Do Markets Reduce Costs

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Do Markets Reduce Costs?
Assessing the Impact of Regulatory Restructuring
on the Efficiency of Electricity Generation
Nancy L. Rose MIT and NBER
COMPETE Forum November 5, 2007? Washington, DC
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Electricity markets in historical perspective

• Early industry evolution led to monopoly concerns
• Government ownership or regulation arose to limit
  firms exercise of pricing power
• Traditional rate-of-return regulation of
  investor-owned utilities (IOUs) dominated in US
• Worked well to keep prices close to costs
• But provided limited incentives to keep costs low
• Higher costs generally flowed through to
  ratepayers
• Distortion of investment incentives
• Insulation from competition reduces feedback and
  cost pressure

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

• Institutional choices balance costs/benefits of
  imperfect markets vs. imperfect regulation
• Generation and Retail Services Vertically
  disintegrate, move to markets
• Natural monopoly not relevant to current
  technologies, scale of markets in generation and
  retailing
• Recognition that cost inefficiencies entail
  first-order welfare loss
• Transmission and Distribution Incentive
  regulation
• Trade-off market power (potentially substantial
  in these sectors) and efficiency concerns
• Natural monopoly/ Network domains benefit from
  smarter regulation

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Does restructuring improve efficiency?

• This is the billion dollar question
• Theory Changes in incentives can change
  behavior
• Empirical evidence What happens?
• Focus on electricity generation

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What does restructuring do to generation?

• US 1,000 interconnected generating plants
  built and operated mainly by investor-owned
  utilities (IOUs).
• What changes in restructured regimes?
• New incentives for operation by existing owners
  (anticipatory, short- to medium-run)
• Divestitures/new owners of existing plants
  (short- to medium-run)
• Investment in new plants (long-run)

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What choices might restructuring affect?

• Start with a stylized description of what plants
  do
• To produce electricity (MWhs), plants combine
  fuel, labor, materials and capital
• This process can be described by a production
  function
• y f(F,L,M,K)

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A one-input production function
y f(F)
Electricity (MWh)
Efficient plant
Lost MWhs
Inefficient plant
Excess fuel
Fuel (Btu)
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What might change plant level

• Technical efficiency (e.g. improved heat rates)
• Input mix (e.g. substitute away from fuel)
• Cost of inputs (e.g. fuel procurement practices
  change)
• Balance between expense of preventative
  maintenance and cost of forced outages

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What might change dispatch level

• Mix of plants included in the dispatch improves
  due to expanded coordination areas ()
• Regional trading organizations may improve
  inter-regional trade and congestion management
• Mix of plants included in the dispatch worsens
  due to dispatch on price (bids) not costs (-)
• If some firms withhold capacity from the market
  to exercise market power, it will be replaced by
  power from plants that otherwise would have been
  too expensive to run.
• Mix of plants brought online improves ()

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Empirical assessment Measuring the effects of
restructuring

• We cant simply compare prices, costs or
  efficiency measures across restructured v.
  traditional regulatory environments
• Restructured states tended to have higher
  electricity prices before restructuring
• Input shocks, especially fuel prices, change
  costs over time even without restructuring
• Plant mix is different in states that have
  restructured
• We need a counterfactual What would have
  happened without restructuring?

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Empirical assessment The importance of the
counterfactual

• To measure empirical effects of restructuring,
  consider a set of efficiency measures
• X ? investment, fuel use, staffing levels, etc.
  
• Some candidate counterfactuals
• X before restructuring
• X in other parts of the world.
• X in states that arent progressing
• with restructuring quickly.

Restructuring Effect X2000 X1990
difference in differences (X2000, CA
X1990,CA) - (X2000,KY X1990,KY)
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Restructuring effects on generation efficiency

• Fabrizio, Rose and Wolfram (2007) explore whether
  impending restructuring caused existing owners
  (IOUs) to operate their plants differently.
• Difference in difference analysis
• Compare changes at large fossil IOU plants in
  restructuring states over 1980-1999 to two
  control groups
• Similar IOU plants in non-restructuring states
• Cooperatively- and publicly-owned plants
• Restructuring states are those that passed
  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) 971250-1277.
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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
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Divestiture and Efficiency

• Bushnell and Wolfram (2006) estimate that fossil
  plants have 2 lower heat rates after
  divestitures
• At current fuel prices, this amounts to 1/MWh or
  more
• At the plants that were divested, this adds up to
  savings of roughly 1 billion per year
• Barmack, Kahn, Tierney (2007) estimate nuclear
  plant capacity factors increase about 10
  post-divestiture
• Improving efficiency helps achieve environmental
  goals, especially with respect to CO2

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)
31151184.
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Markets improve the mix of plants in dispatch

• Mansur and White (2007) examine effects of PJM
  market expansion
• Centralized market replaced bilateral trading
  between PJM East and the Midwest
• Dramatic increase in volumes that flowed from
  inexpensive coal plants in the Midwest to
  Pennsylvania, New Jersey and Maryland.
• Estimated 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.
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Quantities traded Day-ahead net exports,
Midwest ? East
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Whats the bottom line on restructuring?

• Remind ourselves about the source of potential
  gains from restructured electricity markets
• Its not about short-term price effects
• That may be due to temporal shifts (from
  differences in plant age, regulatory rate base
  accounting, treatment of stranded costs, ), or
  changing input prices, especially fuel
• Real benefits arise from lower costs due to
  increased efficiency (short- to medium-run) and
  better investment decisions (long-run)
• Evidence on operating efficiency at existing
  generating plants is positive.
• Additional efficiency gains possible through
• More efficient long-term (capital) investment.
• Incentive regulation for transmission and
  distribution.