San Francisco Chronicle - 24 Dec 01

Prof. Robert B. Laughlin
Department of Physics
Stanford University, Stanford, CA 94305
(Copied 29 Apr 09)

The Energy Crunch: A Year Later

State's deregulation folly is no laughing matter
Consumers face inflated bills for years for failed electricity plan

Carolyn Said
Monday, December 24, 2001

It was supposed to save money.

Now that California has burned billions of dollars to keep the lights on over the past 18 months, it seems absurd. The entire impetus for the state's grand experiment with electricity deregulation was to cut costs -- for everyone from manufacturers to consumers to utilities to power generators.

Instead, California could be paying the tab for years. The state must come up with billions to cover its new role as electricity purchaser. And even though energy prices now have fallen, consumers and businesses still pay the higher rates imposed during the dark days of last spring.

It's a far cry from the rosy scenario of savings for everyone envisioned when deregulation got its start.

As predictable as characters in a commedia dell'arte, representatives of assorted interest groups trooped to Sacramento in the mid-1990s, enacting set pieces about their agendas -- all with the common interest of structuring deregulation to their benefit.

-- Manufacturers, who had just weathered a devastating recession in the early '90s, wanted flexibility to negotiate better power rates from providers other than the state's investor-owned utilities.

"Before deregulation, California had 50 percent higher (electricity) rates than its neighboring states," said Gino DiCaro, spokesman for the California Manufacturers and Technology Association. "That's why large industrial users pushed for it so hard."

Governor Gray Davis at the July 2, 2001, opening of a new Calpine power plant near Yuba City. Associated Press photo by Rich Pedroncelli.
Rolling blackouts hit San Francisco Jan. 17, stranding some in elevators. Associated Press photo by Jakub Mosur.

-- Utilities -- San Diego Gas and Electric, Pacific Gas and Electric and Southern California Edison -- wanted a way to recoup the billions of dollars in "stranded costs" they had sunk into nuclear power plants and contracts for alternative energy.

-- Consumer advocates wanted to shield electricity users from future hikes.

-- Power generators wanted every home, office and factory to be able to buy electricity directly from a supplier -- i.e., themselves.

-- Power regulators and lawmakers wanted to loosen the utilities' monopoly on both power production and supply.

Crafting Legislation

The Legislature was eager to accommodate everyone.

Once the Public Utilities Commission voted in 1995 to institute deregulation, the task of crafting a plan was entrusted to state Sen. Steve Peace (D-El Cajon).

Peace, such a policy wonk that he makes Al Gore look like Dan Quayle, plunged enthusiastically into the minutiae; his marathon late-night sessions to thrash out arcane details became known as the "Steve Peace Death March."

The complex bill passed with no dissenting votes, although later lawmakers admitted that many hadn't understood it. Gov. Pete Wilson signed it on Sept. 23, 1996.

The plan had something for everyone.

Manufacturers -- the steel makers, mining concerns and cement makers that spend a quarter of their overhead on electricity costs -- could line up their own sources of energy. Utilities were instructed to sell off their power plants so they would get payback for their initial investments, and also would no longer have a monopoly over both power production and supply. Consumers got a 10 percent rate cut and a promise of no rate hikes until 2002 or until utilities paid off their capital investments in power plants, whichever came first. The rate freeze also mollified the utilities, who wanted to make sure that rates would not go down.

Flawed from the Get-Go

The fundamental flaws stemmed from the fact that deregulation tried to have the best of both worlds: rate controls that applied only to wholesale prices, not retail prices; power plant ownership that rested in the hands of out-of- state generators, not local utilities; a dependence on the volatile spot market for purchases; and no flexibility for those buying electricity to just say no when the wholesale price got too high.

The breakdown on specific defects in the plan:

-- Rate freeze. Even though the consumer rate freeze was what made deregulation palatable to consumers -- and thus legislators, who wanted credit for saving people money -- it didn't encourage conservation among consumers or competition among electricity suppliers.

-- No cap on wholesale rates. The rate freeze affected only half the equation -- the amount consumers paid for electricity. There was no concurrent cap on what the utilities paid for electricity. That meant things could -- and did -- get drastically out of control. In fact, to encourage power generation, deregulation guaranteed the highest price for wholesale electricity. The last bidders in the market, who paid the most, set the price for everyone.

Former Gov. Pete Wilson. Associated Press photo by Chris Pizzello.

-- No long-term contracts. The plan forced most electricity purchasing to occur a day ahead or on the volatile spot market. The result was no ability to lock in cheap rates with longer-term contracts.

-- No flexibility to say no. The ISO managers were bred in the bone to keep the lights on at all cost. That meant that when supplies were tight, they would pay any price to ensure a consistent flow of juice. Power companies figured this out: Charging what the market could bear meant the sky was the limit.

-- No true competition. Competition among electricity generators was supposed to be one of the hallmarks of the new market. Theoretically, consumers would shop for the best electricity plan just as they do for the best long-distance phone plan, and the electricity companies would vie to offer the best rates. But because of the rate freeze, consumers didn't have any reason to switch suppliers. By early 2000, only 1 percent of consumers had switched.

-- Tight supply. A new power plant costs a staggering half a billion dollars for a 500-megawatt facility (large enough to light 500,000 homes). During the years the state thrashed out deregulation, companies were reluctant to invest in building plants in California, because they didn't know if the new market structure would let them recoup their investments.

Consequently, throughout the 1990s, the state built only a handful of small plants totaling 1,075 megawatts. But by the mid-90s, California was back to being a gold-rush state, with the population on the upswing and the tech economy booming. Generating capacity fell behind demand.

Clues Something Was Wrong

One of the first steps in implementing deregulation was for the utilities to sell off their power plants. That would open the market to a bevy of competitors, who would then vie to offer the lowest prices -- or so the theory went.

Out-of-state power companies, not ordinarily known for their spendthrift ways, bid big bucks to take over decades-old power plants -- a motley collection of black-smoke belching, decades-old electron factories. Six power firms spent $3.5 billion, many times the book value of the 17,000 megawatts of facilities. In retrospect, experts said, those big-bucks purchases showed that the companies must have realized that deregulation was going to be a happy hunting ground for them.

"Most industry observers thought those older-generation assets would go for bargain-basement prices," said state Sen. Joe Dunn (D-Santa Ana), who heads the Senate Select Committee to Investigate Price Manipulation in the Wholesale Energy Market. When instead they sold for huge prices, it should have raised some suspicions: "What did they know that the rest of us didn't?"

The Bay Area got a taste of blackouts during a bout of hot weather in June 2000. The sudden spike in demand not only shorted out the grid, it brought about an epiphany for power generators, according to Michael Shames, head of Utility Consumers Action Network in San Diego.

"The generators figured out how to game the market when San Francisco had that blackout from the freak heat wave," he said. "When the prices went as high as they did, they realized, 'You know what? If there's a shortage, there's no limit on what we can ask.' "

Ongoing hot weather down south kicked off another ominous chain of events. In San Diego, which essentially was the canary in the coal mine, the little clause that said the rate freeze could end once utilities paid off their debts turned out to have teeth.

The windfall from selling off its power plants gave SDG&E enough money to pay off its $2 billion in stranded costs. That meant the rate freeze was no longer in effect; instead, customers' prices would be determined by the market.

And the market went haywire.

Power generators "started holding back from the day-ahead market and pushing transactions closer and closer to real time," said Arthur O'Donnell, editor and associate publisher of California Energy Markets, a newsletter in San Francisco. "That turned out to be a recipe for disaster. Essentially, (generators) could double or triple what they might get by holding back."

Rates soared by a factor of up to 20 times for the 3 million SDG&E customers. The Legislature had to step in in late August to impose price caps.

PG&E and Edison were experiencing similar difficulties with ballooning power rates. As they were still barred from passing their escalating costs to customers, they began to accumulate billions of dollars in debts.

Mother Nature Steps In

Meanwhile, weather conditions were building to create a "perfect storm" scenario that would come into play for the entire state later in the year:

-- For several years, winters had been mild, so consumers used less heat, so natural gas providers slowed exploration, while utilities allowed stockpiles to be depleted.

-- The Pacific Northwest was in the third year of a drought in 2000; that meant the source for a significant portion of California's electricity would have an empty cupboard when crunch time hit.

-- The summer of 2000 was unusually hot, triggering increased use of electricity.

-- The winter of 2000-01 was unusually cold and everyone cranked up the heat. Natural gas was in short supply, so its price soared overnight. Most power plants in California also use natural gas to produce electricity, so suddenly their basic input was astronomically expensive -- which meant so was their output.

Hitting the Fan

By last winter, human myopia and greed, coupled with nature's relentlessness, had set the stage for an electricity fiasco.

And that's exactly what we got.

In January, the first rolling blackouts directly attributable to deregulation, not the weather, hit California. Their timing was mysterious, coming during the winter when electricity demand is low because no one's using power-guzzling air conditioners. The proximate cause was that a number of power plants were unexpectedly off-line, a situation that caused power prices to shoot up.

Power generators "would reduce power and see what happens to the price, just like Homer Simpson in the Barcalounger saying, 'The chair goes up; the chair goes down,' " O'Donnell said.

Still, he added, "There was nothing illegal or even especially bad about such activities -- merely profit maximization behavior by sellers taking advantage of flaws in the system to make money."

This pattern repeated itself for months. It led to speculation that generators were "gaming" the market, purposefully taking plants out of service to drive up prices. But substantiating those charges would require a smoking gun -- some tangible proof that electricity firms explicitly colluded to set prices -- something that has eluded investigators.

"If you go to a plant, and they tell you it's down, they'll say they have good reasons," said Severin Borenstein, director of the University of California Energy Institute. "What are you going to say, 'We don't think that cog needs to be replaced'?"

As the situation continued to spiral out of control, the state had to step in to take over the purchase of electricity from the foundering utilities, and slapped Californians with a rate hike to help pay the piper.

Edison and PG&E essentially ran out of money -- although their parent companies continued to exhibit healthy balance books. PG&E filed for bankruptcy reorganization in April, with Edison cutting a separate, $3.3 billion rescue deal with California.

Long-term Contracts

Grasping for a lasting solution, Gov. Gray Davis negotiated long-term power contracts so blackouts would no longer loom as a threat, paying $43 billion for power over the next 20 years.

But his timing was equivalent to buying, say, stock just before the dot-com swoon on the Nasdaq. "He basically bought this huge insurance policy through long-term contracts (but) paid way too much," said Peter Navarro, an economics professor at the University of California at Irvine Business School.

By signing the contracts at the height of the market, Davis locked the state into billions of dollars more than it should have to pay, observers said.

Davis retorted that the contracts were what brought down power prices. Now, Davis is scrambling to renegotiate those deals.

Philip Verleger, a Newport Beach economist, sees the genesis for the whole debacle in the blueprints for deregulation so tortuously drafted over half a decade ago.

"It's like the old joke about an economist: someone who knows 250 ways to make love and has never had a date," he said. "Everybody who was involved with the designing of this electricity system knew lots of ways to set up a market for electricity, but they had never traded.

"There's a wonderful saying by Ben Franklin: There's no uglier sight in life than a beautiful theory mugged by an angry gang of facts. California got squeezed about a million times, and its electricity market didn't figure it out."

About this Series

Yesterday: What ever happened to the energy crisis?

Today: The march of folly that led to the energy problem

Tomorrow: Deregulation is not dead...yet

Power Deregulation Chronology


April: California Public Utilities Commission indicates it favors deregulation.


October: Framework of deregulation laid out in memorandums between large users, energy providers and utilities.


January: Bills introduced in Legislature to codify deregulation plan.

August: The "Steve Peace Death March" hashes out fine points of law. It passes both houses unanimously.

Sept. 23: Gov. Pete Wilson signs the deregulation bill.


March 31: After a four-month delay, deregulation begins.


May: Wholesale electricity prices begin an unprecedented rise.

June: San Diego rate cap is lifted. Shortages drive prices up 300 percent in some cases.

September: The utilities begin to warn of billions in mounting debt and seek an end to the rate cap that has prevented them from passing costs on to customers.

November, December: More shortages put energy system in state of perpetual crisis.

Dec. 16: Davis calls a special session and reserves $1 billion in his 2001- 02 budget to deal with the power crisis.


Jan. 4: PUC announces three-month rate increase of 10 percent for PG&E and Edison customers.

Jan. 17: Rolling blackouts ordered in California for the first time. Davis declares a state of emergency.

Jan. 19: Davis signs $400 million bill to buy electricity and resell it to utilities.

Feb. 1: State lawmakers empower California to spend up to $10 billion to buy thousands of megawatts of power and sell it to consumers.

March 5: Davis announces he's signed long-term contracts for enough electricity to light 9 million homes over the next decade, at an average cost of $69 per megawatt hour. Details are kept secret.

April 5: Pacific Gas and Electric Co. files for Chapter 11 bankruptcy reorganization.

May 15: State regulators adopt most sweeping electricity rate increase in California history: up to 40% for residential and 50% for industrial customers.

June 18: Federal Energy Regulatory Commission unanimously imposes a sweeping price ceiling on wholesale price of electricity around the clock throughout the 11 states of the West.

July 23: Officials say California has lost $14 million in past three weeks selling surplus electricity back to power generators as mild temperatures and energy conservation reduce demand statewide.

Oct. 2: State regulators approve a bail-out plan for Southern California Edison that lets it keep higher rates in place through 2003.

Oct. 18: Davis administration says it hopes to renegotiate some of the $43 billion in power contracts to get a better rate than $69 a megawatt hour, now that average prices are around $30 a megawatt hour.