The Knowledge Problem
Commentary on Economics, Information and Human Action

Thursday, November 14, 2002  

BABY STEPS TOWARD MARKET-BASED RETAIL PRICING: Demand response programs at utilities and ISOs are not full-on market-based retail pricing, but they at least serve as evidence that demand incentives interacting with supply incentives can discipline prices very effectively. This article on PJM's demand response program illustrates how sharing the benefits of load shaping kept peak hour wholesale prices down in summer 2002 relative to summer 2001.

posted by lkkinetic | 11/14/2002 11:49:00 AM

Wednesday, November 13, 2002  

FERC'S STANDARD MARKET DESIGN PROPOSAL: Brian Mannix of the Mercatus Center and I have written a comment on the Federal Energy Regulatory Commission's Standard Market Design proposal. The press release and the Reason policy study are available on the Reason Public Policy Institute website.

From the press release: The Federal Energy Regulatory Commission’s Standard Market Design proposal is a bold attempt to simplify the regulation of electricity markets but risks locking the electricity industry into a regulatory structure that ignores technological advances and is unable to adapt to changing market conditions, according to a new report. The study, released by Reason Foundation, a Los Angeles-based think tank, finds that the best way for FERC to monitor electricity markets, discipline suppliers, and provide optimal investment motivation is to allow demand-side and supply-side incentives to interact.

posted by lkkinetic | 11/13/2002 06:57:00 PM

And while you're enjoying your glass of small-vineyard zinfandel that you have mail ordered from California, think about living disconnected from the electricity grid and having the quality of life to which you would like to become accustomed. This New York Times article provides some insight into living off the grid, which technology is now making more feasible and affordable for more people. Thanks to Joel Schwartz for alerting me to this article!

posted by lkkinetic | 11/13/2002 06:44:00 PM

VICTORY FOR LIBERTY AND OENOPHILES! According to this Declan McCullagh article from, a New York state judge has ruled that the state's ban on interstate shipment of alcoholic beverages is indeed a violation of the interstate commerce clause of the Constitution. Much of the success on this front in various states is due to liberty-loving oenophile and attorney Clint Bolick, whose Institute for Justice is responsible for several of these legal challenges.

Here's an article on the subject that I wrote two years ago and never published anywhere; it's a little dated (note the reference to disintermediation, how 20th century dot-com bubble), but still relevant:

Days of Wine and Rent-Seeking

A lot of high-tech “buzz” highlights market disintermediation as one consequence of the internet and increasingly reliable communications technologies. In the context of these changes in the transaction costs of trade and exchange, an entrenched liquor distributor system, a relic of Prohibition, has successfully fought to maintain and increase its profits in the past few years. Two dramatic manifestations of this fight exist: the prohibition of interstate mail-order purchase of alcoholic beverages, and efforts by large distributors to limit retail customers’ ability to shift their business to other distributors.

This distribution network, known as the three-tier system, arose during Prohibition as a combined federal and state response to smuggling and black-market profits (never mind that the power and profits would not have existed without Prohibition). By law, wineries, distilleries and breweries cannot sell directly to retail customers (stores, bars, restaurants) or consumers, but must contract with a wholesale distributor that will market and sell their products, along with products of their competitors, to these retail outlets. These relationships are exclusive, with each producer having only one distributor in a region. Through some unfortunate (for everyone except the distributors!) path dependence, probably aided by some lobbying at the time, the three-tier system survived Prohibition. Furthermore, the 21st Amendment, which repealed Prohibition, granted individual state governments the right to regulate the sale and shipment of alcoholic beverages. Thus if an ultimate consumer is visiting a brewery, distillery or winery, he or she can purchase beverages for personal consumption (unless, like Jack Daniels, the distillery is in a dry county; how paradoxical is that?). Whether they have to lug them home themselves or can have the business ship to them, though, is a hugely complicated issue, thanks to the tangled web of state laws surrounding the 21st Amendment. As a result of these laws, regional wholesale distributors have become large, powerful and profitable companies, and their numbers have decreased over the past decade.

This legal structure generates market power, and therefore economic rents, for the small number of wholesale distributors. For example, the three-tier system encourages distributors to engage in product tying or bundling, which is a typical indicator of a firm having market power. Behavior similar to this got Microsoft in trouble with the Justice Department, but wholesale liquor distributors do so under legal protection.

On the other hand, the distributor structure does save on transaction costs for both producers and retail customers. Producers can focus their marketing resources on advertising to ultimate consumers (within stringent government guidelines, of course, and without discussing health benefits of moderate drinking), not on hunting out and developing relationships with stores, bars and restaurants around the country. Distributors work in conjunction with the marketing personnel at producers to generate regional and in-store promotions. Distributors also provide information benefits to their retail customers, enabling them to avoid spending a lot of time and effort gathering information on all of the wines, beers and spirits in the market. Because of these intermediation benefits that a distributor could provide upstream and downstream in the transaction, such a system has had benefits and could have arisen in the absence of the three-tier law.

However (and this is a big however, heard in many guises and venues today), information technology and the internet have decreased those transaction costs, making direct communication and trade between producers and retail outlets cheaper and easier. A direct market would also enable producers and retail outlets to avoid paying for some of the economic rents associated with the substantial market power of the distributors. Therefore, although the wholesale distributors would obviously suffer in the change, the evolution of the liquor market away from the three-tier setup would probably increase overall social welfare. This disintermediation, mirroring others in the past five years, could increase the variety and availability of, for example, small-producer wines that might otherwise only be available at the winery. Increasing customer choice and happiness, potentially at lower prices, increasing producer market reach and profit – sounds like a win-win, except for those pesky distributors.

The three-tier system also prevents the development of alternate distribution structures like liquor brokers. A bar owner could, in this alternate universe, hire a broker to negotiate with distributors, or directly with producers. Current law prohibits this market, to the benefit of existing wholesale distributors and the detriment of retail customers.

Wholesale distributors have had over 65 years to develop market power and a vigorous interest in maintaining their own importance and role in liquor sales. This situation has many of the traits of a typical rent-seeking context. The distributors enjoy concentrated benefits from this legislation. The legislation’s costs, though are diffuse at both the upstream (producer) and downstream (retail consumer) level. Not surprisingly, then, we find distributors engaging in lobbying and other rent-seeking activities to create legislative legitimacy for their continued existence.

The product in question further complicates the situation. As the Wine Institute puts it, “People have an ATTITUDE about alcohol. Over time, these attitudes develop legal and political properties.” ( Distributors have been able to exploit the increasingly moralistic and paternalistic treatment of drinking, particularly among teenagers and college students. This paternalism has also shown up in federal government zero-tolerance attitudes to drinking:
-Withholding highway funds from states in the 1980s if they did not increase their drinking ages to 21 (all states now have a 21 drinking age, what a surprise);
-The current public service announcements of the FDA; and
-The ongoing controversy over acknowledging the health benefits of moderate alcohol consumption, and whether that would constitute government “approval” of drinking.
Thus we see the same slippery-slope lack of logic that leads people to argue that marijuana use leads to crack cocaine use, abuse and addiction.

Mail-order wine purchase is a beautiful, painful example of distributors manipulating this attitude to their own rent-seeking benefit. Some states, like Maryland and Florida, have made mail-order alcohol purchase a felony. The Wine Institute’s web page has a map showing the legal treatment of mail order in each state in the US. See also the Wine Spectator for further discussion and links; their reader comments also indicate that consumers recognize the concentrated benefits to the wholesalers at the diffuse expense of consumers and small producers. Wholesale distributors, working with state legislators, support the political rhetoric that the interstate prohibition is directed specifically at minimizing underage drinking (see, for example the Wine and Spirits Wholesalers Association web page). This red herring is patently absurd – how many underage drinkers would pay the high shipping costs for something as heavy as liquor in glass bottles? Shipping costs would greatly increase the cost per buzz.

Mail-order prohibition also stifles the growth of small wineries and breweries. Many are not large enough to land on the radar screen of the distributors or to market their products far beyond their local communities; they would be able to reach larger markets of consumers interested in distinctive, high-quality beverages if they could ship products directly to consumers. Organizations like Free the Grapes are working on behalf of these small wineries and their potential consumers to raise awareness of the consequences of mail-order prohibition.

Another manifestation of wholesale distributor rent seeking has occurred in Illinois and Wisconsin. Untainted by the moral overtones of the mail order controversy, and hopefully more isolated and short-lived, this legislative change is largely being driven by Bill Wirtz, the owner of Judge & Dolph, an Illinois distributor (and also of the Chicago Blackhawks hockey team). Judge & Dolph covers about one-third of the Illinois liquor market with the brands it distributes. Wirtz also owns a wholesale distributor of similar market power in Wisconsin. The Illinois Wine and Spirits Fair Dealing Act and the Wisconsin Fair Dealership Law both stipulated that a retail customer of a wholesale liquor distributor could not “fire” them and hire in another distributor, even if they could demonstrate what might normally be called breach of contract. In Illinois, this legislation passed in conjunction with a state liquor tax that, at least around Chicago, retailers passed on to customers with pleas to them to complain to their state representatives. Distributors also used this opportunity to raise their prices to retail outlets, resulting in a double whammy to consumers.

Thus we see another attempt to exploit concentrated benefits to distributors and diffuse costs to producers and retail customers and consumers. This exercise is more blatant and devoid of the underage drinking red herring found in the mail order controversy, but driven by the same economic incentives.

Private individuals and organizations are working to counter these instances of rent-seeking. In late 1999 a Texas judge said that their state law violates the Interstate Commerce Act. Groups like the Wine Institute and Free the Grapes are working to spread that precedent to other states. Clint Bolick, President of the Institute for Justice and an avid oenophile, is participating in a lawsuit in New York to challenge their mail order interdiction.

The distributor laws in Illinois and Wisconsin also face challenge. Amid customer furor and questions about the constitutionality of the legislation shackling the retail customer to the distributor, the Illinois legislature repealed the legislation last spring. Unfortunately, the rhetoric on the number of distributor jobs that this legislation would save in Wisconsin seems to have kept it from the legislative rubbish bin, to the (widespread) disadvantage of producers, retail customers and consumers in Wisconsin. [Lynne's comment: this law has been repealed since I wrote this, yay]

The alcoholic beverage industry encapsulates the shifting transaction costs that result from technological change, and these changes have laid bare the incentives of wholesale distributors. Hopefully the overreaching greed demonstrated recently in Illinois and Wisconsin and the nationwide efforts to change state mail order legislation will coalesce diffuse consumer interests and create the opportunity for disintermediation in the spirits distribution industry. Consumers can only benefit. Santé.

posted by lkkinetic | 11/13/2002 06:37:00 PM

Friday, November 08, 2002  

THE BBC AND TV REGULATION: According to British television regulators, the CNBC TV show "The Wall Street Journal Editorial Board With Stuart Varney" is a marketing device for the Wall Street Journal, and is therefore not shown in the UK. Apparently this is a thinly-veiled attempt to retain market power for the government-run BBC television programming. The editorial on this censoring highlights some of the most exasperatingly contradictory features of the UK's regulatory environment, and the unsupportable continuing government protection of "the Beeb".

posted by lkkinetic | 11/08/2002 11:13:00 AM

Wednesday, November 06, 2002  

CODA TO THE PUGET SOUND ENERGY DEMAND MANAGEMENT PROGRAM: On Wednesday PSE decided to terminate its residential demand management TOU program, according to this article. I am disappointed but not entirely surprised, as I think some poor strategic decisions were made in determining the residential focus of the program. Furthermore, halfway demand management approaches are more a creature of risk aversion than of courageous, innovative change, which severely limits the success of such programs.

Another guest post today comes from Jim Johnston, former senior economist at Amoco and a policy advisor to the Heartland Institute. Jim has been following electricity "deregulation" for years and brings a refreshing, novel finance-oriented perspective to the issue. Here are Jim's observations on PSE:

I am not surprised at the Puget Sound Energy experience. It is not that I think consumers are ill informed or stupid. They probably realize that demand side management, even when successful in reducing peak loads, does not protect them from crises which are spawned on the supply side. Remember, the supposed payoff from reducing demand during peak periods is measured in terms of less investment in generating and transmission capacity. That, in turn, means that the system is less able to cope with failures of transmission lines and generating plants which might occur at any time, not just during peak periods.

I recently looked at William Vickrey's Bell Journal article in 1971 which was the beginning of this idea of having consumers face real-time pricing. Interestingly, he also proposed the idea for telephone rates and airline fares. Can you imagine not knowing what your rate or fare will be until it comes time to make the call or show up at the gate? Moreover, how would the telecommunications and airline industries plan for peak load capacity and what would happen to prices when the systems fail on the supply side. It would be very inconvenient, to say the least. If it happened to electricity it would be a disaster. In 1965 the blackout in New York City was characterized by the New Yorker as "a festival of inconvenience" when the birth rate jumped nine months later. However, in 1977 when the power went down again, then mayor Abraham Beam called it "a night of terror." Just ask yourself what you would do if the electricity went out for a day starting now.

The stark truth is that demand side management makes the delivery system more vulnerable to failure and I suspect that consumers instinctively know this.

Lynne's observation: I think Jim's comments illustrate the value of simultaneously freeing up regulatory constraints on demand-side retail pricing and on distributed generation, which would provide both alternatives to the susceptible centralized grid as Jim describes it and backup for it. I also think that many of the flaws he points out come from limiting the types of demand side management you implement. If you offer your customers a portfolio of contracts, kind of like when you choose among cell phone contracts, then you can satisfy a certain degree of price certainty (or budget certainty) and still shave peaks and get good changes to load shape.

posted by lkkinetic | 11/06/2002 09:45:00 PM

Tuesday, November 05, 2002  

OIL PRICES AND THE ALASKA PIPELINE: Okay, for those of you who think that drilling for oil in ANWR would make a huge difference in national security and world oil market power dynamics, notice that the pipeline has been down for two days because of an earthquake, BP's Alaskan oil production is halted because of the earthquake (and they're one of the big kahunas up there), and world oil prices have fallen over the past two days. Yes, Alaska's a good thing to have, but it's a drop in the bathtub, and an expensive drop in the bathtub at that.

posted by lkkinetic | 11/05/2002 08:15:00 AM

GUEST POST ON PUGET SOUND ENERGY'S DEMAND MANAGEMENT PROGRAM: I received the following thoughtful analysis from Mike Giberson, an independent energy industry analyst who has been working with energy regulatory policy issues for many years. Recently, Mike returned to graduate study in economics at George Mason University to study market design at the Interdisciplinary Center for Economic Science. The more I reread his points, the more strongly I agree with them. Demand-side management (DSM) program's like PSE's are just baby steps, and by tentatively going only part way can doom themselves to either irrelevance or failure.

Anyway, here's Mike's argument; more from me later.

Here is another news story on the topic, this one from the Seattle Times:

I've been wondering how to interpret PSE's results. By all accounts PSE was enthusiastic about the program and gave it their best efforts (unlike the perfunctory treatment a utility may give to DSM programs intended mainly to satisfy regulatory interest in "doing something" about energy efficiency). Yet the article suggests the program may be failing, and concludes: "Given the experience of some other states that have tried time-of-use programs, the results in the Puget Sound region are not surprising."

From an analytic standpoint, maybe it is too soon to tell whether the program is failing -- all the data is not in. As a practical matter, the program is failing. Since obtaining the quarterly reports showing projected net savings, customers have been quitting the program in droves (more than 1,000 a day). From October 2001 though June 2002, PSE lost 2.3 million dollars on the program. Yet the news story also reports that consumers on the program shifted an average of between 5 and 6 percent to off-peak hours.

Before jumping to conclusions, let's consider the possible conclusions to jump to:

1. Residential consumers are too small to supply an economical demand response - the administrative costs per customer may just be too high to produce net benefits. Of course, only the most reactionary would say such a thing could never work. But given reasonably expected costs and benefits over the near term, perhaps it is more reasonable to invest one's hopes in other places (i.e., commercial and industrial demand response, with residential consumers as a 'free-riding beneficiary' of better functioning markets).

2. TOU rates aren't "good enough" for real demand response - on the other side, some RTP enthusiasts say that TOU rates are still regulated rates and hence, no surprise, they don't work like prices.

3. Too soon to tell - the analyst in me says more data is needed. (How much has the utility saved from the shifting of consumption off-peak? Note some savings are longer in coming, as in avoided construction in the future from slower growth in consumption in the meantime.) More practically speaking, most new ventures "lose money" at the start. Lots of learning has to go on, customers make adaptations over time to time-sensitive rates (buy a dishwasher with a timer function v. buying more efficient windows).

4. Maybe the program was useful during "crisis" times, but not during normal times - giving the expense of deploying a program like this, if it only pays off during times of extraordinary prices, then it probably isn't sustainable.

5. Entrepreneurs haven't been freed to explore the value-proposition space in the market - Well, this is true. We are not even in the realm of a competitive supplier of electricity in the PSE case. This is a regulated firm, offering an optional short-term regulated rate program, subjected to constant regulatory oversight from the beginning. Like #2 above, the "rates are still regulated rates."

There are other possible conclusions towards which you might jump.

Of these five, I think #1, #3, and #4 are probably right. I like #2 and #5, too.

I think one lesson to draw from the experience in the comment in #1: "But given reasonably expected costs and benefits over the near term, perhaps it is more reasonable to invest one's hopes in other places (i.e., commercial and industrial demand response, with residential consumers as a 'free-riding beneficiary' of better functioning markets)."

posted by lkkinetic | 11/05/2002 07:47:00 AM

Monday, November 04, 2002  

Market-based Retail Electricity Pricing: Puget Sound Energy’s Pilot Program

In all markets prices serve a valuable role in enabling exchange, and in leading to efficient outcomes and investment. Prices transmit a great deal of information about the costs and preferences of widespread and disparate economic actors, and do so very parsimoniously. This truth holds for the electricity industry as much as any other industry. Indeed, the ever-changing costs of providing electricity suggest that market prices would be an extremely valuable tool in leading to efficient resource allocation and investment, and that offering customers a portfolio of retail contracts from which to choose would reduce the overall costs in the 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.

Market-based pricing in electricity can include time-of-use (TOU) rates, which are different prices in blocks over a day, based on expected wholesale prices, or real-time pricing (RTP) in which actual market prices are transmitted to consumers. As currently implemented, TOU is typically a program in which predetermined prices apply to specific time periods by day and by season. RTP differs from TOU mainly because RTP exposes consumers to unexpected variations (positive and negative) due to demand conditions, weather, and other factors. In a sense, fixed retail rates and RTP are the endpoints of a continuum of how much price variability the consumer sees, and different types of TOU systems are points on that continuum. Thus RTP is but one example of market-based pricing. Both RTP and TOD provide better price signals to customers than current regulated average prices do.

Several utilities have implemented some limited market-based pricing programs. Although small and exploratory, these have generated some positive results that will be useful as more utilities begin considering market-based pricing. None of these programs implements true market-based pricing, though; instead they are “demand response” programs that use time-of-day price changes to give customers incentives to shift load. That said, they do indicate how powerful price incentives can be for consumers, and how market-based pricing contributes to a reliable, efficient electricity system.

Puget Sound Energy (PSE) characterizes its demand response “Personal Energy Management” program as a conservation program primarily for residential customers. The Personal Energy Management program began in May 2001, and 300,000 customers enrolled in the first six months. This program is a typical TOU program, with lower prices in off-peak periods and higher prices in peak hours (PSE uses a four-period TOU framework). PSE also provides automated meter reading services and real-time pricing data to customers. Customers can see their daily electricity use according to the four time periods through PSE’s website. Typical summer 2001 rates varied from 4.7 cents per kilowatt hour for overnight hours to 6.25 cents per kilowatt hour in peak morning and evening hours.

PSE found that in the first several months of the program, participating customers shifted approximately 5 percent of their demand away from peak hours; in addition, participating customers reduced their overall electricity use. Almost 90 percent of customers took some action to manage their own electricity use when facing TOU pricing. Customers also expressed satisfaction with the program, with 85 percent saying in a PSE survey that they would recommend the program to a friend.

In September 2001 PSE extended its Personal Energy Management Program to 20,000 of its business customers, who had been monitoring their peak load and off-peak load in anticipation of moving to a TOU rate structure. In late 2001 PSE applied to the Washington Utilities and Transportation Commission to make the TOU rate structure a permanent option in PSE’s rate tariff. Last week, PSE announced that they would begin sending quarterly comparisons of their bills under TOU with what they would have paid with fixed rates, as described in this article . TOU customers already receive detailed information about their use.

Lisa Wood at the Brattle Group also has a good article about the benefits that come from market-based electricity pricing. She addresses the one of the important cultural questions – are customers opposed or complacent? I think customers don’t think about the fact that their utilities could offer them more creative value propositions beyond just having the juice come through the wall, and that it’s incumbent upon those of us who advocate for those value propositions to bring the debate into the open. The debate itself will benefit consumers.

posted by lkkinetic | 11/04/2002 09:07:00 AM
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