BACKGROUND ON ELECTRICITY POLICY

Historical Context – 1900-1996

The early electric power industry was developed using direct current transmission, a system in which a relatively low voltage of electricity could travel only over short distances. Typically, numerous power plants were built within a small densely populated area, usually a city, and consumers were able to choose their service provider. This structure created much competition within a local marketplace.

This paradigm began to change as technology rapidly transformed the industry. Newer machines, such as steam turbines, were smaller and less complex, and could create a greater amount of power with a much smaller capital investment. The discovery of alternating current transformers allowed companies to transport power over longer distances at a higher voltage. Savvy entrepreneurs, such as Samuel Insull of Chicago Edison, realized they could exploit the greater economies of scale afforded by these new technologies, and maximize profits by consolidating the smaller utility companies. Fueled by the rapid growth of electricity consumption, the utilities boomed during the early 20th century.

By 1907, Insull had acquired 20 other utility companies and renamed his firm Commonwealth Edison. He and others argued that electric utilities were a “natural monopoly” because it would be inefficient to build multiple transmission and distribution systems due to the great expense of capital investment. Therefore, it was inherent that only one company would dominate the market. The emerging utility monopolies were vertically integrated, meaning they controlled the generation of electric power, its transmission in real time across high-voltage wires, and its low-voltage distribution to homes and businesses. Reformers of the Progressive Era tried to govern these emerging utility monopolies through state regulation. By 1914, 43 states (including California) had established regulatory polices governing electric utilities.

As their businesses grew, the new electric power barons such as Insull began to restructure their companies, largely through the use of holding companies. A holding company is a company that controls a partial or complete interest in another company, and it can be a useful tool in consolidating the operations of several smaller companies. However, the electric utilities of the 1920s began to exploit the use of holding companies to buy up smaller utilities in an effort designed not to improve the company’s operating efficiency, but as a speculative attempt to maximize profits. The growing utility monopolies then exploited this structure, pyramiding holding company on top of holding company, sometimes such that a holding company was as many as ten times removed from the operating company. Each new holding company would buy a controlling interest in the holding company below it and the additional costs and fees for the operating companies were passed along in a higher rate base for the consumer. While the operating companies were subject to state regulation, the holding companies were not; therefore each holding company could issue fresh stocks and bonds without state oversight. The abuse of holding companies allowed for the consolidation of utilities such that by the end of the 1920s, ten utility systems controlled three-fourths of the United States’ electric power business.

The size and complexities of the holding companies were proving state regulation of utilities ineffective and soon caught the attention of the federal government. In 1928, the Federal Trade Commission began a six-year investigation into the market manipulations of the holding companies. The booming utilities of the 1920s traditionally had been seen as relatively secure investments, and utility stocks were held by millions of investors. The pyramidal holding company structure allowed the holding companies to inflate the value of utility securities, which eventually were decimated by the 1929 stock market crash.

Elected to the presidency in 1932, Franklin Delano Roosevelt fought vehemently against the holding companies, calling them “evil” in his 1935 State-of-the-Union address. After a hard-fought campaign by the president and his allies, and in the face of bitter opposition from the utilities, Congress passed the Public Utility Holding Company Act in 1935. PUHCA outlawed the pyramidal structure of interstate utility holding companies, determining that they could be no more than twice removed from their operating subsidiaries. It required holding companies that owned 10% or more of a public utility to register with the Securities and Exchange Commission and provide detailed accounts of their financial transactions and holdings. Holding companies that operated within a single state were exempt from PUHCA. The legislation had a dramatic effect on the operations of holding companies: Between 1938 and 1958 the number of holding companies declined from 216 to 18. This forced divestiture led to a new paradigm for the electricity marketplace which lasted until the deregulation of the 1980s and 1990s: a single vertically-integrated system which served a circumscribed geographic area regulated by either the state or federal government.

Roosevelt made the fight for public power an integral part of his New Deal campaign and pushed for other important legislation to that end. In the same year as PUHCA, Congress passed the Federal Power Act of 1935, which gave the Federal Power Commission (FPC) regulatory power over interstate and wholesale transactions and transmission of electric power. The FPC had been established under the Federal Water Power Act of 1920 to encourage the development of hydroelectric power plants. The Commission originally consisted of the secretaries of war, interior and agriculture. The Federal Power Act changed the structure of the FPC so it consisted of five commissioners nominated by the president, with the stipulation that no more than three commissioners could come from the same political party. The Federal Power Act gave the FPC a mandate to ensure electricity rates that are “reasonable, nondiscriminatory and just to the consumer.”

Another component of FDR’s fight for public power was the creation of federal agencies to distribute power to those who were neglected by the traditional utilities, particularly farmers and other customers in rural areas. His administration created the Tennessee Valley Authority (TVA) in 1933 and the Rural Electrification Association (REA) in 1935 to create and finance rural utility companies. The end result of the New Deal era regulatory intervention into the electric industry led to four primary types of service providers: private investor-owned utilities (IOUs) with stock freely traded in the marketplace by shareholders; publicly-owned utilities, such as those owned by municipalities; cooperative utilities which were usually found in rural communities; and federal electric utilities, such as the TVA and REA.

After the tumult of the Roosevelt years and the end of World War II, the electric power industry enjoyed a period of steady growth, driven by both technological and efficiency advances that were reflected in lower prices. Between 1947 and 1973, the growth rate for the industry held steady at about 8% per year and there was little change in the industry structure. The industry began to promote increased electricity usage through advertising campaigns with slogans such as GE’s “Live Better Electrically” campaign begun in 1956. As the industry grew and prices continued to decline, there was little need for state and federal regulatory intervention. IOUs were the primary service providers for most Americans and their continued growth and low rates satisfied both consumers and investors.

The energy crisis of the 1970s is often symbolized by images of long lines at gas pumps all over the United States resulting from the 1973 OPEC oil embargo. Oil, coal and natural gas shortages, as well as declining public confidence in the nuclear power industry, contributed to rate increases for consumers throughout all the energy industries, including electricity. Elected in 1976, President Jimmy Carter made energy concerns one of his top priorities. In attacking the demand side of the problem, he waged a public campaign focused on conservation to reduce the American public’s high rates of energy consumption. To combat the supply side, he sought to cultivate the growth of new sources of energy, including nuclear power and renewable resources such as solar and wind power. These two approaches were crystallized in the five-part National Energy Act, which Carter signed into law in 1978.

The Public Utility Regulatory Policies Act (PURPA) was the piece of Carter’s National Energy Act that affected the electric power industry. It was designed to encourage efficient use of fossil fuels by allowing non-utility generators (known as Qualifying Facilities or QFs) to enter the wholesale power market. PURPA designated two main categories of QFs: co-generators, which use a single fuel source to either sequentially or simultaneously produce electric energy as well as another form of energy, such as heat or steam; and independent power producers, which use renewable resources including solar, wind, biomass, geothermal and hydroelectric power as their primary energy source. Although intended to be an environmental statute, a primary effect of PURPA was to introduce competition into the generation sector of the electricity marketplace, thus challenging the utilities’ claim that the electricity market encouraged a “natural monopoly.”

One year prior to the National Energy Act, President Carter signed the Department of Energy Organization Act. The act created the Department of Energy by consolidating organizational entities from a dozen department and agencies. Under this legislation, the FPC was replaced by the Federal Energy Regulatory Commission (FERC) as the federal agency that establishes and enforces wholesale electricity rates.

The free-market mania of the 1980s and 1990s further challenged the notion of the electric power industry as a “natural monopoly.” Many politicians and economists argued regulation had outlived its value, and the market should determine prices. The telecommunications and transportation industries were deregulated, and the natural gas industry followed suit. Advocates for deregulating the electricity industry argued the implementation of PURPA had proved non-utility generators could produce power as inexpensively and effectively as the regulated utilities. Large industrial consumers searching for lower prices also chimed in and urged federal regulators to pursue deregulation.

In 1992, Congress passed President Bush’s Energy Policy Act (EPACT), which opened access to transmission networks to non-utility generators. EPACT further facilitated the development of a competitive market by creating another category of generators known as exempt wholesale generators (EWGs), which were exempted from regulations faced by the traditional utilities. To assist in the implementation of PURPA and EPACT, FERC issued Orders 888 and 889 in April 1996. The two orders provided guidelines on how to open electricity transmission networks on a nondiscriminatory basis in interstate commerce.1

 

AB 1890 and the Retail Side of Electricity Deregulation

The push toward electricity deregulation at the federal level led states with relatively high electricity rates, including California, to investigate and pursue deregulation of the state-regulated aspects of electricity service, and retail service in particular. In California, the push was led by large industrial customers facing high electricity costs and an ailing economy. These customers saw advantage in bypassing the IOUs “bundled service” and buying electricity directly from suppliers.

The industrial customers were joined in the push for deregulation by merchant generators and marketers, who wanted to compete on equal footing with the IOUs and sell electricity and related services to selected profitable customers. The IOUs, who saw promising ventures in deregulated electricity markets for themselves, favored deregulation once their primary concern about recovery of investments stranded by the departure of their customers to competitors was satisfied.

In 1996, electricity deregulation, or “restructuring,” legislation was passed by the Legislature. AB 1890 codified a series of deregulation proposals either undertaken or recommended by the CPUC, whose work on deregulation had been inspired by the EPACT and subsequent FERC policies. Chief among the CPUC proposals was “direct access” – the authorization of retail competition within IOU service areas. AB 1890 ended the retail service monopoly of utilities and authorized retail customers to buy power directly from alternative providers, beginning in 1998.

The essential bargain of AB 1890 was to authorize direct access and assure the IOU’s could recover stranded investments, but the CPUC’s implementing decisions took a series of further steps, intended to facilitate competition, and direct access in particular, which would prove disastrous. These included compelling the IOUs to sell off the power plants that generated the electricity needed to serve their own customers, requiring the IOUs to buy and sell all their power through the Power Exchange (PX) and Independent System Operator (ISO) spot markets, and retreating from long-term planning and investment.

Other elements of deregulation, such as the IOUs’ transfer of control of their transmission systems to the ISO to facilitate non-discriminatory access to competing suppliers, were addressed in AB 1890, but likely would have happened anyway pursuant to federal policies, such as FERC’s Order 888. The main contribution of AB 1890 in this area, which was to attempt to ensure accountability of the ISO to the state, met with limited success.

AB 1890 also contained a number of side deals. These included a guaranteed 10% reduction in retail rates for small customers, a guaranteed level of funding for low-income and environmental public purpose programs, and assistance for IOU employees whose jobs would be at risk. The final product was widely supported. At the time, deregulation champions heralded the bill as paving the way for more competitive, efficient, reliable, and affordable electricity service. Many would-be critics saw deregulation in California as inevitable and AB 1890 as the best possible bargain. Few questions were asked. AB 1890 passed without a single “NO” vote.

The Collapse of the AB 1890 Edifice 

In the first two years after its implementation, the deregulation experiment appeared to be paying off well for IOUs and customers alike in California. Service remained reliable, wholesale prices remained below the frozen retail rates, and the IOUs’ stranded cost recovery surged, due in large part to the unexpectedly high prices fetched for the sale of their power plants. Large rate reductions were anticipated once the transition period was over.

Evidence of market power began to surface in 1999. Irregular but enormous price spikes in spot energy and ancillary services markets raised concerns among observers. The potential for market power abuse and increased prices was at the forefront of skepticism over Pacific Gas & Electric (PG&E) Company’s failed attempt to divest its entire hydroelectric system to an unregulated affiliate. The Legislature’s refusal to permit the PG&E divestiture was the first major hiccup in the march toward deregulation.

Then, in mid-2000, unprecedented price spikes began to occur with growing regularity. In San Diego, where the rate freeze had ended, San Diego Gas & Electric (SDG&E) customers were directly exposed to the high prices. Within six months, the market was in disarray, rolling blackouts occurred during periods of relatively low electricity demand, suppliers’ demands for extraordinary prices were unchecked, high wholesale prices caused nearly all customers of the collapsing direct access market to return to the IOUs’ frozen rates, the IOUs became financially unable to pay for electricity, and the state had to assume the IOUs’ power buying duties to “keep the lights on.”

To avoid the dysfunctional spot market that financially decimated the IOUs and threatened catastrophic rate increases, AB 1X (Keeley), Chapter 4, Statutes of 2001, established a structure to permit the Department of Water Resources (DWR) to buy needed electricity for IOU customers under long-term contracts. To ensure the predictable revenue stream necessary for long-term contracts, the issuance of ratepayer-backed revenue bonds, and prevent cost-shifting from direct access to bundled service customers, the California Public Utilities Commission (CPUC) was directed to suspend direct access to prevent additional migration of IOU customers. After a seven-month delay, the CPUC suspended direct access on September 20, 2001.

Between January and June 2001, the vast majority of customers previously served by direct access providers returned to IOU service, benefiting from retail rates which were lower and more stable than market prices. However, between July 1, 2001 and September 20, 2001, thousands of predominantly large industrial customers, who had taken service from the state at below-market rates, departed for direct access as market conditions improved. During the July 1 to September 20 period, direct access increased from approximately 2% to approximately 13% of the total IOU load. Direct access load continued to grow due to the CPUC’s liberal interpretation of the Legislature’s direction to suspend direct access, including allowing customers to begin direct access service after the suspension date and switch between bundled service and direct access service.

Post-AB 1890 Retreat from Deregulation

In addition to the emergency enactment of AB 1X, other state laws enacted during and since the energy crisis have emphasized maintaining and enhancing publicly-accountable, state and/or local control over electricity planning, investment and rate-setting. Examples include:

• AB 5X (Keeley), Chapter 1, Statutes of 2001-2002, and SB 47 (Bowen), Chapter 766, Statutes of 2001, provided for gubernatorial appointment and Senate confirmation of the ISO board.
• AB 6X (Dutra), Chapter 2, Statutes of 2001-2002, put an end to market valuation and divestiture of IOU power plants.
• AB 57 (Wright), Chapter 835, Statutes of 2002, established a CPUC-regulated procurement planning and cost recovery process for IOUs.
• SB 6X (Burton), Chapter 10, Statutes of 2001-2002, established the Power Authority to facilitate public investment in cost-based electricity resources.
• SB 39XX (Burton), Chapter 19, Statutes of 2001-2002, authorized the CPUC and ISO to establish inspection and maintenance standards for merchant power plants to ensure their availability.
• SB 1078 (Sher), Chapter 516, Statutes of 2002, required IOUs to increase procurement of renewable resources subject to a process overseen by the CPUC.
• SB 1389 (Bowen), Chapter 568, Statutes of 2002, required the Energy Commission to prepare an Integrated Energy Policy Report every two years based on its assessment of trends in energy markets, including electricity.

The Consequences for IOU Customers 

Since early 2001, the electricity rates set by the CPUC for the customers of the state’s major IOUs have exceeded the IOUs’ ongoing cost of service, far exceeding the rates of in-state municipal utilities or any neighboring state, and ranking among the highest in the nation.

In January, and again in March, 2001, the CPUC increased rates for the customers of Southern California Edison (SCE) and PG&E a combined average of 4 cents per kilowatt hour. High-usage residential customers and the vast majority of business customers who take bundled service were hit especially hard. The rate increases marked the practical collapse of the rate freeze and transition cost recovery scheme created by AB 1890. 

While DWR has claimed a share of electricity rates for its ongoing operating costs and payments on bonds it issued to finance its high-cost power purchases in 2001, the IOUs have also been collecting an extra measure of rates that would otherwise be dedicated to buying electricity. Under the CPUC rate increase decisions, these extra rates were subject to refund to utility customers.

However, the CPUC has maintained these higher rates, instead of refunding the excess funds to customers or using them for ongoing procurement, and expanded their purposes to include restoring the financial health of SCE and PG&E. For example, in October 2001, the CPUC entered a settlement of federal litigation with SCE permitting SCE to use excess rates to pay off about $3.6 billion of procurement debts incurred in 2000.

In December 2003, the CPUC approved a settlement between itself and PG&E in PG&E’s federal bankruptcy court proceeding. Prior to the settlement, PG&E and the CPUC had been proponents of competing plans of reorganization. The settlement and a plan of reorganization based on the settlement have since been approved by the bankruptcy court. The PG&E settlement committed approximately $4 billion in accumulated cash from excess rates collected by PG&E through 2003 to partially pay off the bankruptcy claims. The settlement also provided for the issuance of new debt to pay off the remaining bankruptcy claims and expenses (more than $8 billion), with the cost collected from customers until 2013.

Major Features of Electric Service Before and After AB 1890

Electricity deregulation is typified by dis-integration, or “unbundling,” of the three major elements of vertically-integrated utility service – generation, transmission, and retail service. The following is a comparison of the operation of these elements prior to AB 1890 and under AB 1890 and subsequent legislation.

Generation

Pre-AB 1890 – IOUs owned or controlled generation needed to meet demand. Power plants owned by IOUs were regulated by the CPUC on a cost-of-service basis. PURPA introduced competition in the form of QFs, which replaced IOU development of power plants. IOUs bought power from QFs under long-term contracts at the IOUs’ avoided cost. Approximately 25% of the electricity demand of IOU customers is now met by QFs.

AB 1890/subsequent legislation – The CPUC compelled IOUs to sell fossil power plants to EWGs to facilitate competition and required IOUs to buy and sell all power through the PX at prices set at auction. EWG plants aren’t dedicated to serve any particular customers, although EWGs may choose to contract with IOUs (or DWR). Since the enactment of AB 6X in 2001, prices for IOU generation have been set on a cost-of-service basis. The bulk of additional generation needed to meet demand (net short) is supplied via DWR contracts with EWGs.

Transmission

Pre-AB 1890 – IOUs owned and operated their transmission. IOUs gave priority access for delivery of power to their customers. Excess capacity was available for wholesale wheeling.

AB 1890/subsequent legislation – IOUs still own transmission lines, but operational control is transferred to the ISO. ISO manages the three IOUs’ transmission grids as a single, open access system. IOU generation has no more access to the system than competing generators and marketers.

Retail Service

Pre-AB 1890 – IOUs have an obligation to provide universal service and customers must take bundled service from the IOU at rates set by the CPUC. Self-generation and municipalization are long-term service alternatives.

AB 1890/subsequent legislation – IOUs retain the obligation to provide universal service, but IOU customers may buy electricity from retail competitors at unregulated prices, to be delivered by the IOU, and may freely depart and return to bundled IOU service. IOU customers attempt to recover IOU investments made on behalf of direct access customers through a non-bypassable “competition transition charge.” In 2001, direct access was suspended to support AB 1X’s long-term contracting effort, but not before the direct access load returned to its historic levels and created new stranded costs. IOU customers attempt to recover DWR investments made on behalf of direct access customers through “cost recovery surcharge.”

 

What Can the Legislature Do?

 

While the Legislature has taken several individual steps to reverse deregulation, the Legislature itself did not enact deregulation, and it cannot itself repeal it. Deregulation has been effected by a complex array of mostly federal and some state statutes, regulatory orders and court decisions dating back at least to 1978. PURPA and EPACT deregulated wholesale generation. EPACT and FERC actions such as Orders 888, 889 and 2000 deregulated IOU-owned transmission to accommodate the delivery of non-utility generation. These federal policies are not reversible, although states can choose the extent to which they wish to participate in their implementation.

Some states have resisted these federal policies by maintaining vertically integrated utilities. California did not resist, and in AB 1890 consented to and furthered the dis-integration of California’s major IOUs, leaving distribution utilities without the means under their control to meet their obligation to serve. Municipal utilities have resisted and remained vertically integrated. The results, in terms of retail rates, speak for themselves.

 1 PBS Frontline – http://www.pbs.org/wgbh/pages/frontline/shows/blackout