Commentary: How to Do Deregulation Right

Let peak rates reflect peak costs, and shortages will vanish

With its rolling blackouts and near-bankrupt utilities, California has given electricity deregulation a bad name. That's too bad. Done right, deregulation of electricity can lower costs, improve reliability, encourage technological innovation, and even promote conservation.

But doing it right requires political courage. For instance, it means making people pay extra if they want to blast their air-conditioning when the electrical grid is verging on meltdown. It also requires the humility to learn from the rest of the world. Britain, New Zealand, and Australia, among others, are ahead of the U.S. in electricity deregulation. If they can do it, there's no reason the U.S. can't.

While the details of deregulation are complex, the principles underlying them are simple and universal. First and foremost:

-- Make prices reflect costs. The biggest flaw in most deregulatory schemes to date--notably California's--is that regulators and politicians have insulated consumers from the true cost of the electricity they use. California Governor Gray Davis acknowledged as much when he said recently: "Believe me, if I wanted to raise rates, I could have solved this problem in 20 minutes."

When prices are frozen, customers have no incentive to limit their consumption, so all of the adjustment has to come on the supply side. That's bad, because at times of peak use, it takes huge price increases to call forth even small increases in output. Power producers have to fire up old plants that are expensive to operate or run their mainstream plants at above their rated capacity, causing costly wear and tear; or import power from far away and pay big fees for transmission. A chart of the marginal cost of producing electricity when usage is high looks like a hockey stick. To put it another way, the true cost of running your dishwasher during peak demand may be 100 times higher than the cost at times of low demand.

It's not as if customers are getting away with a bargain by paying frozen rates. First, there's the danger of blackouts. Second, there's the fact that electricity suppliers can't sell below cost for long without having to raise money from someone. That's what's happening in California. Inevitably, much of the burden of covering the utilities' deficits will be borne by their customers and taxpayers (who, of course, are pretty much the same people).

The good news? Bringing prices in line with costs makes a huge difference. Eric Hirst, an industry consultant in Oak Ridge, Tenn., estimates that at periods of peak demand, cutting usage by as little as 5% can cut the price by as much as 55%. And it's not even necessary to subject all customers to fluctuating prices. Big cuts in peak demand can be achieved by signing up big, sophisticated industrial and commercial customers for variable rates--which they're happy to pay if it lowers their average outlay. Of course, the drop in peak demand--and prices--is more dramatic if household users throttle back when supplies are tight, too.

-- Respect physics. Electrons don't honor corporate or political boundaries. The electrical grid is like a network of canals in which water (electrical current) is poured in at one place and drawn out at another. So if a generator in one state produces electricity for a customer in another, the power often spills over onto transmission lines that are owned by other interconnected utilities hundreds of miles out of the way. That's unfair to those other utilities. It's also a recipe for blackouts, because utilities won't build needed transmission lines if they feel they won't be fairly compensated for their use. Indeed, the ratio of transmission-line mileage to peak summer demand has been falling steadily since the late 1980s (chart).

In the early years of deregulated wholesale power sales, utilities defied physics and charged for transmission capacity as if electricity flowed straight from the contractual seller to the contractual buyer. But the Federal Energy Regulatory Commission has realized that the accounting must conform to the way electricity really sloshes around. So it's encouraging utilities to stop bickering over accounting and pool their wires into a handful of large, for-profit regional transmission organizations. These groups will operate the grids and build new power lines where they're most needed from the perspective of the entire region. The RTOs aren't perfect, and many of their features--such as how their profits will be split among member utilities--are still unclear. But they're a step in the right direction.

-- Stamp out abuse. Severin Borenstein of the University of California at Berkeley and other economists have concluded that some power sellers cut output in California to lower supply and drive up the price received by their other plants. They were simply taking advantage of a flawed deregulatory system, but market manipulation is wrong and must be stopped. On Mar. 9, the Federal Energy Regulatory Commission ordered 13 power sellers to justify some of their high prices or refund $69 million. But that's a slap on the wrist. If imbalances can't be cured quickly, it may be necessary to break up big power sellers so they don't have enough market share to raise prices by withholding output. Meanwhile, Harvard University economist William W. Hogan advocates reining in suspected manipulators by capping how much they can offer to sell their power for. Hogan says such caps are less distorting than ordinary price caps because they affect only the alleged bad guys. The market price could still go above the manipulators' cap if there were a genuine shortage of power.

-- Conserve. Reducing the consumption of electricity isn't just good for the environment--it makes the grid more stable and saves money, too. Amory B. Lovins, CEO of the Rocky Mountain Institute in Snowmass, Colo., argues that new technologies could cut U.S. electricity consumption by 75%. While most analysts put the number lower, there's little doubt that businesses and homeowners could cut usage dramatically through simple measures such as installing more efficient lighting and air conditioning. One problem is that utilities largely got out of the energy-saving "negawatt" business when they were deregulated, and private energy-service companies have been slow to pick up the slack. Richard T. Sperberg, CEO and president of Onsite Energy Corp. in Carlsbad, Calif., and a past president of the National Association of Energy Service Companies, says outfits like his have been hampered by a lack of skilled engineers and the difficulty of educating potential customers--so far. If rates ever start reflecting costs, Sperberg and his colleagues will have to fight off customers with a stick.

-- Don't overbuild. Alarmed by California's blackouts, the Bush Administration and utility commissioners in many states have vowed to smooth the way for a surge in power-plant construction. That's not the answer. While some construction is needed, it's cheaper to close the supply-demand gap by encouraging conservation--using prices to lower peak consumption. Today, with no peak-shaving incentives in place, some companies are building plants that may operate only a few hours a year. That's a waste of resources.

-- Learn from others. By now, we know what works and what doesn't, but some states aren't getting the message. California, for instance, unwisely deprived its independent system operator of the ability to coordinate generation and transmission, each of which is useless without the other. Texas is doing many things right: Next year, it will become the first state to deregulate some retail rates for big customers, representing 40% of usage. But Harvard's Hogan says Texas is also hamstringing its independent system operator and risks "California-like problems." Hogan says the feds should push states in the right direction: "The time for vacillation is over."

Electricity deregulation isn't simple. But it's not impossible, either. By applying a little good sense, California--and the rest of the nation--can still get this one right.

By Peter Coy

Coy is associate economics editor.

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