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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

a financial meltdown. Generators, in turn, increased prices to account for the possibility of not being paid. From November 2000, the California story is a financial meltdown story: Wholesale prices had a large credit-risk component. 3

The central lesson from California is not that market forces have been tried and have failed, but rather that partial deregulation (wholesale deregulation combined with rigid retail prices) is an extremely dangerous institutional design.

The Blackout Story

From our perspective, the Aug. 14, 2003, blackout illustrates the difficulty of managing externalities on the grid. Markets were not responsible for the blackout, but the shift during the last 30 years from a world consisting of balkanized vertically integrated utilities to independent power producers and vertically disintegrated power service providers has increased the number of players whose behavior must be coordinated to maintain satisfactory operation of the North American transmission system.

While blackouts also occurred in the old regime, it's certainly true that, with greater interconnectivity between service territories, the chances of cascading blackouts might be enhanced by the introduction of restructuring as it is currently conceived.

About Those Low-Cost States

The low-costs states are low-cost largely because they did not change very much from the 1965 . Some never abandoned the use of coal in the production of electricity, while others had continued access to cheap hydropower. None of the states aggressively implemented long-term, fixed-price, independent power contracts.

Moreover, traditional rate regulation appears to benefit consumers through the use of weighted average pricing for electricity. Why this appears so-and why it is but a mirage- requires a quick review of some economic fundamentals.

In a free market, the market prices of commodities are determined by the most expensive source of supply necessary to meet demand. As a consequence, inframarginal sources of supply with lower costs receive economic rents.

In an unregulated electricity market, then, marginal sources of electricity-such as daytime peaking units-would need to earn at least a normal return. This implies that those facilities with lower costs whose supply is limited (such as old coal-fired units exempt from plant-specific emission controls under the 1970 and 1977 Clean Air Act amendments) and hydropower facilities (whose supply can't be expanded) would receive rents in an unregulated market.

Rate regulation by the states, however, currently suppresses those rents. Consumers are charged a weighted average of generator costs rather than the market price, which would be at least the marginal cost of the most costly unit necessary to meet demand.

Thus, in a free market, the proportion of electricity produced by coal or hydropower would not affect prices if neither is the marginal source of power. But in regulated electricity markets, cheap inframarginal power does lower electricity prices to consumers because prices are weighted averages of producer costs rather than marginal costs of the most expensive producer. Thus, regulation would seem to play a role in the low costs of the states that maintain the old regulatory regime.

To most, the main consequence of weighted-average prices (that is, lower peak prices) seems like a good thing. But weighted average prices