Date created:24 June 2002
Last modified: 24 June 2002
Maintained by: John Quiggin
John Quiggin

Time to earth electricity

Australian Financial Reviee

23 May 2002

One of the side benefits of bankruptcy as a social institution is that it brings to light documents that any solvent enterprise would keep firmly under lock and key. On a number of occasions in Australia, widespread, but dubious, business practices have been revealed as a result of bankruptcy proceedings.

The bankruptcy of the Enron corporation has brought to light evidence on the workings of electricity markets that might otherwise have taken years to collect. In particular, documents show how strategies with such picturesque titles as 'Death Star' and 'Fat Boy' were used to rig the Californian electricity market during the crisis of 2000 and 2001. Enron's traders created a spurious shortage, then relieved it, making a handsome profit in the process.

As was widely stated at the time, the California crisis was primarily due to the 'flawed' version of deregulation adopted there. Hence, it was claimed, no inferences could be drawn for Australian markets. The term 'flawed' is useful in arguments of this kind, since it is simultaneously undeniable (all human institutions are flawed) and indefinite (no particular conclusions need be drawn).

It is now clear, however, that the Californian system embodied, in an extreme form, defects which may be found in most of the electricity markets created in the last decade, including those in Australia. The biggest problem is the mismatch between a highly variable wholesale spot price and retail demand that cannot adjust rapidly. This mismatch was maximised in the Californian system which required all sales to go through the spot market, with no long-term contracts.

The volatility of the spot market creates huge risks for the retail function of buying electricity and wholesale prices and selling it on to retail consumers, and therefore creates the need for intermediaries such as Enron. Like Orwell's Ministry of Plenty, these intermediaries deal in shortages, and have incentives to create them whenever possible. Even if such manipulative behavior can be prevented, however, the risk created by the spot market system is a real social cost. It is reflected in the large equity base now being required of intermediaries. The market return on this equity investment must ultimately be reflected in the cost of electricity.

The other crucial problem in the new systems is the exclusive reliance on price signals to guide decisions to invest (or not) in new generation capacity. The designers of the Californian system sought to maximise its political appeal by locking in low prices, which discouraged new investment and contributed to the crisis. A similar excessive focus on the benefits of low prices has been evident in many of the more enthusiastic evaluations of the Australian experiment.

More fundamentally, however, the combination of noisy price signals and speculative capital markets has produced a pattern of wild fluctuations in actual and planned investments. In the wake of the Californian crisis, a single, relatively small, company, Calpine announced plans to build 70000 megawatts of generating capacity (enough to supply Australia several times over). Wall Street loved it.

A year later, following the Enron crisis, sentiments changed drastically. Calpine ran into liquidity problems and cancelled most of its plans. Calpine's main competitors have followed a similar path. Readers who have followed the telecommunications boom and bust will know the story well.

Some basic reforms are needed if electricity markets are to function adequately. Pool markets must either be scrapped, as they have been in the United Kingdom, or scaled back to the point where the volume traded in pool markets is comparable to the capacity of large electricity consumers to vary use in response to peak-load problems.

Some degree of central planning of investment must be restored. A decentralised system based solely on price signals may look good on paper. However, in electricity, as in telecommunications, it has not delivered the goods.

The consolidation that is already taking place in the industry will help in restoring coherent investment planning, though the resulting increase in monopoly power will create a need for closer regulation. There is probably a role for more planned investment in peak-load capacity, either by governments or on behalf of the quasi-independent bodies that manage the network and the market.

The final lesson of the Californian experience is that, when crucial infrastructure systems break down, governments invariably end up with the responsibility of fixing them. As the residual risk-bearers, governments should be prepared to intervene when the early signs of systemic failure become apparent, rather than waiting on the sidelines until they are called on to pick up the bill.

Professor John Quiggin is a Senior Research Fellow of the Australian Research Council, based at the Australian National University and Queensland University of Technology.

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