NCPA - National Center for Policy Analysis

Vernon Smith: Deregulate Electric Power Markets

October 16, 2002

The credit crunch in the U.S. electric power industry and California's blackouts are both due to regulations limiting competition and distorting market incentives, says Vernon Smith, a recipient of the 2002 Nobel Memorial Prize in Economics.

This is the crux of the California energy crisis, and a pattern repeated in the Midwest, South and East in the summers of 1998 to 2001. The alternative is to rationalize costs in a way that naturally affects customers' behavior.

Rolling blackouts in California resulted because the wholesale price paid by distributors in California (and earlier in other states) substantially exceeded the fixed regulated price at which the power was resold to customers.

  • During the week of June 26, 2002, the wholesale spot price in California leaped as high as $1.10 per kilowatt hour (kwh), but the power purchased was resold to customers at around $0.11-0.12 per kwh.
  • The cost of power varies by demand throughout the day and seasons, but the cost to retail consumers is regulated and averaged on their bills. Thus they do not have the information or incentives necessary to rationally use electricity.
  • California utilities lost some $14 billion trying to avoid blackouts -- yet a minuscule fraction of this sum would have disciplined prices and avoided the blackouts.

The answer is a deregulated retail market with restrictions on the entry of competing retail energy suppliers removed; a robust and well-structured two-sided spot market for wholesale power; and the freedom for customers to engage in whatever financial arrangements derived from that spot market that best suit their circumstances.

Smith concludes that "What we do not need is a new one-size-fits-all decree from the top -- the kind of policy that created the problem in the first place."

Source: Vernon Smith (George Mason University), "Power to the People," Wall Street Journal, October 16, 2002.

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