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2001 07 Electricity Journal - Vesting Contracts - Author's Version

2001 07 Electricity Journal - Vesting Contracts - Author's Version



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Published by Edward Kee
Article (Contact Edward Kee at edward.kee@nera.com) on the California electricity crisis of 2000 and how vesting contracts would have prevented it
Article (Contact Edward Kee at edward.kee@nera.com) on the California electricity crisis of 2000 and how vesting contracts would have prevented it

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Published by: Edward Kee on Jul 15, 2008
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Vesting Contracts:A Tool for Electricity MarketTransition
Vesting contracts can manage the transition to full competition in electricity, manage the financial risk of market participants and help achieve other deregulation objectives. Vesting contracts could have prevented the financial problems in California.
Edward D. Kee 
 The California electricitycrisis is not proof thatelectricity deregulation can only work if there is an excess of capacity and low spot prices.Instead, this crisisdemonstrates that aderegulation plan based on abelief in low spot prices, without hedging, is very risky. The California deregulationplan was a bet-the-stateelectricity trade that couldsucceed only if spot prices werelow.Vesting contracts, hedgecontracts put in place prior tothe divestiture of generators,could have locked in utilitypower costs and largelyprevented the Californiafinancial crisis. Vestingcontracts can protectcustomers (or the retailersserving the customers) fromspot market prices even incapacity-tight markets, kick-start the hedge contractmarket, maintain a viable spotmarket, provide incentives fornew entry, and facilitate otheraspects of a transition toelectricity markets.Without adequate hedging of spot market purchases,California has focused on spotprice caps to control losses – removing important marketprice signals. Deregulationplans that recognize thepotential for high spot marketprices and incorporateappropriate hedging strategies will be viable regardless of spotprices and without the need forprice caps
Edward D. Kee
is a Vice President at CRA International, Inc. He is aspecialist in the electricity industry,with a focus on nuclear power,industry restructuring, and electricitymarkets. At the time this article was published, Mr. Kee was a partner at PAConsulting Group in Washington, DC, and the head of PA’s Energy Economics practice. He was a Senior Vice President at PHB Hagler Baillywhen PA acquired that firm in late2000. Between 1997 and 2000, Mr.Kee was the leader of the Australian practice of Putnam, Hayes & Bartlett,with a range of client engagementsrelated to the electricity industryrestructuring and privatization.The insights and observations in thisarticle are derived from the author’sexperience as a consultant and  participant in the electricity industry.The author thanks colleagues and  friends who provided comments ondrafts of this article. Mr. Kee is based in Washington, DC and can be contacted at ekee@crai.com.
NOTICE: this is the author's version of a work that was accepted for publication in
The Electricity Journal 
. Changes resulting from the publishing process, such as peer review, editing,
corrections, structural formatting, and other quality control mechanisms may not be reflected in this document. Changes may have been made to this work since it was submitted for 
publication. A definitive version was published in
The Electricity Journal 
[VOL 14, ISSUE 6, (July, 2001), pages 11 - 22; http://dx.doi.org/10.1016/S1040-6190(01)00211-1]
Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001
 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
Utilities that were torecover stranded costs;
Utilities that wererestrained from hedgingspot market exposure;and
Utilities that werefinancially solvent.California utilities wereobligated to supply end-usecustomers at fixed prices while required to purchase inthe spot market, largely without hedging. It is nowpainfully obvious that onlylow spot market prices wouldhave kept these utilitiesfinancially solvent withoutthe need for rate increases.Small commercial andresidential customers weregiven an initial 10%reduction in rates, but couldonly obtain additionalbenefits at end of the ratefreeze period if spot pricesremained low.California’s approachestablished an enormousunhedged financial positionin the electricity market, sothat deregulation became theequivalent of a
bet-the-state electricity trade 
. If spotprices were low, deregulation would work; if spot prices were high, a lot of money would be lost. The financial crisisdemonstrates that aderegulation plan based on abelief in low spot prices, without hedging, is veryrisky. Hedge contractssigned before spot prices were high could have lockedin utility power costs, largelypreventing the currentfinancial crisis. Even better,hedge contracts assigned togenerators prior todivestiture, referred to asvesting contracts, could havesupported the original ratefreeze regardless of spot pricelevels.
 Instead, high spot pricesin California have destroyedthe credit of the investor-owned utilities and threatento burden the State fordecades. Without adequatehedging of spot marketpurchases, California hasfocused on spot price caps tocontrol these losses – removing important marketprice signals. Many partiesare calling for even morestringent and widespreadspot market price caps toease the financial problem,even while the state (and theregion) is in great need of new entry.New generation plants inCalifornia already facesignificant environmentaland siting hurdles and pricecaps will further reduce theattractiveness of power plantinvestments. Also, retailersand customers are unlikelyto hedge spot marketexposure when frozen retailrates and spot market pricecaps are in place.Viewing California’sproblems in the context of hedging and financial riskdoes not mean that the veryreal problems with adequacyof supply and potentialblackouts should be ignored. These capacity supplyproblems must be examinedand resolved on a regionalbasis. The financial crisisand the supply shortage arenot unrelated, but the twoproblems should beconsidered separately.A focus on price caps toease the financial problem islikely to exacerbate thesupply shortage problem.Viewing the California crisisas a risk managementproblem may allow solutionsthat both ease the financialexposure to spot prices andhelp solve the supplyshortage problem (e.g., newentrants signing up for hedgecontracts).
With California’senormous unhedged  financial position, deregulation became theequivalent of a bet-the- state electricity trade.
Before discussing riskmanagement and vestingcontracts, it is useful toexamine another feature of the California deregulationplan – the notion thatcustomers should see wholesale spot prices.
III. Should Customers beForced to Buy atWholesale Spot Prices?
 The Californiaderegulation plan called forcustomers, after the end of the rate freeze, to buy energyat the wholesale spot marketprice. Retailers were to beconduits to pass on the wholesale market price. Thisprobably looked like a niceidea when spot prices wererelatively low compared tothe rate freeze levels. Thereis disagreement among theindustry experts on thisissue, with some arguing thatthe California chose the
Vesting Contracts: A Tool for Electricity Market Transition; by Edward Kee, The Electricity Journal, July 2001

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