A Low-Voltage Energy Bill

Deck: 

While a few provisions are worth embracing, most of its 1,724 pages represent a waste of good timber.

Fortnightly Magazine - October 2005

After four years of legislative trench warfare, contentious legal wrangling, and heated partisan rhetoric, President Bush finally got what he wanted—a really big energy bill. What he did not get, however, was an internally consistent "national energy strategy." Examination of the legislation reveals that its title—the Energy Policy Act of 2005—is less descriptive than the title popularized by Sen. John McCain: the No Lobbyist Left Behind Act of 2005.

The energy bill is an intellectually vacuous document. There is little sense that Congress gave thought to how energy markets work, how they fail to achieve efficiency, and how government intervention might make energy markets work better. Instead, the bill is a massive wish list of contradictory requests forwarded by lobbyists to transfer resources from the general public to their employers.

The Economics of Subsidy

The most remarked-upon feature of the new law pertaining to the electricity sector is the dizzying array of regulatory preferences, tax incentives, and direct subsidies employed to favor some fuels and technologies at the expense of others. By now, the details of those market interventions are fairly well known to the industry. Investments in nuclear power, "clean" coal, and various renewable energy sources are made more attractive than comparable investments in natural gas-fired generators and conventional coal-fired power plants.

What effects will the targeted subsidies have on energy markets? From the consumers' standpoint, the answer depends on the effect those subsidies have on marginal production costs. From an investor's standpoint, the answer depends upon whether there are barriers to enter the generation market.

Subsidies for "clean" coal, nuclear, and renewable energy production appear unlikely to change the marginal cost of electricity. That's because natural gas-fired electricity is setting the price for electricity in most wholesale markets during most times of the day and likely will continue to do so in the future. Accordingly, where wholesale electricity markets have been deregulated, coal, nuclear, and renewable energy subsidies will have no effect on electricity prices.

In states where retail electricity prices are established by the weighted average of production costs, consumers will see a reduction in rates if and only if the coal, nuclear, and renewable energy subsidies increase the share of electricity produced by those fuels at costs lower than the costs of increased natural-gas-fired output. If the subsidies do indeed accomplish this end, the price reduction does not reflect an efficiency gain. Instead, the price reduction is only the result of the flawed weighted-average pricing scheme produced by regulation.

Either way, the subsidies will transfer wealth from taxpayers to the fuel sectors in question-the reason, after all, that those subsidies are so vocally supported by their beneficiaries. The impact of wealth transfers, however, depends on whether there are barriers to enter the sector receiving the transfers. If entry barriers exist (which is the case in most of the states which have yet to undergo state regulatory restructuring), the benefits are capitalized into the market value of existing assets and stock prices. This will make existing asset holders richer, but won't help new entrants to the market. If entry barriers do not exist (which is generally the case in states that have undergone regulatory restructuring), the subsidies will induce entry and dissipate any initial positive wealth effects. The net result would be too much investment in the subsidized activities but no extra returns to shareholders or employees.

One can't help but wonder why subsidies for inframarginal electricity sources are necessary. After all, with natural gas prices double what they were only a few years ago, there are already plenty of profits, and thus plenty of incentives, for investors to consider alternatives to natural gas-fired electricity-with or without the energy bill.

A possible answer is that the most important test for the economical viability of coal and nuclear facilities is not the price of natural gas today but the price of natural gas over the operational life of the coal, nuclear, and renewable energy facilities that Congress hopes will be built as a result of this bill. The price of natural gas in North America is higher than the world price because of the limited ability to ship liquefied natural gas (LNG) into the United States. Most analysts believe that new LNG terminal construction, which will integrate the U.S. natural gas market more completely into world markets, will lower domestic natural gas prices. In fact, LNG is commercially viable at prices that are half their current North American level. That would suggest that the market opportunity for nuclear and "clean" coal power might well be gone by the time any new facility were to come on line.

If that scenario comes to pass, the investments in "clean" coal, nuclear, and renewable energy plants induced by the energy bill will represent a net waste of capital. Accordingly, the subsidies offered by the legislation are either unnecessary (duplicating incentives already in place) or wasteful (inducing investments that don't have economic merit on their own).

Electricity Regulation Nitty-Gritty

Two words-"markets" and "deregulation"-summarize electricity policy over the past 15 years. But the California meltdown and the Northeast blackout drastically have reduced politicians' appetite for electricity regulatory reform. For legislators and voters, change from the old, vertically integrated, rate-regulated regime is associated with bad outcomes. That's because the states that introduced the most wide-ranging regulatory changes also experienced the most problems over the last several years.

A close reading of the bill gives contradictory signals about whether the legislation supports regulatory restructuring (characterized by mandatory open access to transmission lines, small merchant natural gas-fired electricity generation, vertical de-integration, and competitive wholesale markets) or the older, more traditional regulatory regime (characterized by vertically integrated organizational structures and large-station coal and nuclear power generation). That should not come as a surprise. Congress does not like zero-sum games. It prefers to distribute resources and positive political signals to as many groups as possible.

Some provisions suggest that Congress supports independent market generation and mandatory open-access transmission. Section 1221 gives FERC siting and eminent domain authority for interstate transmission projects. Under current law, transmission projects are considered, approved, and paid for at the state level even though they have benefits that cross state lines. Accordingly, there is a mismatch between the decision-making and regulatory frameworks that govern transmission investment and the real geographic impact of those improvements.1 State decision makers understandably resist using ratepayer dollars to pay for investments that will primarily help parties outside the state.

Moreover, incumbent utilities and state politicians in today's "low-cost states" actively resist improving the grid. Vertically integrated companies in those states fear that a more robust transmission system primarily will advantage the competition-merchant generators. Politicians in those states oppose grid improvements because the benefits of cheaper generation technologies-particularly old coal-fired plants-would then flow to the highest bidder rather than flow exclusively to ratepayers within their state.

Two provisions extend the mandatory open-access regime to previously unaffected public transmission subsystems. Section 1231 requires publicly owned transmission systems like TVA and Bonneville to be subject to the same mandatory open-access regime as private utilities in restructured states. Section 1232 allows public transmission systems to participate in RTOs.

Four other provisions also seem to signal Congress's support of the new regime of independent generators. Section 1234 directs DOE to study the benefits of economic (least cost) dispatch of generators. The obvious implication is that some vertically integrated utilities would save their customers money if they used some merchant generators' output rather than their own. Section 1251 mandates net metering that would allow customers with cogeneration to sell as well as consume electricity from the grid. Section 1252 mandates that states consider real-time pricing and advanced metering. Section 1254 mandates interconnection of cogenerators to the distribution system. Section 311 gives FERC siting and permit-approval authority for LNG terminals and reduces the ability of local governments to resist their construction and expansion. More LNG gas would lower gas prices and enhance the viability of merchant generation.

EES North America

Other provisions in the bill seem to favor traditional utilities. Section 1233 gives the retail customers of vertically integrated utilities first priority in the use of their transmission systems. Section 1235 protects the owners of firm transmission rights under the status quo from wealth losses they would incur if a market system were introduced in the Northwest. Section 1236 tells ISO-New England that Congress is wary of its locational installed capacity (LICAP) requirement. Finally, the tax credits for nuclear and clean coal facilities seem more like those we might find in legislation dating from 1975 than from 2005. Can the movie run backward? Those provisions suggest the answer is yes.

The Death of SMD

Provisions prohibiting FERC from implementing its standard market design (SMD) (locational marginal pricing and transmission congestion charges) were not included in the final version of the bill even though both the Senate and House versions of the bill contained such language. The absence of such language in the energy bill is not a sign that SMD has won. In fact, SMD is dead, but Congress allowed FERC to save face with the understanding that the commission got the message.

The repeal of the Public Utility Holding Company Act (PUHCA) eliminates the disincentive to be a vertically integrated utility by ending the special accounting and merger treatment of such companies. But repeal should not be viewed as pro-business and anti-consumer. PUHCA made investment in utilities subject to more scrutiny (and thus, subjected investors to higher costs) than investment in other sectors of the economy. Because investors have choices about where to invest, the result was that returns in utilities had to be higher than they otherwise would have been to compensate investors for the greater scrutiny and cost. Thus the repeal of PUHCA, which will eliminate the barriers in the capital markets between the electric utility and all other sectors, reduces costs and risks, and lowers the cost of capital for the utility sector. The upshot is that the capital market for traditional utilities will become more competitive.

How should we feel about this contradictory grab bag of policy changes? In this journal (February 2004) and in a later Cato Policy Analysis2 we outlined our views on restructuring. Briefly, we argued that the current ownership and regulatory structure of the transmission system creates problems that are analogous to the balkanized ownership patterns of some oil reservoirs and that one could draw on the theory and history of unitization contracts in crude oil markets to provide insights for electricity transmission.3

In the electricity context, the use of the unitization contract analogy leads us to ask the following questions:

  • Is there a set of payoffs to all existing players in electricity transmission (including state regulatory regimes and incumbent utilities) that would induce them to turn over operation of their systems to a welfare-maximizing operator in return for a contractually determined share of the increased profits?
  • What plan would the welfare-optimizing operator implement?
  • Is the plan achievable through private action or are transaction costs prohibitively high?
  • If they are high, is coercion by FERC likely to achieve the same outcome?

The most pertinent question is the first. Are the unexploited gains to trade large enough to allow payoffs to all existing players in electricity transmission and still leave a surplus? The Energy Policy Act of 2005 hopes to secure gains to trade through the encouragement of new transmission investment and the adaptation of real-time pricing.

New transmission investment enhances efficiency only if it connects underused generation capacity that has lower marginal costs than the plants available under existing transmission constraints. And capacity with such characteristics is likely to be available only at existing coal plants. Once that underused capacity is gone and the marginal sources of electricity-both local and long-distance-are natural gas, gains from trade exist only if the transmission costs are less than then higher fixed costs (land and labor) of locating generation near urban consumers. To the extent that current price differences across states represent weighted-average rather than marginal-cost differences, improved transmission connections represent wealth transfers between states rather than efficiency gains.

Real-time pricing promises efficiency gains because, at present, electricity prices are wrong all the time. They are too low on peak and too high off peak. Marginal-cost pricing would reduce peak demand, increase off-peak demand, and reduce the needless political struggles that arise (such as the need to subsidize alternative supplies and demand reduction) because of the absence of prices as a signaling device.

But if real-time pricing has merit, why does the government have to mandate it? Even where it is excluded by regulators, utilities that have to sell below cost at peak have an incentive to pay users not to consume.4 There is no externality that needs fixing unless low peak rates induce inefficient rationing.

No More Blackouts?

Political supporters of the Energy Policy Act of 2005 counter arguments that the legislation is nothing but a grand pork barrel by frequently pointing to provisions of the bill that ostensibly address the reliability of the transmission system. Here too, however, there is less than meets the eye.

The central means by which the law hopes to improve reliability is by mandating compliance with the heretofore voluntary reliability rules promulgated by the North American Electric Reliability Council (NERC). Many analysts have claimed that this will reduce the probability of future blackouts and that had those rules been mandatory prior to 2003, the Northeast blackout would not have occurred.

That argument is hard to square with the final report of the U.S.-Canada Power System Outage Task Force, which concluded that poor tree maintenance along transmission lines in the First Energy (Ohio) service area, combined with inoperative computer software and operator errors, were the proximate cause of the blackout.5 At the time of the blackout, "NERC had no standards or requirements for vegetation management or transmission right-of-way clearances, nor for the determination of line ratings."6 In fact, the task force concluded that "although First Energy's vegetation management practices are within common or average industry practices, those common industry practices need significant improvement to assure greater transmission reliability."7

In short, had the reliability provisions of the Energy Policy Act of 2005 been in place a few years ago, they would have had nothing to say about a central element of the blackout story.

Better Than Nothing?

While there are a few provisions of the legislation worth embracing, most of its 1,724 pages represent a waste of good timber. Still, it could have been worse. When Congress last panicked about electricity prices, it imposed price controls on natural gas and banned its use in commercial electricity generating plants (the 1978 Fuel Use Act). Congress then went on to mandate that utilities buy unconventional power from third parties under terms and conditions established by state public utility regulators. In short, Congressional intervention in electricity markets often has been far more robust and counterproductive than that contemplated by the Energy Policy Act of 2005.

Still, it's distressing that Congress refuses to engage in a serious discussion about electricity regulation. Lawmakers in Washington don't bother to offer an intellectual justification for the policies they impose upon the industry, and the interventions they embrace are internally inconsistent.

While we can blame voters for their vague understanding of energy markets that allows members of Congress to play their diffuse-cost, concentrated-benefit games, some blame should be placed at the doorstep of industry itself. The electricity sector spends less time educating lawmakers than it does securing favors and advantages for itself. The industry can scarcely bemoan a lack of political leadership in Washington when it exhibits little of its own.

 

Endnotes:

  1. Douglas Hale, Thomas Overbye, and Thomas Leckey, “Competition Requires Transmission Capacity: The Case of the U.S. Northeast,”
    Regulation 23, no. 2 (Summer 2000): 40-45. The authors use optimal power flow analysis to demonstrate that small additions to the grid in the Northeast would lower prices for consumers across several states.

  2. Peter Van Doren and Jerry Taylor, “Rethinking Electricity Restructuring” Cato Institute Policy Analysis, no. 530 (November 30, 2004)

  3. Gary D. Libecap and James L. Smith, “Regulatory Remedies to the Common Pool: The Limits to Oil Field Unitization,” The Energy Journal 22, no. 1 (January 2001): 1-26.

  4. Tim Brennan, “Questioning the Conventional Wisdom,” Regulation 24, no. 3 (Fall 2001): 65-66.

  5. U.S.-Canada Power System Outage Task Force,  Final Report on the August 14, 2003 Blackout in the United States and Canada: Causes and Recommendations, April 2004, p. 17, https://reports.energy.gov/.

  6. U.S.-Canada Power System Outage Task Force, Final Report on the August 14, 2003 Blackout in the United States and Canada: Causes and Recommendations, April 2004, p. 59, https://reports.energy.gov/.

  7. Ibid.