Free Market Shock

The California energy crisis isn't over: it's only in
remission, thanks to a massive statewide commitment to conservation, a mild
summer, and the judicious retreat by energy conglomerates from their extortionist
pricing tactics. But the state's electricity consumers have been left with
permanently higher utility bills, and the state's taxpayers have been slapped
with a tab of nearly $10 billion to pay for the past year's price spike.
Democratic Governor Gray Davis is demanding a rebate. We'll see how far he gets
with FERC, the Republican-run Federal Energy Regulatory Commission.

No matter what happens in the short-term battle over rebates and price
caps, however, the long-term problem in electricity markets remains, and not just
in California. Two dozen states have put in place flawed deregulation schemes that
essentially give producers the upper hand in determining what price consumers
will pay to keep the lights on. If there's one thing we've learned from the
California mess, it's that the price of electricity--at least in deregulated
markets--will have little to do with the cost of producing this basic necessity.

California may have generated the headlines, but on an unseasonably warm day
more than a year ago wholesale electricity prices on the New England spot market
briefly soared to $6,000 per megawatt hour--300 times the cost of production and
200 times the average price of the previous year. Since FERC rules
inaugurated electricity deregulation in 1996, similar price spikes have occurred
in Illinois, Ohio, and New York. Even in Pennsylvania, considered the poster
child for electricity deregulation, prices hit $930 a megawatt hour for brief
periods in 1999. In June 2000, on a particularly hot day in New York City when a
regional nuclear power plant was experiencing an "unplanned" power outage, the
wholesale price of electricity soared twentyfold to $1,000 a megawatt hour, the
state-imposed cap. More than $70 million flowed from city consumers to a half
dozen energy companies on a single day.

Some pro-deregulation economists have compared California's electricity crisis
to the perfect storm, an improbable string of onetime events whose confluence led
to disaster. A drought had cut off the Northwest's usually reliable supply of
hydropower; the new wholesale market's design had foolishly forced most demand
into the spot market; regulators had failed to approve new power plants for
nearly a decade; and politicians had imposed a retail price cap. So when the
"inevitable" shortages hit, this unique set of circumstances combined to create a
playing field that allowed market forces to run amok.

Yet a close examination of electricity wholesale markets in the two dozen
states where they now exist shows that California, rather than being the
exception, is merely the most extreme example of newborn wholesale markets that
do not and probably cannot work. That is, they do not work if the goal is to
deliver "just and reasonable" utility rates--which is the law of the land, the
ideal of free market efficiency theorists, and a wise social policy for dealing
with a commodity that is the lifeblood of the twenty-first-century information
economy.

Of course, unfettered electricity markets are working perfectly well if the
goal is to deliver windfall profits to Enron, Calpine, Dynegy, Orion, Duke,
Southern, TXU, El Paso Gas, and the handful of energy conglomerates that stand
astride the emerging national market for electricity just as surely as Sam Insull
stood astride the industrial economy of the 1920s. The collapse of his
utility-holding-company pyramid scheme was one of the factors that triggered the
1929 stock market collapse and helped sink the nation into the Great Depression.

California, which paid $7 billion for electricity in 1999 and $27
billion in 2000, could wind up with a utility tab of $50 billion this year
despite the mild weather and stepped-up conservation. Even with FERC's recently
approved price caps, millions of middle-income Californians are paying
electricity bills that guarantee windfall profits for generators. But California
is no special case. One federal agency, the Energy Information Administration,
projected that the inflation-adjusted average price of electricity in the United
States overall will rise sharply this summer--up 5 percent from a year ago in
inflation-adjusted dollars, even without taking the recent massive rate hikes in
California into account. It's the second year in a row of rate hikes after 17
straight years of declines on an inflation-adjusted basis, according to EIA data.

The Hero: Regulation

Of course, not all consumers will have the same experience. In the 26
states that kept their traditional utility regulations in place, price increases
will be much lower. The 2,000 publicly owned utilities and cooperatives serving
40 million Americans, the legacy of populist struggles against energy
conglomerates a century ago, will also have below-average rate hikes since they
wisely purchase long-term supplies for their constituents. Indeed, municipal
utilities and state-owned power authorities have consistently offered their
customers rates that are 10 percent to 40 percent below their neighboring
investor-owned utilities. So who's getting hammered? Consumers in the states that
bought into deregulation are experiencing the biggest electricity price hikes.

The main architects of deregulated wholesale markets--local
utilities and the power-plant builders and operators--are now the targets of
populist rhetoric the likes of which hasn't been heard in this country for years.
(One of the spicier remarks was California Attorney General Bill Lockyer's
comment about Kenneth Lay, chairman of the Houston-based Enron Corporation: "I
would love to personally escort Lay to an 8-by-10 cell that he could share with a
tattooed dude who says, 'Hi, my name is Spike, honey.'") Governor Davis, a
centrist Democrat, is moving inexorably toward a state-run power-purchasing pool,
California's last defense against power-producer predation.

Undaunted, the power brokers continue to push deregulation to its
logical limits. Lay, whose policy influence over President George W. Bush through
personal ties and financial contributions has been well documented in the nation's
press, is a Ph.D. economist who fervently believes in the genius of
markets. Vice President Dick Cheney's energy plan would provide his firm with
immediate access to the capacity-constrained national transmission grid. That
would give Lay's small army of M.B.A.'s and those at the other wholesalers
free rein to treat the entire nation the way they treated California: with
gaming, gouging, and--if a half dozen lawsuits, investigations, and a state
complaint before FERC pan out--illegal collusion.

Retail utilities in deregulated states, which still own local distribution
systems and any generating capacity they didn't sell to wholesalers, naturally
are worried by that prospect. As their temporary retail-price caps expire over
the next several years, these states will be subjected to the vagaries of the
free market. Consumer groups extracted those caps as the price for their local
utilities' being allowed to recoup the cost of their inefficient fossil-fuel and
nuclear plants--their "stranded costs," in the regulatory argot. Just three years
ago, those plants were thought to be uneconomic in a deregulated environment. But
it turns out that the new owners are running them and making more money than ever
before. How? By selling their electricity at deregulated, higher rates into the
same markets they've always served.

Meanwhile, the parent holding companies of local retail utilities used the
cash from selling those local power plants to buy generating capacity in other
regions of the country. (The 1935 Public Utilities Holding Company Act outlawed
these Insull-style schemes; but the Securities and Exchange Commission no longer
enforces the statute.) PG&E is a classic example of this phenomenon. Its
local retail subsidiary (Pacific Gas and Electric), caught between frozen retail
rates and a soaring wholesale market, declared bankruptcy on April 6. But the
parent company is raking in cash by selling electricity from plants it bought in
other parts of the country. It still owns 13 percent of California's electricity
supply.

The industry and Wall Street lobbyists who worked the corridors of state
capitals and FERC headquarters to design deregulation left it to state
regulators and regional power pools to make the new wholesale markets work. The
Wall Street connection isn't hyperbole. Goldman Sachs is a 41 percent owner of
Orion Power, which now controls 23 percent of the New York City power market.
According to RDI Consulting of Boulder, Colorado, Goldman Sachs now ranks as the
17th-largest electricity generator in the country.

But there is a slight technical glitch in the pure market approach.
Electricity obeys the laws of physics, not supply and demand. It cannot be stored
except in minuscule quantities. Supply must always meet demand or the whole
system will go dark. So deregulated markets have had to operate at mindboggling
levels of complexity that make the old regulatory approach seem like the very
soul of efficiency. Deregulation's market makers must rely on submarkets for the
next day's electricity, the next hour's electricity, reactive power (don't ask),
and so-called spinning reserves, which can be called upon at any moment.

A Market Worse than Bureaucracy

Under the 1996 FERC rules governing deregulation, the power pools
that had always existed for managing the unique physics and reliability of the
system morphed into Independent System Operators, which were charged with
managing all those markets. "Think of the ISO having the job of the New York
Stock Exchange specialist and an air-traffic controller rolled into one," says
William W. Hogan, an economist at Harvard University's John F. Kennedy School of
Government and a consultant for a number of ISOs.

These days, the technicians at the ISO markets that are still operating
(California's has been shut down) are like distracted tinkerers sitting on top of
an ever-expanding Rube Goldberg machine. To give one idea of the complexity of
the enterprise: PJM Interconnection, the ISO for Pennsylvania, New Jersey, and
Maryland, must calculate prices every five minutes for more than 2,000 locations
in the three states. There are volumes of rules governing these markets--and
plenty of niches for opportunistic young M.B.S.'s on suppliers' payrolls to game
the system by withholding supply or choreographing bidding.

The steadily receding goal of the tinkerers is to come up with a
workable market model that delivers electricity at the cheapest price while it
sends appropriate signals to consumers about conservation and to producers about
when and where to build new power plants. And they must do this while wholesalers
like Enron are seeking to extract the maximum possible price. Oh, and don't
forget--they must also keep the lights on.

Even the most forceful advocates of deregulation--or "restructuring," as they
prefer to call it, since it's clear to everyone involved that the density of
rules and regulations required to make these markets work surpasses the number of
rules needed in the bad old days of cost-of-service regulation--are beginning to
have their doubts about the wisdom of trying to meld markets and physics. "It's
very hard to demonstrate analytically that a more competitive market is better
than a well-run regulated market," says Harvard's Hogan.

Richard Cowart, the former head of the Vermont Public Service Board who is now
advising ISO/New England, warns that regulators will always be one step
behind the private-sector mathematicians with Ph.D.'s who are seeking to maximize
gain by gaming the system. "The only way to avoid that is by creating market
structures that yield competitive results," he says. "Can it be done? The jury is
still out."

What Were They Thinking?

Virtually everyone with a stake in the once staid world of electricity
generation--including most consumer and environmental groups--bought into the
idea that the magic of markets could help resolve some of the long-standing
problems of the industry. Under traditional regulation, ratepayers reimbursed
utilities for the cost of providing service, an amount that could be adjusted for
the fluctuating price of fuel. Profits were set at a guaranteed rate of return
based on utilities' capital investment. The results, though generally reliable in
terms of service, were economically and environmentally unacceptable. Utilities
made more money if they built gold-plated plants--and nuclear power was the
expensive option of choice. They ignored the technological revolution that was
making co-generation and gas-fired turbines a less-expensive alternative. The
locally based, vertically integrated utilities also had little incentive to
economize in their operations, and even less to encourage consumers to invest in
conservation, which is almost always the cheapest and most environmentally
friendly way of "increasing" power supplies. Selling less meant earning less, so
why bother?

The energy crisis of the 1970s, coupled with the collapse of the nuclear-power
construction industry in the wake of the 1979 partial meltdown at Three Mile
Island, spelled the beginning of the end of traditional utility regulation. In
1978, Congress passed the Public Utility Regulatory Policies Act, which opened
local utilities to more efficient sources of supply. Local grids had to accept
electricity produced by co-generators and independent generating plants--dubbed
"qualifying facilities" in the law--if they could supply power at less than the
local utility's costs.

Though little noticed at the time, the qualifying-facilities
clause spurred the creation of a new industry: wholesale generators who didn't
have to deal with retail customers. Environmentalists and consumer groups
generally supported this development. They viewed the substitution of
natural-gas-fired turbines for dirty coal plants and the widespread adoption of
co-generation by industrial facilities as valuable sources of cleaner, cheaper
electricity.

In 1992 this emerging wholesale-supplier industry won passage of the
Energy Policy Act. The new law exempted independent wholesale generators from the
utility-holding-company act, thereby allowing them to operate across state lines.
By also guaranteeing generators from outside a utility-service territory access
to the local grid, the law enabled wholesale trading and competition. Just as the
nation was digging itself out from a savings-and-loan fiasco--triggered by the
repeal of long-standing government banking regulations--Congress was laying the
groundwork for the next multibillion-dollar taxpayer bailout.

Back in 1992, government officials thought that the new law would introduce
some competition into the system--though not much, since wholesale generators
were only 10 percent of the market. "That assumption was wrong," Hogan notes.
"The camel's nose was in the tent, and soon the whole camel followed." According
to the Edison Electric Institute, the industry trade group, independent
generators now account for 27 percent of electricity sales nationwide, and in
states that have created wholesale markets, the ratio is well over half.

Concentrated Power

As one might expect from an industry as capital intensive as
electricity production, the new ownership remains highly concentrated. How many
entrepreneurs wake up in the morning with the bright idea of building or buying a
power plant? In California, 10 power generators control 63 percent of supply,
including now familiar names like PG&E (the parent corporation, not the
bankrupt retailer), Reliant, Southern, and Duke Energy. The group includes the
Los Angeles Department of Power and Water, the municipal utility that is also
under investigation by state officials for possible price gouging while selling
its excess electricity to the rest of the state.

In New York City, which must produce 80 percent of its own electricity because
of limited transmission capacity into the five boroughs, four companies control 74
percent of the market. Consolidated Edison, the local utility, and the publicly
owned New York Power Authority have been reduced to about a quarter of supply.
According to statistics compiled by RDIConsulting, similar concentrations can be
found in the wholesale markets operating in New England, New York State, and
Pennsylvania-New Jersey-Maryland. Nationwide, the top 20 suppliers now control
more than half of the U.S. market.

Companies like Duke Energy and Southern, whose home states refused to
experiment with deregulation, went on a nationwide buying spree. In virtually
every case, they paid more than book value for existing power plants. That
shocked local consumer representatives since those plants were thought to be
uneconomic in the coming era of retail competition. "They sold all their
fossil-fuel plants to the highest bidder at a price far higher than anyone
imagined they could get at the time," according to Martin Cohen, who heads
Illinois's Citizens Utility Board. "It should have been taken as a sign. The
people who were putting their money up knew what they expected rates to be."

Unfortunately, few of the industry's traditional watchdogs were giving much
thought to the wholesale end of the business in 1996, when FERC issued
far-reaching rules that went way beyond the letter of the 1992 law. The new rules
allowed states to dismantle the industry completely, dividing it into its
wholesale, transmission, and retail components. Wholesale and retail sale of
electricity would be subjected to wide-open competition, while the transmission
lines, including the local grids leading up to every meter, would be open to all
comers at the same, regulated rate.

States with the highest rates in the nation--California and those in the
Northeast--moved quickly to implement the new rules, and the bills had
widespread, bipartisan backing. Politicians promised the public that rates would
come down. Large-scale industrial and commercial customers were big supporters of
the schemes, thinking that they'd be able to bypass the local utility and cut
their own deals with wholesalers. Consumer groups fought for and won temporary
caps on retail rates in exchange for covering stranded costs. Environmentalists
in a few states won promises to maintain conservation programs.

For the most part, though, the deals were hammered out in back rooms with
wholesalers and local utilities calling the shots. Wholesalers got open access
and secret auction markets (in the name of keeping proprietary information away
from competitors). And local utilities got their stranded costs paid for--a plum
that all but eliminated the possibility of meaningful retail competition for
residential and small-business customers. Consumers could buy cheaper
electricity, but they were going to have to pay a steep toll for stranded costs
to get it to their doorstep.

The biggest loser in the short run was the environment. John
Bryson, chief executive of Edison International, the parent company of Southern
California Edison, won support for deregulation from the Natural Resources
Defense Council (which he co-founded) by pledging to maintain the utility's
historically liberal commitment to conservation programs. Yet shortly after
California's deregulation law passed, Bryson persuaded FERC to overturn the
conservation mandate. Why the change of heart? Out-of-state firms that had entered
the deregulated California retail market were cherry-picking its largest
customers. "Industrials have a single, simple bill compared to millions of home
owners who use a similar amount of power," says Dan Becker, director of the
Sierra Club's global-warming-and-energy program. "The utilities were stuck with
customers they didn't want and losing the easy-to-service industrials."

Bryson's actions were replicated across the nation. A recent survey by
the American Council for an Energy-Efficient Economy found that spending on energy
conservation peaked at $1.6 billion in 1994, just as FERC began discussing
how to implement the National Energy Policy Act of 1992. By 1998 it had fallen to
$800 million. Martin Kushler, who directs the American Council's utilities
program, points out that every dollar invested in conservation is twice as
effective in meeting electricity demand as building new power plants is.

It's worth tarrying briefly on that point. Vice President Dick Cheney lied when
he said conservation programs reflect personal virtue but offer no real relief to
the problem of short-term energy shortage (as his subsequent comments seemed to
recognize). On one hand, it takes at least two years to build a power plant, and
the factories building new gas generators are already booked years into the
future. On the other, Kushler estimates, a targeted conservation campaign
(retrofitting residential and commercial air-conditioning systems, installing new
commercial and industrial lighting, raising appliance standards, and so on) would
eliminate the need for 40 percent of the 1,300 new utility plants the
administration wants to see built over the next two decades. A crash program
based on available supplies could have an immediate impact, as California's
experience this summer proves.

Government's Necessary Role

However, the 15 years of experience in developing conservation programs
around the country has shown that it takes careful government regulation to bring
them to the fore. No matter how high the price of electricity goes, the market
can never send appropriate conservation signals, as the generators, the Bush
administration, and numerous newspaper editorialists seem to think it eventually
will. For example, a 600-unit apartment complex with 600 individual meters has
old, energy-wasting appliances and lighting systems. The landlord doesn't care
because he never sees his tenants' skyrocketing bills. And the tenants have no
interest in buying the landlord new appliances. But in the short run, these
tenants' willingness to respond to rising prices by reducing consumption--what
economists call their elasticity of demand--is close to zero. Know anyone who's
unplugged the refrigerator lately? And in the long run, no one has an incentive
to invest in conservation.

Carefully structured incentive programs can get around such problems, but they
almost always have to be run through local utilities, which alone have direct
access to consumers and their usage patterns. But in today's deregulated
environment, Kushler is not hopeful. "Utilities don't like efficiency programs,"
he says. "Their mind-set is sell, sell, sell, and that's why funding for these
programs has fallen so quickly and so much. They are only maintained because
regulators require them."

Of course, financial disaster tends to focus the mind, and the recent price
spikes have rejuvenated the energy-conservation movement, especially in
California, which will spend $850 million on efficiency programs in the coming
year.

Deregulation proponents have their own solution for promoting
conservation: real-time pricing. Utilities, they say, should retrofit homes and
businesses with meters that will allow them to pass along peak prices to the
consumers that cause them. For instance, using price to force consumers to set
their air conditioner thermostats at 78 degrees "is much more environmentally
sensible than building all those plants that run for only a few days a year,"
says Severin Borenstein, director of the University of California's Energy
Institute. The problem with that approach is that it forces the onus of
conservation onto the most price sensitive--that is, poorest--consumers while
robbing them of collective solutions like utility-run conservation programs that
would allow them to maintain their standard of living (such as a cool house in
summer).

In nearly every state where deregulation bills passed, the media took
the politicians' cues and focused the public's attention on the potential for
retail competition. Yet with the sole exception of Pennsylvania, retail
competition has turned out to be a nonevent. Paying for existing providers'
stranded costs made it almost impossible for new entrants to gain traction in the
market when wholesale prices were low, as they were two years ago. And now that
wholesale prices have risen sharply across the country, most alternative
retailers have abandoned the effort entirely. Even "green" marketers, who gained
some customers by pledging to wheel in cleaner power at a higher price, are
retreating from the field.

"Everybody thought the marginal costs of production in a competitive market
would be so much less than the regulated price," recalls Sonny Popowski, who
serves as Pennsylvania's official consumer advocate. Roughly half a million
Keystone State customers abandoned their default utility in favor of a new
entrant in 1999 and early 2000. But today? "We're seeing a decline in competition
because our wholesale prices are higher," Popowski says. In other words,
competition doesn't guarantee lower prices. It just means that utility customers
in deregulated states are now at the mercy of a wholesale market where price has
become unhinged from the cost of providing the service.

The Bush administration and the wholesale-generation industry it represents
would have the public believe that the new markets are sending a simple signal:
Supply is short and those rising prices are needed to generate more. The high
prices have clearly helped to instigate a building boom in the industry. About 23
gigawatts came on line last year, more than double the annual pace of the
previous decade. At that rate, as the libertarian and anti-subsidy Cato Institute
points out, the industry will reach the nation's projected power demand for 2020
four years early.

Yet New York and New England, areas where there's also talk of shortages
occurring this summer, already have the capacity to generate 14 percent more
electricity than they've ever consumed on a single day within their regions, and
that doesn't take into account imports from Hydro-Québec and other
long-term suppliers. New England has opened 11 new power plants since
deregulation began in 1996 and 15 more are under construction, according to a
spokeswoman for its ISO. "We expect to be a net exporter, to New York and
other places," she says.

Indeed, there's talk that the nation will be suffering from a capacity glut in
a few years. But such talk of a reversal of the past few seasons' price upheavals
ignores the lessons of the California crisis. It wasn't shortages that caused
spiraling prices and rolling blackouts: It was the exercise of the generation
industry's market clout in a dysfunctional marketplace. In an elegant paper
posted on the American Public Power Association's Web site (www.appanet.org),
Eugene Coyle resurrects the work of University of Chicago economist Lester G.
Telser, who in hundreds of pages of dense mathematics written in the 1970s and
1980s showed that collusion is inevitable in industries like electricity. Why?
Consumer demand for electricity is both inelastic (demand falls slowly when
prices rise quickly, and vice versa) and stochastic (highly variable depending on
the time of day, the day of the week, and the season). On the supply side,
generators, who have no way of differentiating their electrons from anybody
else's, have huge sunk-capital costs and very low marginal operating expenses for
each additional unit of electricity supplied to the market. In a truly
competitive market, suppliers faced with such circumstances would engage in
ruinous price competition that would reduce every supplier to bankruptcy.

To avoid that fate, they collude. "This is an industry that lends itself very
well to planning, and actually needs planning," says Coyle. "The only question
is, who is going to do the planning?"

Price caps and the rebate may be a temporary salve for a dysfunctional market.
But those battles ignore the more fundamental, long-run question: Should the
planning that is inevitable in the electricity industry come from unregulated
private corporations, who have every incentive to maximize revenue by holding
down capacity and withholding supply? (And perhaps, as has been alleged in court
cases that will play out over the next few years, collude behind closed doors to
deny supply to artificially drive up price.) Or should it come from regulators,
who can offer generators a reasonable return on investment while creating
incentives for conservation and demanding that new energy facilities are sited in
suitable locations? Both of the latter public goods get short shrift when private
operators do the planning.

As former Vermont regulator Cowart put it, "It's not necessary to reward
generators with extraordinary windfall gains in order to call forth reasonable
investments in generating capacity." Nor is it necessary to make consumers pay
through the nose before we have a society that uses energy efficiently.

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