1. Electricity in California How did things go so wrong? Robert J. Michaels Professor of Economics California State University, Fullerton rmichaels@fullerton.edu Orange County Business Council Jan. 11, 2001

2. The good [but expensive] old days z1960s -- production costs and rates falling z1970s -- energy crises, environmentalism, and Jerry Brown z1980s -- passing through uneconomic plant and contract costs z1990s -- California rates 150% of national average y1993: PUC staff issues the “Yellow Book,” y blames regulation for problems

4. The promise of a new system z1970s: cost-cutting transactions by utilities yAnd deferral of in-state construction z1980s: Independent power arises, wants freedom to trade ySmall, fuel-efficient, clean gas-fired plants y1992 federal legislation and transmission rights yLarge customers want rights yUtilities claim “stranded costs” as obstacle

5. Changing Nature of Industry Cost Characteristics $/MW 1930 1950 1970 1980 1990 MW 502004006008001,000 Source: Williams Company and TR Casten, “Whither Electric Generation? A Different View” Energy Daily, September 7, 2000.

6. 1999 California Power Sources

8. April 20, 1994: The Blue Book zProposes comprehensive “direct access” zUtilities to open lines to user transactions zPhase-in to recover stranded costs zSCE proposes compulsory “Poolco” zTwo years of conflicts and lobbying

9. September 1996 -- A.B. 1890 zFreezes retail rates, 10% cut for small users zUtilities required to use short-term PX yAll power sells day-ahead at highest bid yUtilities must divest some (not all) powerplants zStranded costs recovered as difference between rates and PX prices, 2002 deadline zISO to operate system, real-time markets yNo precedents for PX and ISO markets ySwitch from state to federal (FERC) regulation

10. Markets begin --1998 to May 2000 zCalifornia energy prices fluctuate predictably yMove with short-term prices elsewhere in west yAllegations of market power yPrices in $30 - $80 / MW range at most times zRules make entry of new sellers hard yPX sells 80% of power in state yMunicipal utilities largely untouched by changes zSDG&E freeze ends mid-1999 yRequired to pass through PX prices afterwards

11. 2000 -- the endless summer zShort-term prices rise all over the west zCal utilities’ energy costs above frozen rates yFERC cuts allowable ISO and PX prices yDuration of losses threatens insolvency zNon-Cal utilities buy only small amounts of power in short-term markets zCal utilities can only buy short-term, can’t hedge yIt’s what they wanted in 1996 y

12. Why, and why now? zSummer weather, NW water situation zRising fuel and emission permit costs zCalif demand far higher than expected zCalif in-state supply falling short zWest-wide market equalizes prices zDid producers act monopolistically?

13. 2001 -- Critical Times zUtilities at limits of ability to borrow yUp to $ 1 million / hour in new debt yWhat might bankruptcy mean? zFERC will not force producer refunds yBlames California for own situation yHas overriding interest in region, not state yFound no evidence of monopolization yLow likelihood of winning them in court zUtility solvency requires large rate hikes

14. The State-of-the-State Speech zProposals for state takeovers only conceal risks and losses zProposals to keep power in-state probably illegal zPolitical uncertainty discourages new plants zNo acknowledgement of hard choices that must be made immediately