CERA Alert: December 13, 2000 

Title: California on the Brink 
CERA Knowledge Areas: Western Energy, N. American Power, N. American Gas 

CALIFORNIA ON THE BRINK 
The California Stalemate 
California moved closer to the brink of an outage today as concerns over 
credit-worthiness of buyers brought the possibility that generators would 
avoid selling to the California market. While numerous factors have 
contributed to the high cost of power incurred by California's utilities, the 
root cause of the current crisis is a lack of new generation. The current 
credit crisis and its threat to supplies could spark state action to address 
the situation. The collective efforts of all market participants should be 
focused on increasing generation capacity as quickly as possible.

Western power prices have skyrocketed well beyond the record levels set this 
summer. Perhaps because frozen rates insulate the majority of California 
consumers and companies from tangible effects of the market crisis, 
regulators have been able to postpone meaningful market reforms and 
significant rate increases. The California Public Utilities Commission denied 
the requests of Pacific Gas & Electric and Southern California Edison to end 
their rate freezes, forcing these utilities at least temporarily to finance 
the costs of higher wholesale energy. This has created an unsustainable 
accumulation of costs and a loss of faith in the California market. 

The current credit crisis and the potential for blackouts may become the 
galvanizing events that provide state regulators with a public mandate to 
address the underlying structural problems in the industry. However, there is 
no guarantee that these regulatory actions will expedite an effective 
solution for customers and the industry as a whole. Wholesale and retail 
markets that emerge from regulatory intervention are likely to remain 
muddled. In the necessarily political process that will follow, it is 
possible that-as has largely been the case so far-the steps taken will fail 
to move the California power market toward a more enduring solution and will 
instead continue to mask the underlying structural flaws. 

In the six months since California's supply shortfall began plaguing Western 
markets, regulators have done little to address the underlying problem. 
Rather than addressing the cause of the supply shortage-establishing a market 
environment that encourages timely additions of new generating capacity and 
demand side responses-efforts are instead directed at trying to lay blame for 
the crisis and lessen the immediate financial impact on customers. Indeed, 
several actions taken thus far have served more to compound the problem by 
discouraging new power plant additions. These include price caps, repeated 
changes to market rules, attempts to seize generator profits, and a 
challenging siting and permitting process.

Medicine Worse than the Illness 
Several years of electricity demand growth and low prices in California were 
accompanied by very few additions to the supply base. Regulators did not pay 
adequate attention to the looming supply shortfall. The void of consensus 
over the cause of the current crisis has instead been replaced by a series of 
bandaid remedies that address the symptoms, but not the cause, of 
California's electric market woes.* 

* Challenging siting and permitting. Despite state action to better 
coordinate the siting and permitting process for new power plants, power 
plant developers still face high hurdles. Local community opposition alone 
has struck down some key proposed facilities.

* Price caps discourage investment. State and federal proposals to cap prices 
limit the attractiveness of the California wholesale power market, especially 
for developers who have the option of channeling scarce capital and equipment 
to more stable or more attractive markets outside the state. 

* Repeated rule changes. Frequent rule changes in the ISO markets (including 
the price caps) confound attempts by developers to estimate profits from new 
plant development.

* Calls for refunds. Despite reports by the Power Exchange, the ISO, and the 
FERC that no pattern of abuse could be found from their examination of the 
California markets, state officials continue to accuse power providers of 
gaming the market. Calls by state officials for refunds of generator profits 
are a threat to new plant development.

* Facility inspections. Recent inspections of power plants by state officials 
to verify that operators are honestly reporting the operational status of 
their generating units accentuates the atmosphere of mistrust.

CERA's recent analysis suggests that merchant plant developers in the West 
are not guaranteed? to make a profit. Prospects of new plant profitability 
are affected by the timing and quantity of new plants, decommissioning of 
older units, demand growth, and numerous other difficult-to-forecast factors. 
California's regulatory actions only further cloud the assessment of 
financial viability and degrade the political environment for developers 
considering entering the state. 

Despite efforts by the California ISO to stimulate new capacity additions in 
the state with a special, limited-term capacity payment, CERA estimates that 
demand growth will continue to outstrip supply additions in the West in 2001. 
In addition, the existing siting and permitting process will prevent a 
sufficient quantity of capacity from entering the market until 2003 at the 
earliest. Therefore, three years remain before a sufficient quantity of 
capacity enters service to significantly dampen prices and decrease the risk 
of an outage. 

The Road to Recovery 
There are a number of actions that can be taken to help relieve the capacity 
shortfall: 

* Encourage new build. Supply must be part of the answer. This requires a 
series of steps that can help facilitate new supply build. While in principal 
some have been taken, such as new fast track approval, the success of these 
actions can only be measured by the build itself. For now, there is still not 
enough new supply coming on until 2003 to relieve supply tightness.? 

* Stabilize investment climate. Utilities must have assurance that they will 
ultimately be allowed to recover market costs for power. This provides the 
credit worthiness needed by sellers to produce energy and to stimulate new 
build.

* Move toward more balanced utility supply portfolios. One of the reasons the 
pressure on customers has been so intense in California has been the absence 
(and even discouragement) of diverse supply portfolios among the utilities in 
the state-particularly for residential and small commercial customers. With 
the market at a peak, however, now is in one sense a sub-optimal time to move 
toward term contracting. Yet these contracts provide the foundation for a 
series of actions-including new supply build and demand side investments. If 
they end up above market, they will at least have achieved the desired effect 
of knocking down prices, a fact which by itself should provide sufficient 
justification for recovering the cost of these commitments.

* Encourage market mechanisms that elicit a demand response. Although 
originally a feature of California's market design, most consumers are 
insulated from price spikes through capped or frozen retail rates. Exposing 
customers to at least some of the market price signals would encourage a 
demand response.

* Encourage market mechanisms that dampen the "Boom Bust" characteristic of 
the market. Whether in the form of a capacity payment, a reserve requirement, 
or a minimum term portfolio requirement, the California power market needs to 
move to a structure that encourages investment in new capacity when the 
market is in balance rather than waiting for a shortage and price shock to 
elicit new investment. Such a structure can help dampen (but not eliminate) 
future price volatility.

* Avoid continuously tinkering with the market. While the market does need to 
be restructured as described above, it also needs to be stable and reliable 
to encourage the development of new supply as well as a robust long-term 
contractual market for power in California. Continually tinkering with the 
market structure-such as the three times the price cap has been shifted since 
July-only serves to undermine confidence in the market. California needs to 
do its best to develop a long-term solution and then let the market run its 
course. 

* Allow for greater environmental flexibility. The state should explore a 
more balanced solution to emissions restrictions in the face of a supply 
shortfall that has been exacerbated by generators that cannot operate due to 
emissions restrictions. 

* Free PURPA power plants to generate. Relief should be granted to PURPA 
power plants that are operational, but are restricted by contract from 
operating to generate only power. 

**end** 

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