Locking in a $9-Billion Energy Mistake

Peter Navarro is an associate professor of economics and public policy at UC Irvine. E-mail: pnavarro@uci.edu

Gov. Gray Davis just made a $9-billion mistake--one likely to haunt California's economy for decades. The problem lies in his two-pronged strategy to solve the electricity crisis.

The first prong is fundamentally sound: Purchase the transmission grid to infuse cash into the near-bankrupt utilities and to regain state control over a rapacious wholesale electricity market. The second prong is fatally flawed: Use huge sums of taxpayer money to lock in long-term power contracts, details of which were announced by Davis on Monday.

Currently, California relies on the wholesale market for 40% of its needs; three-quarters of that amount are for large industrial and commercial customers. The power is very expensive--well over 25 cents per kilowatt hour. The other 60% comes from "native load." This is cheap power largely generated or controlled by utilities in California at a cost of about 5.5 cents per kwh. The governor's strategy locks in long-term wholesale power contracts that average about 8 cents per kwh--well below the current short-term wholesale market. The state would then blend the expensive wholesale power with the cheap native load, thereby keeping the average price close to the current retail price cap of about 7 cents.

Large customers like this strategy because it shields them from the extortionist prices of the current wholesale market. And the governor is probably attracted to the political safety of the blended price. But it is a misguided strategy that likely will hurt most of the large business interests in the state.

A little history lesson explains how we already know this is a fatally flawed strategy. During the 1970s energy crisis, panicky state regulators encouraged utilities to enter into long-term contracts amid unfounded fears of $100-per-barrel oil. Utilities wound up paying 15 cents for power that cost 3 cents to generate and Californians got stuck with the nation's highest electricity rates.

Large businesses wanted out of this arrangement so they could buy cheaper electricity. In response, the state Legislature deregulated electricity generation in 1996. The result: Market-manipulating wholesale generators have drained Californians of more than $12 billion amid blackouts. Faced with this free market theft, it's understandable why panicky large customers have assailed Davis, demanding that he "solve" the crisis by including them in any state-purchased power.

It's a shortsighted bargain. In reality, this crisis will last no more than three years. During this time, new centralized power plants and numerous small self-generation units will come on line while natural gas prices are forecast to fall dramatically. The result should be abundant electricity at a cost of 5 cents per kwh or less.

In light of these market conditions, it is absurd to enter into long-term 8-cent contracts. This will commit the state's ratepayers to paying almost double the future market rate for a decade. In fact, the Utility Consumers' Action Network has estimated this strategy will saddle California's industrial base with an electricity bill $9 billion higher than it should be.

There is a better way. The state should sign contracts for no more than three years. During this interim period, the state should blend the cheap native load with the expensive wholesale power just as the governor now proposes.

It should also let both small and large customers have equal access to the blended power. But, after three years, large customers who use more than 500 kilowatts are cut free. They either enter into their own contracts, self-generate, create buying co-ops or have the state use its buying clout to enter into favorable contracts. For big companies with significant heating or cooling needs, self-generation would be the most attractive option. The estimated price for new, high-tech "microturbine" power is 4.5 cents to 6.5 cents per kwh. During the three-year interim time, large customers would be nudged into energy autonomy by progressively racheting up their rates.

At the end of the interim period, the state would dedicate the cheap native load to small business and residential customers only--the remaining 70% of the state's load. This would protect residents and small businesses for years. At the same time, non-core customers would enjoy the unfettered freedom to find the cheapest way to get power.

The result: Large customers would save billions, and the state will vastly improve its competitive economic advantage. Most important, a competitive market would continue to survive in California and emerging innovative energy generation technologies would be allowed to blossom.

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