Saturday, October 29, 2011

Peter Navarro on the Failure of Regulating Electric Utility Companies

Peter Navarro is a famous economist who has written numerous books and given multiple lectures on economics. (Note that you can download his lectures on economics for free from his website.)
He got his start working for the Department of Energy, studying why electric utilities continued to use high-priced oil in power plants, even after the Arab Oil Embargo of  1973-74. In this post, I will be summarizing and analyzing a book he wrote in 1985 titled "The Dimming of America: The Real Cost of Electric Utility Regulatory Failure," because I think that understanding how best to regulate the generation, transmission and distribution of electricity is one crucial way for our to grow our economy. The reason that I'm analyzing a book written in 1985 is that this book gives a series of 'lessons learned' and 'policy suggetions' that apply to today's world just as much as they did in 1985. In fact, the California Energy Crisis of ~2001 can in large part  be understood by comprehending the  basic theme of Navarro's book, "Regulating electric utilities so that they can not pass on increased costs to customers will cause an increase in electric shortages and blackouts." It's a pretty straightforward theme, and the book shows why regulating the price that a public utility can charge for electricity will eventually cause electricity shortages and blackouts. (Note: the same can be said for regulating the price of natural gas...as was done between 1938 and the mid-1980's.)

Before discussing his book, I think that it's important for you to know the inflation-adjusted price of electricity in the US for commercial customers between 1960 and 2010 in 2005 US dollars. The general trend was a decrease in prices in the 1960s, and increase in the prices in the 1970s. This was followed by a decrease in prices between 1982 and 2000, and then followed by an increase in prices between 2000 and 2008.

 


And now, we can begin by discussing Navarro's book on the failure of electricity regulation in the 1970s. He starts out by giving a history of the electricity utilities, both the good years and the bad years. The public utilities (i.e. the private companies regulated by public electricity commissions) were earning an average inflation-adjusted rate of return on investment of 6%/yr throughout the 1960's. And they were generating this rate of return on investment even while the real price of electricity was decreasing. The reason for the high ROI's even during times of decreasing prices was due to technological innovations that were increasing the rate of return on investment of electricity generation (such as improved gas and steam turbines, improved methods of extracting fossil fuels, and relatively cheap capital costs for nuclear power plants.)

This all changed in the late 1960's. Navarro points out what he sees as the four main shocks to the U.S. economy that destroyed the 6%/yr real rate of return on investment for the public utilities. The four main shocks were:
1) Inflation brought on in the late 1960's by President Lyndon Johnson's use of an inflation tax to pay for the Great Society while increasing troop levels in Vietnam. (i.e. increased spending on guns and butter, as Navarro puts it.) The inflation tax was implemented via the printing press of the Federal Reserve and U.S. Treasury.
2) Increased environmental awareness and legislation, such as the Clean Air Act.
3) Arab Oil Embargo of 1973-1974...caused a four fold increase in the price of petroleum liquids.
4) The Three Mile Island Nuclear accident of 1979 caused nuclear regulators to enforce costly increases in the upfront and reoccurring costs for a nuclear power plant.

In a nutshell, these shocks were the reason for the problems of the 70s and early 80s. As you saw above, these shocks caused an increase in the price of electricity (to all consumers, not just the commercial consumers shown above.) The problem was that the prices were controlled by the state regulators of electric utilities. Despite some prices increases that state regulators allowed, the prices that electric utilities could charge were not rising fast enough for them to make us for the increase in the costs from a) inflation b) environmental regulations c) fossil fuel increases and d) nuclear capital cost increases. Had the regulators not enforced price controls, the price of electricity would have increased more than it did in order to account for the shocks of a) through d).

While at first it might seem that price controls are good, it becomes immediately apparent that price controls have many harmful consequences. Navarro argues that rate suppression is a "net-negative-sum game" in which everybody ends up losing in the end. For example, at first it seems that price controls will be good because it prevents consumers from having to pay more for electricity. However, Navarro takes us through the steps of what actually happened in the 1970s and early 80s. (What occurred was overall harmful because there wasn't much 'fat' to trim from the internal budgets of the electric companies.)

1) Not being able to increase electricity prices to fully compensate for shocks a) through d) caused the ratings of Electric Utility Bonds by rating agencies to decrease between 1972 and 1982. For example, the average grade was an AA in 1970 and the average rating in 1982 was between an A and a BBB. The lower rating meant that the interest rate investors required to finance the building of new power plants would increase.

2) As the bond ratings decreased and the required real interest rates increased, the electric utilities canceled orders for new power plants because the electric utilities knew that they would not be able to pay back investors who demanded high returns as long as fuel prices remained high and electricity prices maintained artificially low. Another way of stating this is the following: electric utilities in the 1970s and 80s significantly decreased building new power plants because the rate of return on investment that they were allowed to recover from the construction was less than the rate of return of investment that investors could get on the stock market in general for an equally risky investment.

3) Reserve Margins decrease as the utilities were forced to generate as much revenue as possible from existing power plants in order for the company to pay back existing bond holder and equity investors. The utilities also saw decreases reserve margins because some of their oil-fired power plants were no longer economically viable (except in emergencies.) The traditional rule of thumb was a 20% reserve margin. Navarro wrote "Current [in 1985] reserve margins in California are not only below what is economic but also below the the old 20% reliability rule."  (Note: this only got worse when California regulators in the late 1990's forced price constraints while increasing demands on the utilities. The result was the blackouts in California and Enron executives getting rich during the blackouts.)

4) Demand continued to increase because the prices were maintained articifially low. As we all realize, this is unsustainable. If demand increases while supply stays the same, there will be a problem. In the short term, the price needs to increase in order to lower demand and/or incentive the building of more supply. This doesn't mean that prices will remain high. Investment might led to technologies that can eventually lower the price of electricity, but the point is that if the price is forced to remain low, then there will be a problem (unless somebody comes up with a novel power plant design that can go from the lab into construction with minimal investment of capital.) But the electric utilities would be wary of investing in R&D when the price is maintained artificially low because their main focus is paying their bond holders and equity investors with whatever funds they can bring in. The ability to pay investors was clearly a problem because the rating agencies were continuously decreasing their rating between 1972 and 1982.

5) Black outs occurred.  Examples include the 1977 blackout in New York City and eventually the California Energy Crisis of 2001. One of Navarro's main points regarding the 1977 black out was that it would have been cheaper to build in redundent supply then it was to pay for the costs of the blackout...including overtime pay to police officers, stolen merchandise from looted shops, and loss of production during down time. The cost of a blackout is so large that the cost to prevent the blackout is small in comparison.

And so we get to Navarro's main point in writing his 1985 book:  The attempts by the public utility regulators to control prices ended up doing much more damage than they prevented by following their charter of "not allowing monopolies to control prices." The black outs caused by price controls have been estimated to cost ~$300 million for the case of the New York and between $40 and $45 billion for the California electricity crisis. (Unfortunately, the links above don't give the year dollars for these estimated costs.)

Because of the damage due to blackouts as well as the fact that prices eventually decreased from their highs in ~1982, we can say the public regulators of electric companies in the 70s and 80s failed in their job of helping the public. They most likely ended up hurting the public more than if they had left the electric companies alone.

And now I'd like to end by listing Peter Navarro's main policy suggestions in 1985

1) Increase the salary of the commissioners of public utilities so that they can hire intellignet and talented regulators
2) Remove price constraints, but ensure that there are programs for the poor to adjust to possible price increases in the short term.
3) After removing price constraints, eventually deregulate the electricity generation while maintaining regulations for transmission and distribution.
4) Increase education of the public regarding electricity generation via the Department of Energy

I think that these four suggestions are still valid today. Though, as you might notice in some of my posts, I don't think that the Department of Energy does a good job of educating the public on 'energy issues.' For that manner, neither does academia or industry. The goal of this blog is to try to educate the public (as well as myself) on how to obtain a high rate of return on work invested in our electricity generating power plants.

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As an after note, I wanted to point out that, while I think that Peter Navarro is an excellent economist, speaker and writing, I don't necessary agree or disagree with his themes, conclusions, suggestions or beliefs.

In fact, I have no clue what is Peter Navarro's underlying belief system. It's really hard to figure out where he falls into the political spectrum, and it's hard to figure out what he thinks is the goal of life. (Though, it appears to be some kind of utility maximization.)

Briefly, I want to point out the main error that I've found in what Peter Navarro teaches (either in his portable professor series or in his books.)

He teaches people that there is such a thing as a business cycle. This is not backed by evidence. In fact, to the contrary, the market has proven itself to be scale free, i.e. stock market is chaotic. The stock market is neither periodic or random, but normally exhibits a "1/frequency" dependence for the power spectrum.
You can test this yourself. Take some data on the stock market and apply a FFT (i.e. a frequency analysis), and you'll find that there's no periodic cycles in the data. The economy is not like the periodic 11-yr cycle of Sun spots. So, don't blindly trust Navarro when he says that there's a business cycle.
In a stock market with a power spectrum that goes as 1/frequency, the best way to make money is to have good information, and information that other people don't already know. (and this information can't be information that was obtained illegally, i.e. insider trading.)

But this is something that Peter Navarro does a good job of communication to the public, especially in his book "If it's Raining in Brazil, Buy Starbucks." In this book, he does a good job of explaining that well-timed information can lead to you increasing your investment.
I won't buy into the idea of a business cycle, but what I suggest (if you would like to make money investing) is that a) you find information that has not been communicated to the investment community  and that has been obtained legally, b) estimate what are the secondary and tertiary impacts of this information, c) invest in those companies that will benefit from the secondary and tertiary impacts and short those companies that will be harmed by these effects.
For example, let's say that you are reading your local newspaper and it states that corn outputs are expected to be really high this year. Then you do a search on the internet and find that this information has not reached the national news media yet (just the local media.) So, you sit down and think. A large increase in the corn yields will probably cause the price of corn to decrease. But you think to yourself, the local residents have already probably already started shorting the price of corn. So, you decide to think one more step past this. If corn prices decrease, then cereal manufacturers might see increased profits and so might pig farmers because the price of corn cobs might decrease. Which companies will be harmed by low corn prices? (Perhaps you decide to short the price of wheat because you think that low corn prices will cause wheat prices to drop.)
So, you decide to invest in those companies based off of what you think are the downstream effects of the information you gather.
As Peter Lynch would say, "Invest in what you know."

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