Price Caps Will Not Solve Electricity Problem

Price controls distort market

The drumbeat is again sounding for a return to wholesale price caps in California’s electricity market. While well intentioned, such a move would be a grave mistake.

Price controls have a history of distorting markets where competitive prices are possible, leading to shortages of supply, inadequate investment, over-consumption, and a myriad of other problems. In the case of California’s electricity crunch, a return to price caps would only increase the threat of blackouts, as the supply of electricity would not keep pace with California’s appetite for power. Unfortunately, state leaders pushing for price caps ignore history’s lessons and seem destined to repeat past mistakes.

California already experimented with price caps and it was a dismal failure. As California’s wholesale power prices rose rapidly in the spring of 2000, the state Independent System Operator (ISO) quickly imposed a price cap. As a result, the amount of power supplied to the state decreased as suppliers pursued more lucrative opportunities elsewhere, selling their power in states without price caps. In fact, imported electricity declined 33 percent in 2000 from the previous year.

Consumer prices in two-thirds of the state were not affected and consumers did not reduce demand. Scarcity turned into outright shortages. ISO staffers spent much of their time rounding up power to keep the lights on hour by hour rather than tending to the needs of the grid. As supplies continued to fall, the ISO eventually lifted the caps to avert blackouts.

When a similar situation occurred across the Midwest in 1998, policy-makers pursued a dramatically different course which resulted in a dramatically different outcome. Policy-makers let market prices rise to attract both power and investment to the region, and now new power plants are being built.

So, if price caps are not the solution, what is?

California must choose between two directions for its electricity market to move out of its current dysfunctional state: a state takeover of the market, which is the direction Gov. Gray Davis’ policies are leading, or a transition to a deregulated market with real choices for customers. Given the success of deregulating electricity generation in states like Pennsylvania and Texas, California should pursue the latter course. But the transition will not be easy.

First and foremost, California must articulate a vision of moving toward competition that will encourage new suppliers to enter the market. Too many state leaders are offering isolated policy ideas and conflicting proposals that do not inform the market in what direction policy is moving and what end state is sought. In other cases, the state is hanging a “business not welcome” sign on the door by scaring off would-be suppliers with high-pitched rhetoric and threats of state takeovers.

Once a clear vision is laid out, California will need to move toward a system where consumers pay market prices for electricity, as this is the only way to ensure that demand does not outpace supply. But this move will inevitably cause some transition pains. Laying out a clear plan for this transition will make it easier for the public to deal with.

The state also can encourage utilities to implement real-time pricing and metering so consumers can adjust their use of electricity as prices change. Again, by providing more information, customers are better able to manage this transition.

But the state should ensure that utilities do not simply pass all of their previous losses onto consumers through increased prices. The utilities helped contribute to the problem and must shoulder some of the costs.

Finally, if the state is going to move to a truly competitive market, utilities must be free to purchase power competitively. Rather than trying to oversee every transaction through a central pool, the state should encourage a voluntary, independent competitive exchange and develop bidding rules that attract both buyers and sellers, and enable utilities to purchase long-term contracts at lower prices.

Granted, the electricity crisis is no simple problem that the state can solve with the stroke of a pen or public speech about the need for conservation. Without a doubt, it is going to cause some pain.

But beyond the short-term difficulties, California can still emerge with a robust, reliable power supply that encourages new investment, empowers consumers to choose providers of their choice, and lowers the cost of the fuel our state’s high-tech economy runs on. A return to price caps would all but eliminate that prospect and shatter California’s track record as a forward-looking source of new ideas.

Adrian Moore is Vice President of Reason Foundation.

Lynne Kiesling is director of applied energy research at the International Foundation for Research in Experimental Economics and an adjunct scholar at the Reason Foundation.

Adrian Moore

Adrian Moore, Ph.D., is vice president of policy at Reason Foundation, a non-profit think tank advancing free minds and free markets. Moore leads Reason's policy implementation efforts and conducts his own research on topics such as privatization, government and regulatory reform, air quality, transportation and urban growth, prisons and utilities.

Lynne Kiesling is Director of Economic Policy at Reason Public Policy Institute. She is also Visiting Associate Professor of Economics at Northwestern University. Her previous positions include Assistant Professor of Economics at the College of William and Mary, and Manager in the Transfer Pricing Economics group at PriceWaterhouseCoopers LLP. She has a Ph.D. in economics from Northwestern University, and has published extensively in academic journals.