Consumers scream for relief when supplies are tight and prices shoot skyward, as is now the case in California’s electricity market. Firms scream for relief when supply gluts send prices through the floor, as was the case with domestic oil producers in late 1998. But before Californians succumb to the temptation to further meddle with the electricity marketplace, they should take note: Markets do a far better job managing price shocks than do politicians. First, a reality check. Although polls find that a majority of Californians doubt that a power shortage exists, the electricity market in the state is in the midst of a two-pronged supply shock.
Supply shock No. 1 was triggered by soaring prices for natural gas, the fuel used to generate over 45 percent of the electricity made in California. Demand went up due to the coldest November and December temperatures in the Lower 48 since temperatures were recorded in 1895. At the same time, a pipeline explosion in August curtailed supply, reducing the flow of gas into Southern California by 10 percent.
For most of the time since November, the spot price of natural gas in Southern California has been above $12 per million BTU (on Dec. 9 the spot price reached $60 per million BTU) — an increase of 340 percent over the 1998–99 average price of natural gas delivered to utilities in California of $2.70 per million BTU. And because 90 percent of the marginal cost of natural gas-fired electricity is fuel cost, the marginal cost of electricity would have to spike from 3 cents per kilowatt hour to over 10 cents per kilowatt hour to cover increased production costs. Also, remember that the price of electricity is determined by the marginal costs of the most costly source of supply… in this case, natural gas.
Supply shock No. 2 was triggered by the reduced availability of hydroelectric power. In 1999, hydroelectricity production in California declined by 20 percent due to falling water tables and has not recovered since.
Markets normally handle negative supply shocks through price increases, rationing available supply to those willing to pay the increased costs and inducing others to cut consumption. When it’s difficult for consumers or producers to change consumption or production habits quickly, however, minor imbalances between supply and demand produce extreme price movement. That’s the case in the electricity market. Supply-and-demand patterns change over a period of years rather than days.
Unfortunately, price increases in the California wholesale market (from 2 to 4 cents per kilowatt hour a year ago to 20 to 40 cents per kilowatt hour today) are incapable of reducing demand because no Californian faces real-time hourly prices — and only consumers in San Diego faced actual average prices for a brief time last summer. That makes electricity scarcer and the price hikes steeper.
The implicit premise behind Gov. Gray Davis’ call for a virtual state takeover of the industry is that political management of supply shocks is better for consumers than economic management via free prices. When supply and demand are fairly rigid in the short run — in this case, because of both natural market characteristics and burdensome regulatory policies — high prices in the short run mostly transfer wealth from consumers to firms rather than induce new supply or decrease demand. So governments institute price controls and enact legal orders to require supply increases and demand reductions rather than to wait and allow prices to achieve the same result.
Can politicians intervene in the electricity market to reduce the wealth transfer and yet preserve the important incentive functions of prices? Relatedly, can legal orders substitute for prices in altering behavior? The answer to both questions is “no.”
Consider two past attempts at such schemes; the intervention in oil markets after the 1973 oil shock and rent control in New York City.
The Emergency Petroleum Allocation Act of 1973 allowed “new” supplies of crude oil and increases from “old” supplies to receive market prices but controlled prices for existing supplies.
Similarly, in New York City after World War II rent controls were left on the existing housing stock, but new units were unaffected.
In theory, such schemes can work… but only if the difference between the market price and the controlled price is returned to the public through tax rebates. First, it’s the only way to eliminate arbitrary and counterproductive transfers of wealth from the many to the lucky few. Second, investors must be convinced that new supplies will be free from future price controls. Otherwise, they won’t invest.
In both experiments, however, the wealth transfers suppressed by price controls were not recycled to the public at large. They were instead captured by oil refineries in the case of oil and by lucky tenants who happened to live in price-controlled housing. Moreover, the government repeatedly reneged on its pledge to leave prices for new supply alone.
Can legal orders by government reduce demand or increase supply? They can. But the unintended consequences of such ham-handed dictates make matters worse. The perverse incentives and inefficient reordering of investments that result from such Stalin-esque mandates are potentially legion and impossible to predict. History has shown that governments are incapable of writing legal orders to accomplish changes that would have otherwise occurred if prices were left to their own devices.
The alternative — having government ignore price information, shut down the market, and do whatever the social justice crowd wants — is ruinous. If you doubt it, ask a North Korean peasant… if you can find one not starving for lack of food.
It’s frustrating for consumers or suppliers to get caught in a price spike or collapse when both demand and supply are relatively inelastic in the short term. Someone’s going to take a bath. Still, when government tries to step in, things can and do get worse… far worse. Something for Californians to think about while they mull over Governor Davis’ plan and the fate of their experiment in electric utility restructuring.
