While the market failure aspect of the California Experiment is fairly well understood, the real failure is that it was one of the biggest colossal failures of public policy in our nation’s history. Though many have studied the reasons underlying the market failure of the California Experiment, I think it is more important to understand the public policy failures so they are not repeated.

The most intriguing aspect of this public policy failure is how almost every individual special interest was met, but the collective public interest was not. Not understanding how public policy failed and the regulatory direction in reaction to the California Experiment may be the most significant tragedies and long-term consequences to California.

Throughout the summer of 1996, nearly every special interest in California electric utility industry was locked up in Sacramento crafting AB1890, the legislation that created the California Experiment. AB1890 sailed through both the California Assembly and Senate passing by unanimous votes and was signed by California’s Republican Governor, Pete Wilson. Almost every major player in the electric utility industry including the utilities, regulators and customer interests had their fingerprints on this bad experiment. Certainly, the major utilities all did. The CPUC had its fingerprints on AB1890 and members of the commission were the driving forces behind deregulation starting in the early 1990s. Organizations representing large customers backed AB1890. Even organizations traditionally focused on protecting small customers jumped into the ‘me too’ frenzy, worried that the large customers would be free to buy-up all the “cheap power” in the market. No one seemed to question AB1890.

The dominate forces crafting this legislation were regulatory, legislative and political experts. Electricity market and utility operational experts had little or no influence in the crafting of AB1890. With all of the special interests in Sacramento, AB1890 got dressed up like a Christmas tree with lots of special interest ornaments. Those who understood markets and market structure stood by in silence as the regulatory, political and legal experts took over and crafted an unworkable market structure. As an observation, when the people who really understand their business, whether it is medicine or electricity, lose control of the operation and direction of their business it usually is not a good sign.

The generally accepted myth is that Enron and a handful of others created the California energy crisis and price spikes. However, the seeds of destruction were sown in AB1890 long before Enron traders came up with their ideas. Many predicted the market meltdown well before the California Experiment even launched. These predictions did not rely on any assumptions of market manipulation by traders from Enron practicing ‘death star’ or other forms of manipulation. The meltdown was based on underlying fundamentals of a completely flawed market design and basic economic principles of supply and demand. It is possible that Enron and others made the impact worse, but the meltdown was going to happen even without them.

As the meltdown occurred, it seemed that the main objective of many parties was to find other parties to blame rather than take action to solve the problem. The Governor initially wanted to blame the utilities. The utilities wanted to blame the Governor. The state wanted the blame the FERC. What eventually became the convenient and common scapegoats were the traders like Enron and so-called out-of-state generators. While these were convenient scapegoats, it does not reflect reality. Remember that almost every player in this market from consumer advocates, to regulators to utilities had their fingerprints on the California Experiment.

I find that the average Californian I talk to really believes that Enron and the out-of-state generators caused the crisis and were the sole beneficiaries of the price spikes. This allowed the regulators, utilities, the legislature, the governor and the consumer advocates off the hook in my opinion. My purpose here is not to sort through and reassemble history to show that several parties were actually responsible. Nor do I excuse the bad behavior of those who did manipulate the market. Instead, I want to focus on the longer term implications of the failed California Experiment, which are first, a continued failure to understand how public policy went so wrong and second, a possible reversion to the 20th Century regulatory model for electric utilities.

The obvious and direct impacts of the failed experiment are the tens of billions of dollars California consumers paid for electricity in the midst of the energy crisis, blackouts that caused additional economic losses and billions of dollars that California consumers will pay for years to come. Other impacts were bankruptcies, the massive destruction of equity, default on debt and job losses as the California Experiment caused a loss of confidence in electricity markets across the nation.

Less obvious impacts were the cost realized throughout the Western US as electricity costs soared. Those who understood markets and market structures of the West predicted these impacts would happen as the California Experiment was being enforced. Though it is not consistent with the belief that billions of California dollars were transferred to Enron and out-of-state generators, the reality was that many of the largest beneficiaries of the price run-ups were municipally-owned and government-owned utilities in the US and Canada. Many utilities throughout the West and their customers were harmed by the price run-ups.

The direct impacts of the California Experiment are staggering; however, I believe the most significant impacts are yet to be realized. Specifically, the failed California Experiment has created continued uncertainty both in California and throughout the nation about the future of electric markets, regulation, the role of utilities and other parties in this essential market. In the early 2000s, there was a significant amount of new electric generation put on-line. This created a temporary bubble and cushion of supply and also created low prices. While the low prices help today they make future generation markets weak. Current short-term weak prices combined with a confused and uncertain long-term market will not permit new generation to be financed. The uncertainty over market structure and the roles and responsibilities of who does what is causing our current supply cushion to disappear rapidly and many parts of the US will experience shortages if new generation is not brought to the market within the next one to three years. In spite of a clear and growing demand, the market uncertainty is making it difficult to plan and finance new electric generation and many experts are worried we will see a sequel to the failed California Experiment. This time, however, Enron will not be here to blame.

Beyond the short-term supply concerns, another long-term implication of the failed California Experiment is the trend to go back to the 20th Century utility model for regulation, ownership of generation, transmission and distribution. The traditional 20th Century model served our nation well throughout most of the last century. However, cracks began to appear during the oil crisis years and with the nuclear plant cost overruns. Some utilities and regulators seem to want to return to what were the golden years of the utility industry as a reaction to the California Experiment. In my judgment, this is exactly the wrong thing and a poor public policy for 21st Century electric utility industry. Going back to this outdated model could yet be one of the most tragic results of the California Experiment.

The 20th Century model had many advantages for regulators, utilities and consumers. While the model was stable for many decades, it started to break in the last 20 years. Some of the negative characteristics of this model were lack on innovation, speed and adaptability. Small problems often grew into larger problems as regulators and utilities failed to adapt and find course corrections because they were not exposed to competitive forces. For example, the “used and useful” principle caused billions of dollars to be poured into nuclear plants to just get them on line regardless of their real economic values.

The golden year conditions of the 20th Century model are long gone. The arguments today from advocates of the 20th Century utility model remind me of the arguments from the old phone company before the break-up. Many in the phone company at the time questioned telecom competition when we had the most reliable, universal and cost effective telecom system on the planet. Indeed, if we had listened and followed this status quo argument in telecom we might still have an all copper network and the same indestructible black rotary phones. What worked well yesterday may be exactly the wrong thing for today and tomorrow.

Our nation has many advantages. Among them is a strong culture and capability of innovation and progress. Our basic social and physical infrastructures also provide us significant advantages as well. Social infrastructures such as education, freedom of choices and a government that protects the rule of law are paramount. Our physical infrastructures such as transportation, communications, water and energy are also vital. These physical infrastructures must be able to innovate and adapt to meet new and changing environments and requirements. For example, we have seen an explosion of innovation in areas of communications and transportation. The productivity gains of American workers are in part due to the progress and innovation in these infrastructures.

Going back to a 20th Century model of electricity regulation could be a significant setback because it will stifle innovation and progress in the electricity infrastructure. The 20th Century model of electric utility planning was dominated by engineering views rather than economic principles. In a relatively unconstrained world this was more acceptable. Today, it is not acceptable. Up until the early 1970s, many utilities were in a declining marginal cost business. Expansion of capacity lowered average costs for everyone. However, today, nearly every element of the electric utility is in an increasing marginal cost world. Reverting to the 20th Century model would be socially wasteful and economically reckless.

Rather than letting price signals help control demand, utility engineers attempted to build capacity regardless of social cost to meet demand at fixed average prices. This was the crux of the problem with the California Experiment, where the wholesale market was mandated to be 100% spot market and prices and retail prices were fixed. At the time when I entered the electric utility industry, it was the largest single consumer of capital in the nation and today, it is still one of the largest. As an electrical engineer, I was not interested in the engineering challenges of this industry nearly as much as I was interested in the transformational opportunities to completely rethink the utility industry on different social and economic terms.

Utility asset utilization factors are no where near other capital intensive industries. Utilization factors of 40%, 50% and 60% are typical for many areas of the utility infrastructure. Unfortunately, some utilities try to attack the capital demands by simply under funding the assets rather than coming up with different operating and economic models to improve utilization. For almost the entire 20th Century there was nearly a perfect correlation between GNP growth and investment in electric transmission. During the 1990s, uncertainty in the industry caused a significant slowdown in transmission investment in spite of a decade of massive economic expansion. This infrastructure is now showing serious signs of weakness because of this slowdown in investment. Without significant infusion of capital or a fundamental shift in economically based thinking, this infrastructure is headed for failure. Real economic signals must be introduced as a central component of 21st Century regulation and utility planning. It is possible to move transmission utilization higher in many ways other than simply under funding it. Economics do work.

Perhaps the best evidence of the power of appropriately structured energy markets and the power of price signals and economics was the natural gas market in California. Natural gas prices actually flared up before electric prices did in California in the winter of 1999-2000. Ironically, it was largely the flaw of the electric market design and prohibition on forward prices that were the leading causes of the natural gas market price spikes. The natural gas market predicted early on the coming mess in the electric market. Nonetheless, because large and small customers in most of California experienced the natural gas cost increases almost immediately, the demand for gas dropped and prices dropped almost as quickly as they rose. A well structured natural gas market caused some short-term high bills, but a natural gas crisis was averted because economics and a sound market structure worked. No similar price signals existed in the retail electric markets. In fact, when rates for SDG&E, which had gone off the fixed AB1890 rates in about May, 2000, went up the CPUC lowered and capped them. While politically expedient, these kinds of actions perhaps extended the duration and increased the magnitude of the energy crisis itself. Conservation, higher efficiency appliances and homes, renewable energy and new technology will never have a real chance when such distortions mask the real cost of the traditional electricity supply.

Falling back on the 20th Century model for the utility business and regulation will not serve the public interest. We need to create a sound 21st Century model without fear of the California Experiment disaster repeating. Without a new model, we will not see innovation in this critical infrastructure. What we will see is a reversion to business-as-usual. If we want to continue to see fossil central station generation as the supply of choice, the 20th Century model will serve us well. If we want to see low asset utilization rates, the 20th Century model will serve us well. If we don’t want to see higher efficiency appliances and homes, renewable technologies, distributed generation, new technologies and price-responsive demand through advanced metering, the 20th Century model will serve us well.

There are no real technological or fundamental barriers to innovation. We must allow for innovation such as much high technology conservation and energy efficiency, smart homes, renewable technologies, deployment of distributed generation and advanced metering. Instead, most of the distortions and barriers are economic and institutional. These distortions and barriers are rooted in the 20th Century model. The explosion of communications technologies and networks, the innovation of microprocessors and control technology and new energy technologies are not going to see uptake under the 20th Century model. All of these advancements have created enormous opportunities for change. However, when the true marginal and social costs of the traditional approaches are masked by regulation, new technology and new approaches cannot compete. The 20th Century model relies on an extremely high concentration of authority and power. This concentration of power makes the utility’s job easier. It also makes the regulator’s job easier because they regulate a less complex structure. Easier is not necessarily better.

As environmental concerns over the use of fossil fuels grow and building traditional utility facilities in an increasingly crowded nation becomes more difficult, we must turn to a new approach. Roof top solar, distributed generation and even small technology steps like gas-fired air conditioning have entered the realm of technology and economic feasibility. However, institutional barriers will limit their development and deployment. Only wealthy or very socially conscious homeowners are going to deploy roof top solar photovoltaic systems at a marginal cost of $20,000 to $30,000 for a system. Utilities or generators build gas-fired and coal-fired generation and the costs are financed and blended into average rates masking the real marginal, social and environmental costs of that option.

I believe solar has some of the greatest potential. Ideas such as those being considered in California to mandate solar or solar for new construction represent interesting public policy options. As a life-time Libertarian I used to argue that such government intervention was poor public policy and unnecessary. However, it is necessary to overcome the built-in distortions and poor economic signals in the 20th Century utility model. The best solution is to develop a new 21st Century model.

The real long-term tragedies of the failed California Experiment are two-fold. First, we have yet to fully understand how public policy could have failed so badly. Understanding this is critical because it was a classic example of special interests being met and the collective public interest being lost. I am concerned that this is becoming all too typical of both state and federal public policy making today. This is not just about electric deregulation. It is about how our nation and state are governed and how public policy and laws are made. Second, we must not fall back on the 20th Century utility model because we perceive it to be safe. This will effectively end progress and innovation in the utility sector. For our nation to thrive our critical social and physical infrastructures must grow, innovate and adapt.

Today, I see a reversion to the 20th Century model because it is perceived to be safer and easier. It is easier, but it is not better and it is certainly not safer. Today, I don’t see many utilities and regulators seeking sustainable or breakthrough transformation. Instead, I see examples of unsustainable and artificial transformation based cutting budgets to generate short-term earnings, outsourcing and off shoring jobs with questionable public and private economic costs. I see state and federal regulators fighting over jurisdiction. These actions are not going to move the nation’s critical electricity infrastructure forward and have the potential to create serious long-term consequences.

Utilities must step up, articulate and implement a sustainable and truly transforming vision. Public policy makers and regulators must also step up and accept the challenge. State commissions must work with FERC rather than making this debate sound like one of states rights vs. federalism. A process that protects the public interest rather than a collection of special interests is also necessary. Falling back on the 20th Century model is easier for utilities and regulators, but it will not serve our nation and its citizens well.