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State Meddling, Not Deregulation, Behind Energy Crunch

California did not deregulate

George Passantino
October 1, 2001

In a recent New York Times article, Carl Wood of the California Public Utilities Commission proclaimed that "deregulation is dead," referring to the growing crisis over skyrocketing electricity prices and the looming bankruptcy of California's two largest utility companies.

Unfortunately, Mr. Wood made the correct diagnosis on the wrong cadaver. The experiment California lawmakers undertook in 1996 was not deregulation at all. Instead, through a unanimously approved bill, California lawmakers "restructured" the California electricity industry. Indeed, the distinction is critical not only to correctly understand the current crisis but also to identify appropriate reforms that will bring California closer to the promises of lower prices, more competition, and a more reliable power supply.

To make this point clear, consider the following results of the 1996 legislation:

  1. State regulators determine the prices customers pay for their electricity;
  2. Utilities are not allowed to seek out competitive contracts on their own, but must purchase electricity in a state operated "power exchange" with bidding rules that require paying the highest bid price;
  3. The state determines what business activities the utilities can conduct, such as requiring them to sell their electricity generation plants and buy more electricity through the power exchange;
  4. Price caps and onerous market rules discourage new competitors from entering the market; and
  5. New regulatory strictures created by the restructuring law constrain business decisions on such matters as plant maintenance and transmission lines.

The past year of price spikes and the looming threat of blackouts are not the result of "unfettered free markets," but of the political micromanagement and market distortions, like those listed, that restructuring wrought.

Deregulation means market-driven prices

Deregulation 101 tells us that for a market to work without price spikes and interruptions, the principal signal between producers and consumers, prices, must be free to respond to shifts in supply and demand.

In a symbolic gesture of conservation, California Governor Gray Davis, turned on and then quickly turned off the lights of the state Christmas tree at the lighting ceremony, trying to encourage others to do so. Ironically, were prices deregulated and fluctuating to reflect changes in supply and demand, state residents would have far more incentive to conserve than provided by the governor's gesture.

San Diego bore the brunt of consequences from price controls. Residents there were subjected to a sudden lifting of retail price caps at a time when wholesale prices were surging and the rest of the state was still under retail price caps. San Diego residents saw their bill more than double. Meanwhile the rest of the state enjoyed artificially low rates that eliminated any incentives to conserve power. This, in turn, put upward pressure on San Diego electricity power prices. It is safe to assume that San Diegans did far more to conserve power by reducing the number of hours that the Christmas lights twinkled than the rest of the Golden State. They didn't need the Governor to tell them.

Price controls also resulted in the billions of dollars the state's private utilities have lost in the last year as they are forced to sell power for less than it costs them to buy.

Deregulation means allowing firms to seek better prices

Markets work because buyers and sellers can make offers and counteroffers, and either can look somewhere else if they don't like an offer. But California's restructuring left the utilities with no options, forced to buy all their power from a centralized agency, the Power Exchange, and basically forbidden to make direct contracts with power generators. However, the power generators were not so constrained—if they do not like the deal offered they can sell their power in some other western state. Born out of fear of market power in the utilities' hands, the power exchange rules gave the generators all the market power.

My colleague at Reason Public Policy Institute, Adrian Moore, offers a powerful analogy to reveal the illogic of the current system.

Imagine if you were forbidden from buying groceries directly from a store, but had to tell a "grocery exchange" what you planned to purchase next week. In return, they came back to you with the prices you would pay. But the exchange also required that if you had unexpected guests or a change of appetite, and needed to increase your order on the day you picked up your groceries, you would have to pay the price of the most expensive brand on the shelf for any additional items you required. Who would ever choose to participate in such a market?

Amazingly, that is precisely how California's power exchange and Independent System Operator (ISO) work. Power demands are submitted a day in advance, as are bids to supply power. The ISO creates a plan to match supply and demand, and sends directions to utilities telling them what will be purchased. Since the demand predictions are almost always wrong, and almost always too low, a lot of power gets purchased by the hour, where government-mandated rules require the price to be that of the most expensive of the bids that add up to the power demanded.

Consequently, power generators make more money selling their electricity to utilities in the hour-ahead market than the day-ahead market, and the rules allow them to game the system to get the highest possible prices. Meanwhile utilities are not allowed to make their own arrangements to purchase power or shop for lower prices.

While recent actions by the Federal Energy Regulatory Commission (FERC) have eased these rules and now permit utilities to shop for long-term contracts, it will take some time before it begins to have any effect. Moreover, the financial problems the utilities face due to the past year's losses make power suppliers reluctant to sign long-term contracts, fearing that the utilities may not be able to pay for the energy. However, the end of the year saw power generators become more willing to sign long-term contracts and hedge their own risks from fluctuating markets.

Deregulation means letting firms innovate and experiment with ways to meet consumer demands

Before restructuring, California utilities owned more than enough generation plants to meet most of their customers' demand. But restructuring forbade "vertical integration" and ordered utilities to sell their power plants. The utilities quickly sold their natural gas power plants, which account for most of the power generated in the state, though the sale of hydropower plants has been tied up in environmental concerns.

Imagine telling Paramount studios that they can make as many movies as they want but must not own any movie lots or animation studios. Forced divestiture of assets is not an act of deregulation. In order to deliver lower prices and compete for business, producers must be free to determine what goods and services they will offer, what assets they require, and be able to expand those resources as needed.

Ironically, a key reason why municipally owned utilities have suffered much less, and even done well in some ways, under the current crisis is that they were not required to sell of their generation plants. What is good for government-run utilities should also be good for private enterprise.

Deregulation encourages new competitors to enter the market and offer customers choices

True deregulation encourages new participation and customer choice. California's restructuring froze out new competitors and offered customers no choices. Witnessing the legislative battles and compromises, most out-of-state competitors have sat on their hands with a wait-and-see approach. The most recent attempts to freeze electricity rates at pre-restructuring levels have only confirmed their worst fears—California isn't a deregulated market at all, just some hybrid that they don't know how to navigate.

With deregulation, higher prices in response to a shortage of supply spur more entry and increased supply and customer choice. With electricity, entry and new supply cannot come quickly, but it will come if prices rise, and knowing that spurs forward-looking investment by all players. California's restructuring stifled this dynamic and ensures that no new firms with new energy supplies or options for customers will be seen soon.

Deregulation means less, not more, regulation

Rather than cutting red tape and streamlining regulations, California�s restructuring instituted a whole host of new regulations that did not exist before 1996. For example, California�s utilities lost control over their transmission grids, and thus any incentive to worry about balancing loads or ensuring expanded capacity as demand grew. Power generators would no longer be allowed to determine their own schedules for maintenance and upgrades on power plants based on their condition and needs. Waiting for state approval can take up to a year and delays have contributed to plant breakdowns and further supply shortages.

Deregulation is working in other states

In Pennsylvania, the state restructured the electricity market with far fewer micromanaged political machinations. They set a very high cap on prices only to set an upper bound, did not require the utilities to sell their generation plants, allowed buyers and sellers to exchange in the power pool or through direct contracts, encouraged distributed generation (where buildings or sites generate their own electricity but still hook into the grid for emergency electricity), and encouraged entry of new electricity suppliers into the state.

The result: customers have real choices among power providers, some have seen prices fall, many have chosen "green power" providers, and surveys show they are far more satisfied with their electricity service than the national average. The public debate would be far better served by looking at Pennsylvania for a guide to was is possible, than at California as a guide to what to fear.

Bumpy Road Ahead

While the course charted by successful deregulation efforts like with airlines, interstate trucking, telephone service, and, yes, electricity in states like Pennsylvania, should provide a helpful road map to California, lawmakers seem to lean heavily on new regulation and market-intrusion as the way out of the mess. The current panacea is to extend price caps or nationalize the utilities. Unfortunately, as the current situation adequately demonstrates, such political intervention is the root of shortages, price spikes, defaults, and economic injury. Unless state policy makers follow FERC's lead and start to seek ways to further move the industry toward free and open competition, the worst is yet to come.

George Passantino is director of government affairs at Reason Foundation. He served as a director on Gov. Arnold Schwarzenegger's California Performance Review.

George Passantino is Senior Fellow

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