CAN THE FERC LEAD US OUT OF THE HOTEL CALIFORNIA?
| Jurisdiction | United States |
(2001)
CAN THE FERC LEAD US OUT OF THE HOTEL CALIFORNIA?
Graves Dougherty Hearon & Moody, P.C.
Austin, Texas
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THE CAUSES, THE DAMAGE, AND THE LESSONS OF THE CALIFORNIA ELECTRICITY CRISIS
I. CALIFORNIA'S WHOLESALE ELECTRICITY PRICE SPIKES.
Beginning in the spring of 2000, California's wholesale electricity prices rose sharply:
MONTHLY AVERAGE WHOLESALE ELECTRICITY PRICES
Source: Electricity's New Era: More Price Volatility ... "The Lessons Learned," by Rebecca Smith, The Wall Street Journal, Sept. 17, 2001, at R4, citing California Independent System Operator; PJM Interconnection; ISO New England Inc.
For the Power Exchange ("PX") Day-Ahead market, average prices rose from $30 per MWhour to above $100 during the early fall, then shot up above $250 by December 2000. Congressional Budget Office ("CBO"), Causes and Lessons of the California Electricity Crisis (Sept. 2001) at Figure 4, based on California Energy Commission ("CEC") data. Spot market prices to meet peak demands in the California Independent System Operator ("CASO") realtime markets and for system reliability power purchased or dispatched by CASO rose even more dramatically.
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California refused to substantially lift its retail rate freeze to pay these wholesale prices. This drove the largest retail electric utility in California into bankruptcy, and piled up billions in wholesale electricity bills that remain unpaid. As the risks and then fact of non-payment grew, in-state and out-of-state generators dropped out of California markets, resulting in blackouts especially in January and March 2001. The State of California became the nation's largest wholesale power buyer: California spent, or committed to spend, billions on spot market power, and more than $40 billion in bilateral contracts extending over the next 20 years. California took over the CASO to enhance the State's buying leverage, and abolished retail electric choice to insure that retail ratepayers would be available to repay bonds to be issued to pay the State's wholesale power bills.
Presumably, Don Henley had something other than the electricity market in mind, but "The Hotel California" fits:
"Last thing I remember I was running for the door I had to find the passage back to the place I was before Relax said the nightman We are programmed to receive You can check out any time you like But you can never leave"
— Don Henley and the Eagles, "The Hotel California"
This paper addresses the causes of the California wholesale electric market crisis, the damage done, and the lessons that should and should not be drawn. Both because natural gas in fact played a central role in the California electricity crisis, and because of the focus of this conference, I pay special attention to natural gas and related issues.
The Federal Energy Regulatory Commission ("FERC") occupies center stage in this paper. The FERC's legal authority over wholesale markets makes its policy decisions critical to the ultimate outcome.
The FERC does not bear substantial responsibility for causing California's wholesale electric crisis. California created its own crisis, and then made it worse. But California has also worked hard to shift both the blame for the crisis and the economic costs of the crisis. For this purpose, California has brought enormous political pressure to bear on the FERC, and the FERC has been forced to respond.
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In response to California's political pressure, FERC retreated from market-based rates. For months, FERC imposed ever-more stringent restrictions on sellers' decisions regarding when, where and how much to produce and sell, and hindsight revisions of the financial terms of past transactions.
Recent FERC actions against the CASO for violations of tariff rules designed to ensure neutrality among all market participants suggest that FERC's retreat is over, and a new phase of proactive leadership is beginning. Upon the current FERC's leadership skills depend not only on everyone's escape from the Hotel California, but the future of American energy market restructuring.
Many of the matters involved here are controversial and are or will be in litigation. The following disclaimer is therefore of more than ordinary importance: while I have had occasion to learn about these matters in the course of representing clients, especially Reliant, the views expressed here are purely personal and tentative. The views expressed here are not those of Reliant or any other client, nor of my colleagues at Graves, Dougherty, Hearon & Moody, P.C. My own views expressed here are subject to adjustment in the light of new information and additional studies. I would particularly appreciate any corrections or insights readers may supply or call to my attention.
Because the matters involved are controversial, I have tried whenever possible to rely on governmental sources, especially California governmental sources. When only non-governmental sources are available, I have tried to rely on California nongovernmental sources, or national or California news media, rather than energy industry sources.
II. THE MAJOR CAUSES OF THE CALIFORNIA WHOLESALE ELECTRICITY CRISIS WERE PRE-CRISIS CALIFORNIA POLICY DECISIONS ON SUPPLY, DEMAND AND FUEL MIX.
A. Electricity's Special Characteristics
Electricity has five special characteristics of great importance.
First, unlike natural gas, or gasoline, or wheat, or pork bellies, you cannot store electricity: someone must make the right amount of electricity to meet the demand at the moment it is used. Second, the electricity system's tolerances are very fine. Go much above 60 cycles per second for even a second and you fry the lines; go much below 59.65 cycles for even a second and you trigger blackouts; either way, you risk lasting damage. Third, the swing demand is weather sensitive thermal load that is difficult to predict with rough
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accuracy and impossible to predict perfectly. Fourth, as a result the system must have either a lot of demand that can be voluntarily or involuntarily shed, or a lot of electric generation capacity standing around idle but ready to produce electricity, on very short notice.
Finally, peak power is extremely expensive. This last point may require greater explanation.
B. The Economics of Peak Generation
Peak power is expensive for two main reasons: fuel costs are higher, and capital costs must be recovered over fewer hours.
Variable costs are dominated by fuel. Fuel costs of peak power are higher than fuel costs of baseload power because rational dispatchers, whether in a vertically integrated utility or a working market, dispatch the power plants with lower variable costs. At peaks, the only power plants not already being used are likely to be fueled with the most expensive fuel, which is natural gas, and are likely to be the oldest and least efficient such units, whose heat rates for conversion of MMBtus to k Whs are highest.
Even though at peak moments the capital costs of existing plants are sunk (the bets on profits from those plants have been placed), electricity regulation or markets must allow for recovery of the capital costs of peaking capacity, together with a profit that compares with the profit available in other investments of equal risks. If the rate regulatory system or market structure will not allow investors in peak capacity to recover their investment over time, peak capacity will not be there when it is needed.
Unless owners of peak capacity are paid a standby charge regardless of need, peak capacity costs must be recovered in the prices charged for the electricity with a profit on the unrecovered portion. If peak energy is priced to include recovery, the relevant carrying costs are per MW hour of expected or actual operation. These capital costs result from dividing total annual capital costs by the expected or actual number of hours of runtime each year. For a nuclear or coal baseload plant, run year-round except for scheduled maintenance, the denominator may be 80 or 90% of 8760 hours per year. For a peaker, the denominator may be 200 hours per year; for a needle peaker, maybe only 10 hours.
As a result, although total capital costs per MW of nameplate capacity are lower for natural-gas fired peak units than for, say, nuclear or coal, even if baseload electricity costs only $40 per MWh, peak costs may easily approach $8000 per MWh. (The capital cost per MWh is $7,648.85 if you assume a peaker with a carrying cost of $45,891 per year that is run only 10 hours per year and 40% taxation.)
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Most people are unaware of how much peak electricity costs, because they are never asked to pay the peak price. Instead, most retail electricity customers pay only blended rates for electricity — rates that average 8760 hours per year of inexpensive baseload electricity mixed in with a few hours per year of extremely costly peak electricity. Indeed, most retail electricity meters are not built to allow the customer to be charged more for using electricity at 4 p.m. on a hot summer afternoon than for using electricity on a Sunday at 2 a.m.
Wholesale spot markets, in contrast, are designed to reflect each moment's prices. California designed its restructuring to make its investor-owned retail utilities buy nearly half the electricity needed to meet peak demands in wholesale spot markets, pricing all such electricity at the highest price of any bid needed to meet demand, while requiring the same retail utilities to sell at frozen blended retail rates.
To meet spikes in thermal load driven peak demands, California thus made its electricity system heavily dependent on the market in capacity and on the fuel mix characteristics of that capacity.
C. Economics 101: Supply, Demand, and the Price of Lunch
As discussed below, California electricity prices rose because of temporary...
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