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Power Struggle: The California Energy Crisis

Two economists offer their perspective on the California energy crisis.

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  • GWEN IFILL:

    The politicians and the regulators had their say on Capitol Hill. Now, we turn to two economists, to guide us through the thicket of the energy debate. Severin Borenstein is director of the University of California Energy Institute, and Lawrence Makovich is senior director and co-head of the North American Energy Group at Cambridge Energy Research Associates, an energy research firm in Massachusetts. Welcome, gentlemen. Mr. Borenstein, well we have heard about price mitigation, we have heard about price restraints. Is what the Federal Energy Regulatory Commission has done, is it a price cap?

    SEVERIN BORENSTEIN, University of California Energy Institute: Well it's certainly what economists would call a price cap. It's a floating cap that will change as the cost of production changes, which we definitely need. But it is still a cap. Obviously for political reasons, everybody wants to give it a different name.

  • GWEN IFILL:

    Mr. Makovich, is it price capped to encourage or discourage increased supply?

  • LAWRENCE MAKOVICH, Cambridge Energy Research Associates:

    Well, the reason people don't want to use the term "price cap," is that most people agree that although well intentioned, they seldom solve problems like this. It's not likely it will add any supply nor reduce demand. We've already seen in California that price caps on retail rates increased demand and made the shortage worse and price caps also forced the largest utility, Pacific Gas and Electric, into bankruptcy in four months.

  • GWEN IFILL:

    So what should have been done instead?

  • LAWRENCE MAKOVICH:

    There were lots of missed opportunities here. In just the recent months, there were missed opportunities to bring in emergency power, barge-based power, and other emergency power systems that could have made a very important difference for this upcoming summer.

  • GWEN IFILL:

    How about that, Mr. Borenstein? Was this the right way to go, price caps?

  • SEVERIN BORENSTEIN:

    California is building a lot of power plants. Some of them are going to be online this summer, but the fact is the sellers in this market, this summer, will have tremendous power to raise prices above competitive levels. Even the FERC has now recognized that. They've decided that although they don't want to intervene in a heavy-handed way, they do feel the need to keep the prices from spiraling out of control. Without these sorts of price caps this summer we certainly could have seen prices that were four or five times the levels that these caps are going to be. You really don't need prices that high to encourage investment in the state of California. These caps are going to allow the generators to earn plenty of money.

  • GWEN IFILL:

    Mr. Borenstein, members of Congress and members of the Commission said today that no matter what happened with these price caps there would still be blackouts this summer out there in California. Why is that?

  • SEVERIN BORENSTEIN:

    Well, I think that's right. We still face blackouts. These caps are not going to fundamentally change the amount of supply by very much at all in either direction. What they're going to do is just change the amount of money that gets transferred from consumers to the producers of the power. The reality is, though, we do also have a real shortage of power, and if we don't conserve in California and conserve pretty strenuously, we are going to have blackouts.

  • GWEN IFILL:

    Mr. Makovich, we just heard Senator Lieberman say in Kwame Holman's piece that he was concerned there's still too much room for prices to go up, that basically all generators have to do is make a case that they need the prices to be higher and they can still raise them. How does the Regulatory Commission police this?

  • LAWRENCE MAKOVICH:

    Well it's very, very difficult because the problem here is one of a fundamental set of flaws in the power market. Prices right now are too high because there is a fundamental shortage. If we go back four years before the shortage at the point in time given how long it takes to site and permit and build a power plant and look at the power prices four years ago, it's very clear they were only half the level of what was needed to encourage supply.

    So we didn't get the investment needed in California. Instead, people built power plants in Texas and New England. And the fundamental flaws that made California an unattractive place to invest still exist. Right now most of the construction is being backed by contracts from the Department of Water Resources in California. And one of the unintended consequences down the road may be a fiscal crisis because California really can't finance this power sector on an indefinite basis.

  • GWEN IFILL:

    A short-term price savings perhaps?

  • LAWRENCE MAKOVICH:

    Well, the short term, because so many opportunities have been missed, there really is very few alternatives at this point. Blackouts are going to happen. And the scarcity will make prices quite high.

  • GWEN IFILL:

    Mr. Makovich, what is the incentive for power generators to comply with this plan?

  • LAWRENCE MAKOVICH:

    Well, I think this plan does create a disincentive to investment. Power prices are higher than they need to be right now to encourage investment, but someone that is going to build a power plant that is going to last for 30 years cannot count on periodic shortages to produce prices high enough to recover investment and earn a return. Unfortunately, the record in California is when the market is in surplus or in balance, prices don't support investment because the market was set up wrong.

  • GWEN IFILL:

    How about that, Mr. Borenstein?

  • SEVERIN BORENSTEIN:

    Well, the fact is that these power plants do last 30 years. When an investor makes a decision, they're looking at the future environment of prices over a 30-year period. These are very short-run price caps. The Bush administration, I think, has credibly said that that's going to be the case. So it's very hard to credit the argument that they're going to discourage investment. There's a lot of investment in the state right now, and it was occurring before DWR started buying– the Department of Water Resources in California– started buying power. So we have plenty of power being built.

    The issue is a short-run crisis in California this summer. We do have to conserve. We have a real supply shortage. But our research that we've done said… Looked at 1999 when we paid $7 billion for power and in 2000 when we paid $27 billion for power. Some of that increase was just due to a real shortage of supply, but $7 billion of it, at least by our calculations at the UC Energy Institute, was due to market power; that is, firms raising prices above the competitive level.

  • GWEN IFILL:

    Price gouging?

  • SEVERIN BORENSTEIN:

    Certainly not a competitive market. And pretty much everyone has recognized that now that we haven't had a competitive market. I think we will in the future, but we have a short-run crisis. It requires action from both California on the conservation side, and from the FERC on the price side. The FERC has done its job. The real issue I think now is how well they will enforce this new price cap.

  • GWEN IFILL:

    Mr. Makovich, did it take too long as Mr. Hebert suggested at the congressional hearing for the regulatory commission to step into this — all the time when we heard President Bush saying it's not the country's problem; it's California's problem. Did it take too long?

  • LAWRENCE MAKOVICH:

    Well, yes, the fundamental flaws in the market were there right from the start when they passed the legislation in '96 and set the market up in '98. There's an awful lot of blame here to be placed on people in positions of responsibility who were charged to monitor this market. You know, over the past five years the California economy grows by a third, electricity consumption grows by a quarter and the amount of generating supply actually goes down. And the people that were monitoring this market primarily at the state level but at the federal level as well seem to have been asleep at the wheel.

  • GWEN IFILL:

    Mr. Borenstein, there is all this backing and forthing, as I'm sure you know, finger pointing about who really is to blame. From an economist's point of view, who takes the bigger hit?

  • SEVERIN BORENSTEIN:

    Well I think that both sides were really not doing their job. The monitors actually of these markets associated with the California independent system operator were raising red flags back in 1998. They were saying we have a real problem here and prices could skyrocket. The FERC was made aware of these problems back in 1998, and they basically punted on it. The FERC by the way also approved all of the setup of the market; that is, all of the different ways that… all of the different ways that now clearly are flaws in the market were approved by the Federal Energy Regulatory Commission.

  • GWEN IFILL:

    Now, one of the things Governor Davis suggested today is that $9 billion in overcharges be refunded to rate payers. Do you think that's a good idea? Does that help the situation any?

  • SEVERIN BORENSTEIN:

    Well, I don't think it's going to have much effect on the situation one way or the other. The reality is that the Federal Energy Regulatory Commission operates under the Federal Power Act, and the Federal Power Act requires just and reasonable prices. If they find that the prices were not just and reasonable, then they are supposed to order refunds. I think they are moving towards finding… That finding. How big the number will actually be will, I suspect, go through a lot of negotiation. But I suspect there will be significant refunds. So far the FERC has ordered $100 million or so in refunds, which has got to be considered an insignificant number compared to the payments.

  • GWEN IFILL:

    Mr. Makovich, we heard Senator Lieberman talk about cost-based regulation. What is that and why would the Democrats support such an idea?

  • LAWRENCE MAKOVICH:

    Well, the idea there is that because this market is flawed and not working properly, they want to intervene and set prices to a level where people will be encouraged to utilize the power plants that exist. They won't be given the disincentive not to run because the price isn't high enough. Of course the one issue that they fail to address at all is the long-term issue, since this is one of the most capital-intensive businesses in the U.S. economy, how are people going to make a return on capital and a return of capital in the long run if prices are always set just on fuel and O and M costs.

  • GWEN IFILL:

    And, Mr. Borenstein, speaking of long-term solutions, what about conservation? Does that fit into the formula at all.

  • SEVERIN BORENSTEIN:

    The California Public Utilities Commission did raise rates, which should help to encourage conservation. Frankly, I think California has a lot more work to do. The leadership of California needs to push a lot harder on getting the conservation. We are going to conserve our way through this summer. The only question is whether we'll do that conservation through rolling blackouts, which is just the stupidest way to do it, or through a more moderate form of conservation by everybody cutting back a bit. Normally that's done with the price system. Higher prices encourage people to cut back. Unfortunately, it's now the middle of June. Summer is upon us. We have to conserve now. There isn't time to do more price adjustment.

  • GWEN IFILL:

    Briefly, Mr. Makovich, what do you think about the conservation piece of this?

  • LAWRENCE MAKOVICH:

    Conservation is obviously a very important part of closing this gap — decreasing demand, increasing supply. I think the important thing to realize is conservation alone cannot close the big gap that exists in California. It has to be attacked from both sides.

  • GWEN IFILL:

    Okay. Gentlemen, thank you both very much for joining us.

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