California’s Electricity Debacle

WITH ROLLING BLACKOUTS, nose-diving credit ratings, bankrupt utilities, a huge state budget hole, and a likely economic recession, California’s electricity crisis has turned into a full-blown debacle. Although many elected officials have blamed this mess on deregulation, the real culprit has been and continues to be government intervention into the energy marketplace.

In 1996, California deregulated the wholesale price of electricity (the price utilities paid to purchase electricity), but capped the retail price that the utilities could charge consumers. Nobel Prize-winning UC-Berkeley economist Daniel McFadden observes that the electricity crisis was caused by “rigid regulation of retail prices in the face of rapid increases in wholesale prices.” Wholesale prices increased for several reasons.

First, in 2000, natural gas prices rose fourfold. Since California gets 34 percent of its electricity from natural gas-fired plants, nearly double the national average, the state is vulnerable to gas price swings. Higher natural gas prices increased the cost of gas-produced electricity from 3 cents per kilowatt hour in spring 2000 to 43 cents in February 2001.

Drought in the Pacific Northwest lowered hydroelectric production and reduced electricity exports to California. Also, last year, the state failed to promulgate guidelines to allow the utilities to enter into stable long-term purchase contracts.

Together, natural gas and hydroelectric power account for 75 percent of California’s in-state-produced electricity. The rest of the country relies on natural gas and hydroelectric for just 29 percent of its electricity needs. And whereas California gets none of its in-state-produced electricity from coal, which is cheap, plentiful and clean burning thanks to modern technology, and 15 percent from nuclear, the rest of the U.S. gets 61 percent of its electricity from coal and nuclear.

Add also a huge increase in California’s electricity demand (a 24 percent consumption increase over the last five years) and the failure to build any new major power plants in the last ten due to government and legal red tape. Consequently, California relies on older power plants that have to be taken off line and repaired more often, reducing supply.

High wholesale costs and government-controlled retail prices resulted in the utilities piling up a debt of $14 billion. Lifting the retail price caps would have saved the utilities, reduced demand, and prevented generators from raising wholesale prices above market rates since they would have feared reduced sales.

In February, Governor Davis acknowledged that “if I wanted to raise rates I could have solved this problem in 20 minutes.” Yet, the state was extremely slow to confront the crisis, and is buying electricity at $70 million a day, with the utilities just distributing it. California has also entered into long-term purchase contracts at prices estimated to be 40 to 60 percent above what the market price will be in three years.

For revenue, in May the legislature approved a $13.4 billion bond scheme that will supposedly pay both for past state electricity purchases and future purchases into 2003. This bond band-aid, though, makes several dubious assumptions. For instance, the plan is based on the assumption that summer spot market prices will be lower than current prices. However, the futures market for electricity indicates that wholesale power prices will jump 50 percent by midsummer. Also, the governor assumes that he will sign 50 contracts designed to produce half of the peak-time electricity that the state needs during the summer. However, only 28 such contracts have been signed, which likely means that the state will have to purchase significant amounts of its summer peak electricity on the expensive spot market.

If these assumptions are wrong, the state could spend $5 billion a month by midsummer, and his bond scheme, the largest in state history, would be used up in a few weeks. Democrat State Controller Kathleen Connell has accused the governor of tailoring his assumptions and figures to fit his goal of persuading the public and the financial sector that the crisis is nearly over when reality shows that the worse could be yet to come.

Davis advocates federal controls on wholesale costs, but James Hoecker, the former chair of the Federal Energy Regulatory Commission, notes that wholesale caps drive companies out of the market, sending their electricity to states without caps.

The governor wants the state to buy the utilities’ transmission lines, but state ownership doesn’t increase electricity supply nor decrease demand. He wants drastically increased conservation, but hasn’t said how this could be realistically accomplished.

Although his administration has approved building more power plants, less than 40 percent of the promised 5,000 new megawatts of power will come on line by the July 1st target.

In April, Davis finally dropped his opposition to a retail rate increase and proposed an average increase of 26.5 percent. Standard and Poors, though, indicated that this proposal wouldn’t pay for all electricity costs. Not coincidentally, PG&E immediately declared bankruptcy. In May, the state Public Utilities Commission approved a complicated rate increase scheme that still contains various rate caps and which still fails to link retail prices to wholesale prices in any systematic way.

California should look at other states and nations that have created better energy deregulation models. According to a recent study by Dr. Lynne Kiesling of the Reason Public Policy Institute, Pennsylvania’s retail price cap is more flexible than the initial cap enacted by California, and has resulted in greater competition in the electricity market. Pennsylvania consumers have benefited by receiving better service, more pricing and billing options, and lower retail prices. Countries like the United Kingdom (where rates have decreased 26 percent over the last nine years), Chile and Australia, which have adhered better to free-market principles, have also had much better success in deregulating their markets than California.

The lessons to be learned from California’s failed performance and the successes of other states and nations are clear and should point the way to real market-oriented reforms. For example, real-time pricing, where consumers pay the market rate for electricity at the time they use power, should be instituted. High prices at peak hours would reduce demand at those hours when blackouts are most possible. The poor could be given transitional assistance. Also, market-driven incentives for upgrading the state’s inadequate transmission system should be enacted. Finally, the governor should use his emergency powers, which are broad, to site and hasten construction of power plants. Such an energy program would get supply and demand back into balance and prevent the economic catastrophe lurking just around the corner.


Mr. Izumi is Senior Fellow in California Studies at the Pacific Research Institute for Public Policy.