California: Policy and Reform by Chris Trayhorn, Publisher of mThink Blue Book, April 1, 2003 In the post-Cold War era, we supposedly all understand the benefits of privatization and the deregulation of markets. They bring efficiency, innovation, and lower prices. Yet in California the attempt to form electricity markets — arguably a move away from regulation — ended up with an embarrassing period of black outs, significant price increases, and little in the way of innovation. It didn’t have to turn out this way. Fundamental flaws in market design resulted in serious problems when the market drifted into a supply-demand imbalance. The California experience offers lessons not only about the design of electricity markets, but about the operation of markets more generally. First, the institutional structure of markets matters, especially in complicated industries such as electricity. Second, it is hard if not impossible to capture the benefits of any market unless prices are allowed to signal scarcity and surplus to buyers and sellers. Third, policy makers should fully appreciate the reasons why particular industry structures, (e.g., vertical integration between electricity generation and distribution) have emerged over time, and disband them only with great care. Fourth, the intervention of politics, acrimony and litigation are never propitious for any industry, but especially not for one in a crisis that is also burdened with newly formed or inexperienced institutions. We’ll sketch the origins of the crisis and the major policy errors, then turn to identify principles which, if followed, will fix the situation and restore an investment climate sufficiently positive to support the new investment needed to achieve an improvement in supply and more responsive demand. Because of the complexities, our treatment is necessarily incomplete, but we believe we present an accurate summary of the facts, a correct diagnosis of the policy errors, and a forward-looking view of the reform opportunities. Restructuring in California The deregulation of banking, airlines, trucking, and to some extent telecommunications preceded electricity, and consumers have been the beneficiaries. Admittedly, electricity creates a special set of problems of its own — arguably more challenging than some other industries. In particular, with electricity the ability to store the product is extremely limited, so generators must be motivated to supply exactly the amount that customers want at any time. This “load balancing” requires the active involvement of generators, transmission companies, local distributors as well as customers, and arguably regulators too. The conundrum in electricity restructuring is how to achieve the cooperation necessary to maintain reliability in an interrelated industry, while simultaneously effectuating the competition that’s required to bring about greater efficiency and lower prices. The introduction of competition in the United States has moved at different speeds and in different manners in different states. California was one of the pioneers — beginning with a 1993 policy study. Following authorizing legislation (California’s AB 1890 in 1996), this program was implemented by the California Public Utilities Commission (CPUC) in cooperation with the Federal Energy Regulatory Commission. As a result: • The California Power Exchange was set up to run an independent centralized energy auction. • The California Independent System Operator (ISO) was established to operate the transmission network owned by three investor-owned utilities. • The CPUC essentially required the Pacific Gas & Electric (PG&E) and Southern California Edison to divest 50 percent of their fossil fuel generation capacity. • Rates for residential and small business customers were frozen at 90 percent of prior levels, with the rate cut financed by bonds they were obliged to repay. • Up to four years was provided for utilities to recover stranded costs of prior generation investments, after which retail rates would be set competitively. • The CPUC required utilities to buy their entire net electricity needs from the PX at spot, or near-spot prices only — not through contracts with generators. • Independent power marketers were authorized to sell electricity directly to all customers for delivery over utility distribution systems. Twin Crises Under the new structure, California electricity markets worked reasonably well from April 1998 through April 2000. Wholesale electricity prices averaged $30/MWH, customers enjoyed reduced frozen rates, many new power plants were proposed, utilities progressed on stranded cost recovery, and retail competitors attracted a substantial share of large customer loads. However, the situation changed in the summer of 2000 when (both peak and off peak) prices spiked up to nearly 10 times those of the previous two years, and stayed at elevated levels for an entire year. Regulatory constraints meant that the utilities could neither protect themselves against high spot prices through long-term contracts nor pass on the higher prices to their customers. The resultant financial squeeze forced PG&E and Southern California Edison into insolvency, led to a 40 percent increase in retail rates, killed retail electricity competition, began California’s slide into its current fiscal peril, and led to recriminations and uncertainty from which the state’s energy investment climate may not recover for many years. The wholesale price increases that precipitated the crisis have been attributed to a number of factors, including: Supply-Demand Imbalances During the 1990s, capacity to produce and deliver electricity to users had failed to keep up with growth in demand, amplified by: • Hot weather throughout the Western United States that increased seasonal demand. • Reduced electricity imports due to reduced rainfall in the Pacific Northwest. • Rising, and ultimately skyrocketing natural gas prices. • Increasing costs of emissions credits needed for electricity generation in the Los Angeles basin. Lack of Demand Elasticity Frozen retail prices gave customers no economic reason to curtail demand even as the average wholesale cost of electricity soared. Absence of Real Time Metering There was no mechanism in the market to allow higher relative prices during periods of peak use — thus foregoing beneficial incentives to conserve power when it was most valuable, and to reschedule use for time periods when electricity market costs were lower. Lack of Long-Term Contracts The “buy-sell” rule kept utilities from protecting themselves against high wholesale prices through entering long term contracts. Put differently, the natural hedge contained in the industry’s prior level of vertical integration was undone — and not replaced — when utilities were forced to divest much of their generation capacity. Auction Design The market design adopted for the PX had a single clearing price in which all generators/suppliers got the expected bid price required to clear the market. A tight supply situation created the potential (at least in theory) for market “manipulation” or supply “withholding” — even by individual sellers acting alone — to raise the price of power traded in the market. The market design chosen had important and serious implications for pricing behavior in the market, and for questions of whether market participants may have withheld output to cause prices to rise. Because of the importance and complexity of these market power issues, they are explored in more detail below, albeit in a preliminary and abridged fashion. Figure 1: Monthly Costs for Energy and Ancillary Services for CAISO Control Area per Dollars per MWh Source: CAISO-DMA (2002a); CAISO-DMA (2202b) Market Power Claims abound that the high market prices of May 2000 to June 2001 were largely due to market manipulation and the exercise of market power by some electricity producers and marketers. However, what seems obvious to some turns out to be a rather complicated and very technical issue that turns on economic principles many do not appear to appreciate. Numerous governmental investigations and analogous lawsuits seem premised on the belief that if electricity prices rose to levels several times those experienced in recent years, then producers must have engaged in improper actions designed to raise prices. As a matter of economic principle, this is quite simply wrong. A firm has market power when it can price without regard to competition. More technically, monopoly power is sometimes defined as the ability of a firm to price above competitive levels and sustain that price for an extended period, despite the actions of its competitors. In the California electricity market with no demand responsiveness it was belatedly recognized that tight market conditions might cause even a relatively small generator’s production decisions to have price impacts when market conditions were tight, and most or all available power generation was needed to avoid blackouts. Embedded in these pricing issues is a resource allocation function of considerable importance. In times of scarcity, market prices go up in ways economists recognize as legitimate, important, and not necessarily an indication of market power. So-called “scarcity rents” (the profits that result from scarcity) are a rational way to allocate scarce supplies to those who most value them, and to offer a strong incentive for entry by additional suppliers able to meet consumers’ demands. High natural gas (input) costs can also cause high electricity prices. So can the need for certain electricity generators (“peaking units”) to recover all their costs during only a relatively few hours of operation each year. Understanding why wholesale electricity prices rose in California requires a careful assessment of these (and other) factors. Clearly, high prices alone are not an indication of the presence of market power; they may simply reflect fundamental scarcity. Indeed, the existence of prices above even long-run costs occurs in many industries, and is usually eroded in due course by entry or expansion of other providers. Distinguishing market power from scarcity rents is sometimes an analytical challenge. A key factor is the assessment of “withholding” of output. A producer who is offering to the market all that is economic to produce is not exercising market power even if prices are high — like a landlord charging market rents that far exceed a building’s historical construction cost. An exercise of market power requires many elements and requires a contrived shortage with the artificial shortage or shortfall not being replaced by increased supplies from other providers. Contriving a shortage requires the firm to leave some of its potential output unsold in order to sustain an above-market price. This is why a focus on output — and in particular, whether a firm is using its available capacity to produce electricity — is important to distinguishing market power from scarcity rents. Problems with the design of the California wholesale market complicate the analysis of potential market power. The retail rate freeze imposed by the PUC in conjunction with the determination of the ISO to avoid blackouts, created a market where electricity demand held steady, regardless of price. Neither customers, nor the ISO on their behalf, were able to respond to higher wholesale prices by cutting back demand, as would occur in a normal market situation. This made wholesale prices highly sensitive to small variations in available generation output during high demand periods. Accordingly, the diagnosis of market power (and the alleged “overcharges” that might be associated with it) might potentially hinge on why, for example, a relatively small amount of generating capacity might have been offline at a given time. Even worse, because the CPUC’s “buy-sell” requirement forced the bulk of market purchases to occur at spot prices, volatile prices affected roughly half the state’s power bill at any given time — volatility from which utilities (and ultimately customers) could have been protected through the long-term contracts the CPUC prohibited. In combination, these two market design errors created an unfortunate situation that amplified the effects of many ordinary day-to-day decisions by power plant operators. Not surprisingly some analysts have tried to test for market power in California’s electricity pricing. However, the observation that prices were above producers’ marginal operating costs (the test many studies have employed) is not especially meaningful, especially where scarcity rents may exist, where opportunity costs are significant (as when a hydroelectric system can utilize its water resources now or later), where factors other than operating costs may be relevant, where other regulatory limitations (such as air quality emission limits or taxes, or new plants sighting delays) restrict output or raise costs, or where a flawed bidding scheme may have offered incentives for above-cost bids. The financial crisis caused by insolvency of the distribution companies likewise created a risk that producers would not be paid for their electricity just as natural gas prices (the essential input) reached record levels. Simple operating cost-based offer bids would make no sense for a generator under such circumstances. Arguments about whether particular power plants should have been running at particular times have yet to yield persuasive evidence of strategic outages. Our conclusion is that electricity markets should not be designed in such a way that performance assessment involves subtle distinctions between acceptable and unacceptable market behavior. The good news is that it is entirely feasible to design markets that avoid the problems experienced in California. Reforms That Work The need for reforms in California has already been recognized by many market participants and federal and state regulators, although the CPUC has tended towards a revisionist command-and-control philosophy that will make matters worse. California also bears a unique financial challenge due to the inept response of the state’s officials to the crisis. Concerns about price volatility, competition, and market power can be greatly mitigated by adopting the following basic principles: • Open and free contracting between parties. The CPUC has already recognized the error of its ways in prohibiting utilities from engaging in contracts with power producers that would have mitigated risk for both parties, and ultimately for customers as well. However, it is still not clear that the CPUC is willing to forego the subsequent second-guessing of the merits of such contracts. • Eliminate barriers. California is notorious for its permitting delays for new power plant construction, a process that extends a typical project to about four years. The ability of new producers to readily enter the market (or for existing producers to expand output quickly) is essential to maintaining competition and limiting the scarcity rents that occur naturally. Free and open contracting also reinforces rapid entry. • Implement real-time pricing. Real-time pricing is essential to allow customers to shift their demands in response to what prices tell them about when electricity is cheap, and dear. The wholesale market also needs to feel the impact of such customer responses. • Minimize government’s role. There is clearly a role for government oversight of electricity markets, especially in terms of establishing and policing rules for wholesale markets and the related maintenance of reliable service. But it would be incorrect to read the California crisis as a justification for more traditional (and discredited) market intervention by government. Final Comments We don’t mean to imply that the implementation of these principles is either politically or technically easy. They are not. However, there is sufficient experience from other jurisdictions (in the United States and abroad) to provide strong guidance on the technical issues. The political challenges are undoubtedly considerable. But we do believe that one of the biggest problems the State faces is that it has over-politicized electricity, and tried to obfuscate the reasons for the crisis. With the 2002 gubernatorial elections over, one can only hope that political concerns can be subordinated to the public interest for a period sufficient to allow reform opportunities to be embraced. Filed under: White Papers Tagged under: Utilities About the Author Chris Trayhorn, Publisher of mThink Blue Book Chris Trayhorn is the Chairman of the Performance Marketing Industry Blue Ribbon Panel and the CEO of mThink.com, a leading online and content marketing agency. He has founded four successful marketing companies in London and San Francisco in the last 15 years, and is currently the founder and publisher of Revenue+Performance magazine, the magazine of the performance marketing industry since 2002.