Even my favorite colleagues can’t agree.
When you listen to conversations between energy economists about pretty much anything, it often feels like an episode of Debbie Downer. We find something wrong with everything – from energy efficiency policy to most carbon tax proposals. I find this highly annoying sometimes. Inspired by a discussion about community choice aggregators at the coveted Energy Institute lunch table the other day, I complained about this and challenged my colleagues to actually put down some intellectual stakes and tell us what an economist’s dream distribution utility of the future would look like. The energy sector is undergoing the possibly biggest transformation in the past 100 years and there is a lot of discussion about what institutions this brave new world would require.
Some background. Pour yourself a fresh cup. The electricity sector is not only a marvel of engineering (I think it should be designated the 8th wonder of the world), but also of economics. Here is why. There are essentially three pieces that guarantee that electrons end up in your coffee maker when you need it. Generators make electrons from fossil fuels and renewable sources of energy at power plants (some of which are now located on your roof). “Transmission” gets the electrons from the plant into your broader neighborhood through a large network of wires (above and below ground). Distribution utilities connect short wires to the long ones that lead to your house, meter your electricity (and gas, which comes through a pipe) and bill you for it. Sounds simple right? It is not.
First off, if you let one big utility operate all three branches in a reasonably sized area, and fail to regulate it, it will charge a really high price, and provide an inefficiently low amount of electricity/gas. This is the classical monopoly problem and the reason we have antitrust laws. The usual prescription– to break up the monopoly into more smaller firms– does not work here.
The nature of the infrastructure (think transmission wires and the distribution lines running down your street) requires massive up front (fixed cost) investments that two firms competing would just have to duplicate. Hence, it is cheaper for society to have a single firm provide the service and force them to charge a lower price. Thus, we usually argue that you want a monopolist, but one that is not allowed to charge the very high price it wants to charge and has to produce the desired higher output level. This is essentially called rate of return regulation and agencies like the California Public Utilities Commission are charged with making sure that utilities do not charge inefficiently high prices.
The reality is much more complex than the textbook. There are lots of generators that operate power plants and sell their electricity in a big market (the wholesale market). The cheapest electrons get sold first, then the second cheapest and so on. The last electron that gets sold is generated at a cost that the buyer of that electron is willing to pay. I am going to leave out the “thrilling” economics of transmission. Buy me three beers and I’ll explain them to you (or even better, talk to Jim Bushnell!).
So, here is the pickle. In the old days, the carbon-free sources of electricity were a lot of hydro, some wind and nukes. These generators cost a lot to build and are very cheap to operate. The rest was provided by coal, gas and some oil. These plants were cheaper to build, but cost more money to operate, since you have to pay for coal, gas and oil. Wind and sun are free. In this brave new world we are walking into, we are going to get a lot more of the latter sources of energy – high up front fixed costs and extremely low operating costs. In the long run, if we figure out reasonable amounts of low cost storage, it is possible that we will have a lot of extremely cheap clean electricity. Yet this electricity supply is possibly going to be much more variable during the day and across seasons.
The distribution utility of the future is going to buy electrons in this reordered market (mostly renewables and some fossils) and sell them to its customers. It is also going to engage in massive efforts to improve energy services. It will do this by hopefully:
- Improve the energy efficiency of its customers to deal with “peak-i-ness” of demand.
- Provide innovative (by that I mean stuff suggested by economists in the 1970s) pricing to deal with demand peakiness.
- Advocate for low social cost (counting both the production costs and the pollution they produce) generation
- Provide incentives for load shifting through storage or further behavioral interventions
The question is whether this is better done via a large behemoth distribution utility or a large number of small local providers, something like the community choice aggregators we have seen popping up in recent years. The lunch table did not agree on this one!
Senior famous energy economist #1 argued very much in favor of a small utility type model. (S)he argued that a small local utility is much better at “getting to know” its customers and at providing locally tailored pricing and energy efficiency programs. (S)he recognized that you don’t want duplicate wires running down the street, but once you eliminate the obvious overlap inefficiency, there’s not much evidence that having one firm serve huge areas is helpful.
Senior famous energy economist #2 argued very much in favor of one very large utility. The argument was a large utility through its size would be able to attract better talent, would be more effective at advocating for more efficient generation (less rooftop, more centralized solar for example), would be better at implementing large scale energy efficiency programs and would be able to offer innovative pricing structures in much the same way a smaller local CCA would. (S)he noted that many industries in today’s economy are dominated by very large companies, and we all benefit from their low costs and rapid innovation. Why is almost every Californian happy to have Amazon deliver them everything from videos to cleaning products, but we all want a local, community-based electricity provider?
This is a fascinating discussion to me and much is at stake. I have a number of questions without good answers at this point. At a larger scale there is a tension between possibly allowing retail choice (where you get to choose your distribution utility, which could be a local CCA, a CCA from another region or some other firm [mine would be called HammerTrons!]) and coordination of investment. There is a lively debate about how costly lack of perfect coordination is, with some arguing that the world will come to an end and others just shrugging their shoulders. Further, it is not clear how the regulatory planning process will affect our ability to coordinate – for better or worse.
Overall, getting the institutions right for this brave new world is key. I have had similar discussions with utilities in Germany, France and North America. We have to get to work on figuring this out. There are a number of really smart young (and old) energy economists out there, who have a much better nitty gritty understanding of the issues involved, and should insert themselves into this important debate. I look forward to powering my iPhone XV using 100% properly priced green electrons. I am intrigued by what the utility selling me these will look like.
Maximilian Auffhammer is the George Pardee Professor of International Sustainable Development at the University of California Berkeley. His fields of expertise are environmental and energy economics, with a specific focus on the impacts and regulation of climate change and air pollution.