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The Economics of the Energy Crisis

The energy crisis has consumers asking, "How did this happen?" and wondering about the behind-the-scenes manipulation that seems to be allowing huge profits to a few at a high cost to everyone else.

In a panel discussion on March 6, sponsored by the Center for Applied Professional Ethics, David Gallo, Economics; William Stewart, Political Science; and Thomas Imhoff, Philosophy, addressed the California energy crisis. This is the first of a two-part series covering the forum, in which Professor Gallo discusses the economics of the crisis.

Part I
The Economics of the crisis

The deregulation of 1996 in California precipitated the present energy crisis. Economist David Gallo, who worked with the California Energy Commission (CEC) during a period in the 1980s when deregulation was being debated by the Reagan administration, asserts that deregulation was a mistake for one important reason: privately owned, competitive generators will never have the incentive to build the excess capacity necessary to provide system reliability.

Peak demand periods, primarily during summer weekdays, are actually only a few hundred hours per year. But it is not profitable for energy compainies to build plants only to supply energy for these peak periods, said Gallo. The inevitable result is chronic shortages and rolling blackouts during peak periods.

Assuming that regulation were desirable, or at least inevitable, said Gallo, three safeguards could have been built into the system that would have offered protection to consumers.

Planning for maintenance

The unavailability of California's generating capacity due to scheduled or unscheduled maintenance was foreseeable, and a system could have been put in place ensuring that plants needed to supply necessary power are not taken off-line simultaneously.

This would have entailed extending the transition period for several more years. Extending the transition period would have also stretched out the reconstruction period. As it is, consumers are going to pay the $13 billion in losses to the transmission companies (PG&E and Southern California Edison) through direct compensation to the transmission/distribution system or through the state revenues that will be used to buy the system at a price greater than its value.

PG&E's supply plans during the late 1970s and early 1980s showed a consistent preference for building large-scale coal and nuclear capacity rather than modernizing existing natural gas and oil plants. The stated purpose was twofold: to meet the assumed large increase in demand (which did not occur because of aggressive conservation programs pushed by the CEC) and to allow retirement of their oil-gas-fired power plants (which seemed necessary because federal regulation at the time limited future use of natural gas for energy generation; that legislation was later rescinded).

Rather than converting the old plants to modern, more efficient combined-cycle technology, PG&E chose to neglect maintenance and stick to the replacement policy. Those are the plants that were sold under divestiture and were out of service this winter.

The neglect and failure to modernize led to the predictable result that the plants required major reconstruction and therefore would be unavailable for a significant period of time. While it appeared rational to remove them from service during the ordinarily low demand period of fall and early winter, the number of plants simultaneously taken out of service was responsible for most of the supply shortfall, according to Gallo.

Low supply drove up the wholesale price of electricity to 34 cents per kWh for December and January, while the retail prices were kept at roughly five cents. As the transmission/distribution system's losses mounted, the utilities were forced into the hour-ahead spot market (buying power, literally, an hour before it is needed) that was partly responsible for the high wholesale prices.

Temporarily preventing separation of transmission and generation assets

Part of the deregulation scheme involved divestiture of one-half of the utilities' non-nuclear capacity and the separation of the transmission/distribution and generation aspects of what had been one utility business (PG&E and So Cal Edison). The transmission system was to remain regulated while the generation portion became a separate company competing with other generators. The price charged utility customers was fixed, but the prices paid to electricity generators were not.

A large part of the loss in the utilities' transmission/distribution system (the well-publicized $13 billion) was added profit to the generation portion of the parent businesses. Had the deregulation bill temporarily prevented separation of assets, those profits could have been used to partially compensate for the losses.

The use of a windfall profits tax

The oil deregulation bill passed as part of the National Energy Act of 1978 included a windfall profits tax. PG&E and the CEC knew that supply shortages were a possibility and that there were methods for protecting consumers. One of these, the windfall profits tax, could have been included in deregulation legislation, according to Gallo.

A windfall profits tax imposes a sliding scale tax based on the difference between the cost of production and the price of wholesale. It would have allowed a tax of the large profits being made on the generation side to pay for the $13 billion in losses. Otherwise, the loss gets passed on to consumers, which is what is happening.

Conclusion

There are long-term consequences to the failed deregulation experiment. We will be paying for this mistake with higher utility bills for the next decade.

The long-term contracts the state has signed with generators are for prices around 7 cents per kWh, requiring a 15- to 20-percent rate increase. Repaying the $13 billion (the estimate has risen to $14 billion since March 6) in past losses by issuing additional bonds (repaid with a rate surcharge over 10 years) could increase the average consumer's electricity rates another 15 percent, estimates Gallo.

So, rather than reducing California's electricity cost, deregulation has resulted in reduced system reliability and higher (30% or more) electricity rates for at least another decade.