Deregulation California Style

USA Today (Society for the Advancement of Education), July, 2001 by Tim D. Kane

IN A NOV. 21, 2000, speech on technology, Federal Reserve Chairman Alan Greenspan closed his remarks with some advice to government regulators: "For policymakers, supervisors, and regulators, I would only suggest some general guidelines for the coming years: proceed cautiously; facilitate and participate in prudent innovation; allow markets to signal the winners and losers among competing technologies and market structures; and overall, as the medical profession is advised, do no harm." He has offered this advice before, but perhaps it is no accident that this restatement coincided with the unraveling of California's botched attempt to deregulate electric power.

Amidst the wreckage of California's 1996 plan to achieve free market results through central planning techniques are three important economic lessons for policymakers who wish to "do no harm" and for the rest of the nation desirous of keeping the lights on: First, fixing a commodity's price does not stabilize the market for consumers, but, rather, guarantees an imbalance between demand and supply. Second, removing controls from whole sale, but not retail, prices does not protect consumers from exploitation. Instead, it unleashes powerful forces that sweep far beyond the regulators' jurisdiction, imperiling the efficacy of distant markets and threatening the integrity of the entire system. Third, no group of planners--no matter how intelligent and wise--can replace the invisible hand of the marketplace. A brief review of the rationale for regulating power, details of California's scheme to deregulate the electric power industry, and reasons for its failure will illustrate the importance of these lessons for the nation.

Producing electric power requires huge investments in generating and transmission facilities and much smaller doses of maintenance personnel and fuel to run the generators. The first two costs are incurred up front and are constant whether the generators are running at peak capacity or are idle. Just maintenance and fuel vary with the level of production. Obviously, the power industry does not fit the textbook model wherein many small producers vie for the consumers' favor, competing vigorously on quality and price. The power industry is the classic example of a "natural monopoly." Because most costs are fixed, larger plants not only produce more power, but average costs per kilowatt decline as plant capacity grows. Due to its lower average costs, one large producer could afford to sell power at a lower price than could two or three small plant operators competing to serve parts of the same area. The resulting idea of a regulated natural monopoly proved to be the proverbial two-edged sword. The state could secure the advantages of lower production costs for its citizens by granting one producer the exclusive right to serve the area. The other edge of the sword was described by 18th-century economist Adam Smith: "By constantly keeping the market under-stocked, by never fully supplying the effectual demand, the monopolist sells his product for more than its natural price." To avoid the result of lower output and higher prices implicit in monopoly, state regulators had to set maximum allowable prices.

Why deregulation?

More often than not, the regulated price was unsatisfactory to everyone. Consumers argued it was set too high, while power companies complained that it was too low and precluded rates of return sufficient to attract the new investors upon whom expansion and modernization depended. In practice, determining the "right" price soon gave way to a much simpler approach--cost plus a "fair profit." Here was a powerful incentive for utilities to operate with the greatest possible expense. Regulators struck back, demanding that power companies justify every expense in minute detail. Of course, compliance further elevated the costs of electricity as well as retail power prices.

Then it dawned on someone that electricity was a homogeneous commodity such as #2 red winter wheat. A utility could purchase and resell an electron of power without it having to be the same electron. A generator operator could create an electron of power and put it into a wire, after which a public utility could purchase that electron, then authorize its customer to withdraw a different electron several states away. Multiple generators could feed power back into the transmission grid at several points, and homeowners on the same block could each purchase power from different public utility companies. As long as a public utility did not sell more electrons to its customers than it purchased from generators, regardless of plant location or how many were involved, balance would be maintained. The idea for deregulating the electric power industry was born.

When California officials referred to deregulation, they did not mean they were willing to permit the marketplace to determine retail electricity prices or the optimum industry structure appropriate for this arrangement. Instead, regulators devised an intricate plan for accomplishing the objective. California could have been spared the blackouts, bankruptcies, and bailouts that followed if, in drafting their deregulation bill, state officials had recognized they were acting as Smith's men of "system": "The man of system ... is apt to be very wise in his own conceit; and is often so enamored with the supposed beauty of his own ideal plan of government, that he cannot suffer the smallest deviation from any part of it.... He seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. [But] in the great `chess-board' of human society, every single piece has a principle of motion of its own, altogether different from what the legislature might chuse [sic] to impress upon it."