By Patti Harper-Slaboszewicz
Senior Industry Analyst at Frost & Sullivan
August 9, 2001 — One of the main benefits of electricity deregulation, experts claimed, are lower prices. So why did prices in California, after a shaky first three years of reform, suddenly skyrocket? Are other states that deregulate headed toward a similar misfortune? Upon a review of Golden State’s experience, it appears that the absence of certain market conditions can indeed wreak havoc upon the consumers that deregulation is supposed to benefit in the first place.
Markets have to work properly for deregulation to lower prices. In particular, there must be an adequate supply of energy for the regional load, a workable transition from the regulated state to the deregulated state, numerous retail electric providers, numerous suppliers of energy, an adequate supply of natural gas, and adequate transmission infrastructure. California lacked many of these conditions when it embarked on electricity reform.
Supply and Demand Imbalances Set the Stage for Crisis
The planners of California’s deregulation transition had anticipated not only adequate supplies of energy, but also an excess supply of energy in California. The weather for the first few years cooperated with abundant rainfall providing ample inexpensive hydropower. Beginning in the summer of 2000, supplies began to get tight.
The summer of 2000 was warmer than usual, and many older fossil fuel plants operated more hours than usual to meet the demand. Since these plants were older, they were not as environmentally friendly as the newer natural gas turbine plants being built elsewhere in the country. By December 2000, many of these plants had already produced as much pollution as they were allowed for the calendar year, and could not run anymore.
When the rains didn’t come in the fall of 2000 and the subsequent winter, there was less hydropower available to import from the Northwest and less available within California. When there is not as much water behind a dam, not only is there less water to run over the dam, but the water does not fall as far. For each gallon of water when the level is low, there is less power produced. This increases the impact of low reservoir levels for regions that depend on hydropower.
The construction of new power plants in California had basically been blocked in the 1990’s. By the summer of 2000, the peak demand for the system load in California had grown to 53,257 megawatts (MW), an increase of 11% from the demand of 47,813 MW in 1995. During the transition to the deregulated market, California also was experiencing an economic boom. This contributed to the rising demand for energy in California and in the Northwest.
With less hydro generation, rising energy demand, the environmental shutdown of old fossil fuel plants, no new plants built or planned, California was facing an energy shortage rather than a surplus. Profit oriented firms now owned 54% of the fossil fuel plants. By 2000, when the demand for energy increased and the supply of energy decreased, wholesale prices rose dramatically.
Incentive Structures Malfunctioned for Retail Electric Providers
During the transition to deregulation, the investor owned utilities (IOUs) were established as the provider of last resort. It was expected that most customers would switch to a retail electric provider, who would be selling power at a lower price than the IOUs.
The IOU was required to buy all energy to serve its customers from the Power Exchange (PX). The PX price in effect became the wholesale price for power in California. There was little incentive for a supplier to sell below the PX price. The IOU was to charge a retail customer for generation at an average PX rate based on the customer billing cycle and the customer class. This effectively set a cap for the price at which a retail electric provider could sell energy to a retail customer.
To induce retail customers to switch to a retail provider, the retail provider had to offer a discount to the PX price. The usual discount for residential customers settled at 20%. The retail electric providers had no room to make a profit by buying at the wholesale price and selling at a higher retail price because the retail price was 20% less than the wholesale price.
The only avenue for profit for retail electric providers was to buy certified green power. The retail electric provider was thus able qualify for a credit that varied over time from 1.5 cents to one cent per kilowatt-hour (kWh) with a maximum credit allowed of $1000 per customer per year. The State Energy Commission (CEC) administered the program and never envisioned it would offer the only hope for profit for retail electric providers.
As long as the average PX price stayed below $50 per megawatt-hour (MWh) and the customer used less than 100,000 kWh per year, the retail electric provider had a chance to make a small profit or at least break even. When the average PX price went above $50 per MWh and stayed there, the retail electric provider could not make a profit. The retail electric providers withdrew from the California market, and the retail customers returned to the IOUs.
Transition to Deregulated Markets: the IOU’s Predicament
The IOUs continued to supply most of their customers throughout the deregulation transition. Most customers did not make the effort to switch to a retail electric provider. Residential customers were confused by the PX price; it was easier for most to stay with the IOU. Small commercial customers were busy with the economic boom times and did not show much interest. Larger commercial customers and industrial customers had the biggest switch rate, and for a short while, enjoyed lower prices due to the deregulated markets.
The IOUs were required to buy all of their power to serve their customers on the PX. Pacific Gas and Electric Company (PG&E) and Southern California Edison (SCE) had fixed rates for the bundled power sold to its customers. If the cost to PG&E and SCE were less than the total fixed rate, the IOUs could keep the difference during the transition period. If the total cost were greater than the total fixed rate, the IOUs were to absorb the difference to encourage them to keep the costs down.
Unfortunately, the IOUs had little ability to affect the PX price. The IOUs could not enter into any long-term contracts for buying power. All the IOU power needs were to be met on the PX with short-term purchases. As the PX price began to rise in May 2000 and rose to extraordinary heights in December 2000, the IOUs were in trouble. As retail electric providers left the California market, the IOUs had to buy even more power, which further increased the IOU losses.
Power Generation Rules Allowed for Manipulation
The IOUs were required to divest fossil fuel generation plants. IOU ownership of fossil fuel plants dropped from 54% to 19%. The new owners of the plants were obligated to shareholders to try to maximize their profits by selling power for the highest price each generation asset could command.
The PX price was determined each hour by the last and most expensive power plant required to provide enough power to serve the expected system load. The owners of generation would bid into the PX market, and the bids would be ranked from the lowest to the highest bid price to sell. If 100 plants were chosen to supply the power for a particular hour, and the first 99 bid in a price of $30 per MWh, but the 100th plant bid in a price of $150, the PX price would be set to be $150.
If a supplier were to own several generation plants, it would be advantageous at times to not bid all of the generation capacity into the market. This could result in a higher PX price than if the supplier had bid all of the generation capacity into the market, and the resulting higher PX price offset the lower number of MWh sold into the market for that hour.
Suppose one supplier owned enough generation to bid a total of 3000 MWh for a particular hour. If the 3000 MWh were purchased by the PX at a price of $30 per MWh and the average cost of generation were $25 per MWh, then the profit for that hour would be $15,000 (3000 MWh * ($30 – $25)). If instead, the supplier bid in 2000 MWh, and the PX price rose to $150 and the average cost rose to $80 per MWh, the profit would increase to $140,000 (2000 * ($150 – $80)).
If the IOUs had not been required to buy all of the power on the PX, then the IOUs would likely have not paid the higher prices for all of the power purchases. If the energy suppliers had sold some of their supply in long-term contracts, then the energy suppliers would not have as much to gain from price volatility of the PX market. Allowing long-term contracts has the effect of increasing the number of energy suppliers active in a market. The more market participants, the lower prices tend to be.
Natural Gas Supply and Infrastructure Complicated Matters
Natural gas is used to fuel many of the peaking plants in California and is used for heating in the winter. Prior to deregulation of natural gas and the electric industry, natural gas was prudently stored by the IOUs in California to supply natural gas customers and to supply the power plants. There was not enough pipeline capacity into California to supply the gas needed for winter heating. It had to be purchased in the spring and summer and stored until needed in the winter.
When natural gas was deregulated, some large customers purchased natural gas from competitive suppliers of natural gas rather than the IOU. The IOU then stopped storing natural gas for those large customers. With the deregulation of electricity and the sale of the fossil fuel plants, the IOUs were no longer storing natural gas for the power plants. It was up to the new owners to buy and store the natural gas.
With the proliferation of gas turbine power plants across the country, natural gas prices rose during the summer of 2000. Most of the new owners of the natural gas plants in California deferred buying the expensive natural gas needed for operating the power plants in the fall and winter. When the surplus pipeline capacity into Southern California was sold to an unregulated affiliate of El Paso Natural Gas, that pipeline capacity was no longer available to firms needing to import natural gas. A pipeline explosion near Carlsbad, New Mexico further reduced the capacity of that pipeline. California lost 5% of the pipeline capacity to transport natural gas into California. The result was less gas stored for the winter of 2000-2001.
The winter of 2000-2001 was cold. Natural gas prices rose even higher. Some industrial customers shut down but the IOUs were still obligated to supply power to all of the customers. The power generators passed the higher cost of natural gas along to the IOUs through the PX bidding process.
Transmission Infrastructure Deficiencies Impeded Power Flow Across State
Southern California and Northern California can trade power back and forth and do trade power, but this is limited by a transmission bottleneck between the North and the South. Even if there is enough capacity in the South to help the North, there is often not enough transmission capacity to get the power from the South to the North.
In a situation where there is not enough transmission capacity, it effectively reduces the number of energy suppliers and the available supply in a region, leading to higher prices.
In Summary
In California, the markets were deregulated but not competitive. The effect of the shortage of generation capacity was exaggerated by the requirement that the IOUs had to sell the fossil fuel generation assets, and the IOUs were not allowed to enter into any long term contracts to buy energy to serve the retail customers. The IOUs were fully exposed to the volatility of the short-term wholesale energy prices.
Retail electric providers could not profit by buying power and selling it at 20% less than the wholesale price. Consumers ended up with no choice of retail providers. Even though retail electric providers could enter into long-term contracts, it was difficult for the retail electric providers to have a large enough load to interest energy suppliers.
The California deregulation plan attempted to cap the price that retail customers had to pay; those price caps could not be maintained when the costs of procuring the power remained far above the caps.
The IOUs and the retail electric providers were in an untenable position with the California deregulation scheme. If PX prices stayed low, the IOUs could have done well, but the retail electric providers needed another path to profitability besides the green credit. Once the PX prices rose, the IOUs were squeezed between the fixed lower rates charged to the customers and the high costs of buying the power. The retail electric providers fled the market, abandoning their customers to the IOUs.
Key Lessons
With California’s energy blunders undergoing national scrutiny, other states should be better able to fashion reforms that result in lower prices for consumers. The following seem to have emerged as key elements of successful electricity deregulation:
* Long-term contracts should be encouraged. This reduces the market power of energy suppliers, and reduces the exposure of customers to the volatility of the wholesale spot market price.
* The default-provider price should be higher than the wholesale price, and should be pegged to the price of natural gas or some other suitable price index. This would give room for retail electric providers to be profitable, and thus give the retail customers a choice of provider. Profits are necessary for a competitive market to flourish.
* Permitting of new efficient power plants should not be blocked. This will allow the replacement of aging, inefficient power plants. This will improve the air quality and reduce costs.
* Owners of generation should not be allowed to own enough generation assets to manipulate the price of energy on the spot market. Economies of scale can be achieved by owning generation in disparate markets.
* Customers in California have reduced their energy use this summer, responding to the higher price of energy, and the threat of blackouts. The status of the grid for any region should be public knowledge to give end users a chance to reduce their energy use for the greater good.
* Eventually, the end users of energy should not be entirely shielded from the variations in the cost of generating energy.
* Metering should remain the responsibility of the IOUs, and IOUs should be funded to upgrade the metering systems to allow two-way communication between the meter and the IOU. This will allow retail electric providers to have more choice in rate structure, the IOU to better manage outages and power quality, and will provide customers with more information on energy use.
For more information on this article or on other energy related topics please contact:
Cynthia Cabral
Frost & Sullivan Media Relations Executive -Industrial
7550 IH-10 West, suite 400
San Antonio, Texas 78229
Phone: 210.247.2440
Fax: 210.348-1002
Email: [email protected]
