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Price Spike Reality: Debunking the Myth of Failed Markets

The data is in. Market power fails as an explanatory variable for episodes of high prices.
Fortnightly Magazine - November 1 2000

improvements are needed. Improvements are needed to clarify policing powers related to grid reliability. Independent information is required to replace information provided and sometimes distorted by utilities. Customers need to have choice so that they can react to market forces. The rules of the game need to be finalized federally and in the states to further facilitate entry. But such imperfections do not indicate market power; they mean less than maximum efficiency. 1 The market is strong but not perfect, and those that underestimate the power of the market are doomed to repeat certain mistakes—namely, incorrectly forecast prices.

Correct forecasts of power prices during the past few years were possible, and were made by those focusing on competitive economics. 2 These were lonely voices at the time in part because the focus was on market power rather than competitive economics. Indeed, when forensically assessing economists' electricity price predictions, the culprit usually is the lack of focus on competitive supply.

These obsessive market power-related errors need to be debunked to prevent them from continuing and threatening deregulation. A return to the old regulated world would recreate the same conditions that led to all the problems: the construction of uneconomic nuclear power plants; the chronic prolonged over-construction; the bloated utility and regulatory staffs. It would recreate the politically motivated boondoggles, ranging from forced long-term contracts with uneconomic power producers to shielding customers from market forces no matter how rich they were.

The Revelation: Politics Aside, Spikes Are Common

The second common view of price spikes contends that these episodes are rare events caused by unusually hot summer weather combined with an unusually high number of outages.

This view was exemplified by the Federal Energy Regulatory Commission's fall 1998 report, "Staff Report to the Federal Energy Regulatory Commission on the Causes of Wholesale Electric Pricing Abnormalities in the Midwest during June 1998." The motive of the report was to provide political cover against market power attacks, without appearing to embrace competitive market economics. Politicians have been promising lower power prices, though at most, competition can ensure only efficient decision-making. Politically, admitting prices were high because excess capacity no longer was depressing prices was just as bad as admitting there was market power. But the reasoning is flawed.

First of all, these "abnormalities" (price spikes) now have been proved to be normal and common whenever supply and demand are tight. Indeed, they are the signals to producers to build more plants. Adam Smith, the free-market economist, was a smart guy.

Secondly, neither the weather nor outages were unusual during the past five years. Every other year, on average, weather is hotter than the long-term average. Power plant outages are common, owing to the complexity of the equipment, and every other year plant outages are above their long-term averages as well. So even with supply and demand in rough balance at the summer peak, some years will have more spikes than others. Whenever the reserve margins dip below about 15 percent, hotter summers with lots of outages frequently will drive up prices. What can we expect from