California’s Troubles Not Caused by Deregulation

This essay appeared in the Houston Chronicle on Jan. 15, 2001.
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Skyrocketing wholesale electricity prices and the daily threat of brownoutsand blackouts in California have cast a pall over the regulatory enterprise.

California Gov. Gray Davis, like most pundits and the press, blamedderegulation for the crisis in his recent "State of the State" address. Hewarned that the California meltdown is a harbinger of things to come, notonly in national electricity markets but in industries throughout theeconomy if we continue our mad rush toward laissez faire.

But the California power crisis is not an example of what happens whenbusinessmen are running important industries. It's a story of what happenswhen politicians try to manage competition and impose their vision of amarket.

If "deregulation" means less - not more - political control over anindustry, then the California electricity industry has not been"deregulated."

First, the state forced the electricity companies to sell their power plantsto independent investors and become power distributors.

Second, the state assumed total day-to-day control of the utilities' powergrid to make sure they couldn't abuse their market power.

Third, the state required new owners of the divested power plants to selltheir juice to a state-managed "power pool." The price of that power is setby a daily spot market run by - you guessed it - the state. Electricitycompanies that wanted to compete for your business had to buy theirelectricity from this pool, and the price charged them was equal to thehighest price received by any electricity generator in the dailystate-managed spot market.

Fourth, regardless of what they pay for power in the wholesale market, nocompany can charge a consumer more than 6.5 cents per kilowatt hour. Thatprice can't change until the company has paid off its share of the bailoutthe state gave the electricity companies in order to accept this newregulatory scheme.

Now, what kind of "deregulation" imposes rigid government dictates on howindustries should organize themselves? What sort of deregulation keeps fixedprices on retail providers? What kind of "deregulation" requires retailersto buy power through a state-run central exchange? And what brand of"deregulation" forbids retailers from buying electricity more than one dayahead?

Real deregulation would have meant turning the old power companies loose tobuild what they want, charge what they want, and run the grid as they wishedwhile simultaneously decriminalizing competition and removing barriers tomarket entry. State regulators, however, went in the opposite direction.

If this is the portrait of a free market, then it's a portrait painted bySalvador Dali, not Adam Smith.

But is this new regulatory regime the cause of the fivefold increase inCalifornia electricity costs? Hardly. While it did make things worse, theprimary culprit is the high price of natural gas. Since November, the spotprice of natural gas in Southern California has risen 600 percent over the1998-99 average. And because 90 percent of the marginal cost of naturalgas-fired electricity is fuel cost, the marginal cost of electricity wouldhave to spike from 3 cents per kilowatt hour to above 15 cents per kilowatthour to cover costs. That is what's happened at the wholesale level.

The bottom line: Because the state is so heavily reliant upon natural gasduring periods of peak demand, Californians would be facing the sameunpleasant combination of high electricity prices and blackouts even if theold regulatory rules were still in place.

The situation, however, was made worse by California's long-term hostilityto new power plants. Since 1996, electricity demand in California grew by 12percent while supply grew by 1 percent. Every time you turned around overthe past two decades California state regulators were discouraging newconstruction, arguing that renewable energy would pick up the slack, that"negawatts" - activist jargon for subsidized energy conservation - waspreferable to "megawatts," that minimizing new air emissions was moreimportant than generating new electricity, and in general facilitating thetransformation of the NIMBY ("Not-In-My-Back-Yard") forces into a unifiedBANANA army ("Build-Absolutely-Nothing-Anywhere-Near-Anybody").

Gov. Davis' vow to do whatever it takes to build new generating capacity inCalifornia is a belated acknowledgment that the Naderites have held thestate hostage for too long. But his threats to seize control of power plantsand throw company managers in jail guarantees that few private investorswill risk entering the market.

Decontrolling retail prices might save the utilities from bankruptcy. Butthe trajectory of wholesale electricity prices is a function of thetrajectory of wholesale natural gas prices. Building new capacity will help,but only a bit. This is one "crisis" that politicians are going to have toride out.