New York Times, January 2, 2001

      The Market Flaw California Overlooked

        By Steven Stoft

          California's energy market is on the verge of collapse. Wholesale electricity prices have soared in the
          last six months. The state's largest utilities are threatening that they will be bankrupted unless they are
          allowed to raise consumer electricity rates by 30 percent.

          How could this have happened when deregulation was supposed to increase efficiency and bring
          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 both
          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.

          Before deregulation, 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 electricity
          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 plenty of supply, this market flaw stays hidden. And so it did in California from April
          1998 through April 2000, when power was plentiful and the major utilities' costs to purchase it were
          relatively low.

          Last summer the power supply began to tighten. On hot days there was not enough to meet demand.
          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 of around
          $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 hours in
          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 past
          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

          California now needs both a quick fix and some fundamental market repairs. The first step must be
          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.