Californias Shocking Secret: Deregulation Did Work in Spite of Itself

Although Californias leaders chose to ignore the markets message and exacerbate the problem, the overall market cost of electricity since deregulation began in California is lower than it was under the previous regulated cost-ofservice structure. Looking at the facts, one can only conclude that despite our best efforts to sabotage it, the electricity market workseven in California.
Phillip Muller

I. Introduction
Phillip Muller is President of SCD Energy Solutions of San Rafael, California. He has 24 years experience in the electric and gas utility industry in the West and has been actively involved in Californias electric restructuring process. Prior to forming SCD, he was with Pacic Gas and Electric Company for 13 years. He has represented all three sides of the industry: utilities, nonutility generators, and consumers. According to common wisdom, electric industry restructuring in California was an abject failure that greatly contributed to the current depressed state of electricity markets in the United States. Many claim that the 2000 01 energy crisis demonstrated that the electricity business is somehow different and that we cannot rely on market forces to set prices, assign risk, or encourage efcient operations. They particularly impugn Californias almost total reliance on the day-

ahead spot market. As traumatic as the period from June 2000 through May 2001 was, a dispassionate look at events before, during, and after the crisis shows that, as is often the case, common wisdom may be just plain wrong. In fact, the problems that California continues to work through today are not the result of relying on market forces; they result from governmental intervention in the market. his analysis will demonstrate how electric industry restructuring and the dis-integration of California utilities The Electricity Journal

24

1040-6190/$see front matter # 2004 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2004.11.004

beneted consumers by providing lowered prices, reduced risk exposure, and improved incentives for efcient operation:  Lower prices: Had California ridden out the storm and simply paid the much maligned spot market price for the entire period from April 1998 through June 2004, the average commodity cost of electricity1 over the period would have been 4.7 percent lower than the frozen price in 1998 and over $30 billion less than the rates actually charged by utilities over the same period.  Reduced risk: Relying on the merchant model to build new generation meant that the shareholders of the merchant generators, not captive ratepayers, were held responsible for construction overruns and overbuilt capacity.  Operating incentives: The merchant operators who purchased the utility power plants got more production out of them than the former utility owners did in the previous 20 years. In other words, deregulation really did work in California. Had objective reasoning rather than political expediency reigned supreme, Californians today could well be experiencing the low-cost nirvana envisioned when the restructuring process began 10 years ago.

Cold War. The reduction in military spending in the early 1990s hurt Californias aerospace industry, which impacted the entire economy of the state.2 The economic squeeze led companies to take a hard look at their production costs. One thing they saw was that electricity rates in California were over 40 percent higher than the national average.3 Deregulation, dened as increased reliance on market

Electricity industry restructuring presented a different set of challenges from the gas industry, which was already largely unbundled.

II. Background: The Restructuring Plan

Californias electric industry restructuring program was a consequence of the peace dividend provided by the end of the December 2004

mechanisms rather than regulatory intervention, was seen as an effective approach for reducing prices. The restructuring of the natural gas industry served as a model. By the late 1970s federal regulation of gas production at the wellhead had created shortages of regulated interstate gas relative to non-regulated intrastate gas. Congress responded in 1978 by regulatory intervention imposing a national ban on new gas-red power plants, and deregulation phasing out wellhead regulation for new gas. The power plant ban hampered the development of more-efcient combined cycle

gas turbine generation technology. Wellhead deregulation encouraged exploration, which created a dramatic increase in natural gas supplies. The interstate pipeline system was reformed in the 1980s, ultimately eliminating the monopoly merchant function of interstate pipelines. The result was a highly competitive wholesale gas market with decreasing prices and increasing supplies. Californias experience with restructuring included natural gas price reductions to large consumers of upwards of 50 percent. With this experience in mind, Californias manufacturers pushed to apply the same discipline to electricity markets. lectric industry restructuring, however, presented a different set of challenges. The gas industry was already largely unbundled from a structural standpoint. That is, unlike the vertically integrated monopoly utilities in the electric industry, the gas industry, with a few exceptions, was split into three separate corporate and business functionsexploration and production; transmission by large interstate and intrastate pipelines; and distribution to local homes and businesses. Producers drilled for gas and sold it to pipelines. Interstate pipelines moved the gas to the citygate and sold it to local distribution companies (LDCs). The LDCs in turn sold the gas to the end user. The whole process took place at regulated prices. Gas restructuring primarily consisted of deregulating
25

1040-6190/$see front matter # 2004 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2004.11.004

supply and eliminating the procurement function of the interstate pipelines, turning them into open access common carriers. Restructuring allowed LDCs, electric generators, and industrial consumers to make their own deals with upstream suppliers and marketers, entering into longer- or shorter-term arrangements as they saw t. Non-competitive stranded costs were primarily limited to take-or-pay agreements between pipelines and LDCs, and were resolved in a process adjudicated by the Federal Energy Regulatory Commission (FERC). he electricity industry is more challenging; vertically integrated utilities own and operate generation, transmission, and distribution and sell directly

to the consumer. Deregulating production (generation) would require divestiture or functional unbundling to separate it from the still-regulated monopoly services. Improving competitive access would also require separation of transmission, a FERC-regulated function, from distribution services, which remain under state control. The restructuring process therefore requires coordination of state and federal regulators as well as the cooperation of the utilities subject to the necessary unbundling. In the case of California, the process would have to be adjudicated by the California Public Utilities Commission (CPUC) in coordination with FERC, and ultimately be acceptable to Californias big three investor-owned electric uti-

lities, Pacic Gas and Electric, San Diego Gas, and Electric and Southern California Electric, which together serve about 75 percent of Californias electric load.4 Over 60 percent of their combined annual electric sales of almost $17 billion5 was made up of generation costs that would be potentially subject to competition (Figure 1). The prospect of opening an $11 billion per year market to competition attracted substantial attention. It resulted in a political struggle between the pro-competition forces that favored full utility unbundling and retail competition, and utility interests that preferred wholesale competition through a central Poolco mechanism. After a period of political give and take, highlighted by a widespread

Figure 1: The Figure Shows the Energy Consumption Reported by the ISO for Each Month from June 1998 to May 2003. The Chart Does Not Adjust for the Load of the Sacramento Municipal Utility District (SMUD) Which Left the ISO to Form its Own Control Area in June 2002. SMUDs Load is Roughly 4 Percent of the ISOs Total Load. The Energy Crisis Period (June 2000 through May 2001) is Shown by the Middle Bar in Each Group. Interestingly, the Highest Usage for 10 of 12 Months in the Entire Five-Year Period Occurred Either in 200001 or in the Previous Year
26 1040-6190/$see front matter # 2004 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2004.11.004

The Electricity Journal

blackout in August 1996, legislation was nally passed in October 1996,6 specifying a market structure that combined characteristics of both approaches. Basically, parties agreed to a transition of up to four years during which retail rates would remain frozen to take advantage of low wholesale electric prices and quickly pay down the utilities stranded costs.7 Utilities would begin to get out of the generation business through divestiture, transfer control of the states transmission system to an independent operator under FERC jurisdiction, and rely on a day-ahead auction mechanism to set the wholesale price for the electricity they sell, as well set the benchmark against which competing sellers would price power sales. New competitors would come to California, buy up the utility power plants, and offer competitive alternatives that would inevitably result in a signicant reduction in retail electricity prices in California.

billion by May 2000. San Diego Gas and Electric had even declared its stranded cost recovery complete by July 1999. The CPUC began to look at post-transition rate structures. It was generally expected that stranded costs would be fully recovered well before the end of 2001. nfortunately, the competitive retail suppliers did not experience a comparable level of

infamous trading strategies are examples of these kinds of activities.

IV. The Meltdown

Starting in June 2000, spot market prices took off. During the 12-month period through May 2001, spot prices increased by a factor of six, to an average of $195/MWh for the entire period. During the same period, retail rates remained frozen, subject to a relatively small surcharge (averaging about 10 percent) in January 2001, and an additional surcharge in June 2001, after prices had stabilized. Isolated from the price increase by the aforementioned rate freeze, consumers had little incentive to respond to high prices by reducing their consumption. This lack of incentive is borne out in electricity consumption. With the exception of the month of October, monthly electricity consumption in June through December 2000 was higher than the same months consumption in any other year between 1998 and 2003 (Figure 1). With a continued obligation to serve their customers and no way to pass through astronomical prices, the utilities soon ran out of money and had to turn to the state government, which took over power procurement through 2002. Then, just as quickly as spot prices skyrocketed, they plummeted in June 2001, dipping to below $30/MWh in September. The net impact of the 12-month spot price explosion was that by May 2001,
27

It was generally expected that stranded costs would be fully recovered well before the end of 2001.

III. Implementation of the Plan

For the rst two years after the implementation of electric industry restructuring in early 1998, stranded cost recovery worked like a charm, and wholesale power customers saw highly competitive and relatively low wholesale prices. The difference between the day-ahead wholesale price and what the utilities collected from their customers exceeded $16 December 2004

success in retail market operations. The structure of the market specied in AB1890 meant that they had to price retail sales below the wholesale spot price (with no meaningful opportunity for hedging or risk management) to be competitive. As a result, most suppliers drew back from the retail market and instead focused on wholesale trading and marketing operations, where business opportunities were more readily available and required much less overhead to realize. The resulting trading focus rewarded those who best understood the complexities of Californias wholesale markets.8 Enrons

1040-6190/$see front matter # 2004 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2004.11.004

California had burned through the $16 billion in stranded costs recovered through May 2000, as well as an additional $13 billion. The states utilities were in shambles and actions taken by the state to avoid increasing rates resulted in an average rate increase of 40 percent.

city from April 1998 through June 2004 was lower than it would have been had the pre-1998 frozen regulated utility rates remained in place. As is shown in Figure 2, the weighted average pre-restructuring retail rate for generation was $65.33/MWh. As of June 2004, the volume weighted average price for spot electricity, including the cost of ancillary services, was

V. Deregulations Success
The popular response of politicians and pundits is that Californias energy crisis was a result of deregulation and that we should return to the good old days of vertically integrated utilities, cost-of-service regulation, and monopoly service. The following rush to establish blame, demand refunds, and le law suits was clearly a factor in the apparent demise of the merchant generation business and the sudden halt in deregulation activities throughout the country. Lost in the hyperbole is one very important factderegulation in California provided lower-cost electricity, reduced risk to consumers, and improved incentives for efcient generator operation. A. Lower prices It has now been more than three years since the end of the 200001 energy crisis. The spot electricity market remains anathema to utilities and regulators in the state. Yet, even including the 200001 sustained high prices, the cumulative cost of spot market electri28

markets price signals to consumers. It seems unlikely that consumers, informed that their electricity rates would be increasing by 60 percent or more,9 would have continued the high level of consumption that actually took place throughout the period. Had high prices been passed through when they occurred, rather than spread over 10 to 15 years through high-priced contracts and bond charges,10 consumers could have chosen to reduce consumption, most likely counteracting the supply shortage and forcing down prices in weeks rather than months. Had California embraced the market rather than ignored its message, consumers could now be enjoying the lower prices they were promised, rather than being shackled with another 10 years of high electricity prices.

$62.33/MWh. As a result of the energy crisis, however, the frozen electricity price has been adjusted several times beginning in 2001, so that the actual regulated price collected by utilities over the period was $83.24/MWh. Thus the total spot market cost over the period was actually $30 billion less than the regulated price. Unfortunately, because California chose to protect consumers from high market prices rather than giving them the choice of whether or not to consume, much of the $30 billion has been swallowed up by long-term contract costs. One can only speculate what would have happened had the decision been made to send the

B. Reduced development risk The energy crisis fueled a feeding frenzy of new generation development. Over 17,000 MW of new capacity was proposed in 2000 and 2001. As the crisis subsided and consumers responded to higher prices by reducing consumption, investors began to question the need for new generation. Many of the new plants proposed, approved, and even under construction have been abandoned, withdrawn, or delayed. Of the 17,000 MW proposed, only 1,700 MW is currently operational. Some of these moribund projects will probably The Electricity Journal

1040-6190/$see front matter # 2004 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2004.11.004

Figure 2: The Regulated Pricewas Derived from Various Utility Filings Made as Part of Californias Electric Restructuring Process. It Consists of a Weighted Average of Each Utilitys Unbundled Revenue Requirement and Associated Sales for 1998. Because of the Rate Freeze it Remains Constant Until Surcharges of 1/kWh and 3/kWh were Added in January and June 2001, Respectively. A Rate Reduction of 1.82/kWh by Southern California Edison Effective August 2003, Reduced the State-Wide Average Rate by 0.82/kWh Reecting Edisons 45.3 Percent Share of Total Load. The Spot Price Represents the Monthly Average Spot (Day-Ahead) Electricity Price. From April 1998 to December 2000 it was Derived from the Load-Weighted California Power Exchange (PX) Day-Ahead Zonal Price for Each Month Plus Ancillary Services Costs Reported by the ISO. Starting in January 2001, When the PX Ceased Operation, Prices were Derived from the Prices (Peak and Off Peak for NP-15 and SP-15) Published Weekly in California Energy Markets, Plus Ancillary Services Costs Reported by the ISO. The Cum Price Represents the Cumulative Spot Price from April 1998 Through Each Month Thereafter. It Reects Total ISO Load for Each Month as Reported by the ISO. The CTC Recovered is Equal to the Cumulative Difference Between the Total Regulated Cost (Regulated Price Times Total Load) and the Total Spot Market Cost (Spot Price Times Total Load). It Approximates the Utility Stranded Cost Recovery Without Taking into Account the Long-term Contracts Executed by the State in 2001 or the Cost of Bonds Issued to Cover the Short Position

be completed as market conditions improve. No matter the outcome, however, California consumers will not be on the hook for any costs incurred by unsuccessful merchant developers. Unlike traditional utilities, merchant developers cannot require their customers to pay for uneconomic investment decisions or stranded costs, regardless of how reasonable the uneconomic decisions may have been at the time. While the December 2004

banks and shareholders that invested in the mistakes of merchant developers are likely to lose, consumers will actually benet as generation assets are written down to reect a reduced market value. In deciding to move away from electric restructurings market reforms, on the other hand, the state government stuck California consumers with a new collection of above-market long-term supply contracts negotiated at the height of the

crisis, contracts which turned into new stranded costs almost overnight. C. Improved incentives The merchant generators that purchased the utilities divested power plants in the restructuring process have a much different perspective than the previous utility owners. They applied a market premium to the value of the plants, purchased them for
29

1040-6190/$see front matter # 2004 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2004.11.004

Figure 3: The Figure Shows the Total Output for the Generation Units Divested by Pacic Gas and Electric, Southern California Edison and San Diego Gas and Electric in 12-Month Blocks from June 1981 to May 2002. Data was Obtained from Energy Information Administration Reports and Includes Utility Ownership from 1981 to 1999 and Non-Utility Ownership from 1999 to 2002. Because Non-Utility Data was not Available for 1998 (Edison Sold its Units Effective April 1998), 1997 Utility Production Data was used for the Edison Plants for April 1998 Through December 1998. The Figure Does Not Account for Generating Units at the Divested Plants that were Retired During the Period

almost 75 percent more than book value,11 and then operated them more efciently and more often than they had operated under the earlier utility ownership. Every year from 1999 (when divestiture was completed) to 2001 (when new generation started coming on line, making the old plants less competitive), these plants showed an increase in production from the previous year. Not bad for a mix of old steam plants and combustion turbines that were mostly built in the 1950s and 1960s. The total production of these plants from June 2000 through May 2001 (the same time frame during which the owners were allegedly withholding generation to raise prices) was higher than in any comparable period since 198182 (Figure 3).12 Since they were only paid for energy or ancillary services that they actu30

ally provided, rather than receiving a utilitys return on equity, the incentive of the merchant generator was clearly aligned with the need of consumers. In addition, at least 9,300 MW of new, primarily merchant, generating capacity was in the planning stage in California before 2000. Of this total, 6,601 MW has since been built.13 New generation may have come on-line later than needed, but the development process was well underway before spot market prices went haywire.

VI. Conclusion
Many things contributed to the 200001 energy crisis in California. Acute supply shortage, market design aws, absence of retail price signals, lack of

responsible hedging/risk management practices, and market abuse by both buyers and sellers all inuenced the magnitude and duration of the crisis. The suggestion that the crisis demonstrated a failure of market principles and therefore justies a return to a vertically integrated cost of service electric industry structure is clearly unfounded. Even though Californias leaders chose to ignore the markets message and exacerbate the problem, the overall market cost of electricity since deregulation began in California is lower than it was under the previous regulated cost of service structure. Looking at the facts we can only conclude that despite our best efforts to sabotage it, the electricity market works, even in California.& The Electricity Journal

1040-6190/$see front matter # 2004 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2004.11.004

Endnotes: 1. The portion of electricity rates attributed to power generation as opposed to distribution and transmission. 2. National Science Foundation, Science & Engineering Indicators 93, available at http://www.nsf.gov/ sbe/srs/seind93/start.htm 3. Energy Information Administration, Current and Historical Monthly Sales, Revenues and Average Revenue per Kilowatthour by State and by Sector, available at http:// www.eia.doe.gov/cneaf/ electricity/page/ sales_revenue.xls 4. The remainder was served by municipal utilities and irrigation districts not under CPUC jurisdiction and thus able to avoid participation in the restructuring process.

5. 1998 revenue requirement of $7.7 billion for PG&E, $1.5 billion for SDG&E, and $7.6 billion for SCE. 6. AB1890, passed unanimously by the California Legislature and signed by Gov. Pete Wilson in Oct. 1996, was described as a Christmas tree with ornaments for everyone. 7. These stranded costs were primarily cost overruns from nuclear power plants nished in the 1980s and long-term contracts with qualifying facilities, with prices set based on long-term expectations at the height of the 1970s energy crisis. 8. By May 1999, the California Independent System Operator (ISO) had 61 different items that it paid or charged to market participants with values that could change as often as every 10 minutes. 9. The generation component of the frozen rates was about 60 percent of

the total average rate. Thus a doubling of the generation component from 6.5 to 13/kWh would increase total rates by 60 percent. 10. California issued $12.5 billion in bonds to pay off undercollections of wholesale power costs above the level of retail rates. 11. A total of 20,187 MW were divested for a total sales price of $3,174,000. The total book value of the plants was $1,818,000. See http:// www.energy.ca.gov/electricity/ divestiture.html 12. These gures do not account for unit retirements during the period, making the merchant generation performance even more impressive. 13. California Energy Commission Power Plant applications from 1997 to 1999.

Conference Energy Risk Management Transmission Planning & Reliability Electric Industry International Financial Conference 2005 Middle East Electricity Exhibition & Conference Clean Air Technologies and Strategies Russia Power 2005 Electric Utility Business. . . From the Inside Out Windpower 2005 Conference & Exhibition China International Energy and Power Exhibition

Date January 2021, 2005 January 2526, 2005 February 2023, 2005 March 69, 2005 March 810, 2005 March 911, 2005 May 56, 2005 May 1518, 2005 October 2729, 2005

Place Calgary Toronto London Dubai Baltimore Moscow Madison, WI Denver Beijing

Sponsor Oxford Princeton Program The Canadian Institute Edison Electric Institute IIR Exhibitions Ltd. Institute of Clean Air Companies Russia Power Univ. of Wisconsin at Madison American Wind Energy Association CCCME and CWC Associates Ltd.

Contact 609-524-1132 http://www.canadianinstitute.com/ contentframes.cfm?id=2927 202-508-5496 http://www.middleeastelectricity.com/ http://www.icac.com/CATS05/ CATS05.html http://rp05.events.pennnet.com/ home.cfm?Language=Engl 800-462-0876 http://www.awea.org/wp05.html http://www.cepex2005.com

December 2004

1040-6190/$see front matter # 2004 Elsevier Inc. All rights reserved., doi:/10.1016/j.tej.2004.11.004

31