Restoring the power grid
Posted by aogWednesday, 27 August 2003 at 10:39 TrackBack Ping URL

There’s been a lot of talk about dealing with infrastructure issues in the power grid, where the problem (like for California) was much more of a transmission problem than a generation problem. One of the standard suggestions is that private investors be provided with a guaranteed rate of return for building a transmission line. While a purely private market would be preferable, that’s unlikely in the next decade or two. Instead we need to start with using private investment and build from there.

The problem with a guaranteed return is that it encourages cost overruns. If the promised ROI is larger than is generally available for funds (which must be the case or there won’t be investors) then it makes sense for the builder to spend as much as possible. That’s not an optimal solution. What would seem to make more sense is to guarantee the return based on the original cost estimate. If the builder brings it in lower, then he wins. If, as is far more commonly the case, there are cost overruns, then the private investors eat the cost through lower effective returns (e.g. if the project costs double the original estimate then the effective rate of return is half that originally promised).

The downside of this plan is twofold:

  • Investors would strongly encouraged to make accurate estimates of the real cost of the project. This would spell the end of the standard strategem of low balling a project cost, getting it started and then allowing “cost overruns” to adjust the total cost to something more realistic. Because doing this would be money out of the pocket of the private investors one would expect a lot less of it. But then voters would start to see what things really cost in time to punish politicians for promising to spend the money. Some may consider to be a feature, not a bug.
  • Cost conscious builders would be punished by the anti-business forces. A builder that brought the project in under the original cost element would be called a “profiteer” or “looter” who was stealing the taxpayer’s money. This is an inextricable property of fixed price contracts, which I favor (because it off loads risk from taxpayers to private investors).

Overall, though, I think that this would be a definite improvement.

Comments — Formatting by Textile
pj Wednesday, 27 August 2003 at 11:17

There’s no need for any guarantees. What’s needed is simply a positive rate of return. Alas, that’s been absent. One can increase the rate of return by either letting grid builders receive more revenue, or by reducing the costs of dealing with environmental/planning-zoning/NIMBY obstacles.

Joseph Somsel Wednesday, 27 August 2003 at 17:19

If a regulated company over-invests, it means that the regulator (the PUC) has set the allowable rate of return too high. It is then over the market’s risk/return curve and will draw capital investment with pressure to overbuild. It still risks disallowance after the fact. If it’s set just right, investors will only invest what’s reasonable and useful since prudence reviews make it a risk not worth taking. If set too low, the company fails to attract moneys from the capital markets. Besides, the engineers who ran utility companies adhorred waste as a point of professional pride.

Besides, did anyone dare suggest we’re suffering from OVERinvestment in transmission lines?

aog Wednesday, 27 August 2003 at 19:13

PJ;

The problem is how, in the absence of a fully deregulated market, one provides that return. One could think of the guaranteed ROI as simply “rent” paid by the State to the investors for use of their transmission lines. Presumably in libertarian world there would be transmission fees to reward the investors. But we’re not there yet. I’m offering this primarily as an improvement over what’s done today that is politically feasible.

Mr. Somsel;

I’m not too worried about overbuilding because the building wouldn’t be done by saying in general “build it an we will pay” but rather specific bids for specific transmission lines. E.g., California decides to add another interconnect between southern and northern California. It offers some rate of return and then accepts bids. The over-building problem is handled at a higher level.

I would also note that the guaranteed return required by private investors is actually more out of concern for the regulatory environment than the vagaries of business.

End of Discussion