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June 1, 2001 Power Politics: A Failed Energy Plan Catches Up to New York

By NEELA BANERJEE and RICHARD PΙREZ-PEΡA o understand the troubled progress of electricity deregulation in New York, it helps to consider a cluster of gray prefabricated buildings at the foot of the Williamsburg Bridge in Brooklyn.

Inside are the components of a small power generator, one of 10 that the state is hurriedly installing in the city to avert blackouts and price spikes when temperatures rise this summer.

Things were not supposed to turn out this way. When Gov. George E. Pataki set out to deregulate New York's electricity business five years ago, he offered a simple promise: break up the old utility monopolies, and the free market will deliver new power plants and reduce the high rates that were driving employers out of the state.

But private power companies have not yet built any plants. So to ensure the city's lights stay on, the state has stepped in, installing its small generators and encouraging hundreds of businesses to turn on sooty diesel generators when demand is high.

Meanwhile, with supplies tight, Consolidated Edison's rates — the highest in the continental United States before deregulation — have risen significantly, up almost 40 percent from two years ago. Just yesterday, the managers of the state's power grid predicted that peak summer rates could rise an additional 22 percent by 2003.

Now, Con Ed, Mayor Rudolph W. Giuliani — even the State Public Service Commission, which drafted New York's deregulation plan — are calling for increased government control over the state's electricity market. And the energy plan that President Bush issued last month lumps New York with California among the states with the nation's most severe energy supply problems.

Unlike in California, there have been no utility bankruptcies or rolling blackouts here. And few voices are calling for a return to the old system, in which the state oversaw plant construction and told utilities what they could charge for power. Nevertheless, a host of critics, from former commission staffers to business lobbyists to consumer advocates, say that deregulation in New York has gone awry.

Other states took a cautious approach to restructuring an industry that had been under tight government control for decades. But New York — driven by an urgent desire to lower rates and an abiding faith in the free market — opted for sudden, sweeping change.

The Pataki administration ignored warnings that prices could rise under deregulation unless steps were taken to ensure adequate supplies of power. It cast aside expert findings that the utilities' plans to sell their power plants to just a few buyers might invite the new owners to engage in price gouging.

And while virtually every other state took pains to shield ratepayers during the transition to free-market power, New York let its leading utilities pass their costs through to ratepayers — big companies upstate, and all of Con Ed's customers downstate.

Officials in Albany note that the sharp rise in rates, especially in New York City, has primarily been because of surging prices for the natural gas used to fire many power plants. They say those fuel costs would have been passed along to consumers even under the old, regulated system. For now, they counsel patience.

"We understand that deregulation is in a transition period right now," Governor Pataki said in an interview. "We don't have the wholesale markets the way they should be — not just in New York, but across the nation — so we have to take steps to make sure the consumer is protected, and we've been doing that."

But the experience of other states reveals that their consumers are better protected, and that the transition need not be so painful.

For example, in Massachusetts — a state dependent on a comparable mix of high- priced fossil fuels — rates have gone up just half as much as in New York, and are expected to hold steady through 2001. Con Ed's rates could go still higher this summer, if demand squeezes supplies.

The contrast, critics say, reflects the history of New York's experiment in energy deregulation: a study in faulty assumptions, unheeded omens and unkept promises.

"They thought it was a classic win-win situation," said George M. Knapp, a partner at the Coudert Brothers law firm who represents power producers. "What could possibly go wrong — except everything that did go wrong?"

Relying on an Unreliable Market

When the Pataki administration unveiled its deregulation plan in 1996, New York's utilities were producing more electricity than customers were using. The plan assumed that the surplus would last until 2005, if not longer, by which time market forces would have lured new power generating supplies to meet rising demand.

But the governor's proposal ignored a warning that New York was on the verge of rapidly losing its surplus due to increasing demand. A team at the Public Service Commission had forecast — accurately, it turned out — that New York would need new power plants by 2000.

"The feeling at the P.S.C. was, `Yeah, that's true, but the market will respond,' " said Lawrence DeWitt, who headed the team predicting trouble. "It was consistent with the philosophy. It was the big leap."

Now, though the demand is real, major new power plants remain years away. Power suppliers have proposed 21 large and mid-sized plants around the state, of which two have been approved. They will begin operating in late 2003, at the earliest, and neither is intended to serve New York City, where the need is most acute.

Other states years ago took steps to ensure extra supplies of power. Massachusetts, for example, streamlined the application process for building plants — without softening environmental or other regulations; that is helping New England add enough plants this year to provide power to 2.6 million homes. Michigan, as part of its deregulation plan, has instructed utilities to find a way to increase transmission in the state by about 50 percent by June 2002.

New York, though, decided that its new power markets would be largely free of the state's hand. On taking office in 1995, Governor Pataki eliminated the state energy office, a planning body that he had derided during his campaign as a waste of money. From 1988 to 1999, no state agency had the authority to issue environmental permits for new power plants.

"Essentially there was a lot of rhetoric that the market would do the planning," said Carl Pechman, a former Public Service Commission supervisor and now head of Power Economics, a consulting firm. "The feeling was, `You don't need an agency to plan when you need a steel mill or new refinery, so you don't need an agency to plan when you need new power plants.' "

Meanwhile, to deliver quick dividends on deregulation, the administration eliminated a two percent surcharge on electricity bills that had supported conservation programs. Utilities had used the money to conduct "energy audits" showing consumers how to use less power, and to subsidize their purchases of more efficient appliances. But big power users complained that the surcharge, which cost them millions each year, gave them few benefits.

In the mid-1990's, the state scaled back its energy conservation program, once the country's most aggressive, by more than 70 percent, a process that began before Mr. Pataki took office but which he accelerated. There have been increases since then — particularly this year, as the state looks to conservation as one way to avert an energy crisis.

But New York still spends far less on conservation than it did a decade ago. Environmentalists say that if programs had been financed at the old levels, demand would be about 500 megawatts lower — equivalent to the output of a medium-size power plant. That, in turn, would ease the tight electricity supplies that have helped drive up prices.

Focusing on a Quick Payoff

The very essence of power deregulation was the state's requirement that utilities sell their power plants. The idea was that the new owners — lean companies unburdened by the heritage of monopoly — would compete to sell power to Con Ed and other electricity retailers, thereby forcing prices down.

But here too, critics say, the state's determination to get a quick payoff from deregulation took priority.

The deals that the state negotiated with the utilities counted on proceeds from the power plant sales to finance the governor's promise of an immediate reduction in ratepayers' bills. To maximize those proceeds, the Public Service Commission went along with the utilities' demands to sell their plants in bundles of bigger and smaller plants.

That indeed drew higher bids; Con Ed, for example, received nearly double the book value of its plants in the city. But it sold them in 1999 to just three buyers: Orion Power Holdings Inc., then a private com- pany backed by Goldman, Sachs and the Mitsubishi Corp.; NRG Energy Inc., a Minneapolis-based company; and KeySpan, the energy company in Brooklyn.

Some politicians and economists warned that the concentration of ownership might backfire. Miles Bidwell, an economist and former consultant with the Independent Power Producers of New York, filed testimony in 1997 with the Federal Energy Regulatory Commission stating that New York's plan would create a market susceptible to price manipulation.

Like other analysts, he believed that the plants drew high prices because the buyers expected high rates for their electricity.

"The fact that people were willing to pay such huge amounts for the power plants doesn't in itself mean they're buying market power, but it raises a flag, and you expect people to examine the issue more carefully," Mr. Bidwell said. "I said the economic analysis was never done about the impact of the sales."

Now the impact is becoming clear.

Statewide, suppliers manipulated prices on the wholesale markets about 10 times last year, according to the Independent System Operator, which runs the state's power grid. Just one of those instances, it says, cost utilities about $100 million. In New York City, electricity prices on the real-time market — where Con Ed purchases about 5 percent of its power — have spiked repeatedly near the limit of $1,000 per megawatt hour allowed by the state, which is about 20 times the average price.

The Pataki administration, which long disdained the notion of government controls on energy markets, now wants the Independent System Operator to have the authority to order lower prices when power generators' bids are suspiciously high. It also wants the grid operator to have the authority to fine generators for price gouging.

But the Independent System Operator, which includes energy suppliers, has been reluctant to endorse a system of penalties, and both measures would require the approval of federal regulators, who to date have been hostile to such controls.

The power generators strongly deny any wrongdoing. "I don't believe there is a lot of gouging taking place," said Craig Mataczynski, chief executive of NRG. "Much of what is talked about is mythical in nature."

Other states, besides taking steps to assure power supplies were adequate before unleashing the forces of deregulation, laid plans to police their new wholesale markets more closely than New York.

For example, the PJM Interconnection, the transmission system for all or part of Pennsylvania, New Jersey, Maryland, Washington, Virginia and Delaware, introduced its wholesale market in phases over three years. The idea was to monitor the behavior of power suppliers and iron out any problems.

PJM is not immune to price gouging. But it requires that suppliers report daily the actual cost of generating power at their plants, which makes it easier for the system's managers to spot price manipulation.

"PJM did things one step at a time," said Tim Mount, professor of applied economics and management at Cornell University and an expert on the electricity industry. "One only has to look at California to see how difficult it is to resolve problems on the fly."

Unheeded Warnings on Bill Shock

Experts had warned New York that energy deregulation, because it was complex and untested, could lead to higher prices, at least initially. As early as 1994, the Public Service Commission, under Gov. Mario M. Cuomo, said that in any deregulation plan, "the commission should strive to minimize `bill shock' for any class of customers."

Customers are shielded elsewhere. California, the most extreme case, let generators charge market prices for power, but froze the rates that the utilities could charge consumers. That led to bankruptcy for the state's largest utility, Pacific Gas & Electric.

Other states have so far struck a balance protecting both consumers and utilities. In Massachusetts, for example, utilities are required under the state's deregulation laws to enter into long-term contracts for power. Such agreements mean that customers pay a fixed rate for electricity, and the utilities buy only a small portion of their power on volatile wholesale markets.

But the negotiators whom Governor Pataki charged with hammering out New York's new power markets were confident that prices would fall. And so, unlike utilities elsewhere, Con Ed was allowed to pass the price of power along to its customers.

Con Ed insisted on the pass-through in its deregulation talks with the state. Because the utility takes no mark-up on power it resells to consumers, it says that the arrangement is fair. "Based on what we've seen transpire in California, I think it was correct — not just for us but our customers," said Michael Clendenin, a company spokesman.

In retrospect, the state's critics say that the utility's insistence on a pass-through should have been a red flag that it foresaw rising prices. But the state's focus was on other issues.

"They took a very strong position that if they didn't get the pass-through, they would be at risk financially from buying power on the market," said John O'Mara, who as chairman of the Public Service Commission from 1996 to 1998 was the architect of New York's deregulation plan. "In return, they were willing to give us a better deal over all."

Again, the aim was a big cut in customers' bills. And over the last three years, the utilities have delivered — on the portion of customers' bills that covers the cost of delivering power to homes and businesses. Con Ed, for example, has reduced those rates by 16.8 percent.

But unexpectedly high fuel prices, accentuated by the market power exercised by generators, have eclipsed the savings. Over all, Con Ed bills were 38 percent higher in January than two years earlier.

Upstate, the state allowed the biggest utility, the Niagara Mohawk Power Corporation, to pass through power costs to industrial customers, but not to residents and smaller businesses. The logic was that in a competitive market, big businesses would have enough clout to find cheaper power themselves.

Instead, new suppliers have offered upstate companies electricity at prices as high as Niagara Mohawk's or higher, a situation that customers attribute to tight electricity supplies.

As a result, large manufacturers that once ardently supported deregulation now pay hundreds of thousands of dollars more a month for power than they had budgeted. Some are considering leaving the state.

In a little more than a year, the nation's largest brass mill, Outokumpu American Brass, has gone from bustling to staggering, choking on its vast appetite for electricity. It pays $850,000 a month for power, over $200,000 more than it did in late 1999. The Finnish-owned company, based in Buffalo, is now considering layoffs for the first time in a decade.

"It's killing us," said Earl Robinson, an Outokumpu vice president. "I want everyone to understand that this is a crisis."

http://www.nytimes.com/2001/06/01/nyregion/01POWE.html?ei=5006&en=99301f0e14490a64&ex=992059200&partner=ALTAVISTA&pagewanted=print

-- Martin Thompson (mthom1927@aol.com), June 01, 2001

Answers

New York? Same direction as California? Hard to believe.

-- Qman (qman@c-zone.net), June 01, 2001.

If the price of natural gas does not soon stabilize at a reasonable level it won't be just California and New York in the soup. About 15 other states will join them.

-- Chance (fruitloops@hotmail.com), June 01, 2001.