By David Freshwater and Stephan Goetz
From Foresight, Vol. 5, No. 2
published 1998
We thank the Long-Term Policy Research Center for the opportunity to clarify our analysis of the potential impacts of electricity deregulation on rural Kentucky. As Henry Kissinger observed some years ago, the usual reason arguments among academics are so vehement and intense is because the issues are so minor. However, in this case the issues are important because changes in the electricity industry will have a substantial effect upon all Kentuckians. We made three main points in our paper and we want to reiterate them before turning to a response to the Scott and Berger lecture.
In our minds there are three distinct aspects to be considered in thinking about regulatory policy related to electricity:
the potential for market prices under deregulation to signal that electricity produced in Kentucky should be shipped out of the state to higher bidders;
the potential for price differentials to remain between urban and rural parts of the state and;
the differential impact of electricity price changes on lower and higher income households in rural and urban areas.
Kentucky now enjoys electricity rates that are among the lowest in the nation. While we too believe the logical consequence of the changes taking place in the electricity sector will be movement to a more uniform price, unlike Drs. Scott and Berger, we think that over the next few years price is more likely to be an average of current prices, rather than being below the lowest price now prevailing. Think of the present situation as each power company serving its own geographic territory, primarily with power produced from its own plants. While there is some flow of power between territories, for the most part these flows are to offset temporary shortages or surplus situations. Each "island" has electricity rates set by a regulator to cover the specific costs of production of the company serving the territory. As a result large variations in electricity prices can, and have, developed. Deregulation is intended to link all these markets into a single national grid.
Because the structural changes are so large we chose to use the U.S Department of Energy’s Energy Information Agency (EIA) estimated national average price rather than one of the regional prices in our analysis. The regions used by EIA are based upon historic associations among companies for the purpose of ensuring reliability and do not correspond to potential patterns of interstate market-based flows of power under deregulation. If, as Scott and Berger assume, power can flow from Kentucky to Pennsylvania, we don’t see why it has to stop at the New York border, especially since prices in New York have historically been higher. We note even with the limited deregulation to date that power sales from the upper Midwest to Florida are already taking place.
People in other states who have been paying two to three times what we in Kentucky have been paying for electricity will want to buy our power, and, not surprisingly, the power companies in the state will sell it to them, unless we offer to match that price. That is how markets work. Since Kentucky is a small state we have a correspondingly small share of the national, or even regional, power supply, so our low cost power is going to be used up pretty quickly. Our perspective is that deregulation is going to create a bigger market for electricity generators to serve, and that in the short run the low-cost providers are going to make a lot of money while the high-cost providers will either make very little or go out of business.
Our second point is that when you look at previous deregulation experience in airlines, telephone and even cable, it is possible to argue that society collectively is better off as a result of the change, but there is clear evidence that some groups in society are worse off. While it now costs less to fly form New York to Los Angeles, it doesn’t cost less to fly from Fargo, North Dakota, to Jacksonville, Mississippi. Proponents of electricity deregulation should be honest enough to admit that some people will not be better off and think about ways to minimize the cost to this segment of society, rather than glibly assert that if we only let the market work everyone will see an improvement. In particular, rural residents have seen the least gain from deregulation in other industries because rural areas typically lack sufficient numbers of people and the population density to support competition. In the case of the electricity sector the reason we have federally supported rural electric cooperatives is because in the early part of the century the investor-owned power companies made it clear they saw no profit potential in providing electricity to rural America.
Our third point is that one cannot assume that all households will be equally affected by the change in electricity policy. The share of income spent on electricity decreases as household income increases, so a change in electricity rates, whether up or down, has a considerably larger impact on the poor than on the wealthy. In Kentucky the fact that electricity has historically been a cheap source of energy has led to a higher percentage of homes, particularly cheaper housing, being heated with electricity than is the case in areas where other fuels were relatively cheaper. This makes the rural and urban poor in Kentucky even more sensitive to price changes. If prices go down the poor will have a windfall gain, more income for other expenses, but if prices go up they may have to choose between heat and other necessities.
To this point, we have thought it better to let people form their own opinions about the two studies, but since Drs. Scott and Berger are obviously pained by our lack of prior discussion of their paper, here are a few comments.
First, they argue that all the fixed costs in the industry will be ignored and prices will be driven to the point where firms only cover the direct, or marginal, operating costs of each plant. What they are saying by this statement is that the firm owners equity, or stock value, for much of the industry will be wiped out. We have a couple of problems with this. If it is true, why are power companies arguing for deregulation, and if it is true, why have the share prices of most electricity stocks increased rapidly since deregulation has been actively considered? We suspect a slight problem here.
Second, on a more technical note, their model assumes that following deregulation and the drop in prices there is no decline in power production—that is, supply is invariant with price. Now there are clear differences in the cost of producing power, even within a given utility, depending on the type of power plant being used. Scott and Berger appear to be arguing that the overwhelming majority of these differences are based on the capital costs of the plant and not the operating costs. For example, this means in their mind there is very little difference in unit operating costs between a modern hydro plant in Michigan and an old coal-fired plant in Tennessee. This appears to be what leads to their claim that the incremental cost of producing the last unit of power is what will set the price for all units, and that even with a significant decline in revenue for a large share of the industry there will be no generation facilities going off-line.
By contrast, a significant number of generation facilities are now being shut down due to an inability to operate profitably under deregulation. Notably about one third of the nuclear plants in North America are to be mothballed, and some are concerned that high temperatures in the Midwest this summer will lead to brown-outs. We suggest that any significant reduction in capacity would limit price declines as excess demand would act to support prices at their current levels.
A third point is their optimism about combined-cycle gas turbines as the generation facilities of the future. They suggest in their paper, and indeed argued in our joint seminar, that there will be a rapid transition to these new low-cost units. However, even with current relatively low demand for these new turbines, it takes two to three years to put a reasonably sized unit in production. If there is a sudden increase in demand for gas turbines because existing generating plants are uneconomic, we would expect that two things would happen—the price for a gas-turbine plant would go up and there would be delays in putting them in production, because you don’t just go to a hardware store, take one off the shelf and plug it into the transmission grid. This type of dynamic adjustment is not part of the Scott and Berger analysis. Thus, we see new generation facilities as part of the longer term consequences of change, not a short-term fix. A minor parallel point is that in their study Scott, Berger and Thompson claim that deregulation will be good for the coal industry in Kentucky, yet if new generation capacity is to be gas fueled, how can this benefit Kentucky?
Finally, what our colleagues delivered was a report that should have made the advocates of deregulation for the industry ecstatic, since it promised that things would be markedly better for all electricity users, at least in the region they studied. Strangely we are not aware of a lot of use of their study by advocates of deregulation, including the companies that funded it. Unlike Scott and Berger we don’t claim to know "the truth" which is why we closed our study with a list of questions that we believe the state government should debate publicly and try to have answered before it embarks on policy change. While we are indeed grateful for the effort by Scott and Berger to provide answers to the questions, we suggest that there are enough uncertainties about the assumptions underlying their analysis to make these answers suspect too. Our suggestion is that interested readers get copies of both reports and examine them carefully and then make up their own minds, because we are certain at this point that neither group of academics will convince the other, until regulatory change is well under way and the results are in. Fortunately, unless prices don’t change at all, at that point only one group will be right.