With the implementation of Security Constrained Economic Dispatch (SCED) as on April, 2019 and an goal towards Market Based Economic Dispatch (MBED), India is paving the way towards a deregulated energy market. This article is a look at the early attempt of the California Energy Market towards de-regulation. As the idioms goes, "Experience is the best teacher"!
Enron was the google of the last decade. It was known for innovation and affecting change to the energy landscape of United States. Though the company built power plants and power lines, their unique addition to the energy sector was the trading of power. They were pioneers in realizing that rather than owning physical assets, they could trade commodities of gas and electric futures to make high margins. Such were their prowess in this unique trading business that they created a market for trading weather futures and internet bandwidth.
Trouble started brewing for the company from bad investment decisions and poor management of the company. For example, they invested in a plant in India at a time when the loss-making Indian utilities were in no position to pay their bills. Further, the 2000 dot com bubble burst added to Enron’s woes. Rather than owning to their mistakes, CEO Jeffery Skilling sought to hide them through accounting fraud and earnings management. Reeling under market pressure to keep the share prices high, he resorted to mark-to-market accounting – i.e., future revenue could be booked without realizing them. SPVs were used to hide Enron’s debt. Fake deals like the Nigerian Barge Deal with Merrill Lynch were perpetuated to falsify the books. Because of conflict of interest with the consultancy and auditing business, Arthur Anderson was complicit in these crimes too.
In the midst of all this, Enron found the golden chip to tide through the crisis temporarily – game the California energy market. By finding loop holes in the de-regulated market space, they were successful in creating artificial scarcity. Selective withholding of generation units allowed strategic bidding- even 100 to 200 times the price, however at the cost of reliability. The result was rolling blackouts throughout California. The regulation in the de-regulated energy sector failed. Ultimately, the regulator and the administration failed to curb opportunistic behavior. California was left with no choice but to pay the price of monopoly rents. The golden state raked in debt to the tune of 20 billion dollars (Wiki, California electricity crisis). Often, Enron is associated to accounting and corporate governance failures. However, very few delve into the details on how it impacted the deregulation of power in the United States. This is an initial attempt to look at the policy and political failures of the deregulated California power market.
Enron was the not the only one to blame for this disaster. State and federal regulators did not plug the loop holes that led to opportunistic price gouging. The policies were flawed from the beginning in the first place. They lacked the teeth to curb monopolistic practices due to certain distinguishing characteristics of electricity. In particular, since electricity cannot be stored efficiently, shortages cannot be alleviated through storage. This can lead to volatile prices and shortages. Also, due to the interconnectedness of the grid, shortages threaten the stability of a synchronized grid . Many opine that the re-regulation of the Californian energy market was a political compromise rather than an analytically driven legislation that considered the aforementioned idiosyncrasies of electricity. Some of these flaws include: -
a) The power exchange and the ISO were kept distinct and failed to address electricity economics. The PX was a day ahead market while the ISO was responsible for maintaining the stability of the grid. This structure was susceptible to gaming by sellers. They soon realized that the ISO would be willing to buy their energy at higher prices than PX to ensure grid stability. This gave the sellers like Enron undue market power.
b) The above situation could have been remedied using forward contracts and long-term contracts. However, investor-owned utilities were required to buy all their power through the PX and could not engage in long-term contracts.
c) Further under the power exchange system, sellers were paid the market clearing price (MCP). Due to lack of forward contracts, there was uncertainty in whether the seller could sell through PX and recoup their fixed costs. Hence, the bid price into PX were higher than the marginal cost.
d) All sellers benefited anytime a more expensive resource was the last bid due to MCP pricing. This was likely to occur when trading through ISO. This incentivized “trading” on the ISO further.
Also, FERC grossly under-estimated the power producer’s ability to exercise market power. It assumed that since not more than 20% of the generation was owned by a single company, there was no fear of monopolistic practices. However, 60% of the generation was not competitively bidding in the market- some were serving their own utility’s demand and others had long term contracts. The remaining 40% remained concentrated at the hands of a few players and this gave them higher market power. FERC was relegated to just being a “paper tiger” with absolutely no control over monopolistic practices.
The above regulations resulted in a market structure that precipitated the tumultuous events in California. Also from 1996 to 2000, the warning signs were masked by the above-average hydroelectric generation in the Pacific Northwest. When that generation was low in 2000, the glaring weakness crippled the energy infrastructure with almost no warning.
Three goals needs to be accommodated for the energy market – 1) System reliability 2) Rate stability 3) Efficiency. Maximization of the above three in impossible. In California, for small efficiency gains, society was asked to incur a risk of dramatic reductions in system reliability and price stability. Policy makers failed to create a policy that balances the above-mentioned goals.
Another facet of the Enron debacle is the reactionary measures adopted – especially from a political point of view. There was a misdiagnosis of California’s problems to that of being that of supply-demand imbalance. This was clearly wrong. There was not a single time when the total system demand was greater than that of the installed capacity. Governor Davis adopted this naïve and false reason to explain the crisis and used the generation of new power plants as an election propaganda. Also,to stem the bleeding, he entered into long term contracts. Suppliers took advantage of the situation and sought higher rates. Unable to pay these high rates, PG&E filed for bankruptcy and the state department of water resources had to pick up the tab to keep the lights on. This misdirected focus on supply-demand imbalance led to a massive transfer of wealth from the public to power traders – a wealth that cost the California taxpayers billions of dollars in missed opportunities at least the next fifteen, twenty years.
The rationale for “Utility consensus” - i.e., concerns over access to power, discriminatory policies by monopolists - stand strong when the policy and legislation is weak. The Enron debacle showed that weak policies can lead to monopolistic practices – the very reason the utility consensus was adopted before the deregulation. The very dream of “unleashing the creative energy though competition” had turned into a nightmare due to legislative, administrative and political failures.