Airs – Ian Lance Taylor

Utility Deregulation

The New York Times ran an article today pointing out that in states with competitive electricity markets, rates are higher. Standard market ideology argues that when you have a competitive market, prices will always go down. However, this often fails to happen for utilities like electricity or water. Why doesn’t the market work?

First I should note that it always possible to do some special pleading to explain that the market really will work, but there are just some temporary problems. It’s possible that this special pleading is true. But I think there are some good reasons to think that some things simply aren’t amenable to market solutions.

People can’t survive in the modern world without water or electricity. They will pay any affordable price to receive it. The infrastructure is already built, in the form of water pipes and power lines. People can not meaningfully switch to an alternate provider.

Competition in the electricity market is normally done by making suppliers bid for the chance to sell their electricity. Electricity is purchased from the low bidders until enough is obtained. There aren’t very many suppliers. It takes a significant investment of money and time to become a new supplier.

Any market with inelastic demand and high barriers to entry is a recipe for big profits. Company managers are not rewarded for increasing market share. They are rewarded for increasing profits. In this kind of market there is little incentive to push prices as low as possible. It’s better for all concerned if prices are a little bit high. The high barriers to entry ensure that companies can follow this strategy for a long time without facing new competition. Enron showed an extreme case of this, as they manipulated the supply to keep California electricity prices high.

A longer term problem with utility deregulation is maintenance of the infrastructure. Companies have little incentive to spend heavily on infrastructure. Managers are rewarded for what they do this year, not for how the company performs fifteen years down the road. And since demand is inelastic, the companies can always charge more to fix the infrastructure later.

Markets really only work when it is easy for new suppliers to enter them, or when it is easy for customers to change suppliers, or when it is easy for customers to turn to a substitute. So why does anybody try to deregulate utilities? Is there a good argument other than market ideology?

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15 responses to “Utility Deregulation”

  1. jczeus Avatar
    jczeus

    This is exactly the situation in Germany, where I live. Energy prices are on an all-time high. My blood pressure goes up when I see a commercial on television: what choice have consumers got, anyway?

    The same is about to happen with the railway system. The Deutsche Bahn is about to enter the stock market, and as an indirect consequence, maintenance of the infrastructure has been kept to a minimum for quite a long time already. After the “big event”, it is to be expected that less profitable links will be cancelled, small railway stations closed etc.

    You say that managers are only rewarded for what they do this year. I would even say they are only rewarded for what they do this _quarter_.

  2. ncm Avatar
    ncm

    Is this a serious question? Deregulating a natural monopoly pays well. Corruption is as natural as entropy.

    But maybe I missed your point.

  3. fche Avatar
    fche

    > Standard market ideology argues that when you have a competitive market,
    > prices will always go down.

    Where did you hear that “always”?

    > However, this often fails to happen for utilities like electricity or water.
    > Why doesn’t the market work?

    You may be letting someone else set false standards.

    > So why does anybody try to deregulate utilities?
    > Is there a good argument other than market ideology?

    The market ideology is a good default, as shown by the …
    well … the rest of the economy. The transition from
    regulated or state-run services to market are tricky, but in
    the long run should be healthier. Utilities are not that special.

  4. Ian Lance Taylor Avatar
    Ian Lance Taylor

    Nathan: my question is why people argue that it will do better.

    Frank: it seems to me that observation shows us that market ideology doesn’t appear to help in some specific cases, so citing the rest of the economy isn’t the right sort of argument. Why should it be healthier in the long run? How long is the long run? Why does it take a long time?

  5. Ian Lance Taylor Avatar
    Ian Lance Taylor

    jczeus: thanks for the note.

    Another example of this sort of thing is water privatization in Latin America.

  6. ncm Avatar
    ncm

    I guess you mean, why do people argue for deregulation of natural monopolies when they don’t stand to profit directly? In my experience they don’t have serious arguments. It amounts to fetishism.

    When somebody talks about how prices will come down when you deregulate a monopoly, interject “… and everybody gets a pony!”:
    http://examinedlife.typepad.com/johnbelle/2004/03/if_wishes_were_.html

  7. fche Avatar
    fche

    > Frank: it seems to me that observation shows us that market ideology doesn’t appear
    > to help in some specific cases, so citing the rest of the economy isn’t the right sort of argument.

    “doesn’t appear to help” – isn’t that only if you define it by your “price will
    always be lower” standard?

    > Why should it be healthier in the long run?

    The usual arguments probably include the increase in freedom & competition
    between suppliers and customers — the old “invisible hand” versus “central planning”.

    > How long is the long run?
    > Why does it take a long time?

    I guess it depends, depends, and depends.

    And think about it in reverse … what happens if some politico someday deems google a utility?

  8. Ian Lance Taylor Avatar
    Ian Lance Taylor

    By “doesn’t appear to be help,” I mean that it doesn’t seem to be better along any relevant axis. If prices go up, service does not improve, and the infrastructure is not improved, then things are not better.

    I gave arguments in the original post why the increase in freedom and competition isn’t likely to happen in the specific case of electricity and water. And experience seems to bear me out. So I’m not sure that the “usual arguments” apply.

    Google isn’t a utility, because the switching costs are very low. This is completely different from electricity and water, where the cost for a customer to switch to a new supplier is very high. I’m not talking about political labelling here.

  9. ncm Avatar
    ncm

    I’m sorry, but this stuff is first-week Econ 101. Natural monopolies aren’t subject to market forces, so market logic doesn’t apply. It makes as much sense to expect thermodynamics to prevent evolutionary development. Oops, some people do. On that topic, among the silliest quotes I’ve read from Eric Raymond was “the free market isn’t a ‘device’ any more than love or gravity or sunshine are devices”.

    Perhaps this is a good place to introduce a new term, “ideole”. (Notional usage example: “He needs to get his head out of his ideole.”) The word’s primary value is the graphic connotation it adds to “ideology”.

  10. fche Avatar
    fche

    > By “doesn’t appear to be help,” I mean that it doesn’t seem to be better along
    > any relevant axis. If prices go up, service does not improve, and the
    > infrastructure is not improved, then things are not better.

    It’s hard to be sure though, isn’t it? You shouldn’t compare to some idyllic
    historical moment in 1976, but what it would be like *now* (or in the foreseeable future) under the old rules. California has grown in need (population + per-capita), but has basically neglected to approve the addition of any supply (electrical or water, as far as I’m aware). Right there is a self-created problem that makes comparison of today’s prices to last decade’s – or another state’s – rather suspect.

    I don’t know the mechanics of how California’s electricity deregulation has been occurring – where those natural monopolies were being cracked. Up here, the whole system was broken up in such a way as to make the wide transmission of electricity be the responsibility of someone other than the generators. Then there is a separate company per municipality for the local distribution. Switching between power generation companies is a matter of a phone call, not dragging more copper. I’m not saying that there are too many of them here, but there are more than one. Plus there are more expensive but self-sufficient means available such as solar, micro power generation, and there are probably even more coming. That natural monopoly does not seem quite so monopolistic.

    I don’t know about water; generating it is not quite as “easy” as pushing electrons around … or is it? In some richer Arab states, and on board aircraft carriers, they desalinate the ocean. All it takes is electricity.

  11. Ian Lance Taylor Avatar
    Ian Lance Taylor

    I’m not really thinking about California, which is a poor example of deregulation. Although PG&E (the local gas and electric company) mostly wrote the bill, they decoupled supplier costs from customer costs. Thus they were trapped when the suppliers jacked up the price. I only mentioned it as an example of how a small number of suppliers can easily manipulate the market–in that case just one supplier was enough, by strategically (and illegally) taking electricity sources off-line at times of high demand.

    I’m not saying that the problem with electricity privatization is a natural monopoly problem. I agree that it is possible to have multiple suppliers into a single transmission grid. I’m saying that those suppliers have high barriers to entry and inelastic demand. Thus they face limited competitive pressure.

    In the Canadian system, who maintains the electrical grid? If it is the government, supported by taxes on the electrical suppliers, then that relieves one of the problems with electricity deregulation.

  12. fche Avatar
    fche

    > In the Canadian system, who maintains the electrical grid?

    (It’s a provincial (~state) issue, not federal.) In Ontario, the wide-area
    distribution network is owned by a corporation called Hydro One.
    Different companies generate the power, and different companies/municipalities
    pay for transmitting the power through it.

    > If it is the government, supported by taxes on the electrical suppliers,
    > then that relieves one of the problems with electricity deregulation.

    In what way? I thought your initial complaint was loss of regulation,
    not private ownership.

  13. fche Avatar
    fche

    > […] A longer term problem with utility deregulation is maintenance of the infrastructure.
    > Companies have little incentive to spend heavily on infrastructure. […]

    s/companies/governments/ and you get just as plausible an argument.
    What government, beyond those of the Depression times, has been eager
    to spend tax money heavily on infrastructure?

  14. Ian Lance Taylor Avatar
    Ian Lance Taylor

    I agree, a regulated private company could do just as good a job as the government with regard to infrastructure maintenance.

    Infrastructure support by government comes and goes, but it certainly exists. The government can and does take a much longer view than many private firms. It is possible for a private firm to take a long view, but it is not common, and management is rarely rewarded for a long view. Politicians can take a long view, if they present their accomplishments well.

    Even for more short-sighted politicians, one very simple way that governments spend on infrastructure is in the form of pork barrel spending. There is no equivalent to that in the private sphere.

  15. fche Avatar
    fche

    > one very simple way that governments spend on infrastructure is in the form of pork barrel
    > spending. There is no equivalent to that in the private sphere.

    I believe “management’s pet project” is analogous.

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