Pacific Gas & Electric and Edison International, the largest electric utilities in California, have taken on $11 billion between them in debt to continue operating. They're working in a partially deregulated market, where wholesale prices can rise to the sky and retail ones are fixed. California's regulatory experiment has failed, and it may cause some real problems outside of California's borders as well. The culprit? Poorly conceived policy, badly implemented. Picture blackouts in Silicon Valley.

www.MotleyFool.com - Friday January 12


By Bill Mann

There are many of us on the East Coast who have been watching the California energy crisis with some sense of schadenfreude. After all, we're freezing out here, while in California, as always, the weather is mostly beautiful. I'm not sure what Californians are complaining about. Most people never even get to visit California.

There's just one problem: The power crisis in California could conceivably harm all of us. California, were it an independent country, would be the sixth-largest economy in the world. If you thought things were bad when Thailand cratered in 1997, just imagine what would happen if California's economy gets blasted. Unless there is relief for the utilities there -- and fast -- we could have a major economic crisis on our hands with at least two bankrupt utilities: Pacific Gas & Electric (NYSE: PCG - news) and Edison International (NYSE: EIX - news). The third major investor-owned electric utility in California, San Diego Gas & Electric, and its parent company, Sempra (NYSE: SRE - news), are not under the same pressure.

How is this bad for people outside of California? Consider this comment PG&E issued on Monday: "Unless strong steps are taken over the next few days, the financial crisis facing California's utilities will bring us to the point where we can no longer buy electricity and gas for our customers." PG&E is the former monopoly and current majority utility for Northern California, including San Francisco and the entire Silicon Valley. Imagine for a moment what happens when Cisco (Nasdaq: CSCO - news), Intel (Nasdaq: INTC - news), Exodus (Nasdaq: EXDS - news), and hundreds of other companies critical to U.S. commerce have to suffer through brownouts or blackouts because utilities are unable, or unwilling, to supply them power.

And imagine the disaster were the two utilities to go belly up, taking with them the $11 billion in debt they have racked up from such lenders as Bank of America (NYSE: BAC - news). I hate to color this as a doomsday situation, but if bold action is not taken, all of the little hints about "recession" will be replaced with a situation so severe it could have the effect of toppling over our delicately balanced economy like a bull hopped up on caffeine breaking loose at a chess tournament.

People are quick to point fingers in a crisis, and as the situation has gone from a disaster waiting to happen to a plain disaster, most are doing so. But the silly people who single out deregulation as the major culprit have it wrong. Twenty-three states and Washington D.C. have taken on electricity deregulation, but only in California has it blown up. Why? Too many reasons to count.

Rather than point at deregulation, though, let's look at deregulation badly executed, courtesy of the legislators and regulators of California. It is an important lesson for any investor, because electric utilities are not the types of companies that have gotten people excited -- they are the companies that people put their retirement money into. In the case of those holding PG&E and Edison International, their "safe" utility stocks have been creamed, their dividends cut, their security dashed. It is a warning to all of us that we should not consider regulations to be natural law when choosing an investment. Laws can and will change, not always for the better. Those who invested in these utilities for safety of their principal are in danger of grievous losses.

California's electricity deregulation took effect in 1998. It meant, simply, that where there were once monopolies, consumers could effectively choose their power provider. But in order to allow the utilities to recoup their imbedded investments incurred prior to deregulation, the retail price for power was pegged at an artificially high level until the utilities recouped their investments. Seemed to make sense at the time, and the utilities signed off on it. So retail prices were fixed, but wholesale prices were not. The utilities were compelled to sell much of their generation capacity to other power producers, including Calpine (NYSE: CPN - news), Duke Energy (NYSE: DUK - news), and Enron (NYSE: ENE - news), who would then act as the spot market for the utilities (and other retail competitors) to buy their power.

But this set up a crush on the utilities when fuel stock prices began to skyrocket. There were several problems in California. The state had mandated that much of its power should come from non-greenhouse gas producing sources (with the exception of nuclear power). That's admirable, but also significantly more expensive. It had also outlawed coal-fired power, leaving most of the power in California to come from a single source: natural gas. These heavy restrictions, plus a case of NIMBYism writ large in the state -- no, I take that back, it's more like "BANANAism", or "Build Absolutely Nothing Anywhere Near Anything" -- made it an unattractive place for power producers to come build. And so they did not, and for 10 years (until earlier this year) not a single megawatt of new power generation was built in California. Power generators had better fish to fry: They'd have rather drank axle grease than deal with the headaches of the California market.

The consumers didn't pay much attention because their prices were pegged -- until San Diego Gas & Electric completed recouping its stranded asset costs, and retail costs floated in its service area during the hottest summer on record, causing retail rates to triple. The utilities were already getting crushed by increased costs, as natural gas prices surged. Moreover, as demand screamed higher in California (electricity demand in 2000 was 10% higher than in 1999), supply of natural gas moved in sympathy. California couldn't count on its neighbor states to supply power: Nevada, Arizona, Oregon, and Washington all had surging demand of their own, and used to count on California to provide additional supply.

No new plants, no new external sources, surging demand, and fixed pipeline capacity for natural gas is a potent brew. To add insult to injury, perhaps the stupidest part of California's experiment was to prohibit the utilities from buying futures contracts, beholding them to the price of the moment. That, in a nutshell, is why wholesale power prices in California have risen from $30 per megawatt hour to $1,500. Since the utilities' retail price was pegged, they are in dire danger of complete collapse.

I've received several questions about whether the California utilities are a good buy here. Before I answer, consider this: The most recent relief plan is to allow the utilities to raise their retail prices 9%, and the governor has suggested that the state take over the production of electricity. Neither proposal alleviates the deeper problem: California will still be the screwiest, most-restrictive electricity market in the country. A state-run power authority will have no easier time getting siting plans past local political activists than the current incumbents have now. In other words, these utilities, from what has historically been the safest of equity sectors, are unlikely to gain any relief that will give them -- or other private companies -- much room to make a profit on their investments.

In other words, no. Under these conditions these appear to be horrible investments -- and will continue as such until California loosens up the regulatory burdens on power producers. Californians are going to have to choose: aesthetics or darkness, global warming or coal and nuclear power generation. There is no such thing as immaculate conception of electricity, much as we'd like there to be.

Fool on, and have a great weekend. If you're in California, turn off your computer before you go home.

Bill Mann, TMFOtter on the Fool Boards.

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