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05/25/2005 07:00:00

New Study Suggests That State Proposal Would Drive Electricity Prices Higher

PASADENA, Calif.-A new study, on the organization of the wholesale electricity market conducted by California Institute of Technology and Purdue University economists, suggests that a plan being considered by the California Energy Commission (CEC) to require electric utility companies to make public their procurement strategies would result in higher costs for utility customers.

The study uses new laboratory experimental techniques that were developed by Caltech Professor Charles Plott to study the intricate ways in which the basic laws of supply and demand work in different forms of market organization. Use of the techniques has spread rapidly around the world. One of the first to use laboratory experimental methods in economics was Caltech alumnus Vernon Smith, who was awarded the Nobel Prize for his work.

The proposal considered by the CEC requires that the utility company make available its needs for electricity, as dictated by its customers, to the companies from which the utilities must buy their electricity. While the scientific operations of the law of supply and demand are intricate and present many challenges to science, the principles operating in this case are rather transparent. Common sense tells us that there are situations in life where letting our competitors in on our game plan is a sure way of decreasing our advantage.

For example, if you're a quarterback, the best way to make sure the fans see your team score a bunch of exciting touchdowns is certainly not to invite opposing team members into your huddle. Just as you know you should withhold information from the other football team, you also know that you should hide your cards from your poker competitors, and that you should avoid telling the used-car salesman how much money you can spend on a car.

Surprisingly, this common-sense approach to withholding information in competitive situations is still open to debate in the world of resource regulation. The proposal currently being considered by the CEC would require an openness that may seem like a good idea, but the Caltech and Purdue research shows that it flies in the face of science.

"A presumption exists in regulatory circles that openness of economic processes promotes efficiency in protecting the public interest," says Charles Plott, who is the Harkness Professor of Economics and Political Science at Caltech. "That may be true in political and bureaucratic processes, but it's not true in markets."

Plott and Timothy Cason of Purdue are the authors of a new study in the journal Economic Inquiry showing that the forced disclosure of information is bad for consumers in utilities markets, and that scientific experiments back them up. Their work addresses, in part, the CEC's announcement that it "does not believe that the California ratepayers will be harmed by a more transparent system."

Plott says that this is a long-standing and fallacious assumption that contradicts the basic laws of supply and demand. Nonetheless, it seems to persist because of a confusion between the desire for information that is characteristic of regulators and the efficient workings of a market.

"At face value, openness sounds good," explains Plott. "The argument is that the public needs to know as much as possible, and that by knowing more information the public is better able to monitor a company's behavior.

"But this is just not true, and common sense eventually tells you so," Plott says. "If you think about it, forcing a utility to reveal information about its plans about procurement of power from the wholesale markets doesn't make any more sense than forcing one player to play cards face-up in a poker game."

But the science argues against such disclosure, too, Plott says. Laboratory results in Plotts's Caltech experimental economics lab shows that forcing the utilities to reveal confidential information regarding their energy demands to suppliers will lead to higher prices for the consumer.

In short, if the rules are changed, California consumers can expect to pay higher average prices for electricity, Plott says. The exact amount of the price increases will be dictated by events that are unknown to us now, but it is easy to imagine situations in which the price increases could be on the order of 7 to 8 percent higher, and it is just as easy to imagine circumstances in which the impact of the disclosures could increase prices two or three times more. Under no circumstances would the disclosure lower prices.

In the experiments described in the Economic Inquiry paper, the researchers set up the procedure so that the volunteer test subjects would be financially motivated. The experiments were rather complicated and involved, but the objective was to test the influence of the wholesale power supplier's possession of pertinent information on the eventual price.

The experimental work showed that the manipulation of information strongly controlled the movement of the pricing equilibrium such that perturbations always went to the informed side. In everyday English, this means that a lower price results when buyers in a competitive market are not forced to "tip their hands."

Or to put it another way, the current system that requires each competitor to guess what the other is doing will result in their trying to beat each other out for the lowest price. The party that benefits from the competition is the consumer.

On the other hand, disclosure of information results in a lack of competition. The likely result is a higher price for the consumer, which could be especially burdensome in the future if the supply and demand for power is as unpredictable as it has been in the last couple of years. In fact, the paper concludes, the disclosure of information could work even greater hardships on the public if demand is unpredictable.

The title of the paper is "Forced Information Disclosure and the Fallacy of Transparency in Markets." The paper will appear in an upcoming issue.




Written by Robert Tindol