LA Times - Sunday, January 14, 2001
Firms say California ignored advice and failed to deal with the realities of a 'new' economy. The ISO system 'invites gaming,' one executive says.
By JAMES FLANIGAN, Times Senior Economics Editor

HOUSTON--The big companies in this city that supply a quarter of California's electricity consider themselves loyal Western businesses that have invested heavily in a shared future with the Golden State--not "out-of-state" generators, as Gov. Gray Davis referred to them last week, and certainly not the profiteering gougers he routinely accuses them of being.

"We invested in California. Our headquarters may be in Houston, but our generating plants are in California, and we're trying to be in that market for the long term. We consider ourselves in-state generators," said Joe Bob Perkins, president of Reliant Energy's wholesale group, which owns five generating plants in California.

As Davis and other Californians look eastward to Texas as the source of their power woes, what do the Texans themselves see when they look westward to California?

The Houston companies--Reliant, fellow generators Dynegy and Duke Energy, energy marketer Enron and natural gas pipeline and marketing company El Paso Energy--may be Texan through and through. Their worldview emanates from Louisiana Street in downtown Houston, where every block houses a huge energy conglomerate.

But the Texas firms echo the worries of many Californians when they fret about the summer ahead, forecasting a continual threat of blackouts because there simply is not enough electricity being generated to serve the state's 33.9 million residents.

A Houston business leader even claims credit for helping inspire the continuing meetings called by U.S. Treasury Secretary Lawrence Summers to find a solution to California's electricity crisis, during which the state has only narrowly dodged widespread blackouts and two of the three big utilities teeter near bankruptcy.

"I called Larry Summers three weeks ago and said, 'You have an impending disaster,' " said Kenneth L. Lay, chairman of Enron. ". . . It's going to have ramifications for the financial markets in addition to what it's going to do for the whole economy."
Call them "in-state" or "out-of-state," today's companies are a different breed from the oil companies that once dominated business thinking here. These 21st century firms focus on natural gas and electricity and on using financial trading to offset risks in ways that seem to confirm the worst fears of Davis and most Californians.

"We view a power plant or a gas contract as an option: to decide to produce electricity from gas, or not to produce but sell the gas directly, or to hedge a contract to protect against price volatility," said Ralph Eads, an executive vice president of El Paso Energy, which owns the largest interstate gas pipeline serving California.

"We bring together the physical and financial markets," Eads said. All the major firms and many smaller companies in Houston today have trading floors where contracts on natural gas, electricity and other energy commodities are traded continuously to maximize profit and minimize risk.

In that way, the firms running many of California's power plants are different from the investor-owned utilities--Southern California Edison of Rosemead, Pacific Gas & Electric of San Francisco and San Diego Gas & Electric--that used to run them. The California firms do far less trading of energy commodities. None apparently used future contracts to hedge their risks in purchasing natural gas, which has skyrocketed in price in the last year.

The Houston companies and other energy firms operating in California say they advised the state in 1997-98 to go for long-term contracts for electricity and avoid depending on the spot market--as it ended up doing by establishing the Power Exchange, which conducts an hourly auction in which the vast majority of the state's electricity is bought and sold.

They were spurned, the Houstonians say, because California utilities and regulators believed that the price of electric power and the natural gas used to generate so much of it could only go down. Now, after prices have risen emphatically and California is seeking long-term contracts, the electricity generators and marketers say contracts can't be negotiated without "credit-worthy buyers."

They mean that the state's credit guarantee would have to stand behind the utilities, the Power Exchange and the Independent System Operator, which is charged with maintaining the power grid at all costs--and has found itself spending tens of millions of dollars for emergency electricity.

In Texas, in fact, long-term contracts are the cornerstone of plans to deregulate that state's electricity industry by Jan. 1.

Californians Seeing Texas Profits Rise

California utility executives, as well as the governor and millions of average citizens, note that the generating companies' profits have risen dramatically during the energy crisis and conclude that, at the very least, the companies took advantage of a bad situation.

The self-serving response from Houston to that kind of talk is to say that every supplier to the California system--whether generators from North Carolina and Georgia or the home-state companies from Rosemead, San Francisco and San Diego--probably also delayed selling to the Power Exchange to qualify for the higher emergency prices that could be offered by the Independent System Operator, a practice called "gaming the ISO."

"The system invites gaming," Enron's Lay said. "That's why we opposed the PX and ISO. We felt there was way too much opportunity for gaming the market."

Lay directs his charges at the California utilities, which continue to produce power from the nuclear plants they retained after deregulation. The California companies in turn aim their barbs at the newcomers from out of state. Edison sponsored a study of electricity pricing in the last year that showed power prices peaking at odd times, indicating a manipulated market.

But the differences between the view from Houston and that in California are more than a simple conflict over the prices of electricity and natural gas.

Those differences represent two takes on the economy: Texas prizes the flexibility and pace, and even the fragility, of a "new" economy. California paradoxically seems to be insisting on the stability and reliability of an "old," regulated economy.

For now, at least, the Texas view is holding sway and California's very prosperity will remain in peril unless it can adapt to a changing world.

When California moved to deregulate its electricity markets, the Houston companies saw great opportunity. All of them had grown out of the government's lifting of regulations on natural gas in the mid-1980s. They knew that the aftermath of deregulation in that case had encouraged greater supply of the commodity, because all producers gained access to the interstate pipelines.

But gas deregulation also brought greater volatility in price as gas customers--major industrial users and apartment complexes alike--made long- and short-term contracts to reflect individual needs.

That provided an opening for the services of companies such as Enron, which contracts to manage the energy needs of companies and institutions, using its financial expertise in buying and selling gas contracts to reduce exposure to wild swings in price.

The Texans hoped to expand into a huge new market when California deregulated electricity in 1998. And to be sure, many inside the state think the newcomers have profited--and unconscionably at that.

But that is not the view from Houston. Although the companies acknowledge higher profits, they worry about an unstable situation. So now they see the state as a problem to be fixed, rather than a present opportunity. And Wall Street too has become skittish about the companies, whose stocks have dipped 12% to 25% in the first two weeks of the year.

So the Texans are looking to pastures other than California for further investment.

Enron, for example, won the contract to handle all energy services for the University of California system except UCLA in 1998.

But Enron's wider ambitions for California--that it could win a huge market of residential customers by delivering power from other states--were frustrated. The relatively high pricing the utilities were granted, to allow them to recoup the costs of their nuclear plants and other investments, "made it uneconomic to try to compete for residential business because we couldn't guarantee a lower bill," said Steven Kean, an Enron vice president.

Dynegy, a natural gas trader that expanded into electricity, saw opportunity in buying old power plants in El Segundo and Long Beach at low prices.

"When we bought them, we assumed we'd repower them with new technology," said Stephen W. Bergstrom, president and chief operating officer.

Such an upgrading would require an investment of $200 million. But three years into its ownership of the old plants, Dynegy hasn't made that investment. Demand for electricity was so great "we couldn't take the plants offline to repower them," Bergstrom said. And besides, he said, the imposition of limited wholesale price caps by California regulators and Davis deterred the company.

However, Dynegy in 1999 spent $4 billion to acquire Illinova, the holding company for Illinois Light & Power, which provides electricity to the southern part of that state.

Energy Companies' Earnings Keep Rising

Meanwhile, running that old plant in El Segundo has yielded dramatic profits for Dynegy, as its earnings more than doubled in last year's third quarter.

Reliant Energy, formerly Houston Light & Power, a traditional utility, bought five plants in California but has also expanded in other areas, acquiring 21 plants in the Pennsylvania-New Jersey-Maryland power grid.

Reliant too showed a spike in profit in last year's third quarter, netting $100 million from operating plants in California but more than $170 million from expansion in Pennsylvania, company executives said.

His company is investing in California, said Perkins, the wholesale group president, but the two power plants the company is building are in Arizona and Nevada. The Arizona plant would provide electricity to California--but it would be beyond the jurisdiction of its political leaders and regulators.
The Houston companies' cooling enthusiasm for California is not a good sign for the state.

The view from Houston--and many other places across the country--is that the world is changing for California. It faces higher natural gas prices over a period of several years. It faces vulnerabilities because it must import 26% of its power from outside sources--the Bonneville Power Administration in the Pacific Northwest and utility companies in other states--and, the Texans say, it is not adapting to the challenges.

Even as commodity prices have soared, California has raised electricity rates only temporarily, 7% to 15%. Houstonians are contemptuous of this, saying that the higher prices for gas and thus electricity are not being fully experienced by the state's customers.

"The whole matter is subsidization," says Jack Farley, head of Western wholesale operations for Reliant. "The state orders the utilities to sacrifice their balance sheets to subsidize the customers. Now the state is asking us to subsidize the utilities by risking losses by buying natural gas to make electricity to provide to its utilities, which may not be able to pay.

"Will the governor of Washington say that an old plant in his state should run overtime, with environmental damage, to feed California? I don't think that's going to work."

For all the contrast between Houston and Sacramento, there is little disagreement about what needs to be done. The state must build more generating plants and change from a spot market to one based on long-term contracts.

But Houston and Sacramento differ on the means of achieving those goals.

In Sacramento, Davis and many legislators seem to favor a state power authority.

"We must get control of our energy destiny," Davis said in his State of the State speech Monday.

Financial markets would be Houston's method.

Lay of Enron cautions: "With everything Silicon Valley has done to the world--the Internet Age and technology--there's no way you can centralize decision-making and have an efficient, low-cost, reliable electricity system."

"If California had had a prudent portfolio of contracts coming into this period," he said, the explosion of short-term prices "would have had very little impact on the economy."
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Times staff writer Nancy Vogel contributed to this story.


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