Frontlines

Deck: 
<b>California pays the bill, but who gets the blame- the feds or the fundamentals?</b>
Fortnightly Magazine - September 1 2000

Frontlines

Prices Hit a Pique

California pays the bill, but who gets the blame- the feds or the fundamentals?

What did they know and when did they know it? That's what California consumers are asking utility regulators and system operators, now that the heat of summer has made a shambles of the state's vision of electricity competition.

Yet the regulators and operators appear divided on just who to blame.

According to state Public Utilities Commission president Loretta Lynch in San Francisco, and Electricity Oversight Board Chairman Michael Kahn in Sacramento, California had lost control over its electric industry, having handed over the reins to federal regulators. But down in Los Angeles, the California Power Exchange was claiming to have put together a mathematical model capable of explaining most price fluctuations within PX markets. But the PX had tested its model only through March, before the summer heat really got cooking and power prices took off to levels politically untenable.

Nevertheless, they all should have seen this coming, and taken some preventive measures. Certainly one could predict chaos in a system designed to take commodity prices in a volatile wholesale market and pass them along directly to retail customers without any leavening.

In a report issued at the end of May, the California Power Exchange noted that average market clearing price for the month had doubled from the same period the year before-from about $23 to more than $47 per megawatt-hour. In fact, the price had been climbing steadily since the start of the year. The numbers were there for all to see.

Earlier this year, in February, March, and April, the average PX clearing prices for each month rose above the 1999 averages for the same months by increments ranging anywhere from from 11 percent to 55 percent. (That's what the PX calls the "unconstrained" price, measured without regard to transmission congestion.) Then came June, when it was too late to change course, and prices quadrupled-$120/MWh on average, versus $23.50 for June 1999. July brought precious little relief-$105/MWh, up over two-and-a-half times the average price the year before.

But volumes appeared rather stable, by contrast. Average monthly power quantity traded in May "increased slightly from 1999," according to the PX. Quantity rose 8.5 percent in June against 1999, but then fell 4.3 percent in July from 1999. That means that something else was forcing prices through the roof. Was it market manipulation?

For now, at least, we have price caps through Nov. 15, for purchases by the state's Independent System Operator in markets for real-time energy and ancillary services, plus a request pending by San Diego Gas & Electric to extend the cap to markets run by the PX. What does that mean for the real world-for Wall Street and the private power producers?

At First Union's Evergreen Utility Fund, senior vice president Doris A. Kelley-Watkins draws an analogy.

"If California were to announce that it would regulate utilities in the old way, I would not be the only one looking to get out. You can't put the yolk back into the egg."

Kyle Rudden, vice-president and head of global utilities equity research at J.P. Morgan, sees some companies getting hurt by the market.

"It would likely shoot first and ask questions later," he says.

"It would likely focus on companies that made significant investments in California such as Reliant, Duke, Calpine, Dynegy, and AES-those that right now are making money there and do have capacity there and bought or built capacity there in anticipation of a competitive market. Those would certainly get hit first."

Edward Tirello Jr., managing director at Deutsche Bank, sees the price cap policy as "a pure-and-simple case of regulators and politicians gone crazy."

He adds, "It is delusional to think you can take a rate-of-return industry in which they were losing money on two of the three services they were offering É break it up into three separate business, transmission, distribution and generation, two of which are federally regulated and one regulated by the state, and expect the prices to go down.

"Let's say you put [in] a $500 price cap you know what happens? Everybody bids $499. You put in $250, everybody bids $249. Instead of the price coming down, it stays artificially high. "Price caps cause higher prices. They can't stop what is happening because they caused it."

Meanwhile, the PX says it has a formula that shows that its prices reflect economic reality. Of course, the PX apologizes that it developed its model by taking market observations only through March of this year, but so much the better. That should make the model even more unbiased in testing whether the summer's prices behaved as expected, or whether someone was gaming the market. The PX described its model in its second annual report to the Federal Energy Regulatory Commission, filed on July 31. It relies on six input variables, reflecting demand, supply, and prior market experience:

  • The unconstrained market-clearing price (UMCP) for the previous day.
  • The prior day's UMCQ.
  • The ISO's load forecast.
  • . Temperatures in San Francisco, Sacramento, Los Angeles, and San Diego,
  • The natural gas city gate price for the three major investor-owned utilities, SoCal Edison, PG&E, and San Diego Gas & Electric,
  • Coal plant availability for the three IOUs, and
  • Nuclear plant availability for the three IOUs.

The PX notes that of all the variables in the model, yesterday's price and volume seem to be the least relevant. In fact, the closer the hour to mid-afternoon (hours 14-17), the more important are load, temperature, and unit availability, and the less important still is yesterday's price. All these factors taken together explain all but 12 percent of price movements, says the PX. But its report adds a disturbing observation: During the 12-month study period from April 1, 1999 to March 31, 2000, the off-peak prices fit the model the best. By contrast, the model explained only about 60 percent of price trends seen during the peak hours.

Nevertheless, the PX still refuses to acknowledge any untoward market behavior to account for unexplained price behavior. It suggests instead that other "fundamental factors" might be at work, such as "cost of other inputs, availability of units other than nuclear and coal, hydro conditions, or precipitation."

Eventually, when California and the FERC open their investigations of wholesale power markets, they must confront a vexing question. How does one spot a manipulated market? Must regulators first show that market prices diverge from economic fundamentals? Or, is it simply enough to show that prices fluctuate too much for comfort?

The PX itself alluded to this question in its report, in which it compared the opposing perspectives of the economic theorist and the market technician:

"From a technician's perspective, as opposed to an efficient-markets theorist's perspective, if all information is reflected in the price of a stock or commodity (a principle of the efficient-market hypothesis), why look for external fundamental information when an analysis of price activity is sufficient in understanding market behavior?"

Certainly the temptation has never been greater for regulators to "find" market abuses, show their indignation, and then craft a remedy-even if they're not entirely sure of what is really going on.

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