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Leonard Hyman & William Tilles

Leonard Hyman & William Tilles

Leonard S. Hyman is an economist and financial analyst specializing in the energy sector. He headed utility equity research at a major brokerage house and…

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Four Big Mistakes in Deregulating the Electricity Industry

  • The champions of deregulation also ignored the cost of capital.
  • Architects of deregulation focused too much on cost savings.
  • The deregulators made assumptions based on a simple neoliberal market model.
Grid Edison

When policymakers both here and abroad deregulated and restructured the electricity industry they made four big mistakes. And we are still living with them.   

Number 1: The architects of deregulation, being economists, focused on market structure and operating savings when the big problem facing the industry was increasing capital expenditures and adjusting to climate change. They diverted attention from an existential challenge to achieve modest operating savings that rarely flowed through to consumers. They created markets that ignored externalities and equated customer welfare with the lowest price in tomorrow’s market. They wasted 25 plus years during which they could have readied the industry for growth and a threat it knew about, at a low cost because borrowing costs were then at 800 year lows! Now consumers will pay more not only due to higher capital costs on the equipment electricity suppliers will have to install but also for all the prematurely obsolescent plant that the industry built in the meantime, which it will have to retire prematurely.  

Number 2: The champions of deregulation also ignored the cost of capital. Theory tells us that as business or financial risk increases so does cost of capital. By introducing competition and breaking up the companies, policymakers raised the risk of investment and, therefore, the cost of capital, possibly by one third. After-tax cost of capital makes up 15%-20% of the typical consumer's electric bill now. In short, increased cost of capital may have offset a substantial portion of savings from efficiencies encouraged by competition. Moreover, cost of capital’s portion of the electric bill will go even higher as the industry puts greater emphasis on non-carbon fuel generation. Deregulation, therefore, probably adds to the cost of decarbonization. Related: High Interest Rates Could Slow Down the Energy Transition

Number 3: The deregulators made assumptions based on a simple neoliberal market model that ignored the complications of life. They ignored transaction costs, which multiplied once they broke up the industry. They ignored the importance of contracts which might have reduced capital costs. They ignored noneconomic incentives, with the result that serving the public gave way to gaming the system for maximum profit. They thought that they could design a market that would function in a way to encourage investment, keep margins down and give the public a reliable product into the distant future. Unfortunately, whatever savings achieved by generation efficiencies appear to have been swallowed up by a rise in other costs (or profits).

Number 4. Especially in the UK, they thought that “light-handed” regulators could ride herd over a multiplicity of generators, power brokers, commodity speculators, retailers, market operators, transmission and distribution firms, most of whom had more and better market information than the regulator. They really believed, too, that there was a clear divide between regulated and unregulated operations, a half free and half regulated market. And that belief hampered competition between the two sectors. Proponents of deregulation ignored the reality of powerful, well-heeled lobbyists always at work to thwart them, too. As a result, executives and providers of capital earned excess profits and consumers paid too much.  

None of these observations are novel anymore. But they are more relevant in light of current conditions. Big potential electricity users, like data centers for AI, fear that the grid lacks the capacity to serve them. Transmission lines, designed to carry power long distances, are proving increasingly precarious due to multiplying wildfires. Electric vehicle buyers want easy access to charging stations which also necessitates expensive grid upgrades. Electric industry capital spending is rising, but in our view, it is nowhere fast enough. Global temperatures and weather anomalies are increasing faster than anticipated. So, with power costs rising, reliability in question, demand up perhaps sharply, and the utility operating environment becoming more threatening due to climate uncertainty, why perpetuate a subpar, free market structure that makes solutions more uncertain and more expensive? Just a thought.

By Leonard Hyman and William Tilles for Oilprice.com

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