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What do the British know about regulation that we don’t?



Regulation is back in the spotlight. Moody's, the bond rating agency, just issued a review of  regulation worldwide, that started with these words:  "Prudent regulation key to mitigating risk…"  The bond rating agency put its emphasis on mitigating the risk of carbon mitigation but pretty much opened up the relevance to other risks.  What about   regulation itself as a risk  factor, especially when the regulators decided to change  policies?   American regulators, we know,  have begun to re-examine  their policies in light of experiments elsewhere designed  to encourage  utilities to operate  more efficiently and then pass on  savings to consumers—- most notably the British  effort  that  began in 1990 which failed to radically reduce  prices  but did line the pockets of the utilities.  Whether shifting  American regulation to the British model will reduce risk is a big question.  Evidence indicates that it won't,   but who knows?


What's wrong with American-style regulation?  Critics oppose  it  because it focuses on  rate of return.  The regulator sets prices calculated to cover all operating costs plus a fair return on the investment in assets dedicated to serving the public.    Thus, the American utility has no incentive to reduce costs because it can pass on all costs to customers, and it has every incentive to over- invest  because it can earn a guaranteed return on that investment.   


Way back in 1962, two economists, Harvey Averch and Leland Johnson, published an article making that case, and  policy makers — including the British— have latched onto  the Averch-Johnson Effect ever since. But maybe the policy makers  missed the point,  which economists, incidentally did not.   Namely that  no sensible managers will invest capital unless they expect that investment to produce a return in excess of its cost. 


Financial theory tells us that when a company earns more than its cost of capital, its stock  sells  above  its  book value.  Successful companies generally earn more than cost of capital, so no big deal.    Regulated utilities, though,  have given up their right  to earn a high return profit in exchange  for protection from competition.  Regulators, instead,  set a fair return, generally defined as  cost of capital.  Yet,  the price of utility stocks in the post war period  fell below book value in only 14 of the 71 postwar years.   (Twelve of those fourteen years encompassed the nuclear building disaster and the Energy Crisis.)   Furthermore, the stocks generally sold substantially above book value.  Financial experts  agree that  utilities  should earn more than   cost of capital, as a precautionary matter,   but how much more?


Perhaps, then, the real issue is not  whether rate of return regulation itself encourages expensive over -investment but rather whether regulators set the correct return.  As for whether alternative regulatory formulas encourage greater efficiency in operations,  studies show that they do, but they also increase the cost of capital.. So, for  the alternative system to work for consumers  over the long term,   the additional operating efficiencies must  exceed the increase in  cost of capital. 


We can understand the desire of policy makers to do something different, but perhaps  doing the job they presently have better might be a good start. 


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Government Study Trashes British Electricity Structure



Early in the year, British politicians upset by the high electricity prices brought about, in part, by their energy policies, decided to commission a study (Cost of Electricity Review), but instead of empaneling a committee of regulator and civil servants, they handed the task to one of the UK's pre-eminent energy economists, Dieter Helm, and in reporting back, he minced no words. The report's policy analyses and recommendations have implications for both the American and British electricity markets.  Here are some takeaways:


Consumers pay too much— The British are in the process of decarbonizing their economy , but the government has managed to stumble into some of the most expensive ways of doing so. It started by picking the most expensive and needlessly complicated  ways of doing the job. It should have started with a uniform price on carbon throughout the economy. That would have triggered  the most economic energy saving and decarbonization moves first. It didn't and now consumers are stuck with long term obligations for too expensive renewables. And, the government should have realized and acted on the fact that closing down coal-fired power plants is one of the cheapest ways to reduce carbon emissions.


Neither the government nor the regulator are good at making long-term predictions— As a result, consumers are stuck paying for energy plans based on grossly erroneous assumptions and utilities will benefit for years to come from the bad projections made by the regulator for those long duration price plans that the British extol.  With technology changing so fast, making a long term projection and then signing contracts on that basis (as the government did on behalf of its citizenry) makes little sense. 


Resiliency of the system is a "common property" —  Having too much is definitely better than ha ing too little, but no market participant is going to put up extra money to help the network. 

Getting the right amount of resiliency is  not a problem solved by individual profit maximizers. Therefore the government or regulator has to  make the decision. But the decision-maker can use competitive mechanisms to get the job done at the best price.


Fold the functions of generation, supply (retail sale) and distribution into one entity at the local level— The UK pioneered in separating the functions, apparently believing that the market would get it right, but separation seems not to have led to optimal decisions.  Managers might be able to make better decisions if they can choose between different ways of solving a problem.


Fix a margin on supply (retail)— Right now the supply function is supposed to be deregulated, which has meant that various suppliers, all buying from the same wholesale market, offer a confusing array of price schedules that often lead consumers to pay too much and do not reflect changes in wholesale price fast enough. So, set a default tariff with a fixed margin to help consumers. 


The existing market, with prices set my the marginal cost of fossil-fueled generators will not work in the future—  The industry is heading toward a new structure, in which renewables provide a large proportion of energy, consumers  and producers have the ability to store electricity and  control usage via smart devices.  Renewables have high fixed costs and no fuel costs. The market has to pay the fixed costs no matter what, and no variable costs. Electricity could become similar to cell phone service. You pay a monthly bill for a plan that  allows you up to a given capacity level (let's say, so much data).  In other words, you will pay the monthly bill and get the electricity for free.  The reformed industry structure of wholesale market and four  separate industry sectors (generation, transmission, supply and distribution) each marching to a different tune,  may be on the way out the door. 


Does it look as if the past quarter century of electricity restructuring, with all its brave assumptions about market efficacy and dramatic cost savings, has simply diverted the industry and policy makers from the really big issue, meeting the challenge of climate change in an efficient and timely manner? Dieter Helm does not say that, but that may be the most important takeaway of all. 

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