The Power Perplex

SYNOPSIS: Krugman revisits last year's California electricity crisis -- the market power of a few large firms in the spot market was the cause

Until recently, it seemed unlikely that California would ever get anything back from the energy companies that, in the view of state officials, robbed the state of billions of dollars. Then came the Enron scandal. Will revelations about Enron's political machinations, and new allegations by former Enron employees that the company manipulated California's electricity markets, change the odds?

California officials apparently think so. Yesterday they filed a suit with the Federal Energy Regulatory Commission, seeking a renegotiation of electricity contracts signed during the state's power crisis. They may hope that FERC officials particularly the chairman, Pat Wood, who was recommended for the post by Enron's Ken Lay will feel the need to demonstrate their independence by getting tough with energy companies.

The contracts in question were signed about a year ago, when wholesale electricity prices in California were more than 10 times normal levels. Last June, however, prices suddenly plunged. Now the state wants those contracts canceled.

Does the state have a case? The conventional wisdom is that California has only itself to blame for its power crisis, that the debacle was the result of "flawed deregulation." This conventional wisdom has become conventional mainly because it fits so well with our era's enduring faith in markets. (And I mean faith: "I believe in God and I believe in free markets," Mr. Lay once declared.)

But try asking what "flawed deregulation" means, and you usually get a long pause. Eventually you hear that wholesale prices were deregulated, but retail prices weren't which is true, but doesn't have much to do with what went wrong.

The key fact about California's crisis is that it peaked not in summer, when air-conditioners gobble electricity, but in the cooler months. Supplies should have been ample. Instead, there were severe shortages, because for some reason a third of the state's capacity stayed off line.

The power companies say that generators were shut down for maintenance after being worked hard the previous summer. But the mysterious shutdowns went on for about six months, and continued despite sky- high prices for electricity. Surely there was time and incentive enough to carry out some expedited repairs.

A more likely explanation widely accepted by energy economists is that power companies found that they could make more money by shutting down some of their plants, and hence creating shortages that sent prices into the stratosphere, than they could by actually meeting demand.

If conventional wisdom was right, the crisis should have gotten even worse last summer. Instead, electricity suddenly became abundant, and prices plunged. Frank Wolak, the Stanford professor who heads California's electricity market surveillance committee, has explained why: by June, thanks in part to energetic conservation, most of the state's power needs were being supplied under those long-term contracts. The spot market, which was so easy to manipulate, had become relatively small; so the incentive for power companies to drive up spot prices by taking generators off line had largely vanished. Lo and behold, idle capacity came back on line, and the crisis was over.

Now the truth is that California's deregulation probably was flawed, but the flaw was in trusting markets too much, not too little. As Mr. Wolak points out, California's system differed from other deregulations mainly in offering remarkably few safeguards against market manipulation. And the state paid an enormous price for its gullibility.

Will California win its suit? I have my doubts: money still talks. But at least the post-Enron change in climate makes it possible to revisit California's crisis, a crisis that should have provoked a rethinking of our economic ideology, before the ideologues flush it down the memory hole.

My Feb. 22 column mentioned "line 47" in this year's 1040. What I said was correct, but has been subject to misinterpretation, most of it innocent, some of it deliberate. Let me say it another way: Most people think that they received both a rebate and a tax cut. But the rebate was only an advance on the tax cut; it must be counted against the refund you would otherwise receive. Hundreds of thousands of early filers have already gotten this wrong. The effect is to give many people a rude shock, which is not what this economy needs.

Originally published in The New York Times, 2.26.02