Power Economics

This essay originally appeared in National Review Online, March 28, 2001.

To hear California's politicians tell it, heartless power generators are the cause of the high price of West-Coast electricity. Deregulation, the populists claim, allowed companies to sell electricity at astronomical prices in an utterly dysfunctional wholesale market. The Federal Energy Regulatory Commission (FERC) has now joined the witch-hunt. In February, the FERC invoked its power to rub out "unjust" and "unreasonable" wholesale-electricity prices and ordered generators to refund the state $69 million in "overcharges" unless they could persuade the FERC that their prices during the power emergencies that month were "reasonable." At the end of March, the FERC struck again, ordering another $55 million in rebates for the month of February. Welcome to East Germany.

The FERC thinks that the "right" price for electricity (and thus, the maximum legal price during power emergencies) is not at the intersection of supply and demand, but at the actual cost of generating electricity. The FERC calculates that the least efficient, highest-cost power generator had operating costs of $273 per megawatt hour in January, yet during the week ending January 19, the California Electric System Operator paid, on average, over $320 per megawatt hour. In February, the FERC calculated that those same plants had operating costs of about $430 per megawatt hour during the power emergencies, but that prices on the wholesale market were once again too high and thus "unjust" and "unreasonable."

Still, the FERC's orders clearly suggest that high wholesale-electricity prices are primarily the result of higher fuel-input costs, not corporate greed. According to the FERC, higher natural-gas prices have increased the cost of making electricity in a gas-fired plant from about 3 cents per kilowatt hour in the spring of 2000 to about just over 27 cents per kilowatt hour during January's power emergency, and 43 cents per kilowatt hour during February's power emergency. To be sure, industry analysts believe that the operating costs of the least efficient plants are far higher than the FERC believes, but at least the FERC has recognized that input prices explain most of the increase. That means that higher input prices would have affected California electricity costs even if the legislature had not "deregulated" its electricity market in 1996.

Another interesting nugget to be gleaned from the orders is the FERC's implicit concession that the highest-cost source of supply needed to meet demand is the legitimate price for all power sold in the state. For instance, the cost of producing a megawatt of nuclear, coal, or renewable-fired electricity is in the range of $15-$60, but the FERC does not propose to require those generators to price at cost. Instead, given the overall shortage of electricity relative to demand, the FERC gives those power generators a green flag to charge what the market will bear.

But there's an inconsistency here. Why is it okay with the FERC if some suppliers charge what the market will bear, but not okay for natural-gas generators — the suppliers of the most expensive energy source needed to meet daily demand — to do likewise? Top electricity economists spanning the ideological spectrum agree that power supplies are so tight in the West that most natural-gas-fired generators can charge more than their costs and still find willing buyers. Not only is this not a crime were it to occur in any other market, it's necessary if scarce goods are to be allocated to those who need them the most.

But, for the sake of argument, let's assume that about a nickel out of each kilowatt-hour sold during the last several power outages represents "excess profits." 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 demand because the state insists upon maintaining retail-price controls. Without them, generators would fear that excessively high prices would reduce sales. The upshot is that retail-price controls are themselves primarily responsible for whatever mischief exists.

Still, we're arguing about a nickel out of a bill of 27-43 cents per kilowatt-hour. That's a lot of to-do about relatively nothing. Drum all those alleged excess profits out of the wholesale market and we're still in a world in which the cost of producing electricity is 4-8 times more than the law allows utilities to charge. Those who think that eliminating this alleged market power would return electricity prices in California to 1999 levels have spent too much time in the hot tub.