California's Deregulation Plans Short-Circuited

1.11.2001

California's landmark experiment in energy deregulation has turned into a landmark disaster. Politicians, consumer groups and industry leaders are now tossing about ideas for possible remedies, but the damage may have been done. The eventual success or failure of the California experiment could have far-reaching implications. In 1996, when the California legislature unanimously passed a bill deregulating the state's power industry, the airwaves were full of sugarplum promises of lower prices, more choices, and cleaner and more efficient production. Three years after implementation, the reality has proven a more bitter fruit. The drop in consumer prices has failed to materialize, public utilities have incurred over $10bn in debt, and the state's overloaded power grid is teetering on the verge of collapse. In an annual "state of the State" speech on January 8, California's Governor Gray Davis called the energy deregulation project a "colossal and dangerous failure."

The problem first surfaced in San Diego last summer, when a heat wave turned up air conditioners across the county and spiked up overall demand. Power reserves dropped from 30% of capacity to just 1.5%, leading to forced rolling blackouts and rationing. Wholesale energy producers (who sell energy to the large utility companies that then deliver it to residents and businesses) found that they could triple and even quadruple their prices and still sell their excess energy. Electricity rates tripled for the average consumer in San Diego County before Governor Davis stepped in to sign emergency legislation capping the rate at 6.5 cents per kilowatt-hour, down from a high of 21.4 cents.

In other parts of the state, utilities don't even have the luxury of passing rising costs on to consumers. A key promise attached to the 1996 bill was a price freeze on consumer rates through 2002 (San Diego Gas and Electric retired its outstanding debt early and was granted an exemption). So as wholesalers have jacked up prices, the large utilities have had to swallow the losses and see their debt go through the roof. The two largest - Southern California Edison and Pacific Gas and Electric - now claim they are near insolvency, and most credit rating agencies have downgraded their debt to the "highly speculative" or "junk" level. Of course, in a functioning free market, supply should have risen to meet demand. Clearly, it didn't. California has experienced a phenomenal boom in the last few years - in both population and economic activity - yet not a single new, large-capacity power plant has come online in over a decade.

Why didn't California see a rise in supply? Each side has its own opinion. Mark Stultz of the Electric Power Supply Association (EPSA), an industry advocacy group, blames the "stringent bureaucracy" that governs the construction of generating plants in California, and, of course, the price freeze, which he says serves as a built-in disincentive for would-be providers to jump into the market. Tyson Slocum of the consumer watchdog organization Public Citizen has a less charitable view, noting first that the major utilities were heavily involved with the drafting of the 1996 legislation, and now want to pass the risks they voluntarily incurred on to consumers. But Slocum argues that "true competition can never occur in the energy industry," due to the small number of energy producers that control wholesale markets and the massive capital costs involved in building generating plants.

California does have nine generating plants either under construction or with construction licenses approved, and another twenty-four moving through the approval process. But this does not do much to solve the immediate problem. Last week the California State Public Utility Commission authorized a 9% increase in residential rates and up to 15% increases in commercial rates, but even this, the two major utilities claim, is not nearly enough to allay the staggering increases in the wholesale market, where prices during the peak season have jumped tenfold. They want a price cap on wholesale prices similar to the one on consumer prices; they also want a government bailout, funded by state bonds and repaid through additional charges on consumer bills.

In his annual speech, Governor Davis proposed his own remedies, including the creation of a $1bn fund to buy existing generating plants and stimulate new capital developments in the industry, plus $250m in cash incentives to encourage consumers to replace old appliances with more efficient ones. He also met with Energy Secretary Bill Richardson and other federal officials to argue for a federal wholesale price cap. No sale: James J. Hoecker, chairman of the Federal Energy Regulatory Commission, said in a statement that such a price cap would be "arbitrary and potentially confiscatory....[it could] create uncertainty for investors, discourage entry into the market or even drive resources elsewhere." Federal officials did, however, pledge to extend a credit lifeline to the hardest hit utilities, and to look into stabilizing prices via long-term, fixed-price wholesale purchasing contracts.

The government has been silent on the prospect of a bailout - not surprising, since even mentioning it produces outrage from the public, which feels let-down and even cheated by the whole deregulation experiment. Residential consumers aren't the only ones disillusioned. Business experts are worrying about the impact the power crisis could have on the state's economy (the world's sixth-largest, if counted independently) if businesses respond by slowing down production and halting expansion. On December 10, Intel, the world's leading manufacturer of computer chips, announced a freeze on plant expansion and construction until the crisis is resolved. With indications that the economy is already slowing, the energy crunch threatens to affect more than just heating bills.

With 24 other states and the District of Columbia moving towards energy deregulation, the situation in California serves as a stark warning. Whether it will eventually serve as an example of the bumpy but necessary road towards a functioning free market system, or simply as an example of the folly of utility deregulation, depends on how - and how fast - the system gets back on its feet.


©2001 Joseph P. Sottile
http://www.jpsottile.com