New Dimensions of Market Failure in Electricity and Natural Gas Supply

Journal of Economic Issues, June, 2001 by Harry M. Trebing

Has public utility deregulation been a success or a failure? The answer to this question depends on whether one approaches it from the perspective of mainstream neoclassical economics or from the perspective of institutional economics. The difference between these approaches relates not only to the identification of problems, such as the exercise of market power or the promotion of societal values, but also to the scope and nature of remedial public policies.

Essentially, mainstream neoclassical economics argues that competitive markets will allocate resources efficiently and constrain market power in public utility industries after economic regulation is removed and open access by competitors is assured. Residual evidence of market failure will be minimized and can be readily corrected by the introduction of well-defined property rights and the free exchange of these rights. Market power is typically defined as the ability of the firm to withhold output and raise price above a competitive market price, but neoclassical economics holds that this potential abuse will be rapidly eroded--given the growing availability of information, new technology, and access to superior supply options.

Institutional economics focuses on market failure and market power since they are cardinal factors defining a role for government intervention and regulation. Market power is defined as a dynamic process involving the ability to coerce through pricing, market structure, and political strategies. When skillfully applied, each of these strategies will utilize the unique structural characteristics of public utilities as network industries to establish positions of dominance. This deployment of power will affect the institutions of governance and impact the distribution of income.

A Brief Background

Electric and gas utility industries were traditionally regulated as monopoly services. Beginning in the early 1970s, these industries were exposed to a series of external shocks associated with inflation, fuel shortages, and a failing nuclear technology. These problems, in turn, were translated into escalating electricity and gas prices, falling reliability, cost overruns, and, for natural gas, successive periods of curtailment and oversupply which pipelines sought to correct by price discrimination.

Public policy responded to these problems by shifting from a reliance on monopoly supply to a pluralistic supply and the hopeful introduction of competition. In natural gas, the Federal Energy Regulatory Commission (FERC) compelled the separation of natural gas as a commodity from the pipeline transport of gas. This permitted end users to negotiate directly with producers and marketers. In electricity, FERC moved to implement the Energy Policy Act of 1992 with a series of orders designed to require the functional unbundling of generation and transmission to create wholesale competition among generators and open access to the transmission grid. State initiatives were directed toward the promotion of retail competition with the first steps being taken by Rhode Island, California, Pennsylvania, and Massachusetts. By 2000, over half of the states appeared to be moving toward retail competition.

The driving force behind these changes was the promise of lower prices, improved service, better efficiency, and more rapid innovation. Large energy buyers, utility executives anxious to maximize profits by eliminating regulation, and potential entrants aggressively promoted deregulation.

California's Energy Crisis

California's crisis in electricity and natural gas supply in 2000-2001 dramatically changed public perception of the alleged gains from deregulation. It also served to bring about a reassessment of the neoclassical case for deregulation and a critical evaluation of FERC and state deregulation programs.

California consumers had been promised a 30 percent reduction in electricity prices and an improvement in reliability by introducing market forces. Instead, wholesale electricity prices skyrocketed and peak off-peak electricity prices increased substantially while peak and off-peak usage remained essentially stable. [1] Furthermore, when electricity was deregulated in San Diego these prices increased 5.6 times, compelling the reintroduction of retail price caps. For much of the state, service reliability fell dramatically. On December 7, 2000, the first of a series of stage 3 emergencies appeared, [2] to be followed by rolling blackouts. Clearly, California did not achieve "reliability through markets." At the same time, natural gas prices rose dramatically because of an increase in demand and constrained supply. [3] As a result, the wholesale price of gas at the California border was substantially greater than the average nationwide price of gas in early 2001.

There is no consensus regarding the causes of or the remedies for California's crisis. Investor-owned utilities (IOUs) want full recovery of the cost of purchased power to avoid bankruptcy. Deregulated generators want a continuation of spot market transactions and unrestricted auctioning. Consumer groups argue that the exercise of market power will shift costs to consumers, shelter gains by IOUs within the parent holding company structure, and cover up collusive behavior on the part of deregulated generators.