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The Myth of Energy Deregulation

Mises Daily: Monday, November 07, 2005 by

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While the initiatives on the upcoming November 8 California special election ballot backed by Governor Arnold Schwarzenegger have been receiving all of the media attention, another initiative that addresses an important issue is being overlooked. Proposition 80, the so-called "Repeal of Electricity Deregulation and Blackout Prevention" initiative, would make some significant — and detrimental — changes in the state's energy policy.

The fact that even a government regulatory body such as the California Public Utilities Commission (PUC) is actually against a measure that would increase its regulatory powers should tell you something right off the bat about the merits of Prop. 80.

California energy consumers are currently served by one of three types of providers: investor-owned utilities (IOUs), local publicly-owned electric utilities, and independent electric service providers (ESPs). Before the state's "deregulation" experiment of the 1990s was suspended in 2001 during California's energy crisis, customers could choose to purchase their electricity services directly from ESPs through "direct access" contracts, rather than through an intermediary such as the local IOU or public utility.

Proposition 80 Would Reduce Consumer Choice and Increase Costs

Proposition 80 would permanently prevent all customers receiving electricity services from an IOU from switching to an ESP, effectively eliminating any new direct access (existing direct access contracts would be grandfathered in).[1] Thus, under Prop. 80, instead of having the option to buy electricity directly from independent producers, consumers would have no choice but to buy their electricity from utilities. By effectively eliminating an entire class of providers, the state has stifled competition (and would continue to do so), thereby leading to higher prices and, likely, lower-quality service.

The effect of this provision on prices would be significant. ESP customers include hospitals, local governments, the California State University system, several University of California campuses, community college districts, and local school districts. The nonpartisan Legislative Analyst's Office (LAO) estimates that the UC system alone saves about $12 million per year by purchasing its electricity from a lower-cost independent provider.

According to Mike Florio, an attorney for The Utility Reform Network (TURN, one of the chief proponents of Prop. 80 that helped craft the measure), the ability of consumers to purchase electricity directly from independent service providers "destabilizes the whole business … and we'll truly be at the mercy of the gods of the free market."[2] How dare people be able to choose whom they want to do business with! I suppose TURN hired Mr. Florio not for his legal expertise, but rather by the sheer providence of the "free-market gods."

Proposition 80 Would Impede Innovation and Efficiency

Another provision of Prop. 80 would prohibit the broader implementation of "dynamic pricing" of electricity without the consent of the consumer. Currently, all but the largest energy consumers pay a flat rate for electricity that does not vary by the time of day. Clearly, energy use is not constant throughout the day, however. There are certain "peak" hours of the day when consumers use lots of electricity, and "non-peak" hours when they use very little. The costs of providing electricity vary accordingly. As such, the IOUs have submitted proposals to the PUC to charge all consumers higher rates during peak hours and lower rates during non-peak hours. This price discrimination would be accomplished through the use of high-tech "smart" meters.

In addition to making good sense — one should pay more for something when it is in higher demand — dynamic pricing would encourage conservation via the pricing mechanism. Dynamic pricing would be a more efficient system because higher prices would discourage some from consuming such a scarce resource while ensuring that those who place the highest value on energy use are still able to consume it. Similarly, those who have some flexibility over when they consume their energy would be encouraged to utilize it during non-peak hours, thus placing less strain on the system.

Allowing the consumer to opt out of a dynamic pricing model would be like forcing a hotel owner to offer customers the choice of the nightly room rate or an average of the nightly room rates throughout the week. Since significantly more people stay at hotels during the weekend, rates are much higher on Friday and Saturday nights. The average weekly rate, however, would be higher than normal weekday rates but lower than normal weekend rates. The cheaper "opt-out" weekend rates and higher weekday rates would encourage even more people to stay during the weekend and fewer to stay during the week. The result would be a shortage of hotel rooms during the weekend and a loss of revenue for the hotel owner. No wonder demand strains the electrical grids during hot summer days.

Environmental Issues

Under current regulations, energy producers must increase the portion of energy derived from renewable energy sources — such as solar, wind, and hydroelectric — by one percent per year until 2017, when 20 percent of the energy produced must come from these sources. Proposition 80 would accelerate this deadline to 2010. Interestingly, some environmentalists oppose Prop. 80 because a provision requiring a two-thirds vote of the Legislature to amend the measure could make it more difficult to increase the renewable energy standard in the future.

According to the LAO's analysis, Prop. 80 would also require that "the first priority for IOUs in procuring new electricity is to be from 'cost-effective' energy efficiency and conservation programs, followed by 'cost-effective' renewable resources, and then from traditional sources such as fossil fuel burning power plants."[3] Of course, if renewable energy sources and energy efficiency and conservation programs were truly "cost effective," producers would already be utilizing them in higher numbers because it would make them more profitable. This clearly is not the case. Forcing companies to invest significant amounts of their scarce resources on more costly energy-production methods, which make up a relatively small share of total energy production (for good reason), will only ensure that costs — and, ultimately, consumers' electricity bills — remain higher than necessary.

As new technologies and energy-production methods are developed, this may change, but for now, it is best for both producers and consumers to focus on the most efficient means of producing energy. Of course, if consumers demand "cleaner" energy, in a truly free market, producers will have an incentive to provide it. Indeed, after Pennsylvania successfully implemented its electricity deregulation effort in 1999 (without the pitfalls experienced by California), 20 percent of consumers chose to switch to suppliers of "green power," despite the fact that they had to pay a small premium to do so. Proposition 80 eliminates this choice, instead demanding that all consumers support the higher cost of investing more in renewable energy — whether they want to or not.

Misconceptions Over Electricity "Deregulation" in California

Some blame deregulation for the rolling blackouts, soaring spot market prices, and utility bankruptcies that sprang from the energy crisis of 2000 and 2001. But this anger is misplaced. California has never experienced true deregulation. The "deregulation" implemented in 1996 left price controls in place and created "artificial" markets ripe for manipulation and disparities between supply and demand.

By setting price caps below market prices, California limited the profitability of the industry. When wholesale energy costs increased, the price caps prevented energy producers from passing them on to consumers. Wholesale prices rose dramatically for a number of reasons: natural gas prices rose, hot weather in the Southwest increased demand, a relative lack of water in the Northwest minimized the production of hydroelectric energy, and pollution-control permits, which allow industrial companies that produce less pollution than allowed by regulations to sell the difference as "credits" to higher-pollution-producing companies, rose ten-fold, from $4 to $40.

The price caps additionally discouraged potential producers from entering the market and increasing competition, and they discouraged existing producers from investing profits in adding capacity, of which Californians were (and continue to be) in dire need. As a result of the price caps and pressure from politicians and environmentalists, the building of plants and transmission lines slowed dramatically and energy producers were not able to keep up with demand, particularly in the Silicon Valley, where the booming computer and "dot-com" industries led to even sharper increases in electricity demand.

After the big three investor-owned utilities — Pacific Gas & Electric, Southern California Edison, and SEMPRA (San Diego Gas & Electric) — were forced to sell many of their fossil-fuel-burning generators to private firms, regulators prohibited them from entering into long-term contracts with these firms, forcing them to rely upon the much more volatile short-term and spot markets. In addition, California forced generators and utilities to trade power through the Power Exchange, a state-run pool.

While that requirement was designed to give every company the same wholesale price for power, it also guaranteed that they would be unable to negotiate lower-priced power on their own. The California rules essentially barred utilities from buying power on the futures market, meaning they were unable to lock in supplies and prices.[4]

This is as if Wal-Mart and Marshall Field's were forced to acquire their goods from a non-profit, state-run pool that would guarantee that they would acquire the goods for the same price. Wal-Mart never would have been able to develop its efficient and innovative purchasing and distribution system, meaning it could not generate savings to pass on to customers in the form of lower prices.

At the time of the increase in wholesale prices, PG&E and Edison were still in the deregulation "transition" period, and thus still subject to PUC rate regulations. As a result, PG&E went bankrupt and Edison teetered on the edge of insolvency. To add insult to injury, when the government stepped in to purchase electricity on behalf of the struggling IOUs to try to quell the crisis, not only did it do so at the height of the emergency, when energy prices were highest, it locked in these prices with long-term contracts costing billions of dollars.

The Natural Monopoly Justification for Regulation

The main argument against the full privatization of public utilities such as electricity and water service is that such industries are "natural monopolies." That is, they require such high fixed costs (it is easier to start a new restaurant than to invest in the infrastructure for a new electric grid) that it is inefficient for there to exist more than one producer in a particular location. This, it is feared, will lead the producer to engage in price gouging.

There are several problems with this rationale, not the least of which is the notion that "public utilities" somehow constitute a unique set of goods that must be "protected" by government intervention. As economist Murray Rothbard noted in Power and Market:

The very term "public utility" … is an absurd one. Every good is useful "to the public," and almost every good … may be considered "necessary." Any designation of a few industries as "public utilities" is completely arbitrary and unjustified.[5]

High capital costs certainly will limit the number of actual and potential providers, but there is still a profit motive in a free market that creates opportunities for lower-cost producers. In addition, it is important to note that markets are not static; technological innovations may allow for additional competition in the future.

Another misconception opponents of free markets have concerns the very understanding of the nature of competition. Even if there is only one producer of a certain good or service in town, this does not mean that the producer is "gouging" customers through monopolistic practices. Indeed, just because he is the sole supplier today does not mean he will be the sole supplier tomorrow. As economist Thomas J. DiLorenzo explains:

If competition is viewed as a dynamic, rivalrous process of entrepreneurship, then the fact that a single producer happens to have the lowest costs at any one point in time is of little or no consequence. The enduring forces of competition — including potential competition — will render free-market monopoly an impossibility.[6]

In other words, even if there happens to be only one current provider of a particular good or service, in a free market that provider is held in check by the mere threat of competition — if he charges prices that are too high or provides poor service, there will be an incentive for a competitor to come in and take market share from him by offering lower prices or better service.

The rules change, however, when government regulation erects barriers to entry or otherwise suppresses competition. In addition to the many government regulations purportedly enacted in the "public interest," there are numerous instances where private-sector businesses have been able to successfully lobby policymakers to use the power of government to establish barriers to competition and protect them from existing or potential rivals. Unlike the free-market case, there is no possibility of these monopolists losing out to lower-cost providers (barring the elimination of the regulations), and they are able to "exploit" consumers. These are the truly harmful monopolies. Thus, the only "bad" monopoly is a government-created or government-preserved monopoly.

Conclusions


  The full case against any government regulation: $50

Proposition 80 would be a step backward for California. It would restrict consumer choice, discourage competition, and impose more of the kinds of regulations that got the California power industry into trouble in the first place.

As awful as Proposition 80 is, however, there is good news. It is trailing in recent public opinion polls, and even if it should end up passing it is likely to be discarded by the courts. It was removed from the ballot on July 22 by the Court of Appeals in Sacramento because the court found that, according to the state constitution, the PUC's authority can only be increased by the Legislature, not by initiative. The initiative was restored a few days later by the California Supreme Court, which did not offer an opinion on the merits of the case but felt that the public should have the chance to vote on the initiative before the legal challenge is heard. (Of course, if voters reject the measure, this will be a moot point and the courts will not have to waste their time on it — a fact that surely was not lost on the Supreme Court.)

Politicians and regulators forced a sham of a "deregulation" scheme upon the energy industry in California, and then blamed the free market when it inevitably failed! The problem was not too much free-market competition; it was too much regulation (despite the "deregulation" doublespeak). The real solution to California's energy problem is to eliminate price caps and all government regulation, thereby removing barriers to entry, fostering competition, offering consumers maximum choice, and affording providers the greatest incentives to increase capacity and best serve their customers.


Adam Summers is a policy analyst for the Reason Foundation (asummers1@san.rr.com). Comment on the blog.

[1] This option was suspended during the electricity crisis of 2000 and 2001, but is scheduled to be reinstated when the last of the power contracts signed on behalf of the IOUs by the Department of Water Resources expires in 2015.

[2] Carrie Peyton Dahlberg, "Electricity proposition crackles: Will prices go up? Will it avert an energy crisis? It all depends on who's talking," Sacramento Bee, October 15, 2005, http://www.sacbee.com/content/politics/story/13717834p-14560232c.html (free registration required).

[3] California Secretary of State, Official Voter Information Guide, Statewide Special Election, November 8, 2005, p. 52, http://www.ss.ca.gov/elections/bp_nov05/voter_info_pdf/entire80.pdf.

[4] Terry Maxon, "Power Woes Unlikely in Texas, Officials Say," Dallas Morning News, January 19, 2001, cited in Lynne Kiesling, "Getting Electricity Deregulation Right: How Other States and Nations Have Avoided California's Mistakes," Reason Foundation Policy Study No. 281, April 2001, p. 18, http://www.reason.org/ps281.pdf.

[5] Murray N. Rothbard, Power and Market: Government and the Economy, (Kansas City: Sheed Andrews and McMeel, 1977), p. 76, http://mises.org/rothbard/power&market.pdf. Now integrated into Man, Economy, and State.

[6] Thomas J. DiLorenzo, "The Myth of Natural Monopoly," The Review of Austrian Economics, Vol. 9, No. 2 (1996), p. 44, http://mises.org/journals/rae/pdf/rae9_2_3.pdf.