Director of the University of California Energy Institute and a professor of business at the Haas School of Business, Borenstein also is on the board of governors of the California Power Exchange. Borenstein, who is not opposed to deregulating the energy markets, says that politics overshadowed sound policy when California's plan was drafted.

No, not at all. I worked at the Civil Aeronautics Board during airline deregulation and I've seen that up close. It was done carefully and thoughtfully, with the regulators and deregulators thinking through carefully what incentive of each player in the market would be, and how each player, trying to make as much money as they can, would respond to various rules.

Then what's wrong in this system?

What happened in electricity deregulation is that people who designed the deregulation didn't think through the incentives carefully. So when outsiders like us pointed out, "You know, a firm in that position could jack the price way up," the response often was, "Well, that's never happened before." Well, of course it's never happened before--we haven't deregulated the market yet. So I think what happened is that a group of people who had operated in a quiet, regulated environment for years and years got blindsided by market forces.

And the impact of this is going to spread nationally from California. It already has.

It depends very much on whether the other states are going to learn the lesson from California. There are some signs that they're learning the right lesson, but there're also plenty of signs they're learning the wrong lessons from California. ...

... Do you see similar prices for electricity spreading nationally this summer?

Not this summer. This summer, most of the country is still going to be in reasonably good supply shape. But it depends very much on how hot the summer is, and what the conditions are at the various power plants.

For instance, the Northwest right now has suffered a severe drought during this winter, and there isn't going to be much hydroelectric production. That could very much hurt the entire western grid. The New York area has some bottlenecks where they can't get enough power into particular areas such as New York City, which very well could drive up the wholesale prices in those markets. Whether that shows up in the retail prices depends entirely on the state regulators and whether they let it go through. In California, we haven't let it go through, and that's been a real mistake.

So the villain in California, from your point of view, is the California Public Utilities Commission?

CPUC, no question about it. They blew it by not allowing price increases earlier. That could have prevented some of the financial crises that the utilities are now in, which has led to a whole other set of problems, and it would have encouraged some conservation.

They say the prices were mandated by the legislature--that they were fixed for five years, so they didn't really have a choice.

That's not accurate, because there's a lot of room for interpretation about when exactly they would allow the prices to go up. Although, in their defense, in San Diego everyone agreed that the prices were legally allowed to be passed through, and they were passed through during the summer of 2000. The legislature responded by turning around and immediately capping them again. The legislature obviously also didn't have a stomach for letting these prices go through. Raising retail rates is not the whole answer, but not raising retail rates has been clearly part of the problem.

The fundamental question that's been raised by [California Governor Gray Davis' energy advisor], Mr. [David] Freeman, and by other people is that everyone needs electricity, and it's obviously perishable. It's not the same as any other commodity; and if you just let it out there in the marketplace, unregulated, it's going to be a disaster, especially for people who know how to manipulate the market. ...

That's one of the wrong conclusions that is drawn from California: that deregulation can't work; that electricity is so different that markets would never work in electricity. It is definitely the case that electricity is a much harder product to deregulate than most. But California's approach to deregulation didn't work. It was not carefully thought through. It was sort of sloppy policy-by-analogy to other things that had been done, and it didn't work. That doesn't mean that electricity deregulation can't work.

Mr. Freeman is a lifelong manager of public power organizations, so his interest obviously is in the public power side. I think that people who are more neutral on whether it should be a public or private organization see that we made a lot of mistakes in California, but you really can organize a market that will work more efficiently.

Is there an efficient marketplace for electricity in the United States?

Pennsylvania is working a lot better than we are now. They haven't fully solved their problems either. They still need to make changes in their market to have it work more efficiently. But they have not seen the extremely high bills for consumers that we're going to eventually have to pay here.

But Pennsylvania is not in a situation of scarcity.

They're not in a situation of as much scarcity as California is. ...

And they have rate caps.

Well, so do we.

Right. But they also have rate caps in the wholesale market.

And so do we, or we did until very recently. But it wasn't the end of the rate caps that caused this problem. Even if we had kept the rate caps, we'd still be in deep trouble right now. The problem occurred when utilities were buying throughout the summer at high, [albeit] capped, prices and selling at much, much lower prices. And the reason the prices in the wholesale market were so high is because the structure of the wholesale market was such that the sellers could exercise market power.

But the California Public Utilities Commission would turn around and say, "We couldn't control wholesale prices. That wasn't our job. We went to the people who do that and they did nothing."

That's right. The California Public Utilities Commission could only have responded on the retail side, though if they had responded on the retail side and allowed rates to go up to reflect these costs, there would have been a decrease in demand. And that decrease in demand would have helped to drive down wholesale prices.

On the wholesale side, what we could have done back in 1998 was to structure the deregulated market, so that the firms who were selling power weren't as large as they are. We have a firm in California that sells 8 percent of the power in the state; it has 8 percent of the capacity in the state. ... There are a bunch that are between 6 percent and 8 percent. At the time, that seemed like a really small share, though some of us were pointing out that, even with 6 percent to 8 percent of the market, on a hot summer day, the system operators absolutely need you running; and if the system operator absolutely needs your plant running, you can ask for any price you want.

So it was clear that, even with that deregulation, we were likely to see market power. Many of us pointed that out. There were things that could have been done at the time that weren't done which would've greatly reduced the problem. One would have been to spin the plants off into smaller companies so that no company, for instance, had more than 1,000 megawatts of capacity. Another would have been the utilities could have retained ownership of those power plants, which is what happened for the most part in Pennsylvania. And another is that they could have spun them off, but signed long-term contracts to buy the power back at reasonable prices. They didn't do any of those things.

... So a deregulated market doesn't necessarily mean a competitive market?

A deregulated market doesn't necessarily mean a market with no antitrust intervention. Antitrust intervention is for the purpose of maintaining a competitive market. Had we required the utilities to spin off those plants into small companies, we would have had a much more competitive market.

The FERC was supposed to be the referee on prices, right?

The FERC is supposed to make sure that prices are just and reasonable in the wholesale electricity market. The FERC has not done its job. They, by and large, were uninterested in reviewing and carefully thinking about whether this market would work. And then when it became clear that it didn't work, even to FERC, who in November said the prices were not just and reasonable, their response was to say, "Yes, but we're not going to do anything about it."

What's that all about?

The [current] chairman of the FERC is a person who believes very deeply in markets, regardless of the facts.

But the past chairman?

The past chairman was also of that type. He seemed to not believe that the FERC really needed to worry about prices in these markets.

Democrat or Republican?

I don't think that that philosophy is strictly only associated with one party. There's no question that the Clinton administration would have liked to see more intervention and pressured FERC, but FERC is an independent regulatory agency. There's a limited amount that the president can do to pressure such an agency into specific actions.

The president of the United States couldn't have influenced FERC by appointment, or by just in bully pulpit, concerning what was going on?

There was a lot of pressure towards the end of the administration to do exactly that, and it wasn't very successful.

So FERC took it upon themselves to stay out of the fray?

They went further than staying out of the fray. They stayed out of the fray and they blocked attempts by the California Independent System Operator to control prices and to take actions that would have helped.

What's the rationale behind that?

I'm not a political scientist, and I'm not sure why these people act the way they do. The chairman of the FERC now is somebody who doesn't really understand economics and doesn't really understand how businesses operate. In many speeches very recently, he's said, "You have to just let the market work," which is of more religion than understanding of economics. In any market in the United States, we don't just "let the market work." Every market is regulated to some extent by antitrust laws, by health and safety laws, etc. The question is, how much intervention should there be? And that, when done right, is a careful policy question, and not one that can be addressed by campaign slogans.

... The FERC has a history of being a legal-oriented regulatory agency, where the legal process matters much more than good policymaking. They do have some economists on staff at the FERC, but they actually don't pay any attention to them. The decisions have been made by the commissioners who, by and large, have very little training and history in the energy business or in economics, and by high-ranking lawyers, who also don't seem to understand how markets work, which isn't very surprising. Up until very recently, most of what they regulated wasn't very market-oriented, so they didn't really understand markets and they, for the most part, didn't need to. In the electricity business, that was particularly true. ...

The problem is we're now moving toward the market-oriented industry, and they still don't understand how markets work. So they make claims, for instance, like, "Price caps will discourage investments." Well, that's absolutely right. If price caps are set too low, they will discourage investments. But as any economist knows, there's a level at which they would discourage investment. And price caps that are higher than that won't discourage investment, and actually can improve the operation of industry.

So the FERC could have intervened and stopped this crisis from happening?

The FERC could have intervened and certainly lessened the crisis. I think that, to completely avoid the problems ... we really needed to have a retail price increase in California as well, and we haven't seen that. And that's not the first jurisdiction. The first jurisdiction is at the wholesale level.

We needed both of them acting rationally?

That's right. The FERC has dropped the ball on the wholesale market, and the California Public Utilities Commission has dropped the ball on the retail market....

What's the lesson here? You've been right, but it doesn't make any difference.

Well, the lesson is that you need policymakers who are really interested in getting policy right, and I think that politics has overridden good policy in a lot of cases. The other lesson is that deregulating a market really requires very careful understanding of how that market works, not simply blind devotion to the market process and deregulation.

Many of these problems were completely foreseeable--not all of them. The price of natural gas going through the roof was not at all foreseeable. That is, if you look back in 1998 at the future's price of natural gas, it looked like $2.00 or $2.50 for a million BTUs, out for years to come. That is, most people thought the price of natural gas would remain quite low. It was a surprise to virtually everyone that the price of natural gas suddenly spiked up last summer.

Why would that happen?

The U.S. economy continued growing very strongly, while the supply of natural gas did not grow, which is what happens when prices are very low. There's not much economic incentive to explore. Now the prices have gone up. There're a whole lot of people out there exploring for new natural gas, which is why the best forecasts of the future of natural gas prices, which are from the futures market where natural gas is traded, is that the price is going to go down. It's not going to go down quickly to anywhere near the old level, but starting from about $2.50, it went up almost $10.00. It's now about $5.00, and probably a year of two from now, the best guess is going to be around $4.00. ...

At the California border, it's four or five or ten times that.

No, at the California border right now, it's probably two or three times higher, and that's still a problem. We still are having a problem with the transportation of natural gas to the West Coast. Some people argue that there's just a shortage of capacity to transport natural gas from Louisiana to California. Other people argue that the owners of the pipeline are systematically manipulating the capacity so that you can't get as much gas out to California in order to keep the prices high in California.

And if I told you there are documents on file at the FERC that show that El Paso Gas uses the words, "manipulate the physical spread," as to how they're going to make money off that pipeline capacity, what would that say to you?

Well, that would certainly raise my suspicions that they have taken actions in order to reduce supply in California and raise the price. I wouldn't be certain of that, but that would be probably my first interpretation. I'd want to see the documents.

... The regulated market in California, before deregulation ... If I take you back again to what you said about 1995 in the regulated marketplace--with the exception of some problems, such as nuclear power plants--you had a stable surplus capacity. Those companies were all making money.

The regulated environment, for the most part, worked. But it worked in a very inefficient way in terms of the amount of capacity we built, and it worked in a way that gave us much higher prices than many people thought, and still think, were really necessary. So the regulated environment, while stable, was probably not as efficient as it could be. The goal was to get a more efficient industry through market forces.

I still believe that is a possible goal, but it has to be done through careful thought, not through blind devotion to simply deregulating the market, throwing the doors open and walking out. And, unfortunately, that's what the federal regulators have viewed as their role in this market. ... You can get a much better [deregulated] system than we've gotten, and I've given you examples of how you could have done it. You can make sure that there aren't firms that are so large that they can exercise market power. You can require firms to, say, buy a lot of capacity to sell the power on long-term contracts. There are many things you can do to have a less regulated marketplace that is potentially more efficient.

In fact, you can continue to regulate all the generation that exists, but then new generations would be unregulated or less regulated. Then you would give incentives for new firms to come into the market, while still making sure that the current generation is priced reasonably.

So you don't believe that you could get enough generation just by simply guaranteeing people a just and reasonable rate of return?

Absolutely, you can get enough generation. That's what we did for 50 years and it worked fine. It's just that we had higher prices than were necessary and we built more plants than were necessary. We were building plants so that we had 130 percent of peak demand, 30 percent more than we would likely need. There are real environmental consequences to doing that. They are building plants that sometimes are running for two days a year. It seems like there are efficient ways to operate. For instance, you could have prices that vary at the peak time to discourage usage when the system's tight. By doing so, you might be able to avoid building some of those piker plants. That's something that could have even been done in a regulation, but it never was.

No. But in hindsight now, it sounds to me what you're saying is, "A modified form of regulation in a sort of free market."

Do you think the airline is a free market?

Not really.

Well, that's a deregulated market. There are still rules. There are lots of rules about how they can operate. We haven't said, "We deregulated the airline, therefore you can do anything you want. Sure, if you want to hire somebody who's never flown a plane before, that's OK." No, we still regulate the airline industry. We regulate the way they use airports; we regulate them on safety grounds; we still have antitrust; we review mergers; we do all of those things.

... What is your reaction to, let's say, the philosophy of a company like Enron and Ken Lay, who tells us that everything would be fine if we could get rid of all of the regulation that's in our way; that the market will take care of everything?

If we got rid of all regulation, the next few years would be such a massive transfer of wealth from consumers to companies like those owned by Ken Lay that the voters would never stand for it. We aren't going to have a complete deregulation anymore than we completely deregulated the airline industry or trucking or securities or the natural gas industry. All of the industries still have regulation. ...

...What is the role of a company like Enron, because of their phenomenal growth in the last five to ten years?

Enron's a great company. They actually were the ones who learned early on to hedge risk for various parties that had risk in energy markets by taking both sides of a trade. That is, they would say, "Oh, you're worried about the price of gas you're going to buy in a while? We'll sell it to you at a fixed price." And then they would go to some seller and say, "You're worried about getting a good price for the gas you're going to sell? We'll buy it from you at a fixed price." Then they would balance those two positions, and they take a little something for hedging that risk. So they actually are providing real service in doing that.

They've also figured out that they can do other things that will potentially change the price of natural gas and, just like in electricity, those sorts of positions can be extremely profitable. That's true, by the way, in lots of commodity markets, and we have regulation in lots of those commodity markets. ...

Do you understand the average person look at something like Enron and what goes on there on their trading floor, and says, "Well, these people are just skimming money out of the process, out of the market, on something we all need." Where's the value?

You can say that about people who trade any commodity. You can say that about people who trade stocks on the New York Stock Exchange. ...

In the electricity market, you say that the regulator is out to lunch. He doesn't believe in it.

And that's part of where the problems come from. The regulator, in this case, does not fully understand how the market works, and as a result, hasn't really been doing their job....

David Freeman says to us, "Look around the country. Where are the lights on and the rates low? Wherever there's public power."

And where has the federal government been subsidizing power for a long time? Wherever there's public power. So you have to ask, "What is the reason for low rates in those areas? What is the reason that there are aluminum smelters in the Northwest? Because there's low, subsidized public power." The federal government built those dams. We could do that everywhere. ...

What we've seen in the West with deregulation is that a lot of the municipal utilities have done well. The reason they've done well is not because they're municipal utilities; it's because they own generation. Any company that owned generation made out. LADWP, the Los Angeles Department of Water and Power, has done extremely well under deregulation, because they happen to own a lot of power plants.

Shasta, which is a public utility up in northern California, has had to double its rates. Shasta's had to raise its rates by 50 percent because they had not bought enough power and they did not have enough generation. The difference is not whether they're public or not. The difference is whether they had covered their position, or if they had enough power locked in for the future. ...

There are studies that say that no matter how you do it, deregulation is not going to wind up with cost savings for consumers.

These studies are probably right, in terms of the operational efficiency of a given set of power plants. That is, once you have a certain number of power plants on the ground, running them in an integrated fashion is more easily and effectively done in a single utility. The savings that potentially come about in a deregulated market are in the investment in new power plants--getting efficient investments, and avoiding the costs when bad decisions are made....

The other potential savings from deregulation is through better pricing of electricity. This could also have happened under regulation, but it never has. The reality is that the cost of producing electricity changes hour to hour, and our electricity rates don't reflect that. We have no more incentive to save on a hot summer afternoon than in the middle of the night. That's just a dumb way to price electricity at the retail level, while we could change that through real time pricing of electricity. ...

Every market that's been deregulated in electricity has seen abuse--in the Midwest, in PJM in Pennsylvania, in the Northeast.

No question about it, every market has had problems. That's not a reason that a market can't do better than the regulated structure. The regulated structure also had problems. We can come up with plenty of examples of abuse and of inefficiency under regulation. The right question to be asking is, is it possible to construct a deregulated or less regulated market that will operate more efficiently than the old regulatory structure? I think that's still an important question to pursue. But we've learned a lot about it from California, and it's not nearly as easy as people once thought it was. ...