Case Studies: Elecricity (Panel Transcript)

• Pages: 209-240

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CHAPTER IX

CASE STUDIES: ELECRICITY

(PANEL TRANSCRIPT)

Moderator

Maureen K. Ohlhausen

Wilkinson Barker Knauer, Washington, D.C.

Panelists

James J. Bushnell Jr.

University of California, Berkeley, CA

Frank Wolak

Stanford University, Stanford, CA

MS. OHLHAUSEN: Our first panel of the day is offering a case

study of the electric industry in which there has been a change from

extensive regulation of industry structure and practices to a more

deregulatory approach.

We have excellent panelists for our discussion today: Frank Wolak

and Jim Bushnell. They will examine how deregulation took place in

these industries, the extent of deregulation, the expected benefits and

costs of deregulation, what the actual outcomes were, and, most

importantly for this conference, the implications for the balance between

competition and regulation in setting public policy.

Now, the panelists are economists, whose vocation involves the

study of efficiency. Accordingly, they have asked me to give them very

brief introductions so that we can use our time most efficiently.

We‘ll start with Fr ank Wolak. Frank is a Pr ofessor of Economics at

Stanford University, Chairman of the Market Surveillance Committee of

the California Independent System Operator for electricity supply

industry in California, a visiting scholar at University of California

Energy Institute, and a Research Associate of the National Bureau of

Economic Research. Frank will be followed by James Bushnell, who is a

research director of the University of California Energy Institute and a

professor at the Haas School of Business at Berkeley.

210 Competition as Public Policy

MR. WOLAK: What I‘d like to talk about first is the issue of why

we restructured the electricity industry to introduce more market-based

mechanisms. The second issue is, why did we think it would work? To

give you an idea of why we thought the restructuring would work, I‘ll

give you a little bit about what I‘ll call the theory of market design. And

then I will discuss how it has worked—in other words, have we achieved

the sorts of benefits that we think we should have achieved? The answer

that I‘m going to try to convince you of is ―yes it has, kind of.‖ The

reason my answer is ―kind of‖ is because there are a number of things in

the United States that are quite specific to our situation that make it

difficult for electricity restructuring to benefit consumers.

Another reason that consumer benefits are difficult to come by

relates to electricity markets more generally. There‘s a good reason why

this industry was either r egulated for the last hundred years or it was a

state-owned monopoly. It‘s difficult to have competition in this industry,

but certainly not impossible. I think, as I‘ll show you, there are c lear

economic benefits to it.

The idea here is restructuring—and here the important point I want

to make is, it is restructuring, not deregulation. Why? Because

wholesale prices are still regulated by the Federal Energy Regulatory

Commission (FERC) and retail prices are still regulated by the state

public utilities commissions. There has been no explicit price

deregulation, as there was in 1978 in the airline industry. It was really a

form of regulatory entrepreneurship on the part of the Federal Energy

Regulatory Commission that led to what we currently have in a number

of parts of the United States.

This industry does require some regulatory oversight, simply because

we need a network infrastructure over which to deliver the electricity.

The basic argument here is that competition among multiple network

owners would be very costly and not beneficial to consumers. And so

what we effectively need is one provider, but at a regulated price.

Otherwise the network owner could just capture the monopoly rents that

exist through the pricing of transmission services.

So what is it that we are trying to achieve and how do we want to

think about this? This is where the theory of market design comes in.

What we are trying to do is set the number and sizes of market

participants and the rules for determining how they get paid so the

combined actions of each participant acting in its own interest yields

market outcomes that we, the market designer, like.

Case Studies: Airlines and Electricity (Panel Transcript) 211

The first point here is there are many feasible market designs. The

question is: What is the one that comes the closest to achieving the

market designer‘s goals? I‘ll talk about that in a moment.

But let me first say that a big issue is the fact that what we find in

these market designs—and it‘s similar to a ll markets—is that once you

set up a set of rules, people optimize against them. It‘s li ke the rules you

set for your kids, and how they manipulate them. In that sense, what you

have to worry about is analyzing the strategic implications of your rules

and anticipating how they might be used by the market participants to

maximize profits.

This factor plays a huge role in the electricity market design process,

simply because the agency relationships are quite strong. A multiple-

level principal/agent problem exists, first between the regulator and the

firms they regulate, and also within the firm between the firm owners

and the firm managers. Attempting to solve both of those problems is

really the fundamental challenge of the market-design process.

I am going to give you my economist‘s view of the goal of the

market-design process, which is essentially to maximize consumer

benefits subject to the long-term financial viability of the industry. In

economist language, the goal is to maximize the discounted present value

of consumer surplus subject to the long-term financial viability of the

industry.

Now, there are two dimensions of market design. I am not going to

talk as much about government versus private ownership, because of the

fact that it‘s just not extremely r elevant here in the United States. I‘m

going to focus on regulated versus market pricing.

Just briefly on private ownership, the advantage is that we have a

clear chain of incentives with private ownership. In other words, as a

shareholder in the company wanting the maximum returns I want my

management to maximize profits, make as much money as possible, and

exercise all available unilateral market power that it can (obviously,

within the law).

Public ownership—really, who knows what public ownership is

trying to do? My other favorite industry to study is the postal service,

and that‘s a perfect example of a publicly owned company. It has

extremely unclear incentives as to what it is trying to achieve. That has a

benefit and that has a cost, as does private ownership.

Now, with market mechanisms we are just saying typically the goal

is to replace regulatory mechanisms with market mechanisms wherever

possible. The two places we think that is possible in electricity have

been in generation competition to inject into the transmission network,