Energy Price Controls: Been There, Done That

The electricity crisis in California—now expected to spread to other parts of the country this summer—will soon launch a predictable battle not just over electricity but over gasoline prices as well. On one side are those who almost certainly will call for price controls to cushion the blow to consumers and to limit any price “gouging” by producers. On the other side will be those who will argue that price caps will worsen the problem by failing to encourage consumers to conserve, while discouraging producers—especially independent generators of electricity—from making new investments that eventually will alleviate any supply shortages. Price caps also generate artificial shortages, either electricity blackouts or lines at gas stations.

We should keep in mind that we’ve been here before. In 1979 crude oil prices surged while the nation was still saddled with a Byzantine system of oil price controls inherited from the Nixon administration. We should learn from the solution adopted then: removal of the price controls, coupled with a windfall profits tax on producers and a recycling of the proceeds to consumers. A similar system ought to be put in place for the current situation.

First a quick look back. The crude oil price controls adopted in 1971 eventually flowered into a complicated system that, by early 1979, set prices for 10 different types of crude oil—even though, of course, oil is fungible. The lowest-priced crude sold for about $6 per barrel, while the most expensive, “stripper” oil, sold for about $15. The patchwork system contained many perverse incentives. Rich producing wells were left to expire because producers had no incentive to maintain them, while investments poured into very small wells that would never make a difference to the nation’s energy future.

Today generators of electricity face an equally complicated set of controls. Some independent power firms are effectively exempt from controls and sell their power at the highest possible price. Other generators, usually regulated utilities, produce the 21st century’s equivalent of old oil and are forced to sell at prices one-tenth (or less) the prices charged by their decontrolled competitors. For example, in California, Southern California Edison’s large nuclear unit receives only 3 cents per kilowatt hour, while some of the small, unregulated older plants owned by the generating companies receive 50 cents. Some firms even own both uncontrolled and controlled plants.

It gets worse. In 1979 U.S. allies called for the removal of price controls to bring down the price of oil. The critics asserted that the controls raised the world’s demand for oil while depressing production by those outside the OPEC cartel. The consequence was a higher price for oil. Today electricity price controls have the same effect. Conservation is discouraged and low-cost production is shut down. The gap between supply and demand is filled with output from very high-cost facilities.

President Carter deserves credit for finding a way out of the mess in 1979. He took the bold and controversial step of removing price controls on oil but at the same time proposed a windfall profits tax on producers, which Congress enacted in 1980. The tax didn’t take away all of the windfall profits—the excess generated by prices above the previous controlled prices—but it did take anywhere from 30 percent to 70 percent of them (depending on the price of the crude). The proceeds were recycled to consumers and to support of development of alternative energy sources. The windfall tax was removed by Congress in 1988, when crude prices were far lower and the tax was no longer generating revenue.

President Bush and Congress now have the opportunity to take a similar courageous step: remove all price controls on electricity and enact a windfall energy profits tax. The tax should capture a portion of any electricity and gasoline price increases above a benchmark. The proceeds should be returned to consumers through income tax reductions that moderate the impact on the poor, small businessmen and other consumers who would suffer from higher prices. When prices come down—as they will once increased conservation and new production have come into play—the tax should be removed.

To be sure, a tax-refund system is tricky to design and will not be perfect. But as it was 20 years ago, a windfall profits tax is far preferable to both price controls and the prospect of even higher energy prices and windfall profits.

President Bush is right that the current energy crisis can be solved only in the long run. But wise policy can help all of us in the short run too—to avoid shortages, to preserve the benefits of price signals and to minimize the pain that short-term price increases can cause.