Cato Institute Writers Lament the Unfortunate Loss of Vertical Integration in Electric Power Industry

Michael Giberson

Thursday’s Wall Street Journal carried an essay by the Cato Institute’s Jerry Taylor and Peter Van Doren, “Short-Circuited” (available free via Cato):

After a pretty good 30-year run, deregulation is on the political ropes. Although loosening the shackles on banking, trucking, and airlines delivered lower prices, robust competition and political applause, it hasn’t worked for electricity.…

So did free market reformers take deregulation too far? Yes and no.

Yes, because they promised rate reductions they had no business promising. No, because deregulation of some parts of the system was offset by more ambitious regulations elsewhere. The end result is even more economically artificial than the one we started with.

Our authors then launch into a rough and ready overview of markets and regulation over the last ten or so years. Among other things, they note that from 1990 to 2006 the average increase in rates in regulated retail power markets is about the same as the average increase in rates in deregulated markets. They do a reasonable job of explaining marginal cost pricing at the wholesale level, note that deregulated prices will be higher than average-cost-based regulated prices when fuel prices are rising (and lower when fuel prices are falling) and then they conclude, about 2/3rd of the way through their piece:

In sum, allowing markets to dictate electricity prices is a good thing for consumers, even if they are sometimes higher than under regulation.

Which would be a fine place to stop, but our authors are not just concerned about the effects on consumers, they apparently also have preferences over the structural arrangements within the electric power industry. They write:

Unfortunately – and here is the fly in the ointment – price deregulation has been accompanied by rules encouraging the legal separation of generation from transmission and the purchase of wholesale power through organized spot markets.

This approach is based on the belief that, while the generating sector is potentially quite competitive, the electricity transmission business is not. Thus, the argument goes, deregulation, in order to work properly, must sever the vertical integration of electricity generation, transmission, and distribution under a single corporate umbrella.

While this seems reasonable, there are good reasons why vertical integration makes sense in the electric power business. Unfortunately, none of those reasons have been given much of a hearing.

It isn’t clear from the article where Taylor and Van Doren were during the debates over unbundling, but delving into the voluminous public records of both federal and state regulators of the electric power industry would reveal that vertical integration has been among the matters discussed at length. Earlier in the article they quote MIT economist Paul Joskow, but if they were at all familiar with his work they would not make such “unfortunate” claims. But this is a side issue, not bearing on their core substantive point.

They explain, “First, vertical integration is an efficient response to the so-called ‘holdup’ problem,” and, “Second … efficient investment in [transmission and generation] may not be possible through decentralized arrangements (prices and contracts),” and, “Third, and finally, vertical integration minimizes risk in the real-time operation of the system.” Their second point is really just a variant of the first, but curious that Cato Institute writers are so skeptical about the ability of decentralized arrangements (like prices and contracts) to lead to efficient results.

These considerations largely explain why 10 of the 11 published studies on this issue conclude that vertical integration is the most efficient corporate organizational form for electricity providers. Unfortunately, the debate about utility restructuring has almost completely ignored those studies – assuming rather that vertical integration serves no useful purpose other than facilitating the market power of incumbent electricity providers.

Interestingly enough, the deregulators are trying to create a world that would probably never arise in a totally free electricity market.

The writers then speculate that consumers and producers would likely enter into contracts with each other in order to protect themselves against the problems of booms and busts. Apparently there is no “hold up” issue in these bilateral negotiations. But then couldn’t transmission companies and generation companies and retailers also solve their problems by contract rather than by vertical integration? They continue:

Accordingly, the equilibrium relationship between firms and consumers in a totally unregulated world might resemble that of the old regulatory regime, albeit an equilibrium achieved through contract. The only (unanswerable) question is how different the specifics of such hypothetical contracts would be from current regulatory practices.

This is it? This is the point of their analysis? A “totally unregulated world might resemble … the old regulatory regime”? That is it?

The article ends with a paragraph describing “true deregulation.”

And it dawns on me that through it all, the Cato authors don’t advocate anything at all, not even the “true deregulation” that they describe in the final paragraph. They discuss history, explain some economics, call the loss of vertical integration unfortunate, speculate on preferences for contracts, and suggest that a totally unregulated world might turn out to be like the old regulated world.

Often Cato is bold, or insightful, or both, and sometimes it is over-dramatic in asserting the costs of this-or-that government program or the benefits of some tax cut or another, but almost always Cato offers clear advocacy for liberty.

Taylor and Van Doren don’t give us that Cato in their rambling Wall Street Journal essay. Instead we get what amounts to an implicit defense of the old status quo.

This is not Cato the bold. This is Cato neutered.

UPDATE: Jerry Taylor responds on Cato @ Liberty, the Cato Institute blog.