Agency actions invited power disaster

Critics from within Federal Energy Regulatory Commission ignored

BY ERIC NALDER AND MARK GLADSTONE Mercury News

The federal agency charged with ensuring the stability of the nation's power system gave California the go-ahead to deregulate its electric utilities despite critical flaws evident to its own experts. And once deregulation was under way in 1998, the agency did little to police the state's market, even though it has a legal obligation to ensure that prices are ``just and reasonable.''

Far from being the innocent bystander that top federal officials portray, the Federal Energy Regulatory Commission has played a central role in California's deregulation disaster, weighing in more than 80 separate times with orders approving, revising or rejecting parts of the plan.

To examine the role this small agency has played in California's deregulation, the Mercury News reviewed hundreds of documents and interviewed energy experts and FERC employees, some of whom talked publicly for the first time.

The review found that FERC -- eager to promote deregulation and reluctant to cross California politicians, generating companies and utilities pushing the state's groundbreaking plan -- ignored detailed criticism from one of the nation's top deregulation experts and its own staff members, including its chief economist.

More important, the review reveals the most critical mistake federal regulators made in ushering in electricity deregulation: They set the stage for a new energy-trading market every bit as complicated as Wall Street but failed to monitor it. With California ceding much of its regulatory role, FERC had the critical responsibility to stop market abuses, but it failed to hire enough experts, obtain the data or install the computers needed to keep the market honest.

Subpoenas rare

In contrast to the Securities and Exchange Commission, which frequently takes aggressive action to enforce stock-market rules, FERC almost never uses subpoenas in staff investigations to acquire data on electricity trading that could include evidence of anti-competitive practices that boost prices.

Curtis Hébert Jr., a confident 38-year-old Mississippi lawyer who became FERC's chairman in January, dismisses claims that the agency does not gather enough data on prices or investigate the energy industry thoroughly.

``We do have enough resources, and we are handling it in a way that's appropriate,'' he said of the agency's role in California's crisis. An ardent supporter of free markets, he said FERC's primary job is to create a competitive market for electricity and keep the lights on. Low prices will follow, he promised.

But James Hoecker, FERC's chairman when California implemented its plan, has become more critical of the decisions the agency made under his leadership and now says FERC should have more aggressively scrutinized the plan rather than moving it along.

``I would very much have liked for the commission to be more prepared for California,'' he said.

While the state, utilities and energy companies share blame for California's failed plan, FERC had a unique responsibility under a 66-year-old federal law to make sure the state's new market would lead to ``just and reasonable'' wholesale electricity prices. Neither Congress nor the courts, however, have made clear what that means in a deregulated market.

For decades, FERC's responsibility to monitor prices was much simpler. The agency set rates for wholesale electricity using a formula based on generating costs plus a fair profit.

But the agency took steps to change its role in the early 1980s, when it helped set into motion the forces that would lead to California's deregulation. In 1982, two years after President Reagan's election, a FERC lawyer named Robert Angyal wrote an internal memo assuring commissioners that the ambiguity of ``just and reasonable'' gave them ample room to experiment with free-market sales of electricity.

``We thought we were the good guys then,'' said Steve Greenleaf, who joined the agency in 1986 as a regulatory specialist. Greenleaf, who now works for California's power grid operator, said recent events ``certainly make me go back and consider what we did.''

What he and others did was clear a path for the deregulation bandwagon. FERC commissioners, generating companies, utilities and politicians -- both Democrats and Republicans -- all argued that competition could both reduce rates and boost profits, just as it had for natural gas, airlines and other markets.

In 1992, Congress passed a law encouraging open access. FERC took the next key step when Chairwoman Betsy Moler, a free-market Democrat, sat down at her kitchen table one morning to begin drafting Order 888, named after the agency's address in Washington, D.C.

The order, finalized in April 1996, encouraged the emergence of free markets by requiring utilities to open their transmission lines to competing power companies, but it did little to prepare the agency to monitor the markets and make sure companies competed fairly.

Daniel Fessler, a former University of California-Davis law professor appointed to the state Public Utilities Commission by Republican Gov. Pete Wilson, drafted California's deregulation plan in the mid-'90s. In a brief and reluctant interview -- the first he has granted since the energy crisis began -- Fessler said that he consulted with FERC officials while he worked on the plan and testified several times before the commission.

``Our dialogue was extremely public,'' he said.

But FERC officials say the agency took a hands-off approach, despite conducting hearings and receiving thousands of documents.

Hoecker, who took over for Moler in June 1997, said the agency viewed California's plan as an experiment that raised questions that could not be answered until it was in place. ``Fundamentally, the commission took the stance that no one had experience in the United States anyway with this comprehensive restructuring,'' he said.

At several crucial junctures, the agency's commissioners passed on the chance to explore the advice of critics, both academic and in-house, that could have helped shape California's plan.

One of the nation's top experts on electricity deregulation, Bill Hogan of Harvard University, witnessed how commissioners let a detailed critique of California's plan slip by them at FERC's summer 1996 hearings.

San Diego Gas & Electric, the state's third-largest investor-owned utility, had hired Hogan to analyze the plan, which the utility opposed. His 71-page report offers a blueprint for some of what eventually would go wrong.

Flaws in the plan

Hogan did not predict the disaster -- nobody did -- but he criticized key aspects of the plan: a market structure that made it possible for companies to boost prices, and a complex power auction that opened the door for gaming.

At a hearing, the San Diego utility's chairman presented Hogan's paper to the commission. San Diego's opposition was the last major obstacle the plan faced, and the utility says it came under pressure to get in line so California could meet a start-up date of January 1998.

State lawmakers and other energy executives told San Diego to get on board if it wanted to have a ``meaningful role'' when the Legislature wrote the final plan, said Bill Reed, chief regulatory officer for the utility's parent company.

``I believed, naively as it turned out, that FERC would exercise the ultimate judgment as to what needed to be done,'' Reed said. ``Unfortunately, FERC has taken deference to an extreme that I never considered.''

The San Diego utility withdrew Hogan's report, and the commissioners signed off on the deregulation plan.

``San Diego stopped talking,'' Hogan said. ``I wasn't invited to speak.''

After the San Diego utility dropped its opposition, Steve Peace, a loquacious Democrat from San Diego, led legislators on 18 days of hearings to craft the final details of California's plan.

The Legislature passed the bill unanimously, and Wilson signed it Sept. 23, 1996, hailing it as ``a major step in our efforts to guarantee lower rates.''

To a degree that few seemed to grasp at the time, it was an unprecedented transfer of power from the state to the federal government. Prior to the bill's passage, state regulators had control over most of the power generated in California, setting prices and making sure enough electricity was available. Now much of the power is generated by private companies -- not state-regulated utilities -- and only FERC has the authority to step in when wholesale prices climb.

FERC also continued to rule on each additional step in the state's complicated deregulation plan as it was implemented. Again, the agency missed chances to overhaul the plan, this time based on flaws pointed out by its own experts.

Rube Goldberg

FERC's chief economist, Richard O'Neill, openly called the California plan a Rube Goldberg contraption in conversations with colleagues and California officials, according to sources inside and outside the agency.

Carolyn Berry, a FERC economist who has since left the agency, also reviewed the plan. She, too, saw flaws -- and worried especially that the odd market structure might encourage companies to manipulate prices.

``There was great resistance on the part of many people at the commission to undo the process that California sent in,'' Berry said. ``There was a reluctance to start pulling at the threads for fear that the whole package might fall apart.''

The flaws the two cited, including some of the same ones Hogan flagged, are now widely acknowledged as contributing to the collapse of California's scheme.

The deep concerns of the staff members, however, were never impressed on the commissioners. FERC does not foster a culture of internal debate, insiders say.

Hoecker said the agency made few changes in the plan because ``the commission was too highly deferential'' to California's industry leaders and politicians.

In addition, he said, the agency simply did not have the clout to stop a plan hurtling along on a political fast track.

The agency, like others in Washington, is highly political and, acutely aware of what industry leaders want, often delivers. As far back as 1960, a presidential commission labeled the agency's predecessor ``a virtual Chamber of Commerce for the oil and gas companies.''

Corporate executives have considerable sway over the agency, to the point of helping the White House decide who is appointed to the five-member commission and who becomes chairman.

And there is an active revolving door. Hoecker was an industry lawyer before he was a commissioner, and now he is again. Former Chairwoman Moler consulted for Enron and other energy companies after leaving the agency, and now she is a utility executive.

Industry leaders wanted deregulation, and they pressed hard for California's plan, which they thought would open the door for unfettered markets nationwide.

Several other factors kept FERC from playing a stronger oversight role. While the California plan was being put into effect, many FERC officials were focused on a $12.7 million plan to reorganize their staff and upgrade computers. Hoecker was so proud of the result, he spent $100,000 to have a historian write a book about it.

But key employees say they were distracted by the reorganization for months. More important, a half-dozen employees who were versed in deregulation issues left, leaving FERC handicapped in its ability to police the new market it had created.

Some staff members sought a single, larger enforcement division resembling the one at the Securities and Exchange Commission, where 900 people, half of the agency, handle market investigations and enforcement. But FERC decided to keep its enforcement split between two offices that had a total of about 75 employees at the time -- a fraction of its 1,200 employees.

Warning came soon

The agency was confronted with its first clear warning of the coming disaster soon after California's deregulation took effect.

On a hot day in July 1998, three months after the market opened, energy traders whose names state officials have refused to release decided to test whether the new market could be manipulated. Although electricity had been trading well below $100 a megawatt-hour, they offered a megawatt-hour at $9,999 -- the highest number the traders thought the computer system would accept, they later told regulators.

Desperate for power to keep the grid from crashing, the Independent System Operator -- which monitors the system and buys some power -- paid it. The ISO then made an emergency request for a price cap, and FERC granted it.

Worried that federal regulators were not alert to the potential for market shenanigans, the grid operator repeatedly warned FERC that trouble was ahead. The ISO's market surveillance director, Anjali Sheffrin, was so concerned that she visited the agency twice in the fall of 1999 to try to explain to FERC officials that California's fledgling market needed the protection. ``I don't think they had any thought of what the potential was,'' Sheffrin said.

But at least one FERC economist did.

Ron Rattey, one of the agency's most experienced analysts, made a presentation to his colleagues in March 2000, shortly before the California crisis began. He noted an increase in price spikes nationwide from 1997 through 1999. Among other factors, he blamed regulatory policies and market abuses.

His conclusion: ``We should expect another tumultuous summer in 2000.''

-------------------------------------------------------------------------------- Contact Eric Nalder at enalder@sjmercury.com

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-- Martin Thompson (mthom1927@aol.com), June 03, 2001