no power–again!
I live in a detached house in the northeast US. Hurricane Sandy is the third occasion in a little over a year for my neighborhood to lose electric power for an extended period–a phenomenon I associate more with emerging nations than developed ones. This means no lights, no heat, no hot water for 5-10 days. No TV, no refrigerator, no internet, either. It’s back to checks instead of the bank website to pay bills. For many people (not us, though) it also means no water at all, so, among other negatives, the toilets don’t work.
bad luck? …no
I think that our recent experience isn’t simply horrible bad luck. The more I think about it, the more I’m convinced that long power outages are going to occur routinely where we live from now on (hopefully less frequently than once every few months).
My conclusion has in principle little to do with global warming, although global warming makes the problem potentially much worse.
utilities are a little like banks
For decades, economists have pointed to the potentially disastrous consequences of the dual nature of banks in the developed world. On the one hand, they have an important social function–they’re the main vehicle for transmitting national monetary policy from the central bank to the economy at large. On the other, they’re publicly traded companies whose managements aim at making steadily increasing profits to please shareholders.
Sometimes, these two roles are incompatible.
If the banks take too much risk in seeking net income rises, they’ll lick their wounds and refuse to lend, no matter what signals the central bank sends them. Less often–the only example I can think of is the decade leading up to the US housing collapse–the banks can listen to crazy signals from the government (thanks, Mr. Greenspan), make a pile of unbelievably stupid loans, and bankrupt themselves.
I’m coming to realize that electric utilities are a poor man’s version of the phenomenon of having two conflicting social roles. Actually, I’ve known this in theory for a long while. But we appear to have hit a tipping point here in the Northeast, so that the negative effects of the arrangement are becoming apparent.
my reasoning
rate-setting
Typically, because of the immense expense involved in establishing and expanding an electricity generation and transmission network, governments grant a single company a monopoly over service provision in a given area. In return, that company accepts government regulation of the rates it charges. The economic sense used in the rate-setting process is that the company is entitled to a certain rate of return on its net plant and equipment investment. The big question is what that rate will be.
a growing service area
When a community is growing, the regulators are content to allow generous rates of return. This makes it easier for the utility to raise the capital needed to expand its network. The prospect of high returns on a growing capital base makes banks willing to lend. The promise of rising dividends makes equity investors willing to bid up the company’s stock and to subscribe for new shares in public offerings. Everyone is happy.
a mature area
When the area matures, however, and expansion slows/stops, the dynamic changes in two ways:
–since there’s no necessity to attract new capital, the government sees no need to continue to grant rate increases. More than that, it sees there’s a political advantage to lowering the rate of return. What can the utility do–rip out its lines and leave?
–for a company, the operating profit it gets from providing its services is based on net plant–that is, its initial investment minus yearly depreciation charges. So if it can’t add new plant, the money it receive doesn’t remain constant. It begins to decline as yearly depreciation whittles down the net plant figure.
Voters are happy because utility charges aren’t rising. The utility company, however, undergoes an enormous squeeze.
the utility response
Every capital-intensive company becomes a price taker (meaning it has little or no influence over the price it receives for its goods/services) once its capital investment has been made. It’s true for a cruise ship, a hotel, a cement plant–and a public utility. All it can control is its costs. All it can do to increase profits is to cut costs (the firm can also become a holding company and invest part of its cash flow in non-utility areas, but in this post let’s keep focused on the utility) .
It can merge with other utilities to eliminate administrative overhead. It can also shift from gold-plated repair and maintenance to some less expansive variety. It does so by reducing the number of local employees, planning instead to borrow from neighboring states in case of emergency. It cuts back on inventories of replacement parts. It tries to nurse senescent plant and equipment into working for “just one more year.” Aging infrastructure makes the whole system more fragile. As a result, the utility may be more vulnerable to shocks and less able to respond quickly to emergencies.
My diagnosis is that this is what’s happening in the Northeast US now. Hence my belief that the lengthy power outages of the past year or so aren’t just unfortunate coincidences but indications of what life will be like in the future. Ergo, my upcoming generator purchase.
investment implications?
My main conclusion is that the situation I describe is a negative for utilities in mature areas of the US. One caveat is the possibility that regulators might boost allowed returns in order to get utilities to invest more in their plant and staff. But recent legislation allowing third parties to sell cheap electric power through the existing utility distribution networks cuts against this idea.
I don’t want to point the finger at any one party as having caused the current state of affairs. The bottom line is that we have the utility system we’re willing to pay for.
I can imagine that continuing power outages will accelerate population drift away from the affected areas toward the growing regions of the country in the South and West.
On a more (useful and) micro level, outages should shift internet usage more quickly to mobile. In our area, VZ coverage seems to be proving far superior to that of T, so outages may encourage customer switching to the former.
If we’re still looking for anyone whose “fault” the situation I’m describing may be, try blaming Adam Smith. His “invisible hand,” is, after all, the basis for the idea that leaving everyone to pursue his own self-interest somehow produces the best social outcome.