To hear California Governor Gray Davis tell it, price-gouging power generators are the cause of the California electricity price spike and President Bush refuses to do anything about it because, well, it's Texas power generators who are ransacking the California market. Even Bush's own Federal Energy Regulatory Commission (FERC), Governor Davis charges, reports that wholesale electricity prices on the western grid have been "unjust and unreasonable"…so why not call out the price cops? The reality, however, is that the federal price cops are indeed on the beat, it's just that the president is unwilling to have them do a "Rodney King" on the power market.
First, let's see what's behind FERC's contention that prices were "unjust and unreasonable" in California last winter. The commission maintains that it the legitimate price for power during the power emergencies last January was 27 cents a kilowatt-hour. The operator of the California power grid, however, reports that it paid an average of — hold on to your hats! — 28 cents for that power on the daily spot market.
During February, wholesale natural gas prices exploded, resulting in a legitimate price — according to FERC — of 43 cents per kilowatt-hour during the power emergencies that month. Unfortunately, data are not available about the prices that the grid operator paid for power from February to the present, but given the relationship between prices and costs in January according to the FERC, it's unlikely that wholesale prices after February were on average more than a few cents higher than costs.
For the sake of argument, let's assume that a penny or two of each kilowatt sold in the state represents "profiteering." If so, don't blame the free market — it doesn't exist. In California, generators can charge whatever they want during a crisis without fear that the prices they name will reduce sales because the state insists upon maintaining retail price controls. This is called a "dream scenario." Without those rate caps, generators would find that high prices reduce sales, providing a disincentive against overcharges. The upshot is that retail price controls are themselves primarily responsible for whatever mischief exists.
What exactly is a legitimate price, anyway? The FERC argues that the highest cost source of supply necessary to meet demand sets the legitimate price for all sources of supply in the market. That's textbook economics. And that's how they're planning to regulate the market this summer. But Gov. Davis wants the feds to go further. He'd have the FERC cap prices for each individual generator at no more than 5 percent above production cost (the old "cost-of-service-plus" regime). The idea is that this would bring down the average cost of power and thus allow the state to reduce the retail price of electricity. The problems with that approach, however, are legion.
First, it provides a disincentive for firms to control costs. A relatively low-cost plant gains no economic advantage against higher-cost competitors. The profit margins would be the same, so why bother keeping your costs down?
Second, it would lead to shortages. If consumers aren't paying the cost of the last unit of energy necessary to meet demand — and they don't under average-cost pricing — then generators will lose money on every additional unit sold. And demand will exceed supply at such prices. A firm cannot lose on every additional sale and make it up on volume.
Third, it reduces the incentive to invest in new power plants. Money is pouring into new plant construction because the profit margins are quite impressive for the time being. Reduce the profit margins and you'll reduce investor's interest in power plant construction. Let's face it; there are a lot of profit opportunities out there that promise more than a 5 percent rate of return.
Fourth, average-cost pricing biases the electricity market towards needing new supply. In fact, this very point was once made quite energetically by the political Left to justify energy conservation subsidies. Amory Lovins, a famous advocate of energy conservation, has argued correctly that traditional state regulation of the electric utility business delivered average costs, not marginal costs, to ratepayers, which resulted in inefficiently excessive levels of consumption and losses for the utility whenever marginal costs exceed average costs. Lovins's remedy for this market distortion, however, was not a "first-best" solution — the introduction of marginal-cost pricing — but a "second-best solution" — to have electric utilities subsidize ratepayer purchases of energy-efficient appliances and technologies, which would be cheaper for utilities than investments in additional generation. California has used ratepayer dollars to follow Lovins's advice. But the result was a mess, producing excessively high-cost power and the inevitable demand for deregulation at the start of the 1990s.
So this is the great Bush-Davis debate in a nutshell. The president and his regulators at the FERC believe that prices ought to reflect supply and demand. The governor and his populist allies think that prices ought to reflect the cost of production and nothing more. That this debate is even being held and that serious people are taking it seriously unfortunately says a lot about the level of economic literacy both in the press and in the public at large.
In sum, those who think that eliminating the alleged market power in California's wholesale electricity markets would return electricity prices in California to 1999 levels have spent too much time in the hot tub. Those who think that denying the laws of supply and demand are the best way out of this mess will soon be pondering such thoughts in the dark.