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Part 2: The Power Struggle By Christopher Edmonds Special to TheStreet.com Originally posted at 5:34 PM ET 8/22/00 on RealMoney.com
While the prospects of competition and consumer choice were enticing, behind the facade of California's deregulation promise were scores of erroneous assumptions.
"You have a deregulation plan that did not reason California might come out of the recession of the early 1990s in need of more power than ever before," wrote Rick Stouffer of Resource Data International, a Boulder, Colo.-based consulting firm, in a recent analysis of the California markets. "It also assumed electric supplies to the north and the east would always stand ready to export surplus power to the West Coast."
Unfortunately, both problems have surfaced and are wreaking havoc on California power markets. In short, demand is outpacing supply, nearly 10-to-1. A recent California Public Utility Commission report said only 672 megawatts of generation have been added to the California system since 1996. During that same period, peak demand for power has soared by more than 5,500 megawatts.
And the situation is expected to tighten. Estimates suggest power demand is growing at a 5% annual rate, largely driven by the technology boom in which many users demand "no-fault" power -- absolute reliability from their power source.
Such guarantees are becoming more difficult to provide. Since the beginning of the summer, the California Independent System Operator, or ISO, the organization established to assure reliable power transmission under deregulation, has issued 20 Stage One emergencies, which ask consumers to voluntarily reduce power consumption. And, the ISO has issued a dozen Stage Two emergencies, calling for customers who have agreed to interruptible supply to reduce consumption and possibly lose power from suppliers. A Stage Three emergency, yet to be issued, occurs when reserves drop below 1.5% and can result in involuntary power curtailment and rolling blackouts.
And, what about importing power from other states to satisfy demand? Although California's native plants have 55,000 megawatts of capacity, the state still imports nearly a quarter of its juice. However, it isn't likely additional imports are available. Growth in the surrounding states -- Arizona, Nevada and Oregon -- has pushed demand higher and is beginning to stretch supply.
Oregon's largest utility, Portland General Electric (an Enron (ENE:NYSE - news) subsidiary being sold to Sierra Pacific Resources (SRP:NYSE - news), asked the Oregon Public Utility Commission for permission to increase rates to recover costs of power purchased in the open market as a result of its inability to meet power with its native generation this summer
"There is a shortage of generation across the western United States," says Jay Dobson, director of utility research at Donaldson, Lufkin & Jenrette. "It is especially acute in California."
High Prices, but Not High Enough Prices for power in the West have surged, with reports of $1,000 per megawatt hour power reported in the Pacific Northwest, a result of power shortages, hot weather and low water levels in hydroelectric projects. That is compared with Portland General's projections that power would run around $35 per megawatt hour, which is about average throughout the United States.
Prices in California have been high as well, although the state independent system operator has placed a cap on prices, first at $750 per MWh, and most recently to $250 per MWh. And, while the cap provides some protection to consumers in the short term -- while still providing handsome short-term profits to generators -- the price cap may stifle the solution. "Unless prices stay high and the market is allowed to work, you won't solve the long-term problem [of insufficient supply]," says Dobson. "There may be some short-term pain, but that is what you have to do if you want to see increased supply in California."
Dobson speaks to a solution that many myopic policymakers don't like to acknowledge: the power of a competitive market. As long as California artificially limits the profits of power generators with price caps and otherwise makes it difficult to develop power plants, generators are going to take a cautious approach to developing in the state. One reason for the lack of generation development in the last half of the 1990s was California's stringent environmental regulations. "Permitting was a nightmare," says a former Pacific Gas & Electric (PCG:NYSE - news) manager. Or, as the Research Development Institute's Stouffer wrote, "California was NIMBY (not in my back yard) before NIMBY was cool."
The California Energy Commission, or CEC, is reviewing 13 projects that would produce more than 15,000 megawatts of new generation in the state. And, to the state's credit, Gov. Gray Davis has asked the CEC to develop a process to fast-track approval and permitting of some plants. However, it is likely that the new process will help only five of the 13 projects. (Currently, an additional 2,000 megawatts of generation is under construction and should be operative in 2001, and an additional 1,500 are scheduled for 2002.)
The recent price caps, combined with the rigorous permitting standards, have some utilities quietly reconsidering their development options in California. "Nobody has officially said they will pull out of a project, but we are all watching carefully," says a trader with a large generating company with an interest in California assets. "You have to look at the economics. If you have a turbine and you have an option of building in a difficult market like California or a friendly market where your returns are greater, the choice isn't that hard."
That makes the argument for competitive markets fairly persuasive. Unfortunately, California is in a tough position. Politicians and regulators don't want to take the heat of higher power prices. At the same time, they are reluctant to reregulate the industry, a strategy that would fail miserably, especially given that native utilities no longer own generation.
It's a tough position, something the trader acknowledges. "It's not deregulation that's a bad idea, but the environment. Deregulation came to a market with short supply and exponential growth. That's a recipe for trouble," he says. "Now, the only long-term solution is to let the market work it out."
Posturing or Reality Although many parties in the debate are crying foul, the real victims are the power consumers -- the residents of California. And unless competition is allowed to work and generation capacity grows significantly, the outcry from San Diego customers will seem like a whisper compared with the potentially riotous situation once Los Angeles and San Francisco consumers begin to feel the heat of skyrocketing electric bills.
As for the government, those suggesting a return to old-style regulation are guilty of needless pontification and platitudes. While California's deregulation plan may not be perfect, the long-term solution is to embrace a market-based approach to generation. If the market sends price signals that profits can be generated by building more generation in California, the power moguls will find their way to the border. Handled the right way, it could be the second coming of the Gold Rush to California. In short, policymakers should be encouraging additional generation development with incentives and a friendly regulatory backdrop.
Those utilities and power companies complaining about price caps and regulations might take a closer look at the numbers. After all, the $250 price cap probably isn't that bad. As Donaldson Lufkin & Jenrette's Dobson put it, "Nobody likes to see price caps, but most everybody is living high on the hog, even with the $250 ceiling." Dobson estimates that power companies will have to clear $41 per megawatt hour to break even in California with new gas-fired plants, assuming the price of gas is around $4 per unit. "One-hundred dollar power would be a windfall for most," he says. According to the energy trader with the large utility, the summer months provide the bulk of annual profits. "If we don't make our money in June through early September, we won't have a very profitable year."
Successful Competition If the market is allowed to work its magic, there are two long-term winners. First, the generators: Companies like AES (AES:NYSE - news), Calpine (CPN:NYSE - news), Dynegy (DYN:NYSE - news), Southern Company (SO:NYSE - news) and Duke (DUK:NYSE - news) all have the ability to turn hefty profits by helping California meet its demand for power by operating existing plants and developing new generation capacity.
Finally, the consumer wins. While regulation will remain necessary in the foreseeable future to assure the reliability of the transmission and distribution systems, free and open markets will drive the cost of power lower by advancing new technologies and efficiencies not promoted in a regulated environment. The history of telephone and air travel underscores the economics. The additional layer of assured reliability creates a model that may be even superior to deregulation stories of the past.
If California policymakers have the conviction and fortitude to stand behind their original beliefs, they have a golden opportunity to create a robust, competitive power market. If they give in to short-term pressures, they may very well flip off the switch to future competition in the industry across the country.
Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta
-- Martin Thompson (firstname.lastname@example.org), August 23, 2000