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The Future of Fuel Diversity: Crisis or Euphoria?

The fragmented electric industry structure poses an obstacle to a more stable, diverse, and secure power supply.
Fortnightly Magazine - October 2004

forms of energy development have sometimes been distorted when government regulations operate in the real world. PURPA, for example, resulted in unforeseen consequences, resulting in the development of questionable "PURPA machines" and burdensome power contracts, and synthetic fuel tax credits led to the rampant development of questionable "synfuel" machines. Fuel efficiency standards (CAFE) imposed on auto producers were undermined by the production of car-like vehicles on truck chassis and by the lack of consumer interest in buying fuel-efficient vehicles. On the other hand, introducing appliance efficiency standards accompanied by improved labeling of household appliances' energy consumption was a notable success at modest cost.

A common element in all the suggestions above is that they reduce some of the unnecessary risks affecting debt and equity investment in energy equipment and fuel development. For example, when a regulatory body gives up the opportunity to reconsider a project at a later date, the regulator has an incentive to study the plan carefully at the outset and to make a more informed decision the first time. The cost of this accommodation is small relative to the total capital investment, while the reduction in risk is material.

Even in Euphoria (), it is unlikely that all of the policies and mechanisms suggested above would be implemented. The adoption of one or more of the suggested approaches does not eliminate all business risks. To earn a moderate return, investors still must face normal ongoing uncertainties of operating and maintaining their facilities, variable weather, and changing consumer demands. Debt and equity investors are willing to accept risks and uncertainties, provided that there is a reasonable chance to earn a fair return. But it is foolish to load unnecessary and unproductive uncertainties onto the back of challenging infrastructure spending projects. Taking extra risks off the table expands the pool of capital that is available to fund vital projects.

Once Upon a Time in Euphoria

The hypothetical continent of Euphoria has four power providers, A, B, C, and D, all dependent on gas for power production. Gas supply is dwindling and the price is rising. Companies A and B foresee a severe future shortage, so one invests in facilities capable of generating power from local turnips while the other invests in drilling a deep gas well offshore. A and B incur debt and issue equity securities to finance their investments. Prior to completion, the debt service expenses of A and B begin to mount without any increment in available cash flow to pay the financing costs. Meanwhile, companies C and D do nothing. When the new production comes into operation, the expected shortage is averted, and the price of gas in Euphoria drops.

Case 1: Suppose that all four companies are in a competitive market and compete at freely determined market prices. Companies C and D, which made no investment, benefit from the ability to continue to buy gas at a low market price. They are "free riders." A and B will lose sales to C and D; their new assets will drop to below the cost of acquisition, perhaps to