How the lights went out on a California dream

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The Independent Online

California is well used to being trumpeted as an example for the world. And now it has become a startling example of how not to manage deregulation of a major industry.

California is well used to being trumpeted as an example for the world. And now it has become a startling example of how not to manage deregulation of a major industry.

As a result of its botched attempt to create a free market in electricity, America's flagship state economy has simply run out of power. Last week, after weeks of frantic last-minute searching for supplies to meet the state's roaring demand, California endured its first rolling blackouts. Its two major utility companies, Southern California Edison and Pacific Gas & Electric, defaulted on hundreds of millions of dollars in debt owed to out-of-state generating companies and appeared to be days away from bankruptcy.

The state legislature, acting on emergency orders from the governor, Gray Davis, earmarked $400m (£267m) in public funds to buy electricity on the utilities' behalf. And the nightmare is just beginning. Even last week's power cuts, which hit the northern two-thirds of the state for a few daylight hours on Wednesday and Thursday, cost the economy an estimated $1.7bn, according to Jack Kyser, chief economist at the Los Angeles County Economic Development Corporation.

A handful of major companies are already seeing the writing on the wall. The Miller brewing company, based in Irwindale near Los Angeles, has laid off 200 workers and talked about moving part of its production to Texas. And Intel, the leading Silicon Valley chip-maker, has warned that it will have to consider moving future expansion out of state unless a solution to the crisis can be found quickly.

It is not inconceivable that the crunch could lead California, and the rest of the United States, into recession. And while time is of the essence, it is not on the politicians' side. The state desperately needs generating capacity to protect its distribution companies from the crippling price demands of out-of-state providers but most of the existing plants are old and in need of constant repair while new ones won't come on line for two years.

Governor Davis is determined to avoid significant price increases for consumers but even he can't ignore the fact that wholesale prices have jumped as much as tenfold. Already, lawmakers have nicknamed Edison and PG&E Thelma and Louise: they are terrified that the companies, like the heroines of Ridley Scott's 1991 film, will prefer to drive off the cliff of bankruptcy rather than let the state authorities rush in to save them.

The state's emergency funds will probably stave off further blackouts until Wednesday; but if California wants to keep the lights burning with public funds for another three months, it could end up costing taxpayers a staggering $5bn under current market conditions.

How did this crisis sneak up so devastatingly and so unexpectedly? Its origins, by common consent, lie in the deregulation plan approved in 1996 and initiated two years later. With consumer prices remaining fixed, at least in the short term, and utilities subject to a so-called "competition tax" - supposedly to avoid price-gouging - the new retail market never had a chance. Of the 15 companies that came in to California on January 1, 1998, 10 left again within a few months. A similar lack of incentive deterred companies from building new generating capacity - a fatal blow since almost no new plants were built in the state throughout the 1990s.

As for the current crunch, one prominent analyst compares it with another Hollywood movie, The Perfect Storm. According to Mark Bernstein, an energy expert at the Rand Corporation, California - like George Clooney's fishing boat - has been hit by a confluence of turbulent elements, any one of which would have been manageable in the short term but which, taken together, have proved devastating.

The failed deregulation was one, and soaring demand - stoked by the strong economy, population growth, and the particularly voracious electricity consumption of the hi-tech sector - another. On top of that, a major natural gas pipeline into California exploded last year and has yet to be fixed, triggering dramatic price spikes.

That fact, normally, would have caused California to buy in hydro-electric power from the Pacific Northwest but this winter happens to have been one of the driest on record in the usually rain-soaked states of Oregon and Washington. Add to that a recent cold snap in the region, and you understand why California's possible sources of extra power have shrivelled to nothing.

For the past few weeks California has enjoyed the support of the federal government, which has ordered neighbouring states to sell its electricity - even though they might themselves be short and even though the prospects of being paid by Thelma and Louise have dwindled along with Edison and PG&E's plummeting credit ratings.

With George Bush arriving at the White House the perfect storm is complete. Not only does the Republican administration have little inclination to help out California's all-Democrat political leadership; but Mr Bush is ideologically inclined to support free-market solutions and therefore pressure Governor Davis into letting consumer prices shoot up in accordance with prevailing conditions. It also so happens that in attempting to contain the crisis, Mr Bush will be seeking advice from the man who both helped create the mess and whose company has now made a financial killing from it.

Kenneth Lay, one of the president's best friends and most reliable campaign contributors, is chief executive of the Texas-based Enron Corp that has been one of the generating companies selling billions of dollars of premium-priced power to California's consumers. He is also one of the architects of the ill-fated deregulationintroduced in 1998. some of Mr Bush's best friends are energy producers in Texas and other states who have made a killing from the California crisis and are now his most influential advisers on energy policy.

Governor Davis's insistence on capping prices is attracting growing criticism, not only from Wall Street and the electricity industry but also from the state's neighbours who increasingly feel their consumers are being asked to suffer while Los Angeles keeps crushing ice for its poolside daiquiris. In a typical comment, Utah's governor, Mike Leavitt, said last week: "California consumers cannot be shielded from the true cost of power while major utilities are allowed to perish in bankruptcy and consumers in other Western states are left to pick up the tab." And that's not just political posturing. In Washington state, retail prices have already shot up as much as 50 per cent, in part because of fears that the California utilities will never pay their bills.

Most analysts believe massive price rises in California are inevitable, and if Governor Davis is unwilling to pay the political price for announcing them himself they could be mandated instead by a bankruptcy judge. Thereafter there are, broadly, two options: fixing the botched deregulation; or reversing it. The latter may be tempting, but given the high public cost of taking over power plants - not to mention the likelihood of protracted litigation - it may not be practical. As for the former, there is a risk that the same messy compromise that doomed deregulation first time around could prevail again. With natural gas prices at a historic high and showing no signs of going down soon, even a smooth-running electricity market could prove expensive enough to tip the state, and the country, into economic gloom.