When does state utility regulation distort costs?

I suspect the simplest answer to the title question is “always.” Maybe the answer depends on your definition of “distort,” but both the intended and generally expected consequences of state utility rate regulation has always been to push costs to be something other than what would naturally emerge in the absence of rate regulation.

More substantive, though, is the analysis provided in Steve Cicala’s article in the January 2015 American Economic Review, “When Does Regulation Distort Costs? Lessons from Fuel Procurement in US Electricity Generation.” (here is an earlier ungated version of the paper.)

Here is a summary from the University of Chicago press release:

A study in the latest issue of the American Economic Review used recent state regulatory changes in electricity markets as a laboratory to evaluate which factors can contribute to a regulation causing a bigger mess than the problem it was meant to fix….

Cicala used data on almost $1 trillion worth of fuel deliveries to power plants to look at what happens when a power plant becomes deregulated. He found that the deregulated plants combined save about $1 billion a year compared to those that remained regulated. This is because a lack of transparency, political influence and poorly designed reimbursement rates led the regulated plants to pursue inefficient strategies when purchasing coal.

The $1 billion that deregulated plants save stems from paying about 12 percent less for their coal because they shop around for the best prices. Regulated plants have no incentive to shop around because their profits do not depend on how much they pay for fuel. They also are looked upon more favorably by regulators if they purchase from mines within their state, even if those mines don’t sell the cheapest coal. To make matters worse, regulators have a difficult time figuring out if they are being overcharged because coal is typically purchased through confidential contracts.

Although power plants that burned natural gas were subject to the exact same regulations as the coal-fired plants, there was no drop in the price paid for gas after deregulation. Cicala attributed the difference to the fact that natural gas is sold on a transparent, open market. This prevents political influences from sneaking through and allows regulators to know when plants are paying too much.

What’s different about the buying strategy of deregulated coal plant operators? Cicala dove deep into two decades of detailed, restricted-access procurement data to answer this question. First, he found that deregulated plants switch to cheaper, low-sulfur coal. This not only saves them money, but also allows them to comply with environmental regulations. On the other hand, regulated plants often comply with regulations by installing expensive “scrubber” technology, which allows them to make money from the capital improvements.

“It’s ironic to hear supporters of Eastern coal complain about ‘regulation’: they’re losing business from the deregulated plants,” said Cicala, a scholar at the Harris School of Public Policy.

Deregulated plants also increase purchases from out-of-state mines by about 25 percent. As mentioned, regulated plants are looked upon more favorably if they buy from in-state mines. Finally, deregulated plants purchase their coal from more productive mines (coal seams are thicker and closer to the surface) that require about 25 percent less labor to extract from the ground and that pay 5 percent higher wages.

“Recognizing that there are failures in financial markets, health care markets, energy markets, etc., it’s critical to know what makes for ‘bad’ regulations when designing new ones to avoid making the problem worse,” Cicala said. [Emphasis added.]

Moody’s concludes: mass grid defection not yet on the horizon

Yes, solar power systems are getting cheaper and battery storage is improving. The combination has many folks worried (or elated) about the future prospects of grid-based electric utilities when consumers can get the power they want at home. (See Lynne’s post from last summer for background.)

An analysis by Moody’s concludes that battery storage remains an order of magnitude too high, so grid defections are not yet a demonstrable threat. Analysis of consumer power use data leads them to project a need for a larger home system than other analysts have used. Moody’s further suggests that consumers will be reluctant to make the lifestyle changes–frequent monitoring of battery levels, forced conservation during extended low-solar resource periods–so grid defection may be yet slower than the simple engineering economics computation would suggest.

COMMENT: I’ll project that in a world of widespread consumer power defections, we will see two developments to help consumers avoid the need to face forced conservation. Nobody will have to miss watching Super Bowl LXXX because it was cloudy the week before in Boston. First, plug-in hybrid vehicles hook-ups so the home batteries can be recharged by the consumer’s gasoline or diesel engine. Second, home battery service companies will provide similar mobile recharge services (or hot-swapping home battery systems, etc.) Who knows, in a world of widespread defection, maybe the local electric company will offer spot recharge services at a market-based rate?

[HT to Clean Beta]

Tragedy of the commons, Yugoslavian apartment building laundry room edition

The tragedy of the commons story is well known and examples abound, but I still enjoy finding new examples in unexpected places. Here is one such example, first published in 1992 but new to me.

The building referred to is an apartment building in Yugoslavia; the time described isn’t exactly identified in the article, but perhaps 1960s or early in the 1970s:

In the cellar of our building there was a washing room with a huge concrete washing basin and three new washing machines. At the beginning, everyone washed their clothes downstairs. There was a schedule hung on the door and each family took its turn once a week. The machines didn’t work for long. To put it mildly, people didn’t take very good care of them. After all, these machines didn’t belong to anyone in person, so no one felt responsible for repairing, or even cleaning them. The first machine broke after about a year, then the second one, then the third. In the washing room, people started to store broken chairs, children’s bicycles, beach umbrellas, charcoal for barbecues, skis, mattresses. … The basins were filled with supplies for winter: bags of potatoes, green and red peppers, and wooden barrels of sauerkraut.

We’d lost our common laundry room precisely because it was common. But by that time the standard of living in the country was high enough so, instead of forty people using three common machines, everyone could buy an imported washing machine for themselves, however unnecessary and irrational this really was. Even our own country started to produce them, except that they all were very expensive. This, strangely enough, became a reason to buy one, to prove that you were earning enough, that your social status was high enough, so you could afford household appliances. Social differentiation, starting with cars and TV sets, continued in bathrooms and kitchens. A washing machine became an item of prestige, and it was good for women, even if it really wasn’t meant to ease their lives in the first place.

From “On doing laundry,”
How we survived communism and even laughed, Slavenka Drakulić.

Drakulić’s description of her grandmother doing laundry (in 1950s Yugoslavia) reminded me of Hans Rosling’s TED Talk, “The magic washing machine.”

I have only read a few of the essays in Drakulić’s book, but so far it impresses me as a good collection of sharply-observed and reported essays on life in communist Eastern Europe.

Weak beer and antitrust economics

Yesterday’s Wall Street Journal brought the story, “Bud Crowded Out by Craft Beer Craze.” While Bud Light is currently the highest selling beer in the United States, the flagship brand Budweiser is fading. The international beverage giant is scrambling to win over younger drinkers to boost Budweiser sales, so the familiar Clydesdale horses are out this holiday season and ads will take on a younger vibe.

On Facebook Alexie Marcoux commented that Budweiser’s decline ought to put the end to the old Galbraithian narratives about corporations so powerful they can dictate tastes and preferences. We can hope (but I’m not hopeful — I suspect the demand for evil dragons to be slain by heroic antitrust economists will keep the myth alive).

The beer giant has been through a few mergers over recent years, and I wondered how Budweiser’s troubles were reflected in the related antitrust analysis. Antitrust theory isn’t built on the work of John Kenneth Galbraith, but antitrust narratives conjure similar images of powerful corporations and seemingly helpless consumers (granted that antitrust lawyers write in more leaden prose than JKG).

In January 2013 the U.S. Department of Justice Antitrust office filed a lawsuit challenging Anheuser-Busch InBev’s acquisition of a 100 percent stake in Grupo Modelo. Here is what Justice was worried about just over a year ago:

The Department of Justice filed a civil antitrust lawsuit today challenging Anheuser-Busch InBev’s (ABI) proposed acquisition of total ownership and control of Grupo Modelo.  The department said that the $20.1 billion transaction would substantially lessen competition in the market for beer in the United States as a whole and in 26 metropolitan areas across the United States, resulting in consumers paying more for beer and having fewer new products from which to choose.

Americans spent at least $80 billion on beer last year.  According to the department, ABI’s Bud Light is the best selling beer in the United States and Modelo’s Corona Extra is the best-selling import.  Because of the size of the beer market in the United States, even a small increase in the price of beer could result in billions of dollars of harm to American consumers, the department said.

According to the department’s complaint, the U.S. beer market is already highly concentrated, and prices are increased by strategic interactions among the largest brewers, including ABI and MillerCoors. ABI generally acts as the price leader, implementing annual price increases in the sub-premium, premium and premium plus segments of the U.S. beer industry. MillerCoors and other brewers have typically joined the ABI price increases, while Modelo has not. By pricing aggressively, Modelo–through its importer, Crown Imports–puts pressure on ABI to maintain or lower prices, especially in certain parts of the country. As a result, Modelo has become a particularly important competitor in the U.S. market.

The press release manages to divide the industry into for segments, from “sub premium” (i.e. Busch and Keystone) to “high end” which is described as including Corona, Heineken, “and a variety of craft beers.” This brief mention, as just a fraction of a segment of the industry, is the only mention of craft beers in the press release. Justice’s formal complaint mentions craft beers three times, each time more or less as an aside — they missed the real market action.

In the resulting agreement, the United States federal government sought to promote competition in the beer industry by, among other things, extracting a promise from the company acquiring a few AB-InBev assets that it would expand the capacity of a brewery in Mexico to at least 20 million hectoliters of packaged beer annually.

For this heroic antitrust effort beer consumers in the United States offer a heart-felt yawn. How many of our tax dollars when into deciding whether the Mexican brewery needed a capacity of 20 million hectoliters, rather than 15 million or 23.5 million?

Meanwhile, actual competition in the market continues to force international beverage giant AB-InBev to scramble for new customers.

NOTE 1: See full collection of Justice documents here.

NOTE 2: It isn’t just the Department of Justice, the private think tank the American Antitrust Institute is also worried about concentration in the beer market. Just a few days ago AAI sent a letter to the Department of Justice expressing concern about rumors of a AB-InBev merge with SABMiller. That letter follows AAI’s lengthy report, Global Beer: Road to Monopoly, which two years ago worried about a then-rumored merger between AB-InBev and SABMiller and the prospect of creating “a huge entity with great market power.”

I keep wondering how great the market power can be in a world without barriers to entry? No real secrets in how to brew beer. I suspect the biggest threats to competition emerge because alcohol distribution is highly regulated in the United States — not because one brewery in Mexico has a smaller than desired production capacity — but I suspect the Department of Justice will not be challenging the post-prohibition three-tier system anytime soon.

Charging for non-customer-specific fixed costs

UC Berkeley economist Severin Borenstein has a really, really great post at the Energy at Haas blog on utility fixed charges to recoup system fixed costs. If you want a primer on volumetric versus two-part pricing, this is a good one. After a very clear and cogent explanation and illustration of the differences among variable costs, customer-specific fixed costs, and system fixed costs, he says

Second, as everyone who studies electricity markets knows (and even much of the energy media have grown to understand), the marginal cost of electricity generation goes up at higher-demand times, and all generation gets paid those high peak prices.  That means extra revenue for the baseload plants above their lower marginal cost, and that revenue that can go to pay the fixed costs of those plants, as I discussed in a paper back in 1999. …

The same is not true, however, for distribution costs.  Retail prices don’t rise at peak times and create extra revenue that covers fixed costs of distribution.  That creates a revenue shortfall that has to be made up somewhere. Likewise, the cost of customer-specific fixed costs don’t get compensated in a system where the volumetric charge for electricity reflects its true marginal cost.

He continues with a good discussion of the lack of a theoretical economic principle informing distribution fixed costs.

I want to take it in another, complementary, direction. The asymmetry he points out is, of course, an artifact of cost-based regulated rate recovery, which means that even under retail competition this challenge will arise, even though his explanation of it is articulated under fixed, regulated rates. And the fact that late night regulated rates are higher than energy costs may not generate a revenue excess that would be sufficient to pay the system fixed costs portion in the way he describes as happening in wholesale markets and transmission fixed costs. This is a thorny problem of cost-based regulation.

Consider a regulated, vertically-integrated distribution utility. This utility offers a menu of contracts — a fixed price, a TOU price, and a real-time price (the attentive among you will notice that this setup approximates what we studied in the GridWise Olympic Peninsula Project). It’s possible, as David Chassin and Ross Guttromson demonstrated, for the utility to find an efficient frontier among these three contract types to maximize expected revenue in aggregate across the groups of customers choosing among those contracts. That’s a situation in which retail revenue does vary, driven especially by the RTP customers, and revenue can be higher to the extent that there’s a core of inelastic retail demand. But they still have to figure out a principle, a rule, a metric, an algorithm for sharing those distribution system fixed costs, or for taking them into account when setting their fixed and TOU prices. And then to be non-discriminatory, they’d probably have to allocate the same system fixed costs to the RTP customers too. So we’re back where we started.

And this is also the case under retail competition. Take, for example, this table of delivery charges in Texas, where the regulated utilities are transmission and distribution wires companies.  It breaks them down between customer fixed charges and system fixed charges, but it’s still the same type of scenario as Severin describes.

As long as there’s a component of the value chain that’s cost-recovery regulated, and as long as that component has system-specific and customer-specific fixed costs, this question will have to be part of the analysis.

A related question is whether, or how, the regulated utility will be permitted to provide services that generate new revenue streams that will allow them to cover those costs. That’s a thicket I’ll crawl into another day.

Ride sharing and overcoming taxi discrimination

An interesting story from NPR caught my eye: how ride sharing apps make it easier for riders to overcome racial discrimination. The story tells the tale of Skinny Pants Guy, “a dude who was in his mid-20s — slim, with neat, shoulder-length locks, skinny chinos, loafers and a leather briefcase slung across his torso — standing on the corner, his arm raised skyward. He was trying without luck to hail a cab. …”If I was carrying a gun, where could I even hide it?” he said to us in exasperation.”

Although technically illegal and opening taxi drivers to regulatory punishment and fines if they refuse to accept passengers, racial discrimination among taxi drivers does occur.

Many people of color are embracing these services as a way to avoid discrimination from traditional taxicab drivers. There’s more than anecdotal evidence that that discrimination is widespread. A yearlong investigation by a local reporter in Washington, Russ Ptacek, found last year that taxicab drivers were significantly less likely to stop for black fares than for white fares who were dressed the same.

Phenomena like taxi driver discrimination are an economic conundrum — even in the case of Skinny Pants Guy, who is professionally dressed and unlikely to pose a threat to the driver, why choose no fare rather than pick up the passenger?

Gary Becker’s 1957 book The Economics of Discrimination analyzed this phenomenon, and Becker’s model (inserting a “race taste” parameter into a standard utility function) showed that such discrimination was harmful to both the person discriminated against and the person practicing the discrimination. This model has its limits, of course; if you’re working in a standard framework with stable preferences, this taste parameter represents inherent racism and uses that framework to estimate the cost of such preferences. It doesn’t allow for changing preferences as time and circumstances change. An alternative model that can explain the same phenomenon without such a taste parameter would be a screening model — based on location (good/bad neighborhood) and/or race and/or clothing, a taxi driver could draw inferences based on history or preconceptions and choose whether or not to accept the passenger.

Ride sharing, and technology features such as the ability of riders to rate drivers and vice versa, give riders competing alternatives. What drives this beneficial outcome? Are drivers more willing to pick up riders because they know that they will get to submit a rider rating ex post? Are drivers more willing to pick up riders because the fact that they actively chose Uber or Lyft signals to the driver that such a rider in less likely to be a threat? If that’s the case, why is that the case?

Whatever the motivation, I’m intrigued by this aspect of ride sharing because it’s an unintended benefit, and a broader social benefit of ride sharing. One reason why I’m so interested in ride sharing (see how many posts Mike and I have done!) is that in the process of enabling asset owners to monetize their “dead capital”, it taps into what Adam Smith called our “fellow-feeling” — it inclines us more to sympathy (in the Smithian sense) with the other person, and to act with tolerance. I also think that the reciprocal/mutual ratings system is an institutional design that harnesses fellow-feeling, by giving both drivers and riders an incentive to imagine being in the situation of the other party, and to consider the effects of their behavior on the other party.

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.