Lessons from California's Power Crisis

• Author: John E. Besant-Jones/Bernard Tenenbaum
• Position: Lead Economist/Lead Energy Specialist

"This is a dreadful mess for a state that is held up around the world as a model of innovation. . . ."

-The Economist,

January 20, 2001

Over the past 15 years, more than 30 countries or regions within countries have initiated major reforms of their power sectors. Typically, the reforms involve some combination of restructuring, privatization, and competition. While the reforms are almost always intensely debated by power sector officials, they rarely receive much attention outside the power sector. But this has changed with the skyrocketing prices, blackouts, utility bankruptcies, and potential "deprivatization" that have accompanied the collapse of California's reform program. Clearly, what happened in California was not what was planned.

It is not surprising that policymakers around the world are now asking questions. If things can go so badly with a reform that did not involve privatization in such a rich and sophisticated economy, what is the likelihood for success in much less well endowed countries embarking on the whole gamut of reforms, including privatization? It is also not surprising that prime ministers and power ministers in many developing countries are receiving telephone calls from opponents of power sector reform telling them "you are going to have another California" unless the reforms are stopped or scaled back.

There is no lack of information on the California crisis. Over the past 12 months, thousands of pages have been written on the crisis in industry journals and the popular press. As Newsweek columnist Robert Samuelson wrote in describing another crisis: "[G]etting information is not the problem; the hard part is deciding what it means" (July 17, 1995). This article attempts to assess what the California power crisis "means" for developing countries. While the crisis is far from over, there is, however, enough evidence to suggest some preliminary lessons.

Features of California's reform

In the early 1990s, California's average electricity prices were about 50 percent higher than the U.S. average. The state's economy was in a recession, and major industries were threatening to move to other states. The governor and his advisors concluded that the state's power sector needed major reforms to lower electricity prices to levels comparable to those in neighboring states. Their solution was to restructure the state's power sector and introduce wholesale and retail competition.

When the reform began in 1996, three privately owned utilities-Pacific Gas & Electric (PG&E), Southern California Edison (SCE), and San Diego Gas and Electric (SDG&E)-were the monopoly suppliers of about three-fourths of California's retail sales. These three utilities, known as investor-owned utilities, or IOUs, were vertically integrated monopolies-they generated, transmitted, and distributed electricity to retail customers who generally had no other supply options. The remaining 25 percent of the state's electricity consumers were served by municipal utilities, which were integrated to varying degrees.

The California reform program involved restructuring and competition. (It did not involve privatization because most of the power sector was already privately owned.) Its key elements were

* mandatory divestiture of 50 percent of the IOUs' fossil-fuel generating plants but without any contracts to buy back the output of the plants;

* mandatory participation of the IOUs, both as buyers and as sellers, in centralized spot wholesale markets for day-ahead and day-of power sales run by a new organization called the Power Exchange (PX);

* creation of the nonprofit Independent System Operator (ISO) to take operational control of the high-voltage transmission grid that continued to be owned by the IOUs;

* introduction of retail competition or customer choice with retail customers served by the IOUs now being allowed to switch to other electricity suppliers;

* recovery by the IOUs of "stranded costs" (costs that were anticipated to be above future market prices) through a "competitive transition charge" to be paid by all retail customers; and

* a mandated 10 percent reduction in, and freeze on, retail tariffs for four years or until the IOUs had recovered stranded costs, whichever came first. The 10 percent reduction was largely offset by the competitive transition charge.

Although participation in the new market arrangements was mandatory for the IOUs, municipal utilities were given the option of not participating, and most of the municipal utilities chose that option.

The crisis

California's reform program seemed to work reasonably well for the first two years. But it began to fall apart in the middle of 2000. Prices in the day-ahead wholesale market jumped by more than 500 percent between the second half of 1999 and the second half of 2000. And in the first four months of 2001, these wholesale prices continued to climb to an average of more than $300 per megawatt-hour, or roughly 10 times what they had been in 1998 and 1999. As a consequence, the total annual cost of wholesale electricity for California increased from $8 billion in 1999...