California was the first test, and right from the start economists at the Federal Energy Regulatory Commission saw trouble coming. Their bosses were worried too. In hindsight, some admit they could have done better.
But five years ago, when California officials were rushing to deregulate electricity, the federal watchdog charged by law with overseeing the process and guarding against runaway prices decided not to bark.
In their zeal for free-market competition and their ideological commitment to shifting authority away from Washington to the states, FERC's commissioners brushed aside their qualms and let the process roll forward.
"There were a lot of issues that got swept under the rug," said economist Carolyn A. Berry, who headed FERC's analysis of the California plan. "We were trying to point out the ugly warts, but it wasn't our job to set policy."
Former FERC Chairman James J. Hoecker, who presided over the approval, said the agency "should have been far less deferential." John Rozsa, a state legislative analyst who played a key role in the deregulation law, laughed when he heard that. "FERC wanted it badly," he said.
Today, FERC stands accused of failing to exercise its oversight, enforcement and political muscle just when they were needed most. The agency, critics on the inside and outside agree, helped launch a radical economics experiment without sufficient preparation, adequate staff or a clear sense of how to carry out its mission.
With fully half the states considering deregulation, the story of what a previously obscure federal agency did not do has become more than a case study in regulatory shortcomings. It has become a warning shot across the bow of the whole country.
FERC has approved deregulation plans in New England, New York and the mid-Atlantic states. At stake is a reliable supply of a commodity that fuels virtually every home and workplace in America. California's example is hardly encouraging: months of blackouts and an electric bill that has rocketed from $7 billion in 1999 to as much as $50 billion this year.
Now the commission is caught in what some see as an identity crisis, divided and uncertain as politicians in California and Washington call for mutually contradictory action.
"I think the commission needs to decide what it wants to do when it grows up," said Hoecker, who headed the agency during a critical period ending in January. His own leadership, he concedes, was not always all it might have been.
Without question, there is ample blame for everyone, not just FERC. Certainly in California, state officials devised a flawed deregulation scheme and then insisted on carrying it out. Some power company executives have extracted windfall profits. Politicians have wilted when things went awry.
And, as FERC officials continually point out, its authority is limited to wholesale markets. State officials are responsible for the local utilities and other retailers selling power to consumers.
Nonetheless, it is FERC that Congress charged with overseeing electricity markets and assuring "just and reasonable" prices.
How did FERC choose the course it took? What factors influenced its decisions?
Certainly energy companies, consumer advocates, lawmakers and others lobbied the agency.
Yet even FERC critics say such influence was not dominant. FERC is not insulated from lobbying, but David Nemtzow, president of the Alliance to Save Energy, a coalition of business, consumer and environmental leaders, said: "They are less sensitive to those forces than a lot of other players."
Rather, this seems to have been a case of government decisions driven by ideology. The commissioners, both Republicans and Democrats, were wedded to the idea that deregulation at the wholesale level would lead to lower retail bills. The market, they believed, would inexorably produce greater competition, greater efficiency and falling prices.
To Mark Cooper of the Consumer Federation of America, the primary problem was "their excessive faith in the market."
Even after price spikes occurred across the Midwest and in California as early as 1998, FERC officials dismissed suggestions the surges might reflect market instability or manipulation.
And as California's situation worsened, FERC's response was shaped by a continuing commitment to market forces with a minimum of government intervention--witness its April order allowing temporary price caps but only in narrowly defined emergencies.
In the last few months, under enormous pressure, FERC has ordered a dozen companies to justify high prices or refund $124.5 million to California utilities for January and February. It won an $8-million settlement from Williams Cos. of Tulsa, Okla., which it had accused of shutting power plants last spring to drive up prices. Williams did not admit guilt.
Detractors, including California officials, howl that FERC's actions are too little too late. They have called for a range of solutions, from flat-out price caps, as in the old days of full regulation, to much higher rebates from generators caught price-gouging, to retractions of individual firms' permission to charge market-based rates.
If the agency chose to wield all of its authority, it also could force witnesses to testify under oath and subpoena tapes of phone calls among power traders, and even force the state to change the way the market operates.
Curtis L. Hebert Jr., the free-market champion who succeeded Hoecker as chairman, insisted "FERC is being vigilant in its efforts to ensure just and reasonable rates, while at the same time ensuring" that it fosters new energy supplies.
"I would vehemently disagree with anyone who says otherwise," he added, noting he transferred 75 attorneys--half of the agency's litigators--into market oversight.
Still, a consensus that it's time for aggressive action seems to be forming among commissioners, including two nominees confirmed by the Senate last month: Patrick H. Wood III and Nora M. Brownell.
Wood, a Texas utility regulator nominated by Bush and probably FERC's next chairman, said the agency needs to evolve into a "market cop with a great big old stick," adding: "There is a role that only the federal government can take. . . . The free market ain't a free and full market yet."
Already named FERC's special liaison for California, Wood remains dedicated to market principles but vows to take a fresh look.
Commissioner Linda Breathitt, a Democrat, also talks of change. And commissioner William L. Massey describes agency officials as naive in their past actions, in contrast to what he calls the "very sophisticated players" on the industry side.
If some commissioners are starting to sound more like watchdogs, that's partly because they feel the tug of two conflicting ideas in their mandate to open markets while assuring fair prices.
Americans have always loved the way capitalism gives opportunities to the shrewd and energetic. At the same time, the country has repeatedly turned to government regulation when it thought particular industries, such as the railroads, waxed too powerful.
How well FERC deals with this intrinsic conflict and meets its challenges may have a sizable effect on the country's energy future.
Frightened by events on the West Coast, some states have slowed their progress toward deregulation. Others have decided not to try at all, at least for now.
"If the commission wants to have competitive markets," Hoecker said, "it's going to have to pull the bacon out of the fire."
Though it traces roots back to the Federal Power Commission and development of hydroelectric power in the 1920s, FERC began its present incarnation in the 1980s, with the Reagan administration's deregulation campaign.
FERC undertook to deregulate natural gas, then, spurred by a Democratic Congress and the first President Bush, it moved on to electricity.
The problem is that electricity and its markets differ significantly from natural gas. Electric power cannot be stored to meet future shortages, as gas can. Its markets are more volatile. And the effect of shortages or price spikes cascades through the economy much faster.
Without anyone quite realizing it, FERC was sailing into uncharted waters.
Moreover, as FERC's staff took up the original California deregulation plan, it faced a significant constraint: The commissioners had made a conscious call to let the state have its way most of the time.
As state officials saw it, so much power was available for the Western electrical grid that prices would surely come down. FERC economists, on the other hand, saw myriad problems.
For example, the state's scheme called for generators to submit blind bids with a separate quote for each hour of the coming day. With any power plant, the unit cost is highest when a generator is started up and declines as it runs. So the price charged for later hours should be lower than for the first--but only if the operator can sell both the beginning and the later hours.
Under the California blueprint, though, bidders could not be sure which hours the purchaser might buy. That meant bidders would have to load the higher start-up costs into each hour throughout the cycle to make sure those costs were recovered. By contrast, the mid-Atlantic market requires the power purchaser to add separate payments to cover start-up costs.
Other issues were deferred rather than solved before FERC granted approval, including such questions as how to manage congestion on the grid and what the transmission rights should be for municipalities that generated and sold power.
State legislative aide Rozsa argues that such matters were not crucial and that the biggest flaw in the plan--the insistence that the system operator not have any generators of its own--was conceived with FERC guidance. Both FERC and the state, he said, had "an exaggerated sense of their knowledge and ability."
As the California launch, originally scheduled for January 1998, drew near, FERC's nervousness increased. As late as the Christmas holidays, the state was still tinkering. The agency ordered the state to provide two weeks' written notice before taking the final step, even though FERC had already approved the plan.
When California finally "went to market," FERC analysts snickered at the timing: The first electricity auction was held March 31 for power to be delivered the next day--April Fool's Day.
As for the commissioners, "We were somewhat naive," Massey said. "The commission believed there was so much inefficiency built into the old-fashioned . . . regime that any new market would be better."
With the nation's largest state deregulating, FERC began blessing plans on the East Coast. Hundreds of companies lined up for permission to charge market rates in various open trade zones.
FERC, according to its rules, was supposed to reject any firm that held a big enough share in a market--generally defined as about 20%--to influence prices for a sustained period. But doing the necessary market analyses proved impractical.
For one thing, the rising workload was overwhelming the staff, which had shrunk by more than 25% from its 1980 high of 1,600 employees. The agency, as critics see it, simply buckled.
"Once it got going, it took over," Berry said of the momentum behind deregulation. "FERC was handing out [permission] to anybody who walked in."
FERC economist Steven A. Stoft was infuriated. He wanted to start cautiously, opening one small market, testing before expanding nationally.
"To put in markets everywhere, to affect a lot of people, to just wait and see how it turns out, that's completely irresponsible," said Stoft, who now lives in California and is writing a book for regulators about how to design markets.
At first, the staff Cassandras seemed wrong. Prices generally headed down.
But during the summer of 1998, prices spiked twice--once in the Midwest, once in California.
In the Midwest, several aging nuclear plants shut down for maintenance just as a heat wave sent air conditioners into overdrive. Wholesale electricity rose past $7,000 per megawatt-hour, 100 times normal. Consumers and politicians screamed.
The weather cooled and new supply came in fast. Prices ebbed.
To consumer groups and several FERC economists, the sudden increase suggested the worst can happen. Hoecker and FERC member Vicky Bailey drew a different lesson, as did a staff investigation: The market worked to correct an unusual confluence of events that was unlikely to recur.
About the same time, a strange thing happened in California's reserve market, where the state's independent system operator pays generators with extra capacity to stand ready to meet unexpected surges in demand.
So few companies offered to sign such contracts that the ISO sometimes had little choice but to accept whatever bid came in. It was just a matter of time before someone took advantage. One day in that summer of 1998 someone did: The only offer to provide reserve power was an astronomical $9,999 per megawatt-hour.
To some, it was proof that the California market could--and would--be manipulated. "I was horrified," Berry said.
FERC quickly granted California's request for permission to cap prices in the reserve. The authority quietly expired in November. There was no outcry about this spike because reserve costs are spread around to the states' utilities, thus diffusing their effect.
"Of course, it should have been a warning that the sellers were several steps ahead of us," commissioner Massey says.
In a memo last June, Ron Rattey, a senior FERC economist who has been with FERC since 1975, complained that the staff was "impotent in our ability to monitor, foster and ensure competitive electric power markets." He added in an interview: "FERC doesn't want todiscover that the policy changes it's making aren't working."
Commissioners at the quasi-judicial agency are forbidden by law from privately discussing pending cases. So companies and Congress must officially content themselves with filing briefs, writing letters and testifying at hearings.
No such restraints apply to the issue of who sits on the commission. There, the jockeying for influence can be intense.
Commissioners are appointed by the president and confirmed by the Senate to staggered five-year terms, with a limit of three members of a political party on the panel. The president can also designate at any time which commissioner serves as chairman, a position that bestows broad authority over the FERC's agenda and staff.
When Bush took office, he picked Hebert, then the lone Republican on the commission, to the chairmanship and named his choices for the two vacancies. It was unclear whether Hebert would keep the chair once Bush's nominees were confirmed.
Soon afterward, Hebert talked by telephone with Kenneth L. Lay, who heads Enron Corp., a Houston-based energy marketing giant that recently saw its profits triple in a year. FERC policy decisions could have a huge influence on its future.
Enron spokesman Mark Palmer says Lay, whose friendship with Bush is well known, was returning a call from Hebert. Palmer says Hebert wanted Lay's support for remaining chairman.
Hebert told a FERC official, who heard the new chairman's end of the conversation, that Lay offered support but only if the chairman changed his views in ways that would aid Enron. The official says he heard Hebert decline and characterizes him as offended. The discussion was first reported in the New York Times.
Lay has never been shy about offering advice, nor about courting political access. He golfed with President Clinton, and Palmer wrote a letter to Clinton's personnel chief touting Hoecker for chairman. The Enron executive's ties with Bush bind especially tight; Lay raised and donated hundreds of thousands of dollars to Bush's campaigns and related efforts.
Power companies also scouted candidates for the two slots. Enron went so far as to send the White House a list of a dozen people Lay considered qualified (the two new commissioners were on it).
In the end, however, the evidence suggests that such lobbying mattered less than the faith in free markets and less federal intervention shared by two presidents and just about every recent FERC member. "FERC is filled with true believers," Rozsa said.
The agency's recent California orders underline the point. In December, FERC concluded the market was dysfunctional and ordered a limited version of the price caps that free marketers abhor.
Still, prices remained above $300 a megawatt-hour--10 times the pre-crisis average. So in April, FERC concluded it had to take further action.
But the new version of price caps, approved 2 to 1, actually narrowed the circumstances under which they could be imposed, though it gave the state more flexibility. Even temporarily, the commission would not abandon its market principles.
"I was reluctant to stop in my tracks," said Breathitt, the swing vote. She didn't want "to go back to a form of regulation that this commission and I had departed from five or six years ago."
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
FERC at a Glance
1920: The Federal Power Commission created to oversee development of hydroelectric power.
1977: Power Commission replaced by the Federal Energy Regulatory Commission to oversee interstate transmission of natural gas, oil and electricity and regulate wholesale electric rates.
1992: Congress gives FERC authority on electricity, opens door to full-scale deregulation.
1996: FERC approves California deregulation plan.
1998: Prices spike briefly; FERC puts temporary price caps on California's emergency reserve.
2000: FERC orders staff investigation of market conditions nationwide, declares California market seriously flawed in November; in December, a form of price caps introduced.
2001: Rolling blackouts hit California. FERC orders $124.5 million in refunds from power companies alleged to have overcharged utilities. Agency says California price caps can apply in narrowly defined circumstances
Source: Federal Energy Regulatory Commission; Times reports (BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
Federal Energy Regulatory Commission
FERC Members Chosen by Bush
Patrick H. Wood III, GOP
Nominated by Bush, March 27; confirmed by Senate May 31.
Term: Expires June 30, 2005
Career: Chairman of the Public Utility Commission of Texas, 1995-2001. Attorney for the law firm Baker & Botts in Washington, 1989-1991. Legal advisor to FERC member Jerry Langdon, 1991 to 1993.
Personal: Native of Port Arthur, Texas.
Education: Texas A&M; University, B.S., 1985. Harvard Law School, J.D., 1989. *
Nora M. Brownell, GOP
Nominated by Bush, March 27; confirmed by Senate May 31.
Term: Expires June 30, 2006
Career: Pennsylvania Public Utility Commission, 1997 to 2001. Senior vice president at Meridian Bancorp, 1992-1996. Current president of the National Assn. of Regulatory Utility Commissioners.
Personal: Native of Erie, Pa.
Education: Attended Syracuse University, 1966-1969.
FERC Members Chosen by Clinton
Curtis L. Hebert Jr., GOP
Nominated by Clinton, 1997. Named chairman by Bush in January.
Term: Expires June 30, 2004
Professional career: Chairman of the Southern District of the Mississippi Public Service Commission, 1994 to 1996. Member of the Mississippi House of Representatives, 1988-1992.
Personal: Native of Pascagoula, Miss.
Education: University of Southern Mississippi, B.S., 1985; Mississippi College School of Law, J.D., 1990.
Linda Breathitt, Democrat
Nominated by Clinton, 1997.
Term: Expires June 30, 2002
Professional career: Chairwoman of the Kentucky Public Service Commission, 1995-1997. Past president of the Southeastern Assn. of Regulatory Utility Commissioners. Executive director of Kentucky's Washington office, 1980-1993.
Personal: Native of Lexington, Ky.
Education: University of Kentucky, B.A., 1975.
William L. Massey, Democrat
Nominated by Clinton, 1993, 1998
Term: Expires June 30, 2003
Career: Practiced law in Washington, 1989 to 1993. Served on the presidential transition team for the Department of Energy, December 1992. Served as chief counsel to Sen. Dale Bumpers (D-Ark.), 1981 to 1989.
Personal: Native of Little Rock, Ark.
*Compiled by SUNNY KAPLAN/Los Angeles Times
Differences in the approaches of the three most senior members of the Federal Energy Regulatory Commission were apparent during recent interviews with The Times. Following are excerpts:
How do you define FERC's role as a regulator of wholesale electricity?
HEBERT: "What the commission has attempted to do here since I've been chairman is to provide a balance--making certain that we have just and reasonable rates and, at the same time, making certain that we have given proper opportunity to build out infrastructure and to add much-needed supply so as to correct the flawed market that California has put in place."
BREATHITT: "It is being an effective referee. It's being a cop on the beat. It's being a nurturer of competition. It's being an arbiter of disputes. And it's overseeing a level playing field. And, also, its role--more than we've seen in the past--is going to be a place to listen to the energy consumer."
Is FERC effectively monitoring wholesale electric markets and enforcing "just and reasonable" rates?
HEBERT: "I think FERC is using any and all tools available to it to adequately monitor the markets, continue to look 24 hours, seven days a week for market manipulation, and ensure just and reasonable rates. I would vehemently disagree with anyone who says otherwise."
MASSEY: "We need more people dealing with the monitoring function. The monitoring function requires skills that are precise. I think we need more people involved in hard-nosed investigation work . . . everyone here realizes we still have to do better in that regard."
BREATHITT: "This is new to us. We've been monitoring markets in an old way. We have to get better at monitoring markets within the current framework."
Should FERC revise the test it uses to determine whether a power generator has "market power"?
HEBERT: "Obviously, if I thought we needed to change it, we would have."
MASSEY: "We have this old horse-and-buggy methodology for determining whether generators have market power. Everybody passes, nobody ever fails. If we've learned nothing else, it's that the screen is not sensitive enough to pick up the exercise of market power in California. . . . I don't know how you can say you see no reason for change."
Have wholesale power generators exercised market power to manipulate rates in California?
HEBERT: "I know there are several people in the state of California that continually make remarks, some of them that are completely unnecessary [about manipulation of markets]. If they have information and real evidence, this commission wants to know about it . . . But this anecdotal evidence that they bring forward and is not real is not helpful."
MASSEY: "In a capacity-short market where they need all the generation, even a small company can exercise market power. I'm not talking about some kind of conspiracy. I'm talking about the kind of conduct you would expect from a tough, hard-nosed, profit-maximizing company that owns generation."
Did FERC's April 26 order imposing price caps in California during emergency hours go far enough?
HEBERT: "I embrace the order; I think it will make a real difference. And I wish there was some way to take California through the experience without the price mitigation and show the proof that the price mitigation is going to bear in trying to level out prices while at the same time giving signals to build out infrastructure and needed supply."
MASSEY: "I don't think we've moved quickly enough. Generally, our solutions have been too little too late. We've been hoping the market will settle down, and it just hasn't . . . we should have imposed a timeout . . . on that market to cool it off."
BREATHITT: "I wanted it to mitigate against high prices. I wanted it to have a market orientation. And I wanted it to be effective in controlling what I thought would be high prices this summer. . . . We did control prices on April 26."
Has FERC resolved the question of "just and reasonable" rates in California?
HEBERT: "When it comes to just and reasonable rates, you cannot just pick a price at which no one should pay over, or be allowed to pay over, because you have to give the proper opportunity for infrastructure and supply. . . . We are addressing it and we will fully address all the legal arguments on it in these rehearings pending on recent California orders."
BREATHITT: "This order, I think, will produce just and reasonable rates given the shortage of supply in California."
MASSEY: "We haven't really defined it. I would define it as cost-of-service regulation or price disciplined by a well-functioning market. We don't have either of those."
Jury still out: No smoking gun yet in natural gas rate hearing. A23