Wednesday, October 8, 2014

Thick as Thieves

Regular readers of EE know that Kiesling and Giberson at Knowledge Problem rank very near the top of my list for all-time fave bloggers. Their specialty is the economics of energy heavily informed by public choice. For me, a former nuclear power plant operator and present public choice enthusiast, their work is a perfect blend of the old and the new.This splendid tradition continues with a post yesterday on the philosophy underpinning the regulatory approach taken in utility provision.

You might marvel that anyone could find regulatory theory compelling, but try to take the long view for a moment. You occupy an extremely remarkable time in history. You live in an amazingly well-lit, pleasantly air-conditioned, luxuriously cushioned, outlandishly informed period in the course of human events. The mere fact that a small sliver of the population is able to dig minerals out of the ground and convert them into commonplace creature comforts that would have gobsmacked Solomon himself is miraculous. Humanity got tired of huddling in caves away from the fury of the deities of thunder and said, "you know what? Let's use those blinding columns of the rage of the heavens to look at funny pictures of cats." We live in an age where electricity is boring.

Anyway, because of historical accident, electricity generation and distribution ended up resembling other utilities (water, eg): centralized generation and single-grid parallel distribution. We've mostly got big ol' power plants that make the electricity, transmission gear that send it out, and load centers that consume it. And according to standard (Samuelsonian) economics, the monopoly that naturally arises from this threatens the public weal by potentially charging more for their services than a competitive provider would. The ability of a monopoly to charge higher prices is tied very closely to consumers' alternative arrangements: if the consequences of buying no electricity are extremely unpleasant, the electric company can get away with charging an arm and a leg. To avoid this unpleasant firm-customer relationship, the utility regulatory board is chartered with estimating the cost of power production and setting the price accordingly. In the language of EE, utility pricing regulations exist to prevent the exploitation of BATNA disparity.

But, and it's a big but, this is not the only approach to regulation. Contrast monopoly fetters with regulatory agencies like the Consumer Products Safety Commission. Here's the front matter from the statutory authority for the CPSC:
SEC. 2. [15 U.S.C. § 2051] (a) The Congress finds that—
(1) an unacceptable number of consumer products which present unreasonable risks of injury are distributed in commerce;
(2) complexities of consumer products and the diverse nature and abilities of consumers using them frequently result in an inability of users to anticipate risks and to safeguard themselves adequately;
(3) the public should be protected against unreasonable risks of injury associated with consumer products;
(4) control by State and local governments of unreasonable risks of injury associated with consumer products is inadequate and may be burdensome to manufacturers;
(5) existing Federal authority to protect consumers from exposure to consumer products presenting unreasonable risks of injury is inadequate; and
(6) regulation of consumer products the distribution or use of which affects interstate or foreign commerce is necessary to carry out this Act.
That ain't BATNA disparity, people. It's regret aversion. And it's a guiding principle for the regulation of dynamic industries. It's also the soil in which the precautionary principle grows.

Here's the fun bit that Lynne is asking: what happens when the regulated industry changes from static to dynamic? That is, the institutions that support protections against monopoly rent extraction may not be suitable for an industry looking to adopt new technologies.

Luckily, there's already a pretty good example of a regulatory apparatus that's already gone through (or is going through) a similar transition. Banking and finance were industries where "production is represented by a known cost function with a given capital-labor ratio; that function is the representation of the firm and of its technology" prior to, say, the collapse of Bretton-Woods. Loan originators didn't sell off bundled securities, F. Black and M. Scholes had yet to publish their 1973 paper on options pricing, and you knew what you were getting with the sleepy, predictable 6-3 spread in a Savings and Loan (my younger readers will know the old S&L moniker under the more modern name of "Credit Union"). Well, something happened (some things, actually: plural) that transformed the staid, dull-as-dishwater banking industry into the hydra it is today. Exotic derivatives, loan sales, currency arbitrage, and a phalanx of regulatory agencies to deal with it all now dominate the money side of commerce. Where there were once periodic recessions, we now inhabit a world shared by scary terms like "systematic risk" and "too big to fail."

It'll be interesting to see if the disorderly transition in finance and banking will presage utilities' move towards more rooftop solar, smart metering, and the like. I'm curious if part of the mess that led to events like the S&L crisis or the failure of LTCM (or Enron for that matter) were precipitated by an ill-timed shift in regulatory philosophy. The political kayfabe of the Reagan administration was "deregulate, deregulate, deregulate," but the details surrounding deregulation matter greatly. Was it simply a matter of eliminating flight price controls, as with the Civil Aeronautics Authority, or was it something that disrupted the fundamental cost structure of mortgages? "Deregulation" is just a shibboleth, you guys.

My prediction, if you can call it that, is that any institutional changes that happen in utility regulation should at least consider reviewing the purpose of having a regulatory authority in the first place. If customers are more easily able to share load, then protecting consumers against rapacious pricing is no longer a chief concern. If there is a greater potential for fraud as new electricity generation and delivery is the imminent threat, then the charter authorizing regulatory boards should reflect that.

If we must have regulatory agencies, then it is prudent to align their incentives and their function to best match the interests of the public. Just imagine what would happen if the ruin brought on by the events of 2008 would have centered on power generation and distribution rather than a cabal of oily bankers in Manhattan.

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Do you have suggestions on where we could find more examples of this phenomenon?