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In the aftermath of the 2008 financial crisis it became clear that regulators had allowed many financial services firms to become “too big to fail”. Yet this system-critical firm problem is not confined to financial services. In their paper “Can electricity companies be too big to fail?” Ann van Ackere, Erik R. Larsen and Sebastian Osorio explain how a similar challenge faces the electricity sector, and offer some suggestions to help regulators prevent the lights from going out.

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Ann van Ackere is a Management Scientist. Her research areas focus on the modeling of management and (micro) economic issues using operational research tools.

The 2008 financial crisis and the $700 billion bailout of the US banking system highlighted the “too big to fail” challenge facing governments and regulators. When laissez-faire economic theory comes up against the practicalities of running a national economy in a highly interconnected world, politics often prevails over the free market principle of survival of the commercially fittest. Yet bailing firms out raises the issue of moral hazard. If a business seems too important to be allowed to fail, whether due to the vital services it provides society, or ideological or strategic reasons, what is to stop its managers taking unacceptable risks in the pursuit of profit? They are free to act in the expectation that gains will be privatized and losses socialized.

As Ann van Ackere and co-authors Erik R. Larsen and Sebastian Osorio note in their research paper the “too big to fail” phenomenon is not confined to financial services, but evident in a variety of business sectors. In particular, van Ackere and her co-authors identify the electricity sector as an industry where “too big to fail” problems are likely.

Power problems

The authors draw attention to the increasing size of many electricity companies, whether due to a reluctance to break up incumbent national champions, or the evolution of regional firms into dominant national players. Increased size is often accompanied by increased market share and concentration, leading to greater systemic risk, as is the case in countries such as Greece, Estonia and France.

In addition, national players are expanding operations internationally. In 2017, for example, EDF was active in 25 countries, with more than 30% of profits generated outside France. Such global expansion and interconnectedness can create contagion risks. Especially if, as the authors note, the regulatory environment has not kept pace. The electricity industry lacks institutions such as the Bank for International Settlements (BIS), the Financial Stability Board and the European Banking Authority, which are able to wield supra-national power. Without supra-national regulatory restraint firms can try to game the system and arbitrage regulatory environments.

The impact of new generation technologies is also problematic. The introduction of renewables, such as wind and solar, has disrupted markets lowering electricity prices and threatening the profits of incumbents which have heavily invested in traditional “outdated” thermal generation technologies. This leads incumbent firms to mothball and close plants, creating security of supply problems for regulators.

It is worth noting that capacity margins (the difference between firm generating capacity and peak demand) are tightening in many countries, as a result of the developments outlined above. Indeed, if a generator’s share of installed capacity or share of generation is close to the capacity margin, that company is a candidate for the “too big to fail” list. Another indicator is how the Loss of Load Probability (LOLP) – likelihood of power shortages – would be affected if a particular generator stopped operating. Such considerations should also factor in the availability of substitutes; for instance, is it possible to import significant volumes of electricity, at short notice, at reasonable prices, from a near neighbor with excess capacity?

The California electricity crisis in 2000-2001, which affected over 35 million people and led to a billion dollar state bailout, and the nationalization of Colombian electricity retailer Electricaribe in 2016 are just two examples of a wider issue. Many of the factors that underpinned the problems with one or other of these companies – decreasing capacity adequacy, changes in market dominance, internationalization and the lower profitability of electricity companies – are present in many national and regional energy markets. Consequently, policymakers need to take steps to ensure the future security of electricity supply.

Tackling “too big to fail”

The authors suggest a number of measures policymakers and regulators could take to avoid a “too big to fail” situation. Moral hazard can be limited by making it clear that if a system-critical firm is in difficulty governments will only guarantee the continuation of critical functions, allowing other costs, such as those connected to restructuring, to fall on shareholders and bondholders. A “good bank, bad bank” approach can be adopted for failing firms, as financial regulators did post the 2008 crisis, with the long-term viability of thermal capacity units assuming the role of the “toxic” assets.

Even in the absence of an immediate default risk, regulators should monitor key indicators in an effort to prevent electricity firms becoming system-critical and identify potentially problematic situations. Market concentration should be assessed, merger and acquisition activities observed, preventing or attaching conditions to undesirable mergers where possible, and evaluating newly formed companies with respect to their de-rated reserve margin and potential impact on the LOLP. Regulators might also be given powers to force companies to split or divest certain assets, or even to take over essential but unprofitable generation assets.

Companies using new generation technologies should not be allowed to become too dominant. At present a company specialized in renewable energy, such as wind, for example, might dominate its wind energy sector yet still only command a very small percentage of the total electricity market. However, if wind energy eventually forms a much larger share of the total market, current niche players could become system-critical.

Profitability must be watched closely, especially that of critical generators and all distribution companies. An awareness of international expansion is also important. Indeed, it is sensible for the relevant authorities to adopt a policy of monitoring the market on an ongoing basis with regular in-depth analyses of recent trends, possibly bi-annual, as well as a consideration of how the industry is expected to evolve over a four to five year period.

Ultimately, in exceptional cases, it may be necessary to step in and deal with struggling thermal plants in order to maintain security of supply. The authors suggest different options for the regulator: paying a company to keep a plant ready to operate if needed; limit closures or mothballing by mandating a sale of the plant to an interested buyer where possible; as part of a creating a strategic reserve – place the generator under direct state control, with or without compensation. The aim is to balance compensation and providing capacity against distorting the market.

Along with their observations and guidance, the authors stress that they are not against the general market principle of allowing the failure of firms in essential industries in general or the electricity sector in particular. On the contrary, by avoiding the “too big to fail” phenomenon, they argue, it is possible to keep markets functioning normally, and still keep the lights on.

Related research paper: Erik R. Larsen, Ann van Ackere, Sebastian Osorio, Can electricity companies be too big to fail?, Energy Policy, Volume 119, 2018, Pages 696-703, ISSN 0301-4215.

Featured image by Win Nondakowit – Dreamstime.com