The California crisis doesnot mean that deregulationand electricity markets areunworkable. Instead itshould remind us that spotmarket prices can beunpredictable and sometimesvery high; demonstrate thatderegulation plans withoutappropriate hedgingstrategies are risky; andshow that being wrong on abet-the-state electricity tradecan be very expensive. This article looks briefly atthe California crisis from arisk management point of view, discusses riskmanagement and the use of hedge contracts in electricitymarkets; and then providesan overview of vestingcontracts.
I. Did High Spot MarketPrices Cause California’sProblems?
Some believe that theCalifornia electricity crisis was caused by highelectricity spot prices. Thoseholding this view mayadvocate the use of pricecaps to control spot pricesand try to find a scapegoaton which to blame high spotprices. The most commonscapegoats are in-stategenerators, with out-of-stateutilities, traders and evenFederal Power agencies alsobeing named as culprits.Others hold a slightlymore enlightened view andblame high prices on the lackof new capacity additions inCalifornia over the lastdecade. Some then concludethat California proveselectricity deregulation isonly possible when spotprices are low. An example isthe Governor of California, who stated that:“Deregulation can only workif there is an excess of capacity”
Underlying this statementare three assumptions, onlythe first of which is valid.
1. Spot market prices will be lower when there is an excess of capacity.
Most industry observers would generally agree withthis assumption. Marketdesign, concentration of ownership, the nature of existing infrastructure, andother factors will determinethe level of competition in amarket and the level of spotmarket prices. All thesefactors being equal, anexcess of supply willgenerally lead to lower spotmarket prices compared tothe prices in a market with ashortage of supply.
2. California tried deregulation and it did not work.
If the Governor hadsaid that “California-stylederegulation can only work if there is an excess of capacity,” most would agree.Electricity deregulation andmarkets can and do work. The failure of the particularderegulation plan adopted byCalifornia should not beviewed as a general failure of electricity industry reformand deregulation. Theexperience in PJM, New York,New England, England &Wales, Australia, and otherplaces show that electricitymarkets can work.
3. Deregulation is only possible when prices in the spot market are low (i.e.,because there is an excess of capacity)
I also disagree with this assumption.Governor Davis may bereflecting the political realitythat electricity consumersand voters will favor a shift tomarkets when they getimmediate benefits. Other jurisdictions havesuccessfully implemented ashift to electricity spotmarkets without anoversupply of capacity.
One mistaken assumption:California tried deregulation and it did not work.
While excess capacity andlow spot prices would haveaverted the financial crisis inCalifornia, excess capacityand low spot market pricesare not prerequisites forelectricity deregulation.Another view of the Californiacrisis that high spot pricesexposed a deeply flawed andrisky deregulation plan.
II. CaliforniaDeregulation: A Recipefor Risk
California built significantrisk into its deregulationscheme by setting objectivesthat could
be achievedin total when spot marketprices were low:
End-use customer ratesat stipulated levels (i.e.,no spot market pass-through);
Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001