Welcome to the Hotel California... You can check out any time you like But you can never leave (1)
The consumer in the Sunshine State has checked into the electric future suite at the Hotel California; it will be an extended stay, and the tab is running. The most capital intensive industry in the United States, in the largest state in the Union, which itself is the fifth largest economy in the world, came completely unhinged. From 1999 to 2000, California's expenditures on electricity quadrupled from approximately $7 billion in 1999 to approximately $28 billion in 2000. (2) For 2001, it is expected to be even greater. (3)
Three salient facets of the environment of electric deregulation are exposed by California's problems:
* A fundamental unresolved legal conflict between state and federal authority to address electricity issues.
* Common law court adjudication will replace the traditional role of regulation.
* Re-regulation, in the form of reactive legislative responses, will spawn yet more judicial conflict.
II. WHAT REALLY HAPPENED AT THE HOTEL CALIFORNIA?
Welcome to the Hotel California Such a lovely place, such a lovely face They're livin' it up at the Hotel California What a nice surprise. Bring your alibis. (4)
In late calendar year 2000, California's restructured electric power market imploded. (5) What really happened? The facile answer is that demand exceeded supply. But there is more.
A. The Restructuring
In 1998, California became the third state in the nation, after Massachusetts and Rhode Island, to restructure its electric sector, allow retail competition, and "incentivize" or force its investor-owned utilities to sell their generating assets. Because California's concept of deregulation contained a ten percent price cut to pacify consumers, this discouraged consumers from shifting to alternative retail suppliers. (6) Therefore, a vibrant retail market and significant customer choice did not become a reality. Only about two percent of customers--typically large customers--switched to other suppliers. The conventional utilities continued to supply more than ninety percent of the power being sold in the state. (7) They had to do this after selling their generating assets and by not hedging forward the electricity supply.
After deregulation, the California Energy Commission no longer assessed the state's need for power. Market participants, subject to regulatory siting approval, were responsible for supply. By law, deregulated power supply was bid to the California Independent System Operator (ISO) daily, with the last/highest price accepted setting the price for all sales of power during that period. (8) The utilities were required by regulatory authorities to buy a substantial amount of their power requirements on the "spot" market--day-to-day--rather than through hedged forward contracts.
Rather than rely on hedged forward contracts to mitigate price swings, California sought the imposition of spot electric price caps as a means to control losses. (9) This may work as a political solution, but it destroys the price signals that the market would otherwise send, as well as dampens conservation incentives. California was unique among the states in not allowing hedged forward power contracts for wholesale supply. This prohibited the regulated California utilities, which still supplied by default most of the retail customers in California, from managing the risk of their electric commodity acquisition.
Approximately one-quarter of California's generating capacity is hydroelectric, which was susceptible to annual water flows that decreased. (10) California's reservoirs were down to minimal levels, leaving little energy capacity from these hydroelectric resources in the system. …