Of Public Interest

Volume 3, Number 1
February, 2001

by Richard E. Wagner

In 1998, California took one small step toward the deregulation of electric power, by removing some restrictions on wholesale prices in the southernmost part of the state. The result appears to be little more than a continually growing disaster. We hear increasingly of brownouts and even rolling blackouts. It is easy enough to see the miseries that these can cause. Traffic signals stop working and busy intersections become snarled. Elevators stop between floors, with their passengers stranded until the power returns.

Something is terribly wrong with this picture. About half the states in the nation are in various stages of deregulating electric power. It is important to learn what California’s experience has to teach us. In a 10 December 2000 article titled "California Screaming," the New York Times attributed California’s electric miseries to deregulation, and claimed that our needs for dependable power are too important to be left to the impersonal forces of market competition.

Is it really plausible to claim that California’s experience teaches us that deregulation is a bad thing? One problem with this claim is that deregulation has worked exceedingly well in such areas as interstate trucking, air transportation, and long-distance telephony. Furthermore, there is ample evidence and strong logic in favor of the proposition that for the most part an economic system based on freely competitive markets is better for consumers than a highly regulated or state-controlled economy. One needs only to point to the collapse of communism. If open competition is superior to intense regulation, it would seem but simple common sense to assert that some deregulation is better than none, even if this may in turn be inferior to full deregulation.

This simple intuition, however, lacks general validity. Economists have developed a whole theory to explain this lack of general validity. They call it the "theory of second best." Removing one or two elements of regulation in a highly regulated market may worsen matters, even if a thoroughgoing deregulation improves them. This outcome is possible because the different parts of a market are connected with one another. The few deregulated parts may clash with the many parts that remain regulated. The result of this clash may be chaotic conditions throughout the market.

For deregulation to succeed, it must be embraced whole-heartedly and not half-heartedly. The relevance of the theory of second best is quite evident in the sad tale coming out of California. With true deregulation, the growing demand for electricity would have led readily to an expansion of power supplied in California, both through the expansion of generating capacity within California and through the increased purchase of power generated outside California. The division between these two sources of increased power would be governed by their relative costs of production. With continuing technological improvement, moreover, we would expect real power prices to fall. More and cheaper power would have resulted from true deregulation. There would have been absolutely no reason for traffic to be snarled at blacked-out intersections or for people to be stuck in elevators.

California did not deregulate electric power. It deregulated a little piece of it, while retaining regulation over most of it. California still controls most electric prices. A few wholesale prices were deregulated, but controls were maintained over retail prices. This creates a strange commercial situation: a firm can pay more to get power as a means of preventing brownouts, but it cannot charge a higher price for that more costly power. With regulations like this, it is no wonder that power companies are facing bankruptcy.

California also regulates the construction of new generating capacity, in sharp contrast to the situation in long-distance telephony. Over the past ten years population has roughly doubled in California while generating capacity has remained roughly unchanged. This outcome is reminiscent of the now defunct Civil Aeronautics Board, which never allowed a single new airline to enter the interstate passenger business between the time of its creation in 1938 and its demise in 1979.

While many applications for permits to build power plants have been filed in California, approvals have come slowly and reluctantly. Only plants fired by natural gas are even considered for approval. This form of electricity is more expensive than other forms. For people rationally to invest in such power plants, they need assurance that they will not face competition down the road from nuclear and coal-fired power plants. Such assurances cannot truly be given, of course, because political turnover can alter the future regulatory climate. Thus, capacity is slow to expand because regulation creates great commercial uncertainty.

If the experience in California teaches anything, it teaches us not about the evils of deregulation. Rather it teaches us about the evils of pursuing a good idea only partially and half-heartedly.

Richard E. Wagner is Senior Fellow at the Public Interest Institute and Holbert Harris Professor of Economics at George Mason University.

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