Golden State's Energy Drama Threatens to Maul Big Producers

Great political risk clearly exists in places like China and Cambodia. But investors in power producer stocks are unexpectedly running up against something mighty similar in prosperous California.

Sinking Duke, Calpine hit by crisis

Golden State Gov. Gray Davis, along with other politicians from the state, appears intent on abolishing the state's electricity market. That's bad news for the go-go independent power producers that sell electricity in the Golden State, like AES (AES Quote - Cramer on AES - Stock Picks), Reliant Energy (REI Quote - Cramer on REI - Stock Picks), Calpine (CPN Quote - Cramer on CPN - Stock Picks) and Duke Energy (DUK Quote - Cramer on DUK - Stock Picks).

Here's the issue. Californiaappears close to effectively suspending its semiliberalized power market for a short spell -- and the state could soon permanently dismantle the market. State Assembly members last week voted for a bill that may well end up setting by fiat the price at which producers can sell power in the state.

According to a bill that was approved by the Assembly, the state's Department of Water Resources would spend up to $400 million of its own money buying power from producers at 5.5 cents per kilowatt-hour, a price well below current market rates. Davis has said adamantly that he doesn't want the state paying more than that. The Senate energy committee is likely to remove the 5.5-cent cap to allow room for maneuver but hasn't officially removed it yet, according to a spokesman for Assembly Speaker Robert Hertzberg. The committee is expected to conclude its work on the bill in the latter part of this week, the spokesman adds.

This bill follows one passed last week that also earmarks $400 million for electricity purchases but sets no price cap.

The state plans to pass on that cheaper electricity to big utilities like Pacific Gas & Electric (PCG Quote - Cramer on PCG - Stock Picks) and Southern California Edison, a unit of Edison International (EIX Quote - Cramer on EIX - Stock Picks).

The motive for the state's action is clear: The utilities have been forced to the point of bankruptcy because they aren't able to pass on the soaring market-set power prices to end-consumers like businesses and individuals. Market prices have skyrocketed over the past few months because the cost of natural gas -- needed to fire many power plants -- has also risen sharply. In addition, demand for power in California has been extremely strong, due to the buoyant economy.

Madeleine Albright?

Davis' proudly proclaimed support for price caps gives an unnerving foretaste of the sort of long-term plan that he might come up with. If he gets his way and shuts down the power market for good, California won't be the rich source of profits and growth that many independent power producers have assumed. The power producing firms' stock prices have declined amid default fears surrounding customers like PG&E and Southern California Edison. But, arguably, their stocks have yet to reflect the possibility that they will lose California as a place to make lots of new, high-margin sales.

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Hang on a minute, power market experts will say, what about the feds? Isn't the Federal Energy Regulatory Commission, which has jurisdiction over states' power markets, opposed to price caps and able to prevent them? And isn't the FERC just as likely to maintain that stance under President Bush? Sure. But Davis and U.S. Sen. Dianne Feinstein are apparently trying to undermine the FERC. Feinstein's attempt is a long shot. She wants to introduce legislation that will allow the energy secretary to overrule the FERC on rates.

More likely to succeed is a possible plan from Davis for the state to keep purchasing power in the long term. In a Friday piece, Sacramento Bee columnist Dan Walters says murmurs in the state capital suggest that Davis sees the state becoming "a semipermanent purchaser of power by long-term contract, thereby, it's hoped, stabilizing utility costs." Walters adds: "In theory, purchases would begin around Feb. 1 and last for either a few years until utilities return to health, if Republicans have their way, or become a permanent state power authority, if Democrats prevail."

Financing Options

California's Assembly Democrats are expected to detail a plan Monday that reveals how the state could finance big energy purchases, according to the Los Angeles Times. The plan envisions the state borrowing billions of dollars to buy the energy, which it will sell to the utilities. At the same time, the state would take over hydroelectric plants currently owned by PG&E and Edison, and then use revenue from power sales by those plants to help pay back its extra borrowing. The Democrats' plan doesn't include a rate hike for consumers. Davis, according to the Times, didn't comment on the plan.

But with natural gas prices soaring, Davis' currently favored power purchase price of 5.5 cents per kilowatt hour is too low to persuade most power firms to enter forward-sale contracts, except at advantageously long terms. Duke Energy, for instance, would only sell at that rate in a contract of over 10 years, says spokesman Tom Williams. The state and the utilities favor much shorter contracts.

True, Calpine has a larger number of new, more efficient plants that may allow it to profitably sell at 5.5 cents. But that company accounts for just 2% of the Golden State's energy capacity. A Calpine spokesman declined to comment on rumors that it has agreed to sell at 5.5 cents.

Independent power producers only account for 25% of California's capacity. So why can't other producers come up with the power? It's not that simple, argues Peter Van Doren, a scholar at the free-market Cato Institute. He says natural gas-fired stations (belonging to established power firms as well as the new independents) account for the largest share of Californian capacity -- some 45% of the total. All of these need to pass on the soaring gas prices to customers.

Just over 20% of capacity comes from hydroelectric sources, but these have struggled to meet output targets over the past few years. That leaves only nuclear plants to provide low cost power, says Van Doren. They represent a third of capacity.

Capacity Shortfall

One imperfect market-influenced approach favored by some is to allow the utilities to get back into the power generation business, so they themselves can take advantage of the high market prices. This would provide profits to offset losses from selling to consumers at below-market rates.

But would bond investors, shaken by default fears, really cough up the cash for notoriously inefficient entities like PG&E to start building new generating capacity? And even if investors were coaxed in, the utilities would now be at the back of a very long queue for the enormously expensive turbines needed for generating facilities. In other words, it could be years before they start adding generating capacity.

A wise way forward was suggested by Severin Borenstein, of the University of California at Berkeley, in a Los Angeles Times op-ed piece Wednesday. He says consumers need to be charged more at peak usage times. That way, people would cut back in times of traditionally heavy consumption. Shortages would abate and disrupting blackouts would be aborted, he argues.

Maybe Davis' strident stand against rate hikes is just posturing and he will opt for a halfway house plan that includes a variable peak-pricing mechanism within a band of state-fixed prices. But the fixed prices will have to be set high enough to keep the utilities afloat and thereby encourage independent power producers to sell to them and build new plants. Again, it's hard to see Davis having the guts or sense to let consumer rates go up to the requisite levels.

Of course, there's one awful, unintended solution to the energy crisis. It goes like this: Power shortages and the instability they cause plunge California into recession, causing its power needs to drop off sharply. We're not there yet. But Davis and Feinstein are fast leading the state toward this sort of debacle. As for investors in California power stocks, clearly you need to be talking to people with experience of investing in, say, Pakistan.