In the early eighties Chile completely reformed its electricity sector, introducing a regulatory framework that became extremely influential in the rest of the world. In 1998 and 1999, however, when the La Niņa phenomenon brought one of the worst droughts on record, the price system collapsed. Random outages and three-hour long rotatingelectricity cuts occurred. This paper studies the interaction between regulatory incentives and governance during the 1998-1999 electricity shortage. We present evidence showing that it was feasible to manage the supply restriction with no outages. The shortage can be blamed on the rigidity of the price system, which was unable to respond to large supply shocks, and on deficiencies in regulatory governance, which led to a weak regulator that proved unable to make the system work. We show that the weakness of the regulator did not stem from lack of formal powers. The problems originate in the vulnerability to lobbies and lack of independence. Moreover, the regulator seems not to have fully understood the nature of the incentives in the price system during supply restrictions. We conclude that the Chilean shortage shows the limitations during crisis of a rigid price system requiring heavy regulatory intervention. This suggests that countries where governance structures are ill suited to fill in loopholes left by the law should rely as much as possible on market rules that clearly allocate property rights ex ante and leave the terms of contracts to be freely negotiated by private parties.
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