Perspective

Deck: 
The crisis of confidence in today's power industry is, at its heart, a crisis of ideas.
Fortnightly Magazine - September 1 2003

Perspective

The crisis of confidence in today's power industry is, at its heart, a crisis of ideas.

 

Conflicting regulations and government mandates become increasingly burdensome and, eventually, violate the law of the possible. Politically favored actors-an "aristocracy of pull"-wield influence in opaque backroom meetings, which result in mysterious market interventions. As brute power overshadows reasoned principle in determining the rules of the marketplace, private initiative and risk-taking begin to wither. In time, capital flight leads to a loss of productive capacity and the destruction of large swaths of the economy. Finally, the inviolable laws of physics trump the irrational laws of men; the electric power system fails, and a major American metropolis is plunged into darkness.

Is this a post mortem of the power crisis in Gov. Gray Davis' California? No, these are plot elements from Ayn Rand's epic 1950s novel, . Upon publication, Rand's novel was derided as implausible, jeered for glorifying capitalism, or simply ignored by the mainstream literary establishment. Nevertheless, it built an enduring following among millions of readers. It persists as one of the most widely read and provocative works of fiction of the last century-and, for our new century, has won regard as a work of prophecy. Readers, though, know it chiefly as a work of philosophy. vigorously defends the free enterprise system for its ability to tap the energy of human creativity, but it notes that initiative withers without the right conditions, thereby spreading material and spiritual impoverishment.

Rand's novel is newly relevant because the crisis of confidence in today's power industry is, at its heart, a crisis of ideas. The industry is caught between conflicting and, to a large extent, contradictory visions of its future. Which vision will predominate: wide-area competition, fragmentation and devolution, or a return to regulation? Will the process of planning be market driven or litigated in stakeholder forums? Can decisions regarding the electric power system be depoliticized, or will they be subject to the demands of pressure groups?

Nominally, the Energy Policy Act of 1992 (the Energy Act) adopted a framework of competition and wholesale market liberalization. Yet more than a decade later, market development remains burdened by conflicting jurisdictional claims and an ad hoc patchwork of mandates, prohibitions, incentives, and policy priorities. Without a commitment to clear and consistent market rules and principles, the result has been drift, disarray, and disinvestment.

Gridlock

Consider the new or increased pressures facing today's utilities from a range of constituencies: to furnish equal grid access to competitors at cost; to boost the role of green and distributed generation resources, even with direct or implicit subsidies; to placate NIMBY (not-in-my-backyard) opposition to power line blight; and to freeze or cut consumer rates. Notably missing has been any clear regulatory incentive, let alone public support, for utilities to fulfill what is their most essential responsibility: ensuring that the network infrastructure itself is sufficiently robust and flexible to meet these various demands.

Unsurprisingly, this was the pressure point that yielded. From the late 1980s onward, utilities cut back on grid investments that did not directly serve immediate customer needs. In the long run, of course, engineering realities cannot be denied; as power demand grew and transmission spending declined, the network became increasingly brittle, congested, and prone to market power abuse.

How will the health of the transmission system be restored? It is unlikely that the industry will, or even can, return to the days of old in which the monopoly structure was clear-cut, service obligations were compensated through government-enforced rates and franchise protection, and investors found comfort in a stable equilibrium of modest risk and modest reward. Nor should we overlook the shortcomings of that system. Innovation was slow; industry behavior was risk-averse and bureaucratic. Engineering-driven systems, while offering bulletproof reliability, were perceived by critics as overbuilt, and physically as well as environmentally intrusive.

By the 1980s changes in the technology and economics of power generation-and a reduced tolerance for the environmental impacts of the traditional engineering-driven system-caused confidence in this longstanding bargain to break down, driving the search for a new equilibrium.

So why not plan expansion of the system by committee? The fact is, the industry has been there and done that. In the late 1980s and early 1990s, many states experimented with integrated resource planning. The general result was a miasma of litigation, delay and paralysis, and continued underinvestment in new supply and grid resources. It was this experience, in California and the Northeast, that led to pressure for a radically new approach. With the passage of the Energy Act, and the first state-level retail regulatory reforms of the mid-1990s, the industry took an apparently decisive turn away from the politicized process of monopoly regulation and central planning toward the more objective discipline of market-based competition.

Deregulation Lessons Learned

Adapting the electric industry to market-based principles would require that much of the logic of the regulated monopoly environment be turned on its head. While a monopoly system bars free entry, a market-based system depends upon it. Excess generating capacity is a costly burden for captive ratepayers; by contrast, abundance of supply works to the benefit of consumers in a competitive market.

For decades, regulatory ratemaking had aimed at rate stability and simplicity; market-based systems require free movement of prices to drive dynamic system efficiencies. Cost-of-service regulation tended to penalize risk-taking and efficiency improvements; well-structured markets reward innovation that works. Although monopoly utilities designed transmission systems to move power from company-owned generators to their own customers, a well-functioning market depends upon robust transmission links between companies. Perhaps most important, the monopoly system required that regulators act as ever-attentive watchdogs on behalf of the public; a market-based system, by contrast, requires that regulators establish a level playing field but not interfere unduly with the game itself.

As the states committed to market-based frameworks for electricity services, record amounts of capital began to flow into the industry. Almost as much new generating capacity was brought on line in the United States in the past three years, for example, as in the entire previous two decades. However, even before this new capacity could enter service, it became apparent that the investment incentives embedded in the first wave of reforms-deregulation 1.0-were skewed. Too much generation was going into the wrong places; too little attention was being paid to delivery problems in congested load centers. Transmission "seams" appeared, typically across state lines, where disparate rules prevented efficient trades. A string of price spikes and reliability problems tested political and regulatory support for the reforms.

The different ways in which policymakers responded to these aberrations had important consequences. California's reaction typified one extreme: a reversion to the traditional tools of command and control. Instead of responding adaptively to growing price pressure in wholesale markets, California initiated a wide range of controlling actions that straitjacketed the industry. Unrealistic price caps, by muting and repudiating the alarming signals of the wholesale market environment, had the predictable effect of aggravating shortages and, ultimately, spurring the physical and financial collapse of the PG&E system. As Gov. Gray Davis ramped up his venomous rhetoric aimed at the generators he desperately needed, the electricity marketplace became a highly politicized battlefield. Long after the initial crisis had erupted and dissipated, the state kept its power sector in a dysfunctional condition by focusing on retroactive price changes and, despite clear evidence of need, refusing to support key infrastructure upgrades. Having taken a range of actions to destroy confidence in the power sector, Davis and his allies went on to pronounce that competition in electric power is an impossible goal; in reality, it was never really tried.

Meanwhile, in other regions of the country, policy-makers and market participants responded to the anomalous price spikes of 1998-99 by reading and reacting to the important signals they contained. Across the Northeast and Midwest, market participants have been patiently putting in place rules and institutions to support robust spot and forward markets, liquid trading, and new investment. From one region to the next, market frameworks vary in detail but converge on a set of core elements that have come to be regarded as best practices. These begin with a recognition that the laws of physics must be respected as they apply to the operation of power systems. Subject to these practical constraints, the new market structures provide a great deal of flexibility. Participants may enter into bilateral transactions and employ risk management tools. The wide range of public policy objectives being demanded of the industry-for example, expanded roles for demand response, renewable resources, and distributed generation-can be accommodated within this structure. The unifying factor, very simply, is price, which must be allowed to vary in spot markets, both through time and across space, to integrate all of these demands while preserving system reliability.

These principles, loosely speaking, are what are meant by the phrase "standard market design" (SMD). Far from being an untested experiment as claimed by its detractors, SMD is based on a set of practices that emerged from more than a decade of experience across the United States and around the world. It has gained adherents throughout the industry, from the Federal Energy Regulatory Commission (FERC) as well as market-oriented regulators from 20 states who understand some consistency in rules is as important to electricity as is the dollar currency to our national banking system.

A New Day Dawning, or the Twilight Zone?

Unfortunately, opponents of SMD-motivated by well-intentioned ignorance, or perhaps a fear of losing the advantage or influence they enjoy in today's system-have succeeded in casting the framework as a top-down Washington directive. Within the political arena, they have gained the upper hand for the moment, and succeeded in stalling the adoption of SMD and postponing this effort to end the balkanization of the industry. If one of the goals of restructuring was to reduce the role of politics in industry decision-making, the unfortunate fact is that politics has returned with a vengeance. Analysts now speak of the prospect of a "new hybrid" industry structure-operating in a twilight zone that is neither wholly regulated nor deregulated-as persisting into the indefinite future.

This situation is simply not sustainable in the long term, and it is time for those who care about the future of the industry to say so. With more than a decade having passed since the enactment of the Energy Act, it is critical to put the industry's so-called competitive transition out of its misery; without greater clarity in the rules, there simply can be no symmetry of risk and reward. If experience from around the world counts for anything, this means movement toward something very much like SMD. Private investors will not be willing to commit at-risk capital in today's twilight new hybrid environment (what Ayn Rand called the mixed economy) knowing that their decisions and calculations may be undermined at any time by unpredictable government actions.

If FERC's hands remain tied and clear rules supporting infrastructure development are delayed, are more catastrophic blackouts in the nation's future? In all honesty, this can't be ruled out. What is more likely, though, is that our nation's entire economy could face years of "muddling through," with the suffocating slow growth that marked the postwar economy of Britain.

Electricity is, after all, one of the key ingredients of economic growth. It has been called the "lifeblood of modernity" or, in Rand's picturesque phrase, the "motor of the world." In the era in which she penned her saga, electricity constituted less than 20 percent of end- use energy consumption. Today, that figure exceeds 40 percent, and it is projected to reach 50 percent by 2020. Without a clear framework to encourage needed investment, growth could be constrained and the cost of reliability problems, now pegged by EPRI at $120 billion annually, could surge.

In the end, ideas have consequences. The idea that we can expect to have a reliable power system without offering any clear incentive for the backbone infrastructure investments needed to support it has been exposed as bankrupt. The health, not just of the industry but of the nation's economy, depends on certainty and symmetry of risk and reward for these important endeavors. One way or another, we will pay the price.


 

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