Hayek’s knowledge problem as an issue in electric power market design

Michael Giberson

Recently the Brattle Group submitted a study of resource adequacy issues within the ERCOT power system and the policy options available to ERCOT and the PUC of Texas, the regulatory authority overseeing the ERCOT system. As the Brattle report points out, ERCOT has so far stuck with a so-called “energy-only” market design while the other RTO markets have implemented some form of capacity markets to help assure the market will be adequately supplied with generating resources.

The Brattle report is available from the ERCOT website. The PUCT is taking comments on the report in Project No. 40480, “Commission Proceeding Regarding Policy Options on Resource Adequacy.” A workshop will be held to discuss the Brattle recommendations on July 27, 2012 at the PUCT offices in Austin.

BP Energy Company finds Hayek’s knowledge problem as a key issue in electric power market design. After quoting a segment from “The Use of Knowledge in Society,” BP Energy Company writes:

Hayek’s “Knowledge Problem” and its optimal solution – decentralized commercial markets – provide the best lens for regulators to see the fundamental issue in electricity market design in response to rapid technological change and increasingly diverse groups of willingly innovative buyers and sellers. As the procurement and use of electricity cross a complexity threshold, as a few customer classes are transformed into a multitude of individual market participants, electricity market design needs to move away from centralized planning to a decentralized procurement of resources, to be both sustainable and efficient in meeting the resource adequacy objectives for the bulk power system and society at large.

The unwieldy process of centralized procurement of resources in the organized markets within the Eastern Interconnection is not proving to be a healthy evolution for electricity markets; instead, these interventions have greatly interfered with the natural development of networks among market participants that can lead to a healthier market ecosystem. Utility economist Kenneth Rose, in a recent working paper that highlights the continuing problems of centralized procurement in the capacity mechanisms in the Eastern Interconnect, reprises the “Knowledge Problem” in the following analysis:

“…. They (RTOs and regulators) are attempting to create a final product market for something that is merely one input of many that are needed to generate electricity.

This may explain why the capacity construct that the RTOs are using has become so complex. Every aspect of the capacity market design has to be redesigned and readjusted to fit changing conditions, rather than allowing the market participants to adjust to market information over time, as happens generally in competitive markets…..

The complex mechanism of capacity markets is not self-sustaining since the RTOs and regulators will need to continuously update and fix the apparatus as conditions change…. A truly competitive market, in contrast, changes as circumstances change, without the stakeholders having to agree on changes and without the regulator having to insert its judgment by choosing and approving what it thinks will work. “

The result is that to date, regulators, not market participants, procure virtually all of new resources. Some of those resources, especially “demand resources,” are poorly designed and have questionable value. Incumbent technologies and business practices are favored over innovative ones, to the ultimate detriment of consumers and local businesses.

As might be obvious by the name of this blog, we at KP find Hayek’s identification of the knowledge problem a key discovery in the long history of the study of markets. It is no surprise that efforts to manage the growth of markets run up against knowledge problem issues, and regulators and other market designers would be wise to consider its significance.

NOTES: Hayek’s article, “The Use of Knowledge in Society,” was published in the American Economic Review (September 1945) (ungated here and here). Rose’s report is “An Examination of RTO Capacity Markets,” IPU Working Paper No. 2011-4, Michigan State University (September 2011). I mentioned the Brattle report on ERCOT resource adequacy issues in this earlier post, see also this earlier post on capacity market issues.

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2 thoughts on “Hayek’s knowledge problem as an issue in electric power market design

  1. Thanks for posting this, and I am really happy to see the discussions and ideas that we share here getting out and being useful in policy debates.

    Thank you!

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