Introduction

Although deregulation in trucking, airlines, and railroads has allowed American consumers to save about $50 billion annually, California’s experience with deregulating the electricity generation market has caused many to believe that deregulation itself is a failure. On Thursday, March 1, 2001, the AEI-Brookings Joint Center for Regulatory Studies held a symposium at the American Enterprise Institute. Leading academics and practitioners discussed causes and cures for California’s electricity market and presented lessons for successful electricity deregulation in other states. The primary purpose of this symposium, Joint Center director Robert W. Hahn noted, was to help develop blueprints for the transition to efficient markets in power generation.

Session 1: What Happened in California and How to Fix It?

The first panel, moderated by Robert E. Litan, addressed the crisis itself. Frank Wolak of Stanford University began by stating that while California’s market worked well for approximately two years, several problems combined to create trouble. Some of the general problems would affect all states to some degree: increased demand for limited capacity; rising natural gas prices; adverse environmental conditions (for example, a lack of snow or rain); and the fact that most suppliers are vertically integrated. But California magnified those general problems by not vesting contracts, which would have allowed greater wholesale price certainty. Wolak proposed to give firms that wish to sell electricity in California a choice: they could either be subject to cost–based rates or be allowed to sell part of their power on the spot market while offering vesting contracts for the remainder at a price set by FERC. He cautions, however, against doing away with the spot market altogether.

"Deregulation," said Anne M. Cleary of Mirant California, "has not failed, just gotten confused." The most important element of that confusion, she believes, is that consumers do not know what buying model to use. She stated that the role of deregulation is to open the market for generation and to increase both suppliers and innovation, as well as to protect the transmission and delivery franchise. It is evident from the experience of the natural gas market that deregulation can be successful. In California, however, deregulation was not given enough time—for consumer choice, for default-service questions, for standard offer issues, or for implementation. Perhaps, she suggested, performance-based ratemaking is a step in the right direction, but education and time are crucial to effective deregulation.

The third speaker, John R. Fielder of Southern California Edison, placed the majority of blame on the fact that "politics has overtaken market forces." As long as elected officials make regulatory decisions, they will act in the best interests of those who elected them. Shielding consumers from price fluctuations gives them no incentive to conserve or space their electricity usage and guarantees the failure of a partially deregulated system.

Finally, Paul L. Joskow of the Massachusetts Institute of Technology stated that California did not deregulate, it merely restructured. It failed to provide for new capacity or to streamline the siting process for new generators. It regulated retail sales while deregulating the wholesale market. Most important, the state failed to take into account the unusual attributes of electricity: it cannot be stored; its demand is highly inelastic; and its market needs to be designed for all contingencies. California addressed none of those issues.

Keynote Address

During her luncheon address, Elizabeth A. Moler, former chair of the Federal Energy Regulatory Commission and now senior vice president at Exelon Corp., cautioned that deregulation is not a dirty word. "It is the California model that has failed," she said, "not the principle." As evidence, she offered success stories from Pennsylvania and Illinois, states that have allowed utilities to manage their own commodities, have connected their markets regionally, have avoided price spikes, have generated new capacity, and are even expecting surpluses. While concerns exist in both states—how to provide last-resort service as well as the expiration of price caps, for example—thoughtful deregulation has succeeded in both locations. Moler asserted that to extend that success to other areas Congress will have to take action on energy supply issues. Furthermore, states will need to cooperate with the federal government.

Session 2: Is It Just California? General Lessons About Market Design and Regulatory Transition Mechanisms

At the afternoon session, panelists used the California experience to draw lessons for others considering deregulation. Peter Cramton of the University of Maryland stated that legislators and regulators are reluctant to abandon traditional regulation. But if the goal is to make markets work better, "it is not enough to point out the beauty of deregulation; economists must identify fatal flaws in any system designed to accomplish it." If they do not do so, committees of stakeholders and policymakers will continue to design markets that are likely to fail.

William W. Hogan of Harvard University highlighted the need for fundamental, comprehensive market redesign if states are to deregulate electricity effectively. "First," he said, "we must fix what we know doesn't work." In particular, he noted the importance of developing more efficient transmission networks.

Alvin K. Klevorick of Yale University agreed that design requires expertise and should not be static. But he also stated that design choices are usually made by individuals representing special interests who do not give adequate attention to the interdependence of regional markets and transmission networks. The California experience suggests that market design must take into account the demand side as well as the supply side and that the entity monitoring markets must be independent of the entities running those same markets. Finally, he asked how much federalism the nation needs: the time for experimentation is over.

The final speaker, Richard S. Shapiro of Enron, argued that California points out the failure of political leadership to communicate issues and problems to consumers. All policymakers must make the decision to let markets work. States, for example, should remove restrictions on hedging, while the federal government assures all market participants sufficient transmission information to allow rapid response to developing problems and trends. He asserted that the most crucial elements are to provide for deep forward markets and to resolve transmission impediments. The goal is not political harmony, but a rational, efficient market.

Session 3: Commentary on the Presentations

Stephen G. Breyer, associate justice of the Supreme Court, moderated the last session of the symposium. What, he asked, doomed California's attempt to deregulate electricity? Furthermore, to foster effective government deregulation, how should the government make policy, what actions should industry representatives, lawyers, economists, and regulators take, and what should they avoid?

The panelists, William W. Hogan, Paul L. Joskow and Paul W. MacAvoy, responded to the first question with a variety of answers. For one thing, the motivations were wrong. The California market concentrated on a short-term fix rather than on long-term benefits. In addition, bad luck complicated bad design, most notably in a lack of rain and a bottleneck in natural gas distribution.

While all panelists agreed that the design of the California electricity market had fundamental flaws, they disagreed on the actions that are needed to correct the flaws. They debated several issues, including appropriate forms of government intervention if markets collapse and whether long-term contracts would help foster competition. Despite their differing views on the future of deregulation, all the panelists agreed that California’s electricity market offers significant lessons for those asking questions about new markets elsewhere.