Imagine! Your roof is leaking. You call a roofer, and ask him to fix it. Instead of asking for a quote, you suggest the following: "I will pay you 5 percent of the price of all the tools you bring, and I'll pay for whatever materials you need to fix the problem. Honestly, I really believe that's the only fair way to deal with this."
What do you think? Will the roofer bring more tools than he would have if he were receiving a flat rate? Will you end up paying more than if you had asked five different roofers to provide quotes?
Unless the roofer is overcome by moral qualms about the damage he can do to your future prosperity, he will probably bring every single somewhat relevant tool he's ever bought, as well as multiple borrowed vehicles and solar panels to decorate your roof with. And those materials? Why, his buddy happens to be in the shingle business! His products aren't great, and his prices are worse – but hey, it's not his money! And suddenly what started out as a minor nuisance has turned into a major financial burden.
Remarkably, this strategy is quite similar to the regulatory efforts in large parts of the U.S. electricity market. In most states, regulators allow power plants, owned by the same firms who own transmission networks, to charge their customers a price that reflects the sum of a given rate of return on capital investments and the cost of the fuel inputs they use.
But in the mid- to late 1990s, some states abolished that system in favor of one that separates ownership of network and electricity generating facilities. Power plants were now supposed to compete directly with one another: they provide prices at which they are willing to supply electricity, and the transmission network delivers from the cheapest available sources.
In a remarkable new research paper, newly minted University of Chicago assistant professor Steve Cicala explores the consequences of this move to what, at least in the leaking-roof context, would seem to be a more sensible regulatory framework. His findings suggest that the move to a more market-focused approach did, indeed, lead to significant efficiency gains.
Coal plants that were forced to compete on price managed to purchase cheaper coal. Not just that: remember that power plants used to be reimbursed for their capital investments. No longer -- so they started using cleaner low-sulfur coal, which made it unnecessary for them to invest heavily in capital-intensive abatement technology. What does that remind you of? Yes, the competitive roofer doesn't use his buddy's crummy materials, and doesn't install decorative solar panels when asked to just stop the roof from leaking.
The incentives facing coal plants in states that deregulated the electricity sector thus changed drastically, and the benefits they could reap from cost reductions drove them to realize massive efficiency gains. Cicala estimates that even though only a quarter of all coal-fired plants have been deregulated, the reduction in fuel cost alone amounts to about $1 billion a year. By that logic, deregulating coal plants in all states could bring savings of about $40 billion a decade, a significant sum.
Why then do so many states cling to a regulatory system that rewards bloated production configurations and overly expensive fuel? The trend toward deregulation was halted around the year 2000, mostly as a consequence of the California energy crisis. In California, deregulation was carried out in a clumsy way that pitted powerful power generation companies against retail utility firms that faced price controls. The problem with price controls? If you set prices too low, shortages arise, as toilet paper users in Cuba have known for a while.
It is quite unfortunate that a deregulatory process that has brought massive savings to parts of the country came to a stop as a consequence, and there is no reason not to resume implementation now. Due to the sheer size and importance of the energy sector, even seemingly small improvements in its functioning can bear enormous fruits, while big improvements, like the shale gas revolution, can be game-changers for the U.S. economy.
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