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Hurt by Deregulation of Utilities,
California Gives Itself Lead Role
By REBECCA SMITH and JOHN R. EMSHWILLER
Staff Reporters of THE WALL STREET JOURNAL


SACRAMENTO, Calif. -- In a video made for a political roast, Gov. Gray
Davis, mimicking the Mafia boss in "The Sopranos," complains to his
therapist about Texas bad guys pushing electricity prices sky high. He vows
to get tough. Soon, a Davis confederate ushers four men in 10-gallon hats
into an office, shots ring out, and the aide, emerging blood-spattered,
delivers the punch-line: "Tell the governor his Reliant problem is solved."

While Gov. Davis hasn't gone that far in his fight with suppliers such as
Houston-based Reliant Energy Inc., he is in other ways trying to blast his
way out of the crisis. His moves are coming in rapid succession after months
of criticism of the governor for inaction, and they are fast reshaping the
state's electricity system.


With the acquiescence of other state leaders, Gov. Davis has put California
on the road to creating what amounts to a mammoth state-owned electric
utility, answerable largely to the governor. Moreover, though designed to
solve a short-term emergency, the governor's policies are loading consumers
with obligations that could affect the economy of the most-populous state
for 15 to 20 years.

His actions in some ways hark back to the system of central control that
preceded the disastrous 1996 foray into utility deregulation. But they
aren't simply a return to the days of monopoly utilities strictly regulated
by the state's Public Utilities Commission. What is emerging now is a
California power colossus that operates in important ways beyond the reach
of regulators or the public.

Mr. Davis says his actions will ensure that Californians have a secure
supply of reasonably priced electricity. "This is not a power grab," the
Democratic governor says in an interview. "I had no desire to intervene. I
would get out tomorrow if you would let me out. This is my least-favorite
thing to do."

'Colossal Failure'

Yet in the past six months, pushed by what he calls the "colossal failure"
of a deregulation plan hatched under his Republican predecessor, the
governor has put the state deep into the power business. In January, Mr.
Davis ordered the state Department of Water Resources to begin buying power
in place of California's cash-strapped utilities. Since then, the state has
purchased or committed to purchase $45 billion to $50 billion of
electricity, with some contracts as long as 20 years.


The governor has in effect seized control of the state's electricity-grid
operator, the California Independent System Operator, installing his
hand-picked team as board members. As its name implies, the ISO was supposed
to manage the grid without favoring any one participant.

Mr. Davis also is pushing to have the state buy huge chunks of the
transmission system that are owned by the financially beleaguered utilities.
He recently signed into law a bill that creates a state power authority,
whose director will be appointed by the governor. This agency, which so far
exists just on paper, could be used to build power plants and help run a
state-owned transmission system. Mr. Davis says that the authority is part
of what he sees as a "hybrid" system where public power plays an important
role augmenting private enterprise in the electricity business.

Reviving the Utilities

Having healthy utilities is extremely important, says the governor. He adds
that he has been working hard to revive the state's two biggest utilities,
the Pacific Gas & Electric Co. unit of PG&E Corp. and the Southern
California Edison Co. subsidiary of Edison International. But as the state's
role in the electricity business has grown, the utilities don't seem as
essential as they once did.

This is one reason the governor has had difficulty getting a rescue package
for Edison through the state legislature. The plan, among other things,
calls for the state to buy Edison's transmission system for $2.76 billion
and envisions the utility eventually resuming some power-buying chores.
Talks over a similar rescue package for Pacific Gas failed and that utility
filed for bankruptcy-law protection.

With the state locking up so much of California's future power needs,
legislators openly wonder whether utility-rescue efforts are worth the
billions of dollars they would require. In 2003, for instance, long-term
contracts will cover 90% of the state's projected buying needs. "What does
it mean for Edison to take over the role [of buying power] if the state
already has signed all these contracts?" asks State Sen. Debra Bowen, a
Democrat who heads the senate's energy committee.

Nonetheless, the governor says he is "cautiously optimistic" the legislature
soon will approve an Edison rescue package.

Mr. Davis has been deeply enmeshed in almost every aspect of the electricity
mess this year, after having once been relatively aloof from the burgeoning
crisis. The state's utility-deregulation law, which was enacted in 1996,
worked fairly well until May of last year. Under the deregulation plan, the
state's investor-owned utilities sold off many of their power plants to
other companies and repurchased that electricity through a state-sponsored
auction. Consumer rates were frozen and customers were given the option to
buy electricity from nonutility retail suppliers.

But tight electricity supplies and a flawed auction system led to a sharp
rise in wholesale power costs. With retail rates frozen, Pacific Gas and
Edison racked up multibillion-dollar deficits. In January, Mr. Davis
declared an emergency and put the state into the power-buying business.

Since then, he hasn't been bashful about exercising his emergency powers.
When Mr. Davis couldn't get legislative permission to borrow money
short-term for power purchases, he signed an executive order authorizing the
state to borrow up to $5 billion from commercial lenders. That borrowing is
supposed to be repaid from a roughly $13 billion municipal-bond issue, the
biggest in U.S. history, scheduled for later this year.

In another executive order, the governor suspended emission standards for
power plants to let them run more hours during the peak-demand periods. And
the state has hired a small army of energy consultants and traders.

Despite such actions, some think Mr. Davis isn't being forceful enough. For
example, the state senate last week passed a resolution supporting the
governor's power to "commandeer power plants" if he deems such a step to be
necessary. Mr. Davis has said he doesn't have any plans currently to take
such an action.

'Crisis of Governance'

The electricity mess has produced "the most extraordinary crisis of
governance we've had in California in the postwar period," says Bruce Cain,
director of the Institute of Governmental Studies at the University of
California at Berkeley. Mr. Cain says more power has been placed in the
governor's hands and, as a result, the state has "gotten away from the
separation of powers and the checks and balances that we expect in American
government."

Mr. Davis says his actions have been essential and are working. He credits
the long-term power contracts with helping to cool the spot market for
electricity, where prices in recent weeks have dropped sharply. In June, the
state paid an average price of $167 a megawatt hour for electricity. That
was down from $243 in May, though still far above the $25-to-$27 range of
two years ago.

But some worry about how this rush to address a short-term problem will
affect the longer-term future. An economic forecast issued late last month
warned that continued heavy state involvement and spending in the
electricity business could produce enough of a drag on the California
economy to reduce state output by a total of $90 billion by 2005 and lead to
higher unemployment. "California is at a crossroads" between what amounts to
a "state takeover of the electricity industry" and a more market-oriented
approach to fixing the problem, says the joint study by the Anderson
business school at the University of California, Los Angeles, and Cambridge
Energy Research Associates.

Under a law enacted in February, none of the tens of billions of dollars of
state electricity purchases or related costs can be challenged as imprudent
by the Public Utilities Commission. That's an immunity that regulated
utilities in the old regime could only dream of. Then, if they spent too
much, the PUC could make their shareholders take a hit. Under the new
system, any purchasing missteps the state makes will be borne by consumers.

"It scares the hell out of me," says Henry Duque, a Republican PUC member
appointed by former Gov. Pete Wilson. "The state is so busy looking after
its own interests. ... Who's looking out for the ratepayer?"

PUC President Loretta Lynch, a Davis appointee, acknowledges that the
commission's authority has been seriously eroded. Under the new law, the
commission is supposed to charge consumers for whatever sum the Water
Resources Department spends on energy. She hopes to hold hearings to review
the spending "even if we can't do much about the result."

Gov. Davis says concern about less oversight of power purchases is a "bogus"
issue. "It is not as if a private company or utility was making the
decisions. The PUC doesn't need to second-guess the decisions of a public
body," he says.

But other state moves suggest there's a role for oversight. The state is
only now doing a conflict-of-interest inquiry after several of its new
energy hires filled out disclosure forms that showed they held stock in big
power suppliers to the state. The governor's press secretary, Steve
Maviglio, says he doesn't know whether they were asked about their holdings
before being hired. He says the state will take "appropriate action" where
conflicts of interest are found.

The rush to beef up an outgunned state energy team may have contributed to
the hiring problem. Early on, "we had two or three people sitting around and
dealing with" big and savvy electricity suppliers, says Mr. Davis, almost
like a "tee-ball team playing the New York Yankees."

The state has since hastily assembled a group of about 20 energy traders,
headed by a 30-year-old manager with one year of experience in the energy
business. The manager, Susan Lee, has held four jobs in the past four years
and is getting paid up to $480,000 over two years for her services. Ms. Lee
declines to comment.

Good Enough

Even so, Mr. Davis argues, state negotiators did well enough. They managed
to help lower current power costs, he notes, although that required signing
deals that could force the state to "pay a little more" than it otherwise
would have in the years ahead. "I think Californians are willing to accept
that bargain," he says.

Still, he and some other state leaders are urging the PUC to revoke a
fundamental tenet of deregulation: the right of consumers to shop around for
low-cost electricity. Removing this option is essential to prevent a "jail
break" of customers seeking prices lower than what the state must charge,
says Carl Wood, one of Mr. Davis's three Democratic appointees to the
five-member PUC. A flight of customers could leave too few to pay for
state-purchased power and repay the planned bonds. The PUC is scheduled to
vote in August on the request to revoke consumer choice.

Some users are concerned about being stuck with what amounts to a state
monopoly. "We don't want to lose our options" to shop for lower-cost
electricity, says Shawn Covell, a senior manager at Qualcomm Inc., the
telephone-equipment maker. Earlier this year, Qualcomm signed an agreement
to buy power from an alternative supplier, the kind of move state officials
seek to ban.

While consumer choice is in doubt, public disclosure has already been
lessened in some ways. For months, the state refused to divulge terms of
power deals it was signing, saying that doing so would harm negotiations on
additional contracts. It finally made public the long-term contracts this
month after a lawsuit by a group of newspapers, including The Wall Street
Journal. Details of short-term power purchases were disclosed for the first
time on July 9. They showed the state spent nearly $8 billion on spot-market
purchases in the first five months of 2001, exceeding its projections.

Some Davis allies are troubled. "Decisions are being made, with almost no
public discussion, that foreclose other options," says Ms. Bowen, the state
senator, who is close enough to the governor that she played his therapist
in the "Sopranos" skit. While Sen. Bowen says the governor needed to act
forcefully, she is troubled that so much power has been bought at what she
fears will prove to be extremely high prices in the years ahead. Still, she
voted for the bill that gave the executive branch carte blanche to make
those huge commitments.

The right to go to court also has been limited. Under a law soon to take
effect, challenges to certain aspects of the planned $13 billion bond issue
can be taken only to the state Supreme Court. That panel has accepted only
two utility-related cases over the past decade. Backers of the measure say
it gives adequate opportunity for review without unduly slowing the bond
offering.

'One Voice'

The state's enlarged role in the utility business was on display when
negotiators convened recently at the Federal Energy Regulatory Commission in
Washington to discuss alleged supplier overcharges. California's major
utilities played only a secondary role, even though they paid much of the
purported overcharges and ran up giant deficits in doing so. The governor
had named one of his advisers, Michael Kahn, as head of the 20-person state
delegation, and Mr. Kahn says the delegation "spoke with one voice -- mine."

Mr. Kahn told FERC that California was owed $8.9 billion in refunds. Others,
including the FERC administrative-law judge overseeing the talks, said the
number was probably much lower. The state wouldn't budge, and the talks
ended without an agreement. Last week the judge recommended that a
"trial-like" proceeding be held to sort out who owes what to whom.

Mr. Davis says the state will go to an actual court if it doesn't get all
the money it is seeking through the FERC proceedings. And he vows to do
whatever else is necessary to get California through the electricity crisis.
"I have no desire to subsume the legitimate role of the private sector," he
says. But, he adds, Californians got such a "raw deal" from the deregulation
mess that "I have had to had take a very militant, hard-line view."

Write to Rebecca Smith at rebecca.smith@wsj.com and John R. Emshwiller at
john.emshwiller@wsj.com
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