Are Private Entities Solely To Blame For Making Money Off Structural Problems Created by the Government?

Paul Krugman had this sideswipe comment the other day:

This isn't the only case where news organizations consistently report as truth something that didn't happen, while failing to report what did. Another one that comes to mind is the California electricity crisis of 2001-2002. As some readers may recall, that crisis was caused by market manipulation -- and that's not a hypothesis, Enron traders were caught on tape telling plants to shut down to create artificial shortages. Yet "news analyses" published after the whole thing was revealed would often tell readers that excessive environmental regulation and Nimbyism caused the crisis, with nary a mention of the deliberate creation of shortages.

And as you'll notice, in both cases the imaginary history just happened to be one more comfortable to status quo interests.

I find it hilarious that Krugman is talking about imaginary history, since he plays the same game so often.  In fact, the disconnect between many of Krugman's current political writings and his historical economic work are often jaw-dropping.  Even the differences in Krugman's opinion on the same topic when a Republican vs. a Democrat is in the White House can be amazing.

But I wanted to address the California utility issue.  Certainly Krugman is right, as far as he goes, in that Enron made a lot of money in the California electricity crisis creating some short-term artificial shortages.  But what he leaves out of his brief comment were the structural rules the government had put in place that made Enron's actions possible.  Enron's profits in the California electricity crisis could never have been made in a free market.

I am not an expert on the whole regulatory environment in which these events occurred, but there were three key regulatory facts that need to be understood:

1.  California, due to the NIMBY and environmental concerns Krugman mentions in passing, want lots of electricity but do not want the electricity production near them.  So they have exported the production to other states, and, more importantly, California utilities did not control the production of the electricity they needed.  Thus a lot of California power, and all of its marginal demand, is satisfied by local utilities buying out of state power.  As we will see next, Krugman is really putting up a straw man here, as this is simply background, the least important of the three government factors that drove the problem.

2.  California deregulated wholesale utility prices, but not retail prices.  The point of price deregulation is that suppliers and consumers can make better decisions because the information they get via prices is not distorted by government mandates.   But price deregulation only makes sense if the ultimate consumers have prices that float with the market.  But California consumers still had fixed prices.  There were no changes to pricing signals to consumers that might cause them to conserve more when electricity was particularly short.

So, only wholesale customers saw their prices paid increase when electricity supplies ran short.  This mainly applied to large California utilities that bought power they needed from out of state.   Theoretically, when prices spiked, they could cut back their demand.  This is more awkward for them than consumers, but could be done either with pre-determined shut down priorities or rolling brown-outs.  At some point, one would assume the cost of power would be higher than the cost of service disruptions, but...

3.  California utilities were effectively required by regulation to try to serve all demand.  Right or wrong, they felt they were in a position that if power were available, they had to buy it no matter what the cost.

So step in Enron.  Seeing this mess, they found they could corner the market at a few peak demand times and sell Calfornia power for a gazillion dollars a Kw.   I would not personally have been proud to make money that way, but Enron jumped right in.

I have no problem giving Enron grief for the way they make money, but one has to ask themselves, why the hell were California utilities buying power no matter what the price, and why was it that when electricity was so dear, it was illegal to communicate this to end users via prices (as we do with any other product or commodity).  The story here is a lot more complicated than Enron.

Update: Finem Respice took a more sophisticated look at this same issue a while back in a broader post about trying to close an open system.

On the retail side, just as California was patting itself on the back for "deregulating" in 1996 (via a bill that Pete Wilson created with complexities and exceptions for e.g., San Diego that make the special interest game in Washington look tame by comparison), it froze, just after reducing, retail electricity rates for five years. Add to this the fact that California had long depended on supplies from, e.g., the Northwest, which, for years, enjoyed a hydroelectric power generation surplus. As the surplus vanished with droughts and increased demand in the Pacific Northwest, so did the supply buffer California was so used to, and that it leaned on most heavily over the years to avoid building new generating capacity (new capacity being the bane of the progressively green environmental utopian-paradise that was (is) California energy politics). All this conspired to spike rates. Who is surprised?

It is somewhat unfortunate that Enron's shrewd manipulation of California's badly flawed and outright schizophrenic market scheme was so flagrant, and that unrelated accounting scandals at the company permitted the story to become one of deregulation evils and free market greed rather than the core issue: the political spinelessness exhibited by California officials and their ongoing attempt to insulate voters from anything resembling market prices for electricity


  1. Chris:

    James Taranto from the WSJ enjoys pointing out that Krugman was a former Enron advisor...

  2. NL_:

    Big arbitrage opportunity there. California doesn't have enough power, so take some non-CA power and sell it to CA, pocketing the differential between the two prices. It sounds like California specifically controlled prices for CA power but not out of state power, so one of the scams being run by energy providers was making it look like power came from out of state. California should've seen the arbitrage temptation.

    This is equivalent to blaming cigarette smugglers for the black market in cigarettes. There's plenty of money to be made driving cigarettes from Kentucky (or wherever) to New York because the normal pricing system is not allowed to work, so smart people jump to exploit stupid rules. Massive arbitrage opportunity.

    What happened in CA did isn't all that different from what Soros did to the UK pound. Soros exploited the ERM, a political construct that was economically incoherent. He grabbed an enormous arbitrage opportunity and managed to bring out enormous profits at the expense of stupid British politicians.

    It doesn't make sense that Enron and other energy companies could simply reduce supply and then reap amazing profits. Obviously this could only happen if something is restricting other parties from selling power to California, though I'm not familiar enough with the facts to know what it was.

    If reducing supply works this way as a general rule, and not just under bizarre (usually state-imposed) conditions, then why doesn't every company only make a single unit of every product it sells but then sell it for a bajillion dollars? Because even though I need some products like food and water to live, I can find them for sale from lots of alternatives. California must not have had enough alternate supply.

  3. Ted Rado:

    As I recall, the CA utilities were denied the right to increase prices as their cost of imported electricity went up. I believe some went bankrupt. Isn't it clever of the pols to insist that a product be sold at less than cost? What brilliant economics!!

    The evidence just continues to mount. EVERYTHING governments touch turns to POOPOO.

    For more than two centuries, American free entrprise provided the freeest society and highest standard of living in human history. Now the IDIOTS in government want to play economic tsar and show how smart they are. This will lead to catastrophe.

    Yes, there have been abuses in the past, but that is unavoidable where people are involved. To screw everything up and regulate every little activity in an effort to prevent such things leads to a much worse situation.

    We will always have scam artists and crooks, but the free market has a way of shaking them out. Honest, well-run companies always prosper and provide the best products at the lowest prices.

    There needs to be a government for collective efforts such as roads, the military, etc. Everything that can possibly be done by competitive free enterprise should be left alone by the government. Any good the USG thinks they are doing by their interference is eclipsed by their f---ups.

  4. Another guy named Dan:

    Electricity is a manufactured product. There is nowhere on earth you can take a shovel and fill up a box with it, period. The one distinguishing fator between electricity and shoes and ships and sealing wax is that it has a shelf life that is measured in milliseconds.

    There's is simply no way to economically store electricity today and then sell it tomorrow.This means that the market for electricity must be balanced virtually instnataneously, as each bit that is generated must be purchased and consumed in that extrememly brief time. There is no way to arbitrage in time, though the interconnected grid allows utilities to arbitrage in space to a certain degree.

    Normally in a commodities trade it is the buyer that determines the ultimate price, while the seller determines if the trade will take place. The perverse incentives in the California "Deregulation" law meant that by restiricting supply, the sellers could set the price on trades. The price that they chose was limited only by whichever utility blinked first in a reverse auction.

  5. Mark:

    The Nimbyism did play a huge rule PG&E warned that issues would happen back in 1998. They noted that utilities like to keep a 15% average reserve power from the peak usage, and CA had fallen to 5%. They also noted to keep 5% a lot of plants which needed overhauling were being kept operating well beyond their maintenance schedules. Towards that summer because of repairs our reserve got to be about 1% and then there was a particularly hot summer. With a 1% reserve Enron could manipulate and cause rates to rise. If CA had 15% reserves, and Enron tried that stunt, the Ca utilities could tell them to stuff it.

  6. Xmas:

    There are a couple of other kinks in this story:

    1) The California "de"regulation disallowed long-term contracts. All the utilities, except for the Los Angeles Water and Power, had to by their power on the spot market.

    2) The laws that defined the deregulation process and the electricity spot market were written by outside consultants.

    3) (Some or All? of) Those outside consultants were from Enron.

    So, Enron gamed the rules that Enron wrote. Though, the legislators were complete idiots for passing such a complicated bit of legislation without fully understanding the monster of a system they were about to create.

  7. Xmas:

    The finem respice article was awesome, btw.

  8. ep:

    Thanks, Xmas. And thanks Coyote for the link-love.


  9. Michael Hall:

    There wete 8 or 10 California power plants that were shut down during the power crisis, 4 or 5 of which were owned by Enron through a subsidiary. Information on the "fraud" that was pulled on the people of Cal. was compiled by a formere Cal. public utility administrator; this information was presented to VP Dick Cheny.

  10. Piper:

    A critical point so subtle that it still escapes most people: the effect of the "uniform auction" scheme implemented in California. CA decreed that all electricity would be purchased on the spot market by auction. (Of course that was insane, no rational utility business would act that way.) Suppliers placed bids offering specified amounts of power (MW) during a (short) period for a specified price ($/MWHr). The bids were accepted from lowest to highest until the projected demand was filled, then all generators received the price paid to the last, highest bidder whose bid was accepted. The idea was that generators should never face seller's remorse, lest that prompt some to strategically hold back their bids.

    Well, there were two things drastically wrong with this scheme. First, coupled with CA's ban on long-term supply contracts, it eliminated the formerly-customary "blend" of higher- and lower-priced generation-- under the uniform auction scheme all generators were paid as if they were high-priced, so that efficient but slow-responding "base load" plants (say, large coal-fired) were paid the same as less efficient but fast-responding peak-load plants. The spread between fixed retail prices and varying wholesale prices ("costs" to retail distribution) was no longer moderated by averaging lower and higher wholesale prices-- all generators got high prices regardless of generator characteristics.

    Second, suppliers could too easily game the auctions. Since the generators (e.g., Enron) had complete information, all they had to do was make sure the last-accepted ("marginal") bid was very high--then all bidders would get that very high price for all the power they supplied. Rigging the auction turned out to be easy because of the "chunky" quality of generation bids. There would always be some large bids from big base load plants that wouldn't quite fill projected demand, then some small bids from peak load plants which would set the final price for all generators. Suppliers would just bid the base load plants at low prices (which were irrelevant) and the peak-load plants at very high prices. It didn't matter who "won" the peak-load plant segment of the auction since all suppliers would make out like bandits on the base-load portion. Competition between suppliers to operate base-load plants was eliminated, because it was all too obvious to all suppliers than bidding more offers of base-load (often "must run") generation would just doom everyone to low prices. No supplier would operate (or in the longer run, build) so much base load capacity that the auction would fail to reach the peak load bids. As for the peak load bids, all suppliers rationally calculated (no collusion required--it may have happened, but collusion was not necessary) that they should not compete-down peak-load bid prices. Why? Because all suppliers stood to make MUCH more money getting their base-load plants paid at sky-high peak rates by the uniform auction scheme than they could ever earn by beating out a competitor for a tiny fraction of the overall demand. The whole point of peak load plants is that they're easy to stop as well as run.