I wanted deregulation. But not if we can't do it right.
As an economist, I confess I failed to predict the disaster in California. But I wasn't the only one. Anybody who tells you differently is either lying, fooling himself, or guilty of Monday morning quarterbacking.
Granted, there were those who foresaw problems with electricity deregulation. That was the safe betgiven the path they chose in Californiabut certainly not at the scale that transpired. Some, like myself, thought problems might arise. But we also believed that natural market forces would right most wrongs over a short transition period. That didn't happen. That's where I get frustrated.
Instead, the industry fell into a tailspin that quickly collapsed into free fall. The dynamics of a properly functioning market just never got going. Wholesale prices rose dramatically, followed by rolling blackouts and financial calamity for the state's two largest electric utilities.
We watched an industry self-destruct in real time.
Some say that unfavorable market conditions combined with faulty restructuring rules (easy to spot now) and the inherently strange features of electricity as a commodity to produce a disaster that was all but inevitable.
To me, as an economist, that seems reasonable. Prices rose because of very tight supplies but the new rules for "deregulation" prevented the market from smoothing itself out to a new equilibrium. And electricity markets are truly unlike other marketsdifferent in ways conducive to unstable markets. Lack of storage forces real-time balancing of supply and demand. At the same time, demand and supply show extremely low price elasticities in the short run. All this makes prices volatileand markets prone to possible manipulation. And that's as short an answer as you'll get from an economist, though clearly other forces were also at work.
But for the non-economist, and for skeptics of deregulation, the story seems simpler. Markets, they say, just can't be trusted. And those who buy the costly bulk power (privately owned utilities, in the main) take much the same tack. They argue that the new market rules and design are flawed in allowing power producers the opportunity to charge as-of-now inexplicably high prices to electric utilities and other wholesale buyers. They would have the government step in and bail them out or impose price constraints on wholesale power to stop the hemorrhaging. Meanwhile, the producers say we should expect high prices as the natural outcome of an inherently volatile market, but that normality should return when supply and demand are more in sync.
Who's right? The debate rages on, yet one thing is clear: The politicians smell a rat and want someone to pay, even if they don't yet know exactly who to blame.
As one observer notes, "Certainly the temptation has never been greater for politicians to find market abuses, show their indignation, and then craft a remedy, even if they are not sure of what is really going on." The post-mortem has become a blame game, wasting time and money.
And the repercussions will be enormous. Anyone who believes in utility deregulation with the fervency of a Milton Friedman or Friedrich Hayek, as I do, should be disheartened by the events in California. Deregulation now could be put off indefinitely, not only in the electricity industry, but in other industries as well. Advocates for deregulation should be really angryCalifornia has no right to give deregulation such a bad name. California was supposed to be the trendsettersuburbs, freeways, surfing, sushi, and so onbut this latest "first" has broken the spell. What were they trying to prove? Of course, by taking the lead in electricity deregulation or whatever they did in California, they have become the sacrificial lamb for the rest of the country. For that, I guess we should be truly grateful: Thank you, California!
But hey, I can't get too enthusiastic about this. Not yet, anyway.
What We Learned
Moving beyond the muddle, what have we learned from the California experience? I decline to offer explicit advice on what should be done because I really can't say anything that hasn't been said so far. Other analysts, through various media, have articulated some reasonable proposals that should be seriously considered. I realize that humility may get you to heaven, but it won't win consulting contracts.
The first lesson, what the policymakers must never forget, is that . If the government or anyone else tries to interfere with this natural course of events, bad things will surely happen. Price ceilings and controls eventually make consumers worse off. We knew that already from experience in the natural gas industry. Policymakers intend that price ceilings will help consumers, and they may for a short period. But after a while come the market distortions that inflict harm.
Having said this, however, I concede I am a bit ambivalent about lifting price controls in a market where competitive constraints on prices don't seem to exist. Here I am talking about the California wholesale power market, where perhaps an argument can be made for the Federal Energy Regulatory Commission (FERC) to impose a price ceiling on wholesale power until it is determined that competitive forces can be relied on to control prices. In the case of California's dysfunctional wholesale power sector, price ceilings may be a necessary evilat least until new market rules are put into place to eliminate abnormalities. Notwithstanding the persuasive economic arguments against price ceilings, the political solution may require them, at least as an immediate response to California's worsening state of affairs.
In fact, some evidence exists (though inconclusive) that generators and marketers might have withheld electricity from the market during peak periods. Of course, the danger here is that various interest groups may pressure the FERC to continue with price ceilings when they are no longer justified, leading to a more distorted market than if they were never imposed. They will view price ceilings like putting out a fire with kerosene, or the Federal Reserve System reducing the money supply during the onset of the Great Depression.
The second lesson is that . Californians are more environmentally conscious than most of us. It is their right, but life has few free lunches. (I thought I had one the other day, but I had to sit and listen to some boring speaker.) If you and your neighbors don't like the physical appearance of power plants and transmission lines, you should not be surprised to pay higher electricity price or face shortages. Californians also appear more inclined than the rest of the country to endorse social programsprograms funded by surcharges imposed by utilities. All of this adds up, in ways both direct and indirect, to higher electric bills.
Now if Californians are willing to pay higher electricity bills in return for a more benign environment and clearer conscience, so be it. I have no problem with that. But they must be willing to pay the price-not to expect others, such as U.S. taxpayers, to bail them out when things get tough.
Another lesson learned, which can be construed as a recommendation, is that In California, during the debate over industry restructuring, policymakers sought to "divide the pie" in a way reflective of "pork barrel" politics. That has happened in other states, of course. After all, industry restructuring requires a political act, so what does one expect? Yet one must give credit to California for making the other states seem like amateurs when it comes to interest-group politics.
What I Believe
I am serious about the gravity of rules that constrain markets. Rules that adversely affect one part of the market can easily cascade to problems elsewhere. Things get worse before they get better. For example, price controls could easily lead to a dynamic "death spiral" effect where simultaneously supply declines and demands rises, with shortages and catastrophe the inevitable outcome. Other examples abound in different markets around the globe where a seemingly innocuous rule leads to a problem that, in turn, provokes new problems potentially more serious. This phenomenon is especially true when government imposes price controls not to control market power, but to relieve scarcity.
Often, these rules that bind markets flow from political compromise. One producer may seek greater wealth and well-being, at the expense of others. This rent-seeker may receive a political favor in return for going along with what others want. And such favors may reveal how governments distrust markets. Policymakers hold a natural aversion (obsessive, but arguably rational) toward any outcome that may threaten their job security. I view politicians and other government officials as overly risk averse. Yet they minimize the political risks of their actions.
In the case of electricity deregulation, in California and elsewhere, there was much concern (some of it certainly legitimate) about utilities exercising market power, especially in a less regulated environment. California's restructuring rules reflected thatfor example, the mandatory divestiture of power plants, the requirement to buy and sell at spot prices through the power exchange (PX), and the separation of the PX from the independent system operator (ISO).
All of these actions may reflect good intentions, but the results have been anything but good. In fact, one could now say that some of these policies backfired by creating more market power than less. Again, akin to price controls, good intentions don't always produce good results, especially when they are contrary to sound economic principles.
Scholars surely will study the California episode in the years ahead. They will debate without endon empirical grounds, I hope, and not ideologicalwhether deregulation was a failure, or whether California ever even tried "deregulation," or only something different. The recently joked that California should "forget deregulation and try the real thing," and I agree. But those of us who feel this way will likely remain on the defensive for a long time. The government and the people believe that deregulation failed in California and is liable to fail elsewhere. Regrettably, we may see a stalling, or even scaling back of deregulation efforts throughout the world that may take years to reverseand in all types of industries, not just electricity.
California made us aware that deregulation can increase prices in the short term, the only term relevant to politicians. Long-term benefits may be forthcoming, but they're difficult to prove. And besides, who's willing to wait?
All of this leaves me with the following question:
Today, after all we've been through, I still believe in "genuine" deregulation of the electric power industry. On the other hand, I am even less sure now about pseudo-deregulation driven by interest-group politics.
To me, the pertinent issue revolves around whether we should do it at all if we can't do it right. At least to me, California has caused me to pause and reconsider the merits of real-world deregulation.
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