Why Electricity Deregulation Fell Short Of Expectations

Electricity deregulation began in the 1980s with three articles of faith: regulated firms operated inefficiently, competition would force them to reduce their costs, and it would force them to pass on those cost reductions to consumers.

Deregulation led to dramatic cost reductions, lower prices, new products and financial disaster for the losers in the airline, railroad, trucking, gas pipeline and telecommunications industries. Boosters for electricity deregulation promised 10-40 percent price reductions. Electricity generators would run like oil refineries. Consumers who could figure out how to buy gasoline in competitive markets could easily learn how to buy electricity. In the wonderful world of Thatcher, Reagan and Pinochet, electricity deregulation resonated with the Zeitgeist.

A new energy policy emerged in the U.S. from two primary sources: free market ideology and a grievance. Oil price spikes in the 1970s led to rampant inflation in the energy sector, exacerbated by nuclear difficulties. The Three Mile Island nuclear accident inflamed anti-nuclear sentiment.

The cost and difficulty of nuclear construction skyrocketed. Completed plants often cost ten times the original estimate. Some nuclear units were left incomplete and others proved superfluous when demand fell below expectations. Nevertheless, consumers had to pay for these debacles. Policy makers, driven in part by free market reform impulses, declared, “No more overpriced nukes. And let’s teach the industry a lesson, too. From now on, independent entities — not utilities and their customers— will take the risks of and reap the rewards from new power plant construction.” That new policy removed one of the utility industry’s major sources of growth.

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We now have a quarter century experience with electricity deregulation (now called “restructuring”). Based on our academic research, we can confidently conclude that in the United States, electric generators improved their operating efficiency and electric companies learned to do more with fewer employees (the two factors might have knocked maybe 5 percent off bills if passed on to consumers).

In the United Kingdom, generators slashed operating costs (not necessarily passing on those savings to consumers) but the reduction to customer bills came about principally from the termination of expensive coal contracts with the government-owned mines and from cost reductions at the regulated utilities rather than from deregulation (reducing electric bills by about 9 percent). Yet even regulated utilities can and do increase productivity and reduce costs and prices, so how did unregulated prices compare to regulated prices in reasonably comparable markets during the same time periods?

In the U.S., high-price-electricity states deregulated to reduce prices, but their prices still remained above the average U.S. price and the percentage differential did not diminish. Deregulation did not change the fundamental factors that produced the high prices, apparently.

Figure 1. Average price to ultimate customers in deregulated states as percentage of U.S. national average price.

U.K. electricity prices relative to those in the European Union (original 15 countries), where deregulation began later, did show decline (although largely due to a difference in taxation). In short, deregulation (or restructuring) was not followed by the dramatic electric bill savings predicted.

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As for product innovations, consumers now can buy the same electricity as before from several sellers rather than one, and at least the air is cleaner because the new market encouraged gas rather than coal-fired generation. In short, deregulation failed to meet its goals.

Alternatively, we could make a more charitable assessment: that, from a consumer’s standpoint deregulation has not done much harm, but didn’t do much good either, which is a polite way of saying that the emperor has no clothes but you don’t have to look.

Figure 2. Average U.K. price to ultimate customers as percentage of EU 15 average prices.

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Why did restructuring not meet expectations? We suggest five design flaws:

1. Policymakers, perhaps misled by ideology, misunderstood human motivations. They assumed that those in the regulated industry had no monetary incentive to operate efficiently and therefore did not. But, as Adam Smith explained (yes, that Adam Smith) pride, peer pressure and conscience also motivate people. Maybe the public service oriented people who ran the old electric industry operated it efficiently because it was their job to do so and not overcharge customers. The new people had a different goal, to maximize profit, preferably legally but not always. It was never clear why all those profit maximizers, acting separately, would miraculously produce the lowest priced or most reliable product.

2. Neither policymakers nor industry players fully understood two cost of capital concepts:that shifting the risk does not make it go away, and that the new unregulated generators had substantially higher costs of capital because they were riskier. The unregulated generators, in fact, took on more debt than low risk regulated utilities and many went bankrupt when power demand did not rise to a level that would support the debt. Now builders hesitate to plunge into unregulated generation without either an high return or a contract. Cost of capital makes up around one quarter of electricity costs and unregulated capital costs more than regulated. Competitive operating savings have to exceed the
higher cost of capital or consumers lose out.

3. Deregulation produced transaction costs. In deregulated markets, power may pass through as many as five separate entities, each with its own profit and loss statement, and none with full control of the product or motivation to bring prices down for the ultimate consumer. Pancaking, that peculiar pricing policy of old whereby each transmission owner added a charge to the cost, has returned to the electricity business in a different form.

4. Customers faced additional complexity, an array of service offerings that required professional expertise to fathom  and everyone offering a new service expected to be paid. Confused customers can make bad choices, as the British demonstrated. Many customers seem to have concluded that the savings are not worth the trouble. Maybe somebody should pay attention. In real markets, the customer is always right.

5. Politicians concentrating on specifics rather than policy confused means with ends and undermined the market. F.A. Hayek, the economist, argued that central planners have less information than the millions of market participants, so government should set goals (the ends) and encourage market participants to find the most efficient ways to reach them (the means). Politicians trying to reduce carbon emissions instead mandated particular solutions, probably raised costs to consumers as a result, increased risks to competitive power producers and gave the losers an excuse to claim that their failure was caused by a governmental war against them, thus qualifying them for a bailout.

Electricity restructuring reduced air pollution by hastening the retirement of aging coal-fired stations, raised industry operating efficiency and stirred long-dormant thought processes in an industry running on autopilot. But businesses run for the benefit of their customers, and in that respect, restructuring added to the complexity of the product, increased transaction costs, and gave birth to the smart meter — in short not even coming close to expectations.

By Leonard Hyman and William Tilles for Oilprice.com

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