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March 8, 2001

State's Outlays for Electricity May Be Hard to Recover Without a Rate Hike

By REBECCA SMITH, MITCHEL BENSON and JOHN R. EMSHWILLER Staff Reporters of THE WALL STREET JOURNAL

SACRAMENTO, Calif. -- Earlier this year, Gov. Gray Davis made what may be the biggest bet in the history of the nation's biggest state: that he could tame an out-of-control electricity market and avoid devastating blackouts without busting the state's budget, antagonizing its consumers or derailing his own political career.

His wager is still on the table, but the assumptions that underlie it are looking increasingly shaky these days. The governor has already spent around $2 billion of public money buying hugely expensive wholesale power, taking over the role formerly played by the state's near-bankrupt electric utilities. And California will probably be obliged to spend billions more before its electricity market stabilizes and those utilities are restored to some semblance of financial health.

Under the governor's plan, California aims to recoup the money it is using to buy electricity by issuing $10 billion in bonds. That way it would still have a healthy budget surplus to finance new spending on roads, schools and other public services. But there's a potentially big obstacle to this plan. The state Legislature, worried about racking up billions in new debt, has put limits on the size of any bond offering. In broad terms, the Legislature's action would allow the state to borrow only four times as much as it can recover annually from utility customers.

Right now that doesn't appear to be much. Under the current rate structure, essentially set in place by California's flawed 1996 electricity-deregulation plan, consumers pay far less for power than the cost of acquiring it on the wholesale market. Preliminary estimates submitted by utilities last month to the California Public Utilities Commission show the state's share of the proceeds from electricity sales this year could be as little as $241 million -- not enough to support even $1 billion in bond sales under the Legislature's formula.

That would leave the state on the hook for much of the money it has already paid for power -- not to mention the billions more Gov. Davis will need to spend. That, in turn, raises the prospect that California's economy and its credit rating both could deteriorate significantly. But state finance officials say that, based on their own projections, they will be able to extract enough money to support a $10 billion bond issue.

Walking a careful line between fiscal prudence and political survival, Mr. Davis and others in his administration are scrambling to come up with ways to get around the legislative restrictions without raising rates for consumers. "If I wanted to raise rates, I could solve this problem in 20 minutes," Mr. Davis says.

The governor says he believes that the state can obtain enough affordable power through long-term power-supply contracts to avoid the need for a big rate increase. The billions of dollars the state hopes to borrow would be used to help pay for power until electricity prices drop, as they are expected to do when new power plants come online over the next few years.

The Davis administration fears that what may be its only other option -- a big increase in retail electric rates -- could prompt angry consumer groups to seek new electricity laws through a statewide ballot initiative during next year's election. That's when Mr. Davis is expected to run for a second term as governor.

But trying to save California without rate increases is forcing Mr. Davis to make some colossal gambles with the state's money. State officials estimate that in the next several months, California will need to spend as much as $6 billion on power purchases -- equivalent to the state's entire fiscal surplus. Mr. Davis is also looking to spend several billion more to buy the transmission assets of three investor-owned utilities in order to restore two of them to credit-worthiness. He also has announced plans to spend several hundred million dollars more on conservation programs designed to reduce demand while new power plants are being built in the state.

In order to limit the state's financial exposure in the meantime, the governor and his aides have, in some cases, ignored state law. They have threatened appointed officials who have stood in the way. And they have sharply restricted the flow of information to the public.

None of those steps is expected to do much to reduce state spending on power in the coming months. In a few weeks, power usage is expected to begin a sharp seasonal rise as Californians switch on their air conditioners with the coming of warmer weather. By various estimates, demand during peak periods this summer could outstrip supply by 10%, or several thousand megawatts. That could produce more rolling blackouts like the ones that hit Northern California earlier this year. It is also likely to put strong upward pressure on wholesale electricity prices.

Steven Zimmerman, managing director of Standard & Poor's Corp., says Mr. Davis and his aides don't "have a lot of time" to put a cap on the state's financial exposure to the crisis. The credit-rating agency has put the state on credit watch for a possible downgrade, which would affect the value of all of California's outstanding public debt. Moody's Investor Service Inc. is also concerned. It said in a recent report that the power crisis could soon "seriously threaten the health" of the state's economy.

Mr. Davis, a Democrat and career politician, was dealt a bad hand when he took office in 1999. The deregulation plan that sparked the state's electricity crisis was enacted under his predecessor, Republican Pete Wilson. But Mr. Davis was slow to react to early signs of trouble this past summer and alarms sounded by members of the state Legislature. By the time Mr. Davis finally sprang into action earlier this year, a troublesome power-supply squeeze had escalated into a crisis.

In a Jan. 17 declaration of emergency, the governor designated the state Department of Water Resources to take the utilities' place as the daily buyer of huge quantities of electricity. His hope: that by making the state the dominant player in California's power sector, he would ease electricity producers' concerns about getting paid and give the state enough clout to negotiate lower long-term power prices.

Squeaky Summer

Earlier this week, Mr. Davis announced final or tentative agreements with 20 power suppliers to furnish the state with a total of 8,900 megawatts for periods of as long as 20 years. But the supply situation remains extremely uncertain for this summer, when demand probably will top 45,000 megawatts. If the state can secure enough power under contract and push down demand through aggressive conservation, it might be able to squeak through the summer season. If not, it will be forced to keep buying huge amounts of costly power in the cash market.

Under deregulation, retail electric rates were frozen for several years, while wholesale-power costs were free to fluctuate. When the plan was conceived, wholesale prices were low and expected to go lower. However, a combination of unexpected growth in power demand and a lack of new generating capacity helped produce a supply squeeze. Average wholesale prices more than tripled last year from 1999. And in January those prices were up 10-fold from a year earlier.

By then, California's two biggest investor-owned utilities -- the Pacific Gas & Electric unit of PG&E Corp. and the Southern California Edison subsidiary of Edison International -- faced imminent financial collapse. They had racked up billions of dollars in wholesale power bills they couldn't afford to pay. As generators began shying away from selling to the two utilities, the Clinton administration forced them to sell power into the California market, an order left in place during the first weeks of the Bush administration. Still, northern California was hit by rolling blackouts on several days in early January.

Learning by Doing

Since then, the DWR, which does some electricity trading as an adjunct to its main mission of managing the state's giant system of aqueducts and reservoirs, has had to learn the ins and outs of power markets on the run. It hasn't been easy.

David Mills, trading-floor manager for the federal Bonneville Power Administration, says the water agency has at times offered to pay $50 to $100 per megawatt hour more than the available market price. "They agree to prices that make you wonder," says Mr. Mills, whose organization markets electricity from federal dams in the Pacific Northwest. "You'd at least think they'd check to see what the prevailing price is before throwing out their offer." Mr. Mills says that "to cut California some slack," he occasionally has instructed his traders to sell at prices lower than the DWR had offered to pay.

Ray Hart, the water agency deputy director responsible for the power purchasing, says he isn't aware of any cases in which the DWR has overpaid. He says his team has been "extremely successful by all measures."

Ultimately, the DWR's trading acumen is far less important than the overall arithmetic of power supply and demand in California. With the price of natural gas that feeds many of the region's generating plants at near record levels and some suppliers reluctant to sell into the troubled California market, wholesale electric prices remain stubbornly high and, in recent days, have again been rising.

The Legislature has advanced the DWR about $3 billion from the state's general fund for power purchases. Under emergency legislation passed by the Legislature and signed by Mr. Davis on Feb. 1, the general fund is to be reimbursed from a planned bond sale later this year. But under terms of the emergency law, the water agency would have to wrest $2.5 billion a year in revenue from retail electricity rates in order to sell the $10 billion worth of bonds sought by Mr. Davis.

Assembly Speaker Robert Hertzberg, a Southern California Democrat, says the formula was created to ensure that there would be a way to repay the bonds without draining the state's coffers. "We didn't want to just open our wallets," he says.

According to the language of the Feb. 1 law, the water agency gets what's left of revenue collected from ratepayers after the utilities pay certain of their own power-supply bills and other expenses. And, in their filings with the PUC last month, the utilities reckoned, under their worst-case scenarios, that there would be only $241 million available to the DWR this year.

Changing the Formula

State officials are quietly pushing the PUC to rejigger the formula so that the water department gets more money -- even though that would clash with terms of the Feb. 1 law. Robert Miyashiro, deputy director of the Department of Finance, says the emergency law was "drafted poorly" and has led people to believe the DWR "only gets the leftover money." He predicts there will be "cleanup legislation."

At the request of the Davis administration, the PUC is considering a plan to use a different revenue-sharing formula than the one in the state law. The proposed new formula was written "in close consultation" with Mr. Davis's Finance Department, says PUC President Loretta Lynch, who supports the initiative and is hoping to rush it through.

The effort has drawn some opposition. Commissioner Richard Bilas at a recent PUC meeting questioned the legality of the commission attempting to change a formula set by the Legislature. PG&E is even more emphatic, since the DWR's extra money could come at the utility's expense. The formula "threatens to undo the very financial protections for the utilities that [the new law] attempted to provide," the utility said in a recent filing with the PUC.

Balking at Buying

As politicians and regulators wrestle with that issue, the Davis administration has taken a step to reduce the outflow of state cash that also seems to conflict with the Feb. 1 law. It was widely assumed that the law required the DWR to buy any electricity the state needed to keep its lights on. However, on many occasions, the DWR has refused to buy power on the grounds that it was too expensive, citing a portion of the new law that urges the agency to hold down costs.

The task of covering any remaining shortfall has passed to the California Independent System Operator, which manages the state's energy grid and is charged with buying power when necessary to avert shortages. However, the ISO doesn't have any power-purchasing money of its own, and the major parties it would normally bill are PG&E and Edison, whose inability to pay their power bills was the reason the state started buying electricity in the first place.

Amid criticism of its stance from generators, utilities and Wall Street, the DWR says it has started covering more of the utilities' electricity costs. The water agency is now buying 95% to 99% of what California needs in a given day, says the agency's Mr. Hart. But increased buying only adds to the uncertainty about the eventual tab.

The state's legislative analyst, Elizabeth Hill, recently recommended that lawmakers hold off considering more than $2 billion in state spending on items ranging from college construction to beach cleanups because of continuing questions about the financial impact of the electricity crisis. Like others, Ms. Hill complains that the governor's office and state agencies haven't been forthcoming with information.

Indeed, the DWR refuses to say precisely how much power it is purchasing and at what prices, though it has on several occasions gone back to the Legislature for more money. State officials say that data on its purchasing activities would give suppliers an advantage in continuing electricity-supply contract talks.

State Controller Kathleen Connell, who is running for mayor of Los Angeles in an April election, recently announced plans to post state power-spending information on her department's Web site. But within 24 hours, Ms. Connell suspended that plan after discussions with senior Davis administration officials. "I feel very strongly that this information should be publicly released," says Ms. Connell. "I just don't want to do anything that would weaken the state's effectiveness in negotiating."

In an effort to more tightly control events, the governor obtained legislative approval to abolish the 26-member ISO board, which was made up of everyone from utility executives to representatives of consumer groups. He then appointed a new five-member board. To ensure a quick transition, the California attorney general threatened the old board members with fines of as much as $5,000 each if they didn't immediately relinquish their positions. All did. "I was offended" at the "heavy-handed" treatment, says Karen Johanson, a former ISO board member.

One of the first acts of the ISO's new board was to close a meeting about the electricity crisis. The former ISO board routinely held such meetings in public. ISO attorneys say the meeting was largely designed as a private briefing for new board members and that the organization is committed to keeping its deliberations as open as possible. The Wall Street Journal and other news organizations have unsuccessfully challenged the closure in Sacramento state court.

http://interactive.wsj.com/articles/SB984003403289784731.htm

-- Martin Thompson (mthom1927@aol.com), March 08, 2001