Following the 2008 financial crisis, the U.S. government increased oversight of the finance and banking industries to correct the market failures that led to the collapse – spotlighting the damage that can happen when regulations don’t work as they should. Now, a study in the latest issue of the American Economic Review uses recent state regulatory changes in electricity markets as a laboratory to evaluate what factors can contribute to a regulation causing a bigger mess than the problem it was meant to fix.
“Regulations are not created equal. Instead of debating for or against ‘regulation’ in general, it would be more productive to figure out how to separate the good from the bad,” says the author of the study, Steve Cicala from the Energy Policy Institute at the University of Chicago. “If we know what forces make a regulation unsuccessful, then we can avoid designing new ones in a similar way.”
Cicala uses data on almost one trillion dollars worth of fuel deliveries to power plants to look at what happens when a power plant becomes deregulated. He finds that the deregulated plants combined are saving about $1 billion a year compared to those that remain regulated. This is because a lack of transparency, political influence and poorly-designed reimbursement rates lead the regulated plants to pursue inefficient strategies when purchasing coal.
The $1 billion deregulated plants save stems from paying about 12 percent less for their coal because they shop around for the best prices. Regulated plants have no incentive to shop around because their profits do not depend on how much they pay for fuel. They also are looked upon more favorably by regulators if they purchase from mines within their state, even if those mines don’t sell the cheapest coal. To make matters worse, regulators have a difficult time figuring out if they are being overcharged because coal is typically purchased through confidential contracts.
Although power plants that burned natural gas were subject to the exact same regulations as the coal-fired plants, there was no drop in the price paid for gas after deregulation. Cicala attributes the difference to the fact that natural gas is sold on a transparent, open market. This prevents political influences from sneaking through and allows regulators to know when plants are paying too much.
What’s different about the buying strategy of deregulated coal plant operators? Cicala dives deep into two decades of detailed, restricted-access procurement data to answer this question. First, he finds that deregulated plants switch to cheaper, low-sulfur coal. This not only saves them money, but also allows them to comply with environmental regulations. On the other hand, regulated plants often comply with regulations by installing expensive “scrubber” technology, which allows them to make money from the capital improvements.
“It’s ironic to hear supporters of Eastern coal complain about ‘regulation’: they’re losing business from the deregulated plants,” says Cicala, who is an assistant professor at the Harris School of Public Policy.
Deregulated plants also increase purchases from out-of-state mines by about 25 percent. As mentioned, regulated plants are looked upon more favorably if they buy from in-state mines. Finally, deregulated plants purchase their coal from more productive mines (coal seams are thicker and closer to the surface) that require about 25 percent less labor to extract from the ground and that pay 5 percent higher wages.
“Recognizing that there are failures in financial markets, health care markets, energy markets, etc., it’s critical to know what makes for ‘bad’ regulations when designing new ones to avoid making the problem worse,” Cicala says.