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California Power Crisis Aftershock: The Potential Modification Of Western Power Contracts

Aug 17, 2007
A recent set of decisions from the United States Court of Appeals for the Ninth Circuit raises the prospect that market-based rate transactions, including billions of dollars worth of wholesale power contracts, entered into during the US West power crisis may be modified now, more than six years down the road.

This may set a precedent for regulatory intervention and modification of wholesale power transactions by the Federal Energy Regulatory Commission (FERC) with much broader implications for the US power sector.

The Ninth Circuit decisions include vague, subjective standards for FERC market-based rate intervention, including rate revision in long-term power contracts, should market conditions suddenly change. But sudden market changes are actually normal in an industry characterized by large capital requirements, volatile price patterns, and multiyear business cycles.

Because of the inherently risky pricing dynamics of the power industry, contracting is an important mechanism used to mitigate risks for both buyers and sellers, and to encourage capital investments. It is ironic that the efficacy of the power industry's primary risk management tool-long-term power contracts-would come into question at the precise time when there is a significant need for new investment in additional power plants, environmental control technology, energy efficiency, and demand-side management.

A lack of reliable contracting will inhibit investment, at a minimum, and could set the stage for future power crises. Implications include:

*Higher prices. Less reliable wholesale power contracts will add billions of dollars per year to the costs of the power business and force increases to future power prices. Any significant reduction in the regulatory certainty of wholesale power transactions will make power investments more risky and thus more costly.

Wholesale power contracts are fundamental to risk management in the $240 billion per year wholesale power business because underlying industry characteristics create risky price dynamics-typically including sudden price changes, high price volatility, unpredictability, and multiyear cycles-attributes that both buyers and sellers routinely mitigate through contracts.

*Underinvestment. Reliable wholesale power contracts are necessary for capital formation. A reduction of reliability in wholesale power contracts, especially long-term contracts, may limit the flow of capital into a sector that needs capital expenditures in the next 15 years of about $900 billion-an amount greater than the net plant value of all the capital currently at work in the power sector. Today, the power business is increasingly turning to long-term power contracts to support investment.

*Re-regulation. Using simplistic static criteria to judge and adjust complex and dynamic power markets is likely to cause underinvestment and poor power system performance in the future-conditions not likely to be tolerated for long. A political backlash will likely move the power industry back to cost-of-service regulation and reverse the gains from market-based regulation.
About the Author
Daniel Yergin, chairman of CERA, received the Pulitzer Prize for "The Prize: The Epic Quest for Oil, Money & Power" and the United States Energy Award for lifelong achievements in energy and the promotion of international understanding. Vist CERA .
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