Short circuit: Deregulation -- a movement groping in the dark

Journal Record, The (Oklahoma City), Feb 9, 2001 by Alex Berenson N.Y. Times News Service

This bit of gallows humor has been making the rounds of the electricity industry: The British decide to switch drivers from the left to the right side of the road, just like the rest of Europe. But the queen worries that making the changeover all at once will be too complicated.

So she decides to institute a monthlong transition period. Cars will switch sides in January. Trucks will wait until February.

Welcome to the era of electricity deregulation.

Five years after states began giving up their control over the power industry, power prices have soared in both California and New York, two of the states where deregulation is furthest along. Last month, rolling blackouts hit California, prompting Gov. Gray Davis to label deregulation there "a colossal and dangerous failure."

Over the last two decades, the gospel of deregulation has spread from Washington to London to New Delhi, from trucking to banking to telecommunications to electricity. The United States, which embraced deregulation earlier and more thoroughly than the rest of the developed world, grew almost twice as fast as Europe and nearly three times as fast as Japan in the 1990s.

"Letting market forces work, letting competition work, is better for consumers, better for investors and better for the overall economy," said Philip Hoffman, chief economist of PNC Financial Services Group in Pittsburgh.

Now, however, and possibly for the first time since deregulation began in earnest, this dogma faces a serious real-world failure.

Despite this, many economists still think that electricity deregulation will work. A product is a product, they say, and competition always works better than state control.

"I believe that premise as a matter of religious faith," said Philip J. Romero, dean of the business school at the University of Oregon and one of the architects of California's deregulation plan.

Optimists like Romero say the current period is merely an ugly transition, not yet even true deregulation. Power costs would have risen anyway, they say, because the price of natural gas, which is used to generate electricity, has soared.

In addition, California has been slow to allow building of new plants. That has left power in short supply, causing prices to rise. As new supplies becomes available, prices will fall, Romero said.

Also, California made a crucial mistake when it capped the rates consumers could be charged, while removing controls on the wholesale price of power, said Stephen Slifer, the chief American economist at Lehman Brothers. The caps prevented the state's utilities from passing their costs on to ratepayers, creating no incentive for consumers to conserve, Slifer said.

However, a growing chorus of dissenters worries that the recent price spikes are not an aberration. The way electricity is produced and priced gives too much clout to the power generators, they say.

To economists, prices serve as crucial signals to producers and consumers. In a regulated market, the state sets prices high enough for private companies to cover their costs and earn a guaranteed profit for their investors. But in a deregulated market, prices should vary with demand and supply.

If prices rise, companies will see the opportunity for profit and make investments to meet that demand. Also, high prices tell consumers that supply is scarce and give them an incentive to conserve.

Sounds good. But building power plants is a slow process, so supply shortages can last several years. Also, electricity is the kind of product economists call "demand inelastic," because it is vital for both consumers and businesses. That means its price must go way up before people will use less of it.

In other words, once the supply of power gets tight, generators gain almost unlimited power to set prices. As a result, prices can stay high for far longer than is necessary to signal the marketplace that a new supply is needed. Making matters worse is the fact that electricity cannot be stored, so users cannot build inventory to protect themselves.

The way electricity is priced in deregulated markets only adds to the problem.

Because of the physics of power transmission, producers and utilities must work together to keep power flowing across the electric grid. So New York, California and other states that have deregulated have set up nonprofit "independent system operators" to control their transmission grids.

Every day, the ISOs set the price for the power, using so-called reverse auctions. (California's system works slightly differently, but the effect is the same.) The ISOs receive offers to produce electricity from generators. Then they pick as many plants as they need to keep the lights on, choosing the lowest bid first, then the next lowest and so on. Once the demand for power has been met, the highest bid accepted sets the price that every generator receives.

In theory, the system should encourage generators to bid no more than the cost of running their plants, because, if its bid is accepted, it will break even; then, if a higher bid is accepted, the generator will get that price and automatically make a profit.