While Californians were transfixed by the biennial political circus last fall, the state legislature passed with little notice but much self-congratulation an electricity restructuring law that promises to introduce competition where monopoly once ruled. Electricity regulation, however, lacks sex appeal to all but the most jaded. So, outside the trade press, few Californians realize that a revolution is in the making and big changes are on the horizon. Soon telemarketers will be pestering consumers to change electricity companies. The long-distance telephone wars will come to the power business. And the nation appears once again poised to follow a path blazed by the Golden State.
By all appearances, then, this is a victory for markets over regulation. Think again. While the advocates of California's electricity restructuring are wearing the garb and makeup of Adam Smith, they are in truth Ira Magaziners in drag – political cross-dressers selling higher taxes and more regulation under the guise of "competition."
The need for some kind of regulatory reform, however, is clear. Californians are paying on average 50 percent more for electricity than is the rest of the country. Electricity-intensive industries are reluctant to locate in California, and those already here would rather expand their operations elsewhere. The current regulatory regime, according to economist C. Wayne Crews of the Competitive Enterprise Institute, is costing California residential ratepayers $265 a year, commercial users $1,408 a year and industrial users $23,486 a year.
Moreover, the electricity industry is collapsing under the weight of bad investments in cogenerated power, nuclear power plants and disastrously expensive gambits in renewable energy and "demand-side management." Ratepayers are increasingly finding ways to circumvent high power rates by getting their electricity services elsewhere. The regulatory center, so to speak, cannot hold.
By 1994 even state utility regulators realized that something had to been done to save the system. The scheme they hatched -- and that the legislature eventually adopted last fall -- is managed competition. The central idea is to force utilities to transmit third-party power under heavily regulated rates and conditions (an arrangement known within the industry as "mandatory retail wheeling"). The privately owned electricity transmission and distribution network (the grid of wood and wire) is to be turned into a public highway with contracts made directly between power generator and electricity consumer. To keep the utility companies from unfairly using their market position as owners of the grid to impede competition, "independent system operators" are to assume control of the wires under the direction - not of the utility companies that actually own the grid - but of governmental agents. Utilities are to be prohibited for five years from selling power to any party other than a central state-managed "power exchange," which will replace utilities as the retail seller of power to residential consumers. And as a final touch, electricity services must be marketed in an unbundled fashion while electricity companies are forced to sell most -- and eventually perhaps all -- of their power plants.
Consider how such proposals would look if applied to another retail industry: merchandising. Reformers might well argue that Wal-Mart, for instance, has a de facto monopoly in many small towns; that they refuse to carry all but a few select brands of merchandise (predominantly their "house" brands); that, in the interest of competition, Wal-Mart should be forced to sell the merchandise of any manufacturer that requests the retail space regardless of economic considerations; that the rates Wal-Mart can charge for those services must be neutral, nondiscriminatory and approved by regulators; that the store manager must be independent from Wal-Mart and answerable only to government bureaucrats; that Wal-Mart should be forcibly removed from its customers and allowed to sell products only to a state-owned retailer for the next several years; that the Wal-Mart Corporation should be forcibly broken up into several different companies; and that regulators should be empowered to force the construction of additional retail space at any store to accommodate third-party merchandisers whether Wal-Mart approves of the expansion or not.
Are regulators really the thin blue line that separates us from the electricity robber barons? Hardly. According to the California Public Utility Commission, the economic condition of Pacific Gas & Electric, Southern California Edison, and San Diego Gas & Electric is so anemic that, absent a $28 billion bailout, those companies might well go belly-up if forced to compete against the new breed of small, low-cost independent power producers and natural gas companies. So why the worry? Because a bailout is exactly what's being proposed, and after that, the "monopolists," we are told, must be carefully watched.
That $28 billion bailout - to be collected from ratepayers through a new surcharge on electricity transmission - is nothing less than a naked transfer of wealth from Californians to electricity companies. And why? Because the electricity companies possess a great deal of lobbying power and few Californians understand or care enough about electricity regulation to know when their pockets are being picked. And also because of a not-too-small measure of regulatory guilt. After all, restructuring is a blatant (and uncompensated) seizure of corporate assets, and many of the industry's economic problems stem from ill-considered regulatory orders by the state itself.
Unfortunately for ratepayers, those ill-considered regulatory enthusiasms are protected indefinitely, which virtually guarantees that restructuring will not deliver the rate gains promised by reformers. For example, expensive renewable energy mandates, according to California Energy Commission economist Manny Alvarez, are chiefly responsible for abnormally high state power rates but are firmly protected by the new law. Expensive but demonstrably unproductive energy conservation subsidies are also protected, not to mention state subsidies for energy research and development, low-income assistance and a plethora of special rate discounts. According to economist Ken Costello of the National Regulatory Research Institute, consumer savings from deregulation stem as much from the elimination of such parasitic programs as from the freeing of the marketplace itself.
Apparently, even the legislature was uncertain whether a mountain of new regulations and a multi-billion-dollar bailout could ever produce the rate savings promised by the advocates of restructuring. So they covered their tracks by simply ordering a 10 percent rate cut by the year 1998 (a good tip-off, by the way, that this law has nothing to do with deregulation; governmental agents aren't generally in a position to "order" price decreases). The law directs the California Infrastructure and Economic Development Bank (a previously moribund authority that still lacks a publicly listed telephone number) to issue $10 billion worth of unsecured government bonds to underwrite the rate cut. So the rate cut will be paid for by ... the taxpayer.
Now, that will no more "reduce" rates than extending the term of a mortgage agreement will, in the long run, "reduce" house payments. But by such creative financing, politicians will be able to claim credit for lower rates and thus the success of restructuring. Moreover, as noted by the California citizens group TURN (Toward Utility Rate Normalization), rates would have come down by more than 10 percent without any legislative "restructuring" simply because a plethora of expensive fixed-price utility power contracts is about to expire in California. You have to admit, California politicians are nothing if not clever.
While competition is certainly better for consumers than is legally protected monopoly, the regulatory gymnastics embodied in the California restructuring law put even this rule of thumb in doubt. As industry consultant Charles Cicchetti recently said of proposals for managed competition, "Two things should be obvious. First, none of this should be called deregulation. Second, it is difficult to see how any of these myriad regulatory schemes, unless altered significantly but perhaps not fundamentally, will lower prices."
Proponents of managed competition counter that, since the transmission and distribution grid is a natural monopoly, the only alternatives to mandatory retail wheeling are (1) the current regime, with all its known faults, or (2) unrestrained robber baronry. But the power grid is not a natural monopoly. Before the advent of public utility regulation at the turn of the century, the electricity industry was hotly competitive. Power companies established parallel private grids and delivered power at a lower price than that charged subsequently by the "regulated" monopoly franchises. Even today, several dozen communities, for unique historical reasons, can choose between various power companies -- each with its own grid -- and those communities find that rates are typically significantly lower than in other communities without such competition. That would not be the case if the natural monopoly diagnosis were correct.
Simply put, there are no longer significant economies of scale in the electricity business. Spot and futures markets for electricity have eroded any lingering monopoly. Advances in micro-turbine technology have made self-generation a viable alternative to the grid and threaten to render central station power generation obsolete. Extensive distribution networks and grids are almost impossible to monopolize by their very nature, and user-owned transmission and distribution facilities are a proven way for consumers to protect themselves against the exercise of monopoly power. Finally, as long as markets are theoretically contestable, monopolists invariably price as if competition were a present reality (that is the reason, incidentally, that Wal-Mart doesn't jack up prices once its competitors are neutralized; it doesn't want to tempt others into the market).
For those and other reasons, investigations by the late Nobel laureate economist George Stigler found that "the individual utility system is not possessed of any large amount of long-run monopoly power. It faces the competition of other energy sources in a large proportion of its product's uses, and it faces the competition of other utility systems, to which in the long run its industrial (and hence many of its domestic) users may move." The dean of institutional economics, UCLA economist Harold Demsetz, agrees: "To the extent that utility regulation is based on the fear of monopoly price, merely because one firm will serve each market, it is not based on any deducible economic theorem. . . . Economic theory does not, at present, provide a justification for [regulatory] commissions."
Managed competition not only prevents California from achieving the kind of rate reductions and service vitality that free markets in electricity would deliver, but it also threatens a second bailout of the electricity industry in a decade or so. That's because it's aimed at creating and protecting a new market structure - publicly controlled transmission and distribution of centrally dispatched power - that is being rendered obsolete by market forces that no regulatory body can ultimately control. As Triton Energy CEO Thomas Casten notes, "Central dispatch generation ... is finished as an economically viable technology. In its place, widespread installation of smaller, more efficient generation, close to heat loads, will come to predominate and will collapse the value of much of today's generation – and transmission -- assets." Today's $5 billion bailout of utility generation losses is nothing compared to the bailout that will be required of utility-owned transmission and distribution facilities if managed competition is not somehow sidetracked.
The best answer to these dilemmas is for the state to simply let go of the industry. No ratepayer bailout for utility losses. No public seizure of the grid. No more expensive subsidies for economically retarded programs. Simply tear down the laws protecting utilities from competition and let businesses have at it. If the state legislature can't quite bring it self to trust the marketplace, let it turn the California Public Utility Commission into a specialized antitrust board to serve as a court of first resort for complaints about anti-competitive behavior in the industry.
If the last several decades have taught us anything, it is that the best regulator of markets is dynamic, free and open competition. That such competition exists in electricity service is staring the industry in the face. And if the last several months have taught us anything, it is that whenever California politicians begin to talk about "deregulation," make sure to grab your wallet.