Economics for Today 9th Edition by Irvin Tucker

Exercise 35

WHO TURNED OUT THE LIGHTS IN CALIFORNIA?
Applicable Concept: price ceiling regulation
In order to keep electricity cheap for its state, the California legislature in 1996 set a retail ceiling price of 10 cents per kilowatt-hour. Moreover, no new power-generating plants were built during the 1990s. The plan was to require utilities to sell their power plants and import electricity as needed from the "spot market" through high-speed transmission lines from other states. In the deregulated wholesale electricity market, a spot market is one in which the price of electricity is determined by supply and demand conditions each hour.
The stage was set for the forces of supply and demand to "turn out the lights." First, demand soared during a heat wave in the summer of 2000 as consumers turned on their air conditioners. Second, there was a leftward shift in supply. High natural gas prices increased the cost of producing electricity in all states. Also, low snow-packs and a drought in the Pacific Northwest reduced the capacity of hydroelectric dams in this region.
Facing shortages from both increased demand and decreased supply, California utilities had no choice but to buy electricity on the spot market as prices soared tenfold over their normal levels. Since customer rates were capped, the price paid by consumers did not cover what the utilities were paying for electricity. The utilities quickly found themselves facing bankruptcy, and this threat caused additional spot rate increases. Duke Power Company of North Carolina, for example, stated that 8 percent of its spot price was a premium to cover the risk of selling to California utilities that might not pay their bills. A subsequent investigation by the Federal Energy Regulatory Commission (FERC) reported evidence that power companies such as Enron developed strategies to drive up prices.
Faced with this crisis, Gray Davis, who was governor of California at the time, called for more price caps. He convinced the FERC to cap wholesale prices in the West during hours of highest demand, combined with a daily regime of rolling blackouts and calls for conservation. In April 2001, Davis abandoned the 1996 price ceiling, thus sharply increasing the retail electricity price.
Draw a graph illustrating California's electricity crisis. Put the label "Price of electricity (cents per kilowatt-hour)" on the vertical axis and "Quantity of electricity (megawatts per hour)" on the horizontal axis. As explained in Chapter 4, draw the changes in demand and supply for electricity in California described above. (Hint: Begin the graph in equilibrium below the price ceiling.)