Free Market Shock

August 28, 2001
By

California isn’t a unique failure. Electricity and deregulation just don’t mix

By Merrill Goozner
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 mind-boggling 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.A.’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 wide-spread 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 to 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 RDI Consulting, similar concentrations can be found in the whole-sale 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-Quebec 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.

MERRILL GOOZNER is a professor of journalism at New York University. He was recently named a Kaiser Family Foundation Media Fellow.From The American Prospect

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