1 Lessons from the California Crisis for the Restructuring of Russia’s UES GET Conference at New Economics School Moscow, Russia October 3-5, 2002 Geoffrey Rothwell Department of Economics Stanford University

2 Abstract This presentation reviews the Californian energy crisis following deregulation of electricity generation and the restructuring of the electric utility industry. Three causes are discussed: (1) the lack of markets for long-term supply contracts, (2) the lack of demand response, and (3) conflicting jurisdictions in policing abuses of market power. Three lessons for UES restructuring are presented: (1) care must be taken to design markets that remunerate fixed costs, (2) consumers must be given clear market signals, and (3) a regulatory structure must be established to police market power and regulate natural monopoly segments of the industry.

3 Lessons from the California Crisis for the Restructuring of Russia’s UES Based on Chapter 6, “The California Power Sector,” in Rothwell and Gomez Electricity Economics: Regulation and Deregulation, being published by the IEEE Press through John Wiley, originally written for the Russian Federal Energy Commission, through the World Bank with funding from Spain

4 Why did California Deregulate?: High Prices!

5 History of Deregulation in California 1992: US Energy Policy Act — created Exempt Wholesale Generators and non-discriminatory transmission access 1996: US Federal Energy Regulatory Commission (FERC) issues rules on uniform access to transmission and stranded cost recovery 1996: California legislature passes bill mandating competition among Investor Owned Utilities (“Utilities”) 1997: California Public Utilities Commission (CPUC) issues implementation rules, such as universal Retail Choice 1998: California’s spot market for electricity opens 2000: California energy crisis begins with high wholesale prices and “rolling blackouts” 2001: Energy crisis ends with California state intervention

6 Divestiture of Generating Assets: (1) 18,000 MW of fossil-fuel plants sold by Utilities to “merchant” producers (2) Utilities given opportunity to recover difference between book value and market value of generating assets, (“stranded assets”) over 4 years through the “Competitive Transition Charge” (CTC) (3) Consumers required to pay CTC for up to 4 years (4) Consumers prices frozen at 90% of 1996 rates until CTC is paid  CTC ends in San Diego in Spring 2000: rates double

7 Transfer of Control of Transmission Assets: (1) Utilities retained ownership of transmission assets and responsibility for building new assets (2) Independent System Operator (ISO) assumed control of transmission network on day-to-day basis (3) Transmission charges subject to regulation under Performance-Based Ratemaking (PBR)  Transmission assets might be sold under bankruptcy

8 Distribution and Retail Choice: (1) Utilities retained ownership of distribution assets with charges subject to PBR (2) Utilities continued to bill consumers (3) Consumers could choose their electricity provider under universal Retail Choice  Retail Choice was terminated in October 2001

9 Power Exchange (PX): Day-Ahead and Day-Of Markets (1) Utilities must buy and sell electricity through the PX (2) For each hour, suppliers (Utilities and Merchants) and demanders (Utilities and Energy Service Providers) bid price and quantities (3) PX determined Market-Clearing Price for each hour (4) PX announced Market-Clearing Quantities to the ISO (5) System works well from March 1998 to March 2000  PX was terminated January 31, 2001

10 The California Market (representation of March 1998-March 2000)

11 Natural Gas Prices in California (dollars per 1000 cubic feet, monthly averages)

12

13 “Causes” of the California Energy Crisis (1) Requirement that Utilities purchase electricity in the spot market without long-term contracts (2) Lack of demand response due to rate freeze because of payments for stranded assets (3) Conflicting jurisdictions in policing abuses of market power

14 Abuse of Market Power? “California Power Failures Linked to Energy Companies” New York Times September 18, 2002 By John M. Broder LOS ANGELES, Sept. 17. Widespread power failures during California's energy crisis of 2000 and 2001 could have been avoided if five independent energy companies had not withheld electricity they were capable of producing, a study by state regulators said today. This contributed to the "unconscionable, unjust and unreasonable electricity price spike that California experienced during the energy crisis," the report said. The California Public Utilities Commission did not directly accuse the companies of deliberately trying to drive prices up. Officials said investigations were continuing into possible price manipulation and collusion among the companies.

15 Abuse of Market Power? “Judge Concludes Energy Company Drove Up Prices” New York Times, September 24, 2002 By RICHARD A. OPPEL Jr.. with LOWELL BERGMAN WASHINGTON, Sept. 23. An administrative law judge concluded today that the El Paso Corporation illegally helped to drive up prices for natural gas in California during the state's power crisis in 2000 and 2001, the first time any federal regulatory official has determined there was widespread manipulation of energy supplies. California officials and one of the state's major utilities, which argued the case in hearings at FERC, said they would seek to recover nearly $4 billion in what they contended were higher power and gas prices caused by El Paso's actions. The ruling sent shares in El Paso down $4.16, or 36 percent, to $7.51.

16 Lessons for UES Restructuring: (1) Care must be taken in designing markets so that the fixed costs of providing generating capacity are remunerated (2) Consumers must be given the opportunity to respond to changes in rates given their low short-run elasticities of demand (3) The regulatory structure must be able to (a) contain abuses of market power in generation (including abuses of monopoly power in natural gas and other input markets) and (b) regulate prices for transmission and distribution services