers should pursue is incorporating consumer choice and real-time pricing into the regulatory and market institutions that compete to govern California's electric power network. Providing consumers the ability to react to changes in energy supply creates a dynamic market disciplined by pricing — consumers can shift power usage when prices rise or fall — and provides a platform for product and technology innovation.

Green energy providers can find users willing to pay for environmentally friendly — but more costly — wind, solar and biomass power. Retail energy marketing companies can create contracts with consumers to reduce their consumption when overall demand spikes, in exchange for lower prices. Technology can be installed in homes or businesses to monitor energy prices minute-by-minute and maximize energy use while minimizing cost.

Both the technology and the business know-how exist to implement these changes today, and the technology is cheaper than ever. Allowing entrepreneurs to innovate and reduce peak demand through customer choice may mitigate the need for building new power lines and plants, an enormous cost savings for consumers. Moreover, these changes provide greater security, and a lower impact on the environment.

Customer choice in markets plays a critical role in investment signaling. High peak prices signal a need for investment in more supply or more peak energy conservation, whichever is the cheapest. But the energy regulatory structure prevents the full savings from energy conservation to be enjoyed by consumers.

Without accurate price signals, no amount of regulatory planning can efficiently satisfy consumer demand. The only way to get the right kind of investment signals is to empower consumers with choice, so that customers can communicate their preferences through their choice of providers and service packages.

It is also important that investors risk their own private capital — not taxpayer money or a charge on customers' energy bills — and that they don't invest in an environment in which they can recoup cost overruns from their ratepayers. That precise set of perverse incentives has saddled California and other states with unresponsive, technologically stunted energy markets.

Let independent energy companies separate from the wires monopoly, vie for customers like every other industry, and offer competing service packages. Customers should not be required to buy their energy from the same franchised monopoly that rents them the wires. This is a tie-in sale forced on consumers by regulation. When you rent a car no one requires you to buy the gasoline from the car rental agency. But your local utility, which rents you their wires, requires you to buy its energy.

Gov. Arnold Schwarzenegger has a rare opportunity to empower consumers over special utility interests � while at the same time creating a stable and reliable system through a marketplace that invites innovation and investment dictated by need, not the drive for ratepayer-guaranteed profits.

Lynne Kiesling is an adjunct scholar at Reason Foundation and director of applied energy research at the International Foundation for Research in Experimental Economics.

Vernon Smith, a professor of economics and law at George Mason University, won the 2002 Nobel Prize in Economics.

Analyzing the Blackout Report's Recommendations

info@reason.org (Lynne Kiesling) info@reason.org (Michael Giberson) — Thu, 01 Jul 2004 14:22:00 EDT

The Electricity Journal

...

California's Dueling Electricity Bills

info@reason.org (Lynne Kiesling) — Mon, 26 Apr 2004 00:00:00 EDT

Last week the California Assembly passed new piece of electricity legislation, AB2006. The bill is meant to break the regulatory limbo in which the California electricity industry has been for the past three years. It contains the usual compromises to make it politically palatable, but also happens to contain some substance that would introduce a measure of meaningful value-creating competition. Its legislative competitor, AB428, has some beneficial features that are superior to those contained in AB2006. Each of the bills, though, is a curate's egg, meaning that each is "partly good and partly bad and so not wholly satisfactory".

The foundation of AB2006 is dividing customers into core and non-core groups. Core customers are those who have a maximum peak demand of less than 500 kilowatts. Core customers will not be allowed to choose different electricity suppliers or different electricity contracts, but will be on a cost-based, fixed, average rate plan with their utility. Noncore customers can choose between the cost-based plan, other plans that the utility might offer, or direct purchases from an independent power producer.

A lot of the bill focuses on investment and what's called in the business the "resource adequacy" requirements on the utility. Resource adequacy basically means the utility has to plan for how it intends to meet the demand facing it. One of the really good things about this bill is that it explicitly includes demand reduction as a tool for resource adequacy. This is important because it gives the utility an incentive to consider using price to prioritize use, shift load away from peak hours, and shave peaks as ways to meet its resource adequacy requirements.

The bill also stipulates that the utility will not be responsible for having a resource adequacy requirement for the noncore customers that choose direct access to an independent power producer. The good news about this setup is that it gives the right signals to the right parties (especially customers and independent power producers) about the risks that they are taking on. And the flip side of that is that is allows for flexibility between noncore customers and independent power producers in the types of contracts and levels of reliability that they choose. But it also says that noncore customers who do not choose direct access must sign five-year contracts with the utility. This provision stifles direct access and locks in utility customers. What happened to choice and the benefits of competition?

Another area in which to be careful here is that the utility as transmission owner and transmission service provider must still take into account those power flows in its transmission investment and planning. Nothing in this bill provides for transparency and the flow of information through market processes into the transmission investment decision.

The worst feature of this bill is its requirement that core customers are forced into a fixed, cost-based rate. While this is clearly a compromise that is meant to assure small customers that they will be protected, it imposes a cost on those core customers who would choose a more flexible contract instead of a fixed, average, cost-based rate.

In fact, one of the complaints being lodged against the bill is that the cost-based rate saddles the core customers with the overpriced long-term contracts that the State of California signed in the winter of 2001 while allowing noncore customers to negotiate more attractive contracts. Perhaps the Governor's energy advisors can suggest some creative ways of renegotiating or restructuring those contracts, much in the same way that it's done in commercial contexts, to remove this political obstacle.

But there is hope for at least some demand response programs for those core customers. Pilot programs in both California and Illinois have demonstrated that even residential customers respond to price changes over the day in accordance with changes in the cost of providing them with power. So we may be taking small steps toward retail choice even within the regulated, core customer context.

AB2006's legislative competitor, AB428, has been kicking around the Senate Energy Committee since last July. AB 428 has the same core/noncore structure as AB2006, but says that the noncore customer has three choices: direct access, a contract with the utility for three years or longer, or default (i.e., cost-based) service. The three-year lock-in is not quite as onerous as the five-year lock-in of AB2006, although it's no great improvement. AB428's supporters think that it's more market-oriented than AB2006.

I don't entirely agree. I do think that AB2006 creates opportunities for utilities to get back into the generation business, which I don't think we want to induce artificially at this point. And I think AB2006's explicit recognition of the importance of allowing demand reduction to be considered a reliability resource is a very good thing. But the rest of AB2006 is more restrictive.

A truly market-oriented approach that still acknowledges some of the political obstacles would take the direct access provisions from AB428 and the demand reduction as resource adequacy provisions from AB2006, and throw out the rest. This would rescue each bill from being a curate's egg and create one bill that, while not perfect, is more satisfactory.

An approach that would be more fair to all customers would be simply to have as part of AB(428+2006) the statement that

All customers have the right to choose from a menu of contracts how they will buy and pay for their power.

Then let the customers to whom that choice is valuable exercise it.

Lynne Kiesling is an adjunct scholar at Reason Foundation and director of applied energy research at the International Foundation for Research in Experimental Economics.

Electricity Consumers Prove Their Smarts

info@reason.org (Lynne Kiesling) — Tue, 02 Mar 2004 00:00:00 EST

On Friday I attended an important event in Chicago that shines an optimistic beacon into the stagnant state of electricity policy. The event was the announcement of the first year's results of the Community Energy Cooperative's residential demand response program. This program's results are exciting, and should open our thoughts to a wider range of choices and business models when we think about selling electricity, even to the smallest customers.

Demonstrations that residential customers will respond to electricity price changes are thin on the ground. Common wisdom typically suggests that residential customers are very unresponsive to price changes, and that the price inelasticity of their electric demand would make any residential demand response minimal. In light of this common belief, and in this current state of regulatory limbo and risk aversion, the demonstration of residential demand response from Chicago in 2003 is particularly welcome and refreshing.

The Energy Smart Pricing Plan is a joint effort between the Center for Neighborhood Technology's Community Energy Cooperative and Commonwealth Edison. In its first year, the program had over 750 participants in a variety of neighborhoods and types of homes, from large single-family homes to multiple-unit buildings. Commonwealth Edison provides the hourly prices, on a rate tariff approved by the Illinois Commerce Commission.

The keys to the Energy Smart Pricing Plan are simplicity and transparency in the transmission of information to residential customers. Participants receive a simple interval meter, and can either call a toll-free phone number or visit a website to see what the hourly prices will be on the following day. Furthermore, if the next day's peak prices are going to exceed 10 cents/kilowatt hour, customers receive a notification by phone, email or fax. Customers will never pay a price above 50 cents/kilowatt hour, which the Community Energy Cooperative implemented by buying a financial hedge at 50 cents.

Friday's event included a presentation of the independent evaluator's report on the program. In the first year of the program, customers saved an average of 19.6 percent on their energy bills. They generally joined the program expecting to save $10/month on average, and were not disappointed. Surveys indicate that the participants found the price information timely, and that with this small inducement to save money on their energy bill by making small behavioral modifications, they actually became more aware of their energy use overall, not just in the approximately 30 hours last summer that had higher prices. They also said that their personal contributions toward reduced energy use and improving the environment by participating in this plan really mattered to them.

The most remarkable outcome is that even though it was a mild summer, participants did respond in the few hours that prices rose. Most responded by increasing the temperature on their air conditioners or shifting their laundry time to off-peak hours. The econometric analysis of the results showed a price elasticity of demand in those hours, at the margin, of -4.2 percent. In other words, when price rose by 100 percent, participants reduced their electricity use by 4.2 percent. For residential electricity customers, this is a healthy response, particularly given the lack of severe weather conditions. And that 4.2 percent reduction in use is a reduction at the margin, a margin that can often see prices go up by more than 100 percent in peak hours on hot days. So although the elasticity number may sound low, because it is at the margin and at the right time, it can take strain off of the system and contribute to grid stability and service reliability in those hours. And taking strain off of the grid at the margin in peak hours is crucial, as we saw last August in the Northeast blackout.

Customer response to price changes benefits not only those who respond, but also other customers and the system as a whole. Reducing peak use reduces wholesale market prices and long-run investment requirements that affect all customers, not only those who choose to see price changes. This widespread consequence of customers having the right to say "no" is the most powerful tool for public interest that comes out of demand response.

Utilities can also benefit from such demand response programs. The historic development and regulation of the industry has led to a culture in which the prevailing business model for a utility is "sell more power, make more profit." In this world, utilities are prone to perceive the load reduction that can come from demand response as a direct assault on their profits. But what demand response shows us is that electricity can be sold as a differentiated product according to time, not just as homogeneous electrons. Furthermore, that differentiated product can be priced in ways that reflect the true cost of selling it in that hour.

In other words, demand response opens up the possibility that utilities can make more profit by selling less power. But they have to see it as a viable business proposition, and regulators have to show leadership in enabling utilities to offer their customers a portfolio of contracts from which to choose, even those that include choosing to pay higher prices some of the time.

Customer choice and demand response can also reduce the utility's costs in the long run. Investment in generation and transmission assets is determined by the level of peak demand, and the more extensive programs like the Energy Smart Pricing Plan become across all types of customers, the longer is the timeframe between costly and unpopular investments. Unfortunately, in the current regulatory environment that is based solely on cost recovery and profit as a rate of return on assets, neither the utility nor the regulator has incentives to provide the means for saving on future investment.

Hopefully results from projects like the Energy Smart Pricing Plan will change these counterproductive incentives. Empowering customers to choose when and how they consume and pay for power is good public policy, good for getting the most out of costly investments, and good for the environment.

The Energy Smart Pricing Plan's evaluation report is available here at and I encourage you to read it. Its thorough, quality analysis contributes a lot of insights to the potential for customer choice to improve resource use and electric system reliability.

Lynne Kiesling is an adjunct scholar at Reason Foundation and director of applied energy research at the International Foundation for Research in Experimental Economics.

Socket to California

info@reason.org (Vernon Smith) info@reason.org (Lynne Kiesling) — Mon, 10 Nov 2003 00:00:00 EST

The Wall Street Journal

Despite California's status as the world's fifth-largest economy, Arnold Schwarzenegger finds himself in a position more similar to governing occupied Iraq, a resource-rich but cash-starved state. Mr. Schwarzenegger rode to victory in large measure due to anger over Gray Davis's handling of the 2001 energy crisis. The governor now has a rare political opportunity to learn from the lessons of his predecessor's downfall while addressing the critical deficiency of the California energy system: unfair subsidy to costly peak power use from off-peak users.

In running for governor, Arnold promised that his administration would not be "government as usual." We offer a series of proposals — based on more than a decade of economic experiments — in the hope that California won't follow sterile economics as usual.

In California and elsewhere, the demand for energy at peak levels is more than twice the demand of off-peak levels. Yet the additional cost of producing a kilowatt of energy at peak demand can be three to 10 times the cost at off-peak demand. In a rational world, consumers could pocket this difference in price variation by shifting energy usage away from peaks and toward troughs. But current policy unfairly forces consumers to pay rates based on the average hourly cost of energy and industry capital investment. As a result, peak utility cost is much higher than what consumers pay, and off-peak and weekend cost is much lower than what consumers pay. The utility earns an abnormally high profit from off-peak consumption and loses money from peak sales. Peak period sales are thus subsidized by the implicit transfer of funds from the utility's high profit on off-peak users. In effect, utilities profit on energy needed to dry clothes at 6 a.m. and subsidize clothes dried at 4 p.m.

Relieving this disparity requires a significant shift in thinking and corrections in the regulatory environment. Under the current regime, local utilities enjoy a government-protected monopoly on energy and the wires for delivering it — bundling the sale of energy with an additional charge for the rental of the facilities and wires leading to homes and businesses. Divesting these separable activities — the market for energy and the market for delivery — would create a competitive environment that benefits customers while opening opportunities for new market entrants and the development of new technologies.

The following proposals stem from the separation of energy and delivery and suggest simple regulatory changes that — given California's budget constraints — require effort but not state cash. Unlike regulated utility expansion and development that depend on taxpayer capital or increased utility rates, these proposals require entrepreneurs to risk their own capital.

• Option 1: Maintain a local, regulated wires delivery system and set a future date for all of the local utilities' customers to be provided energy by an alternative retail provider. Energy companies then compete for customers. Those customers who do not choose a provider by the target date are assigned a provider in proportion to the number of customers each competing company has signed up. This is the model Georgia followed for restructuring retail natural gas, and it has the advantage of defining an endpoint. As in Georgia, customers would be served by a single local, regulated delivery company and a number of competing retail energy supply companies.

• Option 2: Require local utilities to create separate companies for their energy and wires businesses. Then allow free entry of self-financed companies to compete only against the local utility's energy business. This scenario builds competition by exposing a single initial firm to entry pressures — forcing the incumbent to price energy low enough to discourage competing entry but still allowing for new entrants to compete on price, service or alternative provisions such as "green energy." This approach stretches the restructuring process, providing a bridge between the current and future framework. It requires stringent oversight, however, to make sure competing suppliers have the same access to the regulated wires network as the incumbent supplier.

Under any of these options, competing energy suppliers also should be free to bypass both the distribution and transmission system wires by locating distributed generation sources — small, local generators that can efficiently power homes or office buildings — near the end-use consumer. Distributed generation provides for new developments motivated by potential profits while further relieving grid congestion, disciplining transmission prices and reducing dependence on grid capacity.

Customers are long overdue to benefit from the new technologies that can be developed when innovators are free to devise novel services, approaches and technologies — and when energy companies recognize the profit opportunities resulting from a new business model. And while it will not be easy to institute major change in a charged political environment, there are opportunities for Mr. Schwarzenegger to work within the current regulatory scheme to provide improvement and serve as a bridge to delivering more vibrant benefits to Californians. These second order, less desirable solutions can be instituted in advance or alongside the more challenging changes required to create a dynamic, decentralized energy environment.

• Option 3: Allow wholesale prices to be passed on to any retail customers by giving all customers a choice between a fixed average price or one of the many time-of-use pricing program technologies, such as remote appliance switches, time-of-use metering or load management systems.

• Option 4: Allow customers to supply their own energy through a distributed generation source without charges for the utilities' wires and infrastructure costs. If a customer uses grid wires only some of the time, the cost should be prorated hourly, giving the customer credit for hours off the grid. This requires utilities to meet the opportunity costs created by new technologies, and it removes the utilities' ability to use regulatory cost-averaging rules to block new cost-saving sources of power. This model has the important effect of making the transmission and the distribution grid contestable, and would relieve transmission congestion.

Any of these steps moves California closer to a fairer, more dynamic energy market — but is only a beginning. Ending the subsidy of peak power users depends on a regulatory structure that allows for entrepreneurial innovation coupled with complete retail consumer choice. California — known for its liberal and environmental affinities — is an unexpectedly ideal state for the suggested, market-driven solutions to its energy crisis. Committed environmentalists will recognize that consumer choice promotes conservation, and that a better utilization of current energy infrastructure will result in less energy consumption and power plant construction. Those whose sympathies run counter to business can seize the activist opportunity to reduce the regulatory incentives the power industry naturally follows: It increases profits only by adding to its rate base through new power plant construction. Actors and celebrities who have taken to driving sub-compact hybrid vehicles as an environmental statement can similarly popularize load management and other conservation systems, making the development of new technologies more attractive. Those who value equality will understand the benefits of a system that allows consumers to control their energy costs while eliminating subsidies to peak energy users.

While more can and should be done, Mr. Schwarzenegger has the opportunity to leverage a historical confluence of events — a dramatic political win, enduring resentment over the energy crisis, and a solution attractive to a range of stakeholders — to craft a dynamic energy system that puts customers first while setting the scene for investment, innovation and development.

Vernon Smith, a professor of economics and law at George Mason University, won the 2002 Nobel Prize in Economics.

Lynne Kiesling is an adjunct scholar at Reason Foundation and director of applied energy research at the International Foundation for Research in Experimental Economics.

Movin' Juice

info@reason.org (Lynne Kiesling) adrian.moore@reason.org (Adrian Moore) — Mon, 01 Sep 2003 00:00:00 EDT

Executive Summary

The dramatic blackouts in the Midwest and Northeast in August of 2003 have focused our attention on electricity policy once again. This time the issue is the grid—the transmission network that transports electricity across regions. Our policies governing electricity transmission— regulating it and moving slowly toward changes to support competitive wholesale electricity markets—are getting a sharp look from more people than ever.

Existing long-distance transmission infrastructure is insufficient to support the changes that have come about in the industry since the deregulation of the early 1990s that led to the dramatic increase in the trade of generated electricity.

Ways to remedy this situation fall into three categories: build and upgrade transmission, build generation closer to population centers, or reduce the demand for transmission services. This study provides an analysis of the institutional changes being proposed and debated, particularly FERC’s RTO policy. By establishing RTO rules, FERC can move the industry toward building and managing a national grid network. But at the same time, FERC risks creating an ordered competition— competition engineered based on an assumption about how competition ought to be— rather than a competitive order, which arises spontaneously from human action and economic evolution based on choices and change over time. While ordered competition through the RTO structure could simply be a step to move the industry toward an institutional structure in which a competitive order can emerge, it is at best only part of the legislative and regulatory changes that would produce competition in the industry. To do that, legislative and regulatory changes will have to focus on removing barriers to entry and to technological change in the industry.

Our recommendations encourage the use of distributed generation technology, innovative forms of contracting, and other institutional and technological changes that would increase the contestability of the transmission segment of the electricity value chain, and could do so in a flexible, open-ended way.

Demand, Not Supply

info@reason.org (Vernon Smith) info@reason.org (Lynne Kiesling) — Wed, 20 Aug 2003 00:00:00 EDT

The Wall Street Journal

Immediately following the failure of the electrical network from Ohio to the Northeast Coast, a cascade of rhetoric swept across news networks, blaming the blackout on an antiquated grid with inadequate capacity to carry growing demand for electrical energy. As in the California energy debacle, we are hearing the familiar call on government to "do something."

The California government response — doing something — left the state with a staggering and unnecessary level of debt. Meanwhile, without any additional action by the state, the demand and energy supplies in California have returned to their normal and much less stressful levels and wholesale prices are back to normal. There is no news except good news, but have we gained any deep understanding of power system vulnerability and its efficient cure from this event?

Before Congress and the administration begins to follow the California model and throw other people's money at the power industry, let's have some sober and less frantic talk.

A systematic rethinking of the power demand and supply system — not just transmissions lines — is required to bring the energy industry into the contemporary age. Eighty-five years of regulatory efforts have focused exclusively on supply — leaving on dusty shelves proposals to empower consumer demand, to help stabilize electric systems while creating a more flexible economic environment.

Under these regulations, a pricing system has developed that is so badly structured at the critical retail level that if it were replicated throughout the economy, we would all be as poor as the proverbial church mouse. Retail customers pay averaged rates, making their demand unresponsive to changes in supply cost. Without dynamic retail pricing, no one can determine whether, when, where or how to invest in energy infrastructure. Impulsive proposals to incentivize transmission investment, without retail demand response, puts the cart before the horse and risks expensive and unnecessary investment decisions, costly to reverse.

At the end-use customer level, the demand for energy is almost completely unresponsive to the hourly, daily and seasonal variation in the cost of getting energy from its source — over transmission lines, through the substations and to the outlet plugs. The capacity of every component of that system is determined by the peak demand it must meet. Yet that system has been saddled with a pure fantasy regulatory requirement that every link in that system at all times be adequate to meet all demand. Moreover, the industry has been regulated by average return criteria, and average pricing.

When the inevitable occurs, as in California, and unresponsive demand exceeds supply, demand must be cut off. Your local utility sheds load by switching off entire substations — darkening entire regions — because the utility has no way to prioritize and price the more valuable uses of power below that relic of 1930s electronic technology. This is why people get stuck in elevators and high-value uses of power are shut off along with all the lowest priority uses of energy. It's the meat-ax approach to interrupting power flows. Between the substation and the end-use consumer appliance is a business and technology no-mans-land ripe for innovation.

When a transmission line is stressed to capacity, and its congestion cost spikes upward, the market is signaling the need for increased capacity in any of three components of the delivery system: increased investment in technologies for achieving price responsive demand at end use appliances; increased generation nearer to the consumer on the delivery end of the line; or increased investment in transmission capacity.

What is inadequately discussed, let alone motivated, is the first option — demand response.

Many technologies are available that provide a dual benefit — empowering consumers to control both energy costs and usage while also stabilizing the national energy system. The simplest and cheapest is a signal controlled switch installed on an electrical appliance, such as an air conditioner, coupled with a contract that pays the customer for the right to cut off the appliance for specified limited periods during peak consumption times of the day. Another relatively inexpensive option is to install a second, watt-hour meter that measures nighttime consumption, when energy usage is low, coupled with a day rate and a cheaper night rate. More costly is a time-of-use meter that measures consumption in intervals over all hours of the day, and the price is varied with delivery cost throughout the day. Finally, a load management system unit can be installed in your house or business that programs appliances on or off depending on price, according to consumer preferences.

More important, better and cheaper technologies will be invented once retail energy is subject to free entry and exit. No one knows what combination of technology, cost and consumer preferences will be selected. And that is why the process must be exposed to the trial-and-error experiment called free entry, exit and pricing. As in other industries, investors will risk their own capital — not your tax dollars or a charge on your utility bill — for investments that fail. Also, as in other industries with dynamically changing product demand, competition will force prices to be slashed off-peak, and increased on-peak to better utilize capacity.

Together with demand response technologies, a simple regulatory fix can give new entrants the incentive to provide customers with attractive retail demand options. Local regulated distribution utilities have always had the legally and jealously protected right to tie in the rental of the wires with the sale of the energy delivered over those wires. But these are distinctly separable activities. Just as rental car companies are separate from gas stations, electricity can be purchased separately from the company that delivers it to you — provided only that they can access the wires to install metering, monitoring and switching devices that fit the budget/preferences of individual consumers.

Remember when Ma Bell would not let you buy any telephone but hers, and would not let you admit any licensed electrician into your house to access the telephone wires except those arriving in her service truck? All that has changed for the better in telecommunications, but we are still stuck in a noncompetitive world in the local utility industry.

* * *

Against the backdrop of the wars in Iraq and Afghanistan, the East Coast blackout stimulated déjà vu speculation of Sept. 11 and fears of shadowy operatives bent on disaster. Since 2002, the Critical Infrastructure Protection Project at George Mason University has worked under a Department of Commerce grant to integrate the study of law, technology, policy and economics relating to the vulnerability of key U.S. infrastructure. Prime among this continuing research is investigation of the susceptibility of the national power grid.

As it turns out, terrorist speculation, though false, did not fall far from the truth. If you were to design an electrical system maximizing vulnerability to attack, it is hard to imagine a better design than what has evolved in response to regulation. If a terrorist attack took out half the energy supply to Chicago, the only viable response would be to shut down half the substations. Demand response would allow a prioritization of energy use, shutting down only the lowest priority of power consumption while supplying high value uses — such as production facilities, computer networks, ports, airports and elevators. Power systems badly need the flexibility to selectively interrupt lowest value uses of power while continuing to serve higher value uses. Retail price responsiveness in a competitive environment provides such a priority system.

The implementation of retail demand response in the electric power industry would provide a wide range of benefits including lower capital and energy costs, fewer critical power spikes, consumer control over electricity prices, and the environmental benefits gained by empowering consumers to use electricity more wisely. Despite Milton Friedman's admonition, by adding increased flexibility to the electricity grid and sparing critical infrastructure from shutdown, demand response creates a more efficient and resilient economic structure while providing more robust security as a free lunch.

Vernon Smith, a professor of economics and law at George Mason University, won the 2002 Nobel Prize in Economics.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.

Rethink the Natural Monopoly Justification of Electricity Regulation

info@reason.org (Lynne Kiesling) — Mon, 18 Aug 2003 00:00:00 EDT

Last week's blackout shows that transmission investment has not evolved in keeping with the dynamics of growing wholesale electricity markets. The deregulation of wholesale prices and the removal of geographic restrictions on sales of generated electricity have unleashed dramatic changes in the industry and led to increasing efficiency. Currently, though, the antiquated transmission system and continuing retail and distribution regulation at the state level hamper growth and efficiency in the electricity industry. Backward-looking, static regulatory thinking about how benefits are generated through competition hampers the unleashing of possible benefits of competition in the electricity industry.

Both federal and state policymakers continue to treat transmission and distribution as natural monopolies, meaning they believe one firm could supply the entire demand at lower cost than multiple firms serving the relevant market. From this premise they conclude that transmission and distribution must continue to be regulated, because in the absence of regulation, transmission and distribution owners would not face sufficient competition to keep prices low to consumers and to achieve economic efficiency in transmitting and distributing electricity. Natural monopoly concerns also include wanting to avoid the "unnecessary duplication" of such expensive capital infrastructure as high-voltage wires and transformers. Thus even under current Federal Energy Regulatory Commission proposals to revise the regulation of electricity, both transmission and distribution would continue to be regulated.

Although regulators are considering ways to incorporate more performance-based rates to move away from rate-of-return regulation, the natural monopoly paradigm locks them into a regulatory framework that is becoming outmoded as a result of technological change. Overcoming the traditional regulatory mindsets is a crucial step in delivering a variety of benefits to consumers, the economy and the environment from competition in electricity. Current regulatory proposals (such as FERC's Standard Market Design proposal) will lead to the construction of additional high-voltage transmission to create a unified transmission network across the country; while this proposal is sure to create some benefits by integrating separate geographic markets, it will also encourage more transmission construction than if regulators allowed for more flexible customer and supplier use of new technologies that will provide substitutes for long-distance transmission. Such substitutes would create competition for transmission, and would reign in a transmission owner's ability to raise prices to consumers. Through such a process we could actually get closer to achieving economic efficiency in transmission, without running the risk of the regulatory mandate to build more grid that could lead to expensive overconstruction.

Many technological and market innovations have reduced the natural monopoly rationale for traditional electric industry regulation. For example, consider distributed generation. Distributed generation (DG) is the use of an energy source (gas turbines, gas engines, fuel cells, for example) to generate electricity close to where it will be used. Technological change in the past decade and deregulation in the natural gas industry have made DG an economically viable alternative to buying electricity from a monopoly utility and receiving it over the utility�s transmission and distribution grid. The potential for this competition to discipline a transmission owner�s prices for transmission services is immense, but it still faces some obstacles.

Some utilities are offering DG, particularly to large industrial consumers who require higher reliability than the standard offering. These systems, though, tend to serve primarily as backup, because the government-granted monopoly franchise still exists for all utilities. This franchise imposes a twofold legal obligation — an obligation on all utilities to serve, and an obligation on all customers to buy. This relic of monopoly regulation has stifled the spread of DG and its ability to inject competition into the transmission and distribution sectors of the industry. FERC has been working with state regulators to craft a consistent set of standards that would enable DG to interconnect with the grid, and to put any excess power generated onto the grid. This effort has met technical and political obstacles, although the political obstacles have been the more daunting. Utilities generally perceive DG as a threat to their revenue stream, because they still operate under the old regulated business model of "sell more power, make more profit." But there are other value propositions out there — once utilities realize that they can make more profit by selling less power (e.g., through offering different contracts with market-based retail pricing), DG becomes much less of a threat to the utility business model. This change in mindset, and in business model, is impossible under the current regulatory environment that treats transmission and retail as a natural monopoly.

Such contestability of what was once thought to be a natural monopoly, and opting out of the use of that one-time natural monopoly, is occurring in other network industries, such as telecommunications. As wireless technology and services improve and digital networks expand, more customers are opting out of having a "land line" into their homes, choosing instead to rely entirely on their cellular telephones for service. Customers (specifically large industrial and commercial consumers right now, given existing technology) could reap similar benefits in electricity. However, policymakers are not yet considering the regulatory changes required to achieve those benefits.

Technological change and market dynamics have made the natural monopoly model of electricity regulation obsolete. While technological changes and market innovations that shape the electricity industry's evolution have received some attention, their roles in making natural monopoly regulation of transmission and distribution obsolete have not received systematic treatment. For that reason, the policy debate has focused on creating regional transmission organizations to rationalize grid construction, but has not dug more deeply into the possible benefits of dramatically rethinking the foundations of natural monopoly regulation. Last week's blackout suggests that this rethinking of natural monopoly is long overdue.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.

Blackout Blame Started as Soon as Lights Went Out

info@reason.org (Lynne Kiesling) — Mon, 18 Aug 2003 00:00:00 EDT

Tech Central Station

The blaming and finger pointing began almost as quickly as the lights went out. First it was the U.S. and Canada blaming each other for causing this particular blackout, but inevitably the blame conversation turned to larger issues of policy, and how something like this could happen in such a heavily regulated industry.

Some of the finger pointing in the national press has been at deregulation — if it weren't for deregulation, we would be better able to control and manage the grid. This misguided contention is incorrect in a number of ways.

First, the "deregulation" that has occurred in electricity has primarily been in opening up wholesale markets for power generators and their customers (i.e., utilities), enabling people in Manhattan to continue consuming power (and clamoring now for more regulation) without Con Edison having to build more power plants on the island itself. The existence and growing vitality of wholesale electricity markets has created substantial value in the past decade, through encouraging generation where it is cheapest and sales of power to where it is most needed.

But this limited amount of market liberalization has left the industry in an awkward place. Generation is largely governed by market processes, but transmission and retail distribution remain heavily regulated. The investment decisions of transmission owners and the retail rates that they can charge to their end customers all hinge on rate cases that are decided by state-level regulators. The rates that regulators allow take into account changes in costs, required investments, and the payment to the utility of a rate of return on the assets they own. For much of the past decade this rate of return has been substantially lower than what utilities could earn from doing other things with their money, so they did not invest in building much new transmission capacity or in upgrading existing lines. Nor did a regulatory environment that is a relic from the 1930s, constructed to govern and control local, vertically integrated utilities, either have the incentive or the wherewithal to force the utilities to invest in transmission assets that would carry power to customers in other states.

This lack of investment in the infrastructure that carries the product exchanged in growing, vibrant wholesale electricity markets has become a problem — not an overnight problem, as those who follow the industry have been concerned about transmission capacity for at least five years. The numbers offered this weekend suggest that electricity volume has increased 30 percent while transmission carrying capacity has increased only 15 percent. This fact illustrates the mismatch between the dynamic markets for wholesale power and the rigid, maladaptive set of state-level regulations and incentives that govern transmission investment decisions.

Markets adapt to changing conditions. The existing electricity regulations do not, and because of that, the transmission infrastructure has not adapted to the increased demand on it from the increasing vibrancy of wholesale electricity markets.

So how do we proceed to ensure that a blackout of this magnitude does not happen again? There are four things that can relieve the strain on the grid. The knee-jerk reaction of many people is "build more wires!" More wires will increase the carrying capacity of the system, and in some cases transmission owners can add lines to existing paths. But this approach faces some serious obstacles — such construction is expensive and time-consuming. Most importantly, though, getting new lines and towers sited is increasingly difficult, as people and communities object to having such large structures near them or strung overhead.

A second option is to use new technologies, such as high-temperature superconductors and sophisticated computer switching, to upgrade the capacity of the existing power lines. While also expensive, this option gets around the NIMBY issues that accompany the siting of new lines.

A third option is to build more generation nearer to customer demand — having more generators near Manhattan would reduce the need to transmit power from Niagra. Again, though, NIMBY concerns have been a strong constraint on large-scale generation construction near population centers. One way to increase generation, though, is distributed generation, which involves installation of small-scale generators on-site. DG is particularly economical for high-rise buildings (indeed, as we saw last Thursday and Friday, many buildings have DG for backup power already), and can reduce or eliminate a building's need to be connected to the grid. DG does increase the complexity of managing a grid, though, because the grid has to be configured to accommodate DG if they are going to be hooked into it.

A fourth option is usually not discussed, because of the tendency to think of the grid as a supply issue. We can, and should, use market-based retail pricing to communicate customer demand into the grid. Under the decades-old regulatory rules controlling the retail sale of power, customer rates are set as averages over the entire year. Averaged rates do not take into account the fact that the cost of supplying power to customers can vary hourly. Averaged rates also give customers no incentive to conserve when the cost of providing them with power is high, such as during the late afternoon on a warm summer day like last Thursday. Grid operators saw power flow anomalies as early as three hours before the blackout that spread in nine seconds, and in those three hours, if we had market-based retail pricing, even the shifting of a few large customers could have lowered the peak demand and prevented the power surge.

Both reality and laboratory experiments show that electricity customers do respond to price changes, and that both suppliers and customers are better off from doing so. This option does not currently exist for most customers in most places — large or small, we cannot choose how to buy and consume power. Imagine if the telephone industry still operated this way; if it did, we would not have the vibrant, competitive, thriving cellular phone alternatives that we do now. One major lesson of this blackout should be the need to revise our obsolete electricity regulatory model, and the ability of market-based retail choice to lessen the strain on the transmission grid.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.

Customer Choice Key to CA Energy Crisis

info@reason.org (Lynne Kiesling) — Mon, 21 Apr 2003 00:00:00 EDT

The past week has seen a few interesting developments related to electricity deregulation, and I found the juxtaposition of them interesting. They further reinforce the reasons for customer choice and retail deregulation in electricity.

First, the denouement of the California electricity crisis continues on, with the California legislature facing two opposing pieces of legislation concerning electricity regulation. Senate bill SB888, sponsored by Senator Joseph Dunn, proposes to return electricity regulation in California to its pre-1996 level of involvement and control over the industry, and would also implement a stringent renewable portfolio standard (the text of the bill is available here). According to an Associated Press story from last week, Dunn trotted out the usual canard that electricity’s lack of storability make it a non-commercial commodity:

“But Dunn said that after two years of investigating the energy crisis, he believes that there isn't any way to deregulate electricity because, unlike other commodities, it cannot be stored; instead it must be consumed when it is produced.”

By that logic, Dunn would probably propose regulating hotel room rates and airfares! I don’t want to make that suggestion to him, but rather I want to illustrate the absurdity of his position.

An editorial in Thursday’s San Jose Mercury News correctly characterized Dunn as reaching for a security blanket, an excessive response to problems from the past. The editorial is much more forward-looking, recognizing that a dynamic, thriving economy and electricity industry requires a more nimble and flexible approach:

“Returning to the old regulatory model is not needed either to re-establish stable prices or to restore the financial health of the utilities.

Going forward, there are two central questions: Who is going to generate and sell electricity? Will consumers have a choice about where to buy power?”

The editorial then goes on to highlight and recommend a second bill, AB428, which would reinstate retail direct access for large commercial and industrial consumers. This approach would inject a much-needed dose of consumer demand response into the California market, leading to optimized investment decisions on both the demand side and the generation side, and resulting in a more efficient and flexible generation of and use of power.

An example from the other side of the country illustrates these points beautifully. An article in Wednesday’s New York Times titled “Cooling the Empire State Building on the Cheap” describes how managers of large buildings have been able to reduce their heating and cooling costs, and their energy usage, through better usage monitoring over the day. The technology for such monitoring has existed for several years, but it took deregulation and market-based retail pricing to give building managers an opportunity to save money by reducing their energy use, as well as shifting it over time across the day.

“Several years ago, ConEdison Solutions had convinced Helmsley-Spear, the Empire State Building's managers, that it could analyze its energy needs, supply energy, improve efficiency and lower costs by monitoring energy market fluctuations. "We equate our role to that of a financial adviser," said Jorge Lopez, vice president for retail commodity services at ConEdison Solutions. "We acquire information, analyze it and develop a set of solutions."

One recommendation was that the Empire State Building alternate using steam and electricity so that depending on temperature, time of day and the price difference between the two sources of energy, the building's operators could switch from one to the other.

"Before energy was deregulated, users basically had to pay a flat rate," said William K. Stoddard, vice president for projects and engineering buildings at the Rockefeller Group, which operates four buildings in Manhattan, including the Time & Life Building.”

This example is a powerful illustration of how retail choice can create benefits for customers, reduce overall energy use, and encourage the development of innovative energy management solutions. Direct access in California would unleash some of the same dynamics that New York’s commercial building managers and energy solution providers are benefiting from. This is a much healthier policy choice than re-regulating to fight yesterday’s demons.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.

FERC Report Moves Toward Regulatory Certainty in CA

info@reason.org (Lynne Kiesling) — Mon, 07 Apr 2003 00:00:00 EDT

On March 26 the Federal Energy Regulatory Commission issued its staff report on price manipulation in western wholesale markets. The report, and the likely FERC actions to arise from it, accomplishes some goals that will reduce regulatory uncertainty and improve the investment prospects in this industry, in the rest of the country if not in California.

The FERC report focuses on fact finding and analysis in several related areas, all of which interact to indicate if wholesale prices were “just and reasonable”:

• The interrelatedness of natural gas markets and wholesale electricity markets, and the effects of scarcity-driven and manipulation-driven natural gas price increases on electricity prices

• The interrelatedness of spot electricity prices and forward electricity prices, which further transmitted the natural gas price increases

• Trading strategically and withholding in wholesale electricity markets

• Liquidity issues, including the effects of Enron’s wash trades and Enron’s ability to move illiquid markets

• Enron’s access to information through its proprietary trading platform

The conclusions and recommendations of the report will lead to estimated refunds of $3.3 billion, instead of the $1.2 billion estimated in December and based on actual natural gas market price. Otherwise, the findings largely support FERC Judge Birchman’s preliminary findings in December.

The crux of the analysis addresses natural gas spot prices during Summer 2000 and Winter 2000-2001, finding that repeatedly during that time period, spot prices indicated more than just scarcity in the natural gas market. In tight markets such as the natural gas market in 2000, higher prices are a logical outcome when demand increases and supply cannot respond sufficiently to keep prices lower. The profits that companies earn from supplying into such a tight market are called scarcity rents, and they communicate profit potential from supplying more to that market, either through entry of new competitors or by investment in capacity to be able to supply more. Those forces drive down prices over time.

But the dynamics of the natural gas market in California in 2000 were complicated by the existence of a “soft price cap” in the wholesale electricity markets. Natural gas is the fuel for the marginal generating units in California, and the price cap varied according to the natural gas price. With a price cap that is a function of natural gas prices, an incentive existed to influence natural gas prices and push them higher. The FERC staff report finds that the natural gas price at the Topock node indicates that BP Energy and Reliant followed those incentives. Furthermore, these perverse incentives carried over into the reporting of natural gas prices to trade publications, whose price indices formed the basis of such policy decisions. The false reporting of prices is a serious problem due to the importance of price transparency.

The findings thus suggest that high natural gas prices reflect both scarcity rents and manipulation to raise prices, which would serve to raise the soft price cap on electricity. The FERC staff report contains a careful, thorough analysis to distinguish between scarcity rents and using market power to increase prices at a particular natural gas node. Part of this analysis is a meticulous exploration overseen by Robert Pindyck, an economist who has done extensive research on price movements in commodity markets. The resulting analysis of natural gas price movements and the extent to which they reflected actual scarcity is careful, extensive, thorough and, I think, persuasive. Professor Pindyck and FERC staff also applied similar analytical rigor to exploring the extent to which spot electricity prices influence forward electricity prices, which further enables the transmission of higher natural gas prices. For further reading on the movement of spot and forward energy prices, I recommend Professor Pindyck’s article entitled “The Dynamics of Commodity Spot and Futures Markets: A Primer,” Energy Journal Volume 22 (2001), pp. 1-29.

Most of the finding of direct electricity market manipulation revolves around Enron, particularly Enron’s ability to use its proprietary online trading platform to give it an information advantage. This advantage, which exploited the lack of price transparency across the market, enabled Enron to profit from its trading strategies, from trading in illiquid markets, and from using wash trades to create the appearance of liquidity.

Separating Enron’s widespread perpetration of fraud from the flawed market rules that they could exploit in California has been a challenge. One thing that FERC staff did was analyze such behaviors, by Enron and others, on the basis of rules included in ISO and PX tariffs. Some of these actions did violate rules in the tariffs, and therefore can and should be pursued. Enforcing such rules is one important step in restoring regulatory certainty in wholesale markets. FERC staff recommend that some companies should substantiate the integrity of their bidding. They comprise both private generators and public power companies, including AES/Williams, Dynegy/NRG, Mirant, Reliant, Bonneville Power Association, Los Angeles Department of Water and Power, Idaho Power, Powerex, and Enron. Interestingly, although Enron’s actual California market share was low, its apparent share of the market manipulation that violated existing rules was high.

So what are the major implications of the findings in this report?

• Bad rules are still primarily to blame. To quote the Findings at a Glance, “staff concludes that supply-demand imbalance, flawed market design and inconsistent rules made possible significant market manipulation as delineated in final investigation report. Without underlying market dysfunction, attempts to manipulate the market would not be successful.” This finding, importantly, and correctly in my view, recognizes that market manipulation arose from the existence of a flawed design, and firms should not be held responsible for responding to the incentives in that flawed design, but should be held accountable for violations of explicit rules in tariffs.

• This thorough analysis can help us move on. The economic limbo and regulatory uncertainty that has hampered this industry is to the detriment of both consumers and the industry. This staff report is so thorough and analytically rigorous that it is unlikely to fall prey to the oft-heard criticism that FERC is not really paying attention to California’s plight. Hopefully this report and subsequent FERC actions will enable California to shift to a forward-looking focus.

• The sanctity of contract remains inviolate. Based on these findings, FERC is unlikely to support nullifying the state’s long-term contracts signed in early 2001. This stance is crucial for maintaining a stable legal framework for ongoing activity in this industry. Furthermore, the state has had success at renegotiating the terms of these contracts.

• Price above short-run marginal cost signals scarcity and the need for investment in the industry, and refunds should not interfere with that. The care that FERC staff took in establishing a refund rule that preserved the scarcity rent component of prices should indicate the prospect for investment-friendly regulatory certainty. Ex post refunds raise the possibility of expropriation and can stifle investment. The refund rule in this analysis is careful to take that into account as much as possible, and to preserve scarcity rents in tight markets.

• Enron aside, the largest magnitude manipulation was in the natural gas input market, not in the electricity market.

• Price transparency, and legal and regulatory simplicity, stability and enforcement, are crucial for the growth of liquid markets that create value for suppliers and consumers.

There are a few more steps in resolving these refunds, but this report and its recommendations are a substantial step toward shifting focus to the future potential value propositions that a market-based electricity environment can deliver to California’s residents and to entrepreneurial firms who could profit from creating that value for them.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.

Scapegoating Isn't an Energy Policy

info@reason.org (Lynne Kiesling) — Wed, 26 Mar 2003 00:00:00 EST

Orange County Register

In winter 2000-2001, California experienced rolling blackouts and state regulators approved electricity rate hikes of up to 46 percent — dramatic symbols of the negative consequences of the state's dysfunctional wholesale electricity market. Today, Californians are stuck paying some of the highest retail electricity rates in the U.S. even as wholesale prices have dropped to one-tenth of their late 2000 peak.

The California Public Utility Commission passed these rate increases to counter its own mistakes and balance the mismatch between the wholesale prices the utilities paid for power and the regulated retail prices they could charge us. Thanks to consumers paying these higher rates for over a year and a half now, the utilities have regained financial solvency.

So when will Californians see a rate decrease? Not anytime soon.

Following the electricity fiasco, Gov. Gray Davis made a hasty retreat to traditional command-and- control regulation and demanded refunds from energy companies. These efforts recently yielded a $1.7 billion settlement with El Paso Corp., and today the Federal Energy Regulatory Commission is expected to announce its findings on price gouging and alleged misdeeds by other energy companies.

Once the decision is in, California should accept FERC's findings and move on. This means shifting the state's focus from searching for scapegoats to developing an actual electricity plan that no longer asks consumers to subsidize past electricity mistakes.

Luckily, there is a blueprint available. Electricity industry experts and analysts have achieved substantial consensus that California needs market-based restructuring of its electricity regulation. In February, a group of prominent industry participants and economists, including Nobel laureate Vernon Smith and UC Berkeley's Severin Borenstein, signed a manifesto endorsing one approach.

It states that California's residents, businesses and electricity industry would benefit in the long- and short-term from competitive wholesale and retail electricity markets, transparent and stable oversight rules governing these markets, freedom of contract for consumers and suppliers, and the option to choose real-time pricing.

Allowing consumers to choose when and how to consume their power with real-time pricing would allow families who need to save money the chance to do laundry and other electricity-draining activities at times when rates are the cheapest. And large companies like Intel or IBM could alter production schedules to take advantage of inexpensive or discounted rates in off-peak hours.

Freedom to choose an electricity provider would enable families and small businesses to shop for discounts and force electricity companies to compete with one another for each customer. We reap the benefits of such competition every time we make a long-distance phone call or choose a cell-phone provider and plan.

Simple and stable oversight rules — such as requiring that energy suppliers who bid into wholesale markets are financially committed to their bids when they make them — would give energy companies the right incentives and prevent price spikes and strategic manipulation of the rules.

Deregulation of electricity markets wasn't to blame for California's plight. The state's poorly devised plan contained so many problems, perverse incentives and regulations that many would argue it wasn't deregulation at all.

Had it featured simple, transparent rules in an unpoliticized framework; integrated wholesale and retail deregulation; and the option for customers to choose among a variety of electricity service offerings, we'd have the foundation for a thriving electricity industry.

In the two years since the blackouts, we've held plenty of hearings and assigned lots of blame. Gov. Davis has garnered more than $2 billion in settlements from companies charged with manipulating the system. But we haven't done anything to improve California's electricity industry. For the sake of the state's businesses and residents, this must change.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.

Utilities Takeover by Cities a Mistake

adrian.moore@reason.org (Adrian Moore) — Tue, 14 Jan 2003 00:00:00 EST

No sooner have San Francisco voters turned down for the second time the idea of the city taking over the local electric utility than the idea pops up all over California, Florida and other states. In many places, consultants have come to town touting the benefits of having the city force private utilities to sell them their assets. And of course hire the consultants to help with the process.

Proponents of "municipalizing" utilities make big claims about new revenue for the city and lower electricity bills for residents. But the truth is whole other kettle of fish.

First, municipalization is a long, contentious, litigious, and costly process. In California, the city of Corona has spent nearly $1 million so far in just getting ready for the process. The direct buyout cost will exceed $300 million including interest. Long Beach turned down municipalization not long ago when they saw the $500 million price tag.

Then add on the costs of lawyers, and be prepared to wait a long time to see any benefits. In 1987, Las Cruces, New Mexico decided to municipalize their privately owned utility. Thirteen years, dozens of lawsuits, and untold dollars later, the plan fell apart. The one sure thing in this process is litigation and local taxpayers supporting the lawyer full-employment plan.

With the state budget crunch meaning big cuts in revenue for local governments, cities are looking at cutbacks in healthcare and education. The money it takes to buy out the local electric utility can buy a lot of basic local services.

A second truth about municipalization is that people should not be fooled into thinking that a city takeover of electricity will mean low costs. Again in California, local officials in the cities of San Marcos and Palm Springs were outraged when cost savings estimates provided by consultants early on turned out later to be much too high. As for electric bills, municipal utilities do tend to charge less to residential customers, but they charge more to businesses. City residents pay for it one way or another.

Municipal utilities have suffered less from wholesale price variations, thanks to federal preference power, but in many states their prices are still way above the national average. Where electricity prices are falling is in states like Pennsylvania and Texas that did not botch their deregulation plans.

Finally, municipalization is such a bad idea, the rest of the world is going the opposite direction. Literally scores of countries are selling their municipal utilities, from Brazil to Oman, and from Australia to Germany. The UK sold all of its electric utilities in 1990 and the results have been falling prices, increasing safety, and increasing service quality.

In the US more utilities have been privatized than municpalized in recent years. Fairbanks, Alaska sold its utility last year, and the Department of Defense has sold dozens of electric utilities on military bases and is in the process of selling more. There are about 1,000 towns and major cities with franchise arrangements with private electric utilities. Since 1988, fewer than 10 have tried to municipalize them, and some of them are still bogged down in red tape.

Outside the United State, only Cuba is embracing government electric utilities.

Any one of these issues should give one pause about municipalization. Together, they show that municipalization is bad policy.

Adrian Moore is Vice President of Reason Foundation.

Electricity Transmission and Rates of Technological Diffusion

info@reason.org (Lynne Kiesling) — Mon, 02 Dec 2002 00:00:00 EST

According to this article, American Superconductor has achieved an important milestone in producing transmission wires from high temperature superconductor material: "American Superconductor Corporation announced it has achieved reproducible results in electrical performance over 10-meter lengths of its second generation, coated conductor composite, high temperature superconductor (HTS) wires that are significantly ahead of the goals set by the U.S. Department of Energy (DOE)."

This is pretty cool, because HTS wires reduce resistance, and therefore line loss, that limits the economic feasibility of long-distance electricity transmission. Overcoming line loss currently (no pun intended) requires augmenting the current at specific distances along its path, which is costly, so reducing line loss would reduce transmission costs. The problem has been, though, that HTS need to be kept cool (don't let that word "high" fool you; it's high on the Kelvin scale!), which typically means having to sheath HTS wires in liquid nitrogen. Such sheathing is not cheap, and could also increase maintenance costs. So the economic tradeoff here is between the value from reducing line loss and the incremental cost of the HTS wires, including sheathing, maintenance, and higher cost of the wires. Particularly in areas of the country that have transmission system congestion (such as Path 15 going into the Bay Area in California), reducing line loss can have sufficient value to encourage investment in HTS wires to replace or supplement old wires.

As the linked article indicates, the next step in American Superconductor's effort is to scale it up — take the small-scale reproducible results they have achieved and produce the HTS wires in large numbers. This step is crucial to HTS wires becoming more economically competitive with existing wires technology — economies of scale in production that lowers average cost will help make HTS wires a more attractive investment option across a wider range of congestion conditions. This tradeoff also means that continued research into cheaper, impervious and low-maintenance sheathing technology will be important in making HTS wires economically competitive with the older wires technology that has line loss. And the old technologies have not been standing still; standard AC transmission wires have improved substantially over the past century, and can now transmit over longer distances with less line loss than even two decades ago.

An example from economic history closely parallels this pattern, and is very informative about technology diffusion. The double-acting steam engine became technologically and economically viable by the late 1780s, largely courtesy of James Watt's ingeneuity, his business partner Matthew Boulton's business acumen, and local blacksmith/engineer John Wilkinson's ability to build to Watt's designs and low tolerances to achieve strong pressure differentials. However, the steam engine did not immediately displace its competing, older technology, the water wheel; in fact the steam engine did not become dominant in powering British industrial manufacturing until the 1840s.

There are two primary reasons for this slow diffusion of a "clearly superior" technology. First, James Watt had a dread fear of explosions, so all of his engines were low-pressure. Watt was also vigorous in defending his patents on his "bundled suite" of steam engine inventions, so inventors who were coming up with novel, high-pressure steam engines that could get more power for a given amount of fuel could not commercialize their inventions until Watt's patents expired. These high-pressure engines, which increased the value of the steam engine relative to other technologies, really came onto the market starting in the late 1820s. Second, the water wheel continued to improve through the early 19th century, with shaped blades to capture as much energy as possible from the water, as well as other inventions (interesting note: this water wheel with curved blades, called the Poncelet water wheel, was the technological precursor of the water and steam turbines invented in the late 19th century and used to generate electricity today). Even if the steam engine was a "clearly superior" technology, it's the incremental or marginal value of the technology that will determine whether or not it gets adopted at a particular time. The marginal value of the superior technology increased slowly from the 1780s until its ultimate dominance in the 1840s.

That's a 60-year diffusion cycle, even for the most dramatic human invention since moveable type/the printing press. The punch line of this story for the HTS wires story is that diffusion is likely to be slower the more that traditional wires technologies continue to improve. Countless examples exist where older technologies hold on for longer than is expected, and this marginal value of the superior technology is the key factor in that pace of diffusion.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.

Keep CA Energy Crisis in Perspective

info@reason.org (Lynne Kiesling) — Mon, 02 Dec 2002 00:00:00 EST

Orange County Register

Unless Enron's latest indiscretion is grabbing headlines or we're actually suffering through blackouts, most of us don't think about electricity. We simply flip a switch and expect the lights to come on.

Despite our inattention to an industry vital to our everyday lives and economy, this is a crucial time in the future of the energy business - and not just for California or a few energy companies. Issues surrounding how electricity will be used, how it will be moved and how consumers will benefit are now being decided.

The Federal Energy Regulatory Commission (FERC) is pursuing a highly needed plan to standardize U.S. energy markets and make them work more efficiently. FERC is in charge of "deregulated" wholesale power markets; in truth, markets are still regulated. In spite of some criticisms, mostly stemming from California's electricity fiasco, there are many safeguards in place for consumers because of FERC oversight.

FERC Chairman Pat H. Wood III wasn't in charge of the commission during Enron's heyday, but he has recently taken immense steps to prevent another "Enron" by increasing scrutiny of market manipulation. Energy companies and traders obviously took advantage of California's poorly designed attempt at deregulation and FERC has acknowledged it could have done more to help the state. But consumers need to understand that deregulation is not synonymous with crime and most energy companies aren't evil villains.

FERC's goal in its proposed "Standard Market Design" is to make our regional electricity systems more efficient and reliable - and better able to move electricity from power plants to homes and businesses. It's about time. The delivery of electricity to end-users is trapped in archaic technology and surrounded by unrealized gains in technology, energy efficiency and reduced environmental emissions.

Those who say the old ways of operating utilities were not so bad — lumping costs into regulated rates and making consumers pay for bad decisions and waste — don't have facts on their side.

An analysis by Washington, D.C.-based Boston Pacific Co. indicates electricity prices have steadily declined since the emergence of competitive power markets. It found that all customer categories paid an average of 35 percent less in real prices for electricity during 1985-2000 than under old forms of regulation.

In Pennsylvania and Texas, retail consumers are the beneficiaries of successful competition among retail energy providers. Now in its sixth year of electric deregulation, Pennsylvania cites $4 billion in cumulative residential savings.

Texas, completing its first full year of residential deregulation, expects an initial savings of nearly $1 billion this year alone under its "price-to-beat" system.

Texas and Pennsylvania deregulated and managed to avoid California's problems - further proof that the Golden State's problems had more to do with its poorly designed plan than with deregulation.

FERC's push for standardized markets would encourage energy companies to build new plants and utilize the latest technologies that will make it possible to distribute electricity over greater distances at cheaper prices.

Right now, the U.S. has an aging inventory of high-cost, nuclear and traditional base-load power plants, which are gradually being retired. We also have a transmission grid that is not suited to the kind of electricity sales that are now technically possible and can benefit consumers by reducing costs.

As several Western states experienced firsthand, the supply "bubble" will eventually burst, and we, as a nation, will be playing catch-up. When that occurs, our policymakers will want, and need, healthy wholesale energy markets with competitive providers able to build new power plants. Most states are experiencing budget problems and can't afford to foot the bill for new plants.

FERC's plan isn't perfect - nothing is. But it's a good start, and one that understands how important electricity deregulation is in helping America avoid a national power squeeze.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.

Market-Based Electricity Pricing

info@reason.org (Lynne Kiesling) — Mon, 04 Nov 2002 00:00:00 EST

In all markets prices serve a valuable role in enabling exchange, and in leading to efficient outcomes and investment. Prices transmit a great deal of information about the costs and preferences of widespread and disparate economic actors, and do so very parsimoniously. This truth holds for the electricity industry as much as any other industry. Indeed, the ever-changing costs of providing electricity suggest that market prices would be an extremely valuable tool in leading to efficient resource allocation and investment, and that offering customers a portfolio of retail contracts from which to choose would reduce the overall costs in the industry.

Without retail pricing that gives consumers the opportunity to choose how they want to consume power, how much wholesale price risk they are willing to bear, and how they want to pay for it, electricity restructuring will fail to deliver efficiency and value to consumers. The "one size fits all" of regulated, fixed, average rates will become increasingly obsolete because of technological change, institutional change, regulatory change, and cultural change that recognizes the diversity of value propositions that the electricity industry can profitably present to consumers.

Market-based pricing in electricity can include time-of-use (TOU) rates, which are different prices in blocks over a day, based on expected wholesale prices, or real-time pricing (RTP) in which actual market prices are transmitted to consumers. As currently implemented, TOU is typically a program in which predetermined prices apply to specific time periods by day and by season. RTP differs from TOU mainly because RTP exposes consumers to unexpected variations (positive and negative) due to demand conditions, weather, and other factors. In a sense, fixed retail rates and RTP are the endpoints of a continuum of how much price variability the consumer sees, and different types of TOU systems are points on that continuum. Thus RTP is but one example of market-based pricing. Both RTP and TOD provide better price signals to customers than current regulated average prices do.

Several utilities have implemented some limited market-based pricing programs. Although small and exploratory, these have generated some positive results that will be useful as more utilities begin considering market-based pricing. None of these programs implements true market-based pricing, though; instead they are "demand response" programs that use time-of-day price changes to give customers incentives to shift load. That said, they do indicate how powerful price incentives can be for consumers, and how market-based pricing contributes to a reliable, efficient electricity system.

Puget Sound Energy (PSE) characterizes its demand response "Personal Energy Management" program as a conservation program primarily for residential customers. The Personal Energy Management program began in May 2001, and 300,000 customers enrolled in the first six months. This program is a typical TOU program, with lower prices in off-peak periods and higher prices in peak hours (PSE uses a four-period TOU framework). PSE also provides automated meter reading services and real-time pricing data to customers. Customers can see their daily electricity use according to the four time periods through PSE's website. Typical summer 2001 rates varied from 4.7 cents per kilowatt hour for overnight hours to 6.25 cents per kilowatt hour in peak morning and evening hours.

PSE found that in the first several months of the program, participating customers shifted approximately 5 percent of their demand away from peak hours; in addition, participating customers reduced their overall electricity use. Almost 90 percent of customers took some action to manage their own electricity use when facing TOU pricing. Customers also expressed satisfaction with the program, with 85 percent saying in a PSE survey that they would recommend the program to a friend.

In September 2001 PSE extended its Personal Energy Management Program to 20,000 of its business customers, who had been monitoring their peak load and off-peak load in anticipation of moving to a TOU rate structure. In late 2001 PSE applied to the Washington Utilities and Transportation Commission to make the TOU rate structure a permanent option in PSE's rate tariff. Last week, PSE announced that they would begin sending quarterly comparisons of their bills under TOU with what they would have paid with fixed rates, as described in this article. TOU customers already receive detailed information about their use.

Lisa Wood at the Brattle Group also has a good article about the benefits that come from market-based electricity pricing. She addresses the one of the important cultural questions — are customers opposed or complacent? I think customers don't think about the fact that their utilities could offer them more creative value propositions beyond just having the juice come through the wall, and that it's incumbent upon those of us who advocate for those value propositions to bring the debate into the open. The debate itself will benefit consumers.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.

Standard Market Design in Wholesale Electricity Markets

info@reason.org (Lynne Kiesling) info@reason.org (Brian Mannix) — Fri, 01 Nov 2002 00:00:00 EST

Executive Summary

Fifteen years ago Vernon Smith wrote of electricity markets:

Replacing the entrenched regulatory regime, after eighty-odd years, with a competitive regime will require regulators to be forward looking, politically bold, and cognizant of the disciplinary value of competition.

Today the Federal Energy Regulatory Commission, and many of the state regulatory commissions, can look back with considerable pride at what they have accomplished. Deregulation of electric power generation has proceeded, perhaps not as quickly as in some other industries, and not without some missteps, but with a deliberate and sustained pace. Competition is now deeply entrenched in the nation’s power generation system, and it has made that system more efficient, more adaptable, more resilient, and more reliable. Much of this progress has been driven by technological innovation and also by economic developments outside the industry, but to a considerable extent it is the product of hard work and innovative thinking within the regulatory commissions themselves, at both the federal and state levels.

FERC's current Standard Market Design (SMD) proposal is a bold—although not final—step in the evolution of electricity markets. It recognizes that, in power generation, competition is now the primary guarantor of “just and reasonable” rates. It seeks to protect and promote that competition by proscribing anticompetitive practices, especially those that take the form of “undue discrimination” by vertically integrated transmission operators. It seeks to expand the scope of competition by erasing the “seams” between different geographic jurisdictions, as well as smoothing some of the seams between wholesale and retail markets. And it seeks to unmask the price signals for transmission investment that will alleviate the troublesome bottlenecks in the existing infrastructure.

These goals are laudable, and some of the features of the proposed SMD are welcome. In our view, however, the current proposal also suffers from several serious flaws, that make us unable to support the current proposal.

1. The SMD is too prescriptive and too quick to impose uniformity for its own sake.

More uniform national, and even international, “ground rules” will provide a better foundation to facilitate exchange and competition, and to encourage investment in new capacity where it is needed. One the other hand, flexibility and variability in market design provide the raw material for evolution and experimentation, both by regulators and by market participants. By locking in a single, detailed, and inflexible market design, the SMD may inadvertently choke off further progress.

Regional variation in market design has created “seams,” transaction costs, and other anomalies that seem desirable to eliminate. But regional variation in market design may also have accommodated legitimate differences in local conditions. And while variation allowed California to walk off a cliff, it has allowed other states, and the Commission, to draw important lessons from that experience.

The proposed rule identifies numerous problems—some theoretical, some anecdotal—in existing markets and asserts that the SMD will fix them. A search of the preamble for “eliminate(d)” and “(re)solve(d)” reveals dozens of problems that will be made, by rule, to vanish. The mixed record of recent experience with market design fails to dent the confidence with which the SMD is proffered:

“In the years since the ISO markets have been operating, dozens of market design flaws have been identified, . . . No region has been exempt from market design flaws of one type or another. . . . Only standardization of electricity market design will solve these problems. Our goal is . . . to raise the quality of all electricity markets simultaneously.”

Unfortunately, standardization also means that unintended consequences of the SMD will affect all electricity markets simultaneously. Good intentions do not prevent errors, unanticipated abuses, or assumptions that turn out later to be misplaced. For this reason, the Commission should proceed with caution. The proposed SMD may appear to be superior to all the others only because it is, so far, untried.

Detailed rules run the risk of regulatory path dependence and lock-in. The new institutional structure in the SMD should be simple, flexible, and reversible, with clear and credible phase-out provisions as technology evolves and market-based retail pricing expands. Robust institutions that will stand the test of time and create value for consumers must be able to adapt to the unknown. Many unknowns exist in electricity, particularly in the regulatory, financial, and technological future. Market design that focuses too heavily on explicit details and not enough on flexible and adaptable rules will be useless at best, and counterproductive at worst.

2. The SMD classifies practices as “undue discrimination” without sufficient examination of economic efficiency.

In policing electricity markets, the Commission faces the same problem faced by antitrust agencies: How can it be sure that its power to intervene is used to protect competition rather than suppress it? In a complex market it can be difficult to distinguish cost-based (and therefore economically efficient) discrimination from “undue” discrimination, and competitive practices from anti-competitive practices. Certainly it will not suffice to rely uncritically on complaints from market participants. Companies will file anticompetitivediscrimination complaints if it is rewarding to do so, regardless of whether the alleged discrimination has an economic basis. And aggressive competition elicits complaints from competitors just as surely as anticompetitive behavior does.

It is the duty of the Commission to ensure that its oversight of markets is not employed to favor one or another participant in the market, but to provide the greatest benefit to consumers as a whole. It should use as its guideposts the notions of economic efficiency and consumer harm that are used to guide antitrust interventions.

The SMD seeks to eliminate discrimination and, in particular, to ensure that a vertically integrated transmission provider will never have competitive advantage over independent generators. In its zeal to eliminate competitive advantage, however, the Commission needs to be careful not to throw the baby out with the bathwater: i.e., not to eliminate real economic efficiencies from the system.

For example, in its discussion of scheduling advantages (paragraphs 45-47) and in its discussion of imbalance resolutions (paragraphs 48-49), the SMD proposal appears to proceed directly from the observation that a practice confers competitive advantage to the conclusion that it should be banned. We do not have enough information to say whether these particular practices are anticompetitive, but surely there are some cases where competitive advantage flows from real economic efficiencies; the Commission needs to make more of an effort to examine this possibility before it bans a practice.

3. The SMD does not recognize the value of competition, or potential competition, in transmission services.

While the SMD recognizes the disciplinary value of competition in power generation, it appears to embrace—and to codify—the status of transmission as a “regulated natural monopoly.” But FERC could accomplish many of the proposal’s objectives regarding transmission investment and congestion pricing by reducing entry barriers in transmission. The standard market design structure as currently envisioned does not address the fundamental supply-side problem that makes transmission a bottleneck—the combination of fragmented ownership and the persistence of artificial barriers to entry facing the grid’s potential competitors. The proposed SMD acknowledges that improved transmission coordination and investment can make wholesale generation markets more competitive, but does not incorporate the insight that the reverse is also true. Changes in generation regulation and technology can make transmission more competitive, so that transmission need no longer be treated as a natural monopoly.

The proposed SMD does not reduce the regulatory barriers to entry that prevent us from putting transmission to a market test. In the absence of these barriers, transmission faces potential competition, or is contestable. Reducing artificial barriers to entry in transmission, and observing the extent to which and the timeframe over which transmission really can be contestable, would create real benefits from dynamic efficiency and optimized investment. Furthermore, reduced entry barriers would enable investors to create redundancy and increased grid security when and where it makes economic sense. Such beneficial redundancy does not exist with transmission regulated as a natural monopoly, as natural monopoly theory is premised on removing redundant infrastructure.

4. The SMD does not recognize that market pricing for retail customers can exert considerable competitive discipline on transmission as well as generation.

Market-based retail pricing is another simple concept that would reduce the need for FERC and independent system operator (ISO) market monitoring functions and associated bureaucracies. Market-based retail pricing connects demand and supply, maximizing information transmission in markets and disciplining supplier exercise of market power better than any other known institution. Clearly, retail pricing is beyond the scope of this rulemaking and beyond the scope of the Commission’s jurisdiction. However, states are slowly moving toward market-based retail pricing and retail choice. It is important for FERC to recognize that retail pricing reforms will make loads responsive to scarcity at peak times, and will thereby alleviate many of the transmission bottlenecks and rigidities that the SMD is designed to address.

Thus the proposed FERC and ISO market monitoring should have sunset provisions as the percentage of retail load on competitive contracts increases. Market-based retail pricing is more likely than market monitoring to create value for consumers, and one reason for that advantage is that market monitoring is almost certain to suppress dynamic investment incentives.

Vernon Smith and Retail Electricity Deregulation

info@reason.org (Lynne Kiesling) — Wed, 09 Oct 2002 00:00:00 EDT

Regulatory change in electricity moves slowly, in part because of human dislike of change and aversion to risk. Convincing people that regulatory change is worth undertaking would be a lot simpler if we could demonstrate the possible outcomes of a change, and thereby that such change need not be disastrous and could even create value and opportunity for many people. But electricity networks are so complex, and so expensive to construct, that real-world experiments are very costly and unlikely to occur. It’s not like opening a new restaurant and seeing if consumers perceive value in the offerings of food, wine, service, and environment. In this context, the methodology of experimental economics is incredibly useful and can help us place bounds on what may occur if we implement fuller retail electricity deregulation. Experimental economics simulates environments having different rules, with real economic agents facing real choices, and with the potential to earn real money payoffs. Because rules influence incentives and therefore shape outcomes, rules and the institutions that create and enforce them matter, including regulatory institutions. Experimental economics can inform us about the relationships between different rules and institutions and different outcomes.

About Vernon L. Smith

Nobel laureate Dr. Vernon Smith speaks to Reason Foundation supporters at Reason Weekend 2002.

• Reason.com Interview of Vernon Smith (Exclusive)
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An experimental approach to analyzing electricity deregulation enables the abstraction of some features of real-world activity to focus on specific features. The recent electricity experiments of Vernon Smith, Bart Wilson, and Steve Rassenti, of George Mason University and the Mercatus Center, illustrate the power of experimental methodology to create information about what is likely, and what we cannot predict, from different features of electricity deregulation. They have created a portable laboratory setup, complete with laptops, wireless networking, and well-designed software, to perform electricity market experiments in a variety of locations, with diverse participants. This description of experimental economics from the Interdisciplinary Center for Economic Science website provides a good overview of experimental economics and how it helps us understand how markets work. Smith’s entry on experimental economics in the Palgrave Dictionary of Economics is also a useful description.

Recently they have been running electricity experiments with groups ranging from college students to Congressional staffers to federal energy regulators. The people in the experiment are electricity generators, participating in a wholesale generation market. They are the supply side of the market, and they can own different types of generation capacity – baseload (low cost), intermediate cost “load followers”, and high-cost peaking units. These levels realistically reflect a typical supply curve, in which generators run their least expensive units until they hit capacity, then move to the intermediate-cost plants, and only run the expensive peaking plants during periods of peak load. Generators bid by submitting schedules of asking prices for their capacity in a given period, and all generators receive the market-clearing price. These rules mirror those found in many wholesale electricity markets. Generators can also have market power, depending on what kind of capacity they own and how concentrated that ownership is.

The experimental design can also vary the rules governing the expression of demand, either to reflect the current fixed “must serve” demand, or to test possible regulatory changes in how consumers are allowed to express their demand. Since state regulation of the electricity industry commenced in 1907, retail customers have faced average rates that change infrequently. Retail electric service is provided on a guaranteed-price basis, under the regulatory “obligation to serve” remit. In terms of consumer expression of their demand, these regulated rates have meant that consumer demand signals are metered, aggregated, and transmitted to suppliers on a monthly basis. With such unchanging rates, the demand or typical aggregate load profile fluctuates greatly across the day.

The response of the typical consumer may be “so what?” Because of the “obligation to serve” requirement facing utilities as part of traditional retail regulation, utilities must be able to generate or buy enough power to satisfy peaks throughout the day. Put another way, the responsibility for satisfying all consumers, whenever they want power, rests with the suppliers. Fixed, regulated rates mean that consumers have no incentive to take on any of that responsibility. The result of this supply-focused approach is lots and lots of generation capacity, because suppliers are required to serve all demand, whenever it occurs, without changing prices to reflect the different costs of serving that demand at different times. Retail prices cannot change even though costs do change, as captured in the three different types of plants used by the industry and in these electricity experiments.

In presenting the economics underlying the power of consumer demand in electricity markets, Smith analogizes between the electricity industry and other industries, particularly the airline and hotel industries. All three are service industries, facing peak demand that fluctuates and that determines capacity, with substantial capital investment requirements to satisfy demand. In competitive markets for airline travel and hotel rooms, where both consumers and producers can provide and respond to price signals, rates typically go up in peak demand periods and plummet in off-peak periods. The high rates in peak demand periods, rates that certainly exceed marginal cost, pay for the capital that is necessary to satisfy the peak, and the interaction of these price signals lead to optimal capacity investment.

That doesn’t mean, though, that all customers who want a seat or a room at peak will get it at a price they are willing to pay. So what do we all do when facing high airfares or hotel rates? We time-shift, traveling on a different day or at a different hour. Hotels and airlines do not operate under a regulatory obligation to serve, yet consumers deal with the fact that they might not be able to consume the flight or the hotel room they want when they want at the price they want. They deal by shifting their demand to different times, trading off convenience for cost depending on their individual preferences. Thus the comparison with the airline and hotel industries reveals exactly the extent to which the “electricity cannot be stored” rationale for regulation is a canard – airline travel and hotel service cannot be stored either, yet no one is arguing that these industries should operate under “must serve” obligations like those in the electricity industry.

In this article in Regulation in Fall 2001 (scroll to p. 70 for their article, although all three are well worth reading), Rassenti, Smith and Wilson compared two bidding systems in a wholesale electricity market – one with only supply-side bidding, and one with both supply-side and demand-side bidding. The demand side of the experiment proceeds as follows: take a very simple rule by which consumers can choose whether or not to let the retail electricity supplier interrupt their service at a couple of different points, and see what effect that rule could have on the outcomes in the wholesale market. They then divided the demand into four types: must-serve demand, off-peak demand, shoulder demand, and peak demand. Under fixed retail rates, all demand is essentially must-serve demand, including the high peaks. One of the important things to learn in this experiment is whether allowing consumers to choose to have their demand interrupted at two different prices would lead to increased consumer benefit, increased supplier profits, and any change in the ability of suppliers to exercise market power in the experiments when they have it. As Rassenti, Smith and Wilson say in their Regulation article, “our small simplifications enabled us to focus on the key issues we wanted to study while still capturing the essence of the daily natural cycle in demand in all electrical delivery systems.”

The generators then have to choose prices at which they bid into the wholesale market; in some experiments the generators face perfectly inelastic must-serve demand, and in some experiments they face consumers who can choose to have their service interrupted. In their experiments the timeframe is several days (compressed into a few hours), so the generators experience bidding over the fluctuating demand cycle. And, at the end of the day, the participants get to keep their profits (with some modifications when performed with government employees), so the incentives are real.

So what happened? When there was no demand-side responsiveness, suppliers with market power were more able and more likely to exercise it by withholding capacity. In the experiments with both demand-side and supply-side bidding, suppliers with market power were not as able to exercise it, and price fluctuations were smaller. Not only were average prices lower, but the variance of prices was also lower; demand responsiveness reduced price levels and price volatility, even in the face of supplier market power. When suppliers did not have market power, demand responsiveness still led to lower and less volatile electricity prices.

In their Regulation article, Rassenti, Smith and Wilson report these results from experiments performed at the University of Arizona. I have also seen similar results from experiments performed at the Federal Energy Regulatory Commission – yes, when facing profit incentives and no demand response, even the regulators exercised market power when they had it.

Experimental economics methodology improves upon “blackboard economics” in reflecting what Michael Polanyi calls tacit knowledge – when we make choices, including social interaction choices like market exchange, we are not always conscious of all of the information and knowledge that we bring to bear in making these choices. Experiments with real people facing real incentives create an environment in which the effects of tacit knowledge are not assumed away to solve the equations on the blackboard.

Market-based retail pricing is a crucial component of the ability to deliver choice and value to customers. Fixed, regulated average rates are an obsolete relic of a regulatory approach that, if it persists, will stifle the application of creativity in this industry. If utilities, regulators, and politicians consider the possibility that utilities can offer different value propositions to their customers than just “juice coming through the wall”, utilities can benefit from using market-based pricing as a tool for offering an attractive portfolio of service options to their customers. Creating value from this change, though, requires vision, and getting the transitions and the institutions right can be extremely tricky. Consumers will change how they think about buying electric service, and what that service is, exactly. For that change to occur, politicians and regulators will have to act on the leadership and vision that would allow consumers to take responsibility for their individual purchasing choices.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.