The line between government and business is often blurred when it comes to regulating the electricity sector, Travis Kavulla, vice chairman of the Montana Public Service Commission, wrote in an essay for the Summer 2017 edition of American Affairs. There is no such thing as a free market for electricity, he argues, because even where there are competitive features, the marketplace is warped by government intervention.

Kavulla's essay offers a clear and detailed explanation of the often-nonsensical way in which electricity markets operate. "Understanding the sector is not just important because electricity is important; the market for electricity is really a window into the workings of the modern administrative state," he writes. 

Here we offer a brief summary of Kavulla's article, which is available on American Affairs in full

The government's all-encompassing relationship with electric power

Kavulla begins his essay by laying out several systemic flaws he sees in the electricity business, starting with the drawbacks of cost-of-service regulation.

Under this century-old model, a regulator reviews a utility's operating expenses and capital investments and enables the company to receive a return through the rate base. Perhaps most importantly, the regulator also allows for a percentage return on investment; "this is usually about 7 to 9 percent in the current environment, applied to the undepreciated amount of capital the utility’s debt and equity investors have contributed," according to Kavulla. A narrow band is also built in, allowing the utility to earn potentially more or less than its regulatory “revenue requirement” by providing more of its service or reducing costs. 

The problem with the cost-of-service model is that it can incentivize the utility to spend more than is necessary, Kavulla writes. The cost-of-service system isn't an abject failure; "However, this revenue model no doubt causes significant measures of deadweight in the system," said Kavulla. "Furthermore, it deprives customers of choice."

This system can cause utilities to assume a hostile stance toward older assets that are still productive, and so far they haven't steered new investments into innovation. That's because innovative products are often cheaper than traditional solutions, reducing a utility's capital spend and thus its regulated return. Innovation may also allow customers to circumvent the monopoly network, "something a utility has reason to fear on an existential level beyond the coming year’s earnings projection," Kavulla said.

The Montana regulator goes on to describe the flaws with today's electricity markets, pointing out that they, somewhat paradoxically, tend to attract more regulation, not less. These markets also promote rent-seeking behavior, where stakeholders devote lots of resources to the regulatory process, knowing that the regulator's decision will determine their revenue. 

Kavulla also describes how federal and state governments have manipulated the inputs and outcomes of competitive electricity markets. Federal tax credits for solar and wind and the state renewable energy standards -- met through the purchase of renewable energy credits (RECs) -- have had significant unintended consequences for the market in electric power, particularly in the sunny Southwest and the windy Great Plains. As Kavulla explains:

"Wind and solar facilities, unlike coal or gas, have no variable or fuel cost. So one would think that they would bid, or be willing to take a market price, of zero or slightly more. That supposition is wrong -- and not because they need a number larger than zero to make their projects pencil out. Since the IRS awards the tax credit on the basis of production, and since RECs likewise are created only when a wind farm or solar plant is producing energy, these renewable power plants have a negative marginal cost equal to the inverse of the value of the PTC plus whatever a REC is worth to a utility under state law. In other words, renewable power plants are willing to pay consumers to take their energy output, up to $23 per megawatt-hour, lest they lose out on the PTC and the piece of paper that is the REC. This is not an insignificant amount of money."

Renewable energy policies also exacerbate the issue of curtailment in the West, according to Kavulla. In California, when energy production from non-dispatchable resources, including nuclear and renewables, outstrips actual customer demand, electricity prices dive into negative territory. "Thereupon, an amusing game of arbitrage begins," he writes, where Californian renewable energy producers look to dump excess generation on someone else -- Arizona, in this case -- to ensure they can still produce a REC. Arizona may not need the power either, in which case solar production in Arizona has to be shut off to make room for imported solar at negative prices.

"One cannot blame the 'market' for this -- it is merely rationalizing irrational public policy," said Kavulla. "But this is a market warped by subsidies before its trading day even begins."

There are challenges on the nuclear power front, too. The zero emissions credit (ZEC) programs approved by governments in Illinois and New York last year represent "a return to the command-and-control, cost-of-service regulation described above, masquerading as innovative, progressive public policy," Kavulla writes. Market operators ISO-New England and PJM have also been introducing new features to their electricity markets. 

To solve the disappearing nuclear power dilemma, the Minimum Offer Price Rule (MOPR) was conceived -- a topic discussed at length at a recent Federal Energy Regulatory Commission technical conference. "The MOPR establishes an administrative price floor to which everyone’s bids are subject, so that subsidized power generators cannot underbid and warp the market," according to Kavulla. The problem is that it "merely swaps bureaucrats in the form of a state utility commission, fixing prices based on costs, for a technocrat market operator effectively doing the same," he said.

"Nowhere, then, is there truly a free market in electricity," Kavulla states, having run through numerous scenarios.

And so, what now?

A list of proposed utility reforms

Amid all of the complexity, Kavulla outlines seven paths he believes should be followed:

  • Putting utilities on a budget. "Where the regulation of prices is inevitable, both federal and state regulators should put utilities on a budget, tied to something other than regulators’ own discretion, such as GDP growth or an index of inflation net of productivity."
  • Making utilities nimble. "Stop the pernicious trend of a utility requesting permission for virtually everything it does and, at the same time, withdraw some of the protections of their exclusive franchise. Does a customer or a neighborhood want to withdraw from the utility? Perhaps it is time to let them exit, but also to give the utility the right to cut a deal with those defectors and offer something better (whether cheaper or of greater value) than the price-regulated service ordained by utility commissions."
  • Competitive project selection. "FERC should reduce the authorized rate of return for incumbents [that] operate in areas not subject to competitive solicitations, and boost the returns for those projects which were competitively selected -- so long as those projects agree to construct the project under a cost cap."
  • Supporting competitive auctions. "Yet supporting competitive auctions -- even if they are just 'sort of' competitive -- is an important tool to rationalize the way power plants are built and operated."
  • Energy in the executive. "A regulator should not be mistaken: the parties appearing before him are not the public, and the interests of stakeholders together do not constitute the public interest. A greater reliance on those positioned to be self-skeptical about the perverse incentives that regulation all too often engenders is essential."
  • Achieving environmental goals. "The only plausible way to regulate GHG emissions is to do it straightforwardly, by taxing emissions directly, or by capping emissions and letting allowances for them be traded between emitters. If sufficient political support for such policies does not exist, the answer to this problem is simply to do nothing."
  • Facilitating energy infrastructure. "There is, finally, one interventionist role that government can play in a way that could benefit consumers and the national interest: permitting energy infrastructure without needless delays."

Several of these steps rely on action from the Trump administration, like approving new infrastructure projects and working toward removing subsidies as a part of tax code reform. President Obama saw the power of the administrative state when it came to energy matters. The EPA's Clean Power Plan is proof of that. Kavulla concludes: "Trump would do well to acknowledge the same: not for the sake of the administrative state’s apotheosis, but for the unraveling of its intimate relationship with this monopoly industry."