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Price Spike Redux: A Market Emerged, Remarkably Rational

Fortnightly Magazine - February 1 1999

rates, and their 13 percent of load is only part of the state's total on market-sensitive rates. Interruptible load and callable generation account for 6 percent of California's peak. Illinois, by contrast, first considered offering payments for callable generation and compensation for interruption in response to the 1998 spikes.

The Midwestern price spikes would have been both less severe and less likely if markets were fully competitive and power could flow unimpeded to buyers who value it most highly. For this reason, we believe the following policies could reduce the risk or severity of price spikes in the future:

n Don't shoot the messenger. Price controls in the bulk power market "prevent" price spikes the same way general wage and price controls "fight" inflation(by creating shortages. Controls are a recipe for blackouts and inefficiency, not a solution to price spikes.

n Move on retail competition. Full retail competition would allow all customers to choose their degree of exposure to market prices, and innovative competitors could offer price breaks to customers who agree to limit their usage when prices peak.

n Don't hamper risk management. Financial instruments reallocate risk to parties most willing to bear it. They allow power buyers to shield themselves from price spikes, and encourage investment by allowing power producers to shield themselves from precipitous drops. Regulation should not stand in the way of mutually beneficial reallocation of risks.

n Let prices allocate transmission and generation. Midwestern prices spiked in part because administrative decisions rather than market processes allocated access to critical resources.

n Allow multiple trading options. Bulk power trades in the Midwest take place through bilateral deals. A mandatory, centralized bulk power market would force market participants to trade only a few types of standardized electricity contracts, preventing them from making deals tailored to their individual preferences and constraints. If centralized power exchanges are created in the Midwest, participation should be voluntary.

Robert J. Michaels is professor of economics at California State University, Fullerton, and Jerry Ellig is senior research fellow at the Mercatus Center at George Mason University, Fairfax, Va. This article summarizes a lengthier research report available from the Mercatus Center. Funding was provided by Americans for Affordable Electricity, Electric Power Supply Association, Electricity Consumers Resource Council and Enron Corp.

1 The FERC has formally approved the TLR rules, ordering utilities to amend their pro forma open-access tariffs. Docket No. EL98-52-000, ER98-3709-000, Dec. 16, 1998, 85 FERC ¶61,353.

2 The survey was undertaken for Enron Corp. as part of its filing in FERC Docket EL98-52, investigating the price spikes.

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