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California energy market strategy criticized

Posted at 11:19 p.m. PDT Sunday, June 17, 2001

BY BRANDON BAILEY, Mercury News

As temperatures climbed in California last July, one power generator offered to sell electricity at $500 per megawatt hour-- almost five times what state officials believe it cost to produce.

When the state's power demand rose to peak levels on five consecutive days, utilities couldn't find enough electricity for sale at a lower cost. On each day, officials who manage the power grid reluctantly accepted the company's offer and paid what they considered an excessive price.

Today, the Federal Energy Regulatory Commission meets to consider limits on the wholesale price of electricity. As they seek Washington's help in fixing the energy market, state officials say that what happened last July is evidence that federal regulators were mistaken when they concluded that competitive forces in California would keep power companies from setting their prices too high.

In order to sell electricity in California's newly deregulated market, each of the state's power suppliers had to win permission from FERC to charge whatever price the market would bear. To do that, each company had to demonstrate it would not have ``market power'' -- the ability to drive up prices and keep them high.

State officials now contend that FERC used a faulty economic premise to evaluate those claims: The commission assumed that if a company controlled less than 20 percent of the electricity supply, it would be unable to exercise significant market power.

``This was a really bad rule of thumb,'' said Severin Borenstein of the University of California Energy Institute. ``The FERC has been using antiquated methods that really don't help in diagnosing market power in electricity markets.''

Each of the state's five big commercial power suppliers controls between 5 and 10 percent of California's electrical generating capacity. But critics say that gives the companies more than enough leverage to charge excessive rates. ``If demand is high, even a 5 percent market share could be pivotal in setting the price,'' said Anjali Sheffrin, an economist for the California Independent System Operator, the state's grid manager.

The ISO has formally petitioned FERC to revoke the big generators' permission to charge unregulated rates, essentially returning to a system where rates are based on the cost of production plus a reasonable profit.

A complex market

Suppliers insist they aren't manipulating prices. But one industry consultant agreed that FERC's 20 percent rule fails to recognize the complexity of the market. The stakes are high: The grid operator has charged that power suppliers reaped nearly $7 billion in excess revenues last year. And the argument may ultimately determine how energy is bought and sold in California.

Other state agencies are investigating whether power suppliers illegally manipulated power supplies or prices. But experts say that's hard to prove. The ISO petitions simply argue that the companies should no longer be allowed to set their own rates, because the market isn't competitive.

Indications are that FERC, which meets today to consider limits on the wholesale price of electricity, will impose new controls. The Washington Post reported Sunday that administration officials said President Bush plans to support less stringent price controls, provided they are based on market factors.

Still, most experts are predicting the commission will stop short of the sweeping changes that state officials want. They said it's likely the state will continue challenging FERC's standard. FERC officials declined comment, but a spokeswoman provided documents confirming the commission has used the 20 percent rule in deciding to let companies charge unregulated rates.

The rule's origin

The rule is derived from a more complicated formula originally adopted by the U.S. Department of Justice to use in gauging whether corporate mergers in other industries would violate anti-trust law, according to economists familiar with the standard.

But critics say it makes no sense to apply this rule to electricity. Unlike other products, electricity can't be stored in large volumes, so consumers can't buy power when prices are low and use it later when prices get high. Conservation can help cut demand, but electricity is so essential that the state has kept buying even when the cost has soared. On a hot day when the state needs plenty of power, for example, demand might reach 38,000 megawatts.

If there are only 40,000 megawatts available, and one company controls 3,000 megawatts, the state will be forced to buy at least 1,000 megawatts from that company. Because the company knows that, the ISO has argued to FERC, the firm can effectively set the price.

The ISO estimated what prices the companies should be able to charge under competitive conditions, based on such factors as fuel prices, operating costs and a reasonable profit. If one company charges higher rates, the theory goes, there should be competing suppliers who will sell for less.

No fear of underbids

Sheffrin said her studies show the major power suppliers have been able to charge essentially whatever price they wanted, without fear that competitors would underbid them. The studies are based on detailed analyses of power sales by the five major companies and other suppliers.

Industry spokesmen say the ISO's economists used flawed assumptions to make normal behavior seem sinister. ``We stand by the fact that we've operated ethically and legally,'' said Richard Wheatley of Reliant Energy Inc. He said the ISO failed to consider all the costs of producing power, including the need to recover long-term investments in buying or building plants.

Without seeing the ISO's confidential data, University of Southern California economics Professor Charles Cicchetti said he's not convinced the power companies are doing anything wrong. But Cicchetti, who advised Duke Energy when it won FERC's permission to charge market-based rates in 1999, agreed that the commission's 20 percent rule was overly simplistic. FERC didn't recognize that California really isn't a single open market, he said.

Power produced in Northern California isn't always available for consumers in Southern California, because of grid congestion. Electricity sold on a long-term contract may not be available in the spot market. And until this year, buyers and sellers could choose between transacting business through the now-defunct California Power Exchange, or the ISO.

Feeling the heat

By asking FERC to revoke the suppliers' right to charge market rates, Cicchetti says, the state is effectively trying to end deregulation. Instead, he believes authorities should concentrate on fixing the flaws in the system. ISO officials have said they will consider legal action if FERC doesn't respond by the end of this month. Democratic leaders in the state Legislature have already raised a similar challenge in a federal lawsuit.

Though a court declined to issue an emergency ruling last month, attorney Joseph Cotchett said he is continuing to press the case before the Ninth U.S. Circuit Court of Appeals. Courts are often reluctant to second-guess a regulatory agency. Still, Frank Wolak, a Stanford economist who advises the ISO, said he raised the issue in congressional testimony last week. ``The truth is going to come out,'' he vowed. ``FERC is going to feel the heat.''

Contact Brandon Bailey at bbailey@sjmercury.com or (408) 920-5022.

-- Swissrose (cellier3@mindspring.com), June 18, 2001