Deregulation of California Energy Production
Karen Street
May 10, 2001
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History of Deregulation

In the early 1990s, the idea that public services could be better provided by the private sector gained prominence. Commercial interests and industry found states such as California, with historically higher electricity prices, particularly attractive for deregulating electricity production.

Most California electricity came from three private utilities: Pacific Gas and Electric (PG&E), Southern California Edison (SCE), and San Diego Gas and Electric (SDG&E). The rest of California received power from municipal utilities, which can buy cheap federal hydroelectric power.

States with lower costs had either larger amounts of hydroelectric power, often federally subsidized, or coal power, which was very cheap when it came from older, high pollution coal plants.

States paying more for electricity did so for a variety of reasons.

States with nuclear power paid more. In states such as California, which had relatively little hydroelectric power and had decided against coal power, the choices in the 1970s were between nuclear power, at pre-Three Mile Island prices, and inefficient oil power plants, with natural gas when available—as it was, most of the time. Many utilities predicted incorrectly: post-Three Mile Island nuclear power was more expensive than natural gas power. (The cost of changing power plants after they are built is substantial. Modern coal plants are competitive with modern natural gas and nuclear power plants, but are probably poor choices as long as the carbon emissions rules are likely to change.) In California, nuclear power accounts for 38% of the stranded costs, i.e., utility assets too expensive at estimated future prices, as calculated in the mid-90s.

Additionally, the 1978 Public Utilities Regulatory Policy Act (PURPA) required utilities to pay avoided costs for producing small amounts of energy and for renewable energy. (The idea was that high costs could be avoided by turning off the more expensive plants.) Many states, California included, set payment for solar and wind energy at a level much higher than their value. In California, PURPA contracts account for 40% of the stranded costs.

PG&E and SCE, at the start of deregulation, were two of the largest private researchers worldwide in solar and wind power, another expense. That policy made sense for companies that were concerned about keeping energy prices low in the future, but did not make sense under deregulation, so research was abandoned in 1996.

California’s present environmental rules mean that coal plants will not be built here, but this restriction has not been a factor in limiting power plant construction.  In the mid to late 1980s, the major California utilities requested permission to build new power plants, but permission was denied by the California Public Utilities Commission (CPUC). No new power plants were planned during the recession. By the mid-90s, the shift to deregulation had begun, and would not end until the 1998 election; no companies began construction while the rules were unclear.

The appropriate question for the mid-90s was why utilities producing fossil fuel power do not pay a tax to compensate for the health and environmental costs they inflict on society. ExternE recommended adding up to 19 cent/kWh to fossil fuel power: coal, natural gas, and oil. Instead, the shortsighted question asked was whether states opting for cleaner forms of energy were paying too much.

PG&E and SCE initially opposed deregulation, but embraced it when they realized that deregulation would occur anyway, and why not? Deregulation would eliminate all but a handful of utilities nationwide, and these two utilities, two of the best run, had a good chance of surviving. While each area would be serviced by more than one electricity provider under deregulation, only a few American utilities were expected to survive, as occurred with long-distance telephone service.

Everyone in California—all of the regulatory agencies, all of the utilities, all of the environmental groups present—all agreed to the new rules of deregulation. Consumer groups were the lone exception, and they complained only that consumers should not be responsible for accelerated payments for nuclear power plants and PURPA contracts.

This thumbnail history provides background for understanding the present energy crisis.

Is There a Shortage of Electricity?

California normally imports energy in the summer. Last summer, however, other states had less energy to export because their own needs had grown and because 2000 had been a dry winter.  California normally exports electricity in the winter, but was a net importer last winter. California, like most of the western states, was unprepared for rapid population growth, a good economy, and increasing per capita consumption.

There are other factors contributing to the energy shortage. California’s natural gas plants average over 30 years old; they are inefficient, and prone to breaking down if not run with a delicate hand and plenty of off-time for maintenance. The utilities have failed to pay smaller energy providers, and many can no longer afford to sell energy. Many power plants have annual pollution limits, and do not operate at the end of the year. Environmental rules will close some natural gas plants for pollution control retrofitting, so Governor Davis will need to decide whether or not to ignore California pollution laws in order to limit energy cutbacks.

Power plants in states normally receiving winter power from California have been required to export power, exacerbating regional energy problems. A dry winter this year will increase this summer’s problems, both in California and regionally.

The first set of power plants to open will replace old natural gas power plants; it will be at least two years before there is excess electricity. Californians should plan on living with less electricity for that long. We can hope that good habits formed now will continue even when electricity is again plentiful.

Why are Prices so High?

Reporters, protesters, and consumers expressed concern over rising electric prices for months without noticing the change in our utility bills was entirely due to increases in the price of natural gas (except briefly for SDG&E customers). No cap exists on the wholesale price of electricity, but a low retail cap allowed Californians last year to buy several billion dollars more in electricity than we paid for, a difference of several hundred dollars per capita.

Many estimates are being produced for the crisis without clear explanations. On top of that, no one really knows. This is my attempt to explain others’ attempts at estimating the magnitude of the debacle.

Wholesale electricity was priced at more than 17 cent/kWh in March, a low-use month. Wholesale electricity cost almost 35 cent/kWh in December. The average wholesale price for 2001 may be 30 - 40 cent/kWh. Additionally, we pay several cents/kWh for distribution costs and accelerated payments on nuclear plants and renewables contracts.

Some economists expect California wholesale electricity prices for 2001 to be $70 billion, more than $2,000 per capita, about 6 - 7% of the Gross State Product, even though per capita electricity use in California is half the average in western states. The costs of electricity last year and this year will be paid, either directly by billing customers, or indirectly through taxes and bonds. It is worth noting that when OPEC oil prices were 2% of U.S. GDP, a recession followed.

Natural gas shortages have caused power prices to increase significantly, especially in the West. The shortage exists because two very warm winters masked a nationwide shift to natural gas use in electricity production, during which time natural gas production remained at a low level. While natural gas wholesale prices have quadrupled, this is only a small part of the price increase.

Consumer failure to respond to the increase in electricity generation costs allows what economists call “the exercise of market power”. While market power exists for all products, it is of more significance in the electric market because electricity is very expensive to store, and a shortfall requires either planned blackouts or a danger to grid stability. Even small producers can exercise market power.

The Federal Energy Regulatory Commission (FERC) has been applying to electricity strict supply/demand economics theory which may not be appropriate. Almost all economists agree that the same rules of economics do not apply, in part because consumers cannot know the cost at time of use, and cannot adjust accordingly, i.e., electricity generation costs are much higher at peak use. It will be several more years before most residences are metered. Meanwhile, market power will be more effective for electricity than any other commodity. This excessive profit is not required to stimulate competition—the new plants will sell power at much, much lower prices, yet there is no lack of desire to build new plants. FERC refusal to cap electricity prices is responsible for much of the high prices.

CPUC, as of May 1, has failed to raise the retail price of electricity to a realistic level. Because the state currently subsidizes energy purchases, the public as a whole pays, rather than those who use large amounts of electricity, and no one pays a penalty for drying clothes during peak use hours. Along with a larger increase in electric rates, real-time metering should be extended, beginning with larger users. Governor Davis agreed April 19 to a $31M program to extend real-time metering to sites with more than 200 kW use; currently only sites using more than 500 kW have real-time metering.

Economists and energy scientists believe that consumers will not conserve sufficiently unless charged the full cost of electricity. Real-time pricing, where feasible, is better than average charge. Without these measures, we will continue to have rolling blackouts at least through the summer. Additionally, there will be calls to ignore environmental concerns: the fish in this dry year, or the high pollution permits—20 cent/kWh—for running some southern California power plants in the summertime.

Is Deregulation a Good Idea?

Many argue that deregulation is a good idea, but that deregulation was applied inappropriately in California, that deregulation will be successful in states that have an oversupply of energy, that well written deregulation law makes good economic sense for the consumer.

While it is certainly true that deregulation, could have been better run, we need to know what good energy policy should accomplish before we know if deregulation is good for society.

A good energy policy provides enough energy for today and tomorrow, and includes research and also mechanisms to implement the research. In California, this means specifically research on distribution, and research on and promotion of efficiency and renewables. Good energy policy is concerned with how much people spend on energy today and tomorrow, and doesn’t focus solely on the short-term. Good energy policy reduces the economic, social, and environmental costs of pollution, today and in the future, emphasizes efficiency and conservation, and begins to shift away from fossil fuels. Good energy policy addresses national and international obligations, so that western states don’t pollute eastern states, the U.S. doesn’t pollute Canada, and all states reduce contributions to climate change.

Are these problems solved better by deregulation than by regulated production? Will the new producers invest more in efficiency, solar, and wind than PG&E and SCE, because they have a long term investment in the state and the solutions? Will long-term investments be able to hold their own against natural gas power with its smaller capital costs and higher fuel cost? Only if the answers are generally yes can deregulation sometimes work. But, in fact, the answers are generally no.

Deregulation often fails when applied to other commodities. If supply exceeds demand by much, the price is determined by the marginal cost of producing energy, and producers lose money. When this happens with other commodities, a call for reregulation occurs. Then there are the costs associated with making electricity production truly competitive. Borenstein and Bushnell (p 51) ask, “(A)re the costs of sustaining competition less than those of sustaining regulation?”

Deregulation is bad for the environment, doesn’t work for energy producers, and doesn’t work for the consumers. However, because of the political environment, we will likely continue to have deregulation. So what should the government do?

What Economists and Energy Scientists Say

It is crucial to increase the price high-usage consumers pay, and, where feasible, to use real-time pricing. Consumers will not conserve significantly without strong incentive; failure to conserve will result in more disruptions to the California economy this coming summer. FERC should end its politically driven policies, and cap wholesale energy prices.

As electric use increases in California this summer, particularly during peak use times (about noon to 9 PM, usually), the price wholesalers charge will also increase. Since the majority of electricity use this summer will not be metered real-time, consumers need to voluntarily reduce peak use of electricity. If we don’t, everyone in California will pay much more for each kWh.

There is no “no-sweat” plan available to Californians. So forget turning your thermostat to 78 F —turn the air conditioner off, unplug your instant-on TV, and walk to the park. Think of a possible economic recession in California, think of your favorite program supported by taxes, think of a $2000+ electric bill, and think about reducing your electric use as much as possible.

The structural problems remain: a lack of responsibility for supply, a lack of long-term contracts (but do not make them while prices remain high), a lack of price-responsive demand, and a lack of adequate market power mitigation tools.

Deregulation was intended to solve the problems of electricity prices, which some considered too high in some areas of the country. But the problems of energy are more than high or low prices, and rolling blackouts.

John Holdren expresses the thinking of much of the energy science community when he says, “Neither complete reregulation nor complete deregulation of energy markets is the answer. Capturing the cost savings available from the appropriate play of market forces in the energy sector is too appealing a proposition to abandon. But energy is too burdened with public-goods dimensions (including national security, environmental sustainability, the macroeconomic ramifications of reliability, and society's commitment to meet the basic needs of its poorest members) to allow complete deregulation. The directions for addressing our short-term energy challenges are easier to describe than designing and implementing the details will be. But more daunting still are the energy challenges looming in the longer term. These include providing a sustainable energy basis for maintaining prosperity where it already exists and achieving it where it does not, limiting dependence on imported oil, reducing the risks from greenhouse gas-induced climate change, and minimizing the contributions of nuclear energy to nuclear weapons dangers.

“Meeting these challenges will require increased efforts to maximize the capabilities and minimize the liabilities of the full array of energy options: improvements in end-use energy efficiency in vehicles, residences, and industries; renewable energy sources; advanced fossil fuel and nuclear fission technologies; and nuclear fusion. There is no silver bullet in this array nor are there any that we can be confident we can do without. Current levels of public and private investment in energy R&D and demonstration are not remotely commensurate with the long-term challenges and opportunities, either in the United States or in any other country.  U.S. federal expenditures on applied energy technology R&D are about what they were, in real terms, just before the oil price shock of 1973-74, although today's economy is more than twice as large. U.S. private sector investments in energy R&D have been falling since the mid-1980s.

“Strengthening R&D is only part of the answer. Incentives must also be strengthened for deploying a wider array of the most attractive options from the menu available at any given time. And increased international cooperation in energy innovation is warranted, because U.S. and other countries' economic, environmental, and security interests are served thereby. Although markets have a large role to play in all this, the government must also be involved. The large public benefits attending the right choices--and the large public costs attending the wrong ones--require it.”

Perhaps the U.S. government should take more responsibility, given the national and international implications of energy policy. Most certainly, we need more state and U.S. control than exists under complete deregulation if we are to have any chance of solving today’s energy problems.

What Can Friends Do?

• Advocate protection of those who already find life not affordable.

• Realize that lower prices for energy today means higher prices in the future:
     • Support a national carbon tax. In “Scenarios for a Clean Energy Future”, five national labs estimate that funding research into efficiency and adding a $50/tonne C-tax (12.5 cents/gallon gasoline, from 0.5 - 1.3 cents/kWh for fossil fuel electricity) will lower our total energy bill in 2020 18% from business as usual.
     • Support steps to reduce climate change. Climate change will increase costs for clean water, air conditioning, disaster mitigation, etc, etc in the lifetime of the power plants built today. Taxing carbon production and high energy use will provide funds to help provide non-carbon fuel sources, and to pay the costs of society over the next few decades as we prepare for a changing environment, and as we deal with the consequences of a changed environment.

• Be a smart energy consumer. Efficient light bulbs, efficient appliances (look for the Energy Star label), and lowered energy use save us money. Increase insulation. Changing time of use to off peak demand times will help others and the environment. Check Energy Star or your newspaper for more suggestions. Turn the water heater off or down and unplug everything but your refrigerator when on vacation. We need to lower household temperatures in winter, raise them in the summer, and give sweaters for Christmas.

• Mount public interest campaigns to change behavior,  mandate higher energy efficiency for appliances and televisions, and mandate limits. People are only somewhat aware that our behavior needs to change. But even being aware is not sufficient—all SUV owners are aware of what society thinks, yet a large number buy SUVs. This voluntary behavior is harmful to society. We can consider mandating that all cars have a minimum mileage, say 30 mpg, as well as require doubling of mileage by 2012 (technically feasible). High-energy behavior also includes lights on in the daytime, roses in winter, and aluminum foil.

• Elect and support energy and environmentally capable public servants. California will face many emergencies in the next few years and decades. Higher gasoline prices and possible shortages, higher water prices and possible shortages, preparing for climate change, increasing land use conflicts as the population grows to 50 million by 2025, a health care shortage. California should have an official who is responsible—but not one elected every four years: an elected official who has to balance the needs of slightly increased energy costs for today vs sharply increased costs for tomorrow will almost always opt for the decision that will win reelection. California needs a government infrastructure that can work to solve the problems of the state, not ineffective turf wars. National and California energy policy organizations must use the expertise of scientists and economists experienced in energy policy.

1 ExternE is the 1997 European Union study of the externalities of the fuel cycle, the health and environmental costs not included in the price. The evaluation of the environmental costs of fossil fuel energy would be higher if calculated this year, as estimated health,  environmental, and economic costs of both fossil fuel pollution and climate change have increased. Return to text

2 Much of the economic analysis comes from Severin Borenstein, the E.T. Grether Professor in Public Policy and Business Administration at UC, Berkeley, and Director, University of California Energy Institute. See especially Regulation v. 23, no. 2, pp 46-52 “Electricity Restructuring: Deregulation or Reregulation”, Borenstein and Bushnell, and Manifesto on the California Electricity Crisis, signed by several prominent economists. Some of the explanation comes from a phone conversation with  Severin Borenstein. Return to text

3 Science February 9, 2001, p. 945 Meeting the Energy Challenge. John Holdren is Teresa and John Heinz Professor of Environmental Policy at Harvard University and director of the Program on Science, Technology, and Public Policy at Harvard's John F. Kennedy School of Government. Return to text

4 Scenarios for a Clean Energy Future  Return to text

5 Energy Star is an EPA project Return to text

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