Beginning in June 2000, California's electricity wholesale market produced extremely high prices and threats of supply shortages.  The situation led to a utility bankruptcy, large retail price increases, and great political turmoil.  But California's is only the most recent and visible example of the trouble with deregulated wholesale electricity markets.  The difficulties that have appeared in California and elsewhere are intrinsic to the design of current electricity markets: demand exhibits virtually no price responsiveness and supply faces strict production constraints and very costly shortage.  Such a structure will necessarily lead to periods of surplus and of shortage, the latter resulting from both real scarcity of electricity and from sellers exercising market power.  Extreme volatility in prices and profits will be the outcome.  This result, however, is not inevitable.  By encouraging price-responsive demand and long-term wholesale contracts for electricity, policy makers can create electricity markets that will function much more smoothly.

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