News Analysis
Summer in San Diego
September 15, 2000
By
Ahmad Faruqui and Kelly Eakin
A shock for
consumers. An epiphany for electricity.
Electricity
bills doubled this past summer in San Diego. That shock-coupled
with an imminent threat of blackouts across California-has now come to
define the meaning of "utility competition."
Several public figures have
raised doubts about the wisdom of deregulating the nation's electricity
industry. They say it has failed in California-the bellwether for the
rest of the nation. They insist it has benefited no one but that handful
of energy suppliers who are raking in the profits at "obscene" levels.
One might dismiss such talk as an overreaction-were it not for the way
it has gained credence among policymakers.
Carl Wood, who holds a seat
on the California Public Utilities Commission (PUC) has stated that Assembly
Bill 1890, the 1996 law that deregulated California's $20 billion energy
industry, was a mistake. "We need to make sure it doesn't turn into a
disaster," he warns. Michael Shames of the Utility Consumers Action Network
raises the rhetoric even a notch higher. "We know what's wrong," he says.
"The patient is bleeding and he needs immediate attention." Then again,
State Sen. Steve Peace, one of the leading architects of California's
grand experiment with deregulation, says the problem has been compounded
by a shortage of generation plants. Tellingly, Peace admits that it may
be easier to build new plants "under a command-and-control system" than
a deregulated market regime.
Meanwhile, the crisis in San
Diego has escalated into a full-blown consumer revolt, reminiscent of
the contentious rate hearings of the '70s and early '80s. Remember that
San Diego lies in a temperate region, where year-round temperatures average
71 degrees. Residents there are unaccustomed to any great monthly variation
in their electric bills.
A former mayor of San Diego,
Maureen O'Connor, is leading a citizens' crusade against deregulation,
calling for emergency measures to protect citizens "from price gouging
by the electric companies." She has joined with Harvey Rosenfield and
other supporters of the failed Proposition 9 ballot measure to ask Gov.
Gray Davis for temporary repeal of AB 1890 until a solution can be found.
In response, the governor has
told the PUC to reduce electricity prices in San Diego by 50 percent and
essentially freeze rates for the next two years.1 The governor's
action comes partly in response to allegations of excessive market power
and anticompetitive practices. These allegations were triggered by estimates
that the energy providers took in $1 billion of revenue in one week and
$3.6 billion in the month of June.2
Yet one should not blame deregulation
for San Diego's summer of discontent. Indeed, rescinding deregulation
would prove counterproductive. It would take California back to the status
quo of 1997, with all its attendant problems such as expensive regulatory
proceedings before the PUC, delays in licensing new capacity, and (yes)
high electricity prices.
Indeed, any retreat would
defy the global trend toward liberalization of public utilities. As stated
by Jan Smutny-Jones, who chairs the California ISO Board and is executive
director of the California Independent Power Producers Association, "The
worst possible outcome is for deregulation to fail. There is no going
backward."
What Went Wrong?
The deregulated electricity
market is still very young, but the experience of this summer already
highlights several key problems from incomplete deregulation. Our list
features the following seven-all of which are readily resolved without
abandoning the basic deregulation thrust.
1. No Derivatives. SDG&E
failed to hedge against risks. It seems that the PUC restricted utilities'
ability to purchase block forward pricing contracts offered by the California
Power Exchange. Consequently, the entire force of the wholesale market
price volatility was passed through to San Diego customers.
2. Too Few Products.
Energy service providers (ESPs) did not provide retail customers with
a menu of risk-differentiated pricing products. Neither was the SDG&E
able to provide such products, since it was forbidden by the PUC to engage
in retail risk management services.
3. Wary Customers. Customers
appeared to be unwilling to pay the price premium for a guaranteed price
product that some ESPs did offer them before the approach of summer. The
actuarially fair price of this premium is greatly increased because most
retail electricity is not purchased at market-based prices.
4. Economic Growth.
Continued growth in the state's increasingly digital economy, and the
boom of Internet-enabled e-commerce in Silicon Valley, caused electricity
demand to rise at the rate of 1,000 megawatts a year. This was not matched
by a corresponding increase in generation plants.
5. Fuel Dependence.
A nationwide trend toward higher natural gas prices and an increased dependence
on natural gas-fired generation capacity. Natural gas prices this summer
are roughly double what they were last summer. While natural gas-fired
generation comprises only about 20 percent of the generation, these gas-fueled
plants are on the margin most of the time.
6. Weak Infrastructure.
Too much transmission congestion around the service territory of San Diego
Gas & Electric Co. That has caused locational shortages and possibly given
rise to periods of locational wholesale market power.
7. Sheer Panic. A panic
has resulted as the public has first faced the tremendously higher summer
bills but has yet to enjoy significantly lower bills in the fall and winter.
To many observers it is tempting
to just apply price caps, but price caps never offer a good long-term
solution. Price caps merely hide the problem. The citizens of the former
Soviet Union faced low prices for bread compared to their counterparts
in capitalist countries, but this was of small consolation to them since
bread was often unavailable or there were long lines at the bread counter.
By contrast, high prices invite new competitors and innovators to join
the industry. These new players force prices lower eventually, as the
supply curve shifts to the right.
In fact, recent data indicate
that $10 billion of private capital is being invested in power plants
and transmission lines in California, and that about 90 percent of this
investment occurred because of deregulation.3
How to Fix
It
Market pricing is the key.
Let markets price electricity to reflect its scarcity. Yet market pricing
should not mean that every customer must buy electricity on the spot market,
at real-time prices. Just as a large fraction of home buyers will always
choose to finance their mortgages at a fixed rate, and will shy away from
adjustable mortgages that might feature a lower average rate, so it should
be with electricity.
Simply allow customers who
value predictability to buy their electricity at a higher flat rate, to
capture the insurance premium that exists in a competitive wholesale market.
These customers represent a potential gold mine for competitive energy
retailers. One can imagine these new retailers courting such customers:
"Don't like those high bills? Stop blaming the utility. They cannot do
anything. Take control of your costs. Adopt our guaranteed monthly rate
plan. Sign up today!"
Other customers-those willing
to trade off lower average prices against higher price volatility-would
buy electricity as priced in real time. Such customers could always choose
to cut back on usage when prices surge. Others who don't want to be exposed
to complete price volatility would buy a price cap. Still others would
buy a portion of their expected demand on a forward market basis, at a
fixed price, and buy the rest at the real-time price.
Taming the
Revolt
Gubernatorial fiat and other
administrative actions in response to the public outcry are effective
in the short run, if at all. Similarly, the California ISO's hastily developed
load management programs have not performed well, drawing in only about
180 MW. (And that number soon dropped to 62 MW because of problems with
pollution and lack of sufficient prior notice.4) Such remedies
will not resolve the underlying problems in the state's energy market.
Instead, the state should consider
some ideas like these:
- Eliminate the PUC's restrictions
on forward contracting by utility distribution companies such as SDG&E.
- Call on the California
Energy Commission to weigh the value of building a new transmission
line from the north and act accordingly.
- Instruct the PUC to encourage
market-based pricing of all retail electricity products (not just spot
pricing) to create a better link between wholesale and retail prices
to reduce price volatility.5
- Invite energy retailers
to add a greater variety of electricity products, to allow customers
to protect themselves against price runups in varying degrees.
- Urge retailers as well
to show commercial or industrial customers how they can reschedule operations
to benefit from flexible prices.
- Encourage retailers to
offer incentives to customers to install intelligent load-shifting technologies
such as smart thermostats, energy management systems, thermal energy
storage, and back up generation.
- Lead efforts to install
more time-of-use and real-time meters regardless of whether customers
switch retailers. Dan Fessler, who presided over the PUC at the time
of the restructuring decision, envisioned that customers would enjoy
"virtual direct access" by being able to buy power on the spot market,
and would have the option to reschedule operations. They cannot do that
until they have intelligent meters.
Open markets are crucial to
implementing the above initiatives. Only with open and competitive electricity
markets will objective, market-based incentives develop and function.
Providing incentives in the absence of open markets can easily lead to
inefficient over-investments, free riders, and other problems reminiscent
of the demand-side management era. Wholesale price caps, on the other
hand, distort market signals and may discourage efficient investment in
load shifting and other enabling technologies.6
When redesigning markets, one
has to be patient. Customer choice, the heart and soul of competition,
cannot be forgotten. Listen to James Hoecker, the chairman of the U. S.
Federal Energy Regulatory Commission. He acknowledges that "retail price
volatility has real impacts on consumers," but has asked federal and state
authorities to "ensure that markets are allowed to work and that energy
suppliers are not prevented from prudently managing the risks associated
with competition."7
Open markets are the only solution.
Stay the course. The state's restructured market will pay rich dividends
in the long run.
Ahmad Faruqui manages a
program of research on retail and power markets at EPRI, the Electric
Power Research Institute. Kelly Eakin is a vice president of Christensen
Associates.
1 "California's
Governor Orders Regulators to Slash Electric Rates in Southern State,"
Wall Street Journal, Aug. 10, 2000. The measure would address
rates for San Diego Gas & Electric Co., the first of the state's three
major investor-owned electric utilities to recover costs left stranded
by deregulation. Thus, SDG&E customers (those not choosing a competitive
retailer) are the first to lose the protection of the rate freeze mandated
by AB 1890, and the first to pay rates that directly reflect prices
set in the California Power Exchange.
2 California
Energy Markets, July 21, 2000.
3 California
Energy Markets, July 28, 2000.
4 California
Energy Markets, July 21, 2000.
5 For a discussion
of how the disconnection between wholesale and retail electricity markets
contributes to wholesale price volatility, see Doug Caves, Kelly Eakin,
and Ahmad Faruqui, "Mitigating Price Spikes in Wholesale Markets through
Market-Based Pricing in Retail Markets," Electricity Journal,
April 2000.
6 "Electricity talks
full to static," San Ramon Valley Times, Aug. 10, 2000.
7 California
Energy Markets, Aug. 4, 2000.
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