The Power Game Is a Contest Involving Many Risks

Retail electric service used to be like a game of chess. There were two players--the utilities and the consumers--and one referee--the state, either through the Public Utilities Commission or the Legislature. Each would try to outdo the other over what costs could be reimbursed, rates, terms of service, etc. Most people paid little attention to this game.

California’s 1996 restructuring of the electricity market introduced a simple concept--allow customers to switch providers to find better prices or services--that turned out to be much more complex. To foster retail competition, California mandated that the utilities sell all of their generated energy into the newly created California Power Exchange, and buy 100% of their energy requirements out of the same exchange. Last month, federal regulators told the utilities to use their generation capacity to meet their own load, and buy the rest on the wholesale market. But when the wholesale market went sky-high, the utilities were not allowed to pass on to customers the real cost. This, as everyone knows now, was the match that lit the current crisis--rolling blackouts and two major utilities on the brink of bankruptcy. It also introduced another set of players: merchant-generators, who purchased more than $3 billion of aging utility power plants from the utilities, and power marketers, who buy and sell electricity.

It’s easy to throw around terms like gouging, price manipulation and piracy. But merchant-generators and power marketers are taking risks that most people are not aware of. As price risk managers, we are no different than lending institutions that give consumers a choice of home loans--variable-rate, long-term fixed-rate or some combination thereof--which are set according to a customer’s credit-worthiness and the going market rates. With a variable rate, consumers hope that the short-term interest rate will stay the same or even fall--and with it their mortgage payments. But they also take the risk that rates could rise and increase their payments. If they don’t like those odds, they can pay more to lock in a firm rate and let the lending companies take the risk. That’s the way our business works, too.

Last week, the state of California entered into the world of power wheeler-dealers in a way none of us could have imagined a few weeks ago. Gov. Gray Davis tried to resolve the electricity crisis by taking bids to secure long-term contracts for, hopefully, less than today’s high wholesale prices. Dozens of suppliers joined in the bidding, factoring in such things as fuel costs, contract length, payment security, penalties for nondelivery, etc.

The misperception on the part of Californian energy consumers is that, by obtaining long-term contracts, Davis will be taming the market, i.e. switching from variable rate loans (the spot market) to fixed rate loans (long-term contracts). But consumers have to make a choice. In my business, we manage the price risk. Consumers tell us what they want, we make the offer and consumers make the choice. When California said everything was a variable rate, we said, you got it. Then we were called gougers when the price on the spot market went very high.

Energy consumer advocates now want the long-term power prices because these prices are currently attractive relative to spot prices, but how will the advocates react if, down the road, energy prices are less than the long-term offers on the table today?

We in the energy brokering and marketing business are eager to provide energy at competitive prices. We compete fiercely among ourselves to gain market share, win new business and earn profits. We have watched as too many of our fellow generators and marketers have self-destructed by offering long-term deals in which the cost of delivery greatly exceeded the contracted price--the exact situation that California utilities are facing today as buyers of wholesale power to serve their retail customers. Markets harbor no fools, because the punishment is exacting and unusually swift. Especially when it comes to electricity.

That was the problem in 1995 when the PUC and the state initiated the restructuring policy. At that time, electric prices in California were 50% higher than the national average, and the wholesale spot prices were going swiftly down. By December 1995, spot prices sank to 0.8 cents (yes, that is zero-point-eight) per kilowatt-hour. Currently the price is 30 to 60 cents per kilowatt-hour.

As with so many other industries that have transformed pricing and service from regulated to market-based (think of the airlines and long-distance phone service), we should expect an adjustment period during which everyone is confused. Eventually the suppliers will figure out what consumers really want and fiercely compete to provide it.

Here’s a suggestion: Let’s stop calling each other names and start working together to figure how to avoid rolling blackouts and keep the existing system solvent. It serves no purpose for power generators to go broke or to file claims against utilities, forcing them into bankruptcy. Everyone loses then.

Despite all the financial pain that we are undergoing, the problem is fixable. It’s time for consumers and merchants to meet each other with a more informed understanding of what each party does and what the other wants. In the words of Mark Twain, doing so will amaze some and gratify the rest.