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Electricity Policy Prime Time: Part II–Analytical, Process & Supply Issues

In an earlier post, I asked readers to consider four thought experiments regarding the reprioritization of our public-policy work on energy. Here is my response to your much-appreciated comments and a proposed path forward.

Thought Experiment 1. Let’s demote oil and climate change to secondary status as analytical issues.

To my surprise, no one seemed to disagree with my proposal. Yet popular media coverage of these issues is probably 90+%.

Thought Experiment 2. Let’s elevate the dialogue about fundamental electric industry reform to primary status.

Again to my surprise, no one seemed to disagree with my proposal, which leads me to wonder why this issue does not get the attention it deserves. My best guess is you cannot boil the solution down to a three word sound bite (Drill Baby Drill! or Climate’s Always Changing!). Maybe it will take a major catastrophe to get our attention à la India.

I make many analogies to other major, successful industry restructurings from statist to market models: airlines, railroads, natural gas, telecommunications, and trucking. I don’t remember that they were either reduced to a three-word slogan or needed a catastrophe to get D.C. moving.

Why is electricity different? Is it possible that we free market fetishists have not put forth a coherent model?

Thought Experiment 3. Let’s debate what is wrong with current electric industry policy.

This will be the subject of this post, more later.

Thought Experiment 4. Let’s identify the set of policies needed to permit the electric industry to enter the 21st Century.

This will be the subject of future posts after we have carefully defined the problem.

A Process Suggestion

Although not widely known, at the outset of the natural gas restructuring, the intellectual leader (Charles Teclaw, Director of the Policy Office) imposed a simple test on the ten or so analysts that had been gathered to “solve” the problem. (Full disclosure: I was a market advocate at FERC when the blueprint was developed and at DOE when much of the blueprint was implemented.) I have come to call it the Tabula Rasa Approach, in contradistinction to the Compounded Regulation Approach, described below.

Tabula Rasa Approach: This approach starts with the simple constraint of using only economics and the physics of natural gas (and being informed by the historical failures of policy) to determine what policies would we adopt if we were writing on a tabula rasa, starting completely from scratch?

Questions of legality, political feasibility, harm to incumbents, history, impact on existing institutions, ruined careers, etc. were explicitly ignored. (Indeed, if one made a recommendation that could be shown to rely on these prohibited lines of analysis, they were literally asked to leave the group.) One could rely only on economics and physics in making recommendations.

Once the policy maker developed an understanding of the Tabula Rasa Solution, then and only then can one make judgments/compromises as to legality (laws can change), political feasibility (political calculus can change), existing institutions (institutions can innovate, creatively destruct, or be newly created in response to changes in incentive structure), always with the goal of doing the least damage to the Tabula Rasa Solution.

Compounded Regulation Approach: This approach, on the other hand, was the approach that is overwhelmingly used in public policy reform. Assume the history, institutions, political impact, and existing laws and make an incremental change that fixes today’s problem even if it was caused by yesterday’s compounded regulation and will cause more compounded problems in the future. Thus, my process suggestion is to adopt the Tabula Rasa Approach to the exercise of envisioning a 21st Century Electric Industry first, and then make compromises to the “perfect” later on.

Why is this a wise approach? An interesting example of kismet is that we began the Tabula Rasa Analysis of natural gas at FERC in November 1984. Our “Foundation Paper” (as it was internally called) was perceived as hopelessly naïve when circulated internally circa March of 1985. All the typical roadblocks were thrown up against its vision.

Then on April 21, 1985, the DC Circuit handed down the Maryland Peoples Counsel case which declared several previous compounded regulation fixes to be illegal (DC Case). FERC went into sphincter shock.

But nine days later (yes 9 as in nine–days as in not weeks), FERC issued a two hundred page proposal, RM 85-1, not a word of which was written prior to April 21. This proposal, based heavily on the Foundation Paper, was possibly the most proposed radical restructuring of an industry in regulatory history. Right place, right time, right answer!

With 25 or so years of hindsight, the natural gas reforms were spectacularly successful. Today, we are blessed with abundant supply of a clean burning fuel at very reasonable prices. Where would we be today without the natural gas option?

With the November election looming large as a “vision” election, I don’t assume anything is politically impossible if the fundamental economics and physics are right.

Fundamental Electric Industry Reform—Statement of the Problem—Supply

Analytically tackling the electric industry all at once would be like trying to eat an elephant in one bite. Let’s break down the discussion into bite size pieces. I propose that we first concentrate on defining the problem in 4 bites: supply (this post), transmission, distribution, consumption. After we have come to some agreement on the problems in these four areas (or more if that is necessary) then we can concentrate on the 4ththought experiment—Tabula Rasa Solutions.

My List of Supply/Production/Generation problems:

1. Fifty-one different state government organizations are required to give permission both as to need and siting to build new supply on the mistaken assumption that there is a natural monopoly in generation;

2. Federal government permission is required to build a nuclear power plant, leading to paralysis for fear of an accident;

3. The federal government made itself responsible for disposal of nuclear waste and thus politics plays a significant role in effectuation;

4. Many states mandate renewables by some percent by some year (renewable portfolio standards) (ironically, natural gas was once outlawed from uses in generation and boiler fuels by the Fuel Use Act; government’s crystal ball on mandates relating to generation is a bit cloudy);

5. Government imposes inefficient environmental policies to deal with otherwise legitimate environmental externalities (EPA standards have created a veritable war on coal);

6. Government provides a myriad of subsidies for different generation fuels that terribly distorts any attempt to achieve economically efficient outcomes for supply (samples: Price Anderson limits a utility’s damages in the event of a nuclear accident and requires the taxpayer to absorb anything above that limit; nuclear has a cents per kwh subsidy for any plants constructed by a date certain; wind and solar subsidies; clean coal research and development, bias against thorium for national security reasons);

7. Costs for much generation is put into “rate base” using regulated utility accounting standards and is amortized based on non-market criteria making level playing field competition impossible;

8. Many states have barriers to self-generation and impediments to reselling self-generated power;

9. Governments own a lot of generation (municipalities and federal power marketing authorities like TVA);

10. Nine states in the Regional Greenhouse Gas Initiative (RGGI) and California have adopted meaningless cap and trade requirements for generation.

That seems like a good start. Does anyone disagree that these all lead to inefficient outcomes? Are there more that should be added to the list?

Quick Responses to Comments on Part I

rbradley { 08.09.12 at 8:13 am }

“Exit contracts” are a Compounded Regulation Solution. I suggest that we first define the “whole problem.”

Tom Tanton { 08.09.12 at 8:19 am }

“Consumer Choice” is a Compounded Regulation Solution. There are lots of moving pieces to “choice.” How does choice fit into a Tabula Rasa Solution?

Ed Reid { 08.09.12 at 8:46 am }

Unfortunately, much of the audience we must convince is too young to get the reference to Casa Blanca. But great laugh for those that did.

Eddie Devere { 08.09.12 at 10:00 am }

Many argued that the natural gas reforms were not legal, i.e. not in the “public interest” or not “just and reasonable.” Admittedly, there was some two steps forward one step back on the legal front but ultimately we were successful in implementing major reforms. I adopt the axiom that law will eventually out to good policy. Remember we have a “vision” election coming up. Anything is possible.

Jon Boone { 08.09.12 at 10:46 am }

I disagree that the “fundamental” problem is lack of consumer choice. There are many much more fundamental problems with the electric industry than lack of choice. Many states do not give their consumers choice but nonetheless have low rates and reliable delivery. Choice may only be a safety valve to circumvent other policy errors. Choice/competition will no doubt be part of the Tabula Rasa Solution, but it is an overstatement to focus on choice alone.

Kent Hawkins { 08.09.12 at 10:50 am }

“Electricity is so imbedded in everything that we do that I do not recommend we think in terms of radical or revolutionary changes at the policy level, but well-thought out evolutionary approaches.”

Sorry, but I disagree. If we “know” what to do, then do it if we have the opportunity. Rip off the bandage and let everyone make efficient adjustments to the new regime. Incremental changes merely create new rent seekers, making “evolving” policy much more difficult. We may never have such a chance again.

Al Fin { 08.09.12 at 1:04 pm }

Maybe we were lucky that health care precluded a full scale green assault. But as we learned with Natural Gas Policy Act of 1978, sometimes bad policy can create conditions that allow for good policy (in that sense Rahm Emanuel is not completely wrong about not letting a “serious crisis to go to waste.”)

Kermit { 08.09.12 at 5:00 pm }

I won’t disagree that many worthy oil and natural gas projects are not undertaken. It’s just a question of priorities. Should I get a face lift or lose 100 pounds? Nothing wrong with face lifts but losing weight is probably a higher priority if you are 100 pounds overweight.

Donald Hertzmark { 08.09.12 at 5:43 pm }

I agree that we have moved in the right direction to some extent. But to reuse my metaphor, don’t declare victory after losing 10 pounds if you need to lose 100. Can we not conceive of better solutions than RTOs, i.e. where is there any analog to dispersed ownership being divorced from operational control that is an effective model?

tfisher { 08.09.12 at 5:57 pm }

Here is your “future post.”

Jim Clarkson { 08.10.12 at 7:41 am }

Jim’s Comment is so good that I will repeat it:

THE UTILITY’S 23RD PSALM

Regulation is my shepherd I shall not want.

Thy maketh me to lie about green programs;

Thy mis-leadeth the stilled public opinion.

Thy restoreth my territorial protections;

Thy leadeth me down paths of monopoly for thy name’s sake.

Yea, though I walk through the valley of the shadow of nuclear debt, I fear no evil cost over-runs: for thou art with me;

Thy guaranteed pass-thrus and thy cover-ups they comfort me.

Thou approveth sweetheart affiliate deals before me in the presence of my potential competitors;

Thou anoinest my balance sheet with inflated assets;

My earnings runneth over.

Surely excess profits and cronyism shall follow me all the days of my life and I shall dwell in the house of regulation forever.”

Blasphemous but unfortunately all too true.

Robert Hargraves { 08.10.12 at 9:26 am }

Great comment. I agree with much of it but I tend to agree with Jon Boone’s response. I am usually most in favor of the “objectivity” of market outcomes rather than placing decisions in the hands of people with mixed motives. Please continue to remake many of these points as they become relevant to the exercise.

Jon Boone { 08.10.12 at 4:37 pm }

Tend to agree with you on your response to Hargraves. Thanks.

8 comments

1 Donald Hertzmark { 08.22.12 at 8:25 am }

Ken,
The clean sheet approach is a good one, perhaps more important for network (transmission and distribution) than for generation. It is easier to see what the obstacles and problems are in generation and many of the potential solutions are relatively straightforward, as implied in your current post.

The network issues are more complex, I think, given the heavy regulation of network investments, operations, and finances–and the difficulty in achieving any unique and efficient analytical solution to network charging. I say this as someone who has written transmission tariffs for several countries.

To the extent that transmission networks are both complements and substitutes for generation this area should not continue to be the poor stepchild of any proposed solution. Also the misuse of transmission and malinvestment in same in proposed “green energy” generation schemes provides a good point of entry into the clean sheet discussion.

My point about RTOs is that some of them have made great advances in bringing more market forces to generation as well as network resource allocation. Our solutions should not be bound by strict adherence to current regulatory boundaries since the state is not perhaps the ideal unit for assessing outcomes.

In the end gas industry restructuring accomplished a great deal by bringing market forces to bear where possible and limiting the destructive impulses of regulated monopolies and their overseers/bedmates.

2 Ken Malloy { 08.22.12 at 9:36 am }

Don
I completely agree that when all is said and done that the transmission piece will be the hardest and most critical. But maybe prematurely I ask you to conceive of a more radical solution that RTOs. Is there any network industry analog for separating ownership from operation? Why do we think we have to do so? I believe it is based on trying to make existing institutional arrangements work rather than starting from a Tabula Rasa Approach. If we were hypothesizing an optimal transmission system, it would be one or a few owners who did nothing but operate transmission under the guidance of FERC. I assume transmission to be a natural monopoly. But I assume the current fractured, dispersed ownership is dysfunction and prevents FERC from regulating efficiently.

3 Kent Hawkins { 08.22.12 at 5:30 pm }

I don’t see how revolutionary approaches at the policy and policy implementation levels avoid rent seekers. I would argue that certainly is what we have now in very large measure.

Here is a simple example to illustrate the difference between the electricity system and the airlines. Consider how long the airplanes were grounded after 9/11. It was two days. What was the effect? Considerable inconvenience. Now consider the effect of not having electricity throughout North America for the same period. For example, how many deaths might result? What would be the effect on government and law and order?

I am for a very realistic, and yes aggressive, fundamental assessment of general energy policy, and pre-judging the result, I suggest that it would lead to the recognition that we have to make what we have had in place for some time work better for the foreseeable future. This should clarify some of the detailed steps that must follow. That should be the focus for assessment of energy policy today.

Perhaps we are saying the same thing at some level, and some of the details are getting in the way.

4 Kent Hawkins { 08.22.12 at 5:32 pm }

Sorry here is my complete comment
Interesting rebuttal to my comment about avoiding radical change to our electricity systems. I still maintain that the complexity of the changes needed and the time that will take to make the right changes in the right way necessitate a more protracted approach. We have had enough of “ripping off the bandages” and the patient is now at risk of dying.

I don’t see how revolutionary approaches at the policy and policy implementation levels avoid rent seekers. I would argue that certainly is what we have now in very large measure.

Here is a simple example to illustrate the difference between the electricity system and the airlines. Consider how long the airplanes were grounded after 9/11. It was two days. What was the effect? Considerable inconvenience. Now consider the effect of not having electricity throughout North America for the same period. For example, how many deaths might result? What would be the effect on government and law and order?

I am for a very realistic, and yes aggressive, fundamental assessment of general energy policy, and pre-judging the result, I suggest that it would lead to the recognition that we have to make what we have had in place for some time work better for the foreseeable future. This should clarify some of the detailed steps that must follow. That should be the focus for assessment of energy policy today.

Perhaps we are saying the same thing at some level, and some of the details are getting in the way.

5 Jon Boone { 08.22.12 at 6:03 pm }

Ken:
Agree with your comments about transmission and the desideratum to go beyond RTOs in the back to square one scenario.

You misstated my comment about consumer choice in your first post on this issue. I had said that the lack of consumer choice was A fundamental problem–not THE fundamental problem. Here I was agreeing with Tom Tanton, who has seen the scope of issues you raise from both a close up and wide-angle view.

I tend to agree there are more overarching matters to address just now, particularly if this is really propitious time to implement positive change. Still, as a practical matter, it rankles daily that I must deal with a “regulated” utility monopoly, with no real choice and in full knowledge that state regulators and politicians are playing sleight of hand footsie with the utility, all the while sanctimoniously pretending to care for the consumer. And there’s little I can do about it except be a gadfly around their honeypot. There’s much better uses of my time. And they well know it.

6 Bill Huber { 08.23.12 at 6:57 am }

I agree with Donald. I recently did a cost analysis of my home electric bill and found distribution costs increased by 20% over last year. So although my generation cost went down, the overall bill was 10% higher for the same kilowatts-hours compared to last year. It is interesting that the focus of the public in my state, Ohio, is on generation when distribution costs are driving the electric bills up.

7 Ed Reid { 08.23.12 at 10:08 am }

Bill Huber 6

I assume that you’re are using the utility “energy charge” as a surrogate for “generation cost” and the “monthly service charge” as a surrogate for “distribution costs”. If so, I would offer a word of caution. The PUCO has typically permitted only a fraction of utility fixed costs (~25%) to be collected through the monthly service charge, the “fixed” portion of the utility bill. The remainder of fixed cost must then be collected through the energy charge, or variable portion of the utility bill. This is the primary reason that utilities “over earn” their allowable rates of return in years of strong economic activity and in years of hotter and/or colder than normal weather; and, “under earn” in soft economies or mild weather years.

It is possible that PUCO has begun to increase the fraction of fixed costs recovered through the monthly service charge, perhaps in response to longstanding complaints from merchant generators regarding the impact of fixed cost allocations to the prices they charge for their power. I believe this is an essential step in the direction of competitive markets and clear communication to customers.

8 Bill Huber { 08.26.12 at 8:03 am }

Ed
In Ohio our electric bill pays two vendors, the company that delivers the electricity and a company that generates it. Naturally the bill is broken into two parts, total delivery charges and supplier energy charges. Like most electricity consumers in Ohio I have one choice for who delivers the power but I have several choices of who generates it. The total delivery charges includes a small $5.50, fixed fee. If we assume that the power company has successfully split their assets and costs into delivery and generation classes for rate making purposes then I am left with the question of why did the delivery charges go up so much? About two years ago I started putting my electric bills into a spreadsheet so I could see the effect of the additional insulation I installed. I must admit that I am a little disappointed that my efforts at energy conservation and picking a low cost energy supplier have been overwhelmed by cost increases in delivery charges.

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