Price gouging-moral insights from economics

Dwight Lee in the current issue of Regulation magazine offers “The Two Moralities of Outlawing Price Gouging.” In the article Lee endorsed economists’ traditional arguments against laws prohibiting price gouging, but argued efficiency claims aren’t persuasive to most people as they fail to address the moral issues raised surrounding treatment of victims of disasters.

Lee wrote, “Economists’ best hope for making an effective case against anti-price-gouging laws requires considering two moralities—one intention-based, the other outcome-based—that work together to improve human behavior when each is applied within its proper sphere of human activity.”

Intention-based morality, that realm of neighbors-helping-neighbors and the outpouring of charitable donations from near and far, is good and useful and honorable, said Lee, who term this as “magnanimous morality.” Such morality works great in helping family and friends and, because of the close relationship, naturally has a good idea of just what help may be needed and when and where.

When large scale disasters overwhelm the limited capabilities of the friends and families of victims, large-scale charity kicks in. Charity is the extended version magnanimous morality, but it comes a knowledge problem: how does the charity identify who needs help, and what kind, and when, and where?

The second morality that Lee’s title referenced is the morality of “respecting the rights of others and abiding by general rules such as those necessary for impersonal market exchange.” This “mundane morality” of merely respecting rules does not strike most people as too compelling, Lee observed, but economists know how powerful a little self-interest and local knowledge can be in a world in which rights are respected. Indeed, the vast successes of the modern world–extreme poverty declining, billions fed well enough, life-expectancy and literacy rising, disease rates dropping–can be attributed primarily to the social cooperation enabled by local knowledge and voluntary interaction guided by prices and profits. The value of mundane morality after a disaster is that it puts this same vast power to work in aid of recovery.

The two moralities work together Lee said. Even as friends and families reach out in magnanimous morality, perhaps each making significant sacrifices to aid those in need, the price changes produced by mundane morality will engage millions of people more to make small adjustments similarly in aid. A gasoline price increase in New Jersey after Sandy’s flooding could trickle outward and lead gasoline consumers in Pittsburgh or Chicago to cut back consumption just a little so New Jerseyans could get a little more. Similarly for gallons of water or loaves of bread or flashlights or hundreds of other goods. Millions of people beyond the magnanimous responders get pulled into helping out, even if unknowingly.

Or they would have, had prices been free to adjust. New Jersey laws prohibit significant price increases after a disaster, and post-Sandy the state has persecuted merchants who it has judged as running afoul of the price gouging law.

Surely victims of a disaster appreciate the help that comes from people who care, but they just as surely appreciate the unintended bounty that comes from that system of voluntary social interaction guided by prices and profits called the market. Laws against post-disaster price increases obstruct the workings of mundane morality, increase the burden faced by the magnanimous, and reduce the flow of resources into disaster-struck regions.

Perhaps you think that government can fill the gap? Lee noted that restricting the workings of mundane morality increases the importance of political influence and social connections, but adds the shift is unlikely to benefit the poor. On this point a few New Jersey anecdotes may inform. See these stories on public assistance in the state:

We often honor the magnanimous, but we need not honor the mundane morality-inspired benefactors of disaster victims.  While the mundanely-moral millions may provide more help in the aggregate than the magnanimous few, the millions didn’t sacrifice intentionally. They just did the locally sensible thing given their local knowledge and normal self-awareness; doing the locally sensible thing is its own reward.

We need not honor the mundanely moral, but we also ought not block them from helping.

ICLE letter to Gov. Christie opposing direct vehicle distribution ban: Over 70 economists and law professors

Geoff Manne of the International Center for Law and Economics has spearheaded a detailed, thorough, analytical letter to New Jersey Governor Christie examining the state’s ban on direct vehicle distribution and why it is bad for consumers. Geoff summarizes the argument in a post today at Truth on the Market:

Earlier this month New Jersey became the most recent (but likely not the last) state to ban direct sales of automobiles. Although the rule nominally applies more broadly, it is directly aimed at keeping Tesla Motors (or at least its business model) out of New Jersey. Automobile dealers have offered several arguments why the rule is in the public interest, but a little basic economics reveals that these arguments are meritless.

Today the International Center for Law & Economics sent an open letter to New Jersey Governor Chris Christie, urging reconsideration of the regulation and explaining why the rule is unjustified — except as rent-seeking protectionism by independent auto dealers.

The letter, which was principally written by University of Michigan law professor, Dan Crane, and based in large part on his blog posts here at Truth on the Market (see here and here), was signed by more than 70 economists and law professors.

I am one of the signatories on the letter, because I believe the analysis is sound, the decision will harm consumers, and the law is motivated by protecting incumbent interests.

I encourage you to read the analysis in the letter in its entirety. Note that although the catalyst of this letter is Tesla, this law is sufficiently general to ban any direct distribution of vehicles, and thus will continue to stifle competition in an industry that has been benefiting from incumbent legal protection for several decades.

Information technology has reduced the transaction costs that previously made vehicle transactions too costly relative to local transactions between consumers and dealers. Statutes and regulations protecting those incumbents foreclose potential consumer benefits, and thus do the opposite of the purported “consumer protection” that is the stated goal of the legislation.

See also comments from Loyola law professor (and fellow runner and Chicagoan!) Matthew Sag.

No net metering without grid connection, no net metering controversy where wires and energy products are unbundled

Around the country lobbyists for utilities and solar power companies are fighting over public policy, mostly for and against reform of net metering policies.* Today, The Alliance for Solar Choice (TASC) trumpeted in a press release recent victories in the states of Utah and Washington over net metering reforms urged by utilities. TASC highlighted the involvement of conservative policy group the American Legislative Exchange Council (ALEC), which joined the battle over net metering via a January 2014 resolution calling for “policies to require that everyone who uses the grid helps pay to maintain it and to keep it operating reliably at all times.”

In the TASC press release the group makes the odd and laughable claim:

Net metering allows rooftop solar customers to … receive full retail credit for any excess electricity sent back to the grid. Utilities turn around and sell this energy at the full retail rate to the neighbors, even though they paid nothing to generate, transmit or distribute that cleaner power.

I wonder how TASC thinks the net-metered customers’ excess electrical power actually flows to the neighbor’s property?

On the other hand, I take the next sentence in the TASC press release as obviously true: “Utilities attacking net metering want to eliminate the policy to stifle energy choice and protect their monopolies.” Evidence for the point is contained in the Washington state bill which, in addition to reforming net metering would have banned third party financing of rooftop solar if the utility itself offered a leasing program.

But one can oppose net metering and still favor “energy choice.” In fact, net metering is in the end incompatible with energy choice since net metering requires a grid connection and a cross-subsidy from grid-connected, non-net metered customers to survive. Giving energy choice to the customers subsidizing their solar-paneled neighbors will, if the burden grows large enough, push unsubsidized customers off the grid.

Currently, the burden is rather small most places. The utility industry is worried, though, about the possible rapid spread of net metering as the economics of rooftop solar improve and the consequent rate “death spiral” as fewer and fewer customers remain who actually pay for the costs of local distribution systems. See the report Disruptive Challenges, distributed by EEI in early 2013, and now the Economics of Grid Defection, published by the Rocky Mountain Institute this year.

The fight over net metering and other rooftop solar policies has broken out in a number of states, from Georgia to Massachusetts to Wisconsin to the solar-rich states of California and Arizona. Perhaps most interesting, however, is to note one solar-rich state lacking a battle over net metering: Texas. As Lynne noted here last summer, with generation and retailing already divorced from the monopoly wires business (in most of the state), Texas’s wires utilities are not nearly as threatened by distributed generation resources.

Power retailers in Texas are free (within limits) to offer a variety of contract to customers with distributed generation capability, and at least one offers a net metered-style product. Reliant’s e-Sense Sell-back plans credit customers for the full retail energy rate for the first 500 kwh of power put onto the grid (about $0.17 kwh at peak prices, and any additional power at $0.05 per kwh). Notice that as Reliant is an unregulated retail power provider, not a regulated utility, there is no forced cross-subsidization of distributed energy resources in the offering.

No subsidy, no undermining of grid finances, supports energy choice without promoting energy poverty. What is not to like?

 

 

*Net metering policies allow consumers capable of self-generation to be credited for any generation put onto the local distribution grid at the full retail price of electricity. Because the full retail price of electricity covers both energy and grid costs, utilities object that net metered customers are overpaid for the power they inject into the distribution grid.

Rent-seeking diary: It’s only Tennessee whiskey if it’s Jack Daniel’s

Today’s Wall Street Journal has an article, Jack Daniel’s Faces a Whiskey Rebellion, that highlights how politically powerful industries can use industry-protecting regulation to raise their rivals’ costs:

At the company’s urging, Tennessee passed legislation last year requiring anything labeled “Tennessee Whiskey” not just to be made in the state, but also to be made from at least 51% corn, filtered through maple charcoal and aged in new, charred oak barrels.

So there are three dimensions on which JD’s competitors could vary, at least slightly, and still make something that consumers could recognize as Tennessee whiskey (not bourbon, not whisky).

Who are the rivals in the Tennessee whiskey market, in which Jack Daniel’s has a 90+ percent market share? Dickel is the largest rival,

Diageo says the George Dickel brand is in compliance with the new law, and that it has no plans to change the way it is made. But the liquor giant says last year’s law puts a lid on innovation and that Brown-Forman shouldn’t be allowed to define the only path to high-quality Tennessee Whiskey.

“We’re in favor of flexibility that lets all distillers, large and small, make Tennessee whiskey the way their family recipes tell them,” said Alix Dunn, a Diageo spokeswoman.

 

… but unless you’ve been under a rock for the past two years you’ve surely noticed the craft distilling revival in the US. Some craft distillers agree with Diageo that such legislation stifles innovation.

But others see a clear legislative definition of what constitutes Tennessee whiskey as providing a strong focal point around which distillers can coalesce, and compete. Although one of these is quoted in the article, I don’t see the argument. Perhaps I’ll mull it over while enjoying a cocktail.

Rent-seeking diary: State dealer franchise laws and Tesla

By now you’ve probably heard that last week the New Jersey Motor Vehicle Commission passed a rule stipulating that automobile sales in the state cannot be direct-to-consumer, and must instead take place via dealer franchises. Tesla Motors was the clear target of this regulation, with its innovative electric vehicles and direct-to-consumer sales model. New Jersey is not the first state in which this regulatory tangle is occurring; last summer Tesla ran into dealer franchise law hurdles in Virginia and New York, as I discussed here in July.

The SF Gate blog post above notes:

Tesla said the administration had “gone back on its word,” claiming two top Christie aides had agreed not to move forward with the regulation. …

But a Christie spokesman rejected the accusations of a double-cross. The regulation, he said, won’t prevent Tesla from seeking legislation to allow direct sales in New Jersey.

Note that the political establishment response is to engage with the political process to get legislation passed to allow direct sales. What would such engagement entail? Will it entail the kind of crony relationships that have led to the entanglement of so many businesses and politicians in the past — will Tesla have to find its own politicians to fund in the hopes of a favorable legislative outcome? If so, that will vindicate my sad statement last July:

When innovative and environmentally correct meets the crony corporatism of existing legislation, is the entrenched incumbent dealer industry sufficiently politically powerful to succeed in retaining their enabling legislation that raises their new rival’s costs?

In New Jersey, it appears that the answer is yes, at least for now, as established car dealers cling to their old business model and hope to avoid being disintermediated. Tesla has thus far avoided the crony trap, and has instead focused on relabeling their New Jersey showrooms as “galleries” while encouraging customers to purchase the vehicle online. Will that legalistic sleight of hand suffice to enable an end-run around status-quo-protecting obstacles?

Alex Tabarrok discusses the Tesla-New Jersey case today, and analyzes it very usefully with a brief history of the evolution of state dealer franchise laws and how they served as a Coasean solution to an incentive problem:

Franchising rules evolved in Coasean fashion so that manufacturers could not expropriate dealers and dealers could not expropriate manufacturers. To encourage dealers to invest in a knowledgeable sales and repair staff, for example, manufactures promised dealers exclusive franchise (i.e. they would not license a competitor next door). But with exclusive franchises dealers would have an incentive to take advantage of their monopoly power and increase profits by selling fewer units at higher profits. Selling fewer units, however, works to the detriment of the manufacturer and the public (aka the double marginalization problem (video)). Thus the manufactures required dealers buy and sell a minimum quantity of cars, so-called quantity forcing. Selling more units is exactly what we want a monopoly to do, so these restrictions benefited manufactures and consumers.

Here Alex’s account dovetails with the history that Elon Musk provided in his open letter to the people of New Jersey on Friday:

Many decades ago, the incumbent auto manufacturers sold franchises to generate capital and gain a salesforce. The franchisees then further invested a lot of their money and time in building up the dealerships. That’s a fair deal and it should not be broken. However, some of the big auto companies later engaged in pressure tactics to get the franchisees to sell their dealerships back at a low price. The franchisees rightly sought protection from their state legislatures, which resulted in the laws on the books today throughout the United States (these laws are not present anywhere else in the world).

Musk’s letter is well worth reading in its entirety, as an eloquent and well-argued statement about regulatory and legislative entry barriers that enable incumbent firms to raise the costs of their rivals. He also provides a thoughtful and economically sophisticated (and accurate, I think) explanation for why they don’t want to sell Tesla vehicles through established dealers.

Here Alex adds another political economy detail of the economic leverage of the franchise dealers in the states — they provided jobs and their sales generated a large share of a state’s sales tax revenue, so politicians found it in their interest to shore up the state-level dealer franchise laws to protect the dealers. Thus a set of laws that initially benefitted both producers and consumers has evolved into industry-protecting regulation.

One other theme I’ve noted in the discussion of Tesla’s reaction to New Jersey cronyism is to criticize Tesla for the benefits it derives from government protection. Tesla’s business intersects with government programs in three areas: (1) taking a DOE-guaranteed loan of $465 million during the financial crisis, which has been paid back in full (and was smaller than the multi-billion-dollar loans to the Big Three); (2) the federal $7,500 income tax credit to individuals purchasing electric vehicles, from which all manufacturers of electric vehicles benefit and which is probably not decisive at the margin for Tesla’s high-income target customers; (3) revenue arising from the existence of a regulation-generated market for vehicle emission credits (ZEV) credits in California, in which Toyota and Nissan also sell ZEV credits to GM and Chrysler. I expect that being practical and not leaving money on the table is a sufficient motive to induce Tesla’s management to engage in those programs. But these benefits from government social engineering and regulation differ in kind from the kind of industry-protecting regulatory cronyism evident in New Jersey (and Texas, and other states forbidding direct-to-consumer car sales).

Permissionless innovation in electricity: the benefits of experimentation

Last Monday I was scheduled to participate in the Utility Industry of the Future Symposium at the NYU Law School. Risk aversion about getting back for Tuesday classes in the face of a forecast 7″ snowfall in New York kept me from attending (and the snow never materialized, which makes the cost even more bitter!), so I missed out on the great talks and panels. But I’ve edited my remarks into the essay below, with helpful comments and critical readings from Mark Silberg and Jim Speta. Happy thinking!

If you look through the lens of an economist, especially an economic historian, the modern world looks marvelous – innovation enables us to live very different lives than even 20 years ago, lives that are richer in experience and value in many ways. We are surrounded by dynamism, by the change arising from creativity, experimentation, and new ideas. The benefits of such dynamism are cumulative and compound upon each other. Economic history teaches us that well-being emerges from the compounding of incremental changes over time, until two decades later you look at your old, say, computer and you wonder that you ever accomplished anything that way at all.

The digital technology that allows us to flourish in unanticipated ways, large and small, is an expression of human creativity in an environment in which experimentation is rife and entry barriers are low. That combination of experimentation and low entry barriers is what has made the Internet such a rich, interesting, useful platform for us to use to make ourselves better off, in the different ways and meanings we each have.

And yet, very little (if any) of this dynamism has originated in the electricity industry, and little of this dynamism has affected how most people transact in and engage with electricity. Digital technologies now exist that consumers could use to observe and manage their electricity consumption in a more timely way than after the fact, at the end of the month, and to transact for services they value – different pricing, different fuel sources, and automating their consumption responses to changes in those. From the service convergence in telecom (“triple play”) we have experimented with and learned the value of bundling. Such bundling of retail electricity service with home entertainment, home security, etc. are services that companies like ADT and Verizon are exploring, but have been extremely slow to develop and have not commercialized yet, due to the combination of regulatory entry barriers that restrict producers and reinforce customer inertia. All of these examples of technologies, of pricing, of bundling, are examples of stalled innovation, of foregone innovation in this space.

Although we do not observe it directly, the cost of foregone innovation is high. Today residential consumers still generally have low-cost, plain-vanilla commodity electricity service, with untapped potential to create new value beyond basic service. Producers earn guaranteed, regulation-constrained profits by providing these services, and the persistence of regulated “default service contracts” in nominally competitive states is an entry barrier facing producers that might otherwise experiment with new services, pricing, and bundles. If producers don’t experiment, consumers can’t experiment, and thus both parties suffer the cost of foregone innovation – consumers lose the opportunity to choose services they may value more, and producers lose the opportunity to profit by providing them. By (imperfect) analogy, think about what your life would be like if Apple had not been allowed to set up retail stores that enable consumers to engage in learning while shopping. It would be poorer (and that’s true even if you don’t own any Apple devices, because the experimentation and learning and low entry barriers even benefits you because it encourages new products and entry).

This process of producer and consumer experimentation and learning is the essence of how we create value through exchange and market processes. What Internet pioneer Vint Cerf calls permissionless innovation, what writer Matt Ridley calls ideas having sex — these are the processes by which we humans create, strive, learn, adapt, and thrive.

But regulation is a permission-based system, and regulation slows or stifles innovation in electricity by cutting off this permissionless innovation. Legal entry barriers, the bureaucratic procedures for cost recovery, the risk aversion of both regulator and regulated, all undermine precisely the processes that enable innovation to yield consumer benefits and producer profits. In this way regulation that dictates business models and entry barriers discourages activities that benefit society, that are in the public interest.

The question of public interest is of course central to any analysis of electricity regulation’s effects. Our current model of utility regulation has been built on the late 19th century idea that cost-based regulation and restricting entry would make reliable electric service ubiquitous and as cheap as is feasible. Up through the 1960s, while exploiting the economies of scale and scope in the conventional mechanical technologies, that concept of the public interest was generally beneficial. But by so doing, utility regulation entrenched “iron in the ground” technologies in the bureaucratic process. It also entrenched an attitude and a culture of prudential preference for those conventional technologies on the part of both regulator and regulated.

This entrenchment becomes a problem because the substance of what constitutes the public interest is not static. It has changed since the late 19th century, as has so much in our lives, and it has changed to incorporate the dimension of environmental quality as we have learned of the environmental effects of fossil fuel consumption. But the concept of the public interest of central generation and low prices that is fossilized in regulatory rules does not reflect that change. I argue that the “Rube Goldberg” machine accretion of RPS, tax credits, and energy efficiency mandates to regulated utilities reflects just how poorly situated the traditional regulated environment is to adapting to the largely unforeseeable changes arising from the combination of dynamic economic and environmental considerations. Traditional regulation is not flexible enough to be adaptive.

The other entrenchment that we observe with regulation is the entrenchment of interests. Even if regulation was initiated as a mechanism for protecting consumer interests, in the administrative and legal process it creates entrenched interests in maintaining the legal and technological status quo. What we learn from public choice theory, and what we observe in regulated industries including electricity, is that regulation becomes industry-protecting regulation. Industry-protecting regulation cultivates constituency interests, and those constituency interests generally prefer to thwart innovation and retain entry barriers to restrict interconnection and third-party and consumer experimentation. This political economy dynamic contributes to the stifling of innovation.

As I’ve been thinking through this aloud with you, you’ve probably been thinking “but what about reliability and permissionless innovation – doesn’t the physical nature of our interconnected network necessitate permission to innovate?” In the centralized electro-mechanical T&D network that is more true, and in such an environment regulation provides stability of investments and returns. But again we see the cost of foregone innovation staring us in the face. Digital switches, open interconnection and interoperability standards (that haven’t been compromised by the NSA), and more economical small-scale generation are innovations that make high reliability in a resilient distributed system more possible (for example, a “system of systems” of microgrids and rooftop solar and EVs). Those are the types of conditions that hold in the Internet – digital switches, traffic rules, TCP-IP and other open data protocols — and as long as innovators abide by those physical rules, they can enter, enabling experimentation, trial and error, and learning.

Thus I conclude that for electricity policy to focus on facilitating what is socially beneficial, it should focus on clear, transparent, and just physical rules for the operation of the grid, on reducing entry barriers that prevent producer and consumer experimentation and learning, and on enabling a legal and technological environment in which consumers can use competition and technology to protect themselves.

Cochrane on ACA’s unravelling: parallels to electricity

John Cochrane’s commentary in last Thursday’s Wall Street Journal, What To Do When Obamacare Unravels, provides a strong and thoughtful analysis of what a free health care market could look like. In his argument he accomplishes two important tasks: he lays out the extent to which the U.S. health care market is not a free market, and he offers some design principles for a set of market rules and regulatory institutions that would enable competition to flourish and improve consumer welfare:

There is an alternative. A much freer market in health care and health insurance can work, can deliver high quality, technically innovative care at much lower cost, and solve the pathologies of the pre-existing system.

The U.S. health-care market is dysfunctional. Obscure prices and $500 Band-Aids are legendary. The reason is simple: Health care and health insurance are strongly protected from competition. There are explicit barriers to entry, for example the laws in many states that require a “certificate of need” before one can build a new hospital. Regulatory compliance costs, approvals, nonprofit status, restrictions on foreign doctors and nurses, limits on medical residencies, and many more barriers keep prices up and competitors out. Hospitals whose main clients are uncompetitive insurers and the government cannot innovate and provide efficient cash service. …

That the rest of the world spends less just shows how dysfunctional our current system is, not how a free market would work.

I encourage you to read his whole argument and think about it in the context of health care, if you haven’t already. But what really struck me while reading it was the relevance of his logic and his general market design principles to electricity. If you, as I did, reread his argument replacing “health care” with “electricity”, you will see parallels.

Long-standing legal entry barriers, erected decades ago as a regulatory corrective against putative market failure, reinforced and perpetuated by the material interests and political power of the groups that have benefited from the regulation (hospitals and insurance companies in health care, regulated utilities in electricity). Beliefs that the market in question is somehow unique, or at least different from other markets because the services in question are considered to be so essential to human well-being and to our living standards. Conviction, especially among policy makers, that the main way to meet the “public interest” is through control rather than choice, and that as political elites they are the right people to make decisions on behalf of those individual consumers whom they have deprived of making their own choices. These parallels mean that much of Cochrane’s critique is as relevant to electricity as it is to health care.

A final parallel makes this point obvious: the challenge of innovation and technological change to those established interests and their ideas about the public interest and business models in these markets. In both health care and electricity, innovation holds great promise for improving consumer well-being at lower costs, but attempts to create or implement innovation within each industry have been … fraught. In health care new technologies have enabled new treatments, but at a paradoxically high cost due to the lack of competition that Cochrane observes. In electricity new technologies have been concentrated in transmission and distribution operations. In both cases technology’s role and use have resulted from top-down regulatory determinations, not from bottom-up choices based on individual value. Economies of scale and information asymmetries may still make such organic, decentralized choices difficult, but information technology has lessened these asymmetries while other technological changes have reduced economies of scale. In fact, in both industries regulations have reinforced economies of scale that would otherwise have eroded.

Both markets also suffer from the Bastiat problem: the seen benefits of the control approach are much more salient than the unseen benefits of the choice approach in each case. In each case the threat of costly disorder (illness and death, electricity outages) is more salient than the benefits of more individual choice.

Cochrane observes that

Only deregulation can unleash competition. And only disruptive competition, where new businesses drive out old ones, will bring efficiency, lower costs and innovation.

His observation is just as true in electricity as in health care, and in electricity new businesses cannot drive out old ones in most retail markets and many wholesale markets. The sad and pathetic irony is that using the tools of regulatory control to attempt to achieve the desired outcomes of efficiency, lower cost, and innovation in each case will in fact achieve the opposite, by slowing down or stifling innovation and learning-by-doing on the part of consumers as well as producers.

Market processes and liberalization face significant political headwinds in both cases:

While economically straightforward, liberalization is always politically hard. Innovation and cost reduction require new businesses to displace familiar, well-connected incumbents. Protected businesses spawn “good jobs” for protected workers, dues for their unions, easy lives for their managers, political support for their regulators and politicians, and cushy jobs for health-policy wonks. Protection from competition allows private insurance to cross-subsidize Medicare, Medicaid, and emergency rooms.

But it can happen. The first step is, the American public must understand that there is an alternative. Stand up and demand it.

As we look forward into 2014 while reflecting on the experience of 2013, the failure of control, regulation, and political processes to achieve their stated objectives is increasingly palpable for more and more people. Control and politics cannot achieve these objectives, in either health care or electricity.

Wind energy’s price suppression effects (Debating wind power cost estimates – 6)

[Series header: On the Morning of October 15 the Institute for Energy Research in Washington DC released a report I’d written about the federal government's wind power cost estimates. (Links available here.) Later that day Michael Goggin of the American Wind Energy Association, the lobbying organization in Washington DC that represents the wind energy industry, posted a response on the AWEA website: “Fact check: Fossil-funded think tank strikes out on cost of wind.” I’m considering points made by the AWEA response in a series of posts.]

Goggin objects to my report’s emphasis on the high cost of wind energy. He said, “The reality is that wind energy is driving electricity prices down, thanks to large recent reductions in its cost.” I agree with Goggin, as I said earlier in this series of replies, at least on price suppression: “Wind power is responsible from bringing down average prices in regional power markets, a consequence of subsidizing entry of generation with high capital costs but low marginal operating costs.”

But the effect of wind energy on prices is only obviously negative in the short run. Longer term the cost of energy could rise. More importantly, the price suppression effect is only tangentially related to the overall benefits and costs of wind power policy and so of only modest policy relevance.

The basic short-run “price suppression” effect is explained various places–here is a bit from a short report produced by the staff of the Public Utilities Commission of Ohio, “Renewable resources and wholesale price suppression” (August 2013):

Price suppression is a widely recognized phenomenon by which renewable resources produce lower wholesale market clearing prices. The economic theory that drives price suppression is actually quite simple. Renewable resources such as solar and wind are essentially zero marginal cost generators, as their “fuel” costs (sunlight and wind) are free. As such, they will always be dispatched first by the grid operator, thereby displacing units with higher operating costs. This results in lower wholesale market clearing prices than would have been experienced in the absence of the renewable resources.

A simple graphical representation appears below. The new renewable resources (depicted by the red line) are added to the dispatch stack, shifting the supply curve out and to the right. This results in a lower cost unit setting the market clearing price, shifting the equilibrium price down from Po to P1.

PUCO, Renewable Resources and Wholesale Price Suppression,” August 2013.

The above analysis, so far as it goes, adequately shows the simple short-run impact of adding low marginal cost resources to a supply curve. The marginal cost of producing wind energy isn’t zero–wind turbines experience wear from operation and non-zero maintenance costs. But the marginal costs are low relative to most other power plants and the short-run impact on spot prices is to push prices down. In the simulations for Ohio analyzed by the PUCO staff, the effect is a price suppression of between $0.05 and $0.20 per MWh (or, to put it in residential consumer terms, a reduction in energy cost of 0.02 cents per kwh).

But, as the staff of the Public Utilities Commission explain in their report, observing a tiny tiny price suppression effect doesn’t indicate anything about overall costs and benefits or about least-cost capacity expansion. The above analysis is a short-run assessment that ignores longer term effects on investments and retirement of assets. A more complete assessment, they said, would need “to consider additional variables such as capital and capacity costs, renewable energy credit (REC) prices, and transmission upgrade expenses.”

And that is among the problems with Goggin’s simple-minded trumpeting of a price suppression effect as some sort of renewable energy triumph: it ignores the future consequences of the policy. Other things being equal, as intermittent low-marginal-cost resources are added to a power system, less-flexible medium-low marginal cost baseload power plants tend to be most disadvantaged and most likely to be retired. At the same time, the resulting increased need for flexible, dispatchable resources will tend to support investment in responsive natural gas generators that have lower capital costs but medium to high marginal costs.

These changes to the generation portfolio in a market will also shift the shape of the supply curve. It is an empirical question, or will be in five or ten years when energy markets have finished adjusting to the 2018-2013 wind energy construction boom in the United States and data is available, whether the overall effect has been to reduce or increase average prices to consumers.

But there is at least on more point: public policy analysis ought to involve a careful counting of projected benefits and costs. It is hardly surprising that subsidizing entry of production capacity would tend to drive down market prices in the short run, but that says nothing about either the short-run or long-run overall benefits and costs of the subsidy policy. The high capital costs of wind energy are one big signal that the steel, concrete, rare earth magnets, other component parts and manufacturing expertise that are drawn into wind energy production all have valuable potential other uses in the economy. We forgo these other potential contributions when policy steers these resource into electric power generation.

Are consumers better off when public policy pulls some of these resources from the manufacture of other goods and services and pushes these resources into electric energy supply? Maybe yes and maybe no, but the price suppression effect is mostly about the division of the spoils of wind power policy, and has little to do with the overall benefits and costs of the policy.

PJM region could handle substantially more renewable generation, study says

PJM Interconnection has been studying, with the help of GE Energy Consulting and other groups, the consequences of adding significantly more wind energy and solar energy to its transmission grid. The “headline result” of a preliminary report, presented to PJM stakeholders recently, is that the system could handle renewable power generation capacity at a 30 percent penetration rate in 2026.

Here is how EnergyWire summarized the preliminary results (may be gated):

The eastern Great Lakes and mid-Atlantic region could rely on wind and solar power for as much as 30 percent of their generation capacity without threatening electricity delivery with net benefits even after additional transmission lines and reserve resources are added, according to a preliminary study released by the PJM Interconnection, the region’s grid operator.

The study, by GE Energy Consulting, investigates several scenarios for additions of wind and solar generation to the PJM grid, which extends from New Jersey to northern Illinois. It calculates the amount of new transmission lines needed to deliver the renewable energy and the required backup generation to support the variable wind and solar power.

The main impacts it reports are lower emissions of pollutants and greenhouse gases; no power outages and minimal curtailment of renewable energy; lower systemwide energy production costs; and lower wholesale customer power costs with the additional wind and solar resources.

“Even at 30 percent penetration, results indicate that the PJM system can handle the additional renewable integration with sufficient reserves and transmission build out,” GE said.

GE Energy Consulting is one corporate unit in the General Electric family, other corporate units make and sell generation equipment including wind turbines, solar pv products, natural gas turbines, etc. We can probably assume that GE Energy Consulting had access to good information in preparing their analysis.

Scanning through the 149-slide presentation reveals a bit about what GE Energy Consulting understands concerning intermittent renewable generation. For example, slides 49-55 discussed the transmission additions needed under the various scenarios studied. Slide 15 summarized the added transmission costs, which ranged from $3.70 to $13.7 per MWh depending on scenario.

On the question of whether adding intermittent renewable generation increases reserves requirements, the report concludes at slide 67, “The study identified a need for an increase in the regulation requirement even in the lower wind penetration scenario (2% BAU), and the requirement would have noticeable increases for higher penetration levels.” Regulation, as the term is used in power systems, refers to a fast-responding reserves service that dispatchable generators can provide to the grid.

Power plant cycling costs are discussed at slides 78-93; the report indicates that adding renewable power results in more cycling operations for dispatchable power plants, higher cycling costs for dispatchable power plants, and less time spent operating in more efficient stable-output baseload conditions. Cost estimates for cycling range from $0 to as much as $21.90 per MWh of renewable output, depending on the scenario studied and the type of unit forced into additional cycling.

Power plant cycling emissions are discussed at slides 94-101; the report indicates that added cycling of fossil fuel plants does offset some of the emission reductions that might otherwise be expected from using wind energy or solar energy, but the effect is pretty small.

The report estimates the overall value of the renewable energy delivered to the system at about $50 per MWh.

The GE Energy Consulting analysis is interesting, in part, because of how their projections relate to my recently released report on wind energy cost estimates. I observed, among other things, that in addition to the costs of wind power capacity to  project developers, there were other costs to be considered when evaluating wind energy in a policy context. Among the factors noted: transmission additions, grid-integration costs (mostly added reserves), some partial offsetting of renewable’s emission benefits due to increased cycling of dispatchable power plants, and added cycling costs imposed on the owners of these dispatchable units.

Michael Goggin of the American Wind Energy Association attacked my report on Into the Wind, the trade association’s blog, for “rely[ing] on obsolete data” and “regurgitat[ing] anti-wind myths that have already been debunked.” (I’ve responded to Goggin in a series of posts.)

I am now looking forward to Goggin’s attack on GE Energy Consulting for perpetuating these anti-wind myths.

NOTE: Here is Goggin’s actual reaction to the GE report, where instead of accusing GE Energy Consulting of failing to understand how the power grid operates, he chooses to accentuate the positive: “Independent grid operator study confirms wind power’s economic, environmental value.” (I guess it would have been awkward to complain too much about the report since GE Energy is an AWEA member.)

Debating wind power cost estimates – 5

[Series header: On the Morning of October 15 the Institute for Energy Research in Washington DC released a report I’d written about the federal government's wind power cost estimates. (Links available here.) Later that day Michael Goggin of the American Wind Energy Association, the lobbying organization in Washington DC that represents the wind energy industry, posted a response on the AWEA website: “Fact check: Fossil-funded think tank strikes out on cost of wind.” I’m considering points made by the AWEA response in a series of posts.]

In the final section of Goggin’s detailed criticisms of my report he takes on my claims with respect to various additional costs associated with the addition of wind power to the grid, including grid integration costs, indirect pollution effects, transmission expenses, and negative prices. He writes:

After starting with a baseline wind cost that is 100% too high, IER compounds the error by claiming that the actual costs of wind are even higher based on obsolete data and a flawed understanding of how the power system works.

IER incorrectly alleges that wind energy imposes large “integration costs” on the power system. In reality, it is far more costly to integrate the unexpected and instantaneous failures of large fossil and nuclear power plants than to accommodate the gradual and predictable changes in wind energy output.

I’m note sure just where the report “alleges that wind energy imposes large ‘integration costs’ on the power system.” All that my report does is (1) observe that grid integration costs are not included in NREL levelized cost of energy estimates so a fuller consideration of costs much include them, (2) summarize the discussion of the topic in the Lawrence Berkeley National Lab’s 2012 Wind Technologies Market Report [WTMR], and (3) highlight factors that tend to increase or decrease those costs.

Here is the core of my wind integration cost claim: “The [WTMR] reported a range of cost estimates from wind power integration studies, with all studies but one falling below $12 per MWh and some studies below $5 per MWh.” From this remark somehow Goggin claims I allege the costs are large.

Goggin then cherry-picks a few examples of low wind integration cost estimates. But each of these examples is included in the far more comprehensive WTMR study produced by the Berkeley Lab. You can find his 3 examples, and 22 others, in figure 37 of the 2012 WTMR, p. 63. The American Wind Energy Association may not like the answers, but again it seems that Goggin’s complaint is with the Berkeley Lab research and not my report.

Goggin again:

IER’s report falsely alleges that wind energy’s pollution reductions are significantly reduced because of this incremental need to operate other power plants more flexibly. IER picked a bad time to once again try to push that myth, as last month a comprehensive report used real-world emissions data from every power plant in the Western U.S. to confirm that wind energy produces the expected pollution reductions. … IER’s claim to the contrary is based on a single report that has been thoroughly debunked for getting the wrong answer because its authors failed to understand how the power system works. [Link in source.]

Goggin discusses issues raised in section 3.3 of my report on additional cycling of baseload units and section 3.4 of my report on environmental costs. I cite a handful of references in these two sections and Goggin doesn’t include links. As best as I can tell by “single report” Goggin is referencing the Katzenstein and Apt article published in the journal Environmental Science & Technology, “Air Emissions Due to Wind and Solar Power,” and the “thorough[] debunking” is the comment on that piece by Mills, Wiser, Milligan and O’Malley.

On this point, while Goggin exaggerates his point in cartoonish fashion, he raises a good point. The nub of the issue is that the Katzenstein and Apt article use a very simplified case to examine the relationship between renewable power intermittency and emissions from dispatchable generators, and the simplified case yields a much higher reduction in emission benefits than renewable power intermittency actually yields when connected to large scale power grids. That is to say, as Katzenstein and Apt acknowledge and Mills et al. emphasize in their comment, the Katzenstein and Apt result is essentially an estimate of the possible upper bound of the effect. Mills et al. make clear that in actual power grids the reduction in emission benefits, while still present, is likely much smaller in practice. In short, the study I emphasize was not the best choice to show the indirect emission effects of renewable energy intermittency in large scale power grids. (Having met Jay Apt once or twice, I’d be very reluctant to accuse him, as Goggin does, of failing to understand how the power grid works.)

Goggin objects to my referencing transmission costs as another factor to be considered as associated with wind power, since “upgrades to the nation’s obsolete and congested electric grid are needed anyway regardless of the addition of wind energy” and transmission upgrades will more than pay for themselves by broadening access to low cost generation. I’m sure Goggin understands enough about how the power grid works to understand that “upgrades to the … grid … needed anyway regardless of the addition of wind energy” will be somewhat different from “upgrades to the … grid … needed” because of the addition of wind energy. Perhaps amusingly, the Western Wind and Solar Integration Study Goggin cites against me on the emissions point tends to support my point on transmission costs: in Phase 1 of the study they assume significant enhancement of the grid in the Western U.S. to accommodate assumed addition of large amounts of wind and solar power.

If modelling assumptions don’t convince Goggin, then surely he has heard of the $6.8 billion CREZ grid upgrades in Texas that were designed accommodate existing and projected wind power production. Most of the CREZ upgrades would not have been useful in the absence of wind power and certainly the ERCOT grid would not have been expanded to overlap the Southwest Power Pool grid footprint in the Texas Panhandle and South Plains area in the absence of a high-quality wind power resources in the region. Transmission upgrades can enhance competition, like Goggin points out, but had ERCOT wanted transmission upgrades primarily to enhance competition then the money would have been spent much differently. The grid upgrade plans and the associated expenses were largely driven by the fact that high-quality wind power resources are location dependent, and those locations are distant from the primary areas of power demand in the state.

Obviously the selection of power plant location is important for any kind of generator, and good locations will always be constrained (usual main factors: access to fuel, access to water for cooling, access to consumers, and cost of land). But for coal, nuclear, and natural gas it is possible to deliver the energy resource to locations nearer ultimate consumers. In the cases of wind, hydropower, and geothermal energy the resource locations are determined primarily by nature (and not with net-system-cost minimization in mind).

Next: Two issues remain, both concerning the effects of wind power on regional power market prices. I’ll look at the price suppression effects of adding wind to the grid in my next post in this series and then I’ll take another look at negative power market prices.