In The Karate Kid, Mr. Miyagi advises that "It is good to know karate. It is good not to know karate. It is not good to know a little karate." With the price caps now coming off in the few states that partially deregulated their electricity grids, there is a rising backlash against competitive markets, with some of that backlash even coming from normally pro-market groups like The Cato Institute. This backlashers generally argue that partial deregulation has taught us that deregulation doesn't work in the electric sector. But we ought to remember Mr. Miyagi's advice, lest we draw the wrong lessons from our little bit of karate.

This subject deserves more discussion on Grist, as evidenced by some of the debate which followed my last post. Let's take a closer look.

Critics of deregulation frequently point out the fact that the prices are higher in deregulated states than in restructured states. This makes a good sound bite, but is ultimately irrelevant, for the simple reason that prices were higher in those states before they chose to deregulate. (Indeed, high prices may well have contributed to those states' desire to try a new approach.)

Consider the following U.S. Department of Energy data: In 1992, before any state or federal deregulation was in place, the average price for power in those states that would eventually deregulate was 2.16 c/kWh higher than in those states that would remain regulated. By 2005 (the most recent year for which we have data available), prices were only 2.08 c/kWh higher in the states that deregulated in the interim. Yes, they were still higher, but on a percentage basis, the bigger price increases have been in those states that remain insulated from competitive pressure. Which means that given the underlying upward pressure on all energy costs, you're better off living in a state that chose to deregulate than one that didn't.

Perhaps the more interesting point is that those underlying price trends are increasingly affecting the coal belt -- which is essentially contiguous with those states which chose not to deregulate. This means that states that chose not to deregulate (a) have seen greater price increases, on a percentage basis, than those which did not deregulate, and (b) are particularly exposed to the next round of price shocks. The Clean Air Act made new coal plants much more expensive -- but the overbuild prior to the Clean Air Act ensured that we didn't have to build those new coal plants until very recently. Now that we've just about used up all the reserve margin in the system, regulators are forced to consider New Coal.

The prior overbuild has lulled us into a false belief that coal is cheap. The reality is that Old Coal is cheap. New Coal, which requires almost twice as much capital investment for pollution control as Old Coal, operates at 10 percent less efficiency (meaning more fuel price exposure) due to parasitic loads for pollution control and needs substantial investment in new transmission to connect to the market -- requiring a delivered retail rate of 10 c/kWh or higher to be cost competitive. If carbon legislation requires these plants to sequester their carbon, the delivered price will need to be closer to 17 c/kWh. At these prices, lots of cheaper (and cleaner) technologies make sense, and would surely be built, thereby compelling those coal plants to run fewer hours and take a massive equity penalty. No reasonable investor would pursue this path.

Here's the rub: regulated power markets are not dominated by reasonable investors. They are dominated by vertically integrated monopolies who need not build competitive plants -- they need only convince commissioners to guarantee their equity returns. The nuclear industry is a great example of how bad regulated markets are for your pocketbook. Whatever else one thinks of nuclear power plants, they are cheap to run, meaning that if they were owned by an economically disciplined investor, they would be run all the time. But wait: the regulated electric monopolies aren't subject to economic discipline. The more they spend, the more they get. So the nuclear fleet provides a great test of the costs of regulation. If regulatory models provided a differential incentive to preferentially deploy low-cost power sources, we'd expect it in nuclear fleet data. Let's look:

The DOE provides exhaustive data on the installed capacity (MW) and total generation (MWh) by state and by fuel type throughout the U.S. Taking this data, one can readily calculate the capacity factor of the nuclear fleet by state (that is, the total MWh, divided by the MWh that would be generated if the plant ran flat out, all year long). The top four highest fleet capacity factors? Massachusetts, Maryland, California, and Illinois (average CF = 94 percent). All are deregulated, though California only partially. The bottom four lowest fleet capacity factors? Alabama, Arizona, Wisconsin, and Missouri (average CF = 71 percent). With the exception of Arizona, all are insulated from competition.

Nationwide, the average is 81 to 85 percent in favor of deregulated states, meaning that if you live in a regulated state, your utility is burning coal or gas at the expense of nuclear, and charging you for the difference. This is but one window into the story, but it is a story of overwhelming economic inefficiency on the part of regulated utilities. Expanding beyond nuclear, it means that so long as we remain shackled by the current regulatory paradigm, we should not assume that our electric utilities will preferentially deploy the cheapest generation. The economic benefits of energy efficiency or renewables not only don't matter to regulated utilities, they actually cost them money!

And these are precisely the vertically-integrated monopolies that Cato and their ilk suggest would be good for the economy. A little karate indeed.

The good thing is that there is a better way. Instead of drawing the wrong lesson from our little bit of upstream karate, let's extend the successes we have already seen in the deregulated states down to the retail level. At the load, customers can install on-site power plants that use low-cost opportunity fuels which cannot be cost-effectively collected and transported to central power stations. These customers can also recover waste heat from power plants that would displace other fuel use, enabling double or triple the overall power plant efficiency (and interestingly, returning to the efficiency levels the power industry achieved in 1910, before the current regulatory regime removed their incentive to conserve).

Where Cato suggests that "transmission and generation are substitutes for one another," these local plants actually displace transmission, cutting way back on the amount of capital that is presently being guaranteed by utility ratepayers. But getting this capital deployed first requires that we open up markets at the load side of the wire. The customer who tries to install that power plant today has no route to market except through the monopoly utility's wire. In 13 states, a third party who tried to build that plant and sell electricity to the host would run afoul of utility regulations that only allow the states' regulated utilities to sell kilowatt-hours. And so the plants don't get built.

If they were built, they would lead not only to lower power costs, but also to a more reliable grid (because more generators equals less probability of system-wide disruption) and lower carbon emissions (because more efficient power plants emit less CO2). What the world needs now is more deregulation, not less.

Sean Casten
http://www.grist.org/article/a-little-karate/