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Analyst: California crisis threatens economy

Jan. 24, 2001—Without a rapid and decisive response by the Bush Administration, California’s power problems threaten to plunge the state into an “economic depression, pulling the U.S. down with it,” says a prominent energy analyst.

The most important immediate need is to reestablish a viable market system, says Ed Krapels, director of Energy Security Analysis Inc. (ESAI), Wakefield, Mass. The usual remedies of encouraging conservation, removing or easing restrictions on power generation, and negotiating with neighboring states will not work, he asserts.

To right the situation, the state must pay the market price for energy. Helped by a faulty trading system which created a “classic trading trap” for the state’s utilities, anomalies in obscure gas and power spot prices were transformed from the nuisance they should have been “to an economic and financial calamity,” Krapels says.

The California Public Utilities Commission (PUC) required the utilities to fix a large part of their sales with a cap on retail rates without fixing their costs. In addition, Krapels says, the PUC further hamstrung the utilities by not allowing them to hedge their risks.

He says the gas and power spot prices increases in 2000 would have had a minor effect on the state, if utilities had been allowed to engage in routine hedging—matching the maturity of their fixed price position with a portfolio of forward contracts.

With prices skyrocketing from $2.50/Mcf in late 1999 to a reported $30/Mcf at the California border this past summer, the state’s high dependence on natural gas further exacerbated the problem. An ESAI analysis shows natural gas accounted for 49% of power during the first 9 months of the year. In comparison, during the same period, gas accounted for 19% of power in New England and 18% of power in New York.

In addition, the number of cooling degree days in the Pacific census region, including California, rose 13% in 2000.

Price caps intended to hold down electricity prices only contributed to the problem, Krapels says. From a trader’s perspective, importing power into California via the bilateral forward markets was practically impossible, if California’s capped forward prices were lower than the California-Oregon Border (COB), Mid-Columbia, Four Corners, and Palo Verde forward prices.

Playing chicken
In the absence of power imports scheduled into California via the month-ahead market, the deficit could only be made up in the day-ahead and real-time markets. “But that meant dependence on short-term markets for a lot of power, which in turn required California’s day-ahead market and real-time market prices be higher than those of competing states,” Krapels says. A $250/MW-hr cap made that impossible most of the time.

Presently, the market price for a 1-week deal is about $200/MW-hr; a 1-month deal, $150/MW-hr; a 1-yr deal, $75/MW-hr; and a 10-year deal is $50/MW-hr. For the most part, California Gov. Gray Davis has insisted state-signed deals can be for no more than $55/MW-hr.

By apparently refusing to consider a deal that will raise consumer prices, Davis is “playing a game of chicken with federal regulators,” Krapels says, because the feds have the power to continue subsidizing state electricity purchases by forcing generators to sell surplus power into California. Tuesday, the Bush Administration extended the order for 2 weeks.

Davis may be crashing the Bush party, creating a distraction from the Administration’s own agenda, but California, it appears, needs to be saved from its own incompetence, Krapels says. Putting the California Department of Water Resources in charge of buying power on behalf of the state is a start.

But Krapels says Davis also needs to acknowledge the fact electricity rates must go up and take the lead to explain the reasons why. Next “tough but realistic” negotiations for 1 or 2-years deals need to take place with suppliers, he says, which will help California put its house in order.

Finally, these deals should contain provisions to allow Californians to pay lower prices should spot market prices fall. “Financial engineers put deals like this together every day,” Krapels says, and “there is no reason they cannot do so for California.”