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California Faces More Blackouts, Lawsuits With No End in Sight by Rebecca Smith, John R. Emshwiller and Mitchel Benson Page One Feature, The Wall Street Journal, January 19, 2001

California has weathered earthquakes, wildfires, floods and droughts.
But now a man-made disaster is threatening to short-circuit the world's sixth-largest economy.

For a second day, rolling blackouts shut down businesses, dimmed households and even threatened California's citrus crop. People were trapped in elevators and traffic was snarled. Supermarkets were crowded with customers buying flashlights and firewood. California Steel Industries Inc. in Fontana shut down its steel-rolling lines Thursday, losing about $2.4 million worth of production. And the crisis set off new legal fireworks as the city of San Francisco, hit by blackouts, sued power traders and generators, accusing them of conspiring to restrict supplies.

The California Independent System Operator, which runs the state's electrical grid and ensures reliability, declared its highest level of power emergency for the fifth time this year. Engineers at the ISO's control room in Folsom, Calif., were pressed into service phoning suppliers to coax a few more megawatts into the system.

Rolling blackouts began at midmorning after the Portland, Ore.-based Bonneville Power Administration had to reduce output because of low water levels in its hydroelectric system. On Wednesday "I borrowed water, and today we are paying the price," said Kellan Fluckiger, director of operations at the ISO. "We so badly wanted not to put the lights out." Nonetheless, rolling blackouts affected about a half a million utility customers Wednesday and two million Thursday.

The crisis has blown up into a dangerous game of brinkmanship by the state's two biggest utilities, power-generating companies, and politicians -- with the California economy in the balance. Many of these players helped design a complex electricity deregulation plan that became dysfunctional when it ran into a tight energy market.

Gov. Gray Davis signed an emergency order Wednesday empowering the state's Department of Water Resources to temporarily become a power buyer. But with only limited buying authority and a mere $400 million to spend -- less than two weeks' worth of electricity at current prices -- the DWR isn't expected to offer much relief. That's especially true because the DWR wasn't authorized to help fund the ISO's critical last-minute power purchases. California lawmakers approved the $400 million rescue plan Thursday night.

The state's unwillingness to commit large sums for buying power is a key sticking point in the two-month-long standoff over how to restructure this market. Mr. Davis, an ambitious Democrat who inherited the deregulation experiment from his Republican predecessor, has repeatedly said he won't use public funds to bail out the state's two main investor-owned utilities.

The two, the Southern California Edison unit of Edison International and the Pacific Gas & Electric unit of PG&E Corp., earlier this week failed to pay some debts to suppliers and financial creditors. They are accumulating vast deficits as the price of the power they must buy soars but what they can charge is fixed -- thanks to a rate freeze they once pushed for. Both say they are now on the brink of seeking protection under federal bankruptcy laws.

SoCal Edison was suspended Thursday from the state's Power Exchange, a clearinghouse for buyers and sellers of electricity, after failing to pay $215 million in bills. The utility must post collateral before it can return to the market, an exchange spokesman said. A utility spokesman refused to comment, and it was unclear where SoCal Edison would go for its power.

Although both utilities had enough cash on hand to cover the bills they didn't pay, they chose not to use it. The companies haven't explained the reason they haven't paid. Some analysts interpreted this as presaging a bankruptcy-law filing, while others saw it as a move by the utilities to put more heat on public officials to bail them out. If that's the case, "this would be the biggest game of chicken I've ever seen," said Dan Scotto, a bond analyst at BNP Paribas. The utilities for several weeks have been angling for the state to issue bonds to help pay their outstanding power bills and to amortize the cost over several years with a levy on ratepayers.

Generators and traders that are on the hook for several billion dollars in unpaid bills by Edison and PG&E are increasingly reluctant to sell more juice to the state without assurances they'll be paid. Mr. Davis said four of them -- Duke Energy Corp., Dynegy Inc., Southern Co. and Reliant Energy Inc. -- threatened to force the two utilities into bankruptcy by 12:01 p.m. Thursday unless the state stepped in with its full faith and credit to buy power on behalf of the utilities. Following that threat, Gov. Davis signed the emergency order, formalizing the state's role as a middleman.

In a conference call with the governor Wednesday, the generators told him that if the utilities didn't meet their obligations by noon Thursday, they'd have the right to put the utilities into bankruptcy. "We told him we were due to be paid," said Marce Fuller, chief executive of Southern's Southern Energy unit. It isn't clear that generators would actually push for a bankruptcy-law filing because some observers believe a bankruptcy judge might force producers to accept sharply discounted payments on the power they've already sold.

In Washington, the Federal Energy Regulatory Commission, which regulates wholesale power markets, has been unwilling to impose price caps on juice sold throughout the Western regional grid, which knits together 11 states, Canada and Mexico. Though Mr. Davis and other Western governors favor price caps, FERC commissioners say such a move wouldn't fix California's market, and would discourage construction of new generating plants.

Test for Bush

The crisis will be an early test for George W. Bush and his cabinet. It threatens to undermine the California economy, a major engine of growth in a generally slowing national economy. The payment woes of the utilities, their suppliers and creditors are sending jitters through the financial markets.

In an interview last week, Mr. Bush indicated he would consider steps to help California but stressed that the problem is a long-term one for the state to tackle. The federal role is likely to be limited to steps "to help California help itself," he said. In a separate interview Thursday with the Associated Press, Mr. Bush appeared to rule out price controls in the California crisis.

Right out of the gate, the administration will face political pressure to act -- and not just in ways that would help California. Thursday, some Western-state senators called on Energy Secretary-designate Spencer Abraham to rescind an emergency order forcing generators in the region to sell uncommitted power into the California market. They worry that power sold to California from the region's hydroelectric system won't be available to heat homes in their states later in the winter. The Energy Department order, however, has been perhaps the single most important force keeping power flowing into California.

The state's problems are chilling enthusiasm for deregulation in several other states, such as Nevada, which has postponed opening its retail power market to competition. It has also highlighted what economists say is a lesson repeatedly learned but just as often ignored: that deregulating only part of a highly regulated market is a prescription for trouble. Under California's plan, the rates charged to consumers were frozen while wholesale electric costs were allowed to fluctuate. When those wholesale prices soared last year, the state's utilities were hit by a financial tidal wave.

California's supply problems have grown more acute in January. Power plants, pushed hard for most of last year, have been out of service for maintenance in unprecedented numbers. These outages have left little tolerance for unexpected events. The loss of even a single unit can send shock waves through the entire system. That's what happened earlier this month when the Diablo Canyon nuclear plant powered down to avoid kelp being swept into its cooling system during a storm. There are also suspicions generators are keeping power off the market because they are afraid they won't get paid, although they say they aren't holding back.

With outages confined to the middle of the day so far, it was business that mainly felt the pinch. Companies that had signed "interruptible" contracts, agreeing to cut power use in times of tight supply in exchange for cheaper prices, were in a tough spot Thursday. Krause's Furniture Inc. shut its sofa-making factory in Brea, Calif., because it anticipated demands from Edison to cut energy usage. The move idled 400 workers.

Universal Studios, a unit of Vivendi Universal, said it had ordered a 50% lighting reduction at its theme park and offices in suburban Los Angeles. Floor wardens in office buildings were making the rounds to turn off unused fax machines and coffee pots. In the theme park, each attraction was being powered down after its last use, rather than being left on through the night. To save electricity, Sony Pictures Entertainment said it closed the studio gym and turned out the lights on its movie billboards surrounding the Culver City lot.

In Silicon Valley, outages prompted technology companies to turn on backup generators -- in place for disasters such as earthquakes -- and accelerate planning to shift production outside the state. Solectron Corp., a big maker of electronic devices, had to close six out of 22 factory buildings in the Bay Area Thursday, sending 2,000 workers home. Executives huddled to determine whether to shift work to other plants around the world. To do so, Solectron would send out new work assignments electronically and then scramble to reroute thousands of parts to those plants.

In California's Central Valley, food basket to much of the nation, citrus growers were frantically trying to ensure power to keep their crops safe from frost. Joel Nelsen, president of the California Citrus Mutual, a group of 800 growers, has been pressing the governor's office to make sure his members get the same treatment during critical nighttime hours as essential services like hospitals and fire stations. He argues that if there's not enough power to run water pumps and wind machines, the three-quarter billion dollar annual citrus crop could be wiped out in one icy night.

In San Francisco, hit by blackouts both days, City Attorney Louise Renne sued power traders and suppliers in state court Thursday, accusing them of violating the California Unfair Competition Act by conspiring to restrict supplies and drive up prices. The city is seeking $1 billion in damages. Ms. Renne said it is running up a huge bill mobilizing emergency workers each time the ISO calls a power alert, and its own power costs have jumped because it buys some electricity on the open market. She contended there is "evidence to suggest wholesale producers aren't only keeping power away from the state but are actually jacking up prices."

Ms. Fuller of Southern Energy said, "We have done nothing outside the rules that were set up. We have not colluded with any other generator."

FERC has been sued, so far unsuccessfully, by utilities for failing to force generators to lower their wholesale power prices. The federal agency, in turn, is preparing to move against the state's day-ahead auction market, known as the Power Exchange, for refusing to implement a FERC order to impose emergency wholesale price rules in the California market. The Power Exchange argues that the rules are unworkable. The exchange, which was supposed to be the main market for wholesale power purchases by utilities, has seen volume dry up as the financial condition of the utilities has worsened and generators have been reluctant to make power available.

The main battleground remains in Sacramento, where state legislators and the governor have been struggling to come up with a package that would both lessen the supply problems and keep PG&E and Edison solvent.

A big problem they face is crafting a solution that doesn't produce public outrage. A new statewide survey released Thursday by the nonpartisan Public Policy Institute of California showed that 62% of Californians disapprove of the way the governor is handling the crisis. "I think it's just maddening to people that this could be the factor that ends this incredible period of prosperity" in the state, says Mark Baldassare, survey director at the San Francisco-based think tank. "Who would have thought that?"

It's clear that legislators are having a difficult time coming up with an acceptable package. At one point during marathon negotiations Wednesday, Senate President Pro Tem John Burton, a San Francisco Democrat, spoke of the need to protect residential and small-business customers from any big rate increases, even if that meant higher rates for commercial and industrial users.

"Job killer! Job killer!" responded Assembly Minority leader Bill Campbell, an Orange County Republican, according to meeting participants. Mr. Burton shot back that any legislation that didn't protect smaller consumers "won't get out of our house."

For Gov. Davis, the electricity mess could prove to be a personal job killer, both for his re-election hopes in 2002 and the presidential ambitions some believe he has beyond that. Mr. Davis, who campaigned in 1998 on education reform, was slow to recognize the severity of the gathering power crisis. Last summer, it started becoming clear that a combination of insufficient supply, rising natural-gas prices and higher-than-expected demand caused by prolonged prosperity would add up to big problems for the utilities. But both politicians and utility executives expected the problems to lessen when the weather cooled.

The weather cooled, but not the crisis. By December, wholesale prices had spiked to more than $600 per megawatt hour, compared with $120 in June and $22 at the time deregulation went into effect in March 1998. The utilities had run through most of their available lines of credit and faced billions of dollars in unpaid power bills. Mr. Davis, who made a quick trip to Washington to consult with President Clinton and other top officials later that month, didn't propose any specific actions until earlier this month.

In early January, the California Public Utilities Commission temporarily increased retail rates by as much as 15%, far short of what the utilities said was needed to close the holes in their balance sheets. Then, last week, legislators, backed by the governor, unveiled a plan to have the state enter into long-term supply contracts with generators. But he said he wouldn't favor paying any more than $55 per megawatt hour -- a fraction of current market prices and a level that some generators say is below their cost of production. Generators say they wouldn't be interested in contracts at that price, although the governor's office says that it has received a few expressions of interest.

Bond Defaults

In the meantime, the financial situation of PG&E and Edison has deteriorated dramatically. Earlier this week, after they defaulted on some of their bills and bondholder payments, credit-rating agencies reduced their debt to junk-bond status. This action, in turn, precluded further access to bank credit.

The generators agree that long-term contracts are the best way to go, but insist that prices either have to be higher than what the legislature is contemplating or the contracts have to be for a duration of 10 to 15 years. Mr. Davis and other politicians are against locking California into such contracts because electricity prices are expected to drop as more-efficient generating plants come on line in the next two to three years.

If enough supply can be locked in at tolerable rates, then the next step will be for the market to be restructured to pass along those market costs directly to consumers, as is currently the case in the natural-gas market, economists say. "We need to get price signals to the guys who can actually do something about it," says Frank Wolak, professor of economics at Stanford University.

If a solution isn't found soon, the current problems might pale in comparison to what's coming. Despite a conservation push by California authorities, the state could find itself with an even bigger gap between demand and supply in the summer months when usage traditionally peaks. Right now, says Shawn Stevenson, a citrus farmer in Clovis, Calif., "it promises to be the summer from hell."