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Tuesday, August 19, 2003

Prof. Krugman Explains How Regulated Companies Operate

We are starting to worry a bit about the Earnest Professor's morale - with recent columns titled "Twilight Zone Economics" and "The Road To Ruin", it occurs to us that his brow may be furrowed over the arc of his professional reputation.

OK, that ends my moment of sensitivity (for 2003!). Today's theme is the recent blackout, and Prof. Krugman delivers a bold new view of how regulated and deregulated companies operate:

...energy experts have long warned that deregulation would lead to neglect of the grid. Under the old regulatory system, power companies had strong incentives to ensure the integrity of power transmission — they would catch the flak if something went wrong.

They would catch flak! Some of us may have thought that companies would review investment plans with the regulator, negotiate some fair return on investment, and upgrade their capacity as appropriate. The incentive was the opportunity to earn the regulated return on investment. Evidently not - it's all about the flak. But there is more:

But those incentives went away with deregulation: because effective competition in transmission wasn't possible, the companies providing transmission still had to be regulated. But because regulation limited their profits, they had little financial incentive to invest in maintaining and upgrading the system. And because of deregulation elsewhere, responsibility was diffused: nobody had a strong stake in keeping the system reliable. The result was a failure not just to add capacity, but to maintain and upgrade capacity that already existed.

In this new economic model, "responsibility was diffused" means "no one catches flak". The opportunity for profit, regulated or otherwise, no longer drives business decisions; rather, investment is targeted to minimize incoming flak.

In some outmoded alternative view, even regulated companies respond to profit opportunities. If more transmission capacity was needed, regulators would (one hopes) agree to an expansion of the rate base. Capacity would be added, prices would be adjusted, life would be good, and the (regulated) profits available to the transmission companies on their new capacity would be acceptable to all.

Now, I understand that this has not happened. However, I am not prepared to discard profit-oriented models in favor of "flak-catching" theories just yet.

The explanation may lie in the fact that the transition from one set of market rules to another can be perilous. If neither regulators nor the transmission companies can predict the future regulatory framework, an investment freeze may occur, regardless of the potential for flak.

Lynn Kiesling has lots more: at Reason, and her blog.

Notes: Prof. Krugman quotes Paul Joskow of M.I.T, whose full comments are here. Despite the scare quote, Paul Jaskow's point was as Prof. Krugman described it: "These experts didn't necessarily oppose deregulation; their point was that deregulation could lead to disaster unless accompanied by policies not just to keep the grid reliable, but to expand it."

UPDATE: The Man Without Peer pulls the plug on the Prof.

MORE: In a vivid display of this phenomenon, Don Luskin presents the Faux Krugmans. I'll pick David Hogberg and John Primmer. And hey, I need to get in there - I have too much free time, too!

MORE: Recovering Krugmaniac Mark Byron takes just one sip. Careful!

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