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A Curious Kid’s Guide to Energy Regulation
The non-boring intersection of law x economics x energy.
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When people meet me at a party, it’s usually 50/50. It goes something like this:
Them: “So… what do you do?”
Me: (exhales heavily) “I’m studying Energy Law.”
Me: “It’s a combination of law, economics, and policy, focused on the energy sector and electricity grids specifically.”
Here comes the 50/50.
IF they were looking for small talk, they usually excused themselves, spun on their heel, and ran for the next party guest. Occasional glaring included 👀
IF, on the other hand, they were interested in climate and energy, we were off to the races 🙌🌳
Truth aside, some people have asked me what I’ve learned so far, and this essay is my answer. It is a human-readable introduction to the most essential concepts of Energy Regulation.
Let’s do this!
A Curious Kid’s Guide to Energy Regulation
By Art Lapinsch
Kids are masters of the laddering technique.
They ask a question and follow it up with endless rounds of why? why? why? What consultants charge big bucks for, kids do for their own curiosity. They are honest truth seekers.
To explain Energy Regulation, I’ll go on an imaginary walk with a curious kid 🙋
Transmission Lines: “What Are Those Funny Spaghetti-Things?”
Short answer: Those are Transmission Lines, and they are like a highway for electricity 🛣
Those funny spaghetti things transport electricity from one place to another. There are two types of them:
🛣 Transmission Lines: Transmission lines transport electricity across large distances - for example, between cities.
🚌 Distribution Lines: Distribution lines transport electricity across short distances - for example, in a district of your city.
This large spaghetti bowl makes it possible to generate electricity on one side of the country and draw electricity from your power outlet on the other side of the country 🔌
Disclaimer: For the rest of this essay, I will primarily talk about Transmission Lines. The following words refer to the same type of entity: natural monopolist; transmission system operator (TSO); infrastructure operator; network operator.
Core Network: “Why Do We Need Electricity?”
Short Answer: Our society runs on electricity 💡
Well, you might think, “what’s the big deal if I can’t charge my phone for a day?”
Everything around you needs electricity. The street lights, the public transportation system, the devices in the hospital, the flush in your toilet, and even the tap water in your kitchen.
If there’s no electricity for an hour it’s a major inconvenience 😒
If there’s no electricity for a day, it’s a major event 😰
If there’s no electricity for a week… all hell breaks loose 🔥
Because electricity is so important, we refer to the grid as an essential facility.
These essential facilities (i.e. spaghetti things) are usually created and looked after by one large company.
Natural Monopolies: “Why Is There Only One Company?”
Short Answer: It is cheaper to have only one company looking after the electric spag bowl.
Energy infrastructure - in this case, the electricity grid (i.e. spaghetti) - is very expensive to build:
💶 Financially: It costs a lot of money.
⏳ Operationally: It takes a lot of time.
⚡️ Physically: It takes up a lot of space.
If multiple companies build such infrastructure, it wastes a lot of resources (money, time, space).
Economists call this Productive Inefficiency - a situation where it is bad for everyone if multiple companies try to compete in the market. Therefore, some markets like telecommunication, railways, and energy markets are considered natural monopolies. In such markets, there can only be one company running the show.
As a result, someone needs to define the rules of the game.
Regulation: “Why Do We Need Rules?”
Short Answer: Players abuse the game if there are no rules 🦹♀️
Think of a game of football - you know, the European game you actually play with the foot ⚽️
In its current form, there are two teams of eleven players each. They play for 90 minutes against each other and try to outscore their opponent.
If there were no rules, one team might show up on the field with 20 players while the other team might decide to play with their hands all over the pitch. To avoid such a mismatch, there are clear rules.
What works in football also works for electricity markets.
Regulation (ex-ante = before the game starts): Regulation is used when you assume that cheating (i.e. market failures) is the norm. Regulators (i.e. the rule makers) try to anticipate the most likely offenses and establish rules to prevent such conduct. In the case of football, it would be FIFA or UEFA 📘
Competition Law (ex-post = during or after the game): Competition Law is used when you assume that cheating is the exception. Judiciaries (i.e. judges; arbiters; etc.) watch the game and interfere when they spot an infraction of the rules. In the case of football, this would be the referee 👮♀️
Now, let me tell you a story about the frog 🐸 and the scorpion 🦂
In our case, a natural monopolist is the scorpion. It is in their nature to abuse the game for their economic benefit.
In short: Set rules for the critical stuff in advance and judge the rest on the fly.
Alternatives to Regulation: “Rules Don’t Sound Fun. Can’t We Do Something Else?”
Short Answer: Alternatives exist, but unfortunately they don’t work.
[This is a slightly more technical excursion 🤓]
There are six experiments that don’t work well in practice:
Competition for Market: The government opens a bidding process for the infrastructure project - think of public tenders. Since the winner of this bidding process can expect to be the sole operator for the rest of the duration, it is in their interest to win the bid. They do so by advertising the lowest price. Once they win and become the natural monopolist, the government and the market are stuck with the winner. Now the winner can start increasing prices. Competition for the Market doesn’t work because of misaligned incentives and the sunk cost fallacy.
Contestability and Threat of Entry: The assumption is that new market entrants can challenge the natural monopolist. This could work if building the infrastructure wasn’t resource-intensive (money, time, space). In practice, this doesn’t exist unless there are other market failures - like limitless venture funding (due to low-interest rates) and regulatory loopholes to set up a new transportation service without requiring the taxi medallion (e.g. Uber/Lyft challenging the yellow cab monopoly).
Competition Law (Ex-Post): The exclusive reliance on competition law is dangerous for the market since it only is applied only after harm has happened. There is a “lag of consequences.” If we are talking about essential facilities, this approach is just too risky for society. (Fun fact: the Swiss rely on ex-post Competition Law 🇨🇭)
Governmental Ownership: How do you feel when you know that you must get something done at a governmental department? … Exactly. No one likes this. Jokes aside, governments have run energy infrastructure for the past century, but in a hyper-competitive world, it just doesn’t cut it. Usually, governmentally-owned utilities still need someone to run this operation. The principal-agent problem arises, and the government is forced to monitor the management (i.e. the agents). If you look at it, this is not too different from regulation. Hence not really an improvement over-regulation.
Negotiated Settlement: Here, the idea is that customers deal directly with the private utilities to arrive at a “fair” agreement where the natural monopolist (i.e. the utility) doesn’t screw over the customers. A corporate negotiating with citizens… what could go wrong. Because this doesn’t work, the regulator still needs to approve any draft arrangement that has been negotiated - meaning there’s no real advantage over standard regulation.
Deregulation and Free Competition: Welcome to the Wild West. The Invisible Hand of the market will solve all problems. A vital footnote of the Invisible Hand theory is that markets balance through competition. Good luck competing with a natural monopolist. It doesn’t work, which brings us back to regulation.
[End of excursion]
The truth is that regulation is the best idea we could come up with so far.
Regulatory Instruments: “How Does Regulation Work?”
Short Answer: Split the monopoly, force them to give access, and control their prices.
Disclaimer: By now, the curious kid has miraculously reached the maturity level of a graduate student, which makes my life easier since I can talk in professional language. What a peculiar kid 🤷♂️
Regulators use policy instruments to achieve their policy objectives. A policy instrument is a law or set of laws that can change the rules of the game.
In energy regulation, we usually talk about the three main regulatory instruments to protect the energy markets:
Unbundling: Reduce the influence of the natural monopolist ✂️
Third-Party Access (TPA): Create free competition by mandating access to the essential facility 💪
Price Regulation: Ensure fair prices in the market 🧾
1) Unbundling ✂️
You can think of the natural monopolist as someone who used to control all value chain steps.
Let’s discuss the example of a food market in a small town:
Production: The monopolist grows all the different types of produce 🍅🥕🍌
Transmission: The monopolist owns the market on which all products are sold to customers 🏪
Supply: The monopolist even owns every single market stand and controls who sells what and at what price 💶
The critical part is the food market. It is the only place in town where food can be sold and bought. This is an essential facility. Without it, people would starve.
But what happens to the other parts of the value chain outside the essential facility?
The regulator decides to open those areas up for other companies. The invisible hand works if competition is possible. For this reason, the regulator uses Unbundling to split up formerly vertically-integrated undertakings (VIU) - a fancy term to describe a monopolist who controls all value chain steps.
In the spirit of Productive Efficiency, it makes sense that only one company builds, operates, and maintains an essential facility (i.e. the spaghetti; the transmission grid).
The regulator grants a special right to the infrastructure provider to remain a monopoly - yet a regulated one - in the transmission area. All other areas are opened up for competition.*
*Disclaimer: This is an oversimplification for the sake of this article. In reality, there are different modes of unbundling. If there’s a demand for analysis, I can discuss this topic in detail in another essay.
In the case of the electricity market, this means:
Production: Everyone can build a power plant to generate electricity.
Transmission: Only the natural monopolist has the mandate from the regulator to build, operate, and maintain the core network.
Supply: Everyone can start a company to buy electricity on the wholesale market and sell it to end consumers (residential and industrial).
Unbundling is usually the first step in regulating and liberalizing energy markets.
2) Third-Party Access (TPA) 💪
First, we unbundle the vertically-integrated energy monopoly; then, we invite other companies to the table.
Competition is useless if other players can’t place their chips and participate in the game. But there’s a problem. The regulator knows that Exclusionary Conduct (i.e. not letting others use their infrastructure) is in the scorpion’s nature.
Natural monopolies have a special responsibility due to their control of the essential facility. Yet, in reality, they don’t always fulfill their responsibility. Instead, they come up with creative reasons (capacity hoarding, etc.) as to why they can’t grant access to their facility.
Think back to the food market. It is as if the market provider only opens the door for some and keeps it shut for others. This is a clear discrimination of market participants, and it is a problem because others depend on access to the market.
To reduce this risk, the regulator introduces Third-Party Access (TPA). It is a legal requirement for the transmission system operator (TSO) to provide non-discriminatory access to its essential facilities.
This law enables competition, but the regulator has to strike a delicate balance. Without TPA there is no competition, but without regulated TPA standards, an infrastructure provider might be overburdened by the volume of access requests - after all, it takes resources (money, time, etc.) to expand and operate the essential facility.
3) Price Regulation 💶
Now that others can finally use the infrastructure, the natural monopolist is charging them for their usage. That’s fair.
What’s not fair is **charging an excessive/monopolist price to other market participants. The regulator is forced to set prices for the regulated monopoly because Exploitative Conduct is in the scorpion’s nature.
Once fair prices are established, the other companies have a chance of participating fairly in the electricity market.
Toolbox of the Regulator
As you can see, energy regulators have the power to shape the rules of the game.
And the good news is that they are actively doing it in many regions of the world, whether it’s the IRA legislation in the US, or the European Green Deal in the EU. The game is changing right before our eyes, and new players are welcome.
As I wrote in my previous essay:
Climate Tech is such a vast opportunity space that it is tough to grasp.
That’s why recently, I started focusing more of my attention on the electricity market. As discussed, three significant trends are happening right now:
🛠 Technical → Unlocking of physical flows
💶 Commercial → Unlocking of informational flows
🇪🇺 Regulatory → Unlocking of legal flows
This piece has given you a basic understanding of the regulatory unlock happening in this market.
Now, where were we? My young friend and I arrived at a crossroads where we said goodbye. But before we parted ways, I asked: “What’s that on the Horizon?”
To which the kid replied: “Opportunity.”
If you enjoyed this essay, please consider forwarding it to a friend who wants to get started with climate 🌳
If you have feedback/ideas/critique/etc., please let me know how I can improve.
The subscriber growth since the last essay has been wild.
100+ new climate buddies joined because of a silly Linkedin post.
On another note, I’m still framing the electricity market as a fantasy/sci-fi short story set in a kingdom full of intrigue and fun creatures.
I’m not quite sure which sub-story I should explore first. Hence, asking y’all what you’d like to read first:
Energy Traders: Story of diplomats who control the flow of information and can spot new developments and trends first.
Distribution System Operators + Energy Supply: Dukes and their armies of goblins. Imagine a green milkman delivering a highly explosive liquid to your doorstep.
… any particular part of the energy market that you’d like to understand in more detail? Let me know!