The way electricity is purchased is changing to give people the power of choice. Opening the electric market to consumer choice means companies will compete to supply electricity to the end users. This could lower electric bills and lead to new, more efficient technologies and additional benefits.

Competition in other industries has often resulted in lower prices and additional products and services. Electric competition should benefit the environment because as new facilities are being built, they are cleaner and more efficient than older plants now in use. Electric suppliers must also offer some of their energy from renewable sources, which mean that the energy is produced from sources that are environmentally friendly.

Yet, the deregulation of the energy market in some states, most notably California, has resulted in countless adverse consequences and the debate over plausible solutions is far from over. One such resolution involves the use of price controls within these troubled states. In the short run, energy price caps will be able to both lower costs as well as increase the quantity supplied to the marketplace.

Efforts to implement a competitive wholesale energy market have been underway since 1996 when the Federal Energy Regulatory Commission (FERC) first issued Order No. 888. This order directed "open access transmission" and since its issuance, the energy industry has undergone a number of sweeping restructuring movements⁶. Yet, there are still large areas of the country that do not have regional wholesale electricity markets and some states are even reluctant to advance the development of such markets.

The electric industry is undergoing a period of reform not seen for over half a century. Twenty-five states have decided to allow customers to choose their electricity provider, while every other state in the country is now considering major changes to the way in which it regulates its electric industry. These changes involve an industry that has been highly regulated throughout its history and one that is the nation's most capital intensive. The economic activity of this industry accounts for between 3 to 4 percent of gross domestic product⁶.

When Congress lifted long-standing controls on the utility industry, which granted states the power to create competitive markets for electricity generation, the purpose was to improve the energy markets and its policies. The idea was designed to give consumers a choice of power suppliers, all of whom would be competing to deliver reliable service at low prices. No longer would businesses and consumers have to rely on the old regional utility to do them justice under the watchful eye of the government.

Thus far, half the states in the US, including the District of Columbia, have embraced deregulation. Nevertheless, the results have been decidedly mixed and restructuring has created a patchwork of approaches that have power flowing to some regions in abundance and leaving others in scarcity. For example, during the summer of 1999 there were extensive brownouts and blackouts across Southern California, spot outages in New England, and a few power shortages in New York⁶. In these areas, customers complained of higher electric bills. Yet, across the Midwest and in New Jersey, Pennsylvania, and Maryland, there were adequate supplies of electricity. In some instances customers actually saw their bills go down. This dichotomy is a prime example of the varying successes of power deregulation.

While some areas have seen drops in energy costs, more have seen unsettling spikes. A national energy policy might prove to be the most unified resolution in the long run, but that would have to pass through some intense and lengthy political fire before it could be put into effect. Another setback is that federal officials can measure adequate supply only regionally, not on a national basis. Therefore, deregulation leaves the FERC with only one course of action in the meantime, to smooth the transition from a heavily regulated utility environment to one that relies more on market dynamics of supply and demand.

That's the whole idea behind deregulating the industry, but getting over the hurdles will take big investments in new power-generation plants, not just by the ancient utilities but also by new competitors eager to make a profit in the market. Large industrial customers will have to seek out independent power supplies and escalating wholesale power markets will have to realize new efficiencies of scale. In addition, the development of alternative energy sources that rely on renewable resources instead of fossil fuels will once again have to become a national priority. While it is evident that the transition toward a healthy, unregulated energy market will be long and painful, there are some remedies that can be implemented today with more immediate results. This is where the discussion of energy price controls begins.

A deeper analysis of the energy markets will provide a solid foundation upon which to launch an examination of the pros and cons to price controls. To begin with, the origins of the current system of energy production and delivery date back to the New Deal era, when Congress brought an end to the tight reign of large interstate holding companies that controlled more than 75 percent of the country’s electric generating capacity⁵. The Public Utility Holding Company Act of 1935 (PUHCA) forced the holding companies to break up, and gave utilities a government-sanctioned monopoly over a limited territory. In exchange, utilities agreed to provide reliable electric service to all customers at a regulated rate. The law resulted in the formation of nearly 300 power systems and 800 rural cooperatives⁵.

OPEC’s worldwide oil embargo in 1973 had a dramatic impact on the electric industry. Although the embargo was most famous for creating interminable lines at the gas pump, it also produced sharp increases in electric utilities’ costs. The result was a surge of interest in alternative forms of energy. In 1978, Congress passed the Public Utility Regulatory Policies Act (PURPA) requiring utilities to use "renewable" energy, which is produced from wind, solar, and other sources⁵. Both PUHCA and PURPA would later be viewed as impediments to workable national electricity deregulation.

In the 1990s, a growing chorus of voices within the electricity industry, Congress, and the federal government chimed up to bring competition to the industry. Congress opened the system to competition in 1992 with the National Energy Policy Act, which allowed power producers to compete for the sale of electricity to utilities⁵. In 1996, the FERC issued what would become one of its most famous orders. The aforementioned Order No. 888, required utilities to open their transmission lines to competitors. Soon thereafter, New Hampshire launched a pilot program allowing competition, as did Arizona, California, Massachusetts, Pennsylvania, and Rhode Island. These actions at the state level fueled the fire for a national deregulation plan.

Today, the U.S. electric industry is undergoing a sea change in the way it delivers electricity to millions of households and businesses nationwide. The $220 billion industry, which has been called the last great government-sanctioned monopoly, is slowly but surely being deregulated and opened to competition¹³. It is giving consumers the power to choose their electricity provider in much the same way they choose telephone carriers today.

Whether or not electricity deregulation delivers the benefits touted by its supporters, including lower prices and more services, is an open question. In triumph, Pennsylvania’s deregulation experiment, which was enacted in 1998, has been a rousing success by most accounts. Nearly 500,000 consumers, more than 11 percent of ratepayers, had chosen to leave their utility company as of Oct. 1999⁷. In the Philadelphia area, residential customers who chose the least-expensive electricity supplier were saving about $10 per month⁷.

The story is much different in California, which in 1996 became one of the first states to enact an electricity-restructuring plan. Not long after the plan went into effect, price increases began to whittle away public support for deregulation in the Golden State. Just two years after deregulation was enacted, California consumer groups succeeded in putting on the ballot an initiative that would have thrown out the state’s deregulation plan, even though the measure failed¹⁰. Criticism of deregulation intensified in the summer of 2000, when limited power supplies and increasing demand caused the wholesale price of power to soar throughout the state. In San Diego, where the retail price of power fluctuates directly with the wholesale market, electric bills doubled². The problem grew markedly worse in the winter of 2000/01, as the state's electric utilities faced a financial crisis and consumers were met with electricity shortages and skyrocketing prices².

California has given electricity deregulation a bad name and the proof can be seen through its rolling blackouts and near bankrupt utilities. If implemented correctly, the deregulation of electricity can lower costs, improve reliability, encourage technological innovation, and even promote conservation among the masses³. Yet, getting to that stage requires political savvy and more constructive solutions in effect now that will ease the transition later down the road. For instance, a plausible deterrent would be making people pay extra for operating their air-conditioners when the electrical grid is verging on meltdown. It also requires the humility to learn from the rest of the world such as Britain, New Zealand, and Australia, who are ahead of the U.S. in electricity deregulation.

While the details of deregulation are complex, the principles underlying them are relatively simple and universal. The issue that evolves from deregulation is that not all states have embraced the concept and those that have, are not setting a positive example and helping to convince other territories that it can work. The surest way to enlist confidence and exploit the overall benefits of deregulation is to take California, the state that is struggling the most with the opening of its energy markets and through the use of price caps, transform it into a model example for others to follow.

California’s energy market has been in chaos over the last few years and while the causes and consequences have been relatively well understood, there is much debate over the solution. In the long run, more power plants would help the situation and many are currently in production, but this will not prevent the blackouts and sky-high prices today. The Governor of California, Grey Davis, has been adherently pushing a policy of limiting the prices of wholesale electricity and the FERC has partially adopted the idea¹¹. This form of price control will lower the cost of electricity in addition to increasing the quantity supplied to the energy market in the short term.

A price cap or ceiling is advantageous for those consumers who are able to purchase electricity at the reduced cost, yet it does create a shortage in that not everyone is able to consume as many watts as they would like⁸. In looking at the market as a whole, it can be declared that the electrical market in California is not operating efficiently. A much-supported notion that the market may fail to achieve an efficient outcome is that suppliers have some degree of market power and have the ability to influence the market price of electricity. Members of California’s electricity market monitoring committee signed a letter sent to President Bush and even testified at a Senate panel to express this view. They contend that conditions are perfect to allow power generators to drive up electrical price levels by withholding supply¹⁰. To further compound the issue, there have been allegations that power companies have intentionally reduced the production of electricity through the closure of plants, to push prices upward⁹. The committee also declared that Californians are stuck in a classic monopoly, which has been created by a flawed deregulation scheme, hydroelectric power shortages from continued droughts, high natural gas prices, a capacity shortage, and an over reliance on the spot markets¹⁰.

If producers do have the ability to raise prices, then the price controls would actually increase the amount of electricity supplied to the market. Without price controls, the electricity producers will face a tradeoff⁸. If they increase production they can sell more power, but the price will be forced down. Given this tradeoff, producers have an incentive to reduce the supply in order to get a higher price for their output and perhaps reap in greater profits. However, if there is a price cap put into effect, then the suppliers no longer have the ability to push prices up. This will result in the manufacturer no longer having the incentive to reduce the quantity that they produce⁸.

This situation can be graphically depicted through a basic supply and demand chart (below) showing a market in which suppliers have some market power, such as when a firm has a monopoly. The result is a decline in the quantity of electricity produced, from Q* to Qmon (monopolistic quantity), as the firm drives up the price, to Pmon (monopolistic price), in an effort to maximize profits⁸.

The chart below shows the result when there is a price cap and the firm can no longer push up prices, therefore having no incentive to reduce production. The result is a need to have greater production at point Qsc (supply cap quantity). As long as the price cap is sufficiently high, above the marginal cost (MC) of the producer at the unregulated level of output, then there will be an increase in production⁸.

In reality, the market structure for electricity is much more complex, but this rationale is based on the notion that there is a significant degree of market power held by producers and that price controls will increase the amount of power produced. In addition, market power by suppliers creates inefficiency in much the same way as the price controls in a competitive market. By suppliers restricting quantity, there is not enough electricity produced and in this case, price controls can create a more efficient outcome⁸. In this scenario, price controls seem to be a plausible solution, yet it’s important to consider some reasons why these price caps may cause concern.

In order to understand what is causing decision-makers to be apprehensive about price controls, it is important to examine a flaw in the concept, which begins with the fundamentals of a competitive market. Such markets tend to "work", that is, they tend to produce the "right" quantity of a good or service⁸. The amount of production will be such that the value to the consumer is greater than the cost of production for each unit.

Government intervention via a price control could distort the market outcome and could interrupt the workings of the market. In the case of a (binding) price cap, sometimes called a price ceiling, the policy may cause the quantity of the good supplied to decline⁸. This is because sellers will have less of an incentive to supply the good to the market¹³. At the same time decline in the quantity supplied, the price cap will cause the quantity demanded to increase. The result will be a shortage, that is, quantity demanded will exceed the quantity supplied.

In this case, the reduction in the amount supplied will be inefficient for the following reason: with the price cap, there are people willing to pay a higher price, and suppliers who are willing to produce at the higher price⁸. This means that there are transactions that would benefit both buyer and seller that are not being undertaken. The loss in value from these forgone tractions is called a deadweight loss (DWL) ⁸.

The graph below shows the basic points from above. A perfectly competitive market will, in equilibrium, achieve a price and quantity, P* and Q*. A price cap, Pcap, will lead to a reduction in the quantity supplied to Q2⁸. The result is a shortage, and a decline in efficiency in the amount given by the shaded area.

This is the basic argument against the imposition of price controls. The problem with this argument with respect to the situation out west is that the California electricity market seems to be far from a well functioning competitive market. Ultimately, these short-term solutions must be part of the long-term resolution.

Clearly there are fundamental imperfections in the current system of deregulation. While competitive markets are beneficial to the consumer, in this case they have resulted in massive shortages in electricity and increased prices. The problem is most evident in the faulty system at work in California. Yet, though the use of price caps, the cost of electricity would be dramatically lower and the quantity increased. Furthermore, the fact that most energy markets are not competitive arenas because of collusion and other illegal behavior, makes the need for price controls that much greater. Another argument favoring the use of temporary price caps illustrates that if they are set at levels allowing reasonable profits, then certainly this type of mitigation will be a necessary part of the broader reform of imperfect markets.

"To dismiss price controls because they were used badly in the 1970’s is as silly as dismissing deregulation because California did it badly." – Severin Borenstein, director of the Energy Institute at the University of California at Berkeley.

1. A turning point, maybe. (2001, June 23). The Economist.
2. Cap and Crunch. (2001, June 22). The Wall Street Journal, p. A14.
3. Cohn, L. (2001, July 2). Energy Price Caps: Will They Work? BusinessWeek.
   
4. Coy, P. (2001, March 26). Commentary: How to Do Deregulation Right. BusinessWeek.
   
5. http://www.eia.doe.gov/cneaf/electricity/page/restructure.html
   
6. http://www.cnn.com/SPECIALS/2001/power.crisis/
   
7. http://www.pbs.org/newshour/bb/infrastructure/power/ca%5Fpower.html
   
8. Irons, J. S. (2001). Price Controls and California Electricity: The good, the bad, and the ugly. About.com [On-line].
   
9. Lazarus, D. (2001, July 4). Federal price limits backfire/Some generators withhold power rather than abide by rate caps. San Francisco Chronicle, p. A1.
   
10. Lochhead, C. (2001, June 18). Tougher price caps prompt controversy/Consumer boon or bane? Experts split. San Francisco Chronicle, p. A1.
    
11. McKenzie, R. (2001, June25). A Cap On Supply: Davis, FERC Are Ensuring The Crisis Only Gets Worse. Investor’s Business Daily, p. A20.
    
12. Sooner or later, federal price controls will backfire. (2001, June 21). USA Today, p. A14.
    
13. U.S. Department of Energy. (2001). The Impact of Wholesale Electricity Price Controls on California Summer Reliability (Publication No. DOE/PO-0065). Washington, DC: Office of Economic, Electricity and Natural Gas Analysis.