Price Controls Affect California's Energy Crisis

A badly flawed utility deregulation scheme was passed by California in 1996. Rolling blackouts and higher prices resulted from the failed implementation of this plan, coupled with regulation that discouraged the construction of new power plants.

The California power crisis has been turned on its head as a result of unseasonably cool weather with recent energy shortages giving way to a glut that’s prompted the state to sell excess power at a loss.

Energy bought at an average of $138 per megawatt is being sold for as little as $1 per megawatt in some cases say traders. However, the prices were disputed although state officials acknowledged selling excess power. If the mercury soars, blackouts are still possible but state believes the sales are a blip during a long hot summer.

Oscar Hidalgo, a spokesman for the Department of Water Resources, which is in charge of purchasing power for three financially ailing utilities said, "This is unusual, but it was anticipated; it is typical in the power buying operation. It’s better than doing nothing with surplus power."

California Tries to Solve an Energy Problem

The past few months have been spent arming the state with long-term energy contracts while weaning itself away from purchasing high-priced power on the last-minute electricity market by the agency.

There suddenly is more power than California can use as a result of those contracts, along with the temperate weather and an increase in energy conservation, though Hidalgo would not say at what price he acknowledged that the state has been trying to sell as much as 20 percent of its daily megawatts.

Gary Ackerman, executive director of the Western Power Trading Forum in San Jose said, "We know from traders who have bought that it’s some as low as a dollar and last week we know it was as low as $5."

Extra electricity, unlike natural gas, cannot be stored and used later. The state has not required the entire 38,000 megawatts it had calculated it would require because Californians haven’t been running the air conditioners as often as expected. About 750 homes can be powered by a megawatt. In its haste to fend off blackouts, the state bought too much power at too high a price.

Ackerman said, "If the price is $138 on average for a month and you have to turn around and sell a chunk of it for a dollar, you’re not going to look real good to a number of people. I just don’t think my people in California truly understood what their state did when they stepped into this business."

Energy Shortages in California

The state’s energy policies have been bitterly criticized in the crisis by some consumer groups. The sales were seized as evidence of what they said was a poorly thought-out plan that has left the state at the mercy of a merciless market.

Harvey Rosenfeld, an official at the Foundation for Taxpayer and Consumer Rights said, "This state agency has no expertise in trading. It is amateurish at best and sometimes incompetent, negotiating with a bunch of M.B.A.’s whose goal is to soak California. The state was panicked into leaping into this business, and it is being outwitted."

A significant reduction in demand resulted from the state’s conservation program. The state energy commission reported total demand declining 12 percent this June from June 2000 which was adjusted for economic growth and the weather.

Consumers were encouraged to reduce energy use further, as much as 40 percent in certain instances, because of big rate increases in June.

Accounting for close to 45 percent of the total purchase in May was the amount of power the state needed to purchase on the so-called spot market, which means a purchase in which the electricity would be supplied immediately.

However, spot purchases have made up just five percent or so of the Department of Water Resource’s total purchases, and of the times of lowest demand, as a result of the reduced demand in July. Therefore, as a result, officials have decided to get what they can by reselling excess power.

Residents could be locked into paying artificially high utility rates for years because Governor Gray Davis locked into a $3 billion long-term power deal.

The price controls and state lawsuits against the generators made it more difficult to justify expanding operations in California said several of California’s major independent power generators.

Action by federal regulators to impose a system throughout the West that looks a lot like price caps – though the White House said it was something different – was half-heartedly welcomed by the White House.

Ari Fleischer, the White House spokesman said, "This is not a price control. This is a market-based mitigation plan that now will extend to all Western states."

What Are Price Controls?

Telling people just what they want to hear is what price controls are all about. Price controls have a long legacy of providing more relief for politicians dodging unpopular realities than for people suffering from high prices.

Companies found ways to avoid the caps when energy regulators instituted the first round of "price mitigation" rules in December. Just to keep up with the innovative ways business finds to slip by, FERC had to revise its rules three times as a result.

Lines to purchase gas quickly ran for blocks in the 70’s the last time government instituted broad price controls on gasoline and enforced them in court.

Since January 2001, retail rates for electricity in most of California had been frozen until a 40 percent increase in June. Consumers were successfully encouraged to conserve energy and lower demand by 12 percent despite the price controls boast California officials.

However, demand had been reduced by more than twice as much where some utilities had been raising their prices since January in Washington state. Blackouts would have not been a threat this summer if California achieved conservation levels like those of Washington.

FERC’s price control strategy does not put new controls on natural gas although much of California’s electricity is produced with natural gas. The cost of natural gas could escalate. While electric prices are reduced and companies run their plants at full capacity, pushing companies between the rising prices for the natural gas that powers the plants and price caps, this could result in more shortages and blackouts.

When Demand and Supply Grow Out of Balance

The cause of California’s electricity problem has been demand exceeding supply. Through price changes, this imbalance is automatically addressed in a free market. When demand for a product exceeds its supply, prices increase. An incentive for producers to generate more of the product or for consumers to reduce their purchases is in turn created by these higher prices. As supply grows to meet the demand or higher prices reduce competition, the balance is restored.

As prices increase, either businesses or individual consumers restrain their consumption until prices start to fall and new electricity supply enters the electric market.

By constraining, through law, the ability of electricity utilities to increase retail prices, Governor Gray Davis unfortunately decided to defy the law of supply and demand. Wholesale electricity prices were deregulated by the Federal Election Regulatory Commission (FERC), which reacted to market forces by increasing as demand rose. Promptly becoming insolvent were California’s two largest utilities that bore the brunt of the price differential.

Price mitigation constitutes government intervention in the marketplace although it is less politically explosive tan the term "price controls."

Government-imposed price caps do not work although many might believe they are a practical solution to California’s energy problem. Generally, by inhibiting the necessary role prices play in markets as the visible measure of supply and demand, they prolong their problem.

Providing a precedent for California’s current electricity shortage was President Nixon’s nationwide price controls on oil during the energy crisis in the 1970’s. Ensuring adequate supply of petroleum products (particularly gas) at reasonable rates by constraining price increases was the object of those price controls. Unfortunately, artificially low prices failed to curtail gas consumption. Also, for producers, incentives were removed to expand capacity through investment or to increase supply through less efficient means of production making supply more expensive. Gas lines and other problems resulted from this centralized price and allocation regulatory system which history has demonstrated.

The impact that increased prices would have had on consumption was undermined by fixed consumer prices on electricity. In addition, when two California electric utilities could not pass their increased costs on to consumers, it drove them into bankruptcy. Especially when combined with excessive regulation, this poor decision-making made new investment in the power sector unprofitable.

Partial deregulation cannot work as was seen in California. Solving the supply-demand imbalance will not be accomplished by intervening in California and other Western states’ wholesale electricity markets – either by price caps or price mitigation.

Price Controls and their Effect on the Economy

Through the economy, prices carry information so complex that even today’s computers cannot completely unravel the prices that encapulate data about supply, demand, labor, tradeoffs, culture markets and raw costs. Prices tell suppliers when to invest more or less in production and help tell consumers when it makes sense to consume more or less of a good.

When prices are set naturally by the interaction of supply and demand, they carry accurate information. In a rate-setting or price-controlling process, the same information cannot successfully be reproduced by analysis and calculation. Without any feedback from actual transactions from suppliers or purchases, government price-setting, at best, creates a rough and inflexible approximation of a market price. Where competitive prices are possible, price controls have centuries-long histories of disturbing and disrupting the markets resulting in over-consumption, inadequate investment, shortages of supply, and a myriad of other problems.

These fundamental economic truths have proven accurate in California’s electricity market. Currently dysfunctional is the electricity market in California and to some extent the entire west. The solution is not to superimpose further distortions but to return to market basics.

California’s energy crisis has been exacerbated by retail price caps, which have alienated consumers from the realities of electricity costs and changes in wholesale prices. As a result, utility consumption increased, rather than decreased, and the state’s electric utilities face daily financial losses because of increased consumption at prices below cost.

The state Independent System Operator (ISO) was quick to impose a price cap as California’s wholesale power prices rose rapidly in the spring of 2000. As suppliers pursued more lucrative opportunities out-of-state. The amount of power supplied to the state quickly declined — an obvious and predictable result of price controls.

Acute scarcity turned into shortages, because consumers, seeing no change in prices, made no effort to reduce consumption. With ISO staff spending more time trying to find power supplies than running the grid, the situation rapidly grew untenable. The ISO had to lift the caps to head off blackouts as supplies continued to decline.

In comparison, price caps were not imposed in the Midwest in the summer of 1998 when the previous "worst-case scenario" of price spikes occurred. Market prices attracted both power and investment to the region resulting in the recent building of power plants. The Midwest price spike problem has not recurred.

In California, the extent to which the supply of electricity had been reduced by price caps is overwhelming. In the summer of 2000, new scheduled imports of electricity to California declined 49 percent compared to the summer of 1999. And declining 33 percent were net real time imports. The increase in exports from California was the main reason for these declines. Generators sold their power to neighboring states because of the ISO’s wholesale caps.

As a result, consumer prices were not lowered and electricity supply diminished because of wholesale price caps. Electricity sellers compensated during off-peak times by increasing prices through cap-lowered peak prices.

Price ceilings on wholesale electricity sales on spot markets in California and 10 other western states over the next 15 months were established by the Federal Energy Regulatory Commission plan, unveiled on June 21, 2001 and put into effect on June 20, 2001.

At a hearing by the Senate Energy and Natural Resources Committee, the five FERC commissioners outlined details of their plan. Hoping to protect consumers against price gouging until California increases its electricity supplies are the price ceilings, which will be in effect through September 2002 said the Commissioner.

Both Republicans and Democrats on the committee applauded the FERC ceilings. However, several Democratic lawmakers questioned why they were not imposed months ago.

The President has indicated some support for the approach taken by the FERC, but he strongly opposes stringent price caps.

A market cleaning price, or ceiling would be established for all wholesale electricity sold in the California spot market and would apply to markets in 10 other Western states under the FERC.

When reserves in California fall below seven percent, triggering a power emergency, the cap will be based on the highest-cost gas-fired generator units bid. When the power reserve again exceed seven percent, the bid will decline to 8.5 percent of the original cap.

During the week of July 2, 2001, it appeared to officials in California and Nevada that generators had withheld supplies as a result of the controls the federal government recently imposed on wholesale electricity prices throughout the Western states.

President Bush opposed price controls, saying they would worsen the shortages prior to bowing to an outcry from the West. The only way to solve California’s energy crisis was an expansion in oil drilling and the construction of more power plants, the President argued. If set properly, caps would prevent the kind of price gauging that has enabled power generators to overcharge California by some $9 billion this year insisted Governor Davis.

Based on an economically complex formula that has sown confusion in the markets are the price controls put in place in June by the FERC. The level at which the caps are set can change rapidly under the process. Generators do not always know how much they will wind up being paid for a given amount of power because the system is so complex and so changeable.

Confusion among the generators has caused them to hold back about 600 megawatts of power – the equivalent of the output of about two large plants – at critical times on July 2, 2001 said Oscar Hidalgo, the spokesman for the Department of Water Resources, the California agency that purchases most of the state’s power on the wholesale market.

Hidalgo said, "A lot of generators were telling us that they were uncertain what they would be paid and so they didn’t want to take the risk. That’s basically what pushed us into the stage 2 alert on [July 2, 2001]."

As conditions [for Nevada] worsened on [July 2, 2001], some suppliers actually held back as much as 200 megawatts said Paul Heagen, a spokesman for the Nevada Power Company, the utility for most of Nevada.

In the Las Vegas area, 45 minutes of blackouts affected about 10,000 homes in the Las Vegas area, creating a critical shortfall at the peak demand in late afternoon.

The problem was caused by the uncertainty among the generators over how much they would be paid under the complex federal pricing formula.

Paul Heagen, spokesman for the Nevada Power Company said, "We know this was not the intention of the price controls, but they are having a chilling effect on supply." The generators "don’t know how much they’re going to get paid for the power, so they are reluctant."

The state was analyzing the data and had drawn no firm conclusion’s yet on what had occurred said Cynthia Messina, a spokeswoman for the Nevada Public Utilities Commission, which regulates the utility.

The caps have been used as the standard for pricing. However, even the least efficient plant can change because power plants can be pulled out of the system for maintenance or placed back on line, complicating matters.

However, the fact that the cap is reset only when the California market is placed on a Stage I alert when supplies decline below seven percent more than actual demand – for one hour or more – is perhaps where the greatest uncertainty lies.

The market naturally does not know whether it will last for minutes or hours when the alert is first called by the Independent System Operator, the agency that manages California’s power grid. In less than an hour, the market slipped into Stage 1 and then to Stage 2 when supplies were less than three percent greater than demand. As a result of quirks in the pricing formula and changes in market conditions, prices fluctuated sharply, declining from $91.87 to $70.49, a megawatt at the time of the first alert, to $81.18 to $89.30 and then back to $72.

Also, the problems in Nevada are not likely to go away quickly similarly to California. The state was hurt by the fact that several large plants were down for repairs on July 2, 2001. However, partly as a result of a spurt in growth and partly for reasons that the utility says it does not understand, Nevada has also run into a soaring demand for power.

At the start of July 2000, peak demand was 3,280 megawatts; the peak was 4,250 megawatts on July 2, 2001 said Mr. Heagen, the Nevada Power spokesman.

About a third of the increase was a result of population growth and about a third was a result of higher temperatures said Heagen.

A puzzle is the other third; however, it does not appear that it will just go away said Heagen.

The Federal Government's Involvement in the Energy Shortages Out West

The Federal Energy Regulatory Commission (FERC) met in June to take up the hottest issues of the summer, the high cost of electric power in the West.

The FERC was given two weeks to deal with the California crisis "responsibly" by Senator Jeff Bingaman (Democrat - Mexico) after he took over chairmanship of the Senate Energy and Natural Resources Committee. He said the Senate would be forced to legislate the issue.

Senator Joseph Lieberman (Democrat – Connecticut), whose Governmental Affairs Committee took up the same issue on June 20, 2000 said, "It is our job to make sure federal agencies are doing their job to fairly and appropriately protect the interests of the American people."

Is the sharp increase in energy prices since June 2000 the result of genuine shortages of supply or the result if a deliberate withholding of supply by energy companies to drive up prices although a tough charge to prove is at the heart of such investigations?

Jerry Taylor, director of natural resources studies for the Cato Institute in Washington said, "There have been 28 investigations of the oil and gas industry in the last 22 years for price gouging, and not one of them found anything of the kind."

Especially in the long term industry spokesmen and many economists say that talk of price caps is more likely to make shortages worse. They say that price caps do not produce any more power. They fail to send appropriate signals to consumers that they need to cut back on consumption and they discourage investment.

In Senate testimony on June 13, 2001, Lawrence Makovich, senior director of the North American Energy Group said, "It will be a mistake to make price caps the centerpiece of a federal response to California power shortage. They would make a bad situation worse, and they do nothing to fix the flaws that so desperately cry out for solution."

To hide their own mistakes, politicians are "demonizing" the energy companies argue industry spokesman.

Richard Wheatley, spokesman for the Houston-based Reliant Energy Inc., which supplies about nine percent of the power in California said, "California failed to build new power generation for more than 10 years. That’s the root cause of the problem."

He added, "Our plants are running about three times harder this year than they have since we bought them in 1998, so the claim that companies like ours have taken power off the market deliberately to drive up prices is not born up by the facts."

Ken Johnson, a spokesman for the House Energy and Commerce Committee said, "We’re convinced that [retail] price caps have led, to a large extent, to the problems in California, and frankly we’re not prepared to dig that hole any deeper."

References: Brett D. Schaefer and Charli E. Coon, J.D. "Why Wholesale Price Caps on Electricity Won’t Solve California’s Energy Woes," The Heritage Foundation, Executive Memorandum, No. 754, June 19, 2001; Adrian Moore and Lynne Kiesling, "Electricity Price Caps: A Recipe For Blackouts and Higher Long-Run Costs," Reason Public Policy Institute, April 19, 2001; James Sterngold, "U.S. Price Controls Are Said to Worsen Power Shortage," The New York Times, July 4, 2001; H. Josef Hebert, "Senate Does Drop Energy-Limit Plan, The Associated Press, June 19, 2001; Karen Gaudettee, "Calif. Selling off Surplus Power," The Associated Press, July 19, 2001; James Sterngold, "California’s New Problem: Sudden Surplus of Energy," The New York Times, June 19, 2001; Rene Sanchez and Peter Behr, "Davis Finds Hope in Calif. Power Crunch," The Washington Post, June 20, 2001; David Esanger, "New Analysis: Bush Finds Market Is Not Always Free," The New York Times, June 20, 2001; Editorial, "Sooner or later, federal price controls will backfire," USA Today, June 21, 2001.

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