California Electricity Economics 101

Adam Hamilton    June 1, 2001    4286 Words


“Price caps do nothing to reduce demand, and they do nothing to increase supply.  [Price caps create] more serious shortages and therefore, even higher prices.”  -  George W. Bush, President of the United States of America (even California), May 29, 2001 in Los Angeles


As we plunge into June, it is not even officially summer yet the razor sharp teeth of the emerging energy crisis in California are already tearing flesh out of California’s struggling economy. 


Long known as the Golden State after James Marshall discovered gold near Sutter’s Mill in January 1848, sparking a massive gold rush that proved to be one of the most exciting episodes in America’s financial history, California is also considered a bellwether for the United States economy in general. 


The importance of the California economy and what happens in the Golden State is hard to overstate.  God forbid, if the Californians grew tired of being ruled by the city-state Washington DC and decided to secede from the Union, their economy would be among the largest in the world.  California has a population around 33m, roughly 12% of the entire United States.  California was ground zero, the very nexus, of the now infamous technology bubble that ballooned in the late 1990s and ultimately shattered in early 2000.  California still retains some of the most innovative and hard-charging entrepreneurs on the planet and the most brilliant engineers and scientists in the world.


California is also a critical transshipment hub for the United States.  Much of the vast trade that America consummates with Japan, China, Korea, and other Asian nations moves through the perpetually busy docks of California.  The skyrocketing US trade deficit and its important implications for the future of the dollar and financial markets aside, many of the Asian goods permeating the US economy first touch US soil in the great state of California.  California is quite literally America’s gateway to the Pacific Rim.


California is unarguably one of the premier states in the United States and an American treasure.  All Americans and anyone who invests in or trades with the United States should be very concerned about the troubling events that are transpiring in California.


Because of California’s critical importance as well as its bellwether status, we have been carefully following the ever-evolving electricity crisis in the state with great interest since last autumn.  We have written much about California over the last six months in Zeal Intelligence for our clients, but until now we have not published anything publicly on the dangerous electricity shortage brewing in the Golden State.


We are deeply troubled by the growing politicization of the very real electrical crisis in California, so we decided it was time to address the electrical problems in California from a purely economic perspective.  Contrary to political rhetoric and mainstream media opinion, the crux of the issue in California is not political and politics can only exacerbate the problem and make an already bad situation much worse.  In order to grasp what is transpiring in the California electrical market, we believe the most effective way to look at the problem is from a wholly economic perspective.


The roots of the current California electricity crisis not surprisingly emerge from a situation where politicians attempted the old unwinnable Soviet-style game of manipulating free markets.


When free markets are left alone to thrive, they are the ultimate models of efficiency and irresistibly self-policing.  Free markets in operation are a wonder to behold, and great thinkers from Adam Smith to Ludwig von Mises have eloquently described the magnificent beauty of free markets when they are left alone to do their thing.


Ultimately, a free market provides a conduit through which every free human on the earth can conduct mutually beneficial transactions with any other free human.  A free market is comprised of millions and sometimes billions of participants, and each individual free market participant buys and sells with one primary goal in mind, to maximize their individual profits.  Paradoxically, the not-so-virtuous attribute of naked greed coupled with the perfectly normal self-interest hard-wired into human brains leads to the most fair and efficient market environment for all market participants.  When everyone involved in buying or selling is able to act in their own self interest free of government molestation, markets are ultra-efficient, competition is intense, prices are stable and fair, and prosperity grows for everyone.


The foundation of free markets is the unfettered movement of PRICES.  When all market participants are free to buy and sell and pursue their own self-interests, market prices are fair and Adam Smith’s invisible hand ensures that any surplus or shortage is immediately addressed and the market is almost always in a market clearing equilibrium state, where demand from buyers in a particular market is exactly met with supply from sellers.  In this perfect free market environment, the price of a good or service automatically ends up at a level where there is no surplus and no shortage.  The price is fair, it provides a valid signal to all buyers and sellers, and the market operates at near-perfect efficiency.


When prices are influenced by extra-market forces such as governments, however, the free markets begin performing poorly and inefficiencies grow like a spreading cancer until the oppressed market reaches a breaking point.  When governments interfere in markets, they almost always do so by attempting to set or influence the price of a commodity, good, or service.  Pricing is THE medium which markets use to signal other participants and to stay balanced in continuous equilibrium, so if the prices are obscured by a government, the market ceases to be free.  Once a price is targeted by an extra-market government bureaucracy, buyers and sellers receive conflicting price signals and the market rapidly decays into hell in a handbasket, with large surpluses or shortages inevitable.


As we continue to diligently study world financial and economic history, it becomes more and more evident that free markets perform beautifully if unmolested, but once a government gets involved the whole intricate system decays into a painful mess.  Like innumerable other failed attempts to manipulate markets in history, the dire California electricity situation is the bitter fruit of politicians mucking around in market areas they should not have touched with a ten foot pole in the first place.  Of the hundreds of historical examples we have studied of governments attempting to break the iron laws of free market supply and demand, 100% end in failure, just as this disastrous California experiment is now proving.


It all started in California with “deregulation”.


Now, if you are a normal well-adjusted literate reader of the English language, deregulation probably means the same thing to you as it does to us.  Deregulation means to REMOVE regulations, right?  If something is deregulated, the plaintext implication is that a government is pulling out and leaving it alone.  Daniel Webster’s namesake four-inch thick unabridged English dictionary defines “deregulate” as “to remove government regulatory controls from an industry, commodity, etc.”  Easy to understand, right?


If governments mucking about in free markets is the nemesis of those same free markets, and deregulation means removing government regulatory controls, then deregulation should be good for free markets, right?  YES!


The problem arises because professional bureaucrats and politicians unilaterally redefined the word “deregulation” in California’s case.  As history has shown over and over and over again, if there is one lesson to be learned by observing bureaucracies and politicians, it is that their words are meaningless.  It’s their actions that must be carefully watched and evaluated. 


To understand the unproductive bureaucrats and the modern self-appointed ruling class of politicians, one must be very crafty and cut through the Orwellian doublespeak.  Examples of this phenomena are everywhere in every country on the planet.  Wherever you find politicians and bureaucrats, you will find them saying one thing for public consumption but really meaning something else entirely than the raw words implied.  A perfect example is the official name of China, “The People’s Republic of China”.  Sounds like a great place, eh?


Unfortunately, every adjective before “China” is a bitter lie.  China is run by a group of godless Communist criminals, who have raped and pillaged the Chinese people and forced them to live in subjugation to the poisonous failed doctrines of Karl Marx.  The good Chinese people basically have zero say in what the abominable Chinese leadership does, so the adjective “People’s” is a typical political deception.  “Republic” is no less a lie. 


A republic is a fantastic form of government perfected in ancient Greece and Rome where people elect their peers to represent them and carry out their wishes.  In a modern republic, the will of the citizens is executed by men and women who the people elected in open and honest elections.  China’s great people, whom we admire and respect deeply, are subjugated by an immoral and evil group of men who are de facto despots of the nation.  The United States of America is a representative republic, but China is a tragic despotic state run by a group of thugs you would not even trust to deliver your morning newspaper.


Like “The People’s Republic of China”, Californian “deregulation” is a bald-faced lie and another example of bureaucratese Orwellian doublespeak.


In the mid 1990s, California “deregulated” its electrical market, except it was really a RE-regulation, NOT a deregulation.


The California state government decided that electrical power companies should have more exposure to free markets.  Unfortunately, however, the bureaucrats running the show had no experience in free markets, so they created a re-regulation scheme that was like tying the hands and the feet of the electrical utilities to a 5000 pound weight, tossing them in the unforgiving free market seas, and seeing if they could tread water.  Obviously, witnessing the havoc California has wreaked on the once strong companies of Pacific Gas and Electric and Southern California Edison, the electrical utilities could not swim in a free market with their severe government imposed handicaps.


In their re-regulation scheme, the bureaucrats said that California utilities could buy wholesale electricity on the spot free market to sell to their retail customers, which was great.  The goofy California bureaucrats, however, clamped down hard with unrealistic price caps on the price electric utilities could charge to their retail customers.  Also, electrical utilities were banned from entering long-term contracts that could hedge the price of wholesale electricity and provide cashflow predictability to the utilities.


The wizards in charge of re-regulating California’s electrical market created a quasi-free market alternate dimension that placed California electric utilities at huge risk.  The utilities would be forced to buy electricity in the open wholesale market to meet marginal demand, the utilities were BANNED from entering into long-term supply contracts to have some protection from wholesale price swings, and the utilities would be FORCED to resell the electricity to their retail customers at some fanciful non-free market price set by a group of command-and-control ivory tower bureaucratic regulators.


As is now obvious, this policy is an unmitigated disaster.


Electric utilities had one flank fully exposed in the free markets on the wholesale side, but their retail operations were shackled down through strict price caps.  When wholesale electricity prices began to roar due to rising demand and flatlined supply, the electric utilities were ripped in half when they could not operate as free market entities.  It does not take a rocket scientist to realize that paying a huge price for a commodity you are forced to immediately sell at a deep discount is a recipe for bankruptcy.


The bottom line on the roots of the current California electrical crisis is that retail price caps levied by a deregulation falsely-so-called scheme forced California utilities into bankruptcy.  Electricity demand rose as the Information Age began thirstily slurping down its electric lifeblood, electrical supply was relatively flat as environmental regulations and price caps discouraged new investment in electrical generation capacity, and the hellish offspring of this unholy union is being laid naked for all to see this summer.


Now, to the great dismay of free market capitalists, politicians with no experience operating in free markets are calling for WHOLESALE PRICE CAPS as a solution to the problem!  That is like someone discovering a fire burning in their living room and then hijacking a tanker truck full of jet fuel to spray on the blaze to try and extinguish it.  The end result, of course, is a far bigger problem.  Wholesale price caps will be a disaster for Californians if they are rammed through.


In order to understand what wholesale price caps will do to push the California electricity crisis over the cliff into a deep, dark abyss, it is useful to illustrate the situation with simple introductory level economics.  Remember the dreaded supply and demand graphs from your freshman year in college?  Well, THEY’RE BAAAACK!


A supply and demand graph attempts to graphically represent a market.  In our case, we are interested in the wholesale electricity market for California.  Price is always graphed on the vertical Y-axis and quantity on the horizontal X-axis.  In the California wholesale electricity market, we are talking dollars per megawatt hour (one million watts of electricity supplied for one hour of time) in terms of price.  Last year, wholesale electricity was running around $30 per megawatt hour (mWh) in California.  Since last autumn, prices have been much higher, in the hundreds of dollars, sometimes spiking above a breathtaking $1500 per mWh during peak demand periods.


In quantity terms for the California wholesale electricity market, we are also talking megawatts.  Total California power demand during non-peak periods of usage is around 30,000 megawatts.  One megawatt is roughly enough electricity to power one thousand homes.  So, we have price graphed on the Y-axis in megawatt hours and quantity graphed on the X-axis in megawatts.  Piece of cake so far.


A supply and demand graph obviously wouldn’t be complete without supply and demand graphed.  We are using the simplified economics textbook example types of supply and demand curves here, which are assumed to be linear and straight.  Although not necessarily true in the real world, this assumption does not alter the analysis or affect the conclusions drawn in any way.


The first element a free market needs is demand.  If demand for anything exists, from electricity to emu eggs, rest assured that supply will arise to satiate that demand.  Demand is the ultimate driver of free markets.  In our graphs in this essay, we represent demand for electricity with red lines.  Demand varies with price, and the typical downward sloping demand curve illustrates that as price decreases the quantity demanded increases.  If electricity cost $1,000,000 per megawatt hour, most of us would be living in caves and riding horses to work.  Only the elite could afford electricity at such a price and demand would be trivial.  On the other hand, if electricity only cost $0.01 per megawatt hour, we Americans would probably air condition the entire atmosphere in the summer and demand would be staggeringly high.


Once demand rears its head, supply will soon follow in a free market.  Suppliers of commodities in free markets are capitalists and business people trying to make a profit and feed their families by supplying needs to the market.  In our graphs in this essay, we represent California wholesale electricity supply curves in blue.  Supply is the inverse of demand, and the supply curve slopes upward to the right.  Using electricity as an example, if electricity sold for $0.01 per megawatt hour but it cost $20 per mWh to produce, no one would be in the electricity business and the supply would be zero.  Conversely, if electricity sold for $1,000,000 per megawatt hour, everyone and their dog would sell all their assets and rush to build electrical generation facilities in their backyards to reap fantastic profits.


The job of the free market is to use price, its signaling device, to tell electricity consumers how much electricity they can afford and producers how much electricity needs to be supplied.  Our first graph shows a normal free market in equilibrium.



In a free California wholesale electricity market, supply would exactly meet demand at a “market clearing equilibrium price”, where there was no surplus or no shortage of electricity.  The price level and quantity in our example is arbitrary, but is in the ballpark relative to the current situation in California.  Our $200 hypothetical equilibrium point is very expensive electricity, as $30 per mWh was common in California last year.  Nevertheless, it is useful to illustrate how free markets operate, as we will see in the final graph of this essay.


First, before we examine the elegant free market solution to California’s wholesale electricity problem, let’s take a look at the socialist bureaucratic band-aid, the oft-discussed WHOLESALE PRICE CAPS.  The mere mention of the words “price caps” should send shivers of terror down the spines of all self-respecting capitalists everywhere!


In Economics 101 terms, price caps are technically called an “artificial price ceiling”.  Economic textbooks are chock full of examples of the kinds of inefficiencies these government imposed schemes of folly compel on free markets.  When governments began mucking around in free markets and impose an artificial price ceiling, a shortage is ALWAYS the inevitable result.  The following graph explains why.



Instead of letting the free market reach its temporary equilibrium of our prior $200 mWh example, imagine the California bureaucrats, who live in their own little fantasy-world insulated from free markets, are able to cajole, sue, or threaten their way to the desperately whined for price ceiling.  The devastating results of wholesale price caps are readily apparent in the graph above, where a hypothetical wholesale price ceiling of $100 per mWh is imposed on the wholesale California electricity market.


When the California government steps up to the plate, sounds its bugles, and declares that no one can buy or sell wholesale electricity above $100, all kinds of dangerous results ensue.  First, at this hypothetical $100 mWh example, the blue supply curve is intersected at a quantity of 20,000 megawatts.  This indicates that the suppliers of electricity can only sell 20,000 megawatts of electricity at $100 mWh.  This is attributable to many factors, including the fact that fewer wholesale electrical suppliers will be able to sell electricity at a profit for $100 mWh than at a $200 mWh price.  The 20,000 megawatts that suppliers are able to supply at the capped price is marked by the blue dot above.


California buyers of electrical power in the wholesale market, however, demand much more power when the wholesale electrical price is artificially cheaper.  At the $100 arbitrary price set by bureaucratic fiat, demand in this example rockets up to 40,000 megawatts, DOUBLE what the suppliers are able to supply at the artificially low price.  The electricity demanded at $100/mWh is marked by the red dot.  The dotted red line that connects the blue supply dot and the red demand dot is the literal artificial price ceiling, the inevitable result of anti-free market price caps.


The yellow and black triangle above this artificial price ceiling represents the engineered shortage that ALWAYS results when price caps are imposed.  If the California bureaucrats are able to ram through yet another price capping scheme, the inevitable result will be a much worse problem, with less power supplied and more power demanded.  This simple supply/demand graph of an artificial price ceiling provides a powerful illustration of why price caps never work and just exacerbate a problem that originally evolved due to earlier retail price caps.


Rather than letting the economically illiterate politicians continue to further wound the free electricity market and increase the pain exponentially for the noble citizens of the great state of California, the free markets offer a simple and elegant alternative that absolutely WILL solve the problem as rapidly as possible.  The free market solution allows the free markets to actually do their thing.  All the California government has to do for this true solution to be implemented is to sit back, get their dirty hands out of the electricity market, and wait for the excellent results.



Please scroll back up to our first graph for a second, and note the $200 equilibrium price.  $200 per mWh is EXPENSIVE electricity, and it perfectly illustrates the free market mechanism for correcting anomalously high prices.  That mechanism?  Anomalously high prices!  High prices are eliminated by… high prices.


Imagine it costs an electrical utility $20 to produce a megawatt hour of power.  If the spot price for electricity in California is $200 per hour, the profits will be absolutely stupendous and the high price will signal to capitalists all over the world who can build electrical generating facilities that the “getting is good” in California.  As these capitalists chase the high profits, they will rush to build new power plants in the Golden State.  Much new supply will come online which will push down prices and save the day for the Californians.


Initially in the current real world California environment, new electrical capacity will not be built even though the free market price of wholesale electricity is stellar.  It costs a lot of money to build an electrical generating plant, and once they are built they are impossible to move.  Since the capitalists who can ably supply California with the power it desperately needs do not want to see the politicians seize their assets or render them unprofitable by fiat, they will wait until the California government gives the all-clear signal.  Once they are comfortable that they can build power plants in California and reap their profits in good faith, they will come in droves and power plants will be built faster than anyone can imagine, springing up like weeds overnight.


On May 17 California Governor Gray Davis told the power companies that California does NOT want their help and does NOT want extra power capacity.  His exact words were, “We are literally at war with the energy companies.”  What a fool!  The citizens of California NEED the power companies to come in, spend their capital, and upgrade and enhance the electrical generating capacity of the state.  As soon as the politicians realize that power companies are the solution to the crisis, and not the problem, they will invite capitalists from around the world to the fine state of California to build power plants.  The politicians will probably have to sign statements in blood swearing the state of California will not muck around with prices and will let the electric utilities operated in a totally free market.  When that day arrives, the electrical crisis is well on its way to being solved.


When capitalists see the high electrical prices in California and truly believe the government will not harass them, they will flock to the Golden State like fireflies to a floodlight.  The stellar $200 electricity price will entice massive new production of electrical generating capacity.  Everyone in the electric business will be frantically building new plants in California to reap the windfall.  The net result of the frenzy will be vast new electrical capacity coming online to supply the Californians.  The blue supply curve will actually shift to the right as in the above graph, indicating a much larger supply base of California electricity.


As the supply curve shifts in response to capitalists chasing electrical profits by augmenting capacity, wholesale electricity prices will began to fall.  Slowly at first, and then faster, wholesale electricity prices in a truly free California wholesale electricity market would ultimately plummet to a price only slightly higher than the cost of production.  Soon, if power still costs $20/mWh to create, it would be selling in a free wholesale market at $22-$25, the cost of production plus a fair profit margin.


This, dear friends, is a simple Economics 101 example is how capitalism works.  If demand rises faster than supply, prices rise.  Rising prices have the dual effect of retarding demand and enticing in new supply.  As capitalists see the high prices seductively beckoning, they start to build new power plants in their quest for profits.  High prices then began to fall as supply increases.  Simple, elegant, and EFFECTIVE!


Free markets are self-policing and efficiently solve any supply/demand discrepancy.   If the free markets are unshackled by the politicians and allowed to run free, the California electrical crisis will be nothing but an unpleasant memory within a couple years.  Only free markets can solve supply/demand problems, NOT command-and-control politicians.


For the demagogue politicians who insist on inflaming popular sentiment over a stopgap price cap measure that always fails historically, we suggest they move to Cuba to exercise their command-and-control desires.  America is the land of the free (men and markets) and the home of the brave under God, not a socialist laboratory for Marxist experiments. 


I have traveled and seen with my own eyes the devastations of the Communist regime in China, and one of my partners has consulted extensively in Russia and the Central Asian Republics.  We have truly and literally witnessed firsthand the dismal failures of market manipulation schemes, and their disastrous effects on ordinary people and economies is truly tragic.  Anyone who thinks price caps and market management are an effective strategy ought to leave America and go see price caps in action around the world before they brazenly attempt to manipulate markets.


For the California politicians, we respectfully suggest they immediately assure capitalists that the state government will quit mucking around in the electricity market, aggressively and publicly denounce government intervention in free markets, stop the counterproductive adversarial taunting of the energy companies, and invite them into the state. 


With these simple first steps, the great state of California will be well on its way to solving its energy problem.


Adam Hamilton, CPA     June 1, 2001     Subscribe