Re: California Energy Crisis: a report from Cato

From: Chris Hibbert (
Date: Sat Jul 28 2001 - 20:44:49 MDT

I found Cato's Policy Analysis on "California's Electricity Crisis" [1] to
be quite informative and very valuable. My conclusions about the
causes were slightly different from those of the authors, but they did
provide important clues about what was going on. The most important
contribution (for me) was to resolve a conundrum that came up earlier on
this list.

My conclusions, after reading the paper are that the primary causes were
independent of the bad design of the restructured (not "deregulated")
California market. The prime contribution of the restructuring to the
crisis was to limit the prices paid by consumers, which made them even
more price insensitive than they were assumed to be. This had the
effect of
ensuring that consumption wouldn't respond to wholesale price increases.
The price increases were caused by a variety of factors outside of
California's control, and would have led only to short term price rises if
California's consumers had been able to react to rising prices.

Shortly after the crisis became big news, several people on this list
became concerned about the auction rules used at the ISO. (See the
discussion rooted at [2].) We heard reports that one cause for the
extremely high prices being charged to the utilities was that the ISO's
rules called for prices to be set every day according to the highest
clearing price in any of the hourly auctions throughout the day. [3] At
the time, I tried to contact the author of a Reason article [4] that
revealed this tidbit, but were unable to get confirmation. Some of the
apparently authoritative sources we consulted said the price was set
according to daily maximums of hourly auctions, and others said the
prices set by the hourly auctions held. According to the details in
this paper and some of its references, it now seems clear to me that the
day-ahead Power Exchange was charging by first-price rules, but that
choice (which, it is now clear to me, is correct) was undercut by the
effect of the ISO's separate market for emergency power.

The first price rule smoothes the market. If the market doesn't pay
suppliers by first price rules, the suppliers will game the system to try
to get the same prices. It's better to pay by first price rules and give
them incentive to describe their price structure honestly. Harvey and
Hogan [5] describe how the difference between the rules on the day-ahead
Power Exchange and the emergency supplies arranged by the ISO would lead
suppliers to try to bid the expected clearing price rather than their
costs of production. This means that the market structure doesn't really
affect the averages prices paid over the long run; a badly designed market
mostly means inefficient bidding, and an inability to forecast.

The report explains that the retail price controls mean that consumers
were more price insensitive than the politicians believed. In the short
term, consumers can't change the kinds of appliances they have, and they
don't hear about prices until the end of the month, so the argument says
they can't react to changing prices. The promised price reductions for
consumers who reduce their use by 20% or more, combined with the high
prices charged recently have resulted in more consumers reaching the
target than anyone expected. Consumers react to prices after all! :-)

In the face of the demand insensitivity, there were a couple of unexpected
hits on the supply of power that moved the market from a relatively
price-sensitive part of the supply curve to a relatively insensitive
The weather was beneficial (wet in the winter and relatively cool in the
summer) from the mid-90s through 97, removing any incentive to build
In 98 and 99, the weather returned to normal, reducing reservoir
2000 was quite dry and the summer was the 6th hottest in 106 years. This
meant that much less of California's power was coming from hydro. In
addition, prices of natural gas rose nationally, and there were problems
with some of the natural gas pipelines coming into the state, reducing
access to supplies of natural gas, just when it was needed to replace the
missing hydro.

All the efficient generators running in uncontrolled smog markets were
running flat out. The marginal generators were either old and inefficient
(prone to more breakdowns than the average) or situated in LA. In LA,
restrictions on Nitrogen Oxide (NOx) emissions led to a steep price curve
as additional plants came on line there. Each plant had to buy emissions
permits in order to burn gas, reducing the supply of permits, and raising
the price of the remaining permits. The price of NOx permits rose from $2
per pound in 1999 to $40 in 2000.

If consumers had been price-sensitive, the huge rises in marginal costs
would have led to marginal reductions in demand. Instead, the utilities
and the ISO reacted as if filling the demand was worth any price, which
of course kept demand steady, and drove prices ever higher.

The weather and pipeline problems were outside the control of the
architects of the restructuring and any of the actors in the power markets
last year and this year. The Cato paper argues that the structure of
market and the lack of long term contracts didn't actually contribute.
Environmentalists and NIMBY effects weren't the constraining factor in
the low number of new plants; even in their absence, the low
opportunities for profit through the late 90s would have kept new
producers from moving in.

The one factor (rising prices) that would normally have allowed demand to
react to supply prices was missing, and that allowed prices to go
sky-high. The most important factor in fixing the problem is to remove
the price caps. Moving some customers to real-time prices would help

[1] Cato Policy Analysis #406 "California's Electricity Crisis: What's
Going On, Who's to Blame, and What to Do". Jerry Taylor and Peter Van

[2] Hal Finney

[3] Hal Finney

[4] "California Scheming: Don't Blame Deregulation for the Golden State's
Electricity Snafus", By Michael W. Lynch.


This archive was generated by hypermail 2b30 : Fri Oct 12 2001 - 14:39:58 MDT