Regulation In, Power Out: Don’t blame California’s energy shortage on deregulation

Many believe California’s power crisis is due to deregulation. The reality, however, is quite the opposite. No free market for electricity was ever established in the state. Rather, a semi-regulated system was set up that has only made the situation worse, by interfering with the law of supply and demand. Energy prices were at their lowest in 1998 ($10 per barrel of oil) and in the reckless view of electrical producers and suppliers, they would stay down indefinitely. The state of California shared this opinion and opted for deregulating wholesale electrical prices while maintaining controls over residential prices until 2002.

Moreover, wholesale prices were never truly deregulated at the start. The California plan required power providers to buy electricity only on the spot market, at rates that varied from day to day and from hour to hour. This market was set up and controlled by the state and prohibited providers from concluding any long-term contracts with their suppliers, the power producers. As was the case in England, California also decided to break up the big power companies by imposing strict separations between production, transportation and distribution activities.

At first, the situation seemed win-win for everyone. Then, over the next two years, power prices began to soar. They leaped from $10 to $30 a barrel in the case of oil, and skyrocketed in similar proportions for coal and natural gas.

Rather than benefiting from a situation they had failed to anticipate, power suppliers were caught short. They were sandwiched between regulated sales prices and soaring supply costs on a daily basis. Maintaining partial price controls, even temporarily, had disastrous effects. It discouraged new companies that could have provided California residents with fresh options. It diminished the interest of producers from neighbouring states. It also failed to give any cues to consumers that they might respond to scarcer supply with moderated behaviour and a greater effort at saving energy.

Ultimately, distortions occurred in terms of supply as well as demand. When we also consider California’s environmental restrictions on setting up new power plants, the crisis could have easily been foreseen. The power supply had remained stable for four years, while demand was growing at some 14% annually. The two biggest suppliers are now on the verge of bankruptcy.

There is only one effective and long-term solution. Completely deregulate both the wholesale and retail electricity markets. Prices will initially leap, but then demand will decline. Supply will rise as producers seek to increase capacity and import power from outside the state. In a few months, the crisis will have been no more than a bad memory.

California teaches us what not to do if we deregulate the power market. Other experiments, conducted elsewhere in the U.S. and throughout the world, have enjoyed greater success. In Pennsylvania, for example, the most advanced state in the area of power deregulation, individual customers can select their suppliers – and setbacks – like those of California have never occurred.

Next May 30, the Montreal Economic Institute will launch a text dealing with this topic called: La libéralisation des marchés d’électricité au Québec et dans le monde. Its co-authors, French economist Henri Lepage and Quebec economist Michel Boucher, cover many cases of deregulation in the U.S., Europe and elsewhere, as well as the performance of the public monopoly known as Hydro-Québec.

It would be highly regrettable if the California failure undermined the deregulatory movement. A special effort should be made to combat myths about deregulation in Quebec, where this discussion is far less advanced than it is elsewhere in North America or in Europe.

Regulation was not responsible for this «colossal and dangerous failure,» as California Governor Gray Davis declared. Rather, this failure was caused by the state’s attempts to let part of the market benefit while irresponsibly maintaining regulatory controls. As Henri Lepage correctly explains: «You don’t organize competition, it organizes itself». Any reform that runs counter to this principle is doomed to failure.

Jean-Luc Migué est chercheur associé à l’IEDM, Michel Kelly-Gagnon est président de l’IEDM.