State officials around the country are getting a lesson from the California legislature in how not to respond to Obamacare.

While the new federally supervised, state-based health insurance exchanges are to be up and running by January 1, 2014, the California legislature is poised to create the California Health Benefit Exchange through enactment of two bills (AB 1602 and SB 900). If Governor Arnold Schwarzenegger—who ran for office as a champion of conservative economic policy—signs these bills, California would be the first state to enact an ideologically compliant set of controls on the California health insurance market, effective January 1, 2011.

The California legislation would create the exchange as an independent government entity run by a politically appointed board with representatives of the governor, the Speaker of the California Assembly, and the Senate Rules Committee. From all appearances, this is the version of a health insurance exchange favored by the left, meaning that its main function would be to regulate insurance options, control benefits, enroll individuals in Medi-Cal (the California version of the Medicaid program) and administer government subsidies for public health. With the California board, its administrative costs would be borne by assessments on the persons getting coverage through the exchange; it would also benefit from appropriations outside of the California budget process.

The board would have the power of “selective contracting” with health insurers; in other words, it could pick winners and losers to compete for business. As the editorialists at The Wall Street Journal note, “The result in practice will be submarket price controls. As a condition of admittance insurers will also have to justify their premium levels and rate changes over time. Plans will still be allowed to sell outside the exchange, but in practice almost all consumers will gravitate to the exchange because of the subsidies.”

The board’s benefit setting would pretty much replicate that of the Massachusetts Connector Board, which, instead of assisting Massachusetts small businesses (as former Governor Mitt Romney intended), ended up ignoring them while driving up state health care costs through excessive regulation and mandates. Under the California legislation, the board would be able to mandate health care benefits, medical treatments, and procedures benefits even beyond those imposed by officials at the Department of Health and Human Services (HHS).

Health benefit mandates, of course, drive up costs. On September 16, 2010, Genest Consulting, a California firm, reported to the California Chamber of Commerce that the legislation poses a budget “risk” for California taxpayers estimated at $1 billion annually, primarily because of this power to mandate benefits in excess of federal requirements. The consultants expect the California board to be “comprehensive” in its approach to health benefit requirements. But any state would be required to assume the cost of any federal subsidy for any person enrolling in the exchange for the coverage of extra benefits beyond those mandated by HHS.

Genest also warned of additional California taxpayer costs because of potential enrollment of ineligible persons in Medi-Cal through the California exchange. Anyone enrolled in a state Medicaid program—and the Medicaid expansion under Obamacare is mandatory—is eligible for health benefits as a matter of entitlement, the consultants note, not simply as a matter of state appropriation.

The California law throws into relief the broader problem with the federal law governing state-based health insurance. As the Congressional Research Service (CRS) notes, taken to the extreme, setting up the state-based exchanges could lay the foundation of a single-payer system by excluding all private insurers—other than those through which the Office of Personnel Management will administer its “multi-state plans”—from participating the exchange.

Though only forthcoming regulations will shed light on the true extent to which this is feasible, according to the CRS, “there is no language that forces an exchange to make available any particular plan except for multi-state plans. … Presumably, unless regulations dictate otherwise, the exchange could have the ability to make a determination that any or all of the private health plans seeking certification are not in the interest of qualified individuals and employers.”

The California legislature has acted quickly, taking the state headlong in exactly the wrong direction. The only issue in California now is whether Governor Schwarzenegger will sign the bills. Other states can do the right thing by designing their own health insurance reforms and learning from the model established by Utah, which promotes real competition rather than restricting it.

Co-authored by Kathryn Nix.