A new analysis shows that people pay 35 percent more for electricity in states that abandoned traditional regulation of monopoly utilities in the 1990s compared with states that stuck with it. That gap is almost certainly going to widen in the coming decade.
Residential customers in the 15 states that embraced wholesale markets paid on average 12.7 cents per kilowatt-hour last year versus 9.4 cents in states with traditional regulation.
Now 3.3 cents extra may not seem like much until you consider the volume of power people consume. Last year American residential customers paid for 1.4 trillion kilowatt hours of electricity.
You might think that the higher prices in the 15 states with markets would encourage investment, creating an abundance of new power plants. That, at any rate, is what right-wing Chicago School economic theories on which the electricity markets were created say should happen. The validity of these theories, and flaws in how they were implemented, matter right now because Congress is considering a raft of energy supply bills that include some expansion of the market pricing of wholesale electricity.
The theory that markets produce the best prices is generally true. The electricity markets are based on a single price, known as the clearing price, for all electricity sold at auction. The idea is that high prices will signal investors to build more power plants, bringing down future prices.
Yet just 2.4 percent of new electric generating capacity in 2013 “was built for sale into a market,” electricity-market analyst Elise Caplan showed in a study last fall fittingly titled “Power Plants Are Not Built on Spec.” The rest were built in states with traditional regulation or under long-term supply contracts that essentially guaranteed repayment of loans to build the plants.
Here’s another measure of failure: Areas covered by electricity markets have 60 percent of America's generating capacity, but enjoyed just 6 percent of new generation built in 2013.
If unregulated markets are invariably better, as the Chicago School holds, why was 94 percent of new generating capacity built in traditionally regulated jurisdictions? Don't owners and executives detest regulation? Why isn’t regulation hobbling investment?
One answer is that Wall Street prefers stability to volatility. Why would investors make risky bets when they could put their money into virtually guaranteed returns in those states that rely on traditional regulation of electricity prices?
In both the United States and the United Kingdom the adoption of market pricing has “failed to produce the expected lower prices to consumers,” professor Richard E. Schular of Cornell and Leonard S. Hyman of Energy Resource Capital said in a paper delivered last year.
Schular and Hyman said that credit-rating company Moody’s “has rated the outlook for merchant power project credit as negative since 2011 and for unregulated power producers as negative since 2012. In contrast, Moody’s has rated the credit outlook for regulated utilities as stable since at least 2008.”
So states with electricity markets suffer a severe lack of investment in new power plants and what they do get is built with expensive capital. By contrast, the 35 states that stuck with traditional regulation of vertically integrated monopolies have no such problem.
The cheaper power in those 35 states confers several economic advantages. First, they more easily attract energy-intensive industries from metal bending to Digital Era companies that analyze, collect and store data. Another advantage is an extra dollar per household per day thanks to cheaper power, which means more money recirculating in those states.
So what went wrong with the unregulated market theory? After all, monopolies are generally inefficient and known for both price-gouging and retarding new investment. Regulators set rates that are supposed to be “just and reasonable” to both owners and customers. And regulators also grant fat profit margins to regulated electric utilities, typically setting profits at 10–12 percent on their assets.
The answer is simple and it goes to the heart of fundamental mistakes made by Chicago School theorists: Their elegant equations made a fundamentally wrong assumption about human behavior. In the real world, the electricity-market rules have the perverse effect of discouraging investment in new power plants.
Let me explain how the incentives work.
In a single price or clearing price auction every power producer gets the highest price. Some producers may offer juice for a dollar per unit. The average price from 100 generating sources might be $30 per unit. But if the highest bid needed to provide the total amount of electricity needed is $1,000 per unit, then every producer gets $1,000 per unit.
But for price caps, some clearing prices might have soared to $3,000 or $5,000 per unit, as the electricity market operators acknowledge in their disclosure reports.
The only way to keep prices high is to restrict the capacity to generate electricity. That’s the perverse signal a clearing-price auction sends: Minimize investment in new power plants and profits will stay high, expand investment in new power plants and profits will shrink. That is so obvious it is hard to understand how Chicago School theorists missed it. Equally hard to understand is the willful refusal of the Federal Energy Regulatory Commission to recognize that the electricity markets are being rigged.
To be fair to the Chicago School theorists, they reject price caps as a distorting influence on markets. When prices are extraordinarily high due to scarcity, investors should get the signal to build new power plants. But people’s pockets are not bottomless, so price caps are a real-world necessity.
Schuler and Hyman point out that “regulated utilities had an obligation to meet the demands of their customers. In the deregulated market, unregulated generators have no obligation to build anything.” So long as limiting investment in new power plants maximizes profits, rest assured that in those 15 states investors will not build and prices will keep rising.