News: Analysis & Commentary
Commentary: Why the Energy Crunch Needs Tough Love
Only the incentives of a free market will encourage building new capacity
When George W. Bush campaigned on policies that would herald a "responsibility era," he wasn't kidding. After newly minted Energy Secretary Spencer Abraham met with 10 Western governors in Portland on Feb. 1-2, some governors asked him to impose a temporary lid on wholesale electricity prices. Unless the Feds stepped in, they said, consumers throughout the West face the same skyrocketing utility costs that have devastated California. Abraham's response? An unequivocal "no."
On the surface, the refusal to impose even temporary price controls may seem an unduly harsh--and needlessly hands-off-- response to the utility crisis threatening the West. "Energy deregulation began with the federal government, and that is where the problems created by failed deregulation efforts must be addressed," says Washington Governor Gary Locke, a Democrat.
But in reality, the Bush Administration's tough-love approach is the best answer. Unpleasant as it may be, the lure of high prices and profits is the only way to get more electric plants built, the real solution to the region's energy crisis.
So why the push for price caps? The governors argued that limiting wholesale prices to a rate that would cover power producers' costs while allowing them a small profit would ease the strain on Western utilities. They also claimed caps would give the states time to develop a strategy for making deregulation work and to add more generating capacity.
Since the Portland powwow, some have changed their tune. On Feb. 6, Secretary Abraham received a letter from several Western governors announcing that they were belatedly taking the "no-cap" pledge. Apparently, electricity generators had called state offices, protesting any caps.
Let's hope the rest of the posse will follow soon. Sure, capping prices would ease the pain of utilities suddenly having to pay for huge increases in the price of wholesale electricity while shielding consumers' wallets. But without the inducement of fat profits, electricity generators and marketers, those most likely to build and deliver additional capacity, won't invest in new plants. Ask Enron Corp. "You've got a supply shortage, so you decide the way you're going to solve that is by reducing the price," says Enron Chairman Kenneth Lay. "That's not exactly the way I was taught economics and not the way most markets work."
Nor is it a solution supported by free-market gurus like Federal Reserve Chairman Alan Greenspan. That's because price caps create an "artificial market," says Curt Hebert Jr., the new chairman of the Federal Energy Regulatory Commission, which oversees electricity markets. "The essential foundation must be based on adequate supply, which California doesn't have, and is showing no sign of having in the very near future," he says."BAD DISEASE." What's more, history shows that government-imposed price caps can backfire. When President Nixon capped wages and prices in 1971, the policy led to a burst of inflation once the controls were removed. Likewise, when the government capped natural gas prices in the mid-1950s through the late '70s, the move created a dearth of natural gas. Only when the caps were lifted was there an enormous rush of investment in natural gas drilling. "This process of capping when costs are rising causes endemic shortages," says Paul W. MacAvoy, a Yale School of Management professor. "It's a bad, bad disease."
True, Pennsylvania has implemented price caps as part of its electricity deregulation scheme. But those caps, set at sky-high levels, hardly shield utilities. And unlike California, the Keystone State allows its utilities to buy power from whomever they want, not just a central supplier.
So what should the Western states do? Focus on inducements for new utility construction while allowing free-market retail rates to encourage conservation. Yes, price caps might make consumers and pols feel better in the short term. But they won't add supply in the long run.By Laura Cohn; Cohn Covers Economic Policy in Washington, D.C.