S ITUATION B EFORE D E R EGULATION

With about 34 million inhabitants, the state of Californian is the most populous state within the United States followed by Texas with about 20 million people4. As the fifth largest economy in the world5 and

1

Joskow, June 2001.

2

Wright, 2001. The author sets up the hypothesis that the more liberalised an electricity market and consequently the more competitive the market, the greater the likelihood of failure.

3

Callum McCarthy, Chief Executive of Ofgem, stated in October 2001:

"California is not the inevitable result of liberalising energy markets. The British experience, as well as that in the Nordic Countries of Europe and individual states in Australia, show that privatisation and liberalisation can bring very real customer benefits."

4

Population Division, 2001.

5

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largely dominated by technologies, California used to be extremely dependent on electricity.

The pre-liberalisation circumstances in California, however, largely differ from international experience. Before the restructuring of the industry in spring of 1998 started, electricity in California was generated and distributed by private, investor owned, vertically integrated utilities which were subject to state regulation in the retail market. Approximately 80 percent of the state’s power is delivered by three big privately owned monopolies which owned and operated generation, transmission and distribution facilities: Pacific Gas and Electric (PG&E), Southern California Edison (SCE) and San Diego Gas and Electric (SDGE)6. In the United Kingdom, in contrast, the electricity industry was being liberalised and privatised at the same time7.

These private utilities were regulated by an independent state regulatory agency, the California Public Utilities Commission (PUC), responsible for setting tariffs and standards for performance as well as for the regulation of investment in new generation and transmission, the control of the mix of fuels and the promotion of conservation programmes. The regulation for transmission rates and power transactions was left to the Federal Energy Regulatory Commission (FERC). The role of FERC initially was both, rather limited – since most generation was owned and operated by the utilities themselves – and critical, since the tariff setting within the FERC was lacking transparency and pursued national rather than local orientation.8

6

There are several municipally owned electric utilities which, however, had not been liberalised. The Legislation of 1996 actually gave the municipal utilities the option of opting in to the system or remaining outside. Almost without exception they decided to opt out. Among them the city of Los Angeles.

7

This difference led to a essential consequence: Once the incumbent utilities heard about liberalisation, they started a totally rational behaviour from their perspective, namely to protect their markets and eliminate competition, which later contributed to capacity shortfalls because private utilities were refusing cheap energy from competitors.

8

The other Federal agency concerned was the Security and Exchange Commission (SEC) guaranteeing that in exchange for an special service

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Both agencies traditionally regulated wholesale power and transmission prices on the basis of cost-of-services-principles, but in the late 1980s they switched to granting power producers the authority to sell at market-based rates.

The rapid growing economy of the early 1990s had the important consequence that overall energy demand was rising and subsequently more capacity was claimed to be needed. By the mid-1990s California turned out to supply some of the highest priced electricity in the nation which was not only the product of the high residential nuclear power station construction costs. The natural geographic conditions of the major urban areas in California proved to be easily susceptible to air pollution and therefore stringent pollution control rules were issued which restricted the choice of fuels and the conditions under which energy generation can be carried out9. The Public Utility Regulatory Policy Act of 1978, for instance, was designed to promote both privatisation and conservation by forcing electricity utilities10 to

territorial utilities were required to offer reliable electricity to all customers at a certain regulated rate.

9 _{"...environmental regulation was under reform pressures as well. California} legislation that had up to the mid-1990s required selective catalytic reduction devices (SCR) as the best available technology for reducing NOx emissions from fossil power plants was drastically modified in the south coast air quality management district (SCAQMD) of California. The Edison Company argued that SCR was too expensive and that instead SCAQMD should adopt a credit trading system to control NOx emissions. That alternative was adopted with the underlying assumption that the electricity sector would continue to function as it had in the past. Immediately a number of things went wrong. First, too many credits were issued and most of them were issued to the private utility – the Edison Company. As a result, Edison didn’t need to clean up its power plants with all the credits issued to them directly and the credits that could be purchased very cheaply in the marketplace". See: Marcus/Harmrin, page 6.

10

A utility is a regulated entity which exhibits the characteristics of a natural monopoly. For the purposes of electric industry restructuring, "utility" refers to the regulated, vertically-integrated electric company. "Transmission utility" refers to the regulated owner/operator of the transmission system only. "Distribution utility" refers to the regulated owner/operator of the distribution system which serves retail customers. See: http://www.energy.ca.gov/glossary/glossary-u.html#u

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purchase power from non-utilities generators11 called Qualified Facilities aiming at furthering cogeneration and the use of renewable energy. This bill made utilities to purchase specified amounts of their electricity at the estimated avoided cost of replacing that power with the cost of power from new construction.

In 1994 – due to a changing political attitude towards reducing overall government intervention in the economy and supported by the Federal Power Act of 1992 which gave FERC the authority to deregulate the wholesale electricity market as well as motivated by both rising electricity prices12 and by growing energy demand and the imminent danger of possible generation shortages – the first step towards liberalisation was set by PUC in ordering new construction to be put out for private bid13. Not to a lesser degree influenced by the reforms undertaken in Britain in 199014 that reduced costs for both production and distribution of power and led to substantial investments in environment-friendly new power stations, all the proposals for a fundamental reforming of the electricity industry were laid down in the so-called "Blue Book". This report included as well the proposition for a new industry structure in which the production from the generators and the entry of new plants would be deregulated and their power sold in a competitive wholesale market.

Based on the PUC’s deregulation efforts, who recommended the utilities to unbundle their integrated systems so that the costs of transmission, generation and distribution would be transparent and could be sectioned off and if necessary sold, in 1996 a restructuring law (Assembly Bill 1890) passed legislation, which introduced overall

11

A non-utility generator is defined as a generation facility owned and operated by an entity who is not defined as a utility in that jurisdictional area. See: http://www.energy.ca.gov/glossary/glossary-n.html#n

12

Comparing energy prices with other neighbouring states it was commonly argued that the reason behind the high Californian electricity prices can be found in the existing system of regulated vertically integrated monopolies, the high investments in nuclear power plants, high-priced long-term contracts with independent power producers, the generation of excess capacity and in the expensive and unproductive regulatory institutions.

13

However, right before its implementation, PUC and the State moved quickly towards complete deregulation of generation and transmission.

14

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liberalisation of the wholesale and retail market in California by March 199815.