THE POLITICS OF POWER : A letter from California - deregulatory policies that led to electric energy shortage

It may be that the first big crisis to confront any elected official is rarely the one he or she would have anticipated. John Kennedy did not foresee the Bay of Pigs. Bill Clinton probably underestimated the furor over his proposal to allow gays to serve in the military. And Gray Davis, a Democrat elected governor of California in 1998, certainly never imagined the mortal threat to the state's economy--to say nothing of his own career--from a dysfunctional wholesale electricity market.

Electricity isn't a subject that most people even think about. They just want to know that when they flick a switch, the lights will go on. But, as summer nears, even that is increasingly in doubt.

Until a year ago, no one outside the industry paid much attention to how California's new law deregulating the supply of electricity was working. The legislation passed both houses of the General Assembly unanimously, and was signed into law in 1996 by then-Governor Pete Wilson, a Republican. It is hard to imagine even a Pledge of Allegiance passing the California legislature unanimously, but this law had a broad base of support from large industrial customers, environmental groups, and the state's investor-owned utilities, such as the one where I was then employed.

The law might have worked as intended, with meaningful competition and a new era of cleaner, more efficient power plants. In other regions of the United States and the world, similar markets produced consumer and environmental benefits. But state regulators--the California Public Utilities Commission (PUC)--made two fateful decisions that created the conditions for a virtual oligopoly to exist and to set prices in the market.

First, the PUC compelled utilities to sell most of their existing power plants, more than the law required. That meant control of most of California's generating capacity passed to new, out-of-state owners. Then, the PUC rejected the utilities' request to purchase electricity from the new plant owners under long-term contracts, the way the vast bulk of electricity is purchased in every other market in the world. This unfortunate decision meant that the electricity needs of 20 million people had to be met every day in the spot market, the market for sales within twenty-four hours of delivery. As one trader put it, "California is short in a spot market for a commodity that can't be stored, and you don't want to be there."

Along with some painfully naive consumer activists, the new owners of the power plants had lobbied the PUC successfully in the spring of 1999 to reject long-term contracting by the utilities. The activists thought they were getting a more "open" market. The suppliers knew exactly what they were doing. Thereafter, they didn't need to collude or otherwise conspire to distort the market. They just had to read each other's bid signals. And beginning last May, that is what they did.

Prices, which had been fairly stable for two years, soared into the stratosphere, averaging more then ten times the previous year, despite similar conditions of supply and demand. Prices for energy bore no relationship to costs of production, even taking into account a rise in the price of natural gas, the principal fuel for the power plants. When the Federal Energy Regulatory Commission (FERC) investigated prices last summer, they found them to be "unjust and unreasonable." This was a key finding, because federal law requires the FERC to take action to mitigate prices when it makes such a finding.

But the FERC refused. The commissioners were asked to impose firm price caps on a market that was manifestly dysfunctional, but a majority of them were ideologically opposed to meaningful price caps and resisted attempts to effectively control the market.

All through the summer, and into the fall, debt for power procurement at the utilities mounted. Under California's law, electricity rates were frozen, and so costs in excess of rates could not be passed on to consumers. The utilities were forced to borrow billions of dollars in the capital markets to finance power procurement for their customers and, under the law, they were not allowed to profit on the activity.

Banks and other lenders ceased lending money to the utilities in late November, because the PUC would not grant assurances that these costs could eventually be recovered. Capital is fungible, as every investor knows, and without such assurances no sane lender wanted to continue throwing good money after bad. Suppliers, fearing they would not be paid, responded by raising their prices even higher, despite the low demand of the winter months. Finally, the state was forced to step in and begin purchasing power in the spot market with funds from the state treasury. As the combined utility and state debts climbed past $20 billion, California's credit rating slipped and political gridlock set in. Finally in early April, Pacific Gas & Electric, the utility which serves San Francisco and Northern California, filed for protection against its creditors in federal bankruptcy court in San Francisco, and Southern California Edison teetered on the brink.

The role of Governor Davis has been central to the crisis. A man whose political life has been defined by caution and problem avoidance is now widely viewed as largely responsible for allowing a problem to become a catastrophe. For the first eighteen months of his term, Davis enjoyed great political fortune. The budget was running a large surplus and Democrats controlled both houses of the legislature. He is the most prodigious fundraiser in California's history, and two years before his next election already had banked more than $20 million for his campaign committee. The governor's first move was to blame his predecessor, saying that he "had inherited this mess." Then he blamed the FERC for not imposing price caps. It isn't hard to sympathize with both impulses, but that begs the question of what actions the administration needed to take to avoid a worsening situation. Aside from a handful of gestures, the governor did very little from May to December.

His closest advisors urged him to act forcefully to get power under contract and to calm the financial markets by assuring that transactions for power purchases would be creditworthy. But the governor was deeply concerned he would be blamed for even a slight increase in utility rates, and he refused to take action. Indeed, at one point he said, "I could have solved the problem in twenty minutes if I had been willing to raise rates." Much later, he had to.

In retrospect, the eight months between May and December were a crucial lost opportunity. By the time the governor finally began seeking long-term contracts, and conceded the need for utility rates to increase, it was too late to solve the crisis. Few power deals were available under reasonable terms, the premiums being paid for risk had become the largest element in the price of electricity, and Davis's standing in the legislature was so low that his own party was balking at passing his legislative package.

Davis hopes to salvage the situation through a complicated plan to purchase the transmission lines owned by the state's utilities so they can use the net proceeds to pay down their debt. It may still pass, but a lot of political capital has been squandered by the year-long delay, and most legislators are reluctant to approve the bonding required to finance the purchase. Last month the PUC approved an average residential rate increase of over 40 percent, which was greatly magnified by the long delay, but which further erodes the governor's political strength. PG&E's bankruptcy makes the resolution even more difficult.

It is not lost on Californians that much of the rest of the country often takes guilty pleasure when the Golden State is in trouble. But when California's economy stumbles, the rest of the country is also at risk of a fall. The electricity crisis is a cautionary tale about putting faith in markets without fully understanding how markets operate, especially for products with inelastic demand. Suppliers will always act in their own interests. When their interests conflict with the public interest, there are enormous market risks when political leaders won't lead. The price of California's political paralysis will be paid in higher electricity rates and a damaged economy for more than a generation. And the blackouts have already begun.

Thomas J. Higgins is a retired senior vice president of Edison International. He lives in San Francisco.

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