An oft-heard argument these days says that states with low-cost power should refrain from restructuring their electric utilities. This argument has gained credence in some states, where protectionists have used it to slow down the liberalization of electricity markets. The rationale is simple: Because the state would export its low-cost power, local consumers would lose. They would face higher electric prices than if their state had somehow confined its low-cost resources within its boundaries. Some regulators voice the same opinion: "Why should we share our low-cost resources with other states when it would only drive up prices in our own state?"
This prediction of higher electric prices in low-cost states comports with a "regional averages" hypothesis. To say it differently, interstate trading yields a zero-sum game; out-of-state consumers would benefit, but at the expense of in-state consumers. Some economists color this outcome as an "exploitation" transaction, suggesting that free-market trading produces gains for some but losses for others.
On the other hand, restricting power exports implies that the current beneficiaries of low-cost electricity are entitled to some special right to it.
The protectionist argument rests on an key premise (em that increasing the demand for low-cost electricity would drive up the price, forcing current users to pay more. In the short run this assumption may be true, but only if, say, a state holds an abundance of hydroelectric power that is being sold at production cost. In that case, consumers would pay less than a market-determined price, defined as the cost of the highest-cost electricity source in the region. The savings would reflect the fact that the owners of the hydroelectric resources (e.g., U.S. taxpayers) were being "short changed" in not collecting a higher return. But a higher return would reflect economic scarcity (em not market power. Apparently, proponents of a protectionist policy disregard or heavily discount the revenues and profits that would flow into a state selling low-cost electricity. They focus on short-term consequences.
The protectionist argument also discounts the effect of interstate trading on lowering the cost of electricity in all states. Even though such trading would induce competitive pressures, the protectionists assume that utilities in low-cost states (and others too) would somehow remain untouched in their operation, planning, and pricing activities.
What's Wrong with Protectionism
I am hard-pressed to find a case where government policy attempts directly to restrict demand for a highly valuable product or service to protect consumers. The one example I can think of comes from developing countries that impose an export tax on certain agricultural products. Economists have generally criticized such a tax as discriminatory against farmers and a deterrent to domestic production (the government takes away some of the revenues that would otherwise be allocated to farmers). Of course, some governments have tried to protect consumers by setting price ceilings that ostensibly fall below market-determined levels (e.g., the old natural gas wellhead price controls). But even there, the direct intent was not to restrict the flow of the product or service, but to limit the prices that consumers had to pay.
Here lies the paradox (and most significant problem) of protectionism: It harms the long-term economic interests of the low-cost state. Hoarding a valuable resource runs counter to promoting economic development. What history has shown, from a countless number of examples across a wide spectrum of facts and circumstances, is that free exchange is almost always mutually beneficial for both seller and buyer.
The protectionist policy now advocated in some states ignores the fact that the trading of a low-cost product or service (em whether electricity, wheat, or computer technology (and whether between states, countries, or regions) (em will inevitably promote the economic well-being of the trading locality. To restrict the export of a given resource (to reserve it for local consumers, for example) is to presume that some consumers are entitled to a subsidy. A subsidy exists because consumers are paying less for the resource that what they would in an open market. No logical reason can explain why certain consumers in a well-functioning market should claim priority over others.
Consider this illustration: A state may be tempted to set up a policy to save its land from sale to buyers from out of state. This policy would strive to hold down real-estate prices for locals who might plan to buy land in the future. It would penalize current property owners. More broadly, however, it would deplete the aggregate income and wealth of the state, because the buyers who would pay the highest price for the land would be excluded from bidding. So why execute such a policy for electricity when it is considered objectionable for foodstuffs, computer software, and all the other products and services that we buy?
The logical answer is, "We shouldn't." An open, competitive, interstate market for electricity would elicit better economic performance from all participants (em even in states that today already pay low prices.
An Argument for Free Trade
More than anything else, a state that enjoys low-cost power should view this resource as a revenue stream. Low-cost power stimulates economic development (em it's an income producer. The revenues from exports would likely incorporate economic rents that could benefit the exporting state.
Trade restrictions can also backfire. A state with low costs today may become a high-cost state tomorrow, as it looks for capacity to satisfy future demand. The ability to import electricity would tend to reduce power costs in the long term.
From a regional perspective, free trade allows resources to be allocated to those placing the highest value on them. Each state can attend to those production activities for which it is best suited. In economics that's called a "comparative advantage." In the case of electricity, interstate trading would not only lower the total resource cost in the region; it would improve the allocation of power supplies, making electricity more valuable.
Finally, by stimulating competition, interstate trading should add downward pressure to electricity prices, even in a low-cost state. It would do this by increasing the availability of imported electricity and by encouraging in-state utilities to cut their costs. To paraphrase: An ebbing tide lowers all boats.
Avoiding Rate Shock
All of this brings us to the one major concern of low-cost states (em that a rise in exports would boost prices for in-state consumers, perhaps significantly.
It is plausible that prices could increase, especially if a state enjoys a low-cost resource for which generators are not currently earning economic rents. On the other hand, in a region with surplus power and open markets, prices could immediately fall for all electricity consumers, even those in low-cost states. To protect in-state consumers from a possible price increase, a state may want to establish a temporary price cap. The cap would apply to those utility customers who are not allowed to purchase on the open market. The cap could incorporate a formula designed to create incentives that would motivate a utility to become more cost-efficient. In one example, the formula would set the allowable yearly price change equal to the change in the consumer price index, minus an allowance (an offset) for gains in productivity.
As another (admittedly less desirable) option, a portion of the economic rents earned by owners of existing generation plants who export power out-of-state might be redistributed or credited back to in-state customers. These credits would be temporary and restricted to those retail customers who continued to take a package of bundled services from the local utility. This idea, in effect, allows customers to retain some of the economic rents they received prior to open trading, in the form of below-market prices.
Either option would inevitably prove superior to a policy designed to curb electricity exports from state to state. That policy, steeped in protectionism, goes against all economic theory. It repudiates the experience of markets and ignores the long-term economic interests of state governments. Its proponents should look carefully at the consequences before espousing it as a way to stall reform of the electric power industry in their state. t
Kenneth Costello is Associate Director for Electric and Gas Research at The National Regulatory Research Institute, Columbus, Ohio. The author gratefully acknowledges the helpful contributions of Kenneth Rose, Senior Institute Economist at NRRI.
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