The Case for Regulated Monopoly in the Electric Grid

Electricity is the lifeblood of modern society. Although not a source of energy in its own right, the electrons generated by coal, oil, nuclear, solar, and countless other sources animate our devices and (quite literally) illuminate our lives. Without electricity, virtually every major innovation from the past century would be lifeless. Gone would be our lifesaving medicines, as it would be impossible to keep them fresh. Gone would be our communications technology, which has brought humanity together as never before. Our ability to bring freshwater to our households, travel hundreds of miles on a whim, or the enduring promise of computing would all be but distant memories of a glorious past if we were to lose the gift of electricity.

Therefore, it is in society’s best interest to ensure that we continue to have affordable and accessible electricity for as many people as possible. In the early 20th century, the pioneers of the electrical age devised and constructed a colossal machine to deliver power to every man, woman, and child in the United States – that system is the electrical grid. The grid is a system of transmission lines, generators, and distribution channels that was built for one purpose: move energized electrons from a central production plant to homes, businesses, and industry as efficiently as possible.

Such a system does not come cheaply. The infrastructure required cost many hundreds of billions of dollars to build, and as such constitutes what is known as a “natural monopoly.” A natural monopoly is a monopoly that is “both persistent and not caused by the government.” (1) In this case, the vast economies of scale and scope involved in building out an electrical grid means that it is both economically inefficient to build multiple redundant distribution networks, as well as unappealing for a hypothetical competitor to come into the market.

As such, historically electricity was provided by a regulated monopoly utility, an entity that vertically integrated all aspects of producing and delivering electrons. In this paradigm, a single company was responsible for operating generation facilities, maintaining transmission lines, and delivering and selling the final product to its customers much in the same way that water or early telecommunication services were governed. Although far from a perfect system, regional grids were run this way for the better part of the 20th century with relatively few blackouts and reasonable electricity prices.

During the latter half of the century the government experimented with “deregulating” industries that had previously been sanctioned monopolies – industries like the airlines and telecommunications. This means that where once companies were given exclusive domain over a certain market, competition was now allowed under the theory that it would provide more efficient and effective service to the end user and to society at large. Although the term “deregulation” would seem to imply that government stepped out of the picture, the reality is closer to a “reregulation” – rules closely governing the provision of these services still applied, but the market was restructured to give those involved greater incentive to minimize costs. Controversial at first, this initiative was met with success in the industries in which it was tried.

In the early 1990s the trend for deregulation made its way to the electricity industry. Under the Energy Policy Act of 1992, the electricity supply market was split into several groups of competing interest. Instead of one company running all aspects of the grid, there were now four main types of organizations. Independent Power Producers (IPP) build and run generation plants, Transmission Companies (TRANSCOs) build and own the transmission equipment, retailers sign up end-use customers, manage their contracts, and provide service, and Independent System Operators manage the whole grid without regard for market outcomes. Under this system any body so interested is entitled access to the TRANSCO’s line, and the ISOs are obligated to use power as ordered by the price. In theory, this opens the grid network to all and enables anyone who thinks they can operate a generator more efficiently or more effectively serve customers to participate in the market.

While a nice theory, the realities of the grid have convinced many that deregulation, at least in this industry, is a poor idea. Although the electricity grid can be conceived as many separate and discrete pieces, the reality is that it is in fact one of the largest single machines ever built. Every generator on the grid must be operating in exactly synchronous motion at a frequency at 60hz. If a generator is out by as little as 2hz, the heat build up can cause it to destroy itself, and even a frequency mismatch of 30 millihertz can cause a loss of up to 1GW of power. Additionally, electricity does not travel in a straight line between two points: when there are multiple avenues from A to B, electrons will travel on all of them in such a way as to equalize the voltages, so that an overload on any one line can cause a cascading failure as electrons seek room on lines that remain. By balkanizing control of this incredibly complex machine, the 1992 act effectively built walls impeding communication and coordination between those responsible for running each subpart. In short, today’s regulatory structure is akin to “having every player in an orchestra use their own tunes.” (2) This deregulation also encouraged companies to transfer power over long distances while simultaneously induced less investment in new transmission lines. Therefore, parts of the system become over-congested and overtaxed — a condition that leads to more frequent blackouts. According to a study by the Lawrence Berkeley National Laboratory, blackouts cost the American economy some $80 billion each year — blackouts that are largely an effect of deregulation. (3) In practice, deregulation means that power outages are becoming more and more common and the grid is being pushed to its breaking point.

Although the short term problems associated with this market structure are significant – blackouts and system reliability chief among them – by far the more troubling is the lack of cooperation between the entities involved in its operation. As the 21st century unfolds, virtually every observer is convinced that the future of our electrical system lies in the “Smart Grid.” While it is many things to many people, at its core it is simply the application of modern communications and information technology to the grid. Many are shocked to learn that, as things stand, a power company often does not know of an outage until the customer calls and reports it themselves. Aside from alleviating this embarrassing lack, the smart grid can more efficiently distribute power at cost reductions on the order of 25% for the end user as well as serving as a key enabling technology for the widespread deployment of alternative distributed generation and electric vehicles, innovations necessary in the near future in the light of climate change. (3)

The smart grid requires the entire grid to operate in harmony for the best of its benefits to materialize. Even if you allow for royalty free and open standards that allow the “players in the orchestra” to speak the same language, the lack of incentive for communication between them alone leads one to conclude they would not be motivated to speak. The full advantages of the smart grid are to be found in coordination between generators, loads, and transmission lines — but if these components do not cooperate then the payoff is not worth the investment. Furthermore, the cost reductions brought on by the smart grid are too dispersed among these disparate agents for any one alone to justify the investment, and none has the scope to justify a large investment in a technology that requires taking on the uncertainty of competitors cooperating in order to fully realize the investment’s returns. (4)

Some may still say that competition is the best structure for the electrical grid, and whatever problems we see today are the result of a framework that is still evolving. However, using a mathematical model of the market for a directly networked good (and indeed, what is the smart grid but a network of users sharing information in order to increase the quality of service), it is possible to show that under certain reasonable assumptions a regulated monopoly performs closer to the social optimum than competition – a result fairly unique in much of economics.

The model of interest is derived from Chapter 10 of  Innovation and Incentives by Suzanne Scotchmer, the full text of which can be found here (http://socrates.berkeley.edu/~scotch/innovation/ch10.pdf) and a concise summary here (https://wesfiles.wesleyan.edu/home/chogendorn/web/318.12s/318class04.pdf). Under the assumption of a constant marginal cost across monopoly and competition, this model clearly shows that competition comes much closer to including the socially optimal number of agents in a network than a monopoly, regulated or not. However, the whole impetus for considering a regulated monopoly in place of a competitive market is that the vertically integrated monopoly can successfully take advantages of economies of scope and play the “orchestra” more efficiently than otherwise. Taking stock of this fact, and modeling it as a marginal-cost advantage of vertical integration, it can be shown that if a monopoly operator can achieve a marginal cost reduction of roughly 15% relative to a competitive group of operators it can operate arbitrarily close to the socially optimum level (or even surpass that level under the original marginal cost assumption).

The astute observer will note that this model’s parameters are chosen as in Hogendorn 318 Class 04 and have little to do with the particularities of the smart grid, or of a vertically integrated electrical grid. Nonetheless, the conclusion that lower monopoly costs can cause it to outperform competition holds without loss of generality. The next criticism is that although this may be true, the parameters such as they apply to the smart grid are such that the required cost reduction is unrealistic. To assuage these fears, an excel spreadsheet containing an automated calculator for the model has been attached. Readers may play with it to their heart’s content, but this author has not found any combination of parameters that result in a greater than 15% cost reduction requirement.

(Network Model Calculator – Right Click -> Download Linked File / Save As)

The Economist notes that, using the most advanced technology, end users can see their electric bill reduced by 25% over the course of a year. (3) If one acknowledges that a vertically integrated smart grid with full communication between users, transmission lines, and generation is the only way to achieve these sorts of benefits, the decision becomes a simple one: reregulate the electric grid to usher in the smart age. The benefits of vertical integration extend beyond simply allowing for the smart grid: even under a “dumb” grid, vertical monopoly can achieve cost reductions on the order of 17% when considering generator-transmission linkages alone. (7) When considering the negative consequences competition has on investment and maintenance of the grid, and the consequent impact this has on a national economy via blackouts, it’s almost inconceivable why the grid is still being run as a competitive industry.

In short, as we transition into the 21st century we find ourselves facing a choice. We can deploy the smart grid, sure, but we may not see the best of it unless we reorganize our electricity market to reflect the physics underlying it as well as the opportunities presented by information technology. In order to fully appropriate the value of this innovation, the grid operators must cooperate and share information freely and fully amongst themselves. While this author is agnostic to the exact method in which this is achieved, the economic and physical realities of the grid strongly suggest a regulated monopoly would be the best structure to achieve this end. This monopoly should be regulated in a very particular way, making sure to allow for intelligently networked distributed generation owned independently but centrally operated so as to best take advantage of the opportunities the smart grids presents. Nonetheless we need to make the transition from cacophonic competition to symphonic synergy for ourselves, for our descendants, and for the planet.

Sources/Further Reading

(1) “Monopoly” by George J. Stigler, The Concise Encyclopedia of Economics. (http://www.econlib.org/library/Enc/Monopoly.html)

(2) “What’s Wrong with the Electric Grid?” by ERic J Lerner, The Industrial Physicist (http://www.aip.org/tip/INPHFA/vol-9/iss-5/p8.html)

(3) “Building the Smart Grid”, The Economist (http://www.economist.com/node/13725843)

(4) “Integration is Key to Smart Grid Management” by Javier Rodriguez Roncero, CIRED Seminar 2008 (https://ece.uncc.edu/~jmconrad/ECGR6185-2010-01/readings/Jebasingh_Integration%20is%20key%20to%20smart%20grid%20management.pdf)

(5) “Networks and Network Effects” (Chapter 10, “Innovation and Incentives”) by Suzanne Scotchmer, 2004 MIT press (http://socrates.berkeley.edu/~scotch/innovation/ch10.pdf)

(6) “Experts Assess Deregulation as Factor in ’03 Blackout” by Matthew L. Wald, The New Work Times (http://www.nytimes.com/2005/09/16/politics/16blackout.html)

(7) “Vertical Economies of Scope in Electricity Supply – Analysing the Costs of Ownership Unbundling” by Roland Meyer, Economics PhD Thesis at Jacobs University Bremen, 2011 (http://www.nextgenerationinfrastructures.eu/download.php?field=document&itemID=586336)

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