Reason Foundation

Reason Foundation

Powering Up California

Policy Alternatives for the California Energy Crisis

Adrian Moore and Lynne Kiesling
February 1, 2001

Executive Summary

Many view California’s electricity crisis as proof that electricity deregulation and indeed deregulation in general does not work. This is wrong. California did not deregulate its electricity market, but rather “restructured” it, requiring far more state intervention in electricity transactions than existed before. In doing so, the law created a micromanaged pseudo-market where suppliers of electricity have the ability and incentive to manipulate prices to their advantage, and utilities are forbidden to shop for better prices.

Now, with the centrally-planned and managed market that restructuring’s architects created falling down like a house of cards, state leaders labor under the anxious eyes of state residents, and the curious eyes of the nation. They must contend with burning short-term issues as the state’s utilities approach bankruptcy and the state grid flirts with blackouts. They also must develop a long-run vision and goals for the state’s electricity market and formulate policies to get us there. We argue that the vision ought to be a competitive electricity market and the goals ought to be addressing immediate crises and long-term structural changes to move electricity generation in the state toward competition.

Unfortunately, state leaders are working in an environment of widespread misunderstanding, such as many mistaking the state’s restructuring for deregulation. Clear and effective policies, and public support for them, depend on an accurate analysis of the issues at hand and alternatives available. To that end, this study examines California’s electricity crisis from three directions, analyzing:

  1. The most important aspects of what went wrong with the restructuring;
  2. How deregulation of electricity has worked in other states, and even other nations; and
  3. Gov. Gray Davis’ action plan, point by point.

All three approaches shed distinct light on the policy options available to state leaders and what their likely outcomes might be, and all three lead us to make similar recommendations. Specifically, we recommend that state leaders:

  1. Articulate a Vision of Moving toward Competition That Will Alleviate Concern of Regulatory Intervention. Too many state leaders are offering isolated policy ideas, would-be silver bullets, and conflicting proposals that fail to tell the market what direction policy is moving and what endstate is sought. Inflammatory, populist rhetoric by state leaders replete with threats of police action and takings only exacerbates uncertainty about California’s electricity market. A clear and well-articulated endstate and set of goals will help policy makers formulate coherent and coordinated policy proposals and reassure the public and the market.
  2. Change the Law to Make the Power Exchange (PX) Voluntary. A spot market is a necessary component of the overall electricity market. But centralized mandatory pools bring to the market perverse incentives and rigidities that create distortions and an inability to adapt to changing market conditions. As a voluntary spot market, the PX can become an independent competitive exchange and develop bidding rules that attract both buyers and sellers.
  3. Help Alleviate the Barriers to Long-term Power Contracts. State leaders have acknowledged that the utilities need to add forward contracts to their portfolios to hedge against wholesale power price fluctuations but have not developed adequate policies to help make forward contracts happen.

    The governor’s 14 January proposal to have the state enter into forward power purchase contracts is not wise. The state would be taking on futures risks with no experience or skills in evaluating those risks, and putting taxpayers at risk for its mistakes. One unavoidable lesson of California’s electricity restructuring is that policy makers are ill-equipped to accurately predict how markets will evolve.

    State leaders could achieve similar results by offering state guarantees to back utilities’ initial forward contracts. This would alleviate the credit risk that is driving up forward prices offered to utilities, but dilute the taxpayer’s risk and let the utilities negotiate the contracts with their experience, expertise, and incentive to prognosticate correctly.

    State leaders should immediately convene a summit of leaders from state agencies and cities that generate electricity for resale to explore opportunities for cost-based forward contracts with the utilities. Government agencies control about one-quarter of the state’s power generation and resell about 40 million mega watt hours (MWh) each year. Though their loads are very seasonal, if even 10 to 20 percent of that load could be forwarded to the utilities at cost, it would help push forward prices down and lever additional contracts.

  4. Create a Plan for Phasing Out Price Caps. A market cannot work without market prices—consumers don’t know when to reduce consumption, and suppliers don’t know when to increase production. In the short run, price caps only guarantee that utilities will continue to bleed red ink, suppliers will look for other markets in which to sell, and consumers will have no incentive to conserve electricity.

    Gradually, but predictably, raise the price caps. Convene a working group to create an initial schedule and revise the schedule periodically as market conditions change.

    Tie rate cap increases to milestones in accomplishing other policy changes that increase competition and customer choice in the market and reduce utilities’ market power. If other policy changes are successful in allowing market entry and new competitive choices for consumers as well as increased electricity supply, the timetable to remove price caps can be moved up.

    Meanwhile, implement a system to guard against exercise of market power in utilities’ customer charges. Until consumers have options in the face of high prices or bad service from utilities, regulatory oversight is necessary.

    Encourage utilities to implement real-time pricing and metering so that consumers can adjust their use of electricity as prices change. Implementing real-time pricing and metering can also justify accelerating the schedule for removing price caps.

  5. Accelerate Completion of New Power Plants with a Constructive Approach to Licensing and Enforcing Environmental Rules. Restructuring spurred a level of investment in new power plants not seen in decades in California, but the permitting and construction process takes years longer than in other Western states. The problem is not as much the standards as how they are enforced. State regulators do not care if power plants get built, only that the standards are followed. State leaders must get state regulators on board with a new, constructive approach that works with developers to get power plants built without violating the standards.
  6. Integrate Municipal Utilities into the Market as the Market Becomes Competitive. California’s electricity market will not be truly competitive if customers in many of its largest cities are not allowed to choose their electricity provider. As restructuring moves forward, municipal utilities should be integrated into the competitive market. Over the long run, state leaders should challenge the federal government to end the inequities and wealth transfers that federal subsidies for municipal utilities and preference distribution of federal hydropower inflict on California residents.
  7. Do Not Dictate Utility Industry Structure. Requiring the utilities to sell their power plants turned out to be a mistake when market conditions changed in ways policy makers did not predict. Forbidding utilities to sell power plants repeats the same error. Policy makers do not know the future of the electricity market and should not lock the utilities into any arbitrary structure based on the exigencies of the moment. Ensuring that utilities do not favor their own generation plants is better served by developing good rules to govern how customer choices are reflected in grid loads, by encouraging distributed generation, and ultimately competitive electricity distribution systems.

Adrian Moore is Vice President, Policy

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