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Deregulation – The Hindenburg and Deregulation

By November 7, 2016Energy Rant
Deregulation – The Hindenburg and Deregulation, Michaels Energy

The Rant: to boldly go where no man has gone before.

Watch what you wish for. You might get it.

Now that I’ve ripped off a line from a TV and movie series I’ve never watched and plopped down a cliché, it’s time to answer where I’m coming from.

  1. Politics on the day before Election Day.
  2. Associated government policy.

The play I’ve seen in multiple forms, like a 1970s cop show where Charlie’s Angels, Starsky and Hutch, Cannon, Barnaby Jones , CHiPs, et al, always get their guy in the end of every episode. The opposite happens to corporations as a result of major government policy they think they want. Executives fall for it over and over.

Exhibit A: The Affordable Care Act

All the big insurers were slobbering to get this passed because it would require everyone to buy their product. It didn’t turn out so well for them as you may have heard. For example, in 2017, Aetna will be pulling out of 11 of 15 states. United Healthcare, likewise, will be pulling out of most states next year. These are the results of losing hundreds of millions of dollars on government policy executives of these companies cheered for. I have no idea what they were thinking, but I could see that coming for reasons I would be happy to explain offline.

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Exhibit B: Electric Utility Deregulation?

Exhibit B could be electric utility deregulation. In some states, and for some utilities, this ended awfully (bankruptcy) and very fast. California lawmakers, in their wisdom going all the way back to the Wilson administration, developed a half-pregnant deregulation model where retail prices were capped and wholesale prices were not. Enron’s overzealousness quickly brought that budding disaster down in Hindenburg fashion.

I learn something new every day. On November 5, 2016, I learned via the video linked above that the Hindenburg had swastikas boldly applied to its tail fins, flying over NYC. Wow. It was 1937. Was that an omen of things to come?

Utility Deregulation Primer

In deregulated states and regions away from California, deregulation is taking, or may take, longer to unwind. Consider some reasons why a competitive electric market is a bad idea[1]:

  • Reliability
    • There is very little tolerance for voltage fluctuation and frequency. It isn’t like the internet where if traffic gets heavy, pages take a little longer to load – big deal.
    • There is nothing remotely close to cost effective storage to meet substantial load for any period of time.
    • Modern life stops across the board without electricity: healthcare, traffic control, banking, retail, and business can do hardly anything without power.
    • Demand is almost completely inelastic. On Delta flights for example, the Wifi is so horribly slow that I quit using it. Conversely, businesses are going to use electricity no matter what, especially when there is no real-time price fluctuation.
  • Regulated utilities have an obligation to serve. Independent power producers in deregulated states – not so much.
  • Capital costs are enormous and are depreciated over decades, making entering a market very difficult, particularly when the system in place was designed and built over 80 years.

These factors and more produce a formula for excessive market power. For instance, in normal commodity markets, prices of orange juice, corn, soybeans, pork bellies, gold, palladium, etc., go up and down due to market forces and other externalities. Meanwhile, producers keep producing because the marginal cost is less than selling price.

For example, a natural gas producer may keep producing gas because it is better to get some revenue in a down market (selling at a loss) than none at all, even though in the big picture, he is not recovering his fixed costs. Similarly, farmers don’t skip a growing season when prices are below breakeven. They have enormous fixed costs, like a utility, and need any revenue they can get.

Ironically, in a regulated electricity market, there is a lack of market power for producers, large and small to withhold supply and drive steep spikes in prices, aka price gouging[2]. Deregulated markets allow some of this, and producers will take what they get.

In the paper, Electricity Restructuring: Deregulation or Reregulation?, the authors note that price caps in “deregulated” (my quotes) have been introduced to limit market power. They say the dirty secret of deregulation is that a new set of price-control regulations have replaced an old set of price-control regulations. As I have written in The Daily, Michaels’ internal blog, you either have a deregulated market or you don’t. Touché. Experts agree. Once you mess with prices it has major implications in the market down the road.

What’s Next?

Tune in next week for short and long term impacts of deregulation and what may happen next.

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[1] This slide deck from Purdue University provides a quick overview of historic utility regulation and a brief description of modern deregulation efforts.

[2] I hate this term because it is typically a populist cry for selling at what the market will bear. However, for electricity, that price is huge and that is why deregulation is a bad idea.

Jeff Ihnen

Author Jeff Ihnen

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