The New York Times on Electricity Pricing

Electric systems are complicated. They aren't deregulated.

[Note: This essay marks the kickoff of my Knowledge Problem Substack. After starting Knowledge Problem in 2002 as one of the original economics bloggers, I wrote there consistently through about 2012. My friend and fellow economist Mike Giberson also wrote at KP, and kept up some posting through 2020. The original KP blog is now archived and available for search, and I'll be writing here about economics, electricity, technology, regulation, and how they interrelate, probably no more than once a week. I will probably also sprinkle in some history of technology and 18th century political economy. Please subscribe and comment. Welcome!]

2023 promises to be an eventful year in energy. 2022's events start the year off with higher oil and natural gas prices due to Russia's invasion of Ukraine and the resulting supply disruptions. Diverse technological changes, from iron-based batteries to advances in nuclear fusion to new systems for making buildings more intelligent and consumers more informed, portend changes to the architecture, operations, and outcomes of electric systems. In the U.S., new federal legislation has changed the legal and financial environments for energy investments. One thing is certain: electric systems will get more complicated.

Electric systems are complicated.

Electric systems have always been complicated, and have gotten more so since I started studying them as an undergraduate in the 1980s. They encompass technology, engineering, economics, law, and public policy, which interact to shape the system architecture and the institutional framework of law, regulation, and the structures of firms and other organizations. Shifting policy objectives have added to the complication. For most of the past century, the primary objectives were safety, reliability, and affordability, and those objectives are embedded in the operations of the organizations in electric systems – utilities, federal and state regulators, the National Electric Reliability Corporation, and the independent system operators (ISOs) that operate transmission networks and organized wholesale power markets. In the past two decades we've added environmental factors (particularly low-carbon goals) and resilience to the original objectives, with ensuing regulatory and investment implications. All of these actors and systems exist within a political system in which federal and state legislators define policy objectives and can exert considerable influence over the operations of these systems.

There are a lot of different actors, policy objectives, private objectives of individuals, technologies, and weights on tradeoffs in these systems. Analyzing trends with all of these moving parts is hard, and inferring causality is close to impossible. A heavy dose of epistemic humility is an essential element of enabling safe, reliable, affordable, resilient, and clean electric systems.

Which is why I was disappointed in last week's New York Times article by Ivan Penn, Why Are Energy Prices So High? Some Experts Blame Deregulation. The question is a good one. Energy prices are high currently, and electricity prices have been increasing since the 2020 low that reflected the demand decreases associated with the pandemic. California, Penn's home state, has the highest average retail electricity rates in the country by a large margin, a factor that seems to motivate his article. Penn's analysis fails to illuminate the question due to three problems: his definition and use of "deregulation", his use of California as an illustration when it is an outlier, and his confusing conflation of retail and wholesale liberalization in a vertically-integrated industry.

They aren’t deregulated.

For those of us working in electricity regulation and market design during the California crisis of 2000-2001, Penn's confusing use of the word "deregulation" to describe the regulatory restructuring that occurred in the U.S. primarily 1996-2003 may trigger some PTSD. Calling the diverse set of policy and regulatory changes that took place "deregulation" is neither accurate nor useful. In every state that restructured its electricity regulation, restructuring involved a move away from a fully vertically-integrated cost-based regulatory and utility model to a hybrid system. This hybrid system varied considerably from state to state; saying that both California and Texas are "deregulated" states elides some pretty substantial differences in regulatory rules, in wholesale power market design, and in history. Every single state that Penn could plausibly consider "deregulated" has a different model and different set of rules, so bundling them all together in one category is not useful – some restructured states have more market-based systems, some less. The word "deregulation" is also not accurate, because even in states that have required utilities to divest their generation and to reduce entry barriers to retail competition, these burgeoning wholesale and retail markets remain regulated, but not in vertically-integrated firms by PUCs. "Restructuring" more accurately captures the essence of these changes and their diversity across states.

California is not representative.

The second problem with Penn's analysis is his use of California, and particularly California's failed restructuring and 2000-2001 events, as an illustration of restructuring when it's an outlier. Their initial regulatory redesign had considerable flaws based on serious misunderstandings of markets – not allowing long-term wholesale contracts, not allowing retail profit margins on top of wholesale prices – as well as Enron's infamous criminal fraud in influencing and manipulating these new market constructs. California's failed restructuring left it with a wholesale power market that to this day could still improve its market design (as is true for all wholesale power markets). It also left the state's residents without any meaningful retail choice for residential customers until community choice aggregation started in 2010, and even that is limited in scope. Since 2001 regulatory changes in California have returned much decision-making to within the regulated utility footprint, amplified by the implications of increased environmental regulations for making grid operations more costly and for increasing customer bills. Penn fails to discuss these regulatory considerations when evaluating why retail rates for a particular California customer are so high.

Wholesale and retail are different. Markets apply to electricity production, not to transmission and distribution, although that’s complicated too.

Penn's analysis also conflates different aspects of what is admittedly a very complicated system. He conflates wholesale markets and prices with retail markets and prices, and does not elucidate their differences for his readers. The electricity industry originated in local vertically-integrated firms that grew bottom-up. When first subjected to government regulation and granted a legal monopoly in a defined geographical service territory, the relevant regulator was the state Public Utility Commission. The first state PUCs were established in New York and Wisconsin in 1907. Over time, as utilities contracted with each other for emergency purposes and even established power pools, some bulk power transactions crossed state lines, and as part of the portfolio of New Deal legislation, Congress passed the Federal Power Act in 1935 that introduced federal regulatory jurisdiction to make sure that the terms of those transactions were "just and reasonable". Since that time, electric utility regulation has had a split jurisdiction, with bulk power transactions regulated federally and distribution regulated at the state level.

That split means that local utilities in restructured states own transmission networks, but the transmission prices they charge are regulated by the Federal Energy Regulatory Commission using this "just and reasonable" standard. Many of the transmission investments they make, particularly in-state, are still regulated using traditional cost-of-service methods. Ari Peskoe has a good, clear Twitter thread explaining the nuances of transmission investment, in part agreeing and disagreeing with Penn’s analysis, and reinforcing the idea that state and federal regulations are a reason why local transmission investments are not receiving enough scrutiny. Utilities in restructured states participate in wholesale power markets as buyers, and are paid for transmission services based on this FERC-regulated open access tariff. Thus when Penn claims that high transmission charges are a consequence of "deregulation", he is incorrect. Robert Fares and Carey King at UT-Austin and, more recently, S&P Global Commodity Insights document that wires costs have increased as a share of total costs while electricity production costs have fallen, and it’s electricity production that has been the primary focus of market-based restructuring since 1996.

Source: EIA Today in Energy, November 23, 2021

Mono-causal explanations are sure to be wrong.

If you take into account the increasingly complicated nature of electricity systems, and you have some familiarity with the history, technologies, and institutions in the industry, you can come up with a list of reasons to explore to explain the current high prices:

• Increased demand since the pandemic,

• Increased fuel costs due largely to Russia's invasion of Ukraine,

• Increased costs of operating and balancing distribution systems with more diverse and decentralized resources,

• Increased cost for things like congestion at the transmission level, and,

• In areas where utilities purchase energy in wholesale power markets for resale, sellers in those markets could exercise market power and raise energy prices.

In the pre-2020 era, these factors all were relevant and important to consider as fuel prices have fluctuated a lot and, until 2008, demand increased steadily until financial crisis-induced energy efficiency investments made demand plateau (in fact, before the pandemic utilities were extremely worried about this plateau). Penn draws primarily on the MacKay and Mercadal working paper that he cited to focus on the the role of supplier market power in wholesale markets to deliver an incomplete and often incorrect analysis of electricity pricing.

He closes the article citing former Illinois Commerce Commission Chairman Brien Sheahan saying that costs are likely to increase more in restructured states due to a lack of oversight. This claim flies in the face of the EIA data presented above that shows how electricity production costs have fallen, as well as an extensive academic literature on the production efficiencies that occurred in states that entered wholesale power markets (e.g., Cicala, Imperfect Markets versus Imperfect Regulation in U.S. Electricity Generation (2022) and the sources he cites). Rivalry and market discipline provide the ultimate oversight. They require attention to rules and market design that are challenging in such a complicated setting.

Other useful commentary on the Penn article comes from Josiah Neeley (his article and mine are definitely complements and not substitutes), and from Travis Kavulla and Mike Giberson and Panos Moutis on Twitter. Resources for the Future has a good Electricity Markets 101 primer if you want a better understanding of the institutional diversity of U.S. electricity markets and how they operate and are regulated.