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The California electricity crisis threatens notonly the economic well-being of ratepayers inCalifornia but the economic well-being of theUnited States as well. Unfortunately, the politicaland economic commentary surrounding the cri-sis is shedding more heat than light.California has been victimized by severalsimultaneous and severe supply and demandshocks—most notably, a run-up in wholesale nat-ural gas prices—that are outside the state’s polit-ical control. Those shocks were made moresevere by air pollution regulations and retailprice controls. Although California’s “deregula-tion” of the electric utility business is beingblamed for the crisis by both the political left andthe political right, we find that the 1996 restruc-turing law has little to do with the run-up inwholesale power prices. That law is primarilyresponsible for the blackouts, however, in that itprohibits utilities from passing on increases infuel costs to consumers.Virtually all the increase in wholesale pricescan be explained by increases in production costsand overall scarcity. While there is some evidenceof the existence of excessive generator “marketpower” (created not by the unfettered exercise offree markets but by poorly conceived regulation),it is relatively minor and responsible for only asmall fraction of the price spike, if it exists at all.We find little evidence to support the argu-ment that environmentalists are primarily toblame for the crisis. We likewise are unconvincedthat, had the state allowed utilities to enter intolong-term contracts with generators, the crisiscould have been either averted or made less severe.None of the remedies thus far proposed—such as a state takeover of the industry, the so-farminimal increase in power rates, energy conser-vation subsidies, prohibitions of “wasteful” ener-gy use, more vigorous wholesale price controls,or the adoption of long-term power contractswith generators—will get the state through thenext two years without frequent and widespreadblackouts and significant economic damage. Infact, all of those alleged remedies would makematters worse.The only remedy to the crisis is the elimina-tion of the retail rate cap and the institution ofreal-time pricing mechanisms for the largest seg-ment of demand possible.
California’s Electricity Crisis 
What’s Going On, Who’s to Blame, and What to Do 
by Jerry Taylor and Peter VanDoren
 _____________________________________________________________________________________________________
Jerry Taylor isdirector of natural resource studiesat the Cato Institute. Peter VanDoren iseditor of Cato’s 
Regulation
magazine.
Executive Summary
No. 406July 3, 2001
 
Introduction
Skyrocketing wholesale power prices inCalifornia and the daily threat of brownoutsand blackouts have cast a pall over the meritsof electricity deregulation. Liberals, led byCalifornia’s governor, Gray Davis, blame therestructuring law passed in 1996 for the cri-sis, arguing that it left the state vulnerable tomarket manipulation by greedy power pro-ducers. According to Davis, the crisis is large-ly artificial but nonetheless a harbinger ofthings to come, not only in national electric-ity markets but in industries throughout theeconomy, if we continue our mad rushtoward laissez faire.Conservatives for the most part agree thatthe 1996 reforms are primarily responsiblefor the crisis. They charge, however, that theregulations attached to those “reforms”—pri-marily the prohibition of long-term con-tracts between utilities and power generatorsand the imposition of a centralized daily spotmarket—are largely responsible for the pricespike. The political right argues thatCalifornia’s regulations, crafted by environ-mental activists and anti-growth consumergroups, have long discouraged investment innew generating capacity and that the black-outs are a long-overdue flock of chickenscoming home to roost.While both sides are busily settling politi-cal scores, the real story of what happened inCalifornia is largely absent from most analy-ses. Accordingly, the important lessons thatthis crisis teaches about regulation and elec-tricity are largely being overlooked: retailprice controls are a recipe for disaster, andstate regulators have little idea how to orga-nize markets and certainly shouldn’t attemptto do so under the mantle of “deregulation.”
The Anatomy ofCalifornia’s “Deregulation”
On the last day of the 1996 legislative ses-sion, California’s legislature adopted byunanimous vote A.B. 1890, the first of manystate attempts to “deregulate” the electricitybusiness. The roots of the confusion overwhat California
did 
and
did not 
deregulatebegan with the PR campaign to sell the bill.Unlike deregulation of the airline and truck-ing industries—which largely curtailed regu-latory oversight of those industries—the“deregulation” of the electricity industry inCalifornia was heavily prescriptive and not,on balance, a loosening of regulatory over-sight at all. A.B. 1890 simply replaced the oldset of regulations with a new set of regula-tions, some of which were less interventionistthan the old, some of which were more.The central thrust of A.B. 1890 was to cre-ate a competitive retail market for electricity.Traditional rate-of-return regulation of state-sanctioned monopoly power companies hadnot kept electricity prices at reasonable levels.By the mid-1990s, California electricity priceswere 35 percent higher than the U.S average,and California residential customers paid 35percent more than the average U.S. residen-tial customer.
1
Those excessive costs threat-ened to slow expansion in California andmake the grid itself obsolete as ratepayersfled to nonutility power providers.
2
The remedy was to allow competitionamong and free entry of electric generators.The generators owned by incumbent utilitieswould compete with nonutility power gener-ators for business, and customers couldchoose from whom they wished to purchasepower. Competition would protect con-sumers from the excessive investments andcost overruns that occurred under tradition-al cost-of-service regulation.
The Crusade against Market Power
While virtually all the nonutility interestgroups endorsed this reform in principle,many of them—particularly the large indus-trial users of electricity, the independentpower producers, and the “consumer rights”lobby—feared that incumbent utilities woulduse their control of the electricity grid (theincumbent-owned network of wood, steel,and wire that connects power plants to con-
2
While both sidesare busily settlingpolitical scores,the real story ofwhat happened inCalifornia islargely absentfrom mostanalyses.
 
sumers) to disadvantage independent gener-ators. Incumbent utilities would excludeindependent generators from the grid, priceaccess exorbitantly, or load the grid with theirown power and thus use congestion torestrict entry. Or utilities could charge retailcustomers below-cost rates while recoupingthose losses through excessively high trans-mission and distribution rates for competi-tors. Because most analysts assume that thegrid is a natural monopoly (building alterna-tive grids is widely thought to be prohibitive-ly costly and impossible politically because offierce community resistance), it was fearedthat allowing nonutility firms to enter thegeneration market would not result in a com-petitive market for wholesale power.Reformers thus concluded that electricity“deregulation” would require a whole new setof regulations and government interventionsto ensure that a competitive market wouldarise. The important provisions of A.B. 1890follow.
3
•
Mandatory Open Access: 
Utility compa-nies must allow any generator access tothe electricity transmission systemunder terms, conditions, and pricesestablished by the state.
•
Vertical Disintegration: 
Incumbent utili-ties are to become transmission anddistribution companies, divestingthemselves of generators. And thedivested generators can sell power onlyto a state-managed power exchange.
•
Centralized Power Exchange: 
Any electric-ity the incumbent utilities need fortheir default customers (those who donot switch to competitive suppliersunder the retail choice program) has tobe purchased from a centralized, state-managed power exchange. Indepen-dent marketers can buy through theexchange voluntarily. The exchangecreates an electricity supply curve fromgenerators’ hourly willingness-to-pro-duce offers. The hourly price is set bythe highest-cost producer whose out-put is necessary to meet estimateddemand from the utilities.
•
Utility Retail Price Caps: 
For those cus-tomers who remain with the threeincumbent utilities (Pacific Gas andElectric, Southern California Edison,and San Diego Gas and Electric), retailrates are frozen at levels 10 percentbelow June 1996 rates until the incum-bent utilities recover their “strandedcosts” or March 2002, whichever occursfirst.
•
Independent System Operator (ISO): 
Theday-to-day operation of the grid (thatis, the management of electricity trafficalong the wires) is directed, not by theutilities that actually own the grid, butby a nonprofit organization governedby a 26-member advisory board of rep-resentatives of grid users. The ISO isfurther empowered to procure electrici-ty on an emergency basis if on any givenday the amount of power procured inthe centralized power exchange isinsufficient to meet demand.
“Stranded Costs” and Retail PriceControls
Although utilities were never particularlyexcited about the proposed change from tra-ditional rate-of-return monopoly regulationto managed competition, they were particu-larly worried that, were they forced to com-pete with independent power generators inthis new wholesale marketplace, some oftheir generating assets (nuclear power plantsand long-term contracts with nonutilitypower producers) would not produce suffi-cient revenues to recover their total costs.This would reduce the market value of thoseassets to much less than their “book” valueon the utilities’ balance sheets. Electricityanalysts coined the phrase “stranded costs”to describe the difference between book andmarket values of certain generating assets. InCalifornia, stranded costs were estimated tobe between $21 billion and $25 billion.
4
Estimates for the United States ranged from$70 billion to $200 billion; the higher figure
3
Reformers con-cluded that elec-tricity “deregula-tion” wouldrequire a wholenew set ofregulations andgovernmentinterventions.
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