Economic Justifications And Implications Of Taxing Windfall Profits In The California Wholesale Electricity Market

ECONOMIC JUSTIFICATIONS AND IMPLICATIONS OF TAXING WINDFALL PROFITS IN THE CALIFORNIA WHOLESALE ELECTRICITY MARKET

TESTIMONY OF DR. MARK N. COOPER
DIRECTOR OF RESEARCH
CONSUMER FEDERATION OF AMERICA

SUBCOMMITTEE ON SELECT REVENUE MEASURES
OF THE
WAYS AND MEANS COMMITTEE
UNITED STATES HOUSE OF REPRESENTATIVES

Mr. Chairman and Members of the Committee,

I appreciate the opportunity to appear before you today to analyze energy tax issues. When I received the invitation to testify, I looked through my files and found that the first time I testified before Congress on energy tax options was at a series of hearings in June of 1982. In the 19 years since I gave that testimony, no series of events has called out for a careful consideration of a windfall profits tax than the complete breakdown of the wholesale electricity market and natural gas markets in California and throughout the Western United States.

Let me put the magnitude of the economic problem created by the unprecedented increase in electricity prices in perspective for you. In nominal dollars, the increase in the amount paid for electricity at wholesale in California between the end of October 2000 and April 2001(1) was larger than the increase in the total national oil import bill in the entire year after the fall of the Shah of Iran, which is widely recognized as the largest energy price shock in the history of the nation.(2) Expressed as a percentage of gross domestic product, the price increase suffered by California in electricity costs is about twice as large as the increase suffered by the nation in 1980 in its oil import bill.(3) The impacts on electricity prices throughout the West would make these numbers even larger.

The problem is certainly large. But, is it a federal problem that merits the imposition of a windfall profits tax? I offer the following observations to suggest that it is.

1. Fundamental demand and supply conditions in the California electricity market make it vulnerable to the abuse of market power by energy producers.

2. The remarkable run up in prices is attributable in significant part to the premature and unjustified deregulation by the Federal Energy Regulatory Commission (FERC) of the wholesale electricity and natural gas markets in California and FERC's subsequent failure to discipline pricing abuse in those and other markets.

3. Prices have been driven up by the strategic behavior of merchant generators who have subsequently profited from those increases.

4. The profits are excessive by any reasonable measure.

5. Taxing away windfalls such as this will not detract from the incentive to build generating capacity to meet demand at a reasonable profit. To the contrary, removing the fun and profit from market manipulation will cause the supply-side of the market to function more efficiently.

In making these points, I do not mean to suggest that California policymakers and California utilities bear no responsibility for a dysfunctional market. They certainly do,(4) but federal policymakers made a substantial contribution to the problem and they have yet to make up for their mistakes. The need for Congress to consider this type of policy stems, in part, from the fact that the FERC has demonstrated its inability to ensure that energy markets function properly. If the FERC cannot be counted on to enforce laws that require just and reasonable rates, then other federal actions must be taken to provide a back stop to an agency that has been derelict in its duty. A windfall profits tax would be one such policy.

1. FUNDAMENTAL DEMAND AND SUPPLY CONDITIONS MAKE ELECTRICITY A VULNERABLE MARKET (5)

In the list of culprits identified above (FERC, merchant generators, California regulators and California utilities), I do not include California consumers. They are the victims in this drama, not the villains.

California is among the most electricity efficient states in the nation.(6) It consumes less than 50 percent as much electricity as the rest of the country per dollar of state output. On a heating and cooling degree day basis, it consumes considerably less electricity than the rest of the nation.(7) California consumers now pay the highest prices in the country for electricity.(8) If the rest of the country were as electricity efficient as California, we would only need the equivalent of 500 new power plants, instead of the 1300 that Vice President Cheney has discussed.(9)

Those who suggest that California consumers do not pay enough for electricity have not looked at the facts of the situation. Electricity is a necessity that has no substitute on the demand side in the short-term.(10) At the start of the twenty-first century, electricity is like oxygen - a basic necessity to daily life.

Necessities like electricity have a low elasticity of demand. By this term, economists mean that as prices increase (or decrease) demand does not decrease (or increase) very much. The elasticity of demand is measured in terms of percentage changes. For example, if a ten percent increase in price results in a 20 percent decrease in demand, the elasticity of demand is said to equal 2 (20%/10%). When the elasticity is greater than 1, demand is said to be elastic. Alternatively, if a 10 percent increase in price results in a 2 percent decrease in demand, the elasticity of demand is said to be .2, and this is considered inelastic. The empirical evidence demonstrates that this is the situation in electricity markets. The best evidence from California is that the short run elasticity of demand is considerably less than 1.(11) In fact, the short term elasticity of demand is less than .1. Even in the long term, it is considerably less than 1.

The empirical evidence in California is that supply is also very inelastic in the short term. The supply curve is very steep, (see Exhibit 1). The best evidence from California is that the short run supply elasticity is considerably less than 1. In fact the supply elasticity is probably less than .2 on the basis of 1999 prices.(12) This is probably a higher price elasticity than observed in 2000-2001, which suggests a supply elasticity considerably less than .1 for the peak of 2000 (demand of 35000 MW to 45000 MW) and in the range of .1 to .15 for shoulder periods (demand between 25000 MW and 35000 MW).(13)

When demand and supply elasticities are this low, the potential for the abuse of market power is substantial.(14) Market power is the ability of suppliers to raise prices and earn excess profits. In simple terms, when we talk about market forces, we mean the ability of consumers to cut back or shift their demand and the ability of producers to increase their output in response to price increases -- we mean supply and demand elasticities. If these elasticities are too small, market forces are weak and the exercise of market power will take place. Under these circumstances, firms with relatively small market shares can increase profits by withholding supplies. The evidence in California clearly suggests that they have beenq the victims of a monumental market failure. (15)

2. FEDERAL REGULATORY RESPONSIBILITY FOR THE PROBLEM

The Federal Energy Regulatory Commission bears a substantial part of the blame for the problem in California because it deregulated prices in a market which was vulnerable to abuse and failed to police that abuse once it began. FERC prematurely deregulated price over the objection of many in California.(16) In fact, FERC fought California authorities to assert control over the Independent System Operator (ISO) and then deregulated the price of energy in the California wholesale market, even though its market analysis was fundamentally flawed.(17) This enabled private interests to take advantage of the bad situation that they had helped to create.

FERC failed to reasonably analyze the market before it deregulated. It treated the state as one big market, when it is evident that there are distinct and separate north-south markets because of a capacity constraint.(18) It failed to identify load pockets that would be constrained at peak times.(19) It deregulated ancillary services, even though it was told market power existed in these markets and accepted on faith that "must run" plants would mitigate market power, without any concrete plan to do so. (20)

FERC refuses to responsibly police the markets it has irresponsibly deregulated.(21) It has defended the secrecy of spot market bidding, which appears to have the effect of allowing tight oligopolies of bidders to play their games behind closed doors.(22) It refused to requisition and study bidding records for abusive patterns after the first price spikes in 1998, (23) and the second price spikes in 1999,(24) which emboldened strategic bidders for the really big killing of 2000. It failed to analyze the data once it was collected and has taken over a year to begin to address the problems in the natural gas market.(25) After finding rates were unjust and unreasonable, it failed to adopt mitigation measures that could discipline the market. (26)

FERC approves rates without subjecting them to refund, so that market manipulators know they will never have to disgorge their ill-gotten(27) gains. It even rushed in to allow a hasty reorganization of one of the California utilities to shield its assets from its creditors.(28) As the only dissenting Commissioner put it, if the FERC had exercised more responsibility earlier, "capping spot market prices at variable operating costs plus a capacity adder… there is reason to believe that applicants would not be in such dire straits now."(29)

3. EXPLOITATION IN A DYSFUNCTIONAL MARKET

Premature deregulation led to profit maximization that tightened electricity markets by reducing supplies, limiting reserves, eliminating back up requirements, undercutting conservation programs, and preventing facilities from being built.(30) The small number of suppliers and the tendency for electricity product and geographic markets to be highly restricted in time and space make the exercise of market power and the implementation of gaming strategies that drive prices up easy to execute. Price spikes produce such huge windfalls that suppliers exhibit an OPEC-like (backward bending) supply curve, in which supplies are reduced, not increased, as prices rise.

On any given day during the recent price spikes fossil fuel plants owned or controlled by merchants were producing between 2000 and 6000 megawatts less than their historic average.(31) The same independent generators also opposed long-term contracts, which would have kept utilities out of the volatile spot market.(32) The disappearance of these assets is part of a pattern of resource denial that has the effect of driving up the price of electricity.(33) Whether it is purely strategic, or illegally manipulative, or even collusive, remains to be seen,(34) but there is no doubt that the pursuit of private interests has denied the electricity market in California substantial resources.(35) This profit driven denial of resources equal to between 10 and 20 percent of peak demand had a substantial impact on price and performance.(36)

The CAL-ISO, the sole entity to produce a detailed analysis of bidding behavior,(37) estimated that approximately half of the price increase through November 2000 is attributable to price gouging (offering prices far above costs) or capacity hoarding (physical withholding of supply). This detailed study of actual bidding behavior by every major player in the California market, charged that there had been either price gouging or physical withholding in virtually every hour between May and November (a total of 25,000 bid/hours). Daisy chains of transactions have been developed to avoid regulatory scrutiny. In the colorful language of a new game of consumer abuse we have hockey stick bidding and megawatt laundering, but they all mean the same thing, consumers are being ripped off. (38)

The inevitable result of greed, irresponsibility and mismanagement in a volatile market(39) for a vulnerable commodity is a massive, inefficient and unjustified transfer of wealth from consumers to producers.(40) Worse still this analysis does not even deal with the period after November 2000, when the excessive pricing become vastly more abusive.

The CAL-ISO has asked for refunds of over $6 billion,(41) but the CAL-ISO analysis does not include the results of any investigation into natural gas prices in the California market and is based on a methodology distorted by a series of erroneous assumptions dictated by the FERC. A detailed and direct comparison of actual costs incurred and prices charged on a plant-by-plant basis, which is the methodology used to order the wholesale electricity market for six decades prior to the deregulation experiments of the 1990s, would inevitably reveal that the abuses are much larger than $6 billion.

4. EXCESS PROFITS

For the purposes of empirically demonstrating excess profits (and the flaw in FERC's recent failed attempts to impose discipline on a dysfunctional market), we analyze evidence in the record for January 2001 (See Exhibit 2).(42) Assuming a least efficient generator using the most expensive inputs for January 2001, FERC's methodology establishes a ceiling price (or market clearing price) of $273/MWh. Since all generators are allowed to charge up to that level without scrutiny, it appears they fully exploited the artificially high benchmark in determining what to charge in California's dysfunctional market. The average wholesale price in January 2001 was $307. (43)

However, 99 percent of the generators did not incur costs at that level, since they are much more efficient than that. Consequently, and inevitably the prices they receive are far above their costs. At the average level of efficiency known to exist in California, the actual costs incurred, even assuming the high cost inputs, would have been half the ceiling level.(44) In other words, not only are virtually all generators more efficient than FERC's benchmark, but also the average generator is twice as efficient. While the FERC methodology would allow them to charge $273/MWh without any scrutiny, the actual costs would be about $150/MWh. The difference, equal to about $120/MWh, constitutes a huge windfall and unreasonable level of profit.

The CAL-ISO has estimated that a new generation unit being brought on line with heavy capital costs would be paid off in less than two years. The implicit return on equity would be approximately 85%.(45) Similarly, the County of San Diego calculated a cost of $120/MWh for a new generation plant. At the FERC authorized ceiling prices, which are not subject to scrutiny, the plant would be paid off in one year.(46) Such rates of return are historically unprecedented and patently unreasonable.

The above analyses still assume that all producers pay the high, spot price for natural gas and air emission credits. In fact, there are many longer-term contracts for gas at much lower prices and the typical generator in California does not require emissions credits. This creates an even larger gap between actual costs and the FERC's ceiling price benchmark (as shown in Exhibit 2). Using an average cost of gas (assume $6.25 per MCF [thousand cubic feet]) and assuming the average generator does not pay emissions credits would increase the estimate of overcharges and windfalls by about one third. (47)

The patently unreasonable rates are not simply a one-month aberration. The CAL-ISO analysis shows that by February 2001, even assuming the spot market price of gas and NOx credits, the costs of a new plant brought on line when the restructured market commenced in May 1998 in California would have been fully recovered in just three years.(48) The implicit return on equity would be in the range of 30 to 60 percent

More to the point, perhaps, the total estimated revenues above costs, even using spot prices for gas and NOx costs, for Non-Utility Distribution Company generators subject to FERC jurisdiction since the start of restructuring in May 1998, is approximately $3.1 billion.(49) This is approximately equal to the total capital paid by merchant generators to acquire the fossil plants of the utilities.(50) In other words, by abusing their market power, these entities have, at a minimum, recovered all of their capital in approximately three years. If actual input costs were used, the full cost recovery would have occurred even earlier. The return on equity based on actual costs would fall in the range of 40 to 80 percent.
These direct estimates of price cost margins are confirmed by the bottom line profit figures of the power generators who are selling into California. Comparing the first quarter of 2001 to the first quarter of 2000, just prior to the meltdown of the California market began; we observe a tripling of operating profits for the largest fossil fuel generators and marketers, as the first quarter financial results, focusing on wholesale or trading business segments and operating results, shows.

PROFITS IN MILLIONS OF DOLLARS
	1Q2001	1Q2000
Enron: Wholesale Services (IBIT)	$755	$429
Duke: Energy Services (EBIT)	428	139
MIR: With California contingency (NI)	420	95
REI:Wholesale, (operating income)	216	(22)
Dynegy: Marketing & Trade (NI)	100	50
Williams : Marketing and Trading (NI)	485	78
TOTAL	2404	769
Sources: Quarterly reports and Wall Street briefings.

Although the companies do not break their profits down by state, there is no doubt that California and the western United States are primarily where the profits accrued.

5. TAXING AWAY WINDFALL PROFITS AND MONOPOLY RENTS DOES NOT HARM ECONOMIC EFFICIENCY

California has paid a heavy price in economic rents(51) - scarcity rents(52) and monopoly rents.(53) An economic rent is "a payment to a factor in excess of what is necessary to keep it at its present occupation."(54) More importantly, "in perfect competition, no rents are made by any factor, because changes in supply bid prices of inputs and labor down to the level just necessary to keep them employed."(55)

It is well established in the economic literature that scarcity rents can be taxed away without harming economic efficiency (see Exhibit 3). Since supply of a fixed asset does not respond to price changes, there is little or no dead weight loss. As Taylor, puts it,

Monopoly rents should be eliminated to promote economic efficiency.(57) In fact, producers do not even have an interest in delivering existing capacity. Indeed, when windfalls become as massive as they have been in California, they distort economic incentives. Producers make more by withholding supplies than by increasing output. Having learned how to manipulate the market, the primary interest of producers is to keep it tight.(58) Exorbitant prices do not elicit efficient supply responses, they reward and create an incentive for more effective gaming. There is a formal theory of this in economics. It is called a backward bending supply curve. It has been extensively applied to labor markets(59) and, not surprisingly, to the OPEC cartel. (60)

To state the concept in layman's terms, you make so much money by running the price up that you are much better off by cutting back production than by increasing output, which would lower the price. You can only get away with this when demand is inelastic (since that creates huge economic rents) and the supply beyond your control cannot be easily expanded in the short-term (since competition would dissipate the rents). (61)

Claims that the market needs electricity priced in the hundreds of dollars per MWh to elicit efficient supply-sided responses are absurd on their face.(62) Neither empirical reality nor economic theory supports this claim. Hundreds of power plants were financed and placed under construction across the country and including California long before anyone dreamed that prices would rise so high. Payback periods of a couple of years for facilities with useful lives that are decades long are unprecedented and unnecessary in a workably competitive market to create adequate supply.

Given the situation in the California electricity market, a windfall profits tax would play the useful role of taking the fun and profit out of market manipulation.

(1) The price of electricity paid in the wholesale market, which falls entirely and solely under the authority of the FERC, increased from just under $40/MWh (megawatt hours) for the month of November 1999 to about $160/MWh for the month of November 2000 November (Cal-ISO filing in Docket NO. EL00-95-012, Attachment A: Analysis of Market Power in California's Wholesale Energy Markets; California ISO, Report on Real Time Supply Costs Above Single Price Auction Threshold: December 8, 2000 - January 31, 2001 (February 28, 2001).. However, since November 2000 the price increased to over $360/MWh in February 2001 (Sheffrin, Anjali, Market Analysis Report (Memorandum to ISO Board of Directors, March 23, 2001). It is reported to have averaged $450/MWh in April.

(2) U.S. Department of Energy, Energy Information Administration, Monthly Energy Review, December 2001, shows an increase in the national oil import bill of $23 billion between 1979 and 1980.

(3) U.S. Bureau of the Census, Statistical Abstract of the United States: 2000, Tables 715 and 719 give the gross national and state product. For the U.S in late 1979-80., the impact of the second oil price shock is calculated as a $23 billion increase in a $2.8 trillion economy. For California in late 2000-01, I assume that prices return to historic levels and calculate the impact as a $25 billion increase in a $1.3 trillion economy.

(4) Reconsidering Electricity Restructuring (Consumer Federation and Consumers Union, November 2000) (hereafter,
Cooper, Reconsidering). Behind the Headlines of electricity Restructuring (Consumer Federation, March 2000), Back To Basics In Analyzing The Failure Of Electricity Restructuring Accepting The Limits Of Markets." Energy Markets in Turmoil, Institute for Regulatory Policy Studies Illinois State University, May 17, 2001

(5) Cooper, Mark, Industrial Organization and Market Performance in the Transportation and Communications Industries: A Review of Current Theories and Empirical Applications to the Railroad, Electric Utility, Airline, Telecommunications and Oil Pipeline Industries with Hypotheses about Natural Gas Pipelines (January 1986) (hereafter, Cooper, Organization), identified basic economic conditions in the electricity industry that raise doubts about the prospects for deregulation as the debate was beginning (see also Cooper, Mark, "Theory vs. Reality," Consumer Federation of America Utilities Conference, April 6, 1987). Cooper, Mark, "Protecting the Public Interest in the Transition to Competition in New York Industries," The Electric Utility Industry in Transition (Public Utilities Reports, Inc. & the New York State Energy Research and Development Authority, 1994), stated the concerns as the policy of restructuring was being formulated. Cooper, Mark, Residential Consumer Economics of Electric Utility Restructuring (Consumer Federation of America and Consumers Union, July 1998) (hereafter, Cooper, Economics), identified specific flaws in the restructuring policies that had been adopted. Electricity Restructuring and the Price Spikes of 1998 (Consumer Federation of America and Consumers Union, June 1999) (hereafter, Cooper, Spike).

(6) Cambridge Energy Research Associates (CERA), Beyond California's Power Crisis: Impact, Solutions, and Lesson (2001), at 36, demonstrates superior efficiency of California.

(7) U.S. Department of Energy, Energy Information Administration, A Look at Residential Energy Consumption in 1997, Table CE3-7e, shows Califronia has 12 percent fewer cooling degree days than the national average.Tabble CE1-7c, shows California consumes 40 percent less electricity per household than the national average. Table CE1-7c, shows that the energy consumption per household where the end use is electric air conditions is 37 percent less in California.Table CE2-7c shows that where electricity is used for space heating, California space heating intensity is 22 percent below the national average.

(8) U.S. Department of Energy Energy Information Administration, Estimated U.S. Electric Utility Average Pr Kilowatt Hour to Ultimate Consumers: December 2000, shows that California residential consumers paid the sixth highest rates in the contiguous 48 states in December 2000 and the recently implemented price increases will drive those rates to the highest level in the country.

(9) National Energy Policy (Report of the National Energy Policy Development Group, May 2001),at 1-6. This comparison assumes a 30 percent difference in efficiency between California and the rest of the nation, applied to the total base of generation capacity of just under 800,000 megawatts (U.S. Department of Energy, Energy Information Administration, Electric Power Annual: 1999, Volume II (October 2000), Table 1)and converted to power plants at an average size of 300 MW per plant.

(10) Webster's Third New International Dictionary, Unabridged (Springfield, MA, 1986) defines a substitute as "something that is put in the place of something else or is available for use instead of something else." This is in contrast to the definition of deprivation, "to take away, to take something away from." Turning out the lights or turning off the air conditioning is not a substitute.

(11) Bushnell, James and Erin Mansur, The Impact of Retail Rate Deregulation on Electricity Consumption in San Diego (University of California Energy Institute, Program on Workable Energy, April 2001). In San Diego, where prices did vary at the meter last summer, it was less than .03. Long run elasticities may be somewhat higher, but they are generally considered to be considerably less than 1. Reviews of dozens of studies can be found in Bohi, Douglas, Analyzing Demand Behavior: A Study of Energy Elasticities (Baltimore: Resources for the Future/Johns Hopkins, 1981) and Pyndyck, Robert, S., The Structure of World Energy Demand (Cambridge: MIT Press, 1979). Joskow, Paul and Richard Schmalensee, Markets For Power: An Analysis of Electric Utility Deregulation (Cambridge: MIT press, 1984), concluded that many geographic markets would exhibit market power problems, in large part because the empirical evidence dictated the use of low elasticities of demand. A decade and a half later, Rose, Kenneth, Electric Restructuring Issue for Residential and Small Business Customers (Columbus, Ohio: National Regulatory Research Institute, June 2000), reviewed more recent literatures and found short run elasticities in the range of .2 (citing Branch, E. Ralph, "Short Run Income Elasticity of Residential Electricity Using Consumer Expenditure Survey Data," Energy Journal, 14:4, 1993 and long run elasticities of about 1.0 (citing Hyman, Leonard, S. America Electric Utilities: Past, Present and Future (Arlington, VA; Public Utilities Reports, 1988). In analyzing the California market, Borenstein, Severin and James Bushnell, "An Empirical Analysis of the Potential for Market Power in California's Electricity Industry," Journal of Industrial Economics, 47:3, September 1999, state that "We have run simulations for elasticities 0.1, 0.4, and 1.0, a range covering most current estimates of short-run and long-run price elasticity."

(12) Puller, Steven L., "Pricing and Firm Conduct in California's Deregulated Electricity Market" (November 2000).

(13) Marcus, William B., and Greg Russzon, Cost Curve Analysis of the California Power Markets, (JBS Energy, Inc., September 29, 2000).

(14) In a seminal analysis of market power, Landes and Posner (Landes, W. M. and R. A. Posner, "Market Power in Anti-trust Cases," Harvard Law Review, 19: 1981, at 942), two prominent conservative economics point out that when demand elasticities are low, market power becomes a substantial problem . As they put it, the Lerner index, the formula for assessing the extent of market power, "comes apart."

The formula "comes apart" because real world markets with elasticities this low cannot work well. Firms raise prices to increase their profits because they do not lose enough sales to competitors, or because consumers lack alternatives. Given what we know about California demand and supply elasticities, the potential for abuse of market power in the short term is substantial. Even in the long run, as currently configured, the demand and supply elasticity is not sufficient to keep the market from "coming apart."

(15) "Official" analyses of the long history of problems in California before 2000 can be found in Bohn, Roger E., Alvin K. Klevorick and Charles G. Stalon, Market Monitoring Committee of the California Power Exchange, Report on Market Issues in the California Power Exchange Energy Markets (August 17, 1998) and Second Report on Market Issues in the California Power Exchange Energy Markets (March 9, 1999). Early "official" analyses of the summer 2000 problem can be found in Borenstein, Everin, James Bushnell and Frank A. Wolak, Diagnosing Market Power in California's Restructured Electricity Market (August 2000), Klein, Michael and Loretta Lynch, California's Electricity Options and Challenges (August, 2000) and Wolak, Frank A., et al., "An Analysis of the June 2000 Price Spike in California ISO's Energy and Ancillary Service Market," Market Surveillance Committee of the California Independent System Operator (September 6, 2000); and ISO filing Analysis of Market Power. Analyses of problems in other markets can be found in Cooper, Mark, Reconsidering Electricity Restructuring (Consumer Federation and Consumers Union, November 2000); Behind the Headlines of Electricity Restructuring: A Story of Greed, Irresponsibility and Mismanagement of a Vital Service in a Vulnerable Market (Consumer Federation of America, March 20, 2001) for discussions of analyses of market power problems in other markets. A recent additional analysis of withholding in another market can be found in Allen, Daniel, Bruce Biewald and David Schlissel, Generator Outage Increases: A Preliminary Analysis of Outage Trends in the New England Electricity Market (Union of Concerned Scientists, January 7, 2001). A recent additional analysis of the exercise of market power in the PJM pool can be found in Mansur, Erin, T., Pricing Behavior in the Initial Summer of the Restructured PJM Wholesale Electricity Market (University of California Energy Institute, Program on Workable Energy Regulation, April 2001.

(16) CAL-ISO reminds the FERC that it raised significant question about the granting of market-based rate authority and asked for prospective mitigation measures long before the market breakdown became apparent (see "Motion to Intervene and Protest of the California Independent System Operator," Williams Energy Marketing & Trading Company, Docket No. ER99-1722-004, April 2, 2001, at 7-8.

(17) Dowden, Lisa G, Robert C. McDiarmid and Will S. Huang, Market Power: Will We Know it When We See It?: The California Experience, American Public Power Association (December 2000).

(18) Borenstein, Severin, James Bushnell and Steven Stoft, "The Competitive Effects of Transmission Capacity in a Deregulated Electricity Market," Rand Journal of Economics, 31:2, 2000, p. 318, state, matter of factly, "Congestion on the north-south transmission lines often divides the state into at least two distinct geographic markets." See also Dowden, Lisa G, Robert C. McDiarmid and Will S. Huang, Market Power: Will We Know it When We See It?: The California Experience, American Public Power Association (December 2000); Marcus, Crisis.
(19) Bushnell, James and Frank A. Wolak, "Regulation and the Leverage of Local Market Power in California's Electricity Market" (July 1999).

(20) Dowden, McDiarmid, and Huang; Marcus, Crisis.

(21) Dowden, McDiarmid, and Huang, recounts the evidence presented to FERC on market power and FERC's seeming inaction; Cooper, Spikes, discusses the failure of FERC to react vigorously to complaints of market power in response to the 1998 price spikes.

(22) Dowden, McDiarmid and Huang.
(23) Cooper, Spikes.

(24) A frustrated FERC staff member wrote a blistering critique of FERC's unwillingness to investigate transaction data in 1998 and 1999, just prior to the onset of the big problems in the California market in 2000. See
Open Memorandum, From: Ron Rattey, OMTR, To:FERC Staff (June 2, 2000).

(25)

(26)

(27) Dowden, McDiarmid, and Huang.

(28) Order Authorizing Disposition of Jurisdictional Facilities, PGE National Energy Group, Inc., PG&E Enterprises and PG&E Shareholdings, Inc, Federal Energy Regulatory Commission (January 12, 2001).

(29) Commissioner Massey, dissenting, Order Authorizing Disposition of Jurisdictional Facilities, PGE National Energy Group, Inc., PG&E Enterprises and PG&E Shareholdings, Inc, Federal Energy Regulatory Commission (January 12, 2001).

(30) Cooper, Behind the Headlines. An interesting perspective on perceptions about the crisis that tracks many of the arguments made below can be found in "Roundtable Dialogue on California Energy Crisis," Sacramento Bee (December 24, 2000). Marcus, William and Jan Hamrin, How We Got into the California Energy Crisis, JBS Energy (2000}) (hereafter, Marcus, Crisis), provides specific estimates of the size of each of the factors, as do ). Harvey, Hal Bentham Paulos and Eric Heitz, "California and the Energy Crisis: Diagnosis and Cure," Energy Foundation, March 8, 2001.

(31) Rose, Other States, shows an increase in unplanned outages between 1999 and 2000 of about 1,000 MW in June, 1,600 MW in July, and 2,500 MW in August. Marcus, Crisis, states, "Forced outage rates for California natural gas plants over the past five years have gone from the traditional 5-10 percent per year outage rate to an average of almost 50 percent."
(32)Krugman.

(33) Borenstein, Everin, James Bushnell and Frank A. Wolak, Diagnosing Market Power in California's Restructured Electricity Market (August 2000).

(34) Puller; Department of Market Analysis, Report on Real Time Supply Costs Above Single Price Auction Threshold: December 8, 2000 - January 31, 2001, February 28, 2001 (hereafter, DMA, Supply Costs)

(35) In addition to findings on market power cited above, see Bohn, Roger E., Alvin K. Klevorick and Charles G. Stalon, Market Monitoring Committee of the California Power Exchange, Report on Market Issues in the California Power Exchange Energy Markets (August 17, 1998) and Energy Information Administration, Horizontal Market Power in Restructured Electricity Markets (March 2000).

(36) Marcus and Russzon call it a summer 2000 shift. They show that the jump in gas prices runs the cost from 8.3 cents per kWh to 16.5 cents at 40,000 MW without the summer shift and 24 cents with the summer shift. At 45,000 MW, the price is 78 cents per kWh and at 35,000 MW, it is 11.4 cents. Adding 5,000 to 10,000 MW to the system has a huge benefit in relieving price pressures.

(37) Hildebrandt, Eric, Further Analysis of the Exercise and Cost Impacts of Market Power in California's Wholesale Energy Markets (Department of Market Analysis California Independent System Operator, March 2001), Impacts of Market Power in California's Wholesale Energy Market: More Detailed Analysis Based on Individual Seller Schedules and Transactions in the ISO and PX Markets (Department of Market Analysis, California Independent System Operator, April 9, 2001); Sheffrin, Anjali, Empirical Evidence of Strategic Bidding in California ISO Real Time Market (Department of Market Analysis, California Independent System Operator, March 21, 2001)

(38)

(39) Siddiqui, Afzal S., Chris Mornay and Karl Khavkin, "Excessive Price Volatility in the California Ancillary Services Markets: Causes, Effects and Solutions," Electricity Journal, 6.

(40) Sheffri, Anjali, Comprehensive Market Redesign: Options, Mitigation (October 4, 2000).

(41) The CAL-ISO and the FERC have been debating which markets to include in the analysis and which abuses are subject to FERC jurisdiction hence publicly discussed figures vary. FERC, Prospective Mitigation Order, at 5-6, gives s brief recounting of the dispute.

(42) Comments of the California Independent System Operator Corporation on Staff's Recommendation on Prospective Market Monitoring and Mitigation for the California Wholesale Electric Power Market," San Diego Gas & Electric Company v. Seller of Energy and Ancillary Services Into Markets Operated by the California Independent System Operator and the California Power Exchange, March 22, 2001; Request for Rehearing on Behalf of the County of San Diego, San Diego Gas & Electric Company v. Seller of Energy and Ancillary Services Into Markets Operated by the California Independent System Operator and the California Power Exchange, March 22, 2001.

(43) Hildebrandt, Further Analysis, at 8.

(44) County of San Diego, at 7-8..

(45) Hildebrandt, Further Analysis, at 2.

On an annualized basis, wholesale energy prices since January 2000 are exceeding the cost necessary for new investment by about 400%, and would allow recovery of an investment in new supply in a period of less than two years.
Hildebrandt's assumed capital cost recovery was 14 to 15 percent. Thus, with an estimate of actual cost recovery more than 400% larger than that, the annual recovery is at least 70%. Moreover, the 14 to 15 percent for annual capital cost recovery is based on a return on equity of 17% (see California Energy Commission, Market Clearing Prices Under Alternative Resource Scenarios, February 2000, at Table III-1).

(46) County of San Diego, at 7, calculates that a five-year capital recovery would require a charge of $32/Mwh. Thus, a one-year pay back would require capital cost recovery of $160/MWH. The cost of operating such a new plant would be just over $120 per MWh, including $32/MWh for capital cost recovery. Thus, at a ceiling price of $273, which implies a windfall of $150/MWh, the total capital cost recovery is over $180 per MWh, indicating a less than one-year payback or a return on investment of over 100 percent.

(47) After averaging over $12 per month for six months, the price of natural gas has recently tumbled to less than $4.00 MCF, which is more in line with historic levels. If the actual costs borne by generators were at this level over the past winter, the windfalls estimated in text would about 50 percent larger.

(48) Combining the results of Hildebrandt, Further Analysis, Tables 3-1, B-1 and B-2, we calculate annual recovery of capital costs under actual prices in effect in California in the past three years as follows:

(49) Hildebrandt, Impacts of Market Power, at Table 2-4.

(50) Stanton, Same, "Buy Out?," Sacramento Bee, May 6, 2001, cites PG&E plant sale revenue of $1.5 billion and SCE revenue of just under $1 billion. SDGE revenues were about $.5 billion.

(51) Teece, David, J. and Mary Coleman, "The Meaning of Monopoly: Antitrust Analysis in High-Technology Industries," The Antitrust Bulletin (Winter 1998), identifies Ricardian (scarcity), Schumpeterian (entrepreneurial) and monopoly (Porterian) rents (pp. 819-822). In an earlier analysis (Behind the Headlines) I have identified the mirror image of Schumpeterian rents as "stupidity rents." These are the substantially attributable to state policy makers and utilities, which are not the subject of this hearing.

(52) Teece and Coleman, p. 819, define scarcity rents as :
In many contexts where knowledge and other assets underpin a firm's competitive advantage, additional inputs cannot simply be purchased on the market to expand output… historically at least, economists have associated Ricardian rents with scarce natural resources like land or iron ore.
The origin of the concept has been associated with land, hence it is occasionally referred to as ground rents (Rutherford, Donald, Dictionary of Economics (Routledge: London, 1992), p. 137).

(53) Teece and Coleman, p. 822) define present Monopoly (Porterian) rents which "stems from the naked exercise of market power by a firm (or firms)."

(54) Pearce, George, The Dictionary of Modern Economics (MIT Press, Cambridge, 1984), p. 124.

(55) Bannock, Graham, R.E. Banock and Evan Davis, Dictionary of Economics (Penguin, London, 1987). P. 128.

(56) P. 350.

(57) Scherer and Ross, pp. 15-29. Abuse of monopoly power imposes static, deadweight loss (see Asch, Peter, Industrial Organization and Antitrust Policy (New York, John Wiley and Sons: 1983) p. 83) and may impose dynamic x-efficiency losses (see Asch, p. 97).

(58) Puller, Steven L., "Pricing and Firm Conduct in California's Deregulated Electricity Market" (November 2000), finds strong evidence of static market power and weak evidence of dynamic gaming in the first year of the market. There is a general consensus that gaming increased in subsequent years (Kahn, Michael and Loretta Lynch, California's Electricity Options and Challenges: Report to Governor Gray Davis, (hereafter, Options) Chapter III; Marcus, William and Jan Hamrin, How We Got into the California Energy Crisis, JBS Energy (2000}) (hereafter, Marcus, Crisis).

(59) That the concept is routine is attested to by its inclusion in introductory texts, see for example, Taylor, John, B., Economics (Houghton Mifflin, Boston, 1998), pp. 327-329.

(60) Adelman, Morris, "OPEC the Clumsy Cartel," The Energy Journal, 1:1980; Bohi, Douglas and W. David Montgomery, Oil Prices, Energy Security and Import Policy (Resources for the Future, Washington, 1982); Aperjis, Dimitri, The Oil Market in the 1980s: OPEC Oil Policy and Economic Development (Ballinger, Cambridge, 1982); Teece, David, "OPEC Behavior: An Alternative View," in James M. Griffin and David J. Teece (Eds.), OPEC Behavior and World Oil Prices (George Allen and Unwin, London, 1982); Adelman, Morris, "OPEC as a Cartel," in James M. Griffin and David J. Teece (Eds.), OPEC Behavior and World Oil Prices (George Allen and Unwin, London, 1982).

(61) Wolak, Frank A., et al., "An Analysis of the June 2000 Price Spike in California ISO's Energy and Ancillary Service Market," Market Surveillance Committee of the California Independent System Operator (September 6, 2000), p. 14 (hereafter, Wolak, Analysis).

(62) FERC, Prospective Mitigation Order, at 3, 4, 7.

	NP15	SP15
Low Cost plant	($500/MWh@ 14%ROI)	46	32
High cost plant	($600/MWH@16%ROI)	39	26