The Power Crisis


"The number one problem facing electric utilities in the cold months ahead is getting adequate supplies of coal, oil, and natural gas."
—David S. Freeman, director of the White House Energy Policy Staff, quoted in BusinessWeek, October 3, 19701

"No homes are going to be without gas or fuel."
—Paul McCracken, chairman of the President's Council of Economic Advisors, quoted in the Los Angeles Times, October 11, 19702

"Fuel oil and coal rationing and price controls were urged by the American Public Power Association in a letter to President Nixon last week."
—Alex Radin, general manager of the association, quoted in Chemical and Engineering News, Sept. 7, 1970. Radin also called for antitrust action against the 'concentration of ownership of competing fuels' and suggested an embargo on coal export.3

As blackouts and brownouts occur with increasing regularity, as fuel prices suddenly shoot skyward, as winter takes its toll on the poor and aged who cannot heat their homes because there is no fuel—it is small comfort to listen to the anxious promises of bureaucrats and the strident demands of lobbyists for price controls, rationing, and other forms of coercive intervention. One does not look to political rhetoric for explanations or analysis; to determine the source of the power crisis requires an inquiry into the economic and political context of the market for power and for its ultimate source, fuel.

A major theorem of free-market analysis is that coercive interventions in the marketplace—whether by restrictions on supply, demand, or prices—inevitably produce shortages and/or surpluses. This is so because in the dynamic process of price determination, supply and demand are continually readjusted so as to be in balance at the free market price. When government interferes with part of this process, the remainder continues to operate as if conditions were normal. If the government enforces a price ceiling on a product, demand for the product will still be a function of its price, but because of the artificially low price, consumption will increase. Unless the fixed price is fixed high enough to afford the producer a good profit, he will have little incentive to expand. Hence, a shortage of the product will develop. In the same fashion, price floors (e.g. farm price supports) tend to produce surpluses.

The power crisis now facing this country consists in a peculiarly interlocked group of shortages, not only of electrical generating capacity but also of every major fuel supply. Behind these shortages lies a system of controls and interventions which not only have failed individually to achieve their intended purposes but have also worked at cross-purposes with one another. In short, if one wished to wreak havoc in the field of power generation, it would be difficult to design a system that would succeed better than the current patchwork of interventions.

The ultimate source of power—whether for heating or for electricity—is fuel. The four primary types of fuel in use today are coal, oil, natural gas, and uranium (for nuclear power plants). Nuclear power plants provide less than 1% of the nation's total electricity and there is no shortage (at present) of uranium; for a variety of reasons, however, a number of nuclear power plants which were expected to be in operation by this time have been delayed, often by several years. Thus, although the delay in nuclear plants contributes to the power shortage, it is not in itself a part of the fuel shortage. It has contributed to the problem because electric utility officials, not anticipating the delays, were counting on the increased nuclear capacity and, consequently, did not pay sufficient attention to assuring adequate supplies of coal, oil, and gas for the current season. The major shortages of these three fuels are being blamed by the utility companies.

The causes are more complex than that, however, as an examination of the fuel market demonstrates. In recent years, both because of anti-pollution regulations and because of its relatively low cost, clean-burning natural gas has become an increasingly popular fuel. In order to protect consumers from the perils of capitalism, however, the Federal Power Commission (FPC) regulates natural gas pricing. In the 1950's the FPC made a vain attempt to regulate individual producers, on a case-by-case basis. Even the federal bureaucracy recognizes some limits on the amount of paperwork which can possibly be handled; therefore, in the 60's, the Commission switched to regulation by geographical area. Even so, the injection of politics into the pricing process resulted in an administrative nightmare. The criterion for setting prices was supposed to be based, not on what the consumer's demand indicated (the market price), but rather on what the political process determined was a "fair" return for the producer, regardless of demand. As a political process, the rate decisions were often challenged in court by one faction or another, who differed on the definition of "fair". The court cases often took several years, and when a previously-set price was eventually ruled "excessive," the producer was ordered to pay huge refunds.

The combined effect of lower-than-market prices and the continual threat of court-ordered refunds, needless to say, has had a powerful disincentive effect on the producers' desire to explore and develop new sources of natural gas. At the same time, the lower-than-market prices provided a strong stimulus to demand for natural gas, since as time went on it became a relatively cheaper and cheaper fuel. The final straw was provided by the money market of 1969 and 1970; with interest rates at 9 and 10%, gas producers could frequently earn a much better return on their money by investing it, rather than spending it on bringing in new sources of gas. Thus, fall and winter of 1970 found many of the pipeline companies and utilities unable to buy sufficient gas from the producers—the latter simply were not producing at the old fixed price. It should be pointed out that as of now there is no actual shortage of natural gas supplies; known reserves (i.e., neglecting all probable but unconfirmed sources) are sufficient for many years. It is just that there is no reason for producers to bring it to market at current prices.

The FPC is finally beginning to bestir itself and admit that something is wrong with its position; it has cautiously proposed exempting small producers from price regulation and has talked about granting large producers a 5 cent per 1000 cu. ft. increase (on new-well gas only). Industry economists estimate that the free-market price would currently be about 10 cents above the current average price of 40 cents per 1000 cu. ft. Thus, the FPC's moves are only a minor step, applying to only a fraction of the market; further, they leave unchanged the basic principle that the government, rather than the market, should determine the price. In that the Commission only invites further shortages. Pipeline companies are taking what few steps they can to obtain more gas.

Several are planning to import liquified natural gas (LNG) from Algeria and Venezuela, although the first small amounts will not be available until late 1971. The price of the imported LNG is expected to be between 65 and 70 cents per 1000 cu. ft.—another indication of how far out of line the current 40 cents price is. Pipeline and utility companies presumably have enough demand for gas to be willing to pay such a price by next winter. If the past is any guide, the shortages will probably be worse by then.

Oil production is probably more entangled in politics than any other industry. Although a complete analysis is beyond the scope of this article, the salient points concerning regulation of supply and pricing can be summarized briefly. The U.S. oil market is divided between the thirty "majors"—large international oil producers—and some 15,000 "independents"—small and medium-sized domestic producers. The federal government controls the market by setting oil import quotas and regulating interstate oil shipments, while the state governments set monthly production quotas. With this type of politico-economic structure, the lobbying aims of the majors and the independents are somewhat different. The majors tend to oppose import quotas and assistance to Israel; they have a stake in Arab oil and want to ensure that they can continue to obtain it and sell it in the U.S. The independents, by contrast, "count amongst Israel's best friends…and they are careful always to advocate a policy which will prevent the flow of Arab oil from endangering their industry, wealth, and future" (from Survival, June 1970)4. They consequently favor strict import quotas.

The President's Task Force on Oil Imports found that import quotas, by restricting imports to 12.5 percent of U.S. consumption, drive up the price of oil from a free market level of $2.24 per barrel to about $3.90 per barrel.5 Put another way, the Task Force estimated that American consumers last year paid about $5 billion more for oil products than they would have in the absence of import restrictions.6 Thus, the widespread complaints by users—both individual consumers and utilities—about the high price of oil supplies, is largely a result of the quota system. In addition, the state regulatory agencies, such as the Texas Railroad Commission, set monthly oil production quotas for the industry, at a certain percentage of the wells' maximum production rate (e.g., for September 1969 the Texas quota was set at 3,354,696 barrels per day—53.7 percent of the wells' ability to produce). The effect of such quotas (another cozy arrangement between the government and the producers) is to restrict the supply in order to support the artificially high price level. The quotas thereby prevent "destructive competition" between producers, in response to the high demand by consumers and utilities.

Once more, the regulations contribute to the non-market high price and short supply. There is an abundance of oil, both in the U.S. and abroad (not only in the Middle East but also in Canada, Latin America, Indonesia, etc.) Foreign oil prices are generally about half of U.S. prices and are generally trending downward, while U.S. prices continue to increase. (As this is written, the foreign oil price is temporarily inflated by the tanker shortage caused by the Middle East war. This is only a minor exception to the general trend, although it does exacerbate the current supply problems.) It is massive political interference with the market that gives the illusion of shortages to the U.S. consumer.

The final major fuel is coal. Historically, coal has been the cheap-and-dirty fuel that was always around in sufficient supply to take up the slack when oil or gas was in short supply. Several years ago, the utilities took coal so much for granted, as they counted on increased nuclear generating capacity (which did not materialize), that they neglected to make long-term commitments to assure a sufficient reserve of coal. Meanwhile, Japan's booming economy resulted in a huge demand (and consequently a high willingness to pay) for coal, which Japanese firms secured via long-term contracts with U.S. producers. As a result, all across the U.S., coal stockpiles are dwindling. The TVA, which normally maintains a 75 to 90-day stockpile, was down to 25 days last winter and 11 days worth this winter. Many utilities and other firms are fearful of having to shut down completely for lack of coal.

Actually, the coal shortage would be nowhere near as severe were it not for the Interstate Commerce Commission. For in fact, as with natural gas, there is actually enough coal to go around, if only it could be delivered to the users fast enough. Nearly all coal is shipped by rail in hopper cars. Years ago the railroads worked out extensive contractual agreements allowing interchange of cars between railroads; it is so much more convenient for railroads to accept and transport loaded cars from connecting railroads (rather than transferring the load to one of their own cars) that they are willing to pay a daily charge to the owning railroad for each day's use of its cars. The value of this privilege fluctuates over time, depending on the demand for freight cars in a particular region; however, the ICC, in order to prevent "profiteering", fixes the price—called the demurrage charge —and seldom changes it.

For the past several years the demurrage charge has been far below the market level for hopper cars, and as a result, severe shortage of hoppers have developed in parts of the country. Railroads near ports serving the export market gladly paid the low price for hanging onto a large supply of other roads' cars—and their owners were powerless to change things. Only in October 1970 did the ICC finally wake up to the reality of the coal shortage—at which point it abruptly doubled the demurrage charge. (So much for the chaotic free market vs. orderly government control.)

Thus, in the case of every major fuel the picture is much the same; apparent shortages exist primarily because of government interference in the market. In the face of such evidence, the response of politicians and statist lobbyists can be seen for the power-seeking demagoguery that it really is Senator Philip Hart recently asked the Federal Trade Commission to investigate the gas producers' request for higher prices, charging that producers are "withholding" gas supplies! Of course they are, as the preceding analysis has pointed out—the producers exist to make a profit, not to sacrifice themselves by producing at below-market rates. The American Public Power Association—a lobby group representing 1400 government-owned utilities—has called for price controls, rationing, an embargo on exports, and antitrust action against fuel producers all in the name of solving the problem brought about by such interventions. Some people just do not learn!

The actual solution should be clear from the foregoing analysis. The market mechanism must be allowed to regain control of fuel pricing; otherwise, the shortages of the last few years will continue to intensify, especially if shortsighted cures such as rationing and price-controls are enacted. But beyond the fuel market, what might be said of the utilities, whose incredible lack of planning and foresight has certainly contributed its share to the present crisis?

The sad fact is that the electric utilities constitute one of those uniquely American hybrids: franchised private enterprise (which translates as monopoly, pure and simple). Conventional wisdom holds that utilities are natural monopolies, and that for this reason they should be either government-owned or government-regulated. Yet this contention is a gross oversimplification, as a number of economists have recently pointed out. As Stigler and Friedland put it in the Journal of Law and Economics in October 1962, "the individual utility system is not possessed of any large amount of long run monopoly power. It faces the competition of other energy sources in a large proportion of its product's uses, and it faces the competition of other utility systems, to which in the long run its industrial (and hence many of its domestic) users may move."7

The first of these points can be illustrated by the growth of total energy systems in shopping centers, schools, and apartment buildings. In such systems, natural gas or kerosene is used to power a gas turbine generator which produces the building's electricity on-site; the exhaust heat is recycled and used to provide heating or air conditioning, depending on the season of the year. Such systems are directly competitive with commercial electric power in many parts of the country.8 Competition between two electric utility systems (the second point above) is quite conceivable, much as there used to be between telephone companies before government franchises became the rule. Manis has described such a case, as follows:

"Companies may send representatives to selected adjacent areas served by competitors. If they could offer better service and/or prices, they could get residents to sign contracts agreeing to take their service for a period of time at stipulated prices if the company builds into the area and offers the service. They can go to the existing company and indicate that they have the contracts and intend to provide service. It will then pay the existing firm to sell their equipment in the area and make something on it, rather than have it become completely useless. This could also be done by individuals without an existing company."9

Thus, it is perfectly feasible to have competition in providing electricity or any other utility service, thereby making regulatory rate-setting commissions unnecessary. Those who argue for government regulation of utilities are quick to conjure up straw-man pictures of evil capitalists, but slow to admit the hidden costs of the monopolies such regulation fosters. An article in Fortune recently described the electric utility industry as "clumsy" and "sluggish" and stated categorically that "utility executives are generally unimaginative men, grown complacent on private monopoly and regulated profits."10 Despite being the biggest industry in the U.S., with assets of over $75 billion, and net income of over $3 billion, the electric power industry spends less than one quarter of one percent on research and development.11 Small wonder, then, that it failed to forecast the current demand for service, the technical problems of nuclear power development, the current fuel shortages, and the growing concern over pollution.

When profits are not guaranteed by public regulatory commissions, but must be earned by good service, companies have a large incentive to forecast correctly, to innovate, and to invest in R&D. Similarly, when the fuel market is unrestricted by coercive price controls and import-export restrictions, the free operation of the price system provides vital feedback on the state of the market for energy sources—allowing long-term decisions to be made accurately. The dead hand of regulation is a death-grip for any industry, and the sooner the fuel and electric power industries shake it off, the better off (and warmer) we'll all be.

1. BUSINESS WEEK, Oct. 3, 1970, p. 14.
2. LOS ANGELES TIMES, Oct. 11, 1970, p. H-1.
3. CHEMICAL AND ENGINEERING NEWS, Sept. 7, 1970, p. 17.
4. SURVIVAL, Vol. XII, No. 6, June 1970, p. 202 (Published by the Institute for Strategic Studies, London)
5. SANTA BARBARA NEWS-PRESS, August 9, 1970.
6. Ibid, Sept. 13, 1970.
7. JOURNAL OF LAW AND ECONOMICS, Vol. V, Oct. 1962, pp. 11-12.
8. Poole, Robert, "A Feasibility Study of Future Domestic Power Systems," BS Thesis, MIT Dept. of Mechanical Engineering, Cambridge, Mass. June, 1966, pp. 14-15.
9. Manis, Rod, "Monopoly," (unpublished).
10. Quoted in SCIENCE, Vol. 168, 26 June, 1970, p. 1556.
11. Ibid, p. 1558.