Monday, July 25, 2005

Same Problem, similar solutions

Earlier last month, I wrote about interruptions in electricity supply in Russia and this week a similar problem is expected to emerge in Boston, USA. Similar disenchantment with Adam Smith (why does he always get blamed?) is expressed, yet the same remedies are available.

In an Editorial piece in the "Boston Globe", under the heading "Electricity Overlord", we read the following:

“With deregulation, the theory went, enterprising power producers would foresee a shortage and, on their own, build or expand plants to fill the market need.
The theory hasn't worked.

Gordon van Welie, chief executive of the ISO, or independent system operator, that oversees New England's electricity system, fears that the region could face brownouts by 2008 unless new capacity is built. But, outside of the wind farm proposed for Nantucket Sound, no big projects are in the pipeline. So van Welie is trying to get approval from the Federal Energy Regulatory Commission to send a signal to power producers by raising rates, with special bonuses going to producers in areas like Boston and southwestern Connecticut that are underserved with transmission lines.

The problem, as Massachusetts Attorney General Thomas F. Reilly and the other five New England states' consumer defenders have pointed out, is that this could cost regional ratepayers as much as $13 billion over five years. The high cost of the plan has also earned the opposition of the Energy Consortium, a group of large power users. Moreover, there is no guarantee that any new plants actually will be brought on line.

There has to be a better way, and there is. ISO New England should conduct an auction in which power generators are invited to bid for the right to supply the new capacity, with the award going to the firm willing to do it for the lowest increase in rates. If this looks like a partial return to the old days of the regulated market, so be it. The ISO's top-down imposition of a rate increase that would raise Bostonians' bills by 21 percent by 2010 (on top of fuel costs) does not come out of Adam Smith's free-market playbook, either.”

In the tussle between Regulation of power companies and total Deregulation there is something forgotten, which Adam Smith would have reminded his readers if he had been writing about a similar problem. At root of the problem is the lack of re-investment in very expensive capital projects. In Boston those affected appear to be playing ‘pass the parcel’ to avoid footing the high cost of investing sufficient capital to avert ‘brownouts’.

In Russia, you may remember, the ‘brownouts’ were happening now, not in 2008. Commentators suggested re-nationalising electricity supply, a perhaps overly drastic response to a basic problem: suppliers, Smith would have reminded readers (accepting, of course, that Smith knew nothing of our modern dependence on ‘electricity’), were in breach with the customers they had contracted to supply their product.

If they did not invest sufficient capital to ensure delivery of what they had promised, they should be vulnerable to court fines and damages. If such fines were paid by the firms, or if they declared bankruptcy, were collected from the owners and shareholders (to the full value of their personal wealth in my opinion, given the strategic importance of electricity supply), then owners and investors in electricity supply would take due care that they met their promises by investing to avert brownouts in 2008. The extra costs would be collectible from consumers of electricity (and from consumers of products using electricity in their production). They would price accordingly.

In Boston, a similar solution would follow similar paths. The idea of an auction to select a supplier willing to undertake the most efficient solution of supplying sufficient capacity is a good one, provided that it is backed with a Smithian contract to secure their promises against their corporate (and, in extremis, their personal) wealth.

Smith did not advocate ‘free markets’ in all cases. In Book V, “Wealth of Nations”, he clearly stated that where necessary civil projects could not be afforded by private individuals they should be funded by the State. Today, electricity supplies are in the same category as the 18th-century roads, harbours and canals of Smith’s day. How they are managed (state versus private) and how they are charged (Smith preferred they should be paid for by users) was left open to practical solutions based on utility (i.e., which methods worked?). His precepts remain relevant today.


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