Not a natural monopoly? Zombie generation.

The economists assure us: electrical generation is not a natural monopoly.  To this I say: “HA!” 

The grid (wires) is an acknowledged natural monopoly; the operation of generation is not separable from the operation of the grid.  Where you build generation matters.  The process by which generation siting proposals are made under the competitive framework is decoupled from the needs of the grid. 

When I study yet another zombie (stupid, won’t die) generation project conceived with no understanding of the actual electrical system’s needs and fated to end stillborn in (both thru and despite) the diligent labors of a multitude of the scarce, skilled, and scarce-skilled, it seems clear: This is no way to run a railroad.  The ineffectually windmilling arms of the proponents and reviewers of each project are generating much heat but little light.  The end result of all this misallocated expenditure?  Higher power prices for U.S. consumers, and lower productivity for the industry.  No doubt this will be seen as proof of the inappropriately depressed prices extant in U.S. regulated utility markets by the true believers in the miracle of competition, or proof of how the deregulated market is insufficiently de-regulated.  All I can say to that is: “HA!”

While I cannot demonstrate as much, the studies which purport to show that generation is not a natural monopoly MUST incompletely capture the costs imposed both on the grid and grid owners, and on the generators by the increased risk premium of merchant generation.

A simple argument: A cost-efficient electrical grid will have only a barely adequate quantity of generation associated with it.  This is often confused by the presence of generating reserves necessary to meet technical contingencies.  What this means, in short, is that on day 1 in a de-regulated market, the potential for market power exists for any generator owner.  The extent of this market power may be obscured in the short term by favorable circumstances, but scarcity rents will be available to existing plant owners.  However, physical arbitrage against such rent will not be profitable as the marginal price of new generation will be substantially higher than for existing generation.  Thus, assuming growing demand for electricity…the price of power rises.   To the market lover, this must seem all well and good.  Should not the plant owner receive the full price the market may bear, not simply the cost plus a regulated profit?  Well, that isn’t how de-regulation was sold.  More competition, we were and are told, MUST lead to LOWER prices.  Instead, it leads inexorably to higher average prices.

Some similar thoughts a few years back over at Beat the Press (

Residential and commercial rates are up even more than industrial, Tim. 

This (higher prices) is a result of many factors. Here are a couple: The price of capital is a major part of the price of generation. The cost of capital is directly associated with risk. If you build a regulated power plant, you are guaranteed a rate of return. The corresponding cost of capital is low. If you build or buy a merchant generating plant, you are NOT guaranteed a rate of return. The corresponding cost of capital is higher, therefore, the price of power is higher. 

If you run a vertically integrated utility with an obligation to serve load, the downside to shutting down a plant on the hottest day of the year is very high, you have abrogated your obligation and are likely to be subject to investigation, fine, and tinkering with your returns. Further, your operation is entirely transparent, information abounds to show whether this was an appropriate decision. Further, your price of power is fixed and does not increase with scarcity. When backup widget A fails, the CEO tells you to keep the plant on for another hour to get thru peak (“that’s why we have a backup”) 

If you run a fleet of merchant plants, you have pricing power on the hottest day of the year, and you have no reason NOT to shut down the plant when backup widget A goes out of service. No one knows whether you should or should not have shut down the plant because you have no obligation to show, produce or publish records about the internal operation of your plant. 

If you are a vertically integrated electric utility without gas production holdings, it is to your advantage to manage the cost of your gas supply on behalf of your electric customers. A dollar passed thru to a gas supplier is a dollar the PUC won’t let you earn on another part of your system. 

If you are a gas/oil company that bought up merchant power plants, a dollar additional in gas fuel costs is a dollar of additional profit under the corporate umbrella. 

If a power plant is 30 years old and owned by a regulated utility, the plant is paid for. The ratepayers are reaping the rewards of having guaranteed the payments on the plant over the past 30 years. 

If a plant is 30 years old and owned by a merchant generator, the plant WAS paid for, but the OWNERS are continuing to receive a full “market rate” (including the cost of building an alternative plant) for that power, rather than simply being paid their operating costs + a small profit. 

Smart People behind deregulation DIDNT think it would reduce rates, they thought it would improve profitability of generators. 

Posted by: benamery21 | November 14, 2007 12:20 AM  

Available generation supply in a regulated market.
The engineers who determine when to build another generation plant at a vertically integrated utility only build plants which are physically needed to meet physical demand at existing retail prices. This is sometimes confused by the discussion of various types of generation “reserves.” However, these reserves are required by physical factors. They are NOT excess supply.

Now turn all of that generation into market generation. You have a situation in which supply equals demand at the existing retail price. On day 1, every generator has market power. This market power grows each year as demand increases. Without spending a dime, the price point will increase. Because existing prices are based on the average cost of regulated generation, including fully amortized plants and no-risk interest rates, these prices are lower than the cost of new merchant generation. However, given weather variation and the presence of physical reserves, both of these factors (market power and disencentive for new generation) may be masked for a few years. 


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