Electricity Price Ruling Shifts Focus to Fundamentals

In an ironic twist, Monday's Federal Energy Regulatory Commission action, limiting electricity prices in Western markets, may be exactly what is needed to return independent power producers to investors' good graces.

While at first glance the order looks to be a complex method of capping electricity prices in the West, it also serves as a means to end the price-cap debate and to return a focus to the industry's strong fundamentals.

Monday's FERC action, adopted by a unanimous 5-0 vote, uses a complex formula -- including consideration of fuel prices and the credit quality of purchasers -- to establish a price ceiling for power sold within the Western Systems Coordinating Council, or WSCC, a group of 11 states that share certain power transmission interconnections.

You'll Need a Slide Rule, at Least...

The price ceiling is based on the bid from the highest-cost gas-fired unit in California that is needed to serve the California market on any given day. While complicated, think of it this way: California will theoretically dispatch power needed on the spot market, beginning with the most efficient generation available and moving to less efficient sources of power as demand grows. Hence, the price ceiling would move higher as demand moves higher.

While claiming the action stops short of cost-based price caps, FERC Chairman Curt Hebert says the plan will help stabilize fragile Western power markets. "It is a balanced plan that respects market forces and that attempts to restrain prices, while at the same time offering incentives for investment in supply and delivery that is the only real solution to the West's immediate energy problems," he says. "It represents an effort to provide some relief now, while making sure that mitigation is short-lived." The complex price scheme expires in September 2002.

While FERC's action does extend the plan -- termed "price mitigation" by FERC -- to 10 Western states other than California, it only applies to sales in the spot market, or short-term power sales on the day of or the day before delivery. All of California's power used to be purchased on the spot market, which is one reason critics cite for deregulation's failure, but now only about 20% of California's power comes from the spot market. That ratio continues to decline.

In the other WSCC states, much less comes from spot-market transactions. "There will be very little impact on pricing in the other Western states," says a source from a power generation firm. "A vast majority of all power in the West outside of California is bought and sold through bilateral contracts."

Minimal Impact on Generators

In fact, because so little of the power sold in California and the other Western states comes from the spot market, the order should have little impact on the independent power producers and marketers that do business in California and other Western states. "There may be a little bit of exposure to the spot market in 2002," says Jeff Dietert, an analyst with Simmons & Co., a Houston energy investment banking firm and a member of the TSC Energy Roundtable. "But most of the generators have sold forward through at least this summer. Hence, any impact will be extremely limited."

Dietert doesn't think any future exposure will necessarily be a bad thing. "All the generators have budgeted for more normal margins next year," he says. "They have been pretty conservative. I don't see this order having any impact on earnings estimates for 2001 or 2002."

In fact, one can imagine a scenario where the ceiling could become a floor, when the maximum price also becomes a minimum price in that all generators bid power into the market at the highest allowed price.

The FERC order makes just that point: "All bidders in the ISO spot markets will receive the market clearing price without further price justification." Hence, where a competitive market might bring in a range of bids lower than the ceiling, the current order nearly guarantees all spot-market sales will occur at the highest allowable price.

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How do politics play a role in this ruling? How might the action affect the stocks of power generators? Find out in the second part of this column.

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