Frozen in Time

Let’s talk about Utilities (Part II)

“Electricity is different from everything else. We cannot do without it, which makes opportunities to take advantage of a deregulated market endless… In electric power, we must have openness. There is no place for companies like Enron.“ — David Freeman, Chair of the California Power Authority

The US introduced electricity deregulation with the Energy Policy Act of 1992. Power generation was unbundled from other electricity services and turned over to a competitive market, allowing customers to choose where they bought their energy from. Within a handful of years, 20 states had introduced market competition.

Then, in 2000 through 2001, power prices suddenly spiked in California for no reason. California should have had more than enough capacity for the demand, but electricity suddenly became in short supply and prices spiked 20x. By the time the dust settled, major utilities like PG&E had gone bankrupt, Southern California Edison had become nearly insolvent, hundreds of thousands of businesses and households were without electricity, and there were $45B in damages.

It was discovered later that the Western US Energy Crisis of 2000 and 2001 had been caused by an energy consortium all the way in Texas. The company was Enron — Fortune Magazine’s 6-time “America’s Most Innovative Company,” and America’s 7th biggest company on the Fortune 500 (for comparison, the 7th on the 2017 list is CVS). The energy crisis was the result of the total failure in the implementation of electricity deregulation, and the way in which Enron exploited this weakness. This crisis ushered in an era in which utilities became increasingly conservative to change.

And so, energy markets froze in time. Nearly 2 decades later, the electricity markets remain essentially the same as they did back in 2000.

It may not strike you as strange if you don’t work in the energy sector (or if you haven’t lived in multiple states with different regulation policies), but only a dozen states allow a customer to choose his/her own electricity.

So, how did Enron do it? (Note: THE Enron Scandal, in which Enron hid billions of dollars in debt with fraudulent accounting practices, was a totally separate case. Enron was a bad company that did many sketchy things.)

“It doesn’t matter what you crazy people in California do, because I got smart guys who can always figure out how to make money.” — Enron CEO, Ken Lay

How do electricity markets work?

All electricity markets follow the same basic structure: (1) Generators make power, (2) high-voltage transmission lines bring that power to your neighborhood, and (3) low-voltage distribution lines bring power to your home. Generation (1) and transmission (2) make up the “wholesale market” and are regulated by the federal government, while distribution (3) makes up the retail market and are regulated by the state. The difference between a deregulated and a regulated market is:

1. Ownership— with deregulation, companies in transmission/distribution must allow for competition in power generation. If they own their own generators, they aren’t allowed to give them preferential treatment.
2. Pricing — with deregulation, power generators are allowed to charge whatever electricity price the market has set. With regulation, the state decides the price to set.

In regulated markets, these three entities essentially act as a single conglomerate controlled by the state. In deregulated markets, they must be independent from one another.

In the 1990s, California wanted to deregulate its electricity generation industry. So California told their utilities (like PG&E and Southern California Edison) to sell their electricity generation to private companies (like AES, Dynegy, and Enron). From then on, utilities needed to buy their electricity from them (essentially buying the electricity they used to own themselves).

Then, things went terribly wrong.

No market control

In the summer of 2000, a drought in the northwest reduced the amount of hydroelectric power available to California. Even with constrained available power supply, California should have had more than enough generating capacity, but the state suddenly faced immense supply shortages. What regulators later discovered was that the hydro power shortage had made the electricity reserves low enough for Enron to hold California hostage. By gaining control over a substantial portion of available power, Enron suddenly controlled the market, with the ability to shut down their plants for “maintenance” to create artificial shortages, and pretend that their power lines were congested and couldn’t get electricity to places that needed it. Enron further bought up electricity to sell out of state (creating an even bigger shortage), and then sold it back into California at a highly inflated “imported” price. Skyrocketing prices further enabled Enron to sign long-term contracts with businesses that feared increases in electricity prices (signing more than $1B in contracts with Compaq, Starwood Hotels, Prudential, etc.)

The wholesale market’s role is to allow trading between generators and financial intermediaries for short-term delivery and future delivery of electricity. The retail market’s role is to allow end use customers to choose their supplier from a variety of retailers (this type of market is also called ‘energy retail choice’)

This vulnerability to market manipulation displayed California’s lack of foresight. Every market exerts some kind of regulatory control. Anti-monopoly laws exist for a reason. Electricity markets should have exerted some kind of regulatory control. A simple solution would have been to keep capacity under some limit so that no party could manipulate the market.

These manipulative practices could have also been mitigated with better electricity accounting, as is possible today with smart meters (which allow us to measure the amount of electricity coming in, and where it’s coming from). Another reason why such a panic occurred was because there wasn’t a scalable solution to store electricity back then — supply needed to match demand at all times, or the grid could crash. This resulted in the need to create strong price signals to protect the existing infrastructure. Batteries would have protected the grid from price spikes and supply volatility.

The failure of partial deregulation

California also failed in its price regulation. While California decided to let wholesale prices (on the generation side) reflect supply and demand, California decided to still control retail prices (on the customer side). This was with the expectation that deregulation would create lower electricity prices — California wanted to ensure that the utilities would be able to recover their costs from assets that they had already invested in.

But this was a massive oversight. Prices increased. Even as electricity prices shot up and energy became more expensive to purchase, utilities couldn’t charge a higher price for this electricity. Utilities were buying electricity at over $0.50/kWh, but were limited to selling them at $0.06/kWh. This was exacerbated by the fact that wholesale prices are under the jurisdiction of the federal government (and the Bush era government refused to regulate), and California couldn’t impose any price caps on its own.

It would have been much more difficult to exploit the market had the market implemented complete deregulation, since retail prices would have gone up as well, and would have shrank demand. And changes in pricing could have been rolled out slower and been better targeted to allow for the CapEx in new assets to be recouped (as New York is doing currently with VDER).

Again, smart meters could have helped by enabling real-time pricing (rather than monthly or annual pricing), which would have allowed consumers to react to times of high demand and high wholesale prices with reduced demand. The International Energy Agency estimates that even a 5% reduction in demand (or a 5% increase in flexible supply) would have resulted in a 50% price reduction during the peak hours of the electricity crisis.

Lack of financial incentives

The biggest problem that exists even today is that the financial model for utilities are not structured for improvement.

The predominant method for setting rates for utility services is from the cost of service — meaning, utilities charge customers whatever they need to keep the grid running. This is a problem because this means that the utilities’ profits become a function of how much they spend, and they have little incentive to increase efficiency and cut costs. It was also a problem in California in 2000 because in controlling retail rates, California had essentially eliminated any opportunity for the grid to build out more capacity to compensate for the increased demand.

This kind of incentive structure is completely backwards. If we ever want a system with ubiquitous smart meters and the latest battery technology (technologies that would actually protect the grid from market volatility), we need a system that’s incentivized for improvement. It’s important to implement revenue decoupling, where profits and sales are made independently, or to encourage competitive utility services, where consumers are allowed to choose their electricity provider based on service. Or, regulators will need to allocate revenue and regularly demand for utilities to create new projects and systemwide improvements.

The failure goes all the way up

All in all, the biggest failure was from the federal government and the Federal Energy Regulatory Commission (FERC). FERC’s job is to enforce federal law and prevent market and price manipulation — in other words, exactly what Enron was doing. When FERC was called upon to investigate and regulate these energy companies, FERC barely reacted . Future deregulated systems will need a federal agency that’s empowered to enforce compliance, disclosure, and oversight for all new projects, and ensure that deregulation happens only with projects that are worthy. Deregulated sellers will need to prove their creditworthiness, and allow for periodic reports on the health of their power markets, etc.

“We got no help from the Federal government. In fact, when I was fighting Enron, they were sitting down with Vice President Cheney, “drafting” a national energy strategy. “ — Former California Governor Gray Davis

At the end of the day, nobody in Enron went to jail for this particular crisis, because Enron had been using perfectly legal (though unethical) ways to make money, given the market rules that were in place (though it probably helped that Enron was a huge George W. Bush donor). Ultimately, it was the laws that were wrong.

Deregulating electricity

Deregulation historically lowers costs and fosters innovation in every industry where its introduced. Intuitively, this makes complete sense — monopolies have little incentive to innovate or to operate efficiently. It’s the same with electricity. Just because electricity deregulation failed the first time doesn’t mean that the theory behind electricity deregulation was wrong. It only means that the implementation was wrong.

When the market is efficient, capitalism works beautifully. But when markets are inefficient, and when the marketplace can’t gain access to information about its companies, capitalism fails. The electricity market needed to demand greater transparency, but it didn’t.

Imagine if after the Dot-com crash the internet became regulated, and only allowed certain companies to make new websites. Or if after the 2008 subprime mortgage crisis people were no longer allowed to buy houses on credit. We’d be living in a totally different world. Instead, we brushed ourselves off and demanded greater regulation and transparency, and vowed never to let such a thing happen again.

Though the electricity markets haven’t changed much in the last 20 years, the technology has. We now have the ability to protect ourselves from the things that went wrong the first time.

It’s time we overcame our trauma.

I’ve written over 35,000 words about 20 topics in energy and environment — check them out if you’re looking to learn about the sector. See my Table of Contents for an index of everything I’ve written about so far.

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