Commentary

Electricity Deregulation Must Target Demand

California’s electricity crisis has prompted much discussion about markets “not working.” But commentators are vague about what a “well working market” would look like. They do not seem to appreciate the lessons we should have learned from the era of old-style regulation. Such ignorance explains the support for California Governor Gray Davis’ ill-advised call for the state purchase of electricity under long-term contracts as the best way to “solve” the crisis.

In a technical sense, a well-working market is one in which ratepayers, who have varying willingness to pay for electricity, and generators, which have willingness to supply power at varying prices, interact to allocate available supply among consumers. From the 1920s until recently, however, the electricity system had no market aspects at all. Ratepayers and generators interacted under a state-administered system in which supply and demand were balanced through engineering plans — not the market. Prices served only to recover costs, not to distribute supply to those consumers who valued it most or to signal investors about the need for new supply.

The state-administered system survived for 40 years because it coincided with an era of ever-cheaper electricity. Declining prices, however, were not the result of regulatory efficiency. They were the product of technological advances in power plant operations — changes that stalled in the early 1960s.

Two additional events ended the decline in electricity prices. First, many utilities turned to nuclear power. The least expensive nuclear power plants were cheaper than the least expensive coal plants. But many nukes turned out to be too expensive. Second, the 1978 Public Utilities Regulatory Policies Act (PURPA) required the utilities to accept generation from independent producers at rates set by the state. Some states (particularly New York and California) set those rates sky-high based on expectations of continued high fossil-fuel prices; expectations that turned out to be wildly inaccurate when energy prices collapsed in the mid 1980s.

The combined effect of expensive nuclear and PURPA power triggered angry calls from businesses for rate relief. Rather than deregulate the industry and allow the nuclear and PURPA plants to declare bankruptcy, the regulatory regime was restructured in toto. The restructuring states combined a relatively unregulated electricity-generator market with a regulated transmission and distribution system. At the same time, they taxed consumers to bail the utilities out of their bad nuclear and PURPA investments. The hope was that if market forces governed generators, costly future investments would be avoided.

The main problem with those restructuring plans is that they introduced market forces only on the supply side of electricity market. A well-working market also requires attention to demand as well.

Critics focus on the fact that the restructured California market has fixed retail prices at 6.4 cents per kilowatt hour through March 2002, which keeps demand from reacting to the supply scarcity and produces shortages and blackouts. While true enough, even if prices were not fixed by policy, prices in California would still be wrong all the time: They would be average monthly costs rather than the hourly marginal costs that exist in the wholesale electricity market.

If consumers faced real hourly time varying prices — instead of fixed monthly costs — they would have an incentive to buy or contract for small-scale power sources (fuel cells or small natural gas turbines). Those would be activated by computer whenever the cost of power on the grid exceeded the cost of these small-scale alternatives. Consumers would also have an incentive to shift their electricity-demanding activities away from peak periods.

Remember, it is the shortage of supply at peak demand that is California’s main problem. Moreover, the emergence of supply substitutes and more flexible demand because of “real-time pricing” would reduce the ability of generators to raise prices, as they have in California.

Governor Davis’ call for a return to the “good-old days” is thus unlikely to help. First, signing long-term contracts for energy during times of high prices was tried and failed in the 1970s. An overinvestment in nuclear and independent power contracts resulted, producing rates far in excess of the spot market. A new set of boondoggles is undoubtedly on the horizon. Second, until price controls are removed and real-time pricing put in place, scarcities will continue.

Davis and his allies might not like the marketplace. But, in truth, it’s the only way out.

Peter VanDoren is editor of Regulation magazine, published by the Cato Institute. Jerry Taylor is director of natural resource studies at the Cato Institute.