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Wild Prices Out West: What Can Be Done?

The problems stem from a lack of incentives for long-term, fixed-price contracts.
Fortnightly Magazine - November 1 2000

their cost of capital. Discouraging long-term contracts increases financing costs, translating into less investment and higher energy prices. So CPUC policy not only limited consumer choice, but also impeded growth of new and inexpensive generation capacity, both of which have resulted in higher electricity prices.

Misstep No. 3 — Price Caps

The recently imposed price caps on spot electricity transactions amount to following a series of bad decisions with a worse one. Though such price caps may ease the pain temporarily, they will make the patient sicker by the end of the day.

Price caps on wholesale transactions will create short-term shortages and discourage imports. Price caps also reduce the incentives to invest in generating plants. A low price cap also discourages demand-side participation in the mitigation of shortages through demand-side management (e.g., by reducing cooling to commercial buildings). Such arrangements require investments in specialized equipment, and lower price caps reduce the incentives to invest in such equipment, limiting conservation. Overall, it's not a very successful policy. Similarly, imposing price reductions in the middle of an energy crisis only makes matters worse. First, it reduces the incentives to conserve by the residential users. But also, these price reductions will have to be paid in the future.

The Way Out — Stay the Course

The way out of this mess is not via more regulatory market interference, but rather by further market liberalization. Now is the time for energy service providers to reenter the California retail electricity market. High short-term prices represent an opportunity for them to sign up customers with offers of stabilized, lower prices.

In the meantime, utilities should be encouraged to offer consumers the option of stable rates, backed up with long-term wholesale energy contracts. Because energy costs are expected to fall in the winter, the utilities then can offer an annual stabilized contract at lower energy prices than current wholesale prices. They can cover the risk of such contracts either by building individual portfolios of supply contracts or by underwriting those risks themselves. In the latter case, however, they should be allowed to collect a commercial risk premium, in the same way that in the competitive mortgage market, fixed-rate mortgages have a built-in premium above the expected variable-rate average.

The Feds, Californians, and public representatives should resist the temptation of quick fixes that will make matters worse in the long run. The California PUC already has taken an important step to prevent the repeat of San Diego's plight in other areas by allowing utilities to buy power outside the Power Exchange. The next step must be a regulatory reform introducing performance-based regulation that will provide utilities incentives to enter into long-term supply contracts and buffer some of the inherent volatility of the wholesale spot market. Meanwhile, regulators must work to expedite the construction of new generation that is knocking on California doors.

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