California’s energy crisis: Government, not market, failure

Published March 1, 2001

New York Times columnist Paul Krugman calls it “a warning about the dangers of placing blind faith in markets.” Los Angeles Times commentator Robert Scheer says it’s yet another sign that “capitalism is falling apart.” They’re talking about the electricity situation in California, where demand has been rising faster than generating capacity, leading to sharp increases in wholesale prices. The state’s two biggest utilities, Southern California Edison and Pacific Gas & Electric, are begging for permission to pass these costs on to consumers, warning that otherwise they will go bankrupt.

To judge by most of the press coverage and punditry, the problem is that California recklessly “deregulated” its electricity market a few years ago, allowing prices to spin out of control. “Californians are left to the vagaries of just rampant laissez-faire capitalism,” one activist recently told The Sacramento Bee.

But the fact that utilities still need government approval to raise prices suggests that “laissez faire” may not be the most accurate description of California’s policy. The state legislature’s unanimous approval of the 1996 law that set up the current system is further cause for suspicion: It’s not the sort of vote you’d expect if the bill threatened entrenched interests by creating a genuinely free market.

“The state did not deregulate the electricity market,” observes Adrian Moore, executive director of the Reason Public Policy Institute. “They ‘restructured’ it, requiring far more state intervention in electricity transactions than existed before.”

The law set up what Moore calls “a micromanaged pseudo-market,” requiring the utilities to sell off their generating plants and buy their electricity from a state-administered exchange. Instead of putting together the megawatts they needed at various prices offered by different power suppliers, utilities had to pay each supplier the price demanded by the highest bidder.

The idea was to establish a clear “market price” through a “transparent” process that bears a strong resemblance to central planning. As wholesale prices rose in response to the shortage that began last summer, skyrocketing from about $30 per megawatt hour to as much as $1,500, the pricing policy compounded the utilities’ financial difficulties. So did rules that discouraged them from using long-term contracts as a hedge against rising costs.

The surge in prices was caused by a variety of factors, including unanticipated increases in demand associated with recent economic growth. State regulations have contributed to the problem by encouraging overreliance on increasingly expensive natural gas and making it difficult to build new power plants, which take years to go online. Uncertainty about how California will respond to the shortage is also discouraging generators from investing in new capacity. Critics have suggested everything from price caps to expropriation of power plants.

For their part, the utilities are largely to blame for the bind they’re in. They actually lobbied for the statutory provision that is keeping them from raising their prices.

At the time, the utilities thought 6.5 cents per kilowatt hour was generous–enough to recoup the cost of their bad investments. But now that they’re buying electricity at something like $1 per kilowatt hour, the rate freeze does not seem like such a good idea.

Leaving aside the interests of the utilities and their shareholders, it’s crazy to deregulate wholesale prices while keeping retail prices under tight control. Without the signal of higher bills, households and businesses have little reason to cut back on their electricity use, which exacerbates the mismatch between supply and demand, raising wholesale prices further.

Since the willingness to pay higher prices is a measure of how important a particular energy use is, a rate freeze encourages waste. It prevents the market from allocating electricity to those who value it most: the people running an intensive care unit, say, as opposed to the guy with the blinding Christmas display.

Critics of California’s current system are big on conservation, but they think of it as something you cajole with propaganda and encourage with subsidies, rather than the natural response to rising prices. “We ought to do it in a completely comprehensive way,” V. John White, executive director of the Center for Energy Efficiency and Renewable Technology, told the Bee, practically salivating at the possibilities for new government programs. “The state’s leadership on efficiency and demand is the first step.”

Quite right. With a Department of Shut Off Those Lights and Close the Refrigerator, who needs a market?

Jacob Sullum writes for Creators Syndicate Inc., with whose permission this essay is reprinted.