TransActions - June 2001 (Vol 301)

Lessons Learned From California Have Texas Deregulation Riding High!

In March of 1998, California became one of the first states to deregulate its electricity market based on the promise that competition would lower electricity prices. We all know what happened. In 2000, electricity prices soared more than 100 times the normal regulated level.  The consequences have been well publicized as huge rate increases to certain consumers, numerous small business failures, and the bankruptcy of PG&E, one of California's largest electric utilities. With each passing day, the crisis caused by California's electric deregulation experiment seems to worsen.  There is little prospect for any short-term solution to the problems in California, and as a result, political and public pressure for full re-regulation of the state's generation market has increased. As broader concerns regarding rising energy prices and energy supply shortages in other regions have arisen, numerous states have elected to delay or indefinitely postpone plans to deregulate their retail electricity markets.

All Eyes are on Texas
Texas, however, is marching forward boldly toward deregulation of its electricity market beginning January 1, 2002.  President Bush actively supported the Texas deregulation plan when he was governor of the state, and he recently appointed Texas Public Utility Commission Chairman Pat Wood, one of the main architects of Texas' deregulation plan, to the Federal Energy Regulatory Commission. As a result, all eyes have turned to Texas as a possible model for future electric deregulation policy, though it must be remembered that the circumstances in California are far different than those in Texas.

Supply and Demand
In competitive markets, supply and demand determines the level of electricity prices. The failure of electric deregulation in California has largely resulted from a severe shortage of electricity supply concurrent with high electricity demand.  California's electricity supply shortage is due to three major factors. First, California's stringent environmental policies discourage investment in new electric generating facilities in the state. Second, a significant portion of the electricity which supplies California's market is imported from other states and is thereby subject to curtailment when transmission lines used to transfer the electricity become overloaded. Third, approximately 25% of California's electricity is supplied from hydro generation facilities in the northwestern United States whose output has been sharply reduced by low rainfall levels over the last year. Together, these three factors contributed to the current electricity supply shortage in California. At the same time, California has experience high electricity demand growth in recent years. Furthermore, because California's deregulation plan required incumbent utilities to continue to serve customers at rates which were frozen at the 1996 regulated level, most of California's consumers have been shielded from the extreme electricity market price increases over the last year, and therefore, have not reduced their electric usage as would normally occur in a competitive market environment. This concurrent supply shortage and high demand for electricity resulted in sharply higher wholesale electricity prices.

In contrast to California, Texas will have a significant surplus of electricity when it deregulates its market next year. Texas has an abundant existing supply of relatively low cost electricity plus regulations that favor the construction of new electric generating facilities. By 2003, the capacity reserve margin in Texas is forecast to increase to more than 30% (double the normal level) due to the addition of over 20,000 Megawatts of new efficient gas-fired combined cycle generating capacity. In addition, because Texas has very little hydro generation and imports very little of its electricity from other regions, Texas will not be subject to the weather and transmission related supply shortages that have plagued California. While demand for electricity has been brisk in Texas, the Texas deregulation plan provides for adjustments to "the price to beat" which utilities must offer customers in the event energy prices increase as they have over the last year. As a result, Texas consumers will receive clear price signals that should encourage reduced electricity consumption in the event electricity prices spike as they have in California. 

Price to Beat
The supply and demand factor definitely favors Texas.  So does the "price to beat" item as well as wholesale market differences in its deregulation plan.  For deregulation of electricity prices to be successful in any market, the level of existing regulated prices, which are often referred to as the "price to beat", must be high enough to allow competitive suppliers to enter the market and make a profit.  Before California deregulated its electricity market in 1998, its electricity rates were among the highest of any state.   California policy makers naturally assumed that future deregulated market prices would be significantly lower than regulated prices.  Based on this assumption, California's deregulation plan was designed to require incumbent utilities to continue to serve consumers who chose not to purchase from competitive suppliers at rates that were 10% lower than their regulated rates before deregulation. Under California's deregulation plan, this "hard rate freeze" was to remain in place through March of 2002, or until utilities had fully recovered their stranded costs. Unfortunately, due to electricity supply shortages and rising energy prices and other factors, competitive market prices have been significantly higher than the "price to beat" in California. As a result, consumers have had no incentive to switch to competitive suppliers. In areas such as San Diego, where the incumbent utilities had recovered their stranded costs and the price to beat rate freeze was lifted, consumers were suddenly exposed to the dramatic market price spikes which first arose during the summer of 2000. In other regions of California where the price to beat remains in effect, consumers have been shielded from the market price increases; however, the incumbent utilities have suffered tremendous financial losses as a result of having to buy electricity at the high wholesale market prices and resell the electricity to consumers at the much lower price to beat rate. The inability of incumbent utilities to mitigate these financial losses ultimately lead to their inability to pay for electricity purchased from wholesale suppliers, and in PG&E's case, bankruptcy. The financial instability created by this situation injected additional risk into the California electricity market, thereby further increasing the supply shortage and electricity prices. 

The Texas deregulation plan is designed specifically to avoid the problems created by California's hard rate freeze provisions. The price to beat offered by Texas utilities can be adjusted twice a year if market energy prices increase. The Texas price to beat also will be adjusted to account for the higher level of prices during summer peak periods.  As a result, the price to beat offered by incumbent utilities in Texas will reflect market energy price increases and rise to levels that should encourage competition from other suppliers. Furthermore, any losses incurred by Texas incumbent utilities during the "price to beat" period are subject to future recovery after review in a true-up proceeding to be conducted by the Texas Public Utility Commission in 2004, thereby ensuring financial integrity of the incumbent suppliers.   

Wholesale Market Structure
The final key difference between the California and Texas deregulation plans is the structure of the wholesale electricity markets that serve these states.  In California, policy makers established the California Power Exchange (CPX) as the primary source of wholesale electricity. The CPX provided for electricity sales based on day ahead hourly price bids, with the highest bid clearing the market in each hour setting the price for all electricity sold in that hour.  This "hourly clearing price" approach to selling electricity increased volatility in prices, prevented electricity purchasers from negotiating long-term contracts to hedge supply risk, and allowed electricity suppliers to get the maximum price accepted in each hour. California's deregulation plan required incumbent utilities to sell all electricity they produced into the CPX, and to purchase all of the electricity needed to supply their customers from the CPX. This prevented incumbent utilities from negotiating long-term contracts to hedge energy price volatility.  Because virtually all California consumers continued to buy from their incumbent utilities, the vast majority of all of the electricity bought and sold in California was supplied from the CPX. Over the last six months of 2000, average electricity prices from the CPX averaged over $172 per megawatt-hour (MWh); wholesale electricity prices in Texas averaged less than $40/MWh during the same period.

In sharp contrast to California, the Texas deregulation plan provides a wholesale market structure that emphasizes contracting between individual electricity producers and electricity retailers, with no restrictions on the source or structure of wholesale purchases by incumbent utilities or other competitive suppliers. This "bilateral market" structure is expected to maximize wholesale market competition and greatly reduce the electricity price volatility that has been experienced in California's market. 

Electric Deregulation Benefits
Although the Texas deregulation plan is a great improvement over the plans implemented in California and other states, questions still remain as to whether electric deregulation can really lower costs to consumers.  Under any deregulation model, the electricity supply chain is much more complex and involves many more parties when compared to the historical regulated electricity market. Power generators, power marketers, power retailers, scheduling entities, independent system operators, metering and billing service providers, aggregators and other parties now make up the retail electricity supply chain that once was served only by the incumbent utility.  Each of these new parties must earn a profit that compensates them for the high risk inherent in competitive electricity markets, and somehow still deliver savings to the customer. 

Only time will tell whether this new deregulated system will lower costs when compared to the traditional regulated model.  However, among the states that have committed to deregulate electricity, Texas appears to offer the best chance for electric deregulation to really work.

For comments or additional information, please contact Scott Norwood in our Austin, Texas office at  512-494-0369 or e-mail: info@gdsassociates.com. 

Natural Gas Pipelines.

It’s Time to Tighten Safety Belts
Natural gas is fast becoming the choice for new power generators because it is a cleaner, more efficient fossil fuel than coal or oil. If deregulation of electric utilities can result in decreased electricity prices, this will lead to further increase in demand for natural gas.

It's not as if natural gas is a novel idea. In the United States, we already consume 27% of all the natural gas used in the entire world! 21 trillion cubic feet of natural gas flows through 1.3 million miles of transmission and distribution pipelines every single day to industrial, commercial and residential customers. And, if projections are accurate, the use of natural gas will increase 40% by 2010. (Source: U.S.Energy Information Administration.)

The 40% is significant because it is projected to happen in just a short nine years. With so much happening so fast, there is every possibility that we could have a rash of accidents like the one in New Mexico last year that killed 12 people.

On the other hand, a good number of pipeline and utility people have taken the bull by the horns and are already thinking safety and reliability in the face of increased demand. These people are not just safety conscious. They know that if nothing is done, the U.S. Government, already concerned over pipeline safety, will step in with a truckload of new and costly mandates. 

High-risk Management
Concerned pipeline and utility people are brainstorming and formulating high-risk management plans. GDS is aware of this because we have been asked to take part in discussions concerning these type of plans.  As with any good management plan, there are basic elements that should be considered first for tighter regulation and management. These basics are appropriate for consideration by any pipeline firm, anywhere. 

1.  Outside forces
Over 50% of all pipeline 'accidents' are caused by outside contractors excavating into natural gas pipelines. Pipelines are certainly the safest way to transport natural gas, but they are not built to withstand bulldozers. Safeguards that are in place should be sufficient, but the sad truth is that because of the human element, they aren't. New ways to reduce ignorance and avoid carelessness must be created now.

2.  Sensitive areas
Pipeline companies and utilities are identifying and prioritizing those areas that pose the greatest possible risk. These areas are mostly within heavily populated sectors, although earthquake-prone territory is getting attention, too.  Budgets are being reworked to allocate funds for extended risk control in those areas, such as more frequent inspections and leakage surveys and the development of risk models.

3.  Operators
Prior to 1999, there were no requirements that natural gas operators had to be specially qualified to work on pipeline systems.  On October 28, 1999, the Department of Transportation issued a regulation that employees of natural gas pipeline and utility operators performing certain "covered tasks" had to be qualified. (A "covered task" is identified as an activity that 1) is performed on a pipeline facility 2) is an operations or maintenance task 3) is performed as a requirement under 49 CFR Part 192 of the pipeline safety rules or 4) affects the operations and integrity of the pipeline.)

Exactly what the qualification requirements should be has been left up to the natural gas utility. The DOT regulation requires that written plans of how employees will be qualified was to be completed by April 22, 2001. Operator qualification must then be completed by October 28, 2002.

4.  Information
The more the public knows, the better. A community served by natural gas that knows about the pipelines running underneath it, and what possible dangers exist, will appreciate the safety measures that are in place. The community will be more receptive to regulations, such as stricter guidelines for local excavators. Finally, a public that has been informed of how to recognize and report a pipeline emergency can actually nip a potential catastrophe in the bud.

Any risk management program for the pipeline industry should include these four important elements as well as others. For instance, The National Transportation Safety Board (NTSB), has made many safety and system modification recommendations which could also be considered in high risk management plans.

Finally, current government regulations must be reviewed on a regular basis to ensure they are up to date with measures to protect both the public and the environment.  In this high-technology age of rapid change, what's appropriate today is often obsolete tomorrow.

For more information and/or details about GDS services related to pipeline systems risk management plans or pipeline safety issues, please contact Simon Peña in our Austin, Texas office 512-494-0369 or e-mail: info@gdsassociates.com.   

Deregulation Maze:  What's Going on in Other States

• Arkansas: Senate Bill 324 delays implementation from January 2002 to October 2003. PSC can push back further if the generation transmission systems are found inadequate to support a competitive market.

• District of Columbia: Direct access started January 1, 2001. Plant divestiture completed.

• Florida: Legislature failed to pass wholesale generation deregulation bills that Governor's study commission recommended for the development of a merchant plant market.

• Montana: PSC delays competition from July 2002 to July 2004 due to lack of competitive power market.

• Nevada: Governor indefinitely delays deregulation under Nevada Energy Protection Plan. Legislation passed to re-regulate utilities and bar sales of power plants until July 2003 under AB 369.

• New Mexico: Newly enacted legislation SB 266 delays retail competition until 2007. Original residential start was 2002.

• North Carolina: Legislative study committee backing away from its recommendation that competition starts in 2005. Rather will continue to examine issues including consumer protection and in-state plant development, along with the NCUC.

• Washington: Governor signs HB 2247 that grants tax incentives to promote self-generation at aluminum companies.