The California energy crisis Introduction Wolak March

The California energy crisis • Introduction (Wolak March ‘ 01) – Wholesale: averaged $33 MWH in 1999, $116 MWH in 2000, $310 MWH Jan 2001. – Natural gas $3 -$4 mm btu in late 1990 s – $10 nationally & $56. 54 S Cal Dec 2000 – April 6, 2001 PG&E, bankrupt with debts of $9 billion. – Deregulated market

Investigate cause – Describe old regulated structure – Initial regulated structure – Evolution of the crisis and underlying causes – Mitigation plans – Lessons

Old system • Deregulation began in 1995. • Before this, C-O-S regulation of vertically integrated utilities – Generation, transmission, distribution, retail. – Equivalent of public ownership – Based on idea of natural monopoly – Regulation to set “just and reasonable” rates – Public Utility Commission, Federal Energy Regulatory Commission (FERC)

Problems with Old • Technical, economic, with treatment of depreciation • Very costly • No incentive to reduce costs, innovate, increase efficiency, guaranteed return, promotes cost-padding, unwise investment – Green energy, cost overruns in nuclear

Goals of deregulation • Competition in generation – No natural monopoly here – Increases efficiency, lowers prices, makes better use of existing facilities, gives better signals to generators re new investment • Competition in retail – Consumer choice, innovative packaging of energy products, lower prices, less waste.

Deregulation program • Generation separated, power plants auctioned • Utilities allowed to recover $28 bill re. nuclear and green • Retail tariffs reduced by 10% and frozen till 31. 3. 02 or until debt paid • PG&E and SCE never paid off. San Diego G&E did.

Institutions • Cal PX receives price and quantity offers from generators and bids from buyers • No long-term arrangements allowed. All day-of or day-ahead. • Cal-Independent System Operator: nonprofit, role to avoid blackouts, make sure the system works, buy at any price

Experience • 1998 & 1999 excess capacity, wholesale prices declined, retail fixed, profit of utilities increased, some debt paid off. SDG&E paid off all debt, retail no longer fixed • 2000 demand increased (20%? ) • Result as discussed. Wholesale price increased, retail fixed – PG&E bankrupt, SDG&E customers faced bills up to 20 times higher 2. 7 cents to 52 cents k. Wh

What happened? • Supply and demand or market power? • Supply restricted by the deregulation program – No new power plants, new entrants lumbered with past costs of incumbents, for fairness – Still uncertainty re future regulations/prices restricts new entrants

Market power • Also evidence of market power – Unverifiable forced outages – Generators purchasing gas at high prices through affiliates • Under mediation whether wholesale prices were “just and reasonable”

Proposals • Price caps, soft and hard • Voluntary/compulsory forward contracts • Re-regulation of prices

Subsequently • Natural gas prices in July ‘ 01 $3/mmbtu NYME, about $4/mmbtu Cal. – Temperate weather, increased conservation, increased gas production, slowing economy. • FERC June 19, power emergency in California sets price caps in all western states. Cost of production in marginal plant, was $90 MWH.

2001 • Some suppliers would not sell, increasing emergency • FERC and generators in mediation. FERC claimed $9 bill. Generators offered $1 bill.

My view • Bad legislation • Markets create incentives – True scarcity, high prices give signals to consumers to reduce consumption and producers to increase production (long run) – Here consumers were insulated and producers would not invest for uncertainty. – Result, more scarcity.

My view • Here the incentives the system created were to increase profit by using the faults in the system, like income tax in many countries. • Example: price cap avoidance by selling into other markets, reducing supply to increase price.

Lessons • Markets often work better than planned economies because the players innovate in ways that cannot be anticipated by the planners. • Deregulation should be designed to capture the benefits of this innovation rather than to give an incentive to avoid the rules.