What’s New With The California Wholesale Price Cap?

I haven’t focused on it much here, but the FERC had set the wholesale “soft price cap” in California to rise from $91.87 to $250 today. As this article reports, the new price cap has been delayed a month to allow officials to incorporate changes from a computer test of manipulation possibilities. Of course, this is all happening in a very politically charged environment — FERC is in the process of taking comments on its proposed standard market design, El Paso is accused of exercising market power on its natural gas pipeline at the California border, and Governor Gray Davis simultaneously wants to reverse the increase in the price cap and to force the companies who had proposed building new capacity to go ahead with those proposals, even though the wholesale price of electricity is now hovering around $30/MWH (which is quite low).

But wait, the intelligent reader says, how can Davis simultaneously argue for maintenance of a low price cap and forcing companies to invest in California to increase supply? Precisely. When it looked like electricity prices would be sustainably high, investors were certainly more willing to propose new generation for California than they are at $30/MWH. Now, though, even the $91.87 price cap has not been binding except for a very few instances, and, guess what? Investors don’t see much potential for returns from putting new generation capacity in for California. Add to that the regulatory uncertainty of the future of the wholesale market in California, and is it any surprise that investors are wearing a clear path to the border, or staying away?

Thankfully, FERC Chairman Pat Wood gets it. According to the article cited above,

While the state’s governor, Gray Davis, has criticized the lifting of the California cap to a higher level as giving an opening to generators to profit unreasonably, in his view, Wood pointed out that California’s cap is below similar caps in other parts of the country, and would represent a step to encourage new supply in the state.

Here’s a simple economics lesson for Governor Davis, along the lines of Megan McArdle’s wonderful explanations of the power of simple economic ideas. Think about a typical representation of a market outcome, with a typical supply curve and a typical demand curve. The story we usually tell about equilibrium price is that the interaction of buyers and sellers communicates information about costs and preferences, and that in an equilibrium, all who are willing to pay above that price get the good, and are supplied by those whose costs are lower than that price.

But what else do we know is true at that equilibrium? Most of the consumers pay less than they were willing to, because all pay “the market price”. And, most of the suppliers earn more than their marginal cost that they had to recoup to bring the good to market. These two amounts are called consumer surplus and producer surplus. For those of you who, like me, like to shop, getting a bargain is the best way to understand consumer surplus — if you looked at a sweater and you thought you would pay up to $50 for it, but you only had to pay $29.99 because it was on sale, then you just got $20.01 in pure consumer surplus. Score! Same story, but a little less intuitive, if you are a producer — you only have to receive your marginal cost to be willing to sell something, but at an equilibrium like I’ve described, you get paid more than that for what we call the inframarginal units (the ones sold up to but not including the last one). Score!

OK, now the tricky question, especially for Governor Davis. Is producer surplus price gouging? In the simple scenario I’ve constructed, absolutely not. That producer surplus is going to repay the producers for the fixed costs they’ve had to incur to bring their stuff to market — buying computers, building factories, building generation capacity, whatever. And you know what? If not enough stuff is being produced to satisfy consumer demand, scarcity becomes more binding and equilibrium prices rise.

This scenario also applies to electricity, but it’s a little more complicated because of the very high fixed costs in the industry. Building generation capacity is not cheap and not quick. So that producer surplus sends a very important signal, a very important set of information, to producers and potential producers about what kind of investment needs there are to satisfy demand in this industry. That’s one reason why another term you’ll hear applied to this idea is scarcity rents, and that as scarcity becomes more binding, existing producers earn more money from it and potential producers see profit opportunities in alleviating it, which they would do by investing and entering the market.

This idea of producer surplus raises another really, really important point that frequently gets overlooked in the policy debates and media discussion: the simple scenario I described above is about static efficiency, a snapshot-in-time one-shot idea. But what determines growth, productivity, and incentives for things like technological change is dynamic efficiency, which requires us to look across time.

Punch line: producer surplus promotes dynamic efficiency by enabling producers to earn the means to pay for their investments. If there’s scarcity relative to demand, producer surplus will include some scarcity rents, which signal to opportunistic investors that they should look here to profit from alleviating that scarcity in the future.

And price caps cut those incentives out at the knees. So Governor Davis cannot have it both ways, at least not without compulsion and coercion. And last time I checked, you cannot force actors in a free and open society to invest within the bounds of your geopolitical universe.