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Policy Debate: Has Deregulation Caused the Energy Shortage in California?


Issues and Background

As an economist, whenever I hear the word "shortage" I wait for the other shoe to drop. That other shoe is usually "price control." So it was no great surprise to discover, after the electric power shortage in California made headlines, that there were price controls holding down the price of electricity to the consumers.

In the absence of price control, a shortage is usually a passing thing. When prices are free to rise, that causes consumers to buy less and producers to produce more, eliminating the shortage. But when the price is artificially prevented from rising, the shortage is prevented from ending.
~Thomas Sowell


California's deregulated power industry, in which producers can sell electricity for whatever the traffic will bear, was supposed to deliver cheaper, cleaner power. But instead the state faces an electricity shortage so severe that the governor has turned off the lights on the official Christmas tree a shortage that has proved highly profitable to power companies, and raised suspicions of market manipulation.

The experience raises questions about deregulation. And more broadly, it is a warning about the dangers of placing blind faith in markets.
~Paul Krugman


California began experiencing a serious energy shortage beginning in the summer of 2000. This shortage continued into 2001. During this period, power blackouts became relatively frequent in many areas of the state. These problems appeared to have begun with the deregulation of the electrical power industry in California. Are these problems the result of deregulation? Or are they the result of regulations that result in inefficient outcomes? This question is of particular importance since many other states are in the process of following California's path to deregulation.

Until the mid-1990s, it was argued that there were extensive economies of scale in the production and distribution of electricity and natural gas. These industries were usually cited in economics textbooks as examples of natural monopoly industries. By the mid 1990s, though, advocates of deregulation argued that technological changes had eliminated the economies of scale in the production of energy. The distribution of electricity, it was argued, remained a natural monopoly since distribution would be substantially more costly if each provider of electricity and natural gas were to provide its own power and natural gas lines. (Costs per customer would be substantially higher if there were 4-5 sets of wires and natural gas pipes along every street.)

Deregulation began in California in 1996. The state's two largest utility companies, Pacific Gas and Electric (PG&E) and Southern California Edison were encouraged to sell off their power generation plants and to focus on the distribution of gas and electricity to their customers. These utilities were to buy power on the open market and then resell it to their customers. The prices that these companies could charge to their customers were subject to a price ceiling.

By the summer of 2000, rising energy costs resulted in substantial losses for California utilities. Utilities had to pay substantially more for power, but could not pass the higher costs on to their customers. In response to these losses, both PG&E and Edison International were threatened with bankruptcy. Energy suppliers were reluctant to sell power to these endangered firms, further raising their costs and increasing their losses. Since the supply of electricity was not keeping pace with the growth in demand, brownouts and blackouts became common phenomena. These problems were aggravated by the higher than anticipated electricity demand that resulted from high levels of air-conditioning usage during an exceptionally hot summer.

In January 2001, the state of California purchased long-term power contracts on behalf of these troubled companies through the use of an internet auction. This resulted in lower prices and reduced the probability of a major crisis. While the immediate crisis has been averted, most forecasts suggest that the quantity of electricity demanded will continue to grow more rapidly than the quantity of energy supplied in California unless prices are allowed to rise. During the past two years, retail electricity rates had been allowed to increase somewhat, but regulations restricted the magnitude of the increase for a substantial share of residential households. While the price increase has reduced the problem of shortages, the basic problems still remain.

One issue is that California consumes more electricity than it produces. Critics of the regulatory process argue that this is due to a regulatory environment that discourages the production of new power plants. The construction of new power plants and transmission lines had also generally met with substantial opposition from California residents. Emergency authority was granted to the California Energy Commission between 2001 and 2003 to streamline the application process for the construction of new power plants. During this time period, licenses were granted to 38 new power plants

Those who favor increased deregulation argue that the problems facing California were the result of the price controls that were imposed on the utilities. They argue that higher prices and profits would encourage higher levels of production and distribution of energy.

Advocates of a more activist regulatory approach argue that the problems facing California were the result of poor decision making by California utilities who chose to purchase an excessive amount of energy on the volatile spot market, rather than on more stable long-term markets.

Debate has also focused on whether the energy crisis in California was partly the result of shortages engineered by energy producers in an attempt to raise their prices and profits. In March 2003, the Federal Energy Regulatory Commission issued a report suggesting that price manipulation by producers played a non-trivial role in the crisis.

The debate over the energy problem in California is part of the more general debate concerning the use of price controls in attempts to provide "better" outcome than those that result from market processes. This debate has been ongoing for the past few centuries and is unlikely to disappear in the near future.


Primary Resources and Data

  • U.S. Department of Energy
    The U.S. Department of Energy website contains information about energy markets, energy conservation, federal strategic energy plans, and an extensive collection of data and statistics concerning energy consumption, production, and prices. The state electricity profile page for California is of particular interest.

  • Energy Information Administration, "Energy Prices"
    The Energy Information Administration provides recent weekly, monthly and/or annual data on a variety of energy prices at this website. This information is available in text or Adobe pdf format as well as in the form of a comma-separated data file (for input into a spreadsheet, database, or statistical package).

  • Federal Energy Management Program
    The website of the Federal Energy Management Program contains information about the impacts of utility deregulation on federal agencies.

  • Federal Energy Regulatory Commission
    The Federal Energy Regulatory Commission regulates interstate commerce in natural gas and electricity. It also oversees the enforcement of environmental regulations related to energy production and distribution. This website contains information about its history and operations. Among other useful materials, this site also contains the text of several statements and speeches, Congressional testimony, and press releases dealing with energy issues.

  • INO.COM, "New York Mercantile Exchange"
    This page provides information on a variety of energy prices determined at the New York Mercantile Exchange (NYMEX). Current market prices are displayed for electricity, heating oil, natural gas, light sweet crude oil, unleaded gasoline, and propane.

  • California Energy Commission
    The California Energy Commission is charged with overseeing the distribution of energy in California. This web site contains information on the energy crisis, recommendations for dealing with the crisis, and numerous studies and projections of energy demand and supply under alternative assumptions about future prices and profitability. The Commission's page on electricity is particularly relevant.

  • California Consumer Energy Center
    The California Consumer Energy Center provides descriptions of rebate, grant, and loan programs designed to reduce electricity consumption in California. Information on energy conservation alternatives is also provided.

  • Paul Van Slambrouck, "California's uncertain step to fix power woes"
    In this January 18, 2001 article in the Christian Science Monitor, Paul Van Slambrouck provides a good description of the nature of the energy shortage facing California.


Different Perspectives in the Debate
  • Thomas Sowell, "The Cause of the California Electricity Shortages: 'Price Controls'"
    In this January 11, 2001 article appearing in the online edition of Capitalism Magazine, Thomas Sowell discusses the electricity shortages in California. He argues that the electricity shortage in California is a very simple example of the effect of a binding price ceiling. Sowell argues that the problem would disappear if the price controls were lifted. He also notes that much of the problem is due to the supply restriction that has resulted from the opposition to the construction of new power plants.

  • Paul Krugman, "California Screaming"
    In this December 10, 2000 New York Times article, Paul Krugman argues that some of the problems experienced in California may be the result of market manipulation by utilities. He notes that an unusually high proportion (25%) of the state's generating capacity was offline in December due to breakdowns or scheduled maintenance. Krugman questions the benefits of rushing "into a market solution when there are serious questions about whether the market will work."

  • George Reisman, "In Response - California Screaming, Under Government Blows"
    In this online article, George Reisman provides a response to Krugman's 12/10/00 New York Times article. (Krugman's article is reprinted at the beginning of this document. Scroll down a little to find the beginning of Reisman's response.) He suggests that government regulations are the long-run cause of the supply shortfall. Reisman argues that price controls are the short-run cause of the shortage.

  • Paul Krugman, "Abuses of Power"
    Paul Krugman examines alternative methods of dealing with the energy shortage in California in this January 7, 2001 New York Times article. He suggests that a complete deregulation of utilities would work, but "would also transfer tens of billions of dollars from California consumers to eight lucky power companies." Krugman argues that a more equitable outcome would be to introduce temporary and partial regulations that would place temporary caps on wholesale prices while creating incentives to increase productive capacity.

  • Jerry Taylor, "Paul Krugman Short Circuits"
    In this Cato Institute article, Jerry Taylor raises objections to Paul Krugman's arguments. He suggests that adjustments would occur more rapidly if prices are allowed to freely adjust without government regulations.

  • Adam Hamilton, "California Electricity Economics 101"
    In this online June 1, 2001 Zeal Research article, Adam Hamilton discusses the causes of the energy shortage. He argues that the problem in California is the result of government interference with the market determined prices. Hamilton suggests that deregulation in California is essentially just a poorly designed system of re-regulation. He believes that a market solution to the problem would be more efficient.

  • Reason Public Policy Institute, "Energy and Electricity"
    This web site contains online articles, speeches, and links related to the production of energy and electricity. In general, material found at this site advocates market-based solutions.

  • Brian T. Kennedy, "Making Sense of California's Electricity Mess"
    Brian T. Kennedy, in this September 7, 2000 briefing paper, examines some of the issues associated with deregulation of electricity in California. He argues that free market reforms would help to provide lower prices. Kennedy supports increased competition in the distribution of power, but argues that price caps should be kept in place until demand management systems are available that will allow consumers to automatically reduce consumption when rates increase.

  • Mona Charen, "The Power of Ideas"
    In this January 19, 2001 editorial, Mona Charen argues that deregulation is not the cause of California's energy problems. She suggests that the problem are the result of "stupid, self-defeating regulation." Charen notes that, due to price controls, PG&E was forced to buy electricity at a cost of $1.7 billion that it could sell to consumers for only $70 million. She argues that all price controls must be lifted if this shortage is to be eliminated.

  • California Public Interest Research Group, "Reliable, Affordable Energy"
    On this website, the California Public Interest Research Group argues for a greater reliance on energy conservation and more supervision and regulation of the energy industry.

  • PBS, "Who Caused the Blackout in California? And Who's Profiting?"
    This PBS website contains an extensive collection of information on the energy crisis in California. Among other resources on this site are an interesting collection of interviews dealing with this problem.

  • Robert J. Michaels, "An Energy Policy in Bellbottoms"
    Robert J. Michaels critiques the handling of the energy crisis in California in this January 19, 2001 online article. He suggests that many proposed state policies would result in inefficient outcomes. Michaels suggests that less regulation and a greater reliance on markets would improve economic efficiency.

  • Adam Summers, "The Myth of Energy Deregulation: California never fully deregulated"
    This online November 7, 2005 Reason article suggests that California's energy shortages result from a failure to fully deregulate the production of electricity. Summers advocates the use of a pricing mechanism that raises prices during periods of higher demand. He suggests that energy shortages would not be likely if prices were deregulated.

  • Public Citizen, "Cash, Relationships Help Explain Bush Administration's Hands-Off Policy in California Electricity Crisis"
    This February 15, 2001 press release from Public Citizen argues that political contributions have resulted in policies that benefit profitable utility companies in California. They advocate the use of wholesale price ceilings on electricity.

  • R. Richard Geddes, "Time to Repeal the Public Utility Holding Company Act"
    R. Richard Geddes, in this Cato Journal article, argues for the repeal of the Public Utility Holding Company Act of 1935. This Act, passed during the Great Depression, limits the ability of utilities to merge. Geddes argues that this Act limits the ability of companies to diversify regionally. He suggests that companies that are diversified regionally will face more stable generation costs than those that exist only within a narrow geographical region.

  • William P. Kucewicz, "California's Dreaming: Energy Policymakers Can't Defy Economics Forever"
    William P. Kucewicz argues, in this online article, that prices must be allowed to adjust if the energy shortage is to be eliminated. He suggests that wholesale price ceilings would make the problem worse by reducing the amount of supply sold to California by out-of-state producers. Kucewicz argues for reduced regulation of this industry.

  • Jerry Taylor and Peter VanDoren, "California's Burn-out"
    In this February 7, 2001 article in National Review Jerry Taylor and Peter Van Doren argue that the electricity shortage in California is the result of government regulation. They argue that the elimination of this regulation will result in the elimination of this problem.

  • Cato Institute, "The Energy Crisis?"
    This Cato Institute webpage provides an extensive collection of links to online articles that suggest that the use of market incentives and a reduction in regulations would solve the energy problems in California (and elsewhere).

  • Clyde Wayne Crews, Jr., "Electric Avenues: Why 'Open Access' Can't Compete"
    Clyde Wayne Crews, Jr., argues for more extensive deregulation in this April 13, 1998 Cato Institute Policy Analysis article. He suggests that there are no natural monopoly characteristics associated with the transmission and distribution of electricity. Crews argues for a completely free-market approach to the production, distribution, and sale of electricity.

  • Richard L. Gordon, "Don't Restructure Electricity; Deregulate"
    Richard L. Gordon argues for increased deregulation in this article appearing the in winter 2001 issue of Cato Journal. He argues for the privatization of governmentally owned utilities and the elimination of virtually all regulation and affecting the production, distribution, and sale of energy.

  • Robert J. Michaels, "Stranded Investments, Stranded Intellectuals"
    In this 1996 Cato Institute article, Robert J. Michaels examines the effect of "stranded costs" on utility rates. Stranded costs are losses that utility companies receive when they sell power generation facilities at market prices. Baumol and Sidak (and others) have argued that an implicit contract existed between consumers and the regulated firms in which cross subsidies covered the cost of uneconomic services. Michaels, however, notes that most stranded costs are the result of the construction of nuclear power plants at a time when the demand for electricity was contracting. He suggests that these costs are the result of poor decisions by utilities. Michaels argues that there is no reason to believe that allowing utilities to recover these sunk costs will result in more a efficient provision of services today. He suggests that regulations allowed firms to operate as inefficient monopolies for a long period. Michaels argues that there is no economic rationale for allowing them to charge higher prices today to recover returns from inefficient investments.

  • John E. Kwoka, Jr. "Transforming Power: Lessons from British Electricity Restructuring"
    John E. Kwoka, Jr. examines the British experience with deregulation in this Regulation article. He argues that deregulation in England achieved many of its goals, but the price decline was less than anticipated. Kwoka suggests that one of the problems in England was allowing only two private generating firms to compete in the market. He suggests that this duopoly system resulted in higher prices than would have occurred under a more competitive environment.

  • R. Richard Geddes, "A Historical Perspective on Electrical Utility Regulation"
    In this Regulation article, R. Richard Geddes examines the history of electric utility regulation. He argues that regulation has involved a very close relationship between the government and utilities. Originally regulation was done at the level of the municipality, but shifted to the state level in the early 1900s. Geddes argues that state regulation appeared to be successful because of the fact that it occurred at a time in which prices were falling due to the exploitation of economies of scale and technological advances. He suggests that the regulatory process was affected more by political factors than by the textbook model of cost-plus pricing.

  • Union of Concerned Scientists, "Clean Energy"
    In several documents available on this site, the Union of Concerned Scientists raise concerns over the possible effects of electricity production on the environment. They note that the utility industry is a major source of pollutants. It is argued that incentives should be created to encourage the development of clean and renewable energy production.

  • Union of Concerned Scientists, "California Energy Crisis: Causes and Solutions"
    On this website, the Union of Concerned Scientists provides arguments concerning the causes of the energy crisis in California along with proposals for solutions. They argue that cutbacks in conservation measures and incentives for the development of renewable energy sources were primary causes of the crisis.

  • Robert J. Michaels, "Vertical Integration and the Restructuring of the U.S. Electricity Industry"
    In this July 13, 2006 Policy Analysis study, Robert J. Michaels suggests that the current systsm of deregulation in the production and distribution of electricity is inefficient because it ignores the efficiencies that occur under vertical integration. The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.

  • Federal Energy Regulatory Commission, "Price Manipulation in Western Markets: Findings at a Glance"
    This March 26, 2003 document describes the evidence that was gathered by the Federal Energy Regulatory Commission on energy price manipulation during the California energy crisis. The Adobe Acrobat viewer plugin is required to view this document. You may download this viewer by clicking here.

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