Power Tripped

Faulty re-regulation turns out the lights in the Golden State.

Adrian Moore & Michael W. Lynch from the June 2001 issue

(Page 2 of 4)

How It Doesn’t Work

Here’s the basic outline of how the restructuring was designed to operate: Seeking a closely managed system, the state’s politicians passed over a more freewheeling "direct access" model, in which businesses and residential customers would enter into agreements with utilities, generators, or whomever they wanted for power. Instead, the wise legislators created an actual centralized marketplace called the Power Exchange (PX) in a building in Pasadena. They prohibited utilities from contracting for power in advance, mandating instead that all electricity must be bought and sold there in day-ahead and hour-ahead spot markets. So all the companies that generated electricity for the California market and all the utilities that delivered that electricity to consumers had to hash out prices daily in that one place. The law allowed the PX to mandate that all the utilities pay the same -- and highest -- price offered on any given day.

Utilities, both established and new, would seek to deliver the power they purchased at the PX as cheaply as possible. Prior to restructuring, California’s public and investor-owned utilities generated most of the power that they sold. But under the new rules, investor-owned utilities were given a strong financial incentive to sell off at least half of their fossil fuel- fired power plants, since vertical integration, like passing out free Web browsers, is supposedly dangerous to consumers. If utilities didn’t divest, they were ineligible to dip into a slush fund to pay off bad investments in other power generating facilities. Before restructuring, the utilities self-generated 72 percent of the power they sold. By August 2000, they generated just 20 percent of the power that passed over their lines, purchasing the rest on the market.

Additionally, utilities were allowed to charge their customers a "competitive transition charge," which almost offset the 10 percent rate cut and allowed them to recoup their "stranded costs," a euphemism for stupid investments in inefficient plants often made at the behest of regulators. They sold their plants for 1.75 times book value, pocketing a total of $3.2 billion. A package of SDG&E peaking plants -- those that fire up in times of shortage -- sold for 3.8 times book value. That anyone was willing to pay such a premium price for the plants was a sign that the market was predicting scarcity in the future.

The utilities also got a cartel scheme worthy of trial lawyers and big tobacco. First, the state agreed to "securitize" the recovery of stranded costs, meaning the state sold bonds to pay off the utilities’ bad debts up front (utility customers have been paying off the bonds through the transition charge). Better yet, any new power providers entering the restructured California market had to charge customers the same "competitive transition charge" and hand the money over to the state.

The net effect was predictable: Between the price controls and the rate cut, any new competitor entering the California market would have to price their juice so cheaply that it wouldn’t be worth the effort. So few companies made one. At first, such sophisticated and aggressive players as Enron, Duke Energy, and Green Mountain Energy entered the market. But despite dispatching hundreds of sales reps and spending $5 million, Enron fell well short of its goal of signing up 700,000 new customers in a few weeks. It acquired a mere 30,000 customers and ultimately pulled out of the market. In all, only 1.7 percent of residential customers and 13 percent of total load changed companies. No competitor to SDG&E ever tried to lure Ciolino, the San Diego restaurateur, away from his traditional power supplier.

Early on, the new setup produced a windfall for established utilities. PG&E, SDG&E, and Southern California Edison, all of whom are crying foul now, pocketed $10 billion in profits -- a combination of the mark-up on the power they sold to customers, revenue from selling off power plants, and revenue from bonds to pay off their stranded costs.

Here’s the final part of the restructuring plan: The utilities still owned the electricity grid over which power was transmitted, but they no longer operated it. Instead, politicians created a nonprofit, quasi-governmental organization called the Independent System Operator, or Cal-ISO for short. If the utilities were unable to secure enough power on the PX, the Cal-ISO purchased whatever extra was needed to keep the state’s lights on and sent the bills to the utilities. Even the ISO was prevented from entering into contracts for power.

Spot Market Pagans

"California wanted to rely on short-term power," says California State University at Fullerton economist Robert Michaels. "They thought they could foist an academic vision of what the market is on people, instead of dealing with the power market that was. Outside of California, there is a diversity of power sources, including some short-term power traded at hour-ahead and day-ahead markets, and some power traded at months and years ahead. There’s power where I have an ownership claim on someone else’s generator. Some is interruptible, some reliable. There are just all these different dimensions. California restricted itself to one kind that was only a small fraction of the real variety out there."

Robert Levin of the New York Mercantile Exchange agrees, though he’s less charitable in his comments. "The essence of the California vision is complete stupidity," says Levin. He notes that it was designed by well-intentioned academics, who, although expert in electricity regulation and economic theory, had no experience in the real world of bilateral contracts and markets. "They deliberately and artificially made the spot market -- the most volatile market -- the primary market," explains Levin, who later adds, "I call them spot market pagans. They pray to it."

The PX price was only the "market" price paid for electricity in California, and that was under totally rigged circumstances. But what consumers paid for energy had nothing at all to do with any market, even the constrained PX one. Consumer rates were effectively set by the government, which capped them at roughly the 1995 level until 2002, or until a utility paid off its stranded costs. (This last point explains why customers of SDG&E got socked with massive increases: The San Diego-based utility, partly as a result of the huge price it got for selling off its power plants, was the first -- and only, so far -- California utility to pay off its stranded costs. Hence, SDG&E was free to raise its retail prices to reflect the increase in wholesale prices.)

Now this scheme may be many things, but a deregulated market it certainly isn’t. The Airline Deregulation Act of 1978 actually eliminated the Civil Aeronautics Board, along with many of its regulations. The 1980 Motor Carrier Act dramatically cut back the Interstate Commerce Commission and its role in controlling interstate trucking. In contrast, California’s electricity restructuring law did not shrink the state Public Utilities Commission, and in fact added two new state bodies -- the PX, to control all transactions between utilities and electricity generators, and the Cal-ISO, to take over control of the state transmission grid. The restructuring law lifted some rules on electricity generation, but imposed many more on the decisions and operations of the utilities.

There are plenty of clues to suggest that a true market for power never existed in California and that everyone knows it. In fact, Robert Scheer’s outrage at utilities demanding "enormous rate increases" is one: Companies operating in the market don’t ask permission to adjust prices. Another came when Public Utilities Commission head Loretta Lynch was asked why the PUC was taking months to act on requests by utilities to approve long-term contracts: "You just can’t allow any contract," she replied (emphasis added).

But the lack of a market that could handle fluctuations in supply and demand didn’t matter much, as long as electricity was plentiful and wholesale prices remained sufficiently under the politicians’ price caps. That was the situation, until last year. "We started out with 30 percent excess capacity," former PUC commissioner P. Gregory Conlon told the Los Angeles Times. "We thought we had enough time to get this up and running." Says Gary Ackerman, executive director of the Western Power Trading Forum, which represents power generators, "The assumption that wholesale power would remain cheap and that there would be no new generation needed until after the transition period turned out to be false."