Lessons from California

There is a need to analyse and understand the causal factors behind California's electricity crisis and to draw the lessons for India and other developing countries.

THE imperative necessity of restructuring/reforming the electricity sector in India to overcome the financial ill-health and technical shortcomings of the electricity boards is being repeated ad nauseum, particularly by the multilateral donors and their acolytes in government and academia. The recommendations are justified with hand-waving references to the successes of reform in the industrialised countries. Just when the process appeared to be virtually unquestionable and unstoppable, the "consensus" has been shattered by the unbelievable news of the California electricity crisis. In a State at the forefront of the Information Technology (I.T.) revolution, there have been unscheduled interruptions of power and rolling blackouts covering hundreds of thousands of consumers. Suddenly, the situation there appears no different from that in the cities of backward, developing countries. One is reminded of Hans Christian Andersen's story where it is discovered that "the Emperor has no clothes". Clearly, there is a need to understand the California electricity crisis and to draw the lessons for India and other developing countries.

California's Governor Pete Wilson signed the deregulation bill on September 23, 1996. The utilities were compelled to sell their gas- and oil-fired (non-nuclear) power plants in California to other companies. It was hoped that a sufficient number of new power plant owners would enter the generation scene so that none could single-handedly influence the price of electricity in California's new marketplace for electricity. Stripped of most of their generation capacity, the utilities had to buy all their electricity requirements in a transparent manner. This had to be done one day in advance from the California Power Exchange, the state-run wholesale electricity market set up on March 31, 1998, to determine wholesale electricity prices. Any shortfalls had to be made up on the last day by a second organisation, California's Independent Service Operator (Cal-ISO). Consumer prices were capped or frozen until utilities paid off their debts or until 2002. The underlying expectation (endorsed by the utilities) was that the pre-deregulation trend of falling wholesale prices would continue and therefore the utilities would realise greater and greater profits from retail prices being increasingly higher than wholesale prices and recoup their stranded investments by 2002.

Since participation by utilities in the deregulation was voluntary, many cities with publicly owned utilities including Los Angeles, Burbank, Riverside, Glendale and Anaheim, did not join the experiment - and incidentally did not experience the California electricity crisis. It was said: "You look at where the lights are on in California, and you look at the municipal utilities!"

The new millennium brought with it many indications of the looming electricity crisis. The electricity demand was far greater than expected - it grew three times more quickly than anticipated. The heat wave in May 2000 aggravated the peak summer demand. From June 2000 onwards, the wholesale price of electricity rose alarmingly - there was a ten-fold increase which was much greater than could be accounted for by the rise in natural gas prices. The State's major utilities (Pacific Gas & Electric and Southern California Edison) were paying far more to buy power than they were allowed by deregulation to charge consumers. In places where there was no cap on consumer prices (for example, San Diego), businesses and homes paid more in the summer of 2000 compared to the same period the previous year. The power system reserve ratio (the ratio of excess capacity to peak demand) started falling to dangerous levels. There was a Bay area blackout in summer of 2000. Traffic lights went out in the Bay area, computer screens went dark, heaters and bank machines went silent, and lights went out in classrooms. The State even declared an emergency because the power system reserve ratio had fallen below 1.5 per cent.

Governor Gray Davis in his State of the State Address on January 8, 2001, declared that "California's deregulation scheme is a colossal and dangerous failure" and proposed steps to reassert the State's control over its power market. It was felt that out-of-State companies selling power to California were charging exorbitant prices for electricity on the spot market for immediate delivery. In fact, power producers were accused of price gouging. It has also been said: "California was hailed as a model for the rest of the nation. And it has been a model - of how not to do it", and deregulation has been "... one of the most expensive public policy miscalculations in California history".

California's deregulation is now deemed a failure needing large-scale intervention in the market. The California electricity crisis has scared the other States in the U.S. that were rushing along into deregulation - they are now applying the brakes on deregulation. It appears that deregulation is dead!

There are several causal factors behind the California crisis.

Supply shortage with respect to demand: There was a gross underestimation of California's electricity demand, which grew by 25 per cent in the 1990s. This was partly because computer-based businesses in particular, and the I.T. sector in general, consumed electricity at rates unheard of in the old economy. But there was also a serious slackening of conservation efforts even when wholesale prices skyrocketed. Further, there were problems on the supply side because polluting plants were idled and old power plants (55 per cent of California's plants were more than 30 years old) operated less efficiently. In the tight supply situation, some generators were shut down because of untimely, unscheduled power-plant maintenance. Although California imported 18 per cent of its electricity, no new major power plants had been built in California in the 1990s. This lack of new capacity has been blamed on the citizens' NIMBY ("Not in my backyard!") attitude to new plants. Finally, just when California depended most on importing power from out-of-State, there was increased demand in States exporting power to California.

Transmission bottlenecks: Trading in power has resulted in greater distances between generators and consumers, as a result of which the transmission grid is overtaxed. Unfortunately, deregulation and unbundling diminished the incentive to invest on a transmission grid that is accessible to all generators.

Natural factors: The weather did not help the situation. Storms led to the shut-down of the 2,200 MW Diablo Canyon nuclear plant because waves of nearly 20 feet in height forced kelp into the pipes that suck in sea water for cooling the plant. And, late runoff on the rivers of the Pacific Northwest reduced hydroelectric generation.

Defects in deregulation: A sweeping divestiture (involving old generators being forced to sell off most of their plants) was implemented without ensuring that the new owners would sell electricity at a reasonable price for a specified period. There was widespread failure on the part of utilities to anticipate that electricity supply companies could earn very much more than the going rate by holding back electricity and selling it when the system was desperate for electricity. There was inadequate regulation of wholesalers. Deregulation did not prompt more competition rightaway. Deregulation has also resulted in disincentives not only for new capacity but also for improvement/expansion of transmission and for research and development relevant to transmission.

Imperfect market: On November 1, 2000, the Federal Energy Regulatory Commission commissioners called the California market "seriously flawed" and said that they found clear evidence of market power based on rising natural gas prices, higher loads and supply disruptions. Cal-ISO also became an easy way of bypassing the market - all that suppliers had to do was to withhold electricity until the last day and, in order "to keep the lights on", Cal-ISO would have to buy at whatever exorbitant prices were quoted.

Financial concerns: As the debts of utilities accumulated to staggering proportions, credit rating agencies started rating California utilities as junk bonds less than investment grade. As investor-owned utilities approached bankruptcy, they could not purchase electricity for distribution.

The Californian electricity crisis holds several lessons for India.

With regard to unbundling the electricity sector and privatising its components, California's deregulation bears a strong similarity to the restructuring approach in India. Hence, it is important to draw lessons from California to safeguard the Indian power sector.

1. The power sector (and for that matter, education, health, water, roads, communication, transport, and all other infrastructural services) cannot be left completely to the market along with a total withdrawal of the state. Markets (provided that they operate with competition) may foster efficiency, but they also have limits and grave shortcomings because of their preoccupation with the bottomline (of balance sheets). They do not safeguard equity and distributional justice. They are not bothered about the environment (unless environmental externalities are internalised). They are unconcerned about the empowerment of people and their communities. And they pay no heed to the long-term, particularly research and development. In short, markets do not protect public benefits.

2. Notwithstanding specific shortcomings of the vertically integrated electricity system, it must not be assumed that an unbundled market-driven system will be ipso facto more successful and advantageous to society. The establishment of the restructured system is associated with transaction costs and gestation times. Hence, a careful comparison of the costs and benefits of the old integrated system and the new unbundled system is essential before dismantling the old and ushering in the new.

3. If a cost-plus price regime is going to be replaced by market-driven prices, then the creation of a market is not sufficient. The market must preclude (in practice, not merely in theory) the exercise of market power, price gouging and gaming. In addition, the extent of competition must be monitored and it must be shown that there is indeed effective competition.

4. Electricity has several unique characteristics - it "cannot" be stored economically; continuous supply-demand matching is required, its demand varies hourly, daily and seasonally, it is relatively price-inelastic, and it is easy to control in the sense that a supplier can easily turn the supply on or off. All this distinguishes electricity from other commodities such as oil or natural gas and makes its marketisation a different and difficult proposition. Hence, the case for unbundling the power sector must not be made merely on economic grounds (such as separated profit centres); the restructuring must also be justified on technical grounds. In particular, a technically stable and institutionally sustainable integrated operation of supply-demand matching must be ensured before unbundling is implemented with the vertically integrated system dismantled into separate generation, transmission and distribution entities.

5. Whereas a vertically integrated system copes with sudden peaks in demand with reserve (capacity) margins of 15-20 per cent, an unbundled system involving a large number of wholesale generators may have no incentive to maintain such reserves. In fact, profitable price increases may be facilitated by reserves falling to precarious levels. So, the policy, and technical and institutional measures to achieve safe reserve margins must be ensured.

6. The affordability of retail electricity prices to consumers is a necessary condition for the success of restructuring, but it is not a sufficient condition. The debt burden of utilities must not increase. Hence, the impact of reform on prices must be anticipated before rushing into restructuring, particularly unbundling and privatisation. In fact, the success of restructuring must be judged by the behaviour of actual electricity prices compared to anticipated prices. If there are any doubts about the reliability of the forecasting of prices, it is advisable to test the assumptions underlying restructuring in limited experimental areas before large-scale implementation.

7. Notwithstanding any general beliefs and expressions of faith regarding the wisdom of leaving the development of the infrastructure to the market, the unique character of electricity is such that a strong role for the state and for regulation is essential. The market alone cannot take care of the integrated functioning of the electricity system, and therefore the requisite regulatory arrangements must be in place. For example, it is important to have mechanisms in place to ensure that there are adequate reserve margins to cope with sudden peaks of demand and shortfalls in supply. In case the process derails - as happened in California - there must be emergency procedures for the state to come to the rescue.

8. The behaviour of the actors involved in the electricity system is radically different under conditions of supply shortages compared to that under conditions of surpluses. Further, it appears that the experience of restructuring and reform has come by and large from countries and systems with surplus capacity. Thus, deregulation under conditions of shortage is not the proven success that is being touted; it is very much an unproven experiment with California yielding the first disastrous results.

9. Compared to increasing capacity by building new power plants, energy conservation measures provide the quickest way out of the crisis.

10. It is unwise to go ahead with restructuring/reform without specifying the criteria by which the success/failure of the restructuring/reform process will be judged.

A former Professor of the Indian Institute of Science, Bangalore, Amulya K.N. Reddy is currently associated with the International Energy Institute.