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Perspective

Two Cato analysts suggest a return to the past-vertical integration, but now with no state regulators.
Fortnightly Magazine - February 2004

Perspective

Two Cato analysts suggest a return to the past-vertical integration, but now with no state regulators.

The defeat of the energy bill in the Senate last year has thrown electricity restructuring back on its heels. There clearly is no consensus among politicians or academics regarding how this industry ought to be organized or how it might best be regulated. Finding our way out of this morass requires a reconsideration of how we got to this dismal point in our regulatory journey. Doing so suggests a surprising series of conclusions about what has gone wrong and where to go from here.

The Case for Restructuring

What, in theory, are we supposed to get out of restructuring? From an economics standpoint, there were two major problems associated with the old system.

First, because investment in capital received a guaranteed return, total generation investment was excessive and skewed toward capital-intensive facilities. Couple that with the one-time enthusiasm for nuclear power (once thought of as a progressive energy source that would be "too cheap to meter") and the growing hostility to coal-fired generation, and it's no surprise that some states moved strongly toward nuclear-with costs generally much higher than antici-pated. 1 Introducing market forces into the utility industry would eliminate the bias for capital-intensive projects by introducing uncertainty about returns.

Second, prices for electricity did not serve their usual role of signaling to consumers the marginal costs of additional consumption. Instead, they served solely as a device to recover costs. Thus, electricity prices were wrong all the time. They were too low on peak and too high off peak. Market forces, it was hoped, would introduce marginal-cost pricing and as a result reduce peak demand, increase off-peak demand, 2 and reduce the needless political fighting (most notably, the eternal fight over more supply versus less demand) that inevitably arises in electricity markets because of the absence of prices as a signaling device.

Average voters and the politicians that listen to them, however, do not associate markets in electricity with positive outcomes. Accordingly, anyone who believes market forces ought to play a larger role in electricity must argue convincingly that:

  • The California meltdown and the Northeast blackout were not the result of market forces;
  • The low costs of the states still under the old regulatory regime are not the result of regulation; and
  • Efficiency improvements not possible in the regulated would take place in a truly deregulated world.

The California Story

During 2000 and 2001, a large supply reduction in hydropower and weather-related demand increases (a hot summer and very cold winter) increased electricity and natural gas prices in California. Those price increases were exacerbated by NO x air pollution regulations in the Los Angeles basin, some design features of the California auction bidding system, and retail price controls.

The price controls were particularly harmful; they encouraged generators to price high because there would be no reduction in demand as a consequence of their pricing behavior. Moreover, retail price controls prevented utilities from passing on their higher costs to consumers, which caused the utilities to suffer

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