Market Lessons From California

The scary thing about California's electricity mess is how quickly things went bad and the way in which seemingly small policy errors are having catastrophic consequences. For deregulators in other states and nations, California serves as a powerful warning that the road to hell is paved with good intentions. An electrical system that appeared to be reasonably stable got slightly out of balance as demand grew faster than supply. Instead of righting itself, the situation became increasingly chaotic, with rolling blackouts and soaring prices for electricity. Power merchants like Enron Corp. became the focus of public distrust and hostility.

Deregulation, done wisely, is still a good idea. But judging from the experience of Britain, Australia, Chile, and other nations at the forefront of electricity deregulation, it works best when there is plentiful power and lots of potential suppliers. Then, deregulation increases efficiency and lowers prices. But if either of those prerequisites is missing, power suppliers can drive prices sky-high. Economic theory says that eventually, stratospheric profits will attract new sources of power and prices will come back down. But consumers aren't willing to wait for "eventually." So the government slaps on price caps, threatens prosecution, and draws up re-regulatory bills. Such actions scare away potential new entrants, and the market becomes locked in a dangerous stalemate.

Here are a few lessons we've learned: Convince investors that the rules won't change, so they'll have the confidence to build power plants. Don't get utilities to sell off all their plants until you're sure there will be plenty of power for them to buy--even if that means delaying full deregulation while new plants are built. Let utilities make long-term contracts for power so they're not subject to short squeezes. Deter collusion among power sellers by making sure there are lots of them, each with its small market share. The message from California? Deregulate, yes, but do it with the utmost care.

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