California’s energy crisis: Who’s to blame?

Published April 1, 2001

California is experiencing a genuine, though entirely man-made, energy crisis. Companies are being forced to shut down to conserve electricity during peak demand periods, and rolling blackouts of business and residential areas have begun. Things will get worse this summer, when electric demand traditionally spikes and the blackouts will hit major business districts, setting the stage for looting and possibly even riots.

Who’s to blame? The answer isn’t “big corporations and utilities.” California’s largest utilities are on the verge of bankruptcy and electric producers are being forced by a federal judge to sell power to consumers without being paid.

The answer isn’t deregulation. As the excerpts on this page show, California never deregulated its electric industry. Instead, it broke up a previously vertically integrated industry and failed to allow the resulting units to hedge their new risk in financial markets. California’s regulators further botched the deal by controlling retail but not wholesale prices, and by failing to approve new generation capacity in the decade leading up to “deregulation.”

Anti-market environmentalists deserve much of the blame. Their anti-energy rhetoric was largely responsible for the failure to ensure an adequate supply of in-state generating capacity, and it gave credibility to NIMBY (“not in my back yard”) sentiments that prevented needed investments in transmission lines to wheel in power from other states.

Anti-market environmentalists are the principal source of the myth that energy consumption is “bad”–morally, environmentally, and maybe in other ways, too. This is a profoundly confused notion. Are street lights, air conditioning, and personal computers all ” bad”? Are preemie units in hospitals, metal detectors in airports, and kidney dialysis machines all “bad”? Only a philosophy that is profoundly anti-technology, and ultimately anti-human, would answer yes to these questions.

The lessons from California are that energy is still vitally important to our security and prosperity; that government policies passed in the name of “breaking up utility monopolies” can undermine the reliability of the nation’s electric power industry; and that the solution lies not in conservation or returning to heavy-handed state regulation, but truly deregulating the nation’s energy sector.

California’s power nightmare

“The California chaos doesn’t weaken the argument for deregulation. But it holds a couple of lessons. There is real deregulation and there is faux deregulation. Real deregulation means allowing market forces to work. California didn’t really trust the market to work. . . .

Electricity is different from natural gas in that it can’t be stored and drawn down when needed. If you’re contemplating deregulation, you had better be sure there is ample production capacity. California didn’t. California embarked on its experiment in 1996, apparently without considering the supply side. No new power plants have been built in that state in a decade. To fill all its electrical needs, California depends on power from other Western states.”

Editorial, Chicago Tribune

January 8, 2001

Manifesto on the California electricity crisis

“The crisis has its origins in mistakes and miscalculations at the time the electricity sector was restructured. Two of many shortcomings stand out at the present time.

“First, utilities were strongly encouraged to divest a substantial portion of their generation, while being clocked by CPUC regulations from entering into stable long-term contracts. Put differently, the utilities were forced to procure their unmet needs on the spot market where extreme price volatility has been realized, especially in the past year.

“Second, California froze retail rates at low levels and banked on low wholesale prices to support a profit margin high enough to enable the utilities to pay off historical uneconomic investments.

“This arrangement appeared to work with only modest problems for two years. However, since May of [2000], wholesale market prices soared, due to rising demand, dramatically higher natural gas prices, lower imports from other states, and strategic behavior by suppliers. Fixed retail prices blocked conservation efforts by insulating consumers from market realities and reduced consumer incentives to turn to competitive retailers. The heavy reliance on spot market purchases, combined with demand that was unresponsive to prices, helped drive prices higher.

“Meanwhile, the investor-owned utilities are losing money on the electricity they buy for resale to their customers. The inversion of the typical wholesale-retail price relationship has brought these utilities to the brink of bankruptcy. Perceived risk of nonpayment has in turn caused generators to be reluctant suppliers, even at dramatically elevated wholesale prices. The natural reluctance of suppliers to supply voluntarily when they did not expect to get paid was a substantial contributor to rising prices and rolling blackouts.

“The destruction of the utilities’ credit and the resulting responses by suppliers has shattered vestiges of a normal market. As a consequence, California now has both a financial crisis and an electricity supply crisis. . . .

“The long-run solution requires creating an environment in which the market can work more effectively. Four key elements must be an integral part of that solution: freedom to engage in long-term contracts, retail price flexibility, competition at both the wholesale and retail levels, and more effective cooperation between federal and state regulators to fix a variety of market imperfections and resulting market performance problems. Some of this will take time, but experience in other jurisdictions in the US and abroad indicates that benefits from deregulation indeed achievable. . . .

“New government ownership of generation and distribution facilities won’t solve the crisis or create below-market power prices. The State must pay full market value for any plants it acquires, even though record electricity prices also mean record purchase prices for energy facilities. For consumers to obtain bargain electricity rates would then require permanent taxpayer subsidies–saddling the State budget in perpetuity.

“It is bad public policy to have taxpayers take up the risks of financing new generation plants in a volatile market. The risks of electricity investments can be managed by the private sector, when profit and loss incentives will minimize electricity costs for California.”

Institute of Management, Innovation, and Organization

Haas School of Business

University of California, Berkeley

For the complete text and a list of endorsees, go to

When the lights go out

“Markets do have their limits, but California’s so-called deregulation of electricity has little light–if you will forgive the expression–to shed on them. The reason is that the system was not in fact deregulated. It would have been possible, as a long-term aim, simply to abolish the old monopoly protections and dismantle the command-and-control apparatus. The utilities rejected that because it would have left them with lots of uneconomic power-generating capacity acquired under the good old days of the previous regime; they wanted compensation for those ‘stranded assets.’

“Organizations claiming to represent the interests of consumers rejected it as well because they wanted implicit subsidies to particular groups to continue (which meant keeping the cost hidden) and because they feared the untrammeled monopoly power of the liberated suppliers.

“The upshot was an overweening regulatory scheme slapped on top of a supposedly market-based system. One feature, rate freezes, is chiefly responsible for the present emergency: it has obliged suppliers (to their surprise) to sell power at a small fraction of the price they have to pay for it. Of course, the risk that costs would rise much faster than they could be passed along to consumers was foreseeable–and could perfectly well have been hedged in financial markets. That was not allowed. So much for market forces.”

The Economist

January 20, 2001

The American energy fantasy

“California’s experience casts doubt on the sanity of power deregulation. Despite theoretical advantages, the separation of power production from power delivery creates practical problems that jeopardize the reliability of the electric network.

“But the larger problem lies in Americans’ energy illusions. We refuse to confront obvious conflicts. If you want cheap power, you have to build power plants (some experts think California needs about 10,000 megawatts more, about a 20 percent increase). If you want to curb pollution and global warming, you can’t have cheap power. If you want to limit dependence on imported oil, you can’t just encourage domestic drilling; you’ve also got to discourage domestic demand, probably through a tax.

By and large, Americans prefer energy fantasy to energy reality. This is good for the news business. It creates recurring controversies and ‘crises.’ Unfortunately, it’s bad for the country.”

Robert J. Samuelson


January 29, 2001