Negative Electricity Prices: Bleg

A couple of years ago, a visitor to our department here at Canterbury told me how sometimes in Texas, windfarms are able to generate so much electricity that the price of electricity goes negative. This recent article in the Economist (HT: Tyler at Marginal Revolution), gives a similar example from Europe. In both cases, I find this puzzling, and so I am seeking enlightenment from those who know the physics of electricity generation better than I do. To explain why it is a puzzle, let’s consider some examples of the economics of negative prices.

First imagine a pure-exchange world (i.e. one where commodities just exist rather than being created, so that economic activity consists of trade and consumption, not production). If all commodities are desired by all consumers, then competitive markets will result in all prices being positive, with prices reflecting the relative desirability and abundance of each good. If, in contrast, one of the commodities is not only not enjoyed but would be positively disliked by all consumers, the extent that its price would reflect that dislike would depend on whether there was “free disposal”, meaning whether the owner of the commodity could costlessly avoid consuming it. If there is free disposal, the price of the commodity would be zero. Without free disposal, the competitive price would be negative, again reflecting the relative (lack of) desirability.

A related situation arises when a firm produces a main product and an associated by-product. For instance, consider a motel that produces accommodation services during the peak holiday season. To provide this service, it has to incur the capital cost of building motel units that exist during the peak period, and then, as a by-product, these units exist during the off-peak times. If off-peak demand is low, some of these units might well be consistently vacant during the off-peak times, even if the price fell to zero. There again is an implicit assumption of free disposal here. If, for some strange reason, there was a requirement that motel units be occupied at all times to prevent depreciation of the capital stock, one could easily imagine the off-peak price going negative; that is, it could be worthwhile to motel owners to pay people to stay in their units during the off-peak times in order to ensure they were available for renting out at positive prices during the peak period. In effect, the opportunity cost of maintaining the units during the off-peak time would be negative, which could be reflected in the price. Again, the key assumption allowing negative prices is no-free-disposal. It does not make sense to see sellers choosing to sell something at a negative price if they could simply dispose of the good or service for free.

So now consider electricity. It is a key attribute of thermal power plants (particularly those using coal as the fuel source), that it is cheaper to keep the plant running 24/7 then to shut it down and heat it back up every day. This is just an on-peak/off-peak problem. Even if one only wanted to generate power during the peak periods each day, it would be cheaper to keep the plant running than to shut it down at off-peak times, giving a negative opportunity cost of generating power during those times. In the examples given above from Texas and Europe, wind or solar generation was able to meet regular demand at off-peak times, but shutdown costs made it economic for thermal stations to keep producing, sending prices negative. But, as we have seen, negative prices require an assumption of no-free-disposal.

My question then is: What is the physical or political constraint that implies an absence of free disposal in the electricity market? Why is it not possible to run a plant spinning the turbines, but simply not connect the station to the grid? In the case of Texas, I have heard that it is a purely political constraint: in a heavily regulated market, it is not palatable to have stations burning coal and not then produce any electricity. Is that all there is, or is there something about the physics of electricity generation that makes it imperative to force power onto the grid when a station is up and running? 

A Failed Market?

I am puzzled by this opinion piece by Rod Oram in last weekend's Sunday Star Times. Two quotes that caught my eye are the following:

Electricity demand fell 2.5 per cent last year but retail electricity prices rose 3 percent; over the past five years, demand has fallen 1.6 per cent but retail prices have risen by 27 per cent, according to figures released by the Government last week.  

Only a failed market delivers such perversely uneconomic outcomes. 

And then

Meridian's ... earnings are the most volatile because it is so dependent on rain to drive its hydro plants. ....Fiscal 2012 was an exceptionally dry year. Transpower's long-term data for New Zealand's hydro assets show that dry years are becoming more frequent and more severe. 

I can ony guess that the Government has not released figures on some careful instrumental variables regression estimate of NZ demand curves, but rather has published figures on the quantity demanded. So what I take from the two quoted paragraphs is that supply curves have shifted up, price has risen and the quantity demanded has fallen. Isn't that exactly what ECON 101 S&D would predict? How, exactly is this evidence of a failed market? Furthermore, there have been only slight changes in the structure of the market over the past five years. How does a level of market structure explain a change in prices and quantities?

Now the electricity market presents its own unique characteristics that make market design difficult, and any system will have imperfections, so certainly evidence can be found to suggest that the market is not perfect; the difficult policy question is whether alternatives would be better. But evidence consistent with ECON 101 S&D theory is not the place I would be looking to suggest that a particular market has failed. What am I missing?

The Tiwai Point Subsidy

Matt and Paul have both covered the subsidy to Rio Tinto that facilitated a new contract between RT and Meridian Power. There is not a lot to say about the actual policy; Matt's "Urg" pretty much sums it up. But a few points about the politics of this are worth noting. 

1. There was nothing inherently wrong about the a long-term contract between Meridian and Rio Tinto at favourable rates. I believe that in the past transmission constraints meant that the opportunity cost of power delivered to Rio Tinto was not necessarily the wholesale price elsewhere on the grid. And I also understand that the smelter was drawing power fairly evenly throughout the day rather than mostly at times of peak demand. I stand to be corrected on both those points, and maybe Meridian negotiated poorly in the past, but, absent government subsidies in the past, these were normal commercial transactions that should not colour our opinion about the subsidy announced yesterday. That subsidy should be criticised on its own merits. 
2. It is hard to believe that the decision was not affected by the political capital the government has tied up in its asset sales programme. Again, however, that should not colour our opinions about the policy. The policy would not be any better if it were motivated by different objectives. 
3. Labour are totally on the right side on this one, but it is notable that Clatyon Cosgrove's reaction reported in this Stuff article, framed things entirely in terms of it using taxpayer's money to facilitate the partial sale of Meridian. It would be good to hear a clear statement from Labour that they are opposed to corporate welfare of any kind, and, if it were them, they would have just let Rio Tinto close down the smelter. As it stands, they might be saying that National paid a subsidy for the wrong reasons, but they would have done the same in order to protect jobs in Southland. I haven't seen the news coverage. Has anyone seen if a journalist has put this question to Labour? 

Increasing consumer surplus through price increases

As I noted last year, the University of Canterbury administration has this year increased the price of an annual parking permit threefold from (roughly) $100 to $300. This raises the price from what was a subsidised rate to something they calculate as being approximately marginal cost. Needless to say, this is something that the Economics department had been advising for a long time, given our propensity to value efficiency even at the expense of our own direct wellbeing. After a few months of experience with the new policy, it has become clear, though, that it is not only efficiency enhancing, but it has also increased consumer surplus even without consideration of what use the university makes of the increased revenue.

How can that be? It is an application of how the deadweight loss triangle in a standard S&D diagram understates the cost of a price floor or ceiling. Previously a parking permit at Canterbury did not confer a right to park; it conferred the right to hunt for a park. Many of us wasted a lot of time searching for a park before giving up and parking on the street several blocks away. The problem was particularly acute on wet days. Some of those who successfully found parks had a low willingness to pay, others who missed out valued the parks much more highly. How do we know this? Well this year, as a result of a trivial price change from next-to-nothing to three times next-to-nothing, the carparks are never full.* Even on the wettest days, one can come in late and always be guaranteed a park. Those cluttering up the parks last year but not this clearly didn’t value the parks highly; this year, it is only those put a high value on parking who get the parks. And how high can that value be. Well we don’t know for sure, but I am sure this story could be replicated here.

So there we have it. The price went up, and so did consumer surplus. Could the same happen in reverse. Well imagine if you were to impose average cost pricing in the retail electricity market despite it being an industry with sharply increasing marginal cost. Everyone would get a lower price for power, but with no guarantee that the lights would come on on demand. Consumer surplus might well go down. And that is without even considering the lost government revenue from publicly owned power companies….

* I find it difficult to comprehend the size of the demand response; think of the Slutzky equation: there is a huge shortage of on-street parking around the university, so there are no close substitutes for on-campus parking; $300/annum is hardly a large fraction of anyone’s expenditure, student or lecturer. Can the income elasticity really be that high? 

The morality of corporate takings

In the comments on my post containing the open-letter to the Labour Party’s two Davids a couple of weeks ago, John Small and I got into a discussion about the morality of a government policy that would wipe value from a private company (in this case, suggested changes to the electricity market that would reduce the profits of privately owned electricity companies). John wasn’t sure why I raised the issue of morality; this is worth post on its own.

It is inevitable that changes in government policy will result in both winners and losers, just as changes in the non-governmental actions will. One of the starting points I argue in my Honours class in welfare economics is that, in terms of practical policy (as distinct from the conceptual benchmark of a mythical social planner) the world is, always has been, and always will be Pareto efficient, and so a rule that policy changes cannot impose costs on anyone is tantamount to a rule that policy changes can never occur. But I think we can suggest some guidelines for when government-imposed costs are justified. The key issues are whether the policy is imposing costs on individuals or corporate bodies, whether the policy is a direct appropriation of property or one the imposed costs are indirect, and whether the policy is designed to improve efficiency or serve some social objective. Let’s take each in turn.  

• Is the cost imposed directly on individuals or on corporations? Takings from individuals require a higher threshold of benefit than takings from corporations. I don’t here mean to that corporations are somehow separate from the individuals who own them, or that their owners have lesser rights than other citizens; this is simply recognising the fact that company owners have the opportunity to diversify risk in their shareholdings, and hence to diversify the implications of government policy changes. A policy that forced lower electricity prices might wipe value from electricity companies, but add value to electricity buying companies as well as final consumers. If such a policy were efficiency increasing, there is no reason for it to impose significant costs on any diversified shareholder.
• Is the policy one that appropriates resources directly or one that changes the value of current assets? A direct takings, such as when the government uses compulsory purchase to acquire land for a highway, is a more serious use of government power than one that imposes costs indirectly through revaluations of assets, simply because a direct takings has the potential to impose far greater costs to an individual if their personal valuation of the asset is greatly in excess of its market value.

Based on these two criteria, I have no problem on morality grounds with, say, the government’s forcing Telecom to give other companies access to its copper wire network, with the anti-trust actions against Microsoft, or with changes to patent law that would stop Apple from suing Samsung. In each case, the question for me would be simply whether such policies would promote long-run efficiency or not. (In the case of these three examples, I suspect the answer would be No, No, and Yes, but that is an empirical question.)  The issue becomes more when the policy is put in place to achieve social objectives.

• Is the policy one that is designed to improve efficiency or to bring about social redistribution? In my view, the hurdle has to set very high before one can justify a direct or indirect takings to fund redistribution. This is not to say that social redistribution is not warranted, but rather the moral case for redistribution should be grounded in a transparent and honest policy that seeks to share the burden broadly rather than hiding the costs. Financing redistribution through indirect takings smacks too much of offering the other kid’s bat for my taste.

This is the key question in the case of Labour’s proposed electricity reforms. If their proposal were based on a view that market power was keeping price above marginal cost so that reducing price would be efficiency enhancing, then the issue would be the technical one of whether there is market power and whether eliminating that market power through a single payer would cause more problems than it would solve. But the proposed policy is explicitly to set price below marginal cost in order to equate price to average cost. John argued from a utilitarian perspective that the redistributive benefit would likely exceed the efficiency cost. We can debate about how large the efficiency cost would be, and whether, if you had revenue available for redistribution, subsidising electricity prices would be the best way of using it. But if we want to have more redistribution, either with an electricity subsidy or with direct transfers, then we should finance that directly with broad-based tax increases. Let’s not get into the game of arguing for a policy to transfer resources from corporate owners to electricity consumers on the basis of “they must have known that regulation is very very common in this industry” and hence that the costs are ethically inconsequential.