A critical assessment of electricity and natural gas deregulation

Journal of Economic Issues, June, 2008 by Harry M. Trebing

In the past, some state commissions promoted demand side management and integrated resource planning to reduce fossil fuel consumption and thereby indirectly control carbon dioxide associated with coal generation. After the Kyoto Protocol Treaty a cap-trade model evolved that attempted to control carbon dioxide directly by introducing a ceiling or cap on emissions and the distribution of tradable emissions credits to relevant parties. Firms with pollution levels below the cap would have excess emission credits that could be traded or saved. Firms with pollution levels above the cap would acquire additional credits or reduce energy output.

The United States was very cautious about coming to grips with carbon dioxide pollution control; however, popular pressure has grown to a point where action appears to be forthcoming. This will probably take the form of adopting the cap-trade model. It is praised because it introduces choice by allowing individual participants to determine what method they choose to reduce their emissions levels.

There are five significant deficiencies associated with the cap-trade model. First, "hot spots" can occur when a polluter chooses to buy emissions credits rather than install pollution control equipment. This can impose significant social costs. If government intervenes to mandate investment in pollution control, then it will violate the cap-trade concept. Second, the estimation of the ceiling cap is by no means infallible. Third, the cap-trade model is ineffectual in dealing with mercury contamination. Fourth, arbitrary political judgments may arise when emission credits are distributed or when ceilings are imposed to curtail the price of emissions credits. (13) Fifth, the cap-trade model does not impose a market-based constraint on the cost of solving the pollution problem, nor does it prevent risk shifting. New entrants producing renewable energy are not low-cost suppliers when compared to coal or natural gas. (14) These firms will not enter without federal and state subsidies. At the same time, there is a strong indication that utility share-holders will be able to shift risk associated with renewables to consumers. This is done through revenue decoupling, which breaks the link between utility revenue requirements and sales. If sales decline, then revenue decoupling keeps revenues and earnings at the level prescribed by the regulator. Even in the absence of regulation, it is reasonable to assume that a dominant utility would employ a variant of revenue decoupling to maintain its earnings. In addition, when utilities build coal fired plants with expensive technologies to control C[O.sup.2] emissions, they typically insist that this investment must be risk free over the life of the asset, with no adjustments to revenue requirements. Again, all risk would be shifted to consumers.

Conclusion

The interaction of market power and market failure necessitates a return to an augmented Institutionalist model of regulation. When market dominance exists, price-earnings regulation would be applied to the dominant firm or to the relevant sector of the market. When oligopoly exists, regulators would impose all of the reporting requirements needed to detect price leadership and collusive behavior.