The Fleecing of California: A Failure by the FERC

In an observation worth remembering, Alfred Kahn, the "father" of deregulation, noted last year that he "stayed away from electricity [deregulation] because it scares me. The demands for perfect integration of flicking on a switch and the immediate generation of power is essentially unique to this industry."

California's electricity deregulation law, enacted in 1996, made exactly that mistake, ignoring electricity's unique nature: a commodity that cannot be stockpiled and must be instantly available on demand.

Viewing electricity is qualitatively no different than steel or water or grain, the deregulators created a market that freed generators to sell their power at a market rate, while utilities that purchased the power were required to resell it to consumers at a capped rate and could not buy power outside the spot market.

Since the utilities could not store that power, and since the law forced them to sell off most of their own generating capacity, they found themselves in a strange hybrid market, free for generators, but tightly capped for utilities.

A Vulnerable Marketplace

The law's numerous loopholes and fundamental flaws in the market abetted unscrupulous energy sellers like Enron in their manipulation of this market. Federal regulators, who should have put a stop to the manipulation, slept.

The result was an inflation in the market that blew wholesale energy costs in California in 2000 up 400 percent above the 1999 costs for the same energy. The explosion in prices continued until June 2001 when the Federal Energy Regulatory Commission (FERC) finally imposed the price cap that California had asked for and which remains in place today.

In a joint study, the California Public Utilities Commission (PUC) and Portland-based McCullough Research found that all Southern California blackouts and 65 percent of Northern California blackouts occurred because generators ramped down production at their power plants.

The PUC said that on all but two of the 32 statewide blackout or service interruption days between November 2000 and May 2001, the state's five largest non-utility electricity generators were not operating at maximum capacity, as reported by the Associated Press in a Sept. 17, 2002 story.

California's deregulation experiment was billed as a way to bring down the cost of electricity through competitive markets. We know now through bitter experience that just the opposite happened.

By the time the crisis ebbed in 2001, the energy crunch had cost California more than $45 billion in higher electricity costs, lost business and a slowdown in economic growth, according to a study by the Public Policy Institute of California.

In 1999, California paid $7 billion for power. In 2000, with the utilities buying the power, we paid $27 billion. In 2001, with the utilities insolvent and the Department of Water Resources buying power on their behalf, we paid slightly less than that – $26.7 billion.

In 2002, with the market once again stabilized, we paid not quite $11 billion for roughly that same amount of power.

The End of the Crisis

California has emerged from that crisis. Our disastrous experiment with deregulation is over.

The investor-owned utilities in the state that were sent into insolvency (bankrupted in the case of Pacific Gas and Electric), are once again buying electricity on their own.

California is out of the electricity buying business; the state still holds title to the long-term power contracts signed in 2001, but the utilities are now responsible for managing them.

Six thousand megawatts of new generation is now on line, and a new California Public Power Authority has been created to help ensure long-term power supply stability.

Most importantly, the cartel that forced prices so high in the state has been broken. Wholesale electricity prices, which peaked at nearly $1,200 a megawatt in early 2001, are now back down to earth.

The state treasury, which loaned out $6 billion to buy energy on behalf of the insolvent utilities, has been entirely repaid through the sale of bonds.

So what lessons do we draw from this experience?

Some have claimed that the California energy crisis was a problem of too much demand because retail electricity prices were too low. They assert that the problem would have been solved if I had simply agreed to allow retail rates to float against the wholesale rates.

With the energy cost to the state growing fourfold for about the same amount of energy between 1999 and 2000, that would have necessitated a 400 percent increase in retail rates. Such an increase would have been unconscionable.

In opposing large retail rate increases, I stated firmly that residential customers hadn't asked for deregulation, hadn't wanted it and shouldn't be victims of its failure.

Generators Withheld Power

Rates ultimately had to be raised because the Federal Energy Regulatory Commission failed to end the gouging, as required by the Federal Power Act.

Many of those same people also believed that the electricity price spikes in the summer of 2000 were an aberration. No one predicted the market meltdown that began in earnest in December of 2000.

Had the investor-owned utilities expected this meltdown, they could have signed long-term electricity contracts in August 2000, after the California Public Utilities Commission voted to allow such contracts.

Those who suggest that utility rate increases would have reined in energy company gouging by lowering consumption ignore the fact that in early 2001 wholesale prices remained high even during low-use periods in the very early morning hours and in the middle of winter, when demand in California is at its lowest point of the year.

What we always suspected and have ample evidence of now is that California fell victim to rampant market abuses.

For example, Professors Severin Borenstein and Frank Wolak, of Berkeley and Stanford respectively, have convincingly shown that the California energy crisis was largely due to withholding of power by energy generators to drive up prices to astronomical levels.

Other experts have reached the same conclusion.

More than a year ago, California gave federal regulators compelling evidence of this market manipulation, supporting our demand for nearly $8.9 billion in refunds.

Seeking a Refund

The Federal Energy Regulatory Commission responded by starting a refund process. But even in that, FERC sided with the generators and not consumers. They said they wouldn't consider California's full request and took more than $6 billion off the table, a decision California is appealing.

Six months later, in February 2002, with that refund process still going on, and with California yet to see a nickel in refunds, FERC began another investigation into market manipulation.

In May 2002, Enron lawyers released the explosive Fat Boy and Ricochet and Get Shorty memos revealing the corporation's seamy system for bilking California.

Once that was released, FERC decided that it should see if anybody else was doing this, and widened its investigation, directing other energy marketers to certify that they hadn't engaged in any manipulation of the California market.

Refunds were still nowhere to be seen. Then, in a staff report issued on August 14, 2002, FERC again spoke, saying it had found "preliminary" evidence of "possible" electricity market manipulation in California in 2001 and 2002.

Thus, in the face of damning evidence that the California energy market had been anything but free, FERC finally acknowledged what I and the energy experts had long been saying, that the greed and manipulation of generators and power marketers had been the cause of inflated prices.

But despite the marketers' revelations and the evidence uncovered by its own investigations, FERC declined to act.

Refunds? None! Action against Enron and the other manipulators? None! Tangible results? None.

Despite more than a year of investigation, FERC's major product has been a staff report saying that more investigation is warranted. FERC has said that they have to give the generators due process.

Where is due process for California?

Natural Gas Prices

The other piece of the August 14 report is equally frustrating. FERC staff took a look at the unexplained spikes in natural-gas prices that had helped drive power prices up in 2000 and 2001.

It has long been clear that FERC's first method of calculating those prices – by analyzing published reports – was inadequate, overestimating the real cost of gas and thus downplaying its impact on the electricity market. California has strongly protested that method.

But here too, while admitting its original methodology was wrong, FERC refuses to offer anything except the possibility that it may reconsider and use a more favorable natural-gas price index in the refund proceeding.

That revised index should be closer to what California is owed than the index that the Commission had originally proposed and that we have disagreed with.

Thus, in natural gas, FERC's big favor to California is just to get us back closer to where the refund talks should have started. That's a pretty thin promise after all those months of investigation.

FERC's Obligations

I have frequently pointed out that FERC's job is to prevent runaway wholesale prices as mandated by the Federal Power Act. The General Accounting Office last June declared that FERC, which approved the structure of California's deregulated market in 1996, "is not adequately performing the oversight that is needed to ensure that the prices produced by these markets are just and reasonable."

FERC Chairman Pat Wood agreed. Yet he and other FERC commissioners continue to move at a snail's pace to rectify the main consequence of the commission's inaction: the fleecing of California.

In December 2002, a FERC administrative law judge agreed that California had been overcharged and entitled to refunds. Unfortunately, FERC had earlier instructed the judge (and we believe wrongly so) not to consider California's full refund request, but a smaller $2 billion amount.

The judge said California was entitled to $1.8 billion of that remaining $2 billion. Unbelievably, if FERC's decision stands, California could end up owing the generators.

Also, despite the Enron and other revelations of corporate misdeeds, a federal court had to order FERC to allow California to introduce evidence of market abuse into the refund proceeding. It seems that FERC has not learned a thing.

Moreover, whether or not FERC punishes the market manipulators, Californians are owed those $8.9 billion in refunds because they paid unjust and unreasonable rates for electricity in 2000 and 2001.

While unwilling to act on refunds, FERC has nonetheless moved quickly to raise the wholesale electricity price cap for California by almost 300 percent.

The commission has also tried to dissolve the board of the consumer-watchdog Independent System Operator that governs California's electricity grid and replace it with a board composed of representatives of the electricity industry.

California has also filed a complaint with FERC calling for a reshaping of the long-term contracts the state had to sign last year. We charged that because of the generators' market power, we had had to sign those contracts at prices above what a fair market would have provided.

With the evidence of manipulation grown clear, we asked FERC to do its duty under the Federal Power Act and restructure those contracts so that they are fair and just.

Did FERC act? Most definitely not! Enter into settlement discussions, FERC effectively said, and if you don't get anywhere in those discussions, then we'll have to do something, but we really would rather you to try to settle it.

Moreover, FERC has been sending strong signals through a similar complaint brought by Nevada Power that it is likely to once again side with the generators and not with consumers.

The FERC Cop-out

In all, FERC has copped out on market manipulation, on refunds owed California, on exorbitant natural gas prices and on long-term contracts signed under duress. FERC has tried to make much of its new post-Enron Office of Market Oversight and Investigation.

But California's experience with FERC provides more than ample justification to dismiss its efforts as just going through the motions and bringing another call for the commission to do its job and protect consumers, not the gougers.

The Federal Energy Regulatory Commission admitted in June 2001 that it waited "too long to step in" to mitigate the damage from California's "dysfunctional market." The GAO concluded that FERC "is not fulfilling its regulatory mandate," and FERC chair Pat Wood agreed.

In the face of the commission's indifference, we in California have moved to ensure our own energy future. The 6,000 megawatts of new generation we have brought on line in the past two years is an important step toward energy stability in California.

Add to this the unprecedented conservation efforts of Californians who have saved record amounts of electricity. In 2001, California energy usage averaged eight percent less per month in 2000.

Even in 2002 with the energy crisis subsiding, Californians still strongly conserved. This level of conservation may have confounded the Bush Administration, which, at least at first, did not see conservation as a worthwhile solution.

But it comes as no surprise to Californians who have among the nation's lowest per-capita use of electricity. We are also making a strong commitment to the growth of renewable sources of energy.

And so we circle back to Alfred Kahn's observation that energy deregulation is perilous. California would have been better off had it ignored deregulation's siren call.

As the mounting evidence of corrupt practices by Enron and other energy traders shows, the deregulated energy market I faced when I took office in 1999 was rotten, perhaps to its core.

We issued strong early warnings about the manipulation that was taking place and about the failure of federal regulators to step in, as the law required, and stop it.

When FERC failed to act, we took strong measures of our own, fast-tracking new generation, encouraging conservation and taming the spot market through long-term power contracts.

We added an unprecedented level of new generation in 16 months. At no other period in California history has so much power come online in such a short time.

Now FERC seems clearly, if grudgingly so, to be coming around to the same conclusion: that while California had bungled its 1996 deregulation law, it was the greed of the energy sellers that turned the problem into a crisis.

I'm proud of the efforts of all Californians in bringing us out of the energy crisis, facing down FERC and the market manipulators, and keeping the power flowing.

These are hard, but valuable lessons we have drawn from that crisis.

Joseph Graham ("Gray") Davis was elected the 37th governor of California in 1998, winning 57 percent of the statewide vote.
Prior to his election, Mr. Davis served as lieutenant governor, where he focused on job growth. Mr. Davis also served as California state controller for eight years. In this role he saved taxpayers more than half a billion dollars by rooting out government waste, cracking down on Medi-Cal fraud, and other efforts. He was the first controller to withhold paychecks from all state-elected officials, including himself, until the governor and the legislature passed a long-overdue budget.
From 1983-87, Mr. Davis served in the State Assembly from Los Angeles County and was chief of staff to Governor Edmund G. Brown, Jr., from 1975-81. As chair of the California Council on Criminal Justice in the 1970s, he started the statewide Neighborhood Watch program.
Gray Davis was born in New York City in 1942. He graduated from Stanford University with distinction in 1964. He went on to Columbia University Law School, where he won the Moot Court award in his freshman year. In 1967 he served in active duty with the U.S. Army in Vietnam, where he earned the Bronze Star for meritorious service. Mr. Davis married Sharon Ryer in 1983.