California’s Electricity Plan Falls Short

For the second time in five years California has adopted new rules to restructure the electricity industry. The first time they tried this they made a hash of things. This second try is unlikely to turn out much better.

The main thrust of this latest intervention is to let the state government play the role of electricity middleman. The state took this step because California’s utilities are nearly bankrupt and lack the funds to buy electricity from the state-controlled spot market. Power generators no longer willingly take IOUs from companies that show little prospect of making good on their promises to pay. So, the state will now buy the power and then sell it to the utilities at a steep discount.

Before we go further, let’s make one thing clear. The near bankruptcy of the California electric utility industry is due to state rules that force those companies to buy power at 15-100 cents a kilowatt hour and prohibits them from selling at more than 6.7 cents per kilowatt hour. Removing the retail price caps would have fixed things, allowing the utilities to end the red ink and reenter the spot market without subsidies or bailouts. Instead, California taxpayers will now assume the losses that were previously assumed by utility stockholders.

California’s politicos, however, think they can minimize those losses by entering into long-term contracts with power suppliers. Five years ago, of course, those same politicos were as convinced that contracts on the spot market would minimize costs. They were so convinced that they, for the most part, stopped utilities from engaging in long-term contracting. The new theory is that long-term contracts allow the state to buy some stability in electricity costs while reducing the overall costs of power.

This is nonsense that desperate politicians peddle. Over the long run, long-term contracts are no “bargain.” They may buy some price relief in the short run, but it’s offset by a commitment to buy at relatively high prices down the road when wholesale costs will presumably be lower. Long-term contracts are a form of insurance. But remember, insurance comes with a premium. The supplier is not about to offer prices that, long term, will return him less than selling on the spot market.

Gov. Davis, however, wants us to believe that these out-of-state power generators — supposedly a fiendishly clever lot who’ve been busy fleecing the unwitting ratepayers of California — will suddenly become country bumpkins the minute the state comes along offering long-term contractual relationships.

It seems everyone has forgotten that we’ve been down this road before. In the late 1970s, soaring electricity prices led Congress to pass the Public Utility Regulatory Policy Act (PURPA). That law forced utilities to sign long-term contracts with independent power producers whenever such contracts were cheaper than the cost of building new utility power plants. Regulators in California and a few other states enforced the law with gusto and utilities — convinced that high electricity prices were here to stay — signed 10-20 year contracts for power at 10 cents or more per kilowatt hour. It looked like a good deal at the time. But when electricity prices collapsed in the mid-1980s, the power companies had to keep buying this power while spot prices were hovering around 2-3 cents per kilowatt hour. Largely because of the PURPA contracts, Californians by the mid-1990s were paying 50 percent more for their electricity than ratepayers in other states, a markup that was costing households $265 a year, commercial users $1,408 a year and industrial users $23,486 a year.

The whole idea behind California’s misnamed “deregulation” of 1996 was to make sure this never happened again. If power generators had to compete with one another and sell in a spot market, the reasoning went, ratepayers would never again be saddled with such contractual boondoggles. Of course, California went overboard. The state has no business telling companies what kind of contracts they can and cannot sign and under what terms and conditions they can and cannot enter. But that’s not to say that a wholesale replay of the disastrous 1970s regime is in order.

What if California’s utilities had signed long-term contracts before the wholesale electricity price spike hit? Wholesale prices would still be sky-high. That’s because the factors driving the spike - skyrocketing wholesale natural gas prices, a decline in regional hydroelectric power due to a two-year drought, and sharp weather-related increases in demand - have little to do with state policy. Under this scenario, independent power producers would be obligated to sell power at, say, 6 cents a kilowatt hour despite the fact that it costs them 15-100 cents per kilowatt hour to make that power. It wouldn’t be long before the independent power plants started to declare bankruptcy and tear up the contracts, which is what happened during the mid-1980s in the natural gas industry. It’s already happening to the few generators (including the natural gas giant Enron) that signed long-term contracts in California.

Nor would long-term contracting have stopped the blackouts. No matter how the contracts were written, it would not have changed the fact that exogenous supply and demand shocks have curtailed the supply (and, accordingly, increased the price) of electricity. As long as the state prevents retail prices from reflecting that scarcity, demand will outstrip supply and shortages will occur.

Why? A fundamental axiom of economics states that the most expensive source of supply at the margin must set prices for all sources of supply. If it didn’t, shortages would occur. So if 99 percent of all the utilities’ power were supplied by long-term contracts at 6 cents per kilowatt hour, as long as 1 percent of that power were coming from the spot market, the price they’ d charge to keep the lights on would reflect the spot — not the contract — price.

The reason for this latest legislative contortion is that California’s politicians cannot bring themselves to fully deregulate retail prices. Even a partial price deregulation — aimed at major industrial users — would largely halt the crisis. Instead, California is opting to soak the taxpayer in the short-run and soak the ratepayers in the long run. A few more legislative “restructurings” are thus inevitable. That’s the way government intervention in any market works: It intervenes, which causes problems, and then it intervenes again to fix (i.e., reform) those problems. And the cycle repeats itself again and again.

Jerry Taylor is director of natural resource studies at the Cato Institute. Peter VanDoren is editor-in-chief of Regulation magazine.