California must control demand for power while supply slowly catches up.
New York Times; New York, N.Y.; Jan 11, 2001; Hal R. Varian

THE reason for the California electricity crisis can be summed up in four words: demand grew, supply didn't.

The next question, of course, is, Why? Strange as it seems now, the problem that motivated industry restructuring in the early 1990's was that California had too much electricity. Unfortunately, it was very expensive electricity: costly expenditures on nuclear plants and long-term contracts dating from the mid-1980's led to much higher prices than in neighboring states.

Under the regulated system then in place, California's public utilities could shift the cost of these uneconomical investments to customers. In a deregulated market, the costs of poor decisions are, ideally, borne by investors, not consumers. Congress encouraged electricity deregulation with the Energy Policy Act of 1992, and it is not surprising that California, along with many other states, regarded electricity restructuring as an attractive path to lower long-run energy costs.

Under the current partly deregulated system, the retail price that utilities can charge consumers for delivered electricity is capped for most users. The generation of electricity, however, is not directly subject to regulation, so the wholesale price can fluctuate within wide limits, responding to the forces of supply and demand.

In the early 1990's, demand for electricity grew slowly because of the 1991-93 recession, and the financial prospects for new power plants in the forthcoming deregulated environment were highly uncertain. The combination of unclear rules, environmental regulation, not-in-my-backyard activism and bureaucratic delay meant that California added only 2 percent to its generating capacity in the three years after deregulation in 1996. Several projects are under development, but given the two to five years it takes to plan and build power plants, it will be some time before the necessary capacity is available.

Meanwhile, in the late 1990's, the California economy started to pick up steam. Electricity use is highly correlated with the growth in income, and with the California economy growing at nearly twice the national average the last few years, it is not surprising that the demand for electricity has increased significantly. Neighboring western states have also experienced increased demand, making them less willing to sell to California distributors.

What can be done? The basic problem is an imbalance in demand and supply. Since supply responds slowly, the only possibility in the short run is to manage demand more effectively. This means that prices will have to rise, probably on the order of 20 percent.

Electricity distributors have been caught in a squeeze between a skyrocketing wholesale price and a fixed retail price, leading to an accumulation of more than $11 billion in debt since summer. California politicians are debating who will be stuck with the bill, but it is a safe guess that all the concerned parties -- consumers, investors and taxpayers -- will end up sharing the burden. A price increase will be economically and politically painful, but letting the utilities go bankrupt would be even more painful and accomplish little.

Higher prices are an effective tool for matching demand and supply. Last summer, when rates in San Diego more than doubled, power consumption dropped 5 percent within a few weeks. Anything that helps users accelerate their adjustment to higher prices would be helpful. California utilities now offer to sell electricity at reduced rates to businesses that allow service to be interrupted when necessary. This program could be expanded and made more financially attractive.

Another way to discourage consumption next summer would be to charge residential users high prices only for the electricity use that is in excess of, say, 90 percent of the amount consumed in the similar billing period last summer. This would make consumers face the full price of incremental consumption of electricity, yet still keep bills relatively low for those who conserve.

But these are just stopgap measures. In the longer run, California should think seriously about time-varying pricing of electricity for all users.

Much of the cost of generating electricity involves building operations to satisfy peak demand. Charging high prices during periods of peak use helps to reduce demand for electricity during those periods and reduces the necessary investment in generating operations.

One of the most cost-effective ways to reduce household energy consumption is to replace old appliances with energy-efficient models like those carrying the Energy Department's Energy Star certification. Most California power distributors already offer rebates for replacement refrigerators and other appliances. In his speech on Monday, Gov. Gray Davis proposed setting aside $250 million to expand this program and publicize it more widely. With all that promotion from Silicon Valley about intelligent appliances that can keep consumers from running out of beer, it is remarkable that no one mentioned that they can also help keep electricity bills down, especially if time-varying pricing is adopted.

A study by Jonathan Koomey and his colleagues at Lawrence Berkeley Labs found that relatively simple steps like turning off unused desktop computers, displays and laser printers can save noticeable amounts of power. Smart office equipment could save even more power, and have the side benefit of stimulating California's moribund computer industry.

On the supply side, Governor Davis proposed providing low-cost loans and issuing executive orders to cut through the red tape that has delayed plant construction. He should also encourage investment in California's aging electricity distribution operations. As Severin Borenstein, James Bushnell and Stephen Stoft, energy economists at the University of California at Berkeley, have argued, extra transmission capacity not only is useful in emergency situations but also dampens the incentive for electricity producers to exploit short-term imbalances in demand and supply.

Finally, the spot market for wholesale electricity needs to be improved. It is almost impossible to store electricity, so demand and supply have to balance minute by minute. Futures markets and long-term contracts are a partial substitute for buffer stocks, but the California markets offer only limited opportunity for futures trading, and, given their earlier experience, distributors have shied away from long-term contracts.

There is no magic bullet for the California energy crisis. Although increased attention to conservation and bringing more supplies online may sound mundane, that is ultimately what will fix the problem.