December 10, 2000
California Screaming
By PAUL KRUGMAN
[C] alifornia'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.
Copyright 2000 The New York Times Company
