1/26/2001

MANIFESTO ON THE CALIFORNIA ELECTRICITY CRISIS
 




                    Generated and endorsed by an ad-hoc
                    group of concerned professors, former
                    public officials, and consultants.




                    Convened under the auspices of the
                    Institute of Management, Innovation,
                    and Organization at the University of
                    California, Berkeley.




                     PREAMBLE

      We, the undersigned, an ad-hoc group of professionals with experience in regulatory and energy economics, share a desire to help end the current crises, and to do so by using public policy solutions that enhance consumer welfare and economic well-being.

      We have convened under the auspices of the Institute of Management, Innovation and Organization at the University of California, Berkeley, and embrace faculty from other universities, former public officials, and consultants. We put forward our own ideas. We do not pretend to be "representative;" nevertheless we cut across a wide range of backgrounds and expertise. Our common goal is to see California solve its current energy crisis and develop a well-performing electricity sector.

      We have come together quickly because we are alarmed. A financial crisis caused by extremely high wholesale prices compounded by concerns about ability to pay has exacerbated already tight supplies and led inevitably to rolling blackouts. Rolling blackouts impose tremendous social and economic costs on California society and threaten to wreck its economy. The situation is very serious and endangers the livelihoods of many citizens in and out of state. The situation does not appear to be well understood.

      Electricity has now become a political commodity, not an economic one. As a consequence, we no longer have just an electricity crisis; we have a serious financial crisis as well. If not managed astutely, the collateral damage to other industries and states could well be quantitatively more significant than the direct damages to California electricity consumers and distributors.

      This manifesto endeavors to provide a clear, fair and effective way out of the current financial-energy crisis.


           MANIFESTO ON THE CALIFORNIA ELECTRICITY CRISIS

The Crisis

      California is confronting an unprecedented electricity crisis which threatens to wreck its economy and cause collateral damage throughout the West. The initial causes of the high wholesale market prices reflect a complex mixture of a faulty restructuring plan, faulty regulation, environmental regulations, and unanticipated reductions in the supply and increases in the demand for electricity. These problems have now been compounded by the potential financial insolvency of the investor-owned utilities. The financial crisis must be solved immediately. Accomplished properly, there will then be the opportunity to develop and apply long-term solutions that enhance supply, reduce prices and encourage conservation.

      The crisis had its origins in mistakes and miscalculations at the time the electricity sector was restructured. Two of many shortcomings stand out at the present time. First, utilities were strongly encouraged to divest a substantial portion of their generation, while being blocked by CPUC regulations from entering into stable long-term contracts. Put differently, the utilities were forced to procure their unmet needs on the spot market where extreme price volatility has been realized, especially in the past year. Second, California froze retail rates at low levels and banked on low wholesale prices to support a profit margin high enough to enable the utilities to pay off historical, uneconomic investments.

      This arrangement appeared to work with only modest problems for two years. However, since May of this year, wholesale market prices soared, due to rising demand, dramatically higher natural gas prices, lower imports from other states, and strategic behavior by suppliers. Fixed retail prices blocked conservation efforts by insulating consumers from market realities and reduced consumer incentives to turn to competitive retailers. The heavy reliance on spot market purchases, combined with demand that was unresponsive to prices, helped drive prices higher.

      Meanwhile, the investor-owned utilities are losing money on the electricity they buy for resale to their customers. The inversion of the typical wholesale-retail price relationship has brought these utilities to the brink of bankruptcy. Perceived risk of nonpayment has in turn caused generators to be reluctant suppliers, even at dramatically elevated wholesale prices. The natural reluctance of suppliers to supply voluntarily when they did not expect to get paid was a substantial contributor to rising prices and rolling blackouts during the past month.

      The destruction of the utilities' credit and the resulting responses by suppliers has shattered all vestiges of a normal market. As a consequence, California now has both a financial crisis and an electricity supply crisis.

      The first crisis must be dealt with immediately before it gets further out of hand. If the credit worthiness of the investor-owned utilities can be restored, California can both solve the immediate supply shortage problems resulting from credit risks and then look to proper long-term solutions to its electricity problems.

Restoring Market Stability and Credibility

      Solving the financial crisis will require sharing the pain amongst the various stakeholders. But an essential element of the solution is to raise retail prices on at least the volume of electricity which the investor-owned utilities do not self supply and to commit to recovery of a sufficient fraction of their accumulated debt to allow them to return to the credit markets to finance their obligations to suppliers and their ongoing investment responsibilities. Raising rates would have the salutary effect of both causing some reduction in demand (which would itself help reduce wholesale prices) while simultaneously restoring financial viability to the utilities, thereby eliminating a risk premium in the current wholesale supply price of electricity and bringing more supplies to California, reducing the likelihood of shortages. Restoring the credit worthiness of buyers would both reassure investors in existing plants that they will get paid if they supply and reinstate the confidence of investors in the many new generation projects in the construction and permitting pipeline that their investments will pay off in the future. A virtuous circle of this kind could settle down the wholesale market quickly. Unfortunately, there is no other way out. Either retail prices go up, or the frequency of rolling blackouts will accelerate, absent even more costly and draconian governmental measures.

      The long-run solution requires creating an environment in which the market can work more effectively. Four key elements must be an integral part of that solution: freedom to engage in long-term contracts, retail price flexibility, competition at both the wholesale and retail levels, and more effective cooperation between federal and state regulators to fix a variety of market imperfections and resulting market performance problems. Some of this will take time, but experience in other jurisdictions in the US and abroad indicates that benefits from deregulation are indeed achievable.

      Quick action must be taken to manage the crisis. It is also important to avoid actions which will make matters worse, or simply push the problems on to taxpayers. In particular, a state takeover of the business would make matters worse, as would turning the State into a permanent electricity purchasing authority. It would also be unfortunate if the State were itself to commit to long-term contracts for a large portion of California's electricity needs. The State's credentials as an astute player in the electricity market aren't impressive, and there is no reason to expect major improvement in the future. Accordingly, emergency state contracts should be avoided if at all possible. Nor would the State buying up existing generation assets add to supply. In the end, new power plants are needed, and the State should focus on creating a supportive environment for necessary new private investment. State ownership is not a solution at all merely a guarantee that the taxpayers will be saddled with additional obligations for decades to come.

      In crafting new arrangements to solve the short-term problems, two fundamental points must be recognized. First, putting questions of bankruptcy law to one side, there must be a firm commitment to pay all legitimate power bills, those so far incurred as well as those to be incurred in the future. Such arrangements will require some sharing of the pain amongst the various stakeholders. Second, there must be a firm commitment to raise the retail price at least for incremental energy usage to a level sufficient to cover the bills and provide an incentive for conservation and demand-side responses.

      We see no escape from the harsh reality that the California Public Utilities Commission must raise customer prices at least for incremental electricity usage. For now, the major utilities can maintain existing rates for the volume of electricity that they generate themselves or already have under lower-cost long-term contracts. But the retail prices for any usage above some base level must be raised to the market price. This approach should preserve the commitment to maintain rates for some portion of the electricity production over which California has control. It would also promote conservation, including voluntary demand reductions and self-supply efforts which, in turn, will help reduce wholesale prices by taking some pressure off the market. Time-of-use rates would be even better, where metering is available. But quick action is required to ensure that retail prices reflect fundamental scarcity. Each additional day under the current unsustainable price caps adds to the problem and makes the crisis more difficult to resolve.

      Immediate commitments to meet obligations and raise the retail prices on all power not under California's control would improve conditions for longer-term contracts, and reassure investors in new California power plants. Without these commitments, rational suppliers will continue to demand high spot prices. Anticipation that future spot prices will be high, will cause long-term contract prices to be high. Furthermore, the chance that some obligations might not be met will also keep prices high. But if the market going forward can include reduced demand, required spot and contract prices should fall.

      There is no other way out. Either retail prices must go up, or blackouts will continue with the consequent high costs to the California economy. Facing the pain now should reduce the ultimate price increase. We must put the horse before the cart. We must raise the retail price for electricity usage for at least those volumes that cannot be secured at existing rates. Only then should we seek contracts to help stabilize prices for the two- or three-year transition until more permanent solutions can be put in place, specially as new power plants already approved (totaling some 6,000MW) come on line over the next two years.

      A number of groups and individuals have expressed concerns that wholesale market prices have increased beyond what would be expected merely from changes in supply and demand conditions in a competitive market as a result of suppliers engaging in strategic behavior aimed at reducing supplies and driving up prices. We are of different opinions regarding the existence or importance of the effects of such inappropriate behavior. However, it is clear that the faith of many California stakeholders and government officials in competitive electricity markets will only be restored if these market power issues are properly and fully evaluated and resolved. Accordingly, we urge FERC, the CPUC and the ISOs Market Surveillance Committee to work together to gather and analyze the information necessary to identify any such problems and to implement market reforms to fix them. At the very least, resolving the allegations of market abuse in a fair way, and implementing any indicated reforms, will help to gain support for the view that the retail price increases are justified by changes in competitive market conditions. However, we must not let this debate detract from dealing with the fundamentals.

Looking To The Long Run

      The long-run reforms that will ensure that similar crises do not reappear in the future require creating an environment in which the market can work. California's flawed efforts at deregulation have not yet allowed this to occur. For the price mechanism to allocate resources effectively, supply and demand pressures must be allowed expression, and not be impeded by unnecessary rules and regulations. Competition must exist to discipline pricing. Absent these elements, market solutions simply won't produce satisfactory results. Experience in other jurisdictions in the U.S. and abroad indicates that effective deregulation works and works well where adequate care is taken in restructuring rules and market design.

      Three key elements compose the right long term approach: freedom to engage in long-term contracts, retail competition and pricing flexibility, and a competitive market environment. It is critical that distribution companies be allowed to enter into long-term contracts in a way that is symmetrical with the commitments of their customers to pay for the associated costs. Long-term contracts provide generators the confidence that they can recover their investments, while granting utilities and their customers protection against price spikes. In the long run we expect to see participants in the industry adopt a judicious balance of long term, medium term, and short-term (spot) contracts. The investment and permitting environment must also be such that additional power plants can be built expeditiously. Only by allowing new entry will rigorous competition characterize the marketplace, letting Californians enjoy supply reliability, efficient supply, and competitive prices. As the long term contracting process takes hold, the influence of spot market prices on rates will drop dramatically. While spot prices may remain high until the real electricity supply expands, Californians' reliance on the spot market will be reduced.

      Second, California should not abandon its goal of fostering retail competition. New competitors need the ample, stable and reliable electricity supplies that a reformed market system will promote. Retail competition can help bring new types of contracts and metering systems, and better awareness of environmental effects as entrants introduce "green" packages, and demand-side innovations. This is another reason why consumers must pay the real cost of electricity, as retail competition cannot thrive in an environment in which supply companies lack retail pricing freedom. As a consequence, companies involved in retail supply, including the California utilities, should be allowed to pass-through their energy costs in a competitive environment.

      Finally, oversight of the electricity business will always be needed. The cornerstones of electricity regulation must be oversight of the distribution function, and ensuring that any anticompetitive behavior by suppliers is circumscribed.

Critical Mistakes California Must Avoid Now

      California must act quickly to manage the crisis, and we have outlined the essential elements of the solution. The atmosphere is currently too politicized. We are fearful that a rush to seek easy solutions will make matters worse, and shackle the economy and consumers for many years to come. Accordingly, we also offer advice on what not to do.

   1. Don't solve today's crisis by foreclosing tomorrow's solutions.

      As explained earlier, we now face an immediate financial crisis in finding credit (and cash) to keep the lights on. But this crisis is different than the longer-term answer to California's energy woes. We need to bridge the immediate financial gap without making quick and ill-considered irreversible commitments that will hamstring future solutions. Solving the financial crisis will also calm the electricity markets and allow better long-run answers to be found.

      For example, the current crisis can be addressed without problematic steps such as trying to isolate California from the western electricity market, turning the State into the permanent electricity purchasing authority for consumers, or committing taxpayer funds to large energy-related projects. Thoughtful long-run answers will be easier to recognize once the crisis is eliminated.

   2. Don't over-commit to long-run electricity contracts.

      Electricity prices are now high because of the credit risks of the utilities, high natural gas prices, reduced supplies from other states, unprecedented outages of generating plants in California, high prices for NOx emissions credits, and inflexible electricity demands by customers. Prices will fall when the financial crisis is managed, and retail price increases and conservation help moderate customer demands.

      Now is precisely the wrong time for the State to commit to long-term contracts for a large portion of California's electricity needs, since below-market prices now can only come at the expense of above-market consumer prices in years to come which would create new problems. Emergency State contracts should last no more than two years, and should be kept small.

   3. Don't nationalize California's electricity system.

      New government ownership of generation and distribution facilities won't solve the crisis or deliver below-market power prices. The State must pay full market value for any plants it acquires, even though record electricity prices also mean record purchase prices for energy facilities. For consumers to obtain bargain electricity rates would then require permanent taxpayer subsidies saddling the State budget in perpetuity.

      It is bad public policy to have taxpayers take up the risks of financing new generation plants in a volatile market. The risks of electricity investments can be managed by the private sector, where profit and loss incentives will minimize electricity costs for California.

In Sum

      California has a crisis which has been deepened by inaction, and by political tradeoffs trumping good public policy analysis. Time is running out. Electricity should not be a political commodity. The laws of supply and demand cannot be ignored except at great peril.



LIST OF MANIFESTO ENDORSEES

NAME AFFILIATION/ADDRESS ENDORSE
Berg, Sanford V.





Distinguished Service Professor--
Economics
Director, Public Utility Research Center
University of Florida
Tel: 352-292-0132
berg@dale.cba.ufl.edu
YES





   
Campbell, Tom






Professor
Stanford Law School
Stanford University
243 Stanford Law School
Stanford, CA 94305
Tel: 650-725-6869
campbell@law.stanford.edu
YES






   
Chandley, John






Principal
Law & Economics Consulting Group
350 Massachusetts Avenue
Suite 300
Cambridge, MA 02139
Tel: 617-761-0118
john_chandley@lecg.com
YES






   
Danner, Carl



Former Chief of Staff to the
President of the California
Public Utilities Commission
cdanner@wilkandassociates.com
YES



   
Demsetz, Harold








Professor Emeritus
Department of Economics
UCLA
8283 Bunche Hall
Box 951477
Los Angeles, CA 90095-1477
(310) 825-3651 (Office)
(310) 825-1011 (dept.)
hdemsetz@ucla.edu
YES








   
Farmer, Roger E.
rfarmer@econ.ucla.edu YES
   
Friedman, Lee









Lee S. Friedman
Professor Of Public Policy
Richard & Rhoda Goldman School of Public Policy
University of California at Berkeley
2607 Heart Avenue #7320
University of California, Berkeley
Berkeley, CA 94720-7320
Tel: 510-642-7513
lfried@uclink.berkeley.edu
YES









   
Gilbert, Rich





Professor
Department of Economics
549 Evans Hall #3880
University of California, Berkeley
Berkeley, CA 94720-3880
gilbert@econ.berkeley.edu
YES





   
Hogan, William W.





Professor
John F. Kennedy School of Government
Harvard University
Cambridge, MA 02138
Tel: 617-252-9994
william_hogan@harvard.edu
YES





   
Joskow, Paul









Professor Paul L. Joskow
Elizabeth and James Killian Professor of
Economics and Management and
Director, MIT Center for Energy and
Environmental Policy Research
MIT
Cambridge, MA 02142-1347
phone: 617-253-6664
fax: 617-258-7070
pjoskow@mit.edu
YES









   
Kleindorfer, Paul R.









Universal Furniture Professor
Professor of Operations &
Information Management
Professor of Public Policy &
Management
The Wharton School
University of Pennsylvania
Tel: 215-898-5830
Fax: 215-573-2130
kleindorfer@wharton.upenn.edu
YES









   
Lahiri, Amartya





Department of Economics
UCLA
8283 Bunche Hall
Box 951477
Los Angeles CA 90095-1477
lahiri@econ.ucla.edu
YES





   
Lawrence, Robert Z.






Professor
John F. Kennedy School of Government
Harvard University
79 John F. Kennedy Street
Cambridge, MA 02138
Tel: 617-495-1118
robert_lawrence@harvard.edu
YES






   
Lewis, Tracy R.






University of Florida
Department of Economics
224 Matherly Hall
PO Box 117140
Gainesville, FL 32607
Tel: 352-392-1154
lewistr@dale.cba.ufl.edu
YES






   
Marnay, Chris






Staff Scientist
Ernest Orlando Lawrence
Berkeley Nat'l Laboratory
1 Cyclotron Road
Berkeley, CA 94720-0001
Tel: 510-486-7028
c_marnay@lbl.gov
YES






   
McFadden, Dan




Professor
Department of Economics
University of California, Berkeley
mcfadden@econ.berkeley.edu
(Nobel Laureate)
YES




   
McLeod, Phil





LECG
2000 Powell Street
Suite 600
Emeryville, CA 94608
Tel: 510-450-5441
phillip_mcleod@lecg.com
YES





   
Michaels, Robert




Department of Economics
California State University, Fullerton
Fullerton, CA
Tel: 714-278-2588
rmichaels@fullerton.edu
YES




   
Ohanian, Lee








Associate Professor
Department of Economics
UCLA
8283 Bunche Hall
Box 951477
Los Angeles CA 90095-1477
(310) 825-1011 (dept.)
(310) 825-9528 (fax)
ohanian@econ.ucla.edu
YES








   
Oren, Shmuel S.





Professor of Industrial Engineering and
Operations Research
University of California, Berkeley
Berkeley, CA 94720
Tel: 510-642-1836
shmuel@euler.berkeley.edu
YES





   
Ostroy, Joseph M.







Department of Economics
UCLA
8283 Bunche Hall
Box 951477
Los Angeles CA 90095-1477
(310) 825-4627 (Office)
(310) 825-1011 (dept.)
ostroy@econ.ucla.edu
YES







   
Ruff, Larry




1221 Jones St., #A4
San Francisco, CA 94109
Voice: 415-440-0654
Fax: 415-440-3573
leruff@attglobal.net
YES




   
Rumelt, Richard





The Anderson School
University of California, Los Angeles
PO Box 951481
Los Angeles, CA 90095-1481
Tel: 310-206-6553
richard.rumelt@anderson.ucla.edu
YES





   
Spiller, Pablo






Professor
Haas School of Business
S545 Student Services Bldg.
University of California, Berkeley
Berkeley, CA 94720-1900
Tel: 510-642-1502
spiller@haas.berkeley.edu
YES






   
Solow, Robert


Department of Economics
MIT
(Nobel Laureate)
YES


   
Sweeney, James








Professor, Management Science and
Engineering
Senior Fellow, Stanford Institute for
Economic Policy Research
323 Terman Engineering Center
Stanford University
Stanford, CA 94305-4026
Tel: 650-322-9835
Jim.Sweeney@stanford.edu
YES








   
Teece, David







Director
Institute of Management,
Innovation & Organization
F402 Haas School of Business #1930
University of California, Berkeley
Berkeley, CA 94720-1930
Tel: 510-642-1075
teece@haas.berkeley.edu
YES







   
Verleger, Philip



PK Verleger LLC
Newport Beach, CA 92660
Tel: 949-640-0563
pverleger@compuserve.com
YES



   
Wilk, Mitch








Former President and Commissioner of
the California Public Utilities Commission (1986-1991)
Law & Economics Consulting Group
100 Bush Street
Suite 1650
San Francisco, CA 94104
Tel: 415-398-2000
mwilk@wilkandassociates.com
YES








   
Williamson, Oliver






Professor
Haas School of Business
S545 Student Services Bldg.
University of California, Berkeley
Berkeley, CA 94720-1900
Tel: 510-642-8697
owilliam@haas.berkele.edu
YES






   
Yellen, Janet






Professor
Haas School of Business
S545 Student Services Bldg.
University of California, Berkeley
Berkeley, CA 94720-1900
Tel: 510-643-1397
yellen@haas.berkeley.edu
YES






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