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Is Electricity Deregulation Beneficial? by Virginia Matzek California Monthly, June 2000

A Conversation with Severin Borenstein

Most people don't think about economic theory and the laws of supply and demand every time they flip on a light switch or start up a car.

Severin Borenstein '78 thinks they should.

A professor at Cal's Haas School of Business and director of the Energy Institute, a UC systemwide research unit, Borenstein has spen much of his career pondering the economics of energy. One of his conclusions is that, for as much as people grumble about their electric bills or prices at the pump, they rarely understand what controls the cost of these commodities.

Biographical information and the first part of Q&A (regarding gas prices) is not included here. . . .

Let's turn now to electricity prices. Deregulating the electricity industry is supposed to bring down rates --

No, it's not. Electricity prices are not going to plummet because of deregulation. The main reason California has extremely high electricity prices compared to the rest of the country is that we made a number of bad investments that we're still paying for, even after deregulation.

Under regulation, we built the Diablo Canyon and San Onofre nuclear power plants and we signed contracts to buy energy at extremely high prices -- unbelievably high prices -- with some generators, including renewable energy generators. Now, the nuclear plants are almost paid off, and those contracts are ending, so prices are going to drop.

The political calculation that somebody made is: Prices are going to drop anyway, so if we deregulate now, we can claim they dropped because of deregulation. And as prices drop over the next few years, people will falsely attribute it to deregulation.

So who was in favor of deregulation? Mostly the independent power companies that wanted to move into the California market

Mostly in independent power companies that wanted to move into the California market. Also, large industrial users of electricity who thought they could use their market power to cut a better deal and get lower prices. that hasn't panned out.

Consumer groups would have been for it if it meant we didn't have to pay for Diablo Canyon and those other stranded investments I just mentioned -- but the politics didn't allow that.

You expressed concern about deregulation because, you said, the electricity industry is better run in a centralized system. Why?

There are several reasons.

One is that electricity is virtually non-storable. You can't have a warehouse of the stuff and pull it out when you need it. You can only store it a extremely high cost and very inefficiently, as in a battery. So you have to eed demand instantaneously. In situations where demand is very high -- like on a hot summer day when everyone's running air conditioners -- there's a threat that you won't have enough power to meet it, and the whole grid will crash and cause blackouts.

In a free market, that means that one supplier can have tremendous power in moving the market. Think about a hot summer day where the grid operator has to have 95 perecnt of all the generators running to meet demand. If one firm owns 6 percent of all the generators, then it is what we call pivotal: you have to have some of their generators running in order to meet the load. So they are in a position to charge pretty much whatever they want for electricity.

In some place after electricity deregulation, prices spiked to over $1,000 a megawatt-hour

Yes. The normal price is about $20. People didn't fully anticipate how a few companies would be able to unilaterally manipulate prices in a free market, and are still trying to figure out if deregulation works, or can be made to work, even. Right now we have a very crude system -- we have a price cap. In California theprice now can't go above $750 a megawatt-hour, which is still very high.

The second obstacle to free-market power generation is that demand for electricity is what economists call inelastic -- it has virtually no responsiveness to price. Airline service is anothe non-storable commodity, but demand is elastic; if the price goes up, people don't have to fly. It may be inconvenient, but it's not like the lights going out.

Third is that consumers don't actually know what the price of electricity is in real time. Until fairly recently, everybody know that if you wait until the evening to make long-distance phone calls, it's cheaper. Nobody thinks that way about electricity. When I lived in Davis, I ran our pool pump from noon to 4, because it never occurred to me to run it at any other time. If somebody had said, "Look, electricity is four times more expensive during the afternoon," I would've done it in the evening. But people have no idea of the correspondence between their consumption of electricity and the cost; not in the way, for example, you know that if you drive your car another 25 miles it's going to burn about a gallon of gas and cost about a dollar and a half.

But when I look at my electricity bill, there's just one rate, no matter what time of day I use power.

Right now we're in a transtion period where the retail rates are frozen. Eventually, though, I think consumers are going to have real-time meters. You'll have a meter that not only records your consumption, but sends you a signal that says, the price right now is X. And you'll have a computer chip that reads it and says, if the price goes above Y, we turn off the air conditioner for a while. There will also be households that won't do this; they'll sign a long-term contract with an energy provider at a fixed rate that protects them from price spikes.

The point is, the free-market interchange of supply and demand can only work if everybody knows what the price is, so that demand can shift in response to changes in price.

One of the promises of deregulation was that the delivery of power -- how it gets through the lines to your house -- would not be interrupted. Has that proved true?

Yes, but one of the big black holes on the legislation was how to finance the future construction and mantenance of transmission lines. that still has not been addressed. Virtually no transmission upgrades have occurred since the start of dergulation.

Whose responsibilty is it? The utilities'? No. The utilities own the lines, but the California Independent System Operator, located in Folsom, runs the grid. And they're the ones who can identify the need for new lines.

The problem is, the redistributive effects of building a transmission line are just immense. Say you have a shortage of transmission capacity from Sacramento to San Francisco, so you can't get enough power in San Francisco. that means the generators in San Francisco are making huge amounts of money. Now, if you build a line from Sacramento to feed San Francisco, it immediatley makes the guys in Sacramento much wealthier and the guys in San Francisco much power. So the guys in San Francisco suddenly become the leading envrionmentalists and oppose building more lines.

Doesn't a neutral third party, this Independent System Operator, determine where a new line should go?

Yes, but somebody's got to pay for it. The environmental stuff has to be cleared. Back in the old days, PG&E owned everything, and had the right incentive to ask, "Is it better to build a new plant in San Francisco or a new line from Sacramento?" But now those are different companies, and each is lobbying its legislator.

So there's going to be a big political battle over every improvement to the system.

Until we figure out a system that can make these decisions away fromm all the glare of politics. That's one of the big unknowns.

What effect will deregulation have on alternative energy -- nuclear, solar, wind? they wre heavily subsidized before deregulation.

Some of those subsidies will continue, post-deregulation. You'll see it on your bill -- X amount extra to support renewable fuels.

After those are removed, it's hard to say. With nuclear power, the prices will be high enough that it's worth running the existing plants. But not high enough that anybody's going to build any more nuclear plants.

Renewables . . . who knows? none of them is particularly economic at this point. Hydro is no longer considered environmentally friendly. Biomass is not very economic. Geothermal plants are economic, but are extremely limited, and they're also not renewable. Solar -- the science just hasn't gotten there. Twenty years ago when I started studying this stuff, solar was "just a few years away" -- and it's still just a few years away.

How does the future look? Can deregulation be made to work?

First of all, we're unlikely to see true deregulatoiin for a long time -- we still have these subsidies and price caps. Right now, if you took the price caps off, and firms weren't worried about the long-term political ramifications and the threat of re-regulation, on a hot day this summer the price would go to $10 billion a megawatt-hour. there would be absolutely nothing to stop it.

But, of course, that wouldn't happen if people could actually see the price day to day. People wouldn't pay $500 an hour just to watch television; they'd turn the TV off. So I think people are going to get real-time meters.

I hope we're going to see new producers enter the market and build more generation facilities, but that's been very controversial, because no one wants one in their backyard. As we see more of those, the market will be more competitive, and a few suppliers won't be so pivotal in the market.

But until those things happen, the market can only work with a pretty heavy government hand.