Do Markets Reduce Costs? Assessing the Impact of Regulatory Restructuring on the Efficiency of

Electricity Generation

Nancy L. Rose

MIT and NBER

COMPETE ForumNovember 5, 2007 Washington, DC

Electricity markets in historical perspectiveElectricity markets in historical perspective

Early industry evolution led to monopoly concernsEarly industry evolution led to monopoly concerns

Government ownership or regulation arose to limit firms’ Government ownership or regulation arose to limit firms’ exercise of pricing powerexercise of pricing power

““Traditional” rate-of-return regulation of investor-owned Traditional” rate-of-return regulation of investor-owned utilities (IOUs) dominated in USutilities (IOUs) dominated in US

Worked well to keep prices close to costs Worked well to keep prices close to costs

But provided limited incentives to keep costs lowBut provided limited incentives to keep costs low Higher costs generally flowed through to ratepayers Higher costs generally flowed through to ratepayers

Distortion of investment incentivesDistortion of investment incentives

Insulation from competition reduces feedback and cost Insulation from competition reduces feedback and cost pressure pressure

Restructuring has recently replaced traditional Restructuring has recently replaced traditional cost-plus regulation in many jurisdictionscost-plus regulation in many jurisdictions

Institutional choices balance costs/benefits of imperfect Institutional choices balance costs/benefits of imperfect markets vs. imperfect regulationmarkets vs. imperfect regulation

Generation and Retail Services: Vertically disintegrate, Generation and Retail Services: Vertically disintegrate, move to marketsmove to markets ““Natural monopoly” not relevant to current technologies, scale of Natural monopoly” not relevant to current technologies, scale of

markets in generation and retailingmarkets in generation and retailing Recognition that cost inefficiencies entail first-order welfare lossRecognition that cost inefficiencies entail first-order welfare loss

Transmission and Distribution: Incentive regulationTransmission and Distribution: Incentive regulation Trade-off market power (potentially substantial in these sectors) Trade-off market power (potentially substantial in these sectors)

and efficiency concernsand efficiency concerns ““Natural monopoly”/ Network domains benefit from “smarter” Natural monopoly”/ Network domains benefit from “smarter”

regulationregulation

Does restructuring improve efficiency?Does restructuring improve efficiency?

This is the billion dollar questionThis is the billion dollar question

Theory: Changes in incentives can Theory: Changes in incentives can change behaviorchange behavior

Empirical evidence: What happens?Empirical evidence: What happens?

Focus on electricity generationFocus on electricity generation

What does restructuring do to What does restructuring do to generation?generation?

US: 1,000+ interconnected generating US: 1,000+ interconnected generating plants built and operated mainly by plants built and operated mainly by investor-owned utilities (IOUs). investor-owned utilities (IOUs).

What changes in restructured regimes?What changes in restructured regimes? New incentives for operation by existing New incentives for operation by existing

owners (anticipatory, short- to medium-run)owners (anticipatory, short- to medium-run) Divestitures/new owners of existing plants Divestitures/new owners of existing plants

(short- to medium-run)(short- to medium-run) Investment in new plants (long-run)Investment in new plants (long-run)

What choices might restructuring affect?What choices might restructuring affect?

Start with a stylized description of what Start with a stylized description of what plants doplants do

To produce electricity (MWhs), plants To produce electricity (MWhs), plants combine fuel, labor, materials and capitalcombine fuel, labor, materials and capital

This process can be described by a This process can be described by a production function:production function:

y = f(F,L,M,K)y = f(F,L,M,K)

A one-input production functionA one-input production function

Fuel (Btu)

Ele

ctric

ity (

MW

h) y = f(F)

Excess fuelInefficient plant

Efficient plant

“Lost” MWhs

What might change: plant levelWhat might change: plant level

Technical efficiency (e.g. improved heat Technical efficiency (e.g. improved heat rates)rates)

Input mix (e.g. substitute away from fuel)Input mix (e.g. substitute away from fuel) Cost of inputs (e.g. fuel procurement Cost of inputs (e.g. fuel procurement

practices change)practices change) Balance between expense of preventative Balance between expense of preventative

maintenance and cost of forced outagesmaintenance and cost of forced outages

What might change: dispatch levelWhat might change: dispatch level

Mix of plants included in the dispatch improves Mix of plants included in the dispatch improves due to expanded coordination areas (+)due to expanded coordination areas (+) Regional trading organizations may improve inter-Regional trading organizations may improve inter-

regional trade and congestion managementregional trade and congestion management Mix of plants included in the dispatch worsens Mix of plants included in the dispatch worsens

due to dispatch on price (bids) not costs (-)due to dispatch on price (bids) not costs (-) If some firms withhold capacity from the market to If some firms withhold capacity from the market to

exercise market power, it will be replaced by power exercise market power, it will be replaced by power from plants that otherwise would have been too from plants that otherwise would have been too expensive to run.expensive to run.

Mix of plants brought online improves (+)Mix of plants brought online improves (+)

Empirical assessment: Measuring the Empirical assessment: Measuring the effects of restructuringeffects of restructuring

We can’t simply compare prices, costs or We can’t simply compare prices, costs or efficiency measures across restructured v. efficiency measures across restructured v. traditional regulatory environmentstraditional regulatory environments Restructured states tended to have higher electricity Restructured states tended to have higher electricity

prices before restructuringprices before restructuring Input shocks, especially fuel prices, change costs Input shocks, especially fuel prices, change costs

over time even without restructuringover time even without restructuring Plant mix is different in states that have restructuredPlant mix is different in states that have restructured

We need a counterfactual: What would have We need a counterfactual: What would have happened happened without without restructuring? restructuring?

Empirical assessment: The importance Empirical assessment: The importance of the counterfactualof the counterfactual

To measure empirical effects of restructuring, To measure empirical effects of restructuring, consider a set of efficiency measures consider a set of efficiency measures XX {investment, fuel use, staffing levels, etc.} {investment, fuel use, staffing levels, etc.}

Some candidate counterfactuals:Some candidate counterfactuals: XX before restructuring before restructuring XX in other parts of the world. in other parts of the world. XX in states that aren’t progressing in states that aren’t progressing

with restructuring quickly.with restructuring quickly.

Restructuring Effect:

X2000 – X1990

“difference in differences”

(X2000, CA – X1990,CA) -

(X2000,KY –X1990,KY)

Restructuring effects on generation Restructuring effects on generation efficiencyefficiency

Fabrizio, Rose and Wolfram (2007) explore Fabrizio, Rose and Wolfram (2007) explore whether impending restructuring caused existing whether impending restructuring caused existing owners (IOUs) to operate their plants differently.owners (IOUs) to operate their plants differently.

Difference in difference analysis:Difference in difference analysis: Compare changes at large fossil IOU plants in Compare changes at large fossil IOU plants in

restructuring states over 1980-1999 to two “control restructuring states over 1980-1999 to two “control groups” groups”

Similar IOU plants in non-restructuring statesSimilar IOU plants in non-restructuring states Cooperatively- and publicly-owned plantsCooperatively- and publicly-owned plants

Restructuring states are those that passed Restructuring states are those that passed restructuring legislation by 2001. restructuring legislation by 2001.

See K. Fabrizio, N.L. Rose and C.D. Wolfram, “Do Markets Reduce Costs? Assessing the Impact of Regulatory Restructuring on US Electric Generation Efficiency,” American Economic Review, (2007) 97:1250-1277.

Figure 1: Employment Trends by Company Type and Restructuring Status

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Figure 2: Nonfuel Expense Trends by Company Type and Restructuring Status

Divestiture and EfficiencyDivestiture and Efficiency Bushnell and Wolfram (2006) estimate that fossil plants Bushnell and Wolfram (2006) estimate that fossil plants

have ~2% lower heat rates after divestitureshave ~2% lower heat rates after divestitures At current fuel prices, this amounts to $1/MWh or moreAt current fuel prices, this amounts to $1/MWh or more

At the plants that were divested, this adds up to savings of At the plants that were divested, this adds up to savings of roughly $1 billion per yearroughly $1 billion per year

Barmack, Kahn, & Tierney (2007) estimate nuclear plant Barmack, Kahn, & Tierney (2007) estimate nuclear plant capacity factors increase about 10% post-divestiturecapacity factors increase about 10% post-divestiture

Improving efficiency helps achieve environmental goals, Improving efficiency helps achieve environmental goals, especially with respect to COespecially with respect to CO22

J. Bushnell and C.D. Wolfram, “Ownership Change, Incentives and Plant Efficiency: The Divestiture of U.S. Electric Generation Plants,” UCEI CSEM Working Paper 140.

M. Barmack, E. Kahn and S. Tierney, “A cost-benefit assessment of wholesale electricity restructuring and competition in New England,” Journal of Regulatory Economics, (2007) 31:151–184.

Markets improve the mix of plants in dispatchMarkets improve the mix of plants in dispatch

Mansur and White (2007) examine effects of Mansur and White (2007) examine effects of PJM market expansionPJM market expansion

Centralized market replaced bilateral trading Centralized market replaced bilateral trading between PJM East and the Midwestbetween PJM East and the Midwest

Dramatic increase in volumes that flowed from Dramatic increase in volumes that flowed from inexpensive coal plants in the Midwest to inexpensive coal plants in the Midwest to Pennsylvania, New Jersey and Maryland.Pennsylvania, New Jersey and Maryland.

Estimated savings on the order of $180m/yearEstimated savings on the order of $180m/year

E. Mansur and M. White, “Market Organization and Market Efficiency in Electricity Markets,” Yale School of Management Working Paper.

Quantities traded: Day-ahead net exports, Quantities traded: Day-ahead net exports, Midwest Midwest East East

What’s the bottom line on restructuring?What’s the bottom line on restructuring?

Remind ourselves about the source of potential gains Remind ourselves about the source of potential gains from restructured electricity markets:from restructured electricity markets: It’s It’s notnot about short-term price effects about short-term price effects

That may be due to temporal shifts (from differences in plant That may be due to temporal shifts (from differences in plant age, regulatory rate base accounting, treatment of “stranded age, regulatory rate base accounting, treatment of “stranded costs,” ), or changing input prices, especially fuelcosts,” ), or changing input prices, especially fuel

Real benefits arise from lower costs due to increased Real benefits arise from lower costs due to increased efficiency (short- to medium-run) and better efficiency (short- to medium-run) and better investment decisions (long-run)investment decisions (long-run)

Evidence on operating efficiency at existing generating Evidence on operating efficiency at existing generating plants is positive.plants is positive.

Additional efficiency gains possible through:Additional efficiency gains possible through: More efficient long-term (capital) investment.More efficient long-term (capital) investment. Incentive regulation for transmission and distribution.Incentive regulation for transmission and distribution.