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Hot Times Ahead for California & West as Shortage Intensifies: CERA Report

Source: Business Wire Publication date: 2001-02-12

HOUSTON--(BUSINESS WIRE)--Feb. 12, 2001--California's current power crisis is the precursor of a much more serious shortage that will occur during the coming summer despite recent steps to expand the state's power generation capacity, according to "Beyond California's Power Crisis: Impact, Solutions and Lessons," a report released today by Cambridge Energy Research Associates (CERA).

"The source of California's far-reaching power crisis is a shortage," CERA's analysis found. "The state is critically short of power plant capacity. At least 5,000 megawatts (MW) of new generating facilities are required to restore balance to the state's grid."

The report warns that the long-term power contracts California is now negotiating are likely to create risky, potentially above-market obligations for the state in the future. It also details CERA's analysis of supply, demand and price fundamentals in the years prior to the shortage showing that California's industry structure produced a competitive outcome, with no evidence of the exercise of market power by generators. The special report was released at a briefing on the opening day of CERA's 20th annual Executive Conference in Houston.

"Although steps have been initiated recently to increase power supply in the short term, under expected conditions this summer, demand will exceed supply for hundreds of hours, necessitating emergency operating procedures to relieve demand," said Lawrence J. Makovich, CERA's senior director of electric power research. "CERA expects as many as 20 hours of extreme shortage in which demand exceeds supply by 3,000 MW, requiring the state to implement rolling blackouts."

Market Structure Flaws

The CERA analysis disagrees strongly with the argument that the crisis represents the failure of the very concept of electricity deregulation. What has been described as "deregulation" in California is only partial deregulation. The crisis is the result of three critical failures:

-- Failure No. 1: Structural flaws -- California's system did not

ensure new generation capacity sufficient to keep pace with

the state's growing demand. The California power market was

set up with serious structural flaws that failed to send the

fundamental signal -- that investments in new power plants

were both possible and profitable. For example, it lacked a

capacity requirement to ensure that supply additions outpace

demand growth by requiring companies to procure enough

supplies to serve their customers, plus a margin for reserves.

It also restricted the ability of companies serving customers

to arrange a portfolio of contracts of various terms.

-- Failure No. 2: Difficult to develop plants -- Even for those

companies actively pursuing projects, it has been enormously

difficult to site and build new plants in the state.

California has perhaps the most time-consuming and costly

power plant approval process in the nation -- including an

open-ended environmental review process, and well-coordinated

local community opposition. This process and the inability to

get approval have thwarted efforts by companies to build

proposed power plants that could have averted the supply

shortfall. California's siting and permitting process has not

been streamlined to incorporate the "best practices" that have

successfully integrated environmental management with the need

for more power generation facilities in other states.

-- Failure No. 3: Wholesale and retail markets not aligned --

Although described as "deregulation," California only partly

deregulated its power market. Initially, retail prices were

capped above wholesale price levels. More recently, wholesale

price levels have soared far above capped retail prices,

causing a fundamental misalignment between the two parts of

the market. This means that customers do not see -- or respond

to -- prices that reflect constrained supply. Yet these very

responses could help avert these extreme price spikes. It has

meant that an energy shortfall has turned into a financial

crisis for the state's largest utilities. And consumers are

still paying the price, not through their bills, but through

the diversion of their tax dollars and the disruptions that

they are experiencing.

Power Markets Unique

"The crisis in California arose because people believed that electric energy markets were just like other commodity markets," the CERA report observed, "that when demand and supply tightened up then prices would gradually rise, stimulate investment and keep supply and demand in balance. This premise is wrong.

"Power markets are not like other commodity markets. The complex characteristics of the power business -- lack of storage inventory, transmission grid delivery and high fixed costs, for example -- mean a unique set of institutions and regulations are needed for successful competitive market outcomes." To achieve power market balance, the megawatts of available supply must equal actual demand plus a necessary minimum reserve for reliability (maintenance, mechanical problems and spinning reserve).

"Given the unpredictability of demand -- due principally to weather -- and power plant outages, it is reasonable to establish a minimum reserve requirement of 15% to 20% as the balance point of supply and demand in the California power market," according to the CERA report. "Unlike other non-storable commodities like telecommunications, a busy signal is not an acceptable way to get around this capacity requirement -- because with electric power a "busy signal" takes the form of a blackout."

ISDEM Analysis

When customers are exposed to the true cost of wholesale power markets, their consumption and investment patterns can shift appropriately. CERA's Integrated Supply and Demand Electricity Market Model (ISDEM) has quantified the responsiveness of electricity consumption to price changes in the near-term, measuring the change in demand with a change in retail consumer electricity prices on a regional basis, holding constant other variables influencing consumption such as real income, weather-sensitive electric end uses and weather.

Based on this analysis, CERA forecasts that if customers in California receive the same level of price increase as other Western customers, it could lower demand by 1,000 to 2,000 MW cutting the expected supply shortfall during the summer by one-third.

Market Power

Much recent popular analysis of the California situation credits the crisis to manipulation of the market rather than shortage. The analysis in the CERA report indicates that, without the shortage condition, the results of the market were clearly competitive. "A focus on the market power issue implies that there is no 'true' supply shortage, making short-term actions to fix the supply problem more difficult to implement," according to the report.

Analysis of supply, demand and price fundamentals in the years prior to the shortage shows California's industry structure produced a competitive outcome, with no evidence of the exercise of market power by generators.

Near-Term Measures

The CERA report indicates that there is a set of measures available in the near-term to lower consumption and increase generation capacity that, if implemented aggressively and immediately, could partially offset 2001's tight supply situation by up to 4,000 MW. California's actions to-date, including the Governor's recent executive orders, accomplish some, but not all, of CERA's recommendations. As a result, according to CERA, California's current response appears to be too little and too late. The measures recommended by CERA include:

-- Expand targeted programs that pay customers to reduce peak

period consumption;

-- Encourage conservation with a variety of steps;

-- Provide flexible emissions restrictions;

-- Coordinate plant outages on an emergency basis; and

-- Provide for flexible hydroelectric facility operations.

Longer-term, the steps needed to restore a properly functioning wholesale energy market in California include:

-- Establish a capacity requirement and a capacity payment

method;

-- Streamline the plant siting and approval process;

-- Resolve the credit crisis facing the state's utilities;

-- Move to portfolio buying over the next three years, rather

than contracting excessive long-term supplies now;

-- End the consumer rate freeze, and confront customers with a

price that reflects the economic cost of consumption;

-- Align the wholesale and retail market structure;

-- Avoid tinkering with market rules;

-- Move beyond investigations;

-- Create a positive investment climate;

-- Restructure the regional power transmission system; and

-- Explore unconventional generation options.

"Beyond California's Power Crisis: Impact, Lessons and Solutions," was prepared for and will be distributed to clients of CERA's Western Energy, North American Electric Power and Global Power Forum Membership Advisory Services, and is also available for purchase. For members of the above services, additional copies are US$50; for non-members, the first copy is US$2,500 and additional copies are US$100. To order, contact Lauren Laidlaw at +1 617 441 2604 or llaidlaw@cera.com.

Cambridge Energy Research Associates (CERA) is a leading advisor to major international companies, financial institutions and organizations, delivering strategic knowledge and independent analysis on energy markets, geopolitics, industry trends and strategy. CERA is headquartered in Cambridge, Mass., and has offices in Bangkok, Beijing, Calgary, Houston, Mexico City, Moscow, Oakland, Oslo, Paris, Sao Paolo, Seoul and Washington, D.C.

Publication date: 2001-02-12

http://cnniw.yellowbrix.com/pages/cnniw/Story.nsp?story_id=18120972&ID=cnniw&scategory=Utilities

-- Martin Thompson (mthom1927@aol.com), February 12, 2001