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Real Electricity Deregulation is the Only Way Out for California

by Thomas M. Lenard

Progress On Point
Periodic Commentaries on the Policy Debate
Release 8.2 n January 2001

It would be more than a little ironic if "deregulation" of California's electricity system led within a few short years to a government takeover. But, this is precisely what Governor Gray Davis is proposing. Declaring California's experiment in deregulation "a colossal failure," the governor's principal response in his state-of-the-state message was to propose a new California public power authority that would build and buy electric power plants. He also suggested that state inspectors stand guard at power plants suspected of "withholding" power – one of several measures that seem designed more for their populist appeal than their ability to offer realistic solutions to the state's problems.

While the state is gearing up to become a full-fledged producer, the governor wants it to become a power broker – buying in the wholesale market and selling to the utilities. This, because the utilities, which are on the verge of bankruptcy and unable to pay their bills, are finding it increasingly difficult to find anyone willing to sell power to them. The governor's proposal does not, however, appear intended as a short-term measure. He apparently envisions the state entering into long-term contracts with power producers, in order to get the most favorable price.

Of course, the other alternative would be for California simply to adopt policies that don't bankrupt its utilities, which could then themselves contract with wholesalers. This would represent a positive long-term solution, but it does not appear to be part of the governor's program.

California will not work its way out of its current crisis by having the government assume a greater role in the electricity business. It also will not find a solution if it persists in thinking that the culprit is deregulation.

Contrary to the governor's assertion, California's electricity market was never deregulated. It was "restructured," which is a very different thing. With the acquiescence of federal regulators, California simply substituted a new regulatory framework for the old one. The new regime was plagued by problems from the start and is clearly unable to withstand the stresses now placed on it by tight market conditions. The lesson is not that electricity deregulation is a failure, but rather that the restructuring approach adopted by California has been a failure.

While the California restructuring plan provided for consumer access to alternative electricity suppliers, in other respects it placed major impediments in the way of a competitive market:

  • California (and other states) froze retail prices, even though wholesale prices – which are under federal jurisdiction – were deregulated. This is obviously a recipe for disaster when supplies become tight, as they obviously have. Utilities can't recover their legitimate costs and consumers won't respond – because they don't see the higher prices – by reducing their demands. This is why the shortages and price spikes in California have been so severe. And, it is why California's utilities are on the verge of bankruptcy.
  • Rather than allowing trading institutions to develop, the California restructuring plan imposed its own institutions. It established a Power Exchange (PX) and then required investor owned utilities (IOUs) to buy and sell all their power through the PX. This made the utilities dependent on the volatile spot market, and made it impossible for them to manage their price risk through forward and long-term supply contracts. (It is also true that the utilities were slow to exercise the hedging opportunities they did have.) The requirement that utilities buy and sell their power through the PX was recently rescinded by the Federal Energy Regulatory Commission (FERC). They can now enter into long-term contracts, if they can find a willing partner on the other side.
  • In a novel economic arrangement, California created a new quasi-regulatory institution – the Independent System Operator (ISO) – operating under a 26-member stakeholder board to operate the transmission grid. Utilities were required to hand over control of their transmission systems to the ISO. Predictably, control of important economic assets by an inherently political board of non-owner stakeholders has not been conducive to efficient operating or capacity investment decisions.
  • The ISO's response to higher prices in the wholesale power market has been to impose price caps. The willingness to impose price caps, even temporarily, has to be a disincentive to investment in new generation, which is sorely needed in California.
In sum, California has tried a half-way approach to competition that fails to provide participants with the normal competitive signals, incentives and mechanisms that markets need to work. Such an approach might have worked (barely) had market conditions not changed, but it is not workable under the tight market conditions that have prevailed since the restructuring plan was put in effect in 1998.

The answer, however, is not government ownership, which has never worked well. Instead, California needs to remove the restrictions that prevent the market from responding to changes in supply and demand conditions:

  • Retail prices need to be unfrozen. While this is politically painful, unfreezing retail prices is essential to putting the industry back on a sound footing and enabling utilities to purchase in the wholesale market on a long-term basis. Moreover, electricity markets will continue to be plagued by excessive volatility and price spikes until consumers are able to respond to price changes. The sooner retail prices are unfrozen, the sooner utilities and other service providers will make the new investments required to enable consumers to respond in real time to price changes.
  • California should transform its ISO into a structure that returns operational control of the transmission grid to its owners, who have better incentives to operate, maintain and expand it efficiently.
  • Finally, wholesale price caps need to be permanently renounced in order to encourage investment in sorely needed new generating capacity. FERC has already rejected the price caps that California imposed on its wholesale market, but has imposed its own "soft" price cap – above $150 per MWH, sellers will be subject to reporting and monitoring requirements. Fortunately, this cap is scheduled to expire in four months. California and its localities also need to remove permitting requirements that have made it almost impossible to build new generation and transmission facilities.

The governor is moving in the wrong direction in all these areas. But, California officials eventually will have to recognize that the only way out of the current morass is real deregulation. If allowed to work, deregulation can bring prices to competitive levels and yield the same kinds of very substantial benefits that have been associated with deregulation of other industries. California just needs to bite the bullet and try it.

Thomas M. Lenard is Vice President for Research at The Progress & Freedom Foundation. The views expressed here are the authors and do not necessarily reflect those of The Progress & Freedom Foundation, its Board, Officers or Staff.



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