“Deregulation shifts the major burden of consumer protection to the competitive market, and therefore, in important measure, to the enforcement of antitrust laws.” – Alfred E. Kahn, Lessons for Deregulation: Telecommunications and Airlines after the Crunch.

I’ve always found the above to be one of the wiser quotes about deregulation. (Kahn, for those who don’t know him, was at the helm of the Civil Aviation Board when airlines were deregulated, and has since written some of the more insightful pieces on deregulatory processes in multiple industries.)

What does this have to do with commodities and Senator Feinstein? Recently, she announced a proposed amendment to the Senate climate bill, one that would commence federal oversight of CO2 markets “to prevent Enron-like fraud, manipulation and excessive speculation in the new federal, state and regional carbon markets that will be established by [a cap and trade] system.”

That sounds perfectly noble, part and parcel of the broader political backlash against commodity market speculators. Recall a few years back, when speculators were being blamed for driving the price of oil and gas to artificial highs. Economists argued that such trading had no effect, but was a part of a healthy market that allowed informed people to make bets and hedge risks. Populists argued that energy is too important a commodity to be exposed to such volatility, especially for folks living paycheck to paycheck. Both points are valid, and with the political turnover in DC, the general mood is shifting from one favoring laissez-faire, let-’em-speculate approaches to one favoring market regulations and speculator constrainment. (See here for the NYT‘s recent take.)

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Speculation pros and cons

Discussions of regulation, populism, and economic theory inevitably take a political turn, so let’s state a few obvious, apolitical truths:

  1. Unless you’re an energy producer, high energy prices stink.
  2. No matter who you are, volatile energy prices stink.
  3. Not withstanding points (1) and (2), high and/or volatile energy prices encourage greater energy efficiency.

To argue that energy price volatility and/or perpetually high energy costs are categorically good or bad is false, and unnecessarily polemical, even if it does make for a good political soundbite. As we now start to contemplate the creation of entirely new markets for entirely new commodities (namely, CO2 emissions rights), it’s not at all surprising to hear the battle joined on familiar sides. Nor is it surprising to hear the e-word word (Enron!) thrown around, which calls for a brief digression.

What Enron did and didn’t do

Enron undoubtedly engaged in a host of amoral transactions, not to mention lots of illegal transactions. But not everything that was amoral was also illegal. This latter point is particularly true with respect to California electricity markets, and it’s worth reviewing some history — especially when Enron-as-metaphor comes to have a meaning so distinct from Enron-in-reality.

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When the California Power Exchange, or CalPX, was first created in 1998, it was essentially the first time that electricity could be bought and sold external to a regulated transaction. After a cautious year learning the rules, the gloves came off once electric generators, buyers, and speculators came to appreciate the magnitude of potential market swings (and how much money could be made therein). Enron’s Star Wars-inspired ploys were the most famous example, making them the poster child for rapacious speculation. So far, so fair.

The awkward wrinkle to this story is that some of those transactions weren’t technically illegal. If you’re an avocado farmer and you can get $2 an avocado at Kroger and $2.50 at Safeway, no one calls you amoral for selling to Safeway. And if that then causes Kroger to raise their avocado prices to draw you back into their supply chain, no one is likely to take out their ire on the greedy avocado broker.

But watch what happens if you replace the word “avocado” with electricity. If your power plant will earn more money tomorrow (given the hot weather forecast) than it will today, and you therefore curtail production today to horde your fuel, are you breaking the law? If you then notice that the price today starts to rise when you curtail, such that you can independently affect price, are you amoral for using that knowledge to your economic advantage?

To be clear, I don’t in any way mean to suggest that Enron wasn’t amoral, nor that society’s access to electricity is no more important than society’s access to avocados. However, when the regulatory rules are set up such that the electricity broker’s regulatory constraints are broadly similar to those of an avocado broker, a fair portion of the blame for whatever next ensues is rightly laid at the foot of the regulator. Every time we simplify the California power crisis to “Enron-type manipulation,” we give the regulator an undeserved free pass.

Why Kahn matters

In a regulated enterprise, the role of the regulator is essentially to set price. That’s how consumers get protected. In an unregulated enterprise, the role of the regulator is to make sure that the market sets the price, but that no individual actor (or collection of actors, acting in concert) can affect that price. That’s why he says that the regulatory function shifts from price setting to anti-trust enforcement. The fact that Enron was allowed to exist in California is all the evidence that you need that antitrust enforcement was absent.

Which brings us back to Senator Feinstein’s efforts to regulate emerging CO2 markets. Should we be leery of amoral market speculators? Yes. Should we guard against market dominance that can affect the price and supply of CO2 credits? Yes. But should we define success by a stable, not-too-high price for CO2 emissions credits? Absolutely not. A healthy market is incompatible with price controls. What’s more, a regulator focused on price controls is often blind to precisely those antitrust-busting games that smart, amoral speculators like to play.

For now, I’m cautiously encouraged by Feinstein’s efforts. Encouraged, that is, to the extent that her invocation of Enron meant that we need to adopt greater regulatory discipline to ensure we don’t repeat our prior regulatory mistakes. But cautious, also, because too often, that invocation turns a blind eye to the culpability of regulatory agencies whenever we have a regulatory failure.