Painful Lessons

Russia is currently considering a major reorganization of its electricity monopoly, Unified Energy Systems. Before moving ahead, however, the country should carefully consider Californias experience in reforming its own energy system. This year, shortly after implementing a deregulation plan, Californians face rolling blackouts and the future of Silicon Valley, the driving force behind the states recent economic boom, is imperiled.

In 1996 the state legislature adopted a major reform of the way Californians get their electricity. The old system had been regulated by the state. State agencies set prices for the utilities that generated and distributed electricity. The system was very stable and seemed to have plenty of excess capacity to meet the states needs. However, prices were much higher than the average in the United States, creating grounds for criticism.

So a coalition of utilities and large manufacturers convinced the legislature to push ahead with a policy of deregulation. The idea was to create separate generators that would distribute electricity through a state-controlled grid, a plan similar to the one Russia is now considering. According to the theory, prices for industrial and residential consumers would fall as more generators jumped into the market to produce more electricity. Market forces, rather than staid government bureaucrats, would be able to provide energy more cheaply and efficiently. California would create a model of electricity reform for the rest of the country.

In reality the results of deregulation turned out to be quite different. Shortly after the reform, consumers in San Diego saw their energy bills double. In the summer of 2000 and then again in the late fall, the state came dangerously close to running out of electricity. Major industrial plants had to "voluntarily" shut down their production lines to reduce the load on the strained utilities.

One key problem is that there is not enough generating capacity in the state and neighboring states do not have the extra capacity to sell California the electricity it needs. Contrary to the reformers expectations, new generators have not entered the market. The problem is that market barriers are too high.

Building generating capacity requires billions of dollars in investment, but no one will invest such large sums in a market that is so unstable. While prices for electricity are high now, no one knows what the market will look like in a few years, especially if the government decides to impose new regulations.

Another problem is that the current generators do not really have the incentive to build more plants. Since they are now able to sell their electricity during peak hours at eight to nine times what it costs them to manufacture it, they are making enormous profits without further outlays. Even though the future of the state economy is at stake, these businessmen have a powerful short-term interest in maintaining the status quo.

In this situation, the major utilities, such as Pacific Gas and Electric and Southern California Edison, seem to be the main losers. They have to buy electricity at a high price from the generators and then sell it to their customers at relatively low prices required by the state. As part of the initial deal, the utilities agreed to low prices for the next few years. Accordingly, they are absorbing enormous losses.

Or so it seems. The utilities probably did not shed their generating capacity completely. Instead, they likely set up shell companies to control some of the generators. Thus, they are still making money from the generators even though they are losing money when they sell it to their customers. Texas-based energy companies also seem to be making a killing, which, of course, is upsetting some Californians. The situation is very murky and the public does not really know what is going on, generating widespread suspicions.

The utilities want to increase the price they are allowed to charge customers, but state regulators face a number of questions in raising rates. Why should consumers bear the costs of a failed reform? Should industry pay more than residential users? Should efficient homeowners pay less per kilowatt-hour than their wasteful neighbors? What about pensioners on fixed incomes who cannot afford a major price hike?

So far, the governor has not presented a road map for the state to address its energy problems, and it looks like California will be dealing with this issue for many years to come. Observers do not know if deregulation destroyed a system that was working fine or simply exacerbated problems that would have appeared anyway. For example, it is not clear why a lack of generating capacity caught the state by surprise. Even though the economy has been expanding rapidly, planners should have foreseen that supply would not meet demand a few years down the road. There are no simple answers. The governor claims that California will have to build more generating capacity and implement a program of stringent conservation. Such calls represent only a minimum of what needs to be done.

Given Californias experience, Russia should not rush into a simplistic reorganization of its electricity monopoly. Russias reformers are promising enormous benefits from a plan that looks very similar to the one that California has adopted. While conditions in Russia are very different from those in California, in this case the similarities could prove to be more important.

Robert Orttung is the editor of the EastWest Institutes Russian Regional Report. He contributed this comment to The Moscow Times.