California Electricity market crisis: causes, remedies, and prevention - IEEE Power Engineering Review C. Mensah-Bonsu, S. Oren California Electricity Market Crisis: Causes, Remedies, and Prevention The competitive electric power market of the stateof California began operation on 31 March 1998 with the California Independent System Operator (California ISO) and the now bankrupt Power Ex- change (PX) as the main operationally independent market facilitators. The market took off smoothly, and the prices were seemingly just and reasonable until May 2000, when the first signs of market crisis emerged. This marked the beginning of the California powercrisis thatcontinueduntil aboutMay2001.Dur- ing that period, California was confronted with an un- precedented electricity crisis that threatened to undermine the reliability of its electricity system, weaken its economy, and impact energy markets throughout the western part of the United States. Root Causes of the Crisis The initial causes of the high wholesale market prices reflect a complex mixture of: � Drought conditions that reduced hydroelectric powerproduction(particularly in thenorthwest re- gion)andcorrespondinglowpower-import levels � Growingeconomythat fueleddemandforpower � Dramaticallyhigherandvolatilenaturalgasprices � Lack of sufficient generating capacity in Califor- nia and throughout the U.S. western region � Inadequate transmission infrastructure � Inadequate demand responsiveness or lackof de- mand elasticity � Lack of forward contracting � Forward scheduling that resulted in thehuge reli- ance on the spot market � Federal Energy Regulatory Commission’s (FERC) hands-off approach in regulating whole- sale markets. These anomalies, among others, culminated into a “perfect storm”andconsequently led to the significant marketpowerabuses inCalifornia.Theproblemswere further compoundedby thepotential financial insolvencyof the investor-owned utilities (IOU). The increasing deterioration of the financial solvency of California’s three IOUs further shat- tered all vestiges of a “normal” deregulated electricity market. Effectively, the California ISO, IOUs, and state government overseers had to resort to desperate measures in keeping the lights on in California with the limited available resources. The crisis had its origins in the unintentional mistakes and miscalculationsadoptedat the time theelectricity sectorwas re- structured in California through the Assembly Bill 1890 (AB 1890) in 1996. Two mistakes stand out as critical. � California required utilities to make nearly all their elec- tricity purchases on a volatile spot basis, divest a substan- tial portion of their generation without allowing them to enter into long-termcontracts toensurestableand“reason- able”pricesduring the transitionperiod followingderegu- lation.The lackofdemandresponsiveness tohourlyprices 4 0272-1724/02/$17.00©2002 IEEE IEEE Power Engineering Review, August 2002 C. Mensah-Bonsu is with the California ISO, Folsom, California, USA. S. Oren is with the University of California, Berkeley, California, USA. © D IG IT A L S T O C K 1 9 9 7 Authorized licensed use limited to: Univ of Calif Berkeley. Downloaded on March 19,2010 at 18:56:01 EDT from IEEE Xplore. Restrictions apply. werepartly due to technical capa- bility limitationfor real timeprice responsiveness, ambiguous ac- countability for the acquisition of reasonably-pricedpowerfor retail consumers, and lack of adequate forward contracting for energy. Transition contracts are found in every successful electricity mar- ket, as well as in other unregu- lated commodity markets, and are particularly important where the utilities divest generation but haveobligations to serve remain- ing customers. � California froze retail rates at low levels and banked on low whole- saleprices tosupportaprofitmar- gin high enough to enable the utilities to pay off historical, un- economic investments, including strandedcosts.Althoughfrozenat 10% below 1996 levels, the rates were supposedly high at the time compared to what a competitive market would presumably have produced. The fixed retail level price discouraged end-users from undertaking nor- mal market responses: to conserve and/or to take advan- tage of the allowed customer choice and opt for an alternative retail supplier. Those responses would have helped restrain prices. InMay2000,wholesalemarketpricessoareddue to risingde- mand, and dramatically fixed retail prices blocked conservation effortsbyinsulatingconsumersfrommarketrealitiesandreduced 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. Impact of Stakeholders and Credit-Worthiness The energy prices were low to moderate in the first 2 years. However, the IOUsmanaged to sell a goodportionof their gen- eration assets at attractive prices, expediting the recovery of stranded costs, presumably due to the reliability must-run (RMR) contracts that most of the divested units had, which en- abled them to sell above book value. Unfortunately, the utilities hadalreadydivestedmostof their generationplantswithoutbe- ing allowed by the California Public Utility Commission (CPUC) to secure contracts that would have ensured their right tobuyback thepowerat somefixedback-stopprice.TheCPUC felt that suchcontractswouldaddunnecessarycosts toconsum- ers’electricitybills andwereconcernedabout “self-dealing”by theutilities.Thedivestituresofgenerationassets by theutilities that were encouraged and sanctioned by the CPUC exposed the utilities to the financial costs associated with high wholesale (purchase) prices and low fixed-retail (sale) prices. Meanwhile, the IOUswere losingmoneyon theelectricity theywerebuying for resale to their customers.The inversionof the typicalwhole- sale-retail price relationship brought these utilities to the brink ofbankruptcy.Theperceived riskofnonpayment in turncaused generators to be reluctant suppliers, even at dramatically ele- vated wholesale prices. The natural reluctance of suppliers to supply voluntarily when they did not expect to get paid was a substantial contributor to the rising prices and rolling blackouts that were seen in California in the early months of 2001. The destruction of the utilities’credit-worthiness and the re- sulting responsesby suppliers shattered all vestiges of anormal market. Consequently, California had to deal with both a finan- cial crisis and an electricity supply crisis. With the utilities’ credit quality destroyed, suppliers fearful of not being paid for their supplies became reluctant to sell into the California mar- ket. In effect, the utilities and their state government overseers had to resort todesperatemeasures tokeep the lightsonwith the available limited resources, with only limited success. CA ISO energy control center employees worked diligently to keep the lights on, a task thatwason-goinguntil FERCorderedamarket mitigation framework in collaboration with the California ISO inDecember2001 to ensure stability, and“just and reasonable” prices in the California ISO electricity markets. However, this framework,whichwasorderedbyFERCtostop the“bleeding,” expires on 30 September 2002. IEEE Power Engineering Review, August 2002 5 A section of the California ISO control room, with (left to right): Anjali Sheffrin, director of the department of Market Analysis; Chris Mensah-Bonsu, market design engineer, Market Operations; Mark Rothleder, manager of Market Integration California Crisis and Its Impact on Worldwide Energy Markets This article is part of a series on the California energy crisis of 2001 and its impact on other energy markets and their deregulatory/reregulatory actions. These articles are based on presentations given at two separate technical ses- sions held during the 2001 IEEE PES Summer Meeting in Vancouver, British Co- lumbia, Canada: California Electricity Market Crisis: Causes, Remedies and Prevention was chaired by Chris Mensah-Bonsu of the California ISO; Is Dereg- ulation at a Dive after California? A View from the Rest of the World, was chaired by T.J. Hammons of the University of Glasgow. Both sessions provided learned opinions of the causes of the crisis and tried to assess possible aftereffects on the regulatory processes occurring worldwide. I took the liberty of selecting the articles that I considered most relevant. I hope you enjoy them and gain some new insight into the complexity of the over- all process. Bill Schwartz, editor in chief (continued on page 11) Authorized licensed use limited to: Univ of Calif Berkeley. Downloaded on March 19,2010 at 18:56:01 EDT from IEEE Xplore. Restrictions apply. Index: CCC: 0-7803-5957-7/00/$10.00 © 2000 IEEE ccc: 0-7803-5957-7/00/$10.00 © 2000 IEEE cce: 0-7803-5957-7/00/$10.00 © 2000 IEEE index: INDEX: ind: Intentional blank: This page is intentionally blank