Why California’s restructuring failed

Published March 1, 2001

Electricity restructuring is a complicated process, in California and across the country. As California faces rolling blackouts and soaring energy prices, the consensus is growing among political activists that restructuring may have been a mistake.

Particularly disturbing is the fact that California’s energy crisis is occurring during the off-peak winter season. Clearly a solution should be found in order to fashion a better restructuring . . . not that the political activists will endorse such a thing. They want nothing less than a total reregulation.

To discover what went wrong in California, and what may yet go wrong in other states that have adopted restructuring policies, one must identify the errors that were made in the restructuring. The November 1, 2000 report by the staff of the Federal Energy Regulatory Commission gives this subject comprehensive coverage.

Why restructuring has failed

The restructuring process in California was very complicated. Stripped to the essentials, it forced utilities to divest themselves of their generating plants and required that all electricity be traded a day ahead in the power exchange. Designers of the system were so confident it would produce lower prices that the rates to residential consumers were reduced in the legislation by 10 percent. In essence, the real option, as it is called by economists, was eliminated, and all transactions were forced into the spot market.

Living solely in the spot market can appear to be a sound money-saving strategy–as can driving without insurance or entering a winter without having made snow removal arrangements in advance. It costs a little less during the off-peak periods. But when the peak period or the accident or the blizzard comes, there is no protection from skyrocketing prices.

So what can be done? Government officials in California propose to place price caps on generation, divert power from neighboring states, enforce overly stringent environmental regulations, take control of the grid away from the owners, discourage investment in new power plants, and inhibit the maintenance and improvement of the transmission and distribution grids. Common sense tells us such policies will prolong the problem, not solve it.

Snow lessons for California

It may also be helpful to compare how a free market institution copes with another emergency: heavy snows.

In the suburbs of Chicago where I live, one can buy snow removal service. The pricing structure is very instructive. One subscribes to the service for a nonrefundable fee of $50. That fee reserves removal effort at fixed prices for the winter season. The prices are $25 for 2 to 6 inches, $50 for 6 to 12 inches, and $100 for more than 12 inches of snow. The $50 reservation fee is a credit toward removal charges.

Those familiar with financial markets will recognize this as a call option. For an options premium, the customer locks in the charges and avoids the very high spot prices for snow removal in the wake of a substantial snowstorm, when all of the plows are busy.

The regulated power industry had a very similar history. For an extra options premium in the rates, the customer, through the local electric utility, locked in a fixed price for power that was virtually guaranteed to be available during peak load periods. The customer was spared the high spot prices. The proceeds of the options premium were invested in extra generating capacity and grid quality to assure that enough power would be available for a future peak load.

After the energy crises of the 1970s, utilities were granted the right to pass through the cost of fuels as an alternative to frequent rate-making decisions. However, the vertically integrated nature of the industry and the control by regulatory commissions of generation kept rates fairly stable. The supply of electricity is typically offered by a single provider, except in areas where power reliability is not a crucial requirement of the local economy.

Restoring the real option

The more effective solution is to reestablish the real option nature of the power system.

First, the requirement that all transactions be conducted in the spot market power exchange must be eliminated. That was done in August by California authorities and reinforced by the FERC in December.

Second, long-term forward contracts should be encouraged, as should the use of electricity and natural gas futures and options contracts traded on the New York Mercantile Exchange and in over-the-counter markets. This arrangement eliminates the need for rate caps that shield consumers from paying the options premium. It would also help encourage generation investment by streamlining the permitting process for new power plants.

Finally, responsibility for operating the grid should be taken away from the independent service organizations and returned to utility owners. Power generators and large consumers should be allowed to purchase equity interests in the grid. Doing so would help resolve disputes and permit a reintroduction of vertical integration, and with it restored incentives for maintenance and improvement of the system. A similar arrangement for interstate oil pipelines and natural gas pipelines in Texas works tolerably well with very little litigation and government intervention.

Restoring the real options premium that was eliminated with the 10 percent rate cut to residential consumers would encourage investment in generation, but this may be difficult for political reasons. The use of forward, futures, and options contracts with the options premium passed on to consumers might accomplish the same result. This occurred in the interstate natural gas market after it was restructured in the 1980s. But in the end, consumers cannot expect protection from price spikes without paying the options premium.

Can it happen elsewhere?

One might reasonably ask if the California problem is likely to occur in other states that have restructured. Those states that rolled back consumer rates and encouraged utilities to sell their power generating plants have made their systems vulnerable. However, other states that encouraged private investment in new generation capacity and the grid by streamlining permitting processes and avoiding forced vertical disintegration should do very well.

The worst may be yet to come, as peak consumption tends to occur in the summer for virtually all of the states that have restructured. Trading of power among pressured utilities in the peak summer season will be difficult.

Businesses understand the implications of this problem very well. That is why many are planning to build their own generators. For reasons of technical reliability, the new generators should be connected to the grid. That would require a substantial upgrading of the grid to reflect the new sources of power and changed consumption patterns.

Jim Johnston is a retired Amoco economist and a policy advisor to The Heartland Institute.