Arnold Kling  

Electricity Economics

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In the wake of the electricity blackout, I have been disappointed that economists have contributed more noise than signal in their comments. For example, Paul Krugman wrote,


Under the old regulatory system, power companies had strong incentives to ensure the integrity of power transmission — they would catch the flak if something went wrong. But those incentives went away with deregulation: because effective competition in transmission wasn't possible, the companies providing transmission still had to be regulated. But because regulation limited their profits, they had little financial incentive to invest in maintaining and upgrading the system. And because of deregulation elsewhere, responsibility was diffused: nobody had a strong stake in keeping the system reliable.

I have re-read this paragraph several times, and I still have no idea what Krugman is saying. Sometimes he uses his web site to clarify his thinking when his columns lack the space to explain his arguments. I hope he does so in this case.

(Brad DeLong points to a similar argument by Nathan Newman, but this also is too terse for me to grasp. When I followed the link to Newman's dissertation chapter, I found only more turgid prose, as well as some truly eccentric accusations about the Internet.)

The first post-blackout economic analysis that makes any sense to me is this piece by Vernon Smith and Lynne Kiesling.


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...

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.

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.

Smith and Kiesling are saying that incentives to prioritize energy usage could be used to prevent blackouts. For example, my electric company offers me lower rates in exchange for the ability to shut off my air conditioner for 15 minutes at a time when there is peak demand. I was not required to take this option, but I chose it. What Smith and Kiesling are saying is that these sorts of adaptations might prove to be less expensive than adding to capacity under a regime without any incentives to reduce peak-load demand.

Most of the other commentary on the blackout says that we need to throw tens of billions of dollars at new electricity infrastructure. However, the approach that Smith and Kiesling recommend seems to me to offer greater reliability sooner and with much less expense. It would have the additional benefits of conserving energy, reducing pollution, and improving homeland security.

For Discussion. How does "rate-of-return" regulation reduce the incentive of electricity suppliers to given consumers mechanisms to alter behavior to reduce peak demand?


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COMMENTS (18 to date)
Eric Krieg writes:

>>How does "rate-of-return" regulation reduce the incentive of electricity suppliers to given consumers mechanisms to alter behavior to reduce peak demand?

Rate of return regulation is also cost plus. The utility gets reimbursed for its costs plus a rate of return on those costs. So higher costs mean higher returns, which seems to me to be an incentive to meet peak demand, not seek ways to lower peak demand.

It also seems to go against the explanation that transmission line operators have no incentive to expand their system. Cost plus is the incentive.

Boonton writes:

I assume by utility we mean the owners of the 'last mile' of line who purchase energy from generators and sell it to consumers? If so then I think 'cost plus' would mean the cost of buying the energy plus a rate of return on capital.

In the old days this is how phone companies worked. They were viewed as a natural monopoly so the feeling was they had to be regulated. An economics professor of mine told me that the regulation was based on their capital investment. The more capital equipment the more profit they could earn. Hence you may remember that phones used to feel like they were made out of lead and they were technically property of the phone company that you had to return if they broke or if you moved.

If regulation of the 'last mile' is based on this model, I don't see why the companies wouldn't have an incentive to make capital investments in transmission capacity. In fact they should have an incentive to over invest a bit...which may not be a bad idea considering that the grid is pretty important to national security.

Why is the last mile regulated? Standard answer is that it is a natural monopoly. Just like the phone company, whoever owned that last mile of line could shut out competition by charging excessive use fees. This is how you are able to choose any long distance service you want even though you only have one phone line coming to your house.

Matt Young writes:

This is not a "last mile problem", a term invented to describe the congestion in data delivery to the home. The congestion occurs in regional delivery. The cost to upgrade regional transmission to meet peak demand raises the cost for average demand to unacceptable levels.

Communities, in their antipathy toward local generation seem to be asking for peak pricing signals, which can easily be accomplished with smart meters. The meters can be programed to limit usage at the household by connecting major appliances to shut off circuits during high peak rate price signals.

What we have today that we didn't have yesterday, is a greater seasonal and daily variation in household use. This is the problem.

Eric Krieg writes:

>>which can easily be accomplished with smart meters

No, not easily. Easier? Easier than what?

Seriously, upgrading every meter in America, adding some sort of communications infrastructure to network the meters, and upgrading the wiring in every home to allow the meters to shut off "major appliances" (why would I want to turn my AC off on a hot day, anyway?) is not easy.

If it were easy, the electric utilities would have already done it.

Adding a backup power system to your home would be easier. Then you would be unnafected by the rolling blackouts. They go for about 5 grand, and run off your natural gas connection.

Jim Glass writes:

>> I have re-read this paragraph several times, and I still have no idea what Krugman is saying.

Jim Glass writes:

"Rate of return regulation is also cost plus. The utility gets reimbursed for its costs plus a rate of return on those costs. So higher costs mean higher returns ..."

Not a higher *rate* of return.

"... which seems to me to be an incentive to meet peak demand..."

Not if the rate of return is set too low. E.g., say the rate of return on investment in power transmission facilities is set at 1%. The company can make more than that investing its capital in practically anything else, even in T-bills. So its incentive is to invest nothing at all, zero, in power transmission facilities.

Everybody, even Krugman, admits the rate of return allowed by the regulators on transmission facilities was too low. People have been saying that for years.

(How Krugman then decides that this clear, admitted regulatory failing is the result of deregulation is something for better psychologists than me to work out).

But regulators, being political appointees, feel a lot of political pressure to keep rates of return -- and thus rates paid by voting customers -- as low as possible. Underinvestment can be expected as a result, as can malinvestment on a larger scale when politically determined rates of return direct investment in an industry generally.

Matt Young writes:

Smart meters:

Telephone communications: $10
Phone wiring to the switch panel: $10
Cost per automated switch: $15

The total cost could be kept under $100 and be recovered in 6 months with a $20/month savings.

Automated switches would fit into existing slots, the com and control device would take up only on vailable switch slot.

Installation costs would run $200, or 2 hours.

Eric Krieg writes:

>>Installation costs would run $200, or 2 hours.

No way. Absolutely not. Look, go out and try and get your phone company to come out and hook up a DSL line. It's a fifteen minute operation, if that, and it will cost you $200.

The cost is in the labor, getting a service tech to come out and do the job, scheduling with the customer, etc. If the equipment costs $100, the labor might cost ten times that much.

Seriously, DSL is the go by here. DSL was a washed up technology until someone figured out how to make a user installed kit. When it required a technician to come to your home, the service was too expensive to be widespread.

Patrick R. Sullivan writes:

" Adding a backup power system to your home would be easier. Then you would be unnafected by the rolling blackouts. They go for about 5 grand, and run off your natural gas connection."

Where do you buy them?

Eric Krieg writes:

Before Y2K, they were selling these things at the Home Depot! That little non-event gave backup power systems a bad reputation.

But they work. Someone in my neighborhood has one, and the last power outage we had, he was the only one with the lights on and the AC cranked.

http://www.colemanpowermate.com/powerstation/residential.shtml

Boonton writes:

I don't see a contradiction between a regulated utility and use of 'smart meters'. In fact, like the old phone company, a properly regulated utility would have every incentive to buy these meters themselves and install them in homes. After all, every capital investment they make would qualify them for additional line charges.

If the problem is that electricity demand has become erratic then we are faced with a need to build over capacity into the system. The other choice is to simply force people not to use electricity by allowing dramatic price spikes. The problem is that electric energy has become one of those necessities of modern life...like a functioning water system, sewer, and so on. When demand spikes for electric power it is because people need it. Heat waves kill people, food spoils, and so on. Sure sure, use the smart meters to soften demand spikes during brief emergancies when 15 minutes with the air conditioner off will keep the lights on all day. But I do not see going from a stable priced, more or less reliable supply of electric energy to an erraticly priced, unreliable supply as a sign of improvement from the days before deregulation.

Jim Glass writes:

"I don't see a contradiction between a regulated utility and use of 'smart meters'. In fact, like the old phone company, a properly regulated utility would have every incentive to buy these meters themselves and install them in homes. "

How so? If the rate of return to the utility is regulated, then the meters make no difference to it. And it is the *rate* of return that matters.

(Unless by "properly regulated" you mean "regulated to mimic how a market would work", in which case it's a lot simpler to get that result by deregulating.)

"The other choice is to simply force people not to use electricity by allowing dramatic price spikes."

A price spike doesn't "force" anyone not to use electricity, it just provides an incentive to those who need it less at the moment to choose not to use it, while others who need it more continue to use it.

A rolling brownout *forces* people not to use electricty no matter how urgently they need it. As a measure to reduce consumption it seems decided inferior alternative to a price spike.

"When demand spikes for electric power it is because people need it. "

If the price for power is the same all the time, then people demand it when it just marginally most convenient for them. There's no reason why anyone has to run the washer and dryer at noon on a hot day while the air conditioner is running too -- but if the price is the same, then why not?

But there is ample data from utilities that do use variable pricing which show that consumption in fact responds significantly to price. When electrity costs the most at noon on a hot day, people run the air conditioner then but do the wash in the morning or evening. And business consumers show a much bigger repsonse.

Using a regulated averge price for something all the time whatever the circumstances is ridiculous. Nobody does that anyhwere else in the economy that functions reasonably. (Well, they do it in government health programs like Medicaid and Medicare, of course, and look at the mess they're heading into.)

Eric Krieg writes:

I plead ignorance on some of this smart meter debate. Exactly how do the meters let you know that the price per kWhr has changed? Or do you just assume that the price goes up on a hot day?

Boonton writes:

"How so? If the rate of return to the utility is regulated, then the meters make no difference to it. And it is the *rate* of return that matters."

If the amount the utility is permitted to charge for usage of its 'last mile' of line is based on its invested capital then the more capital the more revenue they can make. Again, look at the old regulated phone company which used to provide the heavy steel phones themselves (it was part of their capital after all).

"(Unless by "properly regulated" you mean "regulated to mimic how a market would work", in which case it's a lot simpler to get that result by deregulating.)"

We have plenty of models of how a monopoly would work in a market and that is *not* what anyone wants to mimic.


"A price spike doesn't "force" anyone not to use electricity, it just provides an incentive to those who need it less at the moment to choose not to use it, while others who need it more continue to use it."

"A rolling brownout *forces* people not to use electricty no matter how urgently they need it. As a measure to reduce consumption it seems decided inferior alternative to a price spike."

I don't disagree however it is ideal to have neither price spikes nor rolling brownouts. Electricity is a necessity and there should be enough excess capacity built into the system to accomodate periods of increased demand (i.e. during a heat wave).

"Using a regulated averge price for something all the time whatever the circumstances is ridiculous."

The only regulated part of this mix is the utility which is only providing the service of transporting the energy to your house. In many areas the generators are deregulated but this leaves open the question of how to ensure there is a sufficient amount of excess capacity in the market. It's been asserted that under conditions of exceptional demand a generator producing just 3% of the market's power could have monopoly pricing power. IMO we should consider if we really want to accept the market's allocation.

Jim Glass writes:

> How so? If the rate of return to the utility is regulated, then the meters make no difference to it. And it is the *rate* of return that matters.

Boonton writes:

1. A multi-state blackout may or may not have anything to do with regulation. Clearly having the grids connected is usually a good thing because it means that just because a local power plant goes down the community doesn't have to have a blackout. It can import power from the grid. Likewise surplus power can be sent to areas that have a shortage. Until we know more about what exactly caused this blackout, it may very well be that a negative feature of an interconnected grid may very well be that 'once very 30 years' a 'perfect storm' can bring the whole thing down for a while.

2. I agree that setting the rate of return too low will yield to underinvestment. So then just set the rate above the market rate, say twice whatever the 5 year treasury bill is.

Let's think about this, you have the 'last mile' which is just providing the line while the generator provides the power. It's a bit like an internet connection. The ISP provides a basic service while the user selects various information sources to view. Only in exceptional cases such as high bandwidth use (say for doing web site hosting) will the user have to make unusual arrangements with their ISP.

If the 'last mile' ESP can only charge you for maintaining an electric line to your house then we would want a little bit of overinvestment in that area. If the actual electric generation is deregulated then it would make sense for the customer to consider a 'smart meter' or even a full fledged computer hookup that could scan generator prices in real time and perhaps switch to maximize utility.

Another element of regulation could be to not encode any legal monopoly on the lines. 'Last mile' really means many miles from home to power plant. If a competitor felt it could undertake the cost to build an alternate grid then it should be allowed to do so.

John Thacker writes:

Eric, even a crude method of smart metering would be effective. Consider phone prices, where it's more expensive to place a phone call during business hours, and cheaper on nights and weekends. Power companies already have good estimates of when power is used, and could use this to create a fairly simple price structure.

It wouldn't be perfect, but it would lead to a shift in power usage. If power is used more evenly throughout the day, there are huge environmental and efficiency benefits, as well as a lesser need for capacity.

Eric Krieg writes:

>>Consider phone prices, where it's more expensive to place a phone call during business hours, and cheaper on nights and weekends.

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