Headline: On California Stage, A Cautionary Tale -- Prices, Blackouts Spotlight Deregulation's Risks

Source: Steven Pearlstein, Washington Post, 21 August 2001; Page A01 (First of three articles)

URL: http://washingtonpost.com/wp-dyn/articles/A37193-2001Aug20.html

It was only a little more than a year ago, before the blackouts and bankruptcies and skyrocketing prices, that just about everyone thought it a fine idea to deregulate the nation's electricity industry.

Deregulation of air travel, trucking, natural gas exploration and telephone service had delivered more choice and lower prices for most consumers. So it stood to reason that the same benefits could be had by bringing free-market competition to electricity, which was still produced and distributed almost everywhere by a single company under tight government regulation.

"We were so convinced that the old system of regulated monopolies was so inefficient that we couldn't go wrong -- that even a flawed market would be better than the old system," said William Massey, a member of the Federal Energy Regulatory Commission.

Now people aren't so sure.

In California, the earliest and boldest experiment, deregulation has become synonymous with corporate greed, government incompetence and the failure of free-market economics. During the past year, California has suffered through power blackouts and rationing while its annual electric bill jumped at least fivefold, prompting federal regulators to impose price controls. With the state's largest utilities in or near bankruptcy, the state government had to step in and buy $9.5 billion worth of power on their behalf.

Nationally, the California experience has slowed the rush toward deregulation to a cautious crawl. Of the two dozen states that had begun deregulating electricity, six -- Oregon, Nevada, Oklahoma, Arkansas, West Virginia and New Mexico -- have put the process on hold, while others that were considering it have backed away. A recent poll of utility regulators by RKS Research and Consulting of New Salem, N.Y., found that three-quarters "expect the California situation will either stop or decelerate restructuring in their states."

This series will explore several of the problems that have plagued electric deregulation in California and across the country -- the economic flaws in the design of the newly competitive markets, the physical bottlenecks that prevent power from getting to where it is needed, and the behind-the-scenes political battle between the old-line electric utilities and a new breed of merchant energy generators and brokers. Although few experts consider it advisable or even possible to return to the old regulated monopoly, many acknowledge that deregulation has fallen short of its promise.

"The California debacle has distracted people from noticing that some of these other markets aren't working so well for many of the same reasons as California," said Kenneth Rose, senior economist at the National Regulatory Research Institute at Ohio State University. "We are not getting the intended benefits. . . . It's just very hard to get these markets to operate competitively. And it's going to require a lot more refinement than simply slapping on temporary price caps."

In New York, regulators have imposed price caps similar to those in California after concluding that generators manipulated the wholesale market last year to raise prices above competitive levels. In Montana, the decision by the state's utility to sell all its generating facilities to a single Pennsylvania firm has resulted in industrial wholesale power prices 10 times what they were before. More than 1,000 people have lost their jobs as sky-high electric rates caused plants and mines to close.

In New England, officials from several states began an investigation after private studies found that generating companies had artificially driven up the wholesale price of power by shutting down plants and withholding supply, particularly during last summer's heat wave.

Perhaps the most successful deregulatory regime is in Pennsylvania, which participates in a wholesale market with New Jersey, Delaware, Maryland and the District of Columbia. Even there, however, there has been backsliding. In the Philadelphia area last year, nearly two dozen companies competed to provide households and small businesses with retail power, most offering prices below those charged by the old monopoly. As the price of wholesale power has risen to the level of the retail price cap still in effect, however, the number of competitors has shrunk to two.

For those trying to figure out where to go next, California has become the case study in how not to proceed. Opinions differ on what combination of bad luck, bad design and bad execution doomed the California experiment. There is, however, general agreement now that most of the missteps flowed from the faulty assumption that consumers could get all the benefits of free markets without assuming their risks.

More broadly, there is a newfound recognition even among the most market-oriented economists that the qualities that once made the electric market a "natural monopoly" still persist. Creating a market is the easy part. Creating a genuinely competitive one is likely to be more of a challenge.

"I sometimes think people involved during the last four years haven't gotten the message that this isn't a piece of cake," said Paul Joskow of the Massachusetts Institute of Technology, whose early work provided the foundation for electric deregulation. "There were good economic reasons why you had regulation in the first place. You have to respect those realities. It's not something that you can snap your fingers and say you have a competitive market."

A number of experts, in fact, recommend dropping the term "deregulation" altogether because it conveys the false impression that electricity, like copper or cabbage or most other commodities, can be left to the market, with little or no government involvement.

"The magic of the market is no sure thing," said William Hogan, a utility economist at Harvard University. "Electricity is an example of an industry where introducing competition leads not to less regulation, only different regulation. [These] markets are made, they don't just happen."

Passing On the Cost

Most consumers take for granted that when they flip on the switch, the juice will always be there. That was true only because regulators gave electric companies the mandate and the incentives to ensure it. By setting rates high enough to allow the companies to recover all their reasonable costs plus a fair profit, the system effectively invited the utilities to build too many generating plants and build them as expensively as possible.

For consumers, the cost of that reliability was tucked quietly into the price of each kilowatt. But as the cost of building nuclear power plants sent rates soaring in California and many other states, big energy-consuming businesses complained that the cost of power would soon drive them out of the state. A competitive market, they argued, would generate more prudent investments and lower prices.

A competitive market, however, isn't as good at providing reliability. Any firm that does the "responsible" thing by maintaining a reserve capacity in case of a sudden rise in demand runs the risk of losing out to competitors that had lower prices because they maintained no reserve.

Most experts say that totally unregulated electric markets will naturally swing between periods of too much capacity and too little. Companies would tend to wait until there was a shortage looming before adding new plants, and then all rush in with too many plants, creating a glut.

"The energy market is not capable, by itself, of keeping supply and demand in balance," said Lawrence Makovich of Cambridge Energy Research Corp., a firm that consults widely in the electric industry. "There's a natural tendency toward boom and bust cycles."

In that respect, electricity is a lot like gasoline, steel and other commodities that require big, expensive plants to produce them. In such industries, economists say that supply is "inelastic," meaning it does not quickly or easily adjust to changing demand. In the case of electricity, this inelastic quality is magnified by the fact that it can't be stored or stockpiled. While big users of steel and gas routinely try to moderate price swings by filling tanks and warehouses when prices are low and supply is plentiful, electricity users cannot.

If the supply of electricity is inelastic, demand for it is even more so.

In some respects, that's just a fancy way of saying that because electricity is among the most vital commodities of modern life, people are willing to pay high prices to avoid going without it.

Over time, of course, consumers and businesses can figure out ways to use less power if the price gets too high. In the short run, such conservation efforts are hampered by the fact that consumers don't find out what the price is until a month or two after they've consumed it. And even then, because electricity is billed at a single, average rate for all the kilowatts they use, there is no incentive for them to reduce consumption during periods of peak demand, when supply is scarce and the cost of producing power is the highest.

In such a market, "even small changes in supply or demand lead to big swings in prices," said Severin Borenstein, director of the University of California Energy Institute.

"Consumers can't stand the kind of volatility that a completely free market provides for a commodity as vital as electricity," said S. David Freeman, chief energy adviser to California Gov. Gray Davis. "These prices got to the point where they threatened to trigger a recession. They also violate any sense of fairness. That's why [the state and federal governments] have to step in. The idea of a completely free market is not compatible with the needs of society."

Power Politics

If the underlying economics make it difficult to design a workable plan for electric deregulation, the politics make it almost impossible. No political issue was more contentious in California than the question of what to do about billions of dollars that the old regulated utilities had invested in plants that were so expensive to build, or so inefficient to run, that they could never produce power at competitive prices.

Environmentalists and consumer activists argued that utilities and their shareholders should suffer the consequences of those unwise investments by writing off the billions of dollars in "stranded costs" as losses. The utilities argued that it would be unfair to make them pay the full penalty for investments that were incurred with the approval -- in some cases, at the insistence -- of state regulators.

In California and a number of other states, the regulators and politicians hit upon a compromise: Consumers would reimburse the utilities for their "stranded costs," but only out of savings that would flow from deregulation. Deregulation, after all, was projected to cut the average cost of generating electricity from roughly $60 per megawatt-hour to $30. The utilities were allowed to keep the retail price about $60 (equal to 6 cents per kilowatt) and collect the difference between wholesale and retail until they had recouped all their stranded costs. After that, retail prices would fluctuate with the wholesale price.

In California, however, deep distrust of the utilities led officials to make several other changes to the design of the new system that proved to be its undoing.

The first was to encourage the existing utilities to sell most of their power plants to independent merchant generators such as Duke Energy and Mirant. The sales would allow the utilities and regulators to calculate the total value of the "stranded costs" to be recovered without years of contentious hearings and court battles to determine what the plants were now worth.

A second requirement was that all generators had to sell all their electricity to a single state-run power exchange, which would run what amounted to a continuous computerized auction for wholesale power. With a single power pool, state officials figured they could establish a level playing field, with upstart competitors able to buy all the power they needed at the same price, and under the same conditions, as the old monopolies such as Southern California Edison and Pacific Gas & Electric. By preventing utilities from signing long-term contracts, state officials hoped to ensure that consumers would get the full benefit of falling prices that they were confident deregulation would produce.

In the two years after California began deregulation, the wholesale price of power fell even more than had been predicted, allowing the old utility companies to recover their stranded costs ahead of schedule. Dozens of competitors sprang up to enter the newly deregulated market. Other states began to consider adopting the California model.

By the spring of 2000, however, just about everything that could go wrong in California did.

With the California economy growing faster than expected, demand for power quickly caught up with the supply. Although generators eventually responded by proposing new plants, few would be ready much before 2002. Suddenly, what had been a buyer's market with too much supply turned into a seller's market with too little.

Later in 2000, the price of the natural gas used to produce most of the state's peak load power increased by five times. Because plants were running longer to keep up with the increasing demand, the cost of emissions permits under California's stringent clean-air regulations soared.

The decision to require that all power be bought on the spot market put the utilities that delivered it at the mercy of the generators that produced it. With retail rates capped, PG&E and SoCal Edison were forced to sell power for less than it cost them to buy and produce it. After piling up $9 billion in debt, PG&E filed for protection from its creditors in federal bankruptcy court. SoCal Edison is on the brink awaiting a bailout from the state legislature.

How It Might Work

For the moment, the sense of crisis has abated in California. Because of lower-than-normal temperatures and conservation, blackouts predicted for the summer have yet to happen. Natural gas prices have fallen back to normal levels, while federal rules effectively cap the wholesale price of electricity on the spot market at just under $100 per megawatt-hour.

With California knee-deep in the electricity business and billions of dollars in lawsuits hanging over the industry, it could be years before a genuine retail market can develop.

Since the California energy crisis, a consensus has emerged among regulators and economists on five "fixes" that could give deregulation a second chance, not only in that state but also across the nation:

• Long-term contracts. Instead of preventing them, experts say utilities should be required to arrange in advance for at least 75 percent of their power. While studies show that long-term contracts will probably raise the average price of electricity over the long run, they will also prevent much of the price volatility that consumers find so difficult to accept. California is already wrestling with such trade-offs. At Gov. Davis's direction, the state has contracted for more than half of its power needs several years into the future. And while the average prices on those contracts are half of what the spot prices were last winter, they are now two and three times what power is selling for on the wholesale market. As a result, the state has been in the politically embarrassing position of having to sell some of the unneeded power it bought under long-term contracts, at an estimated loss so far of $30 million.

• Capacity reserves. For a competitive market to deliver reliability, every utility should provide a fair share of the system's reserve power. The simplest way would be to require each electric company to buy 10 percent or 15 percent more power than it expects its customers to demand, and include the cost of the power it doesn't sell into the price of the power it does.

• Real-time pricing. Everyone agrees on the need for electricity pricing schemes that would encourage households and businesses to use less power when supply is scarce and the cost of producing it is high. The obstacle is the standard electric meter, which keeps track of how much power is used but not when. New meters, though costly, are available that would allow the utility to charge different rates at different hours, depending on prevailing wholesale prices, while letting customers know what those rates are in real time.

• Independent grid operators. In California and other regions, one reason for shortages and price spikes is that there are not enough long-distance transmission lines to get power from places with too much power to places with too little. The old regulated utilities that own the lines are not eager to expand capacity, or even make existing lines available to competitors, knowing that it will lower prices and profits. But federal regulators, with White House support, are proceeding with a plan to wrest control of the lines from old-line utilities and state regulators and invest them in a few independent regional grid operators regulated by the federal government.

• Vigorous antitrust enforcement.Even the most ardent market-oriented economists warn that the peculiar economics of electricity also require the government to make aggressive, and even novel, use of the antitrust laws.

In other deregulated industries such as airlines and railroads, the initial burst of competition and price cutting often gave way to consolidation in which a few companies dominate the market. Those firms, in turn, found ways to manipulate supply and keep out competitors while studiously avoiding getting into price wars with one another.

Economists call those oligopoly markets, and there are already signs of one developing in electricity, with fewer than a dozen companies consolidating their hold on most of the nation's privately owned generating capacity.

"Historically, there have always been troubles in the transition from regulation to deregulation, and electricity is no exception," said Robert Pitofsky, who stepped down this spring as chairman of the Federal Trade Commission.

"It usually takes a decade to work things out," Pitofsky said. "But in that period, the government has to be especially careful about concentration. Trading a regulated monopoly for a unregulated oligopoly is not a good deal for consumers."

-- Andre Weltman (aweltman@state.pa.us), August 21, 2001

Answers

Eh? Deregulation a good thing?

Phone: more little fees, and a overall higher bill.

Cable: just plain higher bills and still 73 channels of junk.

Airlines: less direct filghts, hub interconnects [ATL, MCO, DFW, Chicago, ...] Longer waits - including parked in the taxiway for hours. And the prices aren't any better. They are significantly more random, some times high or low.

Trucking: more little guys have been squeezed out of the game, and those lil' guys still in the game are wondering for how long.

Power: Californy has been a bad 'de-regulation' it was more like a party for the lobbists and their cronies.

Does deregulation work, not unless we have a real free-market with no gov hands on the till - and in all the above cases are examples of the long uncle sam arm fiddiling with the tuner knob.

-- (perry@ofuzzy1.com), August 21, 2001.