Friday, December 30, 2011

The Quest

Writing in The Quest, Pulitzer Prize-winning author Daniel Yergin (The Prize, The Commanding Heights) describes the circus on Capitol Hill in response to surging gas prices in 2008:
At one hearing, [Rep. Steve Cohen, D-TN] bluntly told oil company executives, "You are gouging the American public and it needs to stop." Another announced the industry should be nationalized outright. 
At a hearing on the other side of Capitol Hill, a senator asked the empanelled oil company executives, "Does it trouble any of you when you see what you are doing to us?" One executive tried to frame a reply: "I feel very proud of the fact that we are investing all of our earnings. We invest in future supplies for the world, so I am proud of that." 
"You," snapped [Sen. Dianne Feinstein, D-CA], "have no ethical compass about the price of gasoline."
Let's first remember what is entailed in the production of gasoline. At its easiest, oil is pumped from a well in Texas (at its most difficult, from deep underneath the ocean floor in the seas near a foreign country after huge sums of money are first spent finding it), refined into gasoline, and then transported to a retail outlet for sale. That this is done for, at worst, roughly the price of milk is best understood as a minor miracle. Thus, the criticisms leveled by our elected officials at those who produce this essential ingredient for the country's economy reveal one of two things:
  • Congressmen are simply ignorant about the economics of the oil industry.
  • Congressmen have a grasp of the oil industry, but are cynically playing to the ignorance and misplaced ire of voters.
Niether is reassuring, and both are further reasons to limit the power wielded by a system as nonsensical as government. In a sense, however, this is government at its most benign -- just mindless grandstanding for the peanut gallery. But now let's examine a case of government at its worst.

Yergin notes that in the 1990s California attempted to deregulate its power generation sector in order to lower energy costs and boost the state's economy. As is common in the legislative process, the deregulation bill was complicated and suboptimal -- best understood as a compromise designed to placate various constituencies. Indeed, Yergin writes:
The restructuring was an extraordinary edifice in terms of political support. The entire California congressional delegation signed a letter urging the Federal Energy Regulatory Commission not to use federal authority to interfere with the plan. The political forces were so finely balanced that any alternation could cause the whole edifice to come tumbling down.
In a nutshell, this is how the bill worked:
Wholesale markets were deregulated -- along with the markets in which the generators that operate the power plants that sold power to utilities that distributed it to consumers. Prices in those markets would be free to fluctuate, in response to supply and demand. But the traditional retail markets -- those between the utilities and their customers (home owners, factories, offices, and others) -- were not deregulated. This meant that these consumers were to be protected -- insulated -- from rising prices. They, after all, were the ones who cast votes for governors and state legislators. (emphasis mine)
Bizarrely, the legislation also specifically prohibited utilities from signing long-term contracts with power generating companies for electricity supplies, placing them at the mercy of sudden price fluctuations. 

The system worked well as long as prices in the wholesale market remained low, preventing any disparity between the costs borne by producers and what was charged to consumers. But in 2000 the situation shifted, as a drought in the Pacific Northwest and Canada reduced the availability of hydro power, natural gas prices increased, California's economy (and thus, electricity demand) boomed and temperatures that summer spiked. 

Yergin describes what came next:
By the beginning of 2001, the state was in the grip of a full-blown electricity crisis. It was now evident to everyone that the market was broken. As the crisis unfolded, delegations from as far away as Belgium and Beijing journeyed to America's largest state to learn what had gone wrong. And plenty was going wrong. Utilities were accumulating tens of billions of dollars of losses. 
Governor Gray Davis announced that the state was living through an "energy nightmare," produced by "price gouging" by "out-of-state profiteers" who were holding California hostage. He earnestly appealed to Californians to save electric power by putting their computers "on sleep mode" when not in use. He also threatened that the state would seize ownership of generating plants and go into the business of building power plants itself. The merchant generators, he declared, "have brought the state to the very brink of blackouts." 
...One obvious answer would have been to permit price signals to work and allow at least some moderate increase in the retail rates paid by homeowners. Davis himself recognized that reality. "Believe me," he said at one point, "If I wanted to raise rates, I could solve this problem in 20 minutes." But he was adamant. He would not do that. 
Instead he blamed everyone else, ranging from the utilities to the federal government. But, by far, his greatest wrath was reserved for companies headquartered out of state, particularly those in Texas, that had bought many of the generating plants and that were trading power. They were, he said, "pirate generators" out for "plunder." 
This was not an environment conducive to collaboration and solutions. The crisis worsened. Spot prices for electricity were, on average, ten times what they had been a year earlier. State regulators began to ration power physically, which meant rolling blackouts. Meanwhile, as wholesale power prices went up, the financial position of the states' utilities became even more dire. 
Because of that iron curtain between the deregulated wholesale market and the regulated retail side utilities were buying wholesale power for as much as $600 per kilowatt hour but were able to sell it to retail customers at a regulated rate of only about $60 per kilowatt hour. As one analyst put it, "The more electricity they sold, the more money they lost." 
The state was in an uproar; its economy, disrupted. In April 2001, after listening to Governor Davis threaten the utilities with expropriation, the management of PG&E, the state's largest utility, serving Northern California, decided that it had no choice but to file for bankruptcy protection. San Diego Gas & Electric teetered on the edge of bankruptcy. 
...But Governor Davis was still dead set against the one thing that wold have immediately ameliorated the situation -- letting retail prices rise. Instead he had the state step in and negotiate, of all things, long-term contracts, as far out as twenty years. 
Here the state demonstrated a stunning lack of commercial acumen -- buying at the top of the market, committing $40 billion for electricity that would probably only be worth $20 billion in the years to come. With this the state transferred the financial crisis of the utilities to its own books, transforming California's projected budget surplus of $8 billion into a mutibillion-dollar state deficit. 
Many joined Davis in fingering the power marketers and merchant generators and the perpetrators of the crisis. They were charged with engaging in various trading and bidding strategies that took advantage of the crisis and with taking plants off-line to push up prices. But a Federal Energy Regulatory Commission review concluded that it "did not discover any evidence suggesting that" merchant generators were scheduling maintenance or incurring outages in an effort to influence prices.  
Rather the companies appeared to have taken whatever steps were necessary to bring the generating facilities back on line as soon as possible. Moreover, it turned out that publicly owned municipal power companies, led by the Los Angeles Department of Water and Power, were among the selling the highest-priced electrical power.
Let's review how this played out:
  • The deregulation bill was passed based not on what was optimal or best for California as a whole, but what was politically feasible and would appeal to the various interest groups involved. 
  • Consumers were insulated from higher prices, as price spikes -- despite being necessary to promote conservation and reduced energy usage -- could prove costly to legislators at the ballot box. 
  • Governor Davis, despite realizing that price spikes could solve the problem in quick fashion, opted to instead demagogue the issue and blame shadowy, unseen forces from outside the state while also appealing to the patriotism of citizens (placing computers on sleep mode) instead of their self-interest (higher electricity prices). This is only a difference in degree, not kind, from the likes of Hugo Chavez and other dictators blaming the United States and other foreign sources for the various ills that plague their countries while also making patriotic exhortations (e.g. "Let us only eat two meals a day!" as in North Korea). 
  • Davis ultimately decided to socialize the costs of the entire mess through government borrowing. While utterly craven, it's sensible from a political perspective as the costs of such a move are dispersed and uncertain -- borne mainly by those in the highest income tax brackets -- while allowing prices to rise would be transparent and obvious, impacting almost everyone.
  • While Davis was ultimately thrown out of office, he was then replaced by a political neophyte whose chief appeal to voters was star power and whose candidacy was spontaneously launched on a late night talk show. 
Such is government and the political process. Why on earth would we want this absurd system to govern any more of our lives than is absolutely necessary? To advocate for greater power to be handed to government, particularly at the expense of the far more efficient and sensible system of capitalism, is best understood as more theo/ideological than driven by anything in the way of evidence or pragmatism.

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