Last week, I couldn't help but be stopped dead in my tracks when two new studies on the California energy debacle flashed across my desk. Conducted by two prominent companies, one a consultant and the other a think tank, the studies point out that the crisis poses tremendous implications for the development of competitive energy markets and could go far beyond the western United States.

Commenting on the first study, Matthew D. Smith, head of Andersen's utility consulting practice, points out that, “California taught the nation that regulatory and political barriers can create and sustain an energy crisis.”

Smith also notes, “No doubt California has demonstrated that the risks in the electricity industry, if not properly acknowledged and managed, can simultaneously and profoundly impact all market participants. To be effectively managed, these risks need to be exposed, assumed or shared, measured and monitored. When they are hidden or ignored, all parties can potentially suffer. A shared integrated view of these risks, and a strategy for their assumption and management is critical to avoiding rapid destruction within the energy market.”

The survey questioned senior executives from 16 non-California utilities (with a combined market capitalization of more than $120 billion and $145 billion in revenues) about the possible implications of the crisis for their companies and the industry. Survey results indicate most utility executives believe they inoculated themselves against the California virus. They believe it is unlikely to affect their operations beyond slowing the pace of deregulation and increasing investor scrutiny.

The survey, conducted between February 19 and March 2 by Knowledge Systems & Research Inc., Syracuse, N.Y., found that companies are observing the California situation carefully, expecting a slowing — but not a turnaround — of deregulation. The executives believe their internal plans are on target for the changing environment. Not surprisingly, the survey centered around five subjects and the executives' responses to those issues.

Deregulation. All the surveyed executives believe recent California events will slow the pace of deregulation over the next five years for states that have not begun or finished writing restructuring legislation. None of them believe it will cause advanced states to re-regulate markets, although many states will review their legislation to assess their risk of duplicating California's situation and make any changes necessary to avoid it.

National legislation. Few executives think the situation will initiate national energy legislation. (They may be wrong on this point, as a comprehensive national strategy has been developed by the Bush administration.) Others believe it will be a continuing issue; however, because of state-to-state variances, Congress will be unable to pass any comprehensive measures or force states to a restructuring timeline. Some expect additional state-level legislation.

Company strategies. Most see no changes to their business models or strategies for generation, distribution, or supply procurement as a response to the crisis. However, many have expanded their risk management programs, reduced spot market purchases, begun emphasizing long-term supply contracts and planning new power generation capacity, and started hedging with futures trades. Those facing price caps are rethinking their stance on them.

Investor scrutiny. Many respondents indicate their shareholders are aware of the situation and investors — particularly institutional investors — are more heavily scrutinizing their actions. Many say news coverage has prompted retail, commercial, and industrial customer skepticism of industry restructuring.

Transmission deregulation. Many executives agree the California situation will increase interest in the FERC's regional transmission organization (RTO) deregulation effort.

To guard against a sudden California cascade and as a potentially powerful competitive thrust, “forward thinking utilities should bolster their basic preparedness with a variety of tactics — or inoculations — specifically aimed to combat a potential California power virus,” says Andersen partner Mark Moskovitz. Moskovitz suggests several ways this can be done.

Improve procurement management and risk management responsibilities. To manage exposure to volatile supply and demand shifts, organizations must make certain comprehensive and clear supply procedures, controls, decision points, risk limits, and communications are in place.

Plan and design innovative rate and pricing structures. Companies and regulators must focus on communicating price signals that create value for the customer and provider. Innovative rate and pricing structures that more closely tie the customer's price to the real cost of supply will better signal the value of the service as well as provide more accurate information upon which the end user and supplier can make decisions.

Increase emphasis on demand-side management strategies. In addition to new pricing strategies to help achieve and maintain supply-demand equilibrium, companies must focus on employing more extensive and innovative demand-side management programs.

Assess the supply and generation dynamics in adjacent jurisdictions. Companies must take a broader view — beyond typical geographic market definitions — of the economics of generation and related business decisions in an increasingly volatile market where supply will follow the best prices.

Develop contingency plans for the continued deferral of new generation capacity. In the face of potential ongoing shortages, companies and regulators must be prepared to move with a portfolio of strategies to meet demand, including DSM, flexible pricing, and distributed generation. In addition, they should explore efficiency-improving upgrades to existing facilities and seize any opportunity to accelerate near-term construction plans.

Proactively address potential organizational disruption. As regulatory and economic changes continue to churn the industry waters and companies adjust and/or restructure, they must be highly cognizant of, sensitive to, and directly address employees' concerns with information about their futures and the company's future.

Decreased Costs

The second study, “Getting Deregulation Right: How Other States and Nations Have Avoided California's Mistakes,” was released by the Reason Public Policy Institute (RPPI) and is authored by Dr. Lynne Kiesling, director of economic policy for RPPI. This study notes that Pennsylvania, which passed electricity deregulation at the same time California restructured its electricity market, avoided many of the problems California is experiencing.

As the study points out, Pennsylvania's customers have seen an average price decrease of 30% in their electricity costs and an increase in service options, including green or renewable power. Of the states that have deregulated wholesale and retail electricity markets, Pennsylvania has had the highest rate of customers switching to alternate generation providers.

Pennsylvania achieved this success through market-based default prices, non-mandatory divestiture of generation, accelerated phase-in of all customers, and the use of financial instruments and regional markets. All of these encouraged alternate providers to enter the market and create real competition.

Texas also appears poised to succeed in realizing the benefits of electricity deregulation, the study says. “While its legislation only went into effect in June 1999 and its pilot program to test the process starts in June 2001, many already view Texas as a blueprint for deregulation success,” says Kiesling. “It has incorporated the negative lessons from California with the successes of Pennsylvania, the United Kingdom, Australia, and elsewhere to craft a process that gives new providers real incentives to enter and provide competitive services at lower prices to Texas consumers. The Texas legislation stipulates a ‘price to beat’ or default price that is 6% below the January 1999 average price; this price is low enough to generate price decreases for consumers but high enough for market entrants to see profit potential.” According to the report, the price to beat then becomes a retail cap that is effective for only five years. Also, Texas has not mandated full-generation divestiture, but has followed the Pennsylvania model of restructuring studies, with the incumbent utility retaining no more than 20% of the generation capacity in their service area. The full retail market is set to open in January 2002.

Finally, but perhaps most important, Texas will not establish a centralized electricity market like California's Power Exchange. Instead, it will allow buyers and sellers to transact how they see fit through for-profit financial markets. This flexibility will enable all market participants to limit their risk of energy price volatility, and to be creative in devising financial instruments to manage that risk.

The RPPI study offers some lessons we can learn about implementing successful electricity reform, which have been derived from the experiences in Pennsylvania, the United Kingdom, and Australia; the evolution of the deregulation process in Massachusetts, Rhode Island, and the United Kingdom; and the great potential for success in Texas and other states.

Set high enough default prices to encourage real competition. The standard offer price is the price customers pay if they do not choose an alternate supplier, and the default price is the price at which a utility will sell electricity in the absence of competition.

Do not mandate divestiture of generating capacity. Instead of mandated divestiture, encouraging utility restructuring created substantial flexibility in Pennsylvania's electricity markets. Divestiture is likely to occur, to some extent, during restructuring when utilities refine their core competencies. Allowing retention of at least some generation capacity enables companies and consumers to reap the benefits of vertical integration where they exist.

Accelerate the phase-in period to allow choice for all customers. Although industrial consumers enjoy much of deregulation's benefits, opening industrial as well as commercial and residential markets to competition more quickly enables more customers to make their own choices of electricity providers and services and see appreciable benefits more quickly.

Encourage the use of voluntary regional exchanges and clearinghouses and the development of associated financial instruments. PJM and other independent system operators (ISOs) in the United States, as well as using the NYMEX to trade electricity futures, enables utilities and wholesale generation companies to plan and price their services. Markets and clearinghouses serve a crucial role by allowing utilities and generators to mix, enter bilateral contracts, and make spot purchases to manage price volatility and balance reliability and cost.

Think about it. Does the reform and restructuring of the electric utility industry need to produce crisis after crisis? Electricity deregulation and reform can bring substantial benefits to consumers, as several worldwide examples of successful reform demonstrate. Careful consideration of factors such as default price, flexible industry restructuring, phase-in period, and membership in regional markets can make the difference between success and failure. In this case, California need not set the tone and mood for a national electricity strategy that has been a long time coming. The nation need not follow in the state's footsteps.

Barry LeCerf, Publisher
Utility, Technology, and Business Group