The Knowledge Problem
Commentary on Economics, Information and Human Action

Monday, October 14, 2002  

EMERGENT ORDER AND THE INTERNET: Here is a nifty Economist article on how the Internet is scale-free, and has evolved into an order that is less random than you might think. These traits have implications for many things, including how you address viruses. It's a great example of decentralized, emergent, spontaneous order, and it does have order as one of its characteristics.

posted by lkkinetic | 10/14/2002 02:32:00 PM

MORE ON EXPERIMENTAL ECONOMICS: David Warsh has written this superb column on experimental economic's development, and Vernon Smith's role in that development. He tells the story very well, illustrating the experimental diaspora from the vibrant group of scholars at Purdue in the late 1950s and early 1960s. Warsh also mentions one of those scholars, Jonathan Hughes, who was a pioneer in applying rigor and economic analysis to economic history. Hughes was the author of two very important books about entrepreneurship (The Vital Few) and the history of government involvement in the U.S. economy (The Governmental Habit), among his many other achievements. He was also a professor of mine in graduate school, a wonderful role model, and a genuinely good person, in addition to being a fantastic economist.

posted by lkkinetic | 10/14/2002 08:45:00 AM

Thursday, October 10, 2002  

Virginia Postrel's New York Times column today addresses new institutional economics and the rich array of fascinating economic research going on in NIE right now.

posted by lkkinetic | 10/10/2002 12:12:00 PM

REASON INTERVIEW WITH VERNON SMITH: This Reason interview with Vernon Smith is a good read, with lots of insight into experimental economics. And this New York Times article from today discusses both Smith's and Kahneman's work.

posted by lkkinetic | 10/10/2002 11:58:00 AM

WALL STREET JOURNAL EDITORIAL: I have an editorial in the Wall Street Journal today on the importance of experimental economics and Vernon Smith's Nobel prize.

posted by lkkinetic | 10/10/2002 11:56:00 AM

Wednesday, October 09, 2002  

VERNON SMITH WINS NOBEL PRIZE: Vernon Smith has won this year's Nobel Prize in Economics for his pioneering work in experimental economics. This is outstanding! See the press release from Mercatus for further details. See also my post from yesterday about electricity experiments and demonstrating the benefits of choice. Vernon Smith and his work form part of the foundation of why I named this website "The Knowledge Problem". Many, many congratulations.

Smith will share the Nobel this year with Daniel Kahneman, whose behavioral work integrates psychology and how humans make decisions in the face of uncertainty into economics. Kahneman's seminal work with Amos Tversky has really broadened our understanding of human decision-making.

This is a great Nobel year.

UPDATE: Article from Washington Post, and Nobel press release.

posted by lkkinetic | 10/09/2002 09:25:00 AM

Tuesday, October 08, 2002  

BRAVO FOR ANDREW CASSEL! In a Philadelphia Inquirer column yesterday, Andrew Cassel said it beautifully:

The real shame of Enron isn't that its top executives got filthy rich off of crooked deals and phony accounting. It's that the company took a good idea and poisoned it.

The good idea is competition, specifically competition in the production and delivery of electricity. It's an idea that has already brought significant benefits and will bring many more if it grows and evolves.

Read the column, and don't blame Enron on deregulation or markets or anything other than the greed and lack of integrity of a few venal characters.

posted by lkkinetic | 10/08/2002 12:57:00 PM

REASON'S INTERVIEW WITH STEVEN PINKER: I've been reading Steven Pinker lately, and his new book The Blank Slate has just arrived. In The Blank Slate Pinker takes on three "myths": the blank slate, the noble savage, and the ghost in the machine. I think the implications of his research, and his writing for laypeople, are profound for economics and the importance of human nature. The most recent Reason magazine has a really, really good interview with Pinker, in which he discusses his new book and other important issues. I recommend the interview, and Pinker's writings, highly. He'll make you stop and think.

posted by lkkinetic | 10/08/2002 12:52:00 PM

Experimental Economics and Retail Electricity Deregulation: Demonstrating the Benefits of Choice

Regulatory change in electricity moves slowly, in part because of human dislike of change and aversion to risk. Convincing people that regulatory change is worth undertaking would be a lot simpler if we could demonstrate the possible outcomes of a change, and thereby that such change need not be disastrous and could even create value and opportunity for many people. But electricity networks are so complex, and so expensive to construct, that real-world experiments are very costly and unlikely to occur. It’s not like opening a new restaurant and seeing if consumers perceive value in the offerings of food, wine, service, and environment. In this context, the methodology of experimental economics is incredibly useful and can help us place bounds on what may occur if we implement fuller retail electricity deregulation. Experimental economics simulates environments having different rules, with real economic agents facing real choices, and with the potential to earn real money payoffs. Because rules influence incentives and therefore shape outcomes, rules and the institutions that create and enforce them matter, including regulatory institutions. Experimental economics can inform us about the relationships between different rules and institutions and different outcomes.

An experimental approach to analyzing electricity deregulation enables the abstraction of some features of real-world activity to focus on specific features. The recent electricity experiments of Vernon Smith, Bart Wilson, and Steve Rassenti, of George Mason University and the Mercatus Center, illustrate the power of experimental methodology to create information about what is likely, and what we cannot predict, from different features of electricity deregulation. They have created a portable laboratory setup, complete with laptops, wireless networking, and well-designed software, to perform electricity market experiments in a variety of locations, with diverse participants. This description of experimental economics from the Interdisciplinary Center for Economic Science website provides a good overview of experimental economics and how it helps us understand how markets work. Smith’s entry on experimental economics in the Palgrave Dictionary of Economics is also a useful description.

Recently they have been running electricity experiments with groups ranging from college students to Congressional staffers to federal energy regulators. The people in the experiment are electricity generators, participating in a wholesale generation market. They are the supply side of the market, and they can own different types of generation capacity – baseload (low cost), intermediate cost “load followers”, and high-cost peaking units. These levels realistically reflect a typical supply curve, in which generators run their least expensive units until they hit capacity, then move to the intermediate-cost plants, and only run the expensive peaking plants during periods of peak load. Generators bid by submitting schedules of asking prices for their capacity in a given period, and all generators receive the market-clearing price. These rules mirror those found in many wholesale electricity markets. Generators can also have market power, depending on what kind of capacity they own and how concentrated that ownership is.

The experimental design can also vary the rules governing the expression of demand, either to reflect the current fixed “must serve” demand, or to test possible regulatory changes in how consumers are allowed to express their demand. Since state regulation of the electricity industry commenced in 1907, retail customers have faced average rates that change infrequently. Retail electric service is provided on a guaranteed-price basis, under the regulatory “obligation to serve” remit. In terms of consumer expression of their demand, these regulated rates have meant that consumer demand signals are metered, aggregated, and transmitted to suppliers on a monthly basis. With such unchanging rates, the demand or typical aggregate load profile fluctuates greatly across the day.

The response of the typical consumer may be “so what?” Because of the “obligation to serve” requirement facing utilities as part of traditional retail regulation, utilities must be able to generate or buy enough power to satisfy peaks throughout the day. Put another way, the responsibility for satisfying all consumers, whenever they want power, rests with the suppliers. Fixed, regulated rates mean that consumers have no incentive to take on any of that responsibility. The result of this supply-focused approach is lots and lots of generation capacity, because suppliers are required to serve all demand, whenever it occurs, without changing prices to reflect the different costs of serving that demand at different times. Retail prices cannot change even though costs do change, as captured in the three different types of plants used by the industry and in these electricity experiments.

In presenting the economics underlying the power of consumer demand in electricity markets, Smith analogizes between the electricity industry and other industries, particularly the airline and hotel industries. All three are service industries, facing peak demand that fluctuates and that determines capacity, with substantial capital investment requirements to satisfy demand. In competitive markets for airline travel and hotel rooms, where both consumers and producers can provide and respond to price signals, rates typically go up in peak demand periods and plummet in off-peak periods. The high rates in peak demand periods, rates that certainly exceed marginal cost, pay for the capital that is necessary to satisfy the peak, and the interaction of these price signals lead to optimal capacity investment.

That doesn’t mean, though, that all customers who want a seat or a room at peak will get it at a price they are willing to pay. So what do we all do when facing high airfares or hotel rates? We time-shift, traveling on a different day or at a different hour. Hotels and airlines do not operate under a regulatory obligation to serve, yet consumers deal with the fact that they might not be able to consume the flight or the hotel room they want when they want at the price they want. They deal by shifting their demand to different times, trading off convenience for cost depending on their individual preferences. Thus the comparison with the airline and hotel industries reveals exactly the extent to which the “electricity cannot be stored” rationale for regulation is a canard – airline travel and hotel service cannot be stored either, yet no one is arguing that these industries should operate under “must serve” obligations like those in the electricity industry.

In this article in Regulation in Fall 2001 (scroll to p. 70 for their article, although all three are well worth reading), Rassenti, Smith and Wilson compared two bidding systems in a wholesale electricity market – one with only supply-side bidding, and one with both supply-side and demand-side bidding. The demand side of the experiment proceeds as follows: take a very simple rule by which consumers can choose whether or not to let the retail electricity supplier interrupt their service at a couple of different points, and see what effect that rule could have on the outcomes in the wholesale market. They then divided the demand into four types: must-serve demand, off-peak demand, shoulder demand, and peak demand. Under fixed retail rates, all demand is essentially must-serve demand, including the high peaks. One of the important things to learn in this experiment is whether allowing consumers to choose to have their demand interrupted at two different prices would lead to increased consumer benefit, increased supplier profits, and any change in the ability of suppliers to exercise market power in the experiments when they have it. As Rassenti, Smith and Wilson say in their Regulation article, “our small simplifications enabled us to focus on the key issues we wanted to study while still capturing the essence of the daily natural cycle in demand in all electrical delivery systems.”

The generators then have to choose prices at which they bid into the wholesale market; in some experiments the generators face perfectly inelastic must-serve demand, and in some experiments they face consumers who can choose to have their service interrupted. In their experiments the timeframe is several days (compressed into a few hours), so the generators experience bidding over the fluctuating demand cycle. And, at the end of the day, the participants get to keep their profits (with some modifications when performed with government employees), so the incentives are real.

So what happened? When there was no demand-side responsiveness, suppliers with market power were more able and more likely to exercise it by withholding capacity. In the experiments with both demand-side and supply-side bidding, suppliers with market power were not as able to exercise it, and price fluctuations were smaller. Not only were average prices lower, but the variance of prices was also lower; demand responsiveness reduced price levels and price volatility, even in the face of supplier market power. When suppliers did not have market power, demand responsiveness still led to lower and less volatile electricity prices.

In their Regulation article, Rassenti, Smith and Wilson report these results from experiments performed at the University of Arizona. I have also seen similar results from experiments performed at the Federal Energy Regulatory Commission – yes, when facing profit incentives and no demand response, even the regulators exercised market power when they had it.

Experimental economics methodology improves upon “blackboard economics” in reflecting what Michael Polanyi calls tacit knowledge – when we make choices, including social interaction choices like market exchange, we are not always conscious of all of the information and knowledge that we bring to bear in making these choices. Experiments with real people facing real incentives create an environment in which the effects of tacit knowledge are not assumed away to solve the equations on the blackboard.

Market-based retail pricing is a crucial component of the ability to deliver choice and value to customers. Fixed, regulated average rates are an obsolete relic of a regulatory approach that, if it persists, will stifle the application of creativity in this industry. If utilities, regulators, and politicians consider the possibility that utilities can offer different value propositions to their customers than just “juice coming through the wall”, utilities can benefit from using market-based pricing as a tool for offering an attractive portfolio of service options to their customers. Creating value from this change, though, requires vision, and getting the transitions and the institutions right can be extremely tricky. Consumers will change how they think about buying electric service, and what that service is, exactly. For that change to occur, politicians and regulators will have to act on the leadership and vision that would allow consumers to take responsibility for their individual purchasing choices.

posted by lkkinetic | 10/08/2002 07:49:00 AM

Thursday, October 03, 2002  

THE ENERGY BILLS AND THE ADMINISTRATION'S PROPOSAL ARE STATIC AND BACKWARD-LOOKING: My colleague Adrian Moore and I argue in this policy analysis, published by the Institute for Research on the Economics of Taxation, that the administration's proposal and the House and Senate versions of the energy bill retain too much government manipulation of markets, and fail to recognize the range of institutional approaches available to address energy challenges.

posted by lkkinetic | 10/03/2002 11:37:00 AM

THE CONSEQUENCES OF FAILING TO DO SOUND ECONOMIC INSTITUTIONAL ANALYSIS: As I argue in this presentation delivered last week at the Ronald Coase Institute Workshop on Institutional Analysis, the bifurcated PX/ISO pool trading structure created a myriad of incentives for both buyers and sellers to behave strategically. Furthermore, because I was making a methodological point to the students, better institutional analysis could have lessened or prevented the ensuing losses and disruptions. I say could have because the political process could have meant that decision-makers would not have found it in their interests to listen to a sound institutional analysis, even if presented with it before the fact. Bottom line: institutions matter, and analyzing them and the incentives they create is important for good policy and good market design.

posted by lkkinetic | 10/03/2002 11:33:00 AM

Wednesday, October 02, 2002  

GOVERNMENT ROLES IN DISTRIBUTED ENERGY: Energy expert and industry veteran Ed Reid and I wrote this article for the Reason publication Privatization Watch. Punch line: distributed generation could go a long way toward helping us deal with energy infrastructure issues (especially transmission construction) in a cost-effective and flexible manner, but intended and unintended government barriers still exist. Here's the conclusion:

Government barriers to distributed energy do still exist at both federal and state levels, across many different agencies and regulators. The current unsettled state of the industry is an opportunity for a revised, coordinated regulatory approach that does not create disincentives for distributed energy. FERC’s interconnection initiative is a good start at the federal level to create coordination among the states, but many other barriers remain in other federal agencies and in other dimensions at the state level.

posted by lkkinetic | 10/02/2002 08:35:00 AM

My friends at the Center for the Advancement of Energy Markets have a superb rebuttal to a Houston Chronicle letter calling for the re-regulation of electricity in Texas. The author of CAEM's rebuttal, Nat Treadway, has written a clear and thoughtful reponse to this ridiculous idea.

posted by lkkinetic | 10/02/2002 08:23:00 AM

Tuesday, October 01, 2002  

MOTHBALLING OLD POWER PLANTS IN TEXAS: Here's a great example of the competitive, market process dynamic at work. According to this article, American Electric Power is planning to retire, or mothball, 16 of its older gas-fired plants in Texas. The article says it well:

The decision to deactivate the plants is a result of the introduction of electricity deregulation and competition in Texas. Many new, highly efficient power plants have been built in Texas as a response to deregulation. These new plants have lowered wholesale power prices to a point below the costs of generating electricity from the 16 older AEP plants.

This is beautiful -- competition has brought technological change to bear in electricity in Texas, so these older plants are now obsolete. Maybe Governor Davis should look at the Texas model if he wants to encourage supply (yeah, right, like that's gonna happen).

posted by lkkinetic | 10/01/2002 02:44:00 PM

WHAT'S NEW WITH THE CALIFORNIA WHOLESALE PRICE CAP? I haven't focused on it much here, but the FERC had set the wholesale "soft price cap" in California to rise from $91.87 to $250 today. As this article reports, the new price cap has been delayed a month to allow officials to incorporate changes from a computer test of manipulation possibilities. Of course, this is all happening in a very politically charged environment -- FERC is in the process of taking comments on its proposed standard market design, El Paso is accused of exercising market power on its natural gas pipeline at the California border, and Governor Gray Davis simultaneously wants to reverse the increase in the price cap and to force the companies who had proposed building new capacity to go ahead with those proposals, even though the wholesale price of electricity is now hovering around $30/MWH (which is quite low).

But wait, the intelligent reader says, how can Davis simultaneously argue for maintenance of a low price cap and forcing companies to invest in California to increase supply? Precisely. When it looked like electricity prices would be sustainably high, investors were certainly more willing to propose new generation for California than they are at $30/MWH. Now, though, even the $91.87 price cap has not been binding except for a very few instances, and, guess what? Investors don't see much potential for returns from putting new generation capacity in for California. Add to that the regulatory uncertainty of the future of the wholesale market in California, and is it any surprise that investors are wearing a clear path to the border, or staying away?

Thankfully, FERC Chairman Pat Wood gets it. According to the article cited above,

While the state's governor, Gray Davis, has criticized the lifting of the California cap to a higher level as giving an opening to generators to profit unreasonably, in his view, Wood pointed out that California's cap is below similar caps in other parts of the country, and would represent a step to encourage new supply in the state.

Here's a simple economics lesson for Governor Davis, along the lines of Megan McArdle's wonderful explanations of the power of simple economic ideas. Think about a typical representation of a market outcome, with a typical supply curve and a typical demand curve. The story we usually tell about equilibrium price is that the interaction of buyers and sellers communicates information about costs and preferences, and that in an equilibrium, all who are willing to pay above that price get the good, and are supplied by those whose costs are lower than that price.

But what else do we know is true at that equilibrium? Most of the consumers pay less than they were willing to, because all pay "the market price". And, most of the suppliers earn more than their marginal cost that they had to recoup to bring the good to market. These two amounts are called consumer surplus and producer surplus. For those of you who, like me, like to shop, getting a bargain is the best way to understand consumer surplus -- if you looked at a sweater and you thought you would pay up to $50 for it, but you only had to pay $29.99 because it was on sale, then you just got $20.01 in pure consumer surplus. Score! Same story, but a little less intuitive, if you are a producer -- you only have to receive your marginal cost to be willing to sell something, but at an equilibrium like I've described, you get paid more than that for what we call the inframarginal units (the ones sold up to but not including the last one). Score!

OK, now the tricky question, especially for Governor Davis. Is producer surplus price gouging? In the simple scenario I've constructed, absolutely not. That producer surplus is going to repay the producers for the fixed costs they've had to incur to bring their stuff to market -- buying computers, building factories, building generation capacity, whatever. And you know what? If not enough stuff is being produced to satisfy consumer demand, scarcity becomes more binding and equilibrium prices rise.

This scenario also applies to electricity, but it's a little more complicated because of the very high fixed costs in the industry. Building generation capacity is not cheap and not quick. So that producer surplus sends a very important signal, a very important set of information, to producers and potential producers about what kind of investment needs there are to satisfy demand in this industry. That's one reason why another term you'll hear applied to this idea is scarcity rents, and that as scarcity becomes more binding, existing producers earn more money from it and potential producers see profit opportunities in alleviating it, which they would do by investing and entering the market.

This idea of producer surplus raises another really, really important point that frequently gets overlooked in the policy debates and media discussion: the simple scenario I described above is about static efficiency, a snapshot-in-time one-shot idea. But what determines growth, productivity, and incentives for things like technological change is dynamic efficiency, which requires us to look across time.

Punch line: producer surplus promotes dynamic efficiency by enabling producers to earn the means to pay for their investments. If there's scarcity relative to demand, producer surplus will include some scarcity rents, which signal to opportunistic investors that they should look here to profit from alleviating that scarcity in the future.

And price caps cut those incentives out at the knees. So Governor Davis cannot have it both ways, at least not without compulsion and coercion. And last time I checked, you cannot force actors in a free and open society to invest within the bounds of your geopolitical universe.

posted by lkkinetic | 10/01/2002 02:37:00 PM

THANKS TO ARNOLD KLING: While I was away, Arnold picked up on a couple of my posts in the context of a commentary on Krugman's column last week about the California energy crisis. I think Arnold is absolutely right to say that "most economists would predict that California's experience is not the shape of things to come. Even among those who believe that companies found it profitable to withhold energy (and by no means do all analysts hold this view), there is a consensus that the California regulatory regime had unique aspects which made it brittle when demand increased." Arnold's post has his usual good discussion question, which I will pose to my environmental economics class later this quarter. Thanks!

posted by lkkinetic | 10/01/2002 01:55:00 PM

ISNIE: After the Coase workshop, most of the attendees stuck around for the annual conference of the International Society for New Institutional Economics, which had lots of great papers on electricity, so I was thrilled.

posted by lkkinetic | 10/01/2002 01:53:00 PM

WHERE HAVE I BEEN? In a hotel that only has dialup, that's where! Last week I was honored and delighted to be on the faculty of the Ronald Coase Institute's Workshop on Institutional Analysis. The workshop gathers together 25-30 economists from developing countries, either graduate students or young Ph.D.s, who are doing research on formal and/or informal economic institutions in their countries. The idea is to incorporate their local knowledge with good economic analysis and an understanding of the importance of institutions, contractual forms, the transaction costs that can impede certain transactions or contractual forms, and so on. I had a great time, and learned a lot.

posted by lkkinetic | 10/01/2002 01:51:00 PM

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
Lynne Kiesling
Reason Foundation
Northwestern University
Weblog Must-reads
Economics Links
Energy Research and News
And now for something completely different...