A Few More Unfriendly Comments on Electric Deregulation
- Dec 23, 2005 7:00 pm GMT
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We are now able to study and teach economics from a number of brilliant textbooks. One of these is Microeconomics and Behavior (6th edition) by Robert H. Frank. Early in his book, Professor Frank alludes to the lure that irrationality has for Mr and Ms Consumer, while later he points out that governments in virtually every part of the world intervene in the price and output decisions of important natural monopolies like electric utilities. The problem is that he questions whether on purely economic grounds these interventions do more good than harm, implying that this is a matter that will have to be settled in the future. The position of this short discourse is that where electricity is concerned, it is already settled. It is impossible these days to avoid being told by friendly bystanders that economics is a non-experimental science, but in truth important experiments are taking place all the time. For example, the fully regulated and fully integrated Southern Company (with headquarters in Atlanta, Georgia) sells electricity at a much lower price and higher reliability than the major electric companies of Texas a state that, only a few years ago, was often referred to as a role model of deregulation.
Let me put this the way that I enjoy putting it in the lectures that I have given on the present subject: electric deregulation has failed, is failing, or probably will fail in the near future in California, Pennsylvania, Texas and Illinois in the United States; Alberta and Ontario in Canada; Brazil, South Australia, Sweden, Norway, New Zealand, and the United Kingdom. There are almost certainly many more candidates for this negative role of honor, but further inquiry into the deregulation tribulations of those given above should be sufficient for impartial observers to determine which way the wind is blowing. Before moving on I would like to note that in my former home state, Illinois, consumers can look forward to an increase in electricity prices of at least 30 percent in 2007, due to agreements of some weird sort that were entered into when deregulation was launched.
What do I mean by failure? Undoubtedly the most important reason for the initial popularity of deregulation was the promise by various enthusiasts and their paid or unpaid propagandists of lower prices and higher or unchanged reliability, both of which would be served up against a background of increased choice for households and businesses. In addition to these delights, the expression higher efficiency was used by the head of the European Unions Energy Directorate at a conference in Brussels recently, however given his obvious inability to distinguish between fact and falsehood, I sincerely doubt if that gentleman had any real insight into the formal meaning of the expression. In any case, the reality for the countries mentioned above is not lower prices but lower reliabilities. For the most part prices are higher, and expectations are that they will continue to increase. As for increased choice, we have that in Sweden, but what difference does it make when it is impossible to avoid an increase in electricity prices that is considerably more than twice the consumer-price inflation rate.
When the crank idea of deregulation was first broached in Sweden, one of the local poster boys praised it to the high heavens because, on the basis of the low-rent economics in which he and his colleagues specialize, it was pictured as ameliorating any electricity shortages that might appear in the future. On the surface this might have appeared to be a sensible proposition, but it so happened that Sweden produced the lowest cost electricity on the face of the earth, even though it possessed one of the highest reserve margins and had perhaps the highest reliability. In addition, this electricity was sold to the industrial sector at the lowest price in Europe, or perhaps in the world. Exactly how this situation would be improved by installing cables between Sweden and Germany where the electricity price was the highest in Europe somehow failed to register with this humble teacher, although apparently it held some attraction for those drowsy colleagues at Swedish universities who had come to the absurd conclusion that there was absolutely nothing for households, small businesses and energy intensive heavy industries to lose if the remainder of Europe was provided with access to the Scandinavian electricity market.
There were of course a few winners in this travesty. As predicted by many journalists, these were the large generating companies and, especially, the Swedish government, which obtained many additional billions of Swedish crowns (i.e. kronor) to squander on the nonsense so dear to Swedish hearts.
VOTE EARLY AND VOTE OFTEN
In theory, though perhaps not in fact, there may be a modicum of good news on the deregulation horizon. The present French government once announced that it intends to privatise 50% of Electricité de France (EdF), but even though they said that they would invest 40 billion Euros in capacity expansion, and would also restrain the rise in electricity prices, the reaction from many of the unions in France was so threatening that a change in plans became necessary, and at present the intention is 15%.
I prefer zero percent, and although not certain, this may be possible if Laurent Fabius takes command in that country after the next election, because he has promised that if given the opportunity he will deprivatise EdF. Some experts do not believe that this option is open. For instance, when the good professor Shmuel Oren (of the University of California) visited Sweden in 2004, he stated that although deregulation in this country was far from perfect, it could not be rescinded.
This happens to be the opposite of the truth, although I doubt whether Dr Oren could get more top-shelf names on his dance card if in his travels he advertised an opinion of this nature. However, if the curse of deregulation can be liquidated in France, it might provide an incentive for the same thing to take place elsewhere. This is why I would like to give colleagues in France the kind of advice that was passed out by the reigning political machine in the Chicago of my youth, but which was actually coined by the criminal mastermind Murray (the camel) Humphries: vote early and (if possible) vote often. This may sound anti-democratic, but please note very carefully that in e.g. the United States, there has not been a (ballot) referendum on deregulation in any state, nor will there be one in any state, city, county, precinct, or hood in any part of that country where voters prefer more money to less.
On another level, I would like to stress that by quashing electric deregulation, Monsieur Fabius would be placing himself in the same moral category as General Dwight D. Eisenhower, commander of allied forces in Western Europe during WW2, and later a two-term president of the United States who, although one of the most conservative presidents in the latter half of the century, refused to endorse the deregulation of natural gas because of the negative effect it would have on low and middle income families. (This does not mean, I might add, that according to the economics I teach, the regulation of natural gas at that time made a lot of sense.)
Gas deregulation is also on the EU agenda for Europe. I will not take it up here, but in many respects it is even higher on the crazy list than electricity, because what it will mean is a deregulated Europe on the buy side of the gas market having to deal with external suppliers that are monopolies or strong oligopolies. This could be a very unpleasant experience for the former, even if it might turn out to be trivial in comparison to the mental or financial discomfort that some of us are presently subject to because of things like the ignorant closing of two highly efficient Swedish reactors.
THE BASIC ACADEMIC ECONOMICS ARGUMENTS
Suppose that I was a reputable academic member of the deregulation booster club, and in order to keep the consulting fees, research grants and travel money coming my way, I was given the opportunity to clarify for the television audience why electricity deregulation was even more beautiful than loves young dream compressed to a video clip. I would start by dramatically insisting that every economics textbook in the world spells out in detail the advantages of a wider and more thorough competition (or what on the electricity scene has come to be called liberalisation). What I would not say is that this story-line appears in the first part of these books, while in later chapters which neither students nor their teachers usually bother to read we often find a detailed explanation of why it doesnt work in the case of industries like electricity and gas. In non-technical but unambiguous language, this reduces to the following.
1) The inability to establish the kind of (theoretically) ideal competitive arrangements found in the first part of your favourite textbook. This is due, for the most part, to increasing returns to scale (i.e. decreasing unit costs) up to a certain output. The way this potentially embarrassing topic was originally handled by deregulationists was simply to state that economic (as opposed to technical) increasing returns to scale do not exist. How did they get this brilliant result? The answer is that they assumed that there would be a fall in the rate of growth in demand for electricity and gas, and so investments that were intended to take advantage of technical returns to scale would take so long to pay off that, in terms of discounted profits, they did not make economic sense! This was perhaps the most looney-tune reasoning of all.
2) Lack of investment in new capacity. As it unfortunately happens, deregulation has provided firms with an increased opportunity to engage in strategic behaviour (as its called in game theory), or gaming the system, as it is often labelled in common parlance. Accordingly, they utilize the well known fact that the less the capacity, the higher the price, and depending upon costs, the greater the profits and bonuses. This is why, in Sweden, the major power firms have been so reluctant to shout bloody murder at the government for their nuclear retreat. Moreover, the Swedish government is even more in favour of deregulation than the power companies, because deregulation in Sweden is configured so that when prices for electricity rise, so do government incomes. In addition, a government that is systematically reducing health care for everyone from children to pensioners, as well as eliminating a range of other welfare amenities, is hardly inclined to be overly attentive to the price of electricity, particularly when one of their partners the environmental party feels that this price is too low.
3) As pointed out at one time by many deregulationists, and correctly, for deregulation to be successful, adequate facilities must be available for hedging (i.e. insuring against) the price risk that accompanies deregulation. Despite what these fine people believed, and perhaps still believe, these facilities are not available, and they are unlikely to appear. This dilemma is constantly referred to in the business press.
4) Because of its importance, allow me to stress that electricity price risk/uncertainty cannot be hedged on conventional derivatives (e.g. futures and options) markets of the kind that function excellently for various commodities and financial assets. As we found out in California and especially New South Wales (Australia) the electricity market is radically different. In fact, there is a simple way to approach this difference. Professor Lennart Berg teaches financial economics at Uppsala University, and he has about 100 finance books of all types in his room. Every new book that is published on this subject comes to him. I have examined at least half of these books and estimate that there are probably less than five pages on electricity and gas derivatives in all his books, or for that matter in any collections of finance books between Uppsala and the Capetown (South Africa) naval yard. Five pages out of thousands or tens of thousands of pages. What none of them bothers to point out is that the most important derivatives exchange in the world, NYMEX in New York, delisted its electricity contracts several years ago, along with at least one of its gas contracts. They may, of course, have reinstated these in one form or another, because the memories of many people who lost money in these markets are too short for their own good, and neither the persons who use or write about platforms of this type are prepared to admit that in theory it would be in the interest of almost every household and business on the buy side of the electricity market if Interpols fraud squads were reinforced and given carte blanche to investigate just why electricity deregulation, electricity derivatives, and the exchanges specializing in them came into existence, when these enterprises are provably detrimental to the interests of almost all consumers and small business, as well as energy intensive large industries.
About a month ago one of electricity deregulations poster boys kindly paid Uppsala University a visit in order to act as discussant on a monograph about electricity pricing. I wont bother going into details, however to my great annoyance I was left with only a few minutes to introduce that gentleman and his small audience to the realities of electricity deregulation, as compared to the bizarre fictions that he and his colleagues have energetically peddled during the last decade.
An hour after suffering through this tedious burlesque, I found myself staring at a full page Comment and Analysis in the Financial Times, with the title POWER STRUGGLE: BRITAINS BATTLE TO ADAPT ITS LIBERALISED ENERGY MARKET TO A NEW CLIMATE (October 6, 2005). Journalists are often smarter about this matter than charter members of the deregulation booster club, however they have their shortcomings too, and so a number of important issues that should have been investigated were overlooked. But there were two important observations. The first was that domestic electricity prices in the UK have increased by more than 30 percent since the start of 2004, while gas prices have increased 35 percent over the same period, with further increases on the way.
There was also a reference to the future use of gas by the UK, and somewhere in the exposition it was noted that the investment bank Goldman Sachs predicts a gas glut. This sounds to me like the kind of off-the-wall thinking that at one time took place in New Zealand, where oddball theories about the availability of natural gas led to electricity deregulation being painted in brighter colors than warranted by the facts. Although not certain, I suspect that any heavily industrialized country that becomes dependent on gas to the extent that was forecast for the UK in that article is asking for trouble. We hear a lot about the price of oil, but the present and anticipated price of gas is just as ominous.
When all is said and done, the most important question associated with the electricity deregulation farce is HOW DID IT HAPPEN?
A few years ago a behavioral economist gave a talk in the economics department at Uppsala University, at the end of which I took the liberty of informing him and everybody else present that as long as I was allowed in that building, behavioral economists would find it difficult to ply their trade. But its likely that I was wrong. The empirical side of their work still strikes me as a pretentious waste-of-time, but they may be correct in contending that a very large number of people are burdened with a hardwired lack of self-control that prevents them from making rational decisions in crucial matters. I woke up to this phenomenon during my last year in the army, although gradually I came to the conclusion that it was no more significant or widespread than carelessness. The kind of unthinking carelessness that often but not always leads intelligent and alert persons to behave irrationally, and to make or support crackpot decisions like electricity and gas deregulation that are completely out of step with the best interests of themselves and their families.
One final observation might be useful. Im mostly concerned with the fate of consumers like myself under the deregulation of electricity and gas, but in the middle of October the managing director of one of the largest firms in Sweden (SCA) said that his firm would not be making a planned very large investment because of the high price of electricity. Somewhat earlier, the directors of other large industries stated that they will form a syndicate in order to purchase electricity from countries in East Europe.
It thus seems that what deregulation is doing by raising electricity prices is to partially eliminate the comparative advantage that Sweden has enjoyed in some of its major export activities over the past 40 years, and which to a considerable extent accounts for the prosperity of the country. Im especially thinking of the industries for processing forestry products. If the present situation is not remedied, these firms will not only cease to invest, but eventually move everything movable out of the country, and Sweden will find itself having to deal with the kind of unemployment and social problems that were unthinkable just fifteen years ago. There was a time when Swedish politicians would have understood this, but that was before their judgements were corrupted by dreams of high-paying, non-jobs in some tax-free paradise far from the consequences of their handiwork.
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*Condensed version of talk given at a conference sponsored by the European Public Services Unions in Brussels, Belgium, November 3-4, 2005.