Incentives Matter

I enjoy a blog called Newmark's Door; it's filled with random musings from an economics professor at Duke. His wife suggested that he ask his students a question, but he decided it was too easy even for an Economics 101 course.  Here's the question: "What happens to the price of corn when Congress passes a law mandating increased usage of it?"

The Republic joined the debate on Sunday.  "Food producers and politicians have begun blaming rising ethanol production for tipping food prices too far and even helping cause world hunger, but the ethanol industry disputes that."

Politicians decided that a huge chunk of the food supply should be converted into fuel and now people are starving.  Is that a big shock?  Dude, incentives matter and if you screw them up, people get hurt.  I don't usually blog about the energy industry because I have energy clients, but the topic of energy incentives have become the latest rage.

It won't surprise you to know that I'm pretty libertarian on the incentive front.  If the mohair industry can't survive without being propped up by the government then it shouldn't survive.  The family farm is a myth so most of the farming subsidies go to big corporations.  Those subsidies also drive up the cost of food and make third world farms less viable. 

However, when properly structured, incentives can do a lot of good.  Here's a great example from the Arizona Corporation Commission. 

The University of Arizona just won an award for a program that shifts almost all of its air conditioning load to the nighttime.  They run a special cooling system at night and freeze huge banks of ice.  The next day, they turn the compressors off and the melting ice cools the 176 building on campus--including the University Medical Center down the street.  The system uses almost no electricity during peak hours. 

What's so important about peak power?

Peak power is really expensive because the utility not only has to pay for the cost of generating the electricity, but they also have to BUILD a plant to generate the peak power.  That new power plant may only run a FEW HOURS a year.  That means that the plant has to recover an entire year's worth of fixed costs in a few hours.  Consumers pay dearly to have that plant available for the peak.

That's where incentives come in.  The ACC didn't subsidize the ice plant; the ACC charges customers more for peak power.  Those higer charges reflect the fact that peak power is much more expensive.  The UA ice system is a great example of the market responding to price signlas.  The government didn't build the ice system, Trane built it. And UA didn't build it out of the kindness of their heart, they built it to save money.  In fact, the system saves the University $560,000 a year. 

More importantly, Tucson Electric Power doesn't have to build a plant to meet the increase in peak demand associated with that massive air conditioning load, so the ice plant saves money for Tucson's other utility customers.

Unlike the ethanol fad, The ACC established the right price signals, and the market responded in creative ways that will lower the costs for everyone. 

Ironically, it's unlikely that any of the Corporation Commissioners will be at the ribbon cutting ceremony.  That's because the dedication and tour is scheduled for Wednesday morning, May 14th at 10:00...the same day and time that the Commissioners will be deciding the latest TEP rate case.

It's too late for UA's new ice plant to be reflected in the current case, but the next rate increase will be smaller because UA has managed to shift all of its cooling to night.

Incentives matter.  When they are done well, people benefit.  When they are done badly, people suffer.  Too bad some of the folks in Congress haven't learned that lesson. 

 

Comments

[ron]

Yup and when people say they want a Super Bowl because it will 'give a lift to the economy' they get today's headline:

"Super Bowl wasn't a windfall: Glendale spend more on game that it made"

[ron]

And if they are going to build it any way, why are city governments giving away all their sales tax dollars to businesses like Walmart - and then coming to us and cutting our services this year because 'sales tax revenues are down'.

[Name:]

I don't think you meant to say the ACC charges customers. The utility does that. But the ACC does set the prices which allow the market to have differences between peak and off-peak rates. Like Congress and the corn example, the ACC does come up with its own arbitrary incentives that have nothing to do with the market. Like the alt energy mandates. No market justification for that incentive, is there?

[Matt]

Speaking of incentives for agriculture; don't we pay farms to not grow crops on the supply side and give out food stamps to increase the demand side? Is that free market capitalism?

[ron]

Greg: " The family farm is a myth so most of the farming subsidies go to big corporations."

Except in North Dakota which, I understand, has a law against coporate ownership of land.

President Bush, to his credit, has been holding the line on stopping these subsidies to millionaire farmers, as he calls them, in the current farm bill before Congress.

[NICK]

Ron,

The ball was in Glendale.
The rest of the story as I heard it was
the td's were scored in other cities.

[ron]

I guess Glendale shouldn't have tried so hard to get the stadium in the first place.

I understand that the plan for the next Bowl is to share the bill for law enforcement, etc with other cities. Good Luck.

[Ray G]

Why is it that everyone - Right and Left - seem to get it on the idea of charging more during peak hours, but both Right and Left scream foul when a hardware store charges more for plywood during a run-up to a hurricane? Or a gas station charges more for a gallon of gas when a pipeline is broken?

The principle is exactly the same, and yet seemingly intelligent people suddenly become incredibly. . um. . not so intelligent.

[John F.]

Greg,

Please use your contacts to get those utility companies to use Plug-In Hybrid electric vehicles. Using the same principle as the U of A, the utility trucks can be plugged into the grid at off-peak hours, substituting electricity for more costly fuel and reducing emissions. The technology already exists and is being adopted in some small municipalities. www.odyne.corp

P.S. Please hurry as my investment in the company seems to be heading to zero!