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The Economics of Pepco

Friday, July 6, 2012

What happens when there is no market for reliability.

A recent storm in the Washington, D.C. area left many households without power for days. Customers served by one company, Pepco, appeared to suffer the worst. Pepco had the slowest rate of power restoration of all the area's electricity suppliers.

As an economist and a Pepco customer, I am concerned by two factors that insulate Pepco from facing market discipline concerning reliability. The first is that Pepco is a regulated monopoly. The second is that there is no price indicating the benefits of reliability.

The fact that Pepco is a monopoly means that its incentive to improve its operations is limited. Regulators may cajole and threaten, but ultimately Pepco is like an employee with tenure—no matter how badly it performs, it can never be fired.

The fact that there is no market price for reliability makes matters even worse. The amount that Pepco invests in ensuring reliable provision of electricity does not have to bear any relationship whatsoever to the value that consumers place on reliability.

Break Up Pepco?

Electric utilities have long been considered natural monopolies. Supposedly, it is inefficient to have multiple service providers in the same area.

First, regulation is inferior to market competition as a force for driving improvements in quality. Second, when there is no market price for something of value, incentives are bound to be misaligned.

However, there might be other ways to organize the maintenance of the local electricity infrastructure. One can imagine breaking the Pepco service area into smaller districts, with each district having its own maintenance contract. The maintenance contract could be put up for bid every five years. To the extent that other utilities have acquired organizational knowledge that makes them better at preventing and restoring power outages, those utilities would have an advantage in bidding for district maintenance contracts. Over time, the least cost-effective competitors would be weeded out.

I am not saying that such a breakup would be simple or costless. Its drawbacks would have to be measured against the benefits of competition.

Tiered Pricing Backed By Reliability Insurance

The other economic consideration that I see is a need for reliability to be priced into the contract between Pepco and its consumers. There are many ways that this could be done. For illustration, let me suggest a form of tiered pricing backed by reliability insurance.

How much would customers be willing to pay for greater reliability? One approach to finding the answer would be to offer tiered pricing. Suppose that there are two tiers. The top tier of households gets a guarantee that in any given year they will not be without power for more than four hours, total. The bottom tier gets a guarantee that they will not be without power for more than seven days, total.

Each household will be asked how much it would be willing to pay to upgrade to tier one. If the median household offers to pay $10 per month, then that is the price that Pepco must offer for tier one service. To ensure that people do not overstate or understate their willingness to pay for reliability, households that bid at or above the median price would have to take the upgrade and households that bid below the median price would not be able to take the upgrade.

The reliability guarantee would have to be backed by an indemnity insurance policy. That is, if a customer experiences more than the guaranteed maximum amount of power outage, Pepco would have to pay that customer, say, $20 an hour for each hour over the limit. For example, if a tier-one customer were to experience a total of 44 hours without power in a year, this would be 40 hours over the limit. At a rate of $20 an hour, Pepco would reimburse this customer $800. To put this another way, suppose that there are 10,000 households who are already over the limit. Leaving these households without power another 10 hours would cost Pepco $2 million.

The regulator would set the indemnity rate. As a first approximation, it could be an actuarially fair rate based on historical experience. That is, looking at past experience, the regulator could set the rate such that, had the system been in place over the past five years (and assuming a random distribution of tier-one customers), the cost of indemnity payments would equal the additional revenue from the reliability surcharge. For example, if the additional revenue from the reliability surcharge is $1 billion and the average amount of excess customer-hours is 100 million per year, then the indemnity rate will be $10 an hour. Note that only historical data (before this system is implemented) would be used; otherwise, going forward, poor performance could help Pepco by lowering the indemnity rate.

This actuarial approach means that if the reliability surcharge that consumers are willing to pay is low, then the indemnity rate will be low too. If the reliability surcharge is high, then the indemnity rate will be high.

One can imagine breaking the Pepco service area into smaller districts, with each district having its own maintenance contract.

The indemnity rate, which is influenced by the extent to which consumers value reliability, will in turn determine the incentive for Pepco to spend resources to increase reliability. If Pepco can make inexpensive investments in reliability in order to avoid paying indemnities, then it will do so. Once the cost of additional reliability gets too high at the margin, Pepco will settle for paying indemnities.

Combining the Two Approaches

It might be interesting to combine the approaches of tiered pricing and competition. For example, if the indemnity rate is set on the basis of Pepco's past performance, a competitor might calculate that it can earn a profit by swooping in and taking over maintenance. If the competitor is more reliable, it will enjoy the reliability premiums from tier-one customers without having the indemnity costs that Pepco would suffer.

I hope that readers understand that I am not proposing these as ideal solutions to the problem of electricity reliability regulation. The main point is that we should appreciate the economics of the situation. First, regulation is inferior to market competition as a force for driving improvements in quality. Second, when there is no market price for something of value (in this case, reliability), incentives are bound to be misaligned.

Right now, we complain about power outages even though at the margin we pay nothing for reliability. My guess is that, under the system proposed here, or any other system designed to align incentives at the margin, we would find that for all their complaining, consumers' willingness to pay for reliability is disappointingly low. After all, not many people have generators.

Arnold Kling is a member of the Financial Markets Working Group at the Mercatus Center of George Mason University. He writes for econlog, part of the Library of Economics and Liberty.

FURTHER READING: Kling also writes “Checks, Balances, and Audits,” “Why We Need Principles-Based Regulation,” and “The Tribal Mind: Moral Reasoning and Public Discourse.” Michael Auslin discusses “Powering Down Japan.” Benjamin Zycher contributes “Wind and Solar Power, Part I: Uncooperative Reality.”

Image by Darren Wamboldt / Bergman Group

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