In a recent article about Ontario’s new electricity market (Policy Options, May-June 2002), John Grant points out that the privatization of Ontario’s electricity generation sector, and the opening of the market to competition, are milestones in making electricity a commodity that, like any other, is “subjected to the innovative and productive forces of competition.”
The article makes strong arguments in favour of privatization and electricity liberalization, but is not convincing when arguing that it is preferable to a revamped government monopoly solution. In fact, Grant mentions that Ontario Hydro “was successful in providing cheap and plentiful electricity.” It would have been helpful to explain why that once successful system could not prevail again.
Mr. Grant correctly emphasizes that the secret to successful deregulation of the industry is a well-developed set of market rules and substantial regulatory support. The latter has been an important component of the relative success of Pennsylvania’s electricity restructuring. However, he does not point out some of the important implications, costs and benefits of electricity deregulation, and provides no suggestions for efficiently mitigating the environmental damage caused by some energy sources used in electricity production. Many other jurisdictions in the United States and Europe have experienced unreliable supply, market price instability, and/or price increases. In all cases of deregulation worldwide (including Pennsylvania’s), it is unclear if market liberalization and privatization have indeed improved social welfare (which includes consumer surplus, producer surplus, government costs, environmental damage and the risk of nuclear accidents).
Electricity deregulation is a major change to an essential service for businesses and residents. The onus of proof that deregulation will improve the well-being of all groups, or at least will provide a net benefit to society, should be on the proponents of deregulation and privatization. Before Ontario rushes into the uncertain development of a privatized electricity market, it is crucial to evaluate all of the potential benefits and costs to all of the affected groups, and compare them to the provincial ownership solution.
The benefits of electricity deregulation are said to include more cost-efficient production due to the market pressures of competing firms. A government monopoly should act in the public interest, and, therefore, should not exert market power in the determination of prices. Government monopolies, however, sometimes fail to use inputs efficiently, and without the yardstick provided by market competition, such monopolies could operate at a less than optimal level of productivity. Private suppliers are likely to produce more efficiently (unless they are a private monopoly), but also could exert market power, if there are only a few (or one) large suppliers. This has been the experience in many newly deregulated markets, like those in the US and Britain.
A competitive market structure requires several relatively small producers, which is quite different from the current industry profile in Ontario, which has just a few suppliers with large capacities. Producers with large capacities can easily create barriers to entry for new technology producers that still need to invest in production facilities. Under the threat of entry, incumbents could invest in capacity, forcing prices to decline to a level at which entry is no longer lucrative. Suggestions to separate production facilities into smaller units do not allow for the full utilization of economies of scale and, therefore, lead to inefficient solutions. Innovation in a private market is not necessarily advantageous if it primarily consists of, for example, improving “dirty industries” instead of investing in green energy sources, or if it consists of new nuclear reactors that introduce the additional uncertainties of nuclear waste removal and the risk of nuclear accidents.
It is not clear if gains from efficiency and electricity producers’ profits will outweigh the loss in consumer surplus caused by increased market prices. A private market is likely to create barriers to entry for new suppliers, further limiting innovation. Apart from the ambiguous gains from privatization and deregulation, there are several additional costs that will definitely be incurred by most groups in society.
In order to prevent suppliers from limiting access to transmission and distribution networks, it is necessary to separate electricity generation from transmission and distribution. This vertical disintegration, however, introduces additional costs to consumers who now have to pay for the markup of independent retailers and wholesalers. Consumers will also bear the risk of fluctuating electricity prices, which depend on uncertain energy markets. Small consumers are clearly riskaverse, and will buy hedging contracts at a risk premium from retailers. In addition, consumers in Ontario will pay the Independent Electricity Market Operator (IMO) in the form of administrative charges to secure excess capacity and to avoid supply shortages. The deregulated system comprising wholesalers, retailers and various energy sources will be very confusing. Small consumers will incur substantial transaction costs in figuring out the market, shopping around and being solicited. Their opportunity cost of time should be accounted for. It might take some time for many consumers to switch, which will be another obstacle for competition to take off.
Mr. Grant favours a playing field that is as level as possible, one that does not impose a portfolio of energy sources or does not award preferred conditions to cleaner renewable energy sources. Instead, consumers are supposed to pay premiums for purchasing greener sources, which is equivalent to paying for the right to clean air. Apart from the property rights issue, economic theory and experiments have shown that the latter suggestion will lead to an underprovision of green energy sources. Some consumers will get a free ride on the generosity of other consumers that for the public good decide to buy more expensive energy. Air quality and the level of global warming are clearly public goods (or bads), and a private market will fail to supply the optimal amount of pollution unless environmental taxation or a tradeable emissions market is established. The Ontario electricity industry would be off to a distorted start if producers were not forced to account for the true social cost of their production, including environmental damage. This would result in an inefficient market outcome with the wrong energy source combinations and improper investment incentives. Once privatization has taken place, and the wrong investments have been made, it will be even more difficult for renewable sources to enter the market because incumbents, through pricing and capacity strategies, can introduce barriers to entry.
A well-designed system of rules and regulations seems essential in order to avoid the tremendous costs of the flawed liberalization attempts in other jurisdictions (e.g., California and Great Britain). Apart from the organizational costs of the regulatory framework, it would be necessary to regularly assess market power in a privatized electricity industry and for authorities to intervene if necessary. We have long witnessed the difficulty of this task with Canada’s airline industry. Additionally, environmental regulations require information about firms’ emission technologies and marginal abatement costs. Why would we want to deregulate and privatize this sector if we have to engage in difficult regulation and incur substantial regulation costs elsewhere? This seems to be a mere transfer of responsibilities and expenditures. It is also uncertain if firms will obey rules, meet emissions standards or targets, i.e. if regulation will be successful in achieving its objectives.
Furthermore, taxpayers will have to finance government bailouts for private electricity suppliers that declare bankruptcy. A competitive market requires a separation of electricity production from transmission and distribution, but the coordination of transmission and electricity generation is often important to guarantee sufficient supplies at all times (of the day, week, month and year) and to avoid excessive investment in capacities. A government owner of a fully integrated network could easily coordinate electricity production, transmission and distribution, and would save all the stated regulation and transaction costs.
The argument that deregulation and privatization of electricity generation will bring innovation and efficiency is not sufficient to restructure a major, essential industry that has many public good characteristics. In order to assess the superiority of a private market over government ownership, we need to consider all of the costs and benefits of restructuring the industry. The security of supply and stability of prices for consumers, transaction costs incurred by consumers, regulation costs and environmental impacts are crucial factors of deregulation (or re-regulation) that are often ignored.
There are no convincing economic reasons to deregulate and privatize Ontario’s electricity industry at this point. It would be a costly and risky experiment that would be better carried out in laboratory settings combined with in-depth social cost-benefit analysis. Ontario should first determine what portfolio of energy sources is best for it now and in the future. Then it is important to predict what energy source or sources would likely emerge in a private market, what investment and pricing strategies firms are likely to use, and what kind of regulation would be necessary. It might be more socially beneficial to have a well-supervised government monopoly that is accountable to an independent control board that consists of experts and representatives of all affected groups. With a government monopoly it is certain that specific energy portfolios are reached, environmental standards are met and prices are secured. A number of regulation, transaction and insurance costs could be saved at the same time. The entry of smaller producers that do not have price setting capabilities and are relatively clean (such as small-scale hydropower, wind, solar and perhaps combined cycle gas turbines) could act to control potential inefficiencies in the management of larger, government-owned production facilities.
