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The California Electricity Crisis
By James L. Sweeney
Hoover Institution PressCopyright © 2002 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
INTRODUCTION AND OVERVIEW
Since mid-year 2000, California's electricity problems have been a central concern in the state. Californians have faced blackouts, seen the state budgetary surplus decimated, watched as Northern California's largest natural gas and electric utility, Pacific Gas and Electric, filed for bankruptcy, wondered if and when Southern California Edison will follow the same route, listened to politicians debate how much to pay to purchase transmission lines from financially strapped utilities, and listened to state officials point fingers at myriad organizations and individuals for causing the crisis.
This book attempts to explain these events as an integrated saga that California has faced and is still facing. The saga began with an opportunity for California to restructure its electricity system to make it more flexible and responsive to changing economic conditions. Following the flawed implementation of this restructuring, California's political leadership failed in 2000 to respond effectively to the challenge of tight electricity markets, mismanaged the electricity crisis in 2001, and thereby saddled the state with heavy long-term, electricity-related financial obligations. As a result of the fundamental policy mistakes made by the state's governor and other political leaders, the saga continues, with California facing an electricity blight as it struggles to recover from its self-imposed wounds.
The electricity restructuring, often mischaracterized as "deregulation," included provisions that put the state and especially the investor-owned utilities in a risky economic situation. With delays in new generating-plant approvals, a failure throughout the western United States to match the growth in the consumption of electricity with new capacity, and problems with the newly created California wholesale markets, the downside risks became reality and California faced a difficult challenge.
Difficult challenges require wise political leadership. Such challenges require strong, courageous political leaders willing to make difficult and potentially politically unpopular choices. But that type of leadership never emerged in California. Rather than solving the challenge by taking appropriate steps, California's governor failed to act and then, once he started to act, overreacted. That failure of political leadership transformed the difficult challenge into California's energy crisis.
The "energy crisis" was a dual crisis: an electricity crisis associated with an insufficient supply to meet the demands of the California economy and the rest of the West, coupled with soaring wholesale prices, plus a financial crisis facing California's investor-owned electric utilities, the California state budget, and ultimately the taxpayers and electricity ratepayers of California.
During the height of the crisis and as the crisis subsided, the governor and the California legislature responded to the short-term crisis by enacting a group of long-term measures, which now threaten to create a continuing blight on the State of California. These measures collectively seem designed to turn California into a public power state rather than one characterized by a free market system for electricity.
The changes in California moved through four somewhat distinct, although overlapping, stages. The following four chapters of this book correspond to those four stages:
California's Restructuring: Turning Opportunity into Risk
From Crisis to Blight
Each stage, and in fact the whole process, should be seen not as a random set of disconnected events but rather as a continuing sequence in which choices were made. At each juncture, there were problems to be solved, often because of earlier policy decisions. At each juncture, there were alternative actions that could have been taken. Given the political and economic forces at play at each juncture, logic underlay the decisions. The choices selected, however, often created new difficulties later. At each juncture, different choices could have led to very different outcomes, and perhaps different problems.
Although one group of events led to another in a causal chain, the results were far from preordained since very different choices were possible at almost all junctures. The totality of the system changes and the consequences for the State of California was the result of this sequence of public policy decisions. Unfortunately, the outcomes are now evolving in directions greatly different from the goals expressed by those instrumental in the initial restructuring.
The focus of this book is this series of policy decisions, the alternatives, and the consequences of the decisions, within the context of the process as a whole.
Figure 1.1 diagrams the chain of causation, linking one decision to the next. The various boxes represent issues, actions, or important system characteristics. The various colors of the boxes represent the four stages of development plus prior conditions. The arrows represent causal links, in the sense that the conditions associated with each action created forces or motivations that encouraged the next decision or constrained the next set of actions.
In green are issues underlying the restructuring decisions that culminated in Assembly Bill 1890 (AB 1890), passed by the legislature in August, signed by the governor in September 1996, and implemented in March 1998. In yellow are some of the important legal provisions of AB 1890 that created a high risk. In addition to these actions are factors or changes that created a challenge to the State of California; the most important ones are shown in orange boxes.
The red boxes represent the key factors or actions that represented the dual crisis: the electricity crisis and the financial crisis, including a group of these factors with a circular set of causation arrows. These factors mutually interacted, causing the system to spiral into a crisis. Indicated above the red boxes and shaping this whole process was the failure of political leadership.
Finally, actions in gray boxes are described here as the growing long-term blight on the state. Taken together, these actions are changing California into a public power state, limiting market operation, and maintaining long-term high electricity prices. The process can be stopped. Future political leadership can determine how far down this road California will proceed.
The ultimate end state of California's energy system remains unknown. Will California continue down the path toward public power? Will it return to the market-oriented goals of the original restructuring? Or will California move to some fundamentally different electricity system? Any of these paths remain open to the state. Which path is chosen depends on a combination of private sector actions, California legislative and regulatory decisions, and federal governmental decisions. These then remain as collective choices for California.
What follows is an attempt to explain and make sense of the changes implemented at each stage of the process. This discussion will comprise Chapters 2 through 5. The final two chapters look to the future. Chapter 6 examines some of the policy issues that California should face that could help move it out of its present difficulty. Chapter 7 offers reflections based on this sequence of events. These reflections, it is hoped, will help other states contemplating restructuring their electricity systems. And perhaps some will be applicable to other major policy initiatives.CHAPTER 2
Turning Opportunity into Risk
CALIFORNIA UTILITIES BEFORE RESTRUCTURING
At the beginning of the saga, California's electricity system operated in a manner similar to electricity systems throughout the United States. It included three large investor-owned utilities, collectively selling most of the electricity in California. Each investor-owned utility had a franchise in one of three separate parts of the state — Pacific Gas and Electric Company (PG&E) in Northern and central California, Southern California Edison (SCE) in coastal, central, and Southern California, and San Diego Gas and Electric (SDG&E) in San Diego. In addition, there were several much smaller investor-owned utilities, several electric co-ops, and numerous municipal utility systems, the largest of which were the Los Angeles Department of Water and Power (LADWP) and the Sacramento Municipal Utility District (SMUD) (see Table 2.1).
The investor-owned utilities serve 78 percent of the California customers and the municipal utilities serve 22 percent. The electric co-ops and the federal agencies collectively serve less than 0.1 percent of the customers. In terms of total megawatt-hours (MWh) of electricity, the investor-owned facilities sell 72 percent, the municipal utilities 24 percent, and the federal agencies 3 percent (see Table 2.1).
The average price of electricity was similar for investor-owned utilities and municipal utilities. As measured by the average revenue per MWh sold, the average retail price of electricity sold by the municipal utilities (including delivery services) was 8 percent less than it was for investor-owned utilities. Retail prices for municipal utilities varied over a wide range, from 30 percent above to 51 percent below the average investor-owned utility price. The largest municipal utility, LADWP, had an average price (more precisely, average revenue per MWh) 6 percent above the investor-owned utilities' average.
Each investor-owned or municipal utility operated as a local monopoly, selling electricity in its own exclusive franchise area, with no direct retail competition from other electricity sellers. The large investor-owned utilities, as well as some of the municipal utilities, were vertically integrated to include three separate functions: generation, transmission, and local distribution. A typical investor-owned utility generated most of its electricity (generation), moved that electricity on transmission lines to local areas where it was needed (transmission), and sold that electricity to industrial, commercial, and residential users (local distribution). Some municipal utilities operated as only local distribution companies; some participated in one or both of the other two functions — generation and transmission.
For investor-owned utilities, almost all significant financial decisions involving any of the three functions were subject to the jurisdiction and control of the statewide regulatory body, the California Public Utilities Commission (CPUC). Customers paid retail prices for electricity based on operating costs plus a regulated rate of return on the prudently incurred "used and useful" invested capital. The CPUC would review whether costs were prudent and determine the "fair" rate of return on invested capital that was meant to approximate a normal rate of return for companies facing equivalent risk. Thus pricing was based primarily on cost of service and only secondarily on market conditions.
The significant decisions made by the publicly owned municipal utilities were subject to the jurisdiction and control of their appointed or elected governing bodies. Thus, their strategies could be based on local decision making, rather than on statewide regulations. They typically were operated, however, so that over a span of several years their revenues roughly equaled their total costs of operation. Thus, for municipal utilities as well as for investor-owned utilities, pricing was based primarily on cost of service and only secondarily on market conditions.
This particular type of industrial organization — utilities operating as regulated monopolies — had been justified for many decades by the increasing-returns-to-scale nature of electricity generation, transmission, and distribution.
Retail distribution (the provision of delivery services: wires, transformers, and other physical equipment) provides the most obvious example of increasing returns to scale in the electric industry. A customer could double the amount of electricity used with no increase in the cost of providing wires to a home. Equivalently, if two competing companies were each to run electric wires down the same streets to compete for customers, total cost and cost per customer would increase even with no change in the quantity of electricity delivered. Cost would be lowest if only one company were providing the wires, transformers, and other physical equipment for local distribution of centrally generated electricity. Thus local distribution of centrally generated electricity is generally considered to be a natural monopoly and, as such, is typically allowed to operate as a monopoly franchise, subject to regulatory oversight, in California, as in other states.
As distinct from electricity distribution services, retail electricity is not characterized by increasing returns to scale. To double the amount of electricity sold, a retailer would need to double the amount of electricity acquired at wholesale. For wholesale electricity prices held fixed, doubling the acquisition of electricity would double the total cost of acquiring the electricity. Thus the cost per MWh sold at retail neither increases nor decreases (at least not significantly) as the scale of retail operations changes. Retail sale of the commodity (electricity itself) is not characterized by increasing returns to scale, and thus the retail electricity sales function cannot be viewed as a natural monopoly.
In principle, the regulatory system could logically separate delivery services from the retail sales of electricity itself. The retail sales function would be amenable to organization as a competitive industry even though the delivery function was not organized in a competitive market structure.
Typically, however, delivery services and the electricity were bundled: customers were charged a price for the combination of electricity and delivery services. In this way, the natural monopoly franchise for delivery services was extended into monopoly franchises for delivery services and for electricity. California operated this way, as did most states.
Increasing returns to scale also characterizes the transmission of electricity, up to a point. Electricity moves on high-voltage transmission lines integrated into an electricity grid. A significant cost of this transmission system is paying for the right-of-way on which to build transmission lines. When the transmission lines are operating well below capacity, it would cost little to move additional electricity through these lines. Even at capacity, installing additional highvoltage wires on an existing transmission link costs substantially less than required to establish the link in the first place. Thus transmission also seems to be appropriately organized as a monopoly along a given transmission path, as it is in California.
Finally, electricity generation also seemed to have the increasing returns to scale characteristic of a natural monopoly. For many years the conventional wisdom was that the larger the electric generating plant, the lower the overall cost of electricity generation. Bigger was cheaper. This increasing returns to scale characteristic of electricity generation led to the common belief that electricity generation should be organized as a monopoly.
Given that all three components of the electricity supply system were operated as monopolies, there was a tendency, although not a necessity, for these three elements to be vertically integrated into a single company. The first reason for this was the need for coordination in planning for capital investments and operations. The amount of electricity sold by the distribution firm determined the amount of generation and transmission capacity needed. The location of transmission facilities and generation facilities required coordination to minimize overall cost. This need for coordination and for appropriate information flows helped justify combining these three entities into one vertically integrated company.
A second, and related, reason for vertical integration was based on reducing transactions costs. Three separate monopolies, all integrated into one supply chain, might choose to operate so as to gain financial advantages over one another. Although this strategic problem could be controlled through the regulatory process, integrating the three entities into one company would reduce or eliminate those incentives and the resulting need for regulatory oversight.
Excerpted from The California Electricity Crisis by James L. Sweeney. Copyright © 2002 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Hoover Institution Press.
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