When does state utility regulation distort costs?

I suspect the simplest answer to the title question is “always.” Maybe the answer depends on your definition of “distort,” but both the intended and generally expected consequences of state utility rate regulation has always been to push costs to be something other than what would naturally emerge in the absence of rate regulation.

More substantive, though, is the analysis provided in Steve Cicala’s article in the January 2015 American Economic Review, “When Does Regulation Distort Costs? Lessons from Fuel Procurement in US Electricity Generation.” (here is an earlier ungated version of the paper.)

Here is a summary from the University of Chicago press release:

A study in the latest issue of the American Economic Review used recent state regulatory changes in electricity markets as a laboratory to evaluate which factors can contribute to a regulation causing a bigger mess than the problem it was meant to fix….

Cicala used data on almost $1 trillion worth of fuel deliveries to power plants to look at what happens when a power plant becomes deregulated. He found that the deregulated plants combined save about $1 billion a year compared to those that remained regulated. This is because a lack of transparency, political influence and poorly designed reimbursement rates led the regulated plants to pursue inefficient strategies when purchasing coal.

The $1 billion that deregulated plants save stems from paying about 12 percent less for their coal because they shop around for the best prices. Regulated plants have no incentive to shop around because their profits do not depend on how much they pay for fuel. They also are looked upon more favorably by regulators if they purchase from mines within their state, even if those mines don’t sell the cheapest coal. To make matters worse, regulators have a difficult time figuring out if they are being overcharged because coal is typically purchased through confidential contracts.

Although power plants that burned natural gas were subject to the exact same regulations as the coal-fired plants, there was no drop in the price paid for gas after deregulation. Cicala attributed the difference to the fact that natural gas is sold on a transparent, open market. This prevents political influences from sneaking through and allows regulators to know when plants are paying too much.

What’s different about the buying strategy of deregulated coal plant operators? Cicala dove deep into two decades of detailed, restricted-access procurement data to answer this question. First, he found that deregulated plants switch to cheaper, low-sulfur coal. This not only saves them money, but also allows them to comply with environmental regulations. On the other hand, regulated plants often comply with regulations by installing expensive “scrubber” technology, which allows them to make money from the capital improvements.

“It’s ironic to hear supporters of Eastern coal complain about ‘regulation’: they’re losing business from the deregulated plants,” said Cicala, a scholar at the Harris School of Public Policy.

Deregulated plants also increase purchases from out-of-state mines by about 25 percent. As mentioned, regulated plants are looked upon more favorably if they buy from in-state mines. Finally, deregulated plants purchase their coal from more productive mines (coal seams are thicker and closer to the surface) that require about 25 percent less labor to extract from the ground and that pay 5 percent higher wages.

“Recognizing that there are failures in financial markets, health care markets, energy markets, etc., it’s critical to know what makes for ‘bad’ regulations when designing new ones to avoid making the problem worse,” Cicala said. [Emphasis added.]