October 22, 2001
Review & Outlook
Governor Chicken
The two politicians who've arguably benefited most from the national focus on war are both Californians -- Congressman Gary Condit and Governor Gray Davis. Too bad Mr. Davis is finding he still can't avoid his own chickens coming home to roost.

Only now are the folks in Sacramento learning that their Governor's "solution" to the energy crisis has been a political sham. A combination of collapsing budget revenues, foolish spending and bad credit ratings threatens to plunge the state into a full-fledged financial crisis.

Governor Davis's chickens left the roost back in May 2000, when California's botched scheme to deregulate electric power encountered a wicked price bubble. Wholesale prices, which had been deregulated, shot up, while retail prices, which were still regulated, didn't budge. This mismatch, along with other factors, generated huge supply disruptions and a first-class energy crisis.

The obvious response would have been to let retail rates rise with the market price. Mr. Davis said so himself in his now infamous observation that if he raised rates, the problem would be solved in 20 minutes. Mr. Davis preferred to play the blame game, including a lot of whining that he had inherited the situation.


Fiscal crisis  
While the Governor complained, California's two largest utilities were pushed into insolvency and neighboring states endured the double whammy of having their power sucked into California and seeing their electric rates shoot up. Californians suffered through rolling blackouts.

Finally, this past January -- eight months after the energy crisis began -- the Governor responded: Retail rates were increased twice, and the state started to purchase power directly from suppliers, using money from its general fund. At the same time, the state negotiated contracts with suppliers at prices that are now well above market prices and for terms as long as 20 years.

And then Mr. Davis got lucky. Although the forecast was for a summer of continued blackouts generated by a strong demand for power, the disaster failed to materialize. Not only was the weather cooler than normal, but higher rates produced immediate conservation; thus demand was moderate and power sufficient. Newsweek went out and hailed the Governor as a political Lazarus.

But now here come the chickens. It seems that almost one-quarter of California's budget revenues were provided by taxpayers with stock options and capital gains, mostly from Silicon Valley companies. When the dot-com industry started to implode, so did revenue projections -- to $12 billion this year, down from $18 billion last year. And this was before September 11 and the collapse in the Nasdaq market.

California would probably be able to absorb this revenue hit were it not for the still outstanding bills from the Governor's electric power fiasco. Consider the toll:

Somebody is going to have to pay for the $14 billion that the utilities owe to suppliers for power consumed before the state started buying electricity. 

Somebody is going to have to repay the $12.5 billion bond issue that California hopes to float to replenish the money borrowed from its general fund. 

Somebody is going to have to pay for those expensive, long-term contracts that the state negotiated. 

Somebody is going to have to repay the bridge loan of $4.3 billion that California got from the banks hoping to underwrite the bond offering. (If this loan is not repaid by November 1, its interest rate jumps to 7% from 4%, resulting in an extra $250,000 in interest payments a day.) 
Whether these bills are ultimately assumed by ratepayers or taxpayers, or some combination of the two, the impact on California's economy and its budget will be dreadful. Observers are estimating a budget deficit of almost $10 billion for next year.

As for Governor Davis, the problems of the "previous administration" are now his own. And Californians know it. A recent statewide poll showed that most voters preferred the former mayor of Los Angeles, Richard Riordan, the leading Republican challenger to Mr. Davis, by several points.

The Governor's response to the ever-worsening economic situation has been typical. He complains. He vetoes a few spending bills. He announces a $5 million campaign to persuade Californians to help the local economy by staying in-state for their vacations. We expect to see a lot of chickens on surfboards.


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