The $3,880 Megawatt-Hour How Supply, Demand and Maybe 'Market Power' Inflated a $273 Commodity

By Steven Pearlstein Washington Post Staff Writer Tuesday, August 21, 2001; Page A09

When Ed Riley, operations director for California's electric grid, headed to work before dawn on Jan. 17, he knew it was going to be another bad day for the state's experiment with deregulation.

A cold snap in the Pacific Northwest had increased demand for power, reducing what could be imported into California. Low water levels flowing into hydroelectric dams had reduced the state's own power supply. Then, that morning, Riley got word that a malfunction had forced the closing of Duke Energy Corp.'s 1,000-megawattgenerating station at Morro Bay, halfway between San Francisco and Los Angeles. Within hours, Riley knew, much of California would be out of electricity. From a windowless control room in an office park outside Sacramento, Riley and a dozen colleagues in the operations control center began telephoning as far away as Mexico and British Columbia in a desperate search for power to import. Among the calls was one to Duke, which had an idle, inefficient, gas-fired unit at its Chula Vista station near San Diego.

Under California's environmental regulations, the Chula Vista unit could operate only a limited number of hours each year, which Duke preferred to save until summer, when wholesale prices are at their highest. But with blackouts beginning to roll across the state and Riley threatening to use extraordinary powers to force its hand, Duke officials offered to fire up the unit -- for $3,880 per megawatt-hour, the highest price ever charged in the state.

Duke officials later acknowledged that the price was many times what they thought it would cost to generate the power. They also calculated that, with several of the state's biggest utilities on the verge of bankruptcy, there was a 1-in-5 chance that they would ever get paid. Most of the proposed fee, executives said later, represented a "credit premium."

Grid officials were in no position to say no. As exorbitant as it might be, the $3,880 megawatts would still be less than the cost to the state's economy of an afternoon of idle aluminum smelters, oil refineries and computer-chip plants. Reluctantly, they agreed to pay the price. The blackouts were over by mid-afternoon, but the political sparks had just begun to fly.

In Washington, the dispute over California's electricity deregulation came down to a single question: Should the federal government step in and cap the wholesale price of power?

To Californians, caps seemed like the quickest and easiest way to bring down prices and prevent generators from profiting from the energy shortage.

But to the power industry and its supporters in the Bush administration, price controls would represent an unacceptable return to the bad old days of government regulation. By keeping prices artificially low, they warned, price caps would only make the situation worse over the long run by discouraging consumers from conserving and investors from building new plants.

That's what every student is taught in Economics 101. But if they stick around for "Economics 101.25," according to Alfred Kahn, the Cornell University economist who deregulated the airline industry as chairman of the Civil Aeronautics Board, students learn that there are some markets in which companies are able to raise prices above competitive levels by withholding supply or engaging in other strategic behavior. When firms have such "market power," Kahn's textbook calls for some form of government price controls.

Whether the six independent generating companies operating in California exercised market power remains a topic of hot debate and extensive litigation. Unquestionably some of the price increase reflected the rising cost of natural gas and environmental emission credits. And even in truly competitive markets, prices are expected to increase when demand outstrips supply. In California, however, independent researchers found other factors at work.

In a study commissioned by Southern California Edison, researchers Paul Joskow of the Massachusetts Institute of Technology and Edward Kahn, a private economist, asserted that by closing plants for repair at crucial times, generators created an artificial scarcity that forced up the price of power on the short-term market. Subsequent data confirmed that there were at least four times as many scheduled and unscheduled plant shutdowns in the fall and winter of 2000-2001 as in the previous winter.

In March, the California wholesale market and grid operator, known as the Independent System Operator, or ISO, submitted two other studies contending that the generators not only routinely withheld supply but also had collectively gamed the bidding system, which taken together accounted for one-third to one-half of the increase in wholesale prices. The ISO estimated this exercise of market power cost California consumers $6 billion last year.

The study revealed that the rules of the hourly auctions made it possible for a small number of generators to manipulate prices to their advantage. Under those rules, generators were allowed to submit up to 10 bids to each hourly auction, each bid for a different batch of electricity. The power exchange would rank the bids from least to most expensive, then go down the list until it had enough bids to satisfy the expected demand for power during the period. The highest bid accepted became the price paid to all bidders. Through that process, the market for electricity was supposed to mirror the workings of most other commodity markets, in which all producers receive roughly the same price on a given day.

According to the ISO report, however, the generators, anticipating tight supplies, submitted such lopsided bids that the only explanation was market manipulation. Typically, the generators would bid in most of their power at prices that reflected the actual cost of producing power, as would be expected in a competitive market. But for the final one or two increments of power, the companies submitted bids that jumped to levels three, five, even 10 times the competitive bids, knowing that in past rounds that their rivals were doing the same. Such strategies would guarantee a lucrative outcome for all the companies whether their last bid was accepted or not.

No one has suggested that the generators illegally got together and agreed to collude in this strategy. But in markets with open bidding and a limited number of participants, economists say, it is possible to accomplish the same thing simply by signaling intentions in the structure of bids at each hourly auction. The strategy works as long as supplies are tight and no competitor tries to gain advantage over the others by offering all its power at competitive prices.

The generators and their consulting economists, in their analyses, attempt to cast doubt on the this "market power" theory. But with generator profits soaring, even longtime advocates of deregulation found it hard to believe that what was happening in California reflected the workings of a healthy, competitive marketplace.

"Clearly when you have power sold at $3,880, it goes beyond any conventional definition of scarcity," said James Hoecker, a former Federal Energy Regulatory Commission chairman who for months resisted calls for price control. "What you've got there is market power . . . that was produced and facilitated by bad market design."

In June, FERC finally acknowledged that the California market had become dysfunctional and voted unanimously to impose bid caps on the generators in California andthroughout the western grid.

As for the infamous $3,880 megawatt-hours, the commission found that the "just and reasonable" price should have been $273 and ordered Duke to return any money collected over that amount. As it turns out, however, there is nothing to return. As Duke officials had feared, they have been paid much less -- only $70.22 -- for each of those megawatt-hours.

© 2001 The Washington Post Company

http://washingtonpost.com/wp-dyn/articles/A37586-2001Aug20.html

-- Martin Thompson (mthom1927@aol.com), August 21, 2001