The California Energy Crisis

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Teachers Guide to "The California Energy Crisis"

Teachers Guide to The California Energy Crisis

The student reading, The California Energy Crisis is intended to prepare students for a class discussion.  As such, it can be distributed as an individual homework assignment or an in-class pairs or small group activity.  In any case, students should have time to read and think about the handout before the large group discussion.

The Thought Questions in the handout provide a review of economic principles and guide students in the application of economic reasoning to the problem at hand.  They are not intended to be a written assignment.  However, as you circulate around the room during the small group task time, you can help students to focus on the salient points.  Suggestions are provided below.

Thought Question #1:  What are the opposing points of view?

The basic disagreement is whether the California energy crisis is the result of a regulated energy market (i.e. what some would call "government failure") or the result of de-regulation (so-called "market failure").

Thought Question #2:  Describe the current electricity market in California.

The description should include recognition that this is a 2-tiered market.  At the wholesale level, the generators are the suppliers and the utilities are the buyers.  At the retail level, the utilities are the suppliers and California consumers are the buyers.  In both cases, the "market" and, therefore, the price of electricity, is affected by law and regulation.  At the wholesale level, prices are administered or engineered; at the retail level prices are fixed. 

Encourage students to play with some graphs to see if they can transfer from their study of other markets with fixed prices - price floors or price ceilings.

Thought Question #3: Were recent changes in the market the result of supply shift, demand shift, or both?  And what was the impact of those shifts?

As students sort through the reading, hopefully they'll come to appreciate the complexity of the situation—and come to the realization that the answer to question #3 is "all of the above! and then some!  Encourage them to consider the market components separately:

  • The building problem has been a long term increase in demand - presumably as the population of California grew.  (In graphic terms, we're talking about a shift to the right.)

  • The more recent phenomenon has been a change in the cost of generating electricity - the rising price of natural gas.  Students should recognize that a change in production cost is a supply shifter.  (Graph shift? Left.) Which part of the market experienced this shift?  Correct - the wholesale market, as power generators compensated for higher resource costs.

Also important is the fact that new generating plants aren't being built.  The quotes tell us that government-imposed restrictions, many of them environmental, have raised the cost of new electricity generating plants to the level that businesses are unwilling to take the risk.

What about the retail market?  The utility companies, facing a higher price for electricity, reacted as the law of demand tells us buyers always react to higher prices—they were unwilling to purchase more electricity to sell on the California retail market. 

This, in turn, means that the supply in the California retail market wasn't responding to the ever-growing demand. Even worse, the fixed price of 6.4˘/kilowatt hour meant that the quantity supplied was less than quantity demanded—hence the shortages.

Thought Question #4: What remedy do you think Jacob Sullum would support—and do you agree or disagree with him?

Clearly, Mr. Sullum has a strong distaste for government intervention, as his sarcastic comments about the "Department of Turn Off Those Lights" indicates.  Students should then respond by predicting what would happen if the market were truly deregulated, and noting the advantages and disadvantages of those outcomes.

Class Discussion Guide

Discussion Topic (post on the board or overhead transparency)

We don't hear of "carouts" or "breadouts" caused by short supply of cars or food, so why is California suffering "brownouts" because of the short supply of electricity?  What's the same and what's different?

Notes:  The difference is the existence of relatively unregulated markets for bread and cars.  The similarity is that consumers and producers respond to the prices of cars, bread, and electricity, regardless of whether or not the market is regulated.  In the markets for bread and cars, that produces desirable results and social cooperation.  In the "market" for electricity, that produces shortages and social conflict.

In the car and bread markets, a short supply doesn't become a persistent shortage.  As the short supply causes prices to rise, the quantity demanded would fall as many consumers chose not spend as much on cars or bread,  In addition, the rising price would serve as an incentive for producers to provide more cars and bread, also helping to eliminate the shortage.

In the California electricity market, fixed prices act as perverse incentives, encouraging producers and consumers to behavior that actually worsens the shortage.  When retail prices are fixed, consumers have no price incentive to purchase less.  The quantity demanded tends to remain the same despite all the public service pleas for people to reduce usage.  On the other hand, fixed prices make it difficult - and eventually impossible - for producers to cover increasing costs, so they have no incentive to produce more electricity for their insistent customers.

Suggested Guide Questions for the Class Discussion

  1. In what ways is the California electricity market regulated?  In what ways was it "deregulated?"

    The California electricity market is highly regulated, or as one of the authors put it, "it has only been restructured."  The points of regulation include:  a fixed or administered retail price range charged to consumers; government-administered prices in the wholesale market; restrictions on construction of new power generating facilities.  The only real point of deregulation is that consumers can choose which utility company to purchase electricity from.

  2. How have consumers and utilities responded to the 6.4 cents/kilowatt-hour fixed price of retail electricity?

    For the consumer, the 6.4 cent per kilowatt-hour price has been fairly constant for the past few years.  As that price, both residential and commercial customers have chosen to use increasing amounts of electricity.  Meanwhile, the utilities have been caught between the relatively low retail price they can charge and the sharply rising wholesale price they must pay to power generators.  The result has been that the utility companies (not the power generating companies) have been losing money as the sell electricity for less than they pay for it.  Many are on the verge of bankruptcy.

  3. Why haven't investors responded to higher electricity prices in California by increasing supply?

    The answer lies in transaction costs and uncertainty.  The legal process of getting permits to build a new power plant in California are so burdensome that even with much higher prices there would not be a big enough incentive for entrepreneurs and investors to undertake the process.  The other contributing factor is that potential power producers are uncertain as to what will be done in the future in terms of permits and pricing.  Without some assurance that they would be able to respond to market conditions, they are very hesitant to risk entering the power generating business.

  4. Why, in most markets, do higher wholesale prices NOT result in shortages at the retail level?

    In markets that are free of regulation, when wholesale prices rise, suppliers cut back on the quantity supplied.  This causes a rise in retail prices, which in turn causes a reduction in quantity demanded.  Result:  no shortage - or at the most a very short-lived one.  The new quantity supplied and quantity demanded coincide, albeit at a slightly higher price.  The higher retail price induces suppliers to continue to supply even though wholesale prices, and thus their costs, have risen.

  5. What role did California lawmakers play in discouraging the building of new power plants.  Do you think the shortage of electricity was their intent?

    California lawmakers increased the cost of new production by making the permitting process so burdensome.  In addition, as the article point out, pollution control requirements force the producers to use natural gas to generate much of the electricity.  The high cost of natural gas has proven a strong deterrent to the construction of new generating capacity, especially in the face of the fixed retail prices.

  6. Does the current regulated market help insure that electricity is put to its best uses?  Why or why not?

    One of the problems that arises when retail prices are held below their natural market level is that buyers who value the product more than someone else have no way to express their higher value.  For instance, as the article points out, the consumer who wants to light his Christmas display is competing directly with the hospital needing electricity to power a kidney machine.  In a market with freely moving prices, the electricity is allocated by price to the uses that people value most.  When fixed prices are in place the allocation process cannot distinguish between users.  While markets do not assure that electricity will always be use wisely, (some people may decide to pay the higher bills for their Christmas lights), they do assume that it will move toward the most highly valued uses.

  7. The proposed remedies fall into 2 basic categories - more regulation and less regulation.  Predict the outcomes of each course of action.

    • More regulation:

      • Control of the wholesale market through fixed prices, limited production levels, or government entry into the power generation business.  (There currently is a plan to force wholesalers to refund some of their profits from the last year.  How do you suppose they will respond in terms of future electricity generation?)

      • Some form of government directed allocation based on some criteria other than price.

      • Continuing misallocation of electricity.

      • Continuing allocation problems because the mismatch between quantity supplied and quantity demanded persists.

    • Less regulation:

      • Decrease in the quantity of electricity demanded as price increases.

      • Increase in the quantity of electricity supplied as price rises.

      • Increased investment in new power generation.

References and Additional Materials:

California's energy crisis:  Government, not market, failure.  Jacob Sullum:  www.heartland.org/environment/mar01/sullum.htm

California's energy crisis:  Not an accident.  Fredrick D. Palmer; www.heartland.org/environment/feb01/crisis.htm

Why California's restructuring failed.  Jim Johnston:  www.heartland.org/environment/mar01/california.htm

California Screamin' . . . About Electricity Deregulation.  Jerry Taylor and Peter VanDoren, access through Policy Bot at www.heartland.org

Wrong Way Out of the Dark?  Jerry Taylor and Peter VanDoren; access through Policy Bot at www.heartland.org