Gowrisankaran, Langer, and Reguant have published an excellent paper, Energy Transitions in Regulated Markets, in the latest issue of the American Economic Review, one of the profession's flagship journals. Its central finding: regulation designed to prevent utilities from building useless power plants can end up inducing them to keep obsolete power plants.

Some background. Electric utilities were regulated under the theory that they were natural monopolies, and that society would do better by pushing their prices down. But what counts as a reasonable price? That is hard to say, so regulated utilities were allowed to recoup their operating costs plus a fair return on their "rate base" — their capital stock. The arrangement makes sense, but once profits depended on the size of the capital stock, utilities had an incentive to build too much — the classic Averch–Johnson effect, first laid out by Harvey Averch and Leland Johnson in a 1962 article in this same journal. Regulators responded with "prudence" requirements and the rule that capital must be "used and useful." In a stable world, that rule serves as a check — albeit an imperfect check — on so-called gold-plating.

Now consider what happens in a time of technological change, such as a rapid decrease in the cost of generating electricity with natural gas, driven by fracking and improvements in combined-cycle natural-gas (CCNG) technology. This is not a hypothetical scenario: the shale boom of the late 2000s and 2010s pushed U.S. natural gas prices down sharply, and CCNG became one of the cheapest ways to build new generating capacity in much of the country. In a free market, large decreases in costs would cause firms to abandon coal and move to natural gas — some to make profits, others to avoid losses. In short, market forces push sunk investments to be abandoned when they are no longer profitable.

Under regulation, however, there is another possibility. A utility can tell the regulator that its plants are still viable. Telling is cheap talk, so the utility keeps burning coal to prove that the plant remains useful. If keeping the plant's base operating is better than abandoning it, and signaling how valuable the coal plant still is matters, it may even be worthwhile to burn coal when the cost exceeds the price of electricity. The authors have data bearing on exactly this point.

Figure 3 of the paper takes a little work to understand, but the pattern is clear. Each point represents a state. In Panel A, the vertical axis shows how much less likely a coal plant is to run when the cost of coal exceeds the price of electricity. A strongly negative coefficient is the economically sensible response: when burning coal is more expensive than buying electricity, the plant should burn less.

The red points represent restructured states and the green points regulated states. In restructured states, coal burning falls when prices fall, just as expected. Coal burning in regulated states responds much less — the red points generally lie below the green points. Indeed, the six states with the largest reductions in coal operation are all restructured states.

One objection to this analysis might be that utilities in general are simply slow to respond to prices. To address this, the authors plot on the horizontal axis how well utilities respond to a higher price of gas. Those coefficients are all negative, and there is no obvious difference between regulated and restructured states. In both types of states, utilities respond well to the price of gas, but only in restructured states do utilities respond strongly to the price of coal. Why coal and not gas? Because the used-and-useful standard binds on capital whose usefulness is in doubt — which, once gas got cheap, meant coal. In other words, the utilities have to defend coal to the regulators, not gas.

Panel B, on the right, shows a slightly different way of presenting the same data. The vertical axis is again how much less likely a coal plant is to run when its cost exceeds the electricity price. The horizontal axis is the fraction of generation owned by electric utilities. Regulated states tend to be vertically integrated, while restructured states opened electricity generation to competition, so utility ownership and regulatory status are closely correlated. Regulated states generally have utility ownership above 60%, while all the restructured states but one are below 30%. The best-fit line slopes upward: in other words, the more generation a state's utilities own, the less coal dispatch responds to price — a different perspective on the same story.

That is the direct empirical evidence. The authors then construct a more ambitious structural model. In theory, regulation could produce either too much or too little investment in the new technology; their estimates imply too much. Much, too much. Not only do regulated utilities retain too much coal, they also build too much gas capacity. In short, they accumulate both too much old capital and too much new capital — Averch–Johnson on steroids.

The paper's setting is the fracking era, but the stakes are current. Coal still supplied roughly half of U.S. electricity in 2008; by 2024, federal statistics put its share below a fifth, and the terms on which the remaining plants retire are still being contested in regulatory proceedings across regulated states. The same rate-base incentives now govern the next wave of capital — renewables, storage, and grid upgrades — and a number of states, among them Colorado and New Mexico, have adopted securitization laws that let utilities refinance retiring coal plants with lower-cost bonds, a policy aimed at exactly the stranded-capital problem the authors document.

The bottom line is that regulation under dynamic conditions is much more difficult than under static conditions. In the view of the Marginal Revolution author, it may not even be worth the candle.

Source: Marginal Revolution