Regulation vs. Deregulation Utilities
This subject matter can be as contentious as religion and political affiliation. Therefore let me start by saying I certainly would be willing to change my mind as I have already done over the past few years. I do like and live by Thomas Paine statement – “You will do me the justice to remember, that I have always strenuously supported the Right of every Man to his own opinion, however different that opinion might be to mine. He who denies to another this right, makes a slave of himself to his present opinion, because he precludes himself the right of changing it.”
What is regulation? Most people understand the need for police, roads, and fireman – hence the need for some tax. Electricity and water have become equal to those needs. A definition for utility can be functional rather than attractive. Society has chosen electricity and water to be utilities. They are a means to an end. However, the complexity of creating and delivering these utilities are not as easy as paving a road or having a fire station. These investments are much larger with much longer time frame of impact.
Natural evolution was to create a framework to allow these investments to occur for the greater good of society. The simple form was a Co-Op model. Local business and municipals come together and state everyone in this area will pay for this service at rate to make the product to support the local need. However, the cost was considered very prohibitive and greater scale could achieve greater cost reduction. The large utility model was created. The incentive structure for these investors to come together and supply such large volume of money was to create a guaranteed return for investment.
Regulation involves a return on investment. The incentive structure of utility in a regulated framework is investment. Without investments the utility would not make any return. Enter the public shareholder utility, the shareholder of these regulated utility makes a return on the investment piece. The cost of maintaining and operating the investments are cost based. There is no return for this part of the business. Balancing this cost pass through is the lack of competition, allowing the ability to recover investments with guaranteed returns even though the decision may have not been the best choice in hindsight.
With this model, if left unchecked inefficiencies will grow in two areas. One the cost structure to maintain and operate has the potential to grow beyond reasonable practice. This includes operating cost and compensation. Reliability becomes the goal over innovation and optimal decision making. Regulated model supports the themes if it is not broken don’t fix it. Economics 101 states rewards are typically commensurate with risk. For management teams in regulated utilities to make relative income to other sectors fails that. As a regulated entity, there is monopoly power with a relative less risk on return as compared to various other sectors. Hence one reason to drive for de-regulation not related to optimal market design was the executive suites desire to justify pay relative to other industry. Regulated utility should be considered similar to government – cost center with structured risk.
The other area of inefficiency comes from the desire of the shareholder and potentially management team to boost earnings. This earnings drive may cause non-optimal investment decision since returns are generated through investments. The higher the investments they can get approved, the higher the return. This does not necessarily bode well for promotion of efficiency and conservation.
The key solution to mitigate these inefficiencies is to have a strong regulatory body. The regulatory body should be compensated as highly as the utility to avoid any regulatory capture. Without this, abuses will likely to occur.
The de-regulation model, in theory, would bring more innovation as competition will necessitates that behavior. Competition in general leads to cycles (e.g. Operating Systems: DOS,Windows,Apple, Android, etc…) There are risk as your competitors can make you obsolete. Currently many of the de-regulated markets can claim they are successful and good for society. This is being masked by the long time frame generation assets offer, 40-60 years. Much of our generation capacity was decided in the 1970’s and 80’s. However, those assets are coming to their end of life. Now these large investments need to be made again, but now you have a competitive landscape with decisions requiring much larger returns due to the risk of making a wrong decision. There are no guarantees for these investments in a fully de-regulated world. Therefore decisions to limit the capital risk will occur. Most new generation build will likely be natural gas. Largely because it’s upfront cost is limited. You saw this even when gas prices were above $8/mmbtu. Future generation decisions will not be balanced nor focused on reliability, but based on the best way to maintain risk and extract as much profit as possible.
At this time, I believe as big of an error as Alan Greenspan suggestions that the bankers would police themselves, the belief that a competitive electric market will bring a more optimal solution than regulation may result in a similar fate. I have seen and do believe the regulated model can be abused as much as the de-regulated model can result in undesired results. The key question is which one of these can be more easily adjusted and remedied when they tend to stray from theoretical operations?
I contend the regulated markets are more likely to be maintained than the de-regulated markets. I only accept this premise under the same premise that I appreciate driving on roads and having a fire force take care of my neighbor’s house on fire before it spreads further. In general, I support free markets, but some things are utilities – purely functional and not attractive.
Please send me your comments or suggestions David K. Bellman [email protected] Perhaps I will change my mind if given more information. I have heard and thought of ways to make the de-regulated markets work, but each of those ways result in making it more regulated. One suggestion was to have the RTO pay for and permit greenfield development and allow participants to bid for those projects. This sounds promising, but I am not sure if it would do enough to offer baseload alternatives such as nuclear.
Given my experience in the power markets, I can help design and/or evaluate various market changes.
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