The Myth of Deregulation

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.