Energy markets are not free

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If modern, distributed generation is more efficient and less polluting, requires half of the capital investment, and reduces system vulnerability to weather and terrorism, why do most countries continue to build central generating plants? The key factor seems to be a flaw in conventional thinking about the role of free markets. Most economists simply assume that market economies have optimized the production of goods and services, and that opportunities for additional efficiency do not exist.

Yet, markets work only when several preconditions exist, and the current market for heat and power is not free. One key attribute is the freedom of business entry. Despite some restructuring, many policies continue to block new firms and protect the monopoly position of franchised utilities. For example, it remains illegal in all 50 states for anyone but the utility monopoly to build an electric wire across a public street. You can construct a natural gas pipeline, an Internet wire, or a steam pipe over or under a street, but stringing an electric wire threatens the utility monopoly and will land you in jail. Being able to ship your end product only through the competitor's wires, of course, is a pretty strong barrier to entry and prevents an open market.

Utility regulatory commissions also effectively guarantee the financial return of centralized generation and its associated wires by including these investments in the 'rate base', on which utilities are guaranteed a profit. If sales of power do not materialize in amounts sufficient to provide the assured rate of return, commissioners simply raise rates in order to meet the targeted levels. Local generators, in contrast, enjoy no public guarantees, even though their dispersed plants can recycle the normally wasted heat, increase efficiency, cut pollutants and provide other public benefits. Power recycling entrepreneurs also face the risk that their manufacturer partner will cease or change operations and stop purchasing as much thermal energy, or will stop producing the expected amount of waste energy. In either case, the entrepreneur suffers reduced revenues and might not be able to pay back its investors and lenders.

Free markets also allow the freedom of business exit, or the freedom to fail. Yet, in the electricity business, no public service commission can stand by and allow its local utility to fail. Mistakes simply disappear into the rate base, raising rates for all consumers. As a result, the electricity business lacks the cleansing mechanism that is essential to functioning markets.

Efficient markets also require clear and accurate price signals, which allow both producers and consumers to make optimal choices about their investments and consumption, yet energy prices ignore an array of costs. Health and environmental expenses associated with power-plant pollution, for instance, are paid by taxpayers and healthcare consumers. The government of Ontario, Canada, estimates that the health and environmental costs of electricity from Ontario's coal-fired generation plants total C$120 per megawatt-hour. Yet, power in the province is sold for just C$60 per megawatt-hour, which covers only fuel and capital amortization. Selling power at one-third its full cost (which includes additional operating expenses, overhead and profit) obviously distorts the market and motivates both producers and consumers to make decisions that are suboptimal for society.

Environmental regulations, moreover, tilt the playing field against new power generators, even when they are significantly more efficient than existing plants. Today's weighted average age of US electricity generating plants is about 40 years, even though most plants have only 25-year design lives. The 1976 Clean Air Act 'grandfathered' emission rights to all existing electricity generators on the assumption they would be retired at the end of their planned lives. By contrast, a new plant must lower its emissions to the best control possible at the time it is built, requiring entrepreneurs to spend up to triple the cost of old plants, and then to compete against plants with grandfathered permits and no cleanup requirements. This regulatory approach effectively grants immortality to the old plants, perversely encouraging their owners to extend the lives of old, dirty and inefficient facilities.

Finally, markets do not work properly in the face of perverse incentives. All 50 states regulate electricity with a structure that magnifies the impact of changing electric sales on utility profits. The Regulatory Assistance Project recently found that a 5 per cent drop in sales of kilowatt-hours typically produced a 57 per cent drop in a utility's profits - nearly a 12:1 ratio. This flaw turns utility CEOs into fierce but hidden opponents of all efficiency improvements, including more efficient motors and light bulbs, because, by reducing electricity use, these improvements substantially threaten the profits of utilities. These CEOs may claim publicly to support improvements in efficiency, and they may even craft small efficiency programs advertised with large public relations budgets, but the 12:1 profit-to-sales ratio makes all regulated utilities the sworn enemies of local generation, regardless of its efficiency or societal benefit. Find an argument against local generation and it almost certainly can be traced to a utility author.

As a result of these deeply flawed policies and market distortions, the US electric system is not a free market and is therefore far from economically optimal. Ninety-two per cent of US generation is from plants in remote locations that burn twice as much fossil fuel and emit twice the CO2 and other pollutants as would be required if local generation plants recycled the inevitable heat byproduct. A remote central plant and its associated T&D also require more than twice the investment per new kilowatt of peak electric load of a local generation plant.

Despite these economic realities, virtually every new power plant has been of the centralized type. There is now, however, strong evidence that alternative approaches can be quite profitable. Over the past 25 years, I have led companies that invested more than US$2 billion in 250 local generation plants in 22 states, Canada and Mexico. The worst of these facilities uses less than half the fuel and emits less than half the CO2 of the average central generation plant. These energy-recycling plants contribute more than 10,000 megawatts of thermal and electric generating capacity. Every one of the plants saves money for its host and yields an acceptable rate of return to its investors.

These local plants achieve savings and emission reductions without any breakthrough technology by simply recycling normally wasted energy. In fact, the plants use the same technologies and fuels that are used by central plants, they are simply smaller versions, sized to meet the industrial host's requirement for heat or waste energy, doing the two jobs with one fire.

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