The Myth of Energy
Deregulation
Monday, November 07, 2005
by Adam Summers
While the initiatives on the upcoming November 8 California special
election ballot backed by Governor Arnold Schwarzenegger have been
receiving all of the media attention, another initiative that addresses
an important issue is being overlooked. Proposition 80, the so-called
"Repeal of Electricity Deregulation and Blackout Prevention"
initiative, would make some significant and detrimental changes in
the state's energy policy.
The fact that even a government regulatory body such as the California
Public Utilities Commission (PUC) is actually against a measure
that would increase its regulatory powers should tell you something right
off the bat about the merits of Prop. 80.
California energy consumers are currently served by one of three types of
providers: investor-owned utilities (IOUs), local publicly-owned electric
utilities, and independent electric service providers (ESPs). Before the
state's "deregulation" experiment of the 1990s was suspended in
2001 during California's energy crisis, customers could choose to
purchase their electricity services directly from ESPs through
"direct access" contracts, rather than through an intermediary
such as the local IOU or public utility.
Proposition 80 Would Reduce Consumer Choice and
Increase Costs
Proposition 80 would permanently prevent all
customers receiving electricity services from an IOU from switching to an
ESP, effectively eliminating any new direct access (existing direct
access contracts would be grandfathered in).[1]
Thus, under Prop. 80, instead of having the option to buy electricity
directly from independent producers, consumers would have no choice but
to buy their electricity from utilities. By effectively eliminating an
entire class of providers, the state has stifled competition (and would
continue to do so), thereby leading to higher prices and, likely,
lower-quality service.
The effect of this provision on prices would be significant. ESP
customers include hospitals, local governments, the California State
University system, several University of California campuses, community
college districts, and local school districts. The nonpartisan
Legislative Analyst's Office (LAO) estimates that the UC system alone
saves about $12 million per year by purchasing its electricity from a
lower-cost independent provider.
According to Mike Florio, an attorney for The Utility Reform Network
(TURN, one of the chief proponents of Prop. 80 that helped craft the
measure), the ability of consumers to purchase electricity directly from
independent service providers "destabilizes the whole business … and
we'll truly be at the mercy of the gods of the free
market."[2] How dare people be able to choose
whom they want to do business with! I suppose TURN hired Mr. Florio not
for his legal expertise, but rather by the sheer providence of the
"free-market gods."
Proposition 80 Would Impede Innovation and
Efficiency
Another provision of Prop. 80 would prohibit the
broader implementation of "dynamic pricing" of electricity
without the consent of the consumer. Currently, all but the largest
energy consumers pay a flat rate for electricity that does not vary by
the time of day. Clearly, energy use is not constant throughout the day,
however. There are certain "peak" hours of the day when
consumers use lots of electricity, and "non-peak" hours when
they use very little. The costs of providing electricity vary
accordingly. As such, the IOUs have submitted proposals to the PUC to
charge all consumers higher rates during peak hours and lower rates
during non-peak hours. This price discrimination would be accomplished
through the use of high-tech "smart" meters.
In addition to making good sense one should pay more for something when
it is in higher demand dynamic pricing would encourage conservation via
the pricing mechanism. Dynamic pricing would be a more efficient system
because higher prices would discourage some from consuming such a scarce
resource while ensuring that those who place the highest value on energy
use are still able to consume it. Similarly, those who have some
flexibility over when they consume their energy would be encouraged to
utilize it during non-peak hours, thus placing less strain on the
system.
Allowing the consumer to opt out of a dynamic pricing model would be like
forcing a hotel owner to offer customers the choice of the nightly room
rate or an average of the nightly room rates throughout the week. Since
significantly more people stay at hotels during the weekend, rates are
much higher on Friday and Saturday nights. The average weekly rate,
however, would be higher than normal weekday rates but lower than normal
weekend rates. The cheaper "opt-out" weekend rates and higher
weekday rates would encourage even more people to stay during the weekend
and fewer to stay during the week. The result would be a shortage of
hotel rooms during the weekend and a loss of revenue for the hotel owner.
No wonder demand strains the electrical grids during hot summer
days.
Environmental Issues
Under current regulations, energy producers must
increase the portion of energy derived from renewable energy sources
such as solar, wind, and hydroelectric by one percent per year until
2017, when 20 percent of the energy produced must come from these
sources. Proposition 80 would accelerate this deadline to 2010.
Interestingly, some environmentalists oppose Prop. 80 because a provision
requiring a two-thirds vote of the Legislature to amend the measure could
make it more difficult to increase the renewable energy standard in the
future.
According to the
LAO's analysis, Prop. 80 would also require that "the first
priority for IOUs in procuring new electricity is to be from
'cost-effective' energy efficiency and conservation programs, followed by
'cost-effective' renewable resources, and then from traditional sources
such as fossil fuel burning power plants."[3]
Of course, if renewable energy sources and energy efficiency and
conservation programs were truly "cost effective," producers
would already be utilizing them in higher numbers because it would make
them more profitable. This clearly is not the case. Forcing companies to
invest significant amounts of their scarce resources on more costly
energy-production methods, which make up a relatively small share of
total energy production (for good reason), will only ensure that costs
and, ultimately, consumers' electricity bills remain higher than
necessary.
As new technologies and energy-production methods are developed, this may
change, but for now, it is best for both producers and consumers to focus
on the most efficient means of producing energy. Of course, if consumers
demand "cleaner" energy, in a truly free market, producers will
have an incentive to provide it. Indeed, after Pennsylvania successfully
implemented its electricity deregulation effort in 1999 (without the
pitfalls experienced by California), 20 percent of consumers chose to
switch to suppliers of "green power," despite the fact that
they had to pay a small premium to do so. Proposition 80 eliminates this
choice, instead demanding that all consumers support the higher cost of
investing more in renewable energy whether they want to
or not.
Misconceptions Over Electricity
"Deregulation" in California
Some blame deregulation for the rolling
blackouts, soaring spot market prices, and utility bankruptcies that
sprang from the energy crisis of 2000 and 2001. But this anger is
misplaced. California has never experienced true deregulation. The
"deregulation" implemented in 1996 left price controls in place
and created "artificial" markets ripe for manipulation and
disparities between supply and demand.
By setting price caps below market prices, California limited the
profitability of the industry. When wholesale energy costs increased, the
price caps prevented energy producers from passing them on to consumers.
Wholesale prices rose dramatically for a number of reasons: natural gas
prices rose, hot weather in the Southwest increased demand, a relative
lack of water in the Northwest minimized the production of hydroelectric
energy, and pollution-control permits, which allow industrial companies
that produce less pollution than allowed by regulations to sell the
difference as "credits" to higher-pollution-producing
companies, rose ten-fold, from $4 to $40.
The price caps additionally discouraged potential producers from entering
the market and increasing competition, and they discouraged existing
producers from investing profits in adding capacity, of which
Californians were (and continue to be) in dire need. As a result of the
price caps and pressure from politicians and environmentalists, the
building of plants and transmission lines slowed dramatically and energy
producers were not able to keep up with demand, particularly in the
Silicon Valley, where the booming computer and "dot-com"
industries led to even sharper increases in electricity demand.
After the big three investor-owned utilities Pacific Gas &
Electric, Southern California Edison, and SEMPRA (San Diego Gas &
Electric) were forced to sell many of their fossil-fuel-burning
generators to private firms, regulators prohibited them from entering
into long-term contracts with these firms, forcing them to rely upon the
much more volatile short-term and spot markets. In addition, California
forced generators and utilities to trade power through the Power
Exchange, a state-run pool.
- While that requirement was designed to give every company the same
wholesale price for power, it also guaranteed that they would be unable
to negotiate lower-priced power on their own. The California rules
essentially barred utilities from buying power on the futures market,
meaning they were unable to lock in supplies and
prices.[4]
This is as if Wal-Mart and Marshall Field's were forced to acquire
their goods from a non-profit, state-run pool that would guarantee that
they would acquire the goods for the same price. Wal-Mart never would
have been able to develop its efficient and innovative purchasing and
distribution system, meaning it could not generate savings to pass on to
customers in the form of lower prices.
At the time of the increase in wholesale prices, PG&E and Edison were
still in the deregulation "transition" period, and thus still
subject to PUC rate regulations. As a result, PG&E went bankrupt and
Edison teetered on the edge of insolvency. To add insult to injury, when
the government stepped in to purchase electricity on behalf of the
struggling IOUs to try to quell the crisis, not only did it do so at the
height of the emergency, when energy prices were highest, it locked in
these prices with long-term contracts costing billions of
dollars.
The Natural Monopoly Justification for
Regulation
The main argument against the full privatization
of public utilities such as electricity and water service is that such
industries are "natural monopolies." That is, they require such
high fixed costs (it is easier to start a new restaurant than to invest
in the infrastructure for a new electric grid) that it is inefficient for
there to exist more than one producer in a particular location. This, it
is feared, will lead the producer to engage in price gouging.
There are several problems with this rationale, not the least of which is
the notion that "public utilities" somehow constitute a unique
set of goods that must be "protected" by government
intervention. As economist Murray Rothbard noted in
Power and
Market:
- The very term "public utility" … is an absurd one.
Every good is useful "to the public," and almost every good
… may be considered "necessary." Any designation of a few
industries as "public utilities" is completely arbitrary and
unjustified.[5]
High capital costs certainly will limit the number of actual and
potential providers, but there is still a profit motive in a free market
that creates opportunities for lower-cost producers. In addition, it is
important to note that markets are not static; technological innovations
may allow for additional competition in the future.
Another misconception opponents of free markets have concerns the very
understanding of the nature of competition. Even if there is only one
producer of a certain good or service in town, this does not mean that
the producer is "gouging" customers through monopolistic
practices. Indeed, just because he is the sole supplier today does not
mean he will be the sole supplier tomorrow. As economist Thomas J.
DiLorenzo explains:
- If competition is viewed as a dynamic, rivalrous process of
entrepreneurship, then the fact that a single producer happens to have
the lowest costs at any one point in time is of little or no
consequence. The enduring forces of competition including potential
competition will render free-market monopoly an
impossibility.[6]
In other words, even if there happens to be only one current
provider of a particular good or service, in a free market that provider
is held in check by the mere threat of competition if he charges prices
that are too high or provides poor service, there will be an incentive
for a competitor to come in and take market share from him by offering
lower prices or better service.
The rules change, however, when government regulation erects barriers to
entry or otherwise suppresses competition. In addition to the many
government regulations purportedly enacted in the "public
interest," there are numerous instances where private-sector
businesses have been able to successfully lobby policymakers to use the
power of government to establish barriers to competition and protect them
from existing or potential rivals. Unlike the free-market case, there is
no possibility of these monopolists losing out to lower-cost providers
(barring the elimination of the regulations), and they are able to
"exploit" consumers. These are the truly harmful monopolies.
Thus, the only "bad" monopoly is a government-created or
government-preserved
monopoly.
Conclusions
Proposition 80 would be a step backward for
California. It would restrict consumer choice, discourage competition,
and impose more of the kinds of regulations that got the California power
industry into trouble in the first place.
As awful as Proposition 80 is, however, there is good news. It is
trailing in recent public opinion polls, and even if it should end up
passing it is likely to be discarded by the courts. It was removed from
the ballot on July 22 by the Court of Appeals in Sacramento because the
court found that, according to the state constitution, the PUC's
authority can only be increased by the Legislature, not by initiative.
The initiative was restored a few days later by the California Supreme
Court, which did not offer an opinion on the merits of the case but felt
that the public should have the chance to vote on the initiative before
the legal challenge is heard. (Of course, if voters reject the measure,
this will be a moot point and the courts will not have to waste their
time on it a fact that surely was not lost on the Supreme
Court.)
Politicians and regulators forced a sham of a "deregulation"
scheme upon the energy industry in California, and then blamed the free
market when it inevitably failed! The problem was not too much
free-market competition; it was too much regulation (despite the
"deregulation" doublespeak). The real solution to California's
energy problem is to eliminate price caps and all government
regulation, thereby removing barriers to entry, fostering
competition, offering consumers maximum choice, and affording providers
the greatest incentives to increase capacity and best serve their
customers.
Adam Summers is a policy analyst for the Reason Foundation
([email protected]).
Comment on the
blog.
[1] This option was suspended during the electricity
crisis of 2000 and 2001, but is scheduled to be reinstated when the last
of the power contracts signed on behalf of the IOUs by the Department of
Water Resources expires in 2015.
[2] Carrie Peyton Dahlberg, "Electricity
proposition crackles: Will prices go up? Will it avert an energy crisis?
It all depends on who's talking," Sacramento Bee, October 15,
2005,
http://www.sacbee.com/content/politics/story/13717834p-14560232c.html
(free registration required).
[3] California Secretary of State, Official Voter
Information Guide, Statewide Special Election, November 8, 2005, p. 52,
http://www.ss.ca.gov/elections/bp_nov05/voter_info_pdf/entire80.pdf
.
[4] Terry Maxon, "Power Woes Unlikely in Texas,
Officials Say," Dallas Morning News, January 19, 2001, cited in
Lynne Kiesling, "Getting Electricity Deregulation Right: How Other
States and Nations Have Avoided California's Mistakes," Reason
Foundation Policy Study No. 281, April 2001, p. 18,
http://www.reason.org/ps281.pdf.
[5] Murray N. Rothbard, Power and Market: Government
and the Economy, (Kansas City: Sheed Andrews and McMeel, 1977), p.
76,
http://mises.org/rothbard/power&market.pdf. Now integrated into
Man, Economy, and State.
[6] Thomas J. DiLorenzo, "The Myth of Natural
Monopoly," The Review of Austrian Economics, Vol. 9, No. 2
(1996), p. 44,
http://mises.org/journals/rae/pdf/rae9_2_3.pdf.
http://mises.org/daily/1954
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