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Power communication.

DEREGULATION, INNOVATION AND MARKET LIBERALIZATION: Electricity Regulation in a Continually Evolving Environment

By L. Lynne Kiesling

189 pages; Routledge, 2009


Discontent with the state of the electricity market has inspired a steady stream of writings about how best to improve the situation. The writings are dominated by discussions, usually from the same able but convention-bound economists, recognizing the defects of current market regulation, followed by proposals for incrementally improving that regulation. The most recent example to reach me is a special issue of the Energy Journal.

However, going back at least to Richard Posner's classic but badly under-cited 1969 Stanford Law Review article "Natural Monopoly and its Regulation," another view is that regulation is a flawed concept from which public policy should turn. Posner's basic case stated the points that remain central (and many that do not). Even if natural monopoly exists, the monopolist's ability to engage in price discrimination means the absence of efficiency losses. The only consequence of monopoly is a change in income distribution. That alteration is too small and of too unclear impact to justify intervention; action on a single commodity at the regulatory commission level is not the best way to deal with redistribution. Moreover, even if regulators had efficiency-raising public interest objectives, they lack the ability to attain those ends. Finally, rent-seeking forces may lead to pursuit of less desirable objectives.

Some subsequent writers have expanded on this view and, in particular, suggested that the presumption of natural monopoly was unjustified. Northwestern economist L. Lynne Kiesling's thought-provoking new book Deregulation, Innovation, and Market Liberalization adds to this literature. She takes up the classic debate in public utility economics over the optimum way for suppliers to interact with consumers that is, to use real-time pricing and other mechanisms to moderate consumer use at times when demand is greatest and grid congestion is worst. Her case boils down to rejection of the skepticism rampant in the more conventional writings about the ability to implement such interaction. Kiesling argues that recent advances in computer technology have dramatically lowered the cost of real time producer-consumer communication, making it possible to implement those technologies on a large scale.

INSIDE The book's introduction concentrates on its unifying theme that the concept of regulated natural monopoly is ill-suited to dealing with industries that experience rapid technical progress. That flaw has become intolerable in an era when such change could profoundly increase power industry efficiency. Chapter 2 provides an all-too-standard capsule history of the industry, its regulation, and the relevant theory. Kiesling's history is mostly solid, but it has a few standard but still bothersome flaws. The most important of these is her failure to discuss the forms of price discrimination that can produce efficient outcomes in a natural monopoly and that are usually employed, and stressing what she recognizes as impractical: the loss-minimizing elasticity-based markups beloved by many theorists. Her thumbnail description of the industry sticks too heavily to an entity-count approach. Such a technique underplays the fact that the industry is dominated by the generation, transmission, and distribution by the private sector, which has far fewer participants than the public and cooperative sectors. (Moreover, the count of private firms, as usual, is bloated by reliance on sources that treat subsidiaries are separate operations.)

In Chapter 3, she deals with the desirability of decentralized decisionmaking and the need to design institutions that facilitate such decentralization. For the first part of the discussion, she invokes the arguments in favor of decentralization that are advanced in Austrian economics; she uses new institutional economics for the rest. The treatment is too long for an academic audience, but it may not be lucid enough for the nontechnical audience. However, it does convey the essence of the argument.

The remaining chapters present her case that communication between utilities and their customers will promote large efficiency gains. These chapters are what justify attention to the book. The discussions examine the implications of interactions with consumers for resolving the critical problems of the electricity industry.

In Chapter 4, she nicely presents both the theoretic argument for communication with consumers that allows prices to respond to changing supply/demand conditions and the successful results of experiments with such communications. Then Chapter 5 argues for reorganizing transmission into separate firms that are joint ventures of electricity retailers. Chapter 6 briefly indicates the short-run advantages of communication in promoting reliability. Chapter 7 turns to why this approach is far superior to the currently favored policy of creating markets for capacity to ensure the long-run optimal reliability of the power industry. This last is a particularly clear example of the implications of effecting continuous communications with consumers. The resulting price response generates precisely those revenues unavailable when prices stay fixed while loads increase to peak levels. Capacity markets are an effort to compensate for such revenue losses. Price flexibility, if feasible, is preferable because it is based on direct, rather than indirect, evidence of demand conditions. These chapters are all solid presentations of the case.

Chapter 8 is extremely problematic because of its equivocation. Her treatment of the public-good nature of reliability confusingly argues that reliability is simultaneously both a public good and a common-pool good. As she correctly indicates, a public good is one that, if provided, is freely available to everyone and such availability is not affected by the level of individual use. A common pool is one that, if provided, is freely available to everyone but its availability is affected by the level of individual use. (National defense is the classic example of a public good; fisheries and oil and gas fields are among the key common-pool resources.) The common-pool aspects of reliability are clearly explained. The discussion of public goods, in contrast, is murky and incomplete. In particular, she neglects Coase's caution about lighthouses; while public in theory, they were initially provided privately because government lack of interest was more of a problem than the free riding. As nearly as I can determine, Kiesling is dealing with the classic problem of when the transition is made from underuse and an optimum price of zero to congestion and an optimum positive price. In any case, an unequivocal contention that reliability is a common-pool resource seems plausible and should have been made. This would have led to a less equivocal conclusion about the undesirability of regulation.

CONCLUSION While Kiesling's is an attractive and plausible armament, caution is necessary. The idea that more flexible pricing is desirable in principle is longstanding and the subject of a substantial literature. The contention that regulation impeded implementation appeared at least as early as Posner's 1969 article. The contention that computer technology had reduced the costs of communications to a level where it was efficient was the core of the 1988 book Spot Pricing of Electricity by Fred Schweppe, Michael Caramanis, Richard Tabors, and Roger Bohn. Neglect of doubts about greater communication is not a critical fault, but neglect of Posner's wider arguments is. He leads to the view, which he refrained from presenting, that regulation has no redeeming virtues. Total deregulation of electricity is justified simply by allowing freedom to experiment. It would be a welcome bonus if responsive prices emerged.

The book is clearly an effort to provide an elucidation for non-specialists of the case for a less regulated, more flexible electricity market. The discussion is kept at a level appropriate for such an audience. It is too bad that this publication is a $130 book directed at academic libraries.

Any effort to break from the assertions that regulation is desirable is welcome. One such as this, which thoughtfully presents and justifies some interesting alternatives, is particularly helpful. One would hope at a minimum that the electricity regulation establishment would be inspired to depart from its cavalier neglect of such arguments.

Richard L. Gordon is professor emeritus of mineral economics at Pennsylvania State University.
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Author:Gordon, Richard L.
Date:Mar 22, 2009
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