***Challenges in Deregulating Electricity:\
Drawing Lessons from the California Experience***

# Tim Brennan

Professor, Policy Sciences and Economics\
University of Maryland, Baltimore County\
\
Senior Fellow, Resources for the Future, Washington, DC\
\
<brennan@umbc.edu>

National Energy Modeling System/Annual Energy Outlook Conference

Energy Information Administration, U.S. Department of Energy\
\
Crystal City, VA

March 12, 2002

# California assessment

## Basic explanations for California crisis seem clear

### Supply/demand crunch

### Bankruptcy when utilities had to buy high, sell low

### Political paralysis: Who pays

## But are popular lessons the right ones?

### "California's deregulation was a disaster"

### "California didn't deregulate enough"

### "Generators 'gamed' PX auction"

### "Too little real-time metering, not enough incentive to conserve"

### "Long-term contracting limited"

### "Generators exercised market power"

### "Wholesale price-caps a temporary fix"

# Fundamental issue: "But for California's mistakes, electricity markets work"

## Reliability: the crucial challenge

## California debacle a distraction from fundamental questions

## Is "Markets or not?" fact or ideology

## Is electricity on the other side of the line?

# What makes electricity unique---three combined factors

## Crucial to the economy

### 2-3% of US GDP an understatement

### The "e" in e-commerce

### Infrastructure industry---economic development tool (US rural electrification, LDCs)

## Vulnerability from load imbalances

### Keeping supply and demand *always* in line

### Prohibitive storage costs

## Inter-relatedness

### Perhaps forgotten in the rush to open markets

### One company's load imbalance can bring down the system

### Varying degrees of central control

# "California wasn't always a disaster" 

![](media/image1.wmf)

# "California didn't deregulate enough"

## In some ways, regulation a clear problem

### Retail rates held down while wholesale rates rose

### PG&E bankrupt; others close, getting bail-outs

## But limits to deregulation

### Local distribution physical natural monopoly

### Transmission -- loop flow externalities

### Only solution: distributed generation

## Need to separate regulated control from unregulated service ownership

### Cross-subsidization, discrimination

### *US v AT&T* precedent

### ISO, "TransCo," RTO, Independent Transmission Administrator: Separate transmission from generation

### Separate retailing from distribution?

# "Generators 'gamed' PX auction"

## Markets worked through May, 2000, over 2 years 

## Auction could hurt when supplies tight

### All get market clearing price

### Bid in supply curves, offer quantity at high price?

### Small loss, big upside

### Car dealership contrast

## Problems

### Free-riding

### No minimum equilibrium quantity

## Mitigation strategies

### Pay only bid price -- leads to high strategic bidding

### Minimum quantity bids, raise losses from high bids not taken

## Why have a central auction?

# "Too little real-time metering"

## Important incentive to conserve

### Conventional metering allows only average pricing

### No incentive to reduce or shift use at peaks

### Very high price differentials (10X or more)

## Is this a policy issue? What is the externality?

### Incentive for those who buy high, sell low to pay consumers to install meters

### Do we mandate real-time pricing in restaurants?

### Benefits of real-time pricing finite

## Possible rationales

### Obligation to serve, no externality

### Possible externality with inefficient rationing (blackouts) Also, in electricity, blackouts not localized

### Third party benefits from reducing the queue

### Market power mitigation?

# "Long-term contracting would be a big help"

## Huge effect in hindsight, but going forward?

### Like "should've bought fire insurance" after house burns

### But does insurance construct more houses?

## Did lack of contracts discourage supply in 2000? Probably not

## Past price effect misleading; contract price equals expected spot price (less willingness to pay to avoid risk)

## More entry would depress price off-peak; all capital recovered on-peak (resort hotels)

## Problems with long-term contracts

### Moral hazard: Too much consumption at low price

### Distributor-generator linkages cross regulated-unregulated boundary

# "Generators exercised market power"

## Crying wolf: Accusations when prices only 20%, not 400+% above prevailing levels

## Collusion possible, but unlikely and illegal (210 defendants)

## Unilateral

### Dominant firm, oligopoly models predict high price-cost margins with small market shares

### Legal, at least under US antitrust law

## Empirical price-cost margin studies confirm, but problems

### Price one gets, not price one sets: buyer bankruptcy risk

### Price does not equal marginal (average variable) cost at peak periods under competition

### Resort hotels, again

# "Wholesale price caps an effective, temporary response"

## Efficiency effects

### With competition, caps would reduce supply, lead to blackouts, rationing

### With monopoly, gaming, caps would increase supply

## Distributional issues huge motivator

### On peak huge rent transfer with deregulation

### Peak capital recovery perhaps 100 times baseload per hour

### Can politicians wait for new entry to depress off-peak prices down to zero profit overall level?

### Do equities outweigh efficiencies, if price "high enough" to induce entry?

### Could long-term contract flexibility accelerate benefits from future efficiencies?

## Implementation difficulties

### Highest average variable cost not appropriate standard; FERC error

### Are they "temporary," if invoked anytime peak demand approaches (predictable) capacity constraint?

# "But for California mistakes, deregulation really works"

## California "troubles" distract attention from core problem

### Market power, environmental problems we know how to solve

### Antitrust, regulation, taxes and permits

### CA mistakes give false sense of security 

##  "Importance," "vulnerability," inter-relatedness" =\> Reliability 

### Unique combination of electricity attributes

### Outages largely local, but could they become regional or national?

### Industry-wide response may be required

## My expected "killer" wasn't price, but finger-pointing when the lines went down

# Can we make reliability compatible with markets?

## Competition vs. cooperation, regulation, or planning -- THE big issue

### Will competitors cooperate? *Should* they cooperate?

### Grid responsibility vs. generator liability

### How much centralized control do we need?

## Jurisdictional issues

### US: Interstate reliability, super-Regional Transmission Operators

### Canada: The role of provincial regulatory authorities

## International governance

### Canada and the US: Merging FERC and the National Energy Board?

### EU, Asia issues

## Have markets met their match?

### Is electricity the exception to our rules?

### Is advocacy based on facts, theory, or ideology?

### Might market advocacy be more effective if exceptions conceded?