Electricity Regulation in California and Input Market Distortions
We provide an analysis of the soft price cap regulation that occurred in California’s electricity market between December 2000 and June 2001. We demonstrate the incentive it created to distort the prices of electricity inputs. After introducing a theoretical model of the incentive, we present empirical data from two important input markets: pollution emissions permits and natural gas. We find substantial evidence that generators manipulated these costs in a way that allowed them to justify bids in excess of the price cap and earn higher rents than they could otherwise. Our analysis suggests that the potential benefits of soft price cap regulation were likely undone by such behavior.