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SCIENTECH IssueAlert, November 2, 2000
FERC Proposes Major Changes to California's Wholesale Market
By: Will McNamara, Director, Electric Industry Analysis
===============================================================

The Federal Energy Regulatory Commission (FERC) issued a draft order outlining
a major overhaul of the California wholesale market, including changes
to market rules concerning the California ISO (Cal-ISO) and Power Exchange
(PX). Conceding that the market rules and structure for wholesale sales
of electricity are "flawed" and have caused "unjust and unreasonable" rates,
FERC has proposed a number of remedies that will become effective in 
approximately
60 days. The full commission is expected to vote on the draft order in
December, after a period of industry comment.

ANALYSIS: FERC based its 77-page draft order on several assumptions, and
through the order intends to offer long-term (rather than band-aid) solutions.
First, FERC wants to hold overall rates to competitive levels that benefit
consumers, while at the same time induce sufficient investment in capacity
to ensure adequate service. Second, FERC acknowledged that some matters
that have adversely impacted the California wholesale market are not under
its jurisdiction, but that of the CPUC. Thus, FERC focused on matters within
its "exclusive jurisdiction," even if some of the proposals preempt prior
state decisions, while at the same time urging the state of California
to rectify issues within its own jurisdiction. This is an important point,
as FERC maintains that, unless the CPUC addresses issues such as the 
inadequate
siting of generation and transmission and demand-side response, California
customers may still be exposed to higher prices that result from low supply.
Third, FERC could find no evidence of market power abuses, although it
did concede that the market in California certainly allows the opportunity
for market abuse when energy supplies are tight.

Further, FERC contends that California IOUs have been bidding up to 80
percent of their load into the day-ahead market and hour-ahead spot markets,
creating substantial short-term cost exposure. Due to regulatory restrictions
from California's restructuring law (AB1890), the IOUs were not able to
pursue a balanced portfolio, including long-term and intermediate contracts.
The central mission of FERC's order is to remove the restrictions that
kept California IOUs from moving significant amounts of wholesale transactions
into forward markets. The less reliant that the IOUs become on spot markets,
so goes FERC's theory, the less chance of price volatility*which should
not only reduce costs for customers, but also increase reliability and
increase prospects for new generation.

With that established, here's what FERC's order prescribes: 1). Eliminate
the requirement that California's three IOUs (PG&E, SCE and SDG&E) must
sell into and buy from the PX. This proposal essentially permits the three
IOUs to establish bilateral contracts with energy suppliers, which was
previously restricted under AB1890. 2). Require market participants to
schedule 95 percent of their transactions in the day-ahead markets. A penalty
charge will be affixed for deviations in scheduling in excess of 5 percent
of an entity's hourly load requirements. Disbursement of penalty revenues
will be distributed to the loads that scheduled accurately. 3). The 
establishment
of independent (non-stakeholder) governing boards for the California ISO
and PX. 4). The establishment of generation interconnection procedures.

FERC wants the CPUC to address the following issues: delays in siting 
additions
of generation and transmission capacity; implementation of additional demand
response programs at the retail level; and elimination of impediments on
load serving entities pursuing power supplies on a forward basis.

Perhaps most contentious within the order is FERC's decision to set a $150/MWh
rate cap so that bids above this amount cannot set the market clearing
price that is paid to all bidders. This policy negates a previous proposal
from the Cal-ISO, under which it lobbied for a $100/MWh bid cap (reduced
from $250/MWh) on electricity purchases in the ISO's spot market. FERC's
order freezes the ISO bid cap at its current $250 level for the next 60
days. However, beyond that FERC is instating what is being referred to
as a "soft price cap" of $150/MWh, to remain in place until December 2002.
 It's referred to as "soft" because sellers may bid above this level and
receive their bid if they are dispatched, but anything higher than $150/MWh
will not set the price that all generators will receive. Also, any generator
setting a bid above $150/MWh must report their bid to the Commission, and
presumably fall under intense scrutiny.

The order revealed again some dissension with the FERC itself. Although
generally the four commissioners that delivered the order (Hoecker, Massey,
Breathitt, and H,bert) probably would agree that it is not perfect, 
Commissioner
Hebert voiced the strongest disagreement with the order's principles. H,bert
"hesitantly concurred" with the order, although he believed the commission
went too far in its attempt to mitigate prices, something he believes FERC
is ill-equipped to do. Specifically, H,bert dissented with the decision
to place any sort of price cap on wholesale transactions, preferring instead*
as
he has advocated throughout his tenure as a FERC commissioner*"to entrust
market participants with the ability and responsibility to mitigate their
price exposure as they deem best."

Moreover, it is questionable whether or not FERC has achieved its goals
of providing long-term solutions to California's problems. Rather, it seems
that the commission is sending a mixed message. On one hand, it is allowing
the California IOUs the freedom to buy and sell power outside of the PX,
which seems like a very pro-competition policy. Yet, on the other hand,
FERC establishes a price cap (albeit a soft, not hard, one) on wholesale
transactions, which arguably will continue to restrict true competitive
market forces from materializing in California. The commission is sending
a clear signal that all bids should be under $150/MWh and will undergo
interrogation if they are not, which essentially puts political pressure
on suppliers to maintain a price cap.

However, if one of the clear goals of this proposed order is to bring down
energy prices for California customers, removing the requirement of the
IOUs to buy and sell through the PX may actually accomplish this. The proposal
changes the California structure to one in which local distribution companies
(LDCs) could possibly wield more market power than the energy suppliers,
who essentially controlled prices when going through the PX. If the LDCs
know how to work economic deals, in which they set the price for the power
they purchase, this could ultimately drive energy costs down for customers.

As noted, FERC will vote on the proposed order in December, after receiving
commentary from industry participants. FERC Chair James Hoecker already
knows the position of one major player. He received a letter from Enron
CEO Kenneth Lay just this week, in which Lay urged FERC to avoid placing
"price cap band aids over hemorrhaging wounds." Lay further predicted that
installing price caps would "plunge markets into greater uncertainty and
discourage new supplies and conservation methods," and stated that a capped
formula would encourage natural-gas suppliers to deploy their turbines
in other states or countries. In addition, several consumer advocate groups
have expressed anger that FERC did not order refunds for San Diego customers,
who bore the brunt of high energy prices this summer. In fairness to FERC,
it is questionable whether or not the commission has the legal authority
to provide a refund to San Diego customers as it did not find any evidence
of market manipulation.

Thus, there is little chance that we will see the end of the debate over
California any time soon. Rather, FERC's order, which presents itself as
a remedy to conflicts surrounding the wholesale market, has shown just
how polarized adversaries are within this debate. Yet, I believe the bottom
line of the proposed order is that it is a good first step to addressing
the fundamental problems within California's wholesale market, and marks
a significant start to what will undoubtedly be an ongoing discussion.

===============================================================
For additional background coverage of the problems related to the wholesale
market in California, please visit SCIENTECH's IssueAlert archives at:


http://www.consultrci.com/web/infostore.nsf/Products/IssueAlert
===============================================================

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Sincerely,

Will McNamara
Director, Electric Industry Analysis
wmcnamara@scientech.com
===============================================================
Feedback regarding SCIENTECH's IssueAlert should be sent to 
wmcnamara@scientech.com
===============================================================

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