ELECTRICITY industry can't seem to stay out of the news.
Warnings of emergency blackouts and skyrocketing prices
have been commonplace since May.
Now the state's two largest electricity distribution
companies, Pacific Gas & Electric and Southern
California Edison, warn that bankruptcy is imminent if
they are not allowed to pass on their enormous wholesale
power costs to consumers through even higher retail
rates. Some producers, citing concerns over the credit
worthiness of California utilities, have threatened to
stop selling power into California for fear of not being
The Los Angeles Times calls the decision to open
electricity sales to the open market "one of the most
expensive public policy miscalculations in California
history." The state has limited options for short-term
solutions, but opportunities are being lost in the fight
over who will pick up the tab for last year.
There is much disillusionment about a process where
the short-term benefits of deregulation were oversold
and the long-term benefits may never be realized.
This is one of the many cautionary lessons for other
states now starting down a similar path.
California's deregulators believed that if utilities
were made to sell off most of the power plants they had
built over the years to unregulated wholesale companies,
retail prices would fall. Consumers would be free to buy
power from the supplier of their choice.
Traditionally, regulated utilities were allowed to
build all the power plants they felt were needed and to
charge prices that recovered the full cost of building
and operating these plants, plus a fair rate of return.
They had little incentive to cut costs and many built
large, overly expensive plants, often nuclear. Under
deregulation, these utilties were reduced to middlemen
distributors; customers were supposed to benefit from
more direct access to wholesale markets. Then why are
prices rising out of control? At the retail level, the
utilities negotiated a rate freeze for themselves that
has completely backfired. At the wholesale level, tight
supply is allowing generation companies to put the
squeeze on utilities and customers.
Most of the price difference in 1996 between electric
rates in California and neighboring states was due to
poor investment decisions by utilities and regulators.
But this money had already been spent. Deregulation
couldn't make those costs magically disappear.
California's electricity companies needed extra
revenue to pay off all the white-elephant power plants
built during the 1980s. With deregulation coming, they
negotiated a freeze on their relatively high retail
rates for a transition period following the opening of
the market. They thought this would guarantee the extra
Wholesale prices, per megawatt hour, averaged about
$20 in 1996, when the deregulation legislation was
passed. Retail rates ranged from $50 to $60 at that
time. California utilities stood to gain about $30 to
$40 for each megawatt-hour sold to their customers, if
wholesale prices remained at 1996 levels.
This deal so outraged some consumers that in 1997
there was a ballot measure to do away with the rate
freeze. A mere three years later, these consumer groups
are fighting to keep the rate freeze in place, and it is
California's utilities that are desperately trying to
What the designers of deregulation failed to
anticipate was that wholesale prices would rise far
higher than 1996 levels. In fact, prices during 2000,
per megawatt hour, averaged over $100-five times the
1996 levels and roughly $40 higher than the frozen
retail rates of the utilities. The utilities are losing
more than $40 for each megawatt hour they sell. Not even
a dot-com company could sell a business plan like that
on Wall Street.
What happened to the wholesale market? It was hit by
two factors that deregulators did not take seriously
enough in the heady days of 1996: rapidly growing demand
and the market power of generation companies. Plus, the
electricity market is peculiar in ways that have made
the situation worse.
In most markets, a supplier that tries to raise
prices risks selling less of its product because
customers either buy it from someone else for less, or
choose not to buy as much. In electricity markets, this
natural ebb and flow of competition often breaks down.
When supply is tight, such as on hot summer days, a
supplier that wants to raise prices knows that most of
its competitors already are operating at full capacity.
Since there is no "inventory" of power to draw down,
this supplier also knows that customers have nowhere
else to go for their power.
Consumers also have no idea what price they are
paying for their power at any given point in time. They
run their air conditioning at the same level whether the
price of power is $20 or $2,000. In a market such as
this, Adam Smith's "invisible hand" pushes prices in
only one direction: up.
For Californians, such conditions have been all too
common during the last year. Rapid growth, spurred by
our robust economy, has dried up the surplus generation
capacity that caused utilities to worry about stranded
power plants four years ago. Plenty of new facilities
are on the way, but not for at least two more years.
Limits on smog-producing emissions have constrained
the output from many relatively dirty power plants in
the Los Angeles basin. The price of natural gas, a key
fuel for making electricity, has also reached
unprecedented levels this winter. Power-production costs
are up and electricity prices in the deregulated
wholesale market are way up.
What lessons can other states take from California's
agony? First, don't deregulate a market without giving
customers a chance to say no to high power prices. This
means that customers need metering systems and rate
structures that let them see and respond to changes in
prices, which can vary wildly by the hour.
A rate structure that averages out price
fluctuations, such as most in place now, forces all
customers to pay monthly bills for power that may cost
more at given times than what they would be willing to
A better system is for a utility or regulator to set
a target rate, say of $60 per megawatt hour, and then
allow customers to meter the fluctuations in price per
hour. Say wholesale spot prices hit $40 in one hour and
$100 in the next. Retail customers would see those
prices translated to $30 in the first hour and $90 in
the next. The average rate would still be $60, but
customers inclined to turn down their air conditioning
in that second hour to save a little money would then
have the chance to do so.
A more fundamental lesson from California may be to
just leave existing power plants regulated with the
utilities that built them. If regulation failed to keep
down prices because of poor investment decisions by the
utilities, then the biggest potential benefit from
deregulation is smarter investments in new power plants.
There is little to be gained from deregulating existing
power plants. Better to focus on how to allow market
forces to drive the construction and pricing of new
What can be done for California? It's too late to
keep power plants with regulated utilities, but the
state could tie up most of their output under contracts
set at prices deemed reasonable by regulators. One major
problem is federal regulators, who have jurisdiction
over the sellers, and California regulators, who have
jurisdiction over the buyers, cannot agree on what a
reasonable price is.
While we cannot add much new generation capacity by
next summer, the state can subsidize, or even compel,
the installation of emissions-reduction technologies
that would allow existing plants to generate much more
power before hitting their environmental limits. Lastly,
most commercial and industrial consumers in California
already have the metering technology for hourly retail
pricing. All we need is a rate structure that gives them
an incentive to respond by charging them prices that
reflect the cost of power at the time they consume it.
Unfortunately, while consumer groups and utilities
fight over who will have the privilege of paying most of
the suppliers' bill, we are losing the opportunity to
take measures that could lower prices for everyone.