Economist John Kwoka Looks at California's Electricity Problems

Feb 22 2001

Appeared as the AAI Column in the February 14, 2001 FTC:WATCH


John Kwoka

As California struggles with its shortage of electric power, there is an abundance of explanations for its problem. Some observers see skyrocketing prices and blackouts as proof that free markets cannot work. Critics of environmental regulations claim that California's tough restrictions on new power plants have led to capacity shortages. Advocates of deregulation assert that the state erred in deregulating only wholesale prices, causing distribution companies to lose money by selling at fixed retail prices. Yet others see the problem simply as one of bad luck-an unusually hot summer, rising natural gas prices, plants down for maintenance, and so forth. And those who just plain do not like California have ridiculed all aspects of their restructuring plan as hopelessly complex and naive.

However satisfying such finger-pointing may be, most of these explanations are off the mark. They cannot logically explain California's problems because they do not identify anything unique about that state's experience: If the same thing is true elsewhere, how can such a factor by itself be responsible for trouble only in California? For example, it is true that California's plan is unnecessarily complicated, but in its essential respects it is much like those in most other states and several foreign countries that have worked without calamity. Similarly, while California's tough environmental regulations (which, it should be remembered, have done that state much good) have hindered new plant construction, other western states with much different restrictions have scarcely increased their generating capacity in many years either. Then, too, fixing retail prices while letting wholesale prices fluctuate may appear to be lunacy, but that explanation is much too facile. After all, California's plan worked precisely as intended for nearly two years.

Most of these supposed explanations, in short, come from individuals who see in California's experience only that which they already believe. As is too often the case in such controversies, believing is seeing. But if we truly want to understand that experience, in order to develop solutions to the problem and to be able to anticipate possible trouble elsewhere, we need an explanation that fits the facts-all the facts, not just those that can be marshaled in support of prior beliefs.

So, what is going on in California? What is different about California that logically might account for its different experience? The answer is both simple and subtle. The problem begins with an acute capacity shortage whose effects have been magnified many-fold by deregulation. No other state or country has deregulated its electric power sector with demand pressing tightly on capacity. The usual circumstance is one of abundant supply sources competing for buyers, holding prices down and giving deregulation a (relatively) good name. But California has faced an increasingly tight capacity situation for several years. With demand pretty unresponsive to price or cost-people continue to use power for heating, cooling, and other purposes-growing demand finally collided with fixed supply. That would have happened with or without deregulation, as would shortages and price rises..

So what does deregulation have to do with California's problems? Deregulation has turned what would have been a very real problem into an incipient disaster. California barely got through last summer's heat wave, has been forced into rolling blackouts this winter, and faces a major threat to the well-being of the state's economy next summer.

There are two reasons for this. First, deregulation is far less well-suited to dealing with capacity shortages than with periods of ample supply. The basic institutions created under deregulation in California and elsewhere-day-ahead power auctions-rely on voluntary offers of supply to determine short-run prices. But when capacity is more-or-less fixed and demand is also fixed but at a different number, that hands-off process can cause enormous price spikes as system operators are basically forced to beg for added power at whatever price suppliers demand. It is worth recalling that during the summers of 1998 and 1999, deregulated power markets in the midwest saw prices temporarily fifty times their normal levels-equivalent to consumers waking up one morning and finding gasoline to be $75 per gallon. Economics may say that such prices reflect scarcity, but the principal effect is to needlessly enrich power generators at the expense of consumers and the utilities who buy power in their name.

But deregulation has exacerbated the problem in a second way-by unleashing the market power of generating companies to exploit supply shortages. Whenever capacity is in the vicinity of demand, any further reduction of supply will create or enlarge the shortage and multiply any price rise several-fold. A plant that is down for maintenance or a reduction in imports from neighboring states will have that effect. So will deliberate withholding of supply by one or more generators. After all, generators are not obliged to bid their supply into the system. If they foresee a near-shortage situation, they can withhold a plant and turn, say, a 10 percent price rise into a 50 or 100 percent price increase. That higher price becomes the price all their other plants earn on the power they offer, a trade-off that can easily pay off handsomely.

There is good evidence of withholding in California-suspicious plant shutdowns and offers of much less power than in the past-and a number of state agencies and other observers have come to the conclusion that the system is being "gamed" by generating companies. Underscoring this, several of those companies have just finished reporting spectacular profit increases for the past six months-exactly the period of California's travails. Is deregulation responsible for this? Deregulation has always been based on the view that the generating sector was and would be workably competitive. But in state after state generating assets are being acquired by a handful of national companies that control an increasing percent of capacity. In periods of ample supply there may be little they can do, but California illustrates the fact that when supply is tight, even a single generator with a couple plants constituting a modest percent of total supply can trigger an extreme shortage and a huge price rise.

We often hear it said that deregulation itself is not the cause of some problem that arises in a deregulated market. Rather, we are told, some other constraint or glitch has interfered with the otherwise-tidy deregulatory process. Some are already making this claim regarding California's problems, advocating greater long-term contracting or greater consumer responsiveness to price forces as ways of getting deregulation back on track. Those actions will help, but the reality is that deregulation has let the dogs out. It exposes weaknesses of the underlying market and permits shrewd players to exploit its operation. A system cannot claim much credit if it can only deal with periods of ample supply and fails so miserably whenever capacity is tight. Nor can deregulation readily shed responsibility for magnifying even modest degrees of market power into storms of immense destructive force.

There is a reason that the electric power sector is the last major industry to undergo deregulation: It poses some uniquely tough problems, unlike airlines, telecommunications, or other industries. While the California experience should not be read as proving that deregulation cannot work, it surely shows that present deregulatory methods are unsuited to, even counterproductive in, some market conditions.

John Kwoka is Columbian Professor of Economics at George Washington University and Senior Research Scholar at the American Antitrust Institute. He also co-directs the Research Program on Industry Economics and Policy at GWU.