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
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
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
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
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
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
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
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
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 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
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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