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Money, Power and Trade: What You Never Knew About the Western Energy Crisis

Fortnightly Magazine - May 1 2001

the state will exceed $26 billion in the next 18 months and will likely lead to a deficit of up to $7 billion in the state budget next year (from the current surplus). %n13%n

Since the 1970s oil and gas markets have transformed themselves into highly efficient and sophisticated commodity markets. Spot transactions lie at the heart of these markets. They determine the daily flow of energy from suppliers to consumers. While the system is highly efficient, it can be risky. That is because the demand for energy remains highly insensitive to price in the short-run (em nearly straight up and down on a chart. In the short term, consumers will pay almost anything for heat, light, and motion. Prices are kept reasonable, because supplies are usually abundant. In fact, most of the time the supply of energy seems to be infinite. It is infinite, in effect, until demand approaches production capacity. But once capacity constraints are reached the supply curve switches from a flat plane to a vertical pillar. At the transformation, energy prices explode. Abundant surplus turns to critical shortage quickly and without much warning. Let's call this kink in the energy supply curve the "devil's elbow." It acts as the principal cause of volatile energy prices.

When faced with critical demand and uncertain supply, it is wise to buy insurance. Such prudence seems to have escaped the attention of California's regulators. California's deregulation plan was based on the assumption that private entrepreneurs would offer "contracts for differences" (CFD) to moderate swings in spot prices. This market never developed in part because the three largest participants, the investor-owned utilities, were discouraged from such activity. Spot purchases were deemed per se reasonable, but the treatment of profits or losses from a CFD or New York Mercantile Exchange (NYMEX) futures contract (even after recovery of stranded costs) was purposely left vague. After it had recovered its stranded costs, SDG&E petitioned the PUC for performance-based ratemaking (PBR) to provide an incentive for the utility to do better than prices posted at the California Power Exchange (PX). The PUC turned down the request and San Diego stuck to the spot market. %n14%n

Recognizing the chasm in market structure, the PX introduced block forward contracts in 1999, which allowed participants to purchase peak power months or quarters in advance. These contracts were no different than a bilateral forward contract, except that the PX acted as intermediary and pricing was transparent. Since the power was procured through the state-sanctioned exchange, the purchases were considered per se reasonable. Nonetheless, the PUC put strict limits on the volume of forward power the utilities could buy, limiting participation to the utilities' "net short position," defined according to average quarterly volume. This artificial limit left the utilities vulnerable to daily and hourly peaks (em the very period of times in which protection from price spikes was critical. As late as July 2000, the PUC continued to enforce strict limits and turned down SCE's request for open-ended participation in PX forward markets. %n15%n

The reluctance of California officials to encourage forward