Knowledge Problem

Lynne Kiesling

Last week the Maryland Public Service Commission rejected Baltimore Gas & Electric’s proposed project to install over 2 million digital electric or gas meters, change the retail electricity rate structure to incorporate time-of-use pricing and peak-time rebates, and recover the meter capital costs through a surcharge on residential retail bills. BG&E’s ambitious and thoughtful project had undergone extensive pilot project testing and had generated economic and physical results similar to those seen in other such projects (customer savings, reduction in peak energy use and in peak strain on system infrastructure, reduction in peak wholesale prices due to the transmission of retail price signals). Their recommended technology and rate designs are not unusual relative to evolving practice in other states (although they are much, much less than I personally would like to see). Despite those promising results, the Maryland PSC rejected BG&E’s business case for structuring their cost recovery from the project as they did.

Although I am pretty familiar with the BG&E pilot, I am not sufficiently informed or expert in rate case matters to have an intelligent opinion on whether the PSC took the correct position. Their position, though, reveals some of the most important and pressing reasons why traditional economic regulation is incompatible with economic dynamism, with technological change, with innovation, and ultimately incompatible with widespread consumer well-being.

1. Traditional economic regulation is based on cost recovery, not on expected value creation, and therefore does a poor job of “standing in for the market” as it is (incorrectly) supposed to do in theory. Whether it’s enshrined in the legislation giving the regulatory agency its mission or in the deeply-embedded Populist culture and history of regulation, traditional regulatory procedures focus regulators and the regulated on providing a narrowly-defined, generic, highly reliable service at the lowest possible long-term cost. As long as you’re in a static environment, the static model from which this theory and culture emanate will do a decent job of providing that generic service. That’s the context in which regulators have developed a norm and a culture of ignoring value creation — focusing narrowly on the provision of generic electricity service and scoping your efforts accordingly fits with that static world. But regulatory models premised on cost recovery fail miserably in a more dynamic context, with pervasive economic and technological change and Schumpeterian creative destruction. That dynamism characterizes the economic and technological context of the early 21st century, and the reason that dynamism and creative destruction become so pervasive in human society is that they create value — value for consumers, variety for consumers, product differentiation for consumers, and value for the risk-taking and opportunity-seeking entrepreneurs who risk private capital to create that value.

If the regulatory institutions and the regulatory culture constrain the electricity value proposition to the provision of generic service to the exclusion of other product/service/pricing bundles, and if they constrain the business model to one of cost recovery instead of value creation, then the regulators will reject the types of projects that are most likely to create value for consumers and entrepreneurial producers. This rejection shows precisely why regulation cannot “stand in for markets”, because the most important function that market processes perform is the pathways for this new value creation. The static, price-determining, resource allocation function of markets is not the most important function of markets, and the formulators of static natural monopoly theory at the end of the 19th century got that wrong. Our current regulatory institutions are built on that incorrect, static natural monopoly theory.

2. Traditional economic regulation stipulates that the regulatory agency controls price determination on behalf of consumers, and regulators are loath to relinquish such power once they have had it for a century. This point is a political economy corollary to the first point. Legislation requires regulators to represent the interests of consumers, and they do so through administrative procedures to control both costs and prices, as well as controlling the profits that the regulated firms are allowed to earn. Control, control, control. Take, for example, this quote from the New York Times/Climatewire story linked above:

The Maryland commission took a fists-up stance toward its powers and prerogatives to rule on utility rates. “For one hundred years, since this Commission was created by the General Assembly in 1910, one of our primary functions has been to establish the rates that public service companies can charge their customers,” the commission said. Currently, it faces a growing trend by regulated companies to cover costs in advance through surcharges rather than subjecting costs to review after they have been incurred.

While it has approved such surcharges in some limited cases, it drew the line on BG&E’s current proposal, it said. “Surcharges guarantee dollar-for-dollar recovery of specific costs, diminish the Company’s incentive to control those costs,” and put those costs outside the commission’s reach, the commission said.

Ironically, Maryland is at least nominally a state that has retail competition and retail choice available for its residential consumers. If they were actually serious about competition and were willing to relinquish this control over prices and costs, then the regulation of prices and costs would occur through the decentralized market processes of firms making retail product/service bundle offerings to consumers, and consumers using their choice and autonomy to say NO. But if you are deeply steeped in regulatory culture, you do not believe that this decentralized process can work effectively for consumers, even though it does so in other markets and industries … even ones that have high infrastructure costs and are considered essential to daily life! You, therefore, believe that your power to control is a salutary intervention, even though the dynamism of economic and technological change are proving you wrong on a daily basis. So you make decisions that reinforce your power and control, believing them to be in the best interest of consumers while you deprive those same consumers of the opportunity to make their own autonomous choices.

3. Traditional economic regulation entrenches the political and economic power of easily identifiable, politically active special interests. Which leads us to the third lesson from this episode for the political economy of regulation. The legislative mandate for regulation, and the stated mission of every regulatory agency, is to control prices and allow the firm to recover costs for the provision of a generic service at a highly reliable level in a way that benefits all consumers. But in the time that I have been involved in regulation, and in debates over smart grid investments and policy, it is abundantly clear that Mancur Olson was correct, and that regulation actually represents the interests of easily identifiable, politically active interests, not the interests of consumers as a whole. On the consumer side, this means that decisions get made frequently based on the organized, coordinated political actions of so-called consumer advocates (who really represent low-income consumers, not all consumers) and groups like the AARP, who perceive their interests as being best served by the perpetuation of the traditional regulatory model — generic service provided at high reliability, controlling price through strict cost recovery.

Take, for example, this quote from the excellent Ahmad Faruqui in the New York Times/Climatewire story above:

While some state utility commissions are willing to back smart meter deployment, they are reluctant to approve new “dynamic” electricity rate plans that allow prices to rise during the day when power demand peaks and fall when demand is slack. Such real-time pricing plans are essential to prompt customers to shift energy usage to slack times and reduce overall consumption, he said.

“There is no doubt in my mind that without state commissions approving the business cases for advanced meters and the smart grid, this is not going anywhere. They control the dollars; they set the rates for the customers,” said Faruqui, an economist and principal with the Brattle Group. Faruqui testified before the Maryland commission in support of the BG&E plan and declined to comment on the commission’s decision in that case.

But he said that around the county, commissions are heeding warnings from state consumer advocates and retiree organizations about possible cost impacts on customers if electricity rates are linked to actual generation costs, hour by hour.

“Most of the state commissions are frozen in time. They are being subjected to these very, very pessimistic, worst-case arguments,” he said.

What’s missed in that calculation is the unseen, lost value that could be created for both these vulnerable groups and for other consumers by moving away from that model. When regulators are already predisposed, by legislation and by culture, to constrain the value proposition of the regulated firm and focus on a generic service and cost recovery, the political action of those who seem to visibly benefit from that constraint will find a big foothold. In that environment, the value proposition based on the idea of better service provision (such as, for example, bundling home health care monitoring services in with a “senior care” electric service contract for the AARP constituency) is going to fight an uphill battle. In open markets with low entry barriers, that type of service bundle would be able to compete, and would sink or swim, fail or profit according to the value it creates for consumers and the ability of the provider to control costs.

In brief, traditional economic regulation is incompatible with economic dynamism, with technological change, with innovation, and ultimately incompatible with widespread consumer well-being because of the enormous extent to which traditional economic regulation stifles experimentation. The really valuable function that market processes provide is this ability for consumers and producers to experiment. Traditional economic regulation is almost reflexively anti-experimentation, and that reflex is the source of lost value creation opportunities from smart grid technologies.

A historical example illustrates why I think these points are important. In the medieval period, China was one of the most forward-looking, open, technologically creative and vibrant societies in the world. Chinese inventions became the foundation of many important technologies, machines, and industries. Yet by 1600, China’s backwardness was obvious to all observers; China had closed herself off from knowledge, had become technologically stagnant. Western Europe and then the young United States surged ahead of China in technology, in economic productivity, in per-capita income, and in living standards for most of the population (China’s elite, of course, continued to enjoy luxury). Economic historians credit this stagnation (or, what Needham argues was “homeostasis”, not stagnation) and worsening of living standards for most of the Chinese population to conscious technocratic policy decisions in China to look inward (growing through population growth and increasing intensification of agriculture), to be backward-looking, and to make strong top-down rules based on status quo bias. Writ large, the dynamic driving the stultification of China had at its core many of the same policy drivers and incentives as we seen in play in electricity regulation in the 21st century.