Common Tragedies

Thoughts on Environmental Economics

Can deregulated electricity markets provide reliability?

Posted by Daniel Hall on February 29, 2008

A new edition of Resources, the quarterly magazine from Resources for the Future, is now out. In it RFF Senior Fellow Tim Brennan has an article about the electricity market. Part of Brennan’s discussion deals with electricity reliability and whether deregulated electricity markets are going to be more effective at offering reliability than centrally controlled and vertically-integrated electricity markets.

He starts with the neoclassical argument that competitive markets should enhance reliability (referred to as “security” in this excerpt), or at least help ensure it for those who are willing to pay:

When it comes to security, markets should help, not hurt. Opening markets to new competitors and, over time, to new entrepreneurs and innovators should result in redundancy. And a region or nation should be less vulnerable to disruptions if it is not depending on the facilities and services of a single monopoly provider.

More directly, markets can actually help to provide security. Security of service, like any other product feature is one of the attributes that suppliers will offer in an open market, as long as the consumer’s willingness to pay exceeds the cost of furnishing it.

He goes on to acknowledge, however, that some of the particular features of the electricity grid may mean that there are insufficient incentives for electricity companies to ensure reliability:

[Electricity] reliability is, in economic terms, a critical “collective good.” Failures of my car, furnace, or computer to start may be serious problems, but they are ones largely between me and the firms I choose to supply and repair those items. If my electricity supplier fails to meet my demand, it is not just my problem; everyone on the grid is blacked out as well.

Although he doesn’t offer a straightforward answer to whether he thinks this is a major problem for deregulating electricity markets, he does include a nice analogy that helps frame the question at hand:

The nature of reliability as a collective good implies some degree of central control. …the key question is the degree to which such centralized control is consistent with the decentralized decision processes essential to entrepreneurial competition. At one extreme,we might need no more central planning than air-traffic controllers exercise in the airline industry. Air space can be policed to avoid collisions without precluding competition among carriers to transport passengers and freight. At the other extreme, a central controller may need to control dispatch of generators in the short run and investment in generation over the long run to ensure reliability as well as efficiency.

My guess is that newer technologies are going to be able to provide some of this differentiated service, e.g. real-time meters and pricing, smart appliances, programmable thermostats, etc. This will allow some consumers to pay a lower electricity rate in exchange for bearing some reliability risk, while allowing other customers who truly value reliability to pay a premium to always have the lights on. But do read the article, it’s a thought-provoking look at the electricity markets, and then drop back by to leave your thoughts on whether deregulated electricity markets can work.

3 Responses to “Can deregulated electricity markets provide reliability?”

  1. Re: “But do read the article, … and then drop back by to leave your thoughts….”

    What? Read first and then spout off???

    Seems like a violation of internet social norms, but if that is the way you want to play, I guess I’ll go read the article first.

  2. Brennan does a pretty good job of identifying the major issues. Not every point is developed and some interesting claims are merely asserted without evidence, but Brennan covers so much ground in a short piece that it seems uncharitable to complain that he left out some potentially important details.

    I was surprised that an economist like Brennan didn’t point out the obvious reliability benefit that comes from customers facing real prices (rather than flat rates). Because high prices typically arise when resources are scarce, customer response in the form of reducing demand when prices are high has a reliability benefit.

    I liked that Brennan referred to reliability as a “collective good,” rather than using the more typical term tossed about, “public good.” In principle, the economic theory of clubs seems a more appropriate foundation for examining grid reliability issues than standard public good analysis. It isn’t clear that Brennan had this point in mind when he chose the words he did, but at least it admits the possibility of something other than the mindless “public good”=>”government provision” reaction that is typical.

  3. Dave said

    What is deregulation anyway?

    Let’s expand on it a little:

    Deregulation, a term which gained widespread currency in the period 1970-2000, can be seen as a process by which governments remove, reduce, or simplify restrictions on business and individuals with the intent of encouraging the efficient operation of markets.

    Many industries in the United States became regulated by the federal government in the late 19th and early 20th century. Entry to some markets was restricted in order to stimulate and protect the initial investment of private companies into infrastructure to provide “public” services, such as water, electric and communications utilities. With entry of competitors highly restricted, monopoly situations were created, necessitating price and economic controls to protect the public. Other forms of regulation were motivated by what was seen as corporate abuse of the public interest by businesses already extant, such as occurred with the railroads following the era of the so-called robber barons. In the first instance, as markets matured to where multiple providers could be financially viable offering similar services, prices determined by competition were seen as more favorable than those set by regulatory process.

    One problem that encouraged deregulation was the way in which the regulated industries often controlled the government regulatory agencies, using them to serve the industries’ interests. Even where regulatory bodies started out functioning independently, a process known as regulatory capture often sees industry interests come to dominate those of the consumer. A similar pattern has been observed with the deregulation process, itself often effectively controlled by the regulated industries through lobbying the legislative process. Such political forces, however, exist in many other forms for other “special interest” groups.

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