California: How Not to Deregulate Electricity

State didn't deregulate, it only restructured

California’s electricity crisis has joined the process of President-elect Bush selecting his cabinet on center stage of the national fishbowl. Much like the way people are drawn to looking at a roadside car accident, other states, from Nevada to Florida, are looking at the mess that California’s electricity market has become and are recoiling from any plans of deregulation in horror.

At first glance, fear of deregulating future utilities is an understandable reaction. However, this surface level of “investigation” misses the true lessons to be learned. Condemning the idea of electricity deregulation because of California’s experience is a mistake for two reasons.

First, and foremost, California did not deregulate the electricity market; they “restructured” it, requiring far more state intervention in electricity transactions than existed before. In doing so, the law created a micromanaged pseudo-market where suppliers of electricity have the ability and incentive to manipulate prices to their advantage, and utilities are forbidden from shopping for better prices.

Second, focusing on California’s failures rather than on states that have had considerable success in deregulating electricity, such as Pennsylvania, is like skipping the Superbowl to watch the last placed teams practice. In Pennsylvania, customers were given meaningful choices between electricity providers. New companies were encouraged to enter the market, prices have gone down, and environmentally-friendly power has achieved a respectable market share. Most important, Pennsylvania citizens reveal in surveys that they are happier with their electricity service than most people in the nation. This is an example of how deregulation, when done right, works and benefit consumers.

Lawmakers in other states would be wise to learn at least as much from Pennsylvania as from California. That being said there are some specific lessons from California’s restructuring that should be understood.

Most important, a market is not an entity, but a process by which buyers and sellers exchange goods and services. California’s restructuring “created” a market-a centralized, planned power exchange where all selling and buying of electricity was mandated to occur. For example, imagine if you were forbidden from buying groceries directly from a store, and instead 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 altered your order on the day you picked up your groceries, you would have to pay the price of the most expensive brand for any additional items you required. Who would ever chose to participate in such a market?

Amazingly, that is precisely how California’s power exchange and Independent System Operator (ISO) work. Utilities are not allowed to make their own arrangements to purchase power or shop for lower prices, instead they have to buy from a market that allows sellers a lot of power to determine prices.

Almost as fatal a flaw of California’s restructuring was price controls on retail electricity, a bad idea even under ideal circumstances. But with demand for electricity growing much faster than supply, circumstances in California were far from ideal. Since price controls discourage additional supply, and give customers no reason to conserve electricity, especially when it is in very short supply, the problem was destined to get worse.

As the shortage of electricity increases, the situation worsens, and state leaders become more enamored with price controls. In a truly deregulated market, prices would have encouraged new companies to strive to create new power supplies for California. However, with the current “restructured” market, state leaders are considering building state-owned power plants, and customers face the prospect of rolling blackouts or worse.

While the leaders and citizens of other states look on as California struggles to correct the problems that market restructuring has created, they should not condemn deregulation. Rather, they should recognize and avoid California’s short-sited policies and benighted belief that creating and centrally managed electricity market is a better solution than creating rules of the road that allow a market to evolve.

Adrian Moore is Vice President of Reason Foundation.