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fixed-price forward contractsobligations for the major suppliers.They find that under thecounterfactual of no fixed-priceforward market obligations inPJM and ISO-New England marketprices are even higher relative tocompetitive levels than those thatactually existed in California inthe summer of 2000. Moreover,giving California fixed-price forwardmarket obligations similar to those inPJM and ISO-New England producedshort-term market outcomes with verylittle unilateral market powerexercised.

References

S. Borenstein, J. Bushnell and F.A.

Wolak, Measuring Market Inefficienciesin California’s Restructured WholesaleElectricity Market, Am. Econ. Rev.

Dec. 2002 at 1367–1405.J. Bushnell, E. Mansur, C. Saravia,Vertical Arrangements, Market Structureand Competition: An Analysis of Restruc-tured U.S. Electricity Markets. AM. ECON.REV. March 2008 at 237–266.F.A. Wolak, An Empirical Analysis of theImpact of Hedge Contracts on BiddingBehavior in a Competitive ElectricityMarket, Int’l. Econ. J. 2000 Summerat1–40.F.A. Wolak, Measuring Unilateral Mar-ket Power in Wholesale ElectricityMarkets: The California Market 1998 to2000, Am. Econ. Rev. 2003 Mayat 425–430.F.A. Wolak, Diagnosing the CaliforniaElectricity Crisis, Elec. J. 2003 Aug./

Sept.at 11–37.F.A. Wolak, Sorry Mr. Falk: It’s Too Lateto Implement Your RecommendationsNow, Elec. J., 2003, 2003 at 50–55.F.A. Wolak (2007), Managing Demand-Side Economic and Political Con-straints on Electricity Industry Re-structuring Processes, June, availableat http://www.stanford.edu/�wolakF.A. Wolak, B. Barber, J. Bushnell, B.F.Hobbs (2004), ‘‘Market Power Mitiga-tion under Locational Marginal Pri-cing,’’ November 23, available athttp://www.caiso.com/docs/2004/11/23/2004112316123829554.pdf

doi:/10.1016/j.tej.2008.08.005

ug./Sept. 2008

Falk: Here Are TwoGrounds for Agreement

L et’s see if I can quickly

zero in two grounds for

agreement:

(1) The world might well be

better off without a ‘‘just and

reasonable’’ standard, but FERC

has been ordered by Congress

and the Courts to create one.

Furthermore, FERC has to con-

sider what ‘‘just and reasonable’’

means: it can’t just passively

permit rates to go into effect

without a finding that the resultant

rates are just and reasonable.

Neither of us has the least interest

in deregulation, at least as Prof.

Wolak and Chairman Kelliher

define it.

(2) FERC’s actual implementa-

tion of a ‘‘just and reasonable’’

reasonable standard hasn’t

worked very well. It maximizes

moral hazard problems and

solves problems like ultra-short-

term volatility that no one really

cares about very much.

I proposed to solve (2) by giving

FERC an alternative definition of

‘‘just and reasonable.’’ We agree

that FERC is entitled under the

FPA to define what ‘‘just and

reasonable’’ means and that,

through Chevron, its finding is

entitled to substantial deference

by the courts, although since its

ability to define the term is

granted by Congress, it can be

taken away so long as both houses

of Congress and the President of

the United States agree.

Prof. Wolak has his own defi-

nition he’d like FERC to use, and

1040-6190/$–see front matter #

he’s entitled to advocate it. But he

has not one word to give against

mine in his response. He doesn’t

think it would have bad conse-

quences (at least not so far as I can

tell). He doesn’t argue that it

wouldn’t solve the moral hazard

problem. He just likes his better.

Well, I agree that his definition is

better than the status quo. But

dynamically, I fear, with good

historical evidence on my side,

that it would devolve into some-

thing that neither of us would

support. That’s my objection to a

guardrail approach: the rent-

seeking forces that like moral

hazard will find ways to modify

the guardrails to become nice

comfy pillows or, to further mix

metaphors, a straitjacket. And

when that happens, Prof. Wolak’s

solution is not better than what

we have now. Actually, it’s worse:

all the efforts that people have to

put into regulatory manipulation

are just social waste.

I don’t believe his quotations

from Morgan Stanley really

buttress his case for ex post

determination, but that wasn’t the

point I was trying to make. First,

FERC is certainly free to use ex

post calculations if it chooses to. It

just isn’t a very good idea. Second,

since FERC never made the

determination that whatever

prices came out of the California

process are per se just and rea-

sonable (unfortunately), I fully

understand why the Court would

tell them to go look at the prices

again.

I avoided commenting on the

specifics of the dispute in Morgan

Stanley because they aren’t central

2008 Elsevier Inc. All rights reserved. 17

The lack of demandresponse meant thatthere was no cap to

where prices could go,so they went, in the

immortal words ofSpinal Tap, ‘‘to 11.’’

18

to my conclusions about the

just and reasonable standard, but

since Prof. Wolak has taken the

opportunity to comment in

some detail on the specifics of

these contracts and the exercise of

market power in the California

market and on capacity markets, I

would like to differ on a few

points.

First, unlike Prof. Wolak and

his colleagues, I’m still not so sure

that any market power was

exercised in California at all, at

least under well-accepted defini-

tions of workable competition. All

of the studies of which I’m aware

are fatally flawed in their treat-

ment of imports into California.

My take on the events of 2000 is

that there was a WSCC-wide

shortage of power. Prices rose

throughout the entire Western

U.S. and in British Columbia.

Snohomish, to take an example,

isn’t in California. Of course, the

vast majority of the West had very

little exposure to electric spot

prices so the uproar elsewhere

was muted. Many lines into

California were not congested

and the WSCC is a highly

unconcentrated electric market in

which the largest market share

belongs to the federal govern-

ment, an unlikely co-conspirator.

The lack of demand response

meant that there was no cap to

where prices could go, so they

went, in the immortal words of

Spinal Tap, ‘‘to 11.’’ Note by the

way that few people have com-

mented that the rolling blackouts

and brownouts of 2000 are

themselves mild evidence against

the exercise of market power,

1040-6190/$–see front matter # 2008 Els

since a rational monopolist has no

interest in blackouts. While I

agree that the subsequent fall in

prices is consistent with a market

power explanation in which the

incentive to exercise market

power is mitigated by forward

contracting, that is far from the

only possibility.

W hy was there no demand

response?1 Oh, that’s right,

the moral hazard problem. I think

it is really quite easy to argue that

the high prices in California were

caused by an ex post interpretation

of the ‘‘just and reasonable’’

standard. All sorts of retail dys-

function could be foisted onto

these markets with the under-

standing that FERC stood as a

stalwart backstop. While Prof.

Wolak eloquently outlines a case

in which the prices and terms of

the Snohomish contracts were

rational, it is far from the only

interpretation. In particular, he

seems to ignore the possibility

that the terms of those contracts

might have been influenced by

the notion that if prices fell, FERC,

or the Ninth Circuit, or the

Supreme Court, would bail

evier Inc. All rights reserved.

them out. Reversing these

contracts surely isn’t public

necessity; keeping them in place

probably is.

H igh prices in California were,

it seems to me, indicative of

the way a market is supposed to

work, at least on the supply side.

Now it is fair to say that FERC,

under Mobile-Sierra, is entitled to

decide that it made a mistake in

certifying the California market

for competition, and to take rea-

sonable actions to fix the pro-

blems it caused if public necessity

demands it. The opinion in Morgan

Stanley makes clear that public

necessity is a higher standard

than ‘‘prices we don’t like.’’

From the opinion:

A presumption of validity that

disappears when the rate is above

marginal cost is no presumption of

validity at all, but a reinstitution of

cost-based rather than contract-

based regulation. We have said

that, under the Mobile-Sierra pre-

sumption, setting aside a contract

rate requires a finding of

‘‘unequivocal public necessity,’’

Permian Basin, 390 U. S., at 822, or

‘‘extraordinary circumstances,’’

Arkansas Louisiana Gas Co. v. Hall,

453 U. S. 571, 582 (1981).

In no way can these descrip-

tions be thought to refer to the

mere exceeding of marginal cost.

The problems in California

were not of FERC’s making for the

most part. And in any case,

whatever remedies it chooses

need to be reasoned with

regards to long-run impacts and

not just a capitulation to what

feels good for the moment. That’s

what I think the implementation

of ‘‘just and reasonable’’ rates

The Electricity Journal

A

ought to mean, and can mean, if

FERC wills it.

Second, we disagree pro-

foundly on capacity markets, or at

least on the following sentence:

Consumers must pay market-

clearing prices for both energy and

capacity to all suppliers of these

products despite the fact that a

standard rationale offered for the

existence of a capacity market is

that only a small subset of

generation units (those with very

high variable costs) do not receive

sufficient revenues from the

energy market to recover their

total costs.

This is economic nonsense. It is

of a piece with those who felt that

pay-as-bid prices are superior to

uniform clearing prices. The

‘‘standard rationale’’ focuses on a

problem for peakers, but I call

Prof. Wolak’s attention to another

provision of the FPA: if two gen-

erators supply the same service

(capacity) and one is paid for it

and the other is not, the discri-

mination thus generated is

‘‘undue.’’ While the so-called

‘‘missing money’’ problem for

peakers is the standard rationale,

it is not the only one. Generators

differ in their ability to supply

capacity and energy to markets:

hydro generators can generally

supply much more capacity

than energy. Wind power can

provide far more energy

than capacity. Capacity markets

can trade off these characteristics

in an efficient manner, but

only if everyone is paid for every

unit of capacity they supply.

In any case, we shouldn’t be

creating ex post pseudo-rationales

in these markets, either, as

ug./Sept. 2008

I stated in the earlier paper.

If capacity markets are competi-

tive, their prices are just and

reasonable.&

Jonathan Falk

Endnotes:

1. Actually, there was some demandresponse when aluminum smelters inthe Pacific Northwest with contracts toget electricity shut down, since theycould make more money selling theirinput than they could make sellingtheir output. Needless to say, had theybeen sheltered by dysfunctional retailagreements the situation would havebeen considerably worse.

doi:/10.1016/j.tej.2008.08.004

Wolak: You Can’t BeSerious, Mr. Falk

I am pleased to learn that

Jonathan Falk believes that

unilateral market power was not

exercised in the California market

during the period June 2000 to

2001. I think this explains all of

our points of disagreement. Falk

has never seen a price for energy

or capacity that he does not think

is ‘‘just and reasonable,’’ even

during the height of the California

crisis when suppliers were paid

prices in excess of $3,000/MWh

for energy supplied to California

and the rest of the Western U.S.

How he is able to hold this view

despite the massive amounts of

empirical evidence, FERC orders

and reports, and legal decisions to

the contrary is both troubling and

puzzling. The title of my reply

1040-6190/$–see front matter #

hints at one possible answer, but

this not a question that will be

addressed here.

I believe that suppliers and

demanders in all markets, not just

those in electricity markets, take

all available unilateral actions to

maximize their profits, which is

equivalent to maximizing all

available unilateral market

power. There is a massive

empirical literature in economics

providing convincing evidence to

most all economists (Falk may be

the exception) that market parti-

cipants exercise all available uni-

lateral market power. In Wolak

(2003d and 2007), I formulated

and implemented a general test of

this hypothesis for bid-based

short-term wholesale electricity

markets. This empirical work

found no statistically significantly

evidence against this null

hypothesis. I have subsequently

implemented this test for a num-

ber of other short-term wholesale

electricity markets and found lit-

tle evidence against its validity.

As discussed in Wolak (2004)

and as well-known to most

economists, short-term, bid-based

wholesale electricity markets

have virtually all of the charac-

teristics that make a market sus-

ceptible to the exercise of

unilateral market power. FERC’s

market-based pricing process,

that a supplier must show it does

not possess unilateral market

power or has adequately miti-

gated it to be paid market-based

prices, is based on the concern

that electricity suppliers could

exercise substantial unilateral

market power.

2008 Elsevier Inc. All rights reserved. 19