Outsourcing Electricity Market Design

A basic principle of virtually every regulation to improve grid reliability and reduce power sector emissions is that market participants change their behavior when regulations make it more expensive to engage in socially harmful activities. To give a concrete example, a carbon tax assumes that increasing the costs of emitting carbon dioxide will lead market participants to reduce energy consumption and switch to less carbon-intensive resources. But this assumption does not apply to large parts of the electricity industry, where investor-owned utilities are often able to pass the costs of climate and reliability rules on to captive ratepayers. The underlying problem, I argue, is that the U.S. legal system outsources investment and market design decisions to private firms that will be financially harmed if state and federal regulators pursue deep decarbonization or take ambitious steps to improve grid reliability. At the state level, this occurs because utilities propose new infrastructure in integrated resource plans that authorize cost recovery from captive customers. At the federal level, this occurs because the Federal Power Act gives incumbent utilities "filing rights" that authorize them to submit, or "file," regulations and rates related to their assets. Utilities use their filing rights both to propose favorable market rules and to design governance structures that allow them to control the multimember organizations that plan grid infrastructure and ensure resource adequacy. Given that regulatory environment, it is little surprise that incumbent utilities design electricity market rules that counteract climate and reliability regulations. These observations underscore that structural changes such as full corporate unbundling, market liberalization, and aggressive governance reforms are needed to make climate and reliability policies more effective and easier to administer.