|
 o
hear California Governor Gray Davis tell it, price-gouging power
generators are the cause of the California
electricity
price spike and President Bush refuses to do anything about it because,
well, it's Texas power generators who are ransacking the California
market. Even Bush's own Federal Energy Regulatory Commission (FERC),
Governor Davis charges, reports that wholesale electricity prices
on the western grid have been "unjust and unreasonable"…so
why not call out the price cops? The reality, however, is that the
federal price cops are indeed on the beat, it's just that the president
is unwilling to have them do a "Rodney King" on the power market.
First, let's see what's behind FERC's contention that prices were
"unjust and unreasonable" in California last winter. The commission
maintains that it the legitimate price for power during the power
emergencies last January was 27 cents a kilowatt-hour. The operator
of the California power grid, however, reports that it paid an average
of — hold on to your hats! — 28 cents for that power on
the daily spot market.
During February, wholesale natural gas prices exploded, resulting
in a legitimate price — according to FERC — of 43 cents
per kilowatt-hour during the power emergencies that month. Unfortunately,
data are not available about the prices that the grid operator paid
for power from February to the present, but given the relationship
between prices and costs in January according to the FERC, it's
unlikely that wholesale prices after February were on average more
than a few cents higher than costs.
For the sake of argument, let's assume that a penny or two of each
kilowatt sold in the state represents "profiteering." If so, don't
blame the free market — it doesn't exist. In California, generators
can charge whatever they want during a crisis without fear that
the prices they name will reduce sales because the state insists
upon maintaining retail price controls. This is called a "dream
scenario." Without those rate caps, generators would find that high
prices reduce sales, providing a disincentive against overcharges.
The upshot is that retail price controls are themselves primarily
responsible for whatever mischief exists.
What exactly is a legitimate price, anyway? The FERC argues that
the highest cost source of supply necessary to meet demand sets
the legitimate price for all sources of supply in the market. That's
textbook economics. And that's how they're planning to regulate
the market this summer. But Gov. Davis wants the feds to go further.
He'd have the FERC cap prices for each individual generator at no
more than 5 percent above production cost (the old "cost-of-service-plus"
regime). The idea is that this would bring down the average cost
of power and thus allow the state to reduce the retail price of
electricity. The problems with that approach, however, are legion.
First, it provides a disincentive for firms to control costs. A
relatively low-cost plant gains no economic advantage against higher-cost
competitors. The profit margins would be the same, so why bother
keeping your costs down?
Second, it would lead to shortages. If consumers aren't paying the
cost of the last unit of energy necessary to meet demand —
and they don't under average-cost pricing — then generators
will lose money on every additional unit sold. And demand will exceed
supply at such prices. A firm cannot lose on every additional sale
and make it up on volume.
Third, it reduces the incentive to invest in new power plants. Money
is pouring into new plant construction because the profit margins
are quite impressive for the time being. Reduce the profit margins
and you'll reduce investor's interest in power plant construction.
Let's face it; there are a lot of profit opportunities out there
that promise more than a 5 percent rate of return.
Fourth, average-cost pricing biases the electricity market towards
needing new supply. In fact, this very point was once made quite
energetically by the political Left to justify energy conservation
subsidies. Amory Lovins, a famous advocate of energy conservation,
has argued correctly that traditional state regulation of the electric
utility business delivered average costs, not marginal costs, to
ratepayers, which resulted in inefficiently excessive levels of
consumption and losses for the utility whenever marginal costs exceed
average costs. Lovins's remedy for this market distortion, however,
was not a "first-best" solution — the introduction of marginal-cost
pricing — but a "second-best solution" — to have electric
utilities subsidize ratepayer purchases of energy-efficient appliances
and technologies, which would be cheaper for utilities than investments
in additional generation. California has used ratepayer dollars
to follow Lovins's advice. But the result was a mess, producing
excessively high-cost power and the inevitable demand for deregulation
at the start of the 1990s.
So this is the great Bush-Davis debate in a nutshell. The president
and his regulators at the FERC believe that prices ought to reflect
supply and demand. The governor and his populist allies think that
prices ought to reflect the cost of production and nothing more.
That this debate is even being held and that serious people are
taking it seriously unfortunately says a lot about the level of
economic literacy both in the press and in the public at large.
In sum, those who think that eliminating the alleged market power
in California's wholesale electricity markets would return electricity
prices in California to 1999 levels have spent too much time in
the hot tub. Those who think that denying the laws of supply and
demand are the best way out of this mess will soon be pondering
such thoughts in the dark.
|
