The Day The Piña Coladas Melted - Resolved: Electricity is too important to be left to a free market

August 01, 2001

The turmoil this year in the California power market has led some states to put their plans for deregulation of electricity supply on hold.  Chadbourne hosted a debate in Colorado in late June on the topic “Resolved: Electricity is too important to be left to a free market.” There were eight debaters.  The following are excerpts from four of their statements.

The speakers are Jerome P. Peters Jr., senior vice president and head of project finance for United Capital, Dennis P. Alexander, senior vice president and general counsel of Cogentrix, Lynn Hargis, former assistant general counsel for electric utility regulation at the Federal Energy Regulatory Commission, and John Cooper, senior vice president and chief financial officer of PG&E National Energy Group.

MR. PETERS.  Once upon a time, in the land nestled between the Great Continental Divide to the Pacific Ocean, there was a great empire.  This land was blessed with long summers, and short mild winters, and an abundance of natural resources, and a group of intelligent and forward thinking regulators.  It was truly a land of milk and honey.

AUDIENCE MEMBER: A fairy tale!

MR. PETERS: Indeed it is.  The citizens of this empire were a demanding lot.  They demanded clean air, clean water and no nukes.  At the same time, they demanded more cars, and more freeways, and more affordable and reliable energy.

AUDIENCE MEMBER: Without smog!

MR. PETERS: They elected legislators who were regulators who saw to it the citizens' demands were met.  They mandated cleaner cars, and they shut down the nukes.  When the regulators began to see the energy as a liability that was being threatened by too much reliance on fossil fuel generation, they initiated programs and tax credits to encourage development of renewable energy projects, which led eventually to a substantial and significant increase in the generating capacity of the empire.  By balancing in full the means of reliability with affordability, the regulators were able to ensure that the empire was well served with the first mix of reliable and affordable power.

The citizens, relaxed in their air conditioned houses and sipping frozen piña coladas, confident in the knowledge that life was indeed good.

The citizenry of this empire, never being satisfied with the status quo, decided life would be better if it were cheaper.  They elected officials who responded by embracing a concept of free market energy where supply and demand would determine the price of generated electricity.  Early on, the wise regulators raised concerns about this new free market approach, warning of price spikes and of power shortages once the plan was implemented.  The regulators’ concerns were brushed aside and, after many years of playing this debate, they got the free market system that they desired.  Almost immediately prices skyrocketed.  Several of the empire’s largest utilities could no longer afford to purchase this free market power.  Soon electric prices to the people rose.  The lights went out.  The houses got hot, and the piña coladas melted.

Then the people cried out: “Who is to blame?” The people blamed the elected officials for flawed legislation, the elected officials blamed the power suppliers for price gouging, and the power suppliers blamed the fuel suppliers and the elected officials.  There was plenty of blame to go around.  It seems that the desired price benefits the empire had hoped for failed to be achieved.

The point is that electric generators in any given market represent an oligopoly where significant barriers to market entry give a limited number of suppliers market power, enabling them to manipulate price by limiting supply.  If anyone doubts this premise, I offer as evidence various actions by members of OPEC over the last 30 years.

The second point is that suppliers seek to minimize production costs of new generating capacity, leading all the suppliers to choose the lowest-cost type of technology that can be developed in the shortest amount of time.  The result has been nearly 100% of all capacity additions in recent years have been gas-fired projects.  The increased utilization of natural gas as a primary fuel source has put pressure on gas supplies and transportation capacity, and it has pushed prices to levels two and three times what they were several years ago.

Reliability has suffered for much the same reason with all new electrical generating capacity using natural gas.  When there is a shortage of gas supply transportation capacity, there is a shortage of electricity.

There is nothing in the dynamics of the free market system that promotes the development of higher-priced renewable energy.  But without such renewable energy sources, wherever will we be in 30 or 40 years? No frozen piña coladas for sure.  What we have learned from the California experience lies not in what they did wrong, but in what they did right.  Prior to the free market debacle, California maintained an adequate reserve margin that was mandated by the California Public Utilities Commission and was paid for by the ratepayers.  After the early 1980s, new capacity was achieved in long-term power purchase agreements between the utilities and the independent power producers.  Regulators encouraged the development of renewable energy through mandated standard contracts, making California the nation’s leader in renewable energy production.

With the advent of so-called deregulation, which began in the early 1990s, virtually all capacity additions in the state ceased.  Little significant new renewable capacity was added and reserve margins plummeted.  As soon as the utilities divested their generating assets, prices rose and reliability dropped.  Is there any reason to expect that free market approach will produce better results elsewhere?

• • •

MR. ALEXANDER.  I am sorry that we have focused on California, because I don’t know of a similar crisis that deregulated markets have created anywhere else in the country.

AUDIENCE MEMBER: Hear, hear!

MR. ALEXANDER.  We in North Carolina don’t have any problems.  In Maine where I was recently, they seem to be getting along just fine.  So let’s call a spade a spade and not condemn the entire nation and the entire industry because of the folly, failures and shortcomings in California.

The perilous situation in California is far worse than anything that could have occurred had the state truly deregulated and let the market work.  In the long run, crises do not serve a free market.  They may serve the politicians, but they do not serve any of the other players in it.

To argue that there is a need to regulate when markets fail is like saying that there is a need to resuscitate after someone clubs someone unconscious.  The other side assumes the current situation is a failure of the market.  An assassination of it is the more correct comparison.  Left to its own devices the marketplace will, given time, come into its own balance and the value from the taker will be matched with value to the provider, and there will be a stable situation created, albeit there will be fluctuations from time to time.

We know in our business that there are fluctuations because it takes time and circumstance to adjust to needs.  But artificial governmental interference merely frustrates the ability of the market to react.

Transmission is something we haven’t really talked about.  Distribution is a natural monopoly and is a vital service that must be regulated and controlled.  Perhaps the delivery of the product must be regulated, but it does not follow that the product itself must be regulated.

What California does not need is to exacerbate the situation by imposing more regulations to fix the ones that are not working.

• • •

MS. HARGIS.  They say if you don’t know history, you are doomed to repeat it.  In 1930, we actually had in this country a free market in wholesale electric rates.  The governor of a very important state became concerned about this because he could not keep down the electric rates in his state.  One of the things he tried was to start a public power authority.  Even that was not completely successful.  So this governor, when he became president of the United States, got enacted an act that would regulate wholesale electric rates and also the holding companies that own them.

Many people now say that this president, Franklin D. Roosevelt, saved capitalism by regulating it, and I propose to you that he also saved investor-owned utilities by regulating them.  If you look around the world, you will notice that, until recently, most other countries own the electric power supply system.  Far from causing them to be taken over by the state, I submit that FDR saved privately-owned utilities.

Alfred Kahn, the guru of deregulation, testified recently before Congress.  Many people are insisting that price caps never work.  They point as an example to Nixon and the oil price caps in the 1970’s.  Kahn said that cost-based regulation of electricity did work — did really work — from 1945 to 1995.

I saw a headline the other day and it said, “Brazil Power Crisis, Another California?” I can remember a time when it would have gone the other way.  If we had some trouble in California they would say, “Are we going to be like Brazil?”

Electricity is different from other commodities.  The most important reason why it cannot simply be left to a free market is all voters have one thing in common: they pay utility bills.  I knew there was trouble when I went to the Federal Energy Regulatory Commission a few years ago for the first time in a long time and saw a sign that the Federal Energy Regulatory Commission “promotes competitive markets, protects consumers.” And I thought, that’s curious.  I know all the statutes under which FERC operates.  None of them says its job is to promote competitive markets.  Someone had put this ahead of what the statutes do require, which is to protect consumers.  What happened next is FERC ignored its own constituency, and Senator Robert Smith, a Republican, introduced a bill jointly with Senator Diane Feinstein, a Democrat, to impose price caps that would have passed both houses of Congress if FERC had not imposed a price cap on its own.

Finally, let me say a word about a real market — the stock market.  The stock market is regulated in this country under New Deal regulation passed by President Roosevelt.  My husband works for the Securities and Exchange Commission, and he goes to countries like Bulgaria, Hungary, and Brazil and helps them with their stock market regulations.  There is one interesting thing about those unregulated stock markets — nobody uses them.  It is front page news if a share is traded in Bulgaria.  I believe there were two shares traded there recently.  And yesterday over a billion shares were traded in the United States stock market.

• • •

MR. COOPER: Our worthy opponents have tried to push this debate to the absurd.  We are not talking about deregulating the whole electricity supply chain.  We are talking about electricity the commodity.

Nobody in his right mind would propose deregulating all the components of the electricity supply chain or natural monopolies.  We are not arguing for deregulation of interstate transmission.  We are not proposing deregulation of the guy who puts the wires in your house.  We are talking about electricity the commodity — the wholesale supply of electricity and the retail purchase of electricity.

Electricity has unique aspects that no other commodity has and that basically require the careful management and transition from regulation to deregulation.  We maintain that deregulation doesn’t exist anywhere in the county yet, and what we are seeing are basically efforts at moving toward deregulation, some more successful than others.

Why have we been talking in this country about the deregulation of electricity the commodity? It is because regulation has failed.  This is not just an academic exercise.  People believe that the prices and cost of power should be lower than under the regulatory regime.  Where, in fact, has the push for deregulation been greatest? It has been in California and New York and New England — the highest price power areas in the country.  And why have those prices been so high? Because of failed regulatory efforts in the past.

Electricity supply and demand must be in balance at every given instance and this needs to be managed by a centralized dispatch system that signals which units are going to run to meet supply and provide stability to the system.  Clearly there is some regulatory role.  Right now, the regulators have failed to perform that role properly in the West, and the rules in some regions are more stable than in others, which is one reason why the new supply under development varies in different parts of the country.  The price signals must be capable of providing for excess supplier reserve margins at all times.

Right now, the way to regulate supply without direct capacity payments is to turn off the lights.  Essentially, the retail market operates on inaccurate price signals.  In order to have true deregulation, you must have consumers understand what they are paying for — what the price of their commodity is — to allow behavior to adjust on the demand side as well as over time on the supply side.

The transition process has failed in California, but is being successfully undertaken in New England and New York where various types of transition arrangements have brought forth a flood of new investment that every economist in the industry is predicting will lead soon to an overbuild situation.  Competition is what is going to provide the best value and the best pricing for consumers over the long term.