All Commentary
Monday, October 1, 2001

Price Caps on Electricity Are a Good Idea?

The Reprieve Is Only Temporary

Editor’s note: On July 4, shortly after this article was written, the San Francisco Chronicle ran this front-page headline: “Federal Price Limits Backfire.”

Will price controls solve the California electricity crisis? Did price controls solve the oil crisis of the 1970s? Did price controls make apartments easily available in New York City? Of course not. Despite the reputation of having earned a gentleman’s C at Yale, President Bush must have been paying attention in Econ 101, since he correctly explained to California Governor Gray Davis that price controls “do nothing to reduce demand, and they do nothing to increase supply.” That of course was before his new appointees to the Federal Energy Regulatory Commission (FERC) placed price controls on power in 11 Western states.

But is Econ 101 really applicable here? Isn’t electricity different? It’s true that electricity is expensive to store and if supply doesn’t equal demand at all times the electric grid can short. As a result, when supply is running dangerously close to demand electricity prices can increase dramatically. Neither of these technical facts about electricity, however, prevents a market in electricity from performing well. To avoid price spikes, for example, electric utilities can own their own generators or enter into long-term contracts with outside generators. (Utility-owned generators and long-term contracts were heavily discouraged in California’s 1996 electricity “deregulation” plan.) The unique aspects of electricity will also not alleviate the detrimental effects of price controls.

Price controls on electricity, even the “soft” caps imposed by FERC, so-called because they are based on costs and are not fixed at a hard number, will have all the usual effects on the supply side, including a reduced incentive to invest in new generation plants. (Governor Davis’s threats to take over generators and claw back refunds have also not helped to encourage new investments.) On the demand side, however, it is true that the new price caps will not have the usual effect of reducing the incentive to conserve. The reason? Retail prices are already controlled!

The California electricity crisis is a great illustration of Ludwig von Mises’s famous dictum that controls lead to further controls. California first ran into trouble when in the spring of 2000 the market-driven wholesale price of electricity rose above the government-controlled retail price. The major California utilities, Pacific Gas and Electric and Southern California Edison, started to hemorrhage money as they were forced to buy high and sell low.

Here, before costs began to skyrocket, was an ideal moment to scrap retail price controls. But instead of decontrolling retail prices, Governor Davis insisted that controls be maintained and vainly promised that retail prices would not increase. (His promise was soon retracted; the government increased but did not free retail prices.)

Rather than repealing retail price controls, which would have nipped the electricity crisis in the bud, the first response of California’s Independent System Operator (ISO) was to cap the price of wholesale power. But California’s ISO could not cap the price of electricity in other states, so electricity generators responded by selling their power elsewhere. The caps increased exports of electricity from California to other states just when California needed electricity the most! Whenever a state program fails, politicians try a federal program. The latest attempt to regulate prices, therefore, comes from the FERC, which has regulated prices in all 11 states in the western power grid. History does not bode well for this new intervention.

PG&E Goes Bankrupt

As a further consequence of Governor Davis’s decision to maintain retail price controls, Pacific Gas & Electric, a California institution for nearly 150 years, was forced into bankruptcy. With Southern California Edison also lying on the verge of bankruptcy and with real deregulation left off the table, the state had little recourse but to replace the utilities as a buyer of electricity.

Ironically, one of the first acts of the state was to enter into a series of long-term contracts, the same sorts of contracts it had previously discouraged! (The state, however, is not a savvy buyer and early indications suggest that California has paid too much for its long-term contracts.) Since the wholesale price continued to exceed the retail price, the state too was required to buy high and sell low—thus explaining why Governor Davis has been anxious to see price controls placed on wholesale power.

Retail price controls led to the bankruptcy of the utilities, the state takeover of wholesale electricity purchases, failed wholesale price controls by the state, and now federal wholesale price controls. Governor Davis has already indicated that he wants the state to take over the transmission lines of Southern California Edison (in return for lifting it out of a grave the government dug); if we continue to follow this path California may end up nationalizing, or rather statizing, most of the electricity market—to the detriment of electricity consumers and taxpayers.

How can we get out of this mess? We must begin by ending the vicious cycle of controls’ leading to further controls. Both wholesale and retail prices should be freed. When the electricity consumer examines his current bill he may feel lucky that retail prices have been held below the wholesale price, but he shouldn’t forget that the reprieve is only temporary. The difference between the wholesale and retail price of electricity is currently being paid by the state. Thus what electricity consumers save in electricity costs today they must pay for in higher taxes tomorrow.

Freeing prices is not enough, however. At the heart of the crisis lies the fact that until recently California had not approved a major power plant in over a decade, the same decade that saw the boom of the electricity-guzzling Internet and also increased immigration to California. It doesn’t take an Adam Smith to figure out that when demand increases and supply remains the same, prices will rise. In addition to freeing prices, therefore, California must also cut green tape so that new power plants can be built.

Regardless of the severity of the electricity shortage, it’s clear that California’s dimmest bulbs reside in its capital.


Vice President and Director of Research

The Independent Institute

  • Alex Tabarrok is a professor of economics at George Mason University. He blogs at Marginal Revolution with Tyler Cowen.