The California Electricity Crisis

Economic Lessons from a Failing Deregulation Process

Paying attention to the demand side and to the process of deregulation is critical as California moves toward a free market in electricity.

In the course of a few months, Californians have witnessed skyrocketing wholesale electricity costs, a state government that has spent billions on electricity purchases, and two state utility companies whose financial condition has gone from good to grave. In this state, that expects the unexpected and routinely encounters earthquakes, fires, and floods, California has been caught off guard by its electricity crisis. The crisis is not like a fire that can be quickly extinguished, so much as it is like an earthquake or flood from which it can take years to recover. The problem will eventually be solved, but the best pathway to recovery is unclear. The electricity market is very complex, and this becomes increasingly apparent as more details on the crisis become available. In the midst of this complexity, however, there are some clear economic lessons for the state, its policy makers, and the businesses that operate within California. These lessons are not necessarily new, but may have been hidden from view when the state’s deregulation plan was being crafted.

Lesson #1: Free Markets Are Not Free

The benefits of free markets are well documented. In a free market economy, businesses and consumers pursue their own self-interests, and we end up with the most efficient outcome: More stuff, less waste, and lower prices. Free markets are called “free” because, at least in a pure free market, no government intervention is necessary. Markets are thus “freed” from government control. However, there are costs, or trade-offs, associated with free markets, and consideration of these costs is important to include in the process of deregulating a market.

One of the significant tradeoffs associated with free markets is that deregulated markets will always be more volatile than regulated markets. Thus, a deregulated electricity market places consumers at greater risk, with low income and high volume users particularly vulnerable. In a regulated market, changes in the price of a megawatt hour, for example, would be made at regular intervals and most likely would not occur more than once or twice a year. In a free market system, changes can occur daily and even hourly. From a consumer’s standpoint, this outcome may not be so pleasant. The experience of the consumers of San Diego Gas & Electric, who saw their bills triple in the summer of 2000, bears this out. However, just like the stock market, with greater risk, can come greater reward. Over time, more electricity will be produced, and at a lower price in a deregulated market than in a market subject to government control. However, this raises an important question for policymakers to consider: What is the amount of volatility that is appropriate in a market for a necessity such as electricity? Low-income consumers and hard-pressed small businesses, in particular, may not have the slack funds to withstand a temporary increase in the price of electricity.

It is precisely this concern for low-income consumers that leads some to make the argument that electricity should not be subject to the volatility of free markets. With public education and clean water, for example, government regulation provides a reliable and affordable supply. Although these arguments have merit, most economists, including the authors of this article, are proponents of a deregulated electricity market. The reason is that the benefits (more output, lower prices) should exceed the costs (increased volatility) over the long haul. In addition, it is possible to mitigate the costs in ways that preserve the majority of the benefits. For example, limited government regulation for low-income consumers could be used to protect them from some of the price volatility. Looked at differently, some of the benefits of deregulation could be used to offset some of the costs. Given the current situation, however, one might wonder when, and if, California will reap benefits from electricity deregulation, a process legislated 5 years ago. This brings us to our next lesson.

Lesson #2: The Deregulation “Process” Can Be As Important As The “Product”

The electricity market has some peculiarities that make it more complex than most markets. These peculiarities, particularly on the supply-side, can make the process of moving from deregulation to free markets more difficult. In many markets, a surplus one-day can be used to supply an excess demand the next day. This smoothing process is not available in the electricity market, since electricity may not be stored. Long-term supply adjustments are also constrained — it takes several years for a new power plant to become operational. These supply peculiarities must be carefully managed in the process of deregulation. Accurate demand forecasting becomes especially important in this environment. Electricity demand forecasts for California in the 1990s were grossly inaccurate. In fact, demand forecasters foresaw a greater possibility of a electricity glut, than they did of a shortage, largely because they did not foresee that the economies of the state and the rest of the region would grow as fast as they did in the late 90’s.

Like most products, electricity has wholesale, distribution, and retail levels. As with any good or service, deregulation on one level, without corresponding loosening of government control on other levels, can lead to undesirable results. Case in point: California. Controls at the generation, or wholesale level, were significantly relaxed, while retailers such as Southern California Edison and Pacific Gas & Electric had a price freeze imposed for a specified time period. This price freeze was designed to allow utilities to cover their operating costs, in addition to a reasonable profit. (Somewhat controversial, this price freeze also allowed utilities to pass on costs from past investments on nuclear and alternative energy sources.) Now, however, in an environment of high costs at the wholesale level, retail prices are not allowed to rise fast enough to give actual electricity consumers an incentive to cut back on electricity usage. This has led to a situation of rolling blackouts and potential retailer bankruptcy. Thus, the claim that “deregulation has failed” should not be made, since the California electricity market is still subject to considerable government control. Stated differently, the California electricity market does not exhibit the characteristics necessary to classify it a deregulated market.

A key characteristic of a free market is the existence of many suppliers. When there are numerous suppliers of a product, competition occurs, leading to lower prices. A market left in the hands of one, or only a few, suppliers can lead to an outcome even less desirable than a government-regulated market. In California, there is some evidence to suggest that generators are practicing what has been referred to as “gaming the system” or “market manipulation,” restricting supply to raise prices. These practices appear to be stemming from either tacit collusion, or manipulating the “rules of the game” as they have been set up by the state. In addition to changing some of the rules of market engagement, the government needs to ensure more suppliers are competing at the generation level. It should be noted that the current calls for “re-regulation” of the wholesale market are likely to serve as a deterrent to potential new suppliers.

It is clear that the state of California has made some significant missteps in the process of deregulation. Two missteps in particular stand out: inaccurate demand forecasting and uneven deregulation across market levels. The road to deregulation in a complex market such as electricity is difficult, and some pain in the process should be expected. However, other states, Pennsylvania as one example, have made fewer missteps in the process, and thus have faced fewer bumps so far on the road to a deregulated electricity market. In Pennsylvania, consumers enjoy lower prices after deregulation, and report high levels of customer satisfaction with utility company service.

Lesson #3: Energy fuels the “New Economy”

Also In the “old days,” as recently as the 70s and 80s, when the US economy was more manufacturing-based, it was clear that our economy was critically dependent on reliable and cheap sources of energy. In fact, oil-price shocks were significant contributors in two of the last four recessions. In our continuing transformation from a manufacturing-based to a service and technology-based economy, we might expect our reliance on energy to become less critical. In fact, many did expect this. This notion has been called into questioned, however, by the circumstances surrounding the California energy crisis. Just as the digital revolution has resulted in an economy that, paradoxically, consumes an ever-increasing amount of paper, the information economy is one in which energy consumption is on the rise. Electricity consumption in California is up 25 percent over the last ten years. In San Jose, a city at the center of the Silicon Valley, consumption is increasing at a rate of eight percent per year.

California’s production of goods and services amount to over $3 billion each day. Beyond the increased risk due to safety concerns, each rolling blackout is likely to cost the state tens, and even hundreds, of millions of dollars of lost productivity. This is a real cost that cannot be recovered. Defiant at first, state officials now concede that electricity customers are going to have to pick up a portion of the billions of dollars of overruns experienced by Edison and PG & E. Californians will also be held accountable for the bill that the state is currently running up as it enters the market as an energy buyer. Thus, regardless of whether future blackouts can be avoided, the California economy is facing a significant cost burden. This is likely to put a damper on an economy that has been outpacing its peers in economic growth since the mid-90s.

Were it a separate country, California’s trillion-dollar economy would place it as a member of the G-7. Thus, if the California economy suffers a cold, it is not only the rest of the US that is subject to contagion, but also the world economy. Whether this contagion will occur or not is still unclear, since the magnitude of the costs is still unknown. However, it does demonstrate why government officials are working hard to find a panacea for California.

Lesson #4: California is an Expensive State in which to do Business

Each year, Economy.com ranks the costliest states in which to do business. In their most recent report, California is ranked as the 9th most expensive state. The ranking considers a number of cost elements, including labor costs, energy prices, tax burdens, and office rents. New Jersey is ranked at the top of the list, and South Dakota ranks at the bottom.

At first glance, we might tend to dismiss these rankings, since there is clearly a great deal more economic activity occurring in California (and New Jersey) than in South Dakota. However, economists have found that business costs do play an important role in long-term economic growth, since they figure into the relocation and expansion decisions of firms. Thus, if California electricity costs, which are already high relative to many other states, rise on a permanent basis, it could have a dampening effect on the long-term growth prospects for the state.

All is not bleak. California has several factors in its favor. Home to a highly skilled workforce, the state is one of the wealthiest regions in the world, and its economy has grown by 32 percent since 1995. High immigration rates for the state appear to be fueling economic growth, and the state’s favorable climate serves as a lure to new employees. In addition, the electricity crisis is already spurring innovations in energy sources and usage; thus, even in the midst of crisis, California could once again serve as a model of innovation for the rest of the world. Storm clouds appear on the horizon, but not unlike California weather patterns, there is a lot to suggest the sun will keep shining in the Golden State.

See also the “Conversation with Mitchell Held

For on-going coverage of electricity de-regulation follow the coverage in the LA Times’ section on power

Authors of the article
David M. Smith, PhD
David M. Smith, PhD,

, is associate professor of economics at the Graziadio School of Business and Management at Pepperdine University. His economic expertise includes the areas of labor pay and productivity, forecasting, and analysis of specific labor markets. A labor economist with an applied focus, Dr. Smith has published numerous articles that have appeared in both academic and practitioner journals. In addition, he has a chapter in an edited volume, a monograph, and published book reviews to his credit. His research on credit unions research has been used in arguments before the US Supreme Court as well as in state legislative hearings. Dr. Smith closely follows current economic trends and has appeared on radio and television and in several newspapers and magazines, including most recently the London Times, the Los Angeles Times, USA Today, the New York Times, and the Investor’s Business Daily.

Al Hagan, PhD
Al Hagan, PhD,
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