In 1996, California began the process of deregulating its electric utilities, a process closely watched nationwide, as twenty-five other states also move toward deregulation. The results thus far in California: A power crisis—electricity shortages, rolling blackouts, utilities on the verge of bankruptcy, and rising rates for customers. Was utility deregulation just poorly managed in California or are the electric utilities fundamentally different than industries that have benefitted from deregulation, such as airlines and telephone? Will the California power crisis bring the national movement toward energy deregulation to a halt or not?
Peter Robinson: Welcome to Uncommon Knowledge. I'm Peter Robinson. Our show today, Energy Deregulation. The energy industry is by no means the first industry to have been deregulated. In the 1970s, the airline industry was deregulated. In the 1980s, AT&T was broken up and the telephone industry was deregulated. In both cases, deregulation led to increased competition, lower prices and by and large at least, better service.
Which brings us to energy deregulation. More than half the states have already deregulated energy in one way or another and more are going to do so, but let's consider just one state, the biggest, California. It was in 1996 that California deregulated energy. The bill passed the California Assembly unanimously indicating that everybody thought energy deregulation was a bright idea. The results, not so bright. Utility companies on the verge of bankruptcy and rolling brownouts and even blackouts throughout the golden state. So what went wrong? Is it just that energy deregulation in California was mismanaged or is it that energy deregulation is a flawed notion in and of itself?
With us today three guests, Carl Wood of the California Public Utilities Commission, Frank Wolak, a Professor of Economics at Stanford and a member of the administration of the California Independent System Operator. You'll be hearing more about the ISO and Gary Ackerman of the Western Power Trading Forum.
Title: Power Play
Peter Robinson: Forty-two of the fifty states have either deregulated electricity or are considering doing so. Governor Gray Davis on the experience of deregulation here in California. I quote, "A colossal and dangerous failure." Carl, is Governor Davis correct?
Carl Wood: Absolutely.
Frank Wolak: I'm not ready to concede defeat.
Peter Robinson: You're not.
Frank Wolak: For deregulation.
Peter Robinson: Gary?
Gary Ackerman: Not at all. It's not correct.
Peter Robinson: The Governor is flatly wrong.
Gary Ackerman: I believe so, yes.
Peter Robinson: Gotcha. Okay. 1990, just a decade ago, the electricity industry is heavily regulated everywhere in the country. Frank, you're the academic here, give me the theory, the rationale for regulating electricity as an industry.
Frank Wolak: Well, I guess there's sort of the traditional view which essentially says this has features of what we think of as a national monopoly meaning that economies [?] to scale. The other is is that supply must equal demand at every instant in time, which creates considerable amounts of problem. The other is the production is subject to severe capacity constraints. All of these things make it very difficult to reign in what market power a firm might have. An alternative view is and this is sort of discussed by several academics is this is also--the structure of the industry also makes it very competitive as well in the sense that once you sink this large fixed cost, you have a very strong incentive to produce as much as you can because of the fact that that lowers your average cost.
And so one of the theories is is that the industry is, in some sense, asked for it because the competition was extremely cut throat in the initial period of the industry. There would be competitive providers of electricity, each of them making these very large investments. So what they essentially did was a bargain between the local government and the entity to say you give me the monopoly franchise and I will promise not to sort of exercise my market power and how you'll do that is by regulating me.
Peter Robinson: 1970s, President Jimmy Carter, a democrat, engages in substantial deregulation of the airline industry. 1980s, Ronald Reagan, a republican, engages in substantial deregulation of trucking, oil and natural gas industries. And yet electricity doesn't get deregulated until well into the 1990s. What makes electricity different?
Carl Wood: We can think of the electrical grid in a region such as the western United States as being a single machine. Whatever happens in San Diego say to a generating plant is influenced by and itself influences what happens to the grid all the way up in the Pacific Northwest or out as far as Montana, there needs to be some sort of central planning and control of that grid system. And while it's in principle possible to have some sort of economic competition at least with parts of that system, it introduces an element of uncertainty which may effect the reliability of the system.
Peter Robinson: That's a technical answer. Would anybody care to offer a political answer?
Gary Ackerman: I think so. That's exactly where I wanted to go with this.
Peter Robinson: Go ahead.
Gary Ackerman: That the politics of power is such that it's an extension of the state's ability to tax consumers for a commodity called electricity. It's done so in a regulatory compact, it's done so through these cozy arrangements that the utilities and the states and the politicians might have. And there's another difference as well about electricity which makes it fundamentally different than any other commodity, and that is it cannot be easily stored. It is stored somewhat, but for all intents and purposes it cannot be easily stored. And it has to be delivered exactly at the time when people want it to turn on lights, to turn on appliances or for industrial processes.
Peter Robinson: But you--so you're not disagreeing with Carl; there are actually technical reasons why electricity is harder to deregulate.
Frank Wolak: If you could bean electricity to customers, this product would be no different from any other product that we have that is characterized by high fixed costs, low variable cost to produce. But the difficulty is, I think, as Carl said quite rightly, is that is--that it has to be delivered over a transmission network that everyone shares. And so my actions in that network affect your ability to sell in that network, and therein lies the reason that we need either some sort of oversight from a larger entity besides any single market participant, and therein also lies sort of the rationale for why we did leave it vertically integrated and regulated for so long.
Peter Robinson: Let's examine California as a test case for deregulation.
Title: Power Markets, Market Power
Peter Robinson: The California deregulation bill breaks up the old, investor owned monopolies such that generation, making the electricity, transmitting it and then distributing it to customers now is in separate hands. In particular, it creates incentives for the large power companies in California to get rid of their power generating plants. Why? Why would you want to--to divest themselves of the plants that make the product, the electricity?
Carl Wood: The rationale that was offered at the time was that because the great majority of the generating capacity in the state was owned by just a few monopoly companies in different geographical areas, that even if the market were opened up to competition, it would be very difficult for a new competitor to get a foothold without breaking up the control over most of the generation by just a few companies.
Peter Robinson: So these things get sold; who's bought them?
Gary Ackerman: Well, my members have bought them. They...
Peter Robinson: Your members are? You represent...
Gary Ackerman: My members are (?) Southern and many of the other generators who have...
Peter Robinson: Your members are players in the energy market outside California.
Gary Ackerman: Around the globe.
Peter Robinson: Around the globe. They come into California and buy up these energy plants.
Gary Ackerman: They compete for the purchase of those energy plants, yes.
Peter Robinson: Okay. The bill required power companies to transfer operations control of their transmission lines to a nonprofit entity, the independent system operator, or ISO. They get to own their lines, but they don't control them anymore. What's going on there?
Frank Wolak: The idea there was is that you want to provide non-discriminatory access, meaning that in the pre--vertically integrated regime, say a company like PG&E owned the transmission lines, as well as owned generation, and so there was the problem that if say a cheaper producer wanted to sell in PG&E's territory...
Peter Robinson: No on my lines you don't!
Frank Wolak: Exactly. And so the idea is that with the ISO as the person, or the entity operating the grid, there would be non-discriminatory access, and therefore the power plant that bids the lowest would be the one that gets to provide, and hopefully that lower prices would get transferred to the consumer...
Peter Robinson: Okay. By the way, does that strike everybody here as a good idea?
Gary Ackerman: Well, not necessarily a good idea, because it's not necessary to have an ISO like we did in California to have transmission access. As a matter of fact, the federal regulators have done what I consider to be an outstanding job over the last four or five years to encourage different states in different regions to have similar kind of transmission access rules. What transmission access means, in simplest terms, is access to markets. That is what my members want. They want to be able to go your house or anybody's house or anybody's business and sell you electricity. One thing that we did right in California is make transmission access available to everybody. What I was trying to point out is you don't have to have a very expensive ISO to get there.
Peter Robinson: You don't have to, okay. And then the bill creates a power exchange, or PX, where is requires--this I have to suppose, as an economist, you'll like this. Requires every--you don't? Okay, you'll--it requires all the producers in effect to post their daily output at the PX, the Power Exchange. Then, people who want to buy the electricity make bids on the electricity--and this is the part I thought you would like, Frank--a computer, according to the magazine and newspaper articles I've read, a computer aggregates the offers and the bids and comes up with a clearing price, an equilibrium price, right? A clearing prices; supply this way, demand this way, and an X in the middle on the computer, and clears the electricity at one price for that day. Is that not what an economist would call an elegant solution to the problem?
Frank Wolak: Yes, I agree, it's an elegant solution, but not necessarily the solution--you could think o fit as an unnecessary solution in the sense that if you just told generators and marketers that look, we need to supply the power that people are demanding, my guess is, is that would come together voluntarily like they do in every other market that we're aware of, and be able to...
Peter Robinson: So far, what happened in California doesn't sound much like deregulation to me.
Title: On Again, Off Again
Peter Robinson: The government provides incentives to restructure the industry, forcing the power--effectively forcing the power companies to sell off their generating plants. It imposes rules--it sets up a new entity to run the transmission lines. It forces people to sell their electricity through on mechanism, the Power Exchange. This--first of all, is it fair to call it deregulation or merely one more government restructuring?
Gary Ackerman: No, and I think frank has pointed this out in some--either recent publications or statements he's made, I think a very good analogy that we've only gone half way in this sort of restructuring, and...maybe I should have just let Frank explain what he meant by that middle of the road analogy that I thought was perfect.
Frank Wolak: Well, it's just that in many ways we've unfortunately handicapped demand, but we've let supply be very um..flexible in what it is able to do. And unfortunately that has some consequences, as we're seeing right now.
Peter Robinson: Is this genuine deregulation to you, the bill that was passed in 1996?
Carl Wood: It's partial deregulation; it's deregulation of--of part of the industry. But I think something that needs to be said here is that electricity is central to the functioning of modern civilization. It's essential to the economy, to health and safety, to convenience of people. And there's a widespread consensus among everybody except for academics and corporations that have an interest in it that the reliable provision of electricity at reasonable rates is more important than the attainment of maximum profits or even of maximum economic efficiency in this industry. And what has happened, in doing this deregulation is that we have put that reliability and that assurance of reasonable prices at risk, and in fact in California the whole concept has crashed and burned.
Peter Robinson: Okay, I want to get to what hit--what's gone wrong in a moment. But first I'd like to tease out that argument. You are making the argument, then, that government has a right, and indeed a duty, to remain right in the middle of the provision of electricity to consumers because electricity is so basic to the way that we all lead our lives, right? Am I correct in that?
Carl Wood: Yes, and the other thing is that some order in this--in this marketplace or in the provision of this essential services is necessary. That we can't leave it to the anarchy of the market.
Peter Robinson: The anarchy of the market means...
Peter Robinson: Let's look at just how California got into such a mess.
Title: Turn Out the Lights, the Party's Over
Peter Robinson: So we have in 1996, we have this deregulation, which as far as I can tell wasn't really deregulation but a government restructuring. And NOW, we have my electricity bill going up, Governor Gray Davis calling deregulation in California a colossal and dangerous failure; what went wrong?
Gary Ackerman: Well, the costs went up, that was one problem, and so therefore the wholesale prices went way up. And then there was another problem...
Peter Robinson: Why did the costs go up?
Gary Ackerman: Because the price of natural gas, which is mainstay fuel for most of the generation in California, went up in California as well as the rest of the nation.
Peter Robinson: And why did the price of natural gas go up?
Gary Ackerman: Because of demand and supply pulling a fixed supply, amount of natural gas that could be produced to more and more users. Cold weather will actually exacerbate the demand for natural gas, so that...
Peter Robinson: It's cold weather...
Gary Ackerman: Cold weather...
Peter Robinson: It's the economic recovery in California...
Gary Ackerman: As well as the rest of the region.
Peter Robinson: The entire west coast, you mean?
Gary Ackerman: The entire western region; I'm talking about thirteen states in the west. The other thing that was in the great formula that you mentioned in 1996 was that the utilities in this state would freeze their retail rates. Which meant when the wholesale costs went up and the retail rates were frozen, they could not adequately recover the costs that they have to bear in order to purchase the utility--which is why they're in such dire straits today.
Peter Robinson: Okay, Carl, so the government screwed it up.
Carl Wood: These prices have not been driven by underlying costs; that isn't true.
Peter Robinson: You don't buy that it's a shortage of natural gas?
Carl Wood: No. If that was the driving force behind it, then we would have seen wholesale prices across the country rise in similar proportions. And they haven't risen by a factor of six or ten as they have in California.
Peter Robinson: So what is going on? Why have the prices gone up?
Carl Wood: The generators and the marketers have figured out how to gain this market. They have figured out how to strategically bid and exercise market power in this market. And therefore they are getting...
Peter Robinson: How many providers are there who push their energy into the PX every day? Roughly.
Carl Wood: There are about six or half--six or eight major ones.
Peter Robinson: So it's actually a small market?
Gary Ackerman: No, that's correct--incorrect. There's over eighty different parties that push their market into the PX every day...
Peter Robinson: But how much of the market do the six or eight biggest represent?
Gary Ackerman: The six--you wouldn't now by any--by any calculation you wouldn't know that, nor would the participants know that at any given hour.
Frank Wolak: On this one I-I completely agree with Carl. There are basically probably less than six large ones that sell in, that own on the order of, let's say, 3, 4,000 megawatts. So quite large relative to the size of the market. And the market in California is on the order of, say a peak day is like 45,000 megawatts.
Peter Robinson: And you're contending that these guys are operating like OPEC, they formed--they have effectively formed a cartel, pulled back supply to drive the price up.
Frank Wolak: No. No, it's not a cartel as much of--it's just that remember, I think it's important to remember that there are capacity constraints, all the sorts of reasons why we've regulated this industry the past hundred years are sort of coming to roost, in the sense that--think of it, if it's a 40,000 load day, and everybody's needed to run the market, you don't really need to collude to set a very high price. I personally don't...
Peter Robinson: They are business people, they sense when they have market power, they sense it and their price tends to drift up; that's what you're saying.
Frank Wolak: Yes.
Peter Robinson: Okay. And you...
Gary Ackerman: Oh, well, I think it's a mischaracterization, because by the fact that somebody owns, let's say, a large position with respect to the megawatts in the state of California, you don't know where those megawatts are being sold to. They could be sold anywhere in the western region. I have all kinds of options in order to sell that, and many, many different parties. What happens is, you don't have price manipulation.
Frank Wolak: I agree. I mean, manipulation, I think, is a loaded word, but I mean, it's the question of profit maximization serving your shareholders. These guys are serving their shareholders, and…
Peter Robinson: Next topic: Why don't we have a national market for electricity?
Title: A Grid Too Far
Peter Robinson: These guys are making what the economist call, at least alleges they're making what the economist would call excess profits; that's supposed to entice other suppliers into the marketplace. Why aren't people down in Texas, where they have an oversupply, why aren't they routing their electricity up here to California?
Frank Wolak: This gets back to the point that we've--that I made at the beginning, which is, if you could beam electricity to final customers, we'd have extremely competitive markets. But the electricity that gets to these customers has got to go through the transmission grid, and we have a transmission grid that's basically designed for the state of the economy in California, say circa 1980, 1985. We've had a lot of growth since then, and so to get the electricity there, it's got to have the road to travel on, and it's got low capacity roads. And so...
Peter Robinson: So what you're telling me is we're a million miles away from actually having a national market in electricity.
Frank Wolak: Well, not a million miles, but I mean we certainly need a far more, if you like, extensive distribution and transmission network.
Peter Robinson: In other words, what we need is better transmission lines, and the 1996 bill stripped PG&E of any incentive it might have to invest in improving its transmission lines.
Carl Wood: Deregulation, so-called, was introduced when we had a transmission system that was made to augment monopoly generation of electricity, not to facilitate a free market. We don't have an interstate highway system of transmission in this country. Really, in any region of the country. Some of the areas are worse than others...
Peter Robinson: Can I just ask, though, as a technical matter, it's very--is it difficult technically, or is it expensive to route electricity from a state where there's oversupply, such as Texas, to a state where there's huge demand, such as California?
Gary Ackerman: It doesn't happen...
Peter Robinson: It just doesn't happen.
Gary Ackerman: It doesn't happen because of the technical constraints on the transmission system. They are not integrated in such a way that you can make that transaction.
Peter Robinson: Who's in a position to cause them to be integrated?
(?): Well, I would say, if you could, then it would have to be at the federal level to begin with, but I don't even think that's going to happen. And it also supposes that we just don't have enough supply or we couldn't create enough supply in the thirteen western sates, plus two provinces of Canada, plus two states in Mexico, to make sufficient supply to satisfy the need for this region. I think we can, without going to Texas, by the way. But if you want to go to Texas, we can get there, it's just an expensive route.
Carl Wood: But even within the region, we don't have the kind of transmission system that you need in order to assure a truly competitive market, if such a thing is possible.
Peter Robinson: Between 1995 and the year 2000 California added zero new power plants. Five years during which the economy is coming out of recession and starting to grow very quickly. Zero. Texas added 22 new power plants during the same period; another 15 power plants in Texas are due to come on line by 2002, and another 34 are already in the works to be built after that. In other words, the problem in California is not deregulation, it's the government is still much too much in the middle of this industry. Environmental regulations, one regulation after the other. It's extremely difficult to built power plants in this state ,and once you've got 'em built, you're going to have deal with those whole political...get government out of it! OK, now will you pick that up and run with it, please?
Gary Ackerman: Sure, I'll run with it, but I don't know where I'm gonna end up. Let's start at the beginning...
Peter Robinson: That isn't an argument made for you to pick up?
Gary Ackerman: Oh, well, I don't know, because what it suggests is you can't build power plants in California, and that's not true, you can. People do come here and are willing to...
Peter Robinson: Why haven't they?
Gary Ackerman: Well, they are right now; there are six under construction and five more under permitting and about seventeen in the queue to come online. But the real important issue is--forget the state border of California; that's not the limiting factor in how we do--transact electricity here. You have to look at the whole entire region. And there's significant development of new power plants in Arizona, in Nevada, in Oregon, in the state of Washington. And they're trying to ease up those rules...
Frank Wolak: Gary's point's right, it's that it's the entire WSC...
Peter Robinson: What's the WSC?
Frank Wolak: Western Systems...in other words, western United States. But once again, it gets back to a point that I think we've all made is that you need a transmission grid that's going to get it into California to deliver to the places that it's demanded, and so…
Peter Robinson: The consensus here...
Peter Robinson: Last topic: How can deregulation be done right? Or shouldn't it be done at all?
Title: Power to the People
Peter Robinson: Give me your top two or three reforms to improve the situation here in California and that ought--that people--the twenty some-odd states who still haven't deregulated but are considering doing so ought to pay attention to.
Gary Ackerman: People should have choices to their electricity provider. In California we offered that choice, but it really wasn't made in such a way that it was effective. We need to separate at least the large customers, but any customer who so wants, to ability to get off their current default monopoly provider and go to a competitor, and then we'll have some real competition and drive prices down.
Peter Robinson: You like that idea?
Carl Wood: No. The key points that they've to be accomplished in California is first of all, we have, in the near and mid-term, we have to get wholesale prices down to reasonable levels that are related to costs. We need to get some breathing room.
Peter Robinson: ...leading producers.
Carl Wood: Through some way, either through the federal commission exerting its authority and responsibility under the Federal Power Act, or the state taking some sort of action within its authority.
Peter Robinson: Okay, let me go back to Gary; you like that idea? I mean, on your--your members?
Gary Ackerman: No, no. It really won't happen that way. Markets are 200,000 point gorillas and regulators are about eight hundred pound gorillas. I don't think the eight hundred pound gorillas got the match.
Peter Robinson: Wait a minute! If the State of California suddenly--at least on some interim basis--six months, eight months, a year--does all, virtually all the buying of electricity in this state, you mean to suggest that your members are just gonna go sell elsewhere, or stop producing?
Gary Ackerman: If we can get a better price, we'll sell elsewhere. But the point is this, if they offer...
Peter Robinson: You're dreaming! You're dreaming. It can't be done. It can't be done. You cannot monkey around with prices because the market is too free.
Carl Wood: Well, I--that's something that's gonna be tested, and frankly we're in for an ugly time here. There's no question because the market--the marketers, this power cartel has declared war on the consumers of California.
Peter Robinson: Can it be done? Can Gray Davis succeed in forcing the price down?
Frank Wolak: I certainly hope so. I certainly think that he can. I mean, in some ways I guess...
Peter Robinson: So Gary's bluffing. They're not going to go sell elsewhere.
Frank Wolak: Well, I guess my view is that, to the generators--and I've said it to them personally--is why kill the goose that lays the golden egg? I mean, this is a great place--this has been a great market for you. I mean, 1999 they thought they were doing very well; 2000 they did fabulously. And so my guess would be, is going back to regulation you're going to get your sort of crumbs. Why not just sort of cut back a little and then let the goose that laid the golden egg continue.
Peter Robinson: Alright. let me give you--I'll give you the chance to...what would be your top reform?
Carl Wood: Well, the next reform is that we need to build new generation or repurchase new--existing generation back under regulatory authority, either of the state directly or of the public utilities commission within the regulated utilities.
Peter Robinson: So you effectively want the state to purchase or build--the state or an agency very closely tied to the state--to purchase or build new generating plants.
Carl Wood: Or the regulated utilities, that's right, so that because we have too much exposure, we don't have enough of a physical hedge in this market to protect the interests of the rate payers against this power cartel that's now driving prices through the roof.
Peter Robinson: Frank, give us your one or two top reforms.
Frank Wolak: Well, the big one would be is, I guess, to any state considering restructuring, my point would be, don't do it until you have in place the necessary retail infrastructure necessary to have a very intelligent, sophisticated demand side of the market. What we need is essentially people to see that, look, if I cut back in this hour, my bill is reduced by this amount, rather than just I read the bill on a monthly basis, and--and that's it.
Peter Robinson: I, as a consumer, ought to be able to go online, figure out that I should be somehow or other using more electricity at night and less at the peak hours during the day...
Frank Wolak: And see the benefits in terms of the reduction n your bill.
Peter Robinson: ...reduction in my bill.
Frank Wolak: And that's sort of point number one. And then point number two is that if you're going to go to competition, you must remember to keep in place the things that regulation used to do a very good job of, cause competition rewards the agile, the intelligent; and it punishes the poor and not so smart, etc. So what you need to do when you make that transition is to build in the necessary protection into the competitive market to protect the people that regulation was desi--designed to protect
Peter Robinson: Let's close it out; it's television, alas, so we have to close it out. As I said at the opening, forty-two out of fifty states have either deregulated electricity or are considering doing so. Ten years from now, will fifty out of fifty have deregulated, or will some of the forty-two who have or will soon deregulate gone back and re-regulated? Which way is it going?
Gary Ackerman: It's going towards deregulation, and I'll tell you why it's got the hiccup right now. Because of the high cost, people are scared and things are--they haven't...
Peter Robinson: Because your guys are gouging us!
Gary Ackerman: We're not gouging, we're providing what the true cost of the energy is. And when people understand what the true cost is, they'll act rationally. Now we'll solve this problem; in two years we'll have much lower cost in California, despite all the regulators and legislators' attempts to do otherwise.
Peter Robinson: Fifty out of fifty, or will we go back from forty-two to some lower number, deregulating?
Carl Wood: We're gonna go back towards traditional regulation, no doubt in my mind.
Peter Robinson: Frank?
Frank Wolak: I--I guess I think that it will go competition, for the simple reason that over the last two years in California, I mean, we had wholesale prices that looked very, very good. It's just this year they look very, very bad.
Peter Robinson: Gary, Frank and Carl, thank you very much.
Peter Robinson: The future of energy? Carl expects it to be re--regulated. Frank and Gary expect deregulation to prevail. I only hope they get it sorted out pretty quickly. Here in California, we've had about enough of these "rolling brownouts". I'm Peter Robinson, thanks for joining us.