In Service to the Governor: A David Freeman Energy Crisis Update

David, when Metro Investment Report last interviewed you in December, you were very direct about saying that the State was in a "full-fledged energy crisis." Clearly, that's proven to be more than true, and since then, you've been enlisted to advise the Governor and the Legislature. Give our readers some sense of the scope of your responsibilities as well as the nature of the now evolving crisis.

My responsibility was to negotiate a portfolio of long-term contracts with private companies for the bulk of the power that the State has taken over responsibility for purchasing, which amounts to about one-third of California's overall electricity use by the private companies. My leave of absence from the L.A. DWP was only about a month, so it was a very intense situation. But we managed to complete at least a basic portfolio.

The job is certainly not finished, but we have moved from being entirely on the spot market for that one-third to being under contract for a large percentage in the years ahead. We have about 30% under contract right now, and that percentage will go up. We deliberately stopped at about 50% because we want to leave open the possibility that a viable and competitive market will return in 2004 or 2005.

In short, we purchased about $40 billion worth of electricity at an average price of 7¢ a kilowatt-hour (compared to spot market prices recently around 30¢). So while we greatly reduced the price, it's still a lot of money.

Could you embellish on the other elements of the State's strategy for handling the crisis?

Mr. Mike Peevey, the other advisor to the Governor, has been negotiating with PG&E and Edison the terms of buy-out deals. Basically, the State will purchase the utilities' transmission systems and possibly some other items, enabling the utilities to pay off overdue debts and giving the State some value for that cash. This will hopefully return the utilities to functioning levels. Right now, they don't have the money to pay their bills.

The reasons for taking over the transmission systems are much more fundamental than the financial status of the utilities, although it does revolve around it. The main problem here is that we have some major bottlenecks in that transmission system, and the down-and-out California utilities have not expanded capacity. Even before they were down-and-out, they didn't have the incentive to expand it because it's a regulated industry with a low rate of return. If you're sitting at the top of a group of companies, some of which are unregulated and some regulated, you're going to put your money in the unregulated sector. As a result, the transmission system in California has not been expanded.

There were many days in the last few months when there was plenty of power in California, but because we couldn't get it from south to north, we had rolling blackouts in the northern part of the State. So one of the main reasons for the State taking over the transmission system is to be able to invest money in expanding the infrastructure so that we can move electricity as it's needed. And if we don't do that, no matter how many power plants we build, we'll still have shortages and high prices.

In addition, if you're ever going to have a competitive industry, the transmission needs to be in neutral hands to be sure that everybody has equal access-just like the highway system and the water system. This purchase is definitely a step forward in serving the public interest.

David, returning to the roots of the current crisis, how did the utilities become so dependent on the spot market? And aren't rate increases for Californians now inevitable?

What people have forgotten is that this deregulation experiment actually worked the first year because there was a surplus of power in California. Then last summer-as loads grew and power plants were not completed-we started to have a shortage. In my view, the Federal Energy Regulatory Commission (FERC) really fell down on the job by refusing to regulate the wholesale price. And because of the shortage, prices shot through the ceiling while the retail price did not go up very much. The two major utilities thus accumulated huge bills that they are now unable to pay. There's a huge argument about whose fault it is, but those are the basic facts.

In order to keep the lights on, the State has taken over the job of buying at least a third of the electricity required to satisfy the customers of the investor-owned utilities. The idea is that for that one-third, the rates will be adjusted to pay back whatever it costs to buy that power.

Whether we can get by without a rate increase-other than the ones already in the works-remains to be seen. It's primarily a question of how well the State can negotiate the contracts with independent power producers (which accounts for another third), as well as what price the PUC sets for the utilities' self-generation. The utilities still own some nuclear and hydro facilities, which are lower in cost per kilowatt-hour than the existing price.

Give our readers a sense of what the magnitude of the State's crisis will or could be this coming summer.

This summer, the name of the game is going to be conservation. While we do have a certain amount of power under contract, the truth is, there is still a very real shortage.

Traditionally, the State has imported about 25% of its electricity. But the current drought in the Northwest-which is not going to be eliminated by a little bit of rain-coupled with the fact that the loads outside of California have grown faster than ever before, means that we are not going to get the out-of-state power that we've relied on in the past. And we're going to be short.

To avoid massive rolling blackouts and skyrocketing energy prices, California must adopt the most aggressive conservation program this country has ever seen. Governor Davis is currently working out the details for such a plan, and I look forward to the announcement. [For Governor's Comments to Wall Street, See page 14.] But with an aggressive program and average weather, the rolling blackouts should be minimal.

David, you've been involved in public power for most of your long and illustrious life, and you're very experienced with the politics. But this current crisis must be an exceptionally difficult challenge. Give us a sense of how this crisis is being handled by our State's leaders.

It's pretty clear that with California's electricity deregulation experiment, the old, fairly stable system of private ownership of utilities and public regulation on a cost-plus basis was thrown out the window without sufficient thought as to what happens in a shortage. Now, since that worst-case scenario has in fact occurred, as far as the people of California are concerned, private power companies and the governmental institutions that regulate them are a complete and utter failure. And public power agencies are a success. Electricity is adequate and prices are stable in the City Los Angeles, which has maintained its public power department, while the surrounding suburbs served by Edison and the City of San Francisco and other areas served by PG&E have experienced rolling blackouts and rate increases. As a result, public power has made a great leap forward in the eyes of Californians. So without trying to argue about whose fault it is and why it happened, those are the simple facts.

We're now in the process of creating a California Public Power Authority in addition to the agency currently buying electricity from the private companies, the State Department of Water Resources (DWR). This is a situation no one ever dreamed would happen. I don't take great joy in the crisis itself, but I do think that creating a greater public presence in the power industry will assure people of an adequate supply and reasonable prices in the future. What may come out of this is a hybrid system made up of functioning private companies and perhaps even a competitive industry for generation, as well as a "supplier and conservationist of last resort," the California Public Power Authority.

The Legislature and the Governor will watch very closely to make sure that we maintain control of our own destiny because we've learned that the federal government is not a reliable regulator. And without a reliable regulator for something as crucial as electricity, you're up a creek without a paddle if ever there's a shortage.

Let's focus on the federal government's role. It appears that there may be a change in the chairmanship of FERC. Can you elaborate on what the impact of such a change would be?

Even if they do change the chairmanship, the Bush Administration is completely dedicated to deregulation. Then Governor Bush said that flatly during the campaign, and that's one promise I think he'll keep.

In my opinion, you can simply count the federal government out; California is on its own.

A number of cities and subregions have come forward to investigate forming joint public power authorities, including the Pasadena/Glendale/Burbank cities. Even the new Mayor of San Diego-both during and after his campaign-has talked about the possibility of public power. What do you see as the practical future of these public power efforts?

A California Power Authority that can build plants and provide cost of service electricity to local public power agencies. It could provide a combination that may very well result in growth for public power.

The corporations that owned the old Edison utility and the old PG&E utility are now dominated by their unregulated subsidiaries, which are competitive businesses that own power plants all over the world. One likely scenario is that these parent corporations-Edison International and Pacific Gas & Electric Corp.-may decide that this regulated utility business is something they'd rather not fool with, which would open the door for public power to dominate. It's likely that private companies will continue to provide the bulk of generation (with a State Power Authority supplementing unmet need), but the distribution facilities may well be turned over to public agencies. That is by no means a radical scenario. These corporations have tasted the finer wine of unregulated profits, and they may not be all that interested in meager rates of return.

This is a fascinating situation that is just beginning to emerge. If there's one thing I've learned, it's that I can't predict the future. But it's certainly useful to observe that public power is taking a giant leap forward and private power has meanwhile fallen on its face. And what hurdles will Burbank/Glendale/Pasadena face in creating and implementing a municipal joint power agreement?

Joint power authorities are a dime a dozen in California. Because they're already public power entities, they can easily form a joint action agency and build a power plant if they want to. There's nothing new about that.

I don't see any real hurdles aside from being able to get together and come up with something that everyone agrees on-which, of course, is a good size hurdle by itself.

Assess for our readers the challenges communities and power companies face when trying to permit new plants, given the environmentally conscious, dense metropolises that make up California today?

Not only is that so-called "conflict" greatly exaggerated, but it's an excuse, in my opinion, that the generating companies are throwing out to explain a very interesting phenomenon-that the price of electricity in 1997 was too low to encourage their investment. That might sound like a new idea, but I've spoken with some of these companies, and many of them would probably admit it's true.

When I came to Los Angeles in September of 1997, we were facing a 2.5¢ market for electricity, which was sufficient to cover the cost of natural gas and operating expenses, but wasn't enough to cover the capital costs of a new plant. So guess what? None were built.

But no one's giving that as the reason the plants weren't built; they're blaming the environmental constraints. Well, about 40% of the power supply in California comes from plants that are 35 to 40 years old, and those facilities could be easily replaced with larger, cleaner plants at the same sites. In fact, that's exactly what the L.A. DWP is doing right now. So don't tell me that the siting and the environmental concerns are the problem.

I'm not saying there was some kind of conspiracy; these generating companies simply acted as rational folks who have no responsibility for power supply. Until the State relieved the utilities of their obligation to keep the lights on, they had done that job very well for 60 or 70 years. We still have that responsibility in Los Angeles, and it's the only place where the lights are on steadily. So that ought to tell you a lot.

David, how good a job are the Assembly, the State Senate and the Governor's Office doing re: handling this crisis?

I don't think anyone realizes the hours that both the Governor and many members of the Legislature-like Speaker Bob Hertzberg, Senator Debra Bowen, Assemblyman Rod Wright and others-have been putting in. We talk about buying power 24/7, and these folks have been working literally around the clock. Now, some may say they should have done this work a lot sooner. But the truth is, "democracy is the worst form of government known to mankind except for all the others."

If it weren't for the leaders in the Legislature and the work of the Governor, these two utilities would have been bankrupt long ago, and that certainly wouldn't have been good for consumers. God only knows what kinds of price increases we would have had to bear in order to pay off all the debts of the creditors.

These leaders were dealt a bad hand, and there wasn't much in the way of corporate history to guide them in fixing it; it basically blind-sided them. All I know is that they're working mightily-almost frantically-on the problem, and they have thus far succeeded in at least keeping the worst from happening. We had some blackouts; we had some slight rate increases. But if you consider the fact that the price for natural gas has gone up 60%, I think the difference in electricity prices is a tribute to the work that's being done in Sacramento.

Bringing this to a close, we asked you at the end of our interview in December to comment on what the landscape would look like six months ahead. You said, "We are in crisis mode, and we are not going to be out of it for a couple of years no matter what we do. The issue is whether we're going to do some things today that will get us out of it two or three years from now." It's now three months later, and you've since been asked to be part of the consulting team for the Governor and the Legislature. What's your take on the timeline for getting past this crisis?

Well, we're mightily trying, and I think there are some good things in the works. Are they done yet? No. I'd say the deals with Edison and PG&E are on the 10-yard line. We have a major conservation program that is still a work in progress. And like I said last time, the price of natural gas is still a giant wild card here, and until we get more of a handle on that, the future price of electricity is very much up for grabs. But there has certainly been a tremendous increase in the level of effort and a good deal of progress in getting the problem properly identified since we last talked.

Whether we get by without a lot of brownouts or blackouts this summer depends in great deal on the strength of our conservation program. But I do think we've acquired enough long-term contracts to be fairly optimistic about 2002 and 2003, and certainly 2004.

So I wouldn't change a lot of what I said three months ago, except that it's more of a work in progress. You know that old and tired expression about light at the end of the tunnel. It's coming, but we ain't there yet.