WSJ

California Needs Deregulation Done Right
By Daniel McFadden

02/13/2001
The Wall Street Journal
A26
(Copyright © 2001, Dow Jones & Company, Inc.)

The electricity market in California has swung over its history from
monopolization by industrialists in its early days to comprehensive
regulation, then to partial deregulation in the 1990s, and now back toward
substantial regulation and government intervention. In the past, each swing
of the pendulum came from public frustration with the way this market
operated, and each produced a result that the public again found
unsatisfactory.
But the memory of politicians and the public is short. The state is poised to
repeat the mistakes of the last cycle of regulation. Measures passed by the
California Legislature this month are an ill-conceived intervention that will
lock the state into high energy costs and put it at a competitive
disadvantage for years to come.
Unless there is further action, the state will maintain subsidized retail
prices that discourage conservation, while capping in-state wholesale prices
in a manner that discourages construction of new in-state generation capacity
and leaves Californians at the mercy of out-of-state generators. Government
subsidization of electricity consumption will drain tax revenues that might
be better used for education and other needs, encumber California's children
with debt to pay the state's energy bills, and threaten the state's future
ability to sell bonds for public projects. The immediate political cost of
consumer outrage from higher electricity rates may be postponed, but the real
economic cost promises to be massive.
The sad thing is that this is all unnecessary.
The source of the crisis was rigid regulation of retail prices in the face of
rapid increases in wholesale prices driven by increased fuel prices and
increased demand in the national electricity market. The only effective
solution to the crisis is to make retail price regulation more flexible, so
that consumers see the real economic cost of electricity and respond to high
prices through conservation efforts that reduce demand and push prices down.
On the supply side, the state should encourage construction of new in-state
generation capacity through the right market signals, giving producers the
opportunity to site plants and sell power under conditions comparable to
other states.
It's true that state action was needed to stabilize the electricity market,
avoid immediate bankruptcy of the distribution companies, and assure
continued delivery of energy. But this step will only postpone the day of
reckoning unless sensible electricity pricing is introduced as well.
To limit the impact of high prices on the poor, increasing block-rate tariffs
can be used in which the rates for "lifeline" electricity use are kept low.
These were effective in limiting demand for water during California's last
drought, and are already used to promote energy conservation. A more
aggressive version that pushes the rates in high-usage blocks to the real
load-linked economic cost of electricity would provide an incentive that
would stimulate conservation at the precise points that will do the most to
moderate demand and push down wholesale prices.
Consumers should have the opportunity to hedge against price spikes and
average their payments to ease the pain of price volatility. The installation
of load-sensitive meters should be accelerated so that consumers can respond
to the economic price of the electricity they are consuming. This is new
technology for U.S. utilities, but has operated well in France for years.
On the supply side, the state and the Federal Energy Regulatory Commission
could use their regulatory power to require that existing generators redirect
excess profits to finance lifeline rates for retail customers and work off
the hangover from previous electricity purchased and not paid for.
However, care should be taken in dealing with generators to assure that every
kilowatt hour that any generation facility can produce at less than the
national wholesale price of electricity is in fact delivered to the market.
The state needs to be very cautious about getting into the power business as
an intermediary between generators and distributors. Government bureaucracies
rarely show dexterity in dealing with private suppliers, and access to
general government revenues dulls their incentive to operate efficiently.
Negotiating long-term contracts right now, when California is in a weak
market position and the out-of-state generators are in the driver's seat, is
likely to put the state at a future competitive disadvantage.
Consumers need to be reminded that money passed through the government to
subsidize electricity comes out of their pockets just as surely as price
increases, without the mitigating benefits of demand reduction.The lessons of
history suggest that in making the Hobson's choice between a dysfunctional
partially deregulated market and a fully-regulated one that promises to be
even more dysfunctional, California is picking the greater of the two evils.
If it fails to move to sensible electricity pricing in which both consumers
and suppliers see the real economic price at the margin, it will face
another, even more serious crisis in the not too distant future.
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Mr. McFadden, a professor of economics at the University of California,
Berkeley, received the Nobel Prize in Economics last year.

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