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How Should Electricity
from the Federal
Hydro System
be Allocated?
A Brief Essay in Clear Thinking
by Mike Katz (a.k.a. Melvin Bernard in his earlier incarnation) Footnote1
Regardless of the cost of competing generation resources (such as gas turbines), federal hydro generators will twirl. They will produce power for sale. Why? Because their variable costs are virtually zero. Nobody can beat it.
It would be transparently wasteful for other generating resources to be up and running while lower cost hydro turbines stand idle. No matter how dreadfully the U.S. Treasury gets ah, er, ah, ... stiffed, those turbines will spin. It is better for the Treasury to lose a little money than a lot of money.
Of course, it is preferable from the owners' standpoint to recover total costs -- variable and fixed. But, so long as variable costs are covered and some contribution, even tiny, made toward fixed costs, owners of the hydro system are at least minimizing losses.
Forget Cost: Economic Rent and the Case for an Auction
Unlike other generating resources (for example, gas turbines), federal hydro resources in the Pacific Northwest are now fully developed for generation of energy and cannot be replicated. They are a function of falling water; a one-of-a-kind asset; part of "the original and inexhaustible gift of nature." Like land, there is no more to be had at any price.
Most everyone agrees at least on one principle: federal hydro generation should not be given away free. That would be mindless, leading to the equivalent of an overgrazed commons or what is the same, long queues of unsatisfied demand. It must be priced and sold. But to whom and for how much? Footnote2
In 1815, a bright cookie named David Ricardo, the leading economist of his age, formulated the theory of economic rent. In a nutshell, he said, certain factors of production, for example, Northwest wheatland, with total supply fixed (that is to say, with perfectly inelastic supply) and with no other uses are said to earn a pure economic rent. Because the quantity of land is fixed, higher prices do not coax out greater supply, nor do lower prices diminish quantity supplied. The price at which wheatland is auctioned off is determined exclusively by demand. Footnote3
Like rents on land, income from the sale of federal hydroelectricity is an "economic rent." The owners (U.S. taxpayers at present) of those hydro facilities will take whatever their product fetches in the market. When prices of alternatives are low, owners may not be able to recover all their costs, fixed and variable, but they will not hold back production. Anything received for the output is better than nothing. Why? Because like land, federal hydropower is in fixed supply, it cannot be replicated, and it can serve no other purpose. In the relevant range it has a perfectly inelastic or vertical supply curve. Footnote4
What can the owners of federal hydro plants get for their product? Surely not a penny more than what buyers would have to pay for the next lowest cost alternative, currently surplus power or unburdened gas-turbine generation. Gas turbines, being eminently replicable and competitive with one another, will have output prices that gravitate towards cost-based levels whether their owners like it or not. That is the nature of replicable factors and competitive firms.
The price for output from limited federal hydro facilities, however, has nothing to do with, and hence should not be based on, cost. When sold, federal hydropower should go to the highest bidders, fetching whatever the auction market offers for it. That is the only sensible way to allocate one-of-a-kind scare resources such as Michael Jordan's hoop proficiencies, Leonardo da Vinci's Mona Lisa, and Jackie Kennedy's tchotchkes, so they will be deployed to their most valued use.
Auction Examples
Illustrations abound of factors or products in permanently short or fixed supply and how they are, or should be, marketed. In each case, cost is irrelevant.
Auction is the technique used today by airlines when they (sensibly) over book flights. Passengers for whom making a scheduled but over-booked flight is of some importance, fly. Those who care less, accept bribes and take a later flight. In effect, the airline is auctioning off a scarce fixed-supply of seats on a particular flight to those who value keeping their scheduled appointments and willingly forego bribes. No one is bumped involuntary. Hence, everyone is happy.
There is a limited amount of water in the arid Southwest. Thoughtful environmentalists agree with economists that water available for diversion in the Southwest should not be sold cheaply and used compulsorily for low-value farming. Instead water should be auctioned off (directly or indirectly) to, and used by, highest bidders. In that way scare water will be deployed to high-value use (presumably domestic or industrial) and not to low-value use (farming). Simultaneously, higher prices encourage users to employ creative ways to conserve water (e.g., lining irrigation canals, switching from sprinkler to gravity-flow trickle irrigation, recycling, watering lawns sparingly and offpeak, flow-restrictor showers rather than humongous tub baths, etc.)
The same is true for tradeable emission allowances for SO2 from coal-fired thermal powerplants, and for cattle grazing rights on federal land. The former are and the latter should be auctioned off (leased or sold) to highest bidders. Again, auction prices are not based on cost.
Finally, in the Northwest we are familiar with Forest Service and BLM timber sales which, being in limited supply, are auctioned off to highest bidders. That is how we see to it that timber goes to those who value it most and, simultaneous, maximize revenues to the owners (again, U.S. taxpayers).
Whenever there is a non-replicable asset, a "commons" so to speak, the proper way to sell it or its output, is by auction to the highest bidder, not by negotiating prices based on costs. In the case of federal hydropower, sale by auction to the highest bidder means it will be acquired by those customers who value it most, i.e., who will put it to its highest use. The Treasury may fall short of recovering total costs but it will gain its greatest return.
Qualifications
Obviously, federal hydroelectric production and distribution is more complicated than a brief discussion here allows There are, for example, differences between energy and capacity, firm and nonfirm, bundled and unbundled, peak and off-peak. There are matters of system control, backup, replacement, load shaping, reliability, firming of non-firm hydro, interruptibility, operational constraints both natural and man-made, transmission access, and more. The product can be packaged and repackaged in countless permutations limited only by the fertility of the human imagination.
If not inevitable, Bonneville's numerous products and product categories will probably be unbundled in one fashion or another. For competitive products not in fixed supply, the market should set cost-driven equilibrium prices based on demand and supply. It is already doing so. For the common-carrier transmission system, the monopoly component, rates should be based on costs to simulate the competitive model and subject to regulatory oversight. And, though this may stun rate-case junkies, the hydro generation components should be auctioned off to bidders.
All of these qualifications notwithstanding, the theory of economic rent applied to federal hydropower generation is central. Auctioning off the hydropower production component, short-term or long-term, firm or non-firm, to highest bidders is fundamental.
A Caution
Finally, we should view with suspicion critics who will argue that while one or another proposal may be theoretically correct, it is unrealistic. Save us from those kiss-of-death words, "theoretically correct but as a practical matter unrealistic." They are the weapons of entrenched interests determined to preserve unmerited subsidies and anachronistic benefactions. They have skewered countless worthwhile proposals.
Decision Rule
Here is a recommended multi-part decision rule:
First, temporarily forget about present stakeholders and the sweetheart deals some of them have enjoyed. (We'll get back to them shortly.) Let us be hypothetical for a bit. Assume that we start from scratch with a clean slate unencumbered by creaky institutional arrangements.
Second, on that clean slate, describe with respect to hydro power the theoretically ideal arrangement. No matter who owns it, ask how should fixed-supply hydro power be allocated if it were unburdened by historical institutional arrangements? Given its nature as a fixed unreplicable resource from which additional production cannot be coaxed by higher price, some form of auction is incontestably sensible. Going through a rate case may be fine for other Bonneville products -- transmission access, load shaping, reliability, backup, et al -- God-knows-what -- but not for hydro power. Auction, and auction alone, is the ideal mechanism that achieves efficiency.
Third, with the theoretically ideal arrangement in mind, return to the real world and examine realistic alternatives. In particular, hypothesize arrangements which feature auctioned hydro power. Among realistic alternatives, which move us towards the ideal and which retreat further from the ideal?
Fourth, if it is politically impossible to shake off the dead hand of the past, at least reject alternatives that, compared to present arrangements, depart further from the ideal. Present arrangements, increasingly unsatisfactory in a growing competitive environment, are better than a further retreat from good sense. Among realistic alternatives, consider those which move furthest towards the conceptually correct -- I detest this word of fashion -- paradigm. The object is not to achieve perfection. That may be unrealistic. The object is to move towards rather than away from an identified ideal.
Fifth, at the beginning, at the end, and in the middle, keep in mind always that the proper way to allocate a fixed-supply, perfectly inelastic factor or product is auction. When it comes to buyers in this circumstance, the term "highest bidder" should be among the most revered in the language.
Conclusion
Having labored on this matter long enough, the prosecution rests.
May 1996
Lecturer in Economics, Portland State University; Chairman, Oregon Energy Facility Siting Task Force; former Chairman, Oregon Public Utility Commission; former senior economist and assistant to the Administrator, Bonneville Power Administration. The views expressed are not exclusively those of the author; in the broadest sense they are shared by virtually all economists who have pondered the matter.
Puts me in mind of the lady who asked her husband if he would like to make love. "I can't," he said, "it's Lent." "Oh!," his wife says, "To whom and for how long?"
Ricardo's theory of economic rent survives virtually intact today. It formed the basis for Henry George's single-tax movement in the last half of the 19th century.
The amount of hydro power output, although not dependent on cost or price received, is not exactly fixed. It will vary from year to year based on streamflow vagaries; but so, too, the output of wheatfields varies from one year to the next depending on rain, sunshine and locusts.
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Last modified: May 29, 1996
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