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Assessing the California Energy Crisis
By Mark W. Seetin

The New York Mercantile Exchange "NYMEX," established in 1872, is the largest energy futures exchange in the world and the only futures market in the United States devoted exclusively to pricing, hedging, and trading industrial commodities. The merger in mid-1994 with Commodity Exchange, Inc. ("COMEX,") that provides a forum for trading gold, silver and high-grade copper futures contracts, created the world's largest physically based commodity exchange.

The Exchange pioneered the development of energy futures and options. From a modest 34,000 heating oil contracts traded in 1978, NYMEX energy futures and options volume grew to more than 89 million contracts in the year 2000 and now includes crude oil, gasoline, natural gas, electricity and propane, in addition to heating oil.

NYMEX provides the world's most efficient forum for energy price risk management. The visible and highly competitive daily trading of energy futures and options on the exchange provides a true world reference price for each of the commodities traded.

NYMEX has no stake in the direct outcome of the current crisis in the California electricity market. As a regulated, neutral public marketplace, it draws no direct benefit from either higher prices or lower prices. NYMEX only seeks the opportunity to compete in the provision of marketplace services, having never sought the role of government-granted franchise to provide these services. In fact, NYMEX has expressly fought against the establishment of government-created or -sanctioned franchises to serve as marketplaces for electricity, believing those institutions should develop in response to market forces alone competing for the business of market participants in the same way that market participants should be competing with each other.

NYMEX has been an active participant in regulatory and legislative proceedings related to electricity deregulation and restructuring at both the state and federal levels since 1994. Directly related to California electricity "deregulation," the Exchange provided testimony four times before the California Public Utilities Commission ("CPUC"), two times before the appropriate California Legislature committees, and more than a half-dozen times before the Federal Energy Regulatory Commission ("FERC"). The Exchange has provided formal written comments in these proceedings on about two dozen occasions. The theme of our testimony and comments has been consistently to support true market competition.

The debate that has taken place over the years regarding electricity deregulation or restructuring has been largely one between supporters of government intrusion to induce prescribed results and the supporters of unmolested competition. To date, there are no examples of a truly competitive free market for electricity in the United States.

Critical Market Considerations Have Been Ignored

The area of consideration where NYMEX has provided most of its input has been on market structure. NYMEX has advocated allowing market structure to develop on its own without government interference. Unfortunately, we have not been very successful in this pursuit. California, in particular, rejected this position. In response to this, in proceedings before the CPUC and legislative bodies in 1995, NYMEX predicted the ultimate outcome of California's policies to be lower competition, higher prices, and lower consumer value. The past eight months these predictions have become manifest.

The chronicle of California's attempts to create a competitive market for electricity is one of mistakes and missed opportunity. California missed the opportunity in the mid-1990s to foster the creation of a truly competitive electricity marketplace. Our remarks today are intended to address the two most frequently asked questions; 1) What went wrong with California's efforts to deregulate the electricity market, and; 2) How can it be remedied?

Mark W. Seetin is vice president for government affairs of the New York Mercantile Exchange. This commentary is based on his April 12 testimony before the U.S. House of Representatives Committee on Government Reform hearing on the California energy crisis.

What went wrong in California?
To call the product of the 1995-96 regulatory and legislative process "deregulation" flies in the face of all generally recognized and accepted definitions of the term. Indeed, as a result of the implementation of AB 1890, and California Public Utility Commission rulings and orders, the regulatory "overburden" of the electricity market in California arguably increased dramatically through the creation of the California Power Exchange (PX) through which the utilities were compelled to buy and sell their electricity, as well as the rules adopted within the PX regarding the "one price clears all" pricing method, and the calculation of the Competition Transition Charge (CTC) designed to compensate utilities for their "stranded costs." The net effect of the legislation and rules was to create a monopoly power exchange, and, worse, force the bulk of the California electricity market into a "day ahead" spot market, instead of allowing the market to choose its own venue of exchange, and terms of commerce. The CPUC went even further in attempts to "micro manage" in last year's actions to effectively forbid the use of commonly used financial instruments such as direct contracts, forward contracts, futures and options, with the sole exception being that of the use of the Power Exchange's "block forwards." The result of that disastrous combination of policies is evident today, as California faces the most serious threat to its electricity marketplace ever. At this time, under AB 1X passed in January, the state of California, through the Department of Water Resources (DWR), is the sole legal buyer and seller of electricity. While the DWR supplanted the now-defunct PX because the utilities had become "insolvent," the net effect is that the California electricity market remains a government monopoly.

How can it be remedied?
Direct access is key because it is the epitome of what is meant by market competition. The engine of competition in any market is the head-to-head competition for a customer that takes place between suppliers of the market's underlying product. Rivalries develop in such head-to-head competition and these rivalries lead to experiments to better serve customers through innovations in product and service or the lowering in cost. The competitive process cannot take place unless the seller directly serves customers - otherwise there is no market whatsoever and no sales. This is how competitive free markets operate for virtually every product and service.

This might seem obvious to the average person, but under "deregulation," electricity has operated according to a different paradigm that has relied to a varying extent on market artifices to serve in the middleman function. The artifices are state-created or -mandated franchises to serve simultaneously in the role as buyer for any (sometimes all) sellers and seller for any (sometimes all) buyers. They have consistently been formed to serve the spot market (i.e. next-day market, hourly market over the next 36 hours) and to clear offers to sell at one price.

It is no accident that where electricity markets have been structured to rely more heavily on this type of artifice, the development of direct access has been more inhibited and the level of real market competition has been muted. As a case in point, California was expressly designed to frustrate the development of direct access. The consequence of this action was eventual disintegration of competition, higher prices, and virtually no customization to better serve customers.

Ironically, direct access has not been the central consideration in either state or federal proceedings to date to "deregulate" electricity. In some venues, it has been accorded serious consideration, but even in these circumstances, the major focus has been on developing competition in generation. This has been conducted without regard precisely to how end-users would directly participate.

NYMEX is of the opinion that direct access is the most critical component of a truly competitive market. In fact, without direct access, there can be no truly competitive market. With respect to competition in generation, suppliers would have at least as great an incentive to reduce their generating costs in serving a direct access market as one where they are steered into selling to a government-franchised artificial buyer. Furthermore, direct access is the only vehicle through which the customized needs of end-users would be served.

NYMEX is of the opinion that direct access is the most critical component of a truly competitive market. In fact, without direct access, there can be no truly competitive market.

Under the alternative to direct access, transactions are concentrated in the state-franchised spot market pool, which is subject to greater overall price volatility and higher incidence of spiking prices. Tending towards the extreme, California adopted policies that drove the overwhelming majority of their transactions into the spot market. In contrast, a market centered on direct access transactions would never find itself at the mercy of the spot market to the extent California has been. There would be far greater reliance on forward contracting.

Coupled with direct access is the critical component of access to the transmission system. Access to firm transmission is the essential "third leg" of a California recovery program. It is axiomatic that there be "user friendly" access to the transmission system to complete and perform the obligations of commercial transactions. For example, for all the goods and services delivered by truck there must be an accessible road and highway system for the deliveries to be completed. Analogous to this, in electricity it is absolutely essential for buyers and sellers to be able to acquire and transfer rights to firm transmission in the electricity grid so that they can be assured they can meet the delivery obligations associated with their commercial operations. As in other markets, it is contemplated that rules and procedures ensure fair, competitive, and effective use of transmission capacity.

In fact, the California Independent System Operator ("ISO") presented such a system in January. The Independent System Operator ("ISO") staff presented a framework to deal with system congestion in a way that was supportive of direct access. Their proposal comes under the generic heading of a "physical rights" model that provides the greatest possible support for direct access. While the California grid is in great need of upgrading and enhancement, a congestion management plan such as the ISO staff developed for action last January was the correct remedy for congestion-induced inefficiencies. This plan would harness market efficiency to enhance the overall performance of the transmission system. This is because, in addition to engineering criteria, it maximizes the market performance of the system based on market incentives as well. Tragically, this has been completely absent from California's market. The California Senate and Assembly should urge the ISO to immediately submit a congestion management plan to the Federal Energy Regulatory Commission ("FERC"), so the tools necessary for California's "electricity recovery program" can be available as soon as possible.

California's major flaws were that it undercut the development of direct access and forced its market to rely artificially on the spot market. It did this through mandating participation in the spot market by utilities, applying the add-on competition transition charge ("CTC") to artificially render direct access transactions as uneconomic, and not providing an effective program for firm transmission. The result has been very limited participation in direct access in California. The remedy for this serious flaw is to immediately implement direct access with as few restrictions and as much flexibility as possible.

Conclusion
Perhaps the single most important thing that California failed to do in avoiding a supply and price crisis was to remove impediments in the electrical grid to true competition among buyers and sellers of electricity. Any California plan that addresses this issue should support direct access to the market for all buyers and sellers - the current system still greatly restricts access. California's plan relied on market artifices, frustrating the development of direct access and driving an overwhelming majority of transactions onto the "spot" market, where one is forced to trade only "day-ahead." The result of the monopoly Power Exchange's "spot" market was higher volatility and higher prices for electricity. Buyers and sellers of power could not be reasonably assured that they could make or take delivery of electricity in forward contracts. The California plan stressed developing competition among generators, but failed to provide for the most critical component - direct access. This and other critical factors, such as access to firm transmission on the power grid, which support truly competitive markets, were omitted in the California plan. These omissions must be remedied for a real and sustained recovery from the current debacle to occur.