California’s Imperfect Electricity Market
As everyone now acknowledges, the dream of making electricity less expensive for Californians by unleashing the power of free markets has become more like a nightmare, at least in the short-term. There have been any number of individuals or groups who have been blamed, including – but not limited to – politicians, utility companies, energy generators, people who block new plants in their neighborhoods, environmentalists, careless consumers, and inept forecasters. Of late, however, generators have received the brunt of the criticism, and there have been widespread allegations of price gouging or unfair use of market power.
Interestingly, relatively few people seem to blame the concept of the market itself. When someone speaks of the market in this context, it is usually to explain that the current situation really is not a “freely-functioning market.”
It may be useful to remember, however, that real markets are not perfectly competitive at all times. In fact, as one of the country’s leading experts on business strategy, Gary Hamel, notes, one key way to succeed in today’s business environment is to exploit, or maybe even create, market imperfections.
Economists start with an assumption of perfect, atomistic competition. They look at any firm earning above-average profits as an anomaly. Industry revolutionaries start with an assumption that the entire goal of strategy is to create imperfect competition. To them, strategy is all about building quasi-monopolies. (Gary Hamel — Leading the Revolution, p. 98)
The line, then, between market manipulation or “gouging” and smart business strategy may depend on where you stand. But in the current California situation, there are many who allege that some energy generators have created – or seen an opportunity to exploit – a degree of “imperfect competition” that has allowed them to profit unfairly at the expense of the public. Some basic information can help you decide whether or not you think this is true.
The electric utility industry is extraordinarily complex. Moreover, it is still quite regulated, even in “de-regulated” states. Given space limitations and the goal of this article, the analysis here will be very broad-brushed, will ignore much of that complexity, and will focus on a limited set of issues. The reader who wants more information may follow the links at the bottom of the article to many other sources of information.
Economics 101 Review
To be able to evaluate the charges of market power and to begin to figure out how to respond to the current situation, it is important to have some understanding of how the electricity market is structured and to be reminded of how markets are supposed to operate and what conditions provide the potential for market manipulation. We begin with the latter.
In a competitive market, demand and supply interact to set a market price. Where there is a great deal of supply relative to demand, the supplier must offer the goods at a lower price than other suppliers in order to move them at all. This is especially true for a commodity where buyers cannot differentiate on other grounds. On the other hand, where supply is short, buyers bid against each other to drive prices up. Or, if there is just one buyer who must buy enough to satisfy the demand of others (as in the case here), all sellers theoretically can set their prices high, trying to be just low enough to not be cut out if not quite all supply is needed. As long as sellers do not collude to set prices, this is not illegal. Where pricing is fairly transparent, it is not really necessary to have collusion.
Such high prices should serve to bring more suppliers into the market because they see a chance to make a profit by filling some of the demand, even if at somewhat less of a profit margin than the current sellers enjoy. If, however, there are significant barriers to entry for new suppliers for any reason – and especially if demand is relatively insensitive to changes in price – there can be an opportunity for the supplier to charge well above the cost of production until others can breech those barriers and bring in additional supply.
The Electricity Market
De-regulation, as it was established in California, so far has applied only to the investor-owned utilities and primarily to the generation or wholesale market. The law envisioned competition at the retail level, but little has materialized for several reasons. The allegations of market power or gouging therefore relate to those who sell electricity at the wholesale level. The current wholesale market for electricity in California fits the “tight supply-high demand” situation. High start-up costs, long construction times, NIMBY, and the regulatory red-tape that must be navigated mean it can take several years for a generating plant to come on line. This creates an environment where price manipulation potentially could occur.
When the de-regulation law was passed, California was generating more electricity than it needed during most of the year. Since that time demand has been increasing slowly, but steadily, at a rate of three-to-four percent per year. However, there were no additional supply sources built in the state until this year. Demand in the West outside of California has risen even faster than demand in the state. It competes for many of these same limited supplies. In addition, supply from hydro-electric power in the Northwest – a usual source of help – is limited this year because of their drought.
When wholesale prices rose dramatically last year, demand did not fall proportionately, as normally would be expected in a tight supply situation, because the ultimate customers were not immediately exposed to the higher costs. A state-mandated freeze on retail electricity prices was part of the de-regulation legislation. Therefore, consumers had no financial incentive to cut demand. The utility companies, caught in the bind of having to buy power for more than they could charge, faced bankruptcy. Until the state took over responsibility for buying power this spring, the buying entity of last resort on behalf of customers was the Independent System Operator (ISO). Its basic mandate is to maintain the reliability of the system. Therefore the ISO was willing to pay any price in the real time electricity markets to keep the lights on.
As part of the de-regulation process, the utilities were required to sell at least 50% of the generating capacity they had built up over the years to outside companies. The goal was to increase the number of suppliers in the market place so that no one supplier could control a sufficient percentage of the market to manipulate the price by withholding part of its generation. In fact, however, a relatively few large power companies bought the existing facilities, with one of them now controlling over 8% of the state’s generating capacity. With a margin of available reserves often less than 5% this winter, any generator with even two or three percent of the market could potentially have an impact on price.
The ISO is charged with the responsibility of being sure that there is a balance between supply and demand on the state-wide grid at all times so that the system does not crash. Using sophisticated models that include weather forecasts, historical patterns, and other data, it projects demand and then adds a small reserve that flows on special circuits to be tapped if demand suddenly goes slightly above the supply. If actual demand turns out to be higher than the available supply, the ISO can also balance the system by not sending as much power as requested to some utilities. They, in turn, cut-off power to certain groups of customers until balance is restored — the infamous “blackout.” Without this capability, the entire system could crash.
Under the de-regulation law, utility companies were not permitted to sign long-term contracts with generators before the energy prices rose significantly. Since the cost of electricity in California was already higher than almost anywhere else in the country, there was concern that long-term contracts would simply lock-in high prices before competition could bring down the price — a concern that is again being expressed with regard to the Governor’s current negotiation for long-term contracts. In addition, the architects of deregulation believed that the existence of a liquid spot market with a transparent price was essential to the success of competition at the retail level and to be able to determine the magnitude of utilities’ above-market or ‘stranded’ costs.
The alternative to long-term contracts is the spot market. Unlike most other products, electricity cannot be stored. Therefore supply must be generated as it is needed. With many companies competing to sell power, the theory goes, prices should fall to a level of modest profit over the cost of the efficient producers. Suppliers would know what the demand was, have a good idea of available supply and price, and would offer their supply at a price just low enough to be accepted.
When supply and demand are about equal, there is little incentive for suppliers to cut prices to compete. Almost everyone’s supply is going to be needed anyway. The charges of gouging, however, have related especially to the “peak periods.” This winter at times of peak demand there often was almost no reserve power available. The costs of having blackouts (both economically and politically) are high enough that those charged with purchasing power will pay just about any amount to avoid them. Therefore, if supplies appear to be very close to demand, a company that has power, but withholds it until the purchasing agency is desperate, can potentially demand exorbitant prices to provide that limited amount that will keep the grid from failing. While generators have denied doing this (and it is illegal), others have raised questions, including questions about the timing of taking plants offline for maintenance. The last reserves to come online are often from the least efficient — and therefore most expensive — plants to operate, and this argument has sometimes been used to justify higher prices for that power.
Selling some electricity out of state can also be a way to create scarcity in state. If the sales are to a market broker who then, later, re-sells on the California spot market, the generator could receive a higher price. The most recent order of the Federal Energy Regulatory Commission makes this practice illegal, but until June of this year, it presumably happened. Additionally, it is standard practice to charge a premium for higher risk. Some generators have claimed they are owed a risk premium because the utilities are — or may soon be — bankrupt and therefore they may not get paid at all. The state’s credit rating has also been affected by its role as a power buyer. Because of this some suppliers have justified maintaining a risk premium even with the state serving as a guarantor.
What Can Be Done
There are significant perils for the economy, as well as for individuals, of maintaining unnecessarily high prices for a basic necessity such as electricity. In theory the higher prices will encourage more companies to come into the market to provide electricity, and competition will then bring down the price. As has been noted, however, there are significant barriers to this happening rapidly. The option of setting up a state power authority to help ensure supply, as advocated by some, would also be a longer-term solution if it passes at all. Thus, depending only on rapidly-increasing supplies to make the situation more competitive is a risky strategy.
If the possibility of using market power for gouging is largely due to an imbalance of supply and demand — and if increasing supply is a longer-term solution — the options are basically on the demand side. Complete re-regulation is not feasible at this point even if it were considered desirable. Certainly there are calls for price caps, at least for a year or so until supply can be increased. But there is also the option of decreasing demand, especially during the peak periods. The potential for market power only exists when there are imperfect markets to exploit, and markets can be balanced on either the supply or demand side.
The constant emphasis on conservation is important at this point in time. Consumers can voluntarily decrease demand and limit the opportunity for possible gouging by keeping demand well below available supply. Alternatively, they can let suppliers charge whatever they want until enough users can no longer afford the product and stop using it, either by going out of business or moving out of state. That happens, however, only if the actual users have to pay. Positive incentives, such as those in the state’s conservation program, are also important.
Both businesses and individual citizens have a role. Re-arranging business practices to limit use during “peak periods” may be one option. Some businesses are even changing their hours of operation this summer so as not to be open during the peak afternoon periods. Educating employees to take the situation seriously is another part. Getting them to turn off lights, computers, and boom boxes during lunch is a start. Even the use of largely symbolic measures may help make the point. Making your own business building and/or home more energy efficient may make good economic sense in the long-term as well as help the state this summer.
It is not easy, but it isn’t really that hard either.
Links to More Information on Electricity and De-Regulation
GBR’s Conversation with Senator Debra Bowen, Chair of the California Senate Committee on Energy, Utilities & Communications.
Senator Bowen also has links to several sources on her home page (link no longer accessible)
Los Angeles Times Special Report on Power (no longer accessible)
State of California’s Energy Challenge Page (no longer accessible)
Silicon Valley Manufacturing Group’s Legislative Page (no longer accessible)
McKinsey Report on De-Regulation (no longer accessible)