California’s Power Market: “Gray” Days Ahead?

This slander on the fair name of deregulation should be rejected. As Federal Energy Regulatory Commission Chairman James Hoecker has noted, deregulation in California “was never fully tried.” That is an understatement, because most of what was done went in the opposite direction. What the state actually did was engage in meddling micromanagement, sailing under the false flag of “deregulation,” through which it thought it could ensure the benefits of a free market without any of the risks. This attempt has failed, and now the state is stuck with the worst features of a regulated system without the benefit of market signals and incentives. In the meantime, someone ought to sue the state for false advertising for daring to use the term deregulation.

Deregulation? Not exactly. A 1996 law passed by the California Assembly forced utilities to divest most of their generating facilities, which were then sold to new generating firms. Generators and distributors were then induced to buy and sell power on the state-managed Power Exchange (PX), which serves as a spot market for power suppliers in the state.

The idea was, since the main suppliers (the three largest utilities are Pacific Gas & Electric, Southern California Edison, and San Diego Gas & Electric) did not have to generate power, they would be able to purchase inexpensive power from new generators (like Dynegy) on the PX for distribution to consumers.

The PX operates by tallying bids for power supply, based on estimates of future needs, until they reach the total quantity demanded of the utilities. Then the bid price of the last bidder, the highest marginal price, becomes the price for that period. That is, California’s Independent System Operator, which runs the grid, tries to “match up” supply and demand on the wholesale power market. The problem, which has become a crisis, is that the estimates for quantity demanded are almost always short and, thus, the utilities have to buy “extra” power on short notice to meet demand.

Besides low demand estimates, what has caused wholesale prices to shoot up? Mostly regulations that limit supply, such as the NOx emission caps that require generation plants to shut down if they exceed the prescribed limits. Other stringent environmental regulations, and the averseness of homeowners to new power plants in close proximity to their neighborhoods, have stifled expansion of the state’s power supply by limiting the ability of generators to build new plants or improve existing ones. All of this came to a head this summer, when unseasonably hot temperatures, combined with growing demand from Silicon Valley, caused demand for power to surge.

The result: Power became scarce and retail prices rose. However, a rate cap, agreed to by utilities before the power industry was restructured, ostensibly protected consumers from high prices. These caps were part of a deal to help utilities recover their stranded costs. Stranded costs are malinvestments in lines and plants that are not profitable. San Diego Gas & Electric recovered their costs under the new system and then began to charge higher rates. Pacific Gas & Electric and Southern California Edison, unable to recoup stranded costs, have remained under the retail price caps and thus are going into debt. These price caps are not helping consumers though, as they are set higher than the old monopoly prices. Thus, no one is happy and threats of serious shortages are on the horizon.

Regulatory measures won’t solve the problem. This situation has led federal and California state officials to seek drastic solutions, such as Governor Davis’s threat to take control of power plants by eminent domain, and to make withholding power from the grid a crime. Democrat Davis blames his predecessor, Republican Pete Wilson, while Senator Feinstein and some consumer groups, like the Foundation for Taxpayer and Consumer Rights, denounce the feds for failing to do enough. This latter group is calling for stricter price controls, open access to transmission lines, and a return to the old state-monopoly power system, as if more government intervention is the solution for instability caused by the original government intervention. Unfortunately, these stopgap and reregulatory measures will not alleviate the problems that Californians are facing in the long run. The solution to a botched regulatory scheme is not another regulatory scheme.

Instead, policymakers should focus on removing regulations. By freeing up electricity producers and consumers from government oversight, Californians would have a real choice in who will generate and deliver their power. Perhaps one company will do this; perhaps five will specialize in a role that allows them to realize maximum productivity.

Fixing California’s power problem is not going to be painless. Years of government intervention and red tape in the power industry will take time and trouble to overcome. Consumers, producers, and distributors will have to absorb some of the cost until a true market solution takes effect. In the end, however, California’s energy market will pay dividends of low-priced, reliable power that will continue to fuel the High Tech revolution in Silicon Valley and spur more innovation in the New Economy. Otherwise, California’s power industry will remain as broken as Humpty Dumpty, as state and federal regulators try to put it back together again.

For further reading:

Reason Public Policy Institute

California Assembly Bill 1890

California Public Utilities Commission

California Independent System Operator