Californian Power Trips

In 1994, a report by the California Public Utilities Commission (PUC) cited regulatory micromanagement and centralized planning for the soaring cost of power in California. Two years later, state legislators passed the 'deregulation' bill, which included the following provisions:

• California utilities, such as PG&E, SDG&E, and Southern California Edison, were directed to "vertically integrate" their operations. In other words, they were not allowed to both generate electricity and sell it to consumers. To limit the utilities' operations to retail sales, AB 1890 included a number of regulations and financial incentives that prompted the utilities to sell their generating facilities. By August of 2000, California utilities only generated 20 percent of the power they sold, as opposed to 72% in 1996.
• To compensate the California utilities for the loss of their generating capacity, the state agreed to help them recover $20 billion in stranded costs. "Recover stranded costs" is a euphemism for a ratepayer bailout of bad investments. To create a slush fund, the state sold bonds that were to be paid off by a 'competitive transition charge.' All newcomers to the retail market were required to levy this charge on their customers. Once surrendered to the state, the proceeds would be used to pay off the bonds. However, to qualify for the slush fund, the state's utilities were required to sell at least half of their fossil fuel-fired power plants.
• Consumer power rates were capped at roughly the 1995 level, and electricity retailers were forbidden to raise rates until 2002.
• Electricity retailers were required to purchase their juice in the newly created Power Exchange (PX), a centralized wholesale market. In the PX, power suppliers can only sell their power in the day-ahead and hour-ahead markets. This meant that retailers could only buy their power one day or one hour in advance. Advanced purchases of power and long-term contracts were prohibited. Furthermore, the bidding rules in the PX required retailers to pay the highest bid price on any given day.
• A new regulatory body, known as the Cal-ISO (Independent System Operator), assumed control of the state transmission grid. This agency dictates the prices and terms under which electricity generators can transport power across the grid.
• AB 1890 charged the ISO with the impossible task of estimating supply and demand. Based on these estimates, the ISO requires utilities to purchase a specified amount of power each day. If the utilities can not acquire enough power at the PX, the ISO purchases the difference and sends the bill to the utilities. However, even the ISO was prohibited from securing long-term contracts for power
.
• New regulations added further restrictions on the construction of generation plants and transmission systems. In addition, a regulatory authority dictates when power generators can schedule maintenance and upgrades of facilities.

Passed unanimously, AB 1890 offered goodies for all of the parties involved. The California utilities were pleased because they got a bailout of their "stranded costs" and a raft of measures that would preclude competition. The environmentalists were placated because the bill virtually assured that new production facilities would not be constructed for several years. And the politicians were happy because the bill introduced new bureaucratic controls and agencies, while also giving the state control of the power grid.

In total, AB 1890 included 67 pages of regulations and controls. If this package is 'deregulation,' then I'm Madonna. I'm not sure what dictionary politicians refer to, but according to my dictionary (The American Heritage® Dictionary, Fourth Edition), a regulation is "a principle, rule, or law designed to control or govern conduct." Therefore, deregulation would be the absence of regulations. While it may be asking too much for the critics of capitalism to reach for a dictionary, they're only off by a letter. AB 1890 wasn't de-regulation, but rather re-regulation.





NO SUCH THING AS A FREE LUNCH





Prices are important not because money is considered paramount but because prices are a fast and effective conveyor of information through a vast society in which fragmented knowledge must be coordinated. - Thomas Sowell

Of all the byzantine measures in the 'deregulation' bill, price controls were the most onerous. Prices play an indispensable role in conveying information throughout an economy. In a free market, prices reflect current conditions with respect to supply and demand. Freely fluctuating prices provide people with the information they need to adapt to changing conditions. When price signals are distorted by controls, the inevitable result is an inefficient allocation of resources. At least since ancient Rome through the 20th century, people have suffered the often-devastating consequences of price controls.

Most fundamentally, prices reflect the supply of goods and the demands of consumers. When the supply of a commodity is low, or when the demand for the commodity is high, sellers raise the price to increase profits. The higher price informs the market of the relative scarcity of the good. Such an increase in price has three primary effects. First, the higher price provides an incentive for consumers to economize on their consumption of the good. By curbing consumption, high prices prevent the exhaustion of current supplies. Secondly, existing producers have the incentive to increase production. Third, the lure of profits attracts additional investment from less lucrative ventures. As the supply of the commodity increases to meet demand, the shortage passes and prices fall

In this way, a free market is self-adjusting. Only with a freely operating price system do producers and consumers have the incentive to adjust their behavior in the event of a shortage. By imposing price controls on retail power, California legislators prevented market participants from making informed economic decisions, thereby short-circuiting the price system in the California energy market.

In the past few years, the state's demand for electricity has skyrocketed. According to the California Energy Commission, the demand for electricity grew by 12 percent from 1996 to 1999. Partially in response to this rising demand, wholesale prices have risen dramatically in the past two years. However, price controls prevented power retailers from passing their increasing costs onto consumers. As a result, the retailers piled up enormous debt, and consumers had no incentive to curb their consumption. Since the retailers were forced to sell their product at a price that would not cover their costs, bankruptcy was inevitable. This spring, PG&E was the first to go, and others are on the verge.

Remarkably, even Governor Davis acknowledged the central role of price controls in crippling California's economy. In a moment of uncharacteristic candor, he said, "(b)elieve me, if I wanted to raise rates, I could have solved this problem in 20 minutes." Of course, this admission did nothing to slow Davis' campaign to demonize the free market and energy wholesalers. Although price controls are a prescription for economic disaster, they offer irresistible leverage for political power seekers. By maintaining price controls, Davis could posture as offering 'cheap power' to voters. This act is always a hit with voters who want something for nothing, and pundits who believe that prosperity flows from the stroke of a legislative pen.





FREE TRADE (BY THE RULES)





When buying and selling are controlled by legislation, the first things to be bought and sold are legislators. - P.J. O'Rourke

In a truly deregulated market, buyers and sellers are free to negotiate mutually acceptable terms for trade. No one has the right to force others to accept disagreeable terms. If a buyer objects to the offer of a seller, they are free to seek a more amenable arrangement elsewhere. The right to contract is fundamental to economic freedom.

With California-style 'deregulation,' the state dictates the terms under which wholesalers and retailers trade. In the PX, retailers were required to purchase power with the most expensive bid price that met the daily requirement stipulated by the ISO. Suppliers and retailers were explicitly forbidden from entering into contracts.

At the time of the bill's passage, California utilities favored exclusive reliance on the PX because they expected short-term prices to continue their downward trend. However, energy prices are notoriously volatile. Due to this volatility, market participants in all other states meet their needs with a mixture of long-term and short-term contracts. Contracts enable buyers to insulate themselves from short-term price spikes, while producers are protected from short-term depressions. In all other states, only small volumes are traded on the short-term market.

Before the crisis erupted, both suppliers and retailers petitioned the state for the right to contract. Repeatedly, the state denied such requests. Last summer, a variety of factors led to a dramatic rise in the price of wholesale power. Since the state had forbidden long-term contracts, the retailers had no protection against rising costs. Instead, by requiring all power to be purchased in the PX, AB 1890 accelerated the retailers' dive to insolvency.





CAUSE AND EFFECT





... economic history is a long record of government policies that failed because they were designed with a bold disregard for the laws of economics. - Ludwig von Mises

Although the 'deregulation' bill has proven financially disastrous for California retailers, these utilities supported the bill at the time of its passage. In addition to providing the bailout of stranded costs, the bill ensured that the California utilities would retain their state-sponsored monopolies for the next few years. Price controls, contract prohibitions, and the competitive transition charge eliminated the lure of profits for new retail ventures. Obviously, a company would be foolish to expand operations in a market where their income would not cover their costs. Therefore, few companies made the effort. Today, five years after 'deregulation,' only 1% of the state's retail customers are served by competing vendors.

On the supply side, California's oppressive regulatory environment, the most expensive in the country, strongly discouraged the construction of new generation facilities. For the past 20 years, the environmental movement has exercised considerable political clout in California. As a result, state law tightly restricts exploration for new sources of power, the development of existing resources, and the construction of new power plants. For instance, over the past decade, state law has only permitted the construction of facilities based on natural gas. Relative to other energy sources, such as hydroelectric or coal, natural gas is quite expensive.

For the construction of new facilities, the state requires as many as 17 different environmental assessments, such as cultural resource and wildlife impact studies. These requirements increase the cost of a single project by as much as $30 million. In contrast, the cost of environmental assessments in Texas averages about $1 million. On average, state approval for projects takes over three years, while some other states process applications in a few months. Ironically, the current system in California actually impedes the improvement of air quality. Since the regulations render the construction of new, more efficient plants unprofitable, older and less environmentally-friendly facilities continue to run.

Due to the stifling regulatory environment in California, the state's energy market remains uncompetitive and stagnant. In the words of Steven Kean of Enron, "California (built) an 'electric fence' around its borders, and (told) private capital - which is desperately needed - to go elsewhere." Consequently, over the past ten years, no new power plants have been completed in California.





HANG THE PRODUCERS





The desire of businessmen for profits is what drives prices down unless forcibly prevented from engaging in price competition, usually by governmental activity. - Thomas Sowell

Despite all of the evidence to the contrary, politicians and their sycophants have orchestrated a campaign to shift the blame for the crisis to out-of-state power suppliers. In the past year, accusations of price gouging have featured prominently in press conferences and editorial columns. In that time, a series of federal and state investigations have been launched to pursue the charges.

Leading the campaign, Governor Davis railed that "(w)hat's going on here, pure and simple, is unconscionable price-gouging by the big energy producers." Davis asserted that "(a) higher-than-usual number of power plants under repair this year shows companies are manipulating the power market to drive up prices." To justify a PUC investigation of "artificial shortages," President Loretta Lynch said that " (t)here are instances where plants could have produced, and they chose not to (emphasis mine).''

Dutifully repeating the mantra, "newspapers" such as the New York Times, LA Times, and San Francisco Chronicle have pointed to record profits as "evidence of price gouging. (footnote) Typically, the theory runs that suppliers withhold electricity from the day-ahead market so they can sell it at a higher price in the hour-ahead market. By doing so, the suppliers 'extort' outrageous prices from resellers desperate to meet customer demand.

When the accusations first arose in the fall of 2000, 25% of California's power capacity was offline. As anyone familiar with energy production knows, generating facilities require routine maintenance on a regular basis. However, due to the exceedingly high demand in the summer of 2000, the indicted companies had pushed their generators at full capacity. This sustained effort allowed little or no downtime for necessary repairs and upkeep. Consequently, an unusually high number of facilities underwent extensive repairs and maintenance in the fall when the weather finally cooled and demand subsided.

This spring, the California Energy Institute at the University of California/Berkeley released a report that concluded that suppliers cannot make higher profits by with-holding power from the day-ahead market. Additionally, the researchers observed that prices in the day-ahead market are about the same as the hour-ahead market. In February, the Federal Energy Regulatory Commission (FERC) completed an investigation of its own. FERC's report determined that the outages were the result of legitimate causes, and not a plot to raise prices. In addition, the investigation revealed that suppliers had actually accelerated maintenance and incurred additional expenses to return the plants to service. Of course, rather than receiving gratitude for their efforts, these companies continue to be targets for politically motivated attacks and investigations.

Regardless of the outcome of ongoing investigations, they have served their purpose. A common political tactic, the investigations have successfully shifted the media spotlight from the political class to the private sector. With most critical analysis focused on the producers, the media has largely failed to hold legislators accountable for their actions.

Sound bite coverage glosses over the state's role in the crisis, and obvious questions are left unasked. For instance, assume for a moment that the 'price gouging' charges are true. If so, why did the suppliers wait until last summer to do it? And why are they only gouging prices in California? Why aren't they equal opportunity gougers? Comically, Senator Burton actually accused the suppliers of targeting his state "because we're California." Rather than characterizing sound business practices, the theory of selective profiteering reflects the business sense of ... well ... California politicians.

Furthermore, if a company only has to raise prices in order to make "obscene profits," why don't all producers do it? And, ultimately, who exactly is to blame, anyway? The power companies for playing by the rules established by the California legislature, or the nitwits who created such a convoluted market in the first place? Why should Californians continue to trust the judgment of professional politicians in matters of economics and energy production? Such questions rarely seem to occur to people eager to condemn producers.

While the price gouging mantra plays well with a public instinctively hostile to private enterprise, there are a number of legitimate reasons for the substantial increases in rates and profits.

First, if a venture is profitable, income will naturally grow when producers increase their output and sell more of their product. In recent years, companies supplying power to California have dramatically expanded their output. For instance, in 2000, Reliant doubled the output of its California plants, while Duke Power increased production by 50%.

Second, the burgeoning demand in California has compelled suppliers to use inefficient generators. Under normal conditions, a supplier will first use the most efficient generators at their disposal. When cost-effective generators are unable to meet the state's demand, less efficient, high-cost generators are employed. These costs are reflected in higher wholesale energy prices.

Third, the price of natural gas has almost doubled since 1999. Since the state of California obstructs the construction of plants powered by hydroelectricity, nuclear reactors, oil, and coal, in-state facilities are forced to rely on natural gas.

Fourth, increasing prices were stimulated by a concern for the credit-worthiness of California retailers. By January of this year, retailers owed roughly $12 billion to suppliers. In February, analysts downgraded their bonds to junk status. As the retailers teetered toward bankruptcy, the suppliers have grown increasingly wary of conducting business in the state. Therefore, suppliers added credit risk premiums to the price of power sold to California retailers. Without these premiums, they had greater incentive to sell their power to more credit-worthy customers in other states.

In explaining high wholesale prices in the PX, a Duke Power official commented that, "(t)he few sales made at the highest price reflected the fact that the parties receiving the power were insolvent and would likely declare bankruptcy. In determining the price to charge, we took into account the likelihood that we would only be able to collect a fraction of the sales price if PG&E filed for bankruptcy protection." Indeed, when PG&E filed for bankruptcy in April, the concerns of the suppliers were validated.

Finally, and most importantly, the power generated by suppliers is the result of their investment, initiative, and ingenuity. As such, they have every right to whatever price they may secure through voluntary exchange. Despite Davis' proclamations that California has lost control of 'its' power, the state of California did not create it and does not own it.

The suppliers also have an obligation to employees and investors to maximize profits. While other sectors in the economy enjoyed healthy returns during the go-go 1990s, utilities often lost money. Since the supply of power was abundant relative to demand, energy prices fell dramatically during this period. If utilities in competitive markets attempted to raise rates, buyers sought less expensive alternatives to meet their needs.

Now that demand outstrips supply, utility companies can make up lost profits by raising rates. Due to California's exclusive reliance on the PX, the state presented itself as a lucrative market for wholesalers. If management passes on an opportunity to maximize returns for a company's efforts, they default on their obligation to employees and investors. When industrious employees are not rewarded for hard work, they will look for opportunities elsewhere. And when investors realize that management is feckless, they will transfer their capital to more responsible enterprises and industries.





GOLF WITH THE GOVERNOR





People constantly speak of 'the government' doing this or that, as they might speak of God doing it. But the government is really nothing but a group of men, and usually they are very inferior men. They may have some better man working for them, but they themselves are seldom worthy of any respect. - H.L. Mencken

Several months ago, Gov. Davis commented that he was dealing with the crisis just as he plays golf, "one hole at a time" (!?). Interestingly, this was a tacit admission of the actual game he's been playing. Throughout the crisis, his actions have been consistent in three significant respects. First, he has adamantly opposed the lifting of retail price controls. Since he had previously acknowledged the central role of price controls in the crisis, his resistance indicated that his foremost concern was not a quick resolution to California's problems. This spring, when the California legislature twice voted to relax the controls, he remained opposed.

Second, Davis spearheaded the campaign to demonize suppliers and 'deregulation.' With the aid of the press, he successfully positioned the producers as Suspect #1. Most California voters now blame the producers for the crisis, and many clamor for an end to 'deregulation.' In addition to ongoing federal and state investigations, Davis allocated another $4 million in a desperate attempt to uncover any evidence of misdealings by suppliers. Yet, for more than a year, he refused to even meet with industry executives. When he finally did meet with them this spring, he used the event as a publicity stunt to air denunciations and threats.

Third, Davis has steadily chipped his way into a position to expand state control over energy facilities. When he first considered a bailout of the state's retailers, he wanted the utilities to surrender their hydropower dams in return. He subsequently abandoned this idea in favor of acquiring stock options for the utilities. However, since the California constitution prohibits the state from holding stock options, he then sought to buy the utilities' transmission lines. All of these proposals aimed to transfer control of energy resources to the state, while sticking taxpayers with the bill.

On May 17th, Davis pulled out the driver. He codified his intentions by signing a bill giving the state the authority to seize power plants. The bill also created the California Consumer Power and Conservation Financing Authority. Unlike private companies, this agency was vested with the authority to build power plants and enter into long-term contracts. Following the signing of the bill, Davis said that "(i)n a deregulated world, the only way you can guarantee reliable, affordable power is to build it yourself if private companies won't do it." He went on to say, "[I]f I have to use the power of eminent domain to prevent generators from driving consumers into the dark and utilities into bankruptcy - then that's what I will do."

By fostering such a hostile environment, Davis has all but assured that private capital will not come to California's rescue. Facing the likelihood of politically motivated investigations and the possibility that their assets may be seized, out-of-state utilities would be insane to invest in Davis' banana republic. As Duke Power chairman Rick Priory said, "It's no different than if it was Ecuador or Peru, and we had investments to make in those places ... investment in California involves some of the same questions you might have in the Third World."





CONCLUSIONS





The root of production is man's mind; the mind is an attribute of the individual and it does not work under orders, controls and compulsion, as centuries of stagnation have demonstrated. Progress cannot be planned by government, and it cannot be restricted or retarded; it can only be stopped, as every statist government has demonstrated. - Ayn Rand

At this stage, it's impossible to predict how far Governor Davis will get with his drive to seize energy facilities. By the time you read this, California will be in the midst of another long, dark summer. In late June, the US Energy Department estimated that California faces 113 hours of rolling blackouts in coming weeks. As the blackouts continue, the howls from the 'anti-deregulation' crowd will grow deafening. If things get bad enough, the governor will assuredly have the necessary public support for nationalization. The only question is whether federal and state law will protect the property of the utilities.

The governor's demagoguery throughout this circus has been nothing less than despicable. From day one, he has stubbornly refused to address the root causes of the crisis, while loudly wailing his concern for the plight of the 'people.' Most of his statist proposals would only add substantially to Californians' tax burden, while doing nothing to increase supply or reduce demand. His other proposals, such as federal bailou ts and price caps, would only transfer California's costs to the rest of the nation.

While the California legislature has grudgingly raised retail rates, Davis has failed to propose or support any measures that would repeal regulations and controls. Instead, after seeing to it that the hands of retailers and suppliers remained firmly tied, he damned producers for the state-induced crisis. With California's retailers in default, Davis angrily demands that producers continue to provide for California's needs. The governor makes these demands while at the same time pressing the federal government to force suppliers to return over $6 billion in 'overcharges.' With payment unlikely, the suppliers are expected to produce with further defamation and punishment as their only reward. Combined with the governor's assumption that the suppliers' product belongs to California, Davis' actions betray his view of producers as mere chattels of the state.

Perhaps worst of all, Davis and his statist sympathizers have purposefully obliterated the meaning of economic freedom. In modern California vernacular, 'free trade' means bureaucratic control, 'competition' is protectionism, and 'deregulation' entails state mandates and requirements. At best, this Orwellian language is an egregious example of economic and philosophical ignorance. At worst, it's a conscious attempt to con the public into surrendering their economic freedom

If Governor Davis were genuinely concerned with providing Californians with an abundant and inexpensive supply of energy, he would get the state out of the way of those who create it. Then, he'd get a real job producing it.

FOOTNOTE: The San Francisco Chronicle reported that its editorial board had held a 'meeting' with Senator Diane Feinstein regarding the charges. Feinstein is one of the most vocal critics of the power suppliers and 'deregulation.' She was also a prime mover in lobbying the Bush administration for federal price caps on wholesale energy prices. I leave it to the reader to surmise the purpose of such a meeting.

REFERENCES

• "Bill Number: AB 1890," California Assembly, 1996.
• "State Meddling, Not Deregulation, Behind Electricity Crunch," George Passatino, Reason Public Policy Institute, 2001.
• "Lights Out: California's Electricity Debacle," Lance T. Izumi, Pacific Policy Institute, 2001.
• "California's Troubles not Caused by Deregulation," Jerry Taylor and Peter van Doren, Cato Institute, 2001.
• "High Voltage Swindle: Why Electricity Restructuring will Electrocute Ratepayers," Jerry Taylor, Cato Institute, 1997.
• "Greens vs. Energy," Dr. George Reisman, The Jefferson School, 2001.
• "California Screaming, under Government Blows," Dr. George Reisman, The Jefferson School, 2000.
• "California Dreaming," Dr. Thomas Sowell, Hoover Institution, 2001.
• "Rolling Blackouts," Dr. Thomas Sowell, Hoover Institution, 2001.

---

If you enjoyed this, why not subscribe?