Electricity Production

• "Resource Adequacy and the Impacts of Capacity Subsidies in Competitive Electricity Markets," by R. J. Briggs and Andrew Kleit. October 2012. SSRN #2165412.
• "The Prospects for Cost-Competitive Solar PV Power," by Stefan Reichelstein and Michael Yorston. October 2012. SSRN #2182828.
• "The Private and Public Economics of Renewable Electricity Generation," by Severin Borenstein. December 2011. NBER #17695.

States that have deregulated their electricity generation markets, with the exception of Texas, have been reluctant to rely simply on market electricity prices to match peak supply and demand in the summer. Instead they cap prices below the market-clearing level. On the Pennsylvania–New Jersey–Maryland Interconnection (PJM) regional electricity grid, the price cap is $1 per kilowatt hour. The price caps create what Massachusetts Institute of Technology economist Paul Joskow calls the "missing money" problem: because of the cap, peak supply generators do not make enough money during the few hours a year in which they generate electricity to cover their long-term average cost, and thus private merchant generators have insufficient incentive to invest in capacity to meet the absolute peak of summer demand.

As a response, state public service commissions or market administrators have created "installed capacity markets" in which the market operator pays generators to provide a stipulated amount of generation capacity above recent summer peak demand (usually 15–20 percent above). The administrator conducts an auction in which peak generation and demand reduction (contractual interruptible service) bid to fill the peak requirement. The price that clears the market for the additional supply above peak demand is then added to the price that clears the electricity spot market.

Some political actors in Maryland and New Jersey have been troubled by the results of these capacity market auctions. Prices for the capacity have been rising, but little additional generation has actually been built. The results are viewed as windfalls for existing generators. Both states have responded with additional specific subsidies for new generation built within their respective borders.

The effect of that subsidized generation is the same as described in Jonathan Lesser's article on wind power subsidies (p. 22): it reduces returns to existing generators. In the short run, consumers appear to benefit from lower electricity prices; but in equilibrium, lower returns to existing, unsubsidized generators result in their exit, reduced supply, and higher prices overall.

The subsidized generators also distort capacity markets, unless low bids from the subsidized generators are excluded from the auction. To prevent this, PJM has implemented changes to its Minimum Offer Price Rule requiring all bids to be at least 90 percent of the cost of new generation. Without this rule, the subsidy program exacerbates Joskow' missing money problem.

Texas is unique in the simplicity and "first-best" character of its electricity market: electricity is priced in real time to equilibrate supply and demand. In contrast, the "second-best" markets elsewhere get evermore complicated and less efficient.

President Obama and his Department of Energy have been vigorous financial and rhetorical supporters of the expansion of alternative energy generation, including photovoltaic electricity. What results have the taxpayers received for their investment? How competitive are solar panels relative to conventionally generated electricity?

Reichelstein and Yorston report that the "levelized cost" (the price of electricity that equates the present value of plant costs with the present value of its lifetime output) of utility-scale solar panel installations is 8 cents per kWh. Their estimate for the levelized cost of natural gas–generated electricity is 5.8 cents per kWh. Thus utility-scale solar panel installations are not competitive. The recent growth in utility-scale installations is the result of public subsidies and renewable portfolio standards.

Commercial-scale solar panel installations (e.g., arrays that supply a single building or factory) have levelized costs around 12 cents per kWh, or about the price of grid electricity to firms in Southern California. Commercial-scale grid parity is very dependent on stimulus subsidies, having a Southern California location, and the current temporary drop in solar panel prices. If all three were eliminated, then solar panel levelized costs would be 30 cents per kWh.

Would consideration of subsidies to fossil fuels and conventional and climate change externalities change the competitiveness conclusions? Borenstein reports that subsidies to fossil fuels are not really that distortionary because they amount to only 0.11 cents per kWh even if environmentalists' estimates are used. Moreover, subsidies for green power cannot be justified as a good "second best" policy alternative to Pigouvian taxes on brown power because the green subsidies reduce the price of electricity below its marginal cost and they do not take into account whether the renewable source displaces coal or a cleaner fuel like natural gas.

Borenstein concludes that the levelized cost of residential solar electricity panels is 24 cents per kWh. Natural gas–generated electricity is at least 15.8 cents per kWh less expensive, even taking the monetized cost of local pollution (0.15 cents per kWh) into account. If the purpose of residential solar is to reduce carbon emissions relative to natural gas–generated electricity, then the tax on carbon emissions would have to be $316 a ton for solar to be competitive.

Bond-Rating Agencies

• "Does It Matter Who Pays for Bond Ratings? Historical Evidence," by John Jiang, Mary Stanford, and Yuan Xie. November 2011. SSRN #1950748.

Reform of the bond-rating agencies has been discussed in previous issues of Regulation. (See "The SEC's Other Problem," Winter 2002–2003, and "A New Law for the Bond-Rating Industry," Spring 2007.) Those articles called for increased competition between the bond raters through a relaxation of regulatory entry barriers created by securities laws and their accompanying regulations. The recently announced Department of Justice civil suit against Standard and Poor's raises a different issue: Does the bond-rating agencies' business model matter? Are ratings of bonds inflated because the issuer of the bonds pays for the analysis rather than the buyer?

Using a sample of 797 corporate bonds issued between 1971 and 1978 and rated by both S&P and Moody's, the authors find that, between 1971 and June 1974, when Moody's charged issuers for bond ratings and S&P charged investors, Moody's ratings were higher on average than S&P's ratings for the same bond. During the subsequent period when both S&P and Moody's charged issuers for bond ratings—July 1974 through 1978—the authors find that Moody's ratings were no longer higher than those of S&P. The change in the difference between the two agencies' ratings was from an increase in S&P's ratings around 1974, rather than any change in Moody's ratings. This finding supports the view that the "issuer pays" model leads to higher bond ratings.

Community Reinvestment Act

• "Did the Community Reinvestment Act (CRA) Lead to Risky Lending?" by Sumit Agarwal, Efraim Benmelech, Nittai Bergman, and Amit Seru. December 2012. NBER #18609.

In previous Working Papers columns (Spring 2011 and Fall 2012) I described papers that examined evidence of the effects of the Community Reinvestment Act on the housing bubble. The research design employed in those papers is called a "discontinuity design"; the papers compare individuals and census tracts that just qualify for credit under CRA affordability goals and those that just miss qualification. The assumption is that the legal distinction of qualification is arbitrary and thus plausibly exogenous, so simple regressions and differences in descriptive statistics are adequate tests of the CRA's effect. Loan frequency should be arbitrarily higher for those individuals and census tracts for which eligible CRA institutions receive "CRA credit" relative to loan frequency for individuals and census tracts for which CRA institutions just miss receiving credit. If the CRA effect is real, subsequent defaults should be higher for those loans that receive credit.

The behavior of the banks in those papers was not consistent with the CRA effect hypothesis because loan performance was better or no different in CRA credit areas than in non-CRA areas. In addition, troublesome "exotic mortgages" such as interest-only, negative-amortization, or teaser-rate mortgages were used by higher-income people ($141,000 average income) with high credit scores (only 7 percent of borrowers had a score below 620) to purchase more expensive houses in areas with high population growth and no price decline in the last 10 years. None of those stylized facts are consistent with the hypothesis that CRA loan affordability goals were causally important in the housing bubble.

Agarwal et al. use a different test to determine the CRA's effect. They compared banks in a particular census tract undergoing CRA exams over the years 1999–2009 with banks not undergoing exams in the same month. The loan origination rate for banks in the treatment group increased by 4 percentage points from the 72 percent average in the sample. Lending increased in CRA-eligible tracts by 8.2 percentage points. The 90-day delinquency rates increased by 0.1 percentage points from an average rate of 1.2 percent to 1.3 percent; the increase was 0.4 percentage points for loans in CRA census tracts. In the six quarters surrounding CRA exams, loan originations increased by 5 percent and loans defaulted 15 percent more often.

There is plausible exogeneity in this research design because under the CRA, small banks are reviewed every five years while large banks are reviewed every two years. The results stem from the random, calendar-driven review of some banks in an area and not others.

How can we reconcile the results of this paper with the others? In this paper, banks under scrutiny by regulators are compared to banks not under scrutiny. In the previous papers, all loans to eligible people and eligible tracts are compared to all other loans. In my view the research design of the previously reviewed papers is more useful in determining the effect of the CRA during the recent housing bubble. Thus the CRA can affect lending behavior as described in the current paper without overturning the no-effect result of the previous papers.

Housing and Unemployment

• "Are American Homeowners Locked into Their Houses? The Impact of Housing Market Conditions on State-to-State Migration," by Alicia Sasser Modestino and Julia Dennett. August 2012. SSRN #2125158.

Many analysts have speculated that a non-trivial component of the persistently high unemployment rates after the official end of the 2008–2009 recession may be homeowners who cannot easily sell their houses and move to find employment elsewhere because of negative equity: their houses are worth less than their mortgages. Some stylized facts are consistent with this theory. Between 2006 and 2009, the number of homeowners who moved out of state declined 25.5 percent, while renters who moved out of state declined only by 13.6 percent. Some 10.7 million (22.1 percent) of all residential properties with a mortgage were underwater by the third quarter of 2011, about the same as two years prior.

The authors of this paper conclude that a one–standard deviation share of households underwater reduces outflow by 2.93 percent, or about 4,000 residents, from the average origin state. For the entire United States this resulted in 110,000 to 150,000 fewer migrants out of 5.6 million people who migrate across state lines on average. If all those who did not migrate because of negative equity were to migrate, were job seekers, and all got jobs, the unemployment rate would decrease by 0.1 percent per year. Thus underwater mortgage "lock-in" would not appear to be an important cause of higher unemployment.

Energy

• "Overriding Consumer Preferences with Energy Regulations," by Ted Gayer and W. Kip Viscusi. July 2012. SSRN #2111450.

All economists teach their undergraduates that market regulation has the potential to improve consumer or firm welfare if and only if fundamental flaws in the market (the absence of property rights and prices) or consumer irrationality exist. In their absence, economic efficiency cannot be enhanced by government regulation.

This paper examines whether recent energy efficiency regulations pass the undergraduate test. In 2012 the National Highway Traffic Safety Administration and the Environmental Protection Agency announced revised auto and light truck fuel economy standards. The rationale was greenhouse gas reduction under the authority mandated by the 2007 Massachusetts v. EPA Supreme Court decision. But according to the agencies, 85 percent of the estimated $521 billion in total benefits from improved fuel economy are savings to consumers—that is, private benefits rather than benefits from unpriced missing markets. Greenhouse gas reduction is only 8–9 percent of the estimated benefits.

Why would consumers forgo all those fuel savings? NHTSA reports that it "has been unable to reach a conclusive answer to the question of why the apparently large differences between its estimates of benefits from requiring higher fuel economy and the costs of supplying it do not result in higher average fuel economy for new cars and light trucks [from market forces alone]." The EPA also acknowledges that "it is a conundrum from an economic perspective that these large fuel savings have not been provided by automakers and purchased by consumers."

Maybe ordinary consumers don't realize that increased fuel economy is cost effective, but the agencies claim the same phenomenon is occurring for heavy commercial trucks, thus justifying the imposition of similar standards. Less than 10 percent of the benefits are greenhouse gas reduction, according to the agencies, while over 90 percent of the benefits are simply fuel cost reductions that truck owners don't seem to value enough. Yet why would trucking firms forgo all those fuel savings?

Gayer and Viscusi tell similar stories about energy use regulations for clothes dryers, room air conditioners, and light bulbs. None would pass a benefit-cost test if environmental externality reduction were the only benefits. Gayer and Viscusi argue that something is wrong with an analysis that concludes that consumers and firms are leaving so many private benefits on the table through their choices.