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CALIFORNIA: ENERGY CRISIS OR MARKET DESIGN CRISIS? Vernon Smith, Stephen Rassenti and Bart Wilson CALIFORNIA: ENERGY CRISIS OR MARKET DESIGN CRISIS?

Vernon Smith, Stephen Rassenti and Bart Wilson
International Foundation for Research in Experimental Economics and Mercatus Center
George Mason University

Electrical energy as a commodity has the uncommon feature that the typical
consumer does not know how much he has purchased and what it will cost him until the
end of the month when he gets his bill. If he should go to the trouble of looking at his
meter at 3 p.m. on a hot summer day with his air conditioning on high, and his clothes
dryer cranking away, he will note that the little monitoring wheels are spinning much
faster than when he inspects it at 3 a.m. in the morning. This comparison would give him
the barest of clues as to his time-of-day consumption rate. If the consumer lives in an
apartment complex, her choice to move there may have been influenced by the managers
advertisement stating free utilities, which means that there is but one meter for all the
apartments in the entire complex. In both examples the time and seasonal variation in the
cost of energy is averaged across all the hours of the month, and in the second the private
cost is also artificially socialized across all consumers who dip into a common pool of
available energy.
This is an incentive nightmare -- a disaster in waiting, caused by the failure to
appropriately deregulate retail entry and prices along with wholesale entry and prices.
The crisis in California is not one of energy; it is a crisis in bad market design.
Here is the crux of the so-called California energy crisis, signaled loud and clear
by the earlier wholesale price spikes in the Midwest, South and East in the summer of
1998, continuing into 1999, 2000 and likely to persist in 2001: no significant portion of
the time rate of demand for electricity is responsive to the extreme time rate of variation
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in its supply cost. A porch light left burning in the daytime and people riding in elevators
are afforded the same priority for energy. If retail utilities get some relief from the cost
squeeze in 2001 it will be a consequence of previous high wholesale prices having
attracted new peaking capacity; it will not be due to the political outcry, the price
ceilings, or the threat of punishing suppliers by making them give back some of their
unjust riches.
How can this be happening in the long-arrived electronic age of cheap
sophisticated switching, sensing and control devices capable of selective programmed
interruption of power flows to particular circuits and appliances, conditional upon almost
anything: time of day, price, temperature? Responsive demand can be implemented
voluntarily by contract between the customer and some energy provider/wholesaler, or
directly by the consumer who buys a programmable load management device. In this
paper, we are going to try to explain some of the technical problems in electricity, and
why its delivery to the end user is trapped in yesterdays technology and cultural mind-
set, surrounded by unrealized opportunity for gains in investment efficiency, energy
efficiency, and for a reduced environmental emissions load.

The Dynamics of Consumption and Supply Cost

The electrical power industry has some key features that help to illuminate its
current market design problems:
1. All local regions exhibit a natural daily cycle in consumption starting at its
lowest level in the early morning hours and rising to a peak sometime in the mid
to late afternoon, with peak levels of consumption two to three times the off-peak
level.

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2. Supply side investment has adapted to this cycle by providing three basic
generator types:
Large capital-intensive, efficient, but inflexible base-load
generators that operate with very low energy costs. These are
nuclear and fossil fuel units that are not designed to be ramped up
and down with changes in the consumption load. They satisfy
almost all of the off-peak daily consumption. Most people do not
know that off-peak power sometimes fetches spot prices at or near
zero. This was common in the California market, and is typical of
spot markets all over the world.
Higher energy cost, flexible load following generators kick in to
supplement the base-load units as the daily load increases from its
early morning low. These generators are designed to ramp up and
down with the jiggles and weaves in consumption, and this
essential ramping flexibility is why they cost more to supply a unit
of power. Flexibility costs money.
Before, during and following a consumption peak, still higher cost
peaking generators are brought into service, if and as needed.
These tend to be smaller quick-start generators that serve most of
the time by waiting. They provide emergency reserves and peaking
power. The energy cost of these generators is high when
committed, but their readiness (capital and maintenance) cost is
less than would be incurred with increased, but more often idle,
load follower capacity. When peak load is small or modest, no
peaking capacity may be needed.

3. Consequently, as the consumption load cycles each day from low to high, there
is a corresponding, but larger amplitude cycle in the marginal cost of generation.
Energy cost alone can vary by a factor of 6 or more from low to high demand.
The purpose of deregulating wholesale markets is to allow wholesale prices to
reflect these natural variations in marginal cost thereby enabling such prices to
efficiently guide economic decisions. But without also deregulating entry and
prices at the retail level, only producer, not consumer, decisions will be able to
adapt to the pricing structure that emerges.

4. Note carefully that if it were not for the diurnal consumption cycle, and if total
consumption were flat throughout the day, electricity would be much less costly.
High generation costs are induced by the dynamic pattern of daily load variation.
Similarly the cost of transmission and distribution is higher because of this
pattern. The capacity of all electrical facilities and their investment cost depends
on peak, not average, consumption.

But the legacy of regulation is to average everything. Only competition, induced
by free choice among alternatives freely offered, can set the stage for a discovery process
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that can undermine the natural tendency toward average cost thinking. Competition
drives every hotel/motel manager to slash prices below average cost off-season and on
weekends, and to increase prices above average cost in-season, during the week, on
holidays, and during annual special events; they do this even if they are average cost
thinkers. No one has to tell them, or teach them, and no regulator has to order them, to do
this because they get immediate negative feedback if they depart from this pattern.
Competition--the search for profit niches--is the reason why you can fly more cheaply on
a 14-day advance nonrefundable airline ticket with a Saturday night stay-over, why you
can sometimes fly more cheaply with a 605am departure than an 8am departure, and why
the ticket may cost you 4 to 10 times more if you want to fly on the same day you
purchase it. This competitive price structure fills the airplane seats on most of the flights.
Before deregulation and the discovery of this price structure the flights were moving lots
more empty seats on weekends. Competition discovers opportunity cost price structures
by trial-and-error experimentation and imitation. Reason alone (without test bedding in
the market) is unlikely to find simple and ingenious conditions, like the Saturday night
stay-over rule for the economy rate, because thinking is not driven by opportunity cost
considerations.
Most people will tell you that it is not fair to pay more for power at 3 p.m. than
at 3 a.m.; to pay more for a flight ticket if you do not stay over Saturday, more if you are
leaving at 8am than at 6am, or because you are going home to see grandma on
Thanksgiving; or to pay more for a hotel room in the peak demand season. But it is the
other way around. It is unfair for peak users not to be charged the full dynamic cost of
their decision to consume on peak. Any other policy will force off-peak users to
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subsidize the peak users. If everybody pays the same price averaged over the cycle, then
the off- peak users pay more than the cost occasioned by their consumption, the
difference being an implicit tax. Similarly, the peak users pay less than the cost of their
consumption, the difference being a hidden subsidy financed by the tax on off-peak
consumption.
Conduct the following mental experiment in the airline and hotel cases: imagine
that a flat average cost price is charged independent of day of week, holidays and season;
then there would be a shortage of airplane seats and accommodation rooms at all peak
demand times, more airplanes and more hotels would have to be built and this extra
capacity would be idle at all other times. All customers able and willing to consume more
off-peak, if they could save money, would be forced to help pay for the idle capacity.
Under retail electricity regulation, monopoly protection from competitive entry
allowed flat time prices to be imposed by average cost thinking, operating under an
adversarial political process that is not well suited to experimentation. This led to
investment in enough capacity to meet peak demand at prices that artificially subsidize
that peak deman