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Electricity Markets: Lessons Learned from California.
Subcommittee on Energy and Air Quality
Mr. Adrian T. Moore
Introduction It is household knowledge nationwide that California's electricity restructuring has proven disastrous. Under pressure to deregulate and lower electricity rates, state legislators acted hastily without understanding the issues at hand or the consequences of their actions, creating a restructured electricity market that was neither fish nor fowl--neither the old, regulated monopoly system nor a competitive, deregulated market. Now state leaders are again acting in haste and with partial understanding and moving the state towards a state-dominated if not state-run electricity system the likes of which is not seen outside of Eastern Europe. Meanwhile, Summer 2001 looms ahead, where the most optimistic projections show the state teetering on the verge of blackouts--the reality is those blackouts are a near certainty given current policy directions. In the end, California residents have been denied the benefits of competition and choice in electricity that residents of other states have enjoyed, and current policies look as though California rates will remain above national averages for years to come. What Went Wrong in California California Did Not Deregulate, and Why That Matters Many consider California a poster child for why electricity markets cannot and should not be deregulated. But this is wrong for two reasons. First, and foremost, California did not deregulate the electricity market, but rather "restructured" it, requiring far more state intervention in electricity transactions than existed before. In doing so, the law created a micromanaged market where suppliers of electricity have the ability and incentive to manipulate prices to their advantage, and utilities are forbidden to shop for better prices. It is simply not accurate to label California's electricity reform "deregulation" when, for example: State regulators determine the prices customers pay for their electricity; Utilities are not allowed to seek out competitive contracts on their own, but must purchase electricity in a mandatory "power exchange" with bidding rules that require paying the highest bid price; The state determines what set of activities utilities undertake, such as requiring them to sell their electricity generation plants and buy electricity through the power exchange; Price caps and onerous market rules discourage new competitors from entering the market; and New regulatory strictures created by the restructuring law constrain business decisions on such matters as plant maintenance and transmission lines. The past year of price spikes and the looming threat of blackouts result not from "unfettered free markets," but from the political micromanagement and market distortions that restructuring wrought. Second, dwelling on California's failures instead of on states that have had considerable success in deregulating electricity, such as Pennsylvania, is like skipping the Superbowl to watch the last place teams work on new plays. States and other entities that have made effective and efficient use of deregulation should be studied for successful strategies, rather than California's experience tarring deregulation with the brush of inevitable failure. Fortunately, despite news stories about a few states delaying their progress towards deregulation, most states are continuing to move ahead. The Causes of Prices Increases are Very Complex, However Much We Want Them to be Simple The simplistic story of why California's electricity prices skyrocketed over the past year is that demand for electricity had grown equal to, and even beyond, the supplies of electricity available in the state. Between 1996 and 1999, California's electricity demand grew by 5,500 MW (14 percent), eight times the 672 MW (2 percent) increase in electricity generation capacity added over the same period. Of course, these numbers do not explain why new electricity capacity was not added as demand grew, or why demand did not shrink as supplies ran short. Even detailed studies of the California electricity market oversimplify the problem--usually highlighting about a half-dozen factors that influence prices. In fact, as the attached Figure (What Caused California's Electricity Prices to Rise?) shows, a tangled web of factors led to price increases. Many of the price influences in the Figure (the un-shaded ones) came about due to factors in other markets or natural changes in the economy, and there is little that policy makers can do to influence them. But many other price influences (the shaded ones) are shaped, and even created, by state policy decisions, most of them part of the restructuring plan. Notably, failure to provide incentives to build new power plants is not a failing of restructuring. Since the restructuring law passed in 1996 the state has seen an unprecedented growth in new power plants--after 12 years of no new plants at all, the last few years have seen nine new plants approved by the California Energy Commission. The problem is not that companies don't want to build more plants, the problem is that it takes four to five years from initial application to starting operations--in other Western states it takes half as long. The key lesson of this example, and of the attached Figure is that simple solutions are not possible--many different facets have to change for prices to return to normal levels. Policy alternatives open-ended enough to accommodate the interconnections between factors and resilient enough to accommodate changes in some or all factors may be able to bring electricity prices back to more normal levels. Specific Pathologies of California's Restructuring California's 1996 restructuring law was intended to bring about competition and customer choice in power generation, but wound up a bundle of compromises, getting unanimous approval only by offering something for everyone (legislators, utilities, consumer groups, environmental groups, etc.), and creating a muddled, centrally planned market lacking equal opportunity for all participants, incentives for new firms to enter the market, and meaningful opportunities for customers to choose among service providers. For a few years these flaws caused not catastrophe but only disappointment. Virtually no new firms entered the market, so few customers switched providers, and prices did not change much beyond the mandated 10 percent rate cut. Indeed, most people seemed to forget California had restructured the electricity market. But the summer of 2000 changed that. For four years electricity demand had grown 14 percent with the state's population and the increasingly digital economy. Meanwhile, electricity supply had limped along to a mere two percent growth. The state had become a big energy importer, bringing in 20 percent of its electricity from neighboring states. In 2000, as temperatures started to rise, demand for electricity threatened to outstrip supply, and flaws in the system created by restructuring became gaping fractures, unleashing a flood of woe. Wholesale prices rose dramatically, causing radical price spikes in San Diego where retail prices were no longer capped. Caps were quickly re-imposed in San Diego, but as the utilities were forced to pay far more for electricity than they were allowed to charge customers, their losses began to rack up to billions of dollars. Meanwhile, with prices capped, customers had no incentive to conserve electricity and thus moderate demand, and the state began to flirt with blackouts. Winter failed to bring sufficient relief, and California's crisis has continued to grow. California's electricity restructuring embraced some vividly unique policies, such as establishing a mandatory, centralized market for all exchanges (the Power Exchange), vesting complete control of the grid in a centralized body (the Independent System Operator), and rejecting the messy, uncontrollable practice of bilateral forward (long-term) contracts between utilities and power generators. A complete discussion of restructuring elements that have proven problematic, and in some cases disastrous, would be tedious, so I will touch on just five fundamental elements. That five substantive problem areas can be singled out is a lesson in itself--something as complex and dynamic as a competitive market cannot be planned and packaged in a piece of legislation. Attempts to repair the mistakes of restructuring can easily fall victim to the same hubris, rather than focusing on simplifying the rules and minimizing interventions and distortions so that market forces can work. Examining these five problem elements of the restructuring demonstrates a cataclysm of unintended consequences and an overall inability of the structure to adapt to changing market conditions. A. Planning the Market--The Independent System Operator and Power Exchange Participants who crafted California's electricity restructuring did not have much faith in the market process. Legislators were concerned about loss of control over the system and that customers would not understand it. The utilities came from a regulated monopoly culture and were not used to operating in competitive markets. Consumer groups are perpetually suspicious of market power and abuses by corporations. Environmental groups did not want customer choices to undermine existing conservation and renewable resource mandates. For all of them, restructuring meant developing a set of specifications for the market that would achieve the new, vaguely defined objective of competition, while retaining those elements of the old system deemed imperative. Two characteristics stand out about the rules for the Power Exchange (PX) that restructuring put in place. First, it is a mandatory centralized market, with the private utilities required to buy and sell all of their power through the PX, and second, the bidding rules created a market-clearing price that aggregated prices upward. The market was mandatory for several reasons. Restructuring architects wanted to be certain utilities did not tie themselves down with long-term contracts that would lock in current prices when everyone expected prices to fall. Regulators were also concerned that the market be transparent--everyone can see what is being bid and bought in the PX. They worried that a market where utilities could make contracts directly with power generators or could use alternative markets would make it difficult for consumers to see how power was being exchanged in the market. Unfortunately, reality has not lived up to the ideal. Data on bids and transactions take months to become available, and the information is often incomplete or aggregated. Nothing in the data on the PX Web site that helps consumers to choose among power providers. The second noticeable fact about the PX--its bidding rules--arose from concerns similar to the first. In order to provide the transparency regulators sought, they enacted bidding rules to create a market-clearing price. Think of this simplified version of the rules. Suppose there are 12 power generators, each of which provides 10 units of electricity. Each day they bid what price they want to be paid for their 10 units of electricity the next day. Suppose total demand for electricity is 100 units. The PX then starts with the lowest bid and adds up the bids until it reaches 100 units (10 power generators). Since the PX governs all transactions between the utilities and generators, and pools them, the market-clearing price is the one that delivers all 100 units demanded--which is the highest of the 10 selected bids (if the price offered was lower, the 10th generator would not sell, and total demand would not be met). All sellers receive this highest bid, market-clearing price, and the utilities have to pay that price for all their electricity. As long as supply is greater than demand, bids under this rule should be competitive. The two highest-bidding power generators' bids are rejected, so the generators have an incentive to bid competitively. When the PX was created, everyone assumed supplies of electricity would grow faster than demand as competition stimulated new entry into the market. But, due to other elements of the restructuring and existing regulations, market entry and increasing supplies did not materialize (more on this below). So, in our simple story, total demand rose to 120 units of electricity. Once that happened, power generators soon realized that all of their bids would be accepted no matter what price they asked. With a myriad of forces at work driving up wholesale electricity prices (again, more on this below), PX bidding rules allowed, and even encouraged, power generators to charge very high prices and make very large profits. Meanwhile, the alternative to buying power in real time in the spot market is to contract for delivery of electricity at a specified price over a specified period--forward contracting. Forward contracts lock in a price, so if prices go up, the buyer has made a good deal, but if prices go down, the seller made the better deal. But both buyers and sellers often prefer to have some forward contracts to balance the risks of the spot market--uncertainty and volatility. By requiring utilities to buy all of their power in the PX, the restructuring bill did not at first allow the utilities to enter into forward contracts. In 1999, the PX began to offer forward contracts, but the PUC would not allow the utilities to contract forward for more than five percent of their load. The PUC also would not allow the utilities to form forward contracts directly with power generators (bilateral contracts), but limited them to the PX block forward contracts. Only in August 2000, well into the summer crisis, did the PUC relent and allow the utilities to seek bilateral forward contracts outside the PX. In December, FERC released the entire 40,000 megawatt (MW) load in California from the mandatory PX, granting utilities discretion to contract forward as much of their load as they deemed necessary through the PX block forward contracts or bilateral forward contracts. However, the PUC has yet to relax its restrictions on utilities' forward contracts. The resistance to allowing forward contracts has several rationales. The arguments against forward contracting, especially bilaterally, are the same as those in favor of a mandatory PX. First, since the PX was intended to offer the perfectly planned market for real-time exchanges, there was deemed to be no need for forward contracts. Restructuring anticipated plentiful supply and a competitive spot market that would drive prices down. Allowing utilities to forward contract would probably mean they would lock themselves into high prices, and the state would wind up having to let them pass those higher prices on to customers. Second, bilateral forward contracts would not be transparent to consumers as are PX transactions, and thus would not feed into their choices. But this is static thinking. As customers are given real choices of electricity suppliers, utilities have to factor those choices into their forward contracts as well as spot purchases. Utilities are obliged to accommodate the supplier choices of the customers in their distribution area. If they wind up with high-price contracts or too much load forward, there is no regulatory failure, just a mistake by the utility, for which their shareholders must pay. There is no need for a regulated pass through. And customers don't care about how the utilities manage their load; they will shop for price and ancillary services. Price Controls Prices are perhaps the most fundamental building block of markets, the mechanism by which information is carried through the economy, encapsulating data about costs and tradeoffs so vast that even today's computers cannot predict price changes. Put simply, prices help tell consumers when it makes sense to consume more or less of a good, and tell suppliers when to invest more or less in production. Unfortunately, cutting and capping rates is almost irresistible to some politicians as they craft restructuring. It offers oft-illusory stability during the transition to competition, as well as an immediate "accomplishment" politicians can point to. The architects of California's electricity restructuring were quick to jump on the bandwagon, severing prices from the market. The law mandated an across-the-board 10 percent rate cut, and created a Competitive Transition Charge (which came close to offsetting the cut) to finance paying down utility stranded costs. The caps on retail rates were set to stay in place for each utility until it had paid off its stranded costs, or 2002, whichever came first. These price controls are the cause of many of California's current problems. They: a) discouraged new firms from entering the California market so customers have never really been offered meaningful choices among electricity providers; b) reduced incentives to invest in new electricity generation plants in the state or new transmission lines to import electricity, either of which might have alleviated the current electricity shortage; c) blocked all signals about electricity shortages from reaching customers, leaving them no incentive for voluntary and gradual demand reductions that might have minimized the current crisis; and d) created a wedge between wholesale and retail prices that led to billions of dollars in losses by state electric utilities. By cutting rates 10 percent from the start, the law set a barrier to entry by new firms. Most people will not switch to a new electricity provider unless they are offered a significant price reduction. With rates already cut 10 percent, entering companies would have to offer electricity for nearly 20 percent less than the pre-restructuring price to get many customers, and that is hard to do right off the bat. Even worse, the law required new companies selling electricity to customers to charge the Competitive Transition Charge to help pay down the stranded costs debt. That added to the new sellers' costs, making it even more difficult to find a way to offer customers dramatic enough rate reductions to persuade them to switch companies. The result protected the incumbent utilities, as few new companies chose to enter California's electricity market. Customers, expecting "deregulation" to bring a flood of marketing mailers and dinner-time solicitation calls to switch electricity providers, are rarely offered any choices, and today still get their electricity from the same company with the same service options as they always have. As of June 2000, only about 2 percent of customers in the state had switched providers, and many of them were industrial and large commercial sites. Price caps also discouraged investment in new power plants in California. In a free market, as demand expands, prices will rise until supply expands as well. The rising prices tell producers it is time to add capacity and give the ones who best estimate future demand better returns on their investments. But with price controls in place, no such signals are sent to suppliers. Instead, they can invest the same money in building power plants elsewhere where there are no price caps to minimize their return on the investment. And electricity plants have unique risks--some plants will not run all year, only going online when demand reaches high levels. Those plants have to cover a whole year's costs (fixed and variable) in those limited hours of operation, and prices must go up at such times of high demand to balance things out. But that balance is knocked flat by controls that don't allow prices to fluctuate with supply and demand. In simple terms, the reason for the current electricity crisis in California is that demand grew while supply remained flat. As demand exceeded supply and prices were capped, limiting conservation, the state started to experience shortages. Prices that rise as demand rises not only signal suppliers to add production but also tell consumers they may want to consume less. Population and job growth drive up the total statewide demand for electricity, even if homes and businesses are each using about the same amount they always did. If that makes prices go up, consumers will look for ways to conserve until supply increases and brings prices back down. Discouraging New Power Supplies California is not an easy state in which to build a power plant. Licensing procedures and rules are expensive and time-consuming. Environmental regulations are among the most stringent in the nation, and power plants are unpopular neighbors, often sparking resistance from local residents. In California, plants often take three to five years from concept to operation, while in other Western states the process can be as short as one year. Thanks to these barriers, in 1996, as restructuring was debated, California had not seen a new power plant built in a decade. Yet the state still had excess energy generation capacity. Indeed, one reason for restructuring was to let market incentives determine capacity decisions. The architects of restructuring assumed that competition and profit opportunity would bring new power plants to keep electricity supply well ahead of demand in spite of the difficulties state regulations present. And, despite restructuring's failure to allow a competitive market, restructuring did stimulate new capacity--between March 1998 and the end of 2000 the California Energy Commission had licensed nine new power plants that will generate over 6,000 MW, about 16 percent of the state's average daily load. But these new plants are so slow in coming--the first won't be online until mid-2001--they won't help solve the current shortage. The long delays in adding capacity in California had set the state on the road to shortages long before restructuring. Since 1988, the state energy commission has been predicting that demand would catch up with and surpass supply. But state leaders did nothing to change the barriers that discouraged new companies from building new power plants. At first, discussions of deregulation may have discouraged new investment, since private companies did not know what kind of law the state would pass. But restructuring ended that uncertainty and companies saw an opportunity to make money from growing demand in California. The new plants they are now building will likely assure that the current shortage will not persist. Government-Owned Utilities Are Protected from Competition, but Allowed to Profit from it. Government agencies generate almost a quarter of the electricity in California (see Figure 2) and thus are an important part of the state electricity market. Restructuring allowed municipal utilities (munis) to choose whether or not to enter the competitive market. So far they have not chosen to do so. Instead, munis and other government power generators took advantage of the PX and ISO to sell their excess power and earn considerable profits in the process. In 2000, government generators made big money from the wholesale price spikes that caused the state so much pain. State agencies and local water authorities sold their excess power into the grid--the State Water Project, for example, made $23.6 million in profit from selling power at high PX prices. Large munis followed suit--the granddaddy of them all, the Los Angeles DWP made close to $200 million in profits. Even small cities like Redding, which earned $8 million in profits, took advantage of the situation. Some of the power that munis sold came from the Bonneville Power Administration (BPA), federal hydropower that is some of the cheapest electricity in the nation and is offered first to government utilities before private utilities can buy any. California's munis bought all of this "preference power" they could and resold it into the PX and ISO for five to ten times what they bought it for. BPA itself sold power into the California market and in 2000 earned $207 million in profits (a 116 percent increase over the previous year). Because they have made money during the crisis, while the private utilities have run up huge losses, munis argue both that deregulation is a bust and that government ownership of utilities is superior to private ownership. But the munis' sunny days are an artifact of restructuring's rules. Unlike the state's private utilities, munis were not required to sell off their generation plants, were not forbidden to use forward contracts to hedge against price increases, and they had the option of buying from and selling into the PX. Ironically, restructuring wound up shackling the state private utilities while leaving the munis free from any state restrictions. In fact, evidence indicates that munis are less efficient than private utilities and could benefit from competition. Munis' average charges for residential customers are slightly lower than the average for private utilities but a bit higher for industrial customers. But munis' average total cost for electricity generation is 10 percent lower than for private utilities, thanks to a batch of subsidies. Since munis' rates are not 10 percent lower, the difference is waste and bloat. A number of studies have shown that private electric utilities are more efficient than munis. As California and other states continue to move toward competitive electricity markets, the distortions caused by government utilities' exceptions and subsidies have to be rectified. Federal preference power is owned by all U.S. taxpayers, but since it is offered with preference to munis, it serves to transfer wealth from customers of private utilities to customers of munis. The fight to make federal hydropower equally serve all U.S. taxpayers has been long and contentious, but recent events in California once again highlight the need for such reforms. Also, a state's electricity market cannot be truly competitive if customers in many of its largest cities are not allowed to choose their electricity provider, and when tax policies and regulations give government generators advantages over private ones. As restructuring moves forward, munis should be integrated into the competitive market. Divestiture--Determining Industry Structure from the Top Down Before restructuring, the state's electric utilities were vertically integrated, meaning they owned all elements of the system--generation, transmission lines, and distribution systems. Fearful that incumbent utilities would give their own power plants favorable access to the grid and thus stifle competing power generators, restructuring's architects created strong incentives for utilities to sell off (divest) their power generation plants. The utilities responded by quickly selling their natural gas power plants, though, due to resistance in court by environmental groups, their hydropower plants have not been sold. Today, many state leaders have changed their mind about utilities selling the rest of their power plants--Gov. Davis has proposed forbidding the utilities to sell any more power plants, and a bill to restrict utility asset sales was introduced in the state Assembly. These proposals make the same underlying mistake as the original decision to get utilities to sell their generators, assuming the future of the market is known and there is a "correct" industry structure for that known future market. Deciding what assets an industry should or should not own requires knowledge about the future, knowledge public officials don't have. Regulators find it easy to theorize about possible bad behavior by vertically integrated utilities in a competitive market but are less able to predict possible harm to the market from dis-integrating utilities. The policy flip-flop of California's leaders on divestiture, as market conditions have changed, brings home the consequences of dictating market structure. There are many advantages to vertical integration--reducing transaction costs, economies of scope (producing multiple goods more cheaply), improved coordination, and hedging against risks, to name a few. Public policy should not dictate industry structure. Utilities can best make their own decisions about what assets they need to own to be competitive. When deregulation aims only to make electricity generation competitive, regulators overseeing utilities' distribution operations will have to guard against utilities favoring their own power plants over those chosen by electricity consumers. Effective rules linking customer supplier choices with requirements into the grid will make such oversight easier. Stark Contrasts: Successful Deregulation by Other States In the rush to condemn electricity deregulation as the cause of California's current woes, many observers have overlooked the success stories in other U.S. states and worldwide, as well as the well-crafted plans of states like Ohio and Texas. These examples show that California's chaos is not the result of deregulation, but rather the consequence of their politicized restructuring process. Indeed, the Center for the Advancement of Energy Markets has ranked state deregulation plans according to how effective they are in transitioning from monopoly to competition and customer choice. In July 2000 they ranked California 16th in the nation, with many states ranking lower only because their deregulation plans were incomplete. At the top of the rankings is Pennsylvania, where customers were given meaningful choices between electricity providers, new companies were encouraged to enter the market, prices have gone down for those who shopped for price, and "green (including renewable) power" has achieved a respectable market share. Most importantly, Pennsylvanians reveal in surveys that they are happier with their electricity service than most people in the nation. Deregulation--done right--does work and does benefit consumers. Pennsylvania, which passed deregulation legislation at the same time as California, has fully implemented deregulation for all customers. Pennsylvania's customers have seen average prices decrease and an increase in service options, including "green power." Of the states that have deregulated wholesale and retail electricity markets, Pennsylvania has had the highest rate of customers switching to alternate generation providers, and Pennsylvania's customers express the highest satisfaction with their electricity services in the United States. Pennsylvania achieved this deregulation success through market-based default (or standard offer) prices, non-mandatory divestiture of generation, accelerated phase-in of all customers, and the use of financial instruments and regional markets, all of which encouraged alternate providers to enter the market and create real competition. Other states with early deregulation, such as Massachusetts and Rhode Island, did not experience Pennsylvania's success, and have recently adopted policies that have succeeded in Pennsylvania (such as higher default prices to encourage entry). Other nations began experimenting with electricity deregulation before the United States, most notably the United Kingdom, Australia, Argentina, Norway and New Zealand. The United Kingdom's process has led to a 26 percent average price decrease and improved satisfaction with electricity service. Australia's national structure, with states responsible for deregulation decisions, resembles the structure of the United States more than the United Kingdom's centralized government effort. Since 1991, Australia's customers have experienced an average price decrease of 24 percent. Texas also appears poised to succeed in realizing the benefits of electricity deregulation. While its legislation went into effect only in June 1999 and its pilot program to test the process starts in June 2001, many view Texas as a blueprint for deregulation success. It has incorporated the negative lessons from California with the successes of Pennsylvania, the United Kingdom, Australia and elsewhere to craft a process that gives new providers real incentives to enter and provide competitive services at lower prices to Texas consumers. The Texas legislation stipulates a "price to beat" or default price that is six percent below the January 1999 average price; this price is low enough to generate price decreases for consumers but high enough for market entrants to see profit potential. The "price to beat" then becomes a retail cap that is effective for only five years. Also, Texas has not mandated full generation divestiture, but has followed the Pennsylvania model of restructuring studies, with the incumbent utility retaining no more than 20 percent of the generation capacity in their service area. The full retail market is set to open in January 2002. Finally, but perhaps most importantly, Texas will not establish a centralized electricity market like California's Power Exchange, but will instead allow buyers and sellers to transact how they see fit through for-profit financial markets. This flexibility will enable all market participants to limit their risk (and their consumers' risks) of energy price volatility, and to be creative in devising financial instruments to manage that risk. California's experience is in no way representative of the consequences of deregulation; in fact, when done well, these success stories show just how much benefit both consumers and innovative sellers can gain from electricity deregulation. Electricity deregulation can deliver consumer choice, consumer savings, and a business climate that encourages entrepreneurship. Recommendations California's electricity crisis requires policy alternatives that balance immediate approaches to ensuring sufficient supplies of electricity and solving the utilities financial crisis with longer-term approaches that will bring California to a competitive market with customer choices, lower prices, and a more reliable power supply. There is no easy way out of the current crisis--the forces acting on the market are very complex, as is the electricity market itself. Policy makers must act quickly, but not in haste, avoiding interventionist policies that lock in yet another round of unintended consequences at some future date. With a little time to learn from the mistakes of the initial restructuring and from more successful deregulations elsewhere, the state's leaders can craft policies open-ended enough to accommodate the complex interconnections in the market and resilient enough to accommodate changes in market conditions. To that end, we offer the following policy recommendations. Recommendations for the State Level 1. Articulate a vision of moving toward competition that will alleviate concern of regulatory intervention. Too many state leaders are offering isolated policy ideas, would-be silver bullets, and conflicting proposals that fail to tell the market what direction policy is moving and what endstate is sought. Inflammatory, populist rhetoric by state leaders replete with threats of police action and takings only exacerbates uncertainty about California's electricity market. A clear and well-articulated endstate and set of goals will help policy makers formulate coherent and coordinated policy proposals and reassure the public and the market. 2. Change the law to make the PX voluntary. A spot market is a necessary component of the overall electricity market. But centralized mandatory pools bring to the market perverse incentives and rigidities that create distortions and an inability to adapt to changing market conditions. As a voluntary spot market, the PX can become an independent competitive exchange and develop bidding rules that attract both buyers and sellers. 3. Help alleviate the barriers to long-term power contracts. State leaders have acknowledged that the utilities need to add forward contracts to their portfolios to hedge against wholesale power price fluctuations but have not developed adequate policies to help make forward contracts happen. The governor's 14 January proposal to have the state enter into forward power purchase contracts is not wise. The state would be taking on futures risks with no experience or skills in evaluating those risks, and putting taxpayers at risk for its mistakes. One unavoidable lesson of California's electricity restructuring is that policy makers are ill-equipped to accurately predict how markets will evolve. State leaders could achieve similar results by offering state guarantees to back utilities' initial forward contracts. This would alleviate the credit risk that is driving up forward prices offered to utilities, but dilute the taxpayer's risk and let the utilities negotiate the contracts with their experience, expertise, and incentive to prognosticate correctly. State leaders should immediately convene a summit of leaders from state agencies and cities that generate electricity for resale to explore opportunities for cost-based forward contracts with the utilities. Government agencies control about one-quarter of the state's power generation and resell about 40 million MWh each year. Though their loads are very seasonal, if even 10 to 20 percent of that load could be forwarded to the utilities at cost, it would help push forward prices down and lever additional contracts. 4. Create a plan for phasing out price caps. A market cannot work without market prices--consumers don't know when to reduce consumption, and suppliers don't know when to increase production. In the short run, price caps only guarantee that utilities will continue to bleed red ink, suppliers will look for other markets in which to sell, and consumers will have no incentive to conserve electricity. Putting a stop to further losses will also make it possible for the utilities to purchase power on their own. Gradually, but predictably, raise the price caps. Convene a working group to create an initial schedule and revise the schedule periodically as market conditions change. Tie rate cap increases to milestones in accomplishing other policy changes that increase competition and customer choice in the market and reduce utilities' market power. If other policy changes are successful in allowing market entry and new competitive choices for consumers as well as increased electricity supply, the timetable to remove price caps can be moved up. Meanwhile, implement a system to guard against exercise of market power in utilities' customer charges. Until consumers have options in the face of high prices or bad service from utilities, regulatory oversight is necessary. Encourage utilities to implement real-time pricing and metering so that consumers can adjust their use of electricity as prices change. Implementing real-time pricing and metering can also justify accelerating the schedule for removing price caps. 5. Accelerate completion of new power plants with a constructive approach to licensing and enforcing environmental rules. Restructuring spurred a level of investment in new power plants not seen in decades in California, but the permitting and construction process takes years longer than in other Western states. The problem is not as much the standards as how they are enforced. State regulators do not care if power plants get built, only that the standards are followed. State leaders must get state regulators on board with a new, constructive approach that works with developers to get power plants built without violating the standards. In an 8 February Executive Order, Governor Davis embraced this approach to speeding up expansion of California's electricity supplies. 6. Integrate municipal utilities into the market as it becomes competitive. California's electricity market will not be truly competitive if customers in many of its largest cities are not allowed to choose their electricity provider. As restructuring moves forward, municipal utilities should be integrated into the competitive market. Over the long run, state leaders should challenge the federal government to end the inequities and wealth transfers that federal subsidies for municipal utilities and preference distribution of federal hydropower inflict on California residents. 7. Do not dictate utility industry structure. Requiring the utilities to sell their power plants turned out to be a mistake when market conditions changed in ways policy makers did not predict. Forbidding utilities to sell power plants repeats the same error. Policy makers do not know the future of the electricity market and should not lock the utilities into any arbitrary structure based on the exigencies of the moment. Ensuring that utilities do not favor their own generation plants is better served by developing good rules to govern how customer choices are reflected in grid loads, by encouraging distributed generation, and ultimately competitive electricity distribution systems. 8. Work out a deal with the utilities to split their current losses between their customers and their shareholders. Since state policy is really to blame for the current crisis, customers and the utilities will have to share the costs, and utilities should not be able to take back all the losses from customers once rates are uncapped. To spread out the portion that will be passed on to customers, the state might back a securitization (as was done with the utilities' stranded costs). Recommendation for the Federal Level 1. The federal role must be limited. State law created California's problems, and the bulk of any resolution of the crisis lies with state law as well. FERC has done a good job of setting California up for success, making the changes in wholesale market rules necessary to return California to the path to a competitive electricity market. Current federal policy allows the states to pursue deregulation their own way and at their own pace, and for most this has proved beneficial. Yet, I recognize the pressure on Congress (especially the California delegation) and the Administration, to do something! 2. Ensure a well-functioning wholesale power market. FERC has done a great job of allowing a functioning wholesale electricity market to evolve. To build on that success, it is vital that the federal government address, as much as it can, disincentives to invest in transmission lines, which are increasingly crucial to the regional movements of electricity on which a competitive electricity market depends. Current rules limit the rate of return on transmission lines to a level that does not compensate for the high risks that political uncertainty impose on transmission investments. Allowing higher rates of return until all parts of a region are deregulated would encourage investment. 3. Reform policies for selling federal hydropower. BPA's role in the California market has highlighted how absurd and distortionary are the policies for selling its power. In the Northwest, BPA power selling policies are so skewed it makes sense for some factories to shut down and resell their electricity. In California, some residents benefit from low-cost federal electricity while others do not, though as taxpayers they all ought to have equal rights to it. The only sensible policy for selling this electricity is in open auction to any viable purchaser. And yes, I recognize this recommendation is a political buzzsaw, but it is still right. 4. Federal agencies need to do their part. In many small ways, decisions by federal agencies have significant impact on California's electricity market. I know of a case where the Interior department has for years delayed a land transfer that would allow a project storing off-peak wind power for peak periods, even though Interior supports the land transfer--its just bureaucratic inertia. In another case, logging and road restrictions in California's National Forests restrict the collection of biomass (dead wood, underbrush, etc.) used to power 31 power plants in California that generate nearly two percent of the state's peak electricity demand--enough to make the difference between a Stage 3 power alert and blackouts. All federal agencies need to work within their means to help the growth California's electricity supply, and they need not compromise other policy goals to do so. 5. In formulating federal restructuring policy, consider the many paths to success. California's failure is unique--other states have hit bumps in the electricity deregulation road, but relatively minor ones. Pennsylvania shows that deregulation can succeed, and Texas shows the process can be refined yet further (though we don't know the outcome there yet). The bottom line is that the move from regulated monopoly to competitive markets is an evolutionary one, with no single right path, and no static end-state to arrive at. Policies have to be open-ended and flexible, and balance transitional interventions with longer-run removal of market restrictions. And patience is a virtue here--markets take time to evolve, if we will wait for them.
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