Although details are complex, the root cause of California’s electricity problem is simple: demand outran supply. A booming economy coupled with little power-plant construction led to a scarcity of generating capacity, which was compounded by low levels of water to produce hydroelectric power. Wholesale electricity prices rose dramatically, in part because prices for natural gas–the fuel used in many of California’s plants–were rising dramatically. Little of this was Davis’s fault, but he made a bad situation worse.
He’s tried to defy the law of supply and demand. The 1996 “deregulation” of California’s electricity industry forced the major utilities to sell many of their generating plants and buy power on the wholesale market, mainly–though not exclusively–from companies that had purchased their old plants. Meanwhile, retail electricity rates were frozen. The idea was that competition among power producers would keep wholesale prices low. When this assumption proved mistaken, Davis resolutely opposed raising retail electricity rates. The consequences were predictable and disastrous.
First, the state’s two largest utilities, Pacific Gas & Electric and Southern California Edison, became insolvent. No business can survive indefinitely if it’s forced to buy its product at $1 and resell it at 75 cents. PG&E has declared bankruptcy. Edison also has billions of dollars of unpaid debt and remains out of bankruptcy only at the forbearance of its creditors. Second, the state had to start buying electricity for the utilities to keep the lights from going out. Early this year the Department of Water Resources (which maintains the aqueducts that move water from northern to southern California) became the buyer of last resort. Through late May it had paid almost $5 billion for electricity. Someday the state hopes to leave the power-buying business. Until then the legislature has authorized the DWR to issue $13.4 billion in bonds to repay the state’s general fund and finance future power purchases.
The point of raising retail rates is not only to cover wholesale power costs but also to dampen demand–to promote “conservation.” People become more energy-conscious. The logic has not impressed Davis, whose rhetoric is self-indulgent and deceptive. Self-indulgent? Here’s what he said on a “Frontline” documentary: “Everybody wants me to raise rates and sock it to the ratepayers–everybody.” Well, not everybody. In a Field Poll of Californians, 59 percent described the shortage “as an attempt by energy companies to increase rates.” Davis’s policy mirrors popular prejudice.
Deceptive? In The Washington Post, Davis wrote that high wholesale electricity rates were crippling the state’s economy and “could quickly threaten our national economy.” This is a stretch. By Davis’s estimate, the state’s wholesale electricity costs could hit $50 billion in 2001, up from $27 billion last year. That’s a big increase, but California is enormously wealthy. In 1999 its income (“gross state product”) was $1.229 trillion. The increase in electricity costs would be less than 2 percent of income. By itself that wouldn’t tip the state into recession–let alone the U.S. economy. The real danger is the legacy of the high-tech investment binge of the late 1990s.
Still, Davis’s rhetoric may resonate with the public. Americans love to attribute high prices to corporate cabals. Studies by academics and state agencies claim that power generators have made billions in “excess” profits since mid-2000 and that some may have withheld generating capacity to push up prices. Davis is clamoring for “price caps” to be imposed by the Federal Energy Regulatory Commission and blaming the White House for inaction. (In fact, FERC provides some price supervision–greater than during the Clinton administration–but Davis wants more and says he may sue to get it.)
California’s problem doesn’t stem mainly from corporate conniving. The studies have two problems: (1) they ignore the fact that electricity demand–and pressure on wholesale prices–was artificially high because consumers were insulated from cost increases; and (2) they assume that companies in “competitive” markets must sell at “marginal” cost. (Marginal cost is the cost of producing the last unit of output, ignoring original investment costs. In reality, most companies enter a market only if they think they can recover their full costs.) Many California power producers have recently made huge profits. But under deregulation they need to make big profits in periods of scarce supply to offset low profits or losses during periods of surplus supply. Otherwise they won’t invest for the future. Perhaps this volatility argues against deregulation, but even under regulation supply and demand must be balanced.
Only belatedly is California addressing this bedrock problem. In late March the state decided to raise retail rates, exempting 53 percent of residential customers. (“I reluctantly, after months of holding out, had a partial rate increase,” says Davis.) The exemption is too large and, unwisely, concentrates too much of the increase on businesses. Still, the announcement of higher rates and calls for conservation are having an effect. In May electricity use was down 11 percent from forecasts. Meanwhile, the state has approved new plants, and it hopes to raise capacity about 10 percent this summer.
How all this affects blackouts and wholesale prices depends partly on the weather and hydro power. One good omen: wholesale prices have recently subsided. The real lesson is that the price mechanism is an essential way of restraining demand and encouraging supply. As Davis’s behavior demonstrates, it’s sometimes unpleasant and unpopular. But he and we condemn it and discard it at our peril.
