Under the Radar: California Power Crisis, Revisited

It could be rekindled, but generators shouldn't feel the pinch.
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The California energy crisis is beginning to look like a bad movie. Just when you thought it was ending, a rapscallion conjures up a scheme that means another hour of torture in the theater.

Enter California Gov. Gray Davis, the very man who demanded that California power generators enter a long-term power-supply agreement with the state after its deregulation scheme failed. That pushed

Pacific Gas & Electric

, the utility subsidiary of

PG&E

(PCG) - Get Report

, into bankruptcy and required the state to rescue

Southern California Edison

, an

Edison International

(EIX) - Get Report

subsidiary, from the same fate.

Now, with the state awash in debt from the contracts and electricity prices continuing to fall, Davis is ready to demand that the generators renegotiate the pricing of the contracts and lower the costs. He's said to be claiming the contracts were negotiated under duress.

To be fair, the original scheme wasn't Davis' doing. Yet, he made it much worse through policy decisions and vilification of the power generators, the very parties he needs as partners to fix the problem. Now, he appears ready to risk his credibility further by trying to recraft his decision to put California in the power-buying business for years to come.

Short-Term Problem, Longer-Term Disaster

The problem began to emerge as early as 1999: California would be faced with too much power demand and too little supply, and that could risk pushing wholesale power prices through the roof.

Under California's deregulation law, the state's utilities were forced to sell their power plants to third-party generators and focus on the retail power business -- buying power from generators at unregulated prices and distributing it to customers in their service territory at regulated retail rates.

The system had one other rub: The utilities would be buying their power through a state-sponsored "power broker," and almost all of their power would come from the spot markets, the buy-as-you-go plan. The utilities were largely prohibited from entering into long-term power-supply contracts with generators that would set a fixed price for power, regardless of market fluctuations

That system works as long as supply exceeds demand and prices remain in check. However, as the utilities began to realize demand would quickly outpace supply, they asked California regulators for permission to enter long-term supply agreements. The

California Public Utilities Commission

, under the Davis administration, rejected the notion.

Then, the worst happened. Power demand soared, and prices followed. Utilities were forced to buy power on the unregulated, wholesale spot market, yet were limited to regulated retail rates for recovery. By late last year, some estimates placed the power-purchase debt of California utilities near $13 billion. Pacific Gas & Electric filed bankruptcy as a result.

Enter Davis' miscues. Instead of focusing on a solution, Davis spent much of his energy blaming others. He called the generators "pirates" and "price gougers," and threatened everything from arresting executives to seizing power plants.

Finally, in what now appears to have been the ultimate contrarian price signal, Davis agreed the state would begin purchasing power directly from the generators because the utilities were no longer creditworthy. At the same time, he demanded the generators enter long-term, fixed-price power-supply contracts with the state. Ironically, that coincided almost precisely with the peak in California power prices.

Davis hired high-powered negotiators and demanded concessions from generators that would put "the state on the path to meeting its electricity needs."

And, they said they were successful. David Freeman, Davis' lead negotiator, said the agreements were great for California. "Our negotiating team has reached agreement with generators on the basic commercial terms of price, quantity and term for power contracts, totaling about 5,000 megawatts, terms ranging from three to 10 years," Freeman said at a February press conference. He added, "The deals we have completed are competitive."

At the same time Davis and his power team were rushing to lock in pricing for up to 10 years, some economists and even generators were warning that prices could come down. In fact, these projections were ignored as the state continued to lock in historically high power prices for up to a decade. The combined value of the contracts is nearly $45 billion.

Indeed, power prices have moderated to precrisis levels, a result of both moderate temperatures and increased supply from in-state generation stations and imports from adjacent states.

Now, Davis is complaining generators took advantage of California in a time of weakness, while in fact generators were pressured to give in to almost every state demand. If any advantage existed, Davis and his political pressure had it.

Generators, not Charities

While companies with significant California power contracts like

Dynegy

(DYN)

and

Williams

(WMB) - Get Report

say they're willing to talk about renegotiating contracts if both parties benefit, they're under no obligation.

"We are not a charity," says an official at one generating company. "California got almost everything they wanted in the contracts, and now they aren't happy. That's not how it is supposed to work."

In fact, while Davis has not officially said he would push renegotiations, any attempt to force the generators to the table would likely be futile and, for California, counterproductive.

"These contracts were signed by the state to bring stability to California's wholesale power market and to insure a reliable and secure power supply," Deutsche Banc Alex. Brown analyst Jay Dobson told clients Friday. "Substantial alteration to the contracts could leave the state vulnerable to another energy crisis and high wholesale power costs. Also, many of the agreements are tied to future construction of much-needed new power facilities in the state, which would be jeopardized by any significant change to the agreements."

Dobson also noted, "Given the strength of these agreements, we do not believe that any possible renegotiations would have a significant financial impact on generators." Other companies with California power contracts are

Allegheny Energy

(AYE)

,

Calpine

(CPN)

,

Constellation Energy

(CEG)

,

El Paso Energy

(EPG)

,

Mirant

(MIR)

and

Sempra Energy

(SRE) - Get Report

.

Davis wanted contracts. He got them. This is one movie that needs to end without a sequel.

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, Edmonds' firm was long Mirant, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to

Chris Edmonds.