OK, the author is Callum McCarthy, chief energy regulator in the UK, and he presumably has a vested interest in defending the status quo. And I don’t understand his convoluted take on overcapacity and price history, as I read McCarthy he is committed to both high and low prices at the same time, these equivocations make me more skeptical about his conclusions. Still, his perspective deserves wider circulation.
Tyler was kind enough to fax me the FT op ed so I could address his questions. McCarthy’s argument starts with what he sees as three “urban myths” being tossed around after the hour-long blackout in London (during rush hour) a few weeks ago:
1. The cause of the London blackout was insufficient investment in the network, as a consequence of the regulator’s price regulation
2. It used to be better when the power industry was nationalized, because we had plenty of overcapacity, so things like this didn’t happen
3. The existing market institutions in England do not create the proper incentives for investment in generation capacity
OK, let’s take each of these in turn; what follows will be an amalgam of my interpretation and what McCarthy said in his op ed.
1′. Since England privatized its electricity industry in 1990 and moved to price regulation, investment in transmission and distribution has been substantial (and, by the way, transmission costs and congestion costs have fallen). McCarthy argues that since privatization, GBP16 billion has been invested in England’s transmission and distribution networks. National Grid, the publicly-traded firm that owns and operates the transmission grid in England, has a very informative website and has produced a report on the incident, the executive summary of which is very thorough and clear. National Grid is also subject to reliability performance regulation — penalized for outages, etc. This style of regulation is in marked contrast to the U.S. approach, which is to mandate excess capacity margins, an input-based approach instead of an outcome-based approach, and one that I believe is decidedly inferior to England’s outcome- and performace-based regulation.
As for price regulation’s role in this — England uses a method of regulation called RPI-X. Under RPI-X, the regulator sets a retail price target (RPI) and an efficiency improvement factor (X) for each retail distribution firm (of which I believe there are 9 in England and Wales). X is based on an analysis of a whole bunch of factors that could lead to the expectation of future cost decreases through efficiency gains, and is specific to each firm based on their market conditions, etc. Obviously, as McCarthy says in his op ed, the regulator has an interest in a low RPI-X, to keep prices low for consumers. But, also as McCarthy says (and this is where I think Tyler thinks that he equivocates), this is a tough balancing act for the regulator, who knows full well that an RPI-X that is too low will result in reduced reliability on the network.
So the job of the regulator is essentially that of a balancing act — set a target RPI-X for each firm that confronts the firms with the proper incentives to reduce costs and invest optimally in reliability, yet gives the consumers value-for-money service. Thus McCarthy says in the op ed “Ofgem has been concerned to reward behaviour that meets consumer needs and ensures reliability.”
Two interesting contrasts with U.S. utility regulation: first, we use rate-of-return (ROR) regulation, in which the utility is allowed to earn a particular ROR on its assets, not RPI-X regulation. ROR regulation is full of perverse incentives, the most famous of which is called the Averch-Johnson (A-J) effect, which is that utilities have an incentive at the margin to invest in more generation and transmission capacity because that’s what their earning their ROR on. Direct evidence on the A-J effect is difficult to isolate, but the fact that most states in the U.S. that have pursued deregulation do so because they are paying for lots of expensive, unnecessary excess capacity is a piece of evidence that is consistent with the A-J effect. Second, regulators (all 51 of them in the U.S., as opposed to one in England and Wales) have different missions and legislative remits. In the U.S., regulators are charged to bring about outcomes that are “in the public interest”, and most commissions interpret this remit as keeping prices low and stable for all consumers (even those who would be better off if they were allowed to take on some share of the price volatility risk, but that’s another post …). In England, Ofgem is charged with fostering and maintaining competitive wholesale and retail electricity markets, with one expected consequence of that being consumer benefit. But consumer benefit is not solely interpreted as low and stable prices for all consumers, as it has come to be in the 51 state regulators in the U.S.
2′. Spare me. As McCarthy says in his op ed, “the halcyon days when ‘things were better’ never existed. Since privatisation, the number of power cuts has fallen by 10 per cent and the duration of those cuts has fallen by nearly a third. Britain’s electricity system is among the most reliable in Europe.” The kind of overcapacity that Britain had under nationalization was just as expensive and inefficient as the overcapacity we’ve built in the U.S. through the A-J effects of ROR regulation. Excess capacity is neither necessary nor sufficient for reliability — you can achieve reliabilty without having that huge and expensive generation capacity cushion, particularly if you take advantage of active demand response to create healthy, diverse retail power markets. England has done that. The U.S. has not.
3′. England’s wholesale and retail power markets are integrated, and their RPI-X method of regulation does not interfere with the transmission of price signals from the retail market to the wholesale market and vice versa. Therefore, generation capacity goes online and offline to varying degrees depending on market conditions. Those who interpret the mothballing of generation capacity over the past two years, in response to low prices due to reduced demand, as a failure of England’s electricity market to send investment signals do not understand (or willingly misunderstand) how investment in industries with fluctuating demand works. It’s a pattern very similar to natural gas exploration and drilling that has been discussed before in these pages — low prices make marginal generators unprofitable, so the owner shuts it down to save on variable costs. If the owner foresees a future increase in demand, the owner will choose to keep the unit, incur the fixed cost, but not operate it. If the owner does not foresee a demand increase that would make running that generator profitable, the owner will choose to sell the unit to someone whose expectations of future demand are more sanguine.
Indeed, as McCarthy states in his op ed, economic growth and expectations of future demand, signalled by increases in electricity futures prices (see how useful financial markets can be in this?), are leading generation owners to un-mothball some of their capacity.
Hope this helps …