The musings of a young engineer: the economy

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by A.G. Nicol

I would like present some thoughts about the economy, specifically the lessons that may be learned from the UK’s management of its power system post-denationalisation.  While I realise that this may at first seem like an odd analogy, there is more than a passing level of similarity.

Firstly though, I should probably introduce myself.  This summer I will be graduating with a Master’s degree in Electrical and Mechanical Engineering from the University of Edinburgh.

My particular speciality is analysing systems from a high-level viewpoint, revealing connections and similarities between different systems that are otherwise difficult to spot.  My hope is that this somewhat different way of looking at the world will allow me to present some ideas that can help stimulate the many debates to be had about the future of this great country of ours.

So, back to the topic in hand.  When the Thatcher government first denationalised the electrical power system, they attempted to set up a system based on the principles of commodity trading.  Now, if we leave the debate on the wisdom of denationalising strategic assets and ignore the fact that electricity is not a commodity as defined by any economics textbook, this arrangement has parallels with today’s economic situation.

The way this system was supposed to work, and actually still does in a number of countries, was that each electricity generation company would submit a bid to generate a specific amount of power in return for a specific payment.  The market operator (aka the Pool) would collate all these bids and determine which generators to schedule to meet the demands of the grid at minimum cost.

This scheduling would take place for a variety of timeframes each with its own level of payment for the generator companies.  When scheduling 24 to 48 hours in advance payments would be comparatively low, whereas in the so-called balancing market, which is used for immediate shortfalls in scheduling, payments can be up to ten times the normal level.

It was this large difference in potential profit which led to the first of the problems with this type of power system.  By holding back their generation capacity, the large generation companies could artificially inflate prices by increasing the demand for the balancing market to make up the shortfall.

However, it is not this failing which is of interest in this instance.  Where there are particularly strong similarities with the current banking and economic system is that there existed so-called “cardboard” generator companies.  These companies would act as middle-men, trading electricity between the actual generation companies and the Pool, without ever needing to own a single piece of electrical hardware.  Worse than this middle-man action, they would also sell generation to the Pool without having first secured any means of actually supplying it.

Given the eye-watering levels of turn-over and profit associated with the day-to-day running of a power system, these companies made vast amounts of profit but never actually contributed anything “real” to the system.  Sounds like any other vast profit producing commercial entities which don’t actually produce anything?

During this period, it was more than a minor miracle that the UK didn’t suffer blackouts as a result of the shameless profiteering of certain commercial entities.  The flaws were eventually admitted and the UK moved to a revised system in 2005.  Among the most important of the regulatory changes brought in was that companies could now only trade what they could generate or purchase from others.  This helped to undo the effects of centralised price fixing and resulted in a fairly significant drop in wholesale electricity prices.  The lower prices didn’t really get passed on to consumers, but that’s something for another day.

While the power system we now have is far from perfect and desperately needs re-examined to pave the way for wide-scale connection of renewables and electric vehicles, it is undoubtedly better that we are now in a situation where companies can’t make money for doing essentially nothing whilst simultaneously risking exposing the populace to dangerous blackouts.

So, here is my thought on how this ties in with the banking and economic systems: it is possible to effectively legislate against commercial entities to prevent them causing harm to the populace by interfering with systems which produce “real” goods.  While this legislation caused a drop in wholesale prices in the electricity markets, it did not cause a mass exodus of power companies from our shores.  I am more than certain that, despite their protestations, the same would be true if the banking sector were to be legislated against and forced to only trade within their means.

The other important point in this is that under the revised trading scheme, generating companies that were uneconomical were allowed to fail.  I cannot stress enough how much this must be applied to the financial system.  The myth of ‘too big to fail’ is so clearly against all of the founding principles of capitalism that it must be challenged at every opportunity.  As the power system has shown us, companies were allowed to fail and the lights stayed on.

Now, I am the first to admit that these analogies can only be taken so far.  There are clear differences between the two sectors. That said, I think it is important that we try to learn the lessons a variety of fields can teach us, especially given the number of economic “laws” which have been shown to simply not hold true in the real world.  The story of electricity generating can help shine a light on the shadowy world of banking.