Re: California Energy Crisis: a report from Cato

From: Chris Hibbert (
Date: Sat Jul 28 2001 - 21:34:09 MDT

And now to respond to Peter's particular points.

"Peter C. McCluskey" wrote:
> They claim that more nuclear power would have had no effect on peak
> prices. They seem to base this on two faulty assumptions. They assume
> the price of natural gas would be unaffected, even though replacing
> some natural gas use by nuclear would seem to reduce total demand for
> natural gas. They also seem to assume that there are no cost differences
> between the natural gas based producer who would be the marginal producer
> with more nuclear power and the one was the actual marginal producer. It
> seems likely that most producers have some costs that differ from competitors
> (e.g. different labor costs due to different locations).

I think you're mostly right about that, though I suspect that under
reasonable assumptions nuclear wouldn't have made much difference. If
we're only talking about a few nuclear plants, it would have moved the
demand curve down to a different marginal producer (with lower cost
structure, as you argue), but it appears that the market could still
have been pushed to use producers who had to pay the LA NOx emissions
charges. But another part of their argument holds here, too. With
prices as they were in the mid-90s there wasn't any reason for anyone to
build nuclear, especially with the huge costs they face in regulatory
costs, and the many thickets of NIMBYism they'd have to face.

> They argue that in an otherwise free market, the restrictions on long-term
> contracts wouldn't have affected prices.
> They have a reasonable claim that it ought not to have affected retail
> prices, but given the actual political climate it seems likely that consumers
> and/or taxpayers will actually end up paying something that approximates
> average prices that the utilities faced.

Yes, but their more important point was that if consumers don't see
actual price variability, they have no incentive to cut down on their
usage. It's the insensitivity of demand to price that allowed prices to
skyrocket once there was a constriction in the supply.

> They also claim that producers who signed long-term contracts at low
> prices would go bankrupt and renege on their contracts, as some who
> actually signed such contracts have done. The claim that a significant
> fraction would go bankrupt seems to reflect an unusual pessimism about
> the reasonableness of the relevant bankruptcy laws,

How so? They said it happened before in the 80s. I don't know the
history, myself. What do you think bankruptcy laws could do?

> and/or an unusual
> lack of confidence in the ability of producers to hedge their risks.
> I'm fairly confident that many producers would or did sign long-term
> contracts with natural gas producers, and that those natural gas producers
> would have wells operating at predictable enough costs to fulfill those
> contracts. My impression is that some of the actual breach of long-term
> contracts to which the paper seems to be refering started when the utilities
> broke the contracts by failing to pay, which would at least have been
> postponed a long time if the utilities had had more such contracts.

The only way I can make sense of their discussion of first price auction
rules is to assume that the long-term contracts are treated as
equivalent to a promise to bid the contracted price in the Power
Exchange market. When prices rise as they have, this would mean that
even the long-term suppliers would recieve the clearing price. If this
rule isn't followed, it undercuts their whole argument about uniform
prices on the spot market.

But I admit I don't know.

> They seem to imply that that long-term contracts would not have affected
> the blackouts, but it sure looks to me like, given the mistaken retail price
> caps, the rate at which the utilities lost money would have been drastically
> reduced, possibly by enough to keep them solvent until the shortage ends.
> If they had been solvent enough to pay the QFs most of what they were owed,
> fewer of those QFs would have shut down due to lack of cash, and the
> available QF generating capacity would have been larger. I suspect this
> would have averted most of the blackouts.

If the long-term contracts are paid at the price bid, then your argument
is sound. It seems that in that case, the crisis would have been
reduced, which given it's self-magnifying nature, could easily have made
the whole thing a non-issue.

> But at least their analysis is better than the airline ticket analogy, which
> suggests that spot prices will normally be much higher than long-term contract
> prices (that kind of price discrimination happens in airline ticketing because
> the last-minute business traveller is less price sensitive than early ticket
> buyers).

It seems plausible, given the current institutions, that the last minute
power buyer is less price sensitive. At least currently, when the last
buyer is buying emergency back-up capacity. If the market were
rational, then you'd be right.

> Their claim that a "three-year dry spell" "reduced hydro-electric generation
> in California" is misleading. California has had three years of increasingly
> dry weather, but 2001 was the first of those years to actually be drier than
> the historical average. Maybe if they had been talking about the west as
> a whole rather than California the claim would be right.

Early in the paper, they were clear that 98 and 99 were fairly normal.
I interpreted the later references to three years of drought to be
relative to the heavy rain years before. Normal weather in California
is pretty dry, and not enough to refill all the reservoirs. The normal
rainfall in 98 and 99 led to less-full reservoirs, and no cushion when
the rainfall was even lower in 2000.

I think we're arguing about minor issues. Do you think other policy
decisions than the price caps were foreseeable, or had a major impact on
the actual shape of the crisis?


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