WSP: Market Ripe for Manipulation...

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Public opinion is the pendulum that swings law...dsg

August 4, 2000

Deregulation Leaves Electricity Market Ripe for
Manipulation by Power Firms

By REBECCA SMITH and JOHN J. FIALKA
Staff Reporters of THE WALL STREET JOURNAL

It's a market ripe for manipulation: surging demand for
an indispensable commodity, weak oversight and a
chaotic new set of rules amid a transition from heavy
regulation to open competition. This is the state of
the U.S. electricity business in the summer of 2000.
And sure enough, there's growing evidence that some
power companies are finding lucrative ways to exploit
the system -- at consumers' expense.

The tactics include manipulating wholesale electricity
auctions, taking juice from transmission systems when
suppliers aren't supposed to and denying weaker
competitors access to transmission lines. None of this
is illegal, and much of it might be considered basic
competition. But as an electricity shortage plunges
sweltering California into an energy crisis and fears
of even worse shortages rattle the Northeast, the
practices of power suppliers face more scrutiny than
ever. (See related article.)

Steamy Conditions

A hot summer day last year shows one kind of
manipulation. On July 28, 1999, wholesale electricity
prices in the Middle Atlantic states hit $935 per
megawatt hour. That was seven times what it costs to
generate power at the most expensive plant in the
region. An analysis of trading data from that day shows
that PECO Energy Corp. and PPL Corp., the old
Philadelphia Electric Co. and Pennsylvania Power &
Light, made the most of steamy conditions.

In the region's power market, deregulated in 1997, a
new corporation called PJM Interconnection LLC runs the
transmission system once operated piecemeal by eight
utilities. It also operates a daily electricity auction
that sorts the hourly bids of 540 generating plants.
The cheapest plants are called on first, but when the
weather is hot and demand is acute, higher offers are
taken as well. To attract as many bidders as possible,
the highest bid, each hour, sets the price for the
entire market for that hour.

Grid and Bear It

Rise in average wholesale electricity prices at key
transmission-interconnection points for the month of
May from 1997 to 2000.
TRANSMISSION-INTERCONNECTION POINT
% CHANGE 1997-2000
Texas +293%
Louisiana-Mississippi-Arkansas +216
Tennessee Valley Authority +165
California-Oregon border +162
New York-West +138
Chicago area +130
New England +117
New York-East +101
Upper Midwest +99
Florida +89
Mid-Atlantic region +80*
*Includes only years 1999-2000

Source: Federal Energy Regulatory Commission, RDI Power

What PECO and PPL did was offer much of their output at
low prices so that the majority of their plants would
be called into service. But knowing demand was so high,
they offered power from their tiniest plants at vastly
higher bids, in a way that often set the peak price for
a number of hours. Consumers that day ended up paying
millions of extra dollars for power.

Cases like this show that during the transition to
deregulation, "there's a good argument the system has
broken down," says William Massey, a commissioner at
the Federal Energy Regulatory Agency. FERC, which
polices the nation's bulk power markets, began the
deregulation movement in 1996.

It wasn't supposed to be this way. In the old days,
utilities generated electricity and delivered it to
customers in exclusive territories. To protect
consumers from gouging, rates were regulated. But while
supply had to be able to meet peak demand at all times,
demand varied widely within regions, between regions
and from one season to another. The result was
tremendous reliability but also inefficiency and waste.

Deregulation, now under way in half the country and
functioning nationally at the wholesale level, allows
new players -- some affiliated with utilities, some
not -- to build power plants and sell electricity.
Prices are supposed to be set by competitive markets.
Risks are borne by investors, not ratepayers.

At the same time, utilities are surrendering control of
long-haul transmission lines to new nonprofit
operators, like the one in the Middle Atlantic region,
which are supposed to ensure fair access to the grid --
the multistate system of high voltage lines.

Under this new regime, energy prices should have
dropped as companies raced to compete with one another.
But the massive U.S. energy infrastructure wasn't
designed to serve as the backbone of a free market. On
hot summer days, when there's little or no surplus
electricity in the nation's most populous regions,
generators can charge prices far in excess of their
production costs and be confident they'll get tapped
for service by grid operators who must keep the lights
on at any cost. Utility holding companies that still
control transmission lines have an added advantage:
They can effectively lock out cheaper competitors.
California Cuts Price Cap for Electricity Once Again
(Aug. 2)Price Cap Is Set for Electricity That Is Sold
in New England (July 27)PPL, KeySpan Say Earnings
Surpassed Wall Street Targets (July 27)Energy Trading,
Internet Operations Help Enron's Net Income Jump 30%
(July 25)PG&E Posts 36% Rise in Net to $248 Million
(July 21)
The new regional grid operators, called independent
system operators, or ISOs, eventually will be in charge
of preventing manipulation. But as nongovernmental
organizations, they won't have basic investigative
tools, like subpoena powers or the ability to impose
significant penalties. FERC, which does have those
powers, rarely uses them, preferring to let the market
discipline itself.

A Strange Drop

Sometimes it's difficult to know what constitutes an
abuse of the market. In July 1999, engineers noticed
that a substantial amount of power was being taken from
the grid for which there was no explanation. They
contacted the North American Electric Reliability
Council, the industry group charged by Congress with
overseeing the grid since the late 1960s. After a
lengthy investigation, NERC determined that Cinergy
Corp., a utility holding company, had surreptitiously
taken enough power over a three-day period, about 9,600
megawatt hours, to light a small city for a month.

Cincinnati-based Cinergy had underestimated power
demands. Rather than buy electricity on the open market
at ferociously high prices or cut power to Cincinnati,
it quietly borrowed power from the system when demand
was peaking and later replaced it in the cool of the
night when demand wasn't so high.

James E. Rogers, Cinergy's chief executive, received a
letter from A.R. Garfield, the chairman of NERC's
regional power-coordination center, accusing his
company of showing "blatant disregard" for the rules
and of using the grid "as a supplemental resource
without regard to the reliability or integrity of the
system."

But Cinergy paid no fine. That's because it runs its
own transmission "control area" and is trusted to
enforce NERC's voluntary rules, even when it is the
violator. Smaller utilities in Cinergy's area, by
contrast, face contractual penalties of as much as
$35,000 per megawatt for unilaterally borrowing from
the grid, a practice known as "leaning on the ties."

Dancing on the Edge?

Mr. Garfield is still steamed about Cinergy's actions,
which he said removed part of the system's essential
reserve needed to avoid cascading blackouts, or a chain
of uncontrollable outages that could darken whole
sectors of the country. "How fair is it that someone
can dance on the edge like that and get away with it?"
he asks.

Mr. Rogers points to old rules that permit utilities to
temporarily borrow small amounts of power during
emergencies. "We were very careful to make sure, when
we leaned on the ties ... we didn't bring the whole
system down," he says. Nevertheless, he concedes, "in a
competitive world, those rules need to be changed." The
region's regulators have since gone to FERC for
authority to charge "borrowers" for the market value of
the electricity they take off the grid.

Leaning on the ties is only one way fair competition is
being frustrated on the country's transmission system,
a vast web of connections that resembles the nation's
highway system before the construction of the
interstates. While there are plenty of routes to get
electricity from outlying power plants directly to big
cities, there are relatively few routes connecting
regions. That makes it possible for some big companies
to shut out competitors.

A Snag in Transmission

St. Louis-based Aquila Energy hit that snag when it
tried to use a transmission corridor owned by New
Orleans-based Entergy Corp. to move electricity to a
buyer in East Texas. Entergy granted the request,
initially, but then it canceled, saying it didn't have
sufficient space on its lines.

Aquila didn't buy it. After analyzing
transmission-capacity data, the company argued to FERC
that Entergy did have enough space on its lines and so
was in effect breaking a rule that required it to
provide transmission-line access when possible. Without
access to Entergy's lines, Aquila was forced to
compensate the buyer and lost nearly $300,000 on the
deal. From whom did the Texas customer end up buying
the power? A unit of Entergy -- and for a higher price
than it would have paid Aquila.

FERC said Entergy had been within its rights to
restrict access in this case, because it had
transmission problems. But FERC found that Entergy, on
other occasions, had hoarded transmission capacity that
should have been made available to the market. Entergy
declines to comment.

Such scenarios are costly for consumers, and they are
among the reasons the electricity industry is enjoying
flush times. In the second quarter just ended,
companies ranging from AES Corp. in Arlington, Va., to
Enron Corp. in Houston reported huge profit increases,
some as much as 50%. To be sure, a lot of those profits
are coming from extraordinary demand growth and a
pickup in energy trading. But Sean Murphy, president of
Southern Energy New England, a unit of Southern Cos.,
Atlanta, Ga., worries that the industry has gotten too
greedy and risks retribution. "Pigs get fat, but hogs
get slaughtered," he says.

Tremendous Volatility

New federal data show that average wholesale power
prices have more than doubled at 14 of 17 key pricing
points across the country in the past three years. By
May of this year, prices had risen across a broad
range -- by 89% in Florida, for example, and by 294% in
Texas. But even these increases mask the tremendous
volatility that has struck all the major wholesale
markets during the past year. In the case of the
Midwest, where prices in July 1999 hit $9,000 per
megawatt hour, it was as if a $1.89 gallon of gas
suddenly sold for $567.

Prices like these have prompted growing calls for
investigations into whether electric companies are
gouging their customers. Some consumer groups, lukewarm
to deregulation in the first place, now are agitating
for re-regulation. Residential electricity bills have
doubled in San Diego, which is notable because it's the
first city in the nation to be served by a utility
that's buying all of its energy on the competitive
market.

Politicians are sounding the alarm in the Pacific
Northwest. There, wholesale prices peaked at a record
$1,300 per megawatt hour during the last week in June.
Energy-intensive industries like mines and aluminum
smelters are cutting back on production and temporarily
laying off workers. "We may be seeing too much
opportunism in the market," says Montana Gov. Marc
Racicot. Demands by Mr. Racicot and his counterpart in
Washington, Gary Locke, were instrumental in prompting
FERC to open a national investigation in late July into
possible market abuses.

A Six-Month Lag

One big premise on which deregulation rests is that a
free flow of information will let markets police
themselves and operate efficiently. But a key tool for
market monitoring, the data on utility Web sites used
to book transmission orders, is often unreliable.
There's a six-month lag on the release of bidding data,
which are coded to mask the identities of bidders.

What's more, the four FERC-controlled ISOs operating in
California, the Middle Atlantic states, New England and
New York don't have the authority to compel market
participants to give them internal documents, like
bilateral contracts, and other information they don't
want to hand over. Without such documents, "there's a
lot more looking than finding," says Bill Museler,
chief executive of the New York ISO.

Even if the ISOs do find something problematic, there
isn't much they can do about it. The tariffs, contracts
and bylaws under which they operate generally prohibit
them from releasing company-specific data and so
exposing wrongdoers. And with the exception of
California, the ISOs' own board meetings are closed to
the public. "The reality is, confidentiality rules
protect the guilty," says Frank Wolak, a professor of
economics at Stanford University and chairman of the
California ISO's Market Surveillance Committee. "And
there are no codes of conduct to instill a sense of
fair play."

That can be a huge problem on hot days. In California,
an independent exchange runs a daily forward auction in
which it tries to match the next day's anticipated
demand to bids by generators. But this summer,
generators often have offered less power than they know
will be needed, so that they can submit higher bids
later when the ISO is forced to pay stiffer prices for
emergency power. On occasion, ISO engineers have had
just 40 minutes to frantically phone around and nail
down suppliers, knowing that if they fail they could be
forced to begin rolling blackouts. The bidding
strategy, while legal, "undermines reliability and
forces the ISO to do some real gymnastics," says Kellan
Fluckiger, chief operations officer for the California
ISO.

Generators say they aren't to blame for the mad
scramble. Utilities, buying power for their customers,
often order less power than they really need for fear
that a big order will drive up the overall market price
to prohibitive levels.

The only real recourse available to the ISOs is to
rewrite the rules governing their local markets. But
FERC is reluctant to let them meddle too often because
generators are investing billions of dollars based on
existing market rules. There's another reason, too,
says Ron Rattey, a veteran FERC economist who in June
wrote a 10-page internal memo criticizing the agency
for not doing more to ferret out unfair conduct. "Every
single ISO has identified strategic abuses," he says.
"And every time the ISOs make adjustments to the rules,
the market participants find new ways around them."

Write to Rebecca Smith at rebecca.smith@wsj.com and
John J. Fialka at john.fialka@wsj.com