I'm off to Aberdeen, the home of the UK oil industry. Can't wait!! I hope to find some good uisge beatha there as well; that's water of life, or whisky in English.

OPEC's MEETING TODAY: Another variable in OPEC's ability to sustain cooperation in the cartel is something they will discuss today at their meeting: the fall of the US dollar. As this story reports, the currency in which oil trades are denominated us the US dollar, so its decline is not good news for oil producers who are trying to raise revenues from the sale of oil by restricting output to raise prices. As this story says,

Continued dollar weakness another incentive for OPEC members to bust quotas, OPEC source says. In the short-term, producers can maintain their purchasing power by selling more crude. The dollar recently traded at 27 month lows against the euro and at seven month lows against the yen.

This Bloomberg News story also summarizes the OPEC meeting, and mentions how much cheating on the production quotas is occurring, as well as the motivations for it:

Rather than raise the targets, members have pumped more than promised to fight Russia, Norway and other rivals for market share.

Isn't competition a grand, disciplining force?

BRITISH EUPHEMISMS: One of the charming and fascinating things about British culture is the contradictory use of euphemisms for some things, and brutally frank phrasings for other things. The word "toilet" is one such contradiction -- whereas we Americans say "restroom" or "ladies room", even properly-brought-up Brits will say "excuse me, where is the toilet?" I must admit, this one grates on my ear much, much more than any other British/American English difference. So I was deeply amused yesterday when I encountered a reversal of this yesterday at Fortnum & Mason. I finally have done something I've wanted to do since I first studied in London in 1986 -- I had a cream tea service yesterday at Fortnum's (it was yummy, and the strawberries were fantastic, perfectly in season). I had some confusion following the waitress's directions to the ladies room, because when I did so all I saw was a door that said "ladies and gents cloakroom". Now, when I think cloakroom, I think coat check; but indeed at Fortnum's, the cloakroom is the restroom is the toilet!

LONDON'S AIR QUALITY: I noticed something yesterday (Tuesday) that is quite different from the last several visits I made here, and from when I lived here four years ago. There are many, many more cyclists on the roads, and the cyclists no longer wear face masks to filter out the particulate in the air. London's air is still by no means pristine, as my skin indicates after just four days here, but it's quite a bit better than it used to be. Some of that improvement is due to fleet turnover, primarily in taxicabs but also a little in buses. Some of the improvement is also due to London's efforts to control congestion and use a fee-based system to reduce congestion in central London. I have not kept up with the developments in the congestion fee program, but I have noticed an appreciable change in air quality here.

THE HISTORY OF ECONOMIC GROWTH THROUGH CERAMICS, A STORY: I spent three-plus hours yesterday at the Victoria and Albert Museum, a monument to Victorian intellectual omnivorousness (and the grandeur of the Empire, of course). Most of this time I spent only in the ceramics and pottery galleries.

The evolution of ceramics uses, decoration, themes and techniques illustrates and parallels economic growth more broadly. The 12th-14th centuries were dominated by Islamic ceramics, which were largely mosque and palace decorations in very ornate, detailed geometric patterns. The dramatic colors of blue, orange/red and yellow were intense, and were the result of using costly vegetable dyes in great concentration. As with medieval cathedrals and castles in Europe, these decorations also functioned as a show of wealth. Increasingly over these two centuries these techniques showed up in home goods. Also increasingly into the 17th century, Islamic pottery showed strong use of Chinese motifs (especially as Ming dynasty pottery became so popular). The use of Chinese motifs also indicated the cross-cultural trade with China that increased up to the 17th century (but then fell off dramatically due to Chinese imperial isolationism), because the Islamic diaspora served as a crucial trade conduit between the Far East and Europe.

Spanish ceramics of the 15th-16th centuries reveal the Islamic influence of the Spanish conquest. Italian ceramics of the same period (15th-16th centuries) show many similarities -- the use of strong colors from expensive dyes, decoration of cathedrals and palaces -- but use largely religious themes (I believe the Koran prohibits human and landscape representations, so this difference is not that striking). The general appearance of Italian ceramics and the integration of geometric designs with human representations reflects an Islamic influence, certainly a result of cross-cultural trade and the growing trade networks of the Italian city-states. One thing I noticed yesterday is that around 1530 you start to see the Mannerist techniques of the Renaissance showing up in pottery, and the human representations become much more realistic and compelling, with more complex facial expressions.

Then the Dutch pottery becomes popular in the 15th-17th centuries, mirroring their growth and role as the commercial and financial juggernaut of the period. Again, Delft china shows a lot of Chinese themes, consistent with their trade and with the popularity of Ming china. Relative to the earlier Islamic, Spanish and Italian pottery, Dutch pottery is thinner and of a more consistent quality, which is the result of the increased ability to fuel hotter fires for kilns in reverberatory furnaces and clay-lined kilns to refract heat back into the kiln.

British pottery was, shall we say, rustic before the 17th century. Very utilitarian, with little emphasis on decoration and much on functionality. The heyday of British pottery comes with the entrepreneurship of Josiah Wedgewood in the mid-18th century, who harnessed the ever-increasing ability to fuel hotter and hotter fires more efficiently with coal and coke to build larger and larger kilns (that's economies of scale for you). He also spearheaded the canal construction of the mid- to late-18th century in the British midlands, which increased transportation networks for heavy and fragile items such as pottery (and, by the way, for coal and coke coming into Staffordshire).

Wedgewood and subsequent Staffordshire potteries, such as Minton, used these transportation networks and economies of scale in production to create consistent, higher quality, diversely decorated and styled, ceramic objects and vessels in a variety of price ranges. Now families in a wider range of incomes than just the wealthy with palaces and estates could have beautifully decorated, higher quality ceramic items to increase the beauty in their everyday lives. Mass production brought higher, and higher variety, quality at affordable prices for more people.

Mass production created a backlash, of course, in the Aesthetic and pre-Raphaelite movements of the late 19th century, with its focus on artisanal pottery. Mass production potters such as Minton cleverly incorporated these motifs as they became more popular, co-opting the arts and crafts motifs for mass consumption, but also thereby increasing their popularity (to this day, even; they are by far my favorite types of ceramics, especially in their American manifestations).

How does this story mirror economic growth? Look at the time periods of the ascendancy of each society's ceramics, the effects of cross-cultural trade on the aesthetics of a society, the effects of technological change on technique, the change in quality that provides increasing value for money for more people, and the role of entrepreneurship in creating growth and profit opportunities by serving wider and wider markets.

OPEC AND VENEZUELA: An interesting story on the political dynamics of OPEC from today's (sorry, no specific link, I am reading the print version). At the upcoming meeting in Vienna, OPEC is expected to choose Alvaro Silva, Venezuela's current energy minister, as secretary general. The current secretary general, Ali Rodriguez, is Venezuelan, and Silva will serve out the remainder of Rodriguez's term. Hugo Chavez recalled Rodriguez after the failed coup against his regime to head PDVSA, the nationalized Venezuelan oil company.

This move is seen as a gambit to keep Venezuela from increasing its production; as I mentioned in a post last week, Venezuela shares Saudi Arabia's need for revenue from oil sales, and in the face of lagging demand worldwide, cheating on the production qoutas and increasing production may be the best way to achieve that. OPEC seems to believe that appointing Silva will undermine Venezuela's incentives to break with the cartel and cheat on its production quota. Silva is infamously anti-market, and opposed opening Venezuela's oil industry to foreign capital in the 1990s.

MUNIS INVOLVED IN MARKET MANIPULATION? According to this Associated Press story and this Reuters story, a California Senate investigation has found email evidence that the Los Angeles Department of Water and Power, the largest municipal utility in the country, may have engaged in some of the same trading practices that have been called "market manipulation" when performed by independent generators. The role of the munis in the California "market" is potentially quite interesting, and the California Senate committe has been looking into it for the past year. The thing that I find the most striking is the completely inconsistent treatment and rhetoric between independent generators and the munis. Public power generators, such as LADWP and BC Hydro (from British Columbia), charged some of the highest hourly prices in the California "market" in late 2000 and early 2001, selling into the ISO in peak hours when the ISO was willing to pay almost anything to keep the juice flowing. My primary interest in this is that the actions of the independent generators and the actions of the munis should be treated consistently. If we're not going to castigate the munis for selling when the need was greatest and profiting from it, or for using arbitrage strategies that were legal (although potentially questionably ethical), then we shouldn't castigate the independent generators. And vice versa.

OFF TO LONDON AND ABERDEEN: I am leaving tomorrow for London and Aberdeen, to give presentations at the Institute of Economic Affairs and the annual meetings of the International Association of Energy Economics. I am leaving town at the right time, as my Cubs continue to be depressing (although at least Alou's hitting is coming along, he just hit a single and is 2 for 4 today) and the first heat wave of the summer is coming this weekend. The paper I am presenting at the IAEE meetings is a version of this comment that I submitted to FERC in April in their market structure and design comment period, which I also mentioned below in my GAO post. I'm going to try to post commentaries on some of the papers, since it is an energy conference, as well as some observations as I travel around one of my favorite places on the planet.

POSTREL ON MICROSOFT, JOSKOW AND TRANSACTION COSTS: Leave it to my eloquent former colleague Virginia Postrel to pick up on an extremely good analysis of the economics of antitrust law by Paul Joskow. I read this article on the plane to San Francisco last Friday, and it was one of the most compelling arguments I've seen yet for why actions, institutions and market structures that might look anti-competitive could really be outcomes of market processes. If you don't take into account transaction costs, you miss them. It's a great article. Virginia's column on it is also far, far better than any summary I could write; go read it and enjoy.

HOW COOL IS THIS? Following up on an article in Monday's Wall Street Journal (subscription required), I've been reading up on Irbis Enterprises. Irbis, which means "snow leopard" in Mongolian, is an organization attempting to align the incentives of nomadic herders in Mongolia with not killing snow leopards to sell their coats. As the WSJ article says,

Irbis ... marries two causes -- wildlife conservation and poverty reduction -- that are often at odds ... [T]he snow leopard ... shares its home with people who have no option but to rely on the land for survival.

Here's how it works: Irbis trains nomadic herders in crafts using local materials. Herders sign a contract with Irbis stating that they will not kill snow leopards, and they keep the proceeds from the international sales of the items they make. Irbis pays each family a 20 percent bonus if no snow leopards are killed in their area, and if a snow leopard is killed, then all families in the area lose that bonus. This summary of Irbis' methods lays out the conservation contract and the bonus arrangement. Also, almost all of the individuals working with Irbis (and by association with the International Snow Leopard Trust) are indigenous Mongolians.

OK, how do the economics of this setup align incentives for human well-being with snow leopard conservation? First, Irbis is focusing on creating trust and relationships through developing local institutions, using local people and local knowledge. These informal institutions are the foundation of successful, ongoing commercial relations and trade. Second, the concept of a contract as a binding agreement between Irbis and the herders to trade skill acquisition and profits from crafts for profits from killing snow leopards creates an institution of visible commitment. Third, the payment of a bonus contingent on the actions of a larger group of families, and the potential loss of future profits from the cheating of any one family, decentralizes enforcement of this contract and creates a strong social norm within groups of herders to avoid killing snow leopards. Thus enforcement is cheaper and more effective because it relies on local personal relationships coupled with a potential real economic loss if any one of them cheats.

This set of institutions illustrates many, many of the lessons we learn from game theory. First, repeat the interactions to increase the possibility of cooperation to achieve mutually beneficial outcomes. Furthermore, exploit the already-existing repeated interactions among herding families that travel in groups together to increase the possibility of cooperation at lower enforcement costs. Second, find some way to make commitment credible, as Irbis is doing with their conservation contract and their trust-building activities. Third, use diffuse local knowledge to customize the institution to fit local culture and norms.

There are about 1,000 snow leopards in Mongolia, and none have been killed in the areas where Irbis has signed contracts with herders. Herder consumption of flour and rice has increased. Irbis is planning on expanding the program, which is quite young, into more of the snow leopard's range. This is very, very cool. Now if we could achieve this kind of institutional success with tiger (my favorite charismatic megafauna!) conservation and human well-being! This PERC policy analysis by Michael 't Sas-Rolfes illustrates only too painfully the incentive problems in wild tiger conservation, and how international treaties to end tiger poaching have little actual effect. The Hornocker Wildlife Institute sponsors and performs extensive conservation and habitat research on Siberian tigers, and you can sponsor individual wild tigers, but their program does not address the core incentive problems in tiger poaching in the way that the Irbis approach addresses the incentive problems in snow leopard killing.

OIL MARKET ANALYSES: Two interesting stories today illustrate some very important points about how world oil markets are evolving. This Bloomberg News story describes how Russia and Norway are changing the dynamics of OPEC's ability to restrict output to raise prices:

Russia and Norway plan to end six months of output cuts and cooperation with the Organization of Petroleum Exporting Countries on July 1, increasing world supply at a time when demand is rising at half of normal levels. A drop in the U.S. dollar has weakened OPEC further, because its oil sales are priced in the currency.

Increasing non-OPEC production, the coincidental economic downturn of the past year, and the weakening dollar have all put tremendous pressure on OPEC's market share. The Bloomberg story concentrates on Saudi Arabia's need for revenue, which will keep it from being able to reduce output in the short run (aside: this pattern suggests that Russia and Norway increasing production makes demand more elastic, or more responsive to price changes -- a hallmark of increasing short-run competition). Apparently the price increase resulting from the reduced output over the past six months has not increased Saudi Arabia's oil revenue, and the country is thus in a pretty steep recession. The same incentives are keeping the oil flowing in Venezuela. Add to that the improving Russia-U.S. relations and the declining Saudi-U.S. relations, and you get a big change in the political economy of OPEC. The article also notes that

Russia is spending billions to rebuild its industry after the collapse of the Soviet Union. Russia in 1991 was the world's largest oil producer, pumping 9.3 million barrels a day, compared with 7.1 million a day last year.

Russia also is encroaching on traditional Saudi customers. AO Yukos Oil Co. has sent a cargo of Russian crude into the U.S., investigating the possibility of further sales.

This is a fundamental, and probably long-lasting, shift in the dynamics of the world oil market, as Joe Becker and I argued in a Harvard Caspian Studies Program Policy Brief published in April. As Brenda Shaffer, Research Director of the Caspian Studies Program, stated in her introduction to the publication,

Russia has emerged as the number two oil producer in the world market and its production share is estimated to continue to grow, especially due to the privatization of Russian oil companies. Russia's independent behavior in the oil market has caused a significant erosion in OPEC's monopoly power.

Second, this Chicago Tribune article today leads off with the implications of uncertainty in the Middle East for U.S. fuel price volatility. The article points out something that oil market analysts have seen for the past six to nine months -- a $5-6 per barrel "war premium" on crude oil prices that reflects the market risk associated with ongoing political tensions. The OPEC output restrictions of the past six months have also contributed to the price staying above $20 per barrel, but it has not had that much of an affect, as mentioned above. Still, crude prices have been hovering around $25 per barrel for several weeks, notwithstanding the seasonal move into increased summer demand and the variability of the political tensions in the Middle East. As mentioned in the Bloomberg article and this one, part of this price stability is due to the slow increase in U.S. demand because of slow economic recovery, and the tendency early in recoveries to focus on increased efficiency and doing more with less. The article provides this concise summary of the current state of affairs:

Three weeks into the summer driving season, a gallon of regular unleaded gasoline, at an average price of $1.38, is 22 cents cheaper than a year ago, according to the AAA Chicago Motor Club. Even in Chicago, which has had notorious gasoline price spikes for two summers running, a gallon of regular unleaded gas averages $1.56--20 cents less than last year at this time, AAA said.

Crude oil prices, a key component in the price of gasoline, are still being propped up by a war premium and by a tough output quota imposed by the Organization of Petroleum Exporting Countries. At Wednesday's OPEC meeting in Vienna, the 10 OPEC member countries with quotas in place are widely expected to extend their current export curbs through the third quarter.

What's the punch line? U.S. crude oil and gasoline inventories are pretty high in historical terms for early summer, the recovery is slow, so demand is increasing slowly and contributing to keeping prices stable and lower than last year. Another important factor in this dynamic is the 15 percent decline in jet fuel demand relative to the same time last year, which has meant that refiners have turned more crude into gasoline.

Finally, this article points out something important that often gets overlooked when we think about gasoline supplies: the production substitution between home heating oil and gasoline:

He [John Felmy, the American Petroleum Institute's chief economist] noted that a year ago the U.S. also was coming out of a very cold winter that had compelled refiners to produce more home heating oil, which put them behind in preparing supplies of gasoline in anticipation of the summer months.

This example illustrates just how complex the interaction is among all of the determinants of gasoline prices.

PAY TO CONSERVE, OR RAISE PRICES? Another Los Angeles Times story, State Energy Plan Offers Conservation Incentives, says that the California Power Authority will pay large industrial users to cut back their electricity use. According to the article,

The program will rely on satellite technology and real-time electric meters to dim air conditioners or lights automatically when the state's power buyers call on the companies.

My question is this: if they have this spiffy technology and can do the real-time metering, why not just free up regulation to allow utilities to offer a real-time pricing alternative to large industrial customers? Industrial consumers would face price incentives to conserve, and taxpayer money wouldn't have to fund it. We'd still get the benefits of reduced consumption and reduced construction of new power plants.

Severin Borenstein of the University of California Energy Institute has written extensively on this issue, including this article and this op-ed from the Los Angeles Times. He's right. Enabling consumer demand to respond to prices in real time would mean that prices would reflect the actual cost of providing us with power in that hour (yes, power costs fluctuate that frequently). More on real-time pricing later, but now I'm off to do some other work.

GASOLINE PRICES RISE IN CALIFORNIA: This story (registration required) does a good job of illustrating how being so close to refinery capacity can contribute to gasoline price spikes. Although prices this summer are not high either historically or adjusted for inflation, they are exhibiting some of the usual "increase before driving holidays" pattern. The fact that refinery production is so close to total refining capacity means that any refinery outage could disrupt supply and lead to an unanticipated price spike. The article also does a nice job of pointing out that reformulated gasoline, as mandated by the EPA in areas with air quality problems, limits the extent of the market by making non-California gasoline less substitutable for California's reformulated gasoline. In the midwest we have enough different reformulations that we call this the "boutique fuels" problem, which contributed to the price spikes we saw in 2000 and 2001, but not this year (touch wood) because we have not had any refinery outages.

UPDATE: As you can see from the time stamp on this post, I was working way too late last night to remember that GAO is General Accounting Office, not Government Accounting Office. Apologies for the slip, which has been corrected below.

Well ... back from celebrating my birthday and my sister-in-law's graduation with my in-law family to ... a GAO report on FERC's ability to perform oversight functions in burgeoning wholesale electricity markets. No rest for the weary these days when it comes to energy policy.

On Monday the Senate Governmental Affairs Committee released a General Accounting Office (GAO) study that it had commissioned to explore the Federal Energy Regulatory Commission’s (FERC’s) oversight abilities. In general, the report found that FERC faces three substantial hurdles to overcome before it can provide the kind of straightforward, flexible regulatory environment consistent with enabling the evolution of a dynamic electricity industry.

The first hurdle is that FERC has a lot on its plate relative to its resources. FERC’s electricity jurisdiction, a relic of the old, vertically-integrated, regulated monopoly model, is ensuring that interstate sales and transmission prices in wholesale electricity markets are "just and reasonable," and the siting of interstate long-distance transmission lines. In the old "command-and-control" mindset, ensuring just and reasonable prices was pretty simple – cost plus a rate of return on the vertically-integrated utility’s rate base – and long-distance transmission was built for different purposes from transporting competitive generation. It was also not particularly technologically feasible to have economical long-distance transmission because of line loss. But now that the regulatory environment has changed, technology has changed, and business models have changed (and the report does a nice job of summarizing these effects over the past 25 years), the old model and its associated bureaucracy are not suited to a new business environment in the electricity industry.

At some level this conclusion is completely consistent with what both experience and theory tell us about regulatory institutions and market institutions. The major (and boy, are they major, as history has shown repeatedly) benefit of market institutions is that they harness human opportunism to create value through mutually beneficial exchange. That trait makes them flexible and quick to respond to changing environments and market conditions. Market institutions do not exist in a vacuum, though, as we have learned from the whole Enron/Andersen/energy trading experience of the past year. The rules underlying market institutions work best when they promote transparency and in most cases deter bad behavior, such as the exercise of market power. Market institutions where the rules provide transparency are self-correcting as long as they really are transparent and provide good information.

The major benefit of regulatory institutions is a level of stability and certainty in the absence of this combination of market processes and transparency-inducing institutions. One problem with regulatory institutions, though, is that they can harness human opportunism to create value for those with political power. More to the point of the GAO study, regulatory institutions can also get bogged down in bureaucratic processes and be very slow to anticipate changing environments and market conditions. Old procedures persist and are slow to change. The GAO report highlighted precisely this problem in its analysis of FERC’s obstacles – changing from a "command-and-control" regulator of a vertically-integrated industry to a more transparency-inducing , rule-simplifying regulatory institution that supports the web of formal and informal rules that create good market conditions.

FERC also has had a lot to prioritize – building more transmission to support competitive wholesale markets, wholesale market structure and design, and market oversight. In 1999 they chose to prioritize in that order, and only in the past six months have they gotten to working in earnest on the market structure item. In hindsight, if they could go back and change their decisions it is likely that they would have focused a bit more evenly among the three priorities, instead of taking them more sequentially. But, for FERC and for many of us, the important contribution of market oversight to transparency is something we are learning about as we go, and we can admit that if foresight were as good as hindsight, some of the electricity price spikes we have experienced (especially in California) could have been lessened somewhat. But asking humans to have perfect foresight is asking us to be something other than human.

FERC’s second hurdle, which the GAO called "daunting," is its human resources. Attracting energy market analysts would be difficult in any situation because of pay differentials between private sector and public sector labor markets, and these difficulties were exacerbated by the apparent (and looking more apparent and less real) energy trading opportunities of the late 1990s. FERC employees are largely grounded in the traditional regulatory model, a feature that contributes to the inertia and the status-quo path dependence mentioned above. Furthermore, many FERC employees are eligible to retire in the next few years, so now is a good opportunity to be strategic in hiring market analysts with human capital to bring to the market oversight function. FERC is also increasing its training and education activities, bringing in economists and market analysts to familiarize its staff with market processes and the dynamics of this changing industry. The GAO report recommends that FERC incorporate a strategic hiring and human capital management plan into its strategic plan.

The third hurdle highlighted in the GAO study is legislative. The kinds of civil penalties that, for example, the Securities and Exchange Commission (SEC) can bring to bear against rule violators are not part of FERC’s toolkit. Again, a relic of bureaucratic inertia – who needs civil penalties to regulate vertically-integrated government-granted monopolies? Which brings up an interesting thought: in all of the introspection accompanying the Enron/Andersen debacle, with the rethinking of the SEC’s enforcement, should we also in that process look for some lessons for FERC? I think so. Changing FERC’s enforcement toolkit is a job for Congress, and the GAO report recommends considering such a change.

The GAO report illustrates precisely the concern articulated in a comment that I submitted to FERC in April as part of their market structure and design rulemaking process. A possible consequence of setting up rigid institutions for regional transmission organizations is what economists call institutional path dependence, where institutions and procedures become entrenched through bureaucratic inertia. Thus one thing that FERC needs to watch out for that the GAO report and my comment both highlight is to beware of institutional change being just a ratchet to another locked-in set of regulatory institutions that are likely to become obsolete more quickly than not, and will almost certainly become obsolete more quickly than the existing regulatory institutions have.

This report is not an argument against competition and market processes in electricity, as many market foes and some of the commentaries I have read today would have you believe. Instead it is an argument for FERC to do the strategic planning and implement performance measures to create a set of regulatory institutions that rely on rules that encourage transparency, and focus on deterring the great majority of bad behavior.

The GAO report lacks something that I think is extremely important. It fails to point out that FERC was not to blame for the over-engineered, overtly politicized, dysfunctional rules that the state of California forced into laws governing its "market." FERC has admitted that in hindsight it would have changed some decisions, but California’s politicians have not been so introspective in public.

FERC is learning the importance of a balanced approach to improving transmission networks, creating rules governing wholesale market structure, and market oversight. This approach should use flexible regulatory institutions where necessary, and rely on market institutions and rules to create transparency and deter bad behavior wherever possible. FERC is also learning the importance of human capital in a dynamic, evolving industry. The GAO study is a constructive contribution to that process.

News stories from today on the report are here (registration required), here(registration required), here, and here. Depending on how the other items on my plate are doing tomorrow, I may say more about the divergence between the political rhetoric on this concerning the California situation and the more far-sighted nature of the GAO study.

Off to my sister-in-law's graduate school graduation from Stanford; have a great weekend! LK

The EPA Announces New Source Review Recommendations: This morning the Environmental Protection Agency released its report on new source review (NSR). NSR is a feature of Title 1 of the Clean Air Act, under which new power plants or refineries would have to meet more stringent abatement technology standards. Under interpretations of the Clean Air Act (that may have gotten stricter over the 1990s), existing facilities have to meet those requirements if they upgrade, but if they make only small, routine changes, those changes do not trigger NSR. One of the most contentious aspects of this regulation is the definition of an upgrade.

Clearly, then, where you draw the line for interpreting maintenance exclusion versus upgrade, and how bright that line is, matters a great deal for whether or not an electric plant or a refinery has an incentive to upgrade its facilities to more energy-efficient or less polluting technologies. This issue of regulatory uncertainty is paramount in determining whether or not further investment is going to take place. Electric plants and refineries have to balance the operational flexibility they require to respond to unanticipated changes in supply or demand with the choice of whether to invest in an upgrade that may or may not trigger a NSR. The conclusion of the report states that

"With respect to the maintenance and operation of existing utility generation capacity, there is more evidence of adverse impacts from NSR. Credible examples were presented of cases in which uncertainty about the exemption for routine activities has resulted in delay or cancellation of projects which sources say are done for the purposes of maintaining and improving the reliability, efficiency and safety of existing energy capacity. Such discouragement results in lost capacity, as well as lost opportunities to improve energy efficiency and reduce air pollution ... "

"Our findings in this report ratify a longstanding and broadly-held belief that parts of the NSR program can and should be improved. For example, we conclude above that changes to NSR that add to the clarity and certainty of the scope of the routine maintenance exclusion will improve the program by reducing the unintended consequences of discouraging worthwhile projects that are in fact outside the scope of NSR."

This issue raises two very important points about the economics of NSR. First, one of the environmental group participants is cited as stating that it does not "believe that there is sufficient information to conclude that NSR is a primary factor driving decisions to invest or not to invest in capacity." Whether or not NSR is a primary factor driving investment decisions is irrelevant; what matters is whether or not at the margin the presence of NSR induced firms to delay or avoid investments that would have increased energy efficiency and reduced emissions. The environmental group cited is concerned about the magnitude of the effect of NSR on the investment decision, when it's the sign of the effect (more investment, less investment, or no effect) that's important. (note: this kind of logical error is the sort of thing that drives us economics professors batty.)

Second, where you draw the line does not influence investment decisions as much as how bright the line is. In other words, regulatory uncertainty can lead to substantial delays in or avoidance of new investment, because when it comes to environmental regulation many firms are risk averse.

Does the existence of NSR change investment decisions at the margin? If it does, does that effect result in increased, decreased or unchanged emissions? Those are the core questions. The report indicates that NSR does change investment decisions for existing facilities, but that the overall effects on emissions reductions that have not happened are small. Those effects are concentrated in pollutants not covered by existing cap-and-trade programs.

The EPA wrote seven recommendations to accompany the report; four of these seven were proposed in 1996 and are in the process of being implemented:
* A simplified application process for pollution control and prevention projects
* Plantwide applicability limits (PALs) to offer plants more operational flexibility and regulatory certainty
* Clean unit operational flexibility
* Changing the calculation of the actual emissions baseline away from the existing 24-hour full running capacity baseline

Three new recommendations are
* Clarification and simplification of the definition of routine maintenance, repair and replacement
* Enable companies to “debottleneck” their facilities through a streamlined process
* New, simplified criteria for aggregation of multiple simultaneous projects

For more information on these recommendations, see the EPA's NSR website.

This report reflects the importance of trying to achieve as much emission reduction as makes economic sense, at as low a cost as possible; when I teach environmental economics I call this the “value for money” approach that lies at the core of economics and human decision-making. NSR may create environmental benefits through emissions reduction, but can we achieve those (and more) reductions at lower overall cost through changing the implementation of NSR? The recommendations in this report suggest that this "more value for money" approach is possible.

A Bloomberg story on the report is available here.

Don't Let Complex Reality Interfere With What I Want: California politicians, and others who want a clear, black-and-white, well-controlled, orderly world for electricity markets, are not going to like this. Federal Energy Regulatory Commission Pat Wood pointed out today that some wash trades might be legitimate. Electricity generators operate with pretty stringent delivery commitments because of the nature of electricity -- it can't be stored, and with an alternating current system like we have, system balance is crucial to the reliability of the grid. What that means is that to achieve system balance, which is done with transactions occurring every ten minutes, sometimes generators may have to buy and sell electricity simultaneously with another party. That's a wash trade of the type that got the CEOs of CMS and Dynegy to resign last month. Other energy companies also used wash trades as a price hedge, which is another volatility-reducing benefit that wash trades can serve when used responsibly. Boy, it sure messes up a neat, pat concept of regulation of electricity markets to have something that can be abused be an essential part of keeping the juice coursing through the grid at more stable prices ...

Many electricity economists, including me, have argued that Texas is the antidote to California. Although neither state has implemented what I would call deregulation, the Texas model is a far sight more flexible, enforceable, and in touch with economic reality than the dysfunctional policy failure we saw in California. Texas' electricity "deregulation" is not a slam-dunk, though, as this article reprinted from the Ft. Worth Star-Telegram indicates. The article provides a nice summary of the complexities and the issues involved in doing partial, incremental deregulation. What it doesn't do, though, is point out how much of the slowness of benefit realization is a function of what I call "regulation hangovers," or vestiges of regulation that persist as part of the political compromise to get deregulation legislation passed. Furthermore, the author relies on the statistics about customer switching, which is a really poor indicator of the benefits derived from deregulation. For one thing, it overlooks the changes in the quality of service that the incumbent can offer to keep its customers from switching. The real benefits of electricity deregulation are about choice, and having choice; whether or not customers choose to exercise that choice is only part of the whole story. I plan to write more on this topic later this month, but for now, I'll leave it at "don't blame deregulation when true deregulation hasn't happened."

According to a Dow Jones Business News report on Yahoo Financial News, the Federal Energy Regulatory Commission is meeting behind closed doors today to discuss how to proceed with enforcement in wholesale electricity markets, in California and elsewhere. Worth watching ...

Electricity deregulation and PUHCA: This article does a decent job of laying out the issues in something that most people find pretty arcane, but is a crucial debate in electricity deregulation -- repeal of the Public Utility Holding Company Act of 1935 (PUHCA). Actually, that article does a much better job of articulating the arguments against repeal of PUHCA, so here I'd like to lay out some of the arguments in favor of repeal. Public power and "consumer advocates" see PUHCA as the sole remaining consumer protection against ever-increasing corporate, private utility market power, and they would like to see the SEC enforce it more vigorously instead of repealing it. On the other hand, opponents cast PUHCA as obsolete regulation that unnecessarily stifles innovation and investment in capital that would provide better service at lower cost. So where does this debate come from?

One of the best sources on this question, and any question dealing with the history of the electricity industry in the U.S. is Richard Hirsh. Hirsh is a Professor of History of Technology and Science & Technology Studies at Virginia Tech, and is author of a fabulous book about the electricity industry's development called Power Loss. Hirsh also wrote content for the Smithsonian exhibit called Powering a Generation, from which I quote here on holding companies and PUHCA:

To help finance the great expansion, the utility industry exploited a financial innovation known as the "holding company." Begun by equipment manufacturers, this type of company started by accepting the relatively unattractive stock and bond issues of utilities in exchange for generating and associated equipment. Thus, nascent utilities could therefore retain cash for their operations ... A favorite holding company investment among many was the Electric Bond and Share Company, created by the General Electric company in 1905, to market the securities it acquired while selling equipment to utilities.

Because the holding company now had a stake in the operating companies, they offered management and engineering services that the smaller firms could not have afforded themselves. Moreover, the holding company often consolidated the equipment and management of smaller companies into larger ones, and it helped them interconnect transmission facilities to ensure higher levels of reliability. Overall, the holding company innovation appeared to facilitate expansion of the utility industry ...

During the go-go years of the 1920s, however, some of the beneficial principles of the holding company concept got lost in the desire to exploit its business structure ... The scheme allowed stockholders of the top company to control the assets of operating companies with very little investment. Samuel Insull was one of the kings of these empires. In 1930, his capital investment of $27 million allowed him to control electric companies and assorted other businesses in 32 states having assets of at least $500 million ... By 1932, only eight holding companies controlled almost three-quarters of the investor-owned utility business. Perhaps best of all for the holding companies, their operations usually were exempt from the investigation of state regulatory commissions, since so much of their business crossed state boundaries.

The abuses of holding companies invited a six-year investigation pursued by the Federal Trade Commission beginning in 1928 ... By passing the Public Utility Holding Company Act of 1935, Congress outlawed the pyramid structure that had been at the core of financial abuses. Holding companies could remain, but they could only have two levels -- one holding company on top and one or more operating subsidiaries below. Meanwhile, the law dissolved holding companies that did not contain contiguous operating utilities; earlier companies held operating companies that were scattered about the country and could not take advantage of consolidated or interconnected operation. Moreover, all interstate holding companies and practically all businesses that produced a substantial amount of electricity would be forced to register with the newly created (in 1935) Securities and Exchange Commission ... By not outlawing holding companies altogether, these New Deal initiatives recognized the engineering and management value that holding companies could provide to operating companies. Nevertheless, the number of holding companies declined, from 216 to 18 in the period between 1938 and 1958, while hundreds of operating companies became separated from holding companies altogether.

So what are the arguments for repeal? In December, 2001, the House Subcommitte on Energy and Air Quality held hearings on H.R. 3406, which is the House electricity bill and is complementary to the House energy bill passed last summer (the Senate version essentially rolls together many proposals of these two House bills). This testimony from Isaac Hunt, an SEC Commissioner, laid out the arguments for repeal quite eloquently. Here are some quotes:

... because much of the regulation required by PUHCA is either duplicative of that done by other regulators or unnecessary in the current environment, the SEC continues to support repeal of PUHCA ... As the SEC has testified in the past, however, we continue to believe that repeal should be accomplished in a manner that also preserves important protections for consumers of utility companies in multistate holding company systems ... repeal of the Act would eliminate regulatory restrictions that prohibit utility holding companies from owning utilities in different parts of the country and that prevent nonutility businesses from acquiring regulated utilities. In particular, repeal of the restrictions on geographic scope and other businesses would remove the impediments created by the Act to capital flowing into the industry from sources outside the existing utility industry. Repeal would thus likely have the greatest impact on both the continuing consolidation of the utility business as well as the entry of new companies into the utility business.

Repeal of the Act would also eliminate any impediments that exist to other regulators' attempts to modernize regulation of the utility industry. For example, during the past year, questions have arisen about how the Act will impact the ability of the Federal Energy Regulatory Commission ("FERC") to implement its plans to restructure the control of transmission facilities in the United States ... As a result of FERC's new regulations, many utilities will cede operating control -- and in some cases, actual ownership -- of their transmission facilities to newly-created entities. The status of these entities, as well as the status of utility systems or other companies that invest in them, raise a number of issues under the Act. Most prominently, it has been asserted that the limits the Act places on the other businesses in which a utility holding company can engage will create obstacles for nonutility companies that may wish to invest in or operate these new transmission entities.

Furthermore, FERC Chairman Pat Wood testified in the same set of hearings that

Sections 111-125 of the Chairman's proposed legislation repeal the Public Utility Holding Company Act of 1935 (PUHCA) and replace it with increased access by the Commission and state regulators to certain books and records. This is appropriate. PUHCA was enacted primarily to undo harms caused by certain holding company structures that no longer exist. In the 65 years since PUHCA was enacted, utility regulation has increased substantially under the Federal Power Act (including oversight of corporate restructurings such as electric utility mergers, discussed below), federal securities laws and state laws, all of which ensure that customers are fully protected.

Other testimony in favor of repeal is here and here. Arguments against repeal are here, here, and here.

(Warning: this is a rant) OK ... the antidote to my hopefulness. I just walked home from the el, which I took to work today because the rain threatened this morning and put me off of bicycling. Greenpeace has a bunch of their summer student employees out and about spreading the word about Mother Earth, their mission, etc. One of them approached me (very politely, may I add) and asked if I wanted to hear about environmental issues. I told him that I teach environmental economics and was in the middle of finals week, so he might want to talk to someone else. He was intrigued and asked me what I thought about environmental issues like global warming. I told him that I think property rights matter, that private enterprise and ingenuity are crucial to a clean environment, that a healthy economy is an important foundation of a healthy environment, and that CO2 is not a human toxin. In response, he said, "oh, you mean acid rain?" I said, "No, that's SO2, CO2 is the global warming that you are worried about. That's one reason why you should take an environmental economics course." Bless his soul, at that point he realized that talking to me was not going to get him where he wanted to go. I am not mocking or faulting this earnest, well-intentioned, polite young gentleman, but if Greenpeace is going to send out folks to canvass, they should teach them some SCIENCE first!

This week is finals week at Northwestern, and that means that I get to read 11 research papers from my Environmental Economics class. Very good brain candy -- I always learn something from their presentations, their evidence, and their arguments. If these students are representative of the future of environmental policymakers, I am hopeful.

I'm not going to get into the California market manipulation fray any further for now, beyond providing links to stories summarizing the issues and commenting on the continuing vituperative rhetoric of politicians in California, without any willingness to acknowledge that the rules of their dysfunctional "market" did not forbid any of these trades. At the big picture level, I truly think this is part of the learning process. We've only been trading natural gas as a commodity since 1989 and electricity since 1992 (and not in any serious volumes until 1996, really), so our experience of dealing with the financial transactions of electricity and gas is pretty short. We've been trading all sorts of other commodities using financial instruments for over 400 years, from tulips in Dutch markets in the 1600s to shares in insurance annuities of young French girls in the 1700s to modern trading of wheat and pork bellies. The SEC is now going to have to think more carefully about how it should treat energy commodity trades to ensure market transparency, and to make the rules for trading energy consistent with the rules for trading other commodities. One complicating factor, though, will be some of the physical characteristics of electricity that could keep it from being a really good tradeable commodity, such as the fact that it cannot be stored given current technology. Anyway ... some good stories on what's going on are here and here. This is a commentary I wrote a month ago about the trading strategies detailed in the Enron memos that FERC released.

Furthermore, the International Energy Agency announced today that it is revising its oil demand estimates downward for the second half of 2002. They cite the slow economic recovery as the primary reason for the revision. Slower oil demand growth increases the likelihood that prices will remain stable (all other things equal, of course). This pattern is not surprising, though -- in the same sense that the beginnings of economic recoveries are often "jobless," companies do more with less of all of their inputs, energy included. It's one of the hallmarks of increasing productivity.

Lots of good oil market news today for consumers; a bit less good if energy stocks comprise a substantial share of your investments! A Platts survey of OPEC production shows a huge increase in May, according to a press release on Yahoo Financial News. Iraq coming back online and Venezuela increasing production after the oil strike and the failed Chavez coup attempt accounted for much of the increase. Interestingly, though, all countries with a stated production quota overproduced. It's a beautiful illustration of why cartels are unstable and usually fail to sustain price increases; if you scroll down to the table showing production and quota by country, each country is exceeding its quota by a pretty small amount. But when you add up these little violations it's enough additional production to stem price increases in the world oil market. We can especially expect Venezuela to continue producing beyond its quota, notwithstanding its strident rhetoric of the past two years, because of the government's revenue requirements. Their incentive to make money in the short run by taking market share from other producers outweighs their long-run incentive to stabilize the cartel at a higher price.

This story from CBS Marketwatch does a nice job of summarizing the myriad developments in the energy industry in the past week. More thoughts later about how this house-cleaning is painful in the short run, but extremely beneficial in the long run as long as it doesn't lead to knee-jerk, reactionary, thoughtless government regulation. Now I'm off to paint an elementary school in the annual Chicago Cares Serve-a-Thon, and then biking in Wisconsin, if the Rock River isn't so high as to swamp our camping space.

I wonder if California's politicians will ever stop externalizing all of the responsibility for their failed electricity restructuring. Now they are moving beyond placing all of blame on Enron and other "greedy, out-of-state, price gouging" power suppliers to Perot Systems, the company that wrote the software to implement California's failed "market" design and made marketing presentations to energy companies about trading strategies for California. Only looking at the facts can determine whether Perot Systems had a conflict of interest in this situation; it's not even clear yet whether the presentation was to an energy company or to the Power Exchange to alert them to possible holes in the system. Since they didn't develop the rules, but only wrote the software to implement them, I'm not sure there is a conflict. I have one question, though: what makes these politicians think that energy companies did not already realize what the flaws were in the rules and structure of the "market"? Governor Davis and some of California's other political leaders stick solidly with their victim rhetoric, with no acknowledgement that the "market" structure and rules created the opportunities for manipulation that they are decrying. This continuing externalizition of responsibility helped deepen the electricity crisis in late 2000 and early 2001, and does little to further progress toward energy choice for California's residents.

In terms of energy markets, the news today seems to be no news. Prices are not fluctuating much, domestic gasoline inventories are higher than last year at this time, OPEC producers are pumping 1.4 million barrels per day over their stated quota (that's 6 percent).

A Reuters article today posted on Yahoo Financial News illustrates a fascinating aspect of the energy future -- the old fossil fuel industries can help create a "green energy" future more cost-effectively than totally green options. This article cites a presentation by a Shell official who discussed how oil refiners can use gasification to turn fossil fuels into hydrogen, and how it's currently far cheaper to do that than it is to create hydrogen through solar-powered electrolysis. It may not be 100% green, but it's an incremental step toward generating hydrogen cost-effectively. I call that progress.

According to Bloomberg News, Germany's largest energy trader is planning to expand its US operations. What a great example of entrepreneurial opportunism -- RWE representatives state explicitly that they have not engaged in the types of questionable trading practices that are driving the financial uncertainty in US energy markets. This is how competition creates stability; hopefully the entry of RWE and other experienced financial firms will help stem this year's shrinkage of US wholesale electricity markets. RWE also plans to retain ownership of some actual physical assets to support its energy trading, unlike Enron's strategy of divesting as much of the physical realm as it could.

Testing, testing...