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Electric Utility Industry Economics and the Role of
Public Power
By John Kelly
Director, Economics and Research
American Public Power Association
June 23, 2007
Presented at the 2007 APPA National Conference, San Antonio, Texas
2
Overview Theory versus Practice?
Selected Economic Principles/Concepts & Problems
Public Enterprise/Public Power in the United States
Pricing Electricity and Related Issues
Issues in Deregulation of Electricity
3
I. Selected Economic Principles/Concepts & Problems
General Principles
Economic Costs
The Problem of Market Power
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II. Public Enterprise/Public Power in the United States
History and Rationale
Economic Issues and Evidence
Special Issues
5
III. Pricing Electricity and Related Issues
The Central Problem of Common Costs
Traditional, Accounting-Based (Average) Costs versus Economic Costs
Benefits of Prices based on Economic Costs
Special Issues: Cross-Class Subsidies; Demand Response; Implementation, et. al.
6
IV. Deregulating the Electric Power Industry
Economic Rationale
Economic Impediments/Barriers to Entry
Evidence to Date
Continuing Controversies
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Theory v. Practice
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Theory v. Practice
“The world of USA Today is a realm of instant fact and no analysis. Hundreds of bits come at us in pieces never lasting more than a few seconds ….”
Stephen Jay Gould
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The Aims of Education and Other Essays (continued)
“The really useful training yields a comprehension
of a few general principles with a thorough
grounding in the way they apply to a variety of
concrete details. In subsequent practice the
students will have forgotten your particular details;
but they will remember by an unconscious common
sense how to apply principles to immediate
circumstances.”
Alfred North Whitehead
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Theory v. Practice
“We are bombarded [with information]
… If we cannot sort the trivial from the profound, we are lost in terminal overload. The criteria for sorting must involve context and theory—the larger perspective ….”
Stephen Jay Gould
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Theory v. Practice
“There is … no genuine progress in scientific
insight through the … method of accumulating
empirical facts without hypotheses or anticipation
of nature. Without some guiding idea we do not
know what facts to gather. Without something to
prove, we cannot determine what is relevant and
what is irrelevant.”
Morris Cohen
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The Role of Economic Theory
“Economic theory proper … is nothing more than a system of logical relations between certain sets of assumptions and the conclusions derived from them.”
William Vickrey
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The Role of Economic Theory
“[It] bears somewhat the same relation … as geometry does to surveying: it provides a logical framework or skeleton in relation to which the necessarily inexact and incomplete observations of the real world can be [understood] with greater insight.”
William Vickrey
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The Role of Economic Theory (continued)
“In addition, there is a marked difference in the care
and rigor with which economists have typically stated
their assumptions and deduced their conclusions, and
the great complexity of the real economic world has
called forth a relatively large number of different
theoretical systems in an attempt to aid in the
understanding of various aspects of reality. But this is
essentially a matter of degree rather than of kind.”
William Vickrey
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Modern Economics (a semi-facetious
definition)
Capitalism is the astounding belief that
the most wickedest of men will do the
most wickedest of things for the greatest
good of everyone.
John Maynard Keynes
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Economics
“The Theory of Economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions.”
John Maynard Keynes
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So Why Study Economics…?
… Not to be Duped by Economists!
(Paraphrase of Joan Robinson admonition)
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I. Selected Economic Principles and Concepts
Demand Curves Completive Markets and Assumptions
about them Non-Competitive Markets Specific Issues
• Costs
• Opportunity Costs
• Subsidies
• Elasticity of Demand
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I. Competition Defined (1)“[It] is rivalry in selling goods, in which each selling unit normally seeks maximum net revenue, under conditions such that the price or prices each seller can charge are effectively limited by the free option of the buyer to buy from a rival seller or sellers of what we think of ‘the same’ product, necessitating an effort by each seller to equal or exceed the attractiveness of the others’ offerings to a sufficient number of sellers to accomplish the end in view.”
J.M. Clark
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A Few Essential Conditions for Competition
Ease of Entry and Exit
Price Flexibility
Large number of buyers and sellers
Information
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Result …Competition Defined (2)
Competition – a “… rivalry among firms to supply the needs of consumers and producers at the lowest price with the highest qualities.” (Joseph Stiglitz)
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Monopoly OutputQ Q+10 Q
I. Demand Curves and Marginal Revenues
$/Q
Dol
lars
per
Uni
t Q
uant
ity
P’
Gained revenue
Lost revenue
D = AR
P"
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I. Competitive Markets – Profit Maximizing Solutions
$/q
Output Quantity
Dol
lars
per
Uni
t Q
uant
ity
q'0 qq*
P
MCAC
AR = MR
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Monopoly/Oligopoly Markets -- Profit-maximizing Solutions
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Two Implications of Effective Competition
Price Taker
Pressure on Prices to Reflect Costs
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Costs: Know Your Costs! Which Costs?
actualadministrativecapacitycommoncontrollabledifferentialdirectdiscretionarydistribution
periodproductprogrammedsemifixedsemivariablestandardsunkvariable or … ?
Sidney Davidson, Ph.D., CPA, et al., “Managerial Accounting,” An Introduction to
Concepts, Methods, and Uses
fixedindirectjointmanagedmanufacturingmarketingnon-manufacturingopportunity
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Accounting Costs v. Economic Costs
Accounting costs typically reflect “out of pocket” expenses, historical costs, depreciation and other bookkeeping entries and are frequently averaged.
Economic costs are forward-looking, reflecting “variations that will result if a particular decision is taken, and the variations that are relevant to business decisions are those” that affect net income (e.g., respective estimates of the cost of fossil fuels used to produce electricity).
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Opportunity Costs“The simple, though far-reaching, observation
that the true cost of any action can be measured by the value of the best alternative that must be foregone when the action is taken;”
The market value of the displaced product;The expected value of the alternative product
at the moment of decision, as estimated by the chooser;
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Opportunity Costs (continued)
Any one of a range of possibilities that must be foregone in order to select a preferred but mutually excluding alternative;
The value placed on the most attractive of several alternatives is the cost of a particular action (i.e., decision/choice);
The cost of any alternative chosen is the alternative that has been given up; where there is not an alternative to a given experience—no choice—there is not economic problem;
The cost of doing anything consists of the [net] receipts which would have been obtained if that particular decision had not been taken.
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A Few Special Types of Costs
Overhead Cost—“Any cost not associated directly with the production or sale of identifiable goods and services.”
Common Cost—“Cost resulting from the use of raw materials, a facility (for example, plant or machines), or a service (for example, fire insurance) that benefits several products or department…”
Joint Costs—“Costs of simultaneously producing or otherwise acquiring two or more products … that must, by the nature of the process, be produced or acquired together, such as the cost of beef and hides of cattle.”
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Common Costs: Further Defined Costs that “cannot be traced home and
attributed to particular units of business in the same direct and obvious way in which, for example, leather can be traced to the shoes that are made from it.”
“Most of the real problems [of common cost] stem from the fact that an increase or decrease in output does not involve a proportionate increase or decrease in cost.”
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Opposing Views on Problem of Common Costs
Accounting Perspective:• “General management must ensure
that … data are reordered along the lines necessary for intelligent product/market management.”
• “Shared costs are a particularly difficult problem for most companies and difficult to attack as a lump sum.”
• “You must break [shared costs] down and assign them to discrete business units or product lines, even if it means being ‘arbitrary’ by some standard.”
• “Allocating all costs is the only way to know what is really going on.”
C. Ames and J. Hlavacek
Harvard Business Review, Jan-Feb 1990
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Opposing Views on Problem of Common Costs (continued)
Economic Perspective:• “Not all costs are relevant
for every pricing decision.”
• Relevant costs are “those that actually determine the profit impact of the pricing decision.”
• “[Relevant costs] are … costs that are incremental (not average), avoidable (not sunk).”
T. Nagel and R. Holden
The Strategy and Tactics of Pricing:
A Guide to Profitable Decision Making, 1994
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Why Economic Costs Are Important
Economic Efficiency—in Production and Pricing:
• Competition drives prices to costs (and other good things)
• Prices reflect cost to firms—and to society
• Results in good use and allocation of resources
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Marginal Costs “Short-Run Marginal Cost”— Cost of utility
producing another kilowatthour (KWh)
“Short-Run Marginal Social Cost”—Wholesale price in markets that are effectively competitive
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Important, Related Economic Concepts
Implications of Competition
Economic Efficiency
Common Costs
Inherent Costs v. Decision Costs
Investment Costs v. Operating Costs
Short-Run Costs v. Long-Run Costs v. Decision Costs
Economic Goods and Commodities
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Investment Costs v. Operating Costs
Investments in, and Forecasted “Prices” of, Mid-Range Hotels—
• Hilton: 100 Garden Inns, 50,000 rooms at $65–$85 per night
• Choice: 10 Mainstay Suites costing $100 million, rooms at $55–$65 per night
• Doubletree: 25,000 rooms converted to Club Hotels, rooms at $50–$70 per night
USA Today, January 26, 1996
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Economic Goods and Commodities
Question: What is it in the nature of things that are daily exchanged on markets that gives rise to exchangeable value?
• Consumers demand not just physical objects, but the qualities with which they are endowed
• It is the characteristics of the goods that potential purchasers first turn their attention
• Such characteristics form a gap between the “actual things” which are exchanged in markets and their “want-satisfying” characteristics—which are the real subjects of demand
Examples: From coal shipments to restaurant meals
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Cross-Class Subsidies
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II. Public Power/Public Enterprise in the United States
History and Rationale
Economic Issues and Evidence
Special Issues
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History and Nature of Public Enterprise/Public Power
Origin of Public Enterprise in the U.S.
Economic Limits of Private Enterprise
Competition between Institutions
The Beginning of Public Power in the U.S.
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Criticisms of Public Enterprise/Public Power
Socialistic
Efficiency: Lack of Management Incentives (property rights and accountability)
Subsidies
43
Evidence on Economic Performance of Public Power
Early Controversies and Studies
IOU-Sponsored Studies (and their refutation)
Professional Economic Journal
Comprehensive Study (John E. Kwoka)
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Related Issues; Summing Up
Selected Related Issues:• Tax-exempt bonds
• Economies of Scale in Electricity Distribution; or Are Most Public Power Systems Too Small?
Summing Up – A View from East Grand Forks, Minnesota (General Manager, Dan Boyce)
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III. Pricing Electricity and Related Issues
The Central Problem of Common Costs
Traditional, Accounting-Based (Average) Costs versus Economic Costs
Benefits of Prices based on Economic Costs
Special Issues: Cross-Class Subsidies; Demand Response; Implementation, et. al.
46
The Central Issue
“The dominant issue is one of whether the pattern of [electric] rates should be based on tradition, inertia, and happenstance, or whether it is to be developed by careful weighing of the relevant factors with a view of guiding consumers to make efficient use of the facilities that are available.”
William Vickrey, 1955
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Allocating Common Costs
Wool Mutton Total
Cost:
Sheep $400 $400 $800
Processing 100 300 400
Total $500 $700 $1,200
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Allocating Common Costs (continued)
Wool Mutton Total
Cost:
Sheep ??? ??? $400
Processing 100 300 400
Total ??? ??? $800
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Allocating Common Costs (continued)
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Demand Charges Demand charges are a form of fully allocated
cost and a method to allocate common costs and price discriminate:• Demand charges were adopted as “price
discrimination” mechanism in order to avoid competition from “isolated plants” and maximize profits.
• The “profit-maximizing” rate structure had to track the costs of the competition—the costs of operating an isolated plant—not the utility’s marginal costof supply.
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Objections to Pricing Electric Services Based on Economic Costs
Under-Recovery of Revenues Over-Recovery of Revenues Annoyance of Having to Monitor Real-Time
Prices Volatility Does Not Affect Consumption Unfair Costly to Implement Others?
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Benefits of Using Economic Costs to Price Electric Services
Charge consumers at least marginal cost of service
Efficiency: lower costs and prices
Efficient use of utility resources—personnel, time, effort, and consulting projects
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Benefits of Using Economic Costs to Price Electric Services
(continued)
Consistent with public power’s goals
Sound understanding of issues—local and national
Need to understand before changes can begin
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Benefits of Using Economic Costs to Price Electric Services
(continued) Consistent framework that guards against contradictory
rate policies Proper understanding of related cost and price issues:
• Demand-responsive pricing/ Demand-side management programs
• Misplaced emphasis on RTP rather than RTC
• Cross-class subsidies
• Price discrimination
• Innovative rate programs
Costing and pricing other utility services
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IV. Deregulating the Electric Power Industry
Economic Rationale
Economic Impediments/Barriers to Entry
Evidence to Date
Continuing Controversies
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Economic Perspectives on the Role and Limits of Markets
Economic Analysis or Value Judgments:
Von Hayek Keynes
Friedman Samuelson
Stigler Stiglitz
Posner Heilbroner
V. Smith Galbraith
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Views of Competition and Monopoly
What are Competition and Monopoly? Formally Stated (Back to Industry
Demand and Supply Curves) Competition and Monopoly in Practice A Long-Run View of Competition
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Rationales for Deregulation
Inherent Inefficiencies of Price Regulation (construction, operation, innovation);
PURPA problems; Markets – imperfect or not – are always
better than price regulation; Monopoly Firms/Power Eventually
Destroyed – just wait; Worked in other industries (airlines, etc.)
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Impediments to Competition? “Competition has elsewhere encouraged efficiency and
innovation better than regulation.
That electricity must be consumed when produced is no different from other time-perishable commodities like airline seats, hotel rooms, movie seats and advertising time on television. No barrier there.
The solution is to improve market rules and market oversight.”
Branko Terzic, Former FERC commissionerNew York Times letter to the editor, 21 Nov 06
60
Impediments to Competition?
The question of whether to stay the course on deregulation or restore aspects of traditional regulation “would have to …
… take into account, above all, the extraordinary and in some respects literally unique characteristics” of the industry.
Alfred Kahn
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Relevance of industry characteristics to competitiveness
Capital intensiveness
Financial capital requirements
Scale economies
Lumpiness of investments
Location of facilities
Technology
Product durability
Sunk costs
Substitutes
Seasonality
Product differentiation
Vertical integration
Number of sellers and buyers
Mobility of resources/ Asset specificity
Foreign competition
Network industry
VerySomewhatNot Very
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Evidence: Consumer Benefits?
“There is growing evidence and convincing studies that show that consumers have saved billions of dollars in energy costs as a result of competitive markets.”
“Open Letter to Policymakers,”Compete Coalition, Washington, D.C.,
June 26, 2006
63
Evidence: Consumer Benefits?Generally: Concluded “that the methodology used in [the]
studies consistently fall short of the standards for good economic research.”
“In particular, despite much advocacy there is no reliable and convincing evidence that consumers are better off as a result of restructuring of the U.S.
electric power industry.”
John Kwoka, Restructuring the Electric Power Sector:
A Review of Recent Studies, Nov. 2006
64
Evidence: Consumer Benefits?
Specifically in regard to the “Open Letter …”: “… Existing studies do not support that
proposition.”
“Indeed, … there is no credible and convincing economic evidence that consumers have been made better off by electricity restructuring.”
John Kwoka, Restructuring the Electric Power Sector:
A Review of Recent Studies, Nov. 2006
65
Evidence: Consumer Benefits?
Specifically in regard to the “Open Letter …”: “The unsupported conclusions of these studies
should not serve as the basis for further ill-defined ‘deregulation’ or ‘competition’ solutions
to the present difficulties in electricity markets.” (Emphasis added)
John Kwoka, Restructuring the Electric Power Sector:
A Review of Recent Studies, Nov. 2006
66
Evidence: Company Profits
ROE (%) Cash Flow to Equity (%)
2005 5-Year 2005 5-Year
Exelon 19 18 33 33
Constellation 13 13 28 25
PSGE 14 16 27 24
PPL 16 20 32 50
Allegheny 10 -1 30 11
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Summary of Stock Holding Period Returns (%)10 yrs. 5 yrs. 3 yrs. 1 yr.
Regulated 10 9 9 12
S&P 500 7 5 10 15
Exelon 22 27 30 26
Constellation 13 22 19 11
PSGE 19 13 20 4
PPL 17 18 23 15
Allegheny 7 3 60 49
Evidence: Company Profits
68
Evidence: Prospective Profits
Year ROE (%)
Exelon 2008 22
Constellation 2008 17
PSGE 2009 22
PPL 2010 23
Allegheny 2010 26
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Warren Buffet on Electric Utilities Investing in electric utilities is “not a way to get rich, it’s a
way to stay rich.”
“Most of deregulation was a mistake” because, in a deregulated market, “generators have a clear incentive to reduce power reserves.”
Owners of generating assets want the market to be tight
“The last thing in the world an unregulated operator wants
is excess capacity.”
Source: Platts Utility Week
November 20, 2006
70
PJM’s Use of Price-Markup Index (PMI)
PJM estimated 3.9 percent for 2005
Important conceptual issues and application of the formula aside …
5 Regions 8-25 %
8-19 % 6-15 % 8-26 %
7-17 %
PJM Market Power Indicator
71
Economic Analysis v. Value Judgments
Why are concerns about impediments to competition and evidence on restructuring ignored or dismissed?
72
Economic Analysis v. Value Judgments
Do Policy Recommendations rest on:
A commitment to the competitive market as an ideal, and consequent belief that any step in the direction of the ideal is desirable;”
-or-
Economic Analysis and Empirical Evidence?
73
Final Thoughts
Threshold question is not about markets v. regulation, as such; rather it’s about competition v. monopoly.
“Imperfect information, imperfect capital markets, imperfect competition: These are the realities of market economics – aspects that must be taken into account.”
Joseph Stiglitz
74
Final Thoughts
“The advocates of deregulation say it was not done perfectly.
They would have us compare an imperfect
regulated economy with an idealized free market
… Rather than an imperfect regulated economy with an even more imperfect unregulated one.”
Joseph Stiglitz
