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.
Write to Rebecca Smith at rebecca.smith@wsj.com, Mitchel Benson at 
mitchel.benson@wsj.com and John R. Emshwiller at john.emshwiller@wsj.com