How could this
have happened when deregulation was supposed to increase efficiency and
down electricity prices? The seeds of this market disaster rest in the flawed deregulation regime that
the state and federal regulators approved three years ago.
On April 1, 1998,
California opened up a market for wholesale electricity. For almost a century
wholesale and retail electricity prices had been regulated, but now power was to be sold to utility
companies by unregulated suppliers at unregulated wholesale prices.
utilities -- like Southern California Edison and Pacific Gas and Electric
generated their own power. But they made costly mistakes, with the regulators' approval, in building
power plants and signing long-term contracts. A deregulated wholesale market where private,
unregulated suppliers would compete to produce power was supposed to eliminate these
inefficiencies. Under deregulation, stockholders, not consumers, would pay for mistakes, and
entrepreneurs with a bottom line would have incentive to hold down costs.
But in order
to create competitors for the new market, utilities were forced to sell
their power plants
to out-of-state companies like Dynegy and Duke Energy. The utility's cost of power would no longer
be the cost of generation, but the price the company paid in the wholesale market. In theory, this
would save money.
The plan might
have worked. But the wholesale market has a fatal flaw: The consumers of
are largely disconnected from wholesale prices. And for the utilities, what was worse was that
deregulation did not change the fixed, regulated prices that consumers pay. So, when wholesale
prices soared this summer, the utilities could not pass this enormous increase through to customers.
When there is
of supply, this market flaw stays hidden. And so it did in California from
1998 through April 2000, when power was plentiful and the major utilities' costs to purchase it were
Last summer the
power supply began to tighten. On hot days there was not enough to meet
So wholesale prices often headed north, not stopping until they hit the price cap of $750 a megawatt
hour, which was roughly 10 times the normal price. But even that price cap has since been
dismantled by federal regulators.
The retail price
now charged by California's two big utilities is based on a wholesale price
$60 a megawatt hour. After six months of buying power for about $250 a megawatt hour, the
utilities ran into deep financial trouble. The problem may be solved by letting them pass through the
wholesale prices, and some of that is now in the works, but that leaves the customers holding the
And passing through
wholesale prices on a monthly basis will not fix the flaw in the wholesale
market. Monthly rate changes for consumers do not keep up with the daily fluctuations in wholesale
prices, which means that customers cannot play their proper role in the market. If the price of
gasoline jumped 10 times to $300 a tank, drivers would fill up less often, thus forcing prices back
down. That is how the market should work.
But when the
wholesale electricity price in New York went up a hundredfold for a few
May, people didn't turn off their air conditioners. This is because the retail price didn't change at all.
Without any decrease in demand, suppliers have no reason to lower their price. After all, utilities are
forced to keep buying at any price because they cannot cut off power to their customers. The failure
of consumers to respond is the fundamental flaw that makes prices reach exorbitant levels when
there is a little scarcity or when suppliers have even a little market power.
The profits from
some generating plants reportedly jumped more than 500 percent during the
six months. Under normal market competition, an extra 10 percent profit is plenty to attract new
suppliers. Yet these windfall profits in California may not draw new investment into power
production. While some officials at the Federal Energy Regulatory Commission have argued that
prices should be allowed to go still higher in the hopes of attracting more investment, investors know
that such outrageous prices cannot be sustained for the three years it would take to build a new
plant. At this point, higher prices provide less incentive to build because they are less believable.
Other factors, like regulatory delays in power plant sitings, are the real impediment to new
needs both a quick fix and some fundamental market repairs. The first step
to stop these windfall profits with a firm regional wholesale price cap. This is necessary for the
success of the federal energy commission's longer-term solution, which is to allow California utilities
to buy power with multiyear contracts, a move that could reduce the market power of the suppliers
and stabilize prices. But suppliers are unlikely to sign contracts at reasonable prices unless the federal
regulators impose a firm price cap.
The federal commission's
reluctance to act against crippling price spikes leaves California in a
difficult position. Right now California consumers are trapped in an endless game of blame shifting
between state and federal regulators. The best way out would be for some higher authority --
perhaps the Energy Department -- to step in and appoint a professional, nonpolitical,
non-special-interest market repair team. When the repairs are done, we can test drive the market
again. But next time, a little caution might be a good thing.