Which State Is Next?

By Daniel Eisenberg

Can it happen to us? As traffic lights and elevators went dead across Northern California last week, millions of Americans were all asking themselves that question, getting nostalgic for that trusty old utility monopoly. Maybe, it suddenly seemed to many shocked onlookers, electricity deregulation wasn't such a great idea after all. Even the most committed capitalists had to be having second thoughts about the merits of the free market for power--while praying that their own state wouldn't soon be plagued by blackouts, near bankrupt utilities and bulging electricity bills.

The short answer is, yes, you are probably in line for deregulation. Nearly half the states, from New York, Pennsylvania and Virginia to Texas, Arizona and Oregon, are in various stages of deregulating their part of the nation's vast, $218 billion electricity system.

That doesn't mean they are going to duplicate California's calamity. But the promised benefits of deregulation have for the most part remained just that. New York City is facing an electricity shortage this summer. In the Northwest, Oregon and Washington, which typically import power from California in the winter, have recently been sending juice south and find themselves exposed to a cruel market driven up by their neighbor's woes. "Retail utilities may lack the financial resources to purchase needed supplies or build the generation we all agree is necessary," Oregon Governor John Kitzhaber wrote in a letter to outgoing Energy Secretary Bill Richardson last month.

To critics, the evidence is clear and the verdict is in: deregulation is a bad idea for something as vital as electricity. "This is not a commodity that is conducive to the market; you can't store it on the demand side," says Mark Cooper, research director at the Consumer Federation of America. "We are finally having a debate we should have had in the 1990s."

Back then it sounded so simple. Deregulation brought prices down on airline tickets and long-distance phone calls. Why not get the government out of electricity and watch prices fall? With demand booming--reserves have declined from 40% excess two decades ago to 15% today--the free market would encourage private suppliers to compete for customers, offering lower rates and more reliable service.

In practice, of course, it has been a whole lot messier. The nation's old, Balkanized transmission grid isn't built to handle so much long-distance traffic. And freshly liberated markets won't necessarily attract new suppliers because the cost of entry--a multibillion-dollar power plant--is high. So real competition is, by and large, harder to find. "If deregulation is a good idea, and it still may be, it needs to be implemented when you have the infrastructure in place," says James Bernstein, commerce commissioner of Minnesota, which still has a regulated electricity system and may have a power shortfall by 2006.

The unusually harsh winter has also served notice that a commodity influenced by weather has plenty of surprises in store for purchasers. Most newer power plants are fueled by natural gas, the price of which goes up as the temperature goes down. In a regulated environment, consumers are more insulated from these free-market insults.

A handful of states, such as West Virginia, Oklahoma, Arkansas, Nevada and New Mexico, are so spooked by the chaos on the West Coast that, at least for the moment, they are pulling the plug on deregulation. "We're going to wait for the smoke to clear," says North Carolina state senator David Hoyle, co-chairman of the legislative commission that just delayed the planned deregulation.

Not everyone, though, is giving up so easily. "In all fairness, we're only in the Henry Ford days of the car," says Ken Malloy, president of the Center for the Advancement of Energy Markets, a pro-deregulation think tank. Malloy and others argue that the California fiasco isn't an indictment of electricity deregulation in general but rather an invaluable lesson in how not to do it. "This can work, and it does work," says John Quain, chairman of the Pennsylvania public utility commission. "But it is a work in progress."

Pennsylvania, which took the leap around the same time as California, is often cited as the model of well-designed deregulation; 550,000 customers, or some 10% of the state's total, have switched to one of the many new suppliers. Competition works: Pennsylvanians have saved $3 billion on their electric bills.

The Keystone State started out with a clear advantage over California: there is more than enough electricity to go around. Like those in many other states that are taking a less radical approach to deregulation, such as Michigan and New Jersey, Pennsylvania's incumbent utilities were not required to sell the bulk of their power plants and become middlemen, vulnerable to the price spikes in the wholesale market. Even if they chose to purchase from other generators, they were allowed to lock in reasonable prices with long-term contracts instead of relying on the daily spot market. "As usual, California fired before they aimed," says Tom Hill, chief financial officer of Pennsylvania utility PECO Energy.

A thriving, mature wholesale market has been a key to Pennsylvania's success. Before completely freeing those prices, the state spent a year learning the ins and outs and ensuring there were enough players to make a truly competitive market (at last count, 200 buyers and sellers). And instead of trying to go it largely alone as California did, Pennsylvania is part of a wholly integrated, five-state trading market, including New Jersey and Maryland, that has effectively managed the high-wire balancing act of swapping power. "Electricity is like an ecological system. You can't do one thing without affecting everything else," says Phil Harris, CEO of PJM Interconnection, which manages the grid. "It has to be a regional solution."

There is one exception to that rule, and it's Texas. Alone among the states, Texas operates its own electricity grid, which makes it less vulnerable to the various bottlenecks in the national system; it imports less than 1% of its power. Like Pennsylvania, Texas didn't require utilities to sell off their plants, and it didn't outlaw long-term contracts. Says state senator Steve Wolens, who co-authored the deregulation bill: "We learned in California that you can't deregulate and keep the government's fist around the market's throat."

More important, the Lone Star State has encouraged power-plant construction. Its environmental regulations are less strict than California's, and its approval process more streamlined. Since 1995, 22 new plants have come online, and an additional 15 should be up and running in a couple of years. With that much capacity, it's no wonder state officials are guaranteeing a 6% rate cut from the get-go when retail deregulation takes effect next year.

Yet most other deregulated states have learned that prices can move in the other direction too. In Massachusetts, where consumers were promised 15% cuts, rates have skyrocketed as much as 50%. A recent report from the Union of Concerned Scientists implied that this spike might not be entirely the result of market forces. Since deregulation began, plants have been shut down for maintenance nearly 50% more often than before, which could have the effect of creating artificial shortages. The producers deny any collusion and point to stricter environmental rules as a reason for the increases.

The same atmosphere of suspicion hangs over New York. In the past year electricity bills for residents of New York City and parts of Westchester County, one of the first areas in the country to have retail rates entirely deregulated, have soared as much as 30%. Although most of that increase is due to rising cost of the gas and oil that power generators in the Northeast, it has also cast a harsh light on independent power producers and middlemen who rule the wholesale market. To reduce any chance of foul play, the New York State public service commission is considering the implementation of a temporary, $150 per megawatt-hour wholesale price cap. Producers say the cap will discourage investment, but commission chairman Maureen Helmer dismisses that as an idle threat. "The market here will always be one of the most lucrative to build--I can't just see people walking away."

She had better hope not. If there is any part of the U.S. that could suffer California's fate soon, it would be New York City, where old transmission lines have a hard time bringing in enough power to satisfy the booming economy. Just as in California, getting a power plant built anywhere near the Big Apple can be a monumental task; in the decade and a half before the state deregulated, only one new large plant went up. There are now dozens of applications in the pipeline, but New York can't wait. So in spite of some vocal community opposition, the New York Power Authority is placing 10 44-megawatt natural-gas-powered generators around the city before the summer arrives (see box).

New York's unorthodox approach is just one of many that states are taking to salvage deregulation. In Ohio, which opened up its market this year, the state is encouraging groups of customers--schools, churches or entire neighborhoods and cities--to band together in pools to negotiate better deals from the suppliers. In New Jersey, where one of the few newfangled energy providers on the scene closed shop because of high costs, officials are trying to reduce the paperwork required for a customer to leave his old utility. Some New England states require their utilities to keep a sufficient reserve on hand, so they don't get caught in a supply squeeze.

More innovative measures may be needed, though, to keep deregulation from short-circuiting. Eventually, for instance, consumers may be able to choose from a set of customized electricity packages, in much the same way we wade through all the long-distance offerings. With the help of the Internet as a real-time monitoring tool, consumers could use their dishwasher or turn on the lights at the cheapest time of the day. "Those analog meters on the side of people's homes today are archaic," says H. Eugene Lockhart, CEO of the New Power Co., a publicly traded spin-off of Enron and the largest unregulated gas and energy supplier in the U.S. "What would happen if they had free Sundays--if we gave people that kind of power?"

That is, if we have enough power to give. Although the North American Electric Reliability Council estimates the U.S. will have enough electricity to keep up with demand even if only half of the proposed plants are actually built, there's no guarantee that many will make it through the lengthy approval process. And until the government can figure out a way to channel much needed investment dollars into the nation's ailing transmission grid, there's no certainty all that power will even be able to get where it wants to go.

Environmentalists are seizing on the California crisis to trumpet alternative energy sources, from solar to wind farms, though cost remains an issue. Still, next month the largest wind farm in the world, which will generate enough electricity to power 70,000 households, will start construction along the Oregon-Washington border, and similar projects are under way in California, Texas, Minnesota and Iowa. If that sounds like a dizzying array of future options, just wait till marketers try to sell you on your own personal fuel cell. Says Erle Nye, chairman of energy giant TXU: "In the short term there will be some pain, but in the long term the consumer is served by having choices." Watching California's problems continue, however, customers are wondering if they might be better off with just one choice--to keep the lights on.

--With reporting by Cathy Booth Thomas/Dallas, Carole Buia/New York and Paul Cuadros/Raleigh

With reporting by Cathy Booth Thomas/Dallas, Carole Buia/New York and Paul Cuadros/Raleigh