Lights Out

Wednesday, October 30, 2002

Although the electricity and financial crisis that so consumed the attention and resources of California last year has faded from our public memory, the saga continues in the background, only periodically leaping to the headlines.

Although largely off the front pages, investor-owned utilities, the state’s regulatory agencies, and the federal government are working relentlessly—but often at cross-purposes—to identify and fix the structural deficiencies of California’s electricity system. Pacific Gas & Electric’s plan to emerge from bankruptcy received broad support from its creditors but faces challenges from the California Public Utilities Commission (CPUC) and intervenors and must overcome scrutiny from the presiding judge. Southern California Edison is regaining financial health but still faces obstacles. California state agencies are attempting to renegotiate the long-term contracts the state signed during the crisis and/or to challenge the contracts in court or through federal venues. The state is proceeding in its plan to issue long-term revenue bonds to pay for public debt incurred during the midst of the crisis. Federal regulators continue to encourage and support regional restructuring efforts, the House Committee on Energy and Commerce considers legislation to promote deregulation, while the California state government demands tighter price controls and more stringent regulation.

At the same time, media headlines have focused the public’s attention on the possibility of market manipulation by big-name companies such as Enron and Perot Systems. Enron has become the poster child not only of corporate greed and deception but also of deregulation failures. Indeed, the fall of Enron has brought into question the viability of some electricity contracts and has led commentators to blame that corporation for its roles in electricity market restructuring and the crisis. A special select committee of the California Senate continues to hold intermittent hearings to investigate price manipulation of the wholesale energy market. And the CPUC just issued a staff report purporting to show that electricity generators had adequate unused capacity to avert all blackouts but that they failed to supply the needed electricity. Federal regulators are conducting their own fact-finding investigation into whether Enron or any other entity manipulated electricity or natural gas prices during the crisis. An initial report recommended further company-specific investigations but also determined that Enron’s “now infamous trading strategies have adversely affected the confidence of markets far beyond their dollar impact on spot prices.” In California, the independent system operator responsible for managing the state’s wholesale power grid is developing proposals for correcting flaws in California electricity markets. Researchers are striving for a deeper understanding of electricity markets in western states and are working to design better electricity market structures.

Even though the story is far from final, it may be valuable to reflect on lessons that emerge from the sad history of the crisis.

Separating Myth from Reality

Unfortunately, one repeatedly communicated message is that the California experience proves that electricity deregulation has been a failure and, by extension, is likely to be a failure elsewhere. For example, Governor Davis stated, “But we must face reality: California’s deregulation scheme is a colossal and dangerous failure. It has not lowered consumer prices; it has not increased supply. In fact, it has resulted in skyrocketing prices, price-gouging and an unreliable supply of electricity. In short, an energy nightmare.” Davis has even used the California experience to urge Mexican authorities to keep complete governmental ownership and control of the electricity system: “Don’t hand over your electricity infrastructure to private interests, unless you have 15 percent more energy than you need. In private meetings, [Mexican] President [Vicente] Fox and I agreed on this.”

Yet a fair assessment of the California experience precludes such an anti–private sector conclusion, as well as negative conclusions about the viability of electricity system deregulation.

First, California’s restructuring cannot be characterized primarily as “deregulation,” although some elements of the system were deregulated. Sales of electricity by non-utility generators were allowed at market-determined prices. But California regulations required investor-owned utilities to divest themselves of most generation capacity and precluded them from entering long-term contracts to buy wholesale electricity. Although residential, commercial, and industrial customers were originally allowed to buy their electricity directly from generators or from new retail electricity marketers, such direct access was ultimately repealed by the California state agencies. And utilities faced a severe price control regime. In short, transactions by non-utilities in wholesale markets were in fact deregulated, but the investor-owned utilities remained under tight regulatory control by state agencies.

Second, electricity system restructuring, including deregulation, has been very successful in other nations and in other regions of the United States. Successful deregulation has been proven possible, even though California’s particular restructuring was flawed and has been terribly managed.

In California, wholesale market deregulation of non-utility generators set the stage for widespread wholesale market competition and adequate electricity-generation capacity. These changes dramatically increased the number of new electricity-generating plants proposed, approved, and under construction. This partial deregulation is thus having the desired impacts on wholesale electricity supply.

The contention still seems to be that deregulation caused the western electricity crisis. However, a fair examination shows that the crisis stemmed primarily from two factors. (1) For more than a decade, population and economic growth in the western states steadily increased electricity consumption but very little new electricity-generating capacity was added. As a result, by the year 2000 western electricity markets had become very tight even under normal conditions. But 2000 and early 2001 were not characterized by normal conditions. (2) Exceptionally low rainfall in the Pacific Northwest and Northern California led to sharp temporary reductions in hydroelectric generation that triggered the electricity crisis. Although the public rhetoric places blame for the crisis on California deregulation, whether this deregulation was more than a minor influence is still unclear.

Buying High and Selling Low

The financial crisis, in contrast, was the direct result of California’s regulatory actions. It was not the result of deregulation but rather of overly stringent regulation. Even though all municipal utilities and investor-owned utilities throughout the entire West faced the electricity crisis, investor-owned utilities in California were the only ones that experienced the financial crisis, thanks to California’s regulatory rules. First, utilities were required to divest themselves of at least 50 percent of their generating capacity, thus reducing the role of self-generation in hedging against wholesale market price variations. Second, investor-owned utilities were precluded from using long-term electricity purchase contracts to protect themselves from wholesale-market price spikes, in stark contrast to practices of other investor-owned utilities and municipal utilities throughout the West and municipal utilities throughout California. The regulatory-imposed absence of financial protection set the stage for the financial crisis. Third, once electricity prices on wholesale spot markets skyrocketed, the California governor and the CPUC refused to allow the retail price increases needed to keep the investor-owned utilities financially viable. The legislature even reestablished retail price control for San Diego Gas and Electric. The regulations forced the investor-owned utilities to purchase electricity at very high wholesale prices and to sell the same electricity at retail prices far below purchase costs. These utilities were required, under court order initiated by the CPUC, to sell as much electricity as their customers wanted to buy, even though they were losing money on all their sales! The CPUC did not allow any increases in retail electricity prices until after the largest two utilities had been drained of all financial assets and of all borrowing capacity and were on the verge of bankruptcy. Only then did the CPUC approve retail price increases; however, the initial increase was far too small to balance sales price and purchase costs.

Once these utilities had become so credit-unworthy that generators and marketers were no longer willing or required to sell them electricity, the state stepped in to buy electricity on their behalf. Buying high and selling low was just as costly to the state as it was to the investor-owned utilities. During the winter and spring of 2001, this program completely drained the state treasury of its projected $8 billion surplus. This ill-conceived scheme was not the result of deregulation but the deliberate choice of the state of California. In short, the financial crisis was not the product of deregulation but rather the product of overly aggressive and inappropriate regulation.

Once again, actions isolating the supply side of markets from the demand side—as California did when it used retail price controls as a primary regulatory mechanism—created or exacerbated the major problems. Such price controls typically reduce system responsiveness and eliminate incentives for consumers to conserve. During the energy crises of 1973–74 and 1980–81, gasoline price controls and governmentally imposed oil allocation controls led to hours’-long gasoline lines. Yet California political leaders, ignoring those lessons, maintained rigid retail electricity price controls until the bitter end.

Retail price controls thus discouraged energy conservation by consumers, which was California’s best hope for forcing wholesale prices to decrease. Thus, California’s decision to keep retail prices at artificially low levels allowed wholesale prices to remain at painfully high levels. Consumers saved money in the short run through lower rates but will pay all the high wholesale costs through long-term increases in the retail rates. And because the retail price controls allowed wholesale prices to remain too high for too long, the total costs consumers will ultimately pay have been sharply increased as a direct result of the retail price controls!

Risk Management

The California experience also shows the importance of managing the risks associated with implementing policies, especially those that radically change the system. California electricity restructuring radically altered an electricity system that itself had never been free of economic risk. As history demonstrates, the production and distribution of electricity carries with it unavoidable risks. On the supply side—the costs of fuel needed to generate electricity change—witness the price fluctuations of natural gas, oil, and coal. Factors that influence fuel costs include public support or opposition to generating technologies and natural forces such as rainfall and temperature, which can vary sharply from year to year. On the demand side, predicting electricity usage is at best an imperfect art, and understanding circumstances in which market power might be exercised—in fact, even determining whether market power is being exercised—is fraught with error. Risks exist and they must be managed.

The regulatory system should distribute those significant economic risks appropriately; however, the restructuring left investor-owned utilities bearing a disproportionate share. Subsequent regulatory implementation made matters worse. Thus, with reductions in available hydropower, the financial consequences of soaring wholesale spot market prices were borne disproportionately by the California investor-owned utilities and their customers.

Some Additional Reflections

The California experience highlights the fact that any major restructuring of important systems will continue to require modifications well after the initial changes. Wise and strong leadership is needed to identify and implement changes after unintended adverse consequences become apparent.

No one should have been surprised to find important unintended adverse consequences of the electricity system restructuring or to find system flaws that required changes. The governor’s responsibility, as CEO of the state, was to ensure that flaws in the changed electricity regulation system were identified and corrected early enough to avoid a crisis or, at least, to avoid the most damaging consequences of the crisis. Real, lasting harm can befall a state when the governor fails to take the appropriate role.

The California experience also highlights the dangers of failing to differentiate between short-run and long-run issues. California, like all the western states, faced a short-term electricity crisis. Although it was impossible to predict its exact duration, information about new generation capacity under construction made it clear that the supply shortage (at the root of the crisis) would be of relatively short duration. It was also possible to foresee that any market-rule problems would become far less important once the generating capacity was on-line. Thus, the short-term nature of the electricity crisis was predictable even during the crisis, although its exact duration and magnitude were not predictable. It was also predictable that entering into long-term contracts for purchasing electricity at prices far exceeding the expected electricity prices would only exacerbate the financial crisis and ensure long-term adverse financial ramifications. Thus, there were foreseeable long-term problems.

Careful differentiation between short-term and long-term problems helps ensure that new long-term problems are not created as “solutions” to short-term problems. Unfortunately, the California state government did not seem to so differentiate. Thus, the state negotiated long-term contracts ostensibly aimed at the short-term crisis; these contracts quickly became long-term problems. The failure to implement rational short-term solutions, such as temporary retail price increases, allowed the short-term challenge to become a crisis and led directly to the long-term financial problems.

As a final reflection, it is important to recognize that California has had severe economic and policy problems in the past and will have problems in the future. But California has a robust economy, boasts a diverse and vibrant population, provides technological leadership for the world, and remains a wellspring of new ideas. California will survive the problems—both short term and long term—associated with the electricity and financial crises. And, in decades to come, perhaps the lessons learned from this crisis will help California avoid similar mismanagement.