Bob Crow, Editor of Business Economics, lives in the San Francisco Bay area

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The Crow Capsule Summary of How California is Becoming Like India

Several people have asked me what is going on in California's electricity market. Here is my take:

Humpty-Dumpty was pushed off the wall. Everybody is a culprit, nobody is guilty. California's energy policy is an object lesson of why countries like India stay poor: misdirected public policy with nominally good intentions has bad outcomes.

Here is what happened:

1) Because California had some of the highest electricity prices in the country (largely because the utilities were ordered by the PUC to buy environmentally friendly capacity when they had excess capacity of their own, plus their own difficulties in building nuclear plants), the decision was made to deregulate and let competition drive down prices.

2) In order to keep the utilities from going bankrupt because of their nuclear plants and the expensive contracts for renewables that they were forced into, the legislature fixed prices. They did this so that even though the forces of competition would drive prices down (Ho! Ho! Ho!), the utilities could recover enough revenue to pay for their "stranded assets."

3) The utilities were forced to sell much of their own thermal generation and got such good prices for it that they decided to sell the rest, leaving them with only hydro and nuclear and a few thermal plants. Thus, most generation that serves investor-owned utilities is in the hands of independent producers that sell power hour by hour (the "spot market") at prices determined by auction through the new California Power Exchange. There are price caps on power sold on the CPE

4) The power available from the CPE is dispatched by the Independent System Operator, who is responsible for maintaining the reliability of the power supply. The ISO sends it along to the distribution utilities, like PG&E, who sell it to end-users. Also, the ISO can buy power on an emergency basis at whatever price it must in order to maintain reliability. One result is that some suspect that producers withhold power from the CPE, where the prices are capped, until they can sell it on an emergency basis to the ISO, where they are not. In any case, the ISO has recently been buying a much higher share of California's power than it did a year ago.

5) The PUC ruled that the utilities could not enter into long-term contracts to buy power. This discouraged some developers from building plants because they could not be sure of their revenue stream. In my opinion, this is the biggest single factor behind the power shortage.

6) California grew a lot faster than expected, increasing the demand for power beyond expectations. Also, under even the best of conditions, it is hard to build power plants or transmission lines because of NIMBYism and numerous state government permitting and licensing requirements. To add insult to injury, Oregon and Washington have had little rainfall for the last few years, so their hydro generation is down.

The consequences of all this: Because there is a shortage of generating capacity and there is a free market, producers are selling power at market-clearing (i.e. exorbitant) prices. (If there was excess capacity, the prices would be ridiculously low.) The utilities are selling it to end users at a much lower price (because the price is fixed by law) than they must pay, so they are in a financial hole. (Really, they are. Maybe not as deep as they say, but it really does not make much difference if you are drowning in eight feet of water instead of fifty.) Because some producers think the utilities are going bankrupt and will not be able to pay, they are refusing to sell to them. This restricts the supply further, meaning more blackouts.

There is more to the story, but I think these are the main ingredients. Who is left standing? Not the utilities, not the PUC or the legislature (who together got us into this mess), not Governor Gray Davis (who reacted late and awkwardly), certainly not the end users.

That leaves the power producers, who are making piles of money (even more, if they get paid by functionally bankrupt utilities). Are they villains? They are if they are gaming the system and withholding power to get a better price. Basically, however, they are playing the game according to the rules written by someone else -- maximizing profits, which is what capitalists are expected to do. Lions will become vegetarians before that behavior is changed.

Are there any heroes? None that I can see. The remedies proposed by "consumer" groups (who are more anti-utility than pro-consumer) are likely to make things even worse.

Is there a remedy? I don't know. How do you unscramble Humpty-Dumpty? If you have any ideas, tell India, Indonesia, Congo, California,....

The problem is not with power industry restructuring itself: the U.K., Chile, Argentina and others have been able to pull it off with success. The problem is with unique features of California: no forward wholesale contracts to ensure supply at a fixed price and also legislated rates that made it impossible for utilities to pass on wholesale power prices that they could not control (leading to bankruptcy fears, unwillingness to supply potentially bankrupt utilities, further blackouts, etc.). Difficulties with getting permission to build plants and a bad hydro year in the Northwest would impact any regulatory regime.

Robert T. Crow
Burlingame, CA

Agree? Or disagree? Let NABE know what you think. Suitable replies will be published

...in my opinion, this is the biggest single factor behind the power shortage...

...The Problem is not with power industry restructuring itself...The problem is with unique features of California....

Feedback

Thanks for your clear, concise and insightful summary of the California
power story. I always chuckle when people say that proves "deregulation"
doesn't work...I reply that really isn't "deregulation". Our story in
Pennsylvania, while not perfect, is a much better case. My colleague John
DelRoccili has lots of experience in the utility world and I think he
shares many of your views. Anyway, your column is helpful putting it all
together, and I'm assigning it to my classes at Penn & Bryn Mawr! Keep up
the good work!

Stephen P. Mullin, Sr
Philadelphia, PA

I just read your concise assessment of the situation published by NABE. If
I may follow up, what is your assessment of the energy disruption risk west
of the Rockies this summer? Reports point to low water behind the generating dams, and less than normal snow. Since roughly a fifth of the GDP comes from this area, it would seem we are faced with an event risk, which could jeopardize the recovery in the second half.
Kindest regards and thank you for your leadership in NABE.

Harry Glenos
Dallas, TX

Bob Crow replies:
Thank you for your kind words, Harry. I cannot claim deep knowledge of other states, but the poor hydro year on the west coast is a reality unless we have a lot of precipitation in February and March. It is hard to be optimistic. Normally, at this time of year California is a power exporter to the Northwest. With California's own hydro situation being bad and a shortage in the Northwest, this summer looks pretty grim for the west. How much it will actually impact GDP is hard to gauge. My own hunch is that rolling blackouts will be more of a nuisance than a major macroeconomic event. I worry more about natural gas prices.

Excellent summary of California's self-created disaster. There is one additional ingredient: California's bizarre black-out rules discourage both conservation and alternate supplies.

1. Alternate Generation: Many communities (such as Palo Alto) have enough back-up generation capacity in local industry that most black-outs could be avoided if the systems could be turned on to provide supplemental power to the community. However, back-up generators cannot be used before a black-out occurs at a specific facility. Using such generators to AVOID black-outs is effectively illegal. We the blacked out consumers would love to buy their back-up power, but they can't sell.

2. Conservation before a black-out also doesn't help. Whatever a community reduces its power demand to, the ISO required cutbacks start from that reduced level. Under these insane rules, the ideal strategy is to use MORE power when a black-out is threatened. (Once a black-out is announced you could easily cut back your unnecessary usage to meet the 2 to 10% required load reduction.) A locality that gets serious about electricity conservation gets no benefit under the ISO rules.

Richard Carlson
Chairman, Spectrum Economics
Member, Palo Alto Utility Advisory Commission

Richard, thanks for the feedback and info on these rules. #2 really is insane and unfair -- a lot like customers getting all of the benefits of utility productivity gains under traditional regulation. #1 also seems insane -- to the point that I wonder if there are some kinds of physical or system constraints that are involved in dispatching these plants. I am curious about what the ISO (or whoever made this rule) would say in its defense .

Best regards,
Bob Crow

Bob:

I got into the detail of this mess as part of my work with our municipal utility. We are ready, willing and able to use the power from back-up generators: there is no physical problem. The regulatory problems are two fold:

A. The air quality permits for back-up generators allow them to be used only 200 hours a year, and only during a black-out.

B. A back-up generator that sells power to the community comes under PUC and ISO rules. This means that the back-up generator can no longer be used for facility back-up -- if there is a local black-out event, they can't cut themselves off and supply only themselves. If this sounds like a Catch-22 it is.

Richard Carlson