psr project group 1 california crisis-lessons learnt

7/31/2019 PSR Project Group 1 California Crisis-Lessons Learnt

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THE CALIFORNIA CRISIS

LESSONS LEARNT

Power Sector Reforms

Prof N.S. Saxena

NAME ROLL NO

Ajay Rawat 12EM02

Deepanker Sharan 12EM05

Manas Joshi 12EM07

Rituraj 12EM10


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TABLE OF CONTENTS

INTRODUCTION....................................................................................................................................................... 3

SEEDS OF CRISIS...................................................................................................................................................... 3

THE STATE OF AFFAIRS......................................................................................................................................... 4

A Risky Situation............................................................................................................................. ............................. 5

The Challenge................................................................................................................................................................5

The Crisis............................................................................................................................. ......................................... 7

LESSONS LEARNT....................................................................................................................................................11

References.....................................................................................................................................................................12


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INTRODUCTION:

The California electricity crisis, also known as the Western U.S. Energy Crisis of 2000 and 2001 was

a situation in which California had a shortage of electricity. The state suffered from multiple large-scale blackouts and one of the state's largest energy companies collapsed.

What pushed California over the edge was a perfect storm of events: a hot summer and cold winter,drought, high natural gas prices and a market design that prevented passing higher costs on toconsumers.

California crisis began with demand outstripping supply in the western United States in the summer of2000. That problem was quickly followed and overshadowed by financial catastrophe, as the utilitiesresponsible for selling electricity were forced to buy all of their power at wholesale prices many timeshigher than what California law permitted them to charge at retail.Political paralysis followed as lawmakers were unable to decide how to distribute the mounting,

multibillion-dollar debt among utility stockholders and creditors (through bankruptcy), customers(through higher rates), taxpayers (through assorted subsidies and bailouts) and generators(through federally-ordered rebates).

SEEDS OF CRISIS:

Basic problem underlying the California crisis was a fundamental imbalance between the steadilygrowing demand for power and the limited increases in generation and transmission capacity duringthe 1990s. That problem was made worse by an inadequate market design in which the wholesalemarket was based on an hourly spot market, retail price signals were not available to moderate the

demand and widely available concepts of risk management were not used. Beginning in 2000, acombination of market forces and external events including a hot summer, an extensive droughtthat crippled hydroelectric power production, high natural gas prices, an above-normal number ofpower plant outages and rapid economic growth precipitated the crisis .

Declining investmentThe National Energy Policy Act (NEPA) of 1992 deregulated wholesale power markets and gavestates in U.S. the impetus to begin moving toward retail competition. However, the ensuing transitioncreated considerable uncertainty in both wholesale and retail markets.This uncertainty stifled investment in the power sector because it introduced ambiguity into marketincentives for building generation facilities, increasing transmission grid capacity and providing

customers with better ways of managing their electricity usage. Ultimately, reduced investment in theelectric power infrastructure for more than a decade caused an imbalance between electricity supplyand demand .From 1988 to 1998, total U.S. electricity demand grew by nearly 30 percent but the transmissionnetwork grew by only 15 percent. Lack of investment in infrastructure made the state vulnerable to apower shortage.

Weather woesContinuing drought produced a dramatic decline in hydroelectric power production, which provided25 percent of Californias installed powerproduction capacity. Making matters worse, year 2000featured an unusually hot summer and cold winter. Anomalous weather increased the demand for

natural gas for both heating and electricity production, pushing gas prices upward. With Californiadepending on natural gas-driven turbines to provide nearly 50 percent of its internally produced
http://en.wikipedia.org/wiki/Californiahttp://en.wikipedia.org/wiki/Power_outagehttp://en.wikipedia.org/wiki/Power_outagehttp://en.wikipedia.org/wiki/California


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power, the price spike led to skyrocketing electricity costs. By January 2000, the price of a forwardcontract for power to be delivered in August had risen to $500/MWh.

Flawed Design of RestructuringThe supply problems were compounded by the design of Californias restructured power market. A

fundamental weakness of the states transition to a competitive market was that wholesale and retailmarkets were de-coupled, and that customers were never fully engaged in the new paradigm.Customers received no market signals to encourage demand response; that is, prices did not increasein times of electricity scarcity.

When California was hit by a combination of external events, the market design showed its manyvulnerabilities. First, the market transition was almost entirely dependent on an hourly spot market, inaccordance with state law. Second, the market organization was fragmented between a powerexchange and an independent system operator. And third, the market rules lacked incentives for eitherdemand-side participation or provision of sufficient capacity.

Last man bidding

Partly due to frozen retail rates and lack of incentives for utilities to pursue innovative pricingprograms, demands were bid into the market without any price elasticity. Thus, the market saw avertical, completely price inelastic demand curve. When a vertical demand curve (say, with high load)and a vertical supply curve (say, with low capacity) do not intersect or even lie close to each other, itleads to a condition known as the last man bidding problem.In other words, suppliers are rewarded for holding their bids off the market until the last minute,when buyers are desperate and high prices can be established. When that occurs, non-competitivebehaviour would arise under any auction design, whether uniform or pay-as-bid, causing the market tobreak down.The combination of those features produced significant price volatility and irregularity in Californiaspower market.

THE STATE OF AFFAIRS:

California went through three stages, all of which presented the State with opportunities for good orbad decisions. These stages were: (1) a risky situation that became (2) a challenge that turned into (3)a crisis.Each stage, and in fact the whole process, should be seen not as a series of random, disconnectedevents, but as a sequence in which choices were made at each juncture. To address problems (oftencreated by earlier policy decisions) at each juncture, alternative actions could have been taken. Giventhe political and economic forces at play, one can understand the logic underlying the decisions thatwere made.However, these decisions often created difficulties later. If different choices had been made at eachjuncture, they would have led to very different and probably much better outcomes.

California had very good reasons for restructuring its energy supply system.First, many experts believed that the vertically integrated system in place was not operating asefficiently as it could. Second, the system had very high costs. Third, the system did not seem toprovide enough incentives for investments in new generating plants. In 1992, the California PublicUtilities Commission (CPUC) began to develop a restructuring plan, which ultimately became thebasis of California Assembly Bill AB1890, passed in September 1996. The restructuring began withthe creation of a group of wholesale markets, with the understanding that deregulation had to beginwith wholesale electricity transactions. To control these new markets, the law created the Power

Exchange (PX) and the California Independent System Operator (CAISO). Creating markets forwholesale transactions was a sensible thing to do. The markets, however, were run as two separate


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organizations rather than as an integrated system, creating market inefficiencies and opportunities formarket manipulation. In addition, retail price controls were established and these served to isolate theconsumer economically from the producer of electricity. California had created at the wholesale levela volatile commodity market but had fixed sales prices for the investor-owned utilities at the retaillevel, a potentially untenable combination.

A Risky SituationThe legislature and the CPUC believed that the competition transition charge, a charge equal to thedifference between the price controlled retail price and the volatile wholesale price would besufficient for utilities to recover enough funds to pay for all of the stranded costs they had incurredprior to deregulation. These stranded costs were mostly based on a combination of green-powercontracts and nuclear power, two power supplies that had been costly under the old system.

The CPUC also ordered additional transition charges to fund the public-interest activities required ofthe utilities, such as a public-interest research program and demand-side energy managementprograms. The utilities were also required to divest themselves of most of their generating assets, and

it was made financially unattractive not to do so. This left the utilities with little generating capacity tofall back on.

Retail price controls meant that cost changes at the wholesale level could not be passed on to retailcustomers, which created the initial risky situation. Because of the rigid price controls in the newsystem, California could not adjust to changing economic circumstances. With the sale of generatingcapacity, risk was increased.Once new wholesale markets had been created, someone had to use them. In fact, the law stipulatedthat all utility sales and purchases had to go through the PX and the CAISO. Power was purchased upto a day in advance, with shorter-term purchases made as late as ten minutes ahead of the time theelectricity was to be sold. This arrangement was apparently believed to be more than sufficient forutilities to make necessary adjustments. Utilities were required to sell what remained of their power

generating capacity and restricted from buying back that capacity, or any other capacity, under long-term contracts. This created a high-risk situation for the investor-owned utilities.

The ChallengeBecause the market system was set up with controlled retail prices, the risk became a challenge forCalifornia. Economists have posited that with higher prices, supplies come forward, and part of theidea behind the restructured system was to elicit new supplies of electricity through construction ofnew generation plants. Engineers and economists know, however, that even if you can offer higherprices, electric generating plants cannot be pushed beyond their capacity.

In the short run, rising wholesale prices in California could allow California to obtain additionalelectricity from western states connected to one another through the power grid. New plants can bebuilt in California or other states, but construction takes time. The time delay between a price signaland the market response was an important part of the market dynamics. California needed more thantime for the construction of new plants, however.

The State also had a difficult and time-consuming process for licensing. In addition, time has to beallowed for advocacy and input from affected parties, which not only delayed construction but alsocreated uncertainties for utilities and generators as to whether they would actually realize benefits byinstalling new capacity. This uncertainty caused delays in the forward momentum of new generatingplants.

Opponents of deregulation claim that the process failed because it did not bring forward new suppliesof electricity. As Figure 1 shows, however, there was a rapid surge in applications and the


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construction of new power plants. More new plant applications were submitted in 1998 than in any ofthe preceding 16 years. And in 1999 and 2000 there were even more applications than in 1998.Deregulation could not bring new plants on line instantly, however.A second claim was that there was a sudden demand for electricity and that it surged in ways nobodyhad predicted. It is true that demand increased about 4 percent from 1999 to 2000, more than inprevious years. But the demand was only slightly higher than projected and not out of the range ofexpectations. At the same time, however, there was a lack of rainfall in the Pacific Northwest and anincreased demand for electricity in the Southwest. Thus, available imports to California were reducedby an average of more than 2,000 megawatts from 1999 to 2000.

The combination of a small delay in new plant construction, a slightly higher demand thanprojections, and a small reduction in imports in a system that was already operating close to the edgecaused problems. Hydroelectric, nuclear generation and newer, more efficient gas-fired facilities werealready working at full capacity.

The result was a significant increase in demand for power from older, less efficient gas- fired plants,which have much higher heat rates (that is, that use more natural gas per MWh of electricity

generated.) Therefore, when there were no other options, the highest cost units of energy wereintroduced.In addition, the spike in the use of natural gas caused an increase in demand on an aging system ofnatural- gas pipelines, which was also forced to operate near to its transport capacity. Because nosubstantial investment had been made in newer pipeline infrastructure, the rapid increase in thedemand for natural gas was constrained by the natural-gas distribution system, which increasednatural gas prices dramatically.Another reason generating capacity was limited in the winter of year 2000 was that the precedingsummer the power- generating system had been operating at such high capacity that it was alreadynear the breaking point. Many plants had to be shut down for repairs during the winter.


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and marketers, say by exporting electricity from California and re-importing that electricity at a higherprice justified by cost, consistent with prices outside California.

During the 2000 2001 period there were two crises an electrical supply crisis and a financialcrisiscreating a feedback loop that made matters worse. Inadequate supplies led directly to highwholesale prices. But California created the financial crisis for itself. With retail price controls, highwholesale prices, and utilities that had already sold off most of their generating assets, the utilities hadto buy electricity from others. The purchase price rose beyond the capped retail selling price. At thispoint most retailers would stop selling the product. But electric utilities were not allowed to stopunder Californias regulatory management.

The net result was that the financial assets and the borrowing power of the big electric utilities, PG&Eand Southern California Edison (SCE) were completely drained and destroyed.With their monetary resources depleted, the utilities were no longer credit worthy, and generatorswould not sell them electricity. At that point, the state stepped in and took over as the sole buyer ofelectricity for the utilities. Unfortunately, state budgets were not unlimited; so the dual financial andelectricity crises continued. Ultimately PG&E declared bankruptcy; Southern California Edison was

on the verge of bankruptcy but eventually negotiated a settlement with the CPUC.

Californias financial crisis was the result of the California governments mismanagement of theelectricity crisis. Most utilities in other states operate under a combination of long-term, medium term,and short-term contracts to optimize their purchases. This is an appropriate financial arrangement forthe electricity market because prices may spike, as happened in 2001.The CPUC however, did not allow long-term contracts. Therefore, the average cost to investor-ownedutilities in California rose far more than average cost to California municipal utilities or utilities inother states. More important, when the cost went up in other states, retail prices followed. Pricesignals were communicating, although both with a lag and attenuated by average cost pricing. Theseutilities were able to collect enough revenue to pay for the power they bought and thus these otherstates did not face a financial crisis.

One result of the financial crisis was that when the utilities ran out of money, they couldnt pay theirsuppliers of electricity. Organizations that the California governor derided as the Texas utilities,(most of which were neither utilities nor based in Texas, several of which were public agencies fromCalifornia, Oregon, or British Columbia) typically were able to face delays in payment yet still keepproducing. But many small cogeneration plants, or qualifying utilities (QFs), which came into beingunder the Public Utility Regulatory Policies Act (PURPA), however, live a more-nearly hand-to-mouth existence. When they were not paid, they were forced to shut down.In short, the initial supply crisis led to a financial crisis that led to a further reduction in supply, whichin turn led to higher prices.Once the investor-owned utilities ran out of money and the PX was shut down, the state took over thepurchase of electricity on behalf of the utilities in mid-January 2001. The financial crisis of the

utilities then became a State financial crisis. Through August 31, 2001, the state had paid $10 billionfor electricity, which was sold back to the utilities at the regulated price for about $3 billion. Thus, thestate lost about $7 billion from the state budget. The good news was that California had a budgetsurplus of $8 billion, so the purchase only decimated the surplus.

As of June 2001, the seven-month California electricity crisis was over: wholesale prices had fallen toless than $50/MWh, demand had dropped, new generating plants were coming on line, and more newplants were in the pipeline. Figure 4 shows a drastic reduction in electricity use, some of which canbe attributed to price increases at the retail level and some to demand side management or otherenergy conservation programs. New generating plants came on line in California, although after thecrisis was over.As a result of the new production coming into the system, there was continuous downward pressureon prices. The electricity crisis was limited by circumstances, but the financial crisis continued.


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Lessons Learned from the California Electricity Crisis:

The most important lesson is that any re-structuring process should begin with a large fractionof final demand covered by long-term forward contracts. Only a very small fraction of totaldemand should be purchased from the medium-term and real-time markets.

Second lesson is that state and federal regulators must coordinate their regulatory efforts toprotect consumers. State regulators cannot protect consumers from market power in thewholesale market without the cooperation of Federal Regulators (here, FERC), because it isthe only regulatory body charged with setting just and reasonable wholesale electricityprices.

An important corollary to the necessity of coordinating federal and state regulatory policies isthat a successful wholesale market design must take into account the existing retail marketdesign. Federal wholesale market policies must be coordinated with state-level retail market

policies.

A third lesson from the California crisis is that FERC cannot set ex ante criteria for a supplierto meet in order for it to be allowed to receive market-based prices without an ex post criteriafor assessing whether the subsequent market prices are just and reasonable. As discussedabove, it is impossible to determine with certainty on an ex ante basis whether a supplierowning a portfolio of generation units has the ability to exercise significant market power.

A transparent definition of unjust and unreasonable prices in a wholesale market regime thatcan be applied to any wholesale market considerably simplifies the process of regulating

wholesale markets. If this transparent standard (that can be computed by all marketparticipants) for prices is exceeded, then regulatory intervention should automatically occur.

Federal Regulators (FERC) were empowered to define what constitutes unjust andunreasonable prices. This created unnecessary regulatory uncertainty and was the cause ofdisagreement between FERC and state regulators over the extent to which wholesale prices areunjust and unreasonable and the appropriate regulatory remedies for these prices.

The unilateral actions of all privately-owned market participants to serve their fiduciaryresponsibility to their shareholders and the unilateral actions of all publicly-owned marketparticipants to serve the interests of their captive customers can result in market outcomes that

reflect the exercise of enormous market power.

Federal Power Act does not specify that prices must be the result of malicious behaviour by amarket participant in order for them to be deemed unjust and unreasonable. The FederalPower Act only required that if FERC determines that prices are unjust and unreasonable,regardless of the cause, then it must take actions to set just and reasonable prices and it mustorder refunds for any payments in excess of just and reasonable levels .The Federal PowerAct does not say that these refunds must be paid only by firms that violated market rules orengaged in illegal behaviour. This was the fundamental logical inconsistency that FERC facedin attempting to introduce wholesale markets without an explicit statutory mandate to do so.


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A final lesson from California crisis is that FERC must regulate, rather than simply monitorwholesale electricity markets. There was no shortage of effective market monitoring. Anumber of state agencies documented the exercise of market power in California. However,none of these entities had the authority to implement any market rule changes or penaltymechanisms to limit the incentives firms had to exercise market power or violate CaliforniaISO market rules. Only FERC has the authority to implement market rule changes and makeregulatory interventions to improve market performance.

Rather than focusing its attention on monitoring market performance, FERC should have had insteadconcentrated on designing pro-active protocols for rapid regulatory intervention to correct marketdesign flaws as quickly as possible and order refunds as soon as unjust and unreasonable prices arefound. What allowed the California crisis to exist was not a shortage of observers with radar gunsrecording the speed of cars on the highway; it was the lack of traffic cops writing tickets and imposingfines on cars that exceeded the posted speed limit.

FERCs soft price cap policy during the period January 2001 through June 2001 illustrates this point.The soft cap policy stated that if a generator could cost-justify a bid in excess of the $150/MWh soft

price cap, then it could be paid as-bid for its energy if it was needed to meet demand. However,regulation that simply says a firm must justify its costs in order to be reimbursed can yield the sameoutcome as no regulation at all. It was easy for an electricity supplier to obtain an invoice for itsnatural gas input fuel purchase at prices in excess of the actual cost to its energy trading affiliate.Consequently, without a rigorous prudency review of how input costs are actually incurred anddisallowances for imprudently incurred costs, there existed little limit on the prices that firms mightbe able to cost-justify.

Conclusion:Thus the problem in California was not electricity deregulation; it was price regulation at the retail

level and rigid regulation prohibiting long-term contracts at the wholesale level. It was an issue ofgross mismanagement by the Californian authorities.

References :

Lessons from the California Electricity Crisis By Frank A. Wolak, Center for the Study of EnergyMarkets (CSEM) .Series. CSEM is a program of the University of California Energy Institute .

Getting out of the DarkBy Ahmad Faruqui, Hung-po Chao, Victor Niemeyer, Jeremy Platt, andKarl Stahlkopf - Electric Power Research Institute.

The California Electricity Crisis: Lessons for the Future By James L. Sweeney, Professor ofManagement Science and Engineering, Stanford University.

psr project group 1 california crisis-lessons learnt

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