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The Economists: On the Future of Energy Markets

The Power of Price Responsiveness
Fortnightly Magazine - April 1 2002

the summer of 2000 was a disaster. San Diego residents were the first customers in the United States to be granted the freedom to choose their electricity supplier without the backstop of price caps, frozen rates, or standard offer service at guaranteed prices.

When electric bills more than doubled with the lifting of price regulation, San Diego residents, who had grown accustomed to steady electric bills on a year-round basis, revolted and the state's regulators were forced to put a cap back on the price of the commodity. Because of the dramatic spike and subsequent political reaction, little was learned from the first full retail electric unbundling episode in the United States.

"I can't say whether we saw any significant response on the demand side or not," says Charles Stalon, an independent economist and a former FERC commissioner. "What we did see was this quick response on the political side. What we also saw then was a revelation of the absurdity of the political compromise that had been put together in California in the early days."

One of the realities of a market system is that price volatility plays a very important role in guiding use of scarce resources, Stalon explains. "But one of the first rules of politics is people hate price volatility. Reconciling those two conflicts is a large part of what we're all about. I don't think the kind of volatility we had in California is necessary for efficiency. But some price volatility is."

Humphrey says he has no problems with what happened in San Diego in terms of the economics of allowing the electricity prices actually to track what was going on in the marketplace. "But the education on the part of San Diego Gas and Electric, even more so on the part of the political powers that be there, were probably inadequate," Humphrey adds.

Joskow agrees that the electric power industry learned that neither politicians nor consumers in California were prepared for the market conditions that emerged in San Diego during the summer of 2000 and the subsequent market turmoil up and down the state. "All of these retail competition programs and industry restructuring programs in California and the Northeast were sold aggressively as programs that would reduce the price of electricity," Joskow says. "The proponents of these programs, especially the marketers, the independent generators and the industrial customers, never entertained the possibility the prices would go up."

Now that politicians have seen that prices can go up or down in a competitive market, they will need to re-educate themselves and consumers about the implications of restructured energy markets, he says.

Joskow also emphasizes that developing a system that benefits consumers should be a high-priority item. "I think that's the primary focus that people's minds should be on," he says. "It's not a question of creating opportunities for marketers or for other entities."

States in the Northeast as well as Texas, Michigan and others, appear committed to trying to make the new approach to organizing the electric power industry work. "I think it's too late in many