California’s Electricity Industry

The debate for and against deregulation of the generation and distribution of electricity was brought to light in the public’s eye in California during the hot summer of 2000. Residents of the fifth largest economy in the world, many who had remained ignorant of the potential impacts of deregulation legislation that had passed through the state government, were forced to endure 100 plus degree weather during rolling blackouts. The entire nation began to debate the pros and cons of deregulation in the electricity industry as episodes of The Tonight Show with Jay Leno were broadcast from studio by candlelight in order to poke fun at the disastrous situation. Two large federal and state water pumps even had to be temporarily shut down to conserve electricity.

The enormous shortfall in energy happened despite, or perhaps because of, recent deregulation efforts within the State of California’s electrical utility industry that were designed to make the system more efficient. Both sides of the argument began pointing the finger to the other, outlining in public debate how the other side was at fault in creating the shortfall. Those in favor of deregulation cried that the legislation had not yet gone far enough for the built-in efficiencies of market economics to take effect.

By deregulating the power generation companies but enforcing price ceilings on the distributors, the State of California had interfered with the market in a way that caused a dramatic excess of demand over supply. Opponents of electricity deregulation point to California’s problems as a case study of why utilities should be regulated. They argued natural monopolies such as electricity utilities will not see the efficiencies that traditional capitalist markets enjoy.

Both sides of the argument make fair points, but there is one inescapable fact. The electricity supply and distribution markets are currently in monopolistic conditions and the entire state’s economy is strongly dependent on their products. The situation offers far too much incentive for utilities to reduce supply or refuse to increase capacity, reaping huge rewards for causing energy shortfalls. If complete deregulation is allowed to run its course, the huge incremental costs will move large sums of money from families and businesses into the giants of California’s energy industry and could cause severe economic recession in the world’s fifth largest economy.

This paper will start out by looking at the economics of the electricity industry, how it fits into the concept of a natural monopoly, and how the United States government has traditionally responded to that situation. It will then look specifically at California’s energy industry, who the major players are, and how the debate for energy deregulation began. It will then show arguments both for and against deregulation in California. Finally, it will demonstrate the natural conclusion of why regulation is necessary for the economy in the State of California to remain healthy.

The question of whether or not electricity should be regulated really begins in a discussion of market economics. Our country was founded at about the same time that Adam Smith’s The Wealth of Nations introduced the concept of the free market and the invisible hand to the world. The work put an emphasis on minimizing the controls that are imposed by the government in the marketplace, a concept that he called laissez-faire. He believed that market forces would act to create efficiencies through the purchasing and supply decisions of individual consumers and businesses within a marketplace. Price increases would cause demand to decrease and supply to increase until a natural equilibrium is established. Profits for companies are short-lived in his hypothetical model as strong competition kept prices low.

However, Adam Smith’s idea of the marketplace had a significant amount of assumptions built into the model. One of the more important ones is that in order for free competition to work effectively, there must be a large amount of suppliers within a given marketplace and suppliers must be able to easily enter and exit the marketplace as prices become more or less favorable. Unfortunately, the implementation of this theoretical model had some serious drawbacks when it came to practical application. One of them came to be known as the natural monopoly. A natural monopoly occurs when the fixed costs for a given industry are substantial, while the variable costs are minimal.

In order to make a profit, companies need to achieve massive economies of scale. In such cases, it is often inefficient and impractical for more than one firm to establish itself in a given market. The production and distribution of electricity has traditionally been a prime example of a natural monopoly. The creation and distribution of electricity demands massive amounts of capital infusion and therefore inhibits the amount of suppliers in the marketplace. Having more than one distributor of electricity would also require more than one set of wires running down the street, an obvious drawback to the general public. The fixed costs also prohibit the ability of companies to move in and out of the market easily as prices change.

The United States government has traditionally responded to the problem of natural monopolies by allowing them to exist and then regulated them to ensure that they would be run to the benefit of the general public. Companies that have a natural monopoly are allowed to realize a “reasonable” rate of return, but are not allowed to charge a price that is the optimal level for a monopoly. The optimal level would keep prices high by creating a shortage of electricity, and therefore doing damage to the general public welfare. Oversight was also maintained to ensure that suppliers of electricity were creating ample capacity for expanding economies. This has caused most regulated electricity markets to maintain excess capacity. While this would be considered inefficient in many markets because the excess costs are passed on to the general public, it ensures that an economy that is extremely dependent on energy will not suffer shortages.

The debate for deregulation of the electricity market in California began with technological changes in the production of electricity. It was becoming more economically feasible to produce electricity without realizing the massive economies of scale that had been previously required. Consequently, some politicians and businesses began to question whether it was wise to maintain a natural monopoly in California if a freer market could bring more efficiency. In December 1995, the California Public Utility Commission declared the system of energy regulation in California “fragmented, outdated, arcane and unjustifiably complex.” The commission, which sets consumer energy rates, voted to open California’s energy industry to competition.