Q: What do the banking crisis and the energy crisis have in common?
A: They have both been created in no small part by government policies that have expressly incentivized risky behavior.
For the banking perspective, pick up any recent issue of The Economist. They have lately been running a series of rather insightful critiques of the recent federal bailout of Fannie Mae and Freddie Mac. (Here's one of many.) Their criticism is essentially that a competitive market is like a pregnancy -- there's no such thing as half. Either nationalize these banks or let them fail, but don't maintain the fiction of a for-profit, publicly traded government-guaranteed company.
But this criticism need not stop at Freddie. It applies equally to any industry that governments deem "too important to fail." In the energy context, a great current example is the recent Supreme Court decision Morgan Stanley Capital Group Inc. v. Public Utility District No. 1 of Snohomish County, not because of the case itself, but because it's brought the 50-year old "Mobile-Sierra" doctrine into the light of day. (See here [PDF] for one, randomly-picked law firm's summary of the recent ruling.)
Fannie and Freddie
Fannie Mae and Freddie Mac as "government-sponsored entities" have always had access to lots of really cheap money. This is because the banks have always assumed that in the event that either failed, the government would bail them out. Seeking Alpha noted last month:
Not only does [Fannie Mae] have to worry about the $741 billion in mortgages and Mortgage-Backed Securities [MBS] on its own books, but it has to worry about the $2,242 billion (or $2.2 trillion, if you like) of MBS held by third parties that FNM has guaranteed! If we throw this onto the balance sheet, where it arguably belongs, this inflates the debt/worth leverage ratio to an absolutely ridiculous 78:1. This equates to a capital ratio of its inverse at 1.3 percent. No normal bank can get away with this kind of leverage.
If you're not familiar with the financial jargon, the relevant ratio here is 78:1. For every dollar worth of stuff they actually owned, they had $78 worth of debt. The problem with that is identical to the problem you would face if you took out a $780,000 mortgage on a $790,000 house. You own $10,000 worth and owe the bank $780,000. If the value of your house goes up to a million bucks, you earn a massive return on your $10,000 investment. If it goes down on the other hand, you are -- as they say in France -- in deep merde.
The value of Fannie Mae's "house" has of course collapsed, rendering it unable to pay off its mortgage. So were lenders foolish to loan it so much money? Nope. Because lenders were guessing that the government would always step-in in the event of default to make sure the debt got paid off. Which we did. Smart lenders.
But the problem isn't the lenders. It's the government guarantee.
Let's say that a bank was willing to loan you debt on the same terms. Might you be inclined to buy a bigger house than you could afford, on the hope that it would rise in value? Probably. And if so, you'd be behaving no differently than Fannie/Freddie managers who also took risks that in hindsight turned out to be unacceptable.
So should they be blamed for taking such bets? Not really -- because government policy made it worth their while to do so. Cheap money plus an implicit bailout if things head south gave Fannie and Freddie managers a chance to earn lots of money if they made good bets, but ensured that they wouldn't lose money if their bets were bad. Given that structure, the message they got was clear: make lots of bets. Which is exactly what they did.
Which brings us to The Economist's argument. Fannie and Freddie probably are too big to fail. But if that's the case, then they ought to be nationalized. On the other hand, one could certainly argue that the government shouldn't be in the mortgage lending business. If that's the case, let them fail. Their shareholders invested private capital in them which managers squandered. Too bad, shareholders.
Instead, we've simply locked in the worst of both worlds, bailing them out while keeping them private and for-profit. Having just lost half of our cash on the roulette wheel, we've made a choice to double down on black. Really, really dumb.
The Mobile-Sierra doctrine
The same problem lurks in the electric sector.
Note: the entire concept of a regulated electric utility is that a for-profit enterprise gets government-guaranteed revenues and protection from bankruptcy. Mobile-Sierra is simply one manifestation of a much larger problem.
Utility rate-making is a complicated, rather bizarre process to anyone who thinks that pricing is simply a function of supply and demand. Utilities ask for rates, commissions ask for justification for those rates, months of analysis ensue and the utility regulator then issues rates that it deems to be "just and reasonable."
Bizarre though this process may be, it is how rates for all regulated monopolies, from railroads to telephones have historically been set. And it runs into an intellectual problem when the utility executes a bilateral contract external to the formal rate-making process. For example, suppose a utility offers a local industrial a 10 percent discount on their power rates as an incentive to keep their factory running. (Such deals are quite common.) The rate is offered only to that industrial and is done only with the mutual consent of the utility and the industrial. Is this rate just and reasonable?
That turns out to be a difficult question to answer, but the Mobile-Sierra doctrine essentially says that the contract is presumed to be acceptable, but is revocable if the state determines that the contract would "adversely affect the public interest."
This may all seem very reasonable, but it is actually a deep subversion of contract law, since it essentially says that all contracts are valid ... except contracts entered into by regulated utilities, which can be severed in certain circumstances.
Which brings us to the recent Supreme Court case.
In that case, a group of utilities entered into long-term power contracts at the peak of the California power crisis. Several years later, as power prices settled down, they were understandably not so keen on those contracts. If they were normal businesses, too bad. You signed the contract, you deal with it. But they aren't normal businesses. They're utilities. Ergo, they cried foul in the name of Mobile-Sierra, arguing that their crummy contracts adversely affected the public interest and should be revoked.
Which gets us right back into the same misalignment of risk and reward that bedeviled Fannie and Freddie. Managers of normal businesses have a reason to be careful about contracts they sign. Managers of regulated utilities, on the other hand, always have a Mobile-Sierra "out," which, like Fannie and Freddie, gives them an incentive to take bigger risks than they should.
The heck of it is, the concept behind Mobile-Sierra itself is a valid one. There are very legitimate concerns for anything as important as electricity when it comes to price and availability. Moreover, there is a robust (and proper) history of common law that recognizes the power of the government to supersede private contracts when those contracts are at odds with the public good. But there is an innate problem with any government-guaranteed, for-profit business because of the way it incentivizes the managers of those businesses to take otherwise unacceptable risks. Nationalize them, or fully deregulate them with full potential for bankruptcy. But stop trying to have it both ways, unless you're willing to bear the inevitable consequences.
Top 25 reasons to give a damn about climate change
Comments
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Gar Lipow Posted 7:05 am
08 Aug 2008
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Jon Rynn Posted 7:26 am
08 Aug 2008
I think there is probably a role for public banks, particularly for small businesses, to fund R&D, and for infrastructure development, because those tend to be ignored by the big financial players.
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David Roberts Posted 7:28 am
08 Aug 2008
But generation? That should be a competitive market, just like end use is.
grist.org
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Delay And Deny Posted 7:37 am
08 Aug 2008
The real problem is we live in an economic slave state where it takes 30 years -- a life time -- to buy a home.
An indentured servant in the 1700s would have worked his way into ownership in 7 years, and he would have ten acres.
You can't expect people to give a hoot about cleaning up a planet when they struggle for survival each and every day.
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Gar Lipow Posted 8:41 am
08 Aug 2008
Keep the grid public, open, and neutral -- net neutrality, just like the internet and for the same reasons.
But generation? That should be a competitive market, just like end use is.
If you want a renewable dominated grid, rather than a grid in which renewables play a niche role this is not as obvious as you think. Or at least your "neutral grid" is going to have to come with a very complicate price structure.
Here is what you need to make a grid 80% or more dominated by sun and wind work:
You will need storage to let shift supply to match demand. (Even if low temp storage and BEV batteries allow demand shifting, you are going to have a lot of demand that has be met as it occurs.)
You are going to want the ratio between solar and wind generation to match demand as closely as possible to minimize the need for storage.
You are going to want to control how much of each type of generation occurs where to minimize that same need for storage.
Yeah, you can have a complicated series of incentives, regulations and tiered pricing structures to accomplish this. But what you end up with is another too big to fail system, privately run, publicly guaranteed. If you want renewables to come fast, and to actually displace fossil fuel, I think you will need heavy public involvement in generation. Because of the weird 21st century market fetishism, it probably will have to be a public-private partnership with all the problems it involves rather than straight public ownership. But maybe for just one moment we can drop the pretense that is either the best or cheapest way to get reliable low-carbon energy.
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Sean Casten Posted 8:44 am
08 Aug 2008
So while I agree with you that a good case can be made for nationalization of certain parts of the power system, I would not apply that logic to everything. Let's do be sure though that the bits we don't apply it to are truly private without any implicit or explicit government crutches to lean on when the going gets hard.
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Sean Casten Posted 8:45 am
08 Aug 2008
You're one smart dude.
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Sean Casten Posted 8:50 am
08 Aug 2008
The services you describe are provided today by the Independent System Operators that are essentially public entities. Not just load balancing as you mention, but also voltage support, power factor correction, opening and closing breakers to route around congested areas, maintaining spinning reserve and any number of other ancillary grid services. (And worth noting that in some cases, they provide those services with complicated market-based processes and in other cases they simply treat it as a system management cost.)
Renewables don't make that management function any more complicated - just different. But in any event, that system management function is readily bundled in with grid operation and need not be tied to the generator.
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Gar Lipow Posted 11:46 am
08 Aug 2008
Note that we already see problems with wind supplying around 24% of total consumption in one of the major Danish grids. I don't think any grid in the world currently runs with a majority of its power coming from variable sources. If you just allow any renewable variable source to attach without any balancing you get real problems. Sure enough operating and spinning reserves can compensate. But many of these will be coal or natural gas, which ends up losing a lot of the carbon reduction benefits. Also if your generation is not balanced right, if you have the "free market" providing a mix that is too far from optimal you will need a lot more spinning and operating reserves than you would otherwise.
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Sean Casten Posted 12:07 pm
08 Aug 2008
But I digress. The point is simply that plenty of market mechanisms exist to factor in differential pricing at differential hours.
Another point: the vast majority of the cogen installed in the world runs baseloaded or thermal-load following. There are exceptions of course, but they are, well, exceptions. My understanding of the Danish issues you mention is that they were a function of wind rather than cogen, since a high concentration of wind on the grid goes on and off as wind patterns shift without regard to load. Moreover, a cogen load - driven by local heat demand - is almost always coupled to a local power load, while a wind load has no such natural linkage. As a result, one finds that wind has much more potential to get out-of-synch with local needs than cogen.
A minor quibble, but worth keeping in mind that the system management issues you raise arise only when intermittent renewables (hydro, wind, solar) become significant fractions of the grid, and don't really arise with other local-gen technologies.
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Gar Lipow Posted 1:49 am
09 Aug 2008
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