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the roots of the crisis
A flawed deregulation scheme?

Dick Cheney

Vice president of the U.S., Cheney is chairman of President George W. Bush's task force on energy policy

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The problem you had in California was caused by a combination of things--an unwise regulatory scheme, because they didn't really deregulate. What they did was they left price caps on the retail level. They forced the utilities to sell off their generating capacity, and required them to go purchase on the spot market. At the time, spot prices were pretty low, and then they had increased demand but no increased supply. So their surplus capacity fell until the point where the prices took off. Now they're trapped from unwise regulatory schemes, plus not having addressed the supply side of the issue. They've obviously created major problems for themselves and bankrupted PG&E in the process.

Jeff Skilling

Chief executive officer of Enron Corporation

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The problem we have in California is not that we deregulated the market. We never deregulated the market. The California market today is one of the most regulated markets in North America. They regulate where you can buy and sell the product, they regulate the form of contract that you can use to buy and sell. They won't allow you to go into a ... long-term purchase contract. That's crazy, absolutely crazy. They have fixed prices to consumers and they've got a regulatory system that basically prohibits you from building new facilities. This is a deregulated market? Come on. Deregulate the market; open it up. Give customers choice. ...

I spent a lot of time in California in 1995 and 1996, where they were coming up with the method of deregulating the marketplace. ... There were two proposals that were offered as they were trying to figure out what the method would be of deregulating the market. One was not deregulation at all. ... There was another model that was called a "bilateral contracting market," which is basically an open competitive marketplace. They decided not to use that. ... You cannot have an effectively functioning electricity market if you don't have a forward market, a contracting market for electricity.

This is the most volatile commodity in the world and you're designing a system where you're requiring the utilities to purchase all of their power in the spot market? This is nuts. On the face of it, it didn't pass the smell test. ...

Gray Davis

Governor of California

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... Is the problem in California, as [Enron CEO] Jeff Skilling said to us in Houston, dumb deregulation?

Well, there's no question that the law passed in 1996 was flawed. It deregulated the wholesale market, meaning the price that the utilities had to pay energy companies for power, but not the retail market. As a matter of fact, it reduced rates to customers and froze them for five years. So that was an inherent conflict.

Secondly, it failed to do what every other state did which deregulated-- which is to say to the people who bought the power plants the utilities were forced to sell off, "You must sell us that power back here in California. You must serve our needs first." So it was flawed in that it didn't require California to have a first claim on the power plants. It deregulated part of the market, but not all of the market. ...

Frank Wolak

Professor of economics at Stanford University, and chairman of the Market Surveillance Committee of the California Independent System Operator (ISO)

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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 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?

Right.

But not in California?

No, not in California. ...

What about the weather?

Ken Lay

Chairman of Enron Corporation

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Up until the last year or two, when California did need extra supplies, it could almost pull on supplies outside the state--get more of the hydro supplies from the Northwest or other surplus supplies in other nearby states and bring it in. Well, now that has dried up, because those states are also getting tight on supply. The tightness has been aggravated by something that really nobody had any control over, and that's the weather.

That means the hydroelectricity capacity in the Northwest is significantly reduced, by 25 percent to 30 percent, and in some cases, 40 percent. So those surplus supplies that could be pulled on by California previously have disappeared.

So it's not just a political ploy to blame the weather?

No, it's not. At the same token, prudence would have said, you don't depend on having high hydro season power every year, because that doesn't happen either. And so, to the extent that they've had some very robust hydro years the last four or five years, there should have been some calculation in there, you know, that's probably not something we're going to get every year. And of course, this year, we're not getting it.

Market Power

Severin Borenstein

Director of the University of California Energy Institute and a professor of business at the Haas School of Business

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It wasn't the end of the rate caps that caused this problem. Even if we had kept the rate caps, we'd still be in deep trouble right now. The problem occurred when utilities were buying throughout the summer at high, [albeit] capped, prices and selling at much, much lower prices. And the reason the prices in the wholesale market were so high is because the structure of the wholesale market was such that the sellers could exercise market power.

Frank Wolak

Professor of economics at Stanford University, and chairman of the Market Surveillance Committee of the California Independent System Operator (ISO)

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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. ...

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. ...

William Richardson

U.S. Secretary of Energy, 1998-2001

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I think those power marketeers didn't cheat, but they took advantage of the price situation. The fact that there were wholesale price caps and a very botched market destroying legislation in the deregulation effort caused these huge price increases.

So you don't believe that ... this was a manufactured crisis?

No. I believe that the deregulation plan was botched. Did the power marketeers take advantage of the situation? Yes. To make more money? Yes. But the rules of the game were created badly by those that passed that flawed deregulation plan in 1996--[former California Governor Pete] Wilson and a legislature that, basically, made market power contingent on a lot of caps and special dispensations for San Diego. It was a typical deal that blew up in their faces. ...

Loretta Lynch

President of the California Public Utilities Commission (CPUC)

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Shortly after I came to the PUC, Harvey Morris, [who] was a lawyer at the PUC who specializes in natural gas litigation in front of the federal regulators, came to tell me that he had unearthed evidence of anti-competitive behavior at the California border, essentially on gas pipelines that come in from the Southwest into California. Some of the gas companies were manipulating the price.

He had built a case against a particular gas producer and pipeline owner and wanted to file suit against them. But before we can file suit against a gas pipeline owner, we have to go to the federal administrative agency that controls pricing and gas pipelines. Because they go through many states, they are interstate pipelines, and the state of California doesn't control them. The federal government controls them.

That's the [Federal Energy Regulatory Commission]?

Right, that's the FERC. Harvey wanted to file a case on behalf of the citizens of California at the FERC, charging that El Paso was manipulating the price, and manipulating behavior on the main pipeline into California. He showed me his evidence. I thought it was a dead-bang, absolute case of price manipulation. So the commission, in late March--right after I had become president--voted to take that case to FERC. ...

Which has, so far...

... Done absolutely nothing. In fact, more than that, they've sat on the complaint. It's now a full year since the state of California brought this clear evidence to the federal government, and they have done absolutely nothing with the complaint--while all of California has suffered from higher natural gas prices.

Robert Glynn

Chairman and chief executive officer of PG&E Corp., which owns California's Pacific Gas and Electric Company

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Was there manipulation in the electricity market that you saw?

I don't know if there was manipulation in the electricity market. I know two things. Prices really went high. I know that FERC has made a conclusion that unjust, unreasonable rates were charged. But I've been asked, did I think that participants in that market had to manipulate in order to collect the high prices that they did? I think that it wasn't necessary for them to do so. I'm not going to try characterize whether they did or they didn't.

But the rules in California that were chosen to set wholesale prices were rules that were going to result in unbelievably high prices in periods of shortage. So it is conceivable that people didn't have to manipulate, because the system by itself generated pretty large prices, and therefore pretty good-sized [profits].

Nettie Hoge

Executive director of The Utility Reform Network (TURN)

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The legislation that was ultimately passed out of California was basically channeled from the corporate headquarters of Edison and PG&E. It was written by the people who work for them. It was part of a grand scheme that was agreed to in the governor's office in the summer of 1996, between the governor, the large customers of energy--that would be your huge industrial users--utilities, and the independent energy producers, those folks who ultimately ended up owning the power plants. There were no small consumers anywhere near the room. ...

The tragedy of that is that we then saw the quarterly profits rolling in. We saw all of the market players in California showing record prices. ... The Texas newspapers were screaming about how all the companies that had bought the plants in California were just going gangbusters. There were 600 percent increases in profit from quarter to quarter. So we knew where the money was going.

As of the time we speak, $13 billion more has been shipped out of the state to pay for electricity than we spent during the same period of time last year. What's going on? This is not an overnight, "Oh, my goodness, we didn't build enough plants ten years ago." This is the exercise in market power. It's traditional. It's textbook. This is going to be in the history books and it's going to look like what Standard Oil did to us....

Robert Glynn

Chairman and chief executive officer of PG&E Corp., which owns California's Pacific Gas and Electric Company

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The California Public Utilities Commission filed a complaint with the FERC back in April of last year, saying that agreements between El Paso Natural Gas, its affiliate company on its main pipeline--which is the largest pipeline in California--would result in manipulation of natural gas prices in California. By August of last year, [CPUC commissioners] were in front of the FERC saying, "We need immediate action." ... Your company filed documents in support of many of their motions. I believe your company said that there was evidence there of market manipulation. So do you believe there was market manipulation?

I haven't seen a credible explanation for why the southern California prices went to $50 when the national prices only went to, let's say, $8 or $9. I think that has yet to be explained, and has raised questions in many, many people's mind. The pipeline that we have in the Pacific Northwest that brings gas to California's northern border didn't experience price spikes like that to any comparable degree.

I understand that your company went to El Paso and, on a number of occasions, said, "We would like to move gas through your pipeline. We know there should be capacity on the pipeline." And you were told, "There is no capacity available. But if you want to buy it at the border price, the $40 or $50 price, we'll give it to you at that price."

That's interesting. I'm not aware on a personal level that those transactions took place. I'm certainly aware of the prices, and they were very, very high.

... People say to us, "There must be some manipulation going on here." It seems to me you're saying, "At least in the natural gas market, it looks like it's true."

What I said was that there's no explanation that I've heard yet for the prices being as high as they were in southern California.

El Paso, in part, says that the reason there was a spike was because you, as PG&E and other utilities in California, don't have enough interstate pipeline capacity to handle the amount of gas you need. Does that make sense to you?

I'm not going to get into a debate here or elsewhere with El Paso. I'm going to describe what I believe. What I believe is that there's yet to be a credible explanation for the high prices that occurred in southern California. ...

Artificial Shortage

Loretta Lynch

President of the California Public Utilities Commission (CPUC)

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The power companies ... withheld power to keep prices up. So they waited to try to push the regulators to make those prices go up, and then they'd produce.

You believe they took plants offline?

Yes, in order to create a shortage in the winter, because California has plenty of power capacity in the winter. To put a number to it, we only use about roughly 30,000 megawatts a day at peak of power in California in a winter day. We have 41,000 megawatts available in California--power plants ready to run. So we've got a big cushion on any given day. But what happened starting in December, and continuing through January and February, is the folks who could run, didn't run--dropping the available amount of power down to--imagine this--just below what our power needs were, creating an artificial shortage and driving prices up.

You have evidence of this?

... We do have some evidence of that, which I really can't speak to until we take legal action on. But yes.

Richard Priory

Chairman and chief executive officer of Duke Energy

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Did any of your plants go offline in California during peak periods?

Absolutely.

Your plants went down when there was high demand?

We're operating 40- and 50-year-old plants that have been run like never before. They generated 50 percent more energy in the year 2000 than they have in the year 1999, for example. That overuse has led to a series of forced outages. And we dealt with those forced outages as quickly as could be dealt with. But we've only had a few. ...

We had plants that were down for environmental selective catalytic reduction modifications--additions that we had to put on because of the Clean Air Acts. And we were doing that as we should. But beyond that, the plants ran exceptionally well. ...

What we're told by both people in California in the government, and also inquiries that have been made apparently with Duke, [is] that 1994 was a comparable drought year, a high demand year in California. And during that year, the same plants which you now own produce 16.3 million megawatt hours during that period. Today, that is in 2000, they did 15.8 million.

That's pretty good with two units ... out for environmental requirements. ...

So you're saying that your performance matched what was going on in 1994?

No, I would say that our performance was substantially better than 1994. ...

Regulators Failed to Act

Severin Borenstein

Director of the University of California Energy Institute and a professor of business at the Haas School of Business

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So the villain in California, from your point of view, is the California Public Utilities Commission?

CPUC, no question about it. They blew it by not allowing price increases earlier. That could have prevented some of the financial crises that the utilities are now in, which has led to a whole other set of problems, and it would have encouraged some conservation....

But the California Public Utilities Commission would turn around and say, "We couldn't control wholesale prices. That wasn't our job. We went to the people who do that and they did nothing."

That's right. The California Public Utilities Commission could only have responded on the retail side, though if they had responded on the retail side and allowed rates to go up to reflect these costs, there would have been a decrease in demand. And that decrease in demand would have helped to drive down wholesale prices. ...

The FERC was supposed to be the referee on [wholesale] prices, right?

The FERC is supposed to make sure that prices are just and reasonable in the wholesale electricity market. The FERC has not done its job. They, by and large, were uninterested in reviewing and carefully thinking about whether this market would work. And then when it became clear that it didn't work, even to FERC, who in November said the prices were not just and reasonable, their response was to say, "Yes, but we're not going to do anything about it."

...The president of the United States couldn't have influenced FERC by appointment, or by just in bully pulpit, concerning what was going on?

There was a lot of pressure towards the end of the administration to do exactly that, and it wasn't very successful.

So FERC took it upon themselves to stay out of the fray?

They went further than staying out of the fray. They stayed out of the fray and they blocked attempts by the California Independent System Operator to control prices and to take actions that would have helped.

What's the rationale behind that?

I'm not a political scientist, and I'm not sure why these people act the way they do. The chairman of the FERC now is somebody who doesn't really understand economics and doesn't really understand how businesses operate. In many speeches very recently, he's said, "You have to just let the market work," which is of more religion than understanding of economics. In any market in the United States, we don't just "let the market work." Every market is regulated to some extent by antitrust laws, by health and safety laws, etc. The question is, how much intervention should there be? And that, when done right, is a careful policy question, and not one that can be addressed by campaign slogans.

So the FERC could have intervened and stopped this crisis from happening?

The FERC could have intervened and certainly lessened the crisis. I think that, to completely avoid the problems ... we really needed to have a retail price increase in California as well, and we haven't seen that. And that's not the first jurisdiction. The first jurisdiction is at the wholesale level.

We needed both of them acting rationally?

That's right. The FERC has dropped the ball on the wholesale market, and the California Public Utilities Commission has dropped the ball on the retail market....


Read more comments on FERC's role in California's energy market.


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