Yes Virginia, Electricity Markets Can Work

Commentary, Energy, Frontier Centre, Uncategorized

The idea that competitive electricity markets can improve the power industry is now widely and mistakenly regarded as a joke. The costly debacle in California—now being duplicated in Ontario—received a lot of bad press, as did Alberta’s faulty first start with deregulation. Nothing sells like bad news, and those who oppose competitive markets, deregulation and privatization in principle enthusiastically trumpet these misfirings in defense of the status quo. It’s not that simple.

While failed experiments get the headlines, successful market conversions in several American states, Britain and Australia receive scant coverage. Places that deregulated in a smart way benefited from both a more efficient industry and lower consumer prices.

California suspended the restructuring of its electricity industry after massive price increases, widespread blackouts and the bankruptcy of its largest utilities. What happened? For years, despite a booming economy and surging demand, the state discouraged construction of new power plants and transmission lines to bring in power. High demand collided with soft supply. In and out-of-state producers responded as the shortage worsened by gaming the public pooling agency, withholding supply to extort higher prices. The state allowed wholesale price competition but froze retail prices so consumers had no reason to cut consumption. With wholesale prices higher than retail, the utilities ran out of money and went bankrupt. The coup de grâce: outside suppliers feared non-payment and held back exports.

Ontario never learned. In moving to a competitive market, it had to separate and absorb the $21 billion debt Ontario Hydro had accumulated as a high-cost government monopoly with nuclear ambitions. Add up a booming economy, new energy taxes to defray the stranded debt and, critically, an uncertain investment climate for potential new suppliers and, no surprise, we have rising prices.

Ontario’s new price controls, announced in early December, dictate a retail maximum of 4.3 cents a kilowatt hour, but suppliers had contracted for the “marginal cost” of power, essentially the price of the last, most expensive kilowatt hour produced, about 7 cents. Either the government will fork over the difference and subsidize consumption, or the lights will go out, probably next summer. It may cost the hapless Ontario taxpayer billions … and the Eves Tories, the government.

Deregulation didn’t force those mistakes in Britain or Australia, where supply has increased, prices have fallen and the industry made much more productive. In Britain, the Office of Electricity Regulation has three missions: to ensure an adequate supply, to keep the industry competitive and to guarantee that generators have the financial resources to keep their promises. With only 200 employees, compared to 900 at California’s Public Utilities Commission, the agency abandoned bureaucratic rate-setting based on the rate-of-return, in favour of a much looser set of price ceilings. The price volatility inherent in pool pricing at marginal cost is dampened by a system of hedging contracts, which estimates prices in advance for 90% of needed supply. It stabilized the returns that generators can expect and encouraged plant expansion. Restructuring had a few glitches in practice, but most of the arguing is over the spoils. Consumers, the workforce and investors have all benefited from lower costs. Prices have consistently posted below the inflation rate.

In the U.S., the northeastern states eagerly deregulated, because they were paying the country’s highest power rates. Only New York experienced California-style rate spikes due to, according to most reports, a similarly flawed market design. Supply doesn’t happen by magic, it needs incentives. In most of the others, prices in constant dollars have been falling throughout the 1990’s. They decontrolled large, industrial consumers first and in many places residential deregulation is just beginning. Average prices in Illinois, Massachusetts and Rhode Island have fallen about two cents per kilowatt hour, and in Texas and Pennsylvania by a cent; twenty and ten percent, respectively.

Given these facts, it’s hard to understand Ontario’s unfolding fiasco. Why electric privatization and deregulation succeeded in some places and not in others has been clear for at least seven years. In fact, several think tanks predicted the California disaster five years in advance.

Meanwhile, Manitoba remains firmly on another planet. Competition and consumer choice merit zero attention on the policy radar screen – think of healthcare, schools or energy markets. In our happy collective we pay higher taxes so the government can subsidize power and own both the gas and electricity sectors. With a slow growth 1970s economic model and ample supplies, we have no demand pressures that might spike prices. The eternal hope is another dam on the brittle foundation of Kyoto and the Tory power misery in Ontario.

No one knows what power markets will look like in the decade it takes to build a dam. Gary Doer needs to think hard before entangling Conawapa in Ontario’s capital mess. If we’re going to do it, we should let real market demand, not political imperatives, determine the issue.