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Contract Killings 

How the state's contracts with crucial electric power providers actually encourage them to gouge us

Wednesday, May 30 2001
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As California's energy crisis heads into what promises to be a brutal summer, the degree of dysfunction within the state's electricity market is already painfully apparent. On May 16 alone, for instance, all of the state's major daily newspapers heralded a record $5.7 billion rate hike, as well as the worse-than-expected forecast of 260 hours of rolling blackouts in the coming months.

How we got here, of course, has been the subject of rampant speculation. One of the most widely held theories -- the subject of both city and state lawsuits, as well as numerous news accounts that have grown increasingly less speculative in nature -- suggests that energy companies have played an active role in running up prices through "gaming" the market. In other words, generators allegedly shut down plants and/or withheld capacity to force the electrical grid to the brink of blackouts, significantly raising the prices for their electricity. But, because this type of behavior has been clearly documented in other newly deregulated electricity markets, this would hardly make California special.

Yet California's deregulation debacle has succeeded in elevating market meltdowns to a new plateau. Clearly, as other states weigh the pros and cons of deregulating their own electricity systems, California's stature as the cautionary tale is well beyond reproach. Years from now, when scholars are studying the Golden State in an effort to learn how not to deregulate an electricity market, they will surely note that the state's electric grid operator (in conjunction with federal regulators) made the following, connected mistakes:

- It let the state's regulated utilities respond to a mandate to sell their power plants by packaging them in geographically concentrated bunches, effectively granting the potential for local electrical monopolies all over the state;

- It attempted to regulate those local monopolies through contracts that actually encouraged generators to ask for outlandish prices; and

- It tried to remedy the original contractual faux pas with a new contract that -- when teamed with federal market rules -- continues to give some of the state's most crucial generators huge monetary incentives to manipulate market prices at the moment electricity is needed most.

Last spring, the entity that operates the state's electrical system, a nonprofit corporation known as the Independent System Operator, or ISO, actually caught a power generator -- dead to rights -- exploiting this contract loophole in what appeared to be a fairly blatant manner. The ISO referred the case to federal energy regulators, who responded in an unusual way.

The regulators allowed the generator to make a $3 million profit on its illegitimate market manipulations.

Although almost everyone with sufficient knowledge of the contract loophole acknowledges it should be closed, neither the ISO nor federal regulators have acted. Market analysts, consumer activists, and even power generators find the ISO's inability to plug the loophole puzzling, bizarre, or even damnable.

"[The special contract] was a good idea, but the ISO made it a very ugly thing," says John Stout, a senior vice president at Houston-based Reliant Energy.

"It's screwy," says Mike Florio, a former member of the ISO's board.

"The ISO," says Stanford economist Frank Wolak, the chairman of the grid operator's independent Market Surveillance Committee, "should fire its lawyers."


Back in the mid-1990s, when state and federal officials were evaluating how, exactly, electricity deregulation was going to unfold in California, it quickly became apparent that the grid was vulnerable to price goug- ing in higher-growth areas where, generally speaking, there was less cushion between power supplies and power demand.

When electric utilities were regulated monopolies, it didn't matter that there were only a few major power plants in, say, the Bay Area. If one of those plants went down, Pacific Gas & Electric Co., which handled most of the generation for Northern California, could simply call on electricity from elsewhere in its grid. The lights would stay on, and power bills would be unaffected.

But this dynamic changed when the state's deregulation program required PG&E and Southern California Edison to sell most of their power plants. The requirement to sell was based on a fear of market power: If the two giant, investor-owned utilities kept all their power plants, they would hold a clear, statewide monopoly and would be able to drive prices higher at will under a market-based electrical system. As it turned out, of course, the new system -- embodied by a cartel of out-of-state energy companies that snatched up the utilities' power plants -- has all but swallowed Edison and PG&E whole.

But there's an element of irony in the utilities' current plight: The manner in which they sold off their plants set them up to be gouged. The utilities, fearing that many of their oldest, smallest, and least efficient plants wouldn't sell, decided to package their worst plants in geographically concentrated bundles containing some of their best. "If you wanted to buy a prince, you had to kiss a frog or two," recalls Gary Ackerman, president of the Western Power Trading Forum, which represents energy companies in California.

Much to the surprise of many industry insiders, many of the out-of-state generators were all too willing to pucker up. The power plants, good, bad, and indifferent, sold for well more than what they were widely considered to be worth. But before the utilities could fully congratulate themselves for making a killing on those sales -- a killing they promptly invested in other markets through their parent corporations -- it dawned on them that the transactions may have been less of a coup than originally thought. The utilities and the state's grid operator realized that statewide monopoly power had, essentially, been swapped for local monopoly power.

For instance, the Atlanta-based Mirant Co. spent $801 million buying plants in the Bay Area. It bought a massive plant in Pittsburg, a midsize plant in Contra Costa County, and something of a dog of a plant on Potrero Hill. It all added up to a transfer, from regulated utility PG&E to private, unregulated generator Mirant, of more than half of the Bay Area's generating capacity.

About The Author

Jeremy Mullman

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