Electricity became more valuable than gold this summer--or at least more valuable than finished aluminum ingots.
At the beginning of June, 270 workers at Ormet Corporation aluminum plant in Hannibal, Ohio, were laid off for the summer when the company concluded that it was more profitable to sell the electric power normally used in its smelting operations than to manufacture aluminum. And that was true even after the company paid its workers benefits and supplemented their unemployment checks so that they took home 70 percent of their base pay.
They were the lucky ones. A few weeks later, Kaiser Aluminum, Georgia-Pacific, and a handful of other companies in Montana and Washington that use large amounts of electric power suspended operations, some for a week and some indefinitely. They laid off more than 2,500 workers when the wholesale price of electricity in the region jumped from 4.5 cents per kilowatt-hour to 90 cents. Those companies did not supplement their workers' unemployment benefits, and in mid-August Kaiser announced it had made a $40-million pretax profit selling the electricity it would have used in production.
In the strange new world of deregulated electric power, where competition was supposed to bring better service and lower prices, what we have instead is a serious lack of generating and transmission capacity and widespread manipulation of the wholesale markets--which together are bringing us frequent shortages, threats of blackouts, and mind-boggling summer prices.
California has been hit especially hard. On June 14, the San Francisco Bay Area suffered rolling blackouts to prevent the crash of the state's transmission system after one of its components became overloaded during a heat wave. That week, which saw temperature records set in many cities in the area, wholesale "purchasers of California power spent more than $1.2 billion for electricity, 300 percent more than they paid for the same period in 1999 and one-eighth of their cost for power for all of 1999," according to a special report to Governor Gray Davis released in early August. People in San Diego, whose electric utility company was the first in California to be deregulated and who were thus the first to see fully deregulated prices show up on their household utility bills, are throwing tomatoes at utility workers and demanding action from the state legislature.
But it's not only California that's suffering power shortages and price hikes. So far, 25 states have deregulated, and the changes nationwide are affecting even those that haven't. Demand in California is sucking power out of the Northwest. New Yorkers complained bitterly about July bills 40 percent higher than last year. New England and the mid-Atlantic states have come close to blackouts several times this summer, and last summer there were half a dozen blackouts in New York City, Chicago, Long Island, and New Jersey, and throughout Louisiana, affecting more than one million customers.
A reliable electric supply system is the quintessential requirement for twenty-first-century life, and it used to be that we could take it for granted. Now, however, as a consequence of what one former regulator has called "mindless deregulation," the U.S. power system is in danger of falling apart.
Under deregulation, utility companies still sell electricity to customers, but most are no longer allowed to own certain power plants. Instead, new wholesale power trading markets have been set up where the utilities can buy electricity from competing suppliers. In theory this is supposed to have all the advantages of a free market. In practice see San Diego.
These are the key factors driving the new deregulated system toward a reliability crisis:
Peaks and Margins
In the past, utilities and their regulators were responsible for the reliability of the system. The companies met their obligation by cooperating and pooling their resources to maintain a reserve margin of about 25 percent more electric generating capacity than they needed at times of peak demand. This was to cover exactly the kind of contingencies we've seen this season: high temperatures, equipment failures, and unscheduled outages (for instance, when generators have to be shut down suddenly for repairs or when transmission lines short out).
But over the past eight years, the reserve margin has dwindled dangerously, as demand has grown faster than projected and few new facilities have been constructed. Because the industry seriously overbuilt nuclear power plants in the 1970s and 1980s, it was able to live off that nuclear glut for a while, but by this year the nation's capacity margin has slipped to 13 percent (10.8 percent in some regions). At a meeting in May on the reliability crisis, a meeting sponsored by the utility industry, Marie R. Corio, president of Applied Economic Research in New York, predicted that the margin will decline to 10 percent by 2007. Several experts are guessing that in some regions the margin could drop to 2 percent or 3 percent by then.
Corio's figures show that to meet the country's current generation deficit and still maintain its historic capacity margin, the industry should have built the equivalent of 160 300-megawatt (MW) generators over the past eight years. The fact that these were not getting built and that we would soon be faced with a reliability crisis must have been seen with increasing clarity by the industry. Jack Casazza--an electrical engineer and a former vice president for planning and research with Public Service Electric and Gas Company in New Jersey--wrote as early as 1993, "During the next seven years, practically no additional baseload generation will be added by the utilities in the U.S., although load growth will continue. As a result generation reserves will decline." Nonetheless, little was done to make up the deficit.
Proponents of deregulation proclaim that "money chases problems." They say the current shortfall of generating capacity is just a "transitional issue" on the way to the day when competing suppliers will build such a surplus of capacity that the price of power will drop significantly. In the interim, they say, periods of high demand can be finessed by such tactics as the utilities paying large customers to shut down their operations on a hot afternoon. Indeed, the utilities are already experimenting with such "demand response" programs.
There is, however, a major problem with this faith that classic free market rules will work in the electric power industry. As George C. Loehr, an industry consultant and former executive director of the Northeast Power Coordinating Council, says, "In the past, utilities had an 'obligation to serve' all of the load all of the time... . Thus they planned, built, and operated as much generation as was required by the peak load [the highest demand the system faces during a year]. But today there is a real question as to whether, in an industry driven by competition and the marketplace, investors will be willing to commit financial resources to supply customer load, which will be realized only a few hours a year."
Richard O'Neill is the chief economist at the Federal Energy Regulatory Commission (FERC), which has been at the vanguard of the campaign to deregulate. He was asked recently how a free market could guarantee that sufficient plants would be built to provide an adequate capacity margin, and he was unable to answer. Three times he started to explain, only to end up saying, "Someone will probably have to ... "--and then he'd break off. To finish that sentence, of course, would be to advocate new regulations.
The problem is even worse when it comes to transmission facilities. Eric Hirst, a researcher at the Oak Ridge National Laboratoryand a utility consultant, reports that since 1990 the amount of annual investment in the nation's transmission grid has declined by 15 percent. He estimates that transmission capacity will shrink from 289 miles per MW of generating capacity in 1989 to just over 200 miles of transmission per MW by 2007.
When this was a regulated industry, generation and transmission additions were often planned together, thereby minimizing investment outlays and operating costs. In the late 1980s, Jack Casazza estimated that the savings achieved by this kind of integrated resource planning added up to about $15 billion by 1985 and $20 billion by 1989. Investment in high-capacity, good-quality, and properly operated transmission systems, Casazza says, reduces the need for as many generating stations by facilitating the sharing of generation capacity and reserves and the coordination of generator maintenance. Yet now, because there's a competitive market, such planning and coordination could be construed as collusion and thus a violation of antitrust laws.
Indeed, in the competitive market, the utilities, which own the transmission lines, actually have considerable incentive to jeopardize reliability. As industry consultant George Loehr has pointed out, "Since their major source of income will be transmission usage fees, there will be a real financial incentive to make [reliability] criteria less stringent [in order to wheel greater amounts of power]... . [But] you can't make the system a little less reliable ... because many critical transmission interfaces are loaded at or close to the maximum transfer capabilities most of the time... . You either design it to survive the single worst contingency or you don't. There's no in between."
Gaming Opportunities
What's so far caused the greatest outrage, however, is the utilities' flat-out abuse of the transmission system to favor particular power suppliers and help them drive up power prices. Even though most deregulated utilities have been forced to sell off most of their generating plants, many utilities are still owned by holding companies that also have power-generating subsidiaries. So abuse happens, as evidenced by a recent spate of complaints to the U.S. Department of Justice and to FERC from independent power producers.
In some regions, utilities are not even required to turn over transmission grid operation to a regional system operator charged with maintaining fair access for all. But even where they are, there seem to be endless "gaming opportunities," as California's regional system operator reported last year. Already in the first 16 months of deregulation, from June 1998 to November 1999, according to an analysis done for the Energy Institute of the University of California, Berkeley, California consumers were charged $800 million above the prices that would have prevailed in a truly competitive market.
One illustration is a game that works like this: Each day power sellers bid their prices for each hour of the following day to a "day-ahead" market, and then they bid to an "hour-ahead" market for the current day. But there's nothing to stop a power producer from pulling a generator out of the day-ahead market--saying, for instance, that it needs to be repaired--and then jumping back into the hour-ahead market the next day (coincidentally during peak afternoon temperatures when hour-ahead prices soar), saying the generator has been repaired.
Manipulation of access to the transmission grid seems to take many forms, however--and under a free market, why wouldn't the principle of profit maximization motivate a company to take advantage of every loophole?
Especially in a system that, in one industry consultant's words, is "virtually impossible to police." California's supposedly independent transmission system operator appears to be dominated by power suppliers with their vested interest in high prices and tight supplies. FERC, the federal agency with authority over these regional system operators, has not even made any rules against utility holding company representatives serving on a regional system operator's board of directors. Furthermore, as the report to Governor Davis noted balefully, the state itself not only has no control over the operations of California's independent system operator (Cal-ISO); it cannot even require the Cal-ISO or the California Power Exchange to turn their records over to the state attorney general to investigate possible collusion.
Power suppliers defend such arrangements by intoning the supply-and-demand mantra: High prices will draw new competition into the market, which will eventually bring lower prices. (This prompted S. David Freeman, general manager of the Los Angeles Department of Water and Power, the nation's largest municipal utility, to comment, "If the economists now are telling us that we need high prices in order to get low prices, then I think we ought to bring back old-fashioned regulation.") But a recent Department of Energy report entitled "Horizontal Market Power in Restructured Electricity Markets" suggests that high prices probably won't do the trick even in the long run. The entry of new power suppliers into the market is not assured, the report concludes. "Because new plants must recover their capital costs as well as their operating costs to be attractive investments, there will be situations in which owners of existing plants who have market power can profitably raise prices above the competitive level without triggering entry... . [T]he exercise of market power could, under some circumstances, offset the projected benefits of competition in electricity generation markets."
The Clinton administration has proposed a deregulation bill that, among other things, would give FERC the authority to require utilities to turn over control of their transmission systems to a regional transmission operator. But there still would be no requirement that the regional transmission operator be completely independent from utilities and power suppliers. In any case, Congress has ignored the proposal for three years. Republican Representative Joe Barton of Texas, chair of the House Commerce Committee's Subcommittee on Energy and Power, has made it clear that the only bill that will get out of his committee is one that leaves the utilities in control of their transmission systems.
None of the measures now before Congress goes far enough, in the opinion of three keen observers of the scene. To checkmate the games that power producers and transmission system owners will play, you must control the network over which the transactions will happen. For Charles Higley, an energy specialist with the consumer group Public Citizen, for Jack Casazza, the former utility executive, and for Harry M. Trebing, former chief economist at the Federal Communications Commission and now professor emeritus of economics at Michigan State University, the key to the successful operation of a deregulated electric power industry is to place control of the transmission system in an institutional structure that will be able to protect the public interest.
Higley argues for a national transmission cooperative owned by consumers. Casazza agrees that the cooperative model is best, and he has had discussions with the National Rural Electric Cooperative Association about the possibility of developing something along this line. He and George Loehr maintain that the most reliable arrangement for North America is to break up the present system of interconnecting grids into eight or 10 areas. Anything larger, Loehr argues, is simply "too complex to manage reliability in competitive markets" with their high volume of trades and the many rules and procedures required to try to make them fair. The reconfiguration of the nation's present grids, he estimates, would cost between $7 billion and $8 billion.
Trebing says that to guarantee freedom from manipulation, the transmission network must become a common carrier that is owned and controlled by the people. If that cannot happen, he says, then the chances for success of piecemeal strategies, like the price caps adopted recently by the independent system operators, are "doubtful, especially when there will be constant pressure to minimize or eliminate regulatory agencies as they exist today."
In late June, Georgia-Pacific laid off more than 600 workers at its Bellingham, Washington, pulp mill following a 2,000 percent increase in the price it must pay for electricity under a five-year contract with its local utility. When Bellingham's mayor, Mark Asmundsen, was asked why the city should help Georgia-Pacific out of the difficulties it got into by willingly signing the utility contract, he listed some of the financial impacts on local workers, merchants, and the city treasury. And then he added, "All of us in our community are interconnected whether we know it or not." When deregulation advocates ask why the government has to get back into the electricity game, the answer is the same. ¤
