On Friday the Wall Street Journal reported that, "California's power crisis is becoming a hot selling point for competing states hoping to lure away businesses that feel stung by rolling blackouts and high energy prices." (W. Pinkston, "Rival States Pitch Power to Woo California Firms," The Wall Street Journal A4 (January 26, 2001).The Journal writers go onto to report that economic developers in states like Nevada are hatching strategies, including media advertising campaigns, aimed at luring energy dependent California jobs and businesses. What is their selling point? The news that the Silver State has put the "brakes on the kind of energy deregulation that left its neighbor in a lurch." I am certain that I am not the only individual in this room who sees the bitter irony that a reform effort designed to address a price disparity has now added reliability concerns to cloud California's economic future.

For six months I have resisted local and national media requests, and even the odd international reporter, that I comment on the unfolding problems with the implicit invitation to either assume or cast blame. I did so for a number of good reasons, none of which has changed. First there was the fact that as of December 31, 1996, I had left the keys on the desk and acknowledged that the responsibilities of an office I had been privileged to hold had devolved on my successor. The notion of hanging around like the ghost of Christmas past to kibbitz the decisions of my former colleagues and successors, as they sought to implement the Commission's policy decision and the subsequent California legislation, was repugnant.

Now, however, I am persuaded to offer some observations and a suggestion in hope of joining the voices seeking to direct California officials toward an understanding of the major causes and, more importantly, to advance a reform that may ease the immediate situation. I will confine myself to offering personal opinions on three questions: 

1. What is the primary factor contributing to the present pricing crisis in the western part of the United States?
2. What feature of the reformed energy markets in California has allowed this factor to be amplified with such devastating intensity in determining energy prices in California? and
3. If I could recommend one reform strategy to Governor Davis, the California Legislature, and my successors at the Commission to ease the crisis, what would I suggest?

With respect to each of these topics what follows are strictly personal observations. Whether they coincide with or contradict the opinions of any of my partners or clients of the firm I do not know. I have not asked them.

In my view the many factors that have contributed to this shortage can be summed up in the statement that in the west we are the victims of our current, prosperity-induced energy demand combined with the apparent conviction that an endless supply of electricity can be obtained from a static number of baseload and load-following generating facilities. While this problem is most exaggerated in California where air quality, land use and related environmental concerns have conspired to preclude the construction of a major power plant during the entirety of the 1990's, urban areas like Las Vegas and Salt Lake City are also experiencing accelerated population growth unsupported by adequate generation.

If I am correct in linking the price problem to an imbalance between a static supply and a growing demand, then the overlooked fact in most press coverage is that California and other sectors of the western markets would be in trouble regardless of the regulated or unregulated nature of the energy infrastructure a factor which, I suspect, is not mentioned in that Nevada sponsored media blitz. This problem had been masked by the deep regional and national economic recession of the early and mid-1990's. Indeed, at the time the California Commission concluded the investigatory portion of its reform agenda, there was broad consensus that the western region enjoyed a thirty to forty percent excess in generating capacity, and that it would take more than a decade before demand could grow back to the levels of 1991. Whatever the accuracy of the estimated dimension of the generating capacity excess, the guess concerning the time and strength of the economic recovery was grossly in error. But the stage had been set. The blessing and curse of the California reforms is the deployment of market mechanisms that unearthed the problem of rapidly shrinking reserves in a time frame which did not accommodate a solution.

What feature of the reformed energy markets in California has allowed this factor to be amplified with such devastating intensity in determining energy prices in California? 

Answer: the separation of the Power Exchange from the Independent System Operator.

The discussion and debate occasioned by the Commission's famous Yellow and Blue Book studies accepted the staff conclusions that generation had long ceased to be the exclusive province of California's vertically integrated utilities, and the state had long ceased to be self-sufficient in terms of energy production. In order to meet recurrent load factors the California of 1993 found it necessary to import electricity and was even more dependent on the importation of natural gas to sustain a growing percentage of in-state generation. Along with others, I judged these hard facts to be part of an enduring, not transitory reality. We reacted by seeking to create a liberalized market structure conducive to region-wide competition in the generation of electricity to the end that any generator, connected to the regional high-voltage transmission grid, could bid to serve the California load via displacement. Indeed, the California Commission decision was openly premised on a silent assumption of the subsequent state legislation: that our reforms embodied the ambitions of a buyer who desired to foster competition using market mechanisms which were transparent to both buyers and sellers. This quality of transparency was critical because of an assumption that the government should exit the roles of central planner and orchestrator of generation additions and, instead, rely upon the industry's ability to react to timely and accurate price signals to determine the sequence and location of new generation.

Originally the Commission's May, 1995 proposed policy decision sought to accomplish all of these goals by fostering a power pool. A 3--1 majority on the Commission envisioned a power pool that would consolidate California's demand for electricity on a forecast basis; invite the electronic submission of bids from in and out-of-state generators capable of utilizing the regional transmission grid; select the least costly set of generators; and configure California's transmission resources in real time to accommodate receipt and distribution of this energy. The proposed power pool was to operate on a wholesale basis for the first three years after which elements of retail competition were to be introduced. Consistent with the open and participatory process that we had developed, the Commission indicated that it would gather oral and written reaction to the proposed policy over the ensuing six months with a view to adopt a final policy decision in December.

In the fall of 1995, reflecting the broad based participation in the Commission rulemaking and the intensity of an inherently political process, a Memorandum of Understanding was published with the support of the state's largest electric utility, the California manufacturing association, the association of independent power producers and a number of prominent energy firms poised to enter a liberalized California market. The single most important modification of the Commission's proposed decision was the MOU's insistence that the functions of market maker and transmission asset operator be severed and assigned to two distinct, unrelated entities. The Commission's final order adopted this suggestion and thus were born the California Power Exchange and the Independent System Operator.

The immediate consequence of this accommodation was support from the signatories of the MOU and their cooperation in the complex process of implementing the reform agenda most of which was accomplished after the expiration of my term of office. Though delayed by what were said to be technical difficulties in the writing and testing of computer programs which lay at the heart of both the PX and ISO functions, these dual entities enjoyed broad support by all segments of the industry including some consumer groups. They were enshrined in the confirming legislation passed in 1996 which added the concept of an immediate 10 per cent rate reduction for residential and small commercial energy users and an authorization to securitize a portion of the anticipated Competition Transition Charge. As my successors embarked on implementation, two other accomplishments reflected broad industry support: (1) the transfer by the investor owned utilities of operational control over their transmission assets to the ISO and (2) the avoidance of litigation challenges to any aspect of the reform package.

Little did I realize that the market design to which the Commission and Legislature had acceded would turn out to bear a striking resemblance to the battle cruiser, that ill-fated darling of virtually every naval power in the period 1910-1914. At Jutland it was belatedly discovered that these vessels, imbued with attributes of speed and weaponry that made them so appealing on paper, could not take a punch. Their armor was too thin a fatal design flaw revealed only when they were tested in battle.

In my opinion, both the PX and ISO functioned admirably from March 31, 1998 until sometime in the second quarter of 2000. They achieved the state's goal of transparency. The PX was responsible for day and hour ahead nominations against forecast load, and the ISO adjusted the nomination in real time to account for transmission constraints.

The initial experience with the price of electricity the commodity was encouraging. In 1993, as California began the slide into what was to develop as a devastating recession, the average cost of SDG&E's generation was 6.7 cent per KWh. PG&E's was virtually identical while Southern California Edison's stood at just over a nickel. By the summer of 1999 when, by general consensus, prosperity had returned, prices had fallen. Taking July 19, 1999 as a typical summer day, the cost of electricity as a commodity was 1.35 cents per KWh in the PX during the off-peak hours of 3---6AM and 4.2 cents per KWh during the peak hour of 4---5PM. But July 24, 2000 price signals were pointing in a very different direction. The PX auction was clearing at 2.47 cents per KWH in the early hours of the morning and had reached 49.3 cents in the peak usage hour of 4---5PM. Sellers of generation watched as the California market appeared to take these price figures in stride. Thus was born the summer, fall and winter of California's discontent.

The history since May of last year is mired in accusation and dispute. Investigations have yet to run their course and I would not presume to forecast their outcome. It is alleged that suppliers took but a little while to realize that if they omitted to bid all of the energy into the PX which they intended for sale to California, the ISO would be forced to conduct a supplemental auction under increasingly desperate circumstances. The utilities are also accused of hobbling the Power Exchange by a retaliatory excursion into the world of fiction: they would short the forecast load in the day ahead market. Neither of these accusations has been established but in my mind it is clear that the separation of the PX from the ISO renders the California markets particularly vulnerable to opportunistic behavior. Had the all-in-one-power pool survived the MOU there would have been no second chance to auction withheld, as opposed to constraint relieving, capacity. The state's utilities, and ultimately its consumers, would have been spared two capacity auctions each of which awarded all sellers the price of the last increment of supply needed to meet demand.

Governor Davis, the Assembly Speaker, members of the Public Utilities Commission, and other state leaders are pressing for a solution to the state's energy crisis. To their credit, all appear to recognize the need for new plant capacity in California. It interesting to note that a similar conclusion has been formed in the minds of the Governors of both Nevada and Utah. But the construction of new generation will take a couple of years at a time when the terms of the market pose an immediate threat. Lending the state's credit may ease the reliability crisis occasioned by the reluctance or refusal of sellers of both gas and electricity to regard California's investor owned utilities as credit worthy buyers for which the Power Exchange and ISO are conduits. Others would like to see the state, itself, become a party to long term power purchase contracts in order to ensure supply and bring stability to prices.

Without seeking to question either strategy, I suggest that both the government and the industry consider a technique which I advocated in 1996 and which remains available for deployment next week. If successfully implemented, my suggestion would directly assail the vehicle of high prices by enlisting self-interested, opportunistic behavior to make the demand curve elastic for the first time in the power crisis. Put in a sentence, I propose that California pay large users to get off the system the moment reserves approach stage one conditions.

Demand bidding would replace interruptible tariffs for the simple reason that they have not worked. In either September or October, the California Commission opened a rulemaking on the effectiveness or lack thereof of interruptible tariffs. The Commission's initial orders in this docket note that California ratepayers have spent hundreds of millions of dollars over the past ten years holding the utilities harmless against the revenue loss occasioned when large users were offered discounts in exchange for their promise to shed an agreed portion of their load in response to telephonic notice that reserve margins were being squeezed.

For nearly a decade advocates for residential consumers assailed these demand management programs as disguised discounts for large users. Month after month, year after year beneficiaries of these programs received substantial discounts which other ratepayers were forced to make up. Yet they were never asked to shed load. In May of 2000 the situation changed and the ISO began to issue load shedding instructions which were to be followed within 30 minutes. Yet the Commission estimates that as much as 1,000 MW of the demand benefiting from these programs ignored the orders. In desperation, the ISO was forced into a price-is-no-object quest for supply to meet a demand that refused to budge.

There must be a better way, one that more closely matches payments with performance. Currently we are told that many users in California are engaging in conservation efforts because they cannot cope with their energy bills. Their sacrifices represent a free ride for those consumers who continue with consumption as usual because the rate freeze makes them immune to the electricity but not the gas price signals. The free rider program is directly addressed by incenting willing users to shed load in return for a portion of society's net savings. I call it "demand bidding," a concept I do not claim to have originated but which I strongly urge be immediately implemented. The transparency of the auction mechanisms in both the PX and ISO render the calculation of the savings manageable. Had it been a feature of the market reforms when I first suggested it in 1996 we would still be aware of an acute capacity shortage but possessed of a dynamic means use market forces to dampen interim costs and ensure reliability.

DAN FESSLER