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    01/07/2001 - Sunday - Page B 4

    West Coast Power Blues

    CALIFORNIA'S 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 paid.

    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 income.

    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 end it.

    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 pay.

    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 ones.

    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.

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