After a three-month delay, caused by computer problems with the Independent System Operator (ISO) and the Power Exchange, California's $23 billion electricity market opened for competition on 31 March 1998. More than 200 marketing companies had registered to resell wholesale electricity to residential and business consumers, and a 10% rate reduction had already been implemented for customers of existing utilities. Nineteen participants (including the state's three major utilities) bid for electricity on the first day of business, with the average wholesale price resting at $19.73 per megawatt-hour (MWh) compared to about $24 per MWh in the days before deregulation.. (For bulk purchases, the MWh unit is used. For smaller purchases, the kilowatt-hour or kWh is the more familiar unit, such that 1,000 kWh equals 1 MWh. The bulk rate of $19.73 per MWh translates to 1.973 cents per kWh.)
For two years, retail competition appeared to be a modest success. Some businesses obtained favorable long-term contract prices for power they bought, and residential consumers benefited from either mandated rate reductions or discounts from some of the new marketers. Some customers even chose to buy power (at a premium price) from companies such as Green Mountain Energy, which offered green electricity produced from wind and water turbines or from other environmentally preferable technologies. In other words, restructuring seemed to be delivering lower prices and new services to customersexactly as deregulation theory suggested.
As part of the restructuring process, utilities were directed to sell many of their generating plants to independent companies. After all, how could competition work without a host of competitors? With the money obtained from these asset sales, the utilities paid off debts they incurred in building some of the plants and in paying for long-term power contracts from qualifying facilities and others (going back to the days of the implementation of the Public Utilities Regulatory Policy Act). According to the restructuring law of 1996, customers' rates would remain frozen until these debts had been paid off or the end of March 2002, whichever came first. Unexpectedly, independent power companies bid up the prices of some power plants being divested by utilities, such as those sold by San Diego Gas and Electric, in southern California. Consequently, on 1 July 1999, the San Diego utility officially ended its rate freeze, making customers subject to free market prices for power.
For months, little changed as electricity prices remained tame. In May 2000, however, prices started rising on the wholesale market, to more than 50 cents per kWh. To customers of both Pacific Gas and Electric and Southern California Edison, still protected by the rate freeze, the higher wholesale prices meant nothing. They still paid their lower rates (around 10 cents per kWh) even if the utilities had to pay prices five times higher. But San Diego customers felt the brunt immediately, and complained bitterly about what they felt were exorbitant and unjustified rates. Taking heed of the complaints, the California Independent System Operator imposed price caps, meaning that the generators of power could not ask for prices above a certain level. Variously set between $250 and $750 per MWh, the caps still allowed for huge price increases compared to prices experienced in the first two years of restructuring. Upset at the caps, power generators often sold power out of the state, thus reducing supply for customers in the state.
Wholesale power prices continued to escalate until August 2000 and then declined somewhat for a few months. In an effort to keep prices down, the state set the wholesale price caps at $250 per MWh, which caused generators to sell more power outside of California, where no caps existed. As the supply of power diminished in California, wholesale power prices in the western part of the U.S. rose as high as $1,400 per MWh. In December, Secretary of Energy Bill Richardson invoked emergency authority to force power suppliers to sell electricity to the California ISO. [5a] His successor, Spencer Abraham, renewed the emergency directive from January to February of 2001.
In December 2000, the Federal Energy Regulatory Commission stepped in and, over the objection of state officials, removed price caps altogether in California as a way to reestablish sales to the state. This action had some ironic effects. For example, aluminum smelters in the Pacific Northwest (heavy users of electricity) cut production and occasionally closed plants due to the rising prices. But they had contracted for a portion of their electricity at low prices and found they could make more money selling that power back into the grid then they could by using it to make aluminum. [5b] The average wholesale power price peaked at more than $300 per MWh in February 2001 before moderating again. (See graph, below, and click on the graph to open an enlargement in a new window.)
Beyond utilities that could not bear the increased costs of power were consumers, who suffered through the spring of 2001. Because of inadequate power supplies the Independent System Operator was forced to declare several stage 3 emergencies, meaning that electricity reserves had fallen below 1.5%. This made rolling blackouts of 60-90 minutes necessary so electricity could be rationed around the state. During all of 2000, only one stage 3 emergency had been declared. The situation became so extreme that during the first six months of 2001 alone, the ISO declared 38 stage 3 emergencies (with associated blackouts).
As the crisis evolved, state politicians became involved in trying to mitigate it. Governor Gray Davis, a Democrat with reported presidential aspirations, at first tried to resolve the supply inadequacies without raising customers' rates. But after several months, Davis (who inherited the restructuring plan from his predecessor, Republican Pete Wilson) felt obliged to intervene more forcefully. Declaring a state of emergency on 17 January 2001, the governor authorized the state's Department of Water Resources (DWR) to assume the task of buying power for utilities. The utilities had become bad credit risks because of their mounting debts to independent power producers, as the price caps restricted utilities from recovering their costs from consumers.
The state legislature further allowed the DWR to enter into long-term contracts with electricity suppliers as a way to guarantee enough power for the state's citizens. To pay for these contracts, the California Public Utilities Commission (CPUC) approved higher electricity rateseffectively ending the price freeze that had previously been promised to last another year. And to help stabilize the chaotic market, the legislature permitted the CPUC to end customers' right to shop for the best price of power. The Commission took advantage of this power and ended retail competition in September 2001. (Customers who had contracts with nonutility suppliers could keep those contracts until they expired, however.) With this order, the California experiment in deregulation ceased to exist.
What caused the California electricity crisis of 2001? Analysts have pointed out several flaws of the restructuring legislationflaws that seemed like positive attributes before problems occurred. Pundits and politicians have also allocated blame on convenient scapegoats, some of whom appear to merit the blame. But as this text is written in June 2002, the information necessary to assess who and what caused the crisis is only just becoming available to the public. State and federal legislative panels (along with the federal Securities and Exchange Commission) continue to study the crisis and its origins, and the court system has begun assessing damages caused by a variety of actors.
Having said this, one can nevertheless identify a few clear problems that exacerbated the electricity crisis. One such problem consisted of the inability of utility companies (the distributors of power) to sign long-term contracts for power supplies. California's restructuring legislation forbade such agreements, which obligate a supplier to provide power at a fixed price for a certain amount of timea period that could span several months or several years. Rather, utilities bought power in the market run by the Power Exchange (in which prices changed hourly and daily) and in the real-time spot market managed by the ISO (in which prices changed each second). By prohibiting long-term contracts, the law's authors hoped that utilities could reap the benefits of prices that fell with the hoped-for emergence of new competitors. For two years, the plan worked well.
But by spring 2000 the plan backfired, as power supplies dwindled and as demand rose (due in part to a vibrant California economy). Simple supply and demand economics dictated that prices would riseunless, of course, the supply of power increased as well. To be sure, some independent power companies built new generating plants in the state, hoping to sell power into the wholesale market. But many generators removed their plants from the grid at a time when prices were heading sky high. (Interestingly, the supply shortage, constituting about one-third of the state's capacity, occurred in the cooler, off-peak months of fall 2000 and winter to spring 2001.) According to the generating companies, such as Duke Power, Mirant, Calpine, and Dynergy, some of the plants simply had to be taken out of service for normal maintenance. After all, plants can't operate continuously without suffering damage, especially after working steadily during the summer of 2000 when demand for power peaked. Moreover, some plants in danger of exceeding their annual state and federal pollution allowances also had to be removed from service.
Critics of the generating firms' behavior contend that the companies cut back on supply because they realized they could benefit by causing wholesale power prices to rise. Suppliers could then reenter the market and make handsome profits. Recent revelations from some independent generating companies (in 2002) partly substantiate such an argument.
Beyond these problems lurked the increased cost of natural gas, the favorite low-polluting fuel that powered many of the state's generating plants. Nationally, the price of this premium fuel soared three-fold in 2001, due to increased demand during the especially cold winter of 2000/2001. The previously low price for natural gas had discouraged exploration for the fuel, thus setting the stage for a typical boom and bust cycle. With little new gas being discovered, existing gas became more costly. In California, the price to industrial customers rose by a factor of 4.5 from September 1999 to April 2001. For power producers using this fuel, the cost of electricity naturally rose as well.
As the importer of about 20% of its electricity, California also felt the impact of higher electricity prices elsewhere. In particular, California drew a large chunk of power from the Pacific Northwest states of Oregon and Washington, which generated electricity largely from hydroelectric sources. But these states had their own electricity problems, resulting from lower-than-normal precipitation levels. (Rain and snowfall filled reservoirs and rivers, which powered the hydroelectric turbine generators. Less precipitation meant less electricity.) As these states saw their electricity resources decline, the price of power increased. Demands for electricity from California only ratcheted up prices further. As wholesale prices soared in the Pacific Northwest, customers there felt the pain too. Seattle City Light raised rates by 28% in early 2001, and the government-run Bonneville Power Administration threatened to raise wholesale rates as much as 250% by fall.
The consumer price caps further exacerbated problems. Part of the political compromise that won unanimous support in both houses of the California legislature, the cap meant that residential customers could expect price stability for several years as the state moved into a competitive market. But by insulating customers from the fluctuating price of electricity on the wholesale market, the cap did not give signals to customers on how (and when) to use power. If the production of electricity became more expensive for whatever reason, the increased costs would not be passed on to consumers. Customers therefore had little incentive to cut back on their use of power or purchase new appliances that used electricity more efficiently. In the aftermath of the energy crisis of the 1970s, the price of oil, gas, coal and electricity increased dramatically. Energy users eventually realized that these higher costs would last for some time, and they conserved and developed more efficient means to use energy. One key to such behavior was the higher price of energy. With the price caps in place, however, customers did not receive these signals. They continued to consume power, happily immune to the problems faced by the companies delivering electricity to them. This action created further demand for power at a time when supply had fallen dramatically.
Many analysts expected the summer of 2001 to aggravate an already perilous electricity crisis. As Californians turned on their air conditioners, demand would peak, as it always did during the summer months. And if the shortfall of supply continued into the summer, then the occasional blackouts of the spring would become a more common and debilitating experience. The Golden State's residents would suffer again.
Happily, the blackouts and high cost for wholesale power did not recur. Several factors appear to have mitigated the crisis, one of which was aggressive energy efficiency and conservation. With emergency legislation authorizing rebates for purchases of energy-efficient appliances, and with citizens realizing the need to cut consumption, demand for power subsided. In May 2001, users reduced peak demand for power by more than 10% over the previous year. In the next month, peak demand was 14% lower than the previous June. And for the entire year of 2001, consumers reduced peak demand by almost 9% while cutting consumption of electricity (kWh) by almost 7%.
Energy efficiency reduced the demand for power on the wholesale spot market considerably. The long-term contracts that the DWR signed with electricity generators took more pressure off the market. Consequently, the amount of power being traded on the wholesale market declined substantially. According to some analysts, the situation in which individual companies could remove power from the grid and manipulate the short-term market no longer existed, and the companies resumed production of power. With more power coming into the overall market and with less demand in the spot market, prices dropped. By early 2002, the wholesale price had returned to the $30 to $35 per MWh range. In fact, the price dropped so low that the state sought to renegotiate $43 billion of long-term contracts, signed at a price of about $70 per MWh. At the time when officials signed the contracts, the spot market price averaged about $300 per MWh. Negotiations continue, along with investigations of improper and illegal manipulation of the markets. Given disclosures by companies of deceptive trading practices, it appears (in June 2002) that some amendments to the long-term contracts will be forthcoming.
The California restructuring experience soured many people on the value of deregulation. Many wondered whether the supposed benefits of competition were worth the price that Californians paid. After all, instead of price reductions resulting from competition, the Golden State's businesses and residents saw the promised price freeze turn into price hikes in efforts to maintain the financial security of the utilities that provided power. And instead of having the free market evolve in a way that encouraged scores of competitors to offer new products and services to customers, the state ended up with a government agency that bought most of the power for utilities and the end to customer choice. Clearly, the outcome in California was not what the authors of restructuring had envisioned.