Markets Need Customers

The average electricity customer has fled from electricity restructuring, returned
to the utility from competitive suppliers, and voted for politicians who kill
restructuring. The experts say, “The customers just don’t understand, but it doesn’t
matter. Once we get the wholesale market right, everything will fall into place.”

Of course, in real markets, when the consumer walks away from a product offering,
that means that something is wrong with the product. In the strange world of
electricity restructuring,the experts tell us that something is wrong with the
customer. “As for the near-bankrupt power producers and marketers, that’s what
happens in a cyclical business,” they say. “There’s nothing wrong with the model.”

However, maybe the customer doesn’t see a product worth buying. Maybe the supply-side
debacle, in part, came about because of the disconnect between customers and
suppliers. Maybe one cannot create a functionally competitive market in which
only sellers can see and respond to price.

It Started in the United Kingdom

In the late 1980s, the Thatcher government decided to privatize the British
electricity supply industry. The government hired an army of American and British
consultants to develop the model. Once done in the United Kingdom, those consultants
then spread the model around the world, even before anyone could show that the
model produced benefits for the public.

The British divided the industry into generation, transmission, distribution
(local wires), and supply (sale of the energy to the public). The generators
sold their electricity into a central pool, which selected generators in order
of price offered, but it paid all the generators the price it had to pay to
the last generator chosen (the highest price). The big buyers of electricity
(such as industrial firms or local sellers to consumers) took their electricity
from the pool, but they had the ability to make all sorts of side deals that
protected them from price fluctuations.

The pool model suffered from two serious flaws. First, an oligopoly controlled
generation. Second, consumers could provide no input to the market about how
much electricity they wanted to take, given a schedule or prices. When you put
a small number of sellers into a one-sided (seller only) market, you create
the right conditions for collusive bidding, gaming the market, and higher-than-competitive
prices. That is the market model we have embraced, even though the British not
only had problems with it before California stole the idea from them, but also
abolished the pool in 2000 in order to try something else.

What did the British actually accomplish? They showed that citizens and governments
can make big money via privatizations and that stifled government bureaucracies
can transform themselves into innovative enterprises. They did not demonstrate
that industry structure and pool would produce significant benefits to consumers.

Real Savings?

From 1990 to 2000, the real price of electricity fell roughly 3 to 4 percent
per year, an impressive decrease. But if you delve into the ways that the U.K.
electric industry saved money, you find that the bulk of the savings came from
measures that any reasonably intelligent nonpolitical management would have
taken to run a competitive enterprise no matter what the structure or ownership
of the industry. The companies stopped buying overpriced British coal, canceled
construction of unnecessary and expensive nuclear and coal facilities, made
existing nuclear plants run better, cut staff, and built efficient facilities
that burned economical fuels. Requiring the industry to run efficiently and
make normal commercial decisions probably accounted for half the real price
reduction in electric bills.

In other words, taking out the impact of what the industry should have done
anyway if it had put its customers ahead of its political obligations, the real
price of electricity declined approximately 2 percent per year from 1990 to
2000. Still impressive, except that the old, inefficient industry managed to
reduce real prices 1.5 percent per year in the previous decade. Interestingly,
the real price of electricity fell 10 percent in 2001, the first year without
the pool.

British suppliers have begun to build up a customer base, although still not
providing the kind of price interaction that would truly integrate customers
in the market. And the British generators, in some cases, have begun to accumulate
their own customers. (Remember, though, that taking on customers is not the
same as re-verticalizing the business. Customers nowadays can take a walk if
they don’t like prices or offerings.)

So far, it looks as if the British did a good job of encouraging electricity
suppliers to run more efficiently, but they did not change the way people buy
or sell electricity. And it is unclear what their one-sided market accomplished,
otherwise, which may explain why they dumped it but not why we adopted it.

Start With the Customer?

In the United States, policymakers focused on a process that placated special
interest groups (“stakeholders” to the politically correct) and produced short-term
political benefits. Management guru Peter Drucker, however, pointed out that
successful businesses design the product first, after which they design the
manufacturing process. That’s what McDonald’s did to the lowly hamburger. Drucker
warned, too, against innovating on a grand scale. Politicians, however, have
pressed forward to create huge markets quickly. Manufacturers usually test-market
their products to obtain consumer input before launching a full-scale effort.

Experimental economics (for which Vernon Smith won the Nobel Price in 2002)
permits the test of market designs ahead of implementation. Policymakers have
preferred expert testimony and back-room negotiations to testing, though. Finally,
Drucker advised that for innovation to work, somebody has to be in charge and
held responsible. The planned structure puts up to six entities in charge of
one or more parts of the planning and execution of the restructuring process,
with none charged with getting an economically priced, reliable end product
to the customer.

The optimists argue that we will eventually get it right, but they are setting
up regional transmission organizations (RTOs) — semi-governmental agencies
— to manage markets according to detailed rules prescribed by federal regulators.
(California also set up a semi-governmental agency to manage markets according
to detailed prescribed rules, of course.) Drucker warned that public service
institutions acquire constituencies that oppose change, which bodes ill for
any efforts to move to a better structure.

Ignored Customers

If you peruse the thousand or more pages of federal orders and proposals for
rulemaking, discussions about the customer only exceed in number the discussions
of sadomasochism. That is because nobody deals with the customer as the final
destination of the chain of products and services. Generators sell into a market,
and the higher the price the better. The regulators haven’t figured out how
to incentivize nonprofit RTOs to operate the network in a way that would reduce
costs to the ultimate customer. The transmission owners collect a return based
on assets, not service. The local distribution company, in many places, has
been reduced to the role of a delivery vehicle for someone else’s electricity,
or, in addition, that of an agent who procures electricity for consumers at
market prices or prices set by regulators.

Admittedly, energy service companies do try to find low-cost supplies and provide
custom pricing packages for their customers, largely the big users. But those
companies have not figured out how to make a profit serving small residential
and commercial customers, who take more than 40 percentof the electricity and
who constitute most of the customers by number. These people have seen little
or no benefit from restructuring other than politically mandated rate cuts financed
by bond issues that those consumers will have to pay for, with interest, later
on. Most of them rely on the local distribution utility’s provider of last resort
(POLR) service for their electricity. The utility may make no profit on that
service and has no incentive to do anything for the customer.

This setup not only strands customers but also creates risks for suppliers,
because no supplier in the chain can be certain that another supplier will continue
to furnish at the service level and the price necessary to keep the customer
satisfied.

A recent survey claimed that consumer “awareness” of electric competition has
hit a six-year low, implying that dim-witted consumers cannot comprehend the
manifest benefits to them of electric restructuring. Maybe, instead, we should
remember that the customer is always right and maybe does not see any benefits
in the current situation because there aren’t any.

Back to Basics

So far, electricity restructuring in the United States has produced blackouts
in California; the financial collapse of the market participants supposed to
lead the way; price controls; criminal prosecutions; big fees for consultants,
bankers, and lawyers; and a monumental disinterest on the part of those who
were supposed to benefit from the process. At least in the United Kingdom, what
the consumers overpaid because of defects in the new market they collected back
from the higher prices of the electric stocks they had bought during the privatization.
No such luck in the United States.

What was the problem in the first place? Vernon Smith makes a persuasive case
that utility regulation, which requires that the utility meet any demand put
on it, combined with pricing that did not distinguish between peak and off-peak
usage, fostered the development of an industry whose plant stood idle for much
of the time. (The load factor, or ratio of average load to peak load has hovered
around 60 percent for decades in the United States. Roughly speaking, 40 percent
of plant sits idle most of the time.)

In addition, the prevalent pricing policy forced off-peak consumers to subsidize
on-peak customers. (Costs were higher at peak, but not prices.) To tackle the
problem, the restructuring process must address pricing first in order to encourage
customers to control demand at peak periods, so that the utility would not have
to carry so much idle plant. Without customer action, nothing happens no matter
who owns the power plants or how they sell the power into the pool.

Customer advocates object to this line of reasoning. They argue that customers
do not want a pricing system that charges more when costs are higher, or that
not enough customers will respond to price changes, or that time-of-use pricing
will lead to high bills, or that needy organizations such as hospitals that
cannot trim demand will face enormous charges. Those arguments miss the point.
Studies show that moving a small percentage of load off of peak will exert a
tremendous downward influence on price. Somebody needs to make a business out
of paying those who will act when they are required to act, so that less flexible
electricity consumers can avoid stiff peak charges, and not just during emergency
situations when the regional transmission organization seeks help.

End Users

Most customers probably do not care whether they take electricity from a distant
power plant or a nearby generator; whether the price hike comes about because
of congestion in the transmission network or because of an increase in natural
gas fuel prices; or whether a failure in service comes about because a generator
broke down or because a truck hit the nearby utility pole. Under the new system,
nobody is in charge of the total quality of service or total price to the end
use customer.

Transmission entities could conceivably focus on the service level and costs
desired by the end use customer, but they don’t get paid to do that. The distribution
entity could configure its network in a way that reduces its costs or pressures
the transmission and generation organizations to lower their prices. But regulators
prohibit it from engaging in certain cost-effective activities, want to keep
the distributors as passive conduits, and set profit limits based on investment
rather than customer welfare. Ideally, policymakers would like to espy the unsullied
knight on white charger come over the horizon, announce “Young Lochinvar is
come out of the West,” and hand the benumbed consumers to the new entity.

But that will not happen. Nobody wants those consumers because nobody can make
money selling to them the same electricity as the utility unless the regulator
jacks up the price charged by the utility. So why not face up to reality and
tell the utility to make a business out of providing whatever energy services
the consumers want at the best price possible. Competitors may complain that
the local utility has an unfair cost advantage. That’s another way of saying
that the competitors have to charge more to offer the same service. How do consumers
benefit from that sort of competition?

In short, policymakers should: make one firm responsible for the end price
and total service for those consumers who do not opt out; pay that firm based
on how well it satisfies the needs of the consumers (as defined by the consumers);
and let it do whatever it has to do (legally, that is) to satisfy that mandate.

Constructing a competitive market without input from customers seems a pointless
exercise. Even worse, the construction may not work.