Platform economics and “unscaling” the electricity industry

A few weeks ago I mused over the question of whether there would ever be an Uber or AirBnB for the electricity grid. This question is a platform question — both Uber and AirBnB have business models in which they bring together two parties for mutual benefit, and the platform provider’s revenue stream can come from charging one or both parties for facilitating the transaction (although there are other means too). I said that a “P2P platform very explicitly reduces transaction costs that prevent exchanges between buyer and seller”, and that’s really the core of a platform business model. Platform providers exist to make exchanges feasible that were not before, to make them easier, and ultimately to make them either cheaper or more valuable (or some combination of the two).

In this sense the Nobel Prize award to Jean Tirole (pdf, very good summary of his work) this week was timely, because one of the areas of economics to which he has contributed is the economics of two-sided platform markets. Alex Tabarrok wrote an excellent summary of Tirole’s platform economics work. As Alex observes,

Antitrust and regulation of two-sided markets is challenging because the two sets of prices [that the platform firm charges to the two parties] may look discriminatory or unfair even when they are welfare enhancing. … Platform markets mean that pricing at marginal cost can no longer be considered optimal in every market and pricing above marginal cost can no longer be considered as an indication of monopoly power.

One aspect of platform firms is that they connect distinct users in a network. Platform firms are network firms. Not all network firms/industries operate or think of their business models as platform firms, though. That will change.

What role does a network firm provide? It’s connection, facilitating exchange between two parties. This idea is not novel, not original in the digital age. Go back in economic history to the beginnings of canals, say, or rail networks. Transportation is a quintessential non-digital network platform industry. I think you can characterize all network infrastructure industries as having some aspects of platform or two-sided markets; rail networks bring together transportation providers and passengers/freight, postal networks bring together correspondents, pipeline networks bring together buyers and sellers of oil or natural gas, electric wires networks bring together generators and consumers.

What’s novel in the digital age is that by changing transaction costs, the technology changes the transactional boundary of the firm and reduces the economic impetus for vertical integration. A digital platform firm, like Google or Uber, is not vertically integrated upstream or downstream in any of the value chains that its platform enables (although some of Google’s acquisitions are changing that somewhat), whereas historically, railroads and gas companies and electric companies started out vertically integrated. Rail network owners were vertically integrated upstream into train ownership and transportation provision, and electric utilities were integrated upstream into generation. In network infrastructure industries, the platform is physical, and firms bundled the network service into their offering. But they have not been seen or thought of as platforms in the sense that we are coming to understand as such firms and industries emerge; I suspect that’s because of the economic benefit and the historical path dependence of the vertical integration.

Another distinguishing feature of platforms and two-sided markets is that the cost-revenue relationship is not uni-directional, a point summarized well in this Harvard Business Review article overview from 2006:

Two-sided networks can be found in many industries, sharing the space with traditional product and service offerings. However, two-sided networks differ from other offerings in a fundamental way. In the traditional value chain, value moves from left to right: To the left of the company is cost; to the right is revenue. In two-sided networks, cost and revenue are both to the left and the right, because the platform has a distinct group of users on each side. The platform incurs costs in serving both groups and can collect revenue from each, although one side is often subsidized, as we’ll see.

In this sense, I still think that the electricity network and its transactions has platform characteristics — the wires firm incurs costs to deliver energy from generators to consumers, and those costs arise in serving both distinct groups.

As I apply these concepts to the electricity industry, I think digital technologies have two platform-related types of effects. The first is the reduction in transaction costs that were a big part of the economic drive for vertical integration in the first place — digital technologies make distributed digital sensing, monitoring, and measurement of energy flow and system status possible in ways that were inconceivable or impossibly costly before the invention of the transistor.

The second is the ability that digital technologies create for the network firm to handle more diverse and heterogenous types of agents in a two-sided market. For example, digital sensors and automated digital switches make it possible to automate rules for the interconnection of distributed generation, electric vehicles, microgrids, and other diverse users into the distribution grid in ways that can be mutually beneficial in a two-sided market sense. The old electro-mechanical sensors could not do that.

This is the sense in which I think a lot of tech entrepreneurs talk about “unscaling the electricity industry”:

If we want secure, clean and affordable energy, we can’t continue down this path. Instead, we need to grow in a very different way, one more akin to the Silicon Valley playbook of unscaling an industry by aggregating individual users onto platforms.

Digitally-enabled distributed resources are becoming increasingly economical at smaller scales, and some of these types of resources — microgrids, electric vehicles — can either be producers or consumers, each having associated costs and revenues and with their identities changing depending on whether they are selling excess energy or buying it.

This is a substantive, meaningful sense in which the distribution wires firm can, and should, operate as a platform and think about platform strategies as the utility business model evolves. An electric distribution platform facilitates exchange in two-sided electricity and energy service markets, charging a fee for doing so. In the near term, much of that facilitation takes the form of distribution, of the transportation and delivery. As distributed resources proliferate, the platform firm must rethink how it creates value, and reaps revenues, by facilitating beneficial exchange in two-sided markets.

Online Library of Liberty forum on McCloskey’s Bourgeois Era

At its Online Library of Liberty, Liberty Fund hosts a monthly “Liberty Matters” forum in which a set of scholars discusses a particular set of ideas. This month’s forum features Deirdre McCloskey‘s Bourgeois Era series of books, two of which have been published (Bourgeois Virtues, Bourgeois Dignity). McCloskey’s main argument is that the various material and institutional factors that we’ve hypothesized as the causes of industrialization and the dramatic increase in living standards are insufficient for explaining why it happened when, where, and how it did — in northern Europe, particularly Britain and the Netherlands, accelerating in the 18th century from previous foundations there. The most important factor, according to McCloskey, was ideas, particularly the cultural acceptance of commerce, trade, and mercantile activity as honorable.

The forum features a lead essay from Don Boudreaux, commentary essays from Joel Mokyr and John Nye, and responses from McCloskey and the other authors. The forum will continue for the rest of the month, with further commentary certain to follow.

If you want an opportunity to think about one of the most important intellectual questions of economics, here it is. The essays, responses, and interactions are an encapsulation of a lively and important debate in economic history over the past two decades. And if you want to dig more deeply, the bibliography and the references in each essay are a reading list for a solid course in economic history. These ideas affect not only our understanding of economic history and the history of industrialization, but also how ideas and attitudes affect economic activity and living standards today. Well worth your time and consideration.

Joel Mokyr on growth, stagnation, and technological progress

My friend and colleague Joel Mokyr talked recently with Russ Roberts in an EconTalk podcast that I cannot recommend highly enough (and the links on the show notes are great too). The general topic is this back-and-forth that’s been going on over the past year involving Joel, Bob Gordon, Tyler Cowen, and Erik Brynjolfsson, among others, regarding diminishing returns to technological change and whether we’ve reached “the end of innovation”. Joel summarizes his argument in this Vox EU essay.

Joel is an optimist, and does not believe that technological dynamism is running out of steam (to make a 19th-century joke …). He argues that technological change and its ensuing economic growth are punctuated, and one reason for that is that conceptual breakthroughs are essential but unforeseeable. Economic growth also occurs because of the perpetual nature of innovation — the fact that others are innovating (here he uses county-level examples) means that everyone has to innovate as a form of running to stand still. I agree, and I think as long as the human mind, human creativity, and human striving to achieve and accomplish exist, there will be technological dynamism. A separate question is whether the institutional framework in which we interact in society is conducive to technological dynamism and to channeling our creativity and striving into such constructive application.

Continuing debate over the economic origins of electric utility regulation

State regulation of electric utilities began in earnest about 1907 and by around 1920 almost all states had begun state regulation. Prior to state regulation, most electric utilities were regulated through city-issued franchise agreements. Was state regulation of privately-owned electric utilities efficiency enhancing relative to the municipal franchise regulation of electric utilities that preceded it?

Thomas Lyon and Nathan Wilson, in the Journal of Regulatory Economics (2012, full cite below), write, “Electricity is perhaps the quintessential regulated industry, yet the historical roots of its regulation remain imperfectly understood. This lack of clarity exists despite the existence of a small but fascinating literature on the subject.”

Two main opposing lines of thought are supported: a public choice story of regulatory capture, and a transactions cost/contracting story of efficiency enhancing state regulation. Lyon and Wilson begin with a quick survey of this literature:

In a pioneering paper that initiated the empirical study of regulation, Stigler and Friedland (1962) argued that the behavior of electric utilities subject to state regulation was not significantly different from that of other utilities. Jarrell (1978) pointed out that interpreting this result was difficult, since utilities not subject to state regulation remained subject to municipal franchise contracting, which had preceded state regulation historically. He showed that not only was state regulation adopted earlier in states with lower rates, these early-adopting states subsequently saw their electric rates fall more slowly than those in other states; he thus characterized state regulation as a classic example of capture by the regulated industry.

More recent work suggests that because municipal franchise contracting was rife with corruption, state regulation was seen as more likely to protect the massive quasi-rents created by large-scale investment in generation capacity. If so, then the relative increase in prices under state regulation could have been necessary to support investment, and state regulation can be seen as a better form of long-term relational contract. Knittel (2006) used an empirical hazard model to shed new light on the drivers of early adoption of state regulation, and found they included not just low prices, but also capacity shortages and low residential electricity penetration rates.

This suggests that a desire to increase investment may have been an important  factor driving the adoption of state regulation. Neufeld (2008), in a similar empirical analysis, finds that states with a higher level of capacity per capita (proxying for larger appropriable quasi-rents) adopted state regulation earlier. This suggests that a desire to protect existing investments may have been an important factor driving the adoption of state regulation. Both papers imply that state regulation was expected to provide better protection for investment than did municipal franchise contracting.

Lyon and Wilson note that both the capture and contracting explanations are consistent with Jarrell’s finding of relative price increases after a move to state regulation, but that the explanations differ with respect to their implications for investment. The capture theory suggests that utilities would raise prices to allow owners to take more profits (with higher prices resulting in slower consumption growth, implying slower capacity growth), while the contract story suggests utilities would raise prices to invest in additional capacity once they had been relieved of the risk of municipal predation.

Lyon and Wilson examine investment in capacity over the period 1902 to 1937 to determine what effect, if any, state regulation had on investment. While data limits challenge the analysis, the authors find a fairly consistent pattern of state regulation being associated with slower rates of investment. That is to say, the authors conclude investment data supports the capture theory of regulation.

From their conclusion:

This paper has tested whether state regulation did indeed result in a stronger propensity to invest on the part of electric utilities. We found no support for this hypothesis. Instead, we found robust evidence that state regulation actually reduced the investment propensity of investor-owned utilities, controlling for existing levels of capacity per capita. From the perspective of enhancing investment, any protection against regulatory opportunism conferred by state regulation was apparently outweighed by its vulnerability to capture by regulated firms.

REFERENCES

Jarrell, Gregg A. “The Demand for State Regulation of the Electric Utility Industry.” Journal of Law & Economics 21 (1978): 269.

Lyon, Thomas P., and Nathan Wilson. “Capture or contract? The early years of electric utility regulation.” Journal of Regulatory Economics 42.3 (2012): 225.

Neufeld, John L. “Corruption, quasi-rents, and the regulation of electric utilities.” Journal of Economic History 68.04 (2008): 1059. [Article discussed earlier on KP here.]

Stigler, George J., and Claire Friedland. “What can regulators regulate? The case of electricity.” Journal of Law & Economics 5 (1962): 1.

Politicized implementation of U.S. oil import quotas, 1959-1973

The oil import quota system in place from 1959 to 1973 restricted imports to an amount equal to the difference between the federal government’s estimate of domestic oil demand and the estimate of domestic oil supply. But, of course, nothing in industry-protection policy can be easy, so the policy contained a number of adjustments and exclusions.

Chief among exclusion was the “overland exemption” for imports from Canada and Mexico. Hilarity ensues.

120. There is an overland “exemption” for imports from Canada and Mexico. The overland exemption has been construed to include imports from Mexico which are transported by tanker to Brownsville, Texas, where they are entered in bond, transferred to trucks which cross the Mexican border, then re-enter the United States where they are released from bond and are said to have entered by overland means. The oil is reloaded aboard tankers for shipment by sea to the U.S. East Coast. On the other hand, the exemption has not been extended to shipments from Canada across the Great Lakes or to rail shipments from Canada to Ketchikan in Southern Alaska because of a short inland waterway crossing by rail car ferry. The “overland exemption” for both Canadian and Mexican imports are further limited quantitatively by intergovernmental agreements.

From Cabinet Task Force on Oil Import Control, The Oil Import Question, (1970), at pp. 9-10.

 

“In the spirit of Apollo, with the determination of the Manhattan Project”: Nixon’s Project Independence

When Arab oil exporters imposed their embargo on the U.S. and the Netherlands in October 1973, George Schultz noted that the United Kingdom and France faced hardly any problem accessing crude oil supplies.Schultz was Secretary of the Treasury at the time and had earlier been in charge of Nixon’s Cabinet Task Force on Oil Import Control.

The United States too, despite the embargo’s intent, faced few problems accessing crude oil supplies–the effect of the embargo was mostly to rearrange tanker routes, at modest additional cost to U.S. importers, and import levels were barely affected. Supplies were not too affected, but world oil prices jumped. The oil import allocation system was not up to the challenges presented by the needed market response, and the result was an uneven pattern of regional shortages and surpluses that were difficult to correct: movements across U.S. government planning regions required government permission.

As I mentioned yesterday, it was the import allocation system in combination with oil price controls that turned the world oil price increase into an energy crisis in the United States.

Economic problems often create political problems for the President. But Nixon, increasingly entangled in Watergate scandal revelations in late 1973, found the growing energy crisis to be a useful political device. On November 7, 1973, the President announced “Project Independence”:

Let us set as our national goal, in the spirit of Apollo, with the determination of the Manhattan Project, that by the end of this decade we will have developed the potential to meet our own energy needs without depending on any foreign energy sources.

Let us pledge that by 1980, under Project Independence, we shall be able to meet America’s energy needs from America’s own energy resources.

No people in the world perform more nobly than the American people when called upon to unite in the service of their country. I am supremely confident that while the days and weeks ahead may be a time of some hardship for many of us, they will also be a time of renewed commitment and concentration to the national interest.

Nixon’s simple political narrative–bad Middle Eastern oil producers were a threat to our economic security–was readily accepted and politicians have seized onto “energy independence” slogans ever since.

Nixon’s popularity had peaked near 67 percent at his second inauguration, January 1973, then began sliding down throughout the year. The Project Independence speech coincided with a stabilization of his popularity around 25 percent, where it remained until his resignation in August of the next year.

RELATED: Peter Grossman’s book, U.S. Energy Policy and the Pursuit of Failure, hammers hard on politician’s invocation of Apollo and Manhattan Project analogies when announcing outsized energy research goals. There is an immense difference, Grossman explains, between pursuing a known technological task at incredible expense and pursuing speculative scientific developments with the goal of fostering a new commercial energy product (fusion power, synfuels, wind power, solar power, cellulosic ethanol fuels, etc.). If the book could only cure politicians of this one failing, it would have been worth Grossman’s efforts in producing it. Of course, as Grossman points out, there are many other political failings as well.

Energy imports and energy security: a view from 1970

A few weeks back George Schultz posted a few happy memories on a Hoover Institution website from his time heading Nixon’s Cabinet Task Force on Oil Import Control way back in 1969 and 1970. The task force was charged with reviewing the existing mandatory oil import quotas, first imposed under the Eisenhower administration, and recommending reforms if needed

At the AEI Ideas blog, Ben Zycher finds Schultz’s recollections of that effort maddening off point. Zycher concludes there is “something about oil imports or ‘dependence’ that has a deeply corrosive effect on clear thinking, a commodity all too rare in policy discussions generally, and in the Beltway in particular.”

I found a copy of the task force’s report at the library* to see what the fuss was about. Overall the report looks pretty comprehensive, and the process of preparing the report seems open and thorough (Schultz mentions receiving 10,000 pages of comments in response to the task force’s list of questions published in the Federal Register on May 22, 1969, and these were followed by task force site visits and extensive deliberations). The majority on the task force recommended scrapping the import quotas, imposition of a tariff that approximated the difference between the then current domestic and world oil prices, then periodic reductions in the tariff to bring the domestic price down to the world price over time.

I noticed how far from prescient the report was about how world oil markets would actually change during the 1970s. Forecasting being hard, and all that.

At the time the Texas Railroad Commission, with the help of the Interstate Oil Compact, import quotas and other supportive federal policies, limited domestic production to keep crude oil prices up in the U.S. Current oil prices were then around $3.30/bbl in the United States, and the task force’s proposed policy of shifting from import quotas to a slowly declining import tariff was deemed likely to yield prices drifting down to $2 over a decade. A dissenting view, included at the end of the report, objected to the tariff approach on the grounds that the lower prices expected would harm the domestic energy industry and therefore be bad for national security. Things went a little differently.

Of course the text frequently points out the hazards of prediction. Many things could happen, it acknowledged, and the report considered several seemingly-plausible scenarios within which to consider the policy alternatives. In any case, Nixon shelved the task force report, imposed price controls on oil the next year, then as energy shortages loomed in early 1973 he abolished the quota system and implemented an import allocation program to ensure that all regions got (the Nixon administration’s idea of a fair share of) access to cheaper imports.

It was this cumbersome oil import allocation system, combined with continued federal oil price controls, that created an energy crisis out of the sharp boost in world oil prices in late 1973. All in all, the task force’s recommendation would have been superior to Nixon’s actual policies.

*Actually, since I have a great librarian, I just emailed him and was able to pick it up at the library’s front desk the next day. (I could have had it delivered to my office in two or three days, but I’m an impatient person.)