Still Another Unfriendly Inaugural Lecture on Electric DeregulationFerdinand E. Banks
University of Uppsala, Sweden, and Asian Institute of Technology (Bangkok)
October 26, 2007
"At the mercy of forces that show no mercy" -Former governor Gray Davis of California (about deregulation)
This lecture is the lecture that I would really and truly like to present at either the Stockholm School of Economics, or at the research organization called Centre for Business and Policy Studies (SNS), which is also located in the Swedish capital. The reason is that several years ago the president of the Stockholm School, Lars Bergmann, published an article with the provocative title 'Why has the Nordic Electricity Market Worked so Well' (2005) - although in reality almost every newspaper in this country has expressed on its front or editorial page the opposite point of view. As for the SNS, this is the latest establishment to organize a crank conclave designed to sing the praises of a failed electric experiment, apparently hoping that the television audience has forgotten the time when Sweden not only produced the lowest cost electricity in the world (which it may still do), but also sold that electricity at a reasonable price. Needless to say, I have not ordered a new suit and new shoes, or new underwear in anticipation of being summoned to wonderful Stockholm in the near or distant future. I can also note that the curse of electric deregulation as experienced in Norway was referred to in an article in Time Magazine by Wallace (2003).
About eleven years ago I published my first article on electric deregulation (1996), claiming at some length that this option was largely a preposterous attempt to rescind the laws of mainstream economics. Since then I have put at least a dozen more papers on this topic into circulation, and given even more lectures. These lectures included - just prior to the Enron scandal and California meltdown - a number of sessions in Hong Kong in which I had the opportunity to assure listeners in unambiguous language that failure was a certainty for the California branch of the deregulation swindle.
I did not, however, predict the magnitude of the failure that actually took place. The normal generating (or 'wholesale') price of power in that state averaged about 50 dollars per megawatt hour (= $50/MWh) in l999, but several years later often touched $500/MWh, and occasionally spiked to $1000/MWh. 'Gaming' (or strategic behaviour that usually features illegally manipulating supply), together with the shortage of local generating capacity, and the absence of rain for hydroelectric installations explain much of this bad news, however it should never be forgotten that while deregulation foolishness prohibited the large California utilities (i.e. 'distributors' or 'retailers') from signing long term contracts when they encountered these outrageous prices, they were not allowed to pass them to e.g. households and small businesses. Why was this? It was because consumer (retail) prices could have escalated by as much as 200%, and as Governor Gray Davis made clear, the California economy might have been shocked into recession. Perhaps the largest utility (Pacific Gas and Electric Company) moved into bankruptcy - although this was after providing occupants of its executive suite with about $50 million in the form of a bonus 'kitty' to divide.
In the course of establishing itself as the wholesale purchaser of power for existing utilities/distributors, the California government spent somewhere in the neighbourhood of $4 billion dollars, with most of this power apparently originating with generating firms that on at least one occasion Governor Gray described as out-of-state criminals. Terminology of this undiplomatic nature apparently came into use when it was surmised that at least some wholesalers intentionally reduced their supply of electricity in order to increase its market-clearing price.
In examining the history of electric deregulation across the world, it appears that failure is the usual outcome, and often sooner rather than later. In the United States, as far as I can tell, electric deregulation has crashed in every state in which it has been attempted. For instance, on the important site EnergyBiz (June 21, 2007), a former state official - Kimery C. Vories - describes what happened in my former home state, Illinois, when its residents were misled by half-baked academics and what John Wayne (in the film McQ) called "servants of the people" into turning their fate over to "unregulated monopolies whose primary motivation is greed". There were price increases of 40 - 50%, a general neglect of transmission line maintenance, and lengthy electric outages. On top of these misfortunes, the salaries of high-level executives were substantially boosted.
In comparing the situation with regulated and deregulated power, I noted in an earlier contribution (2005) that while deregulation was an unambiguous failure in Texas, the regulated and vertically integrated firm Southern Power (with 40,000 Megawatts (MW) of generating capacity, and serving more than 4 million customers in 4 southern states) was an unequivocal success. An important energy observer, Thomas Tanton (of the Institute for Energy Research, Houston), found my comparison "silly", pointing out the different conditions that prevail in Texas as compared to the districts in which Southern operates. In principle I think that I am sufficiently generous to wholeheartedly agree with Mr Tanton, only it happens that deregulation has failed, is failing, and will probably fail EVERYWHERE, and so while Texas is indeed a very special state, it is not so special in the context of American states and regions that its deregulation failure should be attributed to uncommon qualities and circumstances.
In the matter of transmission lines, Governor Davis made the following observation. "In a deregulated environment, investment chases the highest returns, and the highest return is not in upgrading transmission." A former energy minister in the US - Mr Bill Richardson - once declared the transmission system in the US suitable for a Third World country, but not the only remaining super-power. Had presidential candidate Richardson made it clear that, prior to embarking upon the deregulation venture, the US transmission network was generally regarded as sufficient to provide Americans with reliable and economical power, he might have been a leading contender for my humble vote, but having spent a short period of my university training and military service pondering the mysteries of electric power transmission, I cannot remember at any time equating the wires above me in Chicago or Yokahoma to those on the rim of the Kalihari or in the Chaco.
Academic economists make a point of misunderstanding this situation, and so perhaps a short clarification is in order. Deregulation can bring about a rapid shift of the loads on grids. Instead of a vertically integrated system with (approximately) known final demands, there can (in theory) be a shifting amount of buying and selling between (as compared to within) networks and regions. As David Buchan of the Financial Times pointed out (April 11, 2002), this was why Enron - the failed US energy trader - was such a fervent advocate of deregulation: the more trading the more income! What he did not mention was that in Europe Enron wanted comprehensive 'liberalisation' regardless of the cost, because expansive trading might have added enough billions of dollars to corporate profits to compensate for the embarrassing business shortcomings that were later revealed when the directors of that enterprise found themselves expressing their hopes and dreams in a court of law instead of a special edition of Fortune, Forbes or that compendium of London wine bar gossip, the Economist..
As for salaries, a short time after deregulation in the UK, the first page in the business section of a London newspaper displayed a gallery of power-company executives whom deregulation had been catapulted into affluence. This observation might also apply to the major Swedish company Vattenfall, although admittedly executives of that firm were underpaid before deregulation. After deregulation its managing director - and probably a few platoons of his subordinates - shifted the focus of their activities to Germany, where they busied themselves manufacturing fairy tales about their intention to bolster the electric supply in all of Northern Europe. It should be stressed however that some industrial sources in Germany are not impressed by this braggadocio, and it has also been noticed in that country as well as Sweden that highly polluting coal now plays a key role in Vattenfall's business strategy. This is an important reason why they did not protest the insane decision by the Swedish government to begin their nuclear retreat. My new energy economics textbook is filled with unpleasant facts about electric (and natural gas) deregulation, but as they once said in the US Navy, "on every ship there is someone who does not get the message". In the case of Sweden, at the present time, that someone includes the above mentioned SNS, which is tasked with providing some low-level economic research having to do with the Swedish macroeconomy and various industrial activities. Just a few weeks ago I received notice that they were still in the business of praising the success of Swedish deregulation efforts - a success that in a normal setting would only be acknowledged after the cognac had gone around the table a large number of times, because when in the grip of sobriety it is difficult to imagine an intelligent person voluntarily describing the Swedish electricity experiment as anything other than a grotesque mistake that has increased the financial burdens on households, small businesses and even some large businesses.
More will be said about this in my new textbook, but for the last few years my way of dealing with this topic is analogous to the manner in which I approach the subject of 'peak oil'. I examine the history and mechanics of deregulation in the US, and project that on the rest of the world. There are of course many notable failures elsewhere, however it seems clear to me that if successful deregulation could not be achieved in a country as rich, technically advanced, and market-oriented as the US, then it could not be realized anywhere on the face of the earth, at least in the long run. This does not mean that the US cannot learn from other countries. For instance, another former US Energy Minister, Ms Hazel O'Leary, once pronounced deregulation efforts in Pakistan the best in the world, but before they could be applied to her country, some market actors in that country began to shoot at each other with real guns loaded with real bullets, and so a new assessment became essential. This resulted in the Pakistan deregulation experiment being downgraded and reclassified as a lamentable botch, that was distinguished only by an exceptionally heavy slice of corruption. I would like to finish this introduction by pointing out that when I began my work on electric deregulation, there were a number of observers who politely informed me that I did not know what I was talking about: to their way of thinking electric deregulation was the wave of the future. Those ladies and gentlemen seem to have largely disappeared, however even if they were still on their soapboxes or in their fancy offices, their beliefs about this topic no longer have the slightest relevance. Similarly, although I cannot elaborate on the subject in this contribution, I suspect that the intention to restructure natural gas in Europe hardly deserves the appellations loony-tune or fruitcake. It is simply counter-productive.
SOME INTRODUCTORY THEORY
What do I mean by failed or failing when I discuss electric deregulation? Undoubtedly the most important reason for deregulation coming into fashion was the promise by various enthusiasts and their paid or unpaid propagandists of lower prices and higher or unchanged reliability, all of which would be served up against a background of increased 'choice' for households and businesses. Choice was inevitably mentioned in academic circles, because according to charter members of the deregulation booster club like Professor David Newbery of Cambridge University, if 'genuine' choice as opposed to 'ersatz' choice entered the picture on the consumer and producer side, it would lead to the kind of optimality on electricity markets that you find in almost every chapter of your favourite introductory economics textbook.
The word 'efficiency' was also frequently introduced into discussions of the paradise-on-earth that would result from electric (and also natural gas) deregulation, although as far as I can tell, hardly anyone understood its scientific meaning, to include many teachers of economics. Perhaps the best clarification is one derived from financial economics, which underscores that excess profits are only available on a temporary basis in markets with free entry and full transparency. An excellent example here is the great world of hedge funds: a large percentage of these fail every year, but even many who have had some success are now taking a beating as excess profits are squeezed out for all except an elite few. Thus, in an efficient electric market in which there is free entrance, free access by all actors to existing technology, and where consumers have the right to change supplier when and as often as they choose, firms will supposedly be unable to realize excess profits for other than a short time, and therefore, given their preferences, consumers will experience the theoretically correct prices.
My reaction to all this was and is straightforward: according to the economics and finance that I study and teach, as well as the engineering that I briefly studied and practiced, there would not - nor could not - be anything resembling lower prices (or unchanged reliability) in a situation where unregulated monopolies were allowed to practice what the great American songwriter Irving Berlin called 'doing what comes naturally' This was essentially because of the advantages enjoyed by monopolies due to increasing returns to scale (= decreasing unit costs) for themselves, and high investment costs for actual or potential competitors. For instance, in this matter of increased choice, we have been permitted to enjoy that in Sweden, but what difference does it make when it has become impossible to avoid an increase in electricity prices that until recently was considerably more than twice the consumer-price inflation rate.
This might be the right place to quote US Senator Bryan Dorgan: "I'VE HAD A BELLY FULL OF BEING RESTRUCTURED AND DEREGULATED, ONLY TO FIND OUT THAT EVERYBODY ELSE GETS RICH AND THE REST OF THE PEOPLE LOSE THEIR SHIRTS!" (Financial Times, April 22, 2003). Had he elaborated on this pronouncement he might have mentioned that when the deregulation scam was being launched, it was often claimed that returns to scale did not exist, which at the alpine heights of pure theory suggested that generators/wholesalers of the 'Mom and Pop' - 'Seven-Eleven' - variety were possible.
"Now before you ask whether I am still asleep or dreaming or had something extra in my coffee this morning," the chairman of the independent Electricity System Operator of Ontario (Canada) remarked about a year ago, "let me qualify this by noting that I have not given a timetable to arrive at this destination", where "this destination" included a "reliable, efficient, effective, transparent, accountable, credible and competent" supply of deregulated electricity. That's putting it mildly, because on the date when the contents of Madame Chairman's morning coffee came into question, Ontario had less generating capacity than it possessed a decade earlier, and according to the president of the Association of Major Power Consumers of Ontario, a bungled deregulation agenda had resulted in that province losing an invaluable competitive advantage.
The time has now arrived for a slightly more technical recapitulation and extension. 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 love's young dream elaborated on 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 we shouldn't expect it to appear in the case of industries like electricity and gas. In non-technical language, this reduces to the following.
1) The unambiguous inability to establish the kind of (theoretically) ideal competitive arrangements found in the first part of your favourite textbook. As already noted, 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 it's called in game theory), or gaming the system, as it is often termed 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. Moreover, the Swedish government is even more in favour of deregulation than the power companies that became rich when deregulation was introduced, because deregulation in Sweden is configured so that when prices for electricity rise, so do government tax receipts. In addition, a (Social Democratic) government that for some perverted reason was 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, facilities of this nature 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 a total of 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) Navy 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 Interpol's 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.
An interesting turn of events has now taken place in France, where the new government has just announced that it will partially privatize Electricité de France (EdF). Nobody has ever accused Mr Sarkozy of possessing any advanced economic training or street smarts, but hopefully his government will remain in possession of a sufficient amount of EdF to prevent nature from taking its course. In theory, this should be comparatively easy to arrange, although at the present time the eventual scope of the restructuring curse is not easy to discern.
AFTER THE FALL
In the June 18 (2002) issue of the Financial Times there were two mentions of violence in connection with the deregulation of electricity. The countries involved were the Dominican Republic and Peru. The second of these was of particular interest to me because some years earlier, in Lima (Peru), I had the opportunity to deliver a keynote address at a conference that was attended by a large number of energy economists and engineers from the Caribbean and South America, and somewhere in the middle of my talk I changed lanes and launched a all-out diatribe against what I perceived to be the intrinsic stupidity of electric deregulation. Present as an honoured guest was an important member of the international energy economics elite who, it seems, did not conclude that my presentational skills were of exhibition standard, and made this fact known to the conference arranger. This was unfortunate, because had I been invited to a later meeting in that part of the world, I would have made sure to remind participants of the kind of advice that the Brazilian government was forced to give citizens of that country when an insane deregulation concept, in conjunction with a rainfall deficiency, resulted in catastrophic electricity shortages: Brazilians were encouraged to pray to Saint Peter who, according to Brazil's frantic deregulation authorities, is in charge of the rain department.
Not too long ago a senior executive of the Nordic Electricity Exchange (NORDPOOL), Mr. Erling Mork, questioned my motives and competence in describing what I thought were the activities of his organization (2004). In some ways he was correct in doing this, because the only real insight that I have into the activities of that establishment is that it has adopted a mechanism for bleeding electricity consumers that results in some of the most inexpensive electricity in the world, cost-wise, being frequently sold at the price of some of the most expensive in Europe - e.g. that of Denmark and Germany. As alluded to above, these high prices also make it possible for the Swedish government to obtain a few billion more (Swedish) crowns to squander on the kind of nonsense so dear to Scandinavian hearts. That mechanism is none other than the marginal cost pricing that you were taught in your first course in economics.
Just below that pathetic accusation was another amateurish defence of electricity liberalisation by a gentleman from New Zealand, Mr Tony Baldwin. Mr Baldwin took it upon himself to assure interested readers that in New Zealand - and presumably elsewhere - electricity restructuring is essential in order to "improve economic and environmental performance." As in the case of Texas, I once heard someone call New Zealand deregulation the best in the world, and according to Baldwin none other than Professor William Hogan of Harvard University ostensibly went so far as to say that "…the New Zealand electricity market design has been at the forefront of best practice," involving as it did "extensive consideration of the experience of other countries."
Professor Hogan is a brilliant and highly productive energy economist who signed on as a poster boy for electricity deregulation almost as soon as that show hit the road, and I sincerely hope that he doesn't take it to heart when I say that as far as I am concerned, New Zealand gave no consideration at all to the experience of other countries, because there was hardly any to examine when it initiated this "goofy" experiment, as someone in Canada once called it. Instead, the deregulators in that fair land focussed their attention on the large supply of domestic natural gas, whose price - by one means or another - was kept below the scarcity/free-market level in order to ensure the blessings of deregulation. As things often happen, that large supply has become small, which makes it likely that a number of concerned observers are going to find out that despite Professor Hogan's bona fides and enthusiasm, the standard deregulation model is the antithesis of what Mr Baldwin mistakenly feels is an outlet for "efficient investment in new generation." Researchers who have gone to great trouble to point this out include Professors Reinhard Haas and Hans Auer of Vienna's Technical University (1998), and in my journeys I never miss a chance to repeat as often as possible that deregulation increases uncertainty, which in turn leads to a decline in physical investment. Strangely enough, many economists make a point of ignoring this phenomenon, which is perhaps the most important aspect of deregulation.
And for Sweden, worse is to come, because as the journalist Fredrik Braconier notes (2005), another dark cloud in the Swedish heavens is carbon dioxide 'emissions trading', which apparently will also be managed by NORDPOOL. Swedish hydro and nuclear electricity generation is essentially free of carbon dioxide, but not all large firms are so fortunate, and so their costs will be increased. In addition, the trade in emissions 'rights' on the continent, where hydro and/or nuclear resources are scarce in most countries, will (ceteris paribus) increase the price of electricity in that region, which (via NORDPOOL) will likely impact on the price of electricity in Scandinavia. (In fact, more than likely, because as an adviser to President Putin remarked, emissions trading is about making money rather than reducing carbon dioxide.)
As should be obvious, I'm mostly concerned in this article with the fate of consumers under deregulation, and in particular consumers like myself, but 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.
This is extremely interesting, because what deregulation has done by raising electricity prices is to partially eliminate the traditional and highly favorable 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. I'm 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 instinctively understood this, but that was before their judgements were corrupted by dreams of high-paying, tax-free non-jobs outside Sweden, although I won't say just where.
I will conclude by saying that my fondest dream just now is to be invited to the forthcoming deregulation 'gig' of the SNS, and find there a poster boy of the status of Professor Newbery who was ready and eager to defend that malicious practice. The reason I mention him is that despite his considerable knowledge of this subject, he would have about the same chance against me in a seminar room or conference as he would in a cursing competition with one of his university's many rap fanciers. I would also make sure that before he left the room he was informed that the chief energy economists of the very conservative Cato Institute (in Washington D.C.) have now concluded that electric deregulation was a mistake, and should be rescinded.
Readers who want more of the above should examine Casazza (2001) and Watts (2001). If you desire a taste of the other side of this argument, turn to the very important forum EnergyPulse (www.energypulse.net) and particularly the many comments attached to articles on electricity regulation and deregulation, as well as e.g. global warming and nuclear energy. I am thinking in particular of the consultant Jose Antonio Vanderhorst-Silverio. He admits that deregulation has been a disaster, but he also believes that somewhere out there is a magic formula for making everything right. My comment here reduces to the following: no playing games on the consumer side of the market can possibly offset the upward pressure on prices resulting from conventional profit maximizing behaviour on the supply side. Put another way, given the technological configuration of the electric sector (e.g. increasing returns to scale), deregulation inevitably leads to much higher and more volatile electricity prices.
Ferdinand E. Banks
University of Uppsala, Sweden, and Asian Institute of Technology (Bangkok)
October 26, 2007
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