Crisis in California: Part 2 what really happened, and why.

• Author: Mohre, Dave

In Part 1 of this article (Management Quarterly, Summer 2001), we reviewed the events surrounding California's recent experience with retail competition. As we noted, the American electric power system has long been one of the best -- if not the best -- in the world. In stark contrast to that history, California experienced a fundamental system breakdown that resulted in rolling blackouts, soaring wholesale power prices, and the expectation that the state's total cost of power -- $7 billion in 1999 -- will increase to as much as $50 billion this year.

Part 1 of the article summarized the background factors that resulted in a series of rolling blackouts that affected the state throughout the winter and spring of 2001. We identified a set of causes for these events, which are of two kinds: energy market fundamentals, which primarily are driven by supply and demand, and market structure problems, which result from the way that the state defined the competitive marketplace.

Market fundamentals problems include the following:

* The rapid growth of California's economy which occurred without a corresponding increase in new baseload generation.

* Rapidly rising natural gas prices, coupled with the fact that almost half of California's generation uses natural gas.

* Droughts in the state and in the Pacific Northwest that substantially reduced the availability of low-cost hydropower, greatly decreasing the expected seasonal exchanges of energy between the two areas.

* Dramatic increases in the cost of emissions credits.

In combination with federally-mandated wholesale competition, these essentially "perfect storm" factors descended upon the state at just the wrong time. Consequently even without other factors, California and neighboring states likely would have experienced some electricity shortages and increased wholesale prices no matter what.

Unfortunately, in its desire to create an effective competitive market at the retail level, the state designed a market structure that greatly intensified the electricity problems actually experienced. That structure was defined by a set of rules that produced unintended but brutally harmful consequences. These include:

* The state plan capped retail rates until stranded costs were recovered, which created cash-flow problems for the two investor-owned utilities that had not yet completed recovery of their stranded costs when wholesale rates skyrocketed.

* The state plan relied far too heavily on the always more volatile next-day spot market and required the three major IOUs to purchase all requirements for their retail customers in that market.

* The major utilities were initially discouraged from hedging short-term purchases, and were in any case limited in their ability to hedge.

* All competitive generation suppliers got the "market clearing price" no matter what they bid. (The highest price at the time the market was cleared became the price. If all suppliers but one bid $35 a megawatt hour, but the Power Exchange wound up having to buy power from that one supplier for $350 per megawatt hour, every supplier received $350 per megawatt hour.)

* Wholesale power purchases were managed by state agencies, the PX and CAIS0, that were, in retrospect, woefully unprepared for the job. In describing the California Independent System Operator, the New York Times said, "A backwater agency that was never intended to buy power at competitive rates...