The California Electricity Monster

By Thomas A. Smith

April 1, 2001

'Who invented communism?", the old samizdat joke goes, "the politicians or the scientists?" Answer: "The politicians: If scientists had invented it, they would have tried it on dogs first."

Our politicians have given us our current electricity crisis, and we are the dogs in their failed experiment in redesigning the power industry. As we sweat through the hot, un-air-conditioned nights to come, we shall have time to wonder how it happened, who is to blame, and what, if anything, can be done about it.

The currently popular villain, of course, is "deregulation" and "out-of control markets." After two decades of successful utility deregulations in Britain, Australia, and various American states, not to mention numerous other triumphs of economic freedom around the world, the folks who never met a market they really liked think they finally have something to point to.

But criticizing deregulation by pointing to what the politicians did to the electric power industry in California is like criticizing human reproduction by pointing to Dr. Frankenstein's monster. He was not made in the usual way, and is hardly typical of the outcome.

Like Frankenstein, the story of how we got to the point where the Public Utility Commission had to approve, as it did last week, the largest electricity rate hike in California history, is so complex and distasteful that it hardly bears repeating.

Of course, we all know that Gov. Gray Davis had absolutely nothing to do with this rate hike -- more than 40 percent for the electricity portion (but 26 percent of the bottom line because transmission and other fees are not affected) for some Southern California Edison and PG&E customers. (San Diego Gas & Electric customers cannot take comfort; a similar rate increase for them has not been taken up yet.)

The rate increase for the state's other major private utilities was done by the Public Utilities Commission, three of whose members -- including chair Loretta Lynch, were appointed by Davis.

One can only imagine the behind-the-scenes conversation between Davis and Lynch where she learned she would raise rates now, and take the blame for the decision.

Clearly, Davis does deserve the credit -- and it is credit, not blame -- for these massive rate hikes, though this may be like giving a man credit for fleeing a burning house. The rate hikes are necessary because without them, consumers would go on consuming so much power that it would drive the big private utilities such as SCE and PG&E deep into bankruptcy.

This is because under the wonderful system bequeathed to us by the California pseudo-deregulation, the more power the utilities sell, the more money they lose. If this seems not to make sense, it's because it doesn't.

The way deregulation usually works is that utilities are freed to go out and buy power, transportation, or whatever, in the best market they can find, for the best price they can find, and then turn around and compete to sell it to us consumers at some profit. The geniuses who designed the California electricity monster instead decided utilities should pay deregulated market prices for power, but then be required to sell it to consumers at capped prices, and sell us, moreover, as much as we want. By thus buying high and selling low, the utilities have wracked up some $14 billion in debt in the last few months, debt that will be paid off by ... well, that part hasn't been figured out quite yet.

If this buy high, sell low feature of the California electricity monster seems like the stupidest thing you have ever heard of, wait. It gets worse. When the politicians were putting their creature together, they decided that they did not really trust markets, and especially not the sort of long-term contracts utilities and power generators might enter into. After all, markets are strange and mysterious. Much better to have a "market" regulators could monitor and manage. So they invented the Power Exchange or PX. This was the highly regulated, entirely artificial -- and now defunct -- market where until recently the utilities had to buy all the power they needed for their customers, having been all but forced to sell much of their own generating capacity (yes, another stupid mistake).

The PX was a market only politicians could invent. It was a mandatory spot market with no long-term contracts. The energy equivalent of having to buy all your food from only one store, and never more than you need for one day.

Sounds expensive, no? But it gets worse still. Under the exchange's curious auction system, utilities didn't even get to pay the lowest price they could bargain for. Nope, the generators made offers, then the highest price of the last bid necessary to satisfy the short-term demand was what everybody had to pay.

In a supply shortage, the system was a formula for power generators charging just about whatever they wanted. And, as we have seen, they did, with catastrophic results for the utilities.

Perhaps all this was not foreseen by John Bryson, a founder of the Natural Resources Defense Council, former PUC chair, and now president of the parent company of SCE. Holman Jenkins of the Wall Street Journal identifies Bryson as the motive force behind the baffling PX approach. He should have tried it on dogs first.

Indeed, the populists of left and right who cry illegal conspiracy and price-gouging, sound silly when one realizes that the legally mandated PX was a scheme for fixing prices better than any conspirators could ever put together on their own. It was much better organized than your average conspiracy, and it not only was legal, it was required.

Part of the Davis plan, now that the folly of a mandatory spot market is clear to nearly everyone, is to try to buy more power using long-term contracts. The problem, under current circumstances, is that it is like going out to buy insurance when your house is on fire.

Davis deputized the state Department of Water Resources to negotiate these long-term contracts. Since these state employees have little experience or qualifications to deal in this complicated market, they may not save us a lot of money. And as the contracts they make are being (perhaps illegally) kept secret, it may be a long time before we find out how their on-the-job training is proceeding. It would have been better to let the utilities bargain for themselves, but the spirit of the times is that the state knows best.

The electricity monster has not, however, been mean to everyone. Take the Los Angeles Department of Water and Power, for example.

Because LADWP is a public municipal utility, it gets to go to the front of the line to buy ultra-cheap power from federal agencies such as the Bonneville Power Administration. Then, being one of those public-spirited public sector monopolies, it can turn around and pass all these savings on to its customers. Or instead, it can do what it actually is doing, which is to sell that cheap public power on the PX for huge profits, and then strut around saying that it isn't having the problems that the private utilities are having.

S. David Freeman, the general manager of the LADWP, has introduced legislation to set up a state power authority that would build public power plants and have authority to seize private ones through eminent domain. You've got to hand it to the LADWP for seizing the opportunity. But it would seem only fair that if they are going to preach the evils of deregulation, they should at least give the public back some of the millions they have made off it.

But what are a few million in the scheme of things? It's chicken feed compared to the billions the state, the ratepayers or whomever is going to have to come up with to pay the debts the utilities and the state treasury are running up buying power. The state treasury reportedly is spending some $50 million per day buying power. And it's only April. The state is going to the bond market, where the PUC has authorized selling some $12 billion in bonds, the largest issue of its kind in U.S. history. But the state could need a lot more money before we are through. Retail electricity rates may have to go much higher, to reduce demand, pay for power we already have used, and make state and utility power buyers creditworthy enough to buy more.

And what monster story would be complete without the torch-bearing peasants, who don't know much about science, but know evil doings when they see them?

We have various foundations, self-styled consumer advocates and the like, who threaten to launch a ballot initiative to stop rate hikes, re-regulate the power industry, or otherwise attempt to repeal the laws of supply and demand.

It's no wonder, with all this, that some people are speaking of desperate solutions, like suspending all environmental and other regulations to speed the building of new power plants, or handing the entire California industry over to the Federal Energy Regulatory Commission to run. Both situations seem most unlikely now, but who knows how things will look after a few hundred, or a thousand hours of rolling blackouts?

The best course now would be to legalize free contracting between the utilities and generators -- perhaps backing utilities' credit with a qualified state guarantee, get the amateur Department of Water Resources out of the electricity buying business, make the muni's sell federal power into the grid at cost (they've made enough profits for a while), accelerate approval, construction and operating of new plants; and phase in the unfortunate, huge but inevitable additional rate increases necessary for conservation and increases in supply, among other things. The rate hikes, as painful as they will be, are a step in the right direction.

Davis and many Democrats, not to mention the muni's and some private utility players, want to move back to a more regulated industry for reasons both of ideology and self-interest. But Wall Street and FERC, not to mention the Bush administration, will push hard to move the California industry toward real deregulation, and they may hold the ultimate financial and political trump cards. That would mean higher rates, at least until the transition to a truly deregulated industry is complete. Then real competition should push rates down. How much in rate hikes California consumers -- and voters -- will tolerate until that fine day comes will loom as one of the key political questions. This will be a major power struggle, and its outcome is unpredictable. But for now the monster is loose, and I fear it may be a long, dark summer.

Smith is a professor of law at the University of San Diego and served as a senior counsel and economist in President Reagan's Council of Economic Advisers.

Copyright 2001 Union-Tribune Publishing Co.