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California Law Shows How Not to Structure Utility Deregulation

(11/27/00 2:40:06 AM PT)

LOS ANGELES -- When California utilities got into financial trouble in the past, regulators usually let them hit their captive customers with the bill. The deregulation of the electricity industry here two years ago was supposed to change that.

It may not have. The state's two biggest investor-owned utilities, Pacific Gas & Electric Co. and Southern California Edison Co., are back pressing lawmakers, judges and regulators to let them pass on to customers billions of dollars in costs arising under the troubled deregulation program, which just isn't working as planned. The case, pitting utilities and their investors against the public, is shaping up as a titanic struggle that could affect the future of energy deregulation not only here but across the U.S.

Before deregulation, the price of electricity was tied to investments made by utilities in generating and transmission facilities. Under the new scheme, the utilities had to give up their monopolies, sell many of their plants and buy their juice from a state-sanctioned wholesale market. That market was assumed to be big and transparent enough to offer the lowest possible prices. Deregulation's architects promised that in a few years the prices consumers paid for power would fall at least 30%.

'We just thought,' says Jessie Knight Jr., a former Public Utilities Commission member, 'remove the shackles and let the market happen.'

To ease utilities through the transition, state legislators froze the rates companies charged at a relatively high level through March 2002. The idea was to let them buy cheap power on the competitive wholesale market, sell it to customers at higher fixed prices for a few years and use the difference to pay off big debts on old, often ill-performing investments from the past. After March 2002 arrived (or the debts were paid off), the prices consumers paid for power would reflect what utilities paid to buy it.

At first, this system worked. The money the utilities raked in gave them healthy profits and enabled them to pay down $17 billion of debt.

But last summer, electricity supplies on the wholesale market grew tight, and prices began to rocket. As California's economy boomed for the sixth year running, in-state generation was inadequate to meet local needs and not enough power was available for import from elsewhere. And a quirk of the deregulation system increased the prices utilities had to pay. It required that all suppliers be paid the price exacted by the costliest, least-efficient plant operating, even if most generators were willing to provide power for less.

Average wholesale power prices, which were just $12 a megawatt hour in mid-1998, soared to $120 a megawatt hour by June 2000 and during a cold snap this month have hit $200. The utilities are in a bind. Since summer, their cost of power has exceeded what they've been allowed to charge for it by a staggering $6 billion. The deficit climbs by tens of millions of dollars a day. If unrelieved, it could exceed the shareholder equity of PG&E and Edison International, SoCalEd's parent, sometime next year.

As regulators try to figure out what to do about this, the utilities are demanding that they be allowed to raise their rates now, not just when the freeze expires. SoCalEd proposes a series of steps that could boost rates 25% by 2005. The utilities have filed federal suits hoping to win the ability to collect the cost of their power. 'We have a legal and moral right to be reimbursed,' says PG&E Chairman Robert Glynn Jr. 'I think consumers understand the costs incurred to serve them need to be paid.'

Opponents say the utilities' plan would violate both the spirit and letter of the landmark deregulation law and make a mockery of the rate freeze, which was something the utilities demanded at the time for their own protection. The pain utilities now feel stems at least in part, critics add, from utilities' own previous success in blocking efforts to expand power-generation capacity in California. When it comes to winning support for the utilities' rescue plan, 'I don't see this python swallowing that pig very quickly,' says Loretta Lynch, the Democratic president of the California Public Utilities Commission.

But the utilities usually have gotten the python to swallow their pigs in California. Take the case of PG&E's Diablo Canyon nuclear plant, whose ultimate cost, $5.8 billion, was 18 times as much as projected. Some causes were beyond PG&E's control, such as tougher standards imposed after the 1979 Three Mile Island accident in Pennsylvania. But others were blunders, such as a failure to identify seismic problems at the site and an apparent misreading of some blueprints. Consumer advocates at the state PUC said the utility should have taken a $4 billion-plus loss reflecting its mismanagement.

Instead, PG&E reached a deal with the state attorney general in 1988 that let it pass on the plant's total cost to customers. Former Gov. Jerry Brown says California's politicians and regulators have rarely been willing to stand up to the utilities. The companies have influence in every corner of the state, spending $2 billion a year on capital investment and employing 40,000. He also cites their lush political giving, plus the millions of dollars that big state institutions such as the California Public Employees Retirement System have tied up in the utilities' securities. 'When politicians deal with the utilities, they think of themselves,' says Mr. Brown, now mayor of Oakland. 'They consult their own fear.'

It looked that way during marathon public hearings in mid-1996 that led to the 67-page state deregulation law. During the 18 days of hearings, the chairman of a conference committee, Democratic State Sen. Steve Peace, frequently asked utility lobbyists to lend a hand in drafting some of the bill's finer points.

The utilities, which Mr. Peace and others feared wouldn't support deregulation unless thoroughly appeased, got more than just reimbursement for past investments, as was claimed at the time. PG&E, for example, won the right to keep more than $560 million of customer overpayments to use for debt reduction. This was the temporary surplus in 'balancing accounts' whose purpose is to level out energy-price fluctuations.

PG&E also got to collect more than $400 million from customers to beef up its distribution network, even though a PUC hearing judge had previously rejected a PG&E request for just half that amount. The utilities' sway over the drafting of the bill amazed some outside energy executives. 'I call it the Public Utility Protection Act of 1996,' says Steve Bergstrom, president of Dynegy Inc., a Houston company that bought several power plants from the utilities.

Mr. Peace says legislators were in the difficult position of trying to improve on a deregulation plan already set in motion by the PUC, which at the time consisted of five free-market advocates. The PUC's move to deregulate had spooked Wall Street, which feared the utilities wouldn't be able to recover the debt on their old investments, known as stranded costs. Thus, the deregulation statute 'wasn't legislation per se,' Mr. Peace now says. 'It was a settlement agreement.'

It is now clear is that support for deregulation was based on some flawed assumptions. It was thought that the state would have a workably competitive market if it simply forced utilities to sell off some power plants to outsiders. It was assumed that enough new power plants would be built to avoid a shortage. And an electricity infrastructure built for another kind of market was supposed to work well in the competitive era.

Regulators thought electricity deregulation would be a rerun of the successful natural-gas deregulation process. 'We had 16 years of experience with natural-gas deregulation and saw prices drop from $6 to $2 per million BTUs,' says P. Gregory Conlon, a Republican who headed the PUC. 'We always assumed prices would drop for electricity, too.'

With such confidence in markets, crafters of deregulation didn't give consumers a way to track power prices and adjust their usage accordingly. In fact, the rate freeze until 2002 pretty much guaranteed they had no reason to care. And utilities, the buyers of power on behalf of their customers, weren't allowed to opt out of the quirky auction system that produced the high prices. They were required to buy enough juice to meet demand on a daily basis, only belatedly gaining the right to sign long-term contracts to avoid spot-market volatility.

Mr. Knight, the former PUC member, says that with all its restrictions on buying, California never really allowed a free market in power to develop. In any case, now that soaring prices have exposed the system's flaws, alliances and positions are shifting. Mr. Peace, currently a candidate for California secretary of state, has distanced himself from the deregulation law he worked so hard on and used to take credit for. The producer of the cult movie 'Attack of the Killer Tomatoes,' Mr. Peace has made a videotape attempting to debunk 'myths of deregulation,' among them that he was its 'architect.'

The utilities initially banded together with big energy users, renewable-energy backers and others to oppose critics of the plan. Now that alliance is crumbling. One organizer says members don't agree on whether consumers ought to be billed for the $6 billion (so far) by which utilities' power costs exceed what they can charge customers.

As utilities try to make the case for this, they argue that they are bearing costs that the deregulation law gave them no way to avoid. They have made implicit threats that unless they get their way, they will have to slash capital spending and lay off workers, moves that could damage the California economy.

The threats resonate with Gov. Gray Davis, who says the state's booming economy produced a $12 billion budget surplus last year, 'but deregulation threatens to unwind all that.' The Democratic governor's solution would be to seize profits earned by power generators and traders and give them to power purchasers.

The Utility Reform Network, a watchdog group, contends the utilities' shareholders should bear the whole burden. It notes that the companies, led by SoCalEd, blocked a decade-long effort by the PUC in the 1990s to get new power plants built in California, plants that today would be helping to meet demand. To add insult to injury, the watchdog group says, SoCalEd won a provision in the deregulation bill allowing it to collect from customers $90 million that it had spent blocking the plan for more power plants.

In the contest over who will pay, SoCalEd and PG&E have a trump card: the situation in San Diego. It shows what could happen if they unleashed market prices on consumers, as the two are threatening to do unless they are promised eventual full recovery of their power costs.

San Diego Gas & Electric Co., California's third publicly held utility and the smallest, finished paying off its old debts and ended the rate freeze in mid-1999. At first, customers benefited from lower prices. But when wholesale prices for electricity shot up last summer, the utility passed them on.

Taylor Guitars, a maker of acoustic guitars that uses power-hungry drying ovens, found its monthly electricity bill zooming to $60,000 from $17,000. Managers scheduled an unpopular graveyard shift to take advantage of lower power prices at night. 'We are in the cauldron of deregulation, and I can't say we're liking it,' says chief designer Matt Guzzetta.

Bowing to public anger, the state legislature temporarily capped power prices in the San Diego region, at a rate higher than the other two utilities get but still below the power's wholesale cost. Now San Diego Gas & Electric, a unit of Sempra Energy, has begun running up a deficit, though much smaller than the other utilities face.

The utilities haven't yet had to take charges against earnings to reflect these costs, but Wall Street is getting edgy. Fitch rating service recently put PG&E and SoCalEd on negative credit watch. Both utilities have found they need to offer special inducements to the capital markets. For instance, the interest rate on bonds PG&E offered was set at 1.7 points above Treasury rates, but even that wasn't sufficient, and PG&E had to add a 'step up' guaranteeing a still-higher return in case its credit rating slipped.

And as the wrangling continues, utilities' costs have lately been compounded by natural-gas prices that are the highest in the nation. John Bryson, chairman of Edison International, SoCalEd's parent, says whatever solution to the crisis is reached, it had better be reached soon. 'We urgently need decisions.'

If history is a guide, the utilities are apt to get reimbursed, as PG&E did after its planned $320 million nuclear plant ended up costing $5.8 billion. Indeed, it was partly because consumers got stuck with that bill that California stepped to the forefront of the deregulation trend.

'The move to deregulate was concentrated in states where the biggest mistakes were made,' says Alfred E. Kahn, the Carter administration economist who helped kick off the U.S. deregulation drive. 'Now, we're seeing new mistakes that correspond to the old ones.'

-- Martin Thompson (, November 27, 2000

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