The California State Legislature has passed a package of bills to relieve, at least for appearances sake, San Diego rate payers from their high electric bills. San Diego is the first region in the state to enter fully the restructured electricity market, having completed the transition process from regulated utility to electricity supplier. The relief package, part of which Governor Davis has signed, includes a price freeze on the retail cost of electricity and a streamlining of the siting process for new plants.
Left unfixed was the wholesale electricity market which will continue to charge high prices throughout the state. For the meantime this will mean a stabilization of prices for beleaguered San Diego consumers, but also the accumulation of a multi-million, if not billion, dollar debt that will someday have to paid by rate payers, tax payers, or utility shareholders.
The day before the vote, on an unusually cool August day, electric rates hit their wholesale market price cap of $250 per megawatt hour. Demand was low and supply — as measured by total megawatts available to the market — was more than adequate. Theoretically, prices should have been closer to $60 to $80 per megawatt. Legislators were left scratching their heads. In the end they passed a stop-gap measure that will do little to stop the long-term problem of California's electricity market and in fact may worsen it.
In the past, electric utilities were heavily regulated for a reason. In return for building power plants — and attracting the necessary capital to do so — the investor-owned utilities were granted monopoly status over a certain geographic territory. They in turn promised to serve all in the territory. Because they had monopoly power, the Public Utilities Commission set their rates based on a formula that granted them a reasonable rate of return. That system worked reasonably well until government mandates forced the use of higher-cost and environmentally-fashionable renewable sources, and no-growth policies imposed restrictions on the construction of new power plants.
It was believed that the inefficiencies and high costs of the government-regulated monopoly system could be fixed by the restructuring that took place in 1996 with AB 1890. The idea of that law was to develop a competitive marketplace for electric generation, a service that previously was the exclusive obligation of the regional investor-owned utilities and publicly-owned municipalities and power agencies. The investor-owned utilities would sell off their generators to new and existing private power companies. These companies would in turn sell the power into a new "generation market" run through two new state agencies, the Power Exchange and the Independent System Operator. By this means it was thought that competition would drive down prices and ensure consumers a sufficient supply of electricity.
Two serious miscalculations were made. First, the legislature failed to take into account that a competitive free market of electricity requires the ability of new generators to enter the market at a fairly rapid rate. Today it takes three to five years, under the best circumstances, to complete the permitting process before a new power plant can go on line. As a result the monopoly power once held by the investor-owned utilities has been transferred to the existing power generators. But whereas utility company rates were regulated by the PUC, private generators are regulated only by the existing $250/mw price cap. And this cap is still far in excess of what prices were expected to be.
It should be noted that before the price cap was instituted, on one July afternoon in 1998, the price of a megawatt hour reached $9,999--and was held at that level only by the fact that the generator believed the computer receiving its bids would only read four digits! Moreover the old investor-owned utilities, now suppliers, are required to buy their power from the Power Exchange and at whatever price the market clears. What we have today, then, is a market where current generators have enormous market power, and where new generators are not easily able to enter the market and compete.
AB 1890 also miscalculated in assuming that new generators — the catalyst for lower prices — would enter a market that seems so likely to be reregulated. In a free market, capital flows to where it will get the highest return for the risk involved. What investor today would spend the half a billion dollars necessary to site, design, and build a major power plant in California, only to have the PUC or the legislature step in with price controls?
Just this summer we have seen a state senator encouraging San Diego customers not to pay their electricity bills and the legislature has passed a bill that imposes a price freeze on retail prices. Who is going to risk their capital in such an environment? At present of the 15 new plants being proposed, only five have been have been approved, with only two to come on line next year. Who can doubt that discussions are going on right now with nervous investors and financiers of these projects?
In this light the current debate over electrical rates does not lend itself well to the traditional analysis of supply and demand. With no other good or service is there such talk of price controls. Understanding this, the generation companies, which are under investigation by the Federal Energy Regulatory Commission, are behaving perfectly rationally. They have made investments and hope to reap profits. If the wholesale market is capped at $250/mw they will try to reach that price as often as possible, knowing that next week the cap could be $100 or $50 or some politically acceptable amount. Thus even when there is more supply than demand, prices will remain high, and these high prices almost guarantee price controls in the current climate. What legislator or governor, who appoints the members of the PUC, could expect reelection after electricity prices have quadrupled?
For the foreseeable future the demand for electricity in California will be high because of population growth and a burgeoning technology sector. Supply will remain flat since no new power plant has been built in a decade, current plants are aging, only two new plants are in production, and local communities are likely to resist new plants being sited in their communities. And even if a power plant is built here there are no requirements that they even sell their power to California.
What then is to be done? Fortunately, there are two free market reforms that will go a long way toward solving California's electricity problem. It was not until recently that the PUC allowed suppliers Pacific Gas & Electric and Edison to go around the generation market and enter into bilateral contracts with generators of electricity for about a third of their needed supply. These contracts, which can run through 2005, might be able to lock in lower prices and provide some market stability. If greater long-term contracting were allowed for all suppliers in California, generators would compete with each other to enter into these long-term contracts, not wanting to be caught without someone to buy their electricity. Such contracting would also send a positive message to investors and potential investors in power plants.
Coupled with the use of such contracting, the entire system requires a form of demand management, whereby suppliers who have not contracted for enough electricity are not required to buy at excessively high prices on the Independent System Operator's spot market. Under these circumstances the price caps--a discouragement to new investment--could be removed. This raises the specter of blackouts. But in a sufficiently free, competitive, and therefore efficient market, the specter of blackouts will remain just that.
Someday computer monitoring devices will allow consumers to shut off their electricity when prices get too high. This itself will send a price signal to generators on how much people are willing to spend on electricity. Until such demand management is allowed, however, some price cap will have to stay in place lest a generator charge, at least theoretically, a billion dollars for a megawatt of electricity.
The state legislature, the governor, and the PUC should work toward instituting these free market reforms with the greatest speed. Until then, Californians will be accruing daily a multi-million dollar debt that will someday have to be paid.