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California's Panic Was Moneymaker for Energy Sellers By TIMOTHY EGAN and SAM HOWE VERHOVEK

FOLSOM, Calif., Feb. 9 — The largest planned blackout of electricity in California since World War II came in the midst of a heat wave last June, when the mercury hit 103 in San Francisco, and air-conditioners roared. Electricity supplies fell to dangerous levels, and utilities cut power to more than 100,000 homes.

Even more of a shock than the thermal blast in a city known for chilly summers was what came next.

In July, temperatures moderated and energy use fell, but electricity prices still spiked up to the highest ever seen for that month. California utilities paid about $4 billion more for electricity than they did in the summer of 1999.

This pattern has continued. Even now, when energy demands in California are at the low ebb for the year, electric power has been selling at some of the highest prices ever seen.

The attorneys general in California, Oregon and Washington are investigating whether the handful of power companies that sell electricity to the state manipulated the market, cutting back supplies to set off the threat of blackouts — which then led to higher prices and profits. The companies deny that they did.

What happened to throw the normal laws of supply and demand out of whack can be largely explained by the system that California created when it deregulated power three years ago. A backwater agency that was never intended to buy power at competitive rates became a panicky buyer at the mercy of a new breed of energy company that sold electricity like pork bellies in a fast-moving commodities market.

"The simple fact is that a handful of people who were really smart figured out how to make a ton of money selling the same product in essentially the same market conditions as before at 10 times the price," said Michael Kahn, chairman of the California Electricity Oversight Board and co-author of a state study on how the market here collapsed.

The deregulated market quickly took on a life of its own. "You don't put your entire retirement money in a day trader's hands, and we did that — that's crazy," said Kellan Fluckiger, chief operations officer of the California Independent System Operator, the agency created to run the state grid that eventually became the most significant buyer of power.

And in this market, on any given day, at any given hour, California was all but broadcasting to sellers of electricity how much power it needed to buy, and that it would ultimately pay the highest possible price to get it. The sellers capitalized on that, especially on days when California was pinched by other sources of power such as hydroelectric power from the Northwest.

"Did they break the law? They didn't have to," said Steve Klein, superintendent of Tacoma Power, one of many West Coast utilities that got snared in California's troubles.

The eight publicly held, mostly out- of-state companies that generate most of the power for California include some of the biggest names in the business, like Reliant Energy and Dynegy, both based in Houston, and Duke Energy of Charlotte, N.C. They made huge profits last summer, in some cases more than 700 percent over the year before.

These companies say that market conditions — or "unique seasonal dynamics," as one company called last summer's energy woes — presented an opportunity to make record profits in a deregulated environment. And they blame the deregulation law's requirement that the utilities not enter into long-term contracts.

"They didn't have to wait till the last minute to buy all that power," said John Stout, a senior vice president at Reliant Energy. "In any negotiation, if a buyer has to have something, then the longer he waits to buy it, the more the negotiating strength shifts to the seller. That was a choice that California made."

In recent weeks, California has committed $10 billion in bonds to buy long-term power contracts that will be passed on to the struggling utilities.

The people who are running what is left of the deregulatory experiment, now largely abandoned, are still paying record prices for power as they struggle through a 25th day of stage three emergency, a period when blackouts are imminent.

"They know that we're desperate," said Jim McIntosh, referring to the companies that sell power to the grid. "We don't have any leverage to do deals," said Mr. McIntosh, director of scheduling at the system operator.

Nor were the buyers trained in sophisticated trading techniques. "We hired the very best system reliability operators, the people who know how to keep the lights on," Mr. Fluckiger said. "In terms of matching wits with some M.B.A. who's got a Ph.D. in chaos theory, who's working on the derivative of whatever, the answer is no way. We can't do that."

He and other state buyers operate out of a nondescript building in this Sacramento suburb, desperately calling sellers from a room with a NASA-like scheme of power lines and a motto in huge letters proclaiming the deregulation era's promise of "Reliability Through Markets."

The flawed market was one of many factors in California's energy debacle. A dearth of new power plants, unusual weather, high natural gas prices and environmental restrictions have all been blamed. But the regulators say that the market allowed these factors to come together in what some call a perfect storm convergence.

In trying to unravel the mystery of how prices could skyrocket in California even when people were using the same amount of electricity as before, or less, investigators cite two areas of suspicion.

Some regulators contend the California market was toyed with by sellers of electricity to give them an unfair advantage. And they question whether the sellers deliberately took their power plants out of service to reduce available supplies to drive up prices. The regulators point to last August, for example, when the number of power plants out of service was nearly five times greater than in the previous August.

California's deregulated system is like no other. One side — the utilities that buy power and deliver it to customers — remained under state control, with rates for most residential customers frozen until 2002. They sold most of their generating plants, and were largely prohibited from buying long-term electricity contracts. The action would take place on a daily spot market.

The other side, the companies that bought the California plants and now generate power and sell it to utilities in the daily market, was free of state regulation. This imbalance became graphically evident last year, as the buyers, or utilities, plunged into near bankruptcy, losing more than $12 billion, while the power companies that sold them electricity made record profits. For just five days last June, for example, more than $1.4 billion changed hands.

On days when demand was high, some companies had enough electricity that they could withhold to tip the market into an upward price spiral, according to a state regulatory report.

Until the system was dismantled last month, electricity was bought and sold in the California Power Exchange, where buyers and sellers would bid for electricity to be used on the next day. Demand would be matched to supply by a new state agency, the California Independent System Operator.

Only when there was not enough electricity bid a day earlier to meet demand would the system operator have to declare an emergency and buy electricity, usually at exorbitant rates, or risk turning out the lights for parts of the state. The system operator was "a captive buyer of last resort," state investigators wrote in a study done last fall.

No one expected the agency to ever handle much more than 5 percent of daily demand; but at times in the past year, it has been buying almost one-third of all California's power at high last-minute prices.

"It was like buying house insurance when your house is already on fire — you'll pay anything for it," said Robert McCullough, a former utility executive and energy analyst who has done several studies of the California energy disaster.

On the issue of whether the power failures were deliberate, the Federal Energy Regulatory Commission said in a recent report that it could find no proof that companies took their generators out of commission to drive up prices.

For much of the last six months, power plants have been out of service at historic high levels, raising the suspicions of consumer groups and others. A spokesman for Gov. Gray Davis, a Democrat, called the federal finding a "see-no-evil, hear-no- evil type of audit."

The San Francisco city attorney, Louise H. Renne, said a lawsuit the city has filed against the energy companies that supply power will ultimately show that the industry was playing with "marked cards" that allowed it to illegally "take advantage of a deregulated market to make a quick buck." The companies say California's problem is simply that it does not have enough plants and that too many of its generators are old and need frequent repairs.

A state bailout to buy future power will commit every person in California to a bonded debt of about $300, even though the market was restructured at the end of last month.

The fear is that the state will wind up getting hit coming both in and out of its deregulation debacle — for it is possible that as new energy plants go into operation and suppliers finally have to engage in fiercer competition, the prices to which California may commit itself in long-term contracts now under discussion may turn out to be far too high.

Now, condemnation of deregulation seems universal. But in the beginning skeptics were rarely heard, even though there were warnings.

Mr. McIntosh, the scheduling director at the power agency here and a 29-year veteran of the regulated electricity world, recalls being invited by a group of out-of-state energy companies to a Colorado resort five years ago for a "pick-your-brain" conference on how deregulation would work.

"They had a group of M.B.A. types out there that were already figuring out how they were going to make money in the California market," said Mr. McIntosh, who came back to California and wrote a memo to his bosses at Pacific Gas and Electric about the session.

"These guys are going to eat our lunch," he said he recalled writing. "And the rest of California's. And they have."

http://www.nytimes.com/2001/02/11/national/11POWE.html?pagewanted=all

-- Martin Thompson (mthom1927@aol.com), February 11, 2001

Answers

Sunday, February 11, 2001, 12:00 a.m. Pacific

Did power producers manipulate market?

Background, Related Info & Multimedia:

by Susan Kelleher Seattle Times staff reporter As lawyers and lawmakers try to wrest back power and profits from the energy industry, a sneaking suspicion that emerged last summer has gained momentum and credence:

What if the current energy crisis that started in California and spread to the Pacific Northwest was more than a result of too few power plants? What if the people who owned the generators withheld power when people needed it most, driving prices up and making stock in electric companies a ticket to the billionaires' club?

The scenario seems likely to Gary Zarker, superintendent for Seattle City Light and one of dozens of utility officials, lawmakers, and economists who see no other compelling explanation behind California's sudden loss of more than 15,000 megawatt-hours of energy - enough to power 13 Seattles at any given time.

The Northwest has its own shortage problems, as supply has lagged behind demand in the past 10 years and low reservoir levels this winter mean less water for the hydropower system.

But California typically shoots juice north in the winter, and a shortage of power there means Northwest utilities have been forced to shop more regularly in the high-priced spot market to meet their load, or demand.

As rate increases ricochet around the region, more than one official is casting a suspicious eye south.

"Last summer, they had a 47,000-megawatt load, which wasn't even a peak for California," Zarker said. "Somehow, the lights stayed on, which meant they had generating capacity somewhere. The system had enough.

"Now there's a 30,000-megawatt load because of cooler weather, and they're operating in a perpetual state of emergency. What happened to all that generation? Someone needs to answer that question."

So far, the disappearance of about 15,000 megawatts of energy in California is the subject of lawsuits, federal inquiries, academic studies and investigations by a half-dozen California agencies, as well as the attorneys general of Washington and Oregon.

Discovering precise reasons for the steep climb in prices will drive solutions, to the crisis, such as the extent to which environmental laws are loosened to encourage construction of new plants, and whether government regulation or market forces dictate future prices.

Suspicion falls on suppliers

For now, though, angry fingers are pointing to for-profit electric suppliers, many of them based in Texas and the East Coast.

The power-plant operators - which posted record profits last year - deny manipulating the market at any time since 1998, when California's energy industry was deregulated. They say some of their plants were off line for maintenance, while others were fitted for pollution-control devices and still others broke down.

Those with natural-gas generators also say steep increases in the price of fuel have added millions to operating costs, forcing them to charge wholesale prices for electricity that are hundreds of dollars in excess of last winter's prices.

"We're not going to be apologists for what we've done," said Richard Wheatley, spokesman for Reliant Energy of Houston, which operates five plants in California. "We've operated ethically. We've operated legally."

Accusations escalated in January when the company reported that operating income from the sale of wholesale energy increased from $27 million in 1999 to $482 million in 2000.

"We have a responsibility to make money, a reasonable profit, and a big responsibility to our shareholders," Wheatley said. "If California designed a screwed-up system, then California should fix it."

Collusion or bad design?

Although state officials have raised the specter of collusion among the generating companies, energy experts said the system for buying and selling electricity in California was so transparent and counterintuitive that no one had to conspire to make money. All they had to do was watch and wait.

That marketing system is all but dead now in the wake of state and federal intervention, but the effects of its meltdown linger.

To visualize how the California market worked, imagine a swimming pool that must be filled with water every day.

One supplier offers to fill the pool halfway for $1 a gallon. Another offers to fill up half of what remains for $5 a gallon. The bidding continues until the last supplier offers to sell the final cup. The asking price: $400.

And here's the kicker: If the final bid is accepted, everyone who contributed water to the pool will be paid $400 a cup, even if they offered to sell for $1 a gallon.

In theory, the market was supposed to encourage suppliers to bid early at cheap prices to avoid being locked out when the demand was met for the day.

In practice, it produced staggering prices for California and anybody else shopping for extra power.

Most of the power used by California ratepayers was bought on the day- ahead and spot markets run by the California Power Exchange, a not- for-profit agency that served as energy auctioneer for the state's deregulated market.

Under deregulation, California's three largest utilities - which previously enjoyed a monopoly on generation and transmission - were forced to shop on the power exchange, telling suppliers how much they needed and what they were willing to pay.

The state also created the California Independent System Operator, or ISO, which ran the state's power grid and solicited bids from suppliers each day to ensure sufficient reserves.

The daily market gave all suppliers an equal shot, and enabled utilities to buy only the power they needed. But it also telegraphed to generators just how desperate utilities were for power at any given hour, and provided fast feedback about when and where electricity would fetch top dollar.

"Where the system goes up and down in big swings is the weather," said Dave Warren, director of the energy-policy office at the Washington state Department of Community, Trade and Economic Development. "If they're predicting temperatures in the high 90s, you know pretty close how many air conditioners are going to be turned on at any given hour."

Because the system rewarded everyone with the higher price, and because everyone had a good idea about how much electricity was needed, it was obvious that the longer you waited to bid your electricity, the more you would get paid for it, said Daniel Allen, an economist with Synapse Energy in Cambridge, Mass.

"There are all kinds of crafty and technical ways of manipulating bidding strategy," said Allen, whose company conducted a study on the same type of market operating in the Northeast.

In California, three large utilities shopped for all of their power through the exchange. Suppliers, including up to a dozen companies that own the natural-gas plants that provide the bulk of the state's electricity, made hourly or real-time bids until the total demand was met.

By providing hourly feedback on bids, the system made it easy for suppliers to explore the price envelope, said Paul Joskow, an economics professor at the Massachusetts Institute of Technology.

"You experiment," Joskow said. "You bid $200 (a megawatt-hour) and see if it clears the market. If it does, you can try to go higher. If it doesn't, you go lower. A repeated game like that provides a lot of learning opportunities."

Allegations hard to prove

Zarker, the Seattle City Light superintendent, said Northwest utilities got hit with high prices because they were shopping - and continue to shop - from the same suppliers during times of shortage. They also got hit because suppliers, including Northwest utilities that generate power, knew they could charge premium prices.

Steven Klein, superintendent for publicly owned Tacoma Power, said allegations of market manipulation will be hard to prove because there are no laws requiring suppliers to put their goods on the market.

"On the surface, not wanting to sell power from day to day is not breaking the law," he said. "But the day that you learn how to affect the market, you're exercising market power."

If companies used their market power to manipulate prices, the federal government could prosecute them for violating antitrust laws. Klein, however, said it would take a lot of political will to sustain such an investigation, and even more to pursue a remedy.

In a study of California energy prices during summer 2000, Joskow and his partner found "considerable evidence" to support the presumption that suppliers held back power to drive up the price. The study found prices during that period were hundreds of dollars above what one would expect in a truly competitive market, even accounting for such things as higher gas prices.

Two inquiries by the Federal Energy Regulatory Commission (FERC) found no evidence of power withholding, but regulators conceded their probes were not in-depth investigations.

"Generators were not running during hours when we would have expected them to run," Joskow said. Southern California Edison, a utility that owes billions for wholesale power bought at sky-high prices, funded the study.

Several other studies found that a greater number of power plants were on scheduled and forced maintenance during the summer and winter of 2000 than in previous years.

Without access to proprietary records, utility officials can only feed their suspicions, not satisfy them. FERC, which can review suppliers' records, is responsible for keeping prices "just and reasonable."

Gregoire is investigating

Washington state Attorney General Christine Gregoire announced Jan. 30 that her office would investigate whether price manipulation and other unfair business practices were driving West Coast energy prices.

Her concerns, she said, stem in part from suppliers' Securities and Exchange Commission reports, which showed quarterly profits increased by 20 times since last year.

But Joskow, the MIT economist, said the investigations may only reveal what is painfully obvious to everyone: California-style deregulation was a failure.

"Everyone is looking for a bogeyman, and there's enough blame to go around as to why the markets aren't performing well," Joskow said. "The idea of assigning blame to specific suppliers for responding to a market with these attributes is the wrong road."

Susan Kelleher can be reached at 206-464-2508 or at skelleher@seattletimes.com.

http://seattletimes.nwsource.com/cgi- bin/WebObjects/SeattleTimes.woa/wa/gotoArticle? zsection_id=268466359&text_only=0&slug=shortage11m0&document_id=134266 807

-- Martin Thompson (mthom1927@aol.com), February 11, 2001.