Reason Foundation - Authors > Lynne Kiesling

AT&T and BellSouth: Not the Old Ma Bell

info@reason.org (Lynne Kiesling) — Fri, 10 Mar 2006 00:00:00 EST

High-profile mergers typically produce strong reactions, and this week's announced merger between AT&T and BellSouth is no different. AT&T's purchase of Bell South would create a single, more vertically integrated telecommunications provider; to some observers, this increased vertical integration and decreased number of firms means less competition. Importantly, the merged firm would also be multi-product: wired and wireless telephony, data transmission, business services, and ultimately video delivery. These economies of scale and scope are important for all firms to exploit if they want to survive in the modern telecommunications industry, because the economies of scale and scope provide the opportunity to innovate. Instead of reducing competition and moving toward the "old Ma Bell", this merger may actually indicate how robust multi-product and cross-platform competition actually is in telecommunications, and the merger may be an attempt to create more resources for innovation.

As with all previous telecommunications mergers, this proposal provokes concern among "consumer advocates" that the merger would lead to a reduction in the variety of Internet services, and about reduced competition between wired and wireless services because of the loss of a competitor. There's also concern about the "reconstruction of the old Ma Bell."

In 1984, when AT&T was broken up, the competition facing AT&T came from other companies (MCI and Sprint) offering a homogeneous product (long-distance service) and competing primarily on price. In 2006 AT&T and BellSouth face cross-platform competition from other phone companies, from cable companies, and from satellite companies. This cross-platform competition occurs in multiple products; today AT&T offers a wide range of products and services, and thus competes with cable companies, with standalone wireless companies, with standalone Internet providers, and with others in various parts of their product and service line. Thus the comparison between the 1984 AT&T and the 2006 AT&T are nonsensical. Unlike 1984, today's competitive environment is more complex and dynamic — competition today is truly competition for the platform that customers will choose for their voice, data, video, and mobile communications.

But what if the merged AT&T/BellSouth "wins" the competition for the platform and builds substantial market power across the portfolio of products they offer? While such an outcome is possible, it is not that likely to persist because of Schumpeter's perennial gale of creative destruction. Competitive markets reward successful competitors with higher profits, and those higher profits also provide other firms with powerful incentives to invest their capital to compete with those successful competitors. In this case one example of creative destruction is broadband over power lines (BPL). BPL will continue to develop as entrepreneurs seek opportunities to deliver data services to customers and compete head-to-head with telecommunications and cable companies. So even if AT&T can establish substantial market power in multiple data delivery services, just the fact that they can profit from that will induce BPL entrepreneurs to bring their services to market, introducing yet another platform for customers to consider for their multiple data delivery services. If AT&T "wins", it is likely to be a temporary victory, thanks to innovation in other platforms.

Similarly, we should not presume that industry consolidation is necessarily anti-competitive and bad for consumers. Consolidation in and of itself is not anti-competitive, particularly in an environment in which consumers have multiple ways to make phone calls, attach to the Internet, and send and receive data (whether files, music, or video). What matters for competition, and for consumer well-being, is rivalry, not the number of competitors. Even a market with only two firms can be competitive, if those two firms are truly rivals for consumer's business.

Furthermore, firms across these platforms are encroaching on each other's traditional products. Cable companies are offering Internet, data, and phone, and increasingly, phone companies are looking for ways to offer television and video services. Indeed, BellSouth customers would be more likely to have digital video services more quickly if the merger goes forward. This cross-platform competition sounds like a lot of rivalry to me.

In telecom as in all other industries, competition protects consumers better than regulation, because competition characterized by rivalry makes firms focus on delivering the value propositions that customers want at prices they are willing to pay.

Lynne Kiesling is senior lecturer in economics at Northwestern University and blogs at www.knowledgeproblem.com. As a former Reason scholar, many of her columns and policy studies are available here. Reason's work on the AT&T-BellSouth merger is here.

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

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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.

A Federal Ethanol Mandate

Sat, 01 Nov 2003 00:00:00 EST

Executive Summary

The Clean Air Act Amendments of 1990 require that gasoline used in the United States has additives that oxygenate the fuel. The most common oxygenate was MTBE, which is being phased out due to harmful effects on human health. Both the House and Senate energy bill proposals in 2003 contain a mandate making ethanol the only legal oxygenate for meeting the federal fuel oxygenate requirement. But both versions of the energy bill also abolish the federal oxygenate requirement, but add a requirement to use ethanol as a renewable energy source. Navigating these political waters has been challenging for both politicians and the interests on all sides of the oxygenate debate.

The Environmental Protection Agency formed a Blue Ribbon Panel in 1999 to study the health benefits of fuel oxygenates. The Blue Ribbon Panel report highlighted the fact that the air quality benefits of oxygenated fuel are unclear. The environmental problems caused by MTBE reinforce that concern, but little analysis has addressed the combined air, water and soil effects of ethanol.

The Blue Ribbon Panel recommendation was to eliminate the oxygenate requirement altogether. In this study we perform a benefit-cost analysis of the ethanol mandate as an oxygenate; our findings support the recommendations of the Blue Ribbon Panel. We also analyze the political economy dimensions underlying the success of federal ethanol mandate provisions in both the House and Senate proposals. That success rests on the uncoupling of ethanol as a renewable energy source from ethanol as an oxygenate, a subtle piece of political rhetoric. We conclude that ethanol is not actually a renewable energy source, given the fossil fuel use required to produce ethanol.

We find that whether or not ethanol use generates net positive energy or net negative energy, ethanol-oxygenated reformulated gasoline uses more resources overall and does not pass an economic or environmental benefit-cost analysis. The fossil fuel energy used in producing and transporting ethanol imposes environmental costs, and whether or not ethanol produces negative net energy, its consumption also leads to costs. These costs outweigh the health benefits of ethanol use. Adding the cost of environmental detriment from agricultural runoff from growing crops for ethanol reinforces this conclusion.

Examining the political dynamics of the success of the ethanol provisions reveals that separating the fuel oxygenate issue from the renewable fuels issue has enabled Congress to satisfy both the strong farm and oil interests in the debate, even when ethanol does not make economic or environmental sense.

Thus although Congress is following the recommendations of the EPA’s Blue Ribbon Panel and eliminating the fuel oxygenate requirement, the bait-and-switch of ethanol from oxygenate to renewable fuel has created the opportunity for the ethanol industry to succeed politically, at a cost that is spread across all taxpayers, drivers, and natural resources.

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.

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.

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.

MTBE, Ethanol Mandates Aren't Needed

info@reason.org (Lynne Kiesling) — Wed, 02 Jul 2003 16:24:00 EDT

Thank you, Mr. Chairman, for inviting me to participate in this hearing. I am director of economic policy at Reason Foundation, a public policy think tank promoting choice, competition, and a dynamic market economy as the foundation for human dignity and progress. In that role I study energy policy, focusing on fuel and electricity issues. I am also a senior lecturer in the Economics Department at Northwestern University, where among other responsibilities I teach a course in environmental and natural resource economics. I also am a Senior Policy Fellow in the Interdisciplinary Center for Economic Science at George Mason University, where I work with Nobel laureate Vernon Smith and the other outstanding economists there to bring the insights of experimental economics to real-world policy applications. None of my remarks reflect the opinions of either Northwestern University or George Mason University.

Although initially set for December 2002, the state of California’s mandate to eliminate the use of the fuel oxygenate MTBE will take effect at the end of this year. As we have already seen this year, the transition has involved several time-consuming and costly actions:

Depletion of MTBE-oxygenated fuel from refiner inventories
Refitting and retooling refineries to accommodate the differences in production requirements because of ethanol’s higher volatility
Transport by truck and train of ethanol to California refineries from the Midwest

Not surprisingly, the costs of this transition, in combination with the unsettled global oil markets this spring, led to average retail gasoline prices above $2.00 for some time.

Why have we incurred these costs – why shift away from MTBE? MTBE has some negative environmental consequences. However, so does ethanol. So why do we have an oxygenate mandate? The intended objective is environmental protection, but oxygenates fail on that front. Not only do oxygenates fail to improve air quality, their production creates soil and water pollution, and they are more costly than other approaches to cleaner fuel. Furthermore, the oxygenate requirement redirects resources to oxygenate production that could be used more constructively to achieve real improvements in environmental quality.

The volatility of retail gasoline prices illustrates the most pervasive unintended consequence of our existing layered pyramid of fuel regulations: the combination of state and federal fuel regulations balkanizes markets. In an environment in which fuel regulations balkanize markets, fuel in one place is no longer substitutable for fuel in another. That balkanization reintroduces price disparities that diminish naturally through competition. Thus wholesale fuel markets become less resilient and less able to absorb unanticipated shocks such as pipeline mishaps and fires. This balkanization makes consumers vulnerable to unexpected changes in market conditions, most notably because shortages cannot be offset through importing fuel from elsewhere. As engineers say, the pyramid of fuel regulations reduces the fault tolerance of our gasoline markets.

How does this fracturing of fuel markets relate to California? California is subject to both state and federal fuel emissions regulations. Federal regulations, resulting from the Clean Air Act Amendments of 1990, mandate the use of a fuel oxygenate to decrease emissions and produce a cleaner, fuller burn from the fuel. The two prevalent oxygenates are MTBE and ethanol. MTBE is a methane derivative that has been in widespread use because of the ease of blending it with gasoline, as well as its lower cost relative to ethanol. Ethanol, a plant derivative, also decreases emissions of benzene, 1-3 butadiene, formaldehyde, and acetaldehyde, as does MTBE. The switch from MTBE to ethanol, in California and other states, has been the consequence of two features of MTBE: its unpleasant taste and difficulty of removal when it leaks into water, and its potentially carcinogenic action in humans. The MTBE taste shows up in concentrations much smaller than are considered carcinogenic. These traits of MTBE have helped swing the balance of opinion and policy toward ethanol.

Although such ethanol mandates are increasingly popular at both state and federal levels, the comparisons of the desirability of using ethanol or MTBE are far from conclusive. First, the science of ethanol indicates that ethanol is not unequivocally superior to MTBE in cleaning the air, and there are a lot of unknowns about ethanol’s effects on humans when it leaks into water and soil from tanks. One primary question regarding ethanol’s science has been whether or not ethanol has a positive energy balance; in other words, when you take into account all of the energy that goes into producing ethanol, including the energy required to produce the corn inputs, do we get at least that much energy potential out at the back end? A recent study by Tad Patzek, an engineering professor at the University of California-Berkeley, reviews all of the existing studies and provides some new data. Patzek’s analysis indicates that “as much fossil energy is used to produce corn ethanol as can be gained from it.” (p. 9) His analysis more fully takes into account the entire energy chain than the earlier reports from Argonne National Laboratory and the Department of Agriculture did, and suggest that ethanol production and use is not a positive-energy choice.

Furthermore, Patzek and others (including a 1999 blue ribbon panel for the Environmental Protection Agency) point out that ethanol itself does contribute pollutants to the air. Although it can decrease carbon monoxide, ethanol’s volatility means that it can increase volatile organic compounds when burned. Both carbon monoxide and VOCs are ozone precursors and can lead to smog. In addition, the production of ethanol can produce nitrogen oxides and aldehydes, which are themselves ozone precursors.

When discussing ethanol we tend to think about air quality, and we forget that investigating the effect of ethanol on water and soil pollution is a crucial part of the analysis. MTBE is being phased out because of its leakage into groundwater, but ethanol also has implications when it leaks from tanks. Bacteria living in soil metabolize ethanol so enthusiastically that they ignore the otherwise appealing gasoline hydrocarbons, so ethanol leaks can lead to increased benzene concentration in soil, called benzene plumes. Another consequence of ethanol production arises from the increase in corn planting and cultivation. The GAO estimated in 2002 that California’s ethanol mandate would double the amount of ethanol consumed in the United States. Ethanol production is energy intensive, consuming nitrogen fertilizers and producing air emission, carbon dioxide, and waste water. Increased fertilizer use is likely to exacerbate the problems of runoff running into large watersheds, the most dramatic example of which is the demise of certain animal populations in the Gulf of Mexico due to increased nitrogen concentrations from the Mississippi River watershed. In addition, the production of nitrogen fertilizer is very energy-intensive, and itself generates airborne pollutants. Fertilizer production also creates carbon dioxide as a by-product, so increased ethanol production actually implies increased production of greenhouse gases.

A second set of complications from an ethanol mandate comes from the transportation of ethanol from its production sites in the Midwest (which is unlikely to change, because of the substantial cost savings from producing ethanol close to the feedstock (corn) source). Ethanol is both very corrosive and incredibly water soluble, so shipping it via existing pipelines is impossible (and the construction of new pipelines is highly unlikely). Thus ethanol transport involves trucks, trains and barges, which are expensive means of transporting a dense liquid like ethanol. Furthermore, trucks, trains and barges require energy, which means that ethanol transport generates air pollutants. We should also take into account transportation security risks, particularly the effects of crashes and spills on local soils and watersheds.

A full benefit-cost analysis comparing ethanol and MTBE is necessary to ensure that Congress and the states are taking into account all of the costs incurred in order to achieve a set of air quality benefits. The costs described above must be incorporated into any analysis comparing the two:

Increased VOCs from ethanol, consequently increased potential for smog
Increased pollution from fertilizer production and runoff
Increased transport costs
Increased emissions from trucks, trains and barges

We know that MTBE is not a clean, green fuel, but neither is ethanol. Claims of its clean nature ignore the energy and pollution costs incurred in the production and transportation of ethanol, and those costs can be large.

But a head-to-head comparison of these two oxygenates begs a very important question: why have oxygenates? What benefits are we deriving from the federal oxygenate mandate? Several studies in the 1980s and early 1990s suggested that oxygenates would lead to decreased emissions, most notably of carbon monoxide. More recent research, as well as technological change in non-oxygenated fuels, shows that non-oxygenated fuels have closed most, if not all, of that gap. As the head of a National Research Council study on oxygenates testified in 1999,

According to the data available to the Committee, the addition of oxygen to fuel in the form of commonly available oxygenates had little impact on improving ozone air quality. Data suggest that oxygen causes a small reduction in the mass of VOC and CO emissions, and the data on NOX emissions is inconsistent.

Both the NRC study and the EPA blue ribbon panel report from 1999 reach the same conclusion: oxygenates may not provide the air quality benefits that we thought they did, and that technological improvements in non-oxygenated fuels has led to fuels that can achieve air quality objectives without oxygenation. Indeed, California Blended Gasoline, CBG, is a prime example of a non-oxygenated fuel that can deliver air quality benefits.

One of the obstacles to evaluating the performance of the federal oxygenate mandate in achieving environmental benefits is the EPA’s stovepipe or silo approach to measuring impacst on air, water, and soil. If in evaluating oxygenates the EPA looks only at changes in air quality, they overlook the effects, positive or negative, on soil and water.

In the case of oxygenates, we are learning that leakage can have serious implications for soil and water quality. For example, California asked to be exempt from the oxygenate requirement when they realized that MTBE leaks into water were making the water undrinkable, but the EPA refused, based solely on an evaluation of the air quality benefits of MTBE. When the EPA limits its scope to air effects it is ignoring obvious costs, even at the expense of damaging other resources that the EPA is required to protect.

The federal oxygenate requirement does not live up to environmental performance standards. Taking into account the pollution created in the production and transportation of oxygenates, it does not increase air quality, yet it still raises costs of fuel to consumers. It contributes to soil and water pollution, which are not currently taken into account in evaluating oxygenates. It also diverts resources that could be used to improve environmental quality by other means into paying to satisfy the mandate, by, for example, inducing increased corn production to manufacture ethanol.

In 1999, a blue-ribbon panel commissioned by the EPA recommended the elimination of the oxygenate requirement arising from the CAAA of 1990. I concur with that suggestion. I suggest that we ask a related question: are there better ways to achieve meaningful environmental performance than command-and-control approaches, such as the oxygenate mandate we are reviewing here? I recommend that the existing input-based mandate be replaced by a performance-based requirement, enforced by air quality monitoring. A performance-based regulation gives refiners the incentive to produce fuels that increase air quality without dictating how they are to do it, which is an onerous constraint on creativity. A performance-based air quality requirement harnesses the deep knowledge that refiners have of how to achieve cleaner fuels, deeper knowledge than legislators or regulators have.

The past decade has illustrated the power that incentives have to shape human behavior with regard to environmental quality. Regulations that rely on command instead of incentives have repeatedly shown that they are ill-suited to meeting the range of goals that we have, including environmental quality. Performance-based requirements that recognize incentives can generate improved environmental quality, as long as statutory regulations do not dictate how that is to happen.

The Price Isn't Right

info@reason.org (Lynne Kiesling) — Wed, 25 Jun 2003 00:00:00 EDT

Suddenly politicians in Washington are concerned about a natural gas crisis. Indeed, Energy Secretary Spencer Abraham has convened the National Petroleum Council to discuss the matter on June 26 in Washington. Current natural gas prices are high — more than double their low prices five years ago — and futures prices indicate that natural gas supplies are likely to continue tight in the short run. Does that fact mean that we have a full-blown energy crisis and require government action? Maybe; but not the price caps that have been the frequent remedy for high prices in this and other industries.

First, some history. Natural gas markets have been largely deregulated since the late 1970s, after some initial fits and starts. Deregulation unleashed previously unknown value creation that benefited consumers and producers alike. As a consequence, by the 1990s natural gas was widely available at very low prices, so low, in fact, that some producers went out of business or confined their extraction to well-known deposits. This price and profit cycle has historically been lamented in the industry.

Another constructive development since natural gas deregulation has been the creation of thick, liquid, sophisticated financial markets for natural gas. Futures, options, puts, calls, and more complex derivatives — all have enabled risk spreading in natural gas markets. The ability to hedge risk across time and across different market conditions has substantially decreased the volatility in natural gas prices.

So, with this happy story of the ability of market processes to create value and stem price volatility, why this increase in natural gas prices? The price increase is not as sudden as has been the political realization of it. Natural gas prices have been increasing since the late 1990s. It is also, not surprisingly, the consequence of the interaction of demand, supply, and forces that shape demand and supply.

Many analysts and energy industry experts have, correctly, pointed to supply restrictions as the prime cause of the rigidity of natural gas supply. In particular, they argue that limitations on drilling on federal lands, in consideration of the environmental amenities attached to those lands, have constricted potential exploration options. Such limitations do indeed make supply more inelastic.

However, an emphasis on constrained domestic supply works in conjunction with the very important role that demand has played in increasing natural gas prices. Environmental regulations, formulated largely in the 1990s and in the wake of natural gas deregulation, are premised on the fact that natural gas is a clean and cheap fuel for electricity generation, particularly relative to bituminous coal. Based on that presumption, air quality regulations have led to a situation in which the only economical way to build new power plants is to fuel the facilities with natural gas. Furthermore, improvements to existing plants that have occurred in the past 30 years have overwhelmingly used natural gas to comply with the new source review regulations introduced in the early 1970s.

This focus on natural gas as the way to achieve air quality improvements without dramatically increasing power generation costs has had an unfortunate, and likely unforeseen and unintended, consequence of reducing the resiliency of natural gas markets. Regulatory mandates have constrained us away from being able to apply the lessons of portfolio diversification to our energy choices, and our inability to diversify our fuel input portfolios makes for markets that do not adapt to unanticipated and changing conditions. This is a very high price to attach to the environmental amenities of improved air quality, air quality that could conceivably have been achieved through other means had the regulations not so specifically stipulated natural gas as the fuel input.

The potential implementation of the Kyoto Treaty compounds and exacerbates this costly balkanization of fuel portfolios. Even if the U.S. does not ratify the treaty, imagine the consequences of Canada's implementation. Canadian electricity generators would have to substitute into natural gas as they reduce their use of coal to meet the carbon dioxide reduction targets. If Canadian demand for natural gas increases to fuel their own power needs, then barring a substantial increase in Canadian drilling, there will be much less Canadian natural gas available for export to the U.S. Most of our imported natural gas comes from Canada, so the dislocation to the U.S. natural gas market would be staggering.

I started by suggesting that some government action could forestall this impending "crisis". Unlike those who would recommend price caps and other forms of regulation to control prices, I suggest that government officials seek out further deregulation that would make energy markets more robust and resilient. Some of the required action is straightforward — remove existing obstacles to fuel substitution and to the importation of liquefied natural gas (LNG). In fact, retooling existing terminals to take some small LNG imports would be a low-cost first step toward creating integrated global natural gas markets. Construction of new LNG terminals can take up to a decade, taking into account siting and environmental regulatory processes, so imported LNG is more realistically seen as a long-run move furthering the resiliency and global integration of natural gas markets. Alan Greenspan recommended a similar course of action in his testimony two weeks ago in Congress on natural gas prices.

Regulatory obstacles that constrain supply, including limitations on LNG terminal construction, drilling on federal lands, and offshore drilling, should be evaluated and put to a benefit-cost test. This test would ensure that the combined environmental benefits of the regulations and the fuel supply benefits outweigh the costs, including the opportunity costs of the foregone environmental and fuel supply benefits.

On the natural gas demand side, we should rethink our approach to air quality regulation. Too much air quality regulation mandates inputs, such as the use of natural gas, or a particular coal emission scrubbing technology. We would all benefit from an air quality regulatory framework that stipulates air quality objectives and enforcement technologies that regulators will employ. Setting outcome-based air quality performance standards and a transparent means of evaluating and enforcing performance is vastly superior to input-based regulations because it will provide polluters with the flexibility to improve and innovate better ways of meeting the performance standard. This innovation will reduce costs, and will produce new technologies. New knowledge could enhance our ability to achieve higher air quality and make available different fuels at prices we are willing to pay.

One final piece of the constructive action that governments can take to make energy markets more resilient is to free state-level electricity regulations to allow retail competition and demand-side bidding in retail markets. Not only will an active demand in retail electricity markets discipline the ability of suppliers to raise prices, it will also equip consumers with their most effective energy conservation tool. Demand response, particularly in large industrial and commercial customers, can send signals to power producers of how much investment in generation they should undertake. Conservation and shifting of demand away from costly peak hours can actually decrease the amount of required investment in generation capacity, as well as reducing overall fuel use.

Price increases transmit valuable information to consumers that enables them to decide when it is worth it to them to conserve. Price increases serve as the most effective inducement to conservation, because they signal to consumers large and small that the relative value of natural gas has increased. They also tell suppliers when it is worth bringing more to market and when to invest in more capacity, and through this interaction across time and place, fuel portfolios become more certain and prices become more stable. Government removal of obstacles to this vital transmission of information through market processes is the most productive and constructive action that governments can take in the face of this impending "natural gas crisis".

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

Reducing California's Petroleum Dependence

info@reason.org (Joel Schwartz) info@reason.org (Lynne Kiesling) — Tue, 10 Jun 2003 00:00:00 EDT

A. Introduction and Summary

The CEC/CARB AB 2076 Report (hereafter "the Report") recommends that California set goals of reducing petroleum consumption to 15% below the 2000 level by 2020, and increasing the market share of alternative fuels to 15% of demand by 2020. The Report recommends achieving these goals by mandating a doubling of average automobile fuel economy and requiring that a minimum percentage of on-road transportation fuel be derived from non-petroleum sources.

The Report asserts that reducing petroleum use is necessary to mitigate the following problems:

High and volatile gasoline prices
High security costs for protecting middle east oil supplies
Inability to refine enough petroleum in California to meet California's demand
Mitigating environmental problems such as climate change and air pollution

The Report's cost benefit analysis concludes that mandating substantial increases in vehicle fuel economy would result in billions to tens of billions of dollars in net benefits to California's citizens over the next 30 years. On the other hand, the Report concludes that mandating alternative fuel use would result in billions of dollars in net costs to California's citizens.

We have grave concerns over the Report's assumptions about the nature of the problems, what problems are in need of policy solutions, the assumptions of the cost-benefit analyses, and the recommended solutions themselves. We summarize our concerns below and discuss them in greater detail in the rest of this comment letter.

Mandating fuel efficiency improvements will impose net costs on motorists. About 70% of the benefits claimed for fuel efficiency improvements are direct benefits to motorists in the form of savings in gasoline costs. But motorists can already purchase any of a few dozen vehicle models that get more than 30 miles per gallon (mpg), and yet, on average, they choose vehicles that get a bit more than 20 miles per gallon. Motorists are aware of the level and volatility of gasoline prices and no doubt take this into account in their purchase decisions. This suggests that whatever costs and benefits the Report counts in its cost-benefit analysis, they have little to do with motorists' actual valuation of greater fuel economy vis-à-vis other automobile amenities. When automakers can offer high-mileage vehicles with a palatable combination of price and other desired amenities, motorists will choose them without any external prodding. This suggests that mandating fuel efficiency increases will impose net costs on Americans. Therefore, rather than benefiting Californians, implementing the Report's recommendations would likely make people worse off.

Reducing petroleum consumption would not reduce oil security costs. The level of U.S. expenditures to protect middle east oil supplies is a matter of debate in the research literature. But whatever the costs are, marginal reductions in petroleum use won't reduce these costs. The level of military effort that policymakers judge to be necessary to protect the oil supply and meet other U.S. geopolitical interests is likely to be independent of oil consumption over a wide range of oil consumption levels. A 15% reduction in California or even U.S. oil consumption would probably have no effect on such decisions. The estimated benefits due to decreased oil security costs should be removed from the Report's cost benefit analysis.

Implementing the Report's recommendations would worsen future air quality. Existing CARB LEV II requirements will eliminate more than 90% of current vehicle emissions during the next 20 years or so, leaving little marginal benefit to be had through additional measures. Yet by making new cars more expensive, implementing the Report's recommendations will slow the rate of new-car purchases, which would in turn slow progress on air pollution by slowing vehicle-fleet turnover.

Internalizing the environmental cost of CO₂ emissions would not change motorist behavior. The Report estimates the harm from CO₂ emissions to be $15/ton, which is equivalent to about 15 ¢/gallon. These costs could be internalized through a gasoline tax, but such a tax is probably too small to change motorists driving behavior or vehicle-purchase decisions. If internalizing the cost of CO₂ emissions wouldn't appreciably change motorists' behavior, then requiring CO₂ reductions is almost guaranteed to impose net costs on society.

The Report assumes a static petroleum market. The Report assumes no changes in the petroleum market between now and 2030. But the petroleum market is dynamic. New oil development in Russia, the Caspian Sea, and West Africa, along with ongoing reductions in oil exploration and recovery costs, are reducing OPEC's ability to control petroleum supplies. These trends will tend to reduce both the future cost and volatility of petroleum.

The Report ignores government-mandated balkanization of fuel markets as a source of gasoline-price volatility. Some and perhaps much of the volatility in gasoline prices is due to regulatory requirements on fuel composition that vary from place to place. Despite this factor being under the complete control of state and federal policymakers, the Report does not address reforming reformulated-fuel requirements as a means of reducing price volatility.

Importing gasoline from out-of-state refineries is not a problem. The Report notes that California doesn't have enough in-state refining capacity to meet its future fuel needs and dubs this a problem. This is no more a problem than the fact that Los Angeles is a net importer of food. Gasoline producers will efficiently respond to consumer demand if allowed to do so.

Governments have a poor record in picking technology winners. The Report implicitly assumes that government can pick technology and alternative fuel "winners." Political manipulation of funding choices, the need for decentralized experimentation to determine optimal approaches, the rapid evolution of technologies and processes, and the market discipline of prices and consumer preferences to drive determinations of what's worth doing, all ensure that even the best intentioned central planners will do a poor job of picking the "right" approaches. The approaches that will bring net benefits to Californians are unknown and are most likely to be realized through a decentralized, market-based discovery process.

The Report recommends mandating alternative fuels even though its own analysis indicates this would impose billions in net costs. If after considering all costs and benefits of a policy one finds a net cost, then, by definition, implementing the policy will make people worse off. Rather than make California's economy more resilient, implementing the Report's recommendation would make the state's economy more brittle by requiring consumers and businesses to adopt an energy portfolio that they would not choose on their own due to its great costs. The extra energy costs would draw resources away from other productive activities and investments, reducing the resilience of households and businesses.

Summary. Overall, the Report suffers from an errant definition of the problems that need to be solved, and claims benefits for its recommended policies that would not actually materialize. Indeed, implementing the Report's recommendations would cause net harm to California's citizens. The Report's problem definitions and cost-benefit analyses require major rethinking and revision before the Report can be considered as a sound basis for fashioning energy policy in California.

B. The Report's Cost-Benefit Analysis of Fuel-Efficiency Improvements Is Inconsistent with Motorists' Actual Assessments of Costs and Benefits

In the energy efficiency scenarios, the Report estimates that cumulative net benefits from 2002-2030 of tens billions would result from implementing the Report's recommendation for a mandated doubling of average vehicle fuel economy. But the Report's analysis doesn't appear to have real-world validity.

About 70% of the benefits claimed for reducing petroleum use come from direct savings to motorists, who would spend less to purchase fuel if their cars were more fuel efficient. But motorists already have the opportunity to purchase any of a few dozen models that get more than 30 miles per gallon (mpg), yet they choose not to do so. On average, motorists choose cars that get a little over 21 mpg. This "revealed preference" shows that, on balance, motorists value the additional amenities of low-mpg vehicles more than the extra cost of the gasoline they consume. Indeed, motorists have continued to purchase low-mpg vehicles even during the last few years of relatively high and volatile oil prices.

Motorists have told us through their purchasing decisions that, all things considered, low-mpg vehicles provide a better combination of price and amenities than high-mpg vehicles. This suggests that the Report's analysis of the net benefits of raising fuel-efficiency requirements makes false assumptions about what motorists most value, and that raising fuel efficiency requirements would actually result in net costs to California's citizens.

One might argue that technological advances will reduce the cost of improved fuel economy in the future, which will improve the cost-benefit picture. We agree that this is very likely. But that is still not an argument to require improved fuel economy. Motorists will buy high-mpg vehicles without any prompting as soon as automakers can deliver high fuel efficiency in combination with the other amenities that most motorists desire and at a palatable cost.

Indeed, the argument for mandating greater fuel efficiency rests on a logical fallacy. The call for a government mandate is predicated on the assumption that automakers are purposely withholding fuel-efficient technologies that consumers would buy if they were offered. Yet such a claim implicitly assumes that profit-seeking automakers are foolishly refusing to offer products that would help them sell more vehicles and thereby gain market share. To avoid a logical contradiction, we would have to assume that regulators and environmental activists know more about how to please motorists and make auto companies more profitable than the managers, board members, and shareholders of those companies—a highly dubious proposition.

Another argument for requiring greater fuel efficiency is based on the external costs of automobile use that are not included in the purchase price of the vehicle or the cost of gasoline. But to the extent these costs are real, the appropriate way to deal with them is by adding them to the price of fuel and/or vehicles. But this approach would probably do little to increase demand for more fuel efficient vehicles, because the marginal increase in the cost of driving would be small.

For example, using CEC's estimate of $15/ton for the environmental costs imposed by CO₂ emissions, internalizing this cost would add 15 ¢/gallon to the cost of gasoline. Adding in the Report's assumption of 12 ¢/gallon for oil security costs would bring the total tax to 27 ¢/gallon. Assuming an average vehicle life of 120,000 miles, doubling average vehicle fuel economy from about 21 mpg to about 42 mpg would amount to an incremental savings in lifetime vehicle costs of only about $700, or about $60 per year. While this isn't a trivial amount of money, it is probably too small to have much effect on vehicle purchasing decisions or driving behavior. This analysis amplifies the concern about whether mandated fuel economy increases confer net benefits. If internalizing external costs of fuel use wouldn't cause much of a change in motorist behavior, then the Report must be wrong in concluding that mandating large increases in fuel economy would confer net benefits.

Frequent, painful experience keeps motorists acutely aware of both the price and price volatility of gasoline. The average motorist's refusal to purchase high-mpg vehicles is not due to lack of knowledge of benefits. Rather, on balance, the claimed benefits of high-mpg vehicles simply don't exist yet. Motorists find low-mpg vehicles to be a better overall value. When the price-amenity equation changes, as it surely will, motorists will choose high-mpg vehicles of their own free will and the result will be net societal benefits. Mandating higher fuel efficiency would only make motorists worse off.

C. Fuel Regulations Balkanize Markets and Increase Price Volatility

Some and perhaps much of the volatility in gasoline prices is due to regulatory requirements on fuel composition that vary from place to place. In particular, California's reformulated gasoline limits flexibility in the gasoline market by making non-California gasoline less substitutable for California's reformulated gasoline. Likewise, the federal government requires the addition of oxygenates, a requirement which can now practically be met only with ethanol. This balkanization of fuel markets enables price spikes to occur and to persist. Despite these factors being under the complete control of state and federal policymakers, the Report does not address reforming reformulated-fuel requirements as a means of reducing price volatility.

CEC and CARB should commission an independent analysis of the effect of fuel regulations on gasoline-price volatility, and examine opportunities for more flexible regulations that would maintain air quality benefits while reducing the potential for supply disruptions and ensuing price spikes.

D. World Petroleum Markets Are Dynamic, but the Report Assumes A Static Market

The Report is founded on a static view of petroleum markets, one that assumes little or no change in the global oil industry over the decades covered in the analysis. In particular, likely changes in world oil markets over the next 20 years are assumed away. For example, the report ignores the development and capital investment in Russia, around the Caspian Sea, and in West Africa, as well as continually declining costs for oil exploration and recovery. As a result, almost all of the growth in oil production is occurring in non-OPEC countries. This growth reduces OPEC's market power, and threatens to reduce its market share, reducing its ability to control supply and prices.

Another important dynamic aspect of energy markets is the use of financial instruments and contracts to reduce risk and, consequently, to reduce price volatility beyond what it otherwise would have been. The report never addresses the role that financial markets (hedging, derivatives, etc.) play in reducing fuel price volatility, without the need for additional government action, regulation, or planning.

At the very least the Report should incorporate scenario analyses based on different world oil market contexts, as a test of how robust its conclusions are to the dynamics of the ever-changing global oil market.

E. Governments Have A Poor Record in Trying to Pick Technology "Winners"

In discussing the move away from petroleum-based fuels to fuel cells, the Report implicitly assumes that the government policymakers can pick technology winners, and that it can control both the rate and outcome of technology and process innovation. Governments (and corporate bureaucracies, for that matter) have a very poor track record of picking technology winners, and we have little reason to believe that the success rate in this case will be any different.

The most dramatic example of government subsidies to unsuccessful commercialization research is federal subsidies to solar thermal research during the late 1970s. In the wake of the energy crisis of the 1970s, Congress and the Carter Administration approved a large budget increase for research into thermal solar technology. Five years and massive amounts of research did not yield a commercially viable competing technology to the old photovoltaic solar cells, the technology of which had of course also advanced.

In the case of hydrogen generation, storage, and transport, fuel cells, fueling infrastructure, and so on, there are several competing technologies all innovating simultaneously. We do not know which one in each area is the most commercializable, and even if we could somehow generate a sound current ranking, a sudden discovery in one technology could upend that ranking in an instant. Technological developments in other areas could even reduce interest in fuel cells. Government-guided research runs the risk of choosing the wrong technologies.

If the government attempts to pick winners through targeted subsidies and picks wrong, then we are stuck with that bad, costly mistake. This mistake could become particularly costly once, for example, companies start building, hydrogen fueling stations, investing in a lot of fixed infrastructure in special purpose assets if it turns out that the most commercially viable way to deliver the hydrogen is not compatible with those specific assets. Such a costly policy error would lead to significant wasted investment, and if subsidized, a lot of wasted taxpayer money.

Private markets are a superior way to make decisions about technologies and funding levels. Investors use market processes to deal with such unknowns by holding diversified portfolios of venture capital. Venture capital firms do not typically sink all of their resources into one technology that they believe has the highest probability of winning – they hedge that investment by investing in other technologies, in other industries. They want to maximize their risk-adjusted profit, knowing full well that some research will result in new technologies that deliver new and/or improved benefits at lower costs to consumers, and some will not. Such a portfolio approach is a hedge against the pervasive inability to pick winners. Experience with government research suggests that its track record does not improve upon the private investment portfolio approach.

One of the arguments in favor of targeted government technology research subsidies is that such subsidies will reduce unnecessary duplication of research efforts. If there is duplication of research, that means that there is plenty of private-sector interest in the topic, so increasing government subsidies will only serve to crowd out that private investment in research that would have happened anyway. Why spend taxpayer money that way when private investors are willing to incur research costs?

One typical answer to that question is that duplicative research efforts are a wasteful dissipation of resources in the race to be "first to the finish line." That argument ignores the benefits of duplicative research. If you try to channel these efforts and guide research with an objective of minimizing duplication, you are very likely to fail, because the duplication is never perfect—even if several people are working toward the same goal, such as smaller or cheaper fuel cells, the variations in their procedures, materials, ways of approaching the problem, and just sheer luck will all lead them down different paths. This decentralized discovery process maximizes the potential benefits from research. All of that seeming duplication is not duplication at all. Instead, it maximizes the probability that someone will come up with technologies and processes of greater benefit to society. And the fact that the search is decentralized and diverse means that society doesn't have all its eggs in one basket.

Government research subsidies and those who argue for them also tend to overlook a very important part of the technology diffusion process: consumer demand. Technologies that do not meet consumer needs for practicality, convenience, carrying capacity, power, and aesthetics will fail, regardless of their scientific virtuosity or cost-effectiveness. Failure to take into account consumer demand further inhibits the ability of government to pick winners, and also points up another major difference between private investment processes and government subsidy processes.

The Report ignores the preferences of consumers, which is how it was able to manufacture benefits from mandated fuel-efficiency requirements. The costs used in the cost-benefit analysis do not include the changes to vehicles that would have to occur to make the increased fuel efficiency happen: decreased power, decreased torque, decreased size, and possibly decreased safety. These features matter to consumers, and government dictation of the features that peoples' vehicles will have would likely make consumers worse off.

It is important to remember that technological change is incremental and evolutionary, and that important features, processes and technologies can be very different from what one might have expected at the beginning of a research program. Predicting what will succeed and what will be a dead end is difficult, so any policy decisions that steer research into bureaucratically determined paths could do more harm than good.

F. Mandating Alternative Fuels will Harm Californians

Despite finding that requiring alternative fuels would cause billions of dollars in net harm to Californians, the Report recommends a mandated minimum market share of 15% for alternative fuels. The Report's rationale is that it will make California's economy more resilient. But this is a non-sequitur. If after considering all costs and benefits of a policy one finds a net cost, then, by definition, implementing the policy will make people worse off overall. Indeed, the Report's recommendation for an alternative fuels mandate is in effect an argument that we should shoot ourselves in the foot now in order to avoid the risk that we might get shot in the foot later.

Rather than make California's economy more resilient, implementing the Report's recommendation would make the state's economy more brittle by requiring consumers and businesses to adopt an energy portfolio that no one would choose on their own due to its great cost and risk. The extra energy costs would draw resources away from other productive activities and investments, reducing the resilience of households and businesses. The recommendation for an alternative fuels mandate should be removed from the report.

G. Environmental Problems

The Report identifies two major environmental problems—air pollution and global warming, which we take up in turn.

1. Air Pollution

Increasing petroleum use is not an obstacle to improved air quality

The Report states "Increasing our reliance on petroleum would…be an obstacle to improved air quality." This statement is simply false. According to the Report, gasoline consumption rose 50% in California between 1980 and 2002, yet this was a period of extraordinary improvement in California's air quality. During the 1980s, the San Bernardino area, with the worst ozone levels in the nation, exceeded the federal 1-hour ozone standard about 140 times per year. Today, Crestline—the worst location—is down to about 25 exceedances per year, while San Bernardino and Redlands average around 10 to 20. Half the population of South Coast now lives in areas that meet both the 1-hour and 8-hour ozone standards, while about 99 percent of people in the Bay Area and San Diego likewise live in areas meeting both ozone standards. Figure 1 displays the trend in 1-hour ozone exceedances at the worst monitoring location in each of California's major air basins.

Levels of all other pollutants have likewise declined substantially during the last 20 to 30 years. The vast majority of monitoring locations now comply with federal PM10 standards, and the entire state complies with standards for CO, NOx and sulfur dioxide.

Figure 1. Trend in 1-hour Ozone Exceedances at Worst Location in Each Air Basin

Source: CARB monitoring data

These declines will continue, regardless of VMT growth. Tunnel studies show that fleet-average light-duty-vehicle HC emissions in California are declining about 15% per year, while NOx is declining about 9% per year (see Figure 2). Given that VMT is increasing about 1.8% per year, this results in a net annual decline HC and NOx of 13% and 7% respectively. These trends will only continue. A fleet meeting CARB's LEV II requirements for gasoline vehicles would emit more than 90% less HC and NOx per mile of travel than the fleet currently on the road. The fleet will turn over to these vehicles during the next 20 years or so. VMT increases will have little effect on future emissions, given these large per-mile emission reductions. For example, if per-mile emissions decline 90% and VMT increases 50%, total emissions would still decline by 85%.

Thus, the long run problem of air pollution from automobiles has already been solved by existing requirements that will come to fruition during the next 20 years or so. But we still have a near-term air pollution problem. This problem would be most quickly and cheaply resolved through repair or scrappage of high-emitting vehicles. A small percentage of vehicles contributes most fleet emissions (see Figure 3). For example, remote sensing data collected in Riverside, California in 2001 show that the worst 5% of HC emitters account for more than 50% of tailpipe HC emissions. As the chart shows, the vast majority of vehicles have very low emissions, while a few have very high emissions and account for most pollution from the fleet.

This means that most vehicle emissions are not due to petroleum consumption per se, but to the small percentage of vehicles with broken emission control systems. To solve this problem, we should focus on measures to identify and either repair or scrap these high emitters. This is also only a near-term problem, as these older high emitters are slowly but surely being replaced by more recent models that stay cleaner throughout their lives.

Figure 2. Trend in Fleet-Average Emissions of California Light-Duty Vehicles, 1994-2001

Source: A. J. Kean et al., "Trends in Exhaust Emissions from In-Use California Light-Duty Vehicles, 1994-2001," (Society of Automotive Engineers, 2002).

Figure 3. VOC Emissions Distribution of Vehicles Measured by Remote Sensing in Riverside, California in 2001

HC emissions from 1,207 vehicles with 2 or more measurements, ranked from cleanest to dirtiest. Emissions are in grams of VOC emitted per gallon of fuel burned. Negative HC readings represent "real" noise in the data. Data were collected in Riverside, California in 2001 by Gary Bishop of the University of Denver. Data were downloaded from www.feat.biochem.du.edu/light_duty_vehicles.html. These vehicles are 15 years old on average, and 75 percent are at least 12 years old.

Air Pollution Reductions Beyond Current Requirements would Result in Little or No Marginal Benefit. Because current air pollution problems are being solved by existing measures, there is little or no marginal benefit to additional pollution reductions over and above those that will occur due to existing LEV II and other vehicle emission requirements. The Report implicitly acknowledges this, as its estimated air quality benefits from reduced petroleum consumption amount to about 50 cents per person per year, or one percent of all estimated benefits. These presumed benefits are also due to pollution reductions from a baseline pollution level that is already below the limits set by federal and California health standards.

Implementing the Report's Recommendations would Make Future Air Quality Worse than it Would Otherwise Be. Implementing the Report's recommendations would make new cars more expensive. As a result, people would buy fewer new cars and would hold on to existing cars longer. Since fleet turnover is the most important factor for air quality improvements, implementing the Report's recommendations would make future air quality worse than it would otherwise be. Rather than counting air pollution benefits in its cost-benefit analysis, the Report should actually conclude that implementing its recommendations would impose air quality costs.

The Report Overestimates the Health Improvements from Air Pollution Reductions. Even the small amount of health benefits attributed to additional air pollution reductions are overstated. Most of the claimed benefits are due to projected reductions in mortality due to reductions in particulate matter (PM). The Report bases its PM mortality estimate on the Health Effects Institute's (HEI) Reanalysis of the American Cancer Society (ACS) study of PM and mortality. However, residual confounding in this study makes it likely that the results are spurious. For example, the HEI/ACS study reported that PM increased mortality for men, but not women; for those with no more than a high school degree, but not those with at least some college education; for those who said they were moderately active, but not those who said they were either sedentary or very active; and for former smokers, but not current or never smokers. These results are biologically implausible and suggest that residual confounding accounts for them. The report also found no increase in mortality due to respiratory causes specifically, which is surprising given that air pollution would be expected to exert its effects through the respiratory system.

At the very least, taking the HEI/ACS results at face value, only the 25% of the population that is male and has no more than a high school degree would be expected to suffer increased mortality. The Report also ignores the results of a recent epidemiologic cohort study of veterans with high blood pressure that found no relationship between PM levels and mortality, despite that this group was expected to be particularly susceptible to air pollution's effects. These results indicate that the Report's benefit estimates for air pollution reductions are greatly overstated.

Summary. Air quality in 10 or 20 years will be far better than it is today, regardless of California's policy on petroleum consumption. Furthermore, virtually none of the purported benefits of reduced petroleum consumption are due to air quality improvements. Thus, it is at best terribly misleading for the Report to either raise alarms about future air quality, or to suggest that reduced petroleum consumption is a sensible policy for air quality improvement, when other policies would provide greater and more rapid pollution reductions and would do so without the harm that would be caused by mandated fuel efficiency improvements or mandated alternative fuel usage.

Instead, the Report should state prominently that (1) air quality is improving and will continue to improve regardless of California's petroleum consumption trends, (2) mandating higher fuel economy would slow fleet turnover by making new vehicles more expensive, thereby making future air quality worse than it would otherwise be, (3) existing requirements will eliminate almost all remaining automobile air pollution during the next 20 years or so, and (4) near-term air pollution improvement would be most quickly and cheaply achieved through repair or scrappage of high-emitting vehicles.

2. Climate change

Climate change is an analytically complex issue, and forecasts of future climate change and attendant costs are fraught with uncertainties. A detailed discussion is beyond the scope of these comments. However, even taking the Report's damage estimates from CO₂ emissions at face value, eliminating the CO₂ emissions would cost more than the estimated harm caused by the emissions. This alone guarantees that CO₂ reductions will cause net harm. A simple analysis shows why this is the case.

The Report estimates the harm from CO₂ emissions to be $15/ton, which is equivalent to about 15 ¢/gallon. These costs could be internalized through a gasoline tax, but such a tax is probably too small to change motorists driving behavior or vehicle-purchase decisions. For example, buying a 42 mpg vehicle instead of a 21 mpg vehicle would save only about $35 per year in CO₂ taxes. This means that even charging motorists the full estimated cost of all of their CO₂ emissions would likely cause hardly any reduction in CO₂ emissions. If internalizing the cost of CO₂ emissions wouldn't appreciably change motorists' behavior, then requiring CO₂ reductions is almost guaranteed to impose net costs on society.

The Report also notes "Our estimate of $15 per ton of CO₂ equivalent seems reasonable if cost of control or current market trades are any indication. $15/ton is also consistent with the finding of Friedrich and Bickel that damage estimates currently are lower than cost of control or market trades." If the damage done by a ton of CO₂ emissions is less than the cost of reducing those emissions, then reducing the emissions will cause net harm.

H. Oil Supply Risk: Marginal Reductions in Petroleum Consumption will Not Reduce Military or other Expenditures to Protect Foreign Oil Supplies

The Report includes benefits from reduced oil security costs as part of the estimated benefits of reduced petroleum consumption. As the Report notes, there is little agreement in the research literature over just what those costs are. However, whatever the costs are, the reduction in oil security costs due to marginal reductions in petroleum consumption is likely to be zero. This is because the nature and extent of U.S. military activity to protect U.S. interests in the middle east are not elastic with oil consumption. Instead, such missions depend on a range of interacting geopolitical factors of which oil is only one.

Furthermore, the level of military effort judged to be necessary is likely to be independent of oil consumption over a wide range of oil consumption levels. After all, regardless of whether the U.S. imports 20% or 30% of its oil from the middle east, the military effort necessary to ensure its availability would likely be the same. Even if the U.S. imported hardly any of its oil from the middle east, the U.S. might consider it strategically important to protect middle east oil anyway, since many of its allies would import much their oil from the middle east.

The Report bases its estimates of oil security costs on two reports—Delucchi and Murphy (1996), and Lieby et al. (1997). But Delucchi and Murphy base their estimates on the assumption that all middle east oil consumption is ended, rather than on marginal reductions. And Leiby et al. state outright that oil security costs do not necessarily vary with marginal changes in imports. Thus, the research literature cited in the Report actually doesn't support the Report's assumption that the U.S. could achieve marginal reductions in oil security cost through marginal reductions in petroleum consumption.

Ironically, reducing petroleum demand is instead likely to increase the percentage of oil imports that come from the middle east. Middle eastern countries are generally the lowest-cost suppliers, so reductions in demand would push other suppliers out of the market, increasing the middle east's market share.

Improvements in oil security account for roughly 10 to 15 percent of the Report's estimated benefits from reducing petroleum dependence. Since these benefits would not actually materialize, they should be removed from the Report's benefits ledger.

Joel Schwartz is an adjunct fellow at Reason Foundation and visiting scholar at American Enterprise Institute.

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.

Can the Government Pick Technology Winners? Can Anyone?

info@reason.org (Lynne Kiesling) — Fri, 28 Mar 2003 00:00:00 EST

Since President Bush's State of the Union Address, government officials have made three policy proposals regarding government subsidies for hydrogen. President Bush initially proposed $1.2 billion in research subsidies over five years, which has increased to $1.7 billion. Second, the U.S. and the European Union have agreed to coordinate and sponsor joint support of hydrogen research. Third, Representatives Cox (R-CA) and Wyden (D-WA) have introduced a bill in the House of Representatives to subsidize the construction of hydrogen fueling infrastructure.

When politicians put forth subsidy proposals like these, one of our primary concerns should be their answer to this question:

How do you know you are picking the right solution? How do you know? And if you are so sure, then why isn't someone already doing it?

Governments (and corporate bureaucracies, for that matter) have a very poor track record of picking technology winners, and we have little reason to believe that the success rate with hydrogen research will be any different.

The most dramatic example of government subsidies to unsuccessful commercialization research is the thermal solar research during the Carter administration. In the wake of the energy crisis of the 1970s, President Carter approved a $105 million annual budget for research into thermal solar technology. Five years of massive amounts of research did not yield a commercially viable competing technology to the old photovoltaics, which had of course continued to innovate during the solar thermal research. This abysmal success rate was one of the factors leading to the decline in the solar research budget under the Reagan administration. To this day photovoltaic solar is the premier solar technology, and it continues to improve, thanks to both private and public research funding.

The solar thermal example raises two important points. First, government-funded research is subject to political dynamics, which are usually much more short-sighted than the timeframe required in research that goes into new and improving energy technologies. It could have been possible that with more than five years of research solar thermal technology could have hit a breakthrough (although the solar engineers I�ve talked to are not convinced about that), but the political dynamic in Washington typically does not exhibit the kind of patience that is required in the face of applied technology research.

Furthermore, it's important to remember that for hydrogen generation, storage, transport, fuel cells, fueling infrastructure, and so on, there are several competing technologies all innovating simultaneously. We don't know which one in each area is the most commercializable, and even if we have some ranking of them, a sudden discovery in one technology could upend that ranking in an instant.

If the government is going to subsidize them, will they pick one in each area, the one that their scientists perceive as most likely to succeed? Or will they fund parallel duplicate research on competing technologies? Picking one in each area, the "picking-the-winner" approach, is very risky — what if the one they pick is not the winner? Multiply that problem by the fact that we are looking at technologies in at least five different connected areas from generation to fueling, and the probability of picking the combination of those technologies that will succeed technologically and commercially is pretty slim.

If the government attempts to pick winners through targeted subsidies and picks wrong, then we are stuck with that bad, costly mistake. This mistake becomes particularly costly once, say, companies start building hydrogen fueling stations, investing in a lot of fixed infrastructure of very specific assets, and then it turns out that the most commercially viable way to deliver the hydrogen is not compatible with those specific assets. That�s a lot of wasted investment, and if subsidized, a lot of wasted taxpayer money.

In other words, investing in technological change requires accepting both some risk and some uncertainty. There are both risks (facing a known set of choices with known probabilities for each choice) and uncertainty (facing an unknown set of choices in an unknown probability distribution) that some research will not pay off. Should taxpayers bear that risk and that uncertainty?

The way investors use market processes to deal with such unknowns is to hold diversified portfolios of venture capital. Venture capital firms do not typically sink all of their resources into one technology that they believe has the highest probability of winning — they hedge that investment by investing in other technologies, in other industries. They want to maximize their risk-adjusted profit, knowing full well that some research will result in new technologies that deliver new and/or improved benefits at lower costs to consumers, and some will not. Such a portfolio approach is a hedge against the pervasive inability to pick winners. Experience with government research suggests that its track record does not improve upon the private investment portfolio approach. Governments are no better at picking winners than investors using market processes, although neither has a 100% success rate; nor should we expect one.

One of the arguments in favor of targeted government technology research subsidies is that such subsidies will reduce unnecessary duplication of research efforts. If there's duplication of research, that means that there is plenty of private-sector interest in the topic, so increasing government subsidies will only serve to crowd out that private investment in research. Why spend taxpayer money that way when private investors are willing to incur research costs?

One typical answer to that question is that duplicative research efforts are wasteful dissipation of resources in the race to be "first to the finish line." I disagree. If you try to channel these efforts and guide research with an objective of minimizing duplication, you are very likely to fail, because the duplication is never perfect — even if several people are working toward the same goal, such as smaller methanol fuel cells, the variations in their procedures, their materials, their ways of approaching the problem, and just sheer luck will all lead them down different paths. It's that human variation that maximizes the potential benefit from research. All of that seeming duplication also does something incredibly valuable: it maximizes the probability that the researchers will find dead ends and eliminate them from further exploration at that time, in that application.

Government research subsidies and those who argue for them also tend to overlook a very important part of the technology diffusion process: consumer demand. Technologies that do not meet consumer needs for practicality, convenience, carrying capacity, power, and aesthetics will fail, regardless of their scientific virtuosity or cost-effectiveness. Failure to take into account consumer demand even further inhibits the ability to pick winners, and also point to another difference between private investment processes and government subsidy processes.

If government subsidies are going to occur, then they should not be for commercialization of specific technologies or for the rollout of specific fueling infrastructure. Not only is that the area where the ability to pick winners is the lowest, it is also where private companies already invest substantially, and therefore where the potential for government funding to crowd out private funding is the highest.

It is important to remember that technological change is incremental and evolutionary, and that the most potentially important changes can be very different from what you might have expected at the beginning of the research. Predicting what will succeed and what will be a dead end is difficult, so any policy decisions that steer research along this unknown path could do more harm than good.

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

This is part 5 of Reason's 5-part Let the Hydrogen Economy Evolve series:

Part 1: The Science of Hydrogen Fuel Cells
Part 2: The Economics of Hydrogen: Innovation in Mature and New Technologies
Part 3: Are Hydrogen Fueling Station Subsidies Necessary?
Part 4: Hydrogen-Powered Buildings
Part 5: Can the Government Pick Technology Winners? Can Anyone?

Hydrogen-Powered Buildings

info@reason.org (Lynne Kiesling) — Thu, 27 Mar 2003 00:00:00 EST

The public policy debate over hydrogen fuel cells and energy efficiency has focused primarily on vehicles — mobile sources of pollution. But consider the challenges of using hydrogen fuel cells in vehicles: hydrogen is volatile and combustible, and because it is a less intense fuel source than gasoline, storing either hydrogen or the natural gas or water to generate it takes up a lot of space. Even hybrid vehicles face similar problems. The onboard battery that stores electricity to provide the electric part of the power is heavy and bulky. So although the pollution reduction benefits of alternate fuels for mobile sources may be high, the costs and obstacles are also high.

It should come as no surprise, then, that there is a market for stationary hydrogen and/or hybrid power. Installations of hydrogen fuel cells and hybrid engines are occurring in commercial and residential (particularly multi-unit) buildings. Relative to vehicles, the large engine footprint does not matter as much, nor does the weight of the engine. While hydrogen fuel cell and hybrid engines to power buildings may not appear to reduce pollution as effectively as using them in vehicles, using them in buildings provides several benefits and avoids some of the costs encountered with vehicles.

Building power use is increasing as the intensity of our electronics use rises. Thus increasing energy efficiency in buildings enables us to satisfy increased electronics use with a smaller amount of energy input for every kilowatt hour of power generated. Energy efficiency therefore also decreases the energy cost per kilowatt hour of power generated.

Distributed generation (DG) is one effective way to achieve increased energy efficiency in buildings, through both traditional and alternative engines. DG uses an on-site generator to provide power for a building, which means that the building does not have to use power from the local utility, delivered through the local grid. Alternately, it could mean a building manager could choose when to use the DG and when to use power from the grid, or could use the DG as a redundant backup power system. Such backup is crucial for buildings that house high-reliability functions like hospitals, financial services, and data centers. DG can be quite energy efficient, providing a good ratio of power generated/energy input (kwh/BTU). In particular, a DG system called combined heat and power (CHP) can be very energy efficient because CHP uses waste heat from the electricity generation process to provide climate control.

One reason why DG in buildings could be a good use of hydrogen fuel cells and hybrid engines is that on-site DG can use direct current (DC), not alternating current (AC). The existing distribution grid uses AC, which when electricity was young in the late 19th century could transmit more power over longer distances than DC. What is interesting about DC, though, is that some of the largest energy uses in buildings translate AC to DC when the power comes into the building from the grid. Florescent lighting, for example, is much more efficient when run on DC, and florescent lights also come with standard fixtures that can accept either incoming DC or AC. If a building runs an on-site hydrogen fuel cell or hybrid engine generator (or any other kind, for that matter), it creates direct current, and can power lighting systems without the translation from AC to DC, which of course takes some energy. Not having to do this translation improves the energy and economic value of the on-site generators relative to traditional power from the grid. While hydrogen fuel cell and hybrid buildings are still more expensive than traditional grid power per kilowatt hour generated, their continuing innovation provides an alternative to hooking up to the local utility's grid.

Hydrogen fuel cell and hybrid buildings would reduce pollution in various ways. By substituting for fossil fuel-generated power the use of fossil fuels would decrease (although it would not disappear entirely, as discussed on Monday). Furthermore, to the extent that they increase the kilowatt hours generated for every BTU of fuel used, the decrease overall energy use. In an Energy Pulse (www.energypulse.net) article from 11 March 2003, Paul Savage, CEO of Nextek Power Systems, makes the point with regard to hybrid buildings:

"Ultimately, we will see hybrid buildings powered by combinations of grid power and alternative power sources, such as fuel cells, wind turbines and solar energy — without the need for multiple conversions of AC to DC at each device. The result will be energy that is more abundant, less dependent on foreign sources, safer and more reliable than grid power alone. These — networks can deliver loads up to 50 percent more usable energy from DC sources — similar to the pick-up in efficiency hybrid vehicles deliver versus the internal combustion engine alone."

Buildings can also be a good way to test-bed technological change that can later be applied to vehicles. Hydrogen fuel cell and hybrid building research could inform the research on hydrogen fuel cell and hybrid vehicles, and make them cheaper, more energy efficient, and therefore more potentially commercial.

Hydrogen fuel cell and hybrid buildings will not replace traditional grid-powered buildings quickly, both because of higher cost and because of the installed base advantages (and associated high switching costs) of the grid. However, as hydrogen fuel cell and hybrid buildings provide increasingly commercially viable alternatives to traditional grid distribution, building managers are more likely to choose to install them to decrease their energy use rate and to provide the benefits of reliable, cleaner power.

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

This is part 4 of Reason's 5-part Let the Hydrogen Economy Evolve series:

Part 1: The Science of Hydrogen Fuel Cells
Part 2: The Economics of Hydrogen: Innovation in Mature and New Technologies
Part 3: Are Hydrogen Fueling Station Subsidies Necessary?
Part 4: Hydrogen-Powered Buildings
Part 5: Can the Government Pick Technology Winners? Can Anyone?

Are Hydrogen Fueling Station Subsidies Necessary?

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

In the wake of the President's State of the Union Address, Representatives Cox and Wyden proposed a bipartisan bill that would subsidize the construction of hydrogen filling stations. It's common wisdom that hydrogen vehicles suffer from a chicken-and-egg problem — no one will buy hydrogen vehicles until they can get them fueled, and no one is going to build a hydrogen filling station until there's a critical mass of consumers that have purchased hydrogen vehicles. Chicken-and-egg problems are fascinating illustrations of how markets can harness individual incentives to bring complementary new technologies to fruition efficiently.

The hydrogen vehicle/fueling infrastructure chicken-and-egg problem is not the first or only time such an issue of complementary technologies has occurred. Take the example of the major transportation revolution of the 20th century — the internal combustion-powered automobile. Why did Henry Ford and his competitors even consider marketing cars, given that there were no filling stations? Yet by the 1930s an extensive retail filling station industry co-evolved with a thriving automobile industry and we (well, most of us) have never looked back. But how did we get there without government subsidies to build gasoline filling stations?

Before the invention of the automobile and its first commercial sales in the early 20th century, the predominant commercial product from crude oil was kerosene, not gasoline. Kerosene provided primarily cooking fuel and lamp fuel. Consumers bought kerosene at their local dry goods store or general store. Oil companies provided wholesale distribution to these stores. Then, in the early 20th century, the automobile began to create a demand for gasoline (which, interestingly, had been perceived as a waste product in the pre-car era). But early automobiles were not very comfortable and not many folks viewed car journeys as a pleasant way to travel, so gasoline demand increased slowly.

Where do you think those "early adopters" could buy gas? You bet — that same dry goods store! The wholesale distribution channel worked for gasoline much as it had for kerosene.

But the car was not a stagnant technology. Automobile entrepreneurs competed to offer consumers a more comfortable ride, and after World War I and with rising incomes in the 1920s, the market for automobiles grew. More people wanted to drive further, and the technology made it both possible and pleasant.

But the technology was not perfect. Breakdowns and required maintenance created profit opportunities for the mechanically talented — they opened service stations (think, for example, of the tragic cuckolded husband in The Great Gatsby). That created an alternative distribution channel for gasoline, a distribution channel that created profits for service station owners while providing convenience for customers — the full-service filling station.

Note that the early service and filling stations were usually independents — they had wholesale contracts with oil producers. Only once automobile ownership and increased vehicle miles traveled hit a critical mass later in the 1920s did the oil companies start operating retail filling stations, complete with attendants in spiffy uniforms. The fully vertically integrated oil company, from exploration and drilling to wholesale to retail filling station, was therefore a fairly late development, following the increased customer demand for automobiles.

What does the internal combustion engine automobile/gasoline filling station experience tell us about the development of hydrogen fueling infrastructure? I would not expect the development to mirror gasoline development, nor should we force it to. But some simple insights apply.

1. Fueling is likely to follow "early adopter" hydrogen vehicle consumers. We owe a debt of gratitude to early technology adopters, but they do not do it out of altruism — they like being the first ones on the block to have those newfangled fuel cell vehicles, and they feel good about clean technology. As demand for fuel cell vehicles moves beyond early adopters, the demand for fueling will follow.
2. Fueling will be decentralized and local, and will exploit existing distribution channels. Both because of the evolution of demand from early adopters and because of the technology and danger of generating and transporting hydrogen, local inventories of natural gas and/or water to provide fuel make the most sense. Hydrogen's volatility also makes locking in to a fueling technology by subsidizing it extremely risky. In my opinion, those who have both the economic interest and the space for this to make economic sense are automobile dealers. For example, if Honda and Toyota sell fuel cell vehicles and provide their dealers with a profit opportunity to sell hydrogen fuel, that would help them sell more fuel cell vehicles. The oil companies do not have an existing distribution channel to take advantage of like they did in the kerosene/gasoline markets, so they do not really have a leg up relative to automobile manufacturers.
3. Fueling infrastructure will evolve as the vehicles, and the demand for them, do. One major lesson from the gasoline experience is that entrepreneurs who see profit opportunities will cause the evolution of distribution channels, and will do so in ways that benefit consumers.

Forcing hydrogen fueling to replicate the existing gasoline distribution infrastructure by subsidizing the construction of a fueling network is a very static approach to an incredibly, beautifully dynamic co-evolution of technologies and consumer preferences. Such subsidies are also likely to undercut the creativity of entrepreneurs who will seek to find novel and convenient ways to provide hydrogen fueling to consumers who want it, and to profit from it.

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

This is part 3 of Reason's 5-part Let the Hydrogen Economy Evolve series:

Part 1: The Science of Hydrogen Fuel Cells
Part 2: The Economics of Hydrogen: Innovation in Mature and New Technologies
Part 3: Are Hydrogen Fueling Station Subsidies Necessary?
Part 4: Hydrogen-Powered Buildings
Part 5: Can the Government Pick Technology Winners? Can Anyone?

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.

The Economics of Hydrogen: Innovation in Mature and New Technologies

info@reason.org (Lynne Kiesling) — Tue, 25 Mar 2003 00:00:00 EST

The science of hydrogen as a fuel source indicates that hydrogen fuel cells are not a "silver bullet" to generate clean fuel and eliminate fossil fuel dependence. The economics of fuel cells reinforce that interpretation. Platinum and other catalysts are costly and scarce. Natural gas and water as hydrogen sources are also costly and scarce, and have many competing alternative uses. Furthermore, natural gas is also facing increasing demand from electricity generation, because it is a cleaner fuel than coal in many ways. So the combination of increased demand for electricity generation and increased demand for hydrogen generation could increase natural gas prices, making hydrogen power even more expensive.

High natural gas prices are also likely to do two things: induce companies to explore and drill for more natural gas deposits, and induce researchers to work on finding alternative ways to generate hydrogen.

The economics of hydrogen as a fuel derive from the comparison with our existing hydrocarbon fuel framework. Once you take into account the cost of releasing hydrogen from molecules, the use of hydrocarbons to produce hydrogen, the less-than-hoped-for benefits of decreased emissions, the costs of inputs, the much lower energy intensity of hydrogen relative to hydrocarbons, and the costs of transporting hydrocarbons and/or water so they can be processed into hydrogen on-site, it becomes pretty clear that hydrogen is not likely to be ready for economic prime time for a while. Most estimates put commercial fuel cell vehicles at 10-30 years in the future.

Importantly, companies are investing in the research to push that commercial timeframe closer to 10 years. Given those time frames and the risks associated with the research, companies must be investing in anticipation of large future returns.

Of course, this is not the first time in human history that we have experienced an energy transition. From the 18th century move from wood to coal that fueled the industrial revolution to the late-19th century transition from coal toward oil, history abounds with examples of old and new energy technologies evolving simultaneously, created by human striving for better economic and environmental lives.

Take for example the invention of the steam engine during the early industrial revolution. Over six years from 1776 to 1783, James Watt and Matthew Boulton created, built, and marketed the first commercially viable steam engine for uses beyond just pumping water out of mines. However, steam engines did not become the standard power source for industry until the 1840s. Why the 60-year delay in the widespread adoption of a clearly superior technology?

One reason was innovation in the mature power technology — the water wheel. Water wheels had been used for centuries to generate power, but they had some serious shortcomings when compared to steam engines. They were not mobile, the depended on seasonal water levels, and the intensity of their power generation was pretty low. But water wheels had a substantial "installed base", so there was certainly an issue of switching costs. More importantly, though, water wheel technology kept innovating. Inventors like Victor Poncelet applied their increasing understanding of fluid dynamics to invent curved blades for the wheel, which increased the wheel's energy generation from a given amount of water and improved its viability as a power source.

Thus early on, the margin between water technology and steam technology was small. Only as steam technology continued to innovate beyond Watt's and Boulton's original did it start to replace water wheels. During the 60-year transition, water and steam technologies coexisted and evolved simultaneously, increasing power generation at decreasing cost for decades.

We are in the midst of a similar transition from internal combustion to hydrogen engines. The transition will be an incremental evolution because internal combustion engines continue to innovate, as illustrated by the increasing power and commercial viability of hybrid engines. Hybrid technology will continue to evolve as hydrogen technology evolves, and that's a good thing. Given the science of generating hydrogen, it is not clear that hydrogen vehicles would be any cleaner than hybrid vehicles, as a recent MIT study found.

So it comes as no surprise that during our current transition toward hydrogen, which has been in progress for at least two decades, we have made simultaneous innovations that make hydrocarbon technologies cleaner, more energy efficient, and better able to deliver the same amount of power with less energy use.

This simultaneous evolution of mature and new technologies is one reason why diversity of technologies, a portfolio of technologies approach, will deliver cleaner power in a dynamically efficient manner. The flexibility to include both hydrogen and other fuels, and to have these alternatives innovate and compete against each other over time, will lead to better long-run fuel solutions and a cleaner environment.

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

This is part 2 of Reason's 5-part Let the Hydrogen Economy Evolve series:

Part 1: The Science of Hydrogen Fuel Cells
Part 2: The Economics of Hydrogen: Innovation in Mature and New Technologies
Part 3: Are Hydrogen Fueling Station Subsidies Necessary?
Part 4: Hydrogen-Powered Buildings
Part 5: Can the Government Pick Technology Winners? Can Anyone?

The Science of Hydrogen Fuel Cells

info@reason.org (Lynne Kiesling) — Mon, 24 Mar 2003 00:00:00 EST

In the State of the Union Address in January, President Bush promised an additional $1.2 billion in subsidies for hydrogen fuel cell research. Since then the number has increased to $1.7 billion, and President Bush has agreed with European Union leaders to work jointly on a five-year effort to bring hydrogen fuel cells, particularly for vehicles, closer to commercial reality.

Would that be money well spent? Or would federal hydrogen research subsidies be a waste of taxpayer money? The answers to those questions depend on several variables, almost all of which are beyond the control of the federal government. Because of the risks associated with such research, both economic and political, federal research subsidy efforts should proceed with caution.

And public opinion on these questions should be grounded in a firm understanding of the science of hydrogen fuel cells, and how they really work. Several recent articles have done a good job of summarizing the challenges in moving toward hydrogen as an energy source, including this Gregg Easterbrook article in The New Republic, and this International Energy Agency white paper entitled "Moving to a Hydrogen Economy: Dreams and Realities." These analyses highlight some important aspects of hydrogen, and of fuel cell technology, to bear in mind.

1. Pure hydrogen does not exist on Earth. Given existing and foreseeable technology, as well as the fact that pure hydrogen does not exist in isolation on Earth, hydrogen on Earth is an energy medium, not an energy source. Because hydrogen on Earth occurs in molecules that also contain either carbon or oxygen, isolating pure hydrogen involves "reforming" existing hydrocarbon molecules.

2. Isolating hydrogen still requires fossil fuels as inputs. Reformation of hydrogen still means using hydrocarbons such as natural gas as a source of hydrogen, because the primary potential sources of hydrogen on Earth are hydrocarbons and water. Both hydrocarbons and water are in scarce supply. Furthermore, this use of hydrocarbons to isolate hydrogen offsets some of the optimistic predictions about the emissions reductions we could expect from using hydrogen fuel cells.

3. Converting either water or hydrocarbons to hydrogen requires the expenditure of energy. Breaking hydrogen free from hydrocarbon molecules requires an expenditure of energy. Furthermore, depending on the process used, the reaction could actually use more energy than the electrolysis process itself actually produces. In other words, to figure out how much energy has actually been created, we have to subtract out the energy expended in getting to the point where we can separate out the hydrogens in the first place.

The most developed form of hydrogen isolation through electrolysis requires electricity to separate the hydrogens from the carbons in the hydrocarbon molecule, and within that reaction the net energy produced is positive. However, the electrolysis reaction also uses a catalyst to increase the energy release in the process. The catalyst typically used in hydrogen electrolysis is platinum. Mining and processing platinum is incredibly energy intensive, using fossil fuels such as coal to drive machinery that makes platinum available for the electrolysis.

Given the existing electrolysis technologies and platinum mining technologies, the platinum catalyst has to continue to work in the fuel cell without being damaged for almost three decades to get positive energy payback from the fuel cell. Put another way, it takes almost thirty years for the energy production of the fuel cell to equal the amount of energy that went into manufacturing the fuel cell and making the fuel available to it for the electrolysis reaction. So in energy terms, to pay for the fuel cell and start getting a net benefit from it, it has to run for at least three decades.

Furthermore, platinum is a very expensive metal, and its expense lengthens the financial payback period of the fuel cell as well as the energy payback period. Research on other catalysts is crucial for making fuel cells commercially viable, and private companies are actively engaged in undertaking such research.

4. Hydrogen is less intense than fossil fuels. For a given input, hydrogen production and fuel cell technologies generate less energy output (measured in BTUs) than traditional hydrocarbons. Recent estimates by the International Energy Agency suggest that replacing all of the transportation fuel currently used in France with hydrogen would require generating four times the electricity, which would in turn require either covering 6% of France's surface with wind turbines, or 1% of it with photovoltaic solar panels.

Thus replacing fossil fuel systems with hydrogen fuel cell systems will mean an increase in the space required for the production, transport, and use of hydrogen relative to an equivalent amount of potential energy from hydrocarbons. This fact mirrors the energy intensity issue with solar power, in which to generate a given amount of energy, a system of photovoltaic panels would have to cover a much, much larger surface area than generating the same amount of energy using hydrocarbons. Again, though, note that private companies are actively engaged in and investing in research to make hydrogen production, transportation and storage more compact.

5. Handling hydrogen can be dangerous. Remember the Hindenberg. Pure hydrogen is unstable and oxidizes easily, which makes it extremely combustible. Thus long-distance transport of hydrogen, say, to fill hydrogen fueling stations, is potentially dangerous.

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

This is part 1 of Reason's 5-part Let the Hydrogen Economy Evolve series:

Part 1: The Science of Hydrogen Fuel Cells
Part 2: The Economics of Hydrogen: Innovation in Mature and New Technologies
Part 3: Are Hydrogen Fueling Station Subsidies Necessary?
Part 4: Hydrogen-Powered Buildings
Part 5: Can the Government Pick Technology Winners? Can Anyone?

Fuel-cell Powered PDAs? They're Coming

info@reason.org (Lynne Kiesling) — Mon, 17 Mar 2003 00:00:00 EST

This week is National Energy Education Week, and I would like to celebrate by highlighting some fascinating, and potentially incredibly useful, research being done on ways to use hydrogen fuel cells for mobile electronic devices. Electronics companies including Toshiba, Intel, Motorola, and 3M have been investing in research to replace batteries with fuel cells, and some of them are actually nearing commercialization.

Why power electronic devices like cellphones, laptops, PDAs, and video cameras with hydrogen fuel cells? Traditional lithium ion batteries are becoming increasingly exasperating; they are heavy, you have to power down to change batteries in most cases, and as the energy intensity of our electronic demands increases, batteries just don't last long enough to provide practical power. Batteries have not innovated at the same rate as microprocessors, memory, and other electronic technologies, which means that they have not become more productive and have not gotten smaller and smaller.

Research into small fuel cells, called microcells, indicates that they could do what batteries have not. Toshiba is a pioneer in this research, and they released a microcell prototype at a trade show in Germany last week. The prototype currently uses methanol as the source of the hydrogen, and can power a laptop for five hours with one cartridge of fuel. The cell is practical for refreshing on the fly — as the cartridge drains, the user can insert another cartridge without turning off the computer. It is still larger than comparable lithium ion batteries, but Toshiba foresees the cells getting smaller through ongoing research over the next year. Toshiba plans to release the microcells for commercial sale by next year.

An article in Sunday's New York Times delves into these research efforts, noting in particular the role of consumer preferences in shaping this research initiative:

But the biggest reason the smaller cells are expected to become popular sooner is their appeal as a convenience — something that consumers have shown a willingness to pay for — and not as an answer to energy and environmental problems.

Fuel cells that last far longer than do rechargeable batteries would free laptop computer users and television camera crews, for example, from the need to lug heavy and expensive backup battery packs.

The article also contains some good background information on issues with hydrogen fuel cells, as does an article from early March in Wireless News Factor.

The use of methanol instead of some other hydrocarbon to generate the hydrogen also contributes to the practicality of the cells, because methanol can be stored and transported at very high concentration, which means a lot of power in a little space relative to ethanol or pure hydrogen. This feature contributes to what researchers hope will be another manifestation of Moore's Law — that microcells will double in power and halve in size over the next 18 months.

Lots of companies are working hard to make that happen. Large electronic firms like Toshiba, Intel, Motorola, Samsung, and Sony are all working on fuel cells for mobile electronics. But the real innovators are smaller outfits that have traditionally done more scientific instrument research, such as Manhattan Scientific. This pattern of research has created substantial value, and many new and unforeseen products, in mobile electronics. Historically, this pattern has shown up in everything from mass-market ceramics to steel. In this pattern many people work independently toward a shared goal, but want two very important things: to get there first and be the one that becomes the established standard. Thus their profit motive (where profit can include not just financial remuneration, but also status and the satisfaction of being the one who solved it first, or best) creates new and unforeseen products and opportunities to do things that we never imagined before.

Some people characterize this pattern as wasteful, with all of that replication of research effort. I strongly disagree. If you try to channel these efforts and guide research with an objective of minimizing duplication, you are very likely to fail, because the duplication is never perfect — even if several people are working toward the same goal, such as smaller methanol fuel cells, the variations in their procedures, their materials, their ways of approaching the problem, and just sheer luck will all lead them down different paths. It's that human variation that maximizes the potential benefit from research. All of that seeming duplication also does something incredibly valuable: it maximizes the probability that the researchers will find dead ends and eliminate them from further exploration at that time, in that application.

The combination of a perceived benefit from providing consumers with an alternative to batteries and the striving drive of human creativity to solve these technological problems are combining to create this new opportunity. Plus it doesn't hurt that fuel cells can be a cleaner fuel source than batteries, depending on the fuel you use and how you produce the chemical reaction in the fuel cell. And don't forget that microcell research could inform the research on hydrogen fuel cell vehicles, and make them cheaper, more energy efficient, and therefore more potentially commercial.

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.

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.