Mandatory Real-Time Pricing is No Solution to Electricity Crisis

Published March 23, 2004

Cato’s Peter VanDoren and Jerry Taylor analyzed the electricity crisis in the February 2004 issue of the Public Utilities Fortnightly and conclude that the solution to a bad situation is vertical integration and mandatory real-time pricing. In my opinion they have got it half right.

Vertical integration of electric utilities has been the dominant form of organization since the beginning of the industry and even before there was regulation. It is a substitute for long term contracting and as such is a hedge. It is especially relevant now given the need to maintain and modify the transmission grid to meet the new interstate sales of electricity in a reliable manner.

The form of vertical integration that works well for interstate oil pipelines and natural gas pipelines in Texas is one where transmission is typically a joint venture owned by the shippers in rough proportion to the value of their throughput and subject to light-handed regulation. That structure solves the problems of underinvestment and opportunistic behavior in reserving capacity. As any landlord will tell you, owners take better care of property than mere renters. Vertical integration is the part of the VanDoren-Taylor prescription that is right.

The part that is wrong is the mandatory real-time pricing by federal authorities. The history of deregulation is instructive here. Both the system of fixed foreign exchange rates and oil and natural gas regulation were replaced by futures and options contracts. These contracts are very liquid and have substantial open interest. In the case of natural gas futures the volumes traded are on the order of nine times consumption.

These derivative contracts have several useful characteristics. First, they make prices transparent. Second, they provide a vehicle for hedging price risk. Third, exchange-traded contracts have provisions to insure compliance. Insuring compliance was important in the case of natural gas in the wake of the reneging of the take-or-pay contracts and could be useful in resurrecting the sanctity of electricity contracts.

A special version of these derivatives was offered by the New York Mercantile Exchange at the time electricity deregulation began in California. However, they were rejected in favor of mandating spot market transactions. There were two spot markets. One was for the day of consumption and the other was for the day ahead.

Aggravating this situation was a requirement that generation be separated from transmission for much of the power produced in California, and prices to final users were rolled back and made subject to a complex formula to pay off stranded costs. The apparent strategy was pass off the lower spot spices as genuine savings to rate payers. But this was an illusion like a motorist thinking that not having insurance for his car is a real savings. Eventually the crisis comes and spot prices jump above contract prices because not much can be done immediately to increase supply or decrease demand.

Real-time pricing, the second part of VanDoren and Taylor’s proposed solution, is actually a particularly perverse form of spot-market trading, especially for highly volatile markets. It involves a high degree of monitoring and adjustment. It is also vulnerable to government, interference as we learned during the electricity crisis in California. By contrast, longer term contracts can be designed to incorporate seasonality, peak and off-peak differentials and other variations while at the same time providing predictability necessary to make complementary investments. Stability in prices is valuable for both the buyer and the seller. One only need to look around to see that voluntarily negotiated contracts dominate trade in all markets except gambling.

The federal government mandating real-time pricing of electricity brings to mind Colonel Purdy in Teahouse of the August Moon, who promised to bring democracy to the Okinawans even if he had to kill every last one of them.

Jim Johnston is a Senior Fellow and member of the Board of Directors of the Heartland Institute and a retired Amoco economist. He is also a former instructor at the Illinois Institute of Technology’s Financial Market Trading Program.