Electricity Deregulation: Lessons Learned from California

Article excerpt

I. INTRODUCTION

Is electricity deregulation worth pursuing? Or has the failed California "experiment" illustrated that the concept is so inherently flawed that all such efforts should be abandoned? In this article, we examine these questions within the context of some of the lessons learned from the California electricity crisis.2

We offer these lessons on a preliminary basis because, as of the time of this writing, much of the critical information about the California crisis still remains unknown. A myriad of regulatory agencies and private attorneys are embroiled in both criminal and civil investigations; most of these investigations are subject to confidentiality orders, rendering the current public information merely the tip of the iceberg.3

More broadly, new revelations continue to emerge as we write this about the nature of the alleged market manipulations, the full extent of the possible costs involved, and the regulatory processes that may have led to the crisis. With this strong caveat issued, we offer Table One as the foundation upon which we shall build this article. This table summarizes eleven possible lessons from the crisis that may be useful to the major stakeholders in this debate. The stakeholders range from regulatory lawyers, scholars, and policymakers to business leaders, utility executives, and power producers.

Table One: Lessons from the California Electricity Crisis

1. Don't Deregulate Into A Power Plant Shortage

2. Employ A Suite of Mechanisms to Address Supply-Demand

Imbalances

3. Don't Deregulate Into a Congested Transmission Grid

4. Market Monitoring and Enforcement Matters! Don't Balkanize the Market.

5. Rent-seeking Special Interests Will Attempt to "Capture" the Design, Implementation, Monitoring, and Enforcement Processes

6. A Deregulated Market Paradoxically Will Require the Application of Greater Regulatory Resources

7. A Fully Deregulated Market Will Undersupply Demand Side Management (DSM)

8. A Fully Deregulated Market Will Lead to an Over-Reliance on Natural Gas

9. The Natural Gas and Electricity Markets Must Be Viewed as a System - There Can Be No Free Market in Electricity if the Gas Pipelines are Monopolized

10. The Regulatory Authority (e.g., FERC in the U.S.) must be both a Competent and Fair Broker

11. Establish Swift and Sure Punishments for Rule Violations - Consider both Compensatory and Punitive Damages as Well as Criminal Penalties

In each of the sections of this article, we analyze these lessons from the perspective of California's legal, regulatory, and economic history. The article concludes with some reflections on the meaning of these lessons for the broader deregulation movement.

II. DON'T DEREGULATE INTO A POWER PLANT SHORTAGE

To state the obvious, in a perfectly competitive, deregulated wholesale electricity generating market, a shortage will lead to both significantly higher prices and the possibility of supply disruptions, including rolling blackouts.

To state the perhaps more subtle, in an imperfectly competitive electricity generating market, the presence of real physical shortages may increase incentives for market participants to artificially withhold capacity, which exacerbates the shortage condition and thereby sustains higher prices over a longer period of time than might otherwise exist in a perfectly competitive market.

These situations are depicted in Figure One, which illustrates typical supply and demand curves in a market characterized by short run capacity constraints and possible artificial withholding of power from the market.

The supply curve, S1, represents the marginal cost curve of the industry. This curve slopes upward, reflecting the fact that different market participants will have different marginal costs of production which reflect factors such as the vintage and efficiency of a given plant and its fuel source, e. …