The Trouble With Electricity Markets: Understanding California's Restructuring Disaster

S tarting in June 2000, California’s wholesale electricity prices increased to unprecedented levels. The June 2000 average of $143 per megawatt-hour (MWh) was more than twice as high as in any previous month since the market opened in April 1998. These high prices produced enormous proŽ ts for generating companies and Žnancial crises for the regulated utilities that were required to buy power in the wholesale markets and sell at much lower regulated prices in the retail markets. The state’s largest utility, PaciŽ c Gas & Electric, declared bankruptcy in March 2001. The state of California took over wholesale electricity purchases and spent more than $1 billion per month buying power in the spring of 2001, with average prices more than ten times higher than they had been a year earlier. Accusations of price gouging and collusion among the sellers were widespread. Some observers blamed the problems on the format of the wholesale auctions in California, while others focused on the way that transmission capacity is priced and how prices varied by location. A number of economists, myself included, did studies that concluded that sellers exercised signiŽ cant market power. While some of these issues played a role in the difŽ culties that electricity markets encountered in California and elsewhere, the policy discussion thus far has not focused on the fundamental problem with electricity markets: In nearly all electricity markets, demand is difŽ cult to forecast and is almost completely insensitive to price  uctuations, while supply faces binding constraints at peak times, and storage is prohibitively costly. Combined with the fact that unregulated prices for homogeneous goods clear at a uniform, or near-uniform, price for all sellers— regardless of their costs of production—these attributes necessarily imply that