Strategy& and Public Utilities Fortnightly recently collaborated on an innovation roundtable in Washington, D.C. at the offices of the Edison Electric Institute. The experiences of...
FERC, Renewables and Potatoes
Hidden Costs of Externalities
"It is a mistake to think you can solve any major problem just with potatoes."
- "A Hitchhikers Guide to the Galaxy," Douglas Adams
The electric grid has been described as the most complex machine ever. The National Academy of Engineering called it the supreme engineering achievement of the twentieth century. Yet we continue to rush towards a renewable future without considering overall system design, the costs that various renewable scenarios impose on grid operation, and the operation of the grid with these scenarios.
When the externalities of climate change and ocean acidification create an overwhelming mandate to move away from fossil fuels, we have no choice but to go forward. Shouldn't we try to pick the cheapest path?
The clash of opinions in the energy industry today is not caused by regulated versus free market economics. Rather, it's between the utility industry and new free market entrants. The utilities have historically considered reliability and stability to be vitally important and designed the overall system for the lowest overall cost. The new free-market entrants are concerned with profit optimization and growth in their particular segment of the industry, but ignore overall system costs.
Both groups are doing exactly what the economics of their segments prescribe that they should be doing. The market is functioning well, driving us towards the lowest cost of generation.
Renewable companies want to maximize profit. It is not their job to make policy and worry about how to keep the grid updated and running. If a utility executive were managing a renewables company, they would do the same thing, or their shareholders would find new management. Likewise, utilities are doing what they should be doing in operating the grid.
But a huge gap in coverage has opened between what needs to be done and what the individual participants are doing. Regulators must fill that gap. It involves externalities, which the market, by definition, cannot handle.
Markets are not perfect for several reasons. For example, markets cannot make moral judgments. And markets cannot handle externalities. An externality is a cost or benefit to a third party for which no market exists.
For example, if Company "A" manufactures and sells a chemical to Company "B", but in the process emits a pollutant which harms an individual, "C", an externality is created. Here, "C" is the third party.
The "for which no market exists" part of the definition is extremely important. When the free market economy started its exponential growth in the nineteenth century, we faced several externality problems such as pollution, child labor, and dangerous working conditions.
Because the market could not, by its nature, handle externalities, the government had to step in. It adopted regulations prohibiting pollution, child