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California quick-fixes likely to make state’s energy problems worse, CERA says

WASHINGTON, D.C., March 22, 2001 — Actions taken thus far by California officials to remedy the state’s energy crisis not only fail to address its underlying shortage problem, but in some cases are making matters worse, Cambridge Energy Research Associates (CERA) Senior Director Lawrence J. Makovich told the U.S. House of Representatives Subcommittee on Energy and Air Quality today.

“The state is creating large problems for the future by financing current power purchases and pushing payments into the future,” Makovich testified. “California has signed the wrong types of long-term power contracts by agreeing to pay for energy volumes at fixed prices in the future. Having signed these contracts at the height of a shortage market, California is likely to have expensive take-or-pay obligations for decades. This summer is likely to generate billions of dollars of additional wholesale power charges that will appear on the state’s books and need to be paid off over an untold number of years.”

Similar contracts mandated by the Public Utilities Regulatory Policy Act accounted for half of the multibillion-dollar “stranded costs” burden that California’s 1996 electric power restructuring law was intended to solve, Makovich reminded the panel.

“If this crisis drives California back to the heavy-handed regulation that launched deregulation in the first place, or to an expansive public power authority, then the state is likely to find its electric sector becoming increasingly inefficient and expensive – and very much disadvantaged compared to regions with properly structured power markets.

“California is now at a critical juncture. The state can go backwards by re-regulating or even taking outright ownership, or the state can fix the flaws in its power market. The latter is the way to go,” Makovich concluded.

Transmission Market Distortion

California’s plan to acquire the transmission assets of its three major utilities in exchange for a cash infusion to stave off bankruptcy “will further distort the market,” according to Makovich. Serious potential independence questions would be raised by the state’s position as both the largest buyer of power and the owner of all power suppliers’ links to the grid.

The state would have incentives to distort the market by, for example, including costs in its monopoly transmission service pricing to recover profits from suppliers with whom it has signed long-term fixed price contracts. In addition, the prospect of state control of the physical infrastructure necessary for market transactions would produce a chilling effect on power investment, he added.

Wrong Way Price Signals

“Continuing the retail price-freeze at 1996 price levels is subsidizing current power consumption and contributing to demand growth,” Makovich said. “If California customers faced a 20% increase in retail electricity prices, then within a few months demand would decline by over 1,000 MW and close a significant portion of the shortage gap.”

The prospect for price caps also contributes to a negative power investment climate, he indicated. Without fundamental reforms, California remains a power market in which a supplier should expect energy prices to reflect only variable costs in the absence of a shortage. As a result of this flawed design, price caps retain all market downside risk and remove all market upside potential.

Short-Term Actions

Although there is no quick fix for California’s power problems, Makovich pointed to many short-run actions that can reduce demand and add supply, including:

— Reconnecting demand to the market; necessary competitive forces arise when customers react to market prices.

— Finding more conservation and interruptible load on the demand side.

— Adding flexibility in legal and environmental limits on the power supply side by using sources like hospital back-up and emergency generating systems, hotel and office building systems, barge-mounted and mobile emergency power sources to provide additional short-run supply.

— Reactivating mothballed generating units.

— Expediting permitting and construction of power development already under way.

Long-Term Actions

Makovich also recommended the following actions be taken to correct two fundamental long-term structural flaws:

— Establishing an independent and expert market governance structure to replace the stakeholder democracy process used to develop the 1996 restructuring. “When California formulated its deregulation policy with plenty of power plants already in place, it was no surprise that the majority of stakeholders voted not to pay for capacity as long as the reliability was free. Citizens and businesses throughout the West, as well as the utilities, are now stuck with the bill for what has turned out to be a huge and costly failure in deregulation policy formulation,” Makovich said.

— Creating a mechanism to pay for capacity and to set and enforce targets for approval of development plans each year for enough capacity to close the current gap and keep up with demand. “California could mistake its current long-term energy volume contracts for the needed capacity payment mechanism.

Consequently, instead of using the appropriate type of contract or making the proper rules for a capacity market, the market flaws will continue and the politics of ‘not in my backyard’ may subvert real attempts to site and permit supply needed to meet development targets,” he observed.

Cambridge Energy Research Associates (CERA) is a leading advisor to major international companies, financial institutions and organizations, delivering strategic knowledge and independent analysis on energy markets, geopolitics, industry trends and strategy. CERA is headquartered in Cambridge, Mass., and has offices in Bangkok, Beijing, Calgary, Houston, Mexico City, Moscow, Oakland, Oslo, Paris, Sao Paolo, Seoul and Washington, D.C.