California Restructures Electricity Market—Again

Published July 1, 2009

California regulators are rolling out a new attempt to restructure the state’s electricity market. While the new regime attempts to fix some of the problems that led to the collapse of California’s electricity market in 2000 and 2001, it leaves other potential problems unresolved.

Lessons from Market Crash

In 2000 and 2001, the same-day and day-ahead electricity markets in California crashed and burned. The basic problem was a misguided government attempt to force existing long-term electricity generation and distribution contracts and vertical integration into same-day and day-ahead spot markets where a substantial part of power generation was separated from distribution.

The enabling legislation, AB 1890, was adopted by the California legislature in 1996. In 1998, 40 percent of the state’s power generation was spun off to independent power generators, and the system went into operation. That year the Federal Energy Regulatory Commission determined the prices arising from the wholesale spot markets were “just and reasonable.” While wholesale prices were decontrolled, the retail prices were not (until the costs of stranded investments were worked off).

This arrangement works fairly well when there is no external disturbance to energy markets. During normal times the spot prices are lower than the contract prices because the latter have options premiums embedded in them. From 1998 to early 2000, spot prices were selling at a discount.

However, energy prices—especially for natural gas, the fuel at the margin used to generate electricity—rose in late 2000 and peaked in January 2001. That in turn pushed up electricity prices in the spot markets. This led to mass defaults by the distribution companies and in one case, bankruptcy.

Government Takings

The California Public Utilities Commission, Gov. Gray Davis (D), and other officials petitioned the Federal Energy Regulatory Commission (FERC) to reimpose a cap on wholesale electricity prices. FERC did so in mid-2001, and in 2003 it ordered refunds from the independent power generators.

In other energy markets such an action would be considered a government taking. However, the regulatory power of FERC is allowed to trump the Constitution’s Fifth Amendment prohibition against government takings without compensation. The spot markets were replaced by a system of long-term contracts between power generators and distribution utilities at elevated prices that included options premiums.

Another abrogation occurred in early 2001. The South Coast Air Quality Management District (SCAQMD) canceled the trading of RECLAIM (Regional Clean Air Incentives Market) credits, thereby sparing the incumbent utilities from paying high prices for the credits but depriving other nitrogen oxide emission sources a return on their credits from over-reducing their emissions.

SCAQMD was able to cancel the trading because the enabling regulations denied property right status to the RECLAIM Trading Credits, thereby circumventing the Fifth Amendment prohibition against government takings without compensation.

Three-Year Wait

Soon after the market collapse in 2001, the California Independent System Operator (CAISO) began planning to resurrect the electricity market.

Helping this effort was the 2005 review of CAISO’s plan for reestablishing the electricity spot market. The report’s principal author was Harvard University’s William W. Hogan, one of those who helped design the now-defunct electricity market.

The new market design largely incorporated Hogan’s suggestions. On September 21, 2006, FERC conditionally accepted the plan. On January 16, 2009, CAISO filed its certification of readiness to implement the Market Redesign and Technology Upgrade on March 31, 2009 for an initial trade date of April 1, 2009. FERC gave its approval on March 5, 2009 to “go live.”

Note that three years elapsed between the application in 2006 and the green light in 2009. Approximately 18 months of that was devoted to simulations and modifications. That leaves unexplained about half of the three-year gap. If one had to guess why, the energy price spike in mid-2008 looms as an important possibility: Why introduce the new electricity market under conditions like those that caused the earlier market to crash?

Penalties for Mistakes

The Market Redesign and Technology Upgrade (MRTU) consists of a day-ahead auction of approximately 5 percent of the total electricity consumption in the state. CAISO expects this amount to grow as the long-term arrangements expire.

A complicating feature of the MRTU is that prices are to be established daily for 3,000 “nodes” on the grid. Moreover, there will be a cap of $2,500 per megawatt hour. While this is currently 50 times the prevailing price of electricity in California, it is a potential impediment if another energy crisis emerges.

The obvious goal of pricing 3,000 nodes is to identify where the grid capacity is inadequate. With few trades spread over such a large number of nodes, it is unlikely much if any useful price revelation will occur any time soon.

In the press release accompanying the start of trading, CAISO claimed, “These day-ahead electricity schedules are, for the first time, financially binding—meaning there are financial consequences if market participants do not adequately plan where they are getting their power from and how it will be delivered. This prevents grid operators from scrambling to manage transmission line overcrowding in real time. That is why the new market structure is so important; it provides greater visibility and reliability.”

Time will tell whether these are realistic expectations. The suspicion is that they are not, especially during an energy crisis.

James L. Johnston ([email protected]) is an economist and member of the board of directors of The Heartland Institute.