The Knowledge Problem
Commentary on Economics, Information and Human Action

Thursday, September 19, 2002  

BRITISH ENERGY'S FINANCIAL WOES: For anyone interested in the financial difficulties at British Energy, and the dilemma facing the government in thinking of bailing them out, this Financial Times article gives a nice summary of the issues. Bottom line: government-driven nuclear investments and the inability to predict the future.

And people complain about market processes? Please.

posted by lkkinetic | 9/19/2002 04:02:00 PM

WARREN ZEVON: I share the comments of Virginia Postrel, Jim Henley, and others who are very, very sad to hear of Warren Zevon's illness. I think that Virginia's right, that some of his allure is a dark intellectual geek hipness, and that he's also wry and clever and whimsical. His best-of 2-CD set is always in our player. My husband, a huge Zevon fan for decades, got me his recording of "Hit Somebody! (The Hockey Song)" when I started playing ice hockey. I like his quote at the end of Edna Gundersen's USA Today article:

Notice you're alive ... All I can say is what I've always said: If you break your leg, stop thinking about dancing and start decorating the cast.

posted by lkkinetic | 9/19/2002 03:55:00 PM

OPEC LEAVES QUOTAS UNCHANGED: As reported by the Financial Times, the Chicago Tribune, Bloomberg Energy News, OPEC officials meeting in Japan have decided not to change the existing quotas. Crude prices in New York are still flirting with $30 per barrel, the OPEC benchmark price is close to $28 per barrel, and OPEC officials know that this relatively high price induces cheating on quotas by smaller countries who are desperate for revenue, but they are sitting tight for now.

And here's a pretty good article from the BBC on whether or not going into Iraq is about oil. This New York Times article (registration required) describes the new Caspian pipeline from Azerbaijan and Georgia to Turkey that will bypass Russia and Iran. Groundbreaking on the oil pipeline took place today, and a natural gas pipeline is planned for the future. The article gets the economics pretty right, and also illustrates how important multinational consortia are to developing new oil and gas resources -- just check out the number of companies that are collaborating on building this pipeline.

posted by lkkinetic | 9/19/2002 03:35:00 PM

CALIFORNIA PUC STUDY OF 2000-2001 BLACKOUTS ADDS LITTLE SUBSTANCE: On Tuesday 17 September, the California Public Utilities Commission released a study indicating that the five largest private generators in the California wholesale market did not produce up to their capacity during the winter 2000-2001. Looking at 38 blackout days between November 2000 and May 2001, the PUC study concludes that because of this lack of production, blackouts occurred, and that if Duke Energy, Dynegy, Mirant, Reliant, and AES/Williams had sold all of their available capacity, that all of the Southern California and most of the Northern California blackouts could have been avoided.

This study raises several practical and theoretical economic questions. First, the practical. The study did not take into account the fact that many facilities in California were operating as “reliability must run” (RMR) facilities for the California Independent System Operator (ISO), and that therefore much of who put power into the grid in what hour and in what amounts was under the automated control of the ISO. In fact, the authors claim that any and all hours in which plants did not comply with ISO orders to offer power were the deliberate actions of the generators, when many other studies and news reports have indicated the extent to which the ISO engineers were completely overwhelmed and could not keep up with the volume of system balancing work that was required of them. Because of the interplay of the utility bid underscheduling and the generator movement of transactions into the ISO real-time market, the ISO ended up processing many more real-time transactions than had ever been intended, or for which it had been designed. Thus the ISO was scrambling to keep the grid in balance, and probably did not perform optimal dispatch, but the PUC study does not acknowledge that reality.

The report does point out the important fact that the ISO could not compel generators to comply with ISO requests in Stage 2 or Stage 3 alert periods. The ISO did not receive this authority until June 2001.

Amazingly, the report trots out the usual arguments against the generators for their bid withholding from the day-ahead market, but fails to discuss the role of utility bid underscheduling in working in conjunction with that withholding to shift so many transactions to the ISO real-time market. This combination of bid underscheduling and supplier bid withholding tends to happen in bifurcated wholesale market designs, such as the PX/ISO system that California mandated in its restructuring legislation.

Now, the theoretical. On page 14 the report’s authors assert that “the generators should have offered all of their available power supplies to the ISO at all times. Indeed, after FERC imposed comprehensive market controls in June 2001, including a price cap, trading barriers to prevent some types of market manipulation and a ‘must-offer’ obligation, blackouts and service interruptions nearly ceased even though California’s power demand was at its highest in the summer.” Suggesting that generators should have offered all of their available capacity at all times is economically absurd.

Contrary to what some politicians would like to believe, generating electricity costs money, those costs fluctuate even in functioning markets, and those costs were unusually high in the period in question. Two of the cost components that increased the most were natural gas and emissions permits. The report mentions high natural gas prices (alluding also to the ongoing FERC investigation of natural gas price manipulation at the California border), but does not incorporate the important, and scarce, emissions permits. Other studies have suggested that some plants could not operate in some hours because the price they could get for their electricity did not make buying the permits worthwhile.

One revealing piece of economic ignorance in the study is on page 18, where the authors state that “in these calculations, bids are not considered valid if the ISO ordered a generator to produce power pursuant to a bid by that generator, and the generator failed to respond to or rejected the dispatch for ‘economics.’” In other words, the PUC would have preferred to force the generators to produce power even if they would lose money by doing so. I would be interested in knowing how many such bids were excluded from their calculations, and what proportion those bids were of the total capacity that the study attributed to the generators. Unfortunately, though, the appendices that apparently report the data are not available on the CPUC website, so I am unable to replicate their results.

Furthermore, statements like “Generators Failed to Bid in All Supplies During Blackout and Service Interruption Hours Even Though the Power Was Needed” on page 56 seem to indicate that the PUC expects the electricity industry to operate on the basis of charity, not on the economic exchange of value for value between buyers and sellers.

Another economic feature that the study fails to understand or interpret correctly is payment and credit risk. In almost any transaction there will be some credit risk. In the dysfunctional universe that was the California wholesale market in 2000-2001, credit risk was huge – one reason why prices went as high as they did was that generators factored in the probability that they were not going to get paid. Given that PG&E subsequently declared bankruptcy to avoid its creditors, that risk premium in the wholesale electricity price looks like it was pretty important. On page 53 the authors of this study show the extent to which they fail to understand credit risk and the risk premium portion of the wholesale price, when they relate an ISO request to a generator to power up in a Stage 2 hour, but the generator refused because they did not think they would get paid. Apparently the ISO operator took umbrage at being told by the generator that, given how close demand was to supply, the ISO should consider reducing demand. In the archaic, one-sided world of supply dispatch, the only way to reduce demand is involuntary interruption (California did have some voluntary interruption contracts, but only rudimentary ones). In fact, the report characterizes the generators as having disputed prices and terms “improperly” with the ISO. The attitude put forth in this report is not one that understands and appreciates mutually beneficial exchange as a foundation of civil society.

There is not one single mention in the report of the role of exports, or the fact that California gets much of its power from plants that are located out of state and were not required at the time to sell into California, although it counts that capacity as part of what the five generators should have sold into the ISO upon demand. The report obliquely refers to the exports and Western market issue in its final chapter, with the shrill demand that FERC extend the “must serve” conditions that are currently in place for the whole Western interconnection.

The report also invokes the studies that showed that generators had incentives to withhold power to raise prices, and that they did in some hours. Again, though, they add no economic insight or nuance to what has been shown in those other studies. Most importantly, they fail to acknowledge the role that poor, politicized policymaking processes and bad rules played in creating an environment in which generators did have market power. As many have said before me, and many will after, the dysfunctional California restructuring labyrinth gave the generators market power on a silver platter.

The extent to which the authors demand in the final chapter that FERC “do something” indicates precisely the extent to which the PUC intends this report to further its claim on retaining control over the fates of electricity producers and consumers in California. I agree with Jan Smutny-Jones, who was quoted in this LA Times article saying “Clearly, the target here is to affect standard market design in Washington, which is an actual attempt to fix the problem.” FERC has issued a Notice of Proposed Rulemaking in their standard market design process, and the California PUC continues to perceive FERC’s moves as a threat to its power over and control of the electricity industry in California, as this article suggests.

Other news stories on this report are here, here, and here.

posted by lkkinetic | 9/19/2002 02:32:00 PM

BUNDLING OF SERVICES TO BETTER SERVE CUSTOMERS: This nifty Tech Central Station article by Duane Freese talks about the value to consumers of bundled telecom/technology services. I have a similar vision for companies being free to offer a portfolio of contract options to consumers, even extending to bundling with other infrastructure industries if there's a market for it and they can make the costs work. Good article.

posted by lkkinetic | 9/19/2002 02:26:00 PM

WE'RE WEALTHY ENOUGH TO ABSORB THE SHOCK: According to Robert Samuelson at Newsweek, the expected cost of a possible war in Iraq is only one percent of our GDP. Not that our wealthy society is a reason to go wage war, but it does mean that we are more likely to be insulated from most of the economic effects on us experienced in all other wars in history. No rationing of gas and pantyhose! Hmmmm, maybe rationing pantyhose wouldn't be such a bad thing!

posted by lkkinetic | 9/19/2002 02:01:00 PM

THE AIR WE BREATHE IS CLEANER: I've noticed this twice now in London -- many more cyclists, almost none of whom wear face masks. And then I come home to find this commentary by my Reason colleague Joel Schwartz on improvements in air quality in the U.S. in the past decade. Joel knows more about air quality science and policy than anyone else I know, and he argues persuasively, with good evidence, that air quality has gotten better.

posted by lkkinetic | 9/19/2002 01:58:00 PM

Woo hoo! Vacation was fun, lots of stuff happened here in electricity and oil while I was gone. Lots of catching up ... which I started at 5 this morning. Aaah, jet lag!

posted by lkkinetic | 9/19/2002 01:55:00 PM

Wednesday, September 11, 2002  

GOIN' ON VACATION: My husband and I are attending a friend's wedding in London this coming weekend, and are making a vacation of it. Periodic updates if interesting things happen.

posted by lkkinetic | 9/11/2002 10:00:00 PM

I live across the street from an elementary school in the Chicago Public School system, and I was just aroused from my writing by cheering and clapping and honking of cars on the main street through my neighborhood. I looked out the window and saw a parade of all of the school's children, by classroom, coming out with each student holding an American flag. Passers-by on the street honked their horns in support of the students and teachers.

I also live on a main O'Hare flight route, and saw several planes come in for landings as I watched the parade. It is an eerily gorgeous day here, sunny and cool and clear, much as it was in Washington (where I was) last year on this day. We are a strong people.

posted by lkkinetic | 9/11/2002 12:12:00 PM

JOHN MCCRAE AND WORLD WAR I POETS: The poem on Megan's website, "In Flanders Fields", is by John McCrae, one of the group of WWI poets that wrote so poignantly about the waste and destruction of war. Siegfried Sassoon, Rupert Brooke and Wilfred Owen are three of the other most renowned WWI poets

posted by lkkinetic | 9/11/2002 08:12:00 AM

The cello is the most soulful, most personal, most moving musical instrument. Yo-Yo Ma is playing accompaniment to Rudolph Guiliani's reading of the WTC names, and it's deeply moving. Reading the names with such intimate accompaniment reminds us of how personal this was and is, and that this is about real people living real, free, lives.

posted by lkkinetic | 9/11/2002 07:58:00 AM

MARKET-BASED RETAIL PRICES ARE CRUCIAL FOR SUCCESSFUL ELECTRICITY RESTRUCTURING: I have been working on a chapter for a forthcoming book on electricity restructuring, to be published by the Independent Institute. In writing it I wrote some of my most heartfelt arguments for consumer choice and freedom in electricity markets.

Retail prices have always played an important role in enabling exchange, and in leading to efficient outcomes and investment. Prices are a good tool for efficient resource allocation precisely because they transmit a lot of information about costs and preferences of disparate and anonymous economic actors, and do so very parsimoniously. This truth holds for the electricity industry as much as any other industry, even though the complex engineering and network system requirements, and the history and culture of regulation in the industry, have led to an industry where retail rates are guaranteed, fixed and regulated. Indeed, the costs of providing electricity change frequently, even hourly, which suggests that market prices would be an extremely valuable tool in leading to efficient resource allocation and investment. For that reason, integrating supply-side and demand-side response in wholesale and retail electricity markets, and offering customers a portfolio of retail contracts from which to choose, would reduce the overall costs of electric service and benefit consumers.

Since state regulation of utilities began in 1907, retail customers have faced average rates that do not change frequently. Retail electric service is provided on a guaranteed-price basis, under the state-enforced regulatory “obligation to serve” remit. Fixed, regulated rates insulate customers from the price decreases or increases that excess supply or demand would produce, and from the financial risk that often occurs in markets for commodities like electricity. The must-serve obligation on the regulated utility is an obsolete relic of the political dynamic of regulated electric power in the U.S., in which supply reliability is the highest priority, regardless of how much it costs to provide that reliability. Reliability has historically been considered only a supply-side problem, and the industry, regulators, and political institutions have internalized that belief, which persists to this day.

Regulated, average retail rates disconnect the prices individual consumers pay from the marginal cost of providing them power in any hour. Their prices also do not fluctuate to reflect changes in those marginal costs. Regulated rates also provide no consumer incentive to change their consumption as marginal cost changes, because the prices they see bear no relation to the marginal cost of serving them. Inefficient energy consumption and production is the logical consequence of this disconnect, which means that fixed average rates do not satisfy either static efficiency conditions, or dynamic efficiency conditions that induce optimal capital investment in the electricity system. The declining reserve margins and the lack of transmission construction that we have seen in the past decade indicate the absence of dynamic efficiency incentives in the regulated average price system as it currently exists. These existing rate structures also contain embedded cross-subsidization – within the residential, commercial, or industrial customer class, those who could have more elastic demand subsidize those who have more inelastic demand. This cross-subsidization not only leads to inefficient resource, but also is a political obstacle to changes in electricity pricing business models at the retail level.

When institutions are stable and supply capacity is not binding, the negative consequences of these average, fixed retail rates to consumers are not obvious. In the past decade, though, the dynamic factors influencing the electricity industry have revealed the flaws inherent in regulated average rates. In particular, technological change and resulting regulatory change have raised the benefits attached to efficient resource allocation, and prices that communicate information well are an important tool in achieving that efficiency. Regulatory change in the states in the U.S. in the past decade has emphasized wholesale market deregulation because of the technological change that has decreased efficient scale of generation. That focus, however, has disconnected the wholesale and retail markets, and has ironically done so in the states that have been restructuring pioneers. The hodge-podge of partial deregulation at federal and state levels has left fixed average retail rates in place. Proponents of retaining fixed retail rates argue that they protect consumers from the “unpredictable vagaries of the market”. In fact, these fixed rates do nothing more than protect consumers from innovative service offerings and contracts, while also protecting the historic profit margins of utilities.

Retail pricing is a crucial component of an integrated, healthy, dynamic electricity industry. Offering consumers a portfolio of contract choices in a range of market-based prices would make many diverse consumers better off, and would also bolster system reliability and reduce forced outages. This portfolio of contracts approach, though, is a novel value proposition in this historically regulated, vertically integrated industry. Without retail pricing that gives consumers the opportunity to choose how they want to consume power, how much wholesale price risk they are willing to bear, and how they want to pay for it, electricity restructuring will fail to deliver efficiency and value to consumers. The “one size fits all” of regulated, fixed, average rates will become increasingly obsolete because of technological change, institutional change, regulatory change, and cultural change that recognizes the diversity of value propositions that the electricity industry can profitably present to consumers.

This commentary, along with related links, is also published at the Reason website.

posted by lkkinetic | 9/11/2002 07:55:00 AM

Megan McArdle has a beautiful poetic tribute on her webpage today.

posted by lkkinetic | 9/11/2002 07:45:00 AM

When I see the city . . . I feel that if a war came to threaten this, I would like to throw myself into space, over the city, and protect these buildings with my body. The Fountainhead, Ayn Rand

posted by lkkinetic | 9/11/2002 07:44:00 AM

Tuesday, September 10, 2002  

HOW COOL IS THIS? Canadian scientists have found huge deposits of natural gas deep in Pacific ice. These gas hydrates have the potential to increase our energy supplies dramatically. This article suggests something that's crucial to our continuing economic growth, and will also lead to environmental benefits -- technological change in identifying, finding, and extracting energy from sources that weren't obvious or identifiable before will keep energy prices low, and as these technologies mature and we invent new technologies to harness these cleaner fuel sources, the relative value of oil will fall, and our reliance on oil will fall.

posted by lkkinetic | 9/10/2002 08:39:00 AM

OIL PRICE UPDATE: As I expected, the mounting arguments and persuasion efforts toward attacking Iraq have kept oil prices high, both in New York and in London. This CBS Marketwatch article and this Bloomberg News article summarize the oil market's movements. Prices are high and hovering, waiting to hear how different countries respond to President Bush's UN speech on Thursday. Meanwhile, here the industry is sockin' away home heating oil for the winter.

posted by lkkinetic | 9/10/2002 08:32:00 AM

TRADEABLE CARBON CREDITS: And, in another good TCS article today, Marlo Lewis analyzes the effects of several CO2 reduction initiatives. Marlo focuses on the February 2002 Bush administration policy announcement of transferable credits for voluntary reporting of greenhouse gas emissions. You report it, you get to trade it. Interesting idea, sounds sensible and market-based, but ... Marlo eloquently and incisively lays out why it's not as market-based as it appears, and what some of its unintended consequences could be.

posted by lkkinetic | 9/10/2002 08:26:00 AM

PACKETS AND THINGIES: And this article by Arnold Kling is the first of a two-part series looking at the economics and architecture of what I think of as electronic infrastructure. His comments on the economics of Packets are interesting, and I think he's right that we'll see packet delivery priced at different levels for different volumes. Yahoo! is already doing a form of this with its email, briefcase, and other services -- you get X amount for free, but for $Y you get this much more storage, functionality etc. I think Arnold's comments also have some relevance to the electricity industry, because it too is an industry that relies on interconnecting and sharing infrastructure.

posted by lkkinetic | 9/10/2002 08:20:00 AM

THE CELTIC TIGER: Tech Central Station has a lot of good content today, including this article by Ben Powell on Ireland's economic growth. Punch line:

Ireland's successful formula for development for the past 15 years has been a reliance on market forces, lowered taxes, reduced trade barriers and reduced regulatory burdens. This simple, market-driven focus has created opportunities for citizens, industries and businesses - and the market has rewarded all amply. In the span of 15 years Ireland has become one of Europe's most prosperous nations.

Yes. My experience with economic activity in Ireland has to do with US multinationals locating manufacturing facilities there, taking advantage of low tax rates, high education levels, and all of the other things that Ben mentions in his article. Their free-market approach has led to so much job creation in Ireland that there's actually a reverse diaspora of Irish Americans returning to Ireland to live and work.

posted by lkkinetic | 9/10/2002 08:13:00 AM

MADONNA AND MODERN FEMINISM: Andrew Sullivan's comments on an interview with Madonna and Guy Ritchie are simply fabulous. The interview itself is a fascinating window into a modern relationship, but Andrew's analysis is incredibly insightful.

posted by lkkinetic | 9/10/2002 08:01:00 AM

THERE'S NOTHING WRONG WITH CAPITALISM: Many, many thanks to Juan Non-Volokh for posting a link to the lyrics to my favorite Oingo Boingo song. Imagine a slightly edgy, but also synth 80s, beat. I continue to believe that Danny Elfman is a genius.

posted by lkkinetic | 9/10/2002 07:52:00 AM

Friday, September 06, 2002  

CRUDE ABOVE $30 AGAIN: Crude oil prices have gone above $30 again, according to a Bloomberg Energy News story. Still working with this prevailing uncertainty ... it will be interesting to see what happens to prices Monday, after Bush and Blair meet this weekend.

posted by lkkinetic | 9/06/2002 02:11:00 PM

REASON RECOMMENDS EXPANDING THE AIRPORT SCREENING PROGRAM: My colleague Bob Poole also wrote a Reason study released yesterday in which he recommends expanding the number of airports allowed to opt out of the fully federalized security model that is already failing. Several members of Congress have supported the study, most notably John Mica of Florida, who is chairman of the House Transportation Aviation Subcommittee. Bob's recommendations are sensible, implementable, and realistic, and I recommend the study to you.

posted by lkkinetic | 9/06/2002 02:09:00 PM

REGULATION CREATES OPPORTUNITIES: Through my colleague Bob Poole I learned about Baggage Direct, which will pick up your baggage 12-24 hours before your flight, and deliver it to your destination. As with most things, this is good news and bad news -- entrepreneurship and human ingeneuity are thriving, but it will cost us, and that cost is the result of inefficient, wasteful regulation.

posted by lkkinetic | 9/06/2002 02:06:00 PM

In Great Questions of Economics, Arnold Kling always asks important questions that plumb the nuance and power of economics. In this post he raises the issue of intellectual property, specifically with reference to media. I think he's right about our current ugly transition from a mass media era to a distributed media era, and how the mass media companies are fighting it tooth and nail. I also personally think that they are not fighting fair.

posted by lkkinetic | 9/06/2002 01:54:00 PM

Has it been a week? Boy, have I had my head in my work! Except for last weekend, when I had my head in my knitting, trying to finish a sweater to take on vacation next week. I am working on a book chapter on retail electric pricing for an edited volume on electricity restructuring. The focus is, surprise surprise, on the information content of prices, and how the traditional fixed, regulated, average-over-time retail price that we pay throws out a lot of information, doesn't give consumers any incentive to conserve or to make informed choices about their energy consumption, and leads to poor investment incentives. Nowhere, and I mean nowhere, in this country has market-based retail electric pricing, even in places that have "deregulated". This is going to become an increasingly important issue in electricity policy, and it's going to be a sticky one, because it's not just pass a law and bammo -- it's about changing a century of culture, for consumers, for industry, for regulators. My favorite articulation of this problem is from Vernon Smith, at ICES: utilities have to wrap their minds around the thought that they can make more money by selling less power.

posted by lkkinetic | 9/06/2002 01:46:00 PM
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