Markets & Finance

Mr. Davis Goes to Washington


By Michael Wallace California Governor Gray Davis devoted 18 minutes of his 40-minute "State of the State" address on Jan. 8 to the crisis currently unfolding in the Golden State: the staggering financial damage being caused by skyrocketing electricity costs. He offered a conservative outline and limited funds to begin to tackle the onerous long-term energy supply and demand imbalances.

But he didn't propose any quick fix for the most pressing short-run issue: the liquidity crisis faced by the state's two leading electric utilities, Pacific Gas & Electric and Southern California Edison, which have hemorrhaged at least $12 billion in cash reserves by selling low and buying high.

In short, the threat of an energy margin call on the new economy has not abated, and the intractable crisis in California could yet derail U.S. economic growth.

"COLOSSAL FAILURE." Giving his best impression of Jimmy Stewart in the long-ago Frank Capra flick Mr. Smith Goes to Washington, Democrat Davis made scapegoats of out-of-state power generators and federal regulators. He has gone on to the recent energy summit in Washington to plead his case to the lame duck Clinton Administration, though business-friendly Presdient-elect George W. Bush will inherit the protracted crisis.

Describing California utility deregulation, Davis said it had been a "colossal failure." This was compounded by 12 years without a single new power facility being brought on line during one of the most protracted recessions in California history, which was followed by the unprecedented high tech boom. Moreover, deregulation forced utilities to sell off capacity to outside suppliers who in turn "price gouged" -- raising prices up to 900% per megawatt hour in December.

Davis rejected the notion of letting the utilities go bankrupt, demanded an increase in his emergency powers, and threatened the use of "eminent domain" authority to ensure an uninterrupted power supply for the state. But the fact remains that in the short-term, one of the coldest winters on record in the U.S. has driven natural gas prices up over 350% through the past year. The Federal Energy Regulatory Commission (FERC) cannot mandate prices, nor can California afford to buy back its lost capacity or lock in long-term contracts at current sky-high prices.

It turns out that the problem is not so much deregulation as the failure of decisionmakers to hedge energy costs -- which is where Davis stands on the firmest ground.

COURT CLASH? Davis has requested that the state's legislators take some constructive steps, but these will take time to enact and enforce. He is seeking to place public advocates on the Independent System Operator board and a public power authority, overhaul the highest-bid electricity process, streamline low-cost and long-term supplier contracts, hire 50 new Public Utiltiy Commission (PUC) inspectors, and criminalize financial manipulation of the power grid.

Yet in hard financial terms the Governor committed just $5.25 billion in his budget to the crisis: $1 billion for price stability and future plants, $250 million to fund purchases of energy-efficient appliances, and a whopping $4 billion legal fund for the State Attorney General to fight manipulative merchant generators. As with the recent election courtroom drama, it is telling that 75% of his cash is aimed at legal costs -- suggesting a protracted battle in the courts.

And the utilities? They will only get the 7-15% rate hike proscribed by the PUC, representing only half of their obligations and an insufficient buffer to forestall a clean sweep to junk status for the firms by the major credit rating agencies. Indeed, Davis was silent on the key issue of state-backed utility bonds.

What to take away from this mess? Try this: With the Fed already concerned about its "soft" landing, and a credit crunch from California's struggling utilities, just wait until the "hard" reality of drought and peak energy demand return this summer. Wallace is a senior economist with Standard & Poor's


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