Every day, when we in the USA read our newspapers or watch the nightly news we hear about the ongoing power crisis in California. The state has been described as having become a “third-world country” with rolling blackouts, and the crisis is being linked to a possible national recession.

Governor Davis’ efforts to bring about an end to the crisis that satisfies all interested parties – utilities, rate payers, and politicians seeking reelection – has been an ongoing theatre involving political tightrope walking and special interest group manoeuvring. Governor Davis has even been accused by high-level national politicians of attempting to ‘nationalize’ the California utility system or trying to create a California island disconnected from the rest of the nation in terms of the supply of its energy needs.

The current crisis in California is real, and its impacts will be felt not only nationally but globally as well. But will the California crisis create a bust in the current power development cycle, or will it lead to an accelerating boom in new generation development and financing?

An early pioneer

Estimated capacity deficits in the USA in 2002
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It has been said that in deregulating its electric power market, California made almost every mistake possible. While it sought to pioneer the move into the new era of electricity deregulation, California has ended up teaching the USA and the rest of the world how not to deregulate.

One of the original reasons the California legislature was so interested in deregulating its electric power system was a belief that Californians were paying some of the highest rates in the country for electricity. From 1988 to 1999, a kilowatt hour in California cost an average of 9.2 cents, 37 per cent more than the national average, according to the Federal Energy Information Administration. But from 1988 to 1993 as many as six states had higher average retail rates than California.

Since 1993, as many as ten states have averaged higher rates for power than California. Nonetheless, in pursuit of lower rates for its consumers, in 1996, the California legislature created a system that was part free market, part centrally planned economy. This attempt to create an entire market structure from the top down that dictates how market participants interact with that structure, instead of creating a basic framework and allowing a competitive market to develop, has proven to be a complete failure. California did not deregulate its markets, it merely restructured them.

This system resulted in significant market distortions as several factors converged to create the current crisis. Those factors included:

  • Low supplies of power
  • Increased demand for power
  • Rising costs of natural gas and emission credits
  • A lack of market signals to encourage conservation.

Each of these factors has contributed directly to the current California power crisis, but even these factors collectively have not by themselves caused the crisis. Instead, the California crisis is symptomatic of a larger national problem with global implications.

The California model

A fialied model: Utility Distribution Companies (UDCs) were obliged to buy all their power trhough the California Power Exchange, which has now filed for bankruptcy
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It has often been said that all new trends originate west of the San Andreas Fault of creativity. While the UK, Australia, Argentina and Pennsylvania are all global examples of successful deregulation initiatives, for many years California was touted as a model for the world. However, recent events have shown that in fact, rather than a model, California may be a harbinger of what other markets can expect.

As is the case in many parts of the USA, very little generating capacity has been constructed in California over the past three decades. Furthermore, the majority of existing generating units in California, as well as in the rest of the USA, are 35 years old or older and in need of rehabilitation, repair, repowering or replacement.

Much of the blame for the California crisis has been correctly placed on the fact that demand in California over the past decade has risen almost 28 per cent while capacity additions to meet that demand have risen by a mere six per cent. This shortfall is being repeated in several regions around the country and the California crisis has placed a bright spotlight on this capacity shortfall situation.

It is presently estimated that on a national level there is a shortfall in the US of approximately 40 000 MW of capacity, 14 000 of which is represented by the Western Systems Coordinating Council in which California is the largest single component.

Boom or bust?

While California’s power crisis is real and severe, it is entirely possible that the crisis may in fact produce a boom, not a bust, in increased power generation development and deregulation. Thirty-eight states have already implemented some form of deregulation. These states are using California to both reevaluate and reconfirm their deregulation plans.

Many states have recognized that one of the primary causes of California’s failed deregulation system is the fact that it did not put in place the incentives required to allow for construction of new generation to satisfy increasing demand. In those states, such as Texas, which have provided such incentives, deregulation is being implemented at a time when the state is expected to have a capacity surplus of almost 10 000 MW over the next two years. Lenders are already signalling a boom. Recently published numbers indicated over $20 billion in power plant financing in the first quarter of 2001 versus only $24 billion of power plant financing in all of 1999.

One result of the California crisis is that those utilities that have not already divested their generation are recognizing the value in having control over their own power supply portfolios and many utilities have already announced plans to add to their generation asset portfolios because of expectations that price volatility will continue to linger at historically unprecedented levels.

This will likely lead to the end of utility power plant divestitures for the near term and a redevelopment of utility-owned generation. Furthermore, the US is likely to see a return to vertical integration as more utilities follow the convergence models of Duke, Reliant and TXU owing all parts of the supply chain from well head to wall socket.

The California power crisis may also produce a return to long-term power contracting as utilities look to traditional models for managing their supply portfolio. A return to long-term power purchase agreements may result in an increase in non-recourse project financing debt as the utility balance sheet returns to provide back-stop credit for these leveraged financed transactions.

Lessons learned

California seems to have made almost every mistake possible in restructuring its electric power system. The most important lesson to be drawn from this debacle is that future events and their cumulative effects upon electric power markets cannot be accurately predicted. Because of this, deregulated markets must be flexible enough to accommodate the unforeseen stresses that will inevitably occur. Specifically, a successful deregulated market will contain the following characteristics:

  • Deregulation must be accomplished in a phased-in manner with wholesale leading retail
  • Retail demand must be subject to price signals so as to be responsive to market conditions
  • Incentives for the construction of new generation facilities. This must also include a stable set of rules governing the transition to a deregulated market so that investors will have the confidence to build power plants
  • Utilities must be allowed to enter into long-term contracts to both guarantee supplies of power and limit their exposure to price spikes and volatility in the spot market
  • Default prices must be allowed to be set high enough to encourage competition yet low enough to prevent a political revolt that would threaten the implementation of deregulation
  • Incentives should be provided for the construction of new infrastructure across the entire electric and gas supply chain: power generation, transmission and distribution, exploration and production, and natural gas pipelines.