Business Week - 8 Jan 01

Prof. Robert B. Laughlin
Department of Physics
Stanford University, Stanford, CA 94305
(Copied 3 May 09)

California's Power Failure

Why the Attempt to Make the Energy Market More Efficient Has Been a Disaster

Christopher Palmeri, Laura Cohn and Wendy Zellner
Business Week, 8 Jan 01

It wasn't much of a Christmas holiday for California Governor Gray Davis. On Dec. 26, the governor flew to Washington, where he spent two hours with Federal Reserve Chief Alan Greenspan discussing California's unraveling electricity market. A day later, he was confabbing at the White House with President Clinton. If turning out the state's official Christmas tree lights didn't get the nation's attention, then face-to-face meetings with Greenspan and Clinton provided the ultimate wake-up call. California's electricity crisis, with its rolling blackouts, sky-high prices, and the threatened bankruptcy of the state's two largest utilities, now poses a threat that goes well beyond the Golden State.

When it comes to the economy, as California goes, so goes the nation. California accounts for 13% of the U.S. gross domestic product. If the California mess deteriorates, it will obviously damage the local economy. But the ripple effect could have far broader consequences. "It's a very precarious situation in California right now and it could spiral out of control," says Kenneth Lay, chairman of energy trading giant Enron Corp. "It could have a very, very devastating impact on the California economy, as well as the whole U.S."

BANKRUPT. In California, the crisis is quickly coming to a head. On Dec. 27, Edison International's Southern California Edison filed suit against the Federal Energy Regulatory Commission to recover some $4.9 billion the utility says it was forced to overpay to power producers. The company has asked for a ruling by January 5th. Pacific Gas & Electric is also expected to file suit, seeking $4.6 billion. Also on Dec. 27, both utilities asked that the California Public Utility Commission grant rate hikes of up to 30%. While that's sure to enrage consumers, a rate hike is needed to stabilize the utilities' finances. Without the hikes, they claim they may be forced into bankruptcy.

It sure sounds like something akin to a bailout for the utilities. And that could be a huge problem for Davis, who has big political ambitions beyond the state house. For now, though, he's focused on resolving a political and policy nightmare that began with California's landmark 1996 electricity deregulation law--the most comprehensive such legislation in the nation. California's industrial power users were complaining that their rates were among the highest in the country. Deregulation promised lower rates and better service by bringing competition into the market for power generation.

BATTLEGROUND. The resulting legislation, however, was a tottering tower of compromise and fragile political alliances. The legislation pitted Democratic legislators against then-Republican Governor Pete Wilson, consumer groups against the utilities, and the utilities against a new breed of competitive private-sector power generators. Governor Wilson and the independent producers wanted a shift to a free market as quickly as possible. The utilities wanted compensation for their investment in power plants. The consumer groups wanted safeguards that prices wouldn't go up. Everyone got something. But the result is a California electricity policy that seems to combine the worst of free market principles and command-and-control regulation. "It was a crisis by design," says Lawrence J. Makovich, an electricity industry consultant with Cambridge Energy Research Advisors. "Legislators created a power shortage."

The legislators may have created a monster. But all the interested parties went along willingly. Now, looking back, the plan's biggest flaw may have been the agreement by California's utilities to sell much of their generation capacity to private-sector companies. As part of the plan, the utilities agreed to buy all of their customers' power needs on a daily basis through a new, state-sanctioned but independently managed entity called the Power Exchange. The idea was to protect consumers from the power-plant construction fiascos and long- term contracts that had led to high priced power in the past.

But the whole scheme has backfired badly. Daily power purchases subject the utilities to all the vicissitudes of the market place. Regulators and others who have studied the California system say that this last-minute market has given power producers an incentive to withhold power, creating a buying frenzy that sent prices soaring. The state's new sources of power generation--a half-dozen independent power companies and out-of-state utilities, many of whom bought plants from the old California utilities--insist that they have not withheld power. Whatever the truth, the setup devastated the California utilities. "It was just too much power being bought at the last minute at the highest possible price," says Lynn Ledicky, a vice-president for government affairs at Houston-based Dynegy, Inc., which owns power plants in California.

Last minute shopping wasn't California's only problem. In a kind of perfect storm scenario, a host of other circumstances converged that helped send prices through the roof. In the years prior to deregulation, utilities and state regulators argued at length over whether the state needed new plants and, if so, who should build them. The result: New plant construction ground to a halt just as demand was beginning to surge from the high-tech boom.

STRICT RULES. California's stringent environmental rules have low-cost, though relatively high polluting, coal-fired generation in favor of natural-gas fueled plants. More recently, consolidation in the pipeline industry coupled with tight supplies nationwide have caused the price of natural gas, now the state's dominant fuel source, to soar. Strict issuance of environmental permits and a history of local activism also make California the toughest state for building new power plants, industry executives say. Even in the midst of the recent crisis, a number of new plant proposals have been squashed due to local protests.

As if that weren't enough, the California legislation took much of the regulating authority away from local officials and put the state's electric system into the hands of federal authorities and two new independent entities, the Power Exchange and something called the Independent System Operator, which acts as a sort of air traffic controller for the state's transmission lines. Each of these entities has a board comprised mostly of industry players. The result has been inaction or frequent changes of policy that let the crisis mount.

The entire arrangement has exploded in the face of the utilities. During the debate over California's legislation, the utilities argued successfully that they were entitled to compensation for the billions of dollars' worth of plants that they had built in the era of regulation. To reimburse them, California legislators froze the price of electricity for the state's consumers even as they assumed wholesale prices would drop. The state's utilities were supposed to benefit by keeping the difference between the price of power in the open market and what they collected from consumers.

That worked fine until the prices in the wholesale market took off. But as they soared, the utilities couldn't raise what they charged consumers. Now PG&E Corp. and Edison claim they are on the hook for $9.5 billion worth of power that they purchased on behalf of consumers but for which they have not been fully compensated.

Belatedly, action is being taken. The Federal Energy Regulatory Commission, which regulates the transfer of electricity across state lines, ruled on Dec. 15th that California's utilities and power generators must negotiate multi-year contracts for 95% of the state's power needs. State authorities are also trying to speed construction of new power plants. The rate hikes will also help.

Clearly, these are all stop-gap measures to plug the holes in what has escalated into a runaway state energy crisis, a political nightmare for Governor Davis, and a looming worry for the rest of the country. But at this stage, just plugging the holes seems good enough.