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Interview: frank wolak
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Wolak is a professor of economics at Stanford University. He is also chairman of the Market Surveillance Committee of the California Independent System Operator (ISO), which manages the flow of electricity along the bulk of California's transmission grid. Wolak details the shortcomings of California's deregulation plan, and says that the plan allowed energy companies to exercise market power. FRONTLINE interviewed Wolak on March 30, 2001.
You're the chairman of the Market Surveillance Committee. Does that mean that you're looking for market abuse?

I would say it's more just anomalies. Abuse is a very difficult concept to define, I think. The way I would characterize [what the committee is looking for] is: What market rules are allowing generators and other market participants to extract more money than is necessary to get the power that we need from them? In other words, is there a change in the rule that we could make that would essentially result in greater competition in the market? Or are there other rules that lessen the extent of competition in the market? ...

You call them anomalies. I guess some people would call them abuses. But have there been any?

... People will try to demonize the exercise of market power. Well, then you'll ask them the question, do you think firms should maximize profits? You'll get most people on that one.

Do you mean by that, that one person's gouging is another person's fair price?

I don't know about that. But I think it's more of one person's exercise of market power is another person's, perhaps, abuse of market power. And this is why we have antitrust laws; this is why we have courts. ... We usually have to go through a tremendous amount of due process to distinguish between the abuse of market power and simply the unilateral exercise of market power.

[FERC is] doing horrible.  They basically fail to enforce the law.  How can you do anything worse than that? What is market power?

Market power, from the economist's perspective, is just simply the ability to raise prices by your own actions in a market. ... If there are a large number of suppliers and a large number of demanders, [and] one supplier attempts to raise his price, everyone will go buy from all the other suppliers, and hence we'd say he has no market power. On the other hand, if that firm has the ability to say, "I want $10 more for my product," and [then get that price], then we say he has market power. ...

We asked [Enron CEO Jeff Skilling] the other day ... "Is there any evidence of market power being exercised in the electricity or gas markets in California?" And his answer was, "No, there's no evidence."

I guess I'd have to disagree. ... The prices in California are vastly in excess of what we should expect to see from a competitive market, so in that sense, we would have to say that there has been the exercise of market power. It's that simple.

So is this just a matter of interpretation? Or is he just simply saying that because he makes money off of the nature of the California market and doesn't want to admit that there's any manipulation going on?

Once again, it gets back to the issue of manipulation versus just simple guys taking advantage of a very favorable situation. ... Suppose that I've got five people in a room and they all are willing to work for $10 an hour. I come into the room and I say to them, "I need all five of you guys to do the job. But the way that I'm going to make sure that competition happens is I'm going to only pay you [the lowest bid from all five of you]." ... [The workers are] not even going to have to collude [or] ... communicate. ... [Each of them will] say, "If I bid high, I benefit everyone. If I bid low, I nail everyone, including myself. So what am I going to do? Well, I'll bid high." ...

Effectively, the sky's the limit on the price they can offer and it'll be vastly in excess of what they're willing to work for at a minimum. That's what we have in California. ... We have a situation where everybody who owns electricity facilities in California can name their price. ...

And that exists because there is a shortage of this essential commodity?

No, I wouldn't say there's a shortage, because to me, what a shortage means is that supply doesn't equal demand. ... It's not that there's a shortage. I guess the way that I'd characterize it ... is just that there's not a lot of excess capacity.

Many people involved in public power say that historically, electricity in the U.S., at least since Franklin Roosevelt, is classified as a peculiar commodity, if you will?

But I have a different answer to that. That's why we have the Federal Power Act; that's why we have FERC that says, "Rates should be just and reasonable." And historically, "just and reasonable" has meant "reflect costs plus a reasonable return on capital."

And that's true because electricity is different?

Because we, as a society, have decided through the political process, to do that. But we've done it for other commodities like telecommunications. We have the FCC to make sure that there's universal access to the telecommunications network. ... You may argue that's an essential commodity, but I think ... that it's very difficult for us to decide which of those commodities unilaterally are the ones that should get this special treatment.

If there had been a spike in the price for fish, five, six times its normal price in the last year, there wouldn't have been the same social reaction that there's been to the spike in the price of electricity or natural gas.

That's true, but gasoline gives a similar sort of thing, and we don't do anything special with gasoline. There's no federal gasoline act. There's no agency that regulates the price of gasoline at the federal level. ...

At the beginning of all of this, four or five years ago, you and professor [Severin] Borenstein at Berkeley and others put out reports saying that this market wouldn't work.

No, I don't think that's true. We just said that market power is a problem in electricity markets and you have to take precautions to make sure that the market is not going to be susceptible ... and there are certain things that can be done. It's not that they can't work. In fact, I think that it can work very well.

But they didn't do the right things here in California?

Yes. ...

Is it dumb deregulation, the way Jeff Skilling talks about it?

Well, if it's dumb deregulation, then it's dumb deregulation throughout the country. I think there's one thing that California did particularly different from everyone else, and I would argue [that it is] the root cause of what's happened is every place else. When [generators] sell off the assets to the new entrants to the market, there is usually what's called a vesting contract, which says that along with the purchase of this asset, you must agree to supply a significant fraction of the output of this asset back to the entity that you sold it to or back to consumers who effectively paid for it at a just and reasonable price that is set by the [California Public Utilities Commission (CPUC)]. ...

So when PG&E was told to sell off their generating facilities and it was bought by Duke Energy or Southern Company or any independent operator--in other states, they would have been required to sell that energy back at a just and reasonable price.



But not in California?

No, not in California. Suppose I have a 500-megawatt unit. ... You, the new buyer of this 500-megawatt unit, [are obliged] to supply, say, 400 megawatts every hour of every day at a price of $35 per megawatt-hour to the retailer to supply electricity. ...

But that's what was happening under regulation. You got to generate the power and you got a just and reasonable rate out of that, with a fixed profit set by a regulatory agency like the [California Public Utilities Commission]?

Right.

Are we just switching it around?

All this was is a transition period. These contracts traditionally are only in for two years. Why for two years? This is where market power comes in. ... On a day-before basis, if you say to me you're not going to supply, I'll pay you whatever price is necessary to supply. ...

Every time you come to me and we bargain--be it a day ahead, a month ahead, even a year ahead--you're always going to have the upper hand on me in terms of the price. But now, let's go out two years and what I say to you is, "How much will you be willing to supply energy for me two years from now?" [If] you name me an exorbitant price, what am I going to do? I'm going to go to a new entrant and I'm going to say, "This is the price that he's quoting me. Can't you beat that?" ...

But they didn't have [those long-term contracts] in California?

Right, but I'm just saying that's why it's needed. It's not that it's regulation again. It's just that it's temporary regulation ... to protect consumers in the two-year period and then you start up the market.

Why was it that [California's deregulation plan] didn't allow forward contracts, long-term contracts?

Well, I guess I would ask the folks at the CPUC. ... The way that the deregulation was structured, there is what's called a competition transition charge. ... The basic idea is this would allow the investor-owned utilities to recover what was called their "stranded assets."

PG&E is allowed to get rid of their mortgage that's outstanding on their nuclear power plants or other things that they owned?

Right. ... PG&E and all the other investor-owned utilities made a deal with the CPUC and the state where they said, "You give us a frozen rate from April 1, 1998, to April 1, 2002. In exchange, you have to give us the difference between the wholesale price that's implied in that frozen retail rate and the actual wholesale price in the market." ...

That gave the investor-owned utilities very strong incentives to keep that wholesale price very low, because then the difference between their frozen price and the actual wholesale price got bigger and bigger. ...

So for the utilities, it was a bargain, they thought?

Yes. ...

And the FERC, which is supposed to police the wholesale market, has apparently taken the position of Adam Smith?

I would say worse than that--the ostrich. ... If you read the Federal Power Act, it states very, very clearly what their charge is: to make sure wholesale rates are just and reasonable; to take actions to order refunds to any payments in excess of just and reasonable rates; and to immediately, as quickly as possible, set just and reasonable rates. ...

Where in the U.S. has deregulation been good for consumers?

I think it hasn't been that good for consumers in the United States, but I don't attribute it to the fact that deregulation can't work. I attribute it to the fact that we don't have regulators that know how to manage the transition from competition to deregulation. ...

When Mr. Skilling and others tell us [deregulation is] actually working in Pennsylvania and New Jersey and the Middle-Atlantic states, it's not true?

I'd say it's sort of working as well as it's working in California.

Is Pennsylvania the model marketplace of competition?

Not in my opinion. I know there are several people who think so, but I think that it's hard to argue that it's in fact a market. ... I'd say if your definition of working is that the politicians aren't up in arms about what's happening, then yes, it's working. But if your definition of working is, is it delivering lower prices to consumers than we would have gotten had we stuck with regulation? Then I'm not sure that's true, and that's my definition.

Is there anywhere in the United States where this process of deregulating what had been a regulated and controlled market resulted in lower prices for consumers, other than this two-year period in California?

Unfortunately, we really don't know yet. ... Much of the problem is not really, as I say, the fault of deregulation. It's the fault of the fact that we won't let the sort of things that are going to make the market work well actually work. ...

Skilling says that he doesn't blame the utilities or the generators or the regulators for this problem in California. ... He says it's you economists coming up with this complex stuff that no one understands, when really all that should be there is an unregulated marketplace. Let the people who know how to run a market, like Enron, have the freedom to do it.

I don't have a quarrel with that. But my view is that if they listened to economists, we wouldn't be in this mess, for sure. They listened to us about zero; I can guarantee you that. For him to say that they're listening to economists is hilarious. ... Skilling has guys on the ISO board who vote. ... They are the ones who implement the market rules. ...

So he's just throwing blame at the pointy-headed intellectual?

Yes, because we're the easiest target. But to say that it's the economists' fault, that's ridiculous. There's no evidence whatsoever. ... Basically what happened is the market was designed by committees and, moreover, it was designed by the same people who were then going to play in the market. So you think of it as, "If I'm going to design a market that I know I'm going to play in, I would probably design it so I could make a little money in it."

So you think really it's the Enrons and the generators and the major corporations involved that set this playing field up? And they are now basically using it to drain as much capital out of California as they can?

No. ... I have the fable of the lions and the zebras. Lions eat zebras. That's just what they do. Firms maximize profits. That's just what they do. And if you think zebras are the consumers, every now and then that's why we have game wardens, because game wardens will then say, "OK, lions, you've eaten enough. Now I'm going to put you on a diet for awhile so the zebras can come back to life and do what they need to do."

You can't blame the Enrons. That's what they do. They try to make as much money from the money that they get invested. You blame the regulators. It's the regulator who oversees the market, who sets up the incentive structures. ...

Three years ago in California, we spent $7 billion [on power], is that right?

Yes.

And last year we spent...?

$27 [billion]. ...

And it's going to double again?

It could, yes. It all depends on a lot of things that happen. ...

Many people we've spoken to, including the people at Enron, say the model for this deregulation was natural gas. Natural gas was deregulated; it was a great success. Prices went down for about a decade. Then all of a sudden, we come upon last year, and prices for natural gas in California go through the roof again, even along with electricity. Was that a natural phenomenon?

I would argue that most of the sort of haywire in natural gas has to do with FERC again, and the sorts of policies that FERC has put in place. ...

It's an understatement that the FERC is not doing a good job?

Yes.

What do you mean?

They're doing horrible. They basically fail to enforce the law. How can you do anything worse than that? ...

Federal law says rates have to be "just and reasonable." ...

And what "just and reasonable" historically has meant is, as we said, recover costs plus the return to capital. Every one of these market participants in California--Duke, Dynegy, Reliant... would file with FERC to say, "We have no ability to exercise market power. We have no ability, through our own unilateral actions, to raise market prices." ...

FERC then goes through and ... then blesses it and says, "Yes, you have no ability to exercise market power." The methods that they used [to assess whether those power companies had market power] were probably things that in the economics profession we would have said were antique 20 years ago. ... I think the events of the last six months in California have demonstrated that the basic premise of granting these firms market-based rates is false. ...

You sit on a board that monitors these prices. Your board and the organization you're connected to say, "$6.2 billion in overcharges that cannot be reconciled with a competitive market." Right?

Yes.

You guys didn't make these numbers up, did you?

No, I didn't.



You send them to Washington...

Yes.



... And then nothing happens.

Yes. That's been happening since the start of the market.

Now, either somebody's got the fix in Washington with the FERC--that is, the industry that doesn't want to give back the $6.2 billion dollars ...

Yes.

... Or they're stupid?

I wouldn't want to make those two choices. ...

I'm a ratepayer. I don't own a company. I'm not a regulator. I'm not an economist. I'm the ratepayer out there. You're an expert. You're telling me that we paid $6.2 billion too much?

Yes.

That we are going to pay 10 times as much for electricity in California this year possibly than we did two years ago?

Yes.

And that the federal agency that's supposed to take control over this is doing nothing?

Yes. I have to confess I don't understand why this hasn't attracted much more ire from consumers. But instead, consumers choose to yell and scream and blame the governor, who has absolutely no power to do anything about what wholesale prices are. And it is the federal regulator--FERC--who can regulate wholesale prices. ...

Loretta Lynch, the President of the California Public Utilities Commission, tells us that what she has seen is cartel-like behavior.

I have seen no evidence in terms of the bids that I've seen submitted that would say there is ... nor can I say that there isn't. In other words, you say, "Well, gee, they're doing things that a cartel might do," in terms of the ... bids they're submitting. But to say that they are a cartel and they're colluding--I don't know.

She didn't say they were actively colluding. She said they didn't even necessarily have to meet. But because there are only so many suppliers and they can see what everybody is charging--similar to your explanation--that they operate basically like a cartel.

Yes.

With the consumers of California at their mercy.

Yes. Yes.

That is true?

Yes, I think that's true.

And when Enron talks about having a virtual marketplace that they've created, is that just really a cover for the fact that they really have this whole thing gamed? They know what's going on, and they know where to move? Let me put it a different way. When we went out to talk with people and film at Enron ... and we compared that to the Department of Water Resources and their office, it looks like the little league versus the major leagues.

In the market surveillance committee, I remember the first meeting. ... The initial meeting was sort of friends of the bride and friends of the groom. The friends of the bride, being the investor-owned utilities, all sat on one side. And the new market participants sat on the other side. ... All the guys over here look like the students that take my undergraduate finance class. They understand options, derivatives, risk, etc., management.

These are the new guys?

These are the new guys. All the guys over here are the engineers with the pocket protectors, and they're all thinking about, "How do I cover my cost?" And I can assure you, these guys over here are not worried at all about covering their cost--they're worried about maximizing profits.

I just remember one time almost wanting to say, but suppressed in the public meeting, "You guys really should hire some of those guys--because if you don't, they're going take all your money." And, in hindsight, I should have said it.

Because?

They have. ... That's why the investor-owned utilities are bankrupt, because these guys are so effective at doing the market. ...

I remember having a drink with some people a couple of months ago in Manhattan. I told them I might do this energy crisis project and they said, "Oh well, that's you hot tub guys in California. Why don't you get it straight? You're crazy." This isn't just a California problem?

Oh, no. The two reasons why it is more of a California problem is, first, that we're much more dependent upon imports. In other words, many hours of the year we need imports to meet our demand, whereas in the East Coast, ISOs they have more generation within their control area. ... To the generators that are in your control area, you can do lots of things to essentially make sure they can't set high prices. But to generators located outside of your state, all you see is power coming over the line. ...

That's up to FERC to do?

Right.

And they're not doing it?

Right.

So then everybody's vulnerable.

Right, to the extent that you're reliant on imports. And in fact if you looked at the periods when prices are extremely high in these East Coast ISOs, it's when they're reliant on imports. ...

If I go to see a generator like Duke or Southern Company or Reliant, should I say to them, "We talked with Professor Wolak in California, and he says you guys took down billions of dollars, it looks like, in excess profits?"...

Maybe not them, but collectively the industry made substantially in excess of what you would expect from a competitive market. ...

If you were to ask them a question, what would it be?

The question I would ask them is, "Why didn't you think further ahead? ... You clearly made a lot of money in California, but it seems that it would be in your interest to go to FERC to say, 'Look, slap us a little bit; give some of the money back to the citizens of California so that we can really do this for the rest of the country?'" Because it seems to me that, given what's happened in California and the nature of the political process, I think they've effectively killed the goose that laid the golden egg. And that, to me, is very puzzling. ...

I have to confess, I can't spite them for doing what they did. That is what we in the market economy incent them to do. What I spite is that regulators need to regulate, need to enforce the law, and that's where the failure has occurred.

And since they're not, you would hope that the corporations have enough foresight to regulate themselves.

Well, I would expect they're certainly not going to regulate [themselves]. ... I guess the way that I see it is that these guys are going to be regulated eventually. How is that going to occur? Well, the legal process is going to come after them. And the outrage that people feel, "These guys have price gouged." ... I think that they can get a jury very angry, and they can get a very large settlement against these guys. They'll probably be forced to pay, either in lawyers' fees or through jury settlements. It seems, once again, shortsighted, not to recognize that.

It seems incredible that the FERC--which as I understand has jurisdiction over the equivalent of 7 percent of our gross national product--is an ostrich with its head in its ground.

They're, if you like, sort of doing the best they can, given the sort of resources and the way that they think about the world. To a guy with a hammer, everything looks like a nail. But the problem is that now it's something different, and you need to get a different tool to be able to deal with this new world. I think that that's just something, unfortunately, that they just don't have the incentives to adapt that quickly.



FERC doesn't have the incentives? ...

They're 3,000 miles away from California.

Yes, but I mean that there's an economic disaster going on in California. As you said, there's a potential public reaction nationally that would undermine the very deregulation they supposedly want. ... So there's plenty of incentive to do something.

Right. ... I think part of the more recent things that they've done have been attempts--like their token $69 million refund...

You guys say $6.2 billion, and they say $69 million.

Right. And my view is that they are recognizing that they have to at least make it look like they're doing something. I guess what I would say is that's a good first step. ...

And can I assume, for the purposes of accuracy, that the $6.2 billion is as of a certain date?

Yes

And that figure is increasing every day?

Oh, yes. Very fast. ...

We have these utilities like Southern Company that have fixed assets like transmission lines. And at the same time, out of state ... they're building generating plants, trading energy. Have we created some kind of hybrid semi-monopolies in various places that then operate as if they're free marketeers in other places?

That's certainly true. But this is the problem with the regulatory bargain we talked about--that the investor-owned utilities during the first two years got roughly close to probably $12 billion in these stranded asset payments, and then were brought up to their unregulated affiliates. Now that it's gone the other way...

They want to bail them out now.

Yes, that's one interpretation. ...

Didn't you do a study on the amount of megawatts that went offline due to outages, due to forced maintenance? What was the change in the number of megawatts that was taken offline over the last three years?

There certainly were a great amount of forced [outages] in the summer of 2000 than there were in previous summers.

Five times as many?

Yes. That was in the FERC report.

And that's suspicious.

Yes.

They say, when we ask them about it, "Oh, that's because these were old plants and they were working flat out and we had to take them off more often for maintenance." That never happened under regulation.

Yes. But I have to say, that's another perfect example of how the FERC needs to change. What you can no longer do in a competitive market is, if the guy says his plant's out, you don't know if the reason it's out is because it's economically profitable for it to be out, or because it really can't run and you, in designing your regulation and how you compensate these generators, must bear that in mind. But to say, "OK, I'm going to believe you," you're just asking yourself to get taken. ...

When [these companies] say, "There was no manipulation. There was no market power being exercised. This is just a problem of supply and demand," you don't buy it?

I'm very skeptical. Clearly, if you do the analysis that the committee that I chair has done, as well as the ISO has done, it says that had they offered these plants at sort of essentially the standard way we think a competitive market would have offered these plants, prices would have been nowhere this high. I think that sort of speaks for itself. ...

And there's no hope really that anybody is really going to get to the bottom of this?

Oh, I think they will get to the bottom of this.

Who?

The courts. Litigation. I think there will be litigation on these issues for quite a while. I can't tell you how many attorneys and lawyers have approached me to ask me to essentially serve as an expert in these sorts of things and I've sort of said I would prefer not to, given my position in the market. ...

But ... for people who are going out of business for paying higher rates or who are economizing in other ways, that doesn't do them very much good?

No, I mean that's the fundamental problem with FERC. FERC's inaction is not the issue of, "Will we get the money back as consumers?" I think that probably eventually something like that will happen. But the question is that it's the lost economic output and the decisions that have been made that are related to that are going to never be repaid. ...

So what [CPUC President] Loretta Lynch has done is put her finger in the dike, holding back retail rates, which has, in a sense, saved people from the consequences so far?

Yes, but recently, they [the CPUC] have proposed a rate increase. It's still uncertain whether or not ... that rate increase could be all that is necessary. ...

The free market people tell us that price caps are the devil.

I don't know that I'd go that far. But I guess my view is that price caps for a market like this are really difficult, to say the least. For the simple reason ... that a price cap without an obligation to sell is meaningless--meaning that if I say I've capped your price and you say, fine, I won't sell at that price, then we've got a serious problem. It's sort of a game of chicken, and that's effectively what's happened in California when it had a price cap. ...

How important is gas in the whole catastrophe we've been going through?

Oh, huge. ... In California, we have to bid very high for electricity because we have to buy that gas to burn in our generating facilities. That's why we've got to bid so much higher for electricity. ...



And the rise in gas prices--the Cal Public Utilities Commission believes that, in part, is due to manipulation?

... I don't like the word "manipulation," but that firms are exercising the market power that they have. And once again, remember who regulates natural gas markets in the U.S.--it's FERC again. ...



Do you see the policy announcement of the administration, of [Energy] Secretary Abraham and President Bush, to open up wildlife preserves, to have more exploitation of domestic energy, to get the Mexicans to supply us with energy? Is that realistic?

I don't know if it's realistic. I'm just saying that I don't think it's sort of related to the current situation we find ourselves in California.

So it's a non sequitur?

Yes, I would argue that it's very much of a non sequitur. I think what we fundamentally have here is two things: regulatory failure initially at the state level, in terms of the prohibition on forward contracting; and the lack of vesting contracts as the assets were sold, and then an unwillingness of FERC to enforce the law as written. ...

Ken Lay says that what led to all the prices going up was scarcity and high demand in a very delicate system where there was not much of a margin between demand and supply, and that's why prices stayed there.

It's certainly true that there was significantly less supply of hydro from the Pacific Northwest and power from the Southwest into California. That's certainly true. So, in that sense, I think there is truth in his statement. But there's lots of markets where supply reduces just a little bit and the price doesn't go essentially triple. So I think that's the question that I would pose.

As a consumer, as a ratepayer, I'm sitting here and saying to myself, so I got taken to the cleaners here?

Yes, I guess you did. But fortunately, you may not have to pay it until into the future, because your rates still haven't gone up too much. I think that the degree to which people are irate at the federal regulators strikes me as way below what they should be. I showed people a few of the websites at FERC where there are paragraphs from the Federal Power Act. For anybody who would bother to read those, I think you would be quite outraged. ...

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