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Enron Mail |
This sounds like a good idea.
=09"Daniel Douglass" <douglass@ArterHadden.com< =0903/12/2001 06:43 PM =09=09=20 =09=09 To: <Barbara_Klemstine@apsc.com<, <Bob_Anderson@apses.com<,=20 <Vicki_Sandler@apses.com<, <berry@apx.com<, <dcazalet@apx.com<,=20 <billr@calpine.com<, <jackp@calpine.com<, <Ken_Czarnecki@calpx.com<,=20 <gavaughn@duke-energy.com<, <rjhickok@duke-energy.com<, <gtbl@dynegy.com<,= =20 <jmpa@dynegy.com<, <jdasovic@enron.com<, <susan_j_mara@enron.com<,=20 <Tamara_Johnson@enron.com<, <curt.Hatton@gen.pge.com<, <foothill@lmi.net<,= =20 <camiessn@newwestenergy.com<, <jcgardin@newwestenergy.com<,=20 <jsmollon@newwestenergy.com<, <rsnichol@newwestenergy.com<,=20 <nam.nguyen@powersrc.com<, <Curtis_L_Kebler@reliantenergy.com<,=20 <rllamkin@seiworldwide.com< =09=09 cc:=20 =09=09 Subject: Fwd: Review of FERC Analysis Gary Ackerman asked that the attached proposal from Ben Zycher be sent to t= he=20 board. =20 Dan ----- Message from "Benjamin Zycher" <bennyz@pacbell.net< on Sun, 11 Mar 20= 01=20 17:45:55 -0500 ----- To:=09"Daniel Douglass" <Douglass@ArterHadden.com<, "Gary Ackerman"=20 <foothill@lmi.net< cc:=09"Benjamin Zycher" <bzycher@rand.org< Subject:=09Review of FERC Analysis Benjamin Zycher (310) 393-0411 ext. 6436 March 11, 2001 (818) 889-8163 home bzycher@rand.org bennyz@pacbell.net Dear Dan and Gary, Given the FERC order for refunds from the power producers, I think that the time has come for a serious paper critiquing the underlying analyses and explaining market fundamentals. Analytic errors are a prominent feature of the Cal ISO "Report" on supply costs (February 28, 2001), and I would be surprised if the same were not true of the FERC order and any supporting analyses that may have been prepared. (Dan is sending me a couple of relevant FERC documents now, but I will not be able to review them in detail until Tuesday or Wednesday.) In general, however, it is fair to say that a common set of analytic errors underlies such bureaucratic thinking, and the dangers inherent in the ISO and FERC orders suggest that a detailed refutation is something that ought to be done. The central points that I believe I would make include the following, among others. (I'm using a small amount of economic jargon here that I would not use in a report, but I really am quite experienced at making such arguments in plain English.) 1. Such analyses typically are incomplete, in that they ignore (a) a risk premium for non- or under- or late payment. They ignore also (b) the fact that part of the marginal cost of selling today is the forgone opportunity to sell tomorrow, given that units have to be taken down for maintenance and the like. In this sense, electricity can be "stored" in the form of dispatch availability, and it is in the interest of consumers for suppliers to produce when supplies are needed the most, i.e., when (expected) prices are highest. This is true even during a stage 3 alert: Suppose, for example, that even greater problems are foreseen for the ensuing summer. Accordingly, this is not "manipulation." In addition, as explained in my paper in the current issue of Regulation, © market prices under competition include a price premium for the provision of optimal reliability. These three components of cost are important, with measurement requiring econometric and other tools; and they perhaps are impossible to "verify" in regulatory methodology. 2. The ISO and FERC analyses confuse marginal and (average) variable cost, average and marginal producers, average and marginal units of production, etc. Other errors are likely as well: The ISO, and, I suspect, FERC implicitly assume away rising input prices as demand conditions increase. This would yield in perfectly competitive markets a supply curve steeper and a market price higher than measured "marginal cost." Moreover, the ISO, and, again, FERC in all probability, implicitly assume perfectly elastic supply at whatever input "costs" happen to prevail. That is simply incorrect: In the short run, production capacity is limited, so that even if input prices do not rise with demand, there is a "kink" in the competitive supply curve. If demand intersects supply above the kink=02=05that is, if the amount demande= d exceeds production capacity at the "marginal cost" that the regulators measure=02=05price will exceed that "marginal cost." Think about the wholesale market for wheat, for example, which is close to a perfectly competitive market. In the face of bad weather in some agricultural regions, the market price of wheat will rise, even though "costs" for the remaining wheat farmers=02=05labor, insecticide, land rents, fuel, wate= r, etc.=02=05will not have changed, and indeed might actually fall because of reduced demand from farmers affected by the adverse weather. 3. The ISO report admits explicitly that it does not know market marginal cost, because it complains that some suppliers bidding above the "soft cap" have not submitted cost data. Moreover, marginal cost properly defined is for the market as a whole, rather than just for the producers who bid in California. This means, quite literally, even apart from all of the other problems, that the conclusion of "uncompetitiveness" or "unreasonableness" cannot follow from the ISO analysis or from what is likely to be the underlying FERC analysis, because price will equal the marginal cost (defined correctly) of the last unit produced in a competitive market. In short: The sort of analysis offered by the ISO and FERC cannot even in principle determine competitive prices because the regulators lack data for marginal cost for the marginal producer. 4. The implicit definition of consumer welfare ("wellbeing") used by most regulators is incorrect. Consumers are interested not in low electricity prices alone, but in a maximization of the value of the entire consumption basket. Average electricity prices lower than marginal cost reduce consumer welfare by engendering resource use in the electricity sector that is too big, and thus prices in other sectors that are too high. Moreover, price controls of whatever form must create shortages even in markets with inelastic demand, and the true price with a shortage is unambiguously higher than the price that would clear the market in the absence of the controls. (Think about the "cost" of electricity during a blackout.) This is easy to demonstrate analytically. The ISO and FERC clearly are shunting aside the effects of price controls masquerading as "refunds" upon long run expectations and other parameters, which easily can be shown to make consumers worse off over time. Part of this problem is the creation of an asymmetric distribution of expected returns, since suppliers clearly will not be subsidized when prices are low. 5. The ISO errs in its assumption that bids above the soft cap reflect higher capital costs. I would not be surprised if FERC is making a similar error. Capital costs, having been sunk, cannot affect short run pricing; the differing engineering efficiencies of generating units will be reflected in their market values, and thus the opportunity cost of production. This means, in a strict textbook sense, that different generating units cannot have costs that differ, as counterintuitive as that sounds. More efficient units will have lower fuel costs (for example), but higher opportunity costs for employment of the capital assets. I would make this point in a report, simply to erode the credibility of the regulators, but I would not push it too hard, since some people cannot understand it. 6. The Report ignores the market power of the respective regulatory bodies as monopsonists under the implicit system of price controls and refunds. 7. The definition of "market power" is entirely obscure, except implicitly as bids higher than marginal cost as measured by the regulators. This is incorrect, and I think that this needs to be explained clearly. I am sure that other errors and omissions will emerge as the relevant documents and arguments are reviewed. Anyway, I'd like to prepare such a report. I would have to see precisely what it is that must be refuted, but my guess is that this is about a two-week project in terms of required analytic and writing time. An effort to measure marginal cost correctly would be a good deal more involved and time-consuming, and my sense is that at this stage a refutation is more important. If it is a two-week project, then I think that $15,000 would be reasonable. Looking forward to hearing from you. Ben
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