Former Commissioner of the California Public Utilities Commission
On Behalf of Citizen Power
Lessons from the California Energy Crisis for Pennsylvania Electric Customers My name is Carl Wood. I served as a member of the California Public Utilities Commission from May 1999 through January 2005, the period of the California Energy Crisis and of the State’s efforts to recover from it.
This testimony is being offered of behalf of Citizen Power. Citizen Power is a public policy, research, education and advocacy organization based in Pittsburgh. Since 1996, Citizen Power has devoted all of its resources in an attempt to ensure that electricity deregulation is as consumer and environmentally friendly as possible. Accordingly, Citizen Power has participated in several proceedings before this Commission, and has managed to win a number of benefits on behalf of low-income consumers and the environment. I have been asked to speak here today because Citizen Power, like the Commission, is very concerned about the impact of what is likely to be a series of rate increases over the next several years in Pennsylvania.
The California Energy Crisis was a serious disruption of the basic commercial relationships that characterize the modern electricity infrastructure. The integrated and comprehensively managed supply chain from fuel supplier to electric generator to ultimate consumer was dis-integrated by de-regulation. The wholesale, FERC-jurisdictional commercial relationships that replaced integrated operation relied on credit and contract supported ultimately by retail ratepayers’ ability and willingness to pay. Abuse at every level of the de-regulated, dis-integrated structure destroyed credit and confidence.
The pattern of events in California was much like what the Mid-Atlantic (Maryland, Delaware, Virginia) and Pennsylvania face today. The similarity -- and the legal and policy approaches that legitimize the respective crises of California and the Mid-Atlantic – makes the California story relevant in Pennsylvania.
In California, utilities supplying retail customers divested their generation assets and placed themselves in a “net short” position as dependent wholesale purchasers of energy and capacity. A similar process is underway in Pennsylvania and the other Mid-Atlantic States.1 During an initial period of frozen retail rates, wholesale sellers positioned themselves for a pay-day, simply marking up the price of output from formerly regulated plants.2 In California, like the Mid-Atlantic, so-called “market-based” wholesale electric prices spiked as a result of the mark-ups, causing newly unfrozen retail rates initially to spike in San Diego. Retail rate shock generated a political backlash, leading to partially successful efforts to suppress and then manage the high retail rates driven by high ongoing wholesale power costs.3
However, “managing” retail rates had significant adverse consequences for utility solvency and credit. Multi-billion dollar utilities – Pacific Gas and Electric Company (PG&E) and Southern California Edison (SCE) – were completely stripped of their cash and credit in just two months, due to an uncontrolled escalation of wholesale electric costs before rates could be raised to preserve their credit.4 The State of California was forced to become a wholesale buyer of last resort, jeopardizing its credit. Retail rates had to escalate and remain well above cost-of-service for years into the future to preserve the credit of the state and utilities. For most of the 12 million electric customers of PG&E, SCE, and SDG&E rates remain at unacceptably high levels today – system average rates in the 13-14 cent range and rising.
In Pennsylvania the period of capped rates has not yet expired for most utilities. However, rising prices for wholesale energy threatens the same type of rate shock experienced in California and currently occurring in Maryland, Virginia, Delaware and elsewhere. Pennsylvania consumers appear to face the unpleasant dilemma of either waiting for rates to spike or initiating pre-emptive rate increases. The choices for consumers are actually not so limited.
The limited choices currently being proposed in Pennsylvania and the mid-Atlantic have been tested and have had at best mixed results in California. Managing retail rates to avoid rate shock may defuse consumer outrage and political conflict and help to hide the fact that the system is not working. It does not address the root cause of escalating retail rates – exposure to an energy trading regime in FERC-jurisdictional wholesale markets that eschews transparency, and fails the time-honored tests of just and reasonable ratemaking in the name of “market-based” rates.5Any approach to the looming crisis in Pennsylvania and the Mid-Atlantic states that does not address the larger problem of over-exposure to wholesale markets in which seller-side strategic pricing and gaming prevail will fail, and will violate the fiduciary obligations owed to the retail customers of state-jurisdictional retail entities.
Achieving a comprehensive understanding of the forces driving wholesale prices is an important element of any response, necessary but not sufficient. In California wholesale rate spikes were driven both by manipulation of electric supply availability and price and manipulation of fuel availability and price – particularly natural gas fuels.6 Gas prices drove formula rates for wholesale transactions, even though the majority of California generation is not gas fired. Price formation was opaque, and driven by bidding strategies unrelated to costs (the Enron manipulations and “hockey-stick” bidding of unit output), particularly for divested power plants whose operating characteristics and cost structures were known. PG&E and SCE customers were terrorized by threats of blackouts that were largely contrived.7 Generator profits soared on the strength of wholesale price escalation. The Federal Energy Regulatory Commission (FERC) was absent and/or obstructionist, although presented with complaints and evidence of unjust and unreasonable rates and practices in both gas and electric wholesale markets early in the Crisis. FERC’s failure to provide timely relief trapped the utilities and severely damaged customers and the California economy.
Recent studies have begun to suggest the presence of strategic behavior by wholesale sellers in the Mid-Atlantic States.8 Wholesale price formation remains opaque, despite the clear command of the Federal Power Act that rates be “just and reasonable.” 9An aggressive effort to discover how prices are being formed, coupled with actions for enforcement of the just and reasonable requirements of the Federal Power Act, should accompany any decisions to reflect wholesale price escalations in retail rates.
Advocating for more responsible action by the FERC as the regulator of wholesale transactions in interstate commerce – focusing on greater transparency of seller costs, mitigating seller market power and controlling seller positions in the multifarious markets where energy commodities are traded to prevent undue influence, self-dealing, linkage and leverage – is an important element of managing the crisis faced by Pennsylvania and the mid-Atlantic states in the short term.10 Skepticism about any conventional wisdom that justifies escalating prices, and rigorous analysis of all purported justifications is healthy. The Federal Power Act provides both a venue – at FERC -- and authority for state regulators to investigate.11 For example, the divestiture and re-positioning of generation assets outside of state regulatory control and the wholesale pricing schemes under which supply is provided to Pennsylvania ratepayers at elevated mark-ups should be examined from all angles before concluding that elevated prices should be reflected in retail rates. Any transactions found not to be in the public interest should be unwound if possible, under state or federal law.
Consumers hold policy-makers accountable when the “market” reaches bad outcomes. State-level policy makers and the entities they control represent the buyer side of the wholesale market. They must act like responsible providers to and agents for their retail end-use customers. Empowering load serving entities by giving them all of the tools needed to be effective suppliers -- including access to information about price formation under the “just and reasonable” standard and including authority, credit and access to capital for direct investment supported by retail rate revenues – is responsible public policy. Such structural measures, with which California has experience in its recovery from the Energy Crisis, include:
Revitalizing the obligation to serve
Restoring cost-based regulation for retained generation
Establishing a sophisticated long-range planning process that informs construction of a supply portfolio and aggressive conservation investment
In California there were alternatives whose efficacy was demonstrated by consumer-owned utilities, which for the most part pursued their traditional approaches of supply self-sufficiency. Customers representing the 25% of California load served by consumer-owned utilities – the Los Angeles Department of Water and Power (LADWP), the Sacramento Municipal Utility District (SMUD) and two dozen smaller utilities – were much less drastically affected. The basic reason for these different outcomes was that the consumer-owned entities did not “restructure.” That is, they retained and honored their obligation to serve their consumer-owners and retained control over the assets – transmission and generation – that had been built to provide that service over the previous decades. They were not short and thus not vulnerable. The legal and economic structures of consumer self-supply through entities they own and control have served consumers of all types well in California, and for the most part in Pennsylvania.
The traditional utility obligation to serve differs from the “provider of last resort (POLR)” concept in crucial ways. The obligation to serve includes an obligation to plan and to invest to assure the long-term adequacy of supply to meet the demand of customers served by a geographically described distribution grid. The long-term perspective is consistent with the capital intensive nature of the infrastructure and the long-lived character of the facilities. The POLR concept is in essence short-term; it assumes a degree of instability in the customer cohort that in practice becomes a deterrent to new investment and another rationale for sustaining high wholesale prices based on shortage. Revitalizing the obligation to serve with its long-term, investment oriented perspective is a sound alternative that moderates prices and assures service.
Pricing utility retained generation at cost, including reasonable capital cost, is particularly important. Legacy power plants were optimally located in the transmission grid, and have been largely depreciated – that is, ratepayers have fully repaid the capital employed for the installed cost and capital additions. Forcing ratepayers to pay multiple times for these facilities through mark-ups is inequitable. It exacerbates the volatility and wholesale price escalation that drive up retail rates.
Reducing exposure to wholesale markets through strategies of direct investment in supply by load serving entities, subject to direct state-level rate regulation or direct consumer ownership and control, is a cornerstone of these alternatives. Equally important is controlling demand through effective investment in energy conservation and efficiency. Investing on the demand side -- deploying ratepayers’ cash to enable them to reduce their consumption and increase efficiency -- is in the interest of both direct beneficiaries of conservation programs (whose bills go down) and non-participants, who avoid escalating costs on the margin.
Developing long-term plans that guide investment on both the supply and demand sides of the equation is a necessary pre-requisite to effective investment strategy that permits long term moderation and control of retail rates and bills. Planning by load serving entities to enable them to meet their long-term obligations to customers is an important element of the California recovery. The planning process in California is public, and is overseen by state agencies with the authority and competence to acquire and analyze information on local, state and global energy developments.
The objective of a planning process should be to develop a sophisticated approach to managing a portfolio of supply and demand-control resources. Such an approach will provide the flexibility to enable Pennsylvanians to sustain their economy in the face of significant uncertainty and turmoil in the world energy business. It is a more responsible approach to public policy than simply relying on what the market may offer.
The utility business is a cash business. It is the cash paid by retail customers who pay their bills every month that provides the financial underpinnings for any investment in energy infrastructure, whether in the form of an equity investment, a debt instrument a long-term purchase contract or a short-term energy trading account. The only issue from the buyer’s perspective is how to provide adequate service while minimizing the long-term cash outlays of the committed retail customers. Amortization of direct investments over the life of a long-lived asset has significant attractions from this perspective.
Appeasing wholesale sellers to justify high rates, or manage gradual rate escalation, is harder to justify. It has been tried and is failing in California and elsewhere. The theory is that higher prices send “signals” to investors that additional supply is necessary and investment will be rewarded. The California experience suggests that shortages justify high prices, and maintaining shortage is a strategy to sustain high prices that energy suppliers are pursuing.
Prudent investment in energy infrastructure to support state-level economies are ultimately driven by local economic concerns and commitments, backed by ratepayer cash. Investment in new generation in California has been made by municipal entities with a traditional obligation to serve; by regulated utilities directly or through subsidiaries with long-term supply contracts; by developers of renewable projects with must-take obligations on the part of utilities resulting from California’s renewable portfolio standard legislation. The contention that
…under traditional regulation, ratepayers (rather than investors) may bear
the risk of potential investment mistakes….12
is really beside the point. Ratepayers backstop energy investment in all scenarios. Merchant generators are canceling projects and exiting the industry. Consolidation in the utility and energy fuels industries is accelerating the trend toward an approach of strategic under-investing to sustain high prices. This is not consistent with the interests of buyers/consumers. Responsible public policy at the state level will equip load serving entities responsive to their customers to control supply and price through direct investment guided by effective long-range planning.
Protecting the Most Vulnerable Consumers California sheltered the most vulnerable populations – senior citizens and low-income households -- from the worst effects of the Energy Crisis, using several devices. There may also be lessons for Pennsylvania policy-makers in this aspect of the response to crisis.
Pursuant to statute, California’s residential electric and gas rates are inverted (per unit prices increase as usage increases).13 The objective is to promote conservation and preserve affordability. The basic rate structure provides a minimum level of usage – 55 % of average usage in the customer’s geographic area – priced at a discount from the residential average rate. In response to the Energy Crisis the Legislature exempted usage up to 130 % of the baseline allowance – about 70 % of average residential usage – from rate increases driven by the Energy Crisis for all residential customers. The Legislature also offered rebates to customers who reduced their usage by 20 % from the previous year’s level. The idea behind these measures was to reduce the need to purchase the “net short” at high prices in the dysfunctional short-term markets by offering residential consumers both positive and negative incentives to reduce usage dramatically.
The Legislature expanded energy efficiency and conservation programs targeted to low-income households and established a Low Income Oversight Board made up of utility and community representatives to advise the CPUC on the design and implementation of these programs. Home weatherization programs were expanded and programs to improve appliance efficiency and safety were implemented.
The Legislature and the Public Utilities Commission (CPUC) also expanded statutory low-income discount programs in several ways.14 The Legislature exempted eligible CARE customers from Energy Crisis driven rate increases; the CPUC increased CARE eligibility standards to 175 % of the federal poverty level and expanded outreach programs to enroll a larger proportion of eligible customers. Currently, about 75 % of eligible Californians, approximately 2.3 million households, receive discounts of 20 % on their monthly electric and gas bills. Also, their bills do not include Energy Crisis costs.
Pennsylvania and the states around it are facing a crisis caused by rapidly escalating prices in wholesale electric markets. Retail rates for electric service are poised to increase dramatically in the next few years. The choices presented appear to be “Pay me later” – preserve the current capped retail rate regime and wait for big increases in a few years -- or “Pay me now” – begin a series of phased rate increases.
There are other approaches, all of which are rooted in a perspective that the public interest is best served when end-users of the energy infrastructure, who pay the bills and support the investments, are well served. Specifically:
Make transparent the forces driving up wholesale prices, and control them before deciding to reflect them in retail rates.
Eliminate market power and unwind transactions found to be not in the public interest.
Re-invigorate the utility obligation to serve, including
-- Instituting long range planning
-- Making direct investments at regulated rates in both supply and conservation
-- Moving away from primary emphasis on short-term arrangements and transactions
(shopping and POLR and the wholesale arrangements that provision them)
Empower load serving entities to serve their customers using a portfolio of measures, not relying exclusively or primarily on wholesale markets or short-term arrangements
1 First Energy, “Well Positioned for Success,” Annual Analysts Meeting, New York November 30, 2005, Slides 6, 8 and 9 (http://www.firstenergycorp.com:80/ir/cache/_852569AE0049ECB4_la_2005+Analyst+Meeting__file_2005AnalystMtg.pdf);
2 Purchasers of divested power plants in California paid utility sellers several multiples of book value in 1998, purchasing market power as well as physical assets. Utility sellers, rendered indifferent to electricity purchase costs by the “filed rate” doctrine, invested the proceeds in other unregulated enterprises, including asset purchases overseas and in the Eastern United States. PPL Corp. plans a similar result in Pennsylvania. PPL Corp., “2005 Earnings Webcast,” February 1, 2006, Slide 4 shows 2010 generation margins doubling as the result of “remarketing POLR supply.” (http://www.pplweb.com/NR/rdonlyres/5F52F2F0-B074-4250-B65C-2A3B168F92FB/0/Quarterly_Analyst_Call_020106.pdf)
3 Chapter 328, Stats. 2000, (AB 265 (Susan Davis)), adding Cal. Pub. Util. Code section 332.1 capped rates for San Diego Gas and Electric (SDG&E), with a statutory authorization to recover the difference between capped retail rates and wholesale power costs over time, with interest.
4 AB 265 was enacted in the Summer of 2000, before FERC removed wholesale price caps and wholesale prices jumped to an average of over $300/mwh for the month of December 2000 ($1200/mwh for the 24 hour period on December 12, 2000). No legislative solution was possible to rescue SCE and PG&E.
5 “…the prevailing price in the marketplace cannot be the final measure of "just and reasonable" rates mandated by the [Natural Gas] Act. ... In subjecting producers to regulation because of anticompetitive conditions in the industry, Congress could not have assumed that ‘just and reasonable’ rates could conclusively be determined by reference to market price….” FPC v. Texaco Inc., 417 U.S. 380, 397-98 (1974)
6 The infamous remarks on the Enron tapes about turning off power plants, discovered in 2003 although in the available to the FERC two years earlier, were only the most egregious examples of widespread practices involving sharing real-time operating data for the purpose of influencing bidding behavior and prices. Gas suppliers and pipelines also restricted supply and transport of natural gas, with significant effects on gas prices.
7 The first rolling blackouts occurred in January 2001, at a time when electric loads were about 30,000 megawatts and average electric resource capacity exceeded 50,000 megawatts.
8 Spinner, “Was PJM’s Power Price Run Up in the Latter Half of 2005 due to Inappropriate Market Power, or Appropriate Power Markets, or Both ?” Virginia Corporations Commission, March 13, 2006; Rebecca Smith, “Enron Continues to Haunt the Energy Industry,” Wall Street Journal, March 16, 2006.
9 FPC v. Texaco Inc., 417 U.S. 380 (1974)
10 C.f., “Draft Report to Congress on Competition in Wholesale and Retail Electricity Markets,” Federal Energy Regulatory Commission Docket AD05-17-000, June 5, 2006, Section 3.E, pp. 66-71, especially fn. 179 and related text, for a discussion of the difficulty of distinguishing market power from scarcity as a factor in elevated prices. (Hereafter this report is referred to as “FERC Competition Report.”)
11 Federal Power Act section 201(g), 16 USC 824(g), authorizes state commissions to have access to books and records of exempt wholesale generators for regulatory purposes; Federal Power Act section 209(c), 16 USC 824h(c) gives state commissions access to information in the possession of the FERC.
12 FERC Competition Report, page 4
13 Cal. Pub. Util. Code section 739
14 Cal. Pub. Util. Code section 739.1 establishes the California Alternate Rates for Energy (CARE) program to promote affordability of energy costs for low-income customers. The costs of CARE rate discounts are paid by all other customers.