The eagles of deregulation: the role of the courts in a restructured environment.

AuthorFerrey, Steven
PositionCalifornia's electric power energy crisis
  1. INTRODUCTION

    Welcome to the Hotel California... You can check out any time you like But you can never leave (1) The consumer in the Sunshine State has checked into the electric future suite at the Hotel California; it will be an extended stay, and the tab is running. The most capital intensive industry in the United States, in the largest state in the Union, which itself is the fifth largest economy in the world, came completely unhinged. From 1999 to 2000, California's expenditures on electricity quadrupled from approximately $7 billion in 1999 to approximately $28 billion in 2000. (2) For 2001, it is expected to be even greater. (3)

    Three salient facets of the environment of electric deregulation are exposed by California's problems:

    * A fundamental unresolved legal conflict between state and federal authority to address electricity issues.

    * Common law court adjudication will replace the traditional role of regulation.

    * Re-regulation, in the form of reactive legislative responses, will spawn yet more judicial conflict.

  2. WHAT REALLY HAPPENED AT THE HOTEL CALIFORNIA?

    Welcome to the Hotel California Such a lovely place, such a lovely face They're livin' it up at the Hotel California What a nice surprise. Bring your alibis. (4) In late calendar year 2000, California's restructured electric power market imploded. (5) What really happened? The facile answer is that demand exceeded supply. But there is more.

    1. The Restructuring

      In 1998, California became the third state in the nation, after Massachusetts and Rhode Island, to restructure its electric sector, allow retail competition, and "incentivize" or force its investor-owned utilities to sell their generating assets. Because California's concept of deregulation contained a ten percent price cut to pacify consumers, this discouraged consumers from shifting to alternative retail suppliers. (6) Therefore, a vibrant retail market and significant customer choice did not become a reality. Only about two percent of customers--typically large customers--switched to other suppliers. The conventional utilities continued to supply more than ninety percent of the power being sold in the state. (7) They had to do this after selling their generating assets and by not hedging forward the electricity supply.

      After deregulation, the California Energy Commission no longer assessed the state's need for power. Market participants, subject to regulatory siting approval, were responsible for supply. By law, deregulated power supply was bid to the California Independent System Operator (ISO) daily, with the last/highest price accepted setting the price for all sales of power during that period. (8) The utilities were required by regulatory authorities to buy a substantial amount of their power requirements on the "spot" market--day-to-day--rather than through hedged forward contracts.

      Rather than rely on hedged forward contracts to mitigate price swings, California sought the imposition of spot electric price caps as a means to control losses. (9) This may work as a political solution, but it destroys the price signals that the market would otherwise send, as well as dampens conservation incentives. California was unique among the states in not allowing hedged forward power contracts for wholesale supply. This prohibited the regulated California utilities, which still supplied by default most of the retail customers in California, from managing the risk of their electric commodity acquisition.

      Approximately one-quarter of California's generating capacity is hydroelectric, which was susceptible to annual water flows that decreased. (10) California's reservoirs were down to minimal levels, leaving little energy capacity from these hydroelectric resources in the system. (11)

      Some of the problem in California was made more complex by unregulated companies and their affiliates controlling both some of the natural gas supply and a significant share of deregulated wholesale electric power producers. About half of California generation relies on natural gas, a great majority of which is not extracted in-state. (12)

      In California, the largest market participant has a share of only thirteen percent of the market. (13) However, for purposes of exercising market power during certain hours in certain sub-markets, at times when demand is very inelastic, there could still be horizontal market power for a generator with less than a twenty percent share. While the Federal Energy Regulatory Commission (FERC) originally concluded that market power would be fully mitigated by FERC Order No. 888, (14) which established open access transmission tariffs, (15) this conclusion is somewhat contradicted by FERC Order No. 2000, (16) which finds that undue market discrimination still continues in the industry. (17)

      Some of the gas supply companies declined to sell natural gas to the cash-short integrated electric and gas utility companies in California that were required by law to serve residential and other natural gas customers. This drove the price of natural gas higher and, therefore, the cost of power produced at wholesale by natural gas-fired power generation technologies. The utilities were unable to store sufficient amounts of natural gas; the state regulatory commission had discouraged investment in pipeline and in-state storage assets that were owned by the gas distribution companies.

      California's spot market began March 31, 1998. (18) During summer 2000, spot market prices for electricity in California increased by 500%, and then doubled from that new plateau at the end of calendar year 2000. (19) When spot market prices of wholesale power increased dramatically due to shortfall, this caused the ultimate cost of power needing to be passed on in retail rates or otherwise recouped to increase correspondingly. In response to ratepayer protest, the state ordered retail rates frozen at 6.5cents/kilowatt-hour (kWh). (20) Many of the investor-owned retail utilities were purchasing power at substantially higher wholesale spot market prices, but not allowed to pass on the higher acquisition cost in retail rates under this retail rate cap. (21)

      Thereafter, the revenue-strapped regulated California distribution utilities were unable to pay on time for their wholesale power acquisitions because of dwindling cash resources. The utilities teetered on the verge of bankruptcy. Over time, an increasing amount of total load was served through real-time spot market purchases, which reflected near-panic situations. The California ISO was allowed to purchase power from out-of-state suppliers at any price. (22) A phenomenon known as "megawatt laundering" then ensued, where out-of-state suppliers could sell power to neighboring states, which could then be resold to the California ISO at inflated prices.

    2. The Descent

      There she stood in the doorway I heard the mission bell And I was thinking to myself This could be Heaven or this could be Hell. (23) Rolling blackouts were visited on consumers during the off-peak winter and spring months of 2001. It is estimated that outages of electric supply, before adding the California experience, already cost the United States economy approximately $50 billion and could increase significantly in the future. (24) A shortage of electricity has dire social and political consequences; a blackout has been equated to a natural disaster. (25)

      Moreover, allowing rolling blackouts is a very inefficient way to balance electricity supply and demand differences. Not every consumer attaches the same value to electricity at a given hour. For some industries, even a short blackout can ruin millions of dollars of production; for others, it is a minor inconvenience. However, because of simple meters, no residential consumers see price signals that reflect the actual time-sensitive costs their consumption imposes on the system at any given time of day. This fixed retail rate, with no metering feedback system to retail consumers, excludes substantial amounts of retail electric consumption from any meaningful price response role in the deregulated market.

      The situation in California became so extreme that President Clinton used a statute reserved for national emergencies, or when the national defense is threatened by foreign powers, to try to keep the lights on in California. Declaring a "natural gas supply emergency" (26) under the Defense Production Act of 1950, (27) which was enacted at the commencement of the Korean War to keep supplies flowing to the government, the President compelled unregulated out-of-state natural gas companies to keep selling gas to California utilities who were unable to pay for it and were on the verge of bankruptcy. (28) The Clinton administration justified this action by claiming that, had the gas not been ordered moved to California, the California investor-owned utilities (IOUs) could have seized other gas in the pipelines to serve residential customers, cutting off federal military and NASA facilities. (29)

      This was an extraordinary exercise of national defense powers in peace time to cause private companies to act contrary to their market interests. President Bush allowed this order to expire after extending it once. (30) California's Governor Gray Davis (D) urged President Bush

      to stand up to your friends in the energy business and exercise the federal government's responsibility to ensure energy prices are just and reasonable.... What's going on here, pure and simple, is unconscionable price-gouging and market manipulation by the big energy producers and marketers--most of them, incidentally, located in Texas. (31) During the first five months of 2001, only about ten percent of power sales to the state, in fact, were from Texas-based companies. (32) Former Republican Governor Pete Wilson countered that then-Lieutenant Governor Davis did not offer "a peep" during the original California deregulation debate. (33)

      No state, particularly California...

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