California’s Electricity Plan Falls Short

This article originally appeared on on February 7, 2001.

For the second time in five years California has adopted new rules torestructure the electricity industry. The first time they tried this theymade 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 governmentplay the role of electricity middleman. The state took this step becauseCalifornia's utilities are nearly bankrupt and lack the funds to buyelectricity from the state-controlled spot market. Power generators nolonger willingly take IOUs from companies that show little prospect ofmaking good on their promises to pay. So, the state will now buy the powerand then sell it to the utilities at a steep discount.

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

California's politicos, however, think they can minimize those losses byentering into long-term contracts with power suppliers. Five years ago, ofcourse, those same politicos were as convinced that contracts on the spotmarket would minimize costs. They were so convinced that they, for the mostpart, stopped utilities from engaging in long-term contracting. The newtheory is that long-term contracts allow the state to buy some stability inelectricity 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 theshort run, but it's offset by a commitment to buy at relatively high pricesdown the road when wholesale costs will presumably be lower. Long-termcontracts are a form of insurance. But remember, insurance comes with apremium. The supplier is not about to offer prices that, long term, willreturn him less than selling on the spot market.

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

It seems everyone has forgotten that we've been down this road before. Inthe late 1970s, soaring electricity prices led Congress to pass the PublicUtility Regulatory Policy Act (PURPA). That law forced utilities to signlong-term contracts with independent power producers whenever such contractswere cheaper than the cost of building new utility power plants. Regulatorsin California and a few other states enforced the law with gusto andutilities -- convinced that high electricity prices were here to stay -- signed10-20 year contracts for power at 10 cents or more per kilowatt hour. Itlooked like a good deal at the time. But when electricity prices collapsedin the mid-1980s, the power companies had to keep buying this power whilespot prices were hovering around 2-3 cents per kilowatt hour. Largelybecause of the PURPA contracts, Californians by the mid-1990s were paying 50percent more for their electricity than ratepayers in other states, a markupthat was costing households $265 a year, commercial users $1,408 a year andindustrial users $23,486 a year.

The whole idea behind California's misnamed "deregulation" of 1996 was tomake sure this never happened again. If power generators had to competewith one another and sell in a spot market, the reasoning went, ratepayerswould never again be saddled with such contractual boondoggles. Of course,California went overboard. The state has no business telling companies whatkind of contracts they can and cannot sign and under what terms andconditions they can and cannot enter. But that's not to say that a wholesalereplay of the disastrous 1970s regime is in order.

What if California's utilities had signed long-term contracts before thewholesale electricity price spike hit? Wholesale prices would still besky-high. That's because the factors driving the spike - skyrocketingwholesale natural gas prices, a decline in regional hydroelectric power dueto a two-year drought, and sharp weather-related increases in demand - havelittle to do with state policy. Under this scenario, independent powerproducers would be obligated to sell power at, say, 6 cents a kilowatt hourdespite the fact that it costs them 15-100 cents per kilowatt hour to makethat power. It wouldn't be long before the independent power plants startedto declare bankruptcy and tear up the contracts, which is what happenedduring the mid-1980s in the natural gas industry. It's already happening tothe few generators (including the natural gas giant Enron) that signedlong-term contracts in California.

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

Why? A fundamental axiom of economics states that the most expensive sourceof supply at the margin must set prices for all sources of supply. If itdidn't, shortages would occur. So if 99 percent of all the utilities' powerwere supplied by long-term contracts at 6 cents per kilowatt hour, as longas 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 thecontract -- price.

The reason for this latest legislative contortion is that California'spoliticians cannot bring themselves to fully deregulate retail prices. Evena partial price deregulation -- aimed at major industrial users -- would largelyhalt the crisis. Instead, California is opting to soak the taxpayer in theshort-run and soak the ratepayers in the long run. A few more legislative"restructurings" are thus inevitable. That's the way government interventionin any market works: It intervenes, which causes problems, and then itintervenes again to fix (i.e., reform) those problems. And the cyclerepeats itself again and again.