September 16, 2002
Deregulation in the California Electricity Market

This morning's Wall Street Journal has a long article about the failure of deregulation--or maybe, "the failure of the shift to a regulatory regime designed to create maximum feasible competition"--in the California electricity market. My problem is that I don't understand enough about the institutions to understand why the reform failed so badly. My hunch is that it has something to do with old arguments by Marty Weitzman about the relative desirability of price vs. quantity signals in different circumstances. The existence of very many very large firms in our economy demonstrates that there are lots of circumstances in which you would rather have "command" than "market" governing local resource allocation. Is there any reason to think that the inelastic demand for and inelastic supply of electricity makes it one such?


WSJ.com - Major Business News: ...California's energy crisis arrived at the end of an economic boom, but its roots lay in the early-1990s recession, which prompted complaints that high electricity rates were driving away businesses. The grumbling found a receptive ear with then-Gov. Pete Wilson and his appointees at the state's Public Utilities Commission. Encouraged by Congress and federal regulators, the PUC and state lawmakers crafted a plan to disassemble the traditional system for delivering electricity. Under the old system, utilities generated electricity and delivered it to customers in exclusive territories over their own power lines. To protect consumers, rates were regulated. California's new system, unveiled in 1996, sought to unleash the power of market forces, but through an unwieldy structure born of political compromise. Consumer rates would be cut 10%, then frozen for five years. Utilities would be transformed into middlemen, selling off most of their power plants and buying juice for their customers on the open market. And independent energy marketers could buy power plants and sell electricity directly to users around the state.

Though it was bannered as "deregulation," the new electricity market was rife with complex rules and regulations. These were to be administered by two new quasistate agencies with limited policing powers. The California Power Exchange set hourly prices for electricity through auctions conducted the previous day. All wholesale buyers paid, and all sellers received, the highest price needed to satisfy demand in that hour. Economists argued that such an auction system would eventually produce lower prices for consumers. CALIFORNIA'S ENERGY NIGHTMARE California's flawed deregulation scheme sent electricity prices soaring and led to rolling blackouts. Daily peak-hour power prices, per megawatt-hour at Palo Verde trading hub. [chart] June: Price spikes. Blackouts in San Francisco. Rates rise in San Diego. November: Federal regulators refuse refunds for ailing utilities. Gas prices spike. December: Generators briefly halt power sales. January: Rolling blackouts. Utilities suspend payments. State government begins buying power. March: More blackouts. State signs long-term contracts. State raises retail electric rates. May: Last blackouts. June: Gas, electricity prices fall. Federal regulators impose price caps across West. Source: Dow Jones Energy Indexes The second agency, the California Independent System Operator, managed the state's network of transmission lines -- known as "the grid" -- to protect reliability. The ISO ran its own auctions to set payments for last-minute adjustments to supply and demand...

As Blackouts Hit California,
Traders Manipulated Market

By SCOTT THURM, ROBERT GAVIN and MITCHEL BENSON
Staff Reporters of THE WALL STREET JOURNAL

POWER CRISIS
 Energy Firms, California Reach Settlements to Rework Contracts6
09/02/02
 
 FERC Launches New Probes Into Enron, Avista, El Paso7
08/14/02
 
 FERC Proposes Overhauling Wholesale Electricity Market8
08/06/02
 
 In Volatile Power Market, Utilities Got Badly Burned9
07/24/02
 


Shortly before 9 p.m. on Nov. 11, 2000, opportunity fell into Steve Tish's lap, courtesy of California's energy crisis. Mr. Tish, a trader at PG&E Corp.'s National Energy Group, had been buying small blocks of power at a trading hub in Arizona. Now, another trader wanted the juice at the California-Oregon border, more than 800 miles away, at a price more than double what Mr. Tish had paid for it.

RELATED COVERAGE
 Three Former U.K. Bankers Are Indicted in Enron Fraud1
09/13/02
 
See continuing coverage of corporate accounting issues on the Called to Account page2

It was a Saturday evening, and Californians were using around half as much power as on the hottest summer days. But California's deregulated electricity market was so badly broken that even at that late hour, parts of the state desperately needed more juice. The other trader knew he could quickly resell Mr. Tish's power and make a fat profit.

With a few more phone calls, the deal was done. On paper, the power coursed through five owners and more than tripled in price. By the time it reached California, the operator of the state's power lines had to pay $12,500 for Mr. Tish's $3,500 block of electricity.

Nearly a decade ago, California set out to remake the buying and selling of electricity, hoping to cut the power bills of the states biggest users. Instead, the state stumbled into blackouts and a $100 billion crisis, marking a critical turning point in the tussle between free markets and government regulation.

HOW ONE DEAL WENT DOWN
On the night of Nov. 11, 2000, PG&E's National Energy Group engineered a series of trades that had power change hands five times while it more than tripled in price. Here's a summary of how the deals worked.

[little calif.]
1. National Energy buys 50 megawatts of power for $3,500 from the Imperial Irrigation District at a trading hub in Arizona.

2. National Energy sells the power to the Los Angeles Department of Water and Power at the Arizona hub for $3,500.

3. LADWP moves the power to the California-Oregon border and sells it back to National Energy for $4,750.

4. National Energy sells the power to Constellation Energy Group Inc. for $7,500.

5. Constellation sells the power to the California Independent System Operator for $12,500.

The story is a complicated one, but essentially boils down to this: Government created a complex market ripe for manipulation. Growing demand and tight supplies let energy sellers dictate -- and in some cases manipulate -- prices, unchecked by half-hearted and overmatched regulators. Each time policy makers tweaked the rules, energy sellers devised new ways to exploit the system. The state only stanched the crisis through a costly intervention that put it in the power business for the foreseeable future.

The repercussions of California's descent into darkness spread far beyond the state's 35 million people and $1.4 trillion economy. The debacle tarred the concept of energy deregulation throughout the U.S. It exposed massive corporate greed, which in turn triggered an era of scandal and tougher scrutiny. And it set in motion the collapse of a new breed of energy marketers, once seen as engines of innovation and economic growth.

Even though the California power crisis clearly ranks as a watershed event in U.S. business history, many of the details have remained murky. For instance, regulators have yet to sort out what portion of corporate profits generated during the year-long crisis were due to outright manipulation. Nor is it clear the extent to which suppliers conspired to rig the market.

But a detailed examination of recently released internal memos by Enron Corp. lawyers, transcripts of trader conversations gathered by investigators, and scores of interviews with market participants and regulators yields a comprehensive look at how the U.S. energy industry cashed in on and contributed to California's energy crisis. Among the findings:

 Energy companies seized on loopholes and local shortages to charge prices hundreds of times higher than normal.
 
 Suppliers withheld power from the state's primary market, and sometimes idled power plants to induce shortages and boost prices.
 
 Gas companies manipulated supplies and prices, driving up the cost of a main ingredient of electricity.
 
 Enron played a much bigger role than previously believed in California's energy market. Its trading strategies overwhelmed regulators and drove up prices.
 

California's energy crisis arrived at the end of an economic boom, but its roots lay in the early-1990s recession, which prompted complaints that high electricity rates were driving away businesses. The grumbling found a receptive ear with then-Gov. Pete Wilson and his appointees at the state's Public Utilities Commission.

Encouraged by Congress and federal regulators, the PUC and state lawmakers crafted a plan to disassemble the traditional system for delivering electricity. Under the old system, utilities generated electricity and delivered it to customers in exclusive territories over their own power lines. To protect consumers, rates were regulated. California's new system, unveiled in 1996, sought to unleash the power of market forces, but through an unwieldy structure born of political compromise. Consumer rates would be cut 10%, then frozen for five years. Utilities would be transformed into middlemen, selling off most of their power plants and buying juice for their customers on the open market. And independent energy marketers could buy power plants and sell electricity directly to users around the state.

Though it was bannered as "deregulation," the new electricity market was rife with complex rules and regulations. These were to be administered by two new quasistate agencies with limited policing powers. The California Power Exchange set hourly prices for electricity through auctions conducted the previous day. All wholesale buyers paid, and all sellers received, the highest price needed to satisfy demand in that hour. Economists argued that such an auction system would eventually produce lower prices for consumers.

CALIFORNIA'S ENERGY NIGHTMARE
California's flawed deregulation scheme sent electricity prices soaring and led to rolling blackouts. Daily peak-hour power prices, per megawatt-hour at Palo Verde trading hub.

[chart]
June: Price spikes. Blackouts in San Francisco. Rates rise in San Diego.

November: Federal regulators refuse refunds for ailing utilities. Gas prices spike.

December: Generators briefly halt power sales.

January: Rolling blackouts. Utilities suspend payments. State government begins buying power.

March: More blackouts. State signs long-term contracts. State raises retail electric rates.

May: Last blackouts.

June: Gas, electricity prices fall. Federal regulators impose price caps across West.

Source: Dow Jones Energy Indexes

The second agency, the California Independent System Operator, managed the state's network of transmission lines -- known as "the grid" -- to protect reliability. The ISO ran its own auctions to set payments for last-minute adjustments to supply and demand.

In an era of energy surpluses, architects believed that prices would only go down. And they did, for a while. Supplies were so abundant that wholesale power literally was free for two hours on April 1, 1998, the day the new electricity market opened. For two years, power costs remained comfortably below the frozen consumer rates.

Yet almost from the start, participants on all sides probed for weaknesses. One way the ISO seeks to ensure reliability is to pay plant operators to keep generators on standby to meet last-minute surges in demand. In the market's first weeks, payments for this service, set by auction, were typically less than $10 a megawatt-hour. (A megawatt-hour is roughly the amount of power needed to supply 1,000 homes for an hour.)

Then on July 13, 1998 -- 3-1/2 months after deregulation started -- a unit of Houston-based Dynegy Corp. offered to supply standby power at $9,999 a megawatt-hour. Dynegy was exploiting the fact that the market had been set up with few rules on what suppliers could charge. The ISO had to accept the bid because it expected high power demand and there were few other offers of standby power. Thus, Dynegy and three other suppliers wound up splitting $8 million for keeping plants on call for five hours, according to state and federal records. Dynegy declines to comment on the incident.

To Gary Stern, an economist at California's No. 2 utility, the Southern California Edison unit of Edison International, it was a sign "that the degree to which the market can be manipulated was unlimited."

Warm Spring

Such stunts didn't matter much until the warm spring of 2000, which reduced the water available for hydroelectric dams in the Pacific Northwest, source of up to 20% of California's summer power. Meanwhile, electricity use across the West grew much faster than projected. The era of energy surpluses had ended.

Williams Cos., Tulsa, Okla., was one of the first to benefit. Williams had a contract to sell electricity from Southern California power plants owned by AES Corp. The ISO viewed two of those plants as crucial to the local electric grid and paid Williams $63 per megawatt-hour for power from those units, plus a monthly fee for keeping them available. But local supplies were so tight that when either of the units was shut for repairs from April 25 to May 11, the ISO had to buy replacement power from Williams for as much as $750 a megawatt-hour, or a total of $10.9 million.

According to investigators at the Federal Energy Regulatory Commission, the two companies had prolonged the outages so Williams could sell more high-priced power. On April 27, FERC investigators said, a Williams employee urged AES to perform additional repairs at one plant, after a boiler-tube leak had been fixed. A year later, Williams agreed to refund $8 million to the ISO, without admitting wrongdoing. AES denied wrongdoing and didn't have to refund any money.

The incident showed how dramatically the market dynamics had changed -- and how unprepared regulators were for a time of tight power supplies. The system had been designed so that no one company could control the market. But now that California often needed every megawatt, even small producers could dictate prices paid to everyone.

Recognizing this, suppliers began offering less power to the daily auctions at the Power Exchange and at higher prices. On the afternoon of June 28, for example, prices climbed to $750 a megawatt-hour, four to five times as high as on similarly hot days in the summer of 1999. Power Exchange investigators later concluded that all of the power-plant operators -- Dynegy, Williams, Duke Energy Corp., Reliant Energy Inc. and Mirant Corp. -- as well as marketers such as Enron had at times withheld electricity from its daily auctions. The suppliers may have tried to sell the power to the ISO or out-of-state buyers, hoping to fetch a higher price. Or, they may have idled the plants, hoping to induce a scarcity that would drive prices even higher.

It's hard to be more specific about which companies acted this way most often. Even now, the Power Exchange and ISO insist the bids are confidential. The suppliers, in turn, say the price spikes were the result of many factors, not just their actions.

With retail rates frozen, the soaring price of power was catastrophic for the utilities. Wholesale power costs in June topped $3.6 billion, compared with $7 billion for all of 1999. That month, PG&E alone paid roughly $700 million more for electricity than it could collect from customers. And the shortages started to bite. For the first time since World War II, some San Francisco neighborhoods suffered planned blackouts.

No company devised more ways to take advantage of the system than Enron, which remade itself in the 1990s from a pipeline company to an energy trader. The Houston energy giant bought Portland General Electric Co., a regional utility located in Portland, Ore., in 1997, and set up a trading desk later run by Tim Belden. A former researcher at a federal energy lab who typically rode his bike to work, Mr. Belden spent 15-hour days combing through regulatory filings trying to crack the code of California's new market, according to former employees in the office.

He wasn't afraid to take chances. A former co-worker recalls Mr. Belden losing $100,000 of Enron's money on an "experiment" to see how prices would react if Enron simultaneously exported power from California at several locations.

Mr. Belden quickly focused on wringing profits from the state's aging and inadequate transmission network. Enron bid aggressively at the ISO's 1999 auction for transmission rights on heavily used lines, which gave Enron priority for moving electricity on these lines, and a share of the ISO's fees for allocating capacity.

Enron devised multiple strategies for overloading transmission lines and reaping payments for relieving the congestion it had created, according to the memo by Enron's lawyers and interviews with former traders. The congestion fees could be so lucrative -- as much as $600 a megawatt-hour -- that Enron regularly transferred power across the state and sold it at a loss, with the fees more than making up the difference, according to a former Enron trader.

By the summer of 2000, Enron traders had a portfolio of such tactics, with colorful nicknames such as "Death Star" and "Red Congo." Both involved scheduling power to flow in one direction on the ISO system, and in the opposite direction on another system outside the ISO's control, such as a transmission line operated by California cities. In that way, Enron could be paid for "relieving" congestion on the ISO system without actually putting power on or taking it off the grid. To execute these strategies, Enron created complicated chains of transactions using out-of-state partners.

"It's bizarreness," a scheduler at Portland General told a trader on April 6, 2000, when Enron attempted to move power from California to Oregon and back. After being asked to repeat the deal for a seventh time that day, an exasperated Portland General scheduler lamented, "I don't want to hear about Enron. ... Somebody burn Enron. Enron is worthless," according to a transcript submitted to federal regulators.

Grid managers occasionally tried to crack down. On July 20, the ISO says, it caught Enron and Sempra Energy collecting fees for relieving congestion without moving any power. The next day, the grid operator banned the practice. Sempra denies it participated in any such activity. An Enron spokesman said the company is "focusing on the future and cooperating with all the investigations" of California's energy crisis.

But that was an exception. The ISO never saw itself as an enforcement agency. Instead, it repeatedly changed its rules to eliminate gaming strategies, with little success. "Every time we try to come up with a counter, somebody figures out a way around that counter," ISO Chief Executive Terry Winter told a Congressional panel in May.

The congestion schemes apparently produced small gains for Enron, roughly $60 million in 2000, according to FERC. But insights drawn from those strategies may have helped Enron reap $1.8 billion in profits trading electricity during 2000 and 2001. Enron didn't own California power plants, so its profits depended on price volatility, which lets traders buy low and sell high. Congestion, or the appearance of congestion, can make prices more volatile.

To see how, consider what happened in May 1999, when Enron proposed moving 2,900 megawatts of power from Nevada to Southern California on a line that could accommodate only 15 megawatts. The tactic forced the ISO to scramble for replacement supplies, driving prices up 70% for several hours and costing electricity users as much as $7 million. It's not clear whether Enron profited on that day. In April 2000, Enron paid $25,000 to the Power Exchange to settle a complaint and pledged not to repeat the move.

Even without power plants, Enron sold more juice to the Power Exchange and the ISO in 2000 than companies such as Williams and Dynegy, which did control power plants, according to federal records. Walter M. Higgins III, chief executive of Sierra Pacific Resources, the holding company for Nevada's largest utilities, estimates that Enron participated in nearly half the electricity trades in the West during the crisis.

Enron bolstered its California operations by agreeing to manage electricity trades for other Western utilities, from Texas's El Paso Electric Co. to Valley Electric Association, a small co-operative in rural Parumph, Nev. "Everybody in the world thought these were the smartest people who ever lived," says Gary Hedrick, chief executive of El Paso Electric, whose trading profits increased seven-fold to $22 million in 2001.

Last month, FERC investigators said in a report that Enron "fostered a callous disregard for the American energy customer." FERC launched investigations of Enron, Portland General, and El Paso Electric that could lead to fines or the companies losing the ability to sell electricity at deregulated rates.

By mid-summer 2000, soaring electricity prices widened from an economic problem into a political issue. In San Diego, where retail rates had been fully deregulated in July 1999, consumers protested electric bills that doubled between May and August. Elsewhere, ratepayers were shielded, but the utilities were bleeding tens of millions of dollars a day.

California's electricity market clearly was broken, but there was little agreement about how to fix it. Utilities and state officials demanded that FERC limit the prices charged by power producers and require them to refund windfall profits. California officials tried their own fixes: The ISO twice lowered its own price cap, and the Legislature recapped retail electricity rates in San Diego. Energy suppliers argued that the price caps violated the deregulation scheme and wouldn't work. Some suppliers offered long-term contracts, which would have tempered the high prices, but there were no takers.

After months of investigation, FERC on Nov. 1, 2000, proposed changes in what it called California's "dysfunctional" market, with the aim of curbing abuses, but declined to order refunds for high summer prices. Wholesale prices were too high, the commission concluded, but there wasn't enough evidence against any individual power supplier to justify a refund.

Critics, including Gov. Davis, dubbed the report a whitewash framed by FERC's free-market bias. Former FERC Chairman James Hoecker says the commission had just started to strengthen its oversight and enforcement efforts when the California crisis erupted, and "we just weren't there yet."

Shortly after FERC issued its findings, California's power plants started getting sick. By mid-November, nearly one-fourth of the state's generating capacity sat idle for planned maintenance or emergency repairs, more than three times the outage rate in November 1999. But it was difficult to determine, even after state officials began surprise plant inspections, whether the outages were a deliberate attempt to make money by shrinking supply or the predictable result of running 30-year-old plants hard all summer.

"There's something broken in every power plant all the time," says S. David Freeman, director of California's public-power authority, who formerly ran municipal utilities in Sacramento and Los Angeles. Under the old system, Mr. Freeman says, utilities tried to keep plants running. But under the new system, he says, generators had incentives not to.

Energy Bazaar

High prices and growing shortages had turned California into an energy bazaar with mind-boggling deals, such as the one engineered by Mr. Tish on Nov. 11. Here's how it went down: National Energy had bought 50 megawatts of power from the Imperial Irrigation District for $3,500 at a trading hub in Arizona, and immediately sold it for the same amount to the Los Angeles Department of Water and Power. National Energy then repurchased the power from DWP at the Oregon border for $4,750, and sold it to Constellation Energy Group Inc. for $7,500. Constellation then moved the power back into California and sold it to the ISO for $12,500, or the then-price cap of $250 a megawatt-hour.

The fact that the trades concluded at the highest legal price at a time of low demand shows just how warped the market had become. The ISO's lower price caps seemed to have the perverse effect of raising prices during off-peak hours.

The deal was "printing like, really good money," Mr. Tish later told a colleague, Dave Pierce, according to a transcript submitted to state investigators. But when the parties tried to repeat the deal an hour later, the ISO refused. Mr. Pierce later called the ISO, seeking clarification on the rules and training sessions. ISO grid coordinator Matthew Cartier suggested talking to Enron. "Those guys are pretty aware," Mr. Cartier said, according to the transcript. And, "their integrity seems to be pretty good."

A National Energy spokesman says the trades were legal and designed to take advantage of price differences between Northern and Southern California. The spokesman says National Energy lost money when the ISO refused to let the company repeat the trades, leaving it with only a $750 profit.

Around November, another element was added to the upward pressure on electricity prices -- the skyrocketing cost of natural gas, used to fuel most California power plants. On the 18th of that month, prices in California stood at $9.60 per million British Thermal Units, roughly four times the price a year earlier and an astonishing 72% higher than the national average.

State officials blame El Paso Corp., Houston, owner of one of two big pipelines that bring gas to Southern California. California officials say El Paso's pipeline unit and its energy-trading affiliate manipulated gas supplies to increase prices. (El Paso Corp. isn't related to El Paso Electric.)

In February 2000, El Paso sold one-third of the capacity on its pipeline for 15 months to the affiliate, El Paso Merchant Energy. Merchant won the right through an auction, but state officials say the deal was rigged, with a secret discount that wasn't advertised to other bidders. Then, officials say, the two units limited the amount of gas coming into California, with the goal of raising prices.

On April 14, 2000, Greg Jenkins, president of El Paso Merchant, told El Paso Chief Executive William A. Wise in an e-mail that the unit would make money on the contract in part by "widen[ing]" the difference between the price of gas in California and elsewhere in the country. When the price of gas soared in California later that year, El Paso Merchant made $184 million, despite hedging half its potential profits.

A FERC administrative law judge later called the deal "blatant collusion" that violated agency rules on affiliate dealings. The judge initially said he wasn't convinced that El Paso had manipulated California gas prices but is reconsidering that ruling. A new decision is expected any day.

El Paso says the discount, which eventually was offered to all pipeline users and rarely invoked, didn't help El Paso Merchant win the capacity contract. El Paso denies manipulating gas prices. If the company believed it could control prices, El Paso lawyers say, it wouldn't have hedged its profits.

Whether El Paso's actions were to blame or not, natural gas prices continued rising in December to a level roughly six times higher than elsewhere in the U.S., delivering a final blow to the already teetering California electricity market. Some power-plant operators shut down, saying the expensive gas used to fuel their plants made it unprofitable to sell electricity to the ISO under its price cap.

At the same time, California's utilities fell further into debt, and suppliers refused to sell to them without special guarantees. ISO officials made as many as 2,500 phone calls a day seeking power, but it wasn't enough. On Dec. 8, the ISO effectively threw in the towel, abandoning its $250 price cap and adopting FERC's Nov. 1 proposal that allowed suppliers to charge any price they could justify by production costs.

The following week, prices climbed as high as $1,500 a megawatt-hour. Gov. Davis appealed for help from Washington, but said he wasn't willing to let the state's near-bankrupt utilities raise their still-frozen rates, arguing consumers shouldn't be forced to pay for "the unconscionable profits of pirate generators." FERC declined to intervene.

Utilities had been agitating for rate increases since September. But the governor resisted, distancing himself from a "temporary" 10% rate increase approved by the PUC in early January. "If I wanted to raise rates, I could have solved this problem in 20 minutes," Gov. Davis said at one point.

In January, forced blackouts began. On Jan. 17, the ISO ordered PG&E to cut power for 90 minutes to 400,000 users in northern and central California, darkening Silicon Valley factories and two hospitals. That night, Gov. Davis authorized a state agency to buy power.

It hardly solved the problem. Gov. Davis wanted long-term contracts negotiated for most of the state's power. In the meantime, the state's Department of Water Resources got the job of keeping California lit. The water agency had a small power operation, but was ill-equipped to manage multibillion-dollar purchases.

State government spent almost $8 billion buying power in the first six months of 2001, at higher prices than the end of 2000. Suppliers had a field day. Over four days in January and February, Duke sold 4,500 megawatt-hours to the ISO for $3,880 each. A Duke spokeswoman says the company increased its asking price five-fold to reflect its reduced chances of being paid. FERC later slashed the rate to $273 a megawatt-hour, and the spokeswoman says Duke still is owed $51 million by the ISO for January 2001 power sales.

Suppliers again showed their ability to adapt to new rules, this time by possibly manipulating natural-gas prices. Gas prices were a key ingredient in FERC's formula for determining justifiable electricity prices during that period. FERC investigators believe Enron and others may have manipulated gas prices to boost allowable electricity prices. On Jan. 31 alone, investigators say, Enron did 174 natural-gas trades with one other unidentified company, helping to send gas prices in California up 33% in a single day. Investigators proposed changes to the electricity-price formula that would reduce justifiable power prices on some days by two-thirds.

Meanwhile, a team hastily assembled by the state negotiated long-term contracts with suppliers, with few illusions about its bargaining strength. "They had us over a barrel," says Mr. Freeman, the state's chief negotiator.

By March, the state had assembled deals valued at $43 billion for as long as 20 years providing about one-fourth of California's power on a typical summer day. On average, the state agreed to pay roughly $84 a megawatt-hour for the first five years of the contracts, significantly more than power suppliers had sought for similar deals in the summer and fall of 2000.

California's state auditor later said the contracts provide too much power during slack times but not enough for peak summer needs. By July 2001, the state was selling some of its newly acquired power at a loss, for as little as $1 a megawatt-hour.

Mr. Freeman says the long-term contracts "stopped the hemorrhaging" of the electricity crisis and played a crucial role in bringing down prices. Without the deals, he says, "We wouldn't have a stable market yet."

State officials have asked FERC to nullify or curb many of the deals, prompting many suppliers to negotiate. The state has renegotiated 10 contracts, cutting the total cost to $37.7 billion. The state is close to finalizing deals with seven other suppliers.

On April 5, Gov. Davis finally bit the bullet and endorsed an additional 30% electricity-rate increase in a last-ditch effort to keep the utilities solvent. The next morning, the PG&E utility unit, the largest in California, filed for bankruptcy protection, arguing the governor's action was too little, too late.

Suddenly, in June, it was over. The long-term contracts were in place. Gas prices began to fall. More hydro-power was available. Users, reeling from a slowing economy and higher rates, embraced calls for conservation. And finally, FERC imposed price caps across the West, eliminating some loopholes and signaling a new, tougher stand against power suppliers. With peak power demand down 14% from a year earlier, wholesale power prices fell by almost half in June and declined further each month for the rest of 2001.

A year later, an uneasy calm has settled over California's electricity grid. The last rolling blackout was in May 2001. The state survived near-record demand for power during a July heat wave.

But the calm may be sowing the seeds of new troubles. Conservation is slipping even as the state's economy remains sluggish. Aging power plants are being retired as new units begin operating. Ambitious plans for additional power plants are crumbling along with the balance sheets of energy companies; Enron went bankrupt in December 2001 and several other big suppliers are in deep financial trouble. PG&E remains mired in bankruptcy, and federal and state officials disagree about how to redesign the system.

"We may have put a Band-Aid on this problem," says Alan Vallow, utility director for the central California city of Lodi. But the state is "creating a crisis down the road."

Write to Scott Thurm at scott.thurm@wsj.com3, Robert Gavin at robert.gavin@wsj.com4 and Mitchel Benson at mitchel.benson@wsj.com5

Posted by DeLong at September 16, 2002 07:38 AM | Trackback

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Comments

Hi,

You might want to read a bit of Amory Lovins, who advised and influenced the California groups responsible for the late 1990's regulatory re-thinking. The Green Physicist (yes, I know that epithet could refer as easily to Bruce Banner...) has rather good arguments to show that the overall amount of electricity needed in Western Society should actually fall in the next decade. Planners and politicians who buy those arguments have little reason to buy new power plants.

The problem is timing. Even if Lovins is right,
(and that's not a sure bet) the year within the decade during which the electricity market begins to shrink is not specified. Anticipating a move that doesn't come is a recipe for disaster.

(In an analogous case, Jeff Vinik managed Fidelity's flagship Magellan Mutual Fund into the early stages of the dot-com boom -- decided that the entire market was overvalued, and took a large portion of funds that investors expected to be invested in equities and bought bond-like/cash-like investments instead. When the equities market continues to soar, Magellen was left behind, and Fidelity fired Vinik. About a year and a half later, the bubble burst, just as he had foreseen. Being right, at the wrong time, is basically indistinguishable from being wrong.)

Lovins founds his forecasts regarding electricity mainly on two notions. First, that older buildings that were not well-insulated are reaching the end of useful life, and will be replaced by modern, MUCH more energy-efficient, constructions. Second, that concerns about pollution in general and CO2 in particular will lead, shortly, to radical redesign of "smart" automobiles (and Lovins provides one such radical design) -- which will afford distributed electrical generation. Every little personal passenger car will, according to Lovins, contribute a few kilowatts to a 21st century grid; replacing BaseLoad nuclear and coal plants the same way networks of small individually owned PCs (and Macintoshes) replaced MainFrame Computers.

If that had happened, any regulatory body that encouraged investment in BaseLoad generators, or locked in multi-year contracts to buy (presumably expensive) power from BaseLoad; or favored BaseLoad companies over whatever-comes-next -- would have looked as silly as any 1980's group that bought additional IBM-360s MainFrames to run
spreadsheets. (Or highway traffic control programs, university enrollment programs, tax audit and civil service management software etc etc -- events no doubt firmly in the jellyware memories of many modern legislators.)

Aside from timing, the Lovins scenario is not developing in a vacuum. State govt's zoning, building use, and other development regulations that discourage new construction in California (or wherever) delays the predicted energy-efficient building from coming "on-line". On the flip side, policies that encourage energy-hungry industries to relocate into formerly-residential/agricultural areas put big demands onto capacities designed for much less. Specific targeted features of autos (airbags? catalytic converters?) divert development of other technologies, (regenerative electrical braking,
for instance.) Short of appointing Lovins governor-for-life with new and massive powers over every facet of California's economy; there's no way to ensure the transition from now, toward his utopia.

A less dictatorial, more market driven, suite of solutions might include:

- "smart" meters that (visibly!) charge electrical consumers different rates during peak and off-peak periods throughout the day.

- "smart" financial derivitive type contracts
that not only operate over longer terms, but
price themselves based on amounts of rainfall,
daily afternoon temperatures, the Canadian
dollar exchange rate, etc.

and maybe

- "smart" legislators who actually have dayjobs
aside from politics, who (due to term limits?) move more fluidly from the market economy to the public sector and back.

But then, like Lovins, I'm a utopian at heart...

Posted by: Melcher on September 16, 2002 08:30 AM

Should the question be "can deregulation work in a market that is an oligopoly?" Can there be successful deregulation in such a market with government oversight?

Posted by: on September 16, 2002 08:49 AM

After reading the WSJ article, what's really amazing is the Bush administration's simplistic, do nothing response to the problem. This was not a problem resulting from a lack of supply that would be exacerbated by a temporary price cap, but a crisis resulting from a system that allowed for market manipulation and price gouging. Can any still justify their failure to immediately stop the bleeding with a price cap and then figure out what to do next.

Posted by: pj on September 16, 2002 09:09 AM

The problem with electricity markets, as currently formulated, is that the instantaneous nature of electricity purchase and delivery makes development of corners too easy.

An alternative market for power, where wholesale buyers groups periodically (but not minute by minute) purchase generation and transmission capacity to cover load and reserves, and trade associated energy among themselves as conditions require, would work far better. That is similar to the way utilities did it before "deregulation" and that is the easiest way to develop a transparent market for power.

Too stogy, I guess.

Posted by: Tom on September 16, 2002 09:32 AM

I think the WSJ underestimated the impact of the prohibition on long term contracts. 60-90% of electrical consumption can be reliably predicted at time scales of 1 year to 1 month. This portion of the demand could have had rates and relationships established as part of long term contracts. The result is a significant increase in pricing stability compared with the actual regulations. By forcing all pricing to swing in response to instantaneous demand, the system instabilities were greatly magnified.

Most of the problems were driven by reactions to and exploitation of the tremendous pricing volatility. Had long term contracts been permitted, the motivation and impact would have been much smaller. There would still have been the potential for manipulation, but the manipulable market and potential return would be much less.

Note that permitting long term contracts is not the same as biasing for (or against) baseline usage. I can make long term contracts for predictable peak loads by contracting with peaking facilities. The long term contract simply exploits the predictability inherent in electrical usage. If you wish to bias the system you could prohibit contracts longer than 1 or 2 years. That introduces some added instability, but not much.

Posted by: rjh on September 16, 2002 09:35 AM

The Energy Goddess has this column

http://www.rppi.org/051202.html

<<------quote----------
What’s interesting about the Enron-California situation is precisely what the traders were arbitraging in that instance. Primarily, they were arbitraging two traits of the institutional environment: the structural and rules differences between the Power Exchange (PX) and the Independent System Operator (ISO), and a price cap on scheduled trades.

The state government designed the PX as the forum for wholesale electric trades between utilities and generators. By now we are all painfully familiar with the flaws that arose from not supporting longer-term contracts through the PX, but what is less familiar to many observers is the strategic incentives that arose from the interaction of the PX and the ISO. The ISO’s real-time (or imbalance) market was initially intended solely for system balancing and reliability. What eventually happened, though, was that the utilities (who were mandated to buy through the PX) tried to influence the price in the PX day-ahead market by underscheduling, or understating what their likely demand would be tomorrow. Reductions in the PX day-ahead price induced suppliers to, surprise surprise, supply less to the day-ahead market. The interactions of these strategic moves shifted a lot of trades into the ISO real-time market. Strategic? Yes. But does it go beyond taking advantage of poorly-designed set of rules and regulations? I don’t think so.

Price caps exacerbated those incentives. In late 2000 the day-ahead markets faced a $250/mWh firm price cap, which created another arbitrage opportunity for suppliers when day-ahead prices in adjacent regions went above that cap and they could profit from exporting power from California. Thus the price cap created the now-famous “megawatt laundering” option, which the Enron traders called their “Richochet” strategy. The ISO market, because it was so crucial for system reliability, did not face any price caps, so prices rose dramatically as the strategic behavior of both the buyers and sellers moved most of the action to the ISO market. Again, arbitrage like this lays open the distortions that bad rules and bad institutions can inject into markets to create strategic opportunities that wouldn’t have been there otherwise.
------endquote------->

And let's not forget this from Gray Davis:

"Believe me, if I wanted to raise rates, I could have solved this problem in 20 minutes."


Posted by: Patrick R. Sullivan on September 16, 2002 09:48 AM

Notice how price caps immediately freed up the energy supply in California.

Notice how limited use of the government oil reserve freed up heating oil supply in New England and the upper midwest.

We are not dealing with competitive energy suppliers. Again, we are still learning how many price games were played by energy companies as they switched contracts among each other.

I can remember the Enron adds in New England applauding deregulation. Fortunately we were not long left to the tender mercies of Enron.

Posted by: on September 16, 2002 09:54 AM

Deregulation is not a panacea, indeed, it is not even good policy. However, it is an excellent method to allow companies to take advantage of consumers and increase profits especially if they have bound themselves closely with government regulators by well placed campaign contributions.

Posted by: Mike on September 16, 2002 10:22 AM

"Frank Wolak's model starts with a simplified demand curve. We assume that the demand for electricity is totally inelastic at some given quantity - say 900 megawatt-hours - until the price reaches a ceiling, say $1000 per mwh. It doesn't matter for current purposes whether that's a legal ceiling or the price at which utilities simply refuse to buy.

On the supply side, we assume that there are a smallish number of generators, each with limited capacity - let's say 5 generators with a capacity of 200 mwh each. Each generator has a marginal cost of, say, $20 per mwh actually produced.

Wolak assumes that in the market, each generator submits a bid price for its capacity; then the system operator takes the bids in increasing order of price, but pays all producers the highest bid actually taken. This is a stylized version of the PX, or day-ahead, market that actually operated. He also assumes implicitly that the bids are submitted in order - that the generators go one by one, each knowing what the previous bids were. (It's possible to do this with simultaneous bids; in that case it's a mixed-strategy equilibrium, with qualitatively similar results.)

So what's the...equilibrium of this game, given total capacity of 1000 and demand of 900? The first four generators submit bids at $20, their marginal cost; the last generator bids $1000, the maximum. It knows that it will sell only 100 mwh, half its capacity - but far better to sell 100 units at $1000 than 200 at $20!

The really striking thing, of course, is that there is excess capacity in the system - yet the price goes sky-high. And with a little realistic friction added, you could easily imagine blackouts and brownouts as part of the picture. Let me also stress that this is a non-cooperative equilibrium - it doesn't involve collusion, let alone conspiracy, among the generators. All it takes is individual firms, acting in their individual self-interest."

Stanford Professor Frank Wolak's explanation:
By Paul Krugman

Posted by: on September 16, 2002 11:05 AM

California's state officials created a crippled market that was easy to exploit. Period.

The functioning if arguably sub-optimal system, generic regulation, was replaced with a Rube Goldberg maze, rife with opportunities for mischief.

Yes, bad guys picked up the peoples' wallet left on the floor by Sacramento, but the tax and rate-payer's wallet should never have been exposed in this ham-handed way in the first place.

Posted by: George Zachar on September 16, 2002 01:28 PM

Re:

>>California's state officials created a crippled market that was easy to exploit. Period. The functioning if arguably sub-optimal system, generic regulation, was replaced with a Rube Goldberg maze, rife with opportunities for mischief.

Yes, bad guys picked up the peoples' wallet left on the floor by Sacramento, but the tax and rate-payer's wallet should never have been exposed in this ham-handed way in the first place.<<

So what's the lesson? Is it that we can't afford to deregulate, because the legislators who write the deregulation plan are (a) incompetent, or (b) bought and paid for?

Posted by: Brad DeLong on September 17, 2002 01:40 PM

>So what's the lesson? Is it that we can't afford to deregulate, because the legislators who write the deregulation plan are (a) incompetent, or (b) bought and paid for?<

Brad, you made a very good point in the pharma post comments about the value of decentralized decision making. That seems to be at the root of why California-style "deregulation" failed in the spectacular way that it did.

Another commenter mentioned the importance of the prohibition on long-term forward contracts. That comment is dead-on. By limiting the ability of utilities to own power plants and enter into long-term contracts, the new regulations (kinda kicks the term "deregulation" in the head, doesn't it) substituted a large measure of centralized decisionmaking of the regulators for that of the utilities.

The regulators made a fundamental decision that short-term was "better" than long-term. But managing a portfolio of power supply resources is much like managing a financial portfolio. You want a mix of short- and long-term resources and you can balance risk against return.

In my previous job, I managed the power supply for a medium-sized municipally owned utility (not in California). Being positioned solely in the short-term market would be tough enough under the best of conditions. Being forced into a poorly designed short term market that turned out to be ripe for gaming was a nightmare for the CA utilities.

So was it a result of incompetence or corruption?
Hard to say. I certainly don't know. Didn't someone once say that you shouldn't assume a conspiracy when simple stupidity would explain things?

Either way it doesn't mean we shouldn't try to deregulate. I think it means we should learn from California's failure and try to do it right.

But any "deregulation" should tend toward less centralized decision making, not more.

Posted by: Chip Taylor on September 17, 2002 02:50 PM

So what's the lesson?

You ask the same question I've been wrestling with in my internal dialogue.

I think that in "the real world", where pols and traders control the process and have zero incentive to create a truly efficient market, the "old fashioned" way of static regulation may be the "least bad" solution.

The folks on this thread probably have the brainpower and expertise to hammer out a workable electricity market blueprint, but the odds of getting it enacted without crippling alterations are close to zero.

If someone can prove me wrong, that'd make me happy.

Posted by: George Zachar on September 17, 2002 05:17 PM

'By limiting the ability of utilities to own power plants and enter into long-term contracts,'

Doesn't this open it's own avenues for market manipulation?

Does anyone have estimates of the efficiency losses in the current regulated climate, by the way?

(from Atrios)
'Overall, the companies kept more than 30 percent to 50 percent of their power off the market. During some of the worst moments of the crisis, they held back even more -- anywhere from 55 to 76 percent of production -- all in an effort, whistleblowers told CBS News more than a year ago, to cut the power supply and drive up prices.'

That Bush's regulators let them get away with this is by far the worst thing he's done. How clear cut can you get?

Posted by: Jason McCullough on September 18, 2002 02:00 PM

Bizarrely, this blog pretty much says the power was held back because was too expensive to produce. Uh.....

Posted by: Jason McCullough on September 19, 2002 04:00 PM

>>Bizarrely, this blog pretty much says the power was held back because was too expensive to produce.<<

That's truly bizarre. The spot price was close to infinity for all practical purposes...

Posted by: Brad DeLong on September 19, 2002 04:06 PM

>>Bizarrely, this blog pretty much says the power was held back because was too expensive to produce.<<


That's truly bizarre. The spot price was close to infinity for all practical purposes...

This reinforces the Rube Goldberg metaphor of horrific structural flaws in the system, doubly misnamed as a "deregulated market".

Posted by: George Zachar on September 20, 2002 11:09 AM

I should clarify: to my reading, she implies that part of what kept such large proportions of the system offline (30-50%) was that often the production cost was too high, compared to the spot price that could be had for that production.

This doesn't make any sense, though, as at the absurd prices involved just about any sort of production was economically viable.

I agree the root cause was a very bad structure, but the chief symptom was still a very unethical (and possibly illegal, I'm not sure of what's involved with that) bout of predatory profit-taking.

Posted by: Jason McCullough on September 20, 2002 11:53 PM

predatory profit-taking

No trader, no matter how greedy, willingly leaves money on the table. It's not in their nature. I've been around The Street too long to think otherwise.

If there was a way to profitably make and sell power when prices were pinned to the roof, SOMEONE would have done it, if the possibility existed.

The only logical reason for that not happening was the inability of power generators to get power into the grid at the quoted price.

After all, a high price does the SELLER no good, unless he can make the sale.

Posted by: George Zachar on September 21, 2002 04:12 PM

In this case they made a pretty wierd market decision: withholding large amounts of available power, to increase their profits through the very inelastic short-run curve. Yes, the market was structurally flawed, and this wouldn't have happened in a correctly designed one, but I think a good analogy is laws that make it illegal to jack up prices on lumber and water directly after a hurricane comes through. It's not like the sky-high prices appeared immediately once the deregulation was put it place; it required a period of stress/crisis to trigger it.

As a final note, the power producers must think there's something ethically wrong with withholding 35% to 50% of their power, as they've been swearing up and down that they didn't do it; or if it happened, it was done without specific approval by underlings, or etc., etc., etc.

Posted by: Jason McCullough on September 22, 2002 02:52 PM

As a final note, the power producers must think there's something ethically wrong with withholding 35% to 50% of their power, as they've been swearing up and down that they didn't do it...

You give them WAY too much credit. ;)

Their attorneys told their PR guys how easy it would be to find juries to fry them in court, when this mess gets there.

Posted by: George Zachar on September 22, 2002 05:32 PM
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