California’s deregulated power industry, in which producers can sell electricity for whatever the traffic will bear, was supposed to deliver cheaper, cleaner power. But instead the state faces an electricity shortage so severe that the governor has turned off the lights on the official Christmas tree – a shortage that has proved highly profitable to power companies, and raised suspicions of market manipulation.
The experience raises questions about deregulation. And more broadly, it is a warning about the dangers of placing blind faith in markets.
True, part of California’s problem is an unexpected surge in electricity demand, the byproduct of a booming economy. It’s possible that the crisis would have happened even without deregulation.
But probably not. In the bad old days, monopolistic power companies were guaranteed a good profit even if their industry had excess capacity. So they built more capacity than they needed, enough to meet even unexpectedly high demand. But in the deregulated market, where prices fluctuate constantly, companies knew that if they overinvested, prices and profits would plunge. So they were reluctant to build new plants – which is why unexpectedly strong demand has led to shortages and soaring prices.
Now you could say that in the long run there is nothing wrong with that. Building extra generating capacity was costly, and the costs were passed on to consumers; while prices may fluctuate in a system with less slack, on average consumers will pay less. In fact, textbook economics suggests that it’s actually a good thing that electricity prices skyrocket when supply runs short: that’s what gives the power companies an incentive to invest. And so you could argue that no public intervention is warranted – indeed, that the caps that still place an upper limit on electricity prices only worsen the problem, that we should rely on market competition to solve the crisis.
But how competitive is the electricity market? What makes California’s power crisis politically explosive is the suspicion that it’s not just about inadequate capacity, but also about artificially inflated prices.
How might market manipulation work? Suppose that it’s a hot July, with air-conditioners across the state running full blast and the power industry near the limits of its capacity. If some of that capacity suddenly went off line for whatever reason, the resulting shortage would send wholesale electricity prices sky high. So a large producer could actually increase its profits by inventing technical problems that shut down some of its generators, thereby driving up the price it gets on its remaining output.
Does this really happen? A recent National Bureau of Economic Research working paper by Severin Borenstein, James Bushnell and Frank Wolak cites evidence that exactly this kind of market manipulation took place in Britain before 1996 and in California during the summers of 1998 and 1999.
You wouldn’t normally expect this to happen in colder months, when demand is lower. Still, state officials have understandably become suspicious about California’s current power emergency – an emergency precipitated by the odd fact that about a quarter of the state’s generating capacity is off line as the result of either scheduled repairs or breakdowns.
Maybe California power companies aren’t rigging electricity prices. But they clearly have both the means and the incentive to do so – and you have to wonder why the deregulators didn’t worry about this, why they didn’t ask seemingly obvious questions about whether the market they proposed to create would really work as advertised.
And maybe that is the broader lesson of the debacle: Don’t rush into a market solution when there are serious questions about whether the market will work. Both economic analysis and British experience should have rung warning bells about California’s deregulation scheme; but those warnings were ignored – just as similar warnings are being ignored by enthusiasts for market solutions for everything from prescription drug coverage to education.
(Paul Krugman is the Ford International Professor of Economics at MIT, Boston, Massachusettes.)
Copyright 2000 The New York Times Company
In response – California Screaming, Under Government Blows*
By George Reisman, Ph.D. **
The state of California is experiencing a fiasco in its electric power system. The system has repeatedly run near the overload point, necessitating brownouts and threatening rolling blackouts. Wholesale power prices in San Diego County and the southern portion of adjacent Orange County have briefly been as high as $5,000 per megawatt hour and, according to one report, as high as $11,500 per megawatt hour. At first, the local utilities in these counties attempted to pass their greatly increased wholesale power costs on to their customers, in the form of doubled and tripled electric bills, but the state government, in response to widespread protest, soon prevented them from doing so. Now these utilities are threatened with bankruptcy, having lost approximately $6 billion dollars in the process. Out-of-state suppliers of electric power have threatened to cut off further supplies to the state, out of fear of not being paid by utilities on the verge of bankruptcy. At last report, these suppliers have been ordered by the federal government’s Secretary of Energy to continue their supplies.
Incredibly, the fiasco is being blamed on deregulation and the establishment of a free market in electric power. See, for example, the disgraceful article “California Screaming” by Paul Krugman in The New York Times of December 10, 2000. The Times’ lead in to this article, which accurately conveys its tenor, is “California’s blind faith in markets has led to an electricity shortage so severe that the governor has turned off the lights on the official Christmas tree.”
Clearly, it is necessary to review the facts that have caused California’s fiasco, in order to arrive at a rational judgment of its nature. This review will establish that the actual cause of the fiasco is not at all the free market but rather, from beginning to end, destructionist government policy, in large part inspired by environmentalist fanaticism. Assertions, such at that of The New York Times, which was just quoted, will be shown to constitute a literal contradiction in terms.
Destructionist government policy has increasingly restricted the supply of electric power in California and throughout the United States. It is responsible for the fact that for the last twenty years or more, there have been no new atomic power plants constructed and few or no new coal, oil, or hydro power plants built. Indeed, it has caused existing plants of these types to be dismantled. In California, in the last decade, only power plants using natural gas as their fuel have been allowed to be constructed, and such plants now account for most of the state’s generating capacity.
Because power plants using natural gas are substantially more expensive to operate in comparison with the other types of power plants, and would quickly be plunged into unprofitability if exposed to the competition of other types of power plants, investors have been unwilling to invest in additional generating capacity in California, and elsewhere, to the extent they otherwise would have. At the same time, the government-caused dependence on natural gas as the source of fuel for power plants has contributed to the recent sharp rise in the price of natural gas to record levels. The rise in the price of natural gas has been especially great in California, where lack of adequate pipeline capacity has limited natural gas supplies more than in the rest of the United States.
Over the same period that the government has restricted the supply of electric power, there has been a substantial increase in the demand for electric power. The rise in demand has been brought about both by population growth and by the increase in power consumption per capita caused by economic progress. An example of this last is the increase in power consumption caused by the use of personal computers and their peripherals by tens of millions of people.
When these facts are combined with government price controls on electric power (which have existed since the early years of the industry), shortages of electric power are an inevitable result. This is because the government prevents not only the increase in supply that would keep pace with the increase in demand but also the rise in the price of electric power that would keep the demand for power within the limit of the supply available, however artificially restricted that supply might be as the result of government interference.
The government’s responsibility for shortages of electric power, it should be realized, inescapably implies its responsibility for power brownouts and blackouts. For their immediate cause is a demand for power too great for the power system to supply, i.e., a power shortage.
It cannot be stressed too strongly that a shortage is an excess of quantity demanded over supply available. And that it is caused by a government price control, which prevents price from rising high enough to reduce quantity demanded to the supply available, which would eliminate the shortage. Of course, the more the government holds down the supply of electric power, the higher is the price that is required to prevent a shortage of power. When the government refuses to allow a price that is high enough to keep the quantity of power demanded within the limit of the supply of power available, brownouts and blackouts are the result.
It should be understood that when taken in conjunction with price controls on electric power, the government’s inflation of the money supply also contributes to power shortages. This is because inflation contributes both to the increase in the demand for power and to the restriction of its supply. The former results largely from the rise in money incomes that the spending of the additional quantity of money brings about, and which gives people the financial means to afford larger quantities of any given good at any given price. The latter results from the fact that inflation drives up the costs of constructing and operating power plants and thus correspondingly reduces their profitability in the face of controlled selling prices. The process does not have to go very far before it no longer pays to construct power plants-assuming, of course, that the environmentalists did not prevent their construction in the first place.
All this is the basic context of the fiasco now existing in California and which, on the basis of a combination of ignorance and deceit, is being blamed on, of all things, “a free market” in electric power.
The so-called free market in electric power in California consists of the fact that, last summer, price controls were removed from the power supplies of San Diego County and the southern portion of adjacent Orange County, while remaining in force throughout the rest of the state. The power supplies of this relatively small part of California were suddenly opened up to the competition of power companies throughout the rest of the state and in surrounding states who were desperate for additional power to avoid the brownouts and blackouts caused by government price controls in their operating territories. Starting last summer, by offering a higher wholesale price, these power companies could bid away power generated in this area from use by the area’s local residents and businesses. Locally generated power could be retained for use in the area only at a wholesale price that matched the price generated by this competition.
It should be understood that the power companies are in a position in which any customer can turn on additional power-using devices, and they are obliged to supply the additional power needed to meet that additional demand. Price controls and the government’s restrictions (described above) preventing the construction of new power-generating capacity now repeatedly compel the utilities to operate close to the limit of their existing power-generating capacity. To avoid overloading and thereby crashing their systems and causing wide-spread blackouts, they must either find the necessary additional power or induce other customers, typically large ones, to cut back on their power consumption, by such means as the offer of substantial rate concessions. Finding additional power, wherever it is available, can serve to avoid expensive rate concessions and, worse, a system crash. This is the desperate situation for which the limited power supplies of San Diego County and the southern portion of adjacent Orange County were put in the position of having to provide a remedy.
Anyone familiar with economic theory could easily have predicted that the result would be a skyrocketing of power prices in the area. For the limited power supplies of this small area were being made to bear the burden of coping with the statewide and indeed, Western-states-regionwide power shortages caused by destructionist government policies.
Now the truth is that an immediate, partial solution to the sharp rise in power prices in this limited area is the immediate decontrol of power prices throughout the rest of California and, indeed, throughout the whole Western-states region, which shares a more-or-less integrated power grid. The effect of such decontrol would be an immediate substantial increase in the supply of electric power available for the decontrolled market and thus, probably within days, if not hours, a sharp drop in the price of electric power in the decontrolled market.
This increase in supply, it must be stressed, would not come from an increase in production, though very soon there would be such an increase and thus a further increase in supply and reduction in price in the decontrolled market. No, it would come from the more or less substantial portion of the already existing production of electric power that is presently consumed by submarginal buyers, i.e., by buyers unable or unwilling to pay the potential free-market price, which, of course, would be higher than the controlled price still in force over the far greater part of the state. When the price control is removed, this substantial part of the supply, presently not available for the decontrolled market, is made available for the decontrolled market, where its effect is to enlarge the supply and thus correspondingly reduce the price.
Lifting price controls in the remainder of Orange County and in Los Angeles County, for example, would add supplies from these areas to the supplies presently available only from San Diego County and the southern portion of Orange County to meet urgent needs for power throughout the state and the Western-states region in general. The rise in price in these additional areas would serve to reduce the quantity of power demanded in these areas. The supply of power previously used to meet this portion of the demand would be available for the now larger decontrolled market. The effect of this larger supply in the larger decontrolled market would be to reduce the price of power in the decontrolled market. Decontrol throughout the state and in surrounding states would still much more substantially enlarge the supply available in the decontrolled market and drive down the price there. Indeed, at the same time that larger supplies were being made available to meet urgent needs for power, decontrol would serve greatly to diminish the urgency of those needs. This is because the rise in power prices throughout the state would serve everywhere to reduce the quantity of power demanded and thus serve to reduce the amount of power needed from outside sources to prevent brownouts or blackouts.
It should be clear that decontrol limited to the territory of just one or two counties is decontrol in a very high-pressure pressure-cooker, so to speak. It is decontrol in which all the pressure of the shortages of the whole rest of the state and surrounding states come to bear on the very limited supplies of power available just in this relatively small area. Decontrol over the whole state and region would serve to eliminate all of this pumping up of the pressure that has propelled prices so high in San Diego County and south Orange County.
A further increase in supply and reduction in price that would result from state-wide and region-wide decontrol would come from existing power capacity that is presently forced off the market by price control, coming back on to the market. That there is such capacity is confirmed by the following statement in a recent newspaper report: “Natural-gas prices traded at record levels Friday [December 8, 2000], hitting $60 per million British thermal units. That prompted some gas-fueled generating plants to shut down because they couldn’t make a profit under the ISO’s [Independent System Operator’s-a state official] wholesale cap of $250 a megawatt hour.” (The Orange County Register, December 10, 2000, News Section 1, p. 12. Italics added.) The elimination of price control would bring such producers back into the market, increase the market supply, and reduce the market price. As matters stand, the forced withdrawal of such producers serves to further increase the pressure on the very limited supplies of the small area that is free of controls, and to further drive up their price. For buyers who might have been supplied by those producers, and now are not, must turn instead to the supplies of that small area.
The preceding makes clear that the price of a good in a fully decontrolled market is substantially less than the price of a good in an only partially decontrolled market, and is virtually certain to be very substantially less in comparison to the price in a partially decontrolled market as small as the one in California has been. Full decontrol in California would mean lower power prices both for this reason and because of the return to the market of output from existing producers that the controls had driven away by making its production unprofitable.
The following hypothetical example will serve to drive home the principle that the elimination of price control on the full supply of a good available results in a lower decontrolled price than when only a portion of the supply of a good is free of price control. Thus imagine that the full available supply of a good is 100 units and that at a fully uncontrolled, free-market price of $120, the quantity of the good demanded is also 100 units. In this case, the free-market price is $120-that is the price at which quantity demanded and supply available of the good are equal and, consequently, neither a shortage nor an unsaleable surplus of the good exists.
Now imagine that the government imposes a price control on this good of $100 per unit. At this, lower price, the quantity of the good demanded becomes greater than the 100 units of supply available. This is because now the good can be afforded by everyone who values a unit of it above the price of $100, whereas before only those who valued a unit of the good above the market price of $120 could afford it. At the free-market price, all buyers not prepared to pay at least $120 per unit would have been rendered submarginal. They would have been excluded from the market by the $120 price. Now however, as the result of the price control, a more or less substantial number of submarginal buyers become admitted to the market. They can cross the lower bar of the $100 price, while they could not have crossed the higher bar of the free-market price of $120.
Assume that as a result of the lower, controlled price, buyers are now prepared to attempt to buy 130 units of the good. Since only 100 units of the good are available, would-be buyers of 30 units must go away empty handed. The efforts of these would-be buyers to buy 30 units that do not exist is the measure of the shortage that the price control has created.
When there is a price control and shortage, the distribution of the supply is made largely random and chaotic. That is, it becomes an essentially accidental matter which of the buyers seeking 130 units will be supplied and to what extent. It is entirely possible in this situation that a full 30 units of the supply could fall into the hands of buyers who at the free-market price of $120 would have been submarginal, that is, into the hands of buyers who value these units below the free-market price of $120-who value them merely above the $100 controlled price. We do not need to make such an extreme assumption, however. Assume that the effect of the price control and resulting shortage is merely to enable 10 units of the supply to fall into the hands of such submarginal buyers.
Since there are only 100 units of supply available, the diversion of 10 units into the hands of submarginal buyers, means that only 90 units of the supply remain available for buyers able and willing to pay $120 or more per unit. Thus buyers of 10 units, who value them all above $120 are excluded from the market. It is against the law-i.e., the price control-for them to outbid the submarginal buyers, as they would do in a free market. The result is that unless they are lucky, which in this case they are not, they will have to go away empty-handed.
It is entirely possible, and we will assume it to be the case, that among this group of excluded buyers are buyers who value a unit of the good far above the free-market price of $120-who would be prepared to pay as much as $1,000 for a unit of it, or even as much as $2,000. Under price controls and shortages, even buyers with the most vital and urgent need for a good, as these buyers can be assumed to be, may have to go away empty-handed, because the units they seek are obtained instead by buyers who in a free market would have been submarginal and excluded from the market by the free-market price.
Now, finally, imagine that into this situation comes the government of California, with its “blind faith in markets,” as The New York Times has so audaciously called it. It decontrols the price of one unit of the hundred. What happens? The price of this unit is determined by the competition between the most desperate and second-most desperate buyer of an additional unit who have up to now been excluded from the market by the price control and resulting shortage. In the present example, it is determined at a point between the $2,000 maximum potential bid of the most desperate of these buyers and the $1,000 maximum potential bid of the second-most desperate of these buyers. Thus, the resulting price is, say, $1,500.
It should be obvious that if instead of timidly freeing just one unit of the supply from price control, the entire supply of 100 units were freed, the resulting price would be far lower-it would be the $120 free-market price.
Now although, as the above example confirms, the free-market price would be very much lower than the price prevailing in the very narrow decontrolled market of just one and a half counties, it would still be more or less substantially higher than the previously controlled price. Whatever it turned out to be, its immediate effect would be to end the shortage of electric power and thus brownouts and blackouts. This would be to the advantage of all consumers of power-poor consumers no less than rich ones.
The establishment of a free-market price for power means that poorer consumers are enabled to bid more for the power they need to run their one and only refrigerator, say, than many wealthier, higher-income buyers are willing to pay for the power needed to operate a second or third refrigerator. It means that they are enabled to bid more for the electric power that provides the light they need in which to read than many wealthier, higher-income buyers are able and willing to pay for power to run their pool lights or other outside lights. Retention of price control, in contrast, means that the wealthier, higher income buyer has no economic reason not to go on using power for a second or third refrigerator and for his pool lights, which serves to deprive the poorer consumer of the power for his one refrigerator or the light in which to read. A free market price guarantees the availability of electric power for the truly urgent purposes of virtually everyone who has a job.
When faced with the need to restrict consumption, a free market does so by eliminating the least important of the uses to which a good was previously devoted, i.e., its previously marginal uses. In the present case, such uses will probably turn out in large part to be power-intensive industrial uses in the production of products that are unable to bear substantially higher power costs.
To the extent that the resulting free-market price were higher than the previously controlled price, it would operate to increase the profits of power producers and thereby provide both the incentive and the means (the latter through reinvestment of the profits) to increase investment in and thus production of power. This, of course, is part of the more complete, longer-run solution to California’s power fiasco. Obviously, it requires the removal of obstacles to the construction of new and additional power plants, i.e., the environmentalists must get out of the way. The freedom to construct power plants fueled by atomic energy and by coal must be restored.
The effect of stepped up investment in and production of power would be a reduction in the price of power and in the profitability of producing it. The rate of profit in power production would fall from a more or less sharply above-average rate toward the average rate. The price of electric power would gravitate toward its cost of production plus only as much profit as required to provide the average rate of profit, i.e., only enough profit to make the power industry competitive with the rest of the economic system for capital investment. While the high profits of the power industry following the removal of price controls would be temporary, what would endure is a larger-sized power industry.
Thereafter, in order for any power producer to earn a premium rate of profit, he would have become an innovator in improving power production. He would have to find ways to reduce its cost of production and/or improve what he could transmit over power lines. But these premium profits too would be temporary. They would come to an end as soon as competitors succeeded in making the improvements part of the general standard of the industry. Further high profits would have to be earned by further reductions in cost of production and/or further improvements in quality of one kind or another, and so on and on. The long-run beneficiaries would be the consumers of power, who would buy their power at progressively lower real prices.
This, indeed, is the overwhelming thrust of the free market: ever lower, not higher prices. To be sure, this result is not very obvious when prices are expressed in terms of fiat paper money, which is comparable in its cost of production to paper clips or pins, and which gets cheaper faster than businessmen can make most goods and services get cheaper, with the result that prices expressed in paper money almost always rise.
But it is very obvious when prices are expressed in terms of how many hours or minutes of labor the average worker must put in at a job in order to earn the price of something. Once prices are thought of in these terms, it is clear that the real price of almost everything has been falling for generations-precisely because of the free market and its profit motive and freedom of competition. That is the real meaning of a free market in electric power as well.
It should now be clear that the assertion of The New York Times that “California’s blind faith in markets has led to an electricity shortage so severe that the governor has turned off the lights on the official Christmas tree” is the complete opposite of the truth, and is so by the very meaning of the terms involved.
Presenting knowledge of the actual causes of California’s electric-power fiasco will prevent the enemies of the free market, such as The New York Times and its columnists, from getting away with blaming the free market for the consequences of the anti-free-market, destructionist policies they advocate.
In the view of writers such as Krugman, there may as well never have been any governmental restrictions on power production inspired by environmentalism. Lack of sufficient capacity is the fault of “the deregulated market.” In Krugman’s own words: “But in the deregulated market, where prices fluctuate constantly, companies knew that if they overinvested, prices and profits would plunge. So they were reluctant to build new plants-which is why unexpectedly strong demand has led to shortages and soaring prices.”
The same gentleman knows nothing of the distorting effects of price controls on markets that are only partially decontrolled. In his eyes, the cause of the very high power prices in San Diego County and the southern portion of Orange County can only be “manipulation.” To prove it, he imagines the following case:
“Suppose that it’s a hot July, with air-conditioners across the state running full blast and the power industry near the limits of its capacity. If some of that capacity suddenly went off line for whatever reason, the resulting shortage would send wholesale electricity prices sky high. So a large producer could actually increase its profits by inventing technical problems that shut down some of its generators, thereby driving up the price it gets on its remaining output.”
In reality, of course, all kinds of contractual arrangements requiring delivery of specified quantities of power at specified prices would operate to prevent the kind of behavior Krugman imagines. Because of such contracts covering the greater part of their output, any rise in the price of power would go mainly to the benefit of the contract holders, rather than to the companies generating power. The amount of output on which the latter could obtain the benefit of a such a short-term rise in price would be too small to make such behavior on their part worthwhile.
Putting this aside, Krugman ignores the actual, and significant fact, that in the summer of 2000, the power companies of California were operating dangerously close to the limit of their capacity, causing considerable fear of the dire consequences that would result should there be any breakdown in any of their capacity, which became all the more likely, the longer there was no down time for necessary maintenance and repairs.
Now, in the fall of 2000, when approximately twenty-five percent of California’s power capacity is off line, undergoing the maintenance and repairs that could not be performed in the summer, in the face of peak demand, Krugman suggests that this too is part of a process of “manipulation.” Perhaps he believes that the California utilities that have been driven to the brink of bankruptcy are growing rich in this process.
Krugman and The New York Times appear to suffer from the malady of substituting fantasy for knowledge of reality. The seriousness of the malady is not diminished by the fact that The Times is often able to pull it off with a pompousness that is exceeded only by its ignorance.
* Copyright © 2000 by George Reisman. All rights reserved. This article originally appeared on line on the web site of the Ludwig von Mises Institute. The title of the article was inspired by Paul Krugman’s New York Times piece “California Screaming.”
** George Reisman is professor of economics at Pepperdine University’s Graziadio School of Business and Management in Los Angeles and is the author of Capitalism: A Treatise on Economics (Ottawa, IL.: Jameson Books, 1996). Readers are invited to visit his website at http://www.capitalism.net