Vernon Smith’s Electriciy Op Ed In Today’s Wall Street Journal

Lynne Kiesling

This weekend marks the two-year anniversary of the Northeast blackout. Today the Wall Street Journal has published a commentary from my colleague Vernon Smith that reflects on the state of electricity restructuring. One main theme of his commentary is that our failure to separate the energy commodity transaction from the wires transaction has stifled creativity and technological innovation at the retail level.

The failure to liberalize the provision of retail energy is the fundamental reason that there has been so little technical innovation in the local distribution of energy to the end-use customers. The electronic age of switching, metering and monitoring has found little application between the end-use customer and the energy supply system. The dead hand of historical cost pricing is hostile to innovation. Without the free entry/exit trial-and-error discovery process there is no way to know how technology, pricing and differential customer preferences can be matched.

No state has yet tried a mandate to separate electricity from the wires monopoly to allow competition in energy sales. In the natural gas industry, however, one state has separated the customer’s commodity purchases from the utility’s delivery system. Georgia voted to separate the local pipes business from the sale of the natural gas that comes through the pipes. The rental rate for the pipes continues to be regulated as a monopoly, but there are now a dozen competing companies that supply the end-use customer with gas: Each pumps gas vapor into the distribution pool in response to its customers’ decisions to burn gas. The gas is metered at the household and the company bills only its own customers. The same model applied to electricity could yield great benefits since over half of total retail cost is the energy component and that is likely to grow.

Since peaking energy is much more costly to produce than base-load off-peak energy, competition would be expected to lower off-peak prices and raise peak energy prices to reflect their differential costs. But peak-energy pricing is only part of the story. The capacity of the grid is determined entirely by peak-energy demand. Reduce peak consumption and you relieve transmission congestion and increase reliability and security. Hence, regulatory reform needs to address how we price the wires infrastructure.

He ends with what I hope will be a thought-provoking challenge:

Is there a state out there willing to mandate separation of the wires monopoly from energy provision, and allow free entry by retail energy merchants?

Right now, Texas is pretty close. Will Texas, the UK, Australia, New Zealand, and Chile be our natural policy experiment in the value of separating the sale of energy from the wires rental? Retail competition is the key to a vibrant, consumer-focused electricity industry.


6 thoughts on “Vernon Smith’s Electriciy Op Ed In Today’s Wall Street Journal

  1. The other critical issue with state regulation of electricity is the historic unwillingness of regulators to permit residential and small commercial customers to be exposed to the real costs of their on-peak consumption; and, thus, the historic ineffectiveness of demand reduction initiatives which cannot fairly compensate these small customers for their demand reduction efforts.

    While Dr. Smith did not extend his comments to local exchange network telephone service, the same arguments are equally valid. The willingness of the owners of the local exchange telephone wires to accommodate traffic from multiple service providers would be far greater if they were not also the principal providers of service on the network. The FCC has been toying with this issue for years. Broadband expansion has suffered as a result.

  2. With all due respect, I think the snippets of Smith’s article shown here don’t do justice to the full article. I would encourage interested KP readers to follow the link to the full article.

    Smith is not a transmission engineer, and he naturally oversimplifies in some of his statements about transmission capacity. However, his point is well taken that competitive markets will figure out how to rationalize transmission pricing with the physics and economics. Vernon Smith doesn’t have to be exactly precise on the subject, markets will sift out the truth whatever it is.

    As for the challenge to the states, I see little additional movement in that area as long as politicians and the public believes that Enron, trading schemes, and misbehaving generators caused the Western Energy Crisis of 2000-2001, and/or that the whole thing was caused or allowed by California’s restructuring. Smith’s statement on the crisis is correct, but the point needs more emphasis. The truth is obvious if you really look at the data. But when we understand the physical causes of that crisis in the context of the Western Interconnection, it becomes obvious that the crisis is a red herring in the Eastern Interconnection. There is no reason for Virgina regulators, for example, to fear that if they make a mistake they will unleash a California situation in the East. It won’t happen. [Eastern shortages will *not* last 18 months unless they are driven by common-mode nuclear shutdowns or widespread fuel shortages. Rather, they will endure for hours at a time, as in 1998.] Even FERC regulators either don’t understand this, or they politically soft-pedal the point. Until we find permanent homes for the billions of dollars that are still in the air over that crisis, the truth will be obliterated by political rhetoric, and political fear can rule the day, especially when it is pumped up by the entrenched monopolies.

    On the brighter side of the eastern blackout, we should celebrate the successful functioning of MISO as an LMP system since April of 05. Some of us were quick to point out in 2003 that LMP would have been an economic force acting toward resolution of some of the generator-conflict issues that were going on in the hours before the blackout in 2003. Anyone paying attention to the details of MISO’s now-visible LMPs can see these corrective prices in action, in the very same places where the problems occurred in 2003. [These problems were not the direct source of the blackout, but they did distract MISO operators at a critical time.] In any case, the successful implementation of MISO Day-2 operation is huge, and quite fun to watch!

    More information and commentary on my analysis of the data behind the Western Crisis…
    http://tinyurl.com/9gzx7

  3. One item not much addressed in the WSJ article is the potential for innovation in the wires business itself. There is no incentive for an integrated wires/energy firm to provide better distribution or transmission technology to its competitors at regulated prices. However, there should be signficant potential for such innovations if the wires firm can be compensated.

    One example of this is wireless telphony, where third party firms own many of the towers and have incentives to provide the best technology and indeed provide different levels of that technology to different wireless carriers.

  4. JDR is right: we should be celebrating the successful functioning of the MISO LMP market. A good case can be made that power systems integrated with LMP-based power markets are inherently more reliable than open access systems that rely upon “contract path” fictions and NERC TLR procedures to maintain reliability.

    Had the MISO’s new markets and attendant system operations been in place in August 2003, I believe that FirstEnergy’s problems would have been limited to a few downed lines and local outages.

  5. JDR is right: we should be celebrating the successful functioning of the MISO LMP market. A good case can be made that power systems integrated with LMP-based power markets are inherently more reliable than open access systems that rely upon “contract path” fictions and NERC TLR procedures to maintain reliability.

    Had the MISO’s new markets and attendant system operations been in place in August 2003, I believe that FirstEnergy’s problems would have been limited to a few downed lines and local outages.

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