Auros (auros) wrote,

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The CA power crisis, and Gray Davis.

So, I've finally gotten around to reading Frank Wolak's paper Lessons from the California Energy Crisis. Wolak is a Stanford economist, and a member of CA ISO's Market Surveillance Committee; he had a front-row seat to watch the whole thing go down.

It looks to me like the paper ought to be good news for Gray Davis, if he only knew how to make its findings clear to the public.

To quote the Wolak paper:

Despite its own conclusion that wholesale electricity prices in California were unjust and [un]reasonable and reflected the exercise of significant market power and despite the growing volume of evidence from a number of independent sources on the extent of market power exercised in the California electricity market, FERC refused to set just and reasonable prices for wholesale electricity in California. Instead, as discussed above FERC implemented market rule changes that enhanced the ability of these firms to set wholesale electricity prices that reflected the exercise of significant market power.


The California electricity crisis was the direct result of the conflict between the Federal Energy Regulatory Commission and the state of California over the appropriate regulatory response to the extremely high wholesale electricity prices in California during the summer and autumn of 2000.


The lack of [long-term] vesting contracts between California suppliers and the three large LSEs [Load Serving Entities, i.e. the utilities that send power down the line to your door] created strong incentives for suppliers to withhold capacity from the market in order to increase spot prices. By this logic, if enough California suppliers had a substantial amount of their capacity committed in long-term contracts to California LSEs, the incentive California suppliers had to withhold capacity from the market would be substantially reduced and the accompanying very high average spot prices created by this artificial scarcity would be largely eliminated. For this reason, the December 1, 2000 report of the Market Surveillance Committee proposed a joint/federal state regulatory mechanism to implement what amounted to ex-post vesting contracts between California's LSEs and suppliers to the California market at fixed prices set by FERC. However, this regulated forward contract remedy was rejected by FERC in its December 15, 2000 order. Consequently, if the state of California wished to purchase the quantity and mix of forward contracts necessary to commit suppliers to the California market during the summer 2001 and following two years, it would have to pay prices that reflected the market power that suppliers expected to exist in the spot market in California over the coming two years. Suppliers would not voluntarily sell their output in forward contracts that covered this time period at prices below what they expected to receive in the spot market.

In other words, Davis's negotiation for long-term contracts was a significant factor in ending the crisis, and the price at which he was able to negotiate those contracts was artificially high because of the lack of cooperation from a federal agency that was under political pressure from BushCo. After CA was locked into those long-term contracts, and activity on the spot market went way down, FERC stepped in with more realistic price regulations.

What Wolak is suggesting here seems to me to be even more radical than Krugman's position. Krugman generally says that conservation and the price caps that finally came into place were major factors in ending the crisis; Wolak gives those factors some credit (particularly conservation), but mainly focuses on the long-term contracts as the decisive factor. If that's the case, then Gray Davis's argument on that issue is fundamentally sound: the contracts were the only solution available to him, and the high price of the contracts was inflicted on him by FERC.

Wolak again:

... I believe that the FERC July 19, 2001 price mitigation order, at most, had a very limited impact on the competitiveness of the medium-term and real-time spot markets for electricity in California relative to the impact of forward contracts signed by the state of California during the winter of 2001 ...

(Granted, I'm excerpting this from an "although" clause, after which he credits FERC's cooperation with contributing to an improvement in the reliability of the transmission network. The point still stands.)

It seems to me that one of the big lessons here is that, unlike in most industries -- and unlike what one expects to result in an unregulated market -- in both transmission and generation of electricity, it is strongly in the interest of consumers that there exist a significant amount of excess capacity, so that no single player can count on his generation being necessary to meet demand. That factor of necessity is what creates unreasonable levels of market power. (And of course, various artificial scarcity ploys can aggravate such problems.)

In the conclusion of his paper, Wolak comments:

[T]he best way for FERC to deal with this problem is ... to set a transparent standard for what constitutes unjust and unreasonable prices in a wholesale market regime and set a pre-specified regulatory intervention that will occur if this standard is violated.


FERC must regulate, rather than simply monitor wholesale electricity markets.


A final point related to the importance of FERC regulating rather than simply monitoring is the necessity of very accurate data on the physical characteristics of plants, input fuel prices, other input prices and many other aspects of the operation of the wholesale market to carry out this task. For example, in order to perform a satisfactory review of the prudency of costs a firm would like to recover, FERC must have the best available data on these variables. Moreover, in order to compute the best possible estimate of what constitutes a just and reasonable wholesale market price FERC will need, at a minimum, the best available information on the operating characteristics of generation units, input fuel prices, and the physical state of the transmission network. Finally, in order to provide tangible evidence on how well it is doing in delivering economic benefits (in the form of lower prices) to consumers that they would not have received in the former vertically integrated utility regime, FERC will need to be able to determine what prices would have been under the former vertically-integrated utility regime. This will require the same information. Consequently, particularly during the initial transition to a wholesale market regime, FERC should substantially increase, and certainly not reduce, the amount of data that it collects from market participants if it would like to be an effective and credible regulator.

Sic transit gloria deregulatori.

Or at least, certainly that should spell the end of dogmatic Libertarian deregulation. (Does it even make sense to talk about strictly-regulated deregulation?)

This does not, of course, mean that a market solution is not a good idea. Just that an unregulated (or even a poorly regulated) market solution is not a good idea.

Regarding Davis, critics complain that although FERC investigations uncovered wrongdoing, the harm demonstrable from such wrongdoing (with the possible exception of Reliant's tricks to inflate the price of natural gas, which created a vicious cycle in which the price of gas-fired electricity went up, making it look economical to buy gas at a higher price) comes nowhere near explaining Davis's statement that CA was robbed of something like $9B. That sum was arrived at by calculating what prices should have been in the market under fully competitive conditions and subtracting the resulting costs from what was actually paid. So where did all the money go? Quite simply, the market itself was flawed, such that the normal competitive bidding process broke down and led to exorbitant prices.

However, that fact should not let generators off the hook. As Wolak points out:

[T]here is no need for any malicious behavior by any market participant for a wholesale electricity market to produce unjust and unreasonable prices. Moreover, the Federal Power Act does not specify that prices must be the result of malicious behavior by a market participant in order for them to be deemed unjust and unreasonable. The Federal Power Act only requires that if FERC determines that prices are unjust and unreasonable, regardless of the cause, then it must take actions to set just and reasonable prices and it must order refunds for any payments in excess of just and reasonable levels.


The Federal Power Act does not say that these refunds must be paid only by firms that violated market rules or engaged in illegal behavior.

Therefore Davis' request for a full refund is justified under Federal Law, and FERC's refusal to cooperate places it in breach of its obligations under the statute that created it.

One might raise the question of how one should define the "just and reasonable" prices spoken of in the Federal Power Act. But the Act has been around since 1935, and the clause about prices was interpreted for decades, before the '90s deregulation craze began, as meaning what Wolak says it means -- that a fair price for power is the marginal cost plus a few percentage-points worth of return-on-investment (maybe capped at a 5% or 10% annual return; such details can be worked out by regulators). FERC's refusal to follow this precedent is a great boon to Bush campaign contributors, of course, but, as I said before, it is also a breach of its obligations under federal law.

Finally, the media has become fond of accusing Californians of whining, blaming all of their woes on the Texans.

Well, it's hardly surprising, considering that many of the woes are the fault of Texans -- even if some of them do happen to have relocated to DC.


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