Published Friday, Dec. 1, 2000, in the San Jose Mercury News

HOW LARGE INDUSTRIAL CUSTOMERS, UTILITIES, POLITICIANS CREATED CALIFORNIA'S TROUBLED ELECTRIC SYSTEM BY MARK GLADSTONE AND BRANDON BAILEY Mercury News The setting at a San Diego high-tech firm four years ago was a politician's dream. With video cameras rolling and a backdrop of beaming lawmakers and business leaders, Gov. Pete Wilson signed a landmark bill that promised new competition would bring lower electric rates for all Californians.

The promise has failed to come true.

Power bills have skyrocketed in San Diego. The threat of brownouts plagues the Bay Area. Utilities are demanding a $6 billion bailout for unexpected costs. And consumers have been left wondering if they dare plug in holiday lights this winter -- let alone run air conditioners next summer.

Today, Gov. Gray Davis plans to unveil the first part of his plan to clean up the mess created by utility deregulation. One group has already proposed a ballot initiative and, as politicians heed warnings of a ``ratepayer revolt,'' a flurry of bills is expected when the Legislature reconvenes next week.

How did we get here?

A Mercury News review of hundreds of pages of documents and interviews with dozens of participants shows that while deregulation was sold to the public as a change that would benefit all electricity consumers -- big and small -- the basic elements of the plan were crafted primarily to benefit large industrial users and the utilities.

The pioneering experiment to introduce competition into California's electricity market is being watched closely nationwide. Arguably the state's biggest -- and least understood -- political deal of the past decade, it also sheds light on the maneuvering behind the making of public policy in the Golden State.

Here's what happened:

The push for deregulation started in the early 1990s when traditional manufacturing firms -- led by cement and steel industries that use enormous amounts of electricity -- were seeking relief from high energy costs.

Wilson, a pro-business Republican with presidential aspirations, was the driving force behind the historic change. Elected in 1990 as California was plunging into a severe recession, the governor seized on deregulation to improve the state's economic climate.

The state's privately owned utilities were split over the idea. But with Southern California Edison leading the fight against a plan favored by the manufacturers, the governor was forced to intercede. In 1995, his aides negotiated a pivotal compromise between these two influential segments of the business community.

Legislators ratified the bill in a rare, unanimous vote in August 1996 after it was packed with special provisions to pacify potential foes. The final terms, fashioned in a series of marathon hearings chaired by state Sen. Steve Peace, included benefits for a variety of constituencies from environmentalists to Central Valley chicken farmers. One lobbyist labeled it ``the mother of all sausages.''

Criticism from within Wilson's own administration was dismissed. One Department of General Services report suggested the plan was unfair and uncompetitive because it required consumers to pay billions of dollars for utilities' unprofitable investments -- some federally mandated. The report, now filed in state archives, was never publicized.

State regulators pushed utilities to sell off many of their generating plants after the legislation became law. While this helped foster competition, it also left the utilities more vulnerable to high prices on the short-term market. Though the issues were enormously complicated, California's deregulation effort was based on an unquestioning faith in the power of the free market. Despite official state forecasts that electricity demands would increase, for example, there was virtually no discussion of whether California's generating capacity would keep pace.

To be sure, many of those who backed deregulation say they still believe it will turn out to be good for the state. Once supply catches up with demand, and market flaws are ironed out, they say California may yet benefit from competition and lower prices.

But nearly everyone agrees that deregulation hasn't worked out as planned.

``Although well-intentioned, and in some ways visionary,'' the Federal Energy Regulatory Commission recently concluded, deregulation ``not only failed to address many of the existing problems which were plaguing the state, but in many ways it exacerbated and magnified those problems.''

And today, under greater scrutiny from the press and public, even those who forged the deal fear they've wired a political time bomb, not the free-market nirvana Wilson envisioned.

Power of cement Manufacturers make case for an open market During the recession of the early 1990s, businessmen like Earl Bouse were looking for ways to cut costs.

Bouse is an executive with Hanson Permanente Cement, formerly known as Kaiser Cement, which operates a quarry and processing plant in the Cupertino foothills. Energy represented 25 percent of production costs there, Bouse said, and the monthly PG&E bill was nearly $900,000.

At that time, California cement-makers were facing increased competition from overseas. And studies by trade groups showed the state's electricity rates were 50 percent higher than in other parts of the country.

``We weren't going out of business, but the handwriting was on the wall,'' Bouse said. ``We needed to do something.''

California's system had been in place for nearly a century. State law gave private utilities a virtual monopoly on selling power, with an assured return for investors in exchange for close regulation of all their operations. Three companies -- Pacific Gas & Electric, Southern California Edison and San Diego Gas & Electric -- controlled nearly three-fourths of the market.

Deregulation was focused on lifting restrictions on power generation, not transmission or distribution. It was intended to open that market so a variety of companies would compete to produce and sell energy at the lowest possible price, free of government subsidies and controls.

Somewhat surprisingly, the high-tech industry was not among those leading the charge for deregulation. Many chip-makers had already moved production facilities out of state. And the Internet's commercial infrastructure, with its reliance on air-conditioned rooms filled with servers and routers, was just developing.

But the cement and steel producers who made up the California Large Energy Consumers Association were convinced they could buy cheaper electricity directly from other providers. Other industry groups felt the same.

The manufacturers had a natural ally in Wilson, who came into office with the goal of reducing government's role in all the industries under the California Public Utilities Commission's jurisdiction.

Federal authorities already had set the example by encouraging competition in a variety of once-regulated industries: airline, telephone, savings and loan.

In a recent interview, Wilson said he believed electricity deregulation would benefit all California consumers, but he acknowledged the industrial energy-users were the ones calling for change.

``It's perfectly obvious they were the ones who were creating jobs, or who were in the position to create them in some other state than California,'' said the ex-governor, now a managing director of a Beverly Hills investment firm.

``We were interested in making California much more attractive to investment and job creation,'' he said. ``We made no bones about it. We didn't then. I don't now.''

The governor turned to the PUC, a panel of five full-time members who regulate the state's gas, electric and telephone industries. By 1993, four members were Wilson appointees.

The appointees included attorneys, a retired banker, a corporate marketing executive and an accountant whose clients included energy and telecommunication firms.

Starting with President Daniel Fessler, a Harvard-trained lawyer, the commissioners were outspoken in their free-market, anti-regulation beliefs. And they all shared Wilson's view that competition in the electricity industry could help spark a broader economic recovery.

``All five of us at the commission were believers of that,'' said former member Greg Conlon, whom Wilson appointed in 1993. ``If I didn't believe that, I probably wouldn't have been appointed.''

Fessler, who is now with a large San Francisco law office, refused to be interviewed. But Conlon, who succeeded Fessler as president in 1995, said Wilson made his general views clear and left the details to the commission.

Reacting to federal prodding, the PUC had been exploring the potential for developing independent power sources since the early 1990s.

Around that time, the commission ordered utilities to seek bids from a variety of companies interested in producing power for them. The strong response helped convince free-market advocates that a variety of firms -- many of them generating environmentally friendly electricity -- were eager to do business in California.

But the utilities, led by Edison, later persuaded federal regulators to cancel the bids by arguing they were costly and unnecessary. Today, PG&E executive Tom Bottorf concedes those contracts would have helped last summer when energy supplies were strained; Edison officials disagree.

With the emergence of independent power producers, the utilities' traditional monopoly was beginning to crumble.

Defining the vision Utility firms realize change is inevitable In 1993, the PUC produced a report that blamed the state's regulatory system for giving utilities no incentive to become more efficient. The 200-page report, known as the ``yellow book'' because of the color of its cover, depicted deregulation as a logical response to national economic trends and to increasing pressure from industrial customers.

Commissioners followed that in 1994 with a declaration of intent to dissolve the old power monopolies and create an open market within two years. That 100-page policy statement, known as the ``blue book,'' proposed giving all consumers the right to negotiate with competing suppliers to obtain electricity at the lowest cost.

The blue book outlined a broad vision for revamping an electricity market that had been relatively unchanged for nearly 100 years. As part of that vision, it concluded that energy supplies would keep pace with demand -- a miscalculation that policy-makers would repeat.

The California Energy Commission's continuing predictions of mounting demand were largely ignored in the debate; it recently had lost a turf battle with the PUC over statewide power planning.

Supply and demand were not a concern, Conlon said. Power was plentiful in the mid-1990s. And the former PUC member asserted that no one could have predicted the high-tech economic boom that would drive up power consumption.

Wall Street, however, was more than concerned about competition for the utilities. In the days following the blue book's release, for example, PG&E's stock dropped 22 percent before rebounding.

The utilities had sunk tens of billions of dollars into costly nuclear plants and federally mandated contracts for alternative energy such as wind power. They feared they would never recover those investments, known as ``stranded costs,'' if they had to lower their rates to compete with companies selling energy from newer, more efficient plants.

Despite their fears, the utilities could see that deregulation was inevitable, said Bob Foster, an Edison spokesman who played a key role in the process.

And so they set out to shape it.

By 1995, Edison was openly campaigning for the PUC to enact a British-style system, which would end utility monopolies but still channel wholesale energy purchases through a regulated ``pool,'' like a commodities exchange. Edison viewed it as less threatening than other proposals.

Lobbyists for Edison and PG&E, along with Fessler and Conlon, had seen the British model firsthand when they traveled to England in early 1994 on a trip sponsored by an industry-backed foundation.

But the big energy consumers complained that the utilities would control the new market under the British model. They had their own lobbyists, including D.J. Smith, a savvy veteran of the Sacramento scene who pressed state officials to let his clients negotiate directly with other suppliers.

PG&E, while proposing its own variations, generally sided with the manufacturers. And so did out-of-state suppliers like Houston-based Enron Inc. that wanted in on the California market.

By the spring of 1995, Edison and the manufacturers were at loggerheads. And on the PUC, commissioners were choosing sides. Deregulation appeared to be foundering just as Wilson was preparing to run for president.

That's when he directed two top aides to step in. In early May 1995, George Dunn, Wilson's chief of staff, and Philip Romero, the governor's chief economist, convened a meeting of the major players.

Groups representing residential consumers were not invited. But packed into the room were lobbyists and lawyers for the California Large Energy Consumers Association, the California Manufacturers' Association, Southern California Edison and the Independent Energy Producers Association. PG&E monitored from the sidelines.

It was the first of many sessions over the next three months, as the future of California's electricity market was hammered out in hotel conference rooms, the governor's office and the manufacturers' association boardroom in Sacramento. Romero, now dean of the University of Oregon business school, jokingly describes it as a ``long, floating crap game.''

In August 1995, Wilson unveiled a breakthrough agreement between Edison and the big consumers: Utilities would buy and sell their power through a pool, but consumers would be free to buy from suppliers outside the pool.

And in a provision that was essential to win utility support, the deal guaranteed that customers would compensate utilities for unprofitable investments, primarily in nuclear power plants.

That price tag ultimately came to $16.2 billion. Advocates for residential and small-business consumers such as Mike Florio, an attorney for The Utility Reform Network, didn't like the idea of getting stuck with those costs. But the agreement became part of a formal plan adopted by the PUC in December 1995.

As Romero put it: ``We stepped outside the PUC and got the big dogs together to create a deal.''

Consumer advocates and other critics now contend that much of the current problem stems from one wrinkle in the deal that was little noticed at the time. The 1995 compromise created two bureaucracies: the Power Exchange to administer the wholesale pool, and the Independent System Operator to run the statewide transmission grid.

Initially, one agency was proposed to handle both chores, but the manufacturers worried that it would be too easy for utilities to dominate a unified system.

Creating two agencies produced a decentralized system that is too weak to guard against price manipulation and other abuses, according to Peace, D-La Mesa.

But Conlon, the former PUC member who is now a consultant and law student living in Atherton, rejected the idea that a free market needs more centralized control. Aside from maintaining the transmission grid, he said, ``our objective wasn't to have oversight.''

`Death march' Legislative marathon irons out the details The 1995 deal wasn't the end of the road, however.

In the spring of 1996, PG&E came up with a mechanism to reimburse the utilities for unprofitable investments. Without deregulation, analysts knew, electricity prices were headed for a temporary decline because a number of expensive wholesale contracts were about to expire. But instead of passing the benefit on to consumers, utilities would keep most of the savings.

The proposal was contained in an agreement that PG&E negotiated with its large commercial customers, labor unions and independent energy producers.

Now it was time for the Legislature to begin tinkering.

The essentials of the overhaul were in place, but there were still potential opponents and a variety of groups seeking to protect their individual interests.

Then-Assemblyman Jim Brulte, R-Rancho Cucamonga, championed the bill on behalf of Wilson and the manufacturers. But the job of shepherding it through a legislative conference committee fell to Peace, an ambitious Democrat with a penchant for popping M&Ms and a reputation for brokering complex, high-stakes deals.

Though Peace is often described as the ``architect'' of California's electricity deregulation, he has recently portrayed himself as a reluctant participant.

As a young filmmaker before he entered politics, Peace was best known for co-writing, co-producing and co-starring in the 1978 low-budget horror flick, ``Attack of the Killer Tomatoes.'' He is now circulating a short video containing clips of statements he made in 1996, in which he repeatedly insisted deregulation was a bad idea that probably wouldn't benefit big or small consumers.

In a recent interview, Peace explained why he felt powerless to block the deregulation plan: Federal authorities were putting pressure on California by opening the interstate transmission grid to competing energy suppliers. And on the state level, Brulte and the Republicans had gained control of the Assembly, while Democrats had a narrow edge in the state Senate.

``We didn't have the votes,'' Peace said.

While others have questioned his motivations, Peace says he felt a duty to at least make the plan more friendly to consumers, workers and environmentalists.

The major players behind deregulation wanted the Legislature's blessing for a different reason.

They wanted ``assurance, on all sides, about what they had thought they had gotten and what they had given up'' in earlier negotiations, said Dunn, Wilson's former chief of staff. Edison's Foster said his company wanted the terms locked in by law, to minimize reinterpretation by the PUC or the courts.

And Wilson made it clear the Legislature had little wiggle room to alter the deal that was ratified by the PUC in December 1995.

``I will necessarily oppose any legislation which seeks to alter the decision's basic framework or timeline,'' he wrote to the Federal Energy Regulatory Commission in July 1996.

What came next would be known as the ``Steve Peace Death March,'' 18 days of legislative committee hearings that often stretched past midnight.

Committee member Bill Leonard, a veteran GOP legislator from San Bernardino County, dubbed the outcome ``consensus by exhaustion.'' Other participants say that consensus was reached by mollifying each group that might have reason to oppose the deal.

Peace and his defenders cite the marathon hearings, which were televised on some cable systems, as evidence of open government. But some critics say the agenda was largely set by the utilities and the large manufacturers.

While environmentalists did have an advocate on the panel in state Sen. Byron Sher, D-Redwood City, their focus was primarily on protecting a fledgling alternative energy industry. And consumer advocate Lenny Goldberg complained of being ``outmanned and outgunned'' by lawyers and lobbyists for the major business interests.

One committee member now calls the hearings ``a dog and pony show.''

``Ninety-eight percent of the bill was crafted out of the public eye,'' added Diane Martinez, a former Democratic assemblywoman from Alhambra.

The concessions With no opposition, unanimous approval In the end, environmentalists got $540 million in subsidies for renewable energy. Labor unions were promised some job protection and $100 million for retraining and severance benefits if any workers were laid off.

Municipal utilities were allowed to preserve their independence. About a quarter of the state is served by city-owned utilities -- including those in Los Angeles, Santa Clara and Palo Alto -- that operate their own power plants.

Despite reservations, two major groups that represent residential consumers dropped their opposition to the bill and took a neutral stance. That came after legislators promised homeowners and small businesses would get a 10-percent rate cut for four years, although even with that price break, critics noted that rates were still frozen at artificially high levels. PUC analysts later pointed out the price break would be closer to 3 percent after customers paid off the bonds used to finance the cut.

Other special deals included $200 million in price breaks for individual large consumers including, BART, the University of California and San Joaquin Valley agricultural interests.

``I've characterized it as the mother of all sausages,'' said Jan Smutney-Jones, a lobbyist for independent energy producers. ``There was something in it literally for everybody.''

The debate was further influenced by a massive transmission failure Aug. 10, 1996, that knocked out power to 4 million people in nine Western states. Some hearing participants say the outage focused attention on maintaining a reliable delivery grid, rather than on questions of supply and demand.

At the end of August, the committee sent a 67-page bill directly to the floors of the Assembly and state Senate. Both houses voted unanimous approval.

Critics complain that legislative interest in the energy issue was fueled by campaign contributions from a variety of economic interests, including labor, big business, oil companies and utilities.

Harry Snyder, longtime lobbyist for Consumers Union, maintained that lawmakers only helped shape it ``because they couldn't get any campaign contributions if the PUC decided the issue.''

Indeed, in 1998, the year the overhaul took effect, the central political players -- Peace, Brulte and Wilson -- took in $176,000 in donations from utilities, nearly three times the amount they received in 1996, according to a computerized contribution-tracking service.

All three scoffed at suggestions they were influenced by financial donations. Peace strongly denied he was motivated by self-interest, adding that similar refrains are heard in the halls of the Capitol when anything major happens in Sacramento.

Several legislators said the bill was better than the PUC's plan. It trimmed the total amount of compensation that utilities would be eligible to collect for their unprofitable investments. It provided concessions for labor and environmental groups. And by Capitol custom, if no interest group was opposed, lawmakers had no reason to vote against it.

Within the Wilson administration, however, critics were raising pointed questions about the bailout for utilities' investments.

``Is it really appropriate,'' asked a report by the state Department of General Services, for utilities and their shareholders to ``bear no burden whatsoever for poor decisions in the past?''

The 23-page analysis raised other concerns about the bill. But it ultimately recommended approval, saying the bill was an improvement over the PUC's original plan.

The governor agreed with the utilities' argument that the stranded cost investments were approved, and in some cases mandated, under the old system. If those investments became unprofitable now that regulators were changing the rules, Edison's Foster said, it was unfair to make stockholders pay.

On Sept. 23, 1996, Wilson signed the bill.

Plan short-circuits Problems compounded by later decisions The new era officially began in 1998, amid fanfare and an $87 million TV, radio and print ad campaign -- paid for by utility customers. The ``knowledge is power'' effort was supposed to educate consumers about their choices in a deregulated market.

But it was almost immediately clear that deregulation wasn't working as anticipated.

After just a few months, many new suppliers such as Enron stopped signing up new residential customers after deciding there was no profit in that market.

``That was $90 million wasted,'' said Scott Cauchois of the PUC's Office of Ratepayer Advocates.

The PUC, attempting to foster new competition, took steps that created new problems.

The commission offered financial incentives to utilities to sell their power plants to new, unregulated companies and out-of-state conglomerates that wanted a share of the California market. Peace and others now say that turned out to be a mistake: When consumer demand peaked last summer, the utilities had to pay top dollar on the wholesale market to acquire enough electricity to meet customer needs.

Until last year, the PUC also barred utilities from signing long-term contracts with power suppliers. Instead, the utilities were required to buy short-term through the Power Exchange.

The idea, again, was to encourage a competitive market. Deregulation advocates were afraid that utilities might corner the market by negotiating high-volume, long-term contracts with energy suppliers -- and thus get an advantage over any new companies.

But utilities and consumer advocates now agree that the restriction left utilities vulnerable to short-term price hikes, especially at peak times when the utilities had to pay whatever their suppliers asked.

By circumventing the utilities, some manufacturers have obtained savings from other suppliers, though often not as much as hoped. Bouse, the cement company executive, said his company negotiated a rate with New West Energy that is 1 to 2 percent lower than the utilities' frozen rate.

While disappointed that more suppliers haven't entered the market, attorney William Booth of the California Large Energy Consumers Association said he still expects prices will drop further when new generating plants are built and supply matches demand.

As for Wilson, the former governor said he still believes electricity deregulation was a major achievement of his administration. To reverse course now, he warned, ``would be a terrible mistake.''

In the short term, however, some critics wonder if consumers can afford the cost.

And what worries them most is the provision that froze retail rates for up to four years while utilities collected billions of dollars to pay off their stranded costs.

The arrangement worked as planned for the first two years of deregulation. But in the last year, wholesale electricity prices rose substantially above the frozen retail rate. And now the state's two largest utilities, Edison and PG&E, say they want consumers to pay off the more than $6 billion in new deficits the two power companies have racked up.

The utilities are in court asking to lift the retail freeze earlier than expected because they've paid off their stranded costs ahead of schedule, thanks to revenue from selling off power plants and other sources. That would allow Edison and PG&E to raise their rates in coming months to match the recent wholesale price jump.

And that has officials predicting the statewide spread of the ratepayer revolt that began in San Diego last summer.

``The residential customers were never part of this thing to begin with,'' said S. David Freeman, head of the Los Angeles Department of Water and Power. Freeman, a onetime presidential adviser who helped set up California's deregulated system, warned: ``The people who never did ask for this are going to end up paying for it.''

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-- Martin Thompson (mthom1927@aol.com), December 01, 2000