Thursday, July 01, 2004

The Island of California
My friends at the Global Business Network used to display an old map depicting California as an island, as a way of indicating how mental maps can affect planning. This morning's New York Times featured an analysis by Hal Varian, a professor at my B-school alma mater, that explains why California might as well be an island, insofar as its gasoline market is concerned.

Gasoline prices in California are generally higher and more volatile than in the rest of the country. Geography plays a role, since the distance to the main refining centers of the Gulf Coast has made pipeline supplies from there impractical. Regulations have reinforced this isolation, going back to the 1980s, when Southern California enacted its first rules creating gasoline specifications that were stricter than in the rest of the country. This disparity has been exacerbated by the extremely severe California Air Resources Board (CARB) specifications, which make gasoline in the state the toughest to produce in the world.

Professor Varian discusses some recent proposals for state government to play a role in the market and rightly dismisses these as likely to create further distortions. Having already suffered an electricity crisis largely caused by "misderegulation", the Golden State doesn't need another state sponsored energy meltdown.

The proposal he favors is not a new one. When local supply is inadequate to meet demand, refiners and traders would be allowed to import gasoline that meets US specifications--but not California's--by paying a sizable tax to equalize its cost to that of manufacturing CARB gasoline. While this might well alleviate some temporary price excursions, it still fails to address the long-term challenge of a market in which refiners have had little incentive--and many disincentives--to build enough local capacity to create a reserve margin.

In many ways, this situation resembles the conditions that existed just prior to the electricity crisis. Demand was outstripping capacity, which had stagnated for years due to problems of permitting and environmental regulations and litigation. The result was a market with no reserve capacity and highly inelastic demand, mirroring Dr. Varian description of the current gasoline market. The only effective way to redress this would be to encourage the construction of additional refining capacity, something that seems almost inconceivable in a state that has long appeared to have an implicit strategy to force refiners out of state.

So perhaps the only fixes are short-term fixes, until the system breaks completely, and voters demand a long-term solution. If so, then Dr. Varian's proposal is as good as any and better than most.

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