The Myth of Deregulation by Chris Trayhorn, Publisher of mThink Blue Book, April 1, 2003 In 1996, California passed the nation’s first and boldest electricity deregulation law. As we all know now, the state jumped off a cliff with no parachute, and the landing was a hard one. By the time the Federal Energy Regulatory Commission belatedly intervened with price caps, Californians had spent $40 billion more for electricity than they would have under regulation. Deregulation’s supporters have maintained that it was California’s mistakes that caused the failure of deregulation. But a closer look at what happened in California reveals that the fatal flaws are not in California’s form of deregulation, but in deregulation itself. This paper will challenge the fundamental arguments underlying ongoing efforts to restructure the electric industry. California’s catastrophe hasn’t stopped market boosters from trying to re-ignite enthusiasm for electricity deregulation. Explanations for the crisis included: glitches in the design of the PX, shortages resulting from droughts in the Pacific Northwest, and an unprecedented rise in natural gas prices. Some even ventured to say that the elements of the “perfect storm” had coalesced. The truth is that California’s regulated system had weathered such storms before and had managed to keep rates relatively reasonable and stable. Crisis and Revelation If 2000 and 2001 were the years of crisis, then 2002 was the year of revelations. Investigations showed the perfect storm wasn’t a natural market phenomenon but more a product of human greed and malfeasance. Further, the loss of state oversight curtailed the ability of regulators to fix the problems. Where did the $40 billion go? Even the bad guys themselves became market victims. Like a black hole, this failed policy sucked in even those who had initially profited. The energy sector has started imploding at a dizzying rate. Approximately $25 billion in debt by merchant generators will come due during 2003. Surplus energy with soft prices remains on the near horizon. In one company’s case, new plants will be turned over to bankers upon completion. None of this should be a surprise. Sound economic analysis would predict the dismal failure of deregulation — in California or elsewhere — for a host of rather obvious reasons. Competition and Capacity In industries such as electric power, pure competition cannot result in an efficient level of capacity, nor can it result in just and reasonable rates. To get a profitable level of capacity the generators must cooperate to run enough, but not too much, plant. Greed may have driven this to an extreme in California, but keeping plants offline to fix prices is necessary for profits everywhere. Manipulation is, in effect, required under deregulation. The promise that eager competitors — “new entrants” — would add capacity and keep prices in line was an empty one, as evidenced by widespread cancellations of scheduled new plants. Wall Street, rather than system planners or even risk-taking merchant builders, will decide what capacity will be built. Profits, not reliability, will drive additions. Recovery of investment in long-lived facilities like generation and transmission requires years of useful operation. This requires a predictable customer base, assured through contracts or through a franchise that protects the base. Merchant generators, selling into a market, can no longer be financed. Choice was promoted as a benefit to customers — a powerful force that would drive demand for superior products, quality, and services. The powerful and informed customer would not only get the pleasure and satisfaction of having desires met, but would also discipline and direct the market. There are several problems with this analysis. First, customers can’t effectively exercise the most important choice, which is to not consume at all. Electricity is an essential product; when we need it, we have to have it. In 2000 and 2001, companies took advantage of that fact and turned off California’s lights in order to command outrageous prices. In the end, unless the market functions perfectly, which it cannot, customers must suffer the consequences. Second, electricity is a fungible product. Although the largest customers may demand voltage stability and reliability that small customers do not, there is no evidence to suggest that this will be any more attainable in a deregulated environment. Small customers, with few exceptions, will not put effort into shopping for products that are by and large indistinguishable from each other. Only where retail choice promises environmentally sustainable generation have small customers demonstrated any interest in their choice option. And after five years of experimentation, it is clear that regulatory commitments to develop sustainable resources are much more effective and efficient than niche marketing. Finally, choice cannot, as proponents have argued, discipline the market. Marketing to small customers represents substantial transaction costs. There is no incentive for competitors or their agents, assuming they ever emerge, to target individual small accounts. Default Customers For all these reasons, small customers usually default to the utility that has for decades served in the role of default provider with an obligation to serve. Market enthusiasts do not adequately protect default customers. Under a regulatory scheme, these customers are protected by rules that the utility justify its revenue requirement and justify the allocation of that revenue requirement among customer classes. In a deregulated market, default customers are forced to absorb costs that are shifted from attractive customers who might be able to negotiate lower rates. The system envisioned under unregulated electricity markets makes coherent planning for resource development or procurement impossible. Without long-term commitments, energy service providers cannot predict how much capital to commit to the development of new resources. The loss of the ability to pursue integrated resource planning in the context of reasonable projections for increased demand is a tragedy of the deregulated system. It could mean that the system would ricochet between high prices with tight supply and soft prices in surplus supply. More Problems Ahead The crowd that pushed for deregulation is undaunted. Some have been indicted and more have been disgraced, but many prominent advocates still insist that deregulation can be done right. A brief look at the fixes they propose shows, however, that the current advice is no better than what came before. Most of the fixes require regulation to work well, or at all. The fixes proposed to make deregulation work include excess capacity reserves, long-term contracts, real-time pricing, vigorous antitrust enforcement, auctioning of the default market, and independent grid operators. However, only the last will deliver benefits for the public. Market proponents have frequently remarked that the lesson to be learned from California is “don’t start deregulation without excess capacity.” But California had excess capacity when it started deregulation, and the market failed. Solutions aimed at fixing the problems in California won’t fix the essential problems with deregulation. Capacity Reserves It makes sense to have capacity reserves for the expected peak, plus a bit more for the unexpected demand or for the loss of capacity due to equipment failure. Regulated utilities built facilities to meet that required reserve. One of the arguments for deregulation was that it would eliminate excess capacity that existed only, it was claimed, because utilities were regulated. Now the same voices that argued for the elimination of excess capacity are arguing that capacity reserves are required to make deregulation work. Developing and maintaining capacity reserves requires each customer or service provider to pay the cost. But the generators are to be free to refuse to commit to supplying reserves unless they get the price they demand. Thus, this “fix” puts us right back in the danger of supplier manipulation. Because the generators benefit from tight capacity, they will refuse to build until they get a guaranteed high price. Long-Term Contracts Long-term contracts are the preferred fix of many. A service provider should, they say, lock up long-term contracts to avoid the volatility of the spot market. However, if the long-contracts are at prices above the spot market — as they might be from time-to-time — then the individual customers can leave the supplier and shop on the spot market. The supplier then has high-priced power it can’t sell. California found itself in this position because of long-term contracts signed by the Governor. Texas Utilities lost $2 billion bailing out of the United Kingdom in November as its customers fled to avoid high-priced contracts. Customers must be locked to a supplier, or the supplier can’t commit to a contract for power. Essentially, deregulation must be stopped in order to save it. This is not a fix. Real-Time Pricing Economists advocating real-time pricing describe it as “allowing” customers to see the real cost of electricity. Discouraging consumption when capacity is tight makes a lot of sense. But real-time pricing can’t work in a deregulated market. The problem is this: The peak-period price, under this scheme, is the cost of power from the most expensive plant dispatched. This is the pricing scheme that led to manipulation at the California PX. All the lower-cost plants get the high price paid to the costliest plant. Most of the power, however, will come from cheap base-load plants, and the average cost will be much lower than the peak price set by real-time pricing. Profits during the peak hours will not be connected to the cost of production. What’s worse, this pricing scheme is a direct invitation to manipulate the market by withholding capacity, an instant replay of the California crisis of 2000. Curiously, peak-load pricing can work effectively, but only under regulation. Under regulation this pricing can be used with a quite different outcome. The high on-peak prices still result in prices higher than costs during the on-peak period. But since there is a profit constraint under regulation, the profits must be passed back to customers by charging lower prices in other periods. Under regulation, the motive to manipulate disappears. Notice the potential for cross-subsidy here. On-peak prices paid by small businesses would subsidize process industries like refineries and cement plants running around the clock. Utilities historically have supported subsidizing large customers by smaller ones in order to have growth in sales. The regulator’s art would be to combine prices and the length of the peak and off-peak periods to produce the desired outcome — just and reasonable rates. Default Markets Like long-term contracts, the default market curtails choice and undoes a basic premise of retail competition. Individual customers cannot be profitably acquired or served, but large groups of individual customers are very profitable for a generator or electric service provider. For these reasons, adherents to the market solution have come up with the concept of facilitating competition by holding auctions for the opportunity to serve the default market. Instead of freedom to choose, the individual is instead auctioned to the lowest bidder. This solution exposes the fallacy of choice and competitive markets and makes it abundantly clear that deregulation is promoted to serve market participants, but not necessarily the customers they gain title to. Standard Market Design Looking beyond generation, FERC focuses Standard Market Design on locational marginal pricing (LMP). This combines two problems. First, it uses marginal-cost pricing in a segment with large overhead costs so that total costs must be covered by a regulated return on investment, regardless of actual electrons traversing the wires. Ignored under LMP, moreover, is that transmission lines can be providing essential service to the system even when carrying no current. Second, SMD makes Wall Street financiers, rather than system planners, responsible for what transmission gets built. This would be the end of least-cost planning. Vigorous Antitrust Enforcement Antitrust enforcement comes after an abuse, rather than preventing one. The weak record of antitrust enforcement, the rapid consolidation that has already taken place, and the further mergers inevitable given the financial condition of the industry suggest that antitrust enforcement won’t be able to control a very tight oligopoly. Conclusion The final tragedy and the best argument for other jurisdictions to scuttle plans for deregulation is that it is so hard to rebuild the system after it has been destroyed. The current climate of high-profile revelations, investigations, and prosecutions proves only how disproportionate to the damages are remedies cobbled together after enforcement and prosecution. California lost close to $40 billion. This is the best we can expect from the backstop of FERC oversight. It is woefully inadequate. FERC is supposed to be engaged when the market isn’t working. If it is true, as this paper argues, that the deregulated market cannot work, then FERC is going to be very busy from now on providing woefully inadequate remedies. Deregulation did not live up to its promises, because its promises were illusions, or delusions. Deregulation can’t work. The largest experiment in restructuring was a dismal failure, and deregulation made everything worse. Those who defend it or try to fix it have had our attention long enough. Filed under: White Papers Tagged under: Utilities About the Author Chris Trayhorn, Publisher of mThink Blue Book Chris Trayhorn is the Chairman of the Performance Marketing Industry Blue Ribbon Panel and the CEO of mThink.com, a leading online and content marketing agency. He has founded four successful marketing companies in London and San Francisco in the last 15 years, and is currently the founder and publisher of Revenue+Performance magazine, the magazine of the performance marketing industry since 2002.