The Quest: Energy, Security, and the Remaking of the Modern World

by Daniel Yergin

  As part of the deregulation compromise, California also forbade utilities from signing with generating companies any long-term contracts for electricity supply. This was a truly fundamental flaw. It is standard practice—and, indeed, good practice—to hold a portfolio of contracts, some that go out just a few months, others that go out for a couple of years. This kind of portfolio helps to provide a buffer against major surges in market prices that would result if capacity became tight. But since the California model assumed that prices would remain low forever, the state would not permit long-term contracts, which, while more expensive than the spot prices at the time, would have provided an insurance policy for consumers if spot prices shot up.7

  “We had to sell our power plants, which was the heart of a reliable power system, but we were forbidden from doing long-term contracts,” said John Bryson, who was CEO of the parent of Southern California Edison, one of the state’s three major utilities. “Utilities have an obligation to serve their clients, but now there was no way for us to source power except from a spot market.”

  California’s restructuring, with its disconnect between wholesale and retail markets, and its prohibition of the buffers against rising prices, meant that an enormous amount of risk was unintentionally being built into the new system for supplying electricity to the most populous state in the nation. One report did warn in 1997 that this system was “likely to lead to extended periods of low prices followed by periods of very high prices, as supply shortages and surpluses develop. Price volatility will not be conducive to a smooth transition to competition.” But few were listening.

  The system would work well so long as no major changes in the supplydemand balance occurred and prices stayed down, which would have occurred if California had remained mired in an economic downturn. But how quickly markets can change.

  “Deregulation, California-style” officially went into effect in 1998. By then, California’s economy was already starting to recover, real estate was sizzling again, and the Internet was beginning to take off, giving a big boost to the Bay Area. All this was reflected in electricity consumption and a radical shift in the balance of supply and demand. Over a six-year period, California’s economy grew by 29 percent; its electricity use by 24 percent. But no significant new electricity generation was added. Indeed, after 1997 the state’s capacity actually went down as some older, inefficient plants were retired.8

  California was arguably the most difficult state in the Union to site a new project; the process was time consuming and costly, the environmental review process was open-ended, and local community opposition could usually prevail. So for the additional supplies it needed, California drew on other western states and British Columbia—turning them into a sort of vast energy farm to feed its growing economy. That was fine as long as the out-of-state power was abundant and cheap. But states like Arizona were growing fast, and thus they were consuming more and more of their own power production. The year 1999 had been great for hydropower in the Northwest and British Columbia: mild winter, cool summer, and a lot of rain—which meant a lot of cheap hydropower.

  “IT WAS MADNESS”

  But 2000 was something else. A drought in the Northwest and Canada curbed the availability of hydropower. Meanwhile, power demand was surging in California, partly because of a hot summer, partly because of economic growth. More natural gas had to be pulled into power production. But natural gas supplies were tightening, and the price started to go up, which meant that the price of additional electricity—made from natural gas—also started to rise sharply.9

  During the hot summer of 2000, the staff at the agency that managed the state’s power grid frantically shopped for additional power supplies. “We simply couldn’t make enough phone calls,” said one of its managers. “It was a Turkish bazaar. It was madness.” It was at this point that the state began to experience the first convulsions from the physical shortages of electricity. Utilities had to source power “on an hour-to-hour basis,” said John Bryson. And “no one knew what price would be bid in the next hour.” Moreover, the new market had been structured so that utilities had no visibility beyond an hour on the availability of power.

  Many businesses had “interruptible” contracts, which meant that in exchange for lower rates they could be cut off if electricity went short. A steel company east of Los Angeles, which had had its electricity interrupted only once over fifteen years, now found its electricity cut off eighteen times in 2000—with only fifteen-minutes’ notice to shut down all its operations. “We cannot run a business like this,” the president of the company declared. Infrastructure constraints in transmission, particularly between Northern and Southern California, added to the woes. The system was clearly breaking down. Yet still the state government did not react.

  The crisis worsened as the year progressed. Utilities were spending five times as much to buy electricity in the wholesale market as they could sell it to retail customers for—an obviously untenable situation. But they could not do much about it. They were certainly not allowed to raise rates. Seven times Southern California Edison requested permission from the state’s public utility commission to gain protection by signing long-term power-supply contracts, and seven times the commission said no.10

  “PIRATES” AND “PLUNDER”: CALIFORNIA AT SEA

  By the beginning of 2001, the state was in the grip of a full-blown electricity crisis. It was now evident to everyone that the market was broken. As the crisis unfolded, delegations from as far away as Belgium and Beijing journeyed to America’s largest state to learn what had gone wrong. And plenty was going wrong. Utilities were accumulating tens of billions of dollars of losses. Governor Gray Davis announced that the state was living through an “energy nightmare,” produced by “price gouging” by “out-of-state profiteers” who were holding California “hostage.” He earnestly appealed to Californians to save electric power by putting their computers “on sleep mode” when not in use. He also threatened that the state would seize ownership of generating plants and go into the business of building power plants itself. The merchant generators, he declared, “have brought the state to the very brink of blackouts.”11

  It was not just electricity that was in short supply. So was the political leadership and will to bring people together and adjust what has been described as the “extremely complex and untested system” that had just been put in place. One obvious answer would have been to permit price signals to work and allow at least some moderate increase in the retail rates paid by homeowners. Davis himself recognized that reality. “Believe me,” he said at one point, “if I wanted to raise rates, I could solve this problem in 20 minutes.” But he was adamant. He would not do that.

  Instead he blamed everyone else, ranging from the utilities to the federal government. But, by far, his greatest wrath was reserved for companies headquartered out of state, particularly those in Texas, that had bought many of the generating plants and that were trading power. They were, he said, “pirate generators” out for “plunder.” 12

  This was not an environment conducive to collaboration and solutions. The crisis worsened. Spot prices for electricity were, on average, ten times what they had been a year earlier. State regulators began to ration power physically, which meant rolling blackouts. Meanwhile, as wholesale power prices went up, the financial positions of the states’ utilities became even more dire. Because of that iron curtain between the deregulated wholesale market and the regulated retail side, utilities were buying wholesale power for as much as $600 per kilowatt hour but were able to sell it to retail customers at a regulated rate of only about $60 per kilowatt hour. As one analyst put it, “The more electricity they sold, the more money they lost.”13

  The state was in an uproar; its economy, disrupted. In April 2001, after listening to Governor Davis threaten the utilities with expropriation, the management of PG&E, the state’s largest utility, serving Northern California, decided that it had no choice but to file for bankruptcy protection
. San Diego Gas & Electric teetered on the edge of bankruptcy. The management of one of the state’s major utilities hurriedly put together an analysis of urban disruption to try to prepare for the distress and social breakdown—and potential mayhem—that could result if the blackouts really got out of hand. They foresaw the possibility of riots, looting, and rampant vandalism, and feared for the physical safety of California’s citizens.

  But Governor Gray Davis was still dead set against the one thing that would have immediately ameliorated the situation—letting retail prices rise. Instead he had the state step in and negotiate, of all things, long-term contracts, as far out as twenty years. Here the state demonstrated a stunning lack of commercial acumen—buying at the top of the market, committing $40 billion for electricity that would probably be worth only $20 billion in the years to come. With this the state transferred the financial crisis of the utilities to its own books, transforming California’s projected budget surplus of $8 billion into a multibillion-dollar state deficit.14

  “CRISIS BY DESIGN”

  Many joined Davis in fingering the power marketers and merchant generators as the perpetrators of the crisis. They were charged with engaging in various trading and bidding strategies that took advantage of the crisis and with taking plants off-line to push up prices. But a Federal Energy Regulatory Commission review concluded that it “did not discover any evidence suggesting that” merchant generators were scheduling maintenance or incurring outages in an effort to influence prices. Rather the companies appeared to have taken whatever steps were necessary to bring the generating facilities back on line as soon as possible. Moreover, it turned out that publicly owned municipal power companies, led by the Los Angeles Department of Water and Power, were among those selling the highest-priced electric power.15

  Postcrisis investigations revealed rapacious behavior on the part of some of the energy traders, who were middlemen between generators and utilities. This was particularly true of those from Enron, who wielded trading strategies with such vivid names as “Fat Boy,” “Ricochet,” and “Death Star.” Phone records captured their inflammatory conversations as they pursued their trading strategies through the crisis. The records also indicated that at least some of them were deliberately manipulating the movement of electricity supplies in and out of the state to try to drive up prices. Subsequently three traders admitted to such and pleaded guilty to conspiracy to commit wire fraud. By then, Enron itself was long gone. It was done in by a combination of factors: almost $40 billion of debt and obligations that it could not fund, accounting ruses and tricks that hid its true financial position and that depended upon a high stock price to avoid coming undone, a propensity to woefully overspend on investments and then not manage them well, and personal enrichment. When Enron filed for Chapter 11 in December 2001, it was the largest bankruptcy in American history.16

  What was the impact of the traders on the crisis? One of the leading scholars on the topic, James Sweeney of Stanford University, concluded that the “amount and use of market power is unknown but subject to massive debate.” But the ability to wield market power in a very tight market, he added, would have greatly decreased had the state permitted retail prices to go up and allowed utilities to enter into long-term contracts. Trading in electric power goes on every day across the country without a crisis. That the traders sought to take advantage and make money out of the political and regulatory debacle in California is clear. But that they were not the fundamental reason for the crisis is also clear. The causes reside in the way the power market restructuring was designed in the face of shifting supply and demand.17

  Indeed, what unfolded in California was what has been called a “crisis by design.”

  By the summer of 2001 the crisis was easing. The state authorities had finally succumbed to economic reality and allowed retail prices to rise some. The expected happened: consumers reduced their consumption. In addition, the weather moderated compared with the previous year, and new electricity-generating capacity started to enter the system.

  But it was not until November of 2003 that Governor Davis officially pronounced the crisis over. By then so was his own political career. The state’s voters had just turned him out of office in a special election—only the second governor in the history of the United States to be so dismissed. His successor was Arnold Schwarzenegger.

  The Terminator became the Governator. His inauguration was a global event, attended by 650 journalists. Schwarzenegger inherited a $25 billion deficit, much of it the direct and indirect result of the power debacle. “California is in a crisis,” he said after he took the oath of office. “We have the worst credit rating in the country.” But, recalling his days of championship weight lifting, he declared with fortitude, “We are always stronger than we know.”

  Gray Davis offered his own explanation for what had gone wrong: “I was slow to act during the energy crisis.” As he left office, he ruefully offered a lasting truism: “It’s a bummer to govern in bad times.”18

  IN THE AFTERMATH

  Almost a decade after the California crisis first began, the chairman of the Federal Energy Regulatory Commission offered his own judgment: “The California crisis was not a failure of markets,” he said. “It was a failure of regulation.”19

  But still, in the rest of the country, in the aftermath of the California electricity crisis, the brakes were slammed on on the movement toward deregulation. The result was to leave the United States with an “unintended hybrid” system. A map of the country reveals a patchwork among the states. About half of the utilities in the country are traditionally regulated, and half are subject to varying degrees of market competition. The utilities in the latter category own only small amounts of generation of their own within their service territories, or none at all. They are in the wires business—transmission and distribution—and thus buy electricity from generators. Yet underlining the hybrid nature of the system, several utilities today hold a portfolio of power plants, some operating in regulated markets and others operating in competitive markets.20 The markets open to retail competition are clustered in the Northeast, the Midwest, and Texas, while the Southeast is characterized by traditional regulation.

  At the same time, at the wholesale level competitive markets for electricity have been expanding apace over the past decade. Even as California’s system flopped, other markets demonstrated what a well-designed power market actually looks like. The PJM Interconnection, which stretches from Pennsylvania and Washington, D.C., all the way to Chicago and includes all or parts of fifteen states, is one such market. It is the largest competitive power market in the world, serving 51 million people. PJM has deep roots, going back to a power pool that was established between Pennsylvania and New Jersey in 1927 to bring greater stability in electricity supply to the region. Today PJM operates both the high-voltage transmission system in its region and a competitive wholesale market, bringing buyers and sellers together on a real-time basis.

  As for California, the state has kept its wholesale electricity markets open to competition. It now permits long-term contracts. In 2009, after several years of work, the state’s Independent System Operator (ISO) introduced a new market design. It incorporated experience from PJM and other systems as well as the painful lessons from what Mason Willrich, the chairman of the ISO, called the “flawed, flawed market” that had been put in place in California in the 1990s. This new design was intended to better reflect the true cost of electricity, including the cost of transmission congestion in the grid, and, with appropriate market monitoring, deliver the benefits of competition, rather than design a crisis.21

  The major question today for electric power is no longer market design—regulation versus deregulation. Rather, it is fuel choice. Whatever the setup in different parts of the country, the United States faces the same question about the future of its electricity supply as do many other countries: What kind of generation to build? This struggle over fuel choice is not just about meeting today’s
needs, but also about how to meet expected growth in demand—and new environmental objectives. Coal, nuclear power, and natural gas will all be part of the picture, both in the United States and around the world. Each, however, comes with its own constraints.

  20

  FUEL CHOICE

  The prospects for electric power in the twenty-first century can be summarized in a single word: growth. Electricity consumption, both worldwide and in the United States, has doubled since 1980. It is expected, on a global basis, to about double again by 2030. And the absolute amount of the doubling this time will be so much larger, as it is off a much larger base. An increase on such a scale is both enormous and expensive. The cost for building the new capacity to accommodate this growth between now and 2030 is currently estimated at $14 trillion—and is rising. But that expansion is what will be required to support what could be by then a $130 trillion world economy.1

  Such very big numbers generate very big questions—and a fierce battle. What kind of power plants to construct and, then, how to get them built? The crux of the matter is fuel choice. Making those choices involves a complex argument over energy security and physical safety, economics, environment, carbon and climate change, values and public policy, and over the basic requirement of reliability—keeping on not just the lights but everything else in this digital age. The centrality of electricity makes the matter of fuel choice and meeting future power needs one of the most fundamental issues for the global economy.