Buy high, sell low, but only in California

By DAVID MOON, Moon Capital Management
December 2, 2001

It happened much sooner than expected, but California Governor Gray Davis has quickly proven that government can concoct a solution to any problem, even if the solution makes matters worse. In an effort to 'solve' his state's electricity crisis earlier this year, Governor Davis first threatened to take over the state's power producers. Then he decided the state should become a power distributor, borrowing billions of dollars to purchase electricity, guaranteeing affordable energy for all of its state's citizens.

How did the state do? A combination of poor decisions, horrible timing and favoritism to certain businesses resulted in California buying significantly more electricity than it needs and at peak prices. The state will have to find buyers for its excess electricity ' in some cases selling a third of its total power at losses approaching 80 percent. California may pay up to $4 billion for electricity the state does not even need.

A California Department of Water Resources report shows that the state obligated itself to long term, fixed price purchases of electricity at a time prices were at their highest. After paying $75 per megawatt-hour for power, the report suggests the state now expects to sell the power for a scant $16. The state simply did the opposite of what any good investor tries to do: it bought high and plans to sell low.

Of course, the state may justify this in the name of providing affordable electricity to its citizens; after all, they will only pay $16 per megawatt-hour. But who do you think paid the original $75 for the electricity? The same citizens the state claimed it wanted to protect. And those citizens are buying this non-renewable, non-storable resource with long-term borrowed funds. It is like buying all of your groceries at a convenience store ' the most expensive place to buy most groceries ' then putting the purchase on a credit card.

The first problem is that the state decided there was a problem. Despite the rolling blackouts of last spring, there was never a shortage of available electricity in California. But there was a shortage of electricity at prices the state's retail power suppliers were willing or able to pay. This was the result of a poorly constructed utility regulation in 1996 (incorrectly dubbed 'deregulation'), resulting in capped power prices at the retail level but market prices at the wholesale level. Without the ability to let their prices reflect their costs, the retailers found themselves in the position of not being able to pay the wholesale electricity prices. In came the state to save the day.

But in addition to buying electricity at the highest possible price and using long-term debt to do it, California allowed many large businesses to opt out of the state's program and purchase electricity direct from independent producers. The Department of Water Resources estimates the exempted businesses may reduce overall power demand from the state as much as 33 percent. As a result, California is obligated to purchase significantly more electricity than it needs.

The state's 'solution' created its own set of problems, most of which exacerbate the original condition. One of the criticisms in California is that the state went too long without building any new power plants or other electricity sources. With a guaranteed glut of government-owned electricity over the next ten years, what financial incentive is there to produce alternative sources of electricity? Typically, the free market provides a financial incentive for innovation and risk taking, but the state government has short-circuited this mechanism by artificially manipulating both wholesale and retail electricity prices. Then, by buying more electricity than it needs, it guarantees an imbalance in supply, further worsening the problem.

Isn't it interesting that the power users who most depend on a reliable source of affordable electricity ' large manufacturers and other businesses ' decided they would be better off not participating in the state's solution? Free markets and private enterprise win again.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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