Electricity Deregulation Must Target Demand

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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 weshould have learned from the era of old-style regulation. Such ignoranceexplains the support for California Governor Gray Davis' ill-advised callfor the state purchase of electricity under long-term contracts as the bestway to "solve" the crisis.

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

The state-administered system survived for 40 years because it coincidedwith an era of ever-cheaper electricity. Declining prices, however, werenot the result of regulatory efficiency. They were the product oftechnological advances in power plant operations -- changes that stalled in theearly 1960s.

Two additional events ended the decline in electricity prices. First, manyutilities turned to nuclear power. The least expensive nuclear power plantswere cheaper than the least expensive coal plants. But many nukes turned outto be too expensive. Second, the 1978 Public Utilities Regulatory PoliciesAct (PURPA) required the utilities to accept generation from independentproducers at rates set by the state. Some states (particularly New York andCalifornia) set those rates sky-high based on expectations of continued highfossil-fuel prices; expectations that turned out to be wildly inaccuratewhen energy prices collapsed in the mid 1980s.

The combined effect of expensive nuclear and PURPA power triggered angrycalls from businesses for rate relief. Rather than deregulate the industryand allow the nuclear and PURPA plants to declare bankruptcy, the regulatoryregime was restructured in toto. The restructuring states combined arelatively unregulated electricity-generator market with a regulatedtransmission and distribution system. At the same time, they taxed consumersto bail the utilities out of their bad nuclear and PURPA investments. Thehope was that if market forces governed generators, costly futureinvestments would be avoided.

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

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

If consumers faced real hourly time varying prices -- instead of fixed monthlycosts -- they would have an incentive to buy or contract for small-scale powersources (fuel cells or small natural gas turbines). Those would beactivated by computer whenever the cost of power on the grid exceeded thecost of these small-scale alternatives. Consumers would also have anincentive to shift their electricity-demanding activities away from peakperiods.

Remember, it is the shortage of supply at peak demand that is California'smain problem. Moreover, the emergence of supply substitutes and moreflexible demand because of "real-time pricing" would reduce the ability ofgenerators to raise prices, as they have in California.

Governor Davis' call for a return to the "good-old days" is thus unlikely tohelp. First, signing long-term contracts for energy during times of highprices was tried and failed in the 1970s. An overinvestment in nuclear andindependent power contracts resulted, producing rates far in excess of thespot 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'sthe only way out.