THE UNREAL THING

SYNOPSIS: The concept of utility deregulation is fundamentally flawed.

Treason doth never prosper: what's the reason?" asked Sir John Harrington. "Why, if it prosper, none dare call it treason." Fortunately, the stakes are lower these days. A modern version might read: "Deregulation never fails: what's the deal? That when it fails, they say it wasn't real."

On the face of it, California's electricity debacle is an object lesson in the risks of deregulation. The magic of the free market was supposed to provide abundant, cheap, clean power; instead the state faces not only shortages and skyrocketing prices but also insistent demands that it relax air- quality rules. The only bright spots literally are a few cities, including Los Angeles, that own their own power systems.

Nonetheless, a growing chorus denies that deregulation was at fault. According to what seems to be becoming the conventional wisdom, meddling bureaucrats prevented the state from having "real" deregulation, creating instead a neither-fish-nor-fowl system that combined the worst features of both worlds. It's a comforting view: it lets true believers in the infallibility of free markets cling to their faith, and it also lets deregulators in other states continue to claim that it can't happen here.

Alas, a close look at the claims that California's deregulation wasn't "real" suggests that while the deregulation was indeed flawed, the flaws didn't cause the catastrophe.

To understand the limits to California's deregulation, recall that it separated the power industry into two pieces. Generators, mainly owned by out-of-state companies, produce power and sell it wholesale to utilities, which then sell retail power to consumers.

One way in which California didn't fully deregulate was that while prices in the wholesale market were decontrolled, the prices charged by utilities continued to be fixed by the state. This meant that even when power shortages sent wholesale prices sky high, homes and businesses had no financial incentive to conserve electricity. The history of retail price control is a little odd; it was actually a temporary measure intended as a sweetener for the utilities, a way to let them earn some extra profits in the face of what were expected to be falling wholesale prices. As it turned out, however, the rigidity of retail prices made it harder for the state to cope with its crisis.

But would it really have made a big difference if those prices had not been fixed? All the evidence suggests that to reduce demand enough to eliminate today's shortages retail electricity prices would have to rise enormously and that such a rise would be politically unacceptable. In fact, in San Diego the original retail price freeze ended before the crisis struck. But when prices suddenly tripled last summer, a firestorm of public outrage forced the imposition of new controls.

Another way in which deregulation was incomplete was that regulators prevented the utilities from entering into long-term contracts to buy power, forcing them instead to buy wholesale electricity in a short-term "spot" market. Soaring spot prices have bankrupted the utilities, and are forcing the state government to spend billions to keep the power flowing. If the utilities had locked in large supplies at lower prices, they would not yet be bankrupt but they would still be hemorrhaging money.

While long-term contracts might have postponed the financial day of reckoning, would they have made more power available? Some say yes: if much of their output were under long-term contract, the generators would have less market power that is, less incentive to restrict output in order to drive up spot prices. The generators, of course, vehemently deny that they are doing any such thing, despite circumstantial evidence that they are. If we accept their denials, long-term contracts would have done nothing to prevent the current power shortages.

And whose idea was it to prevent long-term contracts anyway? In 1999, some of the major utilities petitioned for the right to sign such contracts. Consumer groups, which initially had qualms, eventually supported the bid. But the regulators turned the request down, largely because any change in the rules to allow such contracts was fiercely opposed by, you guessed it, the generators. There's a myth in the making, one that portrays California as a victim, not of deregulation gone bad, but of quasi-socialist politicians who didn't give deregulation a chance to work. Well, that's not the way it happened. The defenders of deregulation should stop making excuses and look seriously at what went wrong.

Originally published in The New York Times, 2.18.01