California Scheming

Don't blame deregulation for the Golden State's electricity snafus

I spent Christmas with my parents in North San Diego County, the epicenter of the nation's most recent energy crisis. As is widely known, a few years back, California "deregulated" its electric utilities in an attempt to bring market competition (and resulting increases in efficiency) into play. But the unexpected has happened this year: In the wake of "deregulation" (I'll explain those ironic quote marks a bit further down), electricity prices have gone through the roof in the San Diego area. Similar rate spikes -- and serious shortages -- loom as real possibilities throughout the Golden State.

Arriving from the frigid East (I split my time between Washington, D.C. and New Haven, Connecticut), I first wondered why people even need electricity in San Diego, where one can manage an early morning run even in the dead of winter wearing only shorts and a T-Shirt. It wasn't until I hit the links that I figured why the area requires power: Golf carts run on electric motors. Grounding golf carts would destroy a way of life, a true tragedy.

Could I have finally found a free market injustice, an instance where markets actually failed to deliver the goods (and services)? My copy of Human Action says such a thing is impossible, but the Invisible Hand seemed to be slapping around the good people of San Diego, where electric bills have been skyrocketing like the NASDAQ used to. I set out to get to the bottom of this.

I called Adrian Moore, Ph.D., the executive director of the Reason Public Policy Institute, a research organization funded by Reason Foundation, the parent of Reason Magazine and Reason Online (though we share a common parent, the magazine and the think tank, like many siblings, operate fully independently from one another). Adrian is a dismal scientist, an economist, so I knew he would be able to crack this energy nut for me. Not only does he love energy policy, but he lives in Southern California.

My questions were simple: How did it come to pass that California is in danger of North Korean-style blackouts? Is it true, as leftists like the Los Angeles Times columnist Robert Scheer claim, that the impending golf-cart stoppage is a product of the free market, the very same free market that provides in abundant supply such good things as Toyota Camrys, South Park, and $20 Texas-style couch dances? Could the catastrophe be the product of actual deregulation, that same glorious process that gave us Southwest Airlines and Mom-and-Pop long-haul trucking?

Adrian's answer: My parents' newly outrageous power bill, which is fast approaching my wife's cell phone bill, is not the fault of the market. In fact, says Moore, it's not even the product of deregulation, which never actually happened in California. Despite numerous claims to the contrary, the California electricity market wasn't deregulated. It was "restructured" by state politicians, explains Moore. To be sure, power is now bought and sold in the Golden State like other commodities. But that fact doesn't mean there's anything like a free market in energy.

Here's how the current crisis was created. A half-decade ago, energy deregulation became big buzz in Sacramento's political circles. In 1996, Assemblyman Steve Peace, considered by some to be the Sen. Pat Moynihan of the California legislature, decided to get in front of this parade. He organized the relevant players —big industrial customers, utilities, environmental groups, and consumer groups—and the result was an electricity restructuring bill that passed the legislature unanimously. Whenever that happens, you can safely bet something screwy is going on.

Politicians claimed the plan would provide consumers with more choice and lower prices. Big business figured its purchasing power would allow it to secure lower prices, of the sort the feds deliver up in the Pacific Northwest with the heavily subsidized Bonneville Power Administration. Consumer and environmental groups got lots of restrictions on how the utilities could operate, including price controls, which, as Cuba shows, do a great job of protecting consumers from such things as consumer goods, including necessities such as food, clothing, and, well, electricity. They also got a guaranteed 10 percent rate cut right off the bat.

California has both public utilities and investor-owned ones. The investor-owned utilities had to sell off their power plants, since vertical integration is considered almost as sinful as giving out free Web browsers. Still, they too got what they thought was a good deal: They got to charge their customers a "competitive transition charge," which almost offset the 10 percent rate cut and allowed them to recoup their "stranded costs," a euphemism for stupid investments in inefficient plants. They also got a cartel scheme worthy of trial lawyers and Big Tobacco: New competitors had to charge customers the same "competitive transition fee" and hand the money over to the state. Between the price controls and the rate cut, any new competitor entering the California market would have to price their juice so cheaply that it wouldn't be worth the effort.

Seeking a tightly managed market, the pols behind the restructuring made another costly error, the result being a totally mangled market. They mistook a physical marketplace (e.g., the New York Stock Exchange) for the market itself. But the latter is simply individuals or firms agreeing to voluntary transactions wherever they may be, a sort of floating crap game that takes place all the time, everywhere and nowhere. The pols not only created an actual, centralized marketplace called the Power Exchange in a building in Pasadena, they also mandated that all electricity must be bought and sold there. Concerned that all transactions be revealed to the public, they further prohibited buyers and sellers from agreeing to individual contracts and mandated that everyone pay the same -- and highest -- price offered on any given day. So that's how the "market" price for power would be set for the utilities. Here's another catch: Regulators would set the price the utilities could charge energy consumers.

Now this scheme may be many things, but a deregulated market it certainly isn't. But none of this mattered much as long as electricity was plentiful and wholesale prices remained sufficiently under the politician's price caps, a situation which existed until 2000.

Times have been good in California over the past few years; industry has been working at capacity; more people have moved into the state; folks have been buying and air-conditioning larger homes; golf carts have been filling up the state's fairways. Everything, in short, has been expanding in California since the "deregulation."

Except power plants. It's extremely difficult to get a permit and a site for a power plant in California. Residents love electricity, but they also love such things as clean air, pristine beaches, unobstructed views, and critters such as the Kangaroo Rat. Since the early 1990s, not a single plant has been built in California. From 1996 to 1999, electricity demand grew by 12 percent while supply grew by less than 2 percent, according to the California Utilities Commission.

Under the restructuring plan, this capacity crunch is debilitating. The wholesale prices paid by utilities increased until they were as much as 100 times greater than the retail price utilities are allowed to charge consumers. In most of the state, utilities are racking up huge losses. Why have prices jumped so high in the San Diego area? Because the biggest local provider there, San Diego Gas and Electric, has managed to pay off its stranded costs. Under the restructuring arrangement, that means SDG&E is actually allowed to increase its prices to match its costs. It did and people started screaming. Virtually all of the rest of the state, however, is still under price controls, so people don't feel any pressure to conserve.

"The immediate response of every politician in the state," says RPPI's Moore, "is, 'Look at what unfettered free markets have done.'" (If they wanted to look at an actually deregulated electricity market, they should look to Pennsylvania, where consumers, producers, and politicians are all pleased.) California Governor Gray Davis, who blames deregulation, out-of state power producers, and federal regulators, has called for stringent price controls, which will solve the problem by turning off the lights (other things being equal, price controls create demand while undercutting supply). Consumer activist Harvey Rosenfield and state Treasurer Phil Angelides offer plans straight out of the dustbin of history: They want to create a state-run, statewide utility -- since nothing the state provides, like highways, is ever in short supply.

Leftists such as Scheer point out that the public utilities in California—Los Angeles, Sacramento, and Pasadena provide examples—charge customers less for electricity. He's right, but they are only able to do so because they don't pay any taxes, get federal subsidies in the form of tax-exempt debt, and are eligible for sweetheart power deals on cheap federal hydropower from the Northwest (whose full cost is foisted onto taxpayers in other parts of the country). Scheer and others decry private-sector profiteering, as if the public utilities are not among those taking home profits. For instance, Los Angeles' municipal utility has so far raked in nearly $200 million by reselling the power they buy from the feds on the cheap. The Bonneville Power Administration, the leading killer of salmon outside of California's sushi industry, earned $208 million last year selling power to Californians, a 500 percent increase over the previous year.

So the California electricity mess is really a reflection of trying to rig markets, not deregulate them. What's the way out of this mess? All policy pieces are supposed to supply an easy answer, but I'm afraid there's no painless one available. A socialized power scheme would merely replace private managers with bureaucrats and, in one form or another, pass the cost along to taxpayers, who are also rate payers. At least one new power plant is expected to come online this summer, which, along with the coming recession, may help things a bit by changing the supply-demand equation. Many other plants are somewhere in the tortuous design-approval-construction process and will doubtless get a boost from the current turmoil. California could also beg for some sort of federal bailout, but Washington, D.C. is now dominated by Republicans, who are unlikely to be overly charitable to a bunch of West Coast Democrats.

Not that the feds aren't already playing a role. Moore points to an unlikely hero in this fiasco, the Federal Energy Regulatory Commission. Not only did the federal bureaucrats rebuff Davis' pleadings for more regulation, they actually ordered something like the start of a true deregulation of California's market, freeing up the Power Exchange's prices and allowing utilities and electricity producers to enter into bilateral contracts. A Bush Department of Energy could further help Californians by ordering the federally subsidized power producers, like the Bonneville Power Administration, to sell their cheap power to all utilities, not just the ones owned by governments.

Politically, leftists like Scheer are using the issue to smear deregulation and free markets, which have, after all, produced all sorts of awful things like life-saving pharmaceuticals, $300 coast-to-coast airplane flights, and long-distance phone calls for $.07 a minute. In Pennsylvania, this horrible market even gives folks relatively cheap power. Still, many politicians, who fear problems more than they long for innovation, are sure to blame the "market" and oppose actual deregulation.

There is a possible political benefit, however. People like my folks down in San Diego know in their bones that the politicians screwed them, no matter what folks like Scheer write. And even granola-obsessed residents of California are likely to recognize that inexpensive electricity has to be produced someplace. And since, as one writer has noted, transporting electricity is like carrying sand in a burlap bag, some of those power plants need to be located in their precious state, if not in their very own backyards.

So unless Californians want to pay and pay and pay -- whether through their rigged "free market" or through higher taxes for publicly owned utilities -- they ought to be more critical of the claims and motives of environmental and consumer groups who work to block the construction of new power plants. Such a dose of reality for Golden State residents won't be all bad. Indeed, it might even keep those golf carts humming.