Wall Street Journal
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A Lesson From the Blackout: Free Markets Often Need Rules
Federal Agencies Attack Mistakes In Electricity, Broadband and Others

DAVID WESSEL
Staff Reporter of THE WALL STREET JOURNAL

The blackout of 2003 offers a simple but powerful lesson: Markets are a great way to organize economic activity, but they need adult supervision.

In the battles of communism vs. capitalism and rigid regulation of economic activity vs. competition, the market won. Despite persistent diatribes from the left, there is little prospect that the U.S. government is going to reinstate old regulations that once dictated how much airlines or stockbrokers could charge customers or determined which long-distance phone company could serve a particular place or shielded owners of power plants from losing business to more-efficient competitors.

Much the same is true abroad: The economic vision of the Chinese Communist Party is moving away from Marx and Mao and toward Adam Smith and Milton Friedman.

The spread of markets, however, is increasingly focusing attention on the need to make them work well -- or risk blackouts, bankruptcies and backlash. Spectacular failures, such as the blackout, put market advocates on the defensive, including market-loving Republicans who control the U.S. government. They are now turning from advocating markets to fixing them.

In electricity, Patrick Wood, the Bush appointee who serves as chairman of the Federal Energy Regulatory Commission, has been pushing a controversial plan that some utilities and politicians oppose. It would establish a "standard market design" for wholesale electricity markets, mandate regional organizations to manage transmission networks to avoid the chaos that produced the Aug. 14 blackout, and strengthen FERC's clout in overseeing the interstate transmission business.

Elsewhere, politicians and Bush appointees are laboring to improve how other markets function. Congress, attempting to fix flaws in the nation's capital markets exposed by last year's corporate scandals, enacted new rules to improve the information that companies provide to investors and created a new institution to police the accounting industry. Securities and Exchange Commission Chairman William Donaldson is initiating an inquiry into the way stock exchanges compete with one another, seeking a balance, he says, between "fragmentation and competition."

The Federal Communications Commission, in a series of decisions, is struggling to craft a rule book that will foster competition among cable-television, telephone, satellite and wireless companies to deliver broadband Internet service to American homes. The Federal Trade Commission is asking whether the market for wine would function better if legal barriers to online wine sales were dropped.

"Our support for markets must not be based on blind faith," Mr. Wood said in a speech earlier this year. "California will be a constant reminder that poorly designed markets can fail miserably. Ideology alone will not capture the benefits of competition while preserving customer protections."

Speaking to a group of energy experts in Houston in February, he went on to say, "We cannot simply let markets work. We must make markets work."

The past 25 years offer plenty of evidence that making markets work is a lot harder than simply unshackling them.

Building market capitalism from the ruins of communism in Russia and Eastern Europe, for instance, proved more difficult than anticipated. It turned out those societies lacked essential underlying institutions such as property rights, courts and ways to enforce contracts.

The privatization of British Rail in the 1990s failed because the company created to own the rails, Railtrack, didn't have sufficient incentives to invest in new track or coordinate with companies that operate trains. Railtrack went under and was replaced last year by a consortium governed by representatives of passengers, railroads and unions.

The corporate scandals in the U.S. last year exposed weaknesses in what previously had been seen as the world's best system for providing investors with timely and accurate information. They also highlighted the danger of paying executives with stock options that reward near-term increases in share prices even at the expense of the long-term stock price.

And California's electricity crisis made plain the cost of relying on complex markets that offer players incentives to behave in ways that serve their interests rather than consumers'. "When the California market failed, it became clear that the power business was too important economically and socially to restructure on a trial-and-error basis," analysts at Cambridge Energy Research Associates said in a report published last year.

Markets that arise spontaneously -- street vendors, for instance -- rely almost entirely on informal mechanisms because they're so simple: You look, you choose, you buy, you walk away. But such markets aren't typical of a modern economy, says John McMillan, an economist at Stanford University's business school. He published a book titled "Reinventing the Bazaar" last year that traces what he calls "the natural history of markets."

Consider the history of football. Soccer, rugby and football have their common origins in games of folk football played in England since medieval times, Mr. McMillan writes. "What rules there were had emerged spontaneously: They rested on custom and varied from village to village. Any number of people could play," he says. "There was no referee. ... Little skill was on display, just muscle." Contests were often violent and bloody. In the 1860s and 1870s, rules were written and the modern games of soccer and rugby were born; American football followed.

"An absolutely free market," he writes, "is like folk football, a free-for-all brawl. A real market is like American football, an ordered brawl."

The unfolding story of the blackout of 2003 -- ignored warnings from industry Cassandras, inadequate investment in transmission lines, an impotent regional coordinating entity in the Midwest, poor communication among human operators -- makes the U.S. electricity industry look more like a free-for-all.

Until the 1970s, electricity in the U.S. was provided primarily -- and successfully -- by privately owned, state-regulated monopolies that both generated and delivered power to prescribed areas, and didn't compete with one another. Ever-bigger and efficient power plants brought the price of power down by about 20% a decade, according to the Electric Power Research Institute, an industry think tank.

All that ended with the first Arab oil embargo in 1973: Slower-than-anticipated growth in demand upset an industry that had come to rely on steady, predictable increases. Electricity bills became political issues. Environmental rules added to costs. A 1978 federal law encouraged utilities to buy power generated by others, such as manufacturers who burned their own waste to make power. Bigger changes came after British Prime Minister Margaret Thatcher and President Reagan in the 1980s led the charge to reduce government's role in modern economies.

A 1992 federal law encouraged competition in the wholesale market for electricity. Then came state-level experiments with deregulation in the Northeast and California. A 1996 FERC order opened up the transmission grid so competing generators of electricity could get access to potential customers. A 1999 order called for utilities to voluntarily create regional organizations to oversee transmission networks. That was a mixed success, so FERC is now trying to make those regional entities mandatory and make them independent of any company that generates electricity.

The business of generating electricity increasingly was separate from the business of transmitting it. Cambridge Energy Research Associates observed in its report last year that a decade ago the conventional wisdom was that a laissez-faire approach to deregulation would foster negotiation and compromise. These would, in time, produce a market to allow consumers to choose among suppliers of electricity, much as they choose among long-distance phone carriers.

That didn't happen.

States and utilities moved ahead with deregulation in different ways and at different speeds, and some didn't move at all. Some regions, such as the state of Texas and the Middle Atlantic states where utilities long had cooperated, evolved what now appear to be workable wholesale markets for electricity. Other places, including California, did not. And California's crisis -- skyrocketing power prices, rolling blackouts, utilities in bankruptcy and, later, evidence of Enron Corp.'s manipulation of the market -- led several states to delay, cancel or scale back plans to deregulate electricity.

The importance of what industry insiders call the "seams" between regions became increasingly apparent as markets sprawled beyond traditional jurisdictional boundaries. In retrospect, it seems as foolish as deregulating trucking state-by-state despite the interstate highway system. "The institutional structure for the electricity sector has been dismantled, but it has not been replaced by an alternative structure with coherent institutions and rules," the Electric Power Research Institute complained in a report prepared before the blackout but released afterward.

Electricity has its peculiar physical characteristics: Unlike most other commodities, it cannot be stored. Unlike interstate natural-gas pipelines, what happens on one transmission line affects transmission lines and generating plants elsewhere.

The transmission network is particularly important, and particularly vulnerable, as Aug. 14 demonstrated. Competition among electricity generators depends on access to a reliable transmission network with clear rules for pricing, access, avoiding congestion and managing it when it occurs. In England and several other countries smaller than the U.S., the transmission system is operated by a single regulated monopoly.

In the U.S., the network is managed differently in different regions, and -- it is now almost universally agreed -- remaining regulations discouraged investment in new transmission lines. In the old days, utilities built power lines when they needed them, their regulators assured them of a return on the investment and no one much worried about pricing or other details.

Today, amid vocal not-in-my-backyard opposition to new power lines, a community's electricity demands can be met locally or from afar, and no one entity is responsible for the overall system.

Says William Hogan, a Harvard University energy economist: "When you break up the companies, and say, 'We want you to make money as a generator or retailer or transmission company,' then companies respond to the incentives that they see -- and the incentives better be right."

They weren't.

As a result, FERC's Mr. Wood is proposing that each region have a grid operator independent of utilities and generators. The grid operator would oversee a market in which generators can contract for transmission capacity in advance or buy it in a pinch at prices that are set in an open spot market with rules, enforced by the grid operator, to thwart Enron-like abuses.

The obstacles Mr. Wood faces go well beyond the physics of electricity. "Wrangling between pro- and anticompetition forces, jurisdictional disputes between federal and state policy makers, and plenty of ignorance have led our electric-power system to become stuck somewhere between the old system of regulated monopoly and a new system that relies more on competitive power markets," says Paul Joskow, a Massachusetts Institute of Technology energy economist. "This is a very bad place to get stuck."

Critics of the FERC plan -- including some utilities, particularly in the South, who fear more competition will squeeze their profits, and state regulators who fear loss of clout to Washington -- enlisted allies in the Bush administration and the Senate. The latter were, at least before the blackout, poised to block or weaken the FERC initiative in the energy bill pending in Congress.

That may be changing, Mr. Wood said in an interview Wednesday. "I kinda think the blackout made 50 million voters a whole lot more educated, and they might actually start caring about how well it's being administered. Is it every little electricity utility bobbing on the sea by itself, which obviously didn't work the other day? Or does it need more rationality and organization around it?"

Write to David Wessel at capital@wsj.com
Updated August 28, 2003 12:36 a.m.