Special report: How Californians got burned (long)

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Special Report: How Californians got burned -- The state electricity system is in a shambles, and the worst may be ahead. How did things get to this point?

By Sam Stanton, Bee Staff Writer

(Published May 6, 2001)

It isn't like California's political and business leaders got together and decided to wreck the state's electricity system. It just worked out that way.

From the very start, a series of critical miscalculations and behind-the-scenes efforts of energy brokers, politicians and utilities dovetailed almost perfectly to create a new era in California.

But a months-long review by The Bee of what led to the current fiasco reveals that state leaders ignored warnings -- in public testimony, insider memos and trade journals -- that their new system would be prone to manipulation and price gouging.

State officials were so eager to move deregulation forward that they even kept some warnings from landing in the hands of federal authorities who rubber-stamped California's plans.

Today, the results are well-known: California is drawing down its budget surplus at a rate of $50 million or more a day to pay for electricity, utilities are broke, rates are going up and summer blackouts are looming.

But the juggernaut that led to deregulation began a decade ago with the best of intentions. Part of it stemmed from a warning by former Major League Baseball Commissioner Peter Ueberroth. Part of it came from the perilous state of California's economy at the time.

And part of it began with O.J. Simpson.

The first days

The deck was stacked against Robert Levin from the beginning.The expert on energy pricing flew to Los Angeles to warn that California's Public Utilities Commission was making a huge mistake.

An executive with the New York Mercantile Exchange, Levin believed in the increased competition the plan was intended to provide, but he thought California was tilting toward a system that would actually produce less competition -- and higher costs.

Few were listening.

"I'm not getting through," he told himself at the time.

It was June 14, 1994, and even though the PUC convened a daylong hearing at the Los Angeles Civic Center, there were more important things going on in the world.

Composer Henry Mancini died that day from cancer. President Clinton had just unveiled his welfare reform proposal. And Los Angeles police detectives were starting their probe of the mysterious slaying two days earlier of O.J. Simpson's ex-wife and a friend.

"That was kind of the buzz," Levin said of Nicole Brown Simpson's and Ron Goldman's murders. "More than electricity deregulation." O.J. Simpson's influence ended there, but the incident was indicative of how little attention people were paying to the deregulation process at the time.

Today, nearly seven years later, Levin's futile warning stands as one of many that were leveled -- and blithely ignored -- as a consortium of elected officials, utility executives and energy traders marched California into one of the greatest policy blunders of the past century.

The perfect storm

Some now blame California's current predicament on a series of unavoidable acts of nature, the so-called "Perfect Storm" scenario:

A hot summer last year in California that sent demand for power soaring.

A cold snap last winter in the East that drove up prices for natural gas, widely used in plants that generate electricity.

A 50 percent cut in the amount of power received from the Northwest because of drought, environmental concerns and increased demand there.

"It's only because of those three acts of God that we got screwed up," said P. Gregory Conlon, a former PUC president.

Power generators insist the price spikes that began in 2000 resulted from genuine supply and demand imbalances. But scores of market analysts, including officials at the Federal Energy Regulatory Commission, suggest that generators were able to ratchet up prices through various trading strategies, including the simplest: throttling back on production until prices increased.

And ample evidence indicates that policy-makers should have known years ago that the system they set up was ripe for such manipulation.

San Diego Gas & Electric figured it out early.

A consultant for the utility prepared a document describing how the new electricity market would hamstring the people in charge of making sure the state had enough electricity, and that the cumbersome system would drive up electricity costs.

On June 28, 1996, the utility filed a 71-page statement with federal officials explaining its opposition to the market structure supported by the state's other large, publicly traded utilities, Southern California Edison and Pacific Gas and Electric Co.

But the FERC, which had to approve any change in California's market, never considered the statement. SDG&E withdrew its comments under pressure from then-Gov. Pete Wilson's office and others. "Officially, (those comments) don't exist," said John Chandley, a 20-year veteran of the California Energy Commission. "You read those comments, and it's a roadmap of what happened."

It was hardly the only map available.

The California Municipal Utilities Association issued a similar warning in 1996. The Public Utilities Commission cautioned legislators that a power shortage could drive prices up in the new market, although the PUC then turned around and predicted that would never happen.

A 1998 utility industry journal outlined ways to manipulate or "game" the markets; and only three months after deregulation began, someone was able to drive up the cost of a megawatt of electricity from $1 to $5,000 in a matter of hours.

The system was so flawed that a dentist on an airplane figured it out using a pen and a cocktail napkin.

An unstoppable concept

Texas state Sen. David Sibley came to California in January 1998 to visit with energy officials in preparation for moving his state toward deregulation. Yet something about California's new market perplexed him, and on the flight home he started doodling.

"We got a napkin, and it looked like you could game the power exchange," said Sibley. "We had our (PUC) guy and our staff and people just started talking about how you could figure out how to withhold just enough electricity. We were just kind of toying with it, kind of war games things on the airplane." "Now, I'm a dentist," Sibley said, "and if I could figure it out, it seemed like someone else could, too."

Once California joined the rush to deregulate, however, it became unstoppable.

The airlines had been deregulated, and airfares had gone down. The natural gas industry had been freed up, and rates had dropped. Telephone deregulation had spawned entire new industries. Electricity was the next obvious target, and California politicians were under pressure from the state's largest manufacturers to do something -- anything -- to give them a break.

California was under siege in 1992. The recession and massive cutbacks in military spending in California had hobbled the state's economy. The state's power troubles were noted in the 1992 Ueberroth Report, a study on the state's economic competitiveness headed by millionaire Peter Ueberroth, the former baseball commissioner and Olympics czar.

Energy costs were among the highest in the nation, and steel manufacturers and other heavy industrial companies were clamoring for cheaper power. Years of lobbying and millions of dollars in political contributions from energy firms had softened resistance. Among those pushing was Enron Corp., a Houston-based natural gas marketer nosing its way into the $200 billion-a-year electricity business.

In the mid-1990s, Enron was aggressively hopscotching from state to state, urging deregulation and offering money and promises. The company pushed for opening up markets in Iowa and Michigan, priming politicians there with contributions. In 1997, it doled out more than $858,000 in soft money and political-action contributions to members of Congress, becoming the largest contributor from the energy industry. That year it hired Ralph Reed, the former head of the Christian Coalition, to preach its agenda.

At the time, Enron was a comparatively small ($8 billion a year in revenue) marketer of natural gas. But it was on its way toward becoming one of the world's most successful companies, a $100-billion-a-year giant that counts President Bush among its friends.

Enron had qualms about the system California was leaning toward. In testimony before the PUC in June 1994, it warned that the highly centralized market structure could lead to higher prices.

But ultimately the company joined the chorus urging California to plunge ahead. Enron executive Jeffrey Skilling told the PUC in 1994 that California could lower its $23 billion-a-year energy bills by as much as $9 billion -- enough money to triple the police forces of its largest cities.

"Commissioners, the patient is on the ground bleeding," Skilling testified. "Delay kills."

The color books

As California's recession deepened, Wilson's approval rating plummeted, and aides fretted about an economic snowball effect.Wilson settled on a rescue plan -- full deregulation -- and appointed members to the PUC who shared his free-market leanings. Three PUC staffers set things into motion in February 1993 with the release of a 200-page report declaring that change was needed.

That report, nicknamed the "Yellow Book" for its cover, declared that the century-old system was "ill-suited to govern today's electric industry." Consumers would benefit from a change, the report concluded. Slightly more than a year later, the PUC commissioners formalized their staffers' conclusions in a report dubbed the "Blue Book."

The Blue Book outlined a tentative plan for opening up the energy marketplace. Instead of guaranteeing the utilities a monopoly and capping their rates, California would become one of the first states to let customers choose their electricity provider while letting rates float.

By January 2002, the PUC envisioned, every Californian would shop for electricity the way people shop for long distance telephone service.

The book hit with the force of an earthquake, according to one consultant. Markets tanked as investors dumped energy stocks out of fear that competition meant the staid but stable utilities would be shredded by nimble new competitors.

"The barbarians were at the gates," said Tom Willoughby, a retired PG&E lobbyist.

Those barbarians wanted more. Enron and other out-of-state power companies, backed by consumer groups, told policy-makers that in order for everyone to have a fair chance at attracting customers, the three big utilities had to be defanged. Their proposed remedy: Make them sell off most of their power plants.

Faced with this assault, the utilities set their own ground rules. They would break up their monopolies if the state let them charge customers for "stranded costs" -- debts from nuclear power projects and other costs they believed they'd eat in a competitive market. Wilson, who'd collected $120,000 in campaign contributions from the utilities, agreed that the utilities should collect $16 billion in stranded costs from ratepayers.

With that, the utilities became enthusiastic backers of deregulation. "Competition will work to drive costs down," John Bryson, Edison's chairman, told commissioners at their June 1994 hearing. Behind the scenes, Edison was working to make sure it was the right kind of competition.

Edison and the San Diego utility settled on a system where utilities would buy their power from a centralized "pool" of electricity. They and others hit upon the idea of a high-powered field trip. In March 1994, the California Foundation for the Environment and the Economy, a utility-backed group, sent PUC members, lawmakers and utility executives to the United Kingdom to see a pool in action.

During a weeklong, dawn-to-dusk blitz, the Californians toured power plants and utility offices and visited the crown jewel of the U.K. system: the National Grid, a kind of stock exchange through which every electron in England and Wales was bought and sold.

The Californians came away impressed by the Grid and its disciplined trading system. "You just wring out the inefficiencies through the bidding," Conlon recalled. "It just kept driving the rates down."

The compromise

Gov. Pete Wilson was puffed up with pride on Sept. 23, 1996. It was a sunny San Diego day, and Wilson was there to baptize one of his offspring: a bill to deregulate California's electricity markets. "What we are doing is more than signing a new law," Wilson said at the signing ceremony. "We are shifting the balance of power in California."

That balance had begun to tip a year earlier, when Wilson and his top aides stepped in to speed things up. Edison and PG&E were squabbling over details of the new market, and deregulation seemed to be stalled. PG&E was objecting to the "pool" system, which it thought would stifle competition. Instead, PG&E favored a more free-market approach that would let the utilities buy power from whomever they wanted.

Wilson's own attention was more focused on the possibility of running for president and the throat problems that temporarily stole his speaking voice -- and his ability to campaign. But his staff worked to hammer out an agreement with the utilities, the California Manufacturers Association, energy marketers and others.

"CMA had access to the governor's office day-to-day," recalled Eric Woychik, who was acting as an adviser to consumer groups. "We made jokes about how they had their own office in the governor's office."

In the end, Wilson and his aides made a Solomon-like decision. They cut the baby in half. Instead of a completely free-market system, they agreed to a centralized pool for buying and selling power but also allowed buyers and sellers to cut their own, independent power deals.

The pool would be further split in two: Most of the state's electricity would be traded on something called the California Power Exchange. Another entity, called the Independent System Operator, would manage the state's transmission grid and buy last-minute power to balance supply and demand.

Divvying up the pool was crucial to the deal, said George Dunn, then Wilson's chief of staff, because it lessened the utilities' clout by ending their stranglehold on the grid.

Nowadays, Wilson concedes the setup "was not a perfect free-market institution," but at the time it seemed like the only workable compromise. In December 1995, the PUC approved deregulation by a 3-2 vote, putting most of the major elements into place.

The state's big utilities would be directed to sell off many of their power plants. Individual customers, ranging from businesses to homeowners, could go outside the Power Exchange to buy their electricity. But the three big utilities had to rely on the exchange to purchase their electricity.

Most of the commissioners, all Wilson appointees, were sure that having the utilities buy electricity on a daily basis would produce panic selling by the power generators. And prices would drop like stones in a lake.

No dissent allowed

Not everyone was so sure. Officials with San Diego Gas & Electric believed that the rules governing the pool were cumbersome, prone to secrecy and inefficiency.

Some analysts even suggested the power generators and energy marketing firms would be able to play one organization off the other -- holding back electricity from the Power Exchange, then selling to the ISO at the last minute, when prices peaked.

But they were having trouble making themselves heard.

For months following the PUC's December 1995 vote, a group consisting of utilities, government regulators, energy marketers and industrial and commercial users had participated in a series of talks aimed at ironing out the details of deregulation.

These coffee-and-doughnut sessions of the Western Power Exchange Steering Committee were theoretically open to the public, but keeping track of them was complicated because they rotated among airport hotels from San Francisco to Riverside.

At one of the first meetings, Woychik, who had been sent by consumer groups, says he was told by the chairman that he was not welcome: The other members had voted against seating him. Others involved confirmed the recollections of Woychik, who was already known as a critic of the proposed electricity market.

The pressure was on to present a united front. But Woychik still struggled to air his concerns. In January 1996, he told a conference of federal regulators that some parts of the proposed electricity market "are invitations to classic gaming."

He elaborated the next month, writing to the Western Power Exchange that, for savvy operators, gaming the market "should be like shooting fish in a barrel -- not great sport, but lucrative."

Later, in a January 1998 trade journal article, Woychik described in detail four major "games" that could be played in the newly minted California electricity market. One involved generators saying their plants were down during times of peak demand to drive up prices -- a prophecy many believe came true last year.

Deregulation had lots of cheerleaders. But Woychik was not the only one raising red flags. In a July 2, 1996, letter to the Legislature, even the PUC acknowledged that in times of shortage, market manipulation would be a danger. But the PUC predicted that such shortages wouldn't occur, and excess power would keep prices down.

Chandley, meanwhile, had taken up the charge of criticizing the market rules at the Western Power Exchange meetings, speaking on behalf of the California Energy Commission. The Governor's Office was considering whether to let the Energy Commission file an official dissent with federal regulators, who had to OK the plan, when Chandley set off on a business trip to Massachusetts. Changing planes in Dallas, he stopped at a pay phone to check in with his office and got the word: Wilson's office had ruled there would be no dissent.

Within a week, Chandley quit.

Federal regulators later accepted the California plan. As William Massey, a member of the Federal Energy Regulatory Commission, recalls: "Essentially, we deferred to the market plan that was handed us."

Death march

State lawmakers began taking up deregulation in summer 1996, and a bright, ambitious and abrasive Democratic senator from El Cajon named Steve Peace found himself at the forefront. Peace announced plans to scrap the PUC plan in favor of something better and cheaper.

Then Wilson stepped in.

In a letter, the governor made it clear that no tinkering would be tolerated, saying he would "oppose any legislation which seeks to alter the decision's basic framework or timeline." The lawmakers backed off.

For months they labored over deregulation in a series of late-night negotiating sessions that became known as "the Steve Peace death march" -- focused almost exclusively on side issues of deregulation. Unions made sure that power plant employees got treated fairly. Environmentalists got millions in eco-subsidies. Utilities saw to it that billions in "stranded costs" would indeed be paid by ratepayers. Ordinary consumers got a 10 percent rate cut, and consumer groups largely kept quiet.

Even Mother Nature nudged lawmakers forward.

At 2:06 p.m. on a blazing summer day in August 1996, a power line in an Oregon forest began to sag until it touched a tree, shorting out the line. Over the next two hours, four other lines came into contact with trees. By 4 p.m. the shorts along the intricate web of power transmission lines caused a blackout that affected 4 million people in nine U.S. states stretching from Canada to Mexico.

Experts warned that the electricity system was too fragile, that there had to be some sort of backup -- like the ISO -- to protect the grid, some kind of independent organization standing ready to keep the lights on at all costs.

The legislation passed unanimously, Wilson signed it and deregulation was set in motion. The utilities, directed by the PUC to start selling their power plants to establish a free market, went at it with gusto. PG&E sold its plants for $1.5 billion, far more than the book value of $981 million. Southern California Edison got nearly $1.2 billion for plants valued at $677 million.

Power generators ended up spending most of their capital buying those old plants instead of building new ones. Dunn, Wilson's former chief of staff, now sees that as an unanticipated flaw: "It was investment that didn't generate new electrons."

Light-bulb cakes, free power

On March 31, 1998, more than seven years after the PUC started the process with publication of the "Yellow Book," California's deregulated energy market was open for business. Alhambra was home to the new Power Exchange, the state-mandated market where most electricity would be bought and sold.

Up north, in Folsom, was its partner: the Independent System Operator, which was already buying extra power to make certain California had all the electricity it needed. On the first full day of deregulation, ISO officials celebrated with a light-bulb shaped cake. Brochures boasted of "Securing Reliability" and "Power to the people and by the people."

The system worked beautifully.

Competition among providers drove power prices so low that PG&E gave away electricity for free between 1 a.m. and 2 a.m. that day. The biggest problem seen on the horizon was for consumers who would have to pick among a dizzying array of cut-rate power providers.

It would be three months before the party ended, when a worker inside the ISO offices in Folsom noticed something terribly wrong.

The game

Tucked into a leafy office park in Folsom, the ISO consists of a labyrinth of hallways and meeting rooms. Ground zero is a 15,000-square-foot control room with a giant map board curving across one wall that charts the flow of electrons around the state.

In the foreground, somber-looking people sit in front of computers, talking on telephones. Their job is to buy enough power to keep California's needs met.

On July 9, 1998, the price for reserve power needed by the ISO was running at $1 a megawatt hour and was being tracked on computer screens in the market operations department of the agency.

A staffer hurried up to ISO chief executive Jeffrey Tranen with a note. The $1 price tag, set by the power generators, had shot up to $2,500. Then, just as suddenly, it spiked again to $5,000, where it stayed for three hours.

After that, it mysteriously dropped again, all the way back to $1.

Four days later it happened again, but this time the price went to $9,999 and stayed there for four hours. Then it dropped to a penny.

"All of us saw those numbers and realized ... there was nothing to stop someone from bidding infinity," said Tranen, now a software executive.

Under the rules, the identities of power generators are kept secret. But Levin, the New York businessman who'd warned of higher prices back in 1994, said the price spikes were clear signs of someone probing for weak spots. "They were experimenting from Year One," he said. "Early on, people learned how to work the magic."

The ISO saw the problem, too, and moved to cap prices. But it was clear that California markets were vulnerable to manipulation. The damage was done, and the gold rush was on.

This special report on California's energy crisis was written by Bee staff writer Sam Stanton, with reporting from John Hill of The Bee's Capitol Bureau, staff writers Dale Kasler and Stuart Leavenworth and David Whitney of The Bee's Washington Bureau.

The Bee's Sam Stanton can be reached at (916) 321-1091 or sstanton@sacbee.com

Copyright The Sacramento Bee

-- Swissrose (cellier3@mindspring.com), May 06, 2001


What this article fails to mention is that the uncertainties surrounding the looming Y2K Computer Bugs, was an additional good reason against the "deregulation" plan. It should have been known that Y2K would, AT BEST, result in new bottlenecks, thus aggravating any shortages of electric generation and transmission capacity; thus almost assuring the "gouging" scenario that has in fact emerged. We're lucky Y2K effects are relatively mild. Just a minor increment in Y2K effects would have sent the entire situation "over the edge" much more quickly. This was all known before the Rollover, and was a good reason to be concerned about, and prepare for, Y2K problems.

-- Robert Riggs (rxr.999@worldnet.att.net), May 06, 2001.

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