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Economic theory and the Swedish deregulation experience: a warning and not an example*
FERDINAND E. BANKS**
Electric deregulation in Sweden
is an obvious failure insofar as distribution firms and consumers are concerned.
The winners are the large generating companies and the government. Furthermore,
the losers recognize this situation even if the deregulators and their various
support groups still are unable to admit that the deregulation 'experiment'
should not have been launched. Although cost-wise Swedish electricity - which is
based on hydro and nuclear - is (together with Norway) the most inexpensive in
the OECD, and probably the industrial world, its price to Swedish consumers and
small businesses is now among the highest in Europe. Even large industries,
which before deregulation always paid the lowest price in the world for
electricity, now find themselves severely disadvantaged, and if they cannot
obtain inexpensive electricity from Eastern Europe - much of it based on coal -
have threatened to move as much of their energy intensive operations as possible
out of the country. This is a common story throughout much of the OECD, and in
the long run it could bring about severe macroeconomic, political and social
The former Swedish industry minister, who is a warm friend of deregulation, has said that Swedish electricity prices are going to climb to record levels. According to that gentleman, the ”hard competition” in the electric industry has favored consumers, but now – in his opinion – the postponing or cancelling of physical investments due to the negative price developments resulting from this so-called competition must come to an end, and in order to finance new production capacity, electricity prices must escalate.
No matter what you believe or do not believe about deregulation in Sweden, it is difficult to accept that it has favored consumers. In fact a main reason for deregulation was to enable Swedish firms to sell low-cost Swedish electricity to Germany, which had the highest electricity prices in Western Europé. And although the two most recent Swedish finance ministers can hardly claim that they possess an advanced knowledge of economic theory, they understood perfectly that the ensuing rise in domestic (i.e. Swedish) power prices meant extra billions of Swedish crowns in tax revenues, I think that I have made some good decisions as to how I should buy electricity, but even so I am very annoyed by my electricity bills, and the same is true for colleagues who are a great deal more careful in this matter than myself. Some observers say that the high electricity prices of the past few years are not due to deregulation, but a shortage of rain which has kept reservoir levels low, and thus reduced the output of hydroelectric installations. As it happens, however, on a recent occasion the water that provides a large part of the Swedish electricity reserve was turned into electricity and sold at a time when it was judged highly profitable for the now deregulated power companies, but which happened to be wrong for the country as a whole.
What this means is that the electricity reserves have occasionally fallen to a record low level – perhaps as low as 7%, as compared to a 12-14% normal level. While this was taking place, the competition that Mr Industry-Minister was so proud of led to the 5 or 6 firms that produced almost 90% of the (wholesale) electricity in Sweden gradually being reinvented as 3 firms.
Before continuing, let me say that speaking as a student and teacher of economics and finance, I have nothing at all against this change in the composition of the electric sector. However I am unable to be so blasé about those aspects of the Swedish deregulation picture in which some of the lowest cost electricity in the world drastically increased in price as a result of consumers allowing themselves to be convinced that it was beneficial to disregard their self-interest in the name of ’competition’, without being informed of the disadvantages that could result from this transition.
Facing the music
For the past few years I have been giving talks on oil and the deregulation of electricity at various conferences. Here I want to emphasize that I am not an intemperate conference habitué, but a teacher of economics and finance who happens to be in possession of important information about certain existing and proposed deregulation experiments. I am also aware that my uncompromising approach to this topic has lost me the sympathy of many persons who attend these meetings.
Frankly, this doesn’t bother me at all. One reason is because at a recent international meeting of the International Association for Energy Economics (IAEE), members of the electric deregulation booster club kept a low profile. Even Professor David Newbery, chairman of the Department of Applied Economics at Cambridge University, and once a leading deregulation theorist, failed to assure his audience that the day would soon arrive when they could luxuriate in one of the deregulated paradises that was he working so hard to create. As to be expected though, the many failures of electric deregulation have escaped the attention of Swedish representatives of the club, and so given the opportunity they continue to spread the kind of misrepresentations that could result in huge economic losses for their country.
Professor Nils-Henrik von der Fehr, of Oslo University, once wrote that the Nordic power sector reform is a definite success so far (2002). Actually it has been a failure from the start, if you compare results with expectations, although an academic in Sweden who plays fast and loose with this description can say goodbye to research and travel money! I am certain that Professor von der Fehr knows this as well as I do, because he has the kind of analytical ability that many charter members of the Nordic deregulation booster clubs would work night and day to acquire if they were not overwhelmed by growing uuncertainties. He knows a few other things too. In the same review he wrote:
”However, it is also true that in some respects the model has not been tested. Although over-capacity has been reduced, the market has never been really tight except, perhaps, this winter. Consequently, we do not actually know how the model will perform in such circumstances. Is the market mechanism flexible enoough so that demand will be met and rationing avoided? As over-capacity is eroded, will new investments be forthcoming at the required rate? And will tighter market conditions – in combination with increased concentration – mean that market power, which has not really been an issue so far, becomes more of a problem in the future.”
Market power is not a future problem. Because of deregulation, it is a problem today in Sweden and Norway, and almost certainly elsewhere. As for the over-capacity syndrome, this is something that I never really understood – largely because in the context of Sweden and Norway, it wasn’t worth understanding. Let me also note that Frank Wolak (2003) and other investigators in California have shown that in a deregulated electric market, strategic bidding can provide unilateral market power.
Von der Fehr says that new problems emerge as the power industry develops, and regulators must maintain their ”alertness” in order to adjust the model as required. On the basis of existing evidence, however, it could be argued that many regulators have no alertness to maintain.
As I like to emphasize, the only thing that is necessary to comprehend what is taking place in the great world of electric deregulation is an open mind. J.A. Casazza, an engineer and president of the American Education Institute, claims that the annual cost of a comprehensive electric market restructuring in the US would be about 28 billion dollars (2001). This may or may not be true, but regardless of the cost, what I find interesting is his contention that when restructuring was initiated in California, some engineers were required to sign confidentiality agreements that kept them from discussing the problems that were almost certain to emerge in a deregulated setting. Casazza also suggests that economists from some of the most prestigious universities in the United States have failed to fully comprehend the electric power industry. He believes that the economic theory used in restructuring the electric power industry is badly flawed.
The problem is not the theory, but the people using it. The theory would more than suffice if there were not, as US Congressman Peter de Fazio observed, ”millions and billions” are on the table. Millions and billions for the Enrons of this world; thousands and tens of thousands for certain academics who pointedly ignore discussions on this subject in the wonderful microeconomics textbooks that are now available, because they feel that it is not in their interest to discover that electric deregulation is a crusade whose justification has a pronounced voodoo content. There is also a near-conspiracy to ignore or downgrade the historical evidence, which includes outright failures in California and Ontario (Canada), fiascoes in Alberta (Canada), Brazil, and Montana (USA), and an ongoing botch in Sweden, Norway, and South Australia. I can also mention outlandish price variability in some of the midwestern and eastern states in the US, as well as in Australia; and lower reliability just about everywhere. Unexpected and painful outcomes have occasionally surfaced in the UK, Germany, and New Zealand, although in those regions we will have to wait until the inevitable decrease in physical investment (and increases in the cost of inputs such as gas) leads to the price rises that, hopefully, will bring consumers of electricity to their senses.
Final remarks and conclusion
When I began this contribution, I gave some thought to explaining in detail why Nord Pool (i.e. the Nordic Electric Exchange) is a superfluous departure, despite the ability of untruths and pseudo-science to give it an undeserved respectability. The reason I won’t is because examining the background and interior mechanics of this elaborate deception requires more than the comparatively short time available in a conference or workshop.
But even so, I am satisfied that making an informal case against Nord Pool is no more difficult than doing the same thing with (physical) electricity trading in the US, which the international business press has now revealed as a gigantic bluff. To begin, it is important to be aware that the finance literature in book form hardly bothers to mention materials on electricity derivatives. Undoubtedly, the best known books on derivatives/risk management are those of John Hull, however in none of his books is there more than a page on this subject, and generally there is less. Among other things, this shows that he is aware of the topic, but doesn’t think that it deserves to be examined in detail. By the same token, the mainstream economics journals are almost completely void of work on electricity derivatives. Electricity derivatives were first mentioned about ten years ago, and since that time hundreds of papers on various types of derivatives have appeared in the mainstream scientific periodicals, but to my knowledge none about electricity. The situation is not much better in the energy literature.
Not too long ago, liquidity problems caused the New York Mercantile Exchange (Nymex) to delist its electricity futures and options contracts. If this renowned New York exchange – which has enjoyed great success for decades – found it unprofitable to trade these particular assets, it seems presumptuous to assume that Nord Pool deserves to be regarded as a permanent component of anybody’s electric market. For reasons alluded to in my energy economics and international finance textbooks (2000, 2001), the trading of electricity futures and options involves enormous practical difficulties (due to basis risk for futures, and excessive premiums for options), and this is exactly what Nymex and, among others, the futures market in Sydney experienced. Contracts for differences are more useful, although for final consumers of electricity – households and businesses – it would be better if all derivatives were marginalised, and the old system for selling and buying power reintroduced.
Recently, in an editorial in the Financial Times (July 5, 2004), a plea was made to “set energy free”. The most interesting point here was the confession that “proponents of liberalisation no longer have the carrot of price cuts to lure people on.” Instead it was suggested that consumers should be grateful for a more “efficient” energy pricing.
As it happens though, deregulation has always been sold to electricity consumers on the basis of assurances that electricity prices would decrease. As for ‘efficiency’, in the popular mind this means price cuts, and if it means something else then the less said about it the better. It also needs to be pointed out that in Sweden, also on July 5, it was finally recognized (in the largest morning newspaper in the country) that the success of electricity deregulation is a myth. Consumers have definitely lost, and perhaps some distribution companies. The power producers (i.e. wholesalers) have record profits (which they use to invest outside Sweden), while the largest winner is the government.
Finally, given the bizarre mispricing that occasionally takes place in Nord Pool, I want to emphasize that it is only the lack of sophistication of Nord Pool’s customers that can keep the doors of this overpraised and arguably superfluous operation from closing in the near future, and staying closed forever. It has been said that new types of financial assets might appear soon, both in Oslo and New York, however these are a play for the gallery. The most valuable risk management tools in the electric market are still long term contracts in a regulated environment.
Banks, Ferdinand (2001). Global Finance and Financial Markets. Singapore, New York and London: World Scientific.
______. (2000). Energy Economics: A Modern Introduction. Boston, Dordrecht, and London: Kluwer Academic Publishers.
Casazza, J.A. (2001). ’Electricity choice: pick your poison’. Public Utilities Fortnightly (March).
Losekann, Luciano and Joanne Evans (2003). ’Optimal power reform design’. Paper presented at the 2003 meeting of the International Association for Energy Economics, Prague, June 3-5.
Von der Fehr, Nils-Henrik (2002). ’Comment on Lars Bergman.’ Swedish Economic Policy Review, Number 9.
Wallace, Charles P. (2003). ’Power of the Market’. TIME, March 3.
Wolak, Frank A. (2003).’Measuring unilateral market power in wholesale electricity markets’. American Economic Review (May).
* Invited paper for the Second Asian Conference on Energy, Hong Kong Energy Studies Centre, August 24-25, 2003. I would like to thank the Centre director, Dr Larry Chow, for his help.
** Professor with the Nationalekonomiska Institutionen, Uppsala University, Dalbovagen 33D, Uppsala, Sweden, 75633. E-mail: firstname.lastname@example.org.
Pubblicato su www.ambientediritto.it il 09/10/2006