BETTE HILEMAN

As deregulation of electric power industries proceeds in the U.S. and Western Europe, it carries a number of expectations: It will lead to greater competition and lower prices and provide the opportunity for small, distributed renewable generators to compete with the big utilities. In the long run, it should also improve the economy and the environment. But the record so far has been a little uneven.

Twenty-five U.S. states have moved to transform their electric power systems from monopolies into competitive enterprises, and, until recently, few had questioned the wisdom of this move. But something has gone terribly wrong with electricity deregulation in California. And there are growing signs that other states, although their systems are not structured the same as California's, are beginning to experience some of the same problems.

The worst problem is in California. Prices have skyrocketed. Annual power costs went from $7 billion in 1999, to $27 billion in 2000, and to $50 billion to $60 billion this year, even though demand rose only 5% per year. It appears that prices charged for power have no relationship to the cost of producing that power. Wholesale spot prices for power have fluctuated wildly, moving from $30 per MW-hour in the spring of 2000 to $1,900 per MW-hour (the equivalent of $1.90 per KW-hour) on one day last May. Since 1997, energy traders have been buying and selling electricity, a phenomenon unknown before deregulation.

As a result, there has been a massive transfer of wealth from consumers, both residential and industrial, to the large power traders, such as Enron, Dynergy, El Paso, and Reliant Energy, and to utilities such as Duke Energy. Enron, which produces very little energy on its own, trades about $2.5 billion worth of power, natural gas, and oil each day. In 2000, Enron's revenues climbed to $100 billion, more than doubling its $40 billion revenue in 1999. Dynergy's 2000 revenues rose by 90% from 1999; Reliant's, by 92%; and El Paso's, by 107%.

Some officials at the Federal Energy Regulatory Commission (FERC) suggest that generators were able to rachet up prices through various trading strategies, including the simplest: throttling back on production until prices increased. There is also evidence that power traders--using complex financial products such as derivatives--are buying power from California at low prices and selling it back when the price spikes.

FERC, which under a 1935 law is required to ensure a "just and reasonable" price for power, has until recently refused to intervene. But in June, it imposed a very weak, temporary price cap for California and other western states based on the cost of the least efficient power sold during the power emergency. FERC also set new rules prohibiting generators from withholding power from the market or trading power among corporate subsidiaries to drive up prices.

Most observers blame the difficulties in California on bad luck--a lack of rain and melting snow for hydropower, for example--and the state's peculiar hybrid deregulatory scheme that sets guaranteed prices for residential consumers during the first few years while leaving businesses to pay market prices. They also blame it on the fact that California has built only two new power plants during the past decade.

But problems with deregulation are not confined to California. New York, Illinois, Pennsylvania, and the New England states are beginning to see large increases in power bills as they deregulate. In New York City, for example, rates have risen 40% over the past two years. As a result, consumer groups are pushing to abandon deregulation, and many states are reconsidering their decisions to deregulate.

Could it be that deregulation is basically a sound idea, but that there is something fundamentally wrong with the way it is being structured and managed in the U.S.?

It looks that way if you compare it to the U.K., where electricity deregulation has so far been a success. Average British residential customers have seen their annual power bills fall since the move to competitive power began. But the U.K. power market is not totally unregulated. The government has placed an overall cap on the price of power, which by law must decline each year.

Across Western Europe, as electricity deregulation moves forward, the European Commission is constantly guarding against the possibility that market manipulation will create artificially high prices. It takes action if traders attempt to buy power from a utility when the price is low and sell it back after the price goes up.

Based on current experience, it seems that designing a well-run, competitive power system will require a rethinking of some common assumptions about the free market. Otherwise, a deregulated power market may become a monster, moving across the U.S., devouring wealth from small residential customers and large companies alike.

The U.K.'s system, though it probably could not be transferred wholesale to the U.S., appears to have elements the U.S. should emulate. All consumers--especially chemical firms that use huge amounts of power--have a stake in how the move to competition in energy markets is orchestrated. It is time to abandon the hard-line approach that Vice President Dick Cheney took when he told the New York Times he was philosophically opposed to any federal intervention in wholesale power prices, even if they threatened the national economy.

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