July 12, 2004 - From the October, 2001 issue

The California Energy Debacle: A Perspective On The Lessons Learned

Californians have been deluged by media coverage re: the California energy crisis. With each successive news report, we were told who was to blame and how the whole crisis could have been averted. However, most of that coverage was based on interviews with politicians, pundits and advocacy groups each of whom had their own agenda. However, what none of those reports did was provide a macro-level perspective explaining how the economic stress put on the California economy by the electric crisis could have been alleviated. MIR is pleased to excerpt the following Congressional Budget Office report which attempts to get past the rhetoric and look to the lessons learned from this crisis.

By: The Congressional Budget Office

A broad goal of restructuring in California was to secure the benefits of competition for electricity consumers in two ways: by breaking up the vertically integrated, state regulated monopolies to create more wholesale suppliers, and by giving retail customers the chance to choose their power producer. However, the state's response to the crisis and its efforts to secure adequate electricity supplies and control volatile wholesale prices are leaving California with a new market structure.

The new market differs from the old regulated-monopoly system, from the interim restructuring plan, and from the competitive ideal that the state was working toward. Beginning in January 2001, the governor, the California legislature, and the Public Utility Commission acted to give the state a long-term role in buying wholesale power on behalf of private utilities. Lawmakers are also moving toward establishing a new state-owned utility that would not only buy power but also own and operate the transmission systems of the state's private utilities and build and operate new generating plants. The state has effectively abandoned the freeze on retail electricity prices, raising rates to help cover its costs of buying power.

The New Purchasing Agency

The California agency now charged with purchasing electricity is the Department of Water Resources (DWR). That department has become one of the largest buyers of electricity in the country. It has reportedly signed contracts that cover 90 percent of the wholesale purchasing requirements of the state's three large investor-owned utilities-or about one-third of California's total power use. In addition, a new agency, the California Consumer Power and Conservation Authority, will acquire generating capacity to supplement the state's supplies and sell the power it generates to the DWR. A new state bureaucracy will also be needed to manage much of California's transmission grid if the state is successful in taking over the transmission lines of the three large utilities.

California is planning the largest state or local bond issue in history-as high as $13.4 billion-in the fall of 2001 to finance its purchases of electricity and natural gas in 2001 and its acquisition of private transmission assets. Revenue from the sale of those bonds may also be used to help shore up the financial position of the private utilities. In the first seven months of 2001, the DWR spent about $9.5 billion from its general fund and from short-term borrowing to buy electricity and natural gas (recouping only about $1.5 billion from reselling that power to utilities). The agency made those purchases in the spot market for immediate delivery as well as in the markets for short- and long-term delivery, with signed contracts valued at over $45 billion. The contracts guarantee delivery for various periods, some as long as 20 years.

With the emergence of the DWR, the role of the state's private utilities and the PUC (which regulates those utilities) is diminishing. And with one large buyer replacing three utilities in the state's wholesale market, competition will most likely diminish as well. Those utilities may keep their nuclear and hydropower generating plants and their long-term supply contracts with qualifying facilities, but otherwise they will have a small presence in the wholesale market. Instead, the utilities will act as distributors of power purchased by the state, charging retail customers for the full cost of those purchases.

The future position of the state's independent power producers may also be in question. Not only are they facing fewer buyers, but their biggest customer, the state, may have the authority to seize their assets if it believes they are charging too much for electricity or restricting supplies. The California Senate passed a resolution in July 2001 indicating that it would support the governor in such a seizure.

In August, the PUC effectively yielded authority to the DWR to set retail electricity rates without public review in order to ensure sufficient revenues to cover its bond issue. (Both organizations are subject to direction from the governor's office, which appoints members to the PUC and selects managers of the DWR.) The PUC had already approved rate hikes in January and March to help cover the state's costs. In the future, the state will direct the large private utilities to set rates that will repay expenses incurred in 2001 and cover the state's current costs of buying power. The state plans to secure its upcoming bond issue with those power revenues. The PUC will continue to oversee the part of the retail rate that covers the utilities' cost of generating electricity, having power purchased on their behalf, and distributing power. It is not clear which organization-the PUC, DWR, or a new agency-would decide what rates are necessary to finance operations of a future state-owned transmission grid.

Implications of the State's New Role

California's actions represent a blunt solution to the problems of insecure supply and volatile prices-a solution that ultimately may present the state with many of the same problems that restructuring was intended to solve. The goal of securing the benefits of competition appears to be farther away than ever. For example, tension exists between the state's need to raise rates to pay for the debt it incurred during the crisis and the right of ratepayers in a competitive market to contract with other power providers. In fact, since the rate hike of March 2001, some industrial customers have begun exercising their option to choose other suppliers. As a result, the state wants to rescind that option for all customers. The situation is similar to the one that prevailed before the crisis, when utilities with stranded costs opposed a rapid switch to a competitive system because it would leave them unable to recover those costs from ratepayers.

Two other factors that could make it harder to achieve the goal of competitive prices are the lack of transparency of state actions and the possibility of government subsidies to the state electricity business. In general, the state will not be subject to oversight in its rate setting. Electricity rates are supposed to cover financing costs, current power costs, and administrative costs. Because the state is actively concerned about security of supply, it may be putting too much emphasis on costly long-term contracts-much as the private utilities relied too heavily on risky spot-market purchases. Already, in July 2001, as demand and wholesale prices dropped with moderate weather in the West, the average cost of the state's power purchases ($133 per mWh) rose above the average price in the spot market ($82 per mWh). Those and any future losses on power purchases will be passed on to consumers. Moreover, it is not clear what "administrative costs" of the state will find their way into retail electricity prices. With no oversight, California has already demonstrated its reluctance to publish information about the contracts it has signed or its costs of purchasing power and has released that information only under court order.

If the state cannot recover all of its electricity-related costs through retail prices, California taxpayers will have to make up the difference. In short, the state may be at risk of creating a major government-subsidized industry-an industry that private suppliers could be at a disadvantage in competing against. California's problems have occurred at a time when many other states are restructuring, or are debating the merits of restructuring, their electricity markets. The experience of California suggests several lessons for those states about both the supply and demand sides of electricity markets. In particular, if markets rather than regulation are to determine the price of power, prices must be allowed to respond when unanticipated disturbances occur-such as last year's very hot summer in the West. The supply and demand sides of the market together must be sufficiently robust to dampen such swings.

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Supply-Side Lessons

The lessons for the supply side of the market are twofold. First, restructuring is more likely to succeed when more of the power in a market is free to respond to price signals. As California attempted to restructure, regulatory constraints limited the flow of power to the state's wholesale market from municipal utilities in California, from utilities in other states, and from federal power agencies. Second, utilities should be free to manage the risks of adverse price movements in that competitive environment by entering into long-term contracts. One lesson not to take from the California experience relates to the size of the reserve margin: building enough generating capacity to meet the demand for electricity under any scenario may not be cost-effective.

If restructuring is to allow supply to be more responsive to prices by moving power within the market, it must also address regulatory barriers to the construction and operation of transmission systems. A restructured market that works well will probably feature an immediate increase in the demand for transmission services, as communities increasingly acquire power from new sources in new locations not envisioned by the original designers of the transmission grid. The regionwide costs of supplying electricity can drop if low-cost generators from some states in the region are able to provide more power than before. Moreover, the responsiveness of regionwide supply can improve if additional suppliers from part of the region are able to put more power into the grid to offset disruptions in supply locally or unexpected surges in demand elsewhere in the region. To realize those gains, however, consumers must be willing to accept a trade-off: the lower prices that result from access to out-ofstate power supplies will sometimes rise when their state sends supplies to other parts of the region.

Making sure that transmission capacity does not limit the responsiveness of supply may require changing how transmission services are regulated and priced (to create appropriate incentives for new construction) and how new lines are approved. For example, some analysts have called for charging different, market-sensitive rates for transmission in different parts of the overall system-a practice known as node pricing-to provide greater incentives for construction to remove bottlenecks. The FERC believes that creating regional transmission organizations to operate large sections of the grid could help, too.

Restructuring is also more likely to be successful if utilities are allowed to use standard risk-management tools. Letting utilities both enter into long-term contracts with suppliers at fixed prices and hedge through the futures market would help protect them from the financial difficulties that have plagued California's power distributors. It would also enable the utilities to offer greater price certainty to their customers (in place of a freeze on retail rates). That price certainty is important not just because it protects against high prices but because it creates a better climate for producers, distributors, and consumers.

Having a large reserve of generating capacity could ease the transition from a regulated to a competitive market structure. Indeed, if California had implemented its plan in the early 1990s, when the state's utilities still possessed more capacity than they needed, the market could have better handled the stresses that arose in the summer of 2000. That improved response could in turn have masked some of the faults of the restructuring plan.

Creating such a reserve as a matter of policy, however, is an expensive way to ensure price stability. One of the reasons that the state moved to a competitive market structure was to help reduce electricity prices by lowering the costs of the utilities' reserve capacity. In a competitive market, producers' investment in reserve capacity should be consistent with the amount of price stability (or, equivalently, supply security) that consumers are willing to pay for in the form of long-term supply contracts.

Demand-Side Lessons

California's freeze on retail rates inhibited the response of electricity users to the state's supply problems. Thus, it proved to be a major factor in the ensuing crisis. A simple lesson of that experience is that consumers need to face the real cost of electricity. Exposing consumers to price changes will induce them to increase their use of power when prices fall and curtail it when prices rise. When prices do not change along with costs, and when the amount of power demanded cannot respond to prices in that way, a greater adjustment must be made on the supply side of the market.

Price signals should encourage consumers not only to buy more or less power now but also to invest in the ability to adjust their future power use. Some of the same demand responsiveness that results from having consumers pay market prices may also be achieved if utilities either compensate customers for reducing their use or allow customers to resell power to others (in which case, a third party is paying them to reduce their use).

An important distinction exists between long- and short-term capabilities for lowering power use. In California, consumers have already responded over the years to high electricity prices by, among other things, adding thermal insulation to buildings, purchasing efficient appliances, and switching to natural gas. Those are long term investments. Indeed, the state ranks among the lowest nationally in per capita use of electricity by households. However, electricity consumers-particularly households -have acquired few devices that would let them reduce electricity use on short notice, such as real-time meters (which would tell them when prices were changing), backup power supplies, or dual-fuel capabilities. One reason is that consumers do not usually face real-time prices (in particular, the full cost of generating electricity during peak-use times). Another reason is that although electricity prices in California have been high overall, they have historically been stable.

Some analysts believe that the supply adjustments and resulting price increases in California would have been much smaller if various techniques to manage demand had been in wide use before restructuring. For example, several approaches can make real-time pricing easier, such as technologies that monitor electricity use and prices, and contracting arrangements with electricity suppliers that permit the customer (or a designated agent) to interrupt service when the price rises. In many cases, large industrial customers already have the capacity to monitor and adjust their demand in the face of rising prices and, in fact, do so. Successful restructuring may necessitate that residential and commercial customers acquire many of the same demand-management capabilities that industrial consumers have.

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