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Most people don’t think about economic theory and the laws of supply and demand every time they flip on a light switch or start up a car. Severin Borenstein ’78 thinks they should. A professor at Cal’s Haas School of Business and director of the Energy Institute, a UC systemwide research unit, Borenstein has spent much of his career pondering the economics of energy. One of his conclusions is that, for as much as people grumble about their electric bills or prices at the pump, they rarely understand what controls the cost of these commodities. That’s a particular shame in California, where political decisions—for example, the passage of environmental laws—have resulted in Californians paying much higher prices for gasoline and electricity than their neighbors in other states. Borenstein came by his specialty in a roundabout way. A native of Berkeley and Oakland, he attended Carleton College in Minnesota for two years before deciding he “didn’t want to go to a school that was 40 miles from anywhere—anywhere being Minneapolis.” He dropped out and bummed around the construction trades for a year before returning to Berkeley and finishing his economics degree at Cal. Before graduate school, Borenstein worked for the Civil Aeronautics Board when it was in the throes of deregulating the airline industry, one of the first major industries to be deregulated in the U.S. It was, he says, “a unique Washington experience, in that the economists ran the show. There was surprisingly little politics, and surprisingly little legal dithering. We would sit around and try to figure out what rules the airlines needed as they deregulated, and there was no discussion of what could pass Congress or which senator would be upset or whether the White House would approve.” He wrote his dissertation at MIT on price discrimination, the phenomenon of businesses charging different people different prices for the same commodity, in this case airline tickets. He soon noticed the same phenomenon occurring in the gasoline market, where retailers would put a higher markup on unleaded gas than leaded gas. “It made economic sense to the gas stations, since people whose cars burned unleaded gas necessarily owned newer cars, tended to be wealthier, and were less willing to shop around,” says Borenstein. From there he became interested in other aspects of energy pricing and regulation, and in 1994, while teaching at UC Davis, he was appointed director of the Energy Institute. It was an auspicious time to hold the post, because that year California began deregulating its electricity industry, preparing to reduce the Public Utilities Commission’s regulatory control over the electric companies and open up a free market for power in the state. Borenstein was called to testify before the State Senate’s committee on deregulation. “It was a baptism by fire,” he says with a laugh. “I was thrown into the middle of it, learning as I went. And there was a lot to learn. Electricity had been regulated for so long that people hadn’t thought very much about how it would work when you deregulated it.” So far, Borenstein says, it’s not working all that well. Similar to the breakup of Ma Bell when the telephone industry was deregulated, electricity deregulation gave consumers their choice of electric companies and was supposed to lower rates through competition. But rates remain high, few residential consumers have switched electric companies, and the market still requires some government intervention. Borenstein says electricity is “a difficult industry to run in a non-centralized fashion. It takes an unusual amount of attention to make sure supply and demand balance.” Since coming to Cal in 1996, Borenstein has thought a lot about the uniqueness of energy as a commodity, and why consumers in this state pay more for it than in many states. Other economists—and politicians—are also interested in Borenstein’s research, since other states may soon follow California’s example in deregulating electricity and mandating cleaner-burning gasoline. For everyone who has ever wondered, Why is gas pushing $2 a gallon? Why is my electric bill so high?, we spoke with Severin Borenstein in his office at Haas. What do you mean, “gotten its act together”? Well, for years they tried to collude to reduce output and raise prices, but some of the members of OPEC have consistently cheated on the collusive agreement. At the beginning of 1999, prices plummeted to about $11 a barrel, which scared a lot of the governments in OPEC into being more cooperative and sticking to the agreements. Also, Norway and Mexico have gone along and reduced their output to raise world oil prices, which are now at about $30 a barrel. And has the recent increase in gas prices tracked that increase in crude oil prices exactly? No. Another factor is that California burns a different fuel than the rest of the country does. It’s a cleaner fuel, and unfortunately it can only be produced by 16 refineries in the world. So we have a very tight supply in California. Is that why gasoline prices are so much higher in California? Well, our prices should be 5 to 10 cents a gallon higher than the rest of the country because this CARB gas—it’s called CARB because the California Air Resources Board put together the formulation—is more expensive. But, the last statistic I saw, they had spiked to about 30 cents higher than the rest of the country. And last summer, they got as much as 55 cents higher. Do you think that’s evidence of price-gouging? There are certainly people who are taking advantage of the situation. The analogy I use is that when there’s a freeze in Florida, orange growers in California make a lot of money. They’re not “gouging”—the price of oranges has gone up, because there are fewer oranges relative to demand. But if there were only a few orange growers in California, and any one of them individually had the ability to yank the price even higher by pulling a little more supply off the market, that would bother us. That’s probably the case with gas; we start off with a naturally very tight supply, but on top of that, because we have isolated our market from the rest of the country, a few producers have a great deal of influence over the wholesale price, and can make these shortages pinch even more than they should. A few producers control the market at the retail level, too. Yes, the independent retailers, the Rotten Robbies, the Beacons, the Coasts, have been declining in numbers. That’s quite closely related to the tight supply at the wholesale level. If you are a Rotten Robbie, you shop around when you buy gas, because you don’t have to buy only Shell or Chevron brand gas. And when there’s enough product in the market, that’s fine. But when there’s not, the brands serve their own outlets first. And this is exactly what we saw in the first few years of the CARB fuel. When there were shortages, the independents’ prices spiked first and highest, because they couldn’t get gasoline. What’s happening now is that independents have “branded up”—they have become Chevrons or Shells. Unfortunately, the independent stations are the ones that put downward pressure on prices. When they disappear, that pressure disappears. The hope, the shining hope on the horizon, is the number of discount chains that are getting into the gas business. Costco is going to sell gasoline. And Costco is so big it could deal directly with a refinery and bring in a whole tanker. So that might present some relief to the loss of competition. What other solutions could relieve the price increase? Some legislators are floating the idea of repealing the gas tax. Repealing the gas tax is a very bad idea. Why? Because they’re talking about repealing it temporarily, during a time of shortage. But the problem is, during the time of shortage, the gas tax is not what’s determining the price. So, if you repeal the gas tax, it’s quite possible the price won’t fall, or won’t fall by very much. The revenue will simply be transferred from government coffers to oil company coffers. What about increasing domestic production? Or having a strategic gas reserve to draw on during shortages? Well, domestic production has been extremely constrained by environmental regulations, and I think most people are not willing to loosen those up. Offshore oil drilling is about as controversial as you can get in California. And as for a strategic gasoline reserve, gasoline is not very storable. Unlike crude oil, gasoline actually goes “off spec”—it changes so that it doesn’t meet specification in the course of a month or two. No, the issue is to get more supply. And how do you do that? The short-run solution, at least the one I’ve been pushing, is to allow gasoline that doesn’t meet the CARB standard, but does meet the federal reformulation standard, into California. Dirty gas? Slightly less clean gas. Here’s how it would work: When we’re in a situation where the price in California is 50 cents above the price on the Gulf Coast, we’d allow some federally reformulated gasoline in and put a 15-cent surcharge on it. It would still be profitable to ship it here, and we’d use the 15-cent surcharge to offset the pollution effects, by buying back old polluting cars. The real scandal is that we still permit cars from the ’60s and ’70s to drive around that are just massive polluters, that produce ten times as much pollution as newer cars and don’t have to pass smog tests. But there is a buyback program. There’s a pitiful buyback program that’s extremely badly designed. That program, as it works now, says, “Bring us your car. If you can nurse it in the door, we’ll pay you for it.” But the right way to do the buyback program is to actually go to the want ads and buy cars that are being put on the market. Those are cars that people actually think can survive a test drive. The current buyback program is buying back cars that aren’t being driven. We’ve started doing the calculations on what you could buy back with the temporary gasoline surcharge, and it’s clear you could buy cars that would more than offset the additional pollution. That’s your short-term solution. What about the long run? In the long run, people would build more refineries to produce CARB gasoline. Now, existing refineries are extremely expensive to retrofit to produce CARB—it’s in the hundreds of millions of dollars—and it’s extremely difficult to build new refineries in the state. The environmental restrictions, the NIMBY problems, are really severe. But the federal government is gradually pushing its standard towards California’s, which makes it easier for refiners to go the extra step to make California gasoline. The new standard that will be in effect in 2002 will be very close to California’s. Why aren’t we hearing more about conservation? In the ’70s, during the oil crisis, Detroit started making fuel-efficient cars. Now we have SUVs roaming the roads. The government isn’t forcing a response, as it did in the ’70s by passing fuel-efficiency standards. What people really wanted, even then, were cars that had good “range,” meaning, how far you can go between fill-ups. Not because gas prices were high, but because they didn’t want to sit in gas lines. Well, since the deregulation of the retail price of gasoline, we really don’t have gas lines any more. I think people turn out to be not all that sensitive to the price of gasoline, as opposed to spending an hour sitting in line. So the demand for SUVs has basically not changed, despite higher prices. Another thing we should remember is that we have very cheap gas. In fact, oil prices are now substantially below the level they were at during the first half of the 1980s, adjusted for inflation. Why is gas cheaper in the U.S. than in most other countries, if crude oil prices are the same worldwide? We charge lower taxes. The price of gasoline in Japan is in the $5 range because their taxes are in the $3 range. In Europe and Asia, there is a conscious decision to charge higher taxes to discourage private vehicle use. They have much better public transit systems than we do, generally, and people use them more intensively than we do. They also have more fuel-efficient cars. To what extent is U.S. foreign policy concerned with keeping oil prices low? Do I think we would have gone in to defend Kuwait if there were no oil there? No. The threat to Kuwait was clearly serious, and in violation of all sorts of international laws—just like we see in lots of places in Africa, where the U.S. shows no interest at all. I think it’s quite clear that U.S. foreign policy is heavily driven by oil. I don’t think we’re willing to go to war to prevent $30-a-barrel oil. But when it looks like there’s a threat that somebody who’s unfriendly to the U.S. could control a large portion of the world’s oil resources, and potentially give us $100-a-barrel oil, we are willing to go to war. I don’t think it should surprise anyone that we go to war over economic issues. We’ve done it throughout the history of the U.S., going back to the Boston Tea Party. Let’s turn now to electricity prices. Deregulating the electricity industry is supposed to bring down rates— No, it’s not. Electricity prices are not going to plummet because of deregulation. The main reason California has extremely high electricity prices compared to the rest of the country is that we made a number of bad investments that we’re still paying for, even after deregulation. Under regulation, we built the Diablo Canyon and San Onofre nuclear power plants and we signed contracts to buy energy at extremely high prices—unbelievably high prices—with some generators, including renewable energy generators. Now, the nuclear plants are almost paid off, and those contracts are ending, so prices are going to drop. The political calculation that somebody made is: Prices are going to drop anyway, so if we deregulate now, we can claim they dropped because of deregulation. And as prices drop over the next few years, people will falsely attribute it to deregulation. So who was in favor of deregulation? Mostly the independent power companies that wanted to move into the California market. Also, large industrial users of electricity who thought they could use their market power to cut a better deal and get lower prices. That hasn’t panned out. Consumer groups would have been for it if it meant we didn’t have to pay for Diablo Canyon and those other stranded investments I just mentioned—but the politics didn’t allow that. You expressed concern about deregulation because, you said, the electricity industry is better run in a centralized system. Why? There are several reasons. One is that electricity is virtually non-storable. You can’t have a warehouse of the stuff and pull it out when you need it. You can only store it at extremely high cost and very inefficiently, as in a battery. So you have to meet demand instantaneously. In situations where demand is very high—like on a hot summer day when everyone’s running air conditioners—there’s a threat that you won’t have enough power to meet it, and the whole grid will crash and cause blackouts. In a free market, that means that one supplier can have tremendous power in moving the market. Think about a hot summer day where the grid operator has to have 95 percent of all the generators running to meet demand. If one firm owns 6 percent of all the generators, then it is what we call pivotal: you have to have some of their generators running in order to meet the load. So they are in a position to charge pretty much whatever they want for electricity. In some places after electricity deregulation, prices spiked to over $1,000 a megawatt-hour. Yes. The normal price is about $20. People didn’t fully anticipate how a few companies would be able to unilaterally manipulate prices in a free market, and are still trying to figure out if deregulation works, or can be made to work, even. Right now we have a very crude system—we have a price cap. In California the price now can’t go above $750 a megawatt-hour, which is still very high. The second obstacle to free-market power generation is that demand for electricity is what economists call inelastic—it has virtually no responsiveness to price. Airline service is another non-storable commodity, but demand is elastic; if the price goes up, people don’t have to fly. It may be inconvenient, but it’s not like the lights going out. Third is that consumers don’t actually know what the price of electricity is in real time. Until fairly recently, everybody knew that if you wait until the evening to make long-distance phone calls, it’s cheaper. Nobody thinks that way about electricity. When I lived in Davis, I ran our pool pump from noon to 4, because it never occurred to me to run it at any other time. If somebody had said, “Look, electricity is four times more expensive during the afternoon,” I would’ve done it in the evening. But people have no idea of the correspondence between their consumption of electricity and the cost; not in the way, for example, you know that if you drive your car another 25 miles it’s going to burn about a gallon of gas and cost about a dollar and a half. But when I look at my electricity bill, there’s just one rate, no matter what time of day I use power. Right now we’re in a transition period where the retail rates are frozen. Eventually, though, I think consumers are going to have real-time meters. You’ll have a meter that not only records your consumption, but sends you a signal that says, the price right now is X. And you’ll have a computer chip that reads it and says, if the price goes above Y, we turn off the air conditioner for a while. There will also be households that won’t do this; they’ll sign a long-term contract with an energy provider at a fixed rate that protects them from price spikes. The point is, the free-market interchange of supply and demand can only work if everybody knows what the price is, so that demand can shift in response to changes in price. One of the promises of deregulation was that the delivery of power—how it gets through the lines to your house—would not be interrupted. Has that proved true? Yes, but one of the big black holes of the legislation was how to finance the future construction and maintenance of transmission lines. That still has not been addressed. Virtually no transmission upgrades have occurred since the start of deregulation. Whose responsibility is it? The utilities’? No. The utilities own the lines, but the California Independent System Operator, located in Folsom, runs the grid. And they’re the ones who can identify the need for new lines. The problem is, the redistributive effects of building a transmission line are just immense. Say you have a shortage of transmission capacity from Sacramento to San Francisco, so you can’t get enough power in San Francisco. That means the generators in San Francisco are making huge amounts of money. Now, if you build a line from Sacramento to feed San Francisco, it immediately makes the guys in Sacramento much wealthier and the guys in San Francisco much poorer. So the guys in San Francisco suddenly become the leading environmentalists and oppose building more lines. Doesn’t a neutral third party, this Independent System Operator, determine where a new line should go? Yes, but somebody’s got to pay for it. The environmental stuff has to be cleared. Back in the old days, PG&E owned everything, and had the right incentive to ask, “Is it better to build a new plant in San Francisco or a new line from Sacramento?” But now those are different companies, and each is lobbying its legislator. So there’s going to be a big political battle over every improvement to the system. Until we figure out a system that can make these decisions away from all the glare of politics. That’s one of the big unknowns. What effect will deregulation have on alternative energy—nuclear, solar, wind? They were heavily subsidized before deregulation. Some of those subsidies will continue, post-deregulation. You’ll see it on your bill— X amount extra to support renewable fuels. After those are removed, it’s hard to say. With nuclear power, the prices will be high enough that it’s worth running the existing plants. But not high enough that anybody’s going to build any more nuclear plants. Renewables...who knows? None of them is particularly economic at this point. Hydro is no longer considered environmentally friendly. Biomass is not very economic. Geothermal plants are economic, but are extremely limited, and they’re also not renewable. Solar—the science just hasn’t gotten there. Twenty years ago when I started studying this stuff, solar was “just a few years away”—and it’s still just a few years away. How does the future look? Can deregulation be made to work? First of all, we’re unlikely to see true deregulation for a long time—we still have these subsidies and price caps. Right now, if you took the price caps off, and firms weren’t worried about the long-term political ramifications and the threat of re-regulation, on a hot day this summer the price would go to $10 billion a megawatt-hour. There would be absolutely nothing to stop it. But, of course, that wouldn’t happen if people could actually see the price day to day. People wouldn’t pay $500 an hour just to watch television; they’d turn the TV off. So I think people are going to get real-time meters. I hope we’re going to see new producers enter the market and build more generation facilities, but that’s been very controversial, because no one wants one in their backyard. As we see more of those, the market will be more competitive, and a few suppliers won’t be so pivotal in the market. But until those things happen, the market can only work with a pretty heavy government hand. |
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