Transactions Cost and Institutional Economics, in Real Time

This article from Der Speigel is a fascinating article on many levels.  It describes how an environmental mandate-the German mandate to increase the power generated from renewables-is wreaking havoc on high tech German manufacturing:

Sudden fluctuations in Germany’s power grid are causing major damage to a number of industrial companies. While many of them have responded by getting their own power generators and regulators to help minimize the risks, they warn that companies might be forced to leave if the government doesn’t deal with the issues fast.

. . . .

Behind this worry stands the transition to renewable energy laid out by Chancellor Angela Merkel last year in the wake of the Fukushima nuclear disaster. Though the transition has been sluggish so far, Merkel set the ambitious goals of boosting renewable energy to 35 percent of total power consumption by 2020 and 80 percent by 2050 while phasing out all of Germany’s nuclear power reactors by 2022.

The problem is that wind and solar farms just don’t deliver the same amount of continuous electricity compared with nuclear and gas-fired power plants. To match traditional energy sources, grid operators must be able to exactly predict how strong the wind will blow or the sun will shine.

But such an exact prediction is difficult. Even when grid operators are off by just a few percentage points, voltage in the grid slackens. That has no affect on normal household appliances, such as vacuum cleaners and coffee machines. But for high-performance computers, for example, outages lasting even just a millisecond can quickly trigger system failures.

One reason the story is interesting is that it demonstrates-as if further demonstration were needed-that regulatory Sorcerer’s Apprentices take (allegedly) well-intentioned actions that have perverse unanticipated consequences.  Here the likely explanation is that said politicians and bureaucrats have a simplistic understanding of the industry they presume to regulate.  They perceive that the output of the power industry has a single dimension-megawatts produced.  They fail to understand that there are other economically crucial dimensions-such as voltage stability-so when they decree that Fraction X of Megawatts Shall Be Generated With Renewables, they fail to understand the implications of this decree for these other vital dimensions.  Meaning that they underestimate the costs of their lofty dictates.  (The electricity industry is particularly vulnerable to unintended consequences from attempts to structure it via legislation, cf. California.  I wrote a book chapter some years back about the difficulties in choosing the balance between the invisible hand and the visible hand in power.  The complexity of the power system, most notably the need to control its operation in real time, raises acute difficulties in relying solely on the invisible hand-the allocation of resources by price and contract-and makes it vulnerable to catastrophic consequences resulting from ill-considered interventions.)

The other source of interest to me is the Coasean aspect of the story.  Rather than a locomotive casting off sparks that sets farmers’ fields alight, here we have power generators producing random fluctuations in voltage that cause very sensitive-and expensive-machines to break down.  So who is liable for this?  That is a growing source of conflict in Germany:

Although the moves being made by companies are helpful, they don’t solve all the problems. It’s still unclear who is liable when emergency measures fail. So far, grid operators have only been required to shoulder up to €5,000 of related company losses. Hydro Aluminum is demanding that its grid operator pay for incidents in excess of that amount. “The damages have already reached such a magnitude that we won’t be able to bear them in the long term,” the company says.

Given the circumstances, Hydro Aluminum is asking the Federal Network Agency, whose responsibilities include regulating the electricity market, to set up a clearing house to mediate conflicts between companies and grid operators. Like a court, it would decide whether the company or the grid operator is financially liable for material damages and production losses.

But, for now, agency head Jochen Homann wants nothing to do with the idea. He first plans to discuss the problem with experts and associations in detail.

For companies like Hydro Aluminium, though, that process will probably take too long. It would just be too expensive for the company to build stand-alone emergency power supplies for all of its nine production sites in Germany, and its losses will be immense if a solution to the liability question cannot be found soon. “In the long run, if we can’t guarantee a stable grid, companies will leave (Germany),” says Pfeiffer, the CDU energy expert. “As a center of industry, we can’t afford that.”

In a Coasean zero transactions cost world, the liability assignment doesn’t matter.  So the situation in Germany raises the question of what are the transactions costs that preclude negotiations between power producers and power consumers that result in an efficient outcome.  (I should actually say “constrained efficient”, the constraint being the renewables mandate, which is almost certainly not efficient.)

There are only a few utilities to negotiate with, but there are many manufacturers adversely affected by the voltage variance.  Can these manufacturers engage in collective action (through an industry association, for instance) to negotiate?  Will free riders undercut these efforts?  Are the affected firms too heterogeneous to engage in effective collective action?  Does private information about value impede negotiation, either between the manufacturers and the utilities, or among the manufacturers in their attempt to organize collective action?

One factor that affects value is the cost of mitigation.  The article has some interesting detail about that:

At other industrial companies, executives at the highest levels are also thinking about freeing themselves from Germany’s electricity grid to cushion the consequences of the country’s transition to renewable energy.

Likewise, as more and more companies with sensitive control systems are securing production through batteries and generators, the companies that manufacture them are benefiting. “You can hardly find a company that isn’t worrying about its power supply,” said Joachim Pfeiffer, a parliamentarian and economic policy spokesman for the governing center-right Christian Democratic Union (CDU).

. . . .

Even August Wagner, head of a textile firm with roughly 180 employees in Bavaria, is taking precautions against feared power interruptions. A stop in production would be catastrophic for him. “When we dye our materials, there are thousands of meters in the dye factory,” he said. “If the power goes out, all of the goods are lost, and we have huge losses.”

Wagner now regulates the power supply of his production himself so that it doesn’t come to that point. What’s more, for a few months, he’s had an emergency power source standing in container next to the production facilities. Since then, other businesspeople in the area have been dropping by to take a look at his setup.

Aurubis, a major copper producer and recycler in Hamburg, has also spent about €2 million to protect against unwanted power emergencies. “If grid stability doesn’t markedly improve, we’ll have to rely on emergency power supplies this and the coming winter,” the company say

Presumably different companies, with different products and different technologies, incur different costs from a voltage fluctuation, and incur different costs to mitigate it.  Moreover, they almost certainly have private information about these costs.  Furthermore, utilities probably have private information about the costs they incur to address this problem.  All the resulting heterogeneity and private information, combined with the free riding problems inherent in collective action, present challenges to private solutions to this problem.

But they also present acute challenges to regulatory and legal solutions.  Given information about the costs of voltage fluctuations, and the costs of mitigating them, one could theoretically design the right liability rule.  But no one-not the politicians, not the regulators, and not the courts-have this information.

All meaning that the resolution of this issue will probably be time consuming, and beset with errors and false starts.  Especially when one considers the potential for political economy considerations to distort the process.

So this will be interesting to watch going forward.  A real world case study of how a big, heterogenous economy and polity deal with a (regulation-induced) technology shock that creates an “externality”.  Pay attention, PhD students.  There are thesis topics in there aplenty.  Another unintended consequence, to be sure.

About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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