Viewpoint: In Defense of Markets

Deck: 

The latest resistance to deregulation is built on a foundation of lies.

Fortnightly Magazine - June 2007

It is now more than 15 years since the UK deregulated its electricity market. Since then, there has been an inexorable—though fitful, and still far from complete—move toward competitive electricity markets around the world. Sadly, but not unexpectedly, this has been met by opposition and denunciations from a motley assortment of anti-market naysayers and recalcitrants, some driven by philosophical dislike, and others by the preservation of entrenched privilege.

The naysayers have a disdain for markets in all their guises. When not complaining about deregulation, they often can be found protesting the latest meeting of the World Trade Organisation. These groups advance the argument that electricity, or almost any form of economic activity for that matter, is too important to be trusted to markets.

This article does not attempt to mount a comprehensive defense of market economics. For many of us, the benefits of market competition are manifest, including greater operational efficiency, better allocation of capital, product and service innovation, customer choice, and the redistribution of risk from end-consumers to shareholders.

The alternative to markets is to follow the dictates of someone who presumes to know what is best for us. But, as Adam Smith said, “I have never known much good done by those who affected to trade for the public good.” Centralized command economics is a discredited concept that deserves to be consigned to the dustbin of history, along with the other vestiges of socialism.

“The reformer has enemies in all those who profit by the old order,” Machiavelli said. The recalcitrants are beneficiaries of the status quo—monopolists, and those in their orbit. Their opposition to markets is self-interested; seeking to preserve a regulated existence characterized by captive customers and risk-free profits, rather than be exposed to the challenge of competition (a number of seminal studies1 have shown that regulation typically is sought by an industry to gain protection from competition). Historically, this has led to bloated and inefficient organizations, more focused on keeping the regulator happy than serving the customer. As stated by Pat Wood, former Chairman of the Federal Energy Regulatory Commission (FERC), “Regulating monopolies has not been a great success. I’d give the regulated market about a ‘C’ or a ‘C+’ on its best day.”2 Regardless of the best regulatory intentions, the market always will be a far more effective arbiter of customer benefit.

A resistance to competition might be understandable—though not justifiable and ultimately futile—for those afraid they are on the wrong part of this evolutionary bell curve. But the real challenge for the monopolists—one they eventually must face—is to lift their game, not preserve their boon. Some seem keen to have it both ways, not objecting to free markets and competition as long as it’s not on their patch of turf. In fact, major monopolies from some of the least competitive regions in the world, such as in the southern United States and France, which were amongst the first to take advantage of deregulation in other jurisdictions. Hypocrisy for many, but great business for them.

Excuses, Excuses

These odd bedfellows—socialist “true believers” and corporate monopolists—have advanced an ever-changing progression of arguments over the years, shifting to a new excuse as soon as the old one gets stale. A few favorites follow.

** “Markets in electricity won’t work.”

The traditional monopoly utility model is based upon a belief that the supply of electricity (or natural gas, for that matter) is physically and financially inextricable from the infrastructure required for its transportation, and therefore must be managed by a single entity. Over the last 20 years, economists and engineers have broken down this conception to show that the financial flow of electricity can be separated from its physical flow, and therefore that supply rights need not be a monopoly belonging to the owner of the transportation infrastructure. These insights also have made it clear that there is nothing so unique about electricity that it cannot be treated, in a financial sense, like other commodities, and there is no reason why the benefits of market competition cannot be extended to it.

Our argument, however, need not be made on a theoretical level, when an abundance of practical proof is available. Markets in electricity already have been proven to work, as demonstrated by success stories, in the UK, Nord Pool, Australia, and the U.S. Northeast. For example, the Center for the Advancement of Energy Markets estimated that in 2002 the total cost savings to participants in the PJM market totalled $3.2 billion, and that future cost savings will amount to $28.5 billion, purely as a result of market restructuring.3

** “OK. Electricity markets might work in general, but we’re special.”

With the undeniable existence of working electricity markets, the next stage of retreat for the recalcitrants is to claim that their situation is so unique that market forces should be held in abeyance for them. This has been characterized by a litany of excuses, including:

For each new “show stopper” excuse, the problem is not only solvable, but, as can be seen from the counterpoints above, markets that include these features often already exist.

** “But What About the Blackout?”

The 2003 blackout has been used to promote a number of agendas that have little or nothing to do with the actual event. One of the most absurd of these claims is that the blackout came about because of markets and deregulation. The obvious implication seems to be that if the industry was run by regulated monopolies, this would not have happened.

But it did happen, in 1965 and 1977—prior to any deregulation. Additionally, the First Energy system, where the 2003 blackout started,4 was not part of any competitive market at the time,5 while the regions where the blackout was stopped (PJM and ISO New England) both have long-standing markets.

Fundamentally, the blackout was a reliability issue, one that, amongst other things, would be improved by greater regional coordination, rather than a surfeit of control areas based upon the traditional service zones of vertically integrated utilities. Ironically, the central infrastructure required for effective electricity markets commonly provides such coordination.

** “What About Enron?”

This brings us to another frequent red-herring employed by the anti-marketeers—an attempt to create guilt by association through some form of ad hominem reference to Enron. The implied argument goes: “Enron wanted electricity markets. Enron was bad. Therefore, electricity markets must be bad, too.” In addition to the association being gratuitous, such an argument is, by definition, a logical fallacy.

Competitive electricity markets did not cause the collapse of Enron, with its trading activities generally regarded as profitable. However, even if Enron had lost money in these activities—even if they had been the greatest contributing cause to its bankruptcy—the concept of competition and choice, in electricity or any other market, is not invalidated because a participant in that market fails. Poor performers go broke. This is a Darwinian consequence of the free market.

On the flip side of the coin, Enron certainly was involved in trying to manipulate some of the electricity markets in which it participated, with varying degrees of success (generally depending upon the quality of the market design). This behaviour was in most cases unethical and in some cases illegal. It is nonsensical, however, to suggest that this is reason for dismantling the markets themselves. Many of Enron’s most egregious abuses occurred in the securities markets, concerning the trading and manipulation of its own stock, yet no one seriously suggested shutting down the stock markets. It also is ironic that, as an arbitrageur, Enron was no great fan of organized markets, as such markets serve to promote price transparency and trading efficiency, whereas an arbitrageur profits from market inefficiencies and unequal information.

The demise of Enron was a corporate failure in the general sense—involving bad investments, magnified by inadequate governance and executive malfeasance. As such, Enron’s gaming of electricity markets and its broader corporate misdeeds were symptoms of the same cause; a culture of unbridled hubris, willing to play fast-and-loose, with markets and the law.

** “What About California?”

Finally, a legitimate example of electricity market failure. The California malaise was summed up best by Larry Ruff:6

“The disaster in California’s restructured electricity market has been blamed on many things, including failure to build new power plants, high prices of natural gas and air pollution allowances, greedy suppliers, and the lack of demand reductions in response to high prices. But if there had been no restructuring, these same realities would have been managed without outrageous prices or financial collapse, and probably with fewer blackouts. Such factors ‘explain’ the failure of California’s electricity market in the same sense that gravity ‘explains’ the collapse of a bridge. It is an explanation that in no way excuses such a badly botched design.”

The initial Californian market was a classic product of design by committee—an unwieldy mish-mash that attempted to be all things to all people. This led to a number of severe errors, both of omission and commission, including the imposition of fixed retail obligations and generation divestiture without any hedging of wholesale requirements.

The design failed badly. Markets, as with buildings, bridges, or any other product of human thought, can be designed well or poorly. The former requires the application of both intellectual rigor and thorough analysis. The failure of the California market does not serve to refute the value of market competition, just as a bridge collapse does not serve as a condemnation of the entire profession of civil engineering. It does, however, reinforce the importance of good design.

If You Can’t Cancel the Game, Shoot the Umpire

Reading recent press, it would appear that the anti-market sloganeers are building up to a new crescendo. Their latest argument is that the providers of essential market infrastructure—the system and market operators—are too costly.

Before directly addressing some of the arguments that have been advanced, however, it is useful to examine the importance of market infrastructure.

At the heart of any market are the providers of the essential infrastructure to facilitate operations and trading. Imagine, for a minute, air travel without air-traffic control, or stock trading without exchanges. Both are possible, though they would be massively less efficient, and dramatically more risky. Market infrastructure solves these problems, allowing the players in these industries to get on with their core business. Electricity markets have similar infrastructural needs.

Electricity systems are complex networks, consisting of thousands of interdependent resources, and requiring centralized system control by expert system operators. Traditionally, this role was performed by the incumbent monopoly utility. However, as competition emerges, it is no longer appropriate for any party with a vested interest in the outcome of operational decisions to play this role, creating the need for a separate and independent system operator. Additionally, as flows between old utility-based control areas increase, and become more interdependent, it is essential that system operations be managed on a more regional basis8 by a common infrastructure provider—a regional system operator.

Equally important is the infrastructure to facilitate trading. Independent, price-transparent marketplaces provide a venue for liquidity and price discovery, both of which are essential to the development of a robust and competitive market, be it in securities, commodities, or any other type of product. As trading approaches real-time, electricity markets are linked integrally to the processes of physical delivery, which in turn are driven by the constraints of electricity system physics and network topology. Consequently, tight integration between system operations and spot-market operations is essential, whether contained within the same organization (as is common in the United States) or separate entities.9

Markets without infrastructure are a hollow shell. Nowhere is this demonstrated better than in Germany. In April 1998, the German Bundestag passed a law declaring the electricity market to be 100 percent open. No action was taken, however, to establish market infrastructure or guarantee open and equal access to transmission. As a result, competition virtually was non-existent, and when coupled with increasing consolidation of players, the German electricity market has come to be regarded as one of the least competitive in Europe.

The Third Kind of Lie

Benjamin Disraeli said, “There are three kinds of lies: Lies, damn lies, and statistics.” If recent assertions made by their critics are to be believed, market and system operators are bloated organizations, engaged in an orgy of profligate and ever-burgeoning expenditure. Of course, this would lead one to ponder whether their regulators are out-to-lunch, given most of these entities are subject to regulated revenues, or why the hundreds of customers of each organization, who foot the bill, have not been more vocal. Ironically, though, most of the criticism has originated in regions that don’t have markets, or associated market infrastructure, in place.

Market-operator critiques generally are characterized by a mire of statistics, often based on selectively chosen data, jumping around between years, markets and models; what Darrell Huff (How to Lie With Statistics)10 referred to as a “sample with built-in bias.” Common statistical tricks include:

Misleading Extrapolations: A classic example is the presumption that market-operations costs increase linearly with demand—patent nonsense that ignores the potential for economies of scale, and which denies a long-established precept of market operations: Increased volume/liquidity drives down transaction costs.

False Cost Drivers: Assuming market operations costs are driven only by demand, or some other single factor, rather than by a range of variables including functions performed, market-design features, and jurisdiction-specific arrangements.

“Apples Against Oranges” Comparisons: Comparing the benefits of the market against the combined cost of market and system operations, or comparing two market operators performing very different functions (due to differences in market design).

Such tendentious analysis may have emotive impact, but it is frequently without empirical merit. In the words of Huff: “By the time the data have been filtered through layers of statistical manipulation and reduced to a decimal-pointed average, the result begins to take on an aura of conviction that a closer look at the sampling would deny.”11

In a new tactic, some of these critiques have taken to replacing their traditional universal condemnation of electricity markets with a concluding prescription for further navel-gazing, calling for more studies, to add further to the existing statistical morass. Ultimately, though, this “call to inaction” is just another delaying tactic, and the associated market-operator critiques simply another attempt to promote an entrenched anti-market position.

A Prescription for Progress

So everything is perfect? No, far from it! Market restructuring in many parts of the world remains piecemeal, and is still far from complete. Sizable obstacles to competition remain, some of which will not be resolved effectively without concerted action at a public-policy level. As with any competitive endeavours, electricity markets will continue to evolve, driven by changing participant and regulatory requirements, and ongoing corporate improvement. As these markets mature, there is a fair expectation that greater cost and operational efficiencies will begin to be seen, both through evolutionary change, and organizational and functional consolidation on a cross-market basis.

Furthermore, in many parts of the world, most notably the United States and Europe, electricity markets are governed by a patchwork quilt of regulation and legislation, at state, local, and national (and in Europe, pan-national) levels. This has resulted in a confusing muddle, where some classes of utility aren’t subject to competition (e.g., public power in the United States), and others are. Some regions don’t have markets, and others do. No two markets are the same, and regulatory jurisdiction often is murky.

These are not problems that can be solved at the local level. Most logical regions of the grid encompass multiple political jurisdictions (states, for instance). The flow of electricity within these regions, however, is defined by physics, not politics. As stated by Craig Glazer of PJM:12 “When you do this stuff state by state, it doesn’t work. It’s like having an air traffic control system state by state.” Action at the national or pan-national level is called for. This, however, has met with mixed success, as shown by the United States and Europe.

In recent years both FERC in the United States and the EU Directorate General of Energy and Transport (DGET) have driven through some important changes to encourage competition. More progressive regions have embraced these changes and moved forward to institute markets. Neither FERC nor DGET, however, has sufficient teeth to enforce the participation of the recalcitrants, and large areas within their respective domains remain, in real terms, uncompetitive. Even worse, large incumbent players have been able to expand and consolidate—with ineffective competition providing little opportunity for smaller new entrants—leading to increased market concentration and potential to exercise market power, particularly in Europe.

Legislative action at the national level is required if this logjam is to be broken. Almost every successful electricity market in the world outside the United States,13 has had a clear legislative mandate for market restructuring. It is ironic that a nation considered a bastion of free markets is one of the few countries in the developed world that has failed to take concrete legislative action to bring competitive reforms to one of its most important industries. Surely others, besides the authors, find it strange that Southern China has an electricity market, but the southern United States does not.

Moreover, in the last few years, the cost of market operations in many regions increased as markets went through a period of rapid establishment—and in many cases, enhancement to introduce more sophisticated features (e.g., locational marginal pricing, reserve markets). The achievement of these goals within relatively short time frames has, as with any business change of a similar nature, resulted in inefficiencies.

Contrary to mischievous assertions, however, these costs are not increasing inexorably. The cost ramp-up of recent years is primarily a function of the stage of market development. As markets reach a level of maturity, they can be expected to enter a period of stabilization, with operational costs leveling out, or experiencing modest reductions. This is difficult to see in places such as the United States, where many markets are at a similar stage of development, but becomes evident if the horizon for study is expanded to encompass more mature markets, such as NEMMCO in Australia, which for a number of years has experienced stable operating expenses and reductions in participant fees.14 None of this is meant to suggest that these efficiencies will occur by osmosis. They must be actively sought out and implemented.

Organizational and Functional Consolidation

Jurisdictions such as the United States and Europe encompass a number of electricity markets, each with its own set of market rules and separate operating costs. Many participants, however, operate in multiple markets, requiring them to comply with the rules and processes of each. Additionally, market operations costs do not increase linearly with load, but benefit from economies of scale. Both these factors create strong incentives for a market to encompass as large a region as possible.

The most effective way to achieve this is through organizational consolidation—in other words, the merger of existing market operators, particularly those in contiguous geographic regions, and the inclusion of any newly competitive regions into existing markets. Recent years have seen some success with geographic expansion, in markets such as PJM, Nord Pool, and Australia. Most attempts at mergers, however, have failed, due more to issues of politics and parochialism than of engineering or economics.

Where pragmatic or parochial concerns prevent the creation of a single market, harmonization arrangements can result in some efficiencies. For example, Powernext (France), APX (Netherlands), and BelPX (Belgium) have instituted a “market coupling” mechanism to create a single, virtual liquidity pool. In the United States, PJM and Midwest ISO have put arrangements in place for inter-regional congestion management. These mechanisms are superior to standalone operations, but always will be less efficient than full consolidation of these markets.

It also may be possible to gain some efficiency benefits through functional consolidation. Under this model, each market operator remains an independent entity but centralizes selected functions to a service bureau operated by a third party. Functions that are clear candidates include credit management and market-information publication. Benefits include cost savings and a common set of processes across multiple markets. They also may include additional service-specific benefits. For example, for credit management it would be possible to net collateral requirements across markets, and to leverage the operational expertise of an external party, such as the NYMEX clearinghouse, to run the service.

In sum, if the benefits of electricity markets are as elusive as their opponents would suggest, it must set one to wondering why so many regions around the world have engaged in restructuring? Is it a form of collective delusion? Or do these regions see the merits in market competition and recognize electricity market restructuring for what it is—a fundamental transition from the old order to the new?

Unfortunately, the onslaughts of the recalcitrants can be expected to continue until the day restructuring is complete, with the complaints of the naysayers extending even beyond that. Current attacks on market operators eventually will abate as these markets mature and efficiency gains become evident, only to be supplanted by other, more exotic excuses, and continued delaying tactics. Each will need to be countered in its turn. The competitive reform of electricity markets eventually will be seen, in retrospect, as an historical inevitability. Until then, it is essential to stay the course.

 

Endnotes

1. For example: George Stigler, “The Theory of Economic Regulation,” The Bell Journal of Economic and Management Science, Spring 1971.

2. Remarks made at CERA Executive Summit, “Restructuring at the Crossroads,” March 5, 2002.

3. Center for the Advancement of Energy Markets, “Estimating the Benefits of Restructuring Electricity Markets: An Application to the PJM Region,” September 2003, version 1.1.

4. For further information on the blackout and its causes, refer to: U.S.-Canada Power System Outage Task Force, Final Report on the Aug, 14, 2003, Blackout in the United States and Canada: Causes and Recommendations, April 2004.

5. First Energy is part of the Midwest ISO, whose markets didn’t commence until April 2005.

6. Larry E. Ruff, “Where California Went Wrong,” unpublished paper, Jan. 27, 2001.

7. Since the failure of the initial market, and collapse of the California Power Exchange, there has been a fundamental redesign of the California electricity market.

8. The final report on the 2003 Blackout stated, “It is not clear that small control areas are financially able to provide the facilities and services needed to perform control area functions at the level needed to maintain reliability.”

9. It is possible for markets with separate market and system operators to have tight integration between these functions—e.g., New Zealand. By contrast, many believe that the lack of this integration was one of the principal market design faults of the original Californian market (Ruff, op. cit.).

10. Darrell Huff, How to Lie With Statistics, W.W. Norton & Co., 1954.

11. Huff, op. cit.

12. Comments by Craig Glazer, VP of Government Policy, PJM Interconnection, as reported in the New York Times, Aug. 23, 2003

13. The United States has, in some regions, managed to bring about competition through regulatory means alone, e.g., PJM, New York. At the same time, however, most legislative talk at the federal level has focused on retrograde measures to roll back competition.

14. NEMMCO’s operating expenses have not changed appreciably since 2002, with wholesale market costs stable for longer than this (increases in 2000/2001 were driven by the addition of responsibilities related to the retail market).

• The system is predominantly hydro…but so is Nord Pool, Brazil, New Zealand.

• There are complex inter-state and state/federal issues…as in Australia, ISO New England, PJM.

• The system spans multiple countries and currencies…as do the Midwest ISO and Nord Pool.

• The market is too small…though New Zealand has only 4 million people, and Singapore 4.5 million.

• Complex environmental regulations need to be accommodated…as in almost every jurisdiction.

• …insert excuse of the month here.