October 2000

Big Bang Bungle

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2000/11)

Federal legislation crashed and burned. One California newspaper headline was "Deregulation Sucks"; the State legislature subsequently concurred. The leading State utilities declared that the regulatory regimen had resulted in losses which could bankrupt them. The stolid New York Times proclaimed a dwindling faith in deregulation and began to explore re-regulatory options. Time to ask where we go from here. Perhaps we should be influenced by how we got here. The mindset of those who brought us to this dance should be avoided if the deregulation saga is to have a happy ending. Deregulation as psychodrama; regulatory reform as therapy. Here’s why….

It would be neo-Freudian to suggest that the economist sages who coached the dismantling of the two great regulated industrial megaliths of the last century – Soviet Russia and the US Power industry – are motivated subconsciously more by machismo as much as by common sense. The "Big Bang" theory of privatization/deregulation was that very little will happen in an economic structure without bold change. Its name may have been meant by these sages to draw analogy to cosmologist’s theory of universal creation; neo-Freudians will recognize it as an expression of the James Bond like aspirations of intellectuals. What was their collective subconscious thinking? In each restructuring case we have seen sweeping change undertaken in the face of great vulnerability of the economic engine in question to structural deficiencies, shortages of capacity and market fluctuations, all of which common sense and foresight could readily reveal. Ah prudency….

There are practical consequences to the power industry of the chosen manner in which deregulation was introduced. As we enter the post-Thermidor period, we now "discover" a few basic Big Bang principles:

• Deregulation in the absence of sufficient power reserve margins will result in shortages which will drive up prices.
  

• If market forces are intended to reduce the shortages, prices cannot be capped.
  

• If suppliers must meet the requirements of markets from an auction pool which is susceptible of price manipulation, the prices they pay will be higher than they would be otherwise.
  

• If suppliers can get better deals outside of the mandatory pool through bilateral contacts outside of the pool - even outside of the market it represents - they will.
  

• If power distributors are not accountable for prices to end use consumers, they will not absorb hedging risks to absorb those prices; and
  

• If gas prices increase in a deregulated environment, they will rapidly take power prices upward with them, triggering all of the "greedy" principles in the affected markets articulated above.

These are a few fallouts of the nike (Just do it!) approach, we should therefore acknowledge and take commercial cognizance of today, before it is too late:

•  If new construction to meet newly "discovered" shortages resulting from deregulation is all gas-fired, and gas prices are rising, the price of power may not fall anywhere nearly as far as deregulation proponents expect as supply and demand come into balance.
  

•  If gas become pricier at the margin, and/or subject to reliability related concerns, new attention to alternative fuel mixes (notably coal and renewables) will skew current planning/forecasts pertaining to a deregulated market. Imbalances may affect projected returns on new units and ultimately may affect the development of these units.

Not only the major power generation suppliers will be affected. There may be New Economy corollaries: Online purchasing of house brand or multi-brand products, power products may lose its allure, if all it gets the customer is a choice of ridiculously high prices, it will lose its allure. (Similarly, if price spike reactivated re-regulation surges ahead, e-commerce applications for retail customers will also lose the attractiveness which they otherwise would provide.)

Since New Economy businesses are very electricity-intensive and reliability dependent, renewed focus on distributed generation applications are to be anticipated if prices continue to surge.

In short, the major widespread benefits of deregulation can be lost.

Certain political consequences may follow, relecting the resulting and inevitable skewing towards short term and populist fixes in this land of the free (lunch):

• In the absence of a Big Battery to modulate the Big Bang deregulation effect cf. a strategic petroleum reserve for electricity, the only apparent way to lower power prices from a political standpoint will be the worst way from an economic standpoint: price caps.
  

• Many more Congressional hearings will be launched. But there will be very slow progress toward consensus deregulation legislation, since the complexities in making it work, without some centralized imposition of access and standards, (similar to that in the natural gas arena) are substantial and possibly politically unacceptable.

In short, neither trying to fix the Big Bang with another big bang, or with a myriad of "bang aids" is likely to work. The way out of the Big Bungle lies in a non-macho program. Policies must create the right price signals to the private sector to construct needed transmission as well as generation assets; to properly stimulate distributed generation; and to take advantage of the negawatts created by network energy management. In short, to focus on the operating requirements which the actual electric system must meet, which is necessary to be responsive in a constructive manner to the new price signals which the Big Bangers unleashed by instituting deregulation. This is the challenge which the FERC and the next Administration must take on. In short, no more Mr. Macho Man, consciously or unconsciously.

ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon Markets Group has practiced law related to the finance of environmental and energy projects and companies for 40 years.  In particular, he has analyzed and executed a wide variety and substantial value of project financings.  He chairs the American Bar Association’s Committee on Carbon Trading and Finance, serves on the Board of the American Council for Renewable Energy, and has been a senior official in the Federal Energy Administration.  He is a graduate of Brown University, Yale Law School and Harvard Business School.