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Study: Power crisis & wrong remedies may short circuit California economy

LOS ANGELES, June 28, 2001 — Currently planned remedies to California’s electric power shortage crisis could result in 112 hours of power outages this summer, a 1.5% decline in the gross state product, and a more-than one-half percent increase in unemployment.

But the state’s long-term outlook is as much as $90 billion worse if government takes over the power business rather than using market-oriented remedies to resolve the situation, according to an analysis released today by Cambridge Energy Research Associates (CERA) and UCLA’s Anderson Business Forecast. The results were produced using CERA’s electricity market models and UCLA’s economic forecasting models.

“The real issue is how the state attempts to resolve the power crisis,” said Michael Zenker, CERA’s Director of Western Energy. “Our research indicates that an approach to the crisis that postpones the costs will have the effects of encouraging consumption of electricity during this time of scarcity, deepen California’s debt, and increases the costs and duration of blackouts,” he indicates. Explains Dr. Edward Leamer of the Anderson Business Forecast, “With a gross state output of $1.3 trillion, California’s economy is sufficiently large and dynamic that the power crisis will dampen but not derail economic growth. However, the real costs are longer-term. California’s cumulative Gross State Product between now and 2005 will be nearly $90 billion less and unemployment will be higher and extend over a longer period of time if prices are controlled and the investment climate discourages introducing new electricity supply.”

Alternative scenarios

To evaluate the relative economic effects of alternative solutions to the California crisis, CERA and UCLA developed two scenarios – state intervention vs. market responsive measures – representing sets of remedies at opposite ends of a policy spectrum.

“The ability of the state to attract new supply for the California market, or alternatively to build new state-owned generation, will determine the duration of the current supply shortage and the extent of its longer-tem economic effects,” Zenker said “Our analysis assesses the effectiveness of each scenario for creating the best investment climate, market structure, and overall strategy for expediting the arrival of this new supply.”

1. State Takes Charge – The first scenario examines the economic implications of a deepening of the state’s current course of action. In response to heightened public outcries, the case is made that the state must take charge and make the market “behave.” More aggressive state measures are taken to stop what is characterized as gouging and gaming and to restore stability to the volatile wholesale market.

* Controlling Prices – The state maintains retail rates at current levels and the state treasury incurs large debts to cover the difference between persistently high wholesale costs and retail rates. Debt service on the under-collection overwhelms the net revenue likely to result from the state’s DWR funding arrangement, resulting in an outstanding debt of over $22 billion by 2005.

* Taking Over the Market – The state continues to pressure the Federal Energy Regulatory Commission (FERC) to implement price caps and endeavors to control wholesale prices by establishing a California Public Power Authority. By the end of 2001 the state takes over the transmission assets of the investor-owned utilities and plants are prohibited from transporting energy out of the state without California Independent System Operator’s (ISO) permission.

* Poor Investment Climate – Active state intervention in the power market sours the investment climate. Capped retail prices, significant restrictions on merchant power plant owners and a more interventionist regulatory process frighten potential investors in new power generation. In addition, owners of portable emergency generation equipment choose to not move this equipment to California due to the poisoned investment climate and the perception of significant regulatory risk.

* Electricity Prices – State intervention holds rates fixed throughout the period of analysis with residential rates locked in at .16 $/kWh.

* Economic Output – Economic growth in California is expected to be greater following the pay down of debts associated with the crisis. Gross State Product grows 0.2 percent faster with the market restored than with the State Takes Charge scenario. By 2005, the cumulative gross state output is $90 billion smaller as a result.

* Impact on State Finances – Retail electricity prices are locked in to protect consumers in the near term but end up creating significant long term debt liabilities. Because electricity prices are frozen the state’s debt quickly climbs from $8.2 billion in June 2001 to $23 billion by the end of the year. Moreover, without a rate increase none of this debt can be paid down. By 2006, this debt balloons to $40 billion.

2. Restoring the Market – California follows a very different course for resolving the crisis in this case, adopting policies designed to restore a market-based approach for setting power prices and encouraging future investment. This scenario involves a pay-as-you-go approach compared to the pay-later methods of the State Takes Charge scenario. The state takes an active role in re-linking the wholesale and retail markets — exposing all consumers to the market cost of power — and establishing a capacity requirement mechanism that stimulates new power plant construction that outpaces demand growth and restores the market’s balance by 2003.

* Paying Down the Debt — In this scenario the debt accumulated as a result of the crisis, including state debt for purchases of power, is paid off within a period of 24 months. The accumulated debt plus carrying charges are paid by consumers through the electricity prices, which pushes up retail electricity costs. By May 2003 the state is fully relieved of this debt. After debt payment electricity prices can fall with declining wholesale costs. Retail rates remain permanently linked to wholesale costs.

* Align Retail and Wholesale Markets — CERA estimates that the retail prices in the Restoring the Market scenario would initially be about 28 percent higher than the State Takes Charge scenario. This produces a considerable downward demand response, and also significantly reduces the number of hours of unmet demand in 2001 (interruptions and blackouts) from 112 hours to 12 hours.

* Improving the Investment Climate — The state needs to provide leadership in streamlining permitting and siting rules and in resolving local disputes that can prevent plant construction. The addition of new capacity into California can also be expedited by the improved investment climate and the economic incentive of a capacity payment. Capacity additions are expected to total nearly 12,000 MW by 2005, helping to put the market back in balance by the summer of 2003.

* Electricity Prices – Average retail prices shoot to .29 $/kWh in August during the most severe period of supply shortage, but by Spring of 2003, after the final payments of outstanding debt are paid, rates fall dramatically to .10-.11 $/kWh range where they remain.

* Economic Output – After a contraction in the economy in 2001 and 2002, , the trajectories of economic growth begin to diverge. By 2005, the cumulative gross state output is $90 billion larger in the Restoring the Market case.

* Unemployment – The unemployment rate attributable to the power crisis is the same for both scenarios in 2002, contributing an additional 1.1 percent to an anticipated unemployment rate of 5.7 percent. Differences begin to emerge in 2003, when unemployment attributable to the power crisis falling to half a percent in the Restoring the Market scenario but remains at 1.1 percent in the State Takes Charge case. By 2004 the unemployment effects are gone in the Restoring the Market case but continue to linger with negative employment effects in the State Takes Charge case.

* Impact on State Finances – The $20.5 billion in accumulated debt by investor owned utilities and the state are rolled into the retail electricity prices and rapidly paid off. This pushes up retail electricity prices in the near term, but has the positive benefit of quickly liquidating this debt, enabling California to be fully clear of the costs of the crisis by May, 2003. This not only allows rates to fall but has the potential to improve the state’s credit rating and lowering the cost of borrowing.

Putting California on the road to recovery

The results of this analysis highlight the need for enlightened policies to begin the recovery process, prevent deepening the economic impacts of the crisis on western states, and set up a more durable market structure. Future policies must:

* Re-establish certainty about the future – Reaffirming California’s position as an attractive place to make long-term capital investments will be crucial to minimizing the economic fallout from the power crisis.

* Align the wholesale and retail market structure – A key lesson from the California market crisis is retail electricity prices should not be disconnected from wholesale market costs . Deregulation should not result in utilities absorbing wholesale market price risk, especially when denied by state regulators of the authority to manage that risk.

* Invigorate retail competition – Retail markets could provide a powerful tool for consumers to respond to electricity prices by choosing a price/term plan that best suits their needs. By choosing for consumers, regulators thwart the changes in consumption that would be expected as consumers respond to price changes.

* Expedite new capacity build – California needs to commit to permitting enough new energy plants each year to ensure that supply additions outpace demand growth.

* Provide a capacity reserve requirement and capacity payment mechanism – A capacity requirement makes sure that all companies serving customers have contracted for enough power plant capacity to serve their customers, plus a reserve for contingencies thereby ensuring that supply additions outpace demand growth.

“Our study suggests that the advantages of a market where consumers see prices that more clearly reflect supply and demand, accumulated debts are paid off, new supply sources are brought to market quickly and the fundamental flaws of the market structure are fixed, outweigh the advantages of a market aimed at insulating residential, agricultural and small commercial customers from price increases,” said Zenker.

Dr. Leamer adds, “In other words, sheltering small customers from the crisis moderates the impact of the crisis in the very near term but at a high cost to the economy, to customers, and to the public in the longer term as measured in blackouts, gross state output and unemployment.”

Short Circuit: Will the California Energy Crisis Derail the State’s Economy is the second in the series of major, independent studies by CERA addressing the implications of the California electricity crisis and was prepared as part of CERA’s on-going independent research and advisory services. The analysis will be distributed to clients of CERA’s Western Energy, North American Electric Power and Global Power Forum Membership Advisory Services, and is also available for purchase.

Cambridge Energy Research Associates (CERA) is an 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.

UCLA’s Anderson School has grown into the most technologically advanced management school in the world. Its programs, which are consistently ranked in the top ten in the US, are supported by 134 faculty members covering the school’s 15 research centers. The UCLA Anderson Business Forecast is the most widely followed and often-cited forecast for the state of California. The UCLA Anderson Forecast is in its 50th year of operation.