FERC Refunds And CA’s Market Power Design

FERC Judge Finds for California Refunds, But Recognizes State?s Role in Creating Market Power

On Thursday 12 November, Federal Energy Regulatory Commission administrative law judge Bruce Birchman proposed refunds that electricity suppliers should offer in redress of allegedly excessive wholesale power prices in 2000 and 2001. This decision should resolve some of the regulatory uncertainty that has been plaguing the energy industry, but outstanding issues of the causes and exercise of market power, and ongoing threats from the California government of legal challenges to FERC?s finding, could prolong the high regulatory costs of putting California?s policy failure behind us.

Judge Birchman recommended refunds to the California Independent System Operator (CAISO) and the Power Exchange (PX) totaling $1.8 billion, well short of the $8.9 billion that the state of California is agitating to receive. In part, the state of California argues that it is owed these higher refunds because it believes the ?mitigated market clearing price? (MMCP) that Judge Birchman used to come up with the $1.8 billion (which he got from the California ISO) does not reflect supplier exercise of market power. Thus California officials argue that the MMCP used was too high, leading to refund estimates that are too low. In addition, the state is arguing that the Department of Water Resources (DWR), which took over wholesale power purchases once the utilities became financially insolvent in January 2001, deserves refunds. Yesterday?s recommendation does not include either of these items, although Judge Birchman did leave the door open for revising his recommendations if the ongoing FERC investigation into the exercise of market power indicates that he should reduce the MMCP that he used in his analysis.

Two interesting issues arise in considering this finding of fact. First, wholesale electricity suppliers are still owed $3.0 billion for the power they sold into the California market during the period in question, so the refund will act as an offset and reduce CAISO and PX liabilities for payment to $1.2 billion. According to this Dow Jones Newswire story from 12 December, the top ten power suppliers into the ISO and PX are still owed $1.76 billion, are liable for refunds of $875 million, and will therefore receive approximately $890 million in payments from the CAISO and the PX if Judge Birchman?s recommendation stands.

In looking at the recommended refunds, I calculated each company?s refund as a percentage of the outstanding amount owed. When you rank each company according to how much of what they are owed may have to be refunded, the top four companies are Enron, Williams, BC Hydro, and Dynegy. These four companies face recommended refunds above the average refund share, which is 49.56 percent, which is consistent with evidence that these companies may have gone beyond simply taking advantage of a flawed set of market rules. Again, though, Judge Birchman?s finding of fact is not the final word on this, as other investigations and litigation continue.

Second, California officials continue to obfuscate the sources of the market power that was allegedly (I say ?allegedly? in deference to the ongoing FERC investigation) behind the high prices charged. Put simply, why should the CAISO and the PX (and, if the state has its way, DWR) receive refunds for power suppliers finding and profiting from flawed rules that policymakers and these organizations implemented? Judge Birchman?s wording in the introduction and summary of the ruling is instructive:

?The Federal Energy Regulatory Commission (Commission or FERC) found in November 2000 that the electric market structure and market rules for wholesale sales of electric energy in California were seriously flawed and that these structures and rules, in conjunction with an imbalance of supply and demand, caused unjust and unreasonable rates. [emphasis added]? (para. 41)

The existence of and ability to exercise market power is at this point pretty uncontroversial. But the core of the disagreement between the state of California and FERC is that California officials will not acknowledge, even after all of this time, that their flawed rules were the proximate source of the market power. Judge Birchman?s statement, quoted above, acknowledges that culpability.

California?s policy failure and flawed rules created manipulation opportunities by creating market power for suppliers. As many observers (including myself) have said elsewhere, the state-mandated bifurcated PX/ISO structure gave suppliers market power on a silver platter, so is it fair to hold suppliers liable for exercising that market power when they allegedly did not engage in any behavior to create that market power? The distinction between exercising market power and creating market power is crucial, and this distinction is precisely what California officials are trying to obfuscate, because their rules primarily created the market power.

The flawed rules also created enough risk to stymie investment, reinforced by the existence of $250 wholesale price caps after 1999. In an environment of regulatory uncertainty, which California was during the late 1990s and continues to be to this day, power companies would need to expect a return on investment that incorporates a risk premium, and it took demand rising until close to supply capacity to generate the expected return on investment that would repay investors for building power plants to serve California. Add to that the artificially inelastic demand that results from the persistence of retail price caps, and yet again evidence indicates that government policy at least contributed to, or at worst created, the problem of the imbalance of supply and demand.