California Status Report: What Went Wrong, Why and How to Fix It Rick Shapiro Managing Director Government Affairs - The Americas ®

2001 RS-California

2001 RS-California Summary of the Situation in California De-regulation Has Not Failed in California Because California Never De-regulated If Designed Properly, De-regulation Benefits Consumers and Economy Flawed Restructuring Plans Can Have Negative Spillovers – Financial Distress – Economic Dislocation – Political Instability California Must End the Delay and Focus Action on –Increasing Supply and Reducing Demand, NOW –Getting Prices More Aligned with Costsadditional rate increases may be inevitable – Improving the Utilities Financial Position Re-regulation and Bankruptcies Will Fail to Resolve the Crisis

2001 RS-California The Very Big Picture Californias Long History of Flawed Energy Policies Over-reliance on Imports Over-reliance on Monopolies Overly Burdensome Regulatory Programs Little or No Faith in the Value of Market Signals State Assumes Role of Energy Portfolio Manager A History of Energy Booms and Busts A Crumbling Energy Infrastructure The Result

2001 RS-California Demand Is Up Sharply in California and the West Inadequate Investment in Supply and Infrastructure Uncooperative Weather Patterns (Rainfall/Temperature) California Is Living with a Flawed Restructuring Law Political Leadership Is Lacking The Big Picture Californias Most Recent Energy Problems A political crisis A financial crisis A looming economic crisis The Result

2001 RS-California What Went Wrong? California Rejected Markets in Favor of a Risky Lab Experiment MarketsCalifornias Electric Industry Easy entry Siting laws block power plant development Term contracts dominate Utilities forced to buy from and sell to spot market Prices influence supply and -Consumers pay the same whether they conserve or not demand decisions -Sitting Laws trump incentives to expand supply Customers have real choices Lawmakers claim that AB 1890 is not about retail competition The gap between supply and demand is now a chasm Government assumed role of electricity portfolio manager on behalf of consumers. Fewer than 2% of customers switched providers The Result

2001 RS-California Plant capacity in California is down 1,200 MW since 1997 Demand over the same period in California is up 20% Californias reserve margin is 6% when 15-20% is needed In the West, demand is up 14% The West is short 10,000 MWs and is not likely to see supply-demand balance before 2003 Some Sobering Statistics The Situation Is Serious

2001 RS-California Reliance on gas-fired plants has doubled since 1997 Gas prices in California are 2-3 times higher than in 2000 Plants already constrained by annual emission caps Emission credit prices have risen dramatically One of lowest rainfall levels in history in the Northwest But California prices remain frozen at 1996 levels! Some Sobering Statistics The Situation Is Serious Power costs up sharply throughout West CAs Import capability down sharply Plants in CA run harder & fail more often Blackouts have already started in CA The Result

2001 RS-California The Governors Approach – Exercise extreme caution--avoid political risk at all cost – View the crisis as a political campaign – Shift the focus: Assign blame to market power and federal inaction – Rely on Executive Orders and powers rather than work the Legislature – Appease consumer advocatesInsists on no new rate increases! The Legislatures Approach – Follow Governors lead – Avoid becoming political road kill – Express increasing frustration with Governors tendency toward secrecy The Response of California Policy Makers Long on Politics, Short on Solutions Distrust of Governor by Legislature Political paralysis Crisis deepeningno solution in sight The Result

2001 RS-California Resist rate increases….until now…. reality beginning to set in Re-price QFs and IOU plants; demand wholesale caps in West Take over electricity procurement – Appoint obscure agency (CDWR) with little expertise to procurement role – Assume CDWR can purchase power to fit under rate freeze – Tap States general fund as bridge to bond financing Take over transmission – Quid pro quo for keeping utilities solvent Rescind consumer choice – Fear that choice threatens recovery of DWR costs and bond repayment Establish California First energy policy – Confine trade to Californias borders; dictate plant operations Californias Proposal Nationalize, Re-regulate and Hope State viewed as on the wrong track Contradicts national/international trends Creates country risk on par with Indonesia Prompts businesses to consider re-locating The Result

2001 RS-California Any proposal must be better than bankruptcy or the utilities will reject it The Bush administration opposes price caps Finding price that QFs and utilities can agree to is difficult – QFs sue successfully to sell elsewhere (out-of-state; higher prices?) – PG&E announces it sues not to pay QFs Utilities demands in return for transmission sale are steep – Price PG&E demands for TX is unacceptable to consumer groups – Consumer groups resist end of rate freeze; rate de-regulation Californias Proposal Faces an Uphill Battle Both the Math and the Politics Present Problems

2001 RS-California Not surprisingly, CDWR ill-equipped to fill role as energy portfolio manager – Press reports that DWR is buying at above-market prices – Power purchase costs skyrocketing – Significant rate increases…more to come? Legislature becomes increasingly concerned over budget and bond rating – State budget surplus is evaporating and the economy is faltering – Concerns over bonds prompts rating agencies to put California on credit watch – Governors staff reveals that bond issuance may exceed $20 billion Californias Proposal Faces an Uphill Battle Both the Math and the Politics Present Problems

2001 RS-California The Alternative Is Preferable Create the Market that California Was Promised But Never Got Decrease DemandMay Be Too Late – Give Consumers and Businesses Price Signals – Give Consumers Financial Incentives Needed to Respond to Those Signals – Mine Large Amounts of Reductions Now in Anticipation of Summer Increase Supply – Maximize existing sourcesRe-balance power and environmental goals – Overhaul Plant Siting Laws to Create a Stream-lined, One-stop Shop – Remove Road Blocks to On-site Generation Get the Utilities Back on Their Financial Feet – Further increase may be needed; rate shock can be avoided? Create a Real Retail Market – The Market Is the Best Portfolio Manager – Direct Access can save the States budget and its bond rating Fix the Gas Market Before Its Too Late

2001 RS-California What Wont Work? Search for Good Old Days Is Futile Bankruptcy Is a Bad Idea – It doesnt solve any problems Price Controls Lead to One Thing – Shortages Nationalization and Re-regulation Will Make Matters Worse – Every reason to believe the private sector will outperform government – Investment fueled by capital markets or government coffers? Who bears the risks? Schools or electricity? – Californias record as portfolio manager Is very weakOil dependence in the 1970s; Nukes in the 1980s; PX in the 1990s

Fundamental Supply Factors Driving Current Market Prices Center for Public Utilities Conference March 25, 2001 Tim Belden Managing Director Enron North America Appendix

2001 RS-California The Missing Links The relationship between Northwest hydro output and the California crisis The pricing of storable commodities

2001 RS-California Californias Proportion of 1999 WSCC Demand Hydros Proportion of 1999 WSCC Capacity Everything Else Hydro California Everything Else

2001 RS-California Have We Been Fooled by Unusually Strong Hydro in Recent Years? -7- Volume Runoff Percent of Normal

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2001 RS-California Decreased Hydro Results in Fewer Imports into California Annual average MW

2001 RS-California Decreased Hydro Causes Increased Gas Generation in California Scatter plot of June through February Year on Year hydro changes vs. Year on Year gas changes.

2001 RS-California Decreased Hydro has Tremendous Impact on Prices Higher Thermal Forced Outages Higher Gas Prices Higher NOX Prices NOX related Generation Limitations

2001 RS-California NOX Limited Plants and Hydro Are Both Storable Commodities Peaking Plants in Southern California are Limited to 800 Hours per Year BC Hydro Can Store for More than a Year Northwest Utilities Can Store for One Week to Several Months

2001 RS-California How Do You Price a Storable Commodity? Current Offer = NPV (Highest Forward Price) Brings Off-Peak and Peak Prices Together Creates peak summertime prices throughout the year

2001 RS-California Conclusions Hydro Fundamentals Explain Current Prices Current Studies Have Not Addressed Impact of Hydro Current Studies Use Marginal Cost and Dont Consider Storage Pricing Things Will Get Worse Before They Get Better