Background

Instead of that, here is my own `capsule summary' (not nearly as good as Dr Mills' articles):

• In the late 1800s and early 1900s we had the Tesla/Edison wars.  Tesla (really George Westinghouse) won and we used AC, with relatively long distance transmission.  (Edison's idea was to have a coal-fired generator on every block.)
• In the 1930s the US Congress decided the situation was out of hand and passed monopoly regulation.  They granted various utilities a complete monopoly over electric service provided that the utilities cooperated with the state and local governments in rate-setting and planning and so on.
• Throughough the 1940s and on up until the 1970s, new power plants got larger and larger, as that was the best way to make them more efficient.  Planning (and rate-setting) were done more by accountants and lawyers than anything else.  Each plant got even more expensive, too, as the turbines became so large that they began not to fit on standard railroad cars.  (You have to have some way to get the parts and from the generation site, and rail transport was the method of choice.)
• But people were mostly happy, because the increasing efficiency of new plants, and steady growth in electric usage, meant that a planning forecaster could just say `add 6% more power plants per year' and be right, and the accountants and lawyers would pore over the books the utility kept when buying equipment and building plants, and would come up with new lower rates.
• Rural Electrification (decreed in the 1940s and 1950s) was done by spreading out the rather exorbitant cost of new wiring.  Millions of urban and suburban customers paid for it.  Because rates were going down anyway, nobody really complained.
• Because regulators had little else to care about, they cared mostly about `grid reliability'.  That was something they could measure.  Improve grid reliability, they would say, and we'll be happy, and let you pass your costs on to your users, giving you a guaranteed profit.  So, the utilities built bigger, fancier, `gold plated' systems and the regulators were happy, and efficiency still went up and costs still went down, so everyone else was, too.
• The new plants, being bigger and bigger and more and more expensive, had 40 to 50 year anticipated service lifetimes.  If it costs that much to build, might as well built it to last.  And -- if a plant is going to last for 40 years, and it cost 40 million dollars to build in 1960 (thus, expected to be good until at least 2000), that is only $1 million per year -- you just spread the cost out over time.
• Then the world changed.  Someone engineered a practical, working `combined cycle gas turbine'.  Plant efficiencies had gotten as high as the mid-30-percent range, with the old plants.  CCGTs, however, were upwards of 40% efficient.

Who was going to pay for the massive upheaval required to replace all those old, inefficient plants?  Enter deregulation.  Get rid of the monopolies, kill off new investment in `gold plated' reliability, scrap the old plants or let private companies buy them for pennies on the dollar, try to recover the `stranded' costs elsewhere, etc.

Before Deregulation

Power plants are expensive.  Large plants cost many millions, or -- in the case of the large nuclear plants -- billions of dollars.  The reasons are simple enough.  The plants are physically very large, so they need a lot of real estate.  They contain a lot of expensive parts (turbines and plumbing and wiring and controls and transformers and generators ad nauseam) and they take a long time to build.  Nuclear plants in particular take very long to build, because they are held to much higher safety standards than, e.g., gas-fired plants.  If there is a gas leak and a big explosion and a bunch of people die, it is considered very tragic, but nobody really takes that much notice; but if there is a nuclear accident with even slightly measurable radiation levels, it makes world headline news.  I make no arguments as to whether this is or is not a good thing; I merely note that it happens.

In any case, the point remains that plants are expensive to build.  In general -- and this was also true for the CPUC -- most states only allowed a utility to begin to recover the cost of building a plant once the plant came on line.  In other words, if a plant was supposed to cost $500 million, the utility could not bank the $500 million first, then build the plant; instead, they had to borrow the $500 million first, build the plant, and only then start paying the loan.  Plants were expected to last 30 years or more, and were financed accordingly (like buying a house on a 30-year mortgage).

Remember also that utilities were granted a monopoly on power generation, transmission, and distribution, but in return, they had to make a `deal with the devil': the PUC would get to control how much profit they made.  In return for investing (and collecting) all this money, they were guaranteed a return of about ten percent.  This is the situation that made utility stocks so reliable, giving them their nickname of `widow and orphan' stocks.  Thus, the utility would build a big plant, and run it for 30 or 50 years in order to pay off their loan and make their ten percent or so.  All of this was controlled by a complex web of state law.

In the 1980s, the utilities built a lot of plants.  In the early 1990s, California fell into an economic recession.  Southern California was particularly hard-hit, with the collapse of the aerospace and defense industries.  That left the state with a huge oversupply of electric generation plants, not enough people using electricity, and a high cost per kWh for the remaining users (who, after all, still had to pay off those big utility mortgages -- they had a guaranteed return).

A Few Words About Money

The California electricity market is so big today that every penny that someone pays per kWh for electrical energy winds up adding up to nearly three billion dollars a year.  This money is, of course, split across many buyers and sellers, including direct contracts between generators and heavy industrial users, which bypass the utilities almost entirely.   But this still leaves a stark fact: five cents per kWh for energy represents something like ten billion dollars a year in cash flow at PG&E and SCE (SDG&E is smaller than the other two, and still solvent).  Paying a nickel (wholesale) for running a 1000-watt electric heater for one hour may not seem like much, but those nickels add up (and of course if you are a retail customer, it was more like eleven or twelve cents, of which a nickel or so went to the wholesaler).  Keep this in mind when you see numbers like `$14 billion in debt' -- 14 billion is also just 7 cents.

The Deregulation Scheme

AB1890 created a number of new entities.  Chief among these were:

• CalPX, the California Power Exchange.  CalPX was a wholesale market in which electricity would be bought and sold by contract and on `day-ahead' and `hour-ahead' spot markets.  CalPX would take generation and load `bids' on the day-ahead and hour-ahead markets and find the lowest-cost generation, whatever that was, needed to make the generation and load match, more or less.
• CalISO, the Independent System Operator.  The ISO is another wholesale market in which electricity is bought or sold `real-time' as needed to balance the transmission grid.  Their main function was supposed to be to provide reliability of this grid.  The problem being solved here is that when generation and load do not match properly, any number of things can go wrong.  On the whole, though, CalPX was supposed to provide a `well balanced' setup, so that CalISO would only have to take care of some tiny fraction of all electricity bought and sold.

This design was taken more or less straight out of the UK's 1988 deregulation (where it did not work very well either, but that is another matter entirely).  The MCP sounds stupid at first blush.  If Joe was willing to sell 50 MWh for $50 ($1/MWh or $0.001/kWh), why pay him more?  The answer lies in `strategic bidding' and what is called `seller's remorse'.  Suppose Joe sold his 50 MWh for $50 and actually got $50, but Bob down the street sold another 50 MWh for $500.  Joe looks over at Bob and says to himself: Gee, I should charge $10/MWh too.  By having an MCP, Joe can rest assured that even if he `bids cheap', he will get as much as Bob, if Bob gets anything at all.  In theory, this removes Joe's incentive to charge extra.  If everyone plays fair -- if everyone bids their own cost plus some profit -- then the lowest-cost generators will always run, and as more power is needed, higher-cost generators will run only as needed.  No one would ever have any reason to `bid high' because someone else would come in and undercut them.  After all, there was (in 1995) way more generation than load, so there was always plenty of spare capacity.

Where this falls apart is when someone -- anyone! -- has `market power'.  Suppose Bob is greedy and realizes that there is so little power to go around, his power will get bought no matter how high he prices it.  All he has to do is set his price to a million dollars per MWh.  CalPX will go everywhere else first, but eventually only Bob will remain, and they will buy his million-dollar megawatt-hours -- and pay everyone that same price.  Even if Bob is only slightly greedy, he can raise prices quite a bit.  (There are also strategic `gaming' tricks Bob can try; I will describe these later.)

The obvious solution is to switch to `as-bid pricing'.  But that just puts us back at the `strategic bidding' above: Joe gets $1/MWh but sees that Bob is getting more, so Joe raises his price.  In fact, Joe raises it to whatever he figures he could have gotten, if CalPX were using the MCP.  To a great extent, MCP is a red herring -- it has nothing to do with the real problem.  The real problem lies in the ability of generators to use `market power', as if they were a monopoly.  In other markets, someone has to have a huge share to be a monopoly, but because of the real-time load/generation balance problems of electricity, someone only has to control `just enough' generation to be able to unbalance the system.  One single `bad egg' using this ability will send the price up even if everyone else is a `good egg'.  Again, if there are enough generators and transmission lines, this is not a problem.  The one bad egg trying to drive up the prices will get undercut by someone, somewhere.  And in 1995, there was that huge oversupply of generation.

In economics, these problems all really boil down to good old `supply and demand'.  If the supply is large, the prices fall until demand rises or supply falls, or both.  If the demand is large and the supply is small, the price rises until the supply increases -- because people see how much money there is to be made -- or demand falls off, because no one can afford to buy the stuff.  The keys to making this work are pricing (and to some extent, demand `elasticity' -- how quickly demand responds to price changes), and the ability for anyone to jump in and sell the desired item, in this case electric power.  In 1995, things looked okay here.  There were occasional long-distance transmission limitations, but rarely anything serious.

Anyway, the above describes the `goal state', as it were: generators would sell into or through CalPX, who would find the most efficient, least-cost way to make generation meet load (and vice versa).  The utilities would pay out the wholesale cost, and would collect the same wholesale price from their retail customers, plus various fees for transmission and distribution.  To make sure that no one had market power, the utilities would have to sell off their generating plants.  They would become `utility distribution companies' (UDCs) that simply acted as a carrier.  Retail customers could choose to buy power from the UDC (i.e., through CalPX), or through some other retailer who would use the UDC to distribute the power (hence the name).  UDCs would be monopoly distributors, heavily regulated as before, but generators would compete in a free market.

Transition Period

So, suppose you are a utility.  Along come the Federal and state deregulators, and they tell you: `We want you to sell off your plants.  Old, new, whatever, we don't care, we just want things set up so that no generator has a monopoly anymore.'  But you still have plants with big mortgages left on them.  Not only that, you think that you cannot sell them for anywhere near enough money to pay off the loans you are still carrying.  (It turns out that you are wrong, but never mind that yet.)  So what do you do?  How do you get those things paid off?  By law, you -- and those widows and orphans who own your stock -- were guaranteed a payoff.  To suddenly rip that away would hardly be fair.  So you, and the deregulators, had to come up with a way to pay off these stranded costs.

In this case, the utilities came up with an idea.  They took a guess as to what wholesale electricity prices might be.  They figured -- correctly -- that those prices would start out around 3 or 4 cents per kWh ($30 to $40 per MWh) on average.  They had a pretty good idea what it was costing them to generate electricity, after all; they had been doing it for decades.  They agreed with the legislators to set up a fixed wholesale price: an average of 5.5 cents.  If electricity actually cost 3 cents, then, this would give them `headroom', as they called it, of 2.5 cents.  Since every penny becomes billions, this `headroom' would give them a way to pay off the stranded costs.  They could sell their tired old plants cheaply, yet still make their previously-guaranteed profit.

(I should add here that the California PUC apparently had some say over how this `headroom' money was to be allocated.  Its main purpose was to pay stranded costs, but it could get tapped for other things.)

Now, here things get a little tricky.  As the utilities sold off their plants and paid off their stranded costs, they would go through this `transition period' and collect a fixed 5.5 cents, no matter how much they had to pay out for wholesale electricity.  Once they finished the process, they would go to `fully deregulated' status, and collect the actual wholesale price.  To make sure that everything happened on schedule, they would lose their `headroom' in 2002, even if they had not paid off all their stranded costs by then -- everyone, regardless of status, would become fully deregulated in 2002, or when they were done, whichever occurred first.  (Note: the exact amount of headroom, and fixed price, was different for PG&E and SCE, and no doubt for SDG&E too.)

To get that fixed price, every bill would include something called a `competition transition charge'.  If a utility bought 500 kWh for you, and paid $17.50 (3.5 cents per kWh), they would bill you for $17.50 in `energy' and $10 or so in `CTC'.  This way you would pay about 5.5 cents per kWh, giving them their `headroom'.  (On top of that $27.50 they would add other fees to cover their distribution costs and so on -- the $27.50 covered just the wholesale electricity itself, including the headroom.  Your actual bill would be a bit over twice that.)

The Financial Mess

Supply and Demand (or, Why So Expensive?)

For reliability reasons, the ISO likes to have about a 10% `buffer zone' of extra generation ready to be used at a moment's notice (or a moment's light switch, as it were).  If these reserves drop below 7%, the ISO declares a `stage 1 emergency'.  At 5%, they go to `stage 2', and at 1.5% they go to `stage 3' and start ordering utilities to turn out the lights.  Adding the 10% reserve to the typical 30000 MW winter load (at 7 or 8 PM when all the lights are on and many businesses have not yet closed), California needs about 33000 MW available all winter.  33000 out of 48000 leaves 15000, which should be plenty.

Unfortunately, a lot of that 48000 MW is hydroelectric generation, much of which is fed by snowmelt.  In the dead of winter, the snow is not melting, so some of that 48000 disappears.  Some tiny bit is wind-power that mostly runs in summer.  Another tiny bit is solar power, e.g., from the Luz plant in the Mojave desert, which also mostly runs in summer.  No problem -- even subtracting all the summer-only plants, that still leaves plenty, even if they are mostly natural-gas fired.  In any case, the need is highest in summer when that snow is melting nicely, so that part works well too.  So -- why did the lights go out in January?

Out of State, Out of Mind

If you own a bunch of generators, you may not know whether you have market power.  As it turns out, though, you can find out pretty easily in a CalPX or CalISO style setup.  You test for market power by using two different kinds of withholding, called physical withholding and economic withholding.  The process is fairly simple.  You set the price on one of your generators -- such as a small, inefficient peaker -- higher than you really need to.  If it is used, you have not really learned anything, although you know that this price is not yet too high, and of course all your other generators get at least this much money per MWh.  In that case, you crank the price up for the next round, and/or take one of the larger generators off line for maintenance -- physical withholding.  As soon as the small, expensive generator is not used, you have achieved economic withholding.  By using a spectrum of pricing, and taking a small number of generators off line, and repeating until you find the `sweet spot', you can discover whether you have market power, and price your generators so that you exercise it effectively.

It is very hard to prove whether someone is doing this, and in a market clearing pricing system, only one generator company has to do it to raise prices.  The amount gained this way may be just a few percent, but because of the size of the electricity market, that can mean millions of dollars.  (What this really means is that, to prevent easy exercise of market power, most electricity should be bought and sold via contracts.  Operating a residual market with an MCP system can leave pricing problems built into that system, but since it is just a residual market, it does not really matter much.)

Natural Gas Prices

In other words, rather than generator price gouging, perhaps the state should be looking into natural gas price gouging.  (And in fact, they are -- but only FERC have actual legal authority here.)

The Financial Mess, Part 2

The two utilities went to the California Pubic Utilities Commission and asked for their blessings in making contracts.  Traditionally, if a utility makes a contract on their own to buy electricity, a state's PUC comes along later and takes a look at whether the contract was a good idea.  If it was, they praise the utility; if the utility overpaid, they say instead: `bad dog, no biscuit!'  They can even slap the utility with a fine.  So this discourages utilities from getting contracts without getting `pre-approval' from the PUC.  PG&E in particular have said that they felt such pressure and needed explicit approval.  Today, there is finger-pointing by both sides -- the utilities say `we asked for contracts', the PUC says `we said okay', and the utilities say `you did not say okay in strong enough terms to make us feel comfortable'.

Now what?

Remember those stranded costs?  When PG&E and SCE sold generation plants, they got far more money than they had expected.  That means lower stranded costs to begin with.  Then wholesale prices went crazy.  Remember those market clearing prices?  That means higher income from the remaining plants.  Even though the utility distribution business had gone sour, with the CTC eating up any distribution profits and then some, the utility generation business was still going great guns.  That means quicker payoffs.  In early 2001, PG&E and SCE brought two separate lawsuits to the courts, claiming that they had paid off all their stranded costs and that they should now get in on SDG&E's deal.  The PG&E case was referred to the Los Angeles court that was handling the SCE case.  This was one prong of the utilities' plan.

The other was bankruptcy.  Bankruptcy might be good for the distribution company, because it holds off the creditors, and pits a bankruptcy judge against the PUC.  Even if the judge cannot set rates, this at least buys time -- either enough to reach the `deregulation finish line' and stick the ratepayers with the tab, or enough to let a court decide that they had already reached that finish line.

One of the key elements the state extracted in the bailout deal was a promise that SCE would drop the lawsuit mentioned above.  The state was trying to do the same with PG&E; I believe this was a key sticking point in the discussions.  (Another sneaky trick, this time on the part of the CPUC, was to change the accounting methods and/or rules for the `headroom' -- the CPUC is apparently trying to make sure that those stranded costs continue, to keep the negative CTC around.)

update (3 May 2001):  A federal judge has dismissed the PG&E lawsuit for now.  The suit can be resurrected later, but for the immediate future, the utilities will have to depend on the PUC to implement rate hikes.

The state intends to finance the electricity cost over many years.  The `buy now, pay later' plan can hold the price increase down, at the expense of making it last longer.  This is not such an unreasonable idea -- after all, it is how a home mortgage works.  But nobody knows, yet, what the actual cost will be.

The PUC proposed a new four-tier rate structure.  Now they are talking about a five-tier rate structure.  Assembly Bill 1X, passed back in January 2001 or so, has some special provisions for residential customer rate increases: anyone using under `130% over baseline' must not have their rates increased.  That means the entire increase has to go to the so-called `heavy users'.

To pull a few numbers out of a hat, suppose that the ten-year average cost will actually be around $0.09/kWh.  Add a few billion for financing to get $.11/kWh.  The proposed 46% increase would run collections up to about $0.095/kWh.  That means the state would need another 1.5 cents per kWh -- all of which has to come out of Tiers 3 through 5, which only cover about half the electricity, so we should double that to $0.03 more.  The PUC's proposal set Tier 4 for SCE at around $0.25/kWh, so that suggests a ten-year retail price for Tier 4 of perhaps $0.28/kWh.

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