Knowledge Problem

Michael Giberson

In an article to appear in the March 2009 Electricity Journal, C.K. Woo and Jay Zarnikau point out that “to win public support, proponents for electricity market reform to introduce competition often promise that post-reform retail rates will be lower than the average embedded cost rates that would have prevailed under the status quo of a regulated monopoly.”

They follow-up with, “Unfortunately, the promise of lower rates has failed to materialize….”

Of course there is a small slip in the concepts here. In the first phrasing they identify the relevant counterfactual – post-reform retail rates are compared to rates that would have prevailed under the status quo – but in the second phrasing post-reform rates are implicitly compared to pre-reform rates instead of the relevant status quo counterfactual.

They know the difference between the two comparisons, but it doesn’t matter much because many advocates for electric power restructuring overlooked that subtlety and promised plain simple lower rates if you restructure. But bumper sticker slogans make more appealing political rhetoric, and it gets to sell counterfactuals. In retrospect, it would have been better to promise that, post-reform we will get a more efficient allocation of ponies, rather than promising that everyone gets a pony. But the promise was made, and now not everyone is happy to have received a more efficient allocation.

After touching on that debate, Woo and Zarnikau jump to the substantive question of whether electricity market reform will likely reduce retail rates. In what they admit to be “a simple analysis,” this question gets reduced to whether the post-reform system marginal costs are likely to be higher or lower than system average costs. They consider a “high demand” case and a “low demand” case, and in the former marginal costs are higher than average costs, but in the latter marginal costs are lower than average costs. Finally, they note that the high demand case seems a better description of at least the ERCOT market experience, so electricity market reform in ERCOT has led to increased retail rates.

They admit a few qualifications to the simple analysis and then jump into an examination of rates in the ERCOT and non-ERCOT parts of the state of Texas (the ERCOT region features wholesale and retail market restructuring, while the non-ERCOT areas are mostly still served by vertically-integrated regulated monopolies). Their analysis demonstrates that, in fact, prices in the ERCOT-served portion of the state has increased more than prices in the non-ERCOT portions of the state.

They sum up the analysis with “electricity market restructuring heightens the sensitivity of retail electricity prices to marginal costs,” and conclude the article saying, “unless one is very confident that the post-reform marginal costs are less than average costs, electricity market reform will be unlikely to deliver the promised benefit of lower retail prices.”

Excellent advice to political orators opining on the benefits of restructuring the industry, I’m sure, but incomplete as analysis of public policy. Where is the concern for economic efficiency?

Of course during a time of rising marginal cost, a backward-looking average embedded cost rate will be lower than the efficient market price. And therefore, at the margin, consumers will consume more than they would have had they faced efficient prices, and therefore the regulated rate is wasteful. I’ll admit, too, that mine is “a simple analysis.”

If it is true, as they say, that “electricity market restructuring heightens the sensitivity of retail electricity prices to marginal costs,” then we should expect restructured regions to become more efficient users of energy.  The result should count as a plus for electric industry reform.  Woo and Zarnikau don’t emphasize this point.  Rather, they focus on the issue of whether or not consumers will get the ponies that politicians and policy advocates have promised.

But as economists examining public policy, shouldn’t we aspire to go beyond offering advice to overly-enthusiastic political orators, and actually try to say something about the net benefit or costs of policy reforms?