September 21, 2001

Direct Access Officially Terminated in California

By Will McNamara

[News item from Reuters] California utility regulators on Sept. 20 jettisoned Californians' right to choose their power provider, tossing out the core of the state's disastrous bid to deregulate its electric industry. The California Public Utilities Commission (CPUC) voted 3 to 2 to immediately suspend consumers' "direct access" to independent power retailers, further dismantling the 1996 law that was supposed to foster competition among power generators and drive down the state's steep electricity prices. "Direct access is one-half of a failed and collapsed deregulation project," Commissioner Carl Wood said at Thursday's CPUC meeting. He attributed the rest of the blame on the law's retail rate cap, which blocked investor-owned utilities from passing wholesale power costs down to their customers, incorrectly assuming wholesale prices would fall.

Analysis: Well, it has finally happened. The electric choice experiment in California that has had such a checkered history is now officially dead. Of course, direct access was never what could be considered a success in California. Since its launch in April 1998, and despite an advertising and public awareness campaign that cost $80 million, most Californians shunned the opportunity to switch to a new electric provider and opted to stay with their incumbent utility. It is arguable that direct access was somewhat successful for large industrial customers in California, who perhaps gained some level of measurable savings from new providers. However, as a whole, the CPUC estimates that only 5 percent of California's peak electricity demand of 46,000 MW was in direct access contracts when the commission voted to terminate electric choice in the state. Given the huge industry press that surrounded deregulation in California over the last two years, its final death sentence seems rather anticlimactic. The real story here may be the true reasons that the CPUC has terminated direct access in the state, the continuing impact that California's problems will have on other states that are still attempting to deregulate, and the myriad of issues in California that still need to be resolved.

If the CPUC's vote truly represents a death sentence for California deregulation, then it must be acknowledged that the state's energy market has been on life support for some time. The fact that the CPUC has put a final nail into the coffin of California direct access should not come as a surprise to anyone. In fact, Commissioner Wood issued the "epitaph for [California] deregulation" in January of this year when the commission adopted emergency rate increases that apparently were insufficient to extricate the state from the huge amount of debt that it currently carries. What has been particularly curious about the momentum behind the CPUC's decision is the rationale that the state has used to terminate electric competition. Ironically, the state has based its argument on the same concerns that California's investor-owned utilities (Pacific Gas & Electric, Southern California Edison and San Diego Gas & Electric) raised five years ago when competition first began: namely, stranded costs and the uncertainty over who will ultimately be responsible for paying them off. The CPUC's effort to terminate competition is being driven by the state's desire to ensure that a large customer base ultimately bears the responsibility for the huge power tab in California.

In other words, now that direct access is officially over, the state has more certainty that its large customer base will remain intact and will ultimately share in the expected rate increases that are needed to pay off the state's outstanding debt for power purchases. One of the emerging "positives" out of this development is that, according to new reports, the termination of direct access in California should make it easier for the state to tap revenue from retail power sales needed to fund a record high $12.5-billion bond issue planned for later this year. The bond will be used to repay the state Department of Water Resources (DWR) for its emergency power purchases. In January 2001, the DWR stepped into the role as the primary power purchaser for the state when the incumbent utilities' financial instability made it difficult for them to secure power.

This is a very important point and needs to be clearly established. What is driving the CPUC toward its decision to end direct access is a fear that the state will be left holding a hefty bag of debt with no recourse for getting it recovered. Since the DWR assumed the role of operating as California's primary power purchasing agent, the state has already racked up debts over $9 billion. It is the state's intent to recoup this debt through rates affixed on energy customers served by the three incumbent utilities. Yet, direct access would keep the door open for large energy customers to sign deals with other power suppliers and thus avoid having to pay any share of the state's energy tab, including purchases that have already been made. This could leave the state with a surplus of costly power and few customers to pay for it. In addition, the state fears that if small consumers are left to pay a disproportionately high amount of the state's debt due to larger customers leaving the system, this would result in a mass exodus from California, which would also have a negative impact on the state's stability. This dynamic is known as the "fixed-cost death spiral," which the state is now trying to avoid. In the words of Loretta Lynch, the CPUC's president, "We need to ensure a customer base...so that as the power is purchased by the customer, the state is repaid."

Further, now that California direct access has been officially discontinued, the policy will most likely remain in place for at least 10 years, or through the tenure of the long-term contracts that the state has signed with various suppliers. Direct access, which allows an end user to establish deals with private power suppliers, has been in effect in California since the launch of deregulation in the state in 1998. However, earlier this year, California passed a little-known state law that put restrictions on customer choice in the state. Once the state began purchasing electricity, it put restrictions in place such that customers who had not yet switched from the incumbent utility were now prohibited from switching. This formed the legal battle between the California State Universities and Enron, which had attempted to break a four-year power contract. In that case, the universities argued that they would be prohibited from switching to another provider until the state contract expires, which could be as long as 10 years.

The flipside to this argument is that those end users that did leave the California system to buy power from other suppliers (such as the state universities) will now be forced to assume a portion of the debt accrued by the state on behalf of the incumbent utilities. Granted, the number of customers that will find themselves in this position is rather small in number (but large in volume); however, the approach does seem to puncture a hole in the CPUC's attempt to construct a fair policy. The other argument that has been launched by end users against any discontinuation of direct access is that those industrial customers that have exercised their option to choose a new power supplier have saved tremendous amounts on their energy bills. With additional rate increases likely in California, opponents of the CPUC's decision say that customer choice is needed now more than ever before.

Moreover, the effort to re-regulate California is not a new idea, but rather something that has been in the works for about a year. Nevertheless, despite the well-documented structural problems that are inherent in California's competitive model, the end of direct access in California is clearly rooted in the state's fear of competition and the opportunity for new suppliers to come in and take business away from the state.

Still, most would agree that the numbers in California paint a rather dismal picture. At its peak in 1998, direct access in California enticed about 2.5 percent of residential customers and 13 percent of industrial customers to contract with a new power supplier. Over the last year, this number has dropped dramatically as contracts have expired. In addition, many power suppliers have turned customers back to the incumbent utility because the high cost of wholesale power has made it difficult for them to offer a competitive retail price. Reportedly, those contracts still in effect would be allowed to run their course under the new legislation.

Opposition to the CPUC's plan to end direct access has been intense since the commission first began discussing this option. For instance, FERC Chairman Pat Wood had previously weighed in with his disagreement with the CPUC's expected vote to kill direct access. Wood argued that ending customer choice could lock Californians into higher energy prices (through the rate increases). Wood's position is that if direct access is not currently working in California, state officials should continue to modify its restructuring policies until direct access is successful (rather than abandoning it altogether). However, Wood has backed off from interfering in the CPUC's vote, stating that the issue falls squarely under state jurisdiction.

Apart from all of this, the state of California has assumed an enormous and risky role as it not only has become committed to long-term power buying contracts, but also seeks to purchase transmission assets from incumbent utilities and expropriate generation assets. Regardless of the CPUC's ruling on direct access, this does not put California in a very good spot. In addition to the fact that the California government is arguably not prepared to manage the intricacies of the state's complex and huge electric market, there are substantial financial risks associated with the government's new role. For instance, although the actual terms of the contracts have remained proprietary, it is a fairly safe bet that the 10-year contracts that the state of California has entered into are based on today's average wholesale energy price of about 7 cents/kWh. This average compares to wholesale prices of 3 to 4 cents/kWh that were common in the mid- to late-1990s. If prices return to the 3 to 4 cents/kWh range, the state of California will remain locked in long-term contracts based on high prices, which will create a disproportionately high amount of debt for the state government. Granted, the CPUC now has unilateral authority to increase rates to compensate the state for power purchases, but conflict would certainly result if California's rates continue to exceed market rates.

So, what does all of this mean? The CPUC has likely based its decision to end direct access on a belief that "desperate circumstances call for desperate measures." However, the desperate circumstances in which California still finds itself resulted from bad decisions made in the planning of the state's deregulated electric market, including decisions made by the CPUC. Moreover, the decision from the CPUC furthers the transfer of financial vulnerability from the incumbent utilities to the state of California, which creates a very precarious situation for the nation's largest energy market. In addition, electric competition in the nation's largest state, which represents 20 percent of the country's economy, will now be blocked for at least the next decade. This potentially could have a very damaging effect on the level of new technologies and industries that would be brought into (or choose to remain in) the state of California. The total consequences of this measure remain to be seen, but it is clear that the CPUC's decision to end direct access is a huge milestone in the ongoing California energy debacle.

Copyright 2001 SCIENTECH, Inc.