Tag Archives: deregulation

The real lessons from California’s 2000-01 electricity crisis and what they mean for today’s markets

Leave a reply

The recent reliability crises for the electricity markets in California and Texas ask us to reconsider the supposed lessons from the most significant extended market crisis to date– the 2000-01 California electricity crisis. I wrote a paper two decades ago, The Perfect Mess, that described the circumstances leading up to the event. There have been two other common threads about supposed lessons, but I do not accept either as being true solutions and are instead really about risk sharing once this type of crisis ensues rather than being useful for preventing similar market misfunctions. Instead, the real lesson is that load serving entities (LSEs) must be able to sign long-term agreements that are unaffected and unfettered directly or indirectly by variations in daily and hourly markets so as to eliminate incentives to manipulate those markets.

The first and most popular explanation among many economists is that consumers did not see the swings in the wholesale generation prices in the California Power Exchange (PX) and California Independent System Operator (CAISO) markets. In this rationale, if consumers had seen the large increases in costs, as much as 10-fold over the pre-crisis average, they would have reduced their usage enough to limit the gains from manipulating prices. Consumers should have shouldered the risks in the markets in this view and their cumulative creditworthiness could have ridden out the extended event.

This view is not valid for several reasons. The first and most important is that the compensation to utilities for stranded assets investment was predicated on calculating the difference between a fixed retail rate and the utilities cost of service for transmission and distribution plus the wholesale cost of power in the PX and CAISO markets. Until May 2000, that difference was always positive and the utilities were well on the way to collecting their Competition Transition Charge (CTC) in full before the end of the transition period March 31, 2002. The deal was if the utilities were going to collect their stranded investments, then consumers rates would be protected for that period. The risk of stranded asset recovery was entirely the utilities’ and both the California Public Utilities Commission in its string of decisions and the State Legislature in Assembly Bill 1890 were very clear about this assignment.

The utilities had chosen to support this approach linking asset value to ongoing short term market valuation over an upfront separation payment proposed by Commissioner Jesse Knight. The upfront payment would have enabled linking power cost variations to retail rates at the outset, but the utilities would have to accept the risk of uncertain forecasts about true market values. Instead, the utilities wanted to transfer the valuation risk to ratepayers, and in return ratepayers capped their risk at the current retail rates as of 1996. Retail customers were to be protected from undue wholesale market risk and the utilities took on that responsibility. The utilities walked into this deal willingly and as fully informed as any party.

As the transition period progressed, the utilities transferred their collected CTC revenues to their respective holding companies to be disbursed to shareholders instead of prudently them as reserves until the end of the transition period. When the crisis erupted, the utilities quickly drained what cash they had left and had to go to the credit markets. In fact, if they had retained the CTC cash, they would not have had to go the credit markets until January 2001 based on the accounts that I was tracking at the time and PG&E would not have had a basis for declaring bankruptcy.

The CTC left the market wide open to manipulation and it is unlikely that any simple changes in the PX or CAISO markets could have prevented this. I conducted an analysis for the CPUC in May 2000 as part of its review of Pacific Gas & Electric’s proposed divestiture of its hydro system based on a method developed by Catherine Wolfram in 1997. The finding was that a firm owning as little as 1,500 MW (which included most merchant generators at the time) could profitably gain from price manipulation for at least 2,700 hours in a year. The only market-based solution was for LSEs including the utilities to sign longer-term power purchase agreements (PPAs) for a significant portion (but not 100%) of the generators’ portfolios. (Jim Sweeney briefly alludes to this solution before launching to his preferred linkage of retail rates and generation costs.)

Unfortunately, State Senator Steve Peace introduced a budget trailer bill in June 2000 (as Public Utilities Code Section 355.1, since repealed) that forced the utilities to sign PPAs only through the PX which the utilities viewed as too limited and no PPAs were consummated. The utilities remained fully exposed until the California Department of Water Resources took over procurement in January 2001.

The second problem was a combination of unavailable technology and billing systems. Customers did not yet have smart meters and paper bills could lag as much as two months after initial usage. There was no real way for customers to respond in near real time to high generation market prices (even assuming that they would have been paying attention to such an obscure market). And as we saw in the Texas during Storm Uri in 2021, the only available consumer response for too many was to freeze to death.

This proposed solution is really about shifting risk from utility shareholders to ratepayers, not a realistic market solution. But as discussed above, at the core of the restructuring deal was a sharing of risk between customers and shareholders–a deal that shareholders failed to keep when they transferred all of the cash out of their utility subsidiaries. If ratepayers are going to take on the entire risk (as keeps coming up) then either authorized return should be set at the corporate bond debt rate or the utilities should just be publicly owned.

The second explanation of why the market imploded was that the decentralization created a lack of coordination in providing enough resources. In this view, the CDWR rescue in 2001 righted the ship, but the exodus of the community choice aggregators (CCAs) again threatens system integrity again. The preferred solution for the CPUC is now to reconcentrate power procurement and management with the IOUs, thus killing the remnants of restructuring and markets.

The problem is that the current construct of the PCIA exit fee similarly leaves the market open to potential manipulation. And we’ve seen how virtually unfettered procurement between 2001 and the emergence of the CCAs resulted in substantial excess costs.

The real lessons from the California energy crisis are two fold:

  • Any stranded asset recovery must be done as a single or fixed payment based on the market value of the assets at the moment of market formation. Any other method leaves market participants open to price manipulation. This lesson should be applied in the case of the exit fees paid by CCAs and customers using distributed energy resources. It is the only way to fairly allocate risks between customers and shareholders.
  • LSEs must be able unencumbered in signing longer term PPAs, but they also should be limited ahead of time in the ability to recover stranded costs so that they have significant incentives to prudently procure resources. California’s utilities still lack this incentive.

The 20-year cycle in the electricity world

Leave a reply

future_grid_horizon_xl_410_282_c1

The electricity industry in California seems to face a new world about every 20 years.

  • In 1960, California was in a boom of building fossil-fueled power plants to supplement the hydropower that had been a prime motive source.
  • In 1980, the state was shifting focus from rapid growth and large central generation stations to increased energy efficiency and bringing in third-party power developers.
  • That set in motion the next wave of change two decades later. Slowing demand plus exorbitant power contract prices lead to restructuring with substantial divestiture of the utilities’ role in generating power. Unfortunately, that effort ended up half-baked due to several obvious flaws, but out of the wreckage emerged a shift to third-party renewable projects. However, the state still didn’t learn its lesson about how to set appropriate contract prices, and again rates skyrocketed.
  • This has now lead to yet another wave, with two paths. The first is the rapid emergence of distributed energy resources such at solar rooftops and garage batteries, and development of complementary technologies in electric vehicles and building electrification. The second is devolution of power resource acquisition to local entities (CCAs).

Repost: Lessons From 40 Years of Electricity Market Transformation: Storage Is Coming Faster Than You Think | Greentech Media

Leave a reply

Five useful insights into where the electricity industry is headed.

Source: Lessons From 40 Years of Electricity Market Transformation: Storage Is Coming Faster Than You Think | Greentech Media

What lessons should we take from the last wave of California utility reform?

7 Replies

h7main2d

We’re now in the midst of the “third wave” of electricity industry reform in California. The first was in the early 1980s with the rise of independently-owned cogeneration and renewable resources. Mixed with increased energy efficiency, that led to a surplus of power in the late 1990s, which in turn created the push for restructuring and deregulation. Unfortunately, poorly designed markets and other factors precipitated the 2000-01 energy crisis. The rise of renewables and distributed resources is pushing a third wave that may change the industry even more fundamentally.

I wrote a paper in 2002 on how I viewed the history of California’s electricity industry through 2001 and presented this at a conference. (It hasn’t yet been published.) I identify some different factors for why the energy crisis erupted, and what lessons we might learn for this next wave.

 

Four articles on uncertainty and unconventional economics

Leave a reply

From the current issue of American Economics Review:

Robust Social Decisions: We propose and operationalize normative principles to guide social decisions when individuals potentially have imprecise and heterogeneous beliefs, in addition to conflicting tastes or interests. To do so, we adapt the standard Pareto principle to those preference comparisons that are robust to belief imprecision and characterize social preferences that respect this robust principle. [This paper focused on decisions related to climate change.]

Beyond GDP? Welfare across Countries and Time: We propose a summary statistic for the economic well-being of people in a country. Our measure incorporates consumption, leisure, mortality, and inequality, first for a narrow set of countries using detailed micro data, and then more broadly using multi-country datasets. While welfare is highly correlated with GDP per capita, deviations are often large. Western Europe looks considerably closer to the United States, emerging Asia has not caught up as much, and many developing countries are further behind. Each component we introduce plays a significant role in accounting for these differences, with mortality being most important.

(W)hat proportion of consumption in the United States, given the US values of leisure, mortality, and inequality, would deliver the same expected utility as the values in France? In our results, lower mortality, lower inequality, and higher leisure each add roughly 10 percentage points to French welfare in terms of equivalent consumption. Rather than looking like 60 percent of the US value, as it does based solely in consumption, France ends up with consumption-equivalent welfare equal to 92 percent of that in the United States.

A summary:

(i) GDP per person is an informative indicator of welfare across a broad range of countries: the two measures have a correlation of 0.98. Nevertheless, there are economically important differences between GDP per person and consumption-equivalent welfare. Across our 13 countries, the median deviation is around 35 percent—so disparities like we see in France are quite common.

(ii) Average Western European living standards appear much closer to those in the United States (around 85 percent for welfare versus 67 percent for income) when we take into account Europe’s longer life expectancy, additional leisure time, and lower inequality.

(iii) Most developing countries—including much of sub-Saharan Africa, Latin America, southern Asia, and China—are substantially poorer than incomes suggest because of a combination of shorter lives and extreme inequality. Lower life expectancy reduces welfare by 15 to 50 percent in the developing countries we examine. Combined with the previous finding, the upshot is that, across countries, welfare inequality appears even greater than income inequality.

(iv) Growth rates are typically revised upward, with welfare growth averaging 3.1 percent between the 1980s and the mid-2000s versus income growth of 2.1 percent. A boost from rising life expectancy of more than a percentage point shows up throughout the world, with the notable exception of sub-Saharan Africa. When welfare grows 3 percent instead of 2 percent per year, living standards double in 24 years instead of 36 years; over a century, this leads to a 20-fold increase rather than a 7-fold increase.

Bailouts, Time Inconsistency, and Optimal Regulation: A Macroeconomic View:  A common view is that bailouts of firms by governments are needed to cure inefficiencies in private markets. We propose an alternative view: even when private markets are efficient, costly bankruptcies will occur and benevolent governments without commitment will
bail out firms to avoid bankruptcy costs. Bailouts then introduce inefficiencies where none had existed. Although granting the government orderly resolution powers which allow it to rewrite private contracts improves on bailout outcomes, regulating leverage and taxing size is needed to achieve the relevant constrained efficient outcome, the sustainably efficient outcome.

Long-Run Risk Is the Worst-Case Scenario: We study an investor who is unsure of the dynamics of the economy. Not only are parameters unknown, but the investor does not even know what order model to estimate. She estimates her consumption process nonparametrically…and prices assets using a pessimistic model that minimizes lifetime utility subject to a constraint on statistical plausibility…[A] way of interpreting our results is that they say that what people fear most, and what makes them averse to investing in equities, is that growth rates or asset returns are going to be persistently lower over the rest of their lives than they have been on average in the past.

 

 

 

The (telecom) path well travelled: What does it hold for electricity?

Leave a reply

In many ways, the potential for a dramatic transformation in the electricity industry feels like deja vu in the telecommunications industry of the 1980s. That industry evolved rapidly and radically so that what we see today is almost unrecognizable compared to three decades ago. Do we stand on the verge of a similar revolution in electricity?

In the 1980s, it was the entry of microwave transmission that threatened the hardwired long-distance network of AT&T. The combination of the MCI decision allowing competition and the DOJ anti-trust settlement that broke AT&T into the 7 Baby Bells, both in 1982, led to proliferating long distance competition.

The electricity industry had a similar transformative decision in FERC Order 888 in 1996. There was a similar first wave of opening up wholesale competition through a centralized grid through restructuring induce by the introduction of combined cycles. As with AT&T being slow to adopt new technologies, it’s hard to imagine the electric utilities building CCGTs before others forced their hands.

In telecom, allowing more players meant that they started to compete with customers using new technologies, Rapid innovation in computers bled over to phones and cell phones. The FCC facilitated this with innovative auctions of regional wireless band licenses. The entry of cable companies for local service created more competitive pressure. Yes, the industry went through consolidations, but the threat of entry and marketing innovations place caps on what these companies can charge and force more consumer options.

Long distance competition may not have benefited, but such an assessment ignores the second wave of telecom deregulation starting a decade later: the entry of cable companies, the use of the Internet for calling, the rise of messaging, and proliferation of smart cell phones. Now AT&T’s land lines are an afterthought for phone service and those companies offer bundles of services across telephone, television, Internet and cell phone. Long distance and local land line competition are but an afterthought in the industry after three decades. The better question is whether these services will even survive in the near future.

Electricity restructuring may not have delivered on its initial promise, but, as with telecom, it brought new competitors who are looking for different ways to enter market. New technologies that decentralize energy resources look like the second wave of telecom innovation in many ways. NRG is one such example of a company that focused on merchant generation but are now looking to distributed energy resources. Sempra and Duke are utility holding companies that are shifting their mission in promising ways. Will these and other innovators break into the energy services market and offer consumers the type of choices that telecom customers now have? Will the existing modes of delivering electricity lose dominance in the same way as happened in telecom?

The answer will depend in part on decisions made by regulators. The US DOJ and FCC played key parts, and the state commissions eventually backed away from close regulation. This requires support from stakeholders including the utilities. AT&T eventually evolved into a dominant player in the new marketplace although it wasn’t a smooth transition. Will the electric regulators have similar foresight? Will they avoid many of the same pitfalls?