Deregulation

Power Tripped

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

|

Dominic Ciolino has had many headaches in the 13 years that he's owned Dominic's, an intimate restaurant specializing in Sicilian cuisine. But his electricity bill—which hovered around $700 a month—wasn't one of them. That changed last summer, when Ciolino first heard about San Diego's electricity problem on the evening news. "I thought, 'That's cool, whatever,'" says 52-year-old Ciolino, whose restaurant sits in Escondido, California, a blue-collar community about 30 miles north of San Diego. "Then I looked at my bill and said, 'Holy shit.'"

At the peak of the crisis last summer, Ciolino's monthly bill from San Diego Gas & Electric nearly tripled to $2,000, as electricity rates in San Diego jumped from under 4 cents per kilowatt-hour in May to roughly 13 cents in July. Although his electricity bill has shrunken back to about $1,200 a month, last summer's increase devoured his savings and the current cost is gobbling up what used to be his profits. "I had to go to my kitty," recalls Ciolino. "The thing is outrageous. How the hell do you run a small business like mine? You try to put a little money away and you can't."

At least he's still in business. Seeing no relief from his own $2,000-a-month electricity bill, fellow San Diego County restaurateur Steve Gramzay shuttered his 4-year-old Le Peep Grill, a popular breakfast spot in the beach town of Encinitas. "There's no sense in banging your head against the wall," Gramzay told the North County Times.

But bang their heads against the wall—and shake their fists at power companies, politicians, and regulators—is exactly what thousands of San Diegans did last summer, when their electricity bills spiked like the Nasdaq used to. Businesses dimmed their lights, turned up the thermostat, and shut down appliances in order to save power. Individuals turned off air conditioners and sweated it out. And they protested. "The more people talk about it, the more you will get politicians listening," 40-year-old Pam Ashby told The San Diego Union-Tribune last August while protesting outside the Sempra Energy building, headquarters of San Diego Gas & Electric's parent company.

San Diegans were the first, and in some ways only, Californians to experience the full effect of the state's now-notorious electricity crisis. Electricity was in short supply throughout California last summer—reflected in wholesale price spikes of 700 percent—and it remains so at press time. Indeed, rolling blackouts have even dimmed the lights in places as unused to scarcity as Beverly Hills. But SDG&E was in the unique position of being allowed to charge its customers the full cost of power.

Elsewhere, government-mandated retail price caps were still in effect, which kept consumers' bills steady. It was the utilities—PG&E in the North, Southern California Edison in the South—that were looking at their bills and exclaiming, "Holy shit." Buying power for as much as 75 cents a kilowatt-hour and selling it for a measly average of 12.5 cents a kilowatt-hour, the utilities ran up billions of dollars in bills to power suppliers that they couldn't pay.

Of course, it wasn't only utilities and San Diegans that were affected. Energy-hungry businesses found themselves without power, either because they had signed "interruptible" contracts (in exchange for a lower rate, they agreed to go without electricity in times of extreme scarcity) or because they simply couldn't get power. Miller Brewing Co., which lost power 24 times between June 2000 and January 2001, shifted production from its Irwindale plant to Dallas, idling 750 workers. Steel plants shut down, leaving thousands of workers at home, and the production of such essentials as potato chips, pork rinds, and cottage cheese fell victim to the power shortage. As of press time, the lights have gone out five times in California, including twice in March, when demand was roughly half of what it's expected to be in the summer period. Expect to read more tales of people stranded in elevators and staring at darkened movie screens.

The Blackout Bandwagon

Why is cutting-edge California experiencing a power crisis worthy of Cuba or North Korea? "Capitalism is falling apart," vented Los Angeles Times columnist Robert Scheer in late December. "The result [of deregulation] is now bordering on catastrophic with utility companies demanding enormous rate increases or they will declare bankruptcy." Likewise, MIT economist and New York Times columnist Paul Krugman blames "placing blind faith in markets." "California's deregulation is a colossal and dangerous failure," declared Gov. Gray Davis in his January State of the State speech.

Only Scheer totally misses the mark, as capitalism isn't falling apart and has little to do with California's energy crisis. But it's true that a sort of blind faith in markets—academic blind faith in the spot market, to be more precise—helped turn the lights out in California. And the state's deregulation is a disaster, ? la Davis. The governor's only problem—and not an insignificant one when it comes to diagnosis and solutions—is his choice of words. It isn't deregulation that is a disaster in California, but re-regulation. Contrary to all the hand-wringing and accusations, the state never deregulated its electricity industry in the first place.

Roughly half a decade ago, energy deregulation became big buzz in Sacramento, when it dawned on politicians and business leaders that the state's relatively high energy prices were hurting its economy. Other countries had lowered energy costs by opening services traditionally delivered by public utilities to something like market competition, so why shouldn't California? In June 1994, on the day after Nicole Brown Simpson was found dead, the California Public Utility Commission opened hearings on deregulating the state's electricity market. By late 1995, it had completed a plan, and in 1996, state Sen. Steve Peace (D-El Cajon) decided to step to the front of the parade. He gathered the relevant players—big industrial customers, utilities, environmental groups, consumer groups, and the state's utility regulators—and put together an electricity-restructuring bill that passed the legislature unanimously and was eagerly signed by Republican Gov. Pete Wilson.

Such legislative unanimity was the first sign of trouble; whenever that much consensus is reached, especially on a topic that traditionally causes a lot of friction, you can safely bet something screwy is going on. But the restructuring plan was so popular—and so hurried—that there was little time for anyone outside of Peace's working group to really peruse the 67-page law, much less debate its wisdom. Instead, everyone was left to trust that the involved parties had gotten it right.

Some observers did sound alarms at the time. "Two things should be obvious," said former chairman of the Wisconsin Public Service Commission, Charles Ciccehetti. "First, none of this should be called deregulation. Second, it is difficult to see how any of these myriad regulatory schemes, unless altered significantly "will lower prices." The New York Mercantile Exchange, experts in the creation and function of commodity markets, sent the California Public Utilities Commission a memo predicting that the new rules would result in less competition, less product and service information, higher prices, lower consumer value, and higher costs.

But none of that mattered. Everyone involved—the pols, the environmental groups, the power providers—wanted it to work, since, like any successful political coalition, it contained something to placate all the different players.

Politicians, claiming the plan would provide consumers with more choice and lower prices, funded an $87 million propaganda campaign to spread the good news throughout the state. Big businesses figured their purchasing power would mean lower prices. Consumer groups didn't kick up a fuss because they had secured plenty of restrictions on how the utilities could operate; they also got an immediate 10 percent rate cut and price caps. Environmental groups were able to maintain the status quo on environmental rules, including where power plants could be placed; they were additionally titillated by the prospect of environmentally friendly power competing against dirty juice. Utilities got billions in subsidies to retire old debt. And the regulators got to keep their jobs.

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."

Did it ever. Times have been great in California over the past few years: The economy has been working at capacity; more people have moved into the state; folks have been buying and air conditioning larger homes; they've been surfing the Internet and powering up all sorts of new appliances; golf carts have been filling up the state's fairways. Everything, in short, has been expanding in California since the restructuring, a situation that creates more and more demand for electricity.

The Ostrich Approach

There may be only one area in which California has not been growing: the number of power plants. It's difficult to get a permit and a site for a power plant in California, be it in an economically depressed area clamoring for jobs or a high-tech Mecca that demands power. Although no definitive study has been done, it's generally agreed that a power plant that takes two years to build in a business-friendly state takes at least four years in California. Sunlaw Energy Co. wants to build a $256 million natural-gas-fired plant in South Gate, a blue-collar city in Los Angeles County. The plant is projected to bring in $6 million in annual tax revenue and $1 million in neighborhood improvements—neither of which has been enough to assuage community activists who are fighting the plant.

In the Bay Area, new economy behemoth Cisco Systems is leading the charge against a proposed Silicon Valley power plant that makes so much economic and environmental sense that even the Sierra Club supports it. "If there's ever a place that needs a power plant next summer it's the Silicon Valley," says Beth Emery, who served as the general counsel for the Cal-ISO from November 1997 to November 1999 and is now specializing in energy law in the D.C. office of the law firm Ballard, Spahr, Andrews & Ingersoll. "These people have lost their minds." During last summer's crisis, activist groups killed a proposal to float an electricity-producing barge in San Francisco Bay—even as the city faced blackouts. The result of all the obstruction: From 1996 to 1999, electricity demand grew by 12 percent while supply grew by less than 2 percent, according to the California Energy Commission.

That alone would have placed the system under stress. Indeed, the Cal-ISO road-tripped to San Diego in the spring of 1999 to host meetings and to warn anyone who would listen that if nothing was done to get more power on line soon, the lights were going to go out. When the summer turned out to be mild, it looked like a case of Chicken Little. But by last year, a number of shocks, ranging from unusual weather to a shortage of natural gas, combined with the rigid regulatory system, turned the Cal-ISO's prediction into reality.

"Anything that could go wrong did," says Emery. "High temperatures, lack of adequate resources, inability to get the right regulatory policy through, and then, to top it off, it's like every decision the governor and the commissioner had made compounded rather than helped solve the problem."

Jerry Taylor and Peter Van Doren of the Cato Institute chronicle the shocks in a forthcoming study. The price of natural gas, which fuels 49 percent of California's electricity and nearly all of its peak power, shot up in 2000. In 1998-99, natural gas was selling for $2.70 per million British thermal units (Btu). By December 2000, it was selling for $25 per million Btu, and spiking as high as $70. In addition, one of the four pipelines that supply natural gas to Southern California was shut down for much of August due to a break.

Three years of dry winters in the West left California, and other Western states, short of hydropower, with California's average hourly hydropower output dropping 40 percent from 1999 to 2000.

California's clean air regulations also boosted the cost of producing power. Since 1994, California has had a trading system for nitrogen oxide (NOx) emissions that forces utilities to purchase pollution credits in order to generate power. In the winter of 1999, the credits were selling for $2 a pound. One year later, they were selling for as high as $40 a pound. (Plants emit between one and two pounds of NOx per megawatt-hour of electricity. In January, regulators waived the permit requirements for generators.)

On the demand side, a hot summer and cold winter boosted demand. Like Spike Lee at the Academy Awards, the Golden State just couldn't catch a break. The result: On June 29, 2000, electricity was wholesaling on the PX for 43 cents per kilowatt-hour (roughly enough power to run a big-screen TV for a seven-hour Clint Eastwood movie marathon). That was seven times higher than the price had been on equally hot days in June 1999.

In a real market, utilities would have passed on most or all of that increase to customers, as SDG&E did to Dominic Ciolino and others in San Diego County. And customers would have either sucked it up or started using less energy. But with retail prices fixed at roughly 12.5 cents per kilowatt-hour, the state's utilities had to reach into their pockets to purchase the power at a huge loss. They figured they could do it for the short term. But the short term never ended. The utilities' losses mounted, approaching $15 billion when PG&E filed for Chapter 11 protection on April 6.

Shades of Gray

Faced with these problems, Davis has worked tirelessly to shift both the cost and the blame for California's mess. Wedded to retail price controls that were bankrupting the utilities—his primary goal seems to be that no voter's electric bill will increase on his watch—he asked the federal government to put price controls on out-of-state generators and force them to sell power to California. "Never again can we allow out-of-state profiteers to hold California hostage," Davis ranted in his State of the State address. "Never again will we allow out-of-state generators to threaten to turn off our lights with the flip of a switch."

Davis accuses power generators of manipulating the market, shutting down some plants, and withholding power to raise prices, and their profits. His suspicions were bolstered by the research of MIT economist Paul Joskow, who found that power generators were making more money than would be expected if wholesale markets were charging competitive prices. Davis set aside $4 million to fund an investigation by the state attorney general into price manipulation—never mind that federal and other state agencies were already making their own investigations. In mid-March, the Cal-ISO released a report claiming that, based on the costs of inputs, power generators had overcharged California utilities $5.5 billion for power purchased since May 2000. In the same month, the Federal Energy Regulatory Commission, which oversees wholesale energy markets, ordered wholesale power suppliers to refund $124 million in what it considered overcharges.

Yet it's far from clear that anyone was manipulating the market, let alone breaking any law. Economists Nguyen T. Quan and Robert Michaels point out that power sellers can make between 450 and 1,000 bidding decisions each day in California's market. The models used by Joskow and others to measure market manipulation take into account only a handful of bidding choices, and therefore are unable to distinguish between market manipulation and simply good business decisions. The usual accusation is that electricity generators withhold power from the day-ahead market so they can sell it in the hour-ahead market, when utilities are over a barrel to meet customer demand. But research by the University of California at Berkeley's California Energy Institute found that prices are just as often higher in the day-ahead market, and that companies cannot make higher profits just by withholding power to sell in the hour-ahead market. A Federal Energy Regulatory Commission investigation, which wrapped up in February, concluded that power plant outages were based on legitimate business grounds and not designed to raise prices.

"I don't know what market power means in this context," says Michaels. He insists that the relevant benchmark for price isn't the cost of generating power, but the price at which it can be sold in other markets. "There's not much evidence of anyone withholding power. Sure, the power is over cost, because demand is highly inelastic. But I don't call that market power. I call that equilibrium." Adds the Mercantile Exchange's Levin, "They invented a doomsday machine, and they want to blame the people who used it."

California's policy response has been even worse than Davis' jawboning. The first response came in July 2000, when the state reimposed price caps on SDG&E. "People conserved when the prices went up," says the Cal-ISO's Emery. "Then they capped prices and usage went back up. So this summer there's no incentive for people to conserve."

A January Public Utilities Commission order "temporarily" raised rates about 9 percent, but left the utilities still selling most of their power at a loss. By then, the utilities owed roughly $12 billion to suppliers and were unable to finance the purchase of any more power. In response to the situation, Davis called a special session of the legislature, which authorized the state to purchase electricity for delivery to customers. By mid-February, California was spending $45 million a day on power, and by early March the state's expenditures had already reached $3 billion.

In February, the legislature passed a $250 million conservation bill designed to cajole consumers into switching to energy-efficient appliances and battery-powered MP3 players. It authorized the creation of a state power authority: the California Consumer Power and Conservation Financing Authority, which can issue bonds to build power plants. (The bonds will be paid off with revenue from selling the power.) The legislature is working on bills to authorize the state to buy the transmission lines from the utilities, the tab for which is expected to be between $7 billion and $9 billion. If they don't want to sell, Davis has threatened to use the power of eminent domain. In late March, the PUC defied the express wishes of Davis and voted to raise electricity rates by nearly 30 percent. It also authorized the state to sell up to $12 billion in revenue- backed bonds to pay for power it has already purchased and to keep the lights on through the summer. In April the legislature passed a $1.1 billion energy conservation package to do such good works as teach children about the importance of turning off lights.

"None of the proposals on the table solves the problem, which is structural," says Levin. "The state is really taking over the electricity industry. It's a march to Marxism and a march to bankruptcy, we just don't know which march ends first."

More to Come

Davis was unwilling to allow the retail price of electricity to increase, to let the utilities go bankrupt, or to permit private buyers to purchase utility assets. (He hastily rejected an offer by the D.C.-based Trans-Elect to purchase the utilities' grid for $5.25 billion.) "Believe me, if I wanted to raise rates," the governor proclaimed on February 16, "I could have solved this problem in twenty minutes." His answer is a state bailout of the utilities. The only question on the table, it seems, is what form the bailout will take.

Davis first wanted the utilities' hydropower dams in return for the bailout, a plan he abandoned when an idea he liked better came along: options on the utilities' stock. But the California constitution doesn't allow the state to hold stock options, so Davis now proposes to buy the utilities' transmission lines. The common themes here are the state getting a piece of the action in exchange for billions of taxpayer dollars. "I give you a dollar; you give me a hot dog," is how state Sen. John Burton (D-San Francisco) describes the transaction.

Yet at least one of his colleagues, Tom McClintock (R-Thousand Oaks), isn't buying it. He estimates such a plan will stick each ratepayer with a $1,300 bill but do nothing to increase the state's power supply. "The ratepayers end up with the tab while the state ends up with the power lines," he explains, taking issue with Burton's frankfurter metaphor. "A more accurate description of the deal would be, 'You give me $1,300, and I'll give my friend a hot dog.' This kind of transaction usually requires a gun."

Yet Davis is getting considerable support for the takeover. Michael Shames, executive director of the Utility Consumer Action Network, points to four advantages of the state owning the grid. The first is financial, since the state would be able to issue bonds based on its full faith and credit. Savings will also accumulate, at least theoretically, since a state power authority will pay neither taxes nor dividends to investors. As a political entity, the state will be freed from much federal oversight. It will also be much more willing to cooperate with the state's municipal-owned utilities on grid maintenance and allocation. "Having the state purchase the transmission grid differs very little from the current status quo," says Shames, who maintains that the provision of electricity is inherently political. "The ISO will continue to run the grid; the utilities will continue to maintain the grid. The only change is literally on paper."

Others disagree, arguing that inefficiencies of political control will quickly overwhelm any possible financial advantage. They predict disaster. "They are on a full-bore Cuban-style recovery plan," says the Cato Institute's Jerry Taylor. "The state hasn't shown itself to be a particularly adroit player in electricity markets so far, and I doubt turning over the entire industry to these guys is going to make things better."

On April 5, Davis finally admitted the state faces a crisis and announced a plan to increase rates on less than half the utilities' ratepayers. His plan, which hinged on the utilities agreeing to sell their power grid, would provide the utilities with less money than the existing PUC plan. Unimpressed, PG&E filed for bankruptcy protection the next morning. Meanwhile, the state has locked in contracts for less than half the summer's expected load and experts are predicting blackouts.

"Armageddon is on the way," prophesies Levin of the New York Mercantile Exchange. He fully expects the lights to go out in California many times this summer unless its government wises up and forces businesses to contract directly with power companies for electricity. "The state is not an able-bodied commercial agent," he says. "It's a patsy, and everybody knows it. They are not buying that much power, and they are having trouble keeping the lights on now. And that's at 60 percent of load."

Such dire pronouncements are echoed by the Cal-ISO's Emery. "The summer is going to be worse than anything we've seen so far," she offers. "There's no easy way out now."