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Commentary : Power Lines Part 1: The Power Struggle By Christopher Edmonds Special to TheStreet.com Originally posted at 5:32 PM ET 8/22/00 on RealMoney.com

Californians are furious. Power prices are rising faster than steam from a generating plant. Consumer groups are blaming utilities, utilities are blaming the government and the government is scrambling to do damage control.

Ever since California began to deregulate the electric utility industry in 1996, some analysts and consultants warned that the components existed for disaster -- a serious shortage of supply worsened by growing demand from the robust tech-driven economy, the government's unwillingness to allow free-market pricing and the difficulty in bringing in new power generating sources.

Today, the effects of skyrocketing demand, soft supply and spiraling costs are hitting home, with San Diego Gas & Electric, a unit of Sempra Energy (SRE:NYSE - news), at ground zero. There customers are outraged and frustrated over power bills that have more than doubled, thanks to deregulation -- a process they believed would actually lower their power bills.

California Gov. Gray Davis has called on state regulators to cut power bills in half, prompting them to propose rolling back rates to 110% of June 1998 levels. The California Public Utilities Commission voted to cap electricity rates in the San Diego area on Monday, while the California Assembly is scheduled to address the issue this week. Meanwhile, utilities and proponents of deregulation are urging regulators to let the immature power market work through the problems on its own.

Federal regulators also seem to be circling. According to San Diego Gas & Electric's Aug. 14 filing with the Securities and Exchange Commission, the Federal Energy Regulatory Commission is "investigating the electric bulk power markets and California's attorney general is investigating whether there has been market manipulation." The inquiries could result in refunds to consumers, the SEC filing says. Still, most industry sources say action from the Federal Energy Regulatory Commission, or FERC, is unlikely. "FERC investigates everything; however, they are loath to act," says one industry source. "They like to use investigative persuasion to prompt action."

Investors in San Diego Gas & Electric haven't seen the windfall either. The company's second-quarter net dropped 13% from the 1999 period -- and that was before it volunteered this month to return nearly $100 million to customers. That's because, thanks to deregulation, the company has become little more than a transmission and distribution utility, with little control over the power it provides customers.

With apparently so few benefiting from California's grand experiment with deregulation, regulators, utilities and investors are wondering whether it's time to reregulate or let the markets work out the kinks. Those hoping to benefit from utility deregulation around America -- consumers, investors and power companies -- are looking closely at California for hints of how the process might play out elsewhere.

Transferring Power When California passed its landmark electric utility competition law in 1996, it was the first state to begin the complex process of deregulating electric utilities. The thinking was similar to what had prompted deregulation of both the telecommunications and airline industries: to promote competition, to advance technology that would cut costs and to provide customers with choices and ultimately lower prices.

Yet the differences between telephone, air travel and electric power are vast, most notably the infrastructure and capital costs of producing, transmitting and distributing power. These costs for the power industry are unsurpassed by any other industrial endeavor.

To advance deregulation, California was forced to make choices, primary among them the decision to allow utilities to recover the costs of developing costly generation assets, the costs which were built into the regulated rate base and which likely could not be recovered in a more competitive landscape.

So, California came up with a plan that, at the time, was hotly debated . Utilities would be able to recover those costs through issuing asset-backed securities. All told, the state decided nearly $28 billion in costs could be recovered. To repay the bonds, the utilities would sell their generation assets to both independent power producers and the unregulated subsidiaries of existing utilities and apply the proceeds to the debt. (Under the asset-backed scheme, utilities were to issue bonds secured by the power plants, use the bond revenues to pay off the debt from the building plants, then sell the plants and use the proceeds to repay the bonds. In the interim, ratepayers are assessed a modest premium to help cover the interest on the debt.)

Until the bonds were paid off, retail power rates would remain regulated. (Actually, a 10% rate cut was ordered, but was largely offset by a surcharge to help cover the interest on the newly issued bonds.) Then, once the bonds were paid off, utilities were to be free to charge market rates. In turn, consumers would be able to choose the electricity provider, which, in theory, promoted competition and lower prices. In the event, only 1.5% of Californians chose to replace the provider they had.

That brings us to the powerful irony of today. The spike in power prices for the 1.2 million customers of Sempra's San Diego Gas & Electric unit is the result of the company's prudent financial management. San Diego power prices began to fluctuate last summer when Sempra completed the sale of its generation assets and paid off the balance of its outstanding asset-backed debt. That allowed the utility to charge market rates to all its customers.

The other investor-owned utilities in California will soon be in the same position, having sold their generation assets so they could pay off the remaining debt and begin charging market-based rates. The rate freeze and 10% reduction expire in 2002. While many California utilities have acquired generation assets in other parts of the country, their traditional units serve simply as transmission and distribution companies that purchase power from other providers.

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta.

http://www.thestreet.com/comment/powerlines/1050114.html

-- Martin Thompson (mthom1927@aol.com), August 23, 2000