Power Risks California Power Problems Caused by Dumb Regulation, Not Deregulation

February 2001 Energy & Utilities

Recent news concerning power outages have been of dour amusement for this Chicagoan. Once again, a subset of people (read: the state) is trying to tell another subset of people (read: the utilities) how to live. In this case, it is what the prices should be for retail electricity and what geographic markets they serve. Although California touts itself as a liberal hotbed of the New New Thing – all too often the state turns its focus into delineating the acceptable from unacceptable – for instance, if you can smoke in a bar or ride a motorcycle without a helmet. If you want real freedom, stay in the Midwest where authors like William S. Burroughs can write existentialist/dadaist novels in rural Lawrence, Kansas (may his genius rest in peace), cigar bars proliferate, and helmets are optional.

But back to energy – the current career of yours truly.

The utilities of electricity and natural gas have mostly been privatised in the U.S. but only recently have these industries been able to enter freely into new markets under the current push for deregulation. In the past, these utilities were treated as a public good that operated best under a natural monopoly. Accepting that the monopolies were natural, state governments in all their wisdom set the rates at which the utilities could charge for their goods of electrons in a wire or methane in a pipe. As such, these monopolies acted wisely and negotiated their prices with the state to be equal to the cost to serve plus an allowed profit margin – an interesting rewrite of the basic business truth to read P? = C + ?. For investors, this meant low risk and low return while for the utilities this meant there were little incentives to lower the cost structures, compete on customer service, or brand their services. For consumers, residents and businesses became expectant of uninterrupted power-on-the-tap.

Deregulation is changing all of this – and the hope is that it is for the better. For most states, the first step of deregulation is to separate the power generating activity from the distribution and customer service aspects of the industry. Along the paradigm that there are only three types of industries: creative, relationship, and infrastructure, they have attempted to separate the infrastructure portion of generating power from the relationship portion of reading meters and billing customers. So far, so good.

But California mismatched the risks-to-reward portion of business. Energy retailers like PG&E or Southern California Edison must buy their inputs – power from the generator – on the open market and pay the spot prices. The price they can charge for their output – power to the consumer – is set by the state and only changed through a rate-case with the government. When Southern California Edison suggested that they should be able to enter into long-term contracts for power to relieve themselves from the fluctuations in the spot prices, the government said no! In the legislature’s wisdom, this would have created an unnecessary barrier-to-entry into the market. Thus, for the energy retailer, the firm that bills consumers and buys power on the open market, their risks are high and the rewards are still set by the state.

The results of this poor wisdom are now pathetically obvious. True, the state has relieved its residents from higher electricity bills but at the cost of rolling blackouts and the possible bankrupting two of the strongest utilities in the U.S. In light of these catastrophes, many states are reconsidering their intentions for deregulation, but some more enlightened friends are pressing forward.

The error wasn’t to deregulate electricity but rather to prescribe the industry structure and prices. Because of California’s error, they are now considering becoming the power-broker of the state in buying energy from the generators and reselling it to the retailers. The result will be a smoothing-out of the price of raw power, but the cost will be that the government will bare the risk and soak the taxpayers with the bill. Firms like Enron have already proven highly capable of taking this role and efficiently buying futures contracts to hedge against short-term fluctuations raw fuel. May the Midwest get it right.

“Power Risks, California Power Problems Caused by Dumb Regulation, Not Deregulation”, Timothy Smith, Chicago Business, February 5, 2001, p9.

About the author

Tim J. Smith, PhD is the Managing Principal of Wiglaf Pricing, and an Adjunct Professor at DePaul University of Marketing and Economics. His most recent book is Pricing Strategy: Setting Price Levels, Managing Price Discounts, & Establishing Price Structures.

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