June 6, 2022

The Most Reliable Part of the Energy System: Politicized Criticism of its Unreliability

Summer hasn’t even started and we’re already hearing warnings of impending power shortages.  Of course, everything these days is in short supply except editorial page political diatribes placing blame.  Not being experts on baby formula, we will stick with the energy system and attempt to shed some light on the underlying issues causing energy in general and electric power in particular to run so low on spare capacity.

The simple answer: the business cycle.

Most everyone understands that oil and natural gas are cyclical commodities produced primarily by privately owned companies, many of which are publicly traded.  Our March 17th Insight, The Energy Blame Game and Other False Narratives, presented the data about where we are on that boom-bust cycle.

The electric power market is more complex because it is made up of two parts: a cyclical merchant power generation market and a regulated transmission and distribution system. The regulated part is a complex patchwork of entities regulated primarily at the state level, three-quarters of which are owned by investors and the rest being owned by municipalities and special districts.  This construct is unique in our economy, and it presents a complex but, in our opinion, remarkably well-run hybrid system.  It’s a hybrid because the regulated entities are granted monopolies in return for three basic things: a limit to what they can charge (essentially the sum of their costs including a return on equity for the owners), an obligation to serve anyone and everyone who wants electric power, and a requirement that their poles, wires, transformers, etc. be held open as a common carrier to any supplier.

That’s where the hybrid part comes in.  Companies that own unregulated merchant power generation assets bid into the wholesale market at one of thousands of delivery points on the grid and earn a profit on the spread between their costs and the wholesale market price for electric power. These merchant providers have no obligation to serve nor an obligation to be available 24/7.  Like virtually all businesses they simply have an obligation to obey the law and make a profit for their investors and when they can’t do the latter, they close or sell the power plant.

Now that explanation of about 250 words exceeds the 280-character limit on Twitter as well as the attention span of the average voter who just wants the lights to go on when they flip the switch. They gripe to their elected officials when the lights go out and the elected officials gripe to the regulated utilities who in many cases have no control over those who provide the power. Meanwhile, the unregulated merchant generators who provide much of the power have no obligation to maintain a surplus.  And therein lies the rub.

In the beginning, power generation was part of the regulated utility monopoly along with the poles and wires.  Cost overruns in the 1970s and 1980s led large industrial customers to begin making their own power for less than they could purchase it from the utility. This led to a negative feedback loop where the remaining consumers who lacked this option bore a larger and larger portion of the fixed costs.  De-regulation of electric power was the policy solution and from a cost standpoint was an overwhelming success.  In the early 1980s, before there was a true wholesale market for electricity, the largest industrial customers paid about 5-6 cents per kilowatt hour[1].  Adjusted for inflation, that’s 14-17 cents today, about three times the average wholesale price for the last five years[2].   But the competition that drove down those costs has made the merchant power business unprofitable for many of the players, leading to a withdrawal of investor capital and the closure of older, large power plants that cannot profitably extend their useful life.

As deregulation unfolded in the early 1990’s, each state faced a choice as to whether the legacy power generation assets owned by the utilities would stay as part of an integrated utility regulated asset base or be spun into the merchant market.  Today, just over 60%[3] of electric power is provided by integrated utilities, like Florida Power & Light and Georgia Power that operate under cost-plus monopoly regulation.  For these companies, the cost of maintaining surplus capacity (that’s typically needed less than 5%[4] of the time) is recovered under their cost-plus regulated tariffs as their power plants are embedded in the regulated “rate base.”  How then do we incentivize the other (roughly) 40% of our power generation run by the merchant power generators to maintain a surplus without losing the cost efficiencies gained by de-regulation?

That is the $64,000 question to which there is no simple answer.  One could argue that this is an issue facing many industries now that the long, thin, highly efficient supply chains that evolved over the last 40 years are showing the disruptive strains of COVID 19 and a war because they too lack an incentive for investors to build and hold surplus capacity, and they too failed to anticipate a global pandemic and a Russian invasion that in hindsight would have made the surplus a good investment.

But other industries lack the hybrid market construct we have in electric power and natural gas. One of the tools this hybrid system has developed in some areas of our country is auction-based markets for surplus capacity, whereby power generators are provided an economic incentive, determined by the marketplace, for holding surplus capacity that may only be needed less than 5% of the time.  But markets are not perfect in their construction and are distorted by incentives for different kinds of power, and like all markets they lack an ability to predict the future.  It is nonetheless a tool whose rules and pricing could be tweaked until a larger cushion of surplus capacity is established. And places without these capacity auctions, like Texas, could establish them.

As investors, we have largely sought to avoid merchant businesses of all kinds and have generally run a portfolio dominated by natural and legal regulated monopoly energy infrastructure.  We have that choice. We have the choice not to commit capital to a cyclical business with poor returns on capital.  But society needs the products produced by those businesses and policy interventions in markets to change the supply and demand dynamics risk doing more harm than good.  Nonetheless, intervention that does not change the calculus of risk-averse investors like us are unlikely to attract needed capital and therefore unlikely to succeed.  And if new capital is formed how will regulators protect consumers from the moral hazard of over building?  We don’t have all the answers, but we do believe that outcome-driven economic incentives – both in the regulated and unregulated parts of the system – are one method worthy of further consideration.

So, while the editorial and Op-Ed pages are full of criticism and defense of intermittent wind and solar power, remember these businesses are simply taking the tax incentives offered and bidding into wholesale markets that do not require them to offer their electrons 24/7.  And they aren’t the only energy suppliers taking tax incentives.  Early shale producers took tax incentives until shale drilling became profitable. Nuclear power would never have happened without billions of government-funded R&D and is today receiving state-level incentives to keep plants running because they’re not being compensated in the market for the around-the-clock, resilient, and carbon-free power they provide.  And let’s not forget recent attempts to save coal.

Some might argue that all these incentives are the problem, as they create distortions in market signals that ultimately cost consumers even more.  Perhaps, but it is difficult to imagine the shale revolution without the Section 29 tax credits used by Mitchell Energy in the Barnett Shale.  It is difficult to imagine a nuclear power industry without a partnership with the U.S. government. But even if politicians all changed their spots and resisted the temptation of offering tax incentives for those who help fund their campaigns, we would be left with a pure, free market system that still would have little incentive to provide surplus capacity to protect against either the boom-bust business cycle or disruptive events that are always predicted to be few and far between; yet keep happening.

[1] Source:  EIA, Annual Energy Outlook 2011, page 255.
[2] Bloomberg CPI Index.
[3] Source:  EIA, Bloomberg, EIP estimates.
[4] EIP estimates.

The above is Energy Income Partner LLC’s (EIP) opinion and such opinions may change without notice or duty to update. The information is based on data obtained from third party publicly available sources that EIP believes to be reliable, but EIP has not independently verified and cannot warrant the accuracy of such information. References to a particular company or funds are for informational purposes only and are not an offer to purchase or sell or a solicitation to purchase or sell a particular security, company or fund.

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