Debate: Has Deregulation Caused the Energy Shortage in California?
Issues and Background
As an economist, whenever I
hear the word "shortage" I wait for the other shoe to drop. That
other shoe is usually "price control." So it was no great surprise
to discover, after the electric power shortage in California made headlines,
that there were price controls holding down the price of electricity to the
In the absence of price
control, a shortage is usually a passing thing. When prices are free to rise,
that causes consumers to buy less and producers to produce more, eliminating
the shortage. But when the price is artificially prevented from rising, the
shortage is prevented from ending.
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
The experience raises
questions about deregulation. And more broadly, it is a warning about the
dangers of placing blind faith in markets.
California began experiencing a serious energy shortage in
the summer of 2000. Power blackouts became relatively frequent in many areas
of the state. These problems appeared to have begun with the deregulation of
the electrical power industry in California. Are these problems the result of
deregulation? Or are they the result of regulations that result in
inefficient outcomes? This question is of particular importance since many
other states are in the process of following California's path to
Until the mid-1990s, it was argued that there were extensive economies of
scale in the production and distribution of electricity and natural gas.
These industries were usually cited in economics textbooks as examples of
natural monopoly industries. By the mid 1990s, though, advocates of
deregulation argued that technological changes had eliminated the economies
of scale in the production of energy. The distribution of electricity, it was
argued, remained a natural monopoly since distribution would be substantially
more costly if each provider of electricity and natural gas were to provide
its own power and natural gas lines. (Costs per customer would be
substantially higher if there were 4-5 sets of wires and natural gas pipes
along every street.)
Deregulation began in California in 1996. The state's two largest utility
companies, Pacific Gas and Electric (PG&E) and Southern California Edison
were encouraged to sell off their power generation plants and to focus on the
distribution of gas and electricity to their customers. These utilities were
to buy power on the open market and then resell it to their customers. The
prices that these companies could charge to their customers were subject to a
By the summer of 2000, rising energy costs resulted in substantial losses
for California utilities. Utilities had to pay substantially more for power,
but could not pass the higher costs on to their customers. In response to
these losses, both PG&E and Edison International were threatened with
bankruptcy. Energy suppliers were reluctant to sell power to these endangered
firms, further raising their costs and increasing their losses. Since the
supply of electricity was not keeping pace with the growth in demand,
brownouts and blackouts became common phenomena. These problems were
aggravated by the higher than anticipated electricity demand that resulted
from high levels of air-conditioning usage during an exceptionally hot
In January, 2001, the state of California purchased long-term power
contracts on behalf of these troubled companies through the use of an
internet auction. This resulted in lower prices and reduced the probability
of a major crisis. While the immediate crisis has been averted, most
forecasts suggest that the demand for power will continue to grow more
rapidly than energy supplies in California unless prices are allowed to rise.
By the summer of 2001, retail electricity rates had been allowed to increase
somewhat, but regulations restricted the magnitude of the increase for a
substantial share of residential households. While the price increase has
reduced the problem of shortages, the basic problems still remain.
One issue is that California consumes more electricity than it produces.
Critics of the regulatory process argue that this is due to a regulatory
environment that discourages the production of new power plants. The
construction of new power plants and transmission lines has also generally
met with substantial opposition from California residents.
Those who favor increased deregulation argue that the problems facing
California are the result of the price controls that were imposed on the
utilities. They argue that higher prices and profits would encourage higher
levels of production and distribution of energy.
Advocates of a more activist regulatory approach argue that the problems
facing California are the result of poor decision making by California
utilities who chose to purchase an excessive amount of energy on the volatile
spot market, rather than on more stable long-term markets.
Primary Resources and Data
- U.S. Department
The U.S. Department of Energy website contains information about energy
markets, energy conservation, federal strategic energy plans, and an
extensive collection of data and statistics concerning energy
consumption, production, and prices. The state
electricity profile page for California is of particular interest.
Information Administration, "Energy Prices"
The Energy Information Administration provides recent weekly, monthly
and/or annual data on a variety of energy prices at this website. This
information is available in text or Adobe pdf format as well as in the
form of a comma-separated data file (for input into a spreadsheet,
database, or statistical package).
- Federal Energy
The website of the Federal Energy Management Program contains
information about the impacts of utility deregulation on federal
- Federal Energy
The Federal Energy Regulatory Commission regulates interstate commerce
in natural gas and electricity. It also oversees the enforcement of
environmental regulations related to energy production and distribution.
This website contains information about its history and operations.
Among other useful materials, this site also contains the text of
dealing with the California energy crisis (and other energy issues).
"New York Mercantile Exchange"
This page provides information on a variety of energy prices determined
at the New York Mercantile Exchange (NYMEX). Current market prices are
displayed for electricity, heating oil, natural gas, light sweet crude
oil, unleaded gasoline, and propane.
The California Energy Commission is charged with overseeing the
distribution of energy in California. This web site contains information
on the energy crisis, recommendations for dealing with the crisis, and
numerous studies and projections of energy demand and supply under
alternative assumptions about future prices and profitability. The
Commission's page on electricity
is particularly relevant. This web site also contains a list of programs
that have been created to deal with the energy shortage.
Consumer Energy Center
The California Consumer Energy Center provides descriptions of rebate,
grant, and loan programs designed to reduce electricity consumption in
California. Information on energy conservation alternatives is also
- Paul Van
Slambrouck, "California's uncertain step to fix power woes"
In this January 18, 2001 article in the Christian Science Monitor,
Paul Van Slambrouck provides a good description of the nature of the
energy shortage facing California.
- Sacramento Bee,
"Energy Crisis Archive"
At this web site, the Sacramento Bee provides an archive of their
articles on the California energy crisis.
Different Perspectives in the Debate
- Thomas Sowell,
"The Cause of the California Electricity Shortages: 'Price
In this January 11, 2001 article appearing in the online edition of Capitalism
Magazine, Thomas Sowell discusses the electricity shortages in
California. He argues that the electricity shortage in California is a
very simple example of the effect of a binding price ceiling. Sowell
argues that the problem would disappear if the price controls were
lifted. He also notes that much of the problem is due to the supply
restriction that has resulted from the opposition to the construction of
new power plants.
- Paul Krugman,
In this December 10, 2000 New York Times article, Paul Krugman
argues that some of the problems experienced in California may be the
result of market manipulation by utilities. He notes that an unusually
high proportion (25%) of the state's generating capacity was offline in
December due to breakdowns or scheduled maintenance. Krugman questions
the benefits of rushing "into a market solution when there are
serious questions about whether the market will work."
- Paul Krugman,
"Abuses of Power"
Paul Krugman examines alternative methods of dealing with the energy shortage
in California in this January 7, 2001 New York Times article. He
suggests that a complete deregulation of utilities would work, but
"would also transfer tens of billions of dollars from California
consumers to eight lucky power companies." Krugman argues that a
more equitable outcome would be to introduce temporary and partial
regulations that would place temporary caps on wholesale prices while
creating incentives to increase productive capacity.
- Jerry Taylor,
"Paul Krugman Short Circuits"
In this Cato Institute article, Jerry Taylor raises objections to
Paul Krugman's arguments. He suggests that adjustments would occur more
rapidly if prices are allowed to freely adjust without government
- Adam Hamilton,
"California Electricity Economics 101"
In this online Zeal Research article, Adam Hamilton discusses the causes
of the energy shortage in this June 1, 2001 online article. They argue
that the problem in California is the result of government interference
with the market determined prices. He argues that deregulation in
California is essentially just a poorly designed system of
re-regulation. Hamilton suggests that a market solution to the problem
would be efficient.
- Reason Public
Policy Institute, "California's Electricity Crisis"
This web site contains online articles, speeches, and links related to
the electricity crisis in California. In general, material found at this
site advocates a market-based solution to the electricity crisis.
- Brian T.
Kennedy, "Building a Free Market of Electricity in California:
Current Obstacles to Competition"
Brian T. Kennedy, in this November 9, 1999 briefing paper, examines some
of the issues associated with deregulation of electricity in California.
He argues that: "market competition is essential to good service
and low prices." Kennedy supports increased competition in the
distribution of power.
- Mona Charen,
"The Power of Ideas"
In this January 19, 2001 editorial, Mona Charen argues that deregulation
is not the cause of California's energy problems. She suggests that the
problem are the result of "stupid, self-defeating regulation."
Charen notes that, due to price controls, PG&E was forced to buy
electricity at a cost of $1.7 billion that it could sell to consumers
for only $70 million. She argues that all price controls must be lifted
if this shortage is to be eliminated.
Public Interest Research Group
The California Public Interest Research Group argues that deregulation
has resulted in higher prices to consumers and higher profits for
utilities. It is argued that the "bailout" money that the
utilities have received exceed their debts.
- PBS, "Who
Caused the Blackout in California? And Who's Profiting?"
This PBS website contains an extensive collection of information on the
energy crisis in California. Among other resources on this site are an
interesting collection of interviews
dealing with this problem.
- Robert J.
Michaels, "An Energy Policy in Bellbottoms"
Robert J. Michaels critiques the handling of the energy crisis in
California in this January 19, 2001 online article. He suggests that
many proposed state policies would result in inefficient outcomes.
Michaels suggests that less regulation and a greater reliance on markets
would improve economic efficiency.
- George Reisman,
"In Response - California Screaming, Under Government Blows"
In this online article, George Reisman provides a response to Krugman's
12/10/00 New York Times article. (Krugman's article is reprinted
at the beginning of this document. Scroll down a little to find the
beginning of Reisman's response.) He suggests that government
regulations are the long-run cause of the supply shortfall. Reisman
argues that price controls are the short-run cause of the shortage.
- Public Citizen,
"Cash, Relationships Help Explain Bush Administration's Hands-Off
Policy in California Electricity Crisis"
This February 15, 2001 press release from Public Citizen argues
that political contributions have resulted in policies that benefit
profitable utility companies in California. They advocate the use of
wholesale price ceilings on electricity.
- R. Richard
Geddes, "Time to Repeal the Public Utility Holding Company
R. Richard Geddes, in this Cato Journal article, argues for the
repeal of the Public Utility Holding Company Act of 1935. This Act,
passed during the Great Depression, limits the ability of utilities to
merge. Geddes argues that this Act limits the ability of companies to
diversify regionally. He suggests that companies that are diversified
regionally will face more stable generation costs than those that exist
only within a narrow geographical region.
- William P.
Kucewicz, "California's Dreaming: Energy Policymakers Can't Defy
William P. Kucewicz argues, in this online article, that prices must be
allowed to adjust if the energy shortage is to be eliminated. He
suggests that wholesale price ceilings would make the problem worse by
reducing the amount of supply sold to California by out-of-state
producers. Kucewicz argues for reduced regulation of this industry.
- Jerry Taylor and
Peter VanDoren, "California's Burn-out"
In this February 7, 2001 article in National Review Jerry Taylor
and Peter Van Doren argue that the electricity shortage in California is
the result of government regulation. They argue that the elimination of
this regulation will result in the elimination of this problem.
- Cato Institute,
"The 'Electricity Crisis'"
This Cato Institute webpage provides an extensive collection of
links to online articles that suggest that the use of market incentives
and a reduction in regulations would solve the energy crisis in
- Clyde Wayne
Crews, Jr., "Electric Avenues: Why 'Open Access' Can't
Clyde Wayne Crews, Jr., argues for more extensive deregulation in this
April 13, 1998 Cato Institute Policy Analysis article. He
suggests that there are no natural monopoly characteristics associated
with the transmission and distribution of electricity. Crews argues for
a completely free-market approach to the production, distribution, and
sale of electricity.
- Richard L.
Gordon, "Don't Restructure Electricity; Deregulate"
Richard L. Gordon argues for increased deregulation in this article
appearing the in winter 2001 issue of Cato Journal. He argues for
the privatization of governmentally owned utilities and the elimination
of virtually all regulation and affecting the production, distribution,
and sale of energy.
- Robert J.
Michaels, "Stranded Investments, Stranded Intellectuals"
In this 1996 Cato Institute article, Robert J. Michaels examines the
effect of "stranded costs" on utility rates. Stranded costs
are losses that utility companies receive when they sell power
generation facilities at market prices. Baumol and Sidak (and others)
have argued that an implicit contract existed between consumers and the
regulated firms in which cross subsidies covered the cost of uneconomic
services. Michaels, however, notes that most stranded costs are the
result of the construction of nuclear power plants at a time when the
demand for electricity was contracting. He suggests that these costs are
the result of poor decisions by utilities. Michaels argues that there is
no reason to believe that allowing utilities to recover these sunk costs
will result in more a efficient provision of services today. He suggests
that regulations allowed firms to operate as inefficient monopolies for
a long period. Michaels argues that there is no economic rationale for
allowing them to charge higher prices today to recover returns from
- John E. Kwoka,
Jr. "Transforming Power: Lessons from British Electricity
John E. Kwoka, Jr. examines the British experience with deregulation in
this Regulation article. He argues that deregulation in England
achieved many of its goals, but the price decline was less than
anticipated. Kwoka suggests that one of the problems in England was
allowing only two private generating firms to compete in the market. He
suggests that this duopoly system resulted in higher prices than would
have occurred under a more competitive environment.
- R. Richard
Geddes, "A Historical Perspective on Electrical Utility
In this Regulation article, R. Richard Geddes examines the
history of electric utility regulation. He argues that regulation has
involved a very close relationship between the government and utilities.
Originally regulation was done at the level of the municipality, but
shifted to the state level in the early 1900s. Geddes argues that state
regulation appeared to be successful because of the fact that it
occurred at a time in which prices were falling due to the exploitation
of economies of scale and technological advances. He suggests that the
regulatory process was affected more by political factors than by the
textbook model of cost-plus pricing.
- Union of
Concerned Scientists, "Renewable Energy"
In several documents available on this site, the Union of Concerned
Scientists raise concerns over the possible effects of deregulation on
the environment. They note that the utility industry is a major source
of pollutants. It is argued that incentives should be created to
encourage the development of clean and renewable energy production.
- Los Angeles County Economic Development
Corporation, "Energizing California’s Economic Future"
The Los Angeles Country Economic Development Corporation provides a plan
for dealing with the short-term and long-term energy problems facing
California in this online document. It is argued that enhanced powers
should be given to the Governor in the short term to deal with immediate
problems. They suggest that increased incentives are needed to encourage
energy conservation. In the long term, they recommend the use of
economic incentives to encourage communities to accept additional energy
distribution and transmission facilities. They also argue that the
government should use transfer payments, rather than price controls, to
reduce the impact of higher energy costs on low-income households.