What will the paper pushers finally do?
energy.senate.gov
Full Committee Hearing Testimony:
Hearing: To receive testimony on California's Electricity Crisis and Implications for the West
Date and Time: January 31, 2001, 9:30 a.m.
Location: Senate Hart Office Building, Room SH-216
Witness Name and Title: Larry Makovich, Senior Director of Research, North American Electric Power, Cambridge Energy Research Associates, Cambridge, MA
Testimony: California Power Crisis: What are the Real Lessons?
When California passed its electric power restructuring law in 1996, it prided itself withwith being on the leading edge of deregulation in the United States. when the state passed its power restructuring laws in 1996. At that time, the state took on the daunting task of power deregulation for good reasons. The state's power prices were among the highest in the country, and the industry was mired in a complex regulatory system that promised to lead to still higher prices.because the inefficiencies of traditional regulation made California’s power prices among the highest in the country. The hopes were that deregulation would deliver lower prices and that California would be a model for other power markets to follow. That's not what happened. The results, instead, are today’s power crisis: stand in stark contrast to the shortages, skyrocketing prices, induced prices run-ups rolling blackouts, financial distress and political turmoil.
Today, one of the biggest problems in California is that no one can agree on what went wrong. Customers, regulators, politicians and power producers are all pointing a finger at each other to assign blame. Although tempting, it would be incorrect to blame the problems in California on deregulation itself. Indeed, there is a grave danger of drawing the wrong lessons. If this crisis drives California back to the heavy-handed regulation and control that launched power restructuring in the first place then the state is likely to find its electric sector becoming increasingly inefficient and expensive—and very much disadvantaged compared to regions with properly structured power markets. California is now at a critical juncture—the state can go backwards by reregulating—or even taking outright ownership—or the state can fix the flaws in its power market. The latter is the way to go.
Urgent action is needed not only to meet the current crisis but swift and dramatic steps are needed to avert an ever more severe shortage in the coming summer.
THE REAL LESSONS
The real lesson of the California power crisis is that there is a right way and a wrong way to set up and run a power market. California's electricity crisis is the result of three critical failures:
California set up its power market with serious structural flaws that made timely investment in new power supply neither possible nor profitable. These flaws were part of the California market design right from the start of deregulation. Consequently, the current power crisis was both inevitable and yet could have been prevented.
It has been enormously difficult to site and build new plants in the state. California has perhaps the most daunting power plant approval process in the nation. This process and the inability to site have thwarted efforts by companies to build the new power plant facilities that could have averted the supply shortfall.
Although described as "deregulation," the California system is only a partial deregulation. Customers remain under controlled prices (retail) that are well below the prices paid by utilities to generators (wholesale). This is a fundamental misalignment between the two parts of the market that creates a liquidity problem for utilities and disconnects the demand side from the market.
The crisis in California arose because people believed that electric energy markets were just like other commodity markets—when demand and supply tightened up then prices would gradually rise, stimulate investment and keep supply and demand in balance. That assumption, however, is wrong. P However, power markets are not like other commodity markets. The power business is complex and has due to unique characteristics. Research over several decades pointed out that These characteristics led economists to develop a complete but rather obscure literature from the 1920’s to the 1970’s concerning how to set up a power market the right way. Their message was clearpower markets are far more challenging to set up properly than most other markets. The system that was set up in California could have taken these realities into account—and come out with a good result. The system that was set up did not take these realities into account—with the results that we now see.
WHAT TRIGGERED THE CRISIS
The flaws of the market design prevented supply from keeping up with demand. Five years ago, when California passed its power restructuring legislation, the state had a surplus of power generating capability. Since that time, the California economy grew a phenomenal 32 percent, fueled by a 24 percent increase in electricity consumption. The fact that electricity use increased less than overall economic growth meant that the state was becoming more efficient in its use of power. Yet conservation and greater efficiency could not stem the need for additional supply. By 1998, demand growth had ended California’s power surplus. The record of the past five years is clear—California failed to approve the siting and permitting of anything near the 1,200 Mw needed each year to keep demand and supply in balance. As a result, far too few new power plants were added to California’s power sector over the past five years. Moreover—and this point needs to be faced—not enough power plants are currently under construction to end this shortage in the near term.
Why was new generation not added? That is the heart of the matter. The California power market was simply not designed to add enough generating capacity at the right time.
THE MARKET DESIGN
California’s restructuring law involved sweeping changes that did many—but not all—of the things necessary to make a power market work properly. The legislation unleashed competitive forces: customers could by allowing customers to choose choose electric service providers (ESPs); utilities were required to divest at least 50 percent and by requiring divestiture of at least 50 percent of their generating capacity owned by incumbent utilitiesto set upto create a large number of independent rival generators. The legislation replaced the existing decentralized wholesale power market with a centralized energy market called the California Power Exchange (PX). Another institution called the Independent System Operator (ISO) became the traffic cop in the transmission grid that physically interconnected the electric consumers and producers. The ISO also ran a market for other services power plants provide (for example, voltage control) to manage power flows on the grid.
The California restructuring plan faced a particular complication —was complicated by "stranded costs." The traditional utilities had billions of dollars of costs that could not be recovered at expected market prices. Thus, California included a transition plan to move to a market while recovering these above market costs. To do this, the state backed utility bonds to finance a rate reduction of 10 percent along with the establishment of a retail price cap with a competitive transition charge—otherwise known as the or "CTC." The CTC was the difference between the retail rate cap and sum of all power costs, including the wholesale power price. The retail price cap and its associated CTC expired once a utility recovered enough revenues to cover stranded costs. At this point, utilities remained obligated to serve customers by buying power from the power exchange and passing along this cost. The California crisis exploded when stranded cost recovery began to end and thousands of customers were released to the market just in time for the shortage to hit with far too little additional power supply in the works. As an emergency measure, the state returned to price caps to counter the shortage driven price shocks.
TOO FEW NEW PLANTS: OBSTACLES TO SITING
The state's approval process creates significant obstacles to building new plants. These includeThe market flaws that caused the shortage were barriers to entry and the lack of a capacity payment mechanism. The barriers to entry in California arose from an open-ended environmental review process, tough siting and permitting procedures and well-organized community opposition. These hurdles make California one of the most difficult places on earth to build a power plant. As a result, year after year, the state failed to approve anything near its annual requirement for new supply to keep up with its growing demand.
TOO FEW POWER PLANTS: INSUFFICIENT INCENTIVE TO ADD '"CAPACITY"
Even without these obstacles to siting and building, no barriers to entry, California set up a power market guaranteed power prices that were too low to support enough timely investment in new supply. California set up an energy market that paid power generators to run their power plants but did not set up any market mechanism to pay generators for capacity—in other words, no capacity price signal to create an i ncentive to bring on new capacity. This meant that prices were lower in the short run, but it also meant that prices would eventually explode in a future shortage.
Long ago, economists recognized that Ssetting up a power market with the right price signals the right wayrequiresd payments for two electric commodities—energy and capacity. For example, when someone turns on a 100-watt light bulb, the power system needs to have a power plant with the capacity to produce an additional 100 watts of power. If capacity is available to meet this demand then utilization of the capacity through time can produce the watt-hours of energy. Unlike other commodities, electric energy is not stored in an inventory and thus requires capacity as well as utilization of that capacity to meet customer needs. Unlike other non-storable commodities like telecom, a busy signal (a blackout) is not an acceptable way to get around this capacity requirement —because, when you're talking about electric power, a "busy signal" takes the form of a blackout.t.
California needs enough capacity at any point in time to meet the sum of customer demands —for example, ten 100 watt bulbs add up to a kilowatt of demand and 1000 kilowatts add up to a megawatt. During the summer time when air conditioners are humming, California reaches a peak demand of about 53,000 megawatts. Since generating capacity can break down or hydroelectric capacity can vary depending on how much snow there was the previous winter,conditions can vary, California like any other power market needs a capacity reserve—an additional 15 percent or so of capacity to insure that supply meets demand at all times. This margin provides the cushion that can absorb shocks caused by shortfalls in supply or surges in demand. In California, that cushion was eliminated by the growth in demand, on the one side, and lack of new capacity on the other.
Five years ago, when California passed its power restructuring legislation, the state had a surplus of power generating capability. Since that time, the California economy grew 32 percent and became more efficient in its electric consumption—electric consumption increased 24 percent during that time. Yet conservation and greater efficiency could not stem the need for additional supply. Demand growth ended California’s power surplus by 1998. The record of the past five years is clear—California failed to approve the siting and permitting of anything near the 1,200 Mw needed each year to keep demand and supply in balance. As a result, far too few new power plants were added to California’s power sector over the past five years and currently, not enough power plants are under construction to resolve this shortage in the near term.
Although compelling evidence of a developing shortage was apparent, most industry observers were complacent due to the belief that when new supply was needed the energy price would rise and bring forth new power plant in time. This faith in the energy market was ill founded. The California energy market alone was incapable of providing a timely investment signal because it was successful in doing the job of providing a price signal to efficiently utilize existing power plants.
Most of the time the amount of generating capacity available to meet customer needs exceeds the sum of customer demands. Thus the typical problem for a power market is to figure out which plants ought to be running to minimize production costs at any hour. To do this, sunk costs are irrelevant and competition should drive energy prices to reflect the short run costs of rival producers—even at time of peak. The evidence in California is compelling—as long as a surplus existed, the wholesale energy market cleared on the basis of short run production costs with a level and volatility that was half of what was needed to support new investment. Similarly, when demand and supply were in balance, energy prices continued to reflect production costs. Even in a slight shortage during 1999, competitive forces were so strong that the energy market did not break significantly from production costs.
When the market tipped to a severe shortage in 2000, energy prices soared and volatility exploded to levels that were multiples of what was needed to support new investment. Besides being higher than needed to support investment, these price increases were also too late. The price signal for new investment needed to come several years before demand and supply reached balance to account for the lead time needed to site, permit and construct new power plants.
Clearly, a properly structured power market can not rely on periodic shortages and reliability crises to provide timely investment incentives. Instead, a properly structured power market needs a capacity payment mechanism. This begins with the simple requirement that anyone selling electric energy to customers must also buy enough capacity to cover these customers capacity needs plus a reserve. A capacity requirement met by the right type of bilateral contract or through a formal capacity market can provide the timely price signal needed to avert shortages and keep power markets in balance in the long run.
HOW OTHER STATES HAVE SOLVED THE PROBLEM
California’s lack of a capacity payment mechanism stands in stark contrast to other restructured power markets such as Texas, New England and the Middle Atlantic region. For example, Texas had a market rule that required anyone supplying electric energy to customers to also have enough capacity (either owned or under contract) to meet demand plus a reserve. As a result, power developers in Texas expected to sell both the capacity and energy from power plants. Besides looking more profitable due to two revenue streams instead of just one, building new electric supply in Texas was also possible. Texas approved the siting and permitting of more than enough new supply to keep the market in balance. Texas implemented its restructuring program after California and with less of an initial capacity surplus. The Texas power market is about the same size as the California market, yet last year Texas added over 5,000 Mw of new supply and expects to add 8,000 Mw more this year.
SHORT TERM ACTION
California is currently about 5,000 Mw short of supply. Unfortunately, there is no quick fix. Nevertheless, there are many short run actions that can reduce demand and add supply. These measures include:
Find more conservation and interruptible load on the demand side.
Add greater flexibility in legal and environmental limits on the power supply side. For example, the back-up and emergency generating systems at hospitals, hotels and office buildings in addition to barge mounted and mobile emergency power sources could provide a critical amount of additional supply in short order.
Reactivate mothballed generating units.
Expedite permitting and construction of power development already underway in California.
Unfortunately, actions taken so far do not address the underlying problem and in some cases are making matters worse. The retail price-freeze solved the price shock problem of this shortage but created a grave a serious liquidity problem. The state's utilities are trapped in a sort of no-man's land, between high wholesale prices and regulated, frozen retail prices. Forcing California’s utilities to buy power at levels many times greater than the level they can charge customers caused major utilities to accumulate over twelve billion dollars of uncollected power expenses in just the past six months. Besides bringing these utilities to the brink of bankruptcy, the liquidity problem makes power sellers very nervous about selling their power creates a disincentive to power sellers and never being paid.
The long run solution is clear—California needs a mechanism to pay for capacity and needs to approve development plans each year for enough capacity to close the current gap and keep up with demand. These reforms are not simple— instead of using the appropriate type of bilateral contract or making the proper rules for a capacity market, California could mistake long term energy contracts for the needed capacity payment mechanism and create massive take-or-pay obligations in the future. In addition, the politics of "not in my backyard" may subvert real attempts to site and permit needed supply.
FLAWED DECISION-MAKING
The problem in California is not deregulation itself. The system was only partially and not properly deregulated. The flaws in California’s power markets resulted from a flawed process of deregulation based on an idea riddled with uncertainties risks—stakeholder democracy. Stakeholder democracy is the belief that if all of the stakeholders of a problem are brought together, the correct policy will emerge through negotiation and compromise. Instead of independent, expert oversight, California intentionally designed large committees of stakeholders for the governance boards of the California Power Exchange and the Independent System Operator. When California formulated its deregulation policy with plenty of power plants already in place, it was no surprise that the majority of stakeholders voted not to pay for capacity as long as the reliability was free. Citizens and businesses throughout the West, as well as the utilities, are now stuck with the bill for what has turned out to be a huge and costly failure in deregulation policy formulation.
If this crisis drives California back to the inefficiencies of government regulation and control that launched power restructuring in the first place then the state is likely to find its electric sector becoming increasingly cost disadvantaged in the future compared to regions with properly structured power markets. California is now at a critical juncture—the state can regress by re-regulating or the state can fix the flaws in its power market.
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Lawrence J. Makovich is Senior Director for North American Electric Power at Cambridge Energy Research Associates (CERA) and heads CERA's Global Power Forum. His recent writings include: "A Crisis by Design:California’s Electric Power Crunch" and "Regulation versus Market Competition: Is Electricity Restructuring Changing Course?" His recent studies include, High Tension: The Future of Power Transmission in North America and Electric Power Trends 2001. |
