With Governor Arnold Schwarzenegger vowing to terminate California's energy shortages, and last summer's blackout in much of the US Northeast and Midwest a fading memory, it might be tempting to think that the worst of the country's electric-power woes are over. In fact, the opposite may be true. The United States faces potential supply shortages and sharp price increases during the next five years as economic and political uncertainties—particularly rising natural-gas prices and shifting environmental policy, respectively—make energy companies reluctant to commit the billions of dollars required for new power projects.

The looming power shortage brings with it an uncomfortable dilemma. Rising energy prices could make US corporations less competitive and fuel the movement of jobs offshore. Yet building a new generation of coal plants—probably the most economical alternative to expensive natural gas—could result in a difficult-to-accept increase in air pollution.

To ameliorate the situation, the US power industry can do many things, such as modifying its pricing practices to reduce peak demand. But balancing the country's need for energy with its desire to protect the environment will force regulators to reform its state-by-state patchwork of disjointed policies. Right now neither those regulations nor the efforts of the Federal Energy Regulatory Commission (FERC) to promote continued deregulation and the industry's "disintegration" do much to mitigate the risks that keep energy investors on the sidelines. What the United States needs is an integrated national energy policy that compensates producers for the risks they bear—and thus encourages the building of new power plants—while also balancing the need to protect the environment and to generate power.

Change and deregulation

A quick look at the history of energy market deregulation in the United States reveals the roots of the country's impending power shortage. In the states where deregulation took place, it cut prices by promoting competition and rooting out inefficient capacity—especially costly nuclear plants.¹ As a result, real US retail-power prices have dropped by about 40 percent over the past two decades while the system's aggregate reliability has improved.

By encouraging the elimination of inefficient capacity, deregulation also opened the door for investors to build more efficient and economical plants, many of them fueled by natural gas. Compared with coal, gas-fired plants are relatively clean burning and cheap to build. Since construction times, at two years, are so short, there was limited risk that changing market conditions might render such plants uneconomical. During the 1990s, these characteristics permitted independent power producers such as AES and Calpine to build the lion's share of natural-gas plants (Exhibit 1), which met much of the growing need for electricity in the United States.

So far, so good—at least while natural gas remained relatively cheap. As US demand for it increased, however, prices jumped, and building gas-driven plants became less attractive. The deteriorating economics of these plants brought to the fore a troubling question surrounding deregulated power markets: would they be able to attract, on an ongoing basis, the huge amounts of new capital the industry needs to meet demand?²

The alternatives to natural gas include massive imports of liquefied natural gas (LNG), the construction of coal plants, and increased reliance on renewable energy sources. But in the absence of guarantees from regulatory authorities that investors would recover their money—guarantees that exist at present, of course, in regulated markets—they are discovering that none of these alternatives is really attractive, largely because each is highly dependent on shifting political winds. Interrelated economic and political uncertainties have thus combined to undermine the deregulatory conditions that helped prices to fall and capacity to grow during the 1990s.

Economic uncertainty

The new generation of gas-fired plants built by investors in deregulated markets led to staggering increases in natural-gas consumption, thereby straining gas supplies and the transmission infrastructure and driving skyward the price of natural gas (Exhibit 2). The likelihood that prices will remain high has made it difficult to justify building new gas-driven plants, since throughout the life cycle of coal plants the capital and operating costs are lower than those of gas ones when natural-gas prices exceed about $3.50 per million British thermal units.

Paradoxically, although that fact would seem to argue for coal-fired plants, the volatility of natural-gas prices makes the building of new coal facilities look risky. The reason is that in deregulated markets, gas-fired plants are generally the marginal producers, setting prices for the whole sector. Building coal plants therefore implies taking on the risk associated with fluctuations in the spread between gas and coal prices. Since independent power producers can't hedge this risk over the 40-year life of a plant, uncertainty around gas prices makes plunging ahead with a billion-dollar coal investment problematic in a deregulated environment.

Political uncertainty

Economic uncertainty, in and of itself, need not halt new construction. Companies, after all, are accustomed to such risks—and to methods for mitigating them. Yet energy investors face not only economic but also political unknowns.

How much LNG? These political uncertainties are visible, for example, in the circumstances surrounding the importation of low-cost liquefied natural gas. Importing LNG to complement domestic gas reserves is a leading option for alleviating the natural-gas crunch. Yet this approach has limitations because receiving and distributing LNG requires custom-built terminals, ships, and other kinds of support infrastructure costing billions of dollars. Still, dozens of new terminals—from Harpswell, Maine, to Tampa, Florida—have been proposed, and several existing ones are slated for expansion.

A prospective look at the cost curve for natural gas, however, suggests that by 2010 even this additional supply will only hold the market-clearing price to about $5.00 per million British thermal units in the event of limited LNG development. The massive development of new terminals, beyond what's currently planned, could knock prices down to $3.50 to $4.00 per million British thermal units (Exhibit 3). But it's far from clear whether adding this capacity is politically feasible. Local opposition to regasification facilities tends to be strong, both for environmental reasons and because, in the post–September 11 world, there is concern about erecting highly exposed targets for terrorists.

What's next for coal? Since political issues make it unlikely that LNG will alleviate the economic uncertainty around gas-fired plants, there is little choice but to consider coal. If society's objective were simply to minimize power costs, coal is a winner at today's natural-gas prices. But there are additional legitimate objectives, such as keeping the environment clean.

So even as plans for a number of coal plants are hitting the drawing board, uncertainty around environmental policy raises real questions about the feasibility of deregulated coal plants. It takes five or more years to get a permit and construct a coal generating plant. Who is willing to bet a billion dollars or more today on what regulation of the power market and the environment might look like in 2010? The embrace of the Kyoto Protocol or the adoption of new carbon taxes could require plants to be retrofitted, and that would cost hundreds of millions of dollars for each of them. Only the remaining traditional regulated electric utilities are big enough to absorb such risks. The 35 to 40 percent of the United States that is deregulated will struggle to find efficient mechanisms to keep the lights on past 2010.

Independent power producers, with their less robust balance sheets, are particularly ill suited to making coal investments. In the past, these players often financed the construction of new power plants by committing themselves to bilateral contracts called purchase-power agreements. But when Standard & Poor's pointed out that signing such contracts is akin to taking on more debt, it dramatically reduced their attractiveness. Risky as coal plants are, in almost all cases a utility would be better off building the plant itself rather than signing a purchase-power agreement, which strains balance-sheet capacity and involves taking on risk but offers no prospect of a return.

What about alternative energy sources? Politics also weighs heavily on some likely alternatives to natural gas and coal. With natural-gas prices at today's levels, solar and wind power are uneconomical without subsidies larger than today's production tax credits. And because no one can guarantee when the wind will blow or the sun will shine, these power sources are inherently unreliable, so they aren't likely to be more than a small part of an overall solution. Nuclear power is a legitimate economic alternative, but it has been politically infeasible to build nuclear plants since the 1979 incident at Three Mile Island. Hydroelectric power, by contrast, isn't hamstrung by politics. But it has been so attractive to western states that they have already dammed nearly every high-elevation water source capable of generating low-priced electricity.

The road ahead

It's hard to believe that the world's biggest economy would sit idly by as rising energy prices rendered its corporations uncompetitive, tight supplies caused blackouts, or a new generation of coal plants cast a pall over its skies. Yet the United States faces difficult trade-offs—particularly between jobs and the environment—that create a risk of political paralysis. Solutions require painstaking reevaluation, by regulators and the power industry alike, of the demand and supply sides of the generation equation. The danger is that today's fairly low prices (Exhibit 4), combined with the long lead time needed to build new capacity, will delay action until it is too late.

Tough choices

The United States faces a dilemma. Should the country seek to secure cheaper electricity by eliminating some of the risks of constructing coal plants—particularly the risk of tougher environmental laws—even if aggregate emissions rise? Or would it be better off staying with natural gas or subsidizing alternative energy sources, both of which would lead to higher electricity prices?

This trade-off is even more difficult than it appears because of the far-reaching impact of electricity price hikes. A first-order effect would be raising manufacturers' operating costs so much that many businesses and jobs would go offshore. This movement could trigger second-order effects, such as pollution at overseas manufacturing and power-generation plants that are more environmentally damaging than their counterparts in the United States—not to mention the fumes spewed by freighters carrying goods across the Pacific.

These issues, which involve the interests of consumers, producers, and other countries, are too big for the power industry or its regulators to tackle independently. They must instead be part of a broader debate. The industry and its regulators can, however, make it possible to build whatever forms of new capacity the country decides to have.

Potential solutions

Unfortunately, the system for constructing new power-generation plants seems to be broken, and we don't see how it can fix itself. Individual states, left to their own devices, will scramble for short-term solutions that don't require federal involvement. Keeping the lights on in the short term may sacrifice efficiency gains that regional or national strategies could help capture. Three courses might get regulators and the industry back on track.

Transparent hourly prices. The California power crisis offered the world a vital lesson that has gone curiously unappreciated: high power prices lead to lower demand. To be sure, in most of California high wholesale power prices weren't allowed to bleed through to the residential consumer.³ But that did happen in the southernmost part of the state. In the service territory of San Diego Gas & Electric, demand for power in the summer of 2000 was 5 percent lower than it had been during the same period for the previous year.

It's hard not to speculate about the impact on demand if all consumers were exposed, in real time, to actual market prices—not the monthly average prices that are typical of utility bills but, rather, time-of-day prices reflecting the fact that electricity has much greater value (and production costs) at 3 PM on a hot summer day than at 3 AM in the autumn. Utilities from Europe to Latin America to Washington State have found that dynamic pricing can smooth demand by curbing it at peak times. That is an enticing possibility for the United States as it considers how to finance and build new capacity.⁴

Rate-based plants in deregulated markets. States in parts of the Northeast, Midwest, and West (not to mention Texas) are largely deregulated. Putting the genie of deregulation back in the bottle may prove more difficult than bending some of the rules. Builders of new generating capacity, for example, might negotiate asset-specific settlements permitting plants to be treated in a rate-based way—that is, one that makes it possible for them to recover in full their reasonable capital costs. In California this approach is, in effect, already in the works. When politicians in other states contemplate the prospect of creating several thousand jobs and of averting embarrassing price hikes or shortages through the construction of new capacity, they too may head back to the future.

To avoid price increases, regulators in parts of Western Europe and in some US states employ performance-based rate making, which gives utilities incentives to cut their costs by letting them keep a share of the benefit while passing most of it on to consumers. Given the proper incentives, utilities could dramatically improve their costs and customer service. But the industry is spending so much time fighting for or against the deregulation of wholesale markets that it is missing these opportunities.

An integrated national energy policy. As the United States wrestles with tough environmental and economic trade-offs, it can only benefit from debating a more integrated national energy policy. Today government agencies separate power deregulation from environmental policy. LNG and the fear of terrorism aren't part of the national power debate. Yet it is increasingly clear that all these pieces must fit together.

At present, FERC is promoting a Standard Market Design and Structure (SMD) program that would separate transmission assets from power creation on a nationwide basis. The SMD has become involved in a politically heated battle, between proponents of federal authority and advocates of states' rights, that could distract the industry from more pressing issues. This approach can't lower the price of natural gas or the risks associated with alternative forms of capacity. Moreover, as the economics of natural-gas plants become more problematic, the independent-power-producer and merchant-generating models that have flourished over the past quarter century may be nearing their end.⁵ Consequently, the persistent deregulatory mantra of "workably competitive markets" could doom entire states and regions to reliability problems and volatile prices.

Vertical integration is unnecessary and uneconomic in most industries. But in this one, as currently structured, it is hard to manage and distribute risks and to deploy capital to meet new demand, and these realities challenge the conventional wisdom favoring disintegration. The country must either fix the conditions inhibiting the deployment of capital or be open to the idea of greater vertical integration, which can bring benefits when markets are extremely risky and contracts designed to overcome those risks are costly to write and administer.⁶

Striking the right balance—between competition and vertical integration, low prices and adequate generating capacity, and economic and environmental considerations—is an issue for all states, regulated or deregulated. It's up to them, the industry, and FERC to provide a more sound basis for the future of energy in the United States. Given the long lead time for building new plants, now is the time to start.