Filip Igrcic

A state of gloom
Jan 18th 2001
From The Economist print edition

One of the wealthiest regions in the world is on the brink of an energy crisis of third-world dimensions. How did California come to this?

ON JANUARY 16th, the Californian state assembly passed a bill giving the state a central role in the local electricity market. This, in effect, turned the clock back on the deregulation of California’s power industry begun in 1996 amid grand promises of reduced rates for consumers, more secure supplies for business, and bigger markets for power companies. But in fact the state had few options. On the same day, two of California’s largest utilities had their debts reduced to junk by the leading credit agencies after one of them, Southern California Edison (SCE), announced that it would not be paying $596m due to creditors, in order to “preserve cash”.

That undermined the ability of SCE and of Pacific Gas & Electric (PG&E), the other big utility in the state, to buy power on credit, and pushed them to the brink of bankruptcy. On the same day, a “stage 3” emergency was declared, the highest level of alert, called only when power reserves fall below 1.5% of demand. On January 17th, one-hour black-outs rolled round the area of northern California served by PG&E. And Governor Gray Davis declared a state of emergency, authorising the state water department to buy power.

This is a dreadful mess for a state that is held up around the world as a model of innovation and dynamic markets, and that was the first in America to pursue deregulation. What on earth has gone wrong?

The short answer is, botched deregulation. The peculiarly bad way in which California’s deregulation was organised freed prices for wholesale electricity while putting a freeze on retail rates. As a result, the state’s utilities have been forced to buy power on the red-hot spot market (where prices have soared recently—see chart 1) for far more than they are able to recoup from consumers. Catastrophe has been looming for some time now. The state’s residents have already endured a series of annoying and expensive “brown-outs”. Indeed, power emergencies have become so common that they are announced along with the traffic and weather reports on the morning news.

Only recently, however, have local politicians begun to take action. Earlier this month, the state’s legislature approved a temporary rate increase to ease the pain for the utilities. Mindful of the state’s noisy consumer lobbies, legislators approved a hike of only about 10%, and then only for three months. And even that is subject to reversal. It came nowhere near the 30% hike that the utilities claim they need to survive.

Mr Davis, the state governor, tried to bully his way out of the crisis during his “state of the state” speech on January 8th. “Never again can we allow out-of-state profiteers to hold Californians hostage,” he declared, threatening to seize electricity assets and run them himself if necessary. Needless to say, his speech did not help much. Curtis Hebert, a Republican commissioner on the Federal Energy Regulatory Commission (FERC), the country’s top electricity regulator, fumed: “You’ve got a governor who cares more about being on a night-time news show than he does about fixing the problem in California.”

British fog

If California fails to tackle its power problems swiftly, the knock-on effects could be severe. Morgan Stanley Dean Witter, an investment bank, has just warned that “California’s crisis could magnify the downside for the whole economy. In the end, the state’s energy crisis could prove to be an unwanted wild card for the American financial markets and the global economy at large.”

Such fears of contagion explain why the outgoing Clinton administration has been scrambling to organise a series of summits between state and federal officials, the utilities, and their main power suppliers. The legislation passed this week, if it ever becomes law, would allow California’s creditworthy Department of Water Resources to buy additional power directly under long-term contracts and to sell it on to the utilities at a fraction of the current spot-market price. But, inevitably, this can serve only as a stop-gap measure; the talks brokered by federal officials, aimed at providing the foundation for a longer-term solution, are due to resume on January 23rd.

To see how California might move forward, look first at how it got itself into such a pickle. Largely inspired by Britain’s success in opening up its power sector a decade ago, California led the United States into the brave new world of liberalised electricity markets. After years of haggling among various interest groups—from the big utilities to greens and consumer organisations—the administration of Mr Davis’s predecessor, Pete Wilson, put together a compromise deregulation bill with enough bells and whistles to please almost every interest group.

Through the whole process, Britain’s power deregulation was the inspiration. Stephen Baum, the boss of Sempra (which owns San Diego Gas & Electric, a utility that is in better financial shape than PG&E and SCE), says that “California embraced competition as a religion and the English model as our guide.” However, California’s zealous reformers forged ahead without taking into account some important differences between California and Britain—for example, in areas such as reserve capacity. In Europe, deregulation has not resulted in reliability problems. But credit for that belongs not to European models of reform, but rather to excess capacity. Europe’s top-heavy, state-dominated power sector has tended to “gold-plate” its assets (through higher tariffs paid by captive customers). California was not in such a happy position.

Another difference between the two models is that Californian officials let pork-barrel politics inhibit the development of the retail market. Rather than allowing prices to fluctuate, politicians decided to freeze electricity rates for a few years—supposedly in the interests of the consumer. But that gave consumers no reason to cut power use even when wholesale prices sky-rocketed—as they have done recently.

Also, under pressure from the big and politically powerful utilities, the state’s politicians agreed to compensate the companies generously for “stranded assets”—such as the big power plants built before deregulation suddenly changed the rules of the game. That sounds fair enough, but California agreed to value those assets much more generously than other states. Worse still, officials decided to burden new entrants to the business with part of the cost of the “stranded assets” built by the incumbents. Hence newcomers have been severely handicapped in their ability to compete on price.

A number of other states largely avoided making these mistakes. In Texas, for instance, firms are free to enter into long-term contracts in order to hedge against the risk of volatile prices. And Pennsylvania has had great success in spurring competition from newcomers.

California allowed none of this, and the upshot is that hardly any Californians have switched retail suppliers, unlike Pennsylvanians. In Britain, one-quarter of the public has switched. What California dubbed “deregulation” did very little to unshackle the power sector from the state. Supply, demand and politics

Yet even with its half-baked, half-British model, the state might have muddled along for quite some time. The snag is that a bunch of uniquely Californian forces conspired to bring things to a head: fierce opposition to new power supply; a dramatic surge in demand; and, in particular, the politics of pork and populism.

For a start, the state’s supply picture has grown ever bleaker. New power plants are rarely popular in any part of the world, but in California the famous “not in my back yard” (NIMBY) syndrome has reached ridiculous levels, thanks to the state’s hyper-democratic balloting process. The state has also long had the toughest environmental laws in America, and these have helped to make power generation unattractive. Thanks to greenery gone mad, neighbourhoods turned selfish and surly, and red tape and regulatory uncertainty run amok, the state’s utilities have not built a new power-generation plant in over a decade.

Yet the state’s appetite for electricity has shot through the roof. Defying official forecasts made early in the decade, California’s power consumption grew by a quarter during the 1990s (see chart 2). The most dramatic factor fuelling the growth in demand has been the digital revolution, spawned in northern California. As computing power has spread to everything from the manufacture of microchips to the frothing of cappuccinos, California has defied eco-pundits and state officials who forecast that the Internet and the “new economy” would inevitably lead to less consumption of electricity. In San Jose, the heart of Silicon Valley, consumption has been growing at about 8% a year.

The clincher, though, has been the peculiar politics of California. Politicians and regulators have been fiddling with the reform process in ways that are both capricious and counterproductive. Amazed that the free market for wholesale power responded to last summer’s supply squeeze by raising prices, panicky officials ordered “caps” on those prices. Predictably, the caps have failed miserably—as the more recent supply crunch amply demonstrates.

Power prices shot up because supply was scarce, and the right solution would have been to let markets respond—as mid-western states did when they suffered similar price hikes a few summers ago. They did not meddle in the wholesale markets, and generators responded to the price signals by rushing to add supply. Notably, the crises there have not recurred.

The most disturbing failure in California, however, lies with the regulators themselves. Sometimes they trust not at all in market forces: for example, they actually discouraged utilities from hedging their price risks by purchasing derivatives. This lunacy as much as anything explains why the state’s utilities are now on the verge of insolvency, compelled to buy power on the spot market. Yet at other times, the regulators naively expect the market to sort out the problems of transition by itself. When Britain deregulated, for example, its pricing mechanism offered power suppliers an explicit top-up to encourage them to create reserve capacity. Though California deregulated into a much tighter market, its regulators offered no such incentive, relying entirely on the market to secure adequate supplies. This schizophrenia explains why the Californian reforms are a ragbag of muddled half-measures and downright anti-competitive clauses.

Given the imminent collapse of the state’s utilities, there is much agitation from all quarters for the state or federal government to do something. But what? James Hoecker, the current head of FERC, says that “California’s market is clearly flawed by design...it will be very difficult to reform, but reform it we must, and reform it we can.”

The Clinton administration might have offered some help: Bill Richardson, the departing energy secretary, has long advocated regional price caps. Mr Hoecker saw those caps as too hard to implement, but he too sought a regional solution on the grounds that the Californian crisis is really “an enormous struggle between sellers of power, mostly in the interior states, and the buyers of power, mostly on the coast.” But both Mr Richardson and Mr Hoecker are leaving office this weekend, and the men chosen by George Bush to replace them will be likely to oppose anything that calls for heavy-handed federal involvement.

One option for those looking for a way to bring the state out of this mess is to let the utilities go bankrupt. Some market-minded folk argue this case, pointing out that companies in all sorts of industries go bust all the time. Setting aside politics, why not power too? Surely the lights can be kept on, argue such voices, by the bankruptcy court, the state or, ultimately, by the new managers of those assets?

This is a tempting argument, but the reason why bankruptcy is not a solution, argues Tom Higgins of Edison International, the parent of SCE, is that “this situation is directly the result of government action and inaction; it is not due to management failure.” Any new manager of the utilities’ assets would find it impossible to run them under the perverse conditions mandated by California’s current regulatory regime.

Another option is for the state to give in to the popular backlash and to re-regulate the power business. That is not such a remote possibility. Carl Wood of the Public Utilities Commission, California’s top electricity regulator, wants not only to re-regulate, but to go further and introduce a big state presence in power. Mr Wood says: “I’m not an economist, so I’m flying by the seat of my pants, but it seems to me that it is orthodox economics that got us into this mess in the first place.” Mr Davis also hinted at a reversal in his recent speech, with its sinister threats of expropriation and criminal action. While such a move cannot be ruled out, it would be sheer folly to let the state’s incompetent, bungling politicians and regulators run the power utilities as a reward for having run them into the ground in the first place. What next?

The sensible way forward is to see any state intervention as a short-term fix that merely buys time to sort out the regulatory mess, and so propels the state towards a market-based long-term solution. Any short-term fix, which must surface soon in view of the parlous state of the utilities’ finances, needs to deal with three separate aspects of the current liquidity crunch: paying for yesterday’s power; paying for today’s power; and paying for tomorrow’s power.

Yesterday’s power led to the $12 billion or so in debts now owed by the utilities to banks, power producers and other creditors. Any deal will probably include an agreement to allow delayed repayment in return for some sort of guarantee, implicit or explicit, from the state that the creditors will indeed get their money some day. This week’s legislation suggests that today’s power will probably be purchased by the state. As for tomorrow’s power, even the state cannot afford to pay spot prices for long. So some sort of long-term contracts offering prices closer to historical norms are inevitable.

Having bought a few months’ respite, which may not last beyond this summer’s peak demand, Californian officials must restructure the electricity system to put it on a sounder footing. Mr Baum of Sempra says they must focus on the following: “What will reduce the demand for power? What will increase power supplies? Unless the basic laws of supply and demand are repealed, those two questions must be answered. Everything else is just a sideshow. ”

California needs to reform its laws in order to encourage power generation. This will mean, for example, ensuring that environmental regulations are not needlessly prohibitive. It must also involve paring back red tape. This may not be easy, but surely there is no justification for power-plant approvals taking twice as long in California as elsewhere in America (including places that have similar concerns about air quality).

Officials must also find ways to get around the NIMBY problem. One possibility may be a suggestion by Mr Davis that the state withhold funds from localities that are particularly obstructive, in the way that the federal government withholds highway funds from wayward states. An even better solution would be to remove barriers to entry for distributed generation, and to ensure that the established incumbents do not obstruct new micropower plants.

As important as boosting generation is fixing the consumer market. In the long run, liberalisation and competition will deliver lower electricity prices for companies and households alike. But there is a case for protecting domestic households from price volatility until a genuinely competitive retail market emerges. Unless consumers see fluctuations in prices, however, especially at peak times, they will have no incentive to save power or to shift their use off-peak. This leads to an obscene waste of energy.

To allow retail prices to fluctuate with market conditions requires the installation of sophisticated meters for all the state’s consumers. Crucially, proper metering will speed the arrival of such innovations as fixed-price “energy service” contracts, which promise outcomes such as certain levels of heating, rather than the mere delivery of kilowatts. Price transparency will also allow micropower plants to sell and buy power on the grid as demand dictates, so improving the grid’s reliability.

If California’s politicians see today’s crisis as a chance to fix this deregulation gone awry, then the future may be bright for the state’s suffering citizens. Muddling along and hoping for manna from heaven is no longer an option. The state’s irresponsible politicians have one last chance to fix the mess that they have created. If they do not, then at best it will be a sweltering summer for Californians this year.

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