Beware of a national energy crisis that eclipses California's.

It seems rather elementary in an economic downturn to say that generating capacity will easily match demand over the next few years, especially with all the new plants that have been built lately. But what happens to the supply picture when you factor in a possible economic upswing, with continued high natural gas prices, an illiquid wholesale market, and an aging transmission infrastructure?

These were but some of the concerns voiced by David Sokol, chairman and CEO at MidAmerican Energy Holdings, before the U.S. Senate Committee on Energy and Natural Resources in March, testifying on the financial condition of the industry.

At the Senate meeting, Sokol said, "In the last three years, more than 170,000 megawatts (MW) of planned new capacity have been tabled or canceled. Some of these cancellations represent an appropriate correction for overbuilding, but some needed projects are also being suspended. Moreover, there is significant under-investment in transmission facilities, also caused by the lack of capital availability."

In addition, Sokol said that if the industry fails to turn the situation around, he fears that the industry will be laying the groundwork for a repeat of the Western energy crisis. In fact, Sokol sees more than a few similarities between the current state of the industry and the conditions that led to the Western crisis.

"For the many senators on this committee from the West, I hope you will ask yourselves why an Enron was able to manipulate markets in your region, but not the markets of other regions. The answer, I believe, is that the West was dangerously short of both capacity and the infrastructure to deliver that supply to market. Coupled with the terribly conceived California market structure, conditions were ripe for anti-consumer behavior," he says. But many ask just how to develop "sensible market rules" and "adequate infrastructure" to ensure that a California style crisis does not repeat itself? Especially as results have been mixed in the movement to develop greater confidence and liquidity in wholesale energy markets, as well as to attract capital to develop aging transmission infrastructure .

The Committee of Chief Risk Officers: Failure Is not an Option

It has been rather unfortunate that the Committee of Chief Risk Officers, which has set out to strengthen risk management and disclosure practices in the physical and financial trading and marketing of electricity and natural gas, hasn't really had the success yet that other best practices groups have enjoyed. In fact, some members of the media and the financial sector have dismissed the organization as nothing more than an industry smoke screen to ward off Draconian regulations. The critics argue that the CCRO has not gone far » enough in promoting best practices and that it lacks credibility because the recommendations it makes are non-binding on its members.

Certainly, this was the charge leveled at the Group of Thirty, a well-known best-practice group that was set up in 1978 to help upgrade operations in the banking industry. That organization found great credibility during the early 1990s, after a spate of banking industry disasters linked to financial derivatives. The group succeeded in doing something that few best-practice groups have achieved: It persuaded one of its most prominent members to go public and officially endorse recommendations adopted by the group as a whole.

At the time, the CEO of J.P. Morgan held press conferences in New York and London supporting the group's recommendations-and inspiring other banks to make such declarations. Furthermore, the Group of Thirty is made up of industry professionals as well as some regulators and academics (not the case with the CCRO). Many believe this grouping has contributed to more sober and realistic recommendations. In fact, the 1990s recommendations exceeded the scope of the regulator's proposals-another aspect that gave the group credibility.

When the CCRO unveiled its proposals for improving energy price indexes in late February, many industry watchers voiced disappointment to see so few utility companies stand up and support the standards publicly. In fact, so loosely fashioned are the best practices for price indexes that many feel the industry may never succeed in developing indexes that offer an accurate picture of the market. That, of course, would be disastrous. Without a true understanding of how much power to buy or sell on the open market, utilities are setting themselves up for more decades of paying for overpriced contracts that they may or may not be able to pass on to ratepayers.

The bottom line is that the CCRO exists to help utilities satisfy their most singular mission-to provide power for their customers. While some bold utilities may claim that they have more than enough generation to meet load and do not need liquid wholesale markets, there are more than a few divested, wires-only distribution utilities in which a contract with a supplier is the thread by which they fulfill their obligations. One can think of many situations by which that thread might be cut. Recall the late 1990s Midwest price spikes and how suppliers, outages, and weather failed one Midwest utility that was forced to pay egregious power prices on the open market to meet its obligations.

The Regulators: Putting the Screws to Utilities

Even as utilities seek the best supply contracts they can find for their customers, it's obvious that they are being forced to go back to the old days of establishing resource adequacy. Take, for instance, Duke Power, which in late January issued a request for proposals to wholesale power suppliers and power marketers to supply the company with up to 500 MW of electricity beginning in 2005 and up to 1,500 MW beginning in 2009. According to press statements from Duke, the company intends for the RFP to help it use the competitive wholesale power market to meet its customers' growing need for electricity. And sources say Southern Co. is actively engaged in providing supply contracts to various regional entities. But without a viable regional market to point the way on price, these utility buyers and sellers risk the wrath of state regulators, who eventually may launch prudence reviews and disallow long-term purchased power costs that later prove to be bad bargains.

For example, the Montana Public Service Commission sounded an ominous warning in accepting procurement practices for power purchase contracts for PPL-Montana and Duke Energy, as part of its review of the default supply portfolio of Northwestern Energy:

"Northwestern is not guaranteed full recovery of the costs incurred under PPL-Montana and Duke Energy purchase power agreements-failure by Northwestern to prudently administer its supply contracts for the benefit of ratepayers could result in cost disallowances."

So utilities are left without any kind of safety net-except, perhaps, by the development of a truly competitive wholesale market and the development of more transmission infrastructure. Should the crystal-ball-gazers be wrong about reserve margins, capacity additions, and the affect of an improving economy on the industry, utilities may find out quite soon what a true crisis is.

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