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Report 2001-009 Summary - December 2001

California Energy Markets:

Pressures Have Eased, but Cost Risks Remain

HIGHLIGHTS

The Department of Water Resources (department) faced an immense challenge in purchasing the net-short energy of the three investor-owned utilities. The department entered into 57 long-term contracts for power with an estimated cost of $42.6 billion over the next 10 years. Although the energy crisis has now eased, significant cost and reliability risks remain. Specifically, we determined that:

  • The speed in which the department entered into contracts in response to the crisis precluded the planning necessary for a power-purchasing program of this size. As a result, it assembled a portfolio of power contracts that presents significant risks that will need careful management to avoid increased costs to consumers.

  • The portfolio does not contain sufficient power for peak-demand periods, thus potentially exposing consumers to high market prices if energy supply becomes limited during those periods.

  • The majority of the contracts are not written to ensure a reliable source of power, but instead they convey lucrative financial terms upon the suppliers to ensure that energy is delivered. In addition, the terms of the contracts contain provisions that can increase the cost of power; thus they need careful management to avoid additional costs to the consumers.

  • The department lacks the infrastructure needed to properly manage the purchases of the net short, but is taking steps to build up its capabilities.

  • Many decisions need to be made about the State's future role in the power market. The department's authority to contract and purchase the net short ends after 2002, yet it or another entity will need to manage the considerable market and legal risks of the power contracts and, if the utilities are not creditworthy, purchase the net short.

  • Operational improvements are needed to strengthen the department's administration of the power-purchasing program.

RESULTS IN BRIEF

The California energy crisis, which peaked between late 2000 and mid-2001, was unprecedented. Energy prices rose to all-time highs, and blackouts occurred in several instances. The wholesale energy prices were symptomatic of deeper problems, some of which-like the weather and recent high prices for natural gas-were beyond state regulatory control. For instance, abnormal weather patterns in the western region during the summer of 2000 exacerbated a long-standing energy imbalance, in which demand for electricity increased faster than the supply in California. The two largest investor-owned utilities in the State of California (State) were unable to pass the increased costs for electricity to ratepayers due to restrictions imposed by the laws that had restructured California's energy market, while a third utility was able to do so because it had met certain cost recovery criteria. However, all three utilities soon experienced credit problems and had difficulty convincing energy power generators to sell electricity to them. By late 2000, the State clearly needed to intervene.

In response to the crisis, the Legislature passed a number of bills, including Assembly Bill 1 of the 2001-02 First Extraordinary Session (AB 1X), which authorized the Department of Water Resources (department) to purchase the net-short energy for the three investor-owned utilities. The net short is the difference between the power that the three investor-owned utilities provide from their own supplies and the total consumer demand for power, an amount that varies considerably over the course of a day, week, month, and year. Despite the inadequate lead time to prepare for its new role as purchaser of the State's power, the department did step in and buy the power needed to keep the lights on in California. Before the enactment of AB 1X, the department's organization focused on managing the State's water system. The department managed the State Water Project's electrical power requirements through the department's own power generation and through power purchase agreements that were, for the most part, balanced with its power needs. In addition, the department purchased extra power in daily volumes of tens or hundreds of megawatts.

The new power-purchasing role was an immense challenge that would have been difficult even for an organization with the needed infrastructure in place. Through September 2001 the department had spent nearly $10.7 billion to purchase energy under contract or in the spot market to meet the daily needs of the ratepayers of the three investor-owned utilities. When implementing AB 1X, the department-along with its consultants and the energy advisers appointed by the governor-undertook an effort to sign long-term contracts with power generators in an attempt to calm power prices. Subsequently, the department entered 57 long-term power contracts at a total value of approximately $42.6 billion over the next 10 years.

The portfolio of long-term contracts that the department has assembled as a response to the crisis contains cost risks that must continue to be carefully managed. Extraordinary circumstances have complicated the department's efforts: the large size and scope of the net short; the immediate need to buy the net short on the spot market at record high prices; a reliability crisis in the State's power system; and concerns about whether the department was creditworthy. Nevertheless, the department was charged with providing reliable power at the lowest possible cost, yet the portfolio of contracts emphasizes year-round energy but does not similarly emphasize delivery during peak-demand hours. The risk in the portfolio that the department must carefully manage is that the portfolio leaves it exposed to substantial market risk in high peak-demand periods if supply shortages occur and to substantial market risk with surplus contract amounts in other hours of the year. Compounding this problem is that many of the contracts are nondispatchable, meaning that the department must pay for the power whether or not it is needed. Further, based on present forecasts, from the fourth quarter of 2003 through the first quarter of 2005, the department has procured more power than consumers in Southern California need. Because facilities powered by natural gas produce most of the energy for which the department contracted, the department could also have employed more tolling agreements, which would have allowed the contract price to decrease if gas prices decrease, as is predicted. However, according to the department, before receiving an opinion from the attorney general on February 28, 2001, affirming its authority, the department was not certain that AB 1X authorized it to purchase the natural gas supplies required under tolling agreements.

The department is considering various mitigation strategies for these risks and the extent to which the strategies will be successful is unknown at this time. For example, the department presently expects to fill energy needs in peak-demand periods with market purchases rather than more contract purchases. The premise behind this approach-adequate supply availability and low prices during peak periods-may in fact occur and the strategy may be successful. However, it is also possible that the suppliers not under contract will choose to not make supply available, at least not for low prices. Also, the department hopes to exchange some of its excess power in low demand periods in California with the entities in the Pacific Northwest in exchange for power in peak-demand periods in California, since the energy needs of the two regions complement each other. Due to the length of some of the long-term contracts, 10 or more years, and the uncertainty over what entity will be managing the net short, it is also important to note that whoever manages the net short could choose to put more of the peak-demand period needs under short- or long-term contracts if that entity assesses its risk for these periods differently than the department presently does.

The department's rush to obtain contracts quickly-it entered about 40 agreements with a value of $35.9 billion in just 30 days-may have played a role in the composition of the portfolio because the department's rush precluded the planning and analysis that are necessary for developing a portfolio of this magnitude. Given the urgency to gain control of power prices and the pace that it chose in reacting to the crisis, the department had little opportunity to conduct the planning that was needed. The choice to move quickly was one of the options that the department could have taken. However, going slower may have resulted in a portfolio with fewer, or less extensive, cost risks to manage.

Most of the contracts that the department has entered with power generators do not include the terms and conditions that one would expect to see in agreements that ensure the reliable supply of energy. A key goal of AB 1X is for the department to obtain a portfolio of power contracts to supply a reliable source of power at the lowest possible cost so that the State could address the unprecedented financial and supply emergency in its electricity markets. When measuring the adequacy of the terms and conditions of the contracts, we tested them against the conditions that prompted the State to engage in purchasing electricity. In other words, we analyzed whether the contracts assure reliable delivery of power in times of high prices and tight supply.

Our detailed review of 19 transactions, constituting 61 percent of the total gigawatt-hours purchased, and a screening of others concluded that most of the power supplies fall under contracts with terms and conditions that may not assure that reliable sources of power will be available to the department. For example, under the terms of most of the contracts, the department cannot terminate the contract or assess penalties even if generators repeatedly or intentionally fail to deliver power at times when the State urgently needs power. Instead, the department can only recover the difference between the contract price and the cost of the replacement power. The department needed these contracts to include a remedy like the right to terminate the agreements when generators repeatedly fail to deliver so that the department has the leverage to compel generators to deliver power in times of severe need or to replace generators with other, more reliable generators.

The department's contracts also often lack terms and conditions that would better ensure other reliability goals of the contracting effort, including terms that would better ensure that generators are making appropriate progress on building the facilities that will supply the power for which the department has contracted and allowing the department to inspect facilities that the generators say are unable to produce power because of mechanical difficulties. Moreover, the contracts may not always ensure that when the State pays a premium for construction of new generating facilities, the new construction occurs and the generators actually make available and deliver the power produced by the new facilities.

Although the department was in a weak bargaining position because of the financial crisis in the electricity markets, its rush to ease the electricity crisis by locking in power supply through long-term contracts weakened its position even further. In its request for bids, the department did not request contract terms and conditions that are standard in the power industry for entities that must ensure reliable delivery of power. We found that in later contracts sellers agreed to terms and conditions that better assure reliable power delivery. Because the department apparently did not ask for certain reliability terms recognized by the power industry until after it had made the bulk of the deals, we cannot determine whether the department would have been able to obtain more favorable reliability terms in the earlier long-term contracts. We did note that while the terms and conditions improved in the long-term contracts negotiated after March 2001, the department negotiated the vast majority of the power, costing $35.9 billion, before March 2, 2001, during the period in which we found that the terms and conditions regarding reliability of power delivery were least favorable to the State.

The contract costs are not fixed and could rise substantially if the department does not manage its legal risk in anticipation of exposure to potential liabilities and to defaults by energy sellers. For example, the department needs to guard against potential events of default that could expose the State to huge early termination payments. Also, the department needs to protect itself from generator costs that the contracts have shifted to the department. Such costs could include governmental charges, environmental compliance fees, scheduling imbalance penalties, and gas imbalance charges.

Once the department became responsible for the net short, it began purchasing up to 200,000 megawatts of electricity each day. From January 2001 through August 2001, the department spent more than $8 billion on transactions for short-term power agreements. Because California lacked creditworthy buyers, the department became the market, purchasing most of the State's power.

Various factors hampered the department's efforts in its new role. Specifically, the department initially had to purchase much of this power each day in a dysfunctional market from market-savvy sellers. The department's challenge became especially difficult because it lacked the infrastructure and the experienced, skilled staff needed to perform at this level. Consequently, at the same time that the department struggled with purchasing needed power, it also struggled to establish the organization it would need to meet the challenge.

The department has not yet implemented the infrastructure and hired the staff required to meet its continuing challenges. For example, the department is still developing systems for working with the investor-owned utilities to forecast demand, schedule the least-cost available power, and manage the delivery risks. In addition, the department still needs to resolve settlement process problems associated with the energy and ancillary services functions that the department has been conducting and continues to conduct on behalf of the California Independent System Operator (ISO). This resolution is important because under a recent Federal Energy Regulatory Commission (FERC) order, the failure of the department and the ISO to reach agreement on how to facilitate the payment of long-outstanding power obligations may disrupt the future supply of available power in the ISO's short-term markets.

The governor, the Legislature, and the department need to make many decisions about the future role of the State in the power market. To a large extent, the problems we identified in the department's implementation of the power program arose because the department was given this mission in the midst of the power crisis with too little time to plan and prepare adequately. Now that the crisis has eased, the Legislature and the governor should consider how best to serve the power requirements of the State's consumers over the long term and how best to manage the costs and mitigate the risks of the power contracts. This analysis should result in a comprehensive strategic plan that considers both whether the department should continue to administer all aspects of the power-purchasing program as well as a specific set of plans on how to improve the current operations. The plan is necessary regardless of whether the department continues to manage the program or whether the program becomes a separate state agency or a different type of governmental entity.

The Legislature will also need to evaluate whether to extend the department's responsibilities beyond January 1, 2003, to allow time for present uncertainties that affect these decisions-such as the financial health of the investor-owned utilities and the role of the new state power authority-to be resolved. Other relevant factors that decision makers must consider include the fact that current long-term contracts do not permit the State to renegotiate or quit contracts that become burdensome or unfavorable, such as when the contracted power is no longer needed or costs are significantly greater than market prices. In addition, although the department can assign contracts to other governmental entities, assignment to utilities generally requires the sellers' consent. Further, the Legislature needs to take into account that the administering entity must have the ability to carry out the full functions of a power program of this scale. For example, the department needs advisers experienced in protecting the interests of power programs before regulatory bodies to minimize its regulatory risks. Even though the California Public Utilities Commission (CPUC) and FERC do not directly regulate the department, the actions of those commissions have substantial bearing on the market within which the department operates. In addition, the department still needs authority to enter financial transactions to manage gas and electric transaction risks.

The department's responsibilities remain substantial, not the least of which is its current management of a $42.6 billion contract portfolio focused on minimizing legal and cost risks to ratepayers. The department needs to make significant efforts to improve its internal capabilities and operations so that it can effectively administer the power-purchasing program.

RECOMMENDATIONS

To plan and manage the economic aspects of its portfolio effectively, the department should do the following:

  • Conduct within 90 days an in-depth economic assessment of its contracts and the overall supply portfolio that serves customers of the investor-owned utilities. This assessment should occur in conjunction with the legal review noted below to assure that the department can develop an effective overall strategy for contract management. In addition, the assessment should focus on how the contracts fit into the overall portfolio and on the costs relative to current expectations of market conditions.

    Develop a contract renegotiation strategy, informed by legal and economic reviews, that centers on improving the reliability and the overall balance and performance of the portfolio.
To anticipate and manage its legal risk, the department should undertake these actions:
  • Perform within 90 days an in-depth assessment of its legal risk and legal services requirements to ensure that the department can develop an effective strategy for legal management.

  • Establish an ongoing legal services function that specializes in power contract management, negotiation, and litigation to make certain that the department's legal assessment and representation is on par with those of the other parties participating in the contracts. When necessary to avoid conflicts, this legal function should be distinct from counsel retained to sell bonds or provide legal advice to the State Water Project.

  • Investigate all audit and other rights available to the department under its contracts to assure that it can develop a proper program for performance enforcement.
To further develop its operations for entering short-term agreements for power supplies, the department should take these steps:
  • Collaborate with market participants to resolve settlement process problems associated with the energy and ancillary services functions that the department conducts on behalf of the ISO.

  • Coordinate with the investor-owned utilities and the CPUC to ensure that the rate incentives associated with utility-retained generation scheduling are resolved to support the dispatch of the lowest cost energy.
The Legislature should consider developing an appropriate statutory framework, including the possible amendment of AB 1X, to extend the department's purchasing authority to allow adequate time for implementing the strategic framework and to assure continuity of the purchasing function and an effective transition of this function, presumably to the investor-owned utilities. Additionally, the department should develop a strategic plan for the future of the power-purchasing program at the department, and this plan should include the assessment of the necessary transition processes needed to allow orderly transfer of functions to the ISO, the investor-owned utilities, and others, as appropriate. To improve its ability to carry out the full functions of a power program of this scale, the department should do the following:
  • In its future efforts to protect the interests of the power-purchasing program, the department should retain independent legal counsel to advise the department on matters pertaining to state and federal regulatory issues that affect the power-purchasing program when those interests conflict with the interests of the State Water Project.

  • Seek clear statutory authority to use financial instruments to manage gas and electric transaction risks.
AGENCY COMMENTS

The department believes that our report fails in its primary purpose because it does not address the impact of the department's decisions in stabilizing prices and restoring system reliability. It also believes the report uses the wrong standard of evaluation because it believes the report does not evaluate the reasonableness of the department's decisions within the context of the crisis environment that they were made, the information that was available to the department at the time, and against the tremendous risks to the State's economy, and health and safety of its citizens in failing to take decisive action. Notwithstanding its concerns regarding the focus of the report, the department states that it has already moved forward on implementing many of the recommendations in the audit report.

Contrary to the department's assertion, we fulfilled our mandate and focused our analysis on the department's implementation of the power-purchasing program. We did not perceive our mission as trying to identify how much credit should be attributed to a variety of events that contributed to the improved price stability and system reliability in the spring and summer of 2001. Rather, we focused on the potential risks in the portfolio of contracts that the department developed in a time of crisis, which we fully describe, and on how the State should best manage those risks and plan for the future of the power-purchasing program. Our comments to the department's response begin on page 247.















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