---------------------- Forwarded by Lorna Brennan/ET&S/Enron on 07/13/2000 
04:27 PM ---------------------------


webmaster@cera.com on 07/07/2000 11:18:52 PM
To: Lorna.Brennan@enron.com
cc:  

Subject: Power Market Caps: Lower Prices at Higher Risk? - CERA Alert




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CERA Alert: Sent Fri, July 07, 2000
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Title: Power Market Caps: Lower Prices at Higher Risk?
Author: Zenker, Mortizburke
E-Mail Category: Alert
Product Line: Western Energy ,
URL: http://www.cera.com/cfm/track/eprofile.cfm?u=5526&m=1264 ,

Recent events in California, culminating in new market rules established for 
the energy and ancillary services markets, indicate that legislators and 
regulators are dissatisfied with the performance of the markets they 
established. The hot weather in California during June triggered high 
electricity demand, corresponding record-breaking power prices, and rolling 
blackouts in the San Francisco area. Although the economic impact of both the 
outages and the concurrent price spikes is significant, a recent decision by 
California's Independent System Operator (ISO) to intervene in the markets by 
lowering price caps through the summer of 2000 from $750 to $500 per 
megawatt-hour (MWh) may prove to be the most important product of the market 
events.* Ironically, the proclivity to continue to change the market rules, 
whatever the intention, could create market distortions that delay the 
addition of new generating capacity by discouraging plant developers and 
driving away needed capit!
al. This would only prolong the state's supply shortage and resultant high 
prices.

Although the record-setting weather that prompted the rolling blackouts in 
the San Francisco area is not likely to be repeated, the West as a whole will 
experience higher coincident peak demand under normal weather conditions this 
summer. CERA expects that supplies will be sufficient to meet peak demand 
this year, but the high price levels of June will be repeated during peak 
demand conditions not only this summer but during the summers of 2001 and 
possibly 2002.

The Pressure Builds
The blackouts were not spawned by a statewide supply shortfall, but instead 
by a transmission constraint that limits the ability to import sufficient 
quantities of power to the San Francisco area. The quantity of generating 
capacity out of service in the West was near average levels, despite a 
nuclear unit outage in Washington. Although the blackouts were brief and 
wholesale power prices decreased with the temperatures, the intense scrutiny 
over the events and resultant changes to the market rules indicate that 
legislators and regulators are dissatisfied with the performance of the 
markets they designed. The market's architects assumed that competition would 
lower wholesale prices in the state. However, prices in June have been 
roughly eight times higher than in 1997's prerestructured California market, 
leading many regulators and legislators to conclude that the markets are 
flawed, requiring additional caps and market rules. Although some state 
officials strongly favored lo!
wering the price caps, many within the ISO's Board of Governors strongly 
opposed intervening in what they consider to be normal market reactions to 
tight supply and demand fundamentals.

The current tight supply situation in California and the West as a whole is a 
product of recent strong economic growth throughout the region coupled with 
the slow process of permitting new power plants. Owing to strong economic 
growth in California in 1998 and 1999 (5.2 and 5.5 percent, respectively*), 
capacity margins have shrunk from 12 percent in 1997 to 7 percent in 2000. 
Demand growth throughout the West has reduced the amount of energy available 
for export from the Pacific Northwest and Southwest to California.

As a result, even with optimistic levels of energy imports and the 
curtailment of approximately 2,800 megawatts (MW) of interruptible load 
within the state, California capacity margins will fall well below North 
American Electric Reliability Council (NERC) reliability criteria (roughly 15 
percent) this summer. The West is the only region in North America that will 
experience a tightening of capacity margins relative to levels in 1999 under 
normal weather conditions. CERA anticipates peak demand growth to continue to 
outpace new capacity additions through 2001, with slightly growing capacity 
margins in 2002. At these levels, an unusual amount of either plant capacity 
or transmission line capacity out of service during peak demand conditions 
would require the ISO to mandate blackouts of a portion of the state's load 
to maintain the overall stability of the grid.

Thus, the tight capacity situation in the state will continue to pressure 
prices to high levels, which may provoke legislators and regulators to 
attempt to extend the price caps or implement additional market rules.

Market Distorting Effects
Under tremendous pressure from some legislators, regulators, and market 
participants, the California ISO Board of Governors lowered the current price 
caps on energy from $750 to $500 per MWh in a special meeting conducted June 
28.** Owing to the interconnectedness of western markets, the decision to 
lower the caps and the apparent willingness of regulators to continue to 
change the rules governing California's electricity markets will affect power 
market participants throughout the West.

* Profitability of existing and future generators degraded. High power prices 
and volatility levels in June, although detrimental to most buyers, provide 
strong encouragement to plant developers. Limiting the level of price fly-ups 
degrades the ability of plant owners to recover capital costs plus earn a 
return on that capital. In most periods of the year, competition drives 
prices to levels that provide little opportunity for a return on capital. 
Generators therefore seek to recover their investments with higher bids in 
California's energy and ancillary services markets during periods of supply 
scarcity. Existing merchant generators are at increased risk to recover the 
investments they made based on cash flow outlooks developed prior to the 
imposition of caps.

* Supply shortfall prolonged. The process of siting and permitting power 
plants in California is cumbersome, requiring as long as five years from 
plant proposal to synchronization with the grid. The California Energy 
Commission (CEC), the state agency charged with approving new plants, has 
repeatedly expressed concerns about the chronic tight supply situation in the 
state. Price-dampening market intervention indicates to plant developers that 
California officials may continue to reengineer the state's power markets to 
the detriment of generator profitability and, when added to the difficult 
permitting process, potentially delaying the introduction of new capacity to 
meet rapidly growing state demand. Prominent plant developers have recently 
indicated that markets outside of California may provide a more stable market 
and a better environment for deploying scarce resources and generating 
equipment such as turbines.

* Trading positions affected. Lowering price caps reduces the degree of price 
volatility and the level of overall average prices. Market participants have 
executed market positions based on the outlook for prices under the previous, 
higher price cap. By lowering the price cap, not only are the value of 
existing physical (e.g., power plant) and financial (e.g., forward contracts) 
positions significantly affected, but market participants must also 
incorporate the uncertainty of possible future adjustments to the cap into 
their trading.*

* Circumventing market rules. The variety of energy and capacity markets in 
California, as well as the bilateral markets outside of the state, provides 
opportunities to circumvent the intent of the new market rules, further 
distorting the markets in the West.

Although lowering price caps in California will likely temporarily reduce 
price levels, the new power plant capacity ultimately needed in the state to 
reduce price levels and improve reliability on a sustainable basis could be 
discouraged by prolonged and repeated intervention in the market.

**end**

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