June 4, 2001

The Outlook

The Outlook

Alfred Kahn, a Cornell University economics professor, is seen by many in his field as the father of cheap airfares. As chairman of the Civil Aeronautics Board under President Carter during the 1970s, Mr. Kahn led the nation's drive to deregulate the airline industry.

By allowing airlines to set their own prices and pick their own routes, practices previously regulated by the government, competition among airlines drove ticket prices lower on many popular routes. By some accounts, deregulation has saved travelers about $19 billion a year. Letting the market dictate prices "is the best way of bringing customers low prices and improved service," Mr. Kahn says.

Yet when it comes to allowing the market to set prices for California's wholesale electricity, Mr. Kahn is singing a different tune. "The circumstances in electricity are unusual," he says.

Mr. Kahn was one of 10 economists who stepped into the middle of a battle last week between President Bush and California Gov. Gray Davis about the state's energy crisis. Mr. Davis, and the economists like Mr. Kahn who support him, want the federal government to impose caps on wholesale electricity prices in California. California's total electricity bill jumped to more than $27 billion for 2000 from $7.4 billion for 1999, and state officials expect it to reach $50 billion or more this year. The soaring costs have led to a budget crisis for the nation's largest state economy and have prompted the utility unit of PG&E Corp. to file for bankruptcy-court protection. By capping the wholesale price of electricity, Mr. Davis says he can stave off further damage to the California economy.

Mr. Bush, however, says such caps will only make the state's energy problems worse. "Price caps do nothing to reduce demand, and they do nothing to increase supply," Mr. Bush said last week. If anything, say economists who are opposed to price caps, controls will lead to worse shortages. The logic for this is simple: If power companies can't earn a decent return on their investment, they'll redirect their production and cut back future investments, exacerbating the very problem price controls are supposed to fix.

Indeed, government efforts to cap prices have a long history of failure. As early as 301 A.D., Roman Emperor Diocletian imposed economywide price controls. The move led to mass shortages and he ended up abdicating four years later.

A more recent -- and far more vivid -- example of how price controls can backfire occurred during the 1970s when the federal government limited the price that oil companies could charge for gasoline and dictated where it could be distributed. Unable to sell their wares at market-clearing prices, oil companies ended up rationing supplies. Motorists had to wait for hours in long lines at gasoline stations just to buy a few gallons of fuel.

"Price controls are in and of themselves very, very bad," Glenn Hubbard, chairman of President Bush's Council of Economic Advisers, says. "It is in every freshman textbook on economics."

But Mr. Kahn and other pro-control economists say California's problems are unique. In a normally functioning competitive market, price shocks have an immediate impact on supply and demand. Producers respond to higher prices by boosting supply immediately, and consumers respond by cutting back purchases.

But that is not happening in California's wholesale electricity market for several reasons. First, it takes nearly two years for new power plants to come on line, so energy supplies remain constrained. Meanwhile, consumers aren't cutting back their electricity use, because their rates are capped. That has led to a price squeeze and shortages.

Pro-control economists say the small group of power producers who run the plants that supply California with energy are exacerbating the problem by deliberately holding power off the market, forcing prices -- and their profits -- even higher. "They're exercising unilateral market power," says Frank Wolak, a professor at Stanford University. (The power producers dispute this argument. They say they have taken power off the market only when they have had to service old plants that are being overworked.)

Temporary price caps, Mr. Kahn and other pro-cap economists say, would soften the increasing burden on California's state coffers until new power plants come online, easing the supply crunch. The state already has spent $7.7 billion to acquire energy for distressed utilities. To help cover the costs, it is planning to issue a $13.4 billion bond, which taxpayers will have to pay back eventually in the form of high electricity prices.

These economists add that they can avoid the pitfalls of the past by setting price caps at a level that still allows energy producers to earn a strong return on their investments. Several producers say such a move will constrain their investments going forward.

The idea sits well with at least one power producer. Calpine Corp. is planning to invest about $6 billion in new capacity during the next four years, including three new plants that will be up and running this summer. "I don't see anything right now that would dissuade us," Calpine Chairman Peter Cartwright says.

-- Jon E. Hilsenrath

Write to Jon E. Hilsenrath at jon.hilsenrath@wsj.com²

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