Number 75 August 24, 2001

Executive Summary

Current proposals for avoiding a formal bankruptcy by Southern California Edison, as embodied in alternative draft legislative Memoranda of Understanding (MOU) now under consideration, explicitly will create a hierarchy of favored and less-favored creditors. This approach will create powerful incentives for those with lower priority to force Edison into bankruptcy immediately, in substantial part because of fiduciary responsibilities to their owners or shareholders. In short: Despite the ostensible purpose of the MOU in terms of avoiding a formal bankruptcy filing by Edison, this provision seems designed to force such a filing while shifting the attendant political responsibility to the less-favored creditors.

Because the draft MOU would force Edison into bankruptcy, it would have the effect of preserving rather than ending the state’s role in terms of power purchases, since an Edison in bankruptcy proceedings would be less likely to be able to resume that function.

Other proposed provisions of the draft MOU will return California to a highly inefficient system of regulatory rate setting, will politicize electricity rates, will increase investment risks and capital costs, and will erode consumer choice sharply.

The long-term interests of Californians—consumers, producers, workers, and taxpayers—will be served by public policies relying upon market forces.

The partial deregulation, implemented through AB 1890 (1996) and related PUC decisions, has yielded the current problems and inefficiencies afflicting the California electric power sector. Moreover, historical and current policies are poorly suited with respect to the technological advance and competitive pressures characterizing the modern electric power sector.

Introduction

The long-term interests of consumers are furthered by competitive prices, both for electric power services themselves and for the myriad other goods tied to them, and by an investment environment unburdened with artificial risks created by inefficient and shifting public policies. Policies chosen in pursuit of an efficient and reliable electric power sector must rely upon market forces and principles, and thus will serve the interests of consumers and the utilities and power producers in terms of a reduction of the risks perceived as attendant upon large investments in electric power infrastructure. Indeed, the interests of consumers, utilities, and producers are largely consistent in that greater risks yield both higher prices and reduced economic returns over time. Such policies will serve the interests of workers by increasing investment in both the electric power sector itself and also more broadly across the California economy, thus increasing employment opportunities, the stock of capital, and wages. And accordingly, they will serve the interests of taxpayers and government agencies by expanding the tax base.

Background

By the early 1990s, the traditional system of electric rate regulation by the California Public Utilities Commission (PUC) had yielded electricity prices roughly half again as high as those in the rest of the U.S. The evolution of the electric generation system under regulatory incentives and constraints resulted in substantial economic inefficiency in terms of power plant siting, total capacity, the capacity mix distribution, and other central parameters. The regulated structure of electricity rates, inexorably shaped by political pressures, engendered large cross-subsidies among economic sectors, geographic regions, and consumer groups. And the processes of regulatory permitting and public policy formulation that had evolved over time fairly can be described as highly politicized and rife with delay.

At the same time, technological advance and market forces were creating important competitive pressures in both generation and transmission and distribution, with respect to which traditional regulatory and policy processes were poorly suited and inconsistent. These underlying trends—coupled with the severe recession through which California suffered during the early 1990s—imposed substantial costs upon the California economy and created powerful incentives for adverse business location decisions.

The policy response of the California state government was AB 1890 (1996) and a series of related PUC initiatives on contracting and vertical divestiture (de-integration) of generating plants by the electric utilities. In summary, California implemented a partial deregulation that, whatever the political compromises necessary for enactment, yielded highly inefficient pricing at both wholesale and retail levels, an inefficient industrial structure in the electric power sector, an inefficient and costly allocation of risk, a large implicit tax on electricity consumption, disproportionate costs imposed upon the business sector, and other adverse effects.

Those underlying policy weaknesses became clear during 2000 and 2001. In particular, retail electricity rates were frozen while wholesale prices were uncontrolled. Sharp increases in the price of natural gas, reduced supplies from the Pacific Northwest, and weather and other market conditions yielded an unprecedented rise in the price of electricity purchased under short-term contract. The combination of high wholesale prices, controlled retail prices, and the utilities’ obligation to serve resulted in the actual and effective bankruptcies of PG&E and Edison, respectively. Moreover, because of retail price controls and, until the defeat of Proposition 9 in 1998, delays in permit filings for the construction of new generating capacity, as well as other factors, important shortages emerged in 2000.

Government often attempts to deal with the most salient adverse effects of past policies by implementing new policies, themselves destined to yield new adverse impacts prospectively. And so other effects of the prior history summarized above include the recent imposition of a system of wholesale price controls by the Federal Energy Regulatory Commission (FERC), which will have the effect of transferring electricity supplies to California from the rest of the West; and a sharply growing market involvement of the California state government, which generally will introduce important rigidities and, in particular, will politicize the market further, in part because of the pressures to use rate structures to transfer wealth, and in part because of the political incentives of public decisionmakers facing time horizons substantially shorter than those relevant for the economy as a whole.

The vehicle for legislative efforts to avoid a formal bankruptcy filing by Edison is a proposed statutory Memoranda of Understanding (MOU), the specific provisions of which have changed and evolved over time. It is fair to say that the basic goals of the prospective MOU are avoidance of bankruptcy and a return of credit-worthiness for Edison without a further “bailout” in the form of higher electricity rates or taxpayer expenditures. It is fair to say as well that from the perspective of many decisionmakers in Sacramento, recovery of Edison’s past costs in full and repayment of full debts to Edison’s creditors are of far less interest.

Principles for Policy Formulation

The goals of efficiency, reliability, and risk reduction imply several principles in the context of the Edison MOU now under consideration:

Government must honor private contracts and refrain from efforts to impose losses upon particular market participants, as one dimension of a larger imperative to resist incentives to politicize the market. In particular, pursuit of a long-term reduction in the risks perceived to be attendant upon investment in California requires that the utilities and their creditors be made whole.

The imposition of price controls, however tempting politically, must be resisted as perverse for the electric power sector and for the state economy as a whole in the long run.

Direct access, that is, the right of electricity buyers to purchase service from any supplier that they choose, must be preserved as an essential component of a competitive market and as a constraint on the ability of government policy to politicize the market.

The political process should neither bestow nor impose nonmarket (or noncompetitive) rewards or penalties upon business firms; in particular, creation of a hierarchy of creditors outside the context of ex ante legal principles would distort future investment decisions downward by adding a new risk factor related to but distinct from the normal prevailing uncertainties about future prices or the potential for bankruptcy on the part of debtors. This inevitable outcome would increase pressures for governmental involvement in the market through a public power authority and other institutions, increasing the scope for politicized decisions on pricing and other parameters and, thus, reducing the potential for efficiency gains and attendant economic benefits.

Favoritism among creditors that imposes disproportionate penalties upon those perceived (or purported) to have earned high returns are likely to be particularly perverse, since those firms and investors will tend to be the ones facing the highest risks; and this sort of hierarchy would penalize those producing goods valued highly by the market during supply stringencies or strong demand conditions. If full downside risks are borne by producers, but upside potential is truncated, average expected returns over time cannot be competitive.

From a shorter-term perspective, creation of a hierarchy of creditors in the context of insufficient resources to pay all debts would provide powerful incentives for those given lower priority to force the debtor into bankruptcy. This would be both wholly justifiable and inevitable, in that the creditors with lower priority have fiduciary responsibilities to protect the economic interests of their shareholders. This would impose substantial legal costs upon the economic sector of interest, further distort investment behavior, and create inefficient (and costly) expectations with respect to the future rules of the game.

Preservation of policy neutrality among all subgroups of consumers, producers, and other market participants is essential for the long-term achievement of efficient outcomes.

Observations on AB 82xx and SB 78xx

The central features of these draft MOU proposals (as of mid August) are as follows:

Authorization for the PUC to direct the investor-owned utilities to build new generation, with PUC establishment of rates that would recover costs. This inexorably would return California to the historical system of rate regulation based upon accounting cost, putting the state fundamentally at odds with the ongoing national processes of competition and market deregulation, driven in substantial part by technological advance. As was the case leading to the 1996 partial deregulation law (AB 1890), this would yield inefficient investment and politicized resource allocation, and ironically may lead to high prices as well—as was very much the case in the years leading to 1996—if the short-term incentive to avoid supply stringencies results in excess capacity, an outcome far more than merely theoretical given recent supply problems and given the fact that many consumers do not pay the marginal costs imposed by capacity investment for periods of peak demand.

Authorization for the IOUs to obtain financial capital through the Public Power Financing Authority. This is intended to reduce the interest costs of IOU investment; but because this sort of mechanism cannot increase the capital resources of the state as a whole it would have the effect of shifting some of the actual risks perceived by the capital market in terms of the IOUs onto the Public Power Financing Authority, the state government, or the state economy as a whole.

Authorization for a bond issue of almost $3 billion to be serviced with some part of electric rate revenues. Residential customers and small businesses would pay only about 20 percent of these costs, and the proceeds from the bond sales would be used to repay debts only to alternative electric generators and banks. The effort to shield residential and small business customers would eliminate for the electric power sector, as a whole, the prospective competitive economic benefits of direct access; and the favored position given alternative generators and banks would have the adverse effects discussed above because Southern California Edison still would owe more than $1 billion to the power producers and other creditors. In particular, Edison would be forced into bankruptcy. This effect is obvious, yielding the conclusion that a central political goal of the MOU is avoidance of blame for an Edison bankruptcy filing. Moreover, with Edison in formal bankruptcy, the state would remain mired in the business of purchasing power.

Observations on the Common Market Manipulation and Profiteering Arguments

One prominent rationale for the proposed creation of a hierarchy of creditors is that those given lower priority purportedly have enjoyed substantial profitability because of recent market conditions, and, thus, in some sense are less deserving than other creditors. While far beyond the scope of this short paper, suffice it to say that the data on prices paid and received are not wholly consistent with that premise. That has not precluded the use of “market manipulation” and “profiteering” arguments as vehicles with which to drive the public debate; and it is perhaps to be expected that accusations of market manipulation and profiteering would follow sharp price increases as certain as day follows night.

But that does not make such arguments correct analytically. Fully competitive markets yield high prices—perhaps greatly exceeding marginal cost—when demand conditions exhaust production capacity; consider, for example, the market for wheat after a serious drought. In the context of the California electric power market, natural gas prices were high last winter and spring, hydroelectric output in the Pacific Northwest was reduced for various reasons, the weather was unseasonably warm, and prices for emission credits were rising. The manipulation accusation fails to predict which producers will choose to withhold production, thus subsidizing their competitors, and is inconsistent with the sharp increase in power plant license filings observed after the failure of Proposition 9 in 1998.

Moreover, environmental and other regulations may force producers to allocate production capacity over time, an outcome that may resemble—but that is not— “manipulation”. The prominent studies purporting to demonstrate manipulation on the part of power producers have defined and measured marginal cost incorrectly, particularly in terms of cost components that are difficult to quantify, and fail to distinguish between efficient and “manipulated” allocations of capacity over time.

In any event, the issue of reasonable prices and profits will be addressed by FERC and the courts in their normal procedures under law; creation of a hierarchy of creditors, whatever its other effects, creates an additional layer of politicized decision making and uncertainty.

The New Stranded Cost Problem

A new and large “stranded cost” problem has been created by the revenue shortfall caused by retail price ceilings in AB 1890, and perhaps by the excess costs imbedded in the contracts newly signed by the state. Payment of these costs out of future electric service revenues is heavily problematic, because the higher necessary rates would represent an implicit but very real tax on electricity consumption, with adverse short- and long-run allocational effects in terms of business activity and location decisions, and because it is likely to prove highly inefficient to impose retroactive price increases.

Even without such effects, current proposals to repay these stranded costs through rates will distort business location and other decisions among the service territories of the IOUs and the municipal utilities. Direct access would have to be proscribed, and such a system would lead inexorably to a further politicization of a rate structure transferring wealth among geographic regions and, in particular, from the industrial and perhaps commercial sectors to the residential sector. Even after all the stranded costs are paid, the political obstacles to reintroduction of direct access will be formidable. Further analysis of alternative mechanisms with which to retire the new stranded costs is necessary.

Conclusion

The central provisions of the draft Edison MOU now under discussion will create important adverse effects, and clearly are self-defeating in terms of the stated goal of avoidance of bankruptcy for Edison. More broadly, they will move California toward a more politicized electric power sector, with greater rather than lesser governmental involvement, and, thus, are inconsistent with the technological advance and competitive forces shaping that sector in the rest of the United States.

Dr. Benjamin Zycher is a Senior Fellow in Economic Studies at the California-based Pacific Research Institute. He can be reached via email at pripp@pacificresearch.org.