economics & politics of regulation

© UHCBA Energy Institute UHCBA Energy Institute 11

Economics & Politics of Economics & Politics of RegulationRegulation

ECON 3385ECON 3385Economics of EnergyEconomics of Energy


Micro Refresher:Theory of the Firm

Firms aim to maximize their profits. Economic profit (total revenue-total

economic cost) is not the same as business profit (total revenue-total accounting cost).

Total cost includes fixed costs and variable costs.

Profit Maximization Rule: MR=MC.


Theory of the FirmCompetitive Firm

$

P

Output

MCATC

AVCP=AR=MR

Qmax

C

M

B

S

N


Theory of the FirmLong-run equilibrium in a

Competitive Market

LRMC

LRAC

P

Q

P=AR=MR

$

Output


Theory of the Firm

Imperfect Competition: oligopoly & monopolistic competition

Market power is derived from:• number of producers• relative size• barriers to entry• availability of substitutes


Theory of the FirmProfit Maximization under Monopoly

$

Output

MCATC

AVC

Q

P

C

A

B

MRDemand


Market Failure

• Market failure refers to situations where the market generates less than perfect (suboptimal) outcomes from the point of view of the society.

Sources of market failure are:• Public goods• Externalities• Market Power• Equity


Market Failure

• Market failure leads to government intervention which can take the form of social regulation or economic regulation.

• Social regulation is concerned with such issues as workplace safety, health, environmental protection…

• Economic regulation is more directly focused on prices, production and entry-exit conditions.


Consumer Surplus:

AXP* (competition)

AFPm (monopoly)

Producer Surplus:

P*XC (competition)

PmFHC (monopoly)

Competition vs Monopoly

A

P’

P*

Pm

C

O

F

H

Qm Q*

D

S = MC for industry

Q

P

X

Deadweight Loss: FXH


Market Failure -Natural Monopoly

ATC

MC

MR

Demand

Q

$

A

C

B

PA

PD

PC

PB

QA QC QBQD

D


Possible SolutionsPossible Solutions

• A, natural monopoly outcome, is what A, natural monopoly outcome, is what we want to avoidwe want to avoid

• B (P=MC) is equivalent to perfect B (P=MC) is equivalent to perfect competition, but negative profitscompetition, but negative profits

• C yields zero economic profit C yields zero economic profit no no incentive to maintain service qualityincentive to maintain service quality

• D provides a positive return: cost-of-D provides a positive return: cost-of-service (or, rate-of-return regulation)service (or, rate-of-return regulation)


Why Does Deregulation Why Does Deregulation Happen?Happen?

Profit incentive for new firms to enter the Profit incentive for new firms to enter the marketplacemarketplace

Technology drives industry economics drives Technology drives industry economics drives policypolicyNew technologies facilitate the rise of competition

““Contestability” and the limits to monopolyContestability” and the limits to monopolyThe threat of “potential competition”


Technology Industry Economics Policy

C

B

A

Output perworker-hour

Q1

Q2

K1

11K2

22Capital per worker-hour

t=2

t=1

Society as awhole

0

Technical Change Shifts the Production Function


Oil IndustryOil Industry

• From the early days, regulated by From the early days, regulated by TRRC, Interstate Oil Compact, etc.TRRC, Interstate Oil Compact, etc.

• In the 1970s, price capsIn the 1970s, price caps• Small Refiner BiasSmall Refiner Bias• Subsidies for Gasohol (Ethanol)Subsidies for Gasohol (Ethanol)


Price Caps Price Caps Excess D Excess D

S70

D70

Qs Qd

P70*

Q70*

$

Q

D78

S78

Price cap

P78*

Q78*


Small Refiner BiasSmall Refiner Bias

• Emergency Petroleum Allocation Act of 1973: Emergency Petroleum Allocation Act of 1973: refineries <175,000 b/d received extra entitlementsrefineries <175,000 b/d received extra entitlements

• In the first two years, 11 out of 14 new refineries In the first two years, 11 out of 14 new refineries had < 30,000 b/d as compared to previous years had < 30,000 b/d as compared to previous years when average refinery was much largerwhen average refinery was much larger

• The program failed, because:The program failed, because:– Market needed refineries with >200,000 b/d– Smaller refineries used older technology that yielded

more of the less valuable heavy products


GasoholGasohol

• Energy Tax Act of 1978: 4 cents tax exemptionEnergy Tax Act of 1978: 4 cents tax exemption• In 1979, $19 billion for development and In 1979, $19 billion for development and

promotion of alternative fuelspromotion of alternative fuels• Continues to receive 5.4-cent discount out of Continues to receive 5.4-cent discount out of

18.4-cent gasoline tax, costing the government 18.4-cent gasoline tax, costing the government $7 billion in revenues since 1979$7 billion in revenues since 1979

• Still, less than 1% of fuel consumption and Still, less than 1% of fuel consumption and limited to Cornbelt states because of limited to Cornbelt states because of distribution problemsdistribution problems


U.S. Natural Gas Industry U.S. Natural Gas Industry RestructuringRestructuring

Competitive LDC Industry

State Public Utility RegulatoryCommissions, 1800s-1927

Development of InterstateTransportation

Federal Regulation of InterstateTransportation (PUHCA/FPA ‘35)

Federal Regulation of Wellhead Prices(Phillips Decision ‘54)

Decontrol of WellheadPrices (NGPA ‘78)

First Stage Open Accessfor Pipelines (Order 436 ‘85)

Final Stage of Open Access(Order 636 ‘92)

LDC Unbundling Era?


Gas Demand by SegmentGas Demand by Segment

24% 22%

13% 14%

36%

46%

19%15%

0%5%

10%15%20%25%30%35%40%45%50%

1980/19.9 tcf 1999/21.4 tcf

Residential CommercialIndustrial Electric Utilities

Gas consumption by customer group

Source: U.S. EIA


U.S. Natural Gas Prices U.S. Natural Gas Prices (Real)(Real)

$0$1$2$3$4$5$6$7$8$9

$10

67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99

ResidentialCommercialIndustrialElectricWellhead

$/mcf

Source: U.S. EIA


U.S. Value Chain IssuesU.S. Value Chain Issues

$0.00$0.50$1.00$1.50$2.00$2.50$3.00$3.50$4.00$4.50

Wellhead toCitygate

Citygate toResidential

Citygate toCommercial

Wellhead toIndustrial

Wellhead toElectric

84 90 91 92 93 94

95 96 97 98 99

Source: U.S. EIA

Price differentials, $/mcf


U.S. Gas Price ConvergenceU.S. Gas Price Convergence

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

Aug-95

Dec-95

Apr-96

Aug-96

Dec-96

Apr-97

Aug-97

Dec-97

Apr-98

Aug-98

Dec-98

Apr-99

Aug-99

Dec-99

Apr-00

Henry HubKaty HubWaha HubAEOC HubSumas, Wash.Malin, Ore.Opal, Wyo.Los Angeles City GateTopock, Ariz.San Juan BasinPan Handle Field ZoneVentura, IowaEmerson, MannitobaChicago City GateColumbia PoolNiagara Falls, OntarioNew York City GateAtlanta City Gate


The Future of Gas?The Future of Gas?

• Are we in a “new era” of $4-5/MMBtu?Are we in a “new era” of $4-5/MMBtu?• Pipelines are under constructionPipelines are under construction• Several LNG terminals are proposed Several LNG terminals are proposed

and couple of old ones are in rehaband couple of old ones are in rehab• Is it still fuel of choice for power plants?Is it still fuel of choice for power plants?• New areas to explore in North America?New areas to explore in North America?


Restructuring of Restructuring of Electricity Industry Electricity Industry

ISO

Gridco

Transco

Pool /Exchange


Old SystemOld System• Vertically integrated Vertically integrated

because of because of economies of scaleeconomies of scale

• Regulated (or Regulated (or national) monopolynational) monopoly

• Cost-of-service Cost-of-service (rate-of-return) (rate-of-return) regulationregulation

New SystemNew System• UnbundledUnbundled

because competitive because competitive efficiencies in supply efficiencies in supply & retail are expected & retail are expected to surpass benefits to surpass benefits of VIof VI

• T&D remain natural T&D remain natural monopolies with monopolies with regulated regulated open open accessaccess


Remaining RegulationRemaining Regulation

• T&D is regulated natural monopolyT&D is regulated natural monopoly– In the US, cost-of-service regulation will be used:

• T (or D) tariff = cost (fixed + variable) + “fair” rate of return

– In the UK, Australia, Argentina, and so on, they use RPI-X regulation:

• Tariff at year t+1 = tariff at year t + RPI – X + K• RPI is an inflation index; X is a measure of productivity; and K

is exogenous cost• Every few years, X is revised by the regulator

See the link “International Examples” for details.


Electricity PoolsElectricity Pools

• Most places adopted a pool system after the UK Most places adopted a pool system after the UK modelmodel– Day-ahead, hourly (or, half-hourly) blocks– Pool operator has demand forecast for each block– Generators bid into the pool for each block

• Amount of electricity• The price

– Pool operator dispatches electricity from the cheapest in each block until demand is met (this is known as “merit order” dispatch)

– The price of the last unit dispatched is established as the market price


Australian PoolAustralian Pool

www.nemmco.com.au

http://www.nemmco.com.au/


Application of Principles: Application of Principles: Electricity RestructuringElectricity Restructuring

Early Electric UtilitiesEarly Electric Utilities

Samuel Insull and stateSamuel Insull and stateregulation, early 1900sregulation, early 1900s

Development of InterstateDevelopment of InterstateTransmissionTransmission

Federal Regulation of WholesaleFederal Regulation of Wholesaleand Interstate Commerceand Interstate Commerce(PUHCA,FPA ‘35)(PUHCA,FPA ‘35)

North American Reliability Council, ‘68North American Reliability Council, ‘68

Conflicts on Natural GasConflicts on Natural GasUse (PIFUA & PURPA ‘78)Use (PIFUA & PURPA ‘78)

Commitment to Bulk MarketCommitment to Bulk MarketCompetition (EPAct ‘92)Competition (EPAct ‘92)

Open Access Begins (CPUCOpen Access Begins (CPUC‘‘94, Orders 888/889 ‘96) 94, Orders 888/889 ‘96)

Retail Wheeling Era?Retail Wheeling Era?

Guide to Electric Power in Texas link!


Why Restructure:Why Restructure:Role of NUGsRole of NUGs

2,000

2,200

2,400

2,600

2,800

3,000

3,200

3,400

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 990

100

200

300

400

500

600

UtilitiesNUGs

Billion kwh Net Generation Utilities Billion kwh Net Generation NUGs

Source: U.S. EIA

Nonutility generation = 13% of total industryApprox. 30% located in Texas

1999 electricity prices:Residential = $0.082/kwhCommercial = $0.072/kwhIndustrial = $0.044/kwh


Why Restructure:Why Restructure:Role of NUGsRole of NUGs

20%

30%

40%

50%

60%

70%

80%

89 90 91 92 93 94 95 96 97 98 99

UtilitiesNUGs

Natural Gas Generation as % Total Net Generation

Source: U.S. EIA

New generation capacity is increasingly built by NUGs who use gas almost exclusively,but turbine efficiencies may hold down gas use.


U.S. Restructuring: Gas U.S. Restructuring: Gas vs. Electricityvs. Electricity

• Natural gas was both a driver for, and set a Natural gas was both a driver for, and set a precedent for electricity restructuringprecedent for electricity restructuring– Increasing integration is the “logic driver” for electric

restructuring• Gas can be stored, electricity cannot (yet)Gas can be stored, electricity cannot (yet)• Gas is cheapest when used directlyGas is cheapest when used directly

– For electricity, fuel cost of gas is higher -- but capital cost, O&M are less -- than coal or nuclear, thus far

• Seasonal/daily demand, balancing, reliability are Seasonal/daily demand, balancing, reliability are challenges for challenges for bothboth


Issues for Electricity Issues for Electricity Restructuring in the U.S.Restructuring in the U.S.

• Size and complexity of U.S. marketSize and complexity of U.S. market• Market design -- Market design -- How? Who?How? Who?• Individual state approaches vs. federal Individual state approaches vs. federal

interstate commerceinterstate commerce• T&D constraints and developmentT&D constraints and development

– Generation capacity installed at load sites• Permitting and siting for generation, T&DPermitting and siting for generation, T&D• Reliability of service and system Reliability of service and system ……


Market Design: What Is the Market Design: What Is the Role of Regulation?Role of Regulation?

• Can regulators act as “market Can regulators act as “market facilitators”?facilitators”?

• Can regulators design markets? Should Can regulators design markets? Should the U.S. have regional regulatory the U.S. have regional regulatory authorities (“how many regulators do we authorities (“how many regulators do we need?”)need?”)

• Is Is harmonizationharmonization good or bad? good or bad?• Should there be a Should there be a “uniform code”“uniform code” for for

North America?North America?


What Happened in What Happened in California?California?

• Demand growing much faster than expected, but supply not Demand growing much faster than expected, but supply not allowed to catch up allowed to catch up dependence on imports dependence on imports– Environmental regulations (3-7 years for licensing)– No market incentives: price caps, no retail competition, retail-

wholesale price cap gap• Wrong model of electricity marketWrong model of electricity market

– Compulsory trading through the power exchange no hedging– Transmission pricing: postage stamp, limited FTRs, zonal

aggregation– Stranded costs incorporated in retail caps

• Too many regulatory entities (PUC, CEC, FERC, etc.)Too many regulatory entities (PUC, CEC, FERC, etc.)• Politics: Politics: "If I wanted to raise rates, I could solve this "If I wanted to raise rates, I could solve this

problem in 20 minutes," says Gov. Davis!!!problem in 20 minutes," says Gov. Davis!!!


Price Caps Price Caps Excess D Excess DS98

D98

QdQs

P98*

Q98*

Price cap

$

Q

D00

P00*

Q00*


Texas Will Be DifferentTexas Will Be Different• Increased supplies (~14,000 MW in 2000-2) in Increased supplies (~14,000 MW in 2000-2) in

anticipation of demandanticipation of demand– Environmental regulations not a hindrance– No caps to shadow price signals– Retail competition

• Different market modelDifferent market model– Texas will have bilateral contracts instead of a

compulsory exchange– Transmission pricing: postage stamp, flexible contract

markets for ancillary services• More reasonable regulatory environmentMore reasonable regulatory environment


The Future of Electricity The Future of Electricity RestructuringRestructuring

• Probably too late for turning back the clock on Probably too late for turning back the clock on restructuring, butrestructuring, but– California scared many, both in the U.S. and

around the world!– Many are having second thoughts on how far to

go (e.g., is retail competition necessary?)– There is still no model that has proven fully

successful (even PJM and the UK regulators continue to change rules)


Market Failure -Market Failure -ExternalityExternality

PeP*

Q*

D=MPB=MSB

S = MPC

Q

P

Qe

MSC=MPC+MEC

AB

H

R

C

E

V

O


Private Outcome (PPrivate Outcome (Pee,Q,Qee) )

• Total social benefits (consumer and Total social benefits (consumer and producer surpluses): OEAQproducer surpluses): OEAQee

• Total social costs: OCRHQTotal social costs: OCRHQee

• Net social benefits: CEBR - BHANet social benefits: CEBR - BHA


Socially efficient Socially efficient outcome (P*,Q*) outcome (P*,Q*)

• Total social benefits: OEBQ*Total social benefits: OEBQ*• Total social costs: OCRBQ*Total social costs: OCRBQ*• Net social benefits: CEBRNet social benefits: CEBR

• Difference between the two: BHA, Difference between the two: BHA, welfare loss due to externalitywelfare loss due to externality


Solutions to externalitySolutions to externality

• No governmentNo government• GovernmentGovernment

– Moral suasion– Government production– Command & control– Market incentives


Pigovian taxPigovian tax

• Set a tax equal to the difference Set a tax equal to the difference between MSC and MPC at the socially between MSC and MPC at the socially optimum level of output, i.e., BVoptimum level of output, i.e., BV

• But, there are problems:But, there are problems:– How to calculate MSC?– Who bears the burden of tax?


Emissions Allowances Emissions Allowances TradingTrading

• Alternative to taxAlternative to tax• Set a limit to pollutionSet a limit to pollution• Allocate emissions allowancesAllocate emissions allowances• Let the companies trade allowancesLet the companies trade allowances

– Those who clean their act will have extra permits to sell– Those who cannot will have to buy– If the price of allowances is too high because of high

demand, then it may make sense to clean up!• What is the optimal level of pollution?What is the optimal level of pollution?

http://www.epa.gov/airmarkets/arp/allfact.html#how

http://www.epa.gov/airmarkets/arp/allfact.html#how

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