I was raised in Louisville, Kentucky. My father and mother were socially progressive for their time. One was never allowed to use a racial epithet. My father, a state Senator, sponsored or co-sponsored legislation to advance civil rights and the environment. When I went to Columbia University as an undergraduate, I had no problem adapting to the liberal social environment. New York City in the late 1970s and early 1980s was an exciting brew of cultures.
However, like many an undergraduate, I sought ways to distinguish myself. Surrounded by so many Northeasterners, I leaned into my Southern roots.. Aside from professing a love of Bourbon, the Allman Brothers and Lynyrd Skynyrd, I had a Confederate flag in my dorm room. Stupid, in retrospect? Sure. But it was 1982 and I was young and, even though I was a history major, I did not appreciate what that flag symbolized to other people. I was wrong, of course, but how long-lived are the consequences for that mistake? If I were now an elected official of a high enough level, and this came out, could my explanation and apology for youthful insensitivity be accepted? Could my record as an adult be judged rather than my college years?
Missed price signals – short-run mistakes with long-run consequences
I thought about the perils of rushing to judgement and the risk of mistakes with long-lasting consequences when I got a call from a reporter on a case before the CPUC on Natural Gas that occurred last summer. You may recall that in late July, SoCal gas spiked and penalties put in place to ensure reliability were invoked. These “OFOs” (Operational Flow Orders) and associated penalties provide incentives to keep a pipeline reliable. So, when the reporter asked if Southern California Edison’s request to reduce OFO penalties was justified simply because the penalties “raise prices,” I was surprised. Of course it would raise prices – that is the point! The penalty serves as a price signal indicating that natural gas is scarce. Those high prices provide incentive to conserve.
Dampening the price signal in this instance would lead to second-order problems. Many market participants make hedging arrangements that would be undermined if penalties are cancelled or altered. Participants will cease to make those hedging arrangements in the future since the basis of making contract determinations is not to be trusted. If that happens, prices over time rise as the market for supply shrinks because there is no way to trust the market signals – the “fundamentals.”
Advanced economies long-ago determined that prices will lead to a disciplined behavior that would not exist without them. Prices – in the short run – indicate that the market participants or operator must take action. In the long run, prices indicate the need for system upgrades, investment, or accessing new supplies. But the drumbeat in many regulatory quarters against “high prices” and suspicion of “the market” has become so pervasive that a trade reporter asks if a proposal to suspend OFO penalties is justified to avoid high prices? Rather the reporter should ask whether the price signal offered by the penalty helps ensure reliability and economic efficiency? But the underlying predicate – that prices honestly derived in a competitive market – achieve the best solution both in the short-term and over time, seems lost.
Carbon pricing – case in point
The lesson of price signals has not escaped those who wish to promote carbon reduction. We know that a carbon cost – whether an outright tax or a more subtle cap-and-trade program – will cause those that emit offending carbon to increase prices. This, in turn, makes production of less noxious resources more economical. As my favorite new publication, The Economist would say, this is the “non-hairshirted” approach to environmentalism. Nevertheless, even this approach normally leads to higher prices, at least in the short run.
The question has been this: can we allow high prices in the name of driving behavior? Do we need to hide the high prices so that the result is not too transparent as to become unpopular? This may have been one of the attractions of “renewable portfolio standards.” Regulators push the procurement of resources through requirements on the utility and, voila! You get renewable energy to order. No muss, no fuss.
The problem is that to meet the requirements, utilities have entered into contracts that span for multiple years, even as prices have fallen. Unlike generation built to compete in a market that moves and is “marked to market,” the contracts can get more and more expensive in relation to the marginal price in a market like CAISO. That is because CAISO is reflecting the cost as the market develops, not at the cost that was “anticipated” over the course of years and baked into the contract. If the utility runs into financial trouble, the regulator must find a way to stand by the utility. Otherwise, debt holders can call contracts that are “out of market” into question, even if the utility does not reach the point of bankruptcy.
PG&E is an example of this scenario, but so are bets made by big utilities in the East on nuclear power or Clean Coal in the last decade. In fact, the entire effort of moving to power markets in the 1990s was driven by bad utility investments of the 1970s and 1980s abetted by well-meaning regulators without the discipline of a market. As we wish to move to cleaner power, we risk making the same mistakes because sometimes markets “raise prices.” Failing to respect price signals now can lead to inefficient and untenable outcomes for decades. We can move to clean energy, but competitive markets should be allowed to work. Building economic incentives rather than hiding the costs in an “order” to procure renewable resources will make the transition as inexpensive as possible.