This article is from Cal-Tax Digest, published
by the California Taxpayers' Association.
Cal-Tax Home Page | About Cal-Tax | Subscribe

There is plenty of blame and finger-pointing going on as people try to explain what went wrong with California's moribund attempt at partial electricity deregulation. There is no doubt that virtually every supporter of this system got it wrong to some extent. Unfortunately, the real tragedy is that, even given the restructuring law's failed implementation, this crisis did not even have to happen at all. Quick, decisive action to correct the problem once identified could have prevented it from escalating into a crisis - a crisis that will have a severe and lasting impact on electric consumers, taxpayers, and the California economy.

The fundamental problem is an imbalance between the supply side and the demand side of the state's electricity market. This problem was further magnified by a price cap on the demand side that sheltered and insulated electric consumers from the upward pressure on wholesale market prices that result when you have limited supply and unfettered growth in demand. It is like the "perfect storm" where two converging forces magnify the intensity of the maelstrom.

Electricity deregulation is a national phenomenon that is evolving at different paces and under different structures throughout the country. The California Public Utilities Commission (CPUC) took a leadership role in pushing for deregulation when they issued their infamous "Blue Book" in 1994. California had electric rates that exceeded the national average by over 50 percent and the CPUC, prodded by large industrial customers and consumer activists, were demanding open access to cheaper energy sources. Regulated utilities, faced with the prospect of writing off costs that they were required to incur under regulation, needed a transition period that would allow for the recovery of previous shareholder investments. Procurement costs, as always, were assumed to be a pass-through cost unaffected by the rate cap.

What emerged from the deregulation discussions was a grand compromise that was supposed to provide something for everyone. In 1996, AB 1890 was passed unanimously by both the state Senate and Assembly and signed by the governor.

California's investor-owned utilities, i.e., San Diego Gas & Electric, Pacific Gas & Electric, and Southern California Edison, supported the deregulation legislation as an acceptable alternative to the CPUC's original, draconian version.

Utilities agreed to cap rates at 10 percent below then-current levels over a transition period of five years, sell at least 50 percent of their generating assets to alleviate market control concerns, relinquish control of all transmission assets to the state's Independent System Operator, and purchase all electricity demanded by their distribution customers from a newly formed Power Exchange at spot market rates. Utilities were required by law to obtain all power demanded by their customers as the "default provider" under their regulated "obligation to serve."

Anthony L. Smith 
is vice president and director of taxes at Edison International and its utility subsidiary, Southern California Edison.

The first landmine went off in March 1999 when wholesale prices in the Power Exchange spiked from an average of about 3¢ per kilowatt hour (kWh) in March of 1999 to 22¢ per kWh by year end. Despite the utilities' pleadings, the CPUC steadfastly held that the rate cap prohibited passing on procurement costs to customers. Because the utilities are obligated by law to purchase power for electric consumers as the default provider, they were forced to borrow billions of dollars to purchase energy on the spot market through the California Power Exchange and to sell that power at capped rates substantially below that cost.

The irony is that the utilities are prohibited from making any profit on the procurement and sale of electricity. As we all well know, however, there is significant downside risk when a business is forced to purchase a product for sale to consumers but is prohibited from raising its sales price to cover the cost.

The Path to a Resolution
On April 6, Pacific Gas & Electric filed for reorganization under Chapter 11 of the U.S. Bankruptcy Code. The company said it was taking this action in light of its unreimbursed energy charges that were increasing by more than $300 million per month, continuing CPUC decisions that economically disadvantage the company and a breakdown of negotiations with the state over resolution to the crisis.

On April 9, Southern California Edison and Governor Davis announced agreement on a plan to restore the utility to financial health. The decision to enter into such an agreement was tough and difficult. However, the threat of bankruptcy makes this agreement the only real choice for Edison.

According to Edison International Chairman, President and CEO John Bryson, "This negotiated resolution with the governor is far preferable for our company, our employees and our customers than is going into bankruptcy." Although further action is needed by the Legislature and the CPUC, this agreement is a practical approach that protects customers and the state's economic vitality by restoring the utility to financial health. In this way, SCE can retain experienced, skilled employees and invest the billions of dollars necessary to maintain a sound electric system. Terms include:

• The state will receive a primary utility asset - SCE's 12,000-mile transmission system. SCE employees will operate and maintain the system through a contractual arrangement with the state.
• Edison International and SCE commit to no less than $3 billion of capital investment in utility infrastructure over the next five years.
• For the next 10 years, SCE will sell the output from its power plants under cost-based, rather than market-based, pricing.
• For the next 10 years, Edison Mission Energy's unregulated Sunrise power plant will sell its output exclusively to California under cost-based pricing.
• SCE agrees to forego development of 20,000 acres of its Big Creek and Eastern Sierra hydroelectric properties and grants conservation easements in perpetuity to the state for land and habitat preservation on these properties.
• SCE will gain a means of repaying the debt it incurred buying power for its customers during the rate cap period.
• Upon implementation of this agreement by the Legislature and the CPUC, SCE will drop its lawsuit against state regulators.

SCE would never have agreed to give up its transmission system, just like the utility did not initially want to sell its power plants. And, just as in the case of its power plants, Edison is being forced by circumstances beyond its control into the decision to sell them.

Edison continues to believe that this agreement is better for all concerned than facing a bankruptcy proceeding. This agreement provides reasonably priced power to customers, while helping start the process of recovery for the state from this energy crisis. It also provides the state with tangible assets in exchange for the utility's financial viability - not a bailout, but recognition of the importance of financially sound utilities and of the need for the state to provide laws and regulations which ensure a healthy electric system for Californians.

The next two years will be difficult as the state sorts out this complex issue and more power plants begin to come on-line. Supplies will be short and demand must be curtailed. While it will take time to fix all the ills of this failed deregulation scheme, this memorandum of understanding represents a great first step towards that goal.

On April 9, Southern California Edison and Governor Davis announced agreement on a plan to restore the utility to financial health. The decision to enter into such an agreement was tough and difficult. However, the threat of bankruptcy makes this agreement the only real choice for Edison.

Hypothetical Business Case
The California energy crisis is complex, and there is a tremendous amount of misinformation, demagoguery and political rhetoric that confuses an already complex problem. But to put the problem in a form that can be readily understood, I offer the following hypothetical example.

Hypothesis: The California business community and consumers at large believe that gasoline prices are too high and that oil supply and refining companies should not be in control of gasoline retail operations. As a result, a law is enacted that is intended to restructure the market and eliminate market control with the objective of lowering prices at the pump.

First, the legislation requires oil companies to divest their retail gas stations into separate retail gas distributing companies. The new law also requires all of the separate retail gas distributing companies to purchase gasoline through a newly formed independent market-clearing house at daily market prices. The state does not want the new gas distributing companies to lock in the current high prices so it also prohibits the gas distributing companies from entering into any long-term contracts. After all, everyone believes that gasoline prices are too high and that this new structure will result in lower prices.

The new gasoline restructuring legislation recognized that there would be substantial startup cost to separate and form the new gasoline distributing companies, so they imposed a freeze on gas prices for a five-year period at the then current high price of $1 per gallon.

To the extent that gasoline-distributing companies could purchase gasoline at market prices below $1 per gallon, they could use the difference to pay for this startup cost until it was fully recovered. Any difference above that cost recovery would, of course, be refunded to their retail customers.

The state also requires the gas distributing companies to sell gasoline on a nondiscriminatory basis to all and any customers at $1 per gallon and will impose civil and criminal penalties to any retail gasoline distributor that does not have an adequate inventory to serve all customers demanding gasoline.

While prices were expected to decline to about 50 cents a gallon, the capacity of refining facilities was restricted and no new refineries were built, causing a reduction in supply. Also, over the last few years, customers bought bigger vehicles that consumed more gas and drove more miles for commuting and vacation travel, increasing the demand for gasoline. After all, $1 a gallon is not a bad price.

Over time, these supply pressures eventually caused the oil companies to increase the price they bid into the California market and all of their output production was purchased as required by the gas distributing companies. The market clearing price for gasoline ranged from $3 to $65 per gallon and averaged $15 per gallon, but the demand continued to increase because, by law, retail customers could still purchase the gas for $1 per gallon.

The retail gasoline distributors were screaming. They had reached their capacity for borrowing money to buy gasoline and could not continue to borrow money to buy gasoline at a loss without some promise for recovery of the higher cost. They tried to get the message out to their customers to conserve by buying more efficient vehicles and using public transportation, but the public did not respond in any meaningful way. After all, $1 per gallon is affordable.

The gasoline distributing companies also requested approval to enter into long-term contracts to purchase gasoline at prices lower than the spot market price, but the state denied that request because they believed the spike in prices was temporary and they didn't want the gas distributing companies to lock in prices over $1 per gallon for a number of years.

Hypothesis: The California business community and consumers at large believe that gasoline prices are too high and that oil supply and refining companies should not be in control of gasoline retail operations.

Soon, the gasoline distributing companies could no longer borrow money to purchase gasoline and some gas stations ran out of gas for periods of time. Customers were irate and demanded that the government solve this problem. The government stepped in and began purchasing gasoline in the open market at $15 per gallon, but was adamant that they would not increase prices to retail consumers more than 10 percent. The government, however, soon learned that they too could not continue to purchase gasoline for $15 if they could only charge $1.10. The cost was depleting their reserves at a rate of $50 million per day.

The gasoline distributing companies were also demanding that prices be raised to $15 so that they could pay off the debt they had incurred to purchase gas for their customers and avoid bankruptcy, but the government and the public opposed any increase to "bail out the gas distributing companies."

The retail consumers were irate and believed that there was no real gasoline shortage. They believed the gasoline companies were ripping them off and demanded that the government take action - whatever action necessary short of increasing prices.

The government began negotiating with the oil refineries to purchase gasoline under long-term contracts, and they were successful in negotiating contracts at $3 per gallon for the next 10 years for about 65 percent of the supply. The other 35 percent would continue to be purchased in the spot market at market rates that were still averaging $15 per gallon.

The government also began to slash red tape constraining the siting of new refineries, but it takes years to build enough capacity to balance the supply with the demand, especially when retail customers are only paying $1.10 per gallon.

Conclusion: While this hypothetical is a ridiculous, farfetched nightmare, it bears a close resemblance to the failed attempt to restructure and partially deregulate electricity in California. The lesson should be clear to anyone with a rudimentary understanding of the economic laws of supply and demand: the solution to the problem, while painful in the short term, is the only effective way to work our way out of the current crisis and avoid a more serious collapse of the system.

Prices must seek their own level. Price increases are the most efficient vehicle to stimulate a voluntary reduction in demand and will result in downward pressure on wholesale prices. The market cannot operate efficiently unless both ends - supply and demand - are free to seek equilibrium.