Regulatory Uncertainty Over Energy Procurement Impedes Development and Construction of California Power Plants

By Christopher A. Hilen
[May 2004]

While the emergence of Pacific Gas and Electric Company (PG&E) from bankruptcy last month portends a possible return to “normalcy” for California’s energy industry, lingering uncertainty about the regulatory structure of the California energy market remains. This enduring regulatory uncertainty continues to impede the development and construction of needed new power plants in California. In a potentially positive development, California Governor Arnold Schwarzenegger recently encouraged the California Public Utilities Commission (CPUC) to expedite its adoption of the policies that are needed to resolve this regulatory uncertainty.

Broad agreement exists that the California Legislature and the CPUC need to provide greater guidance as to the role of California’s utilities in power generation and procurement. Thus far, however, no clear policy consensus on this issue has emerged from the state’s policy makers. In the wake of the Enron, NRG, Mirant, National Energy and Gas Transmission (the former PG&E National Energy Group), and PG&E bankruptcies and the continued fluctuations in power prices and regulatory changes of direction, financial markets have, in effect, stopped funding the construction of large power plants, absent the developer having obtained a long-term contract for the purchase of the plant’s output with some pricing certainty. With the limitations imposed on direct access, the utilities represent essentially the only viable market for developers to sell their electricity in California. However, absent regulatory assurances of rate recovery the utilities have been generally unwilling to enter into long-term power purchase agreements (PPAs). The net result is that project developers and financing parties are hesitant to construct and finance even fully permitted projects.

The CPUC has been grappling with utility procurement related issues since late 2001 when it instituted Rulemaking 01-10-024. Starting in late 2003, the CPUC has issued several decisions regarding utility resource procurement, but none of those decisions provide definitive policy guidance to utilities and project developers on the execution of long-term PPAs by the utilities or the certainty of cost-recovery.

In December 2003, the CPUC authorized Southern California Edison Company (Edison) to acquire Mountainview Power Company, the owner of the Moutainview Power Project. The CPUC also concurrently allowed Edison enter into a long-term PPA with this new affiliate for the purchase of electricity from the Mountainview Power Project. In authorizing the acquisition and associated PPA, the CPUC cautioned that its decision should not be viewed as precedential. It explained that its approval of the Mountainview transactions was based on a unique set of facts, namely the short-term opportunity for Edison to acquire the company (and its plant) at a “distressed” price.

In a separate decision in December 2003, the CPUC adopted short-term procurement plans for PG&E, Edison and SDG&E. These approvals, however, are limited to the utilities’ respective 2004 resource needs and defer adopting long-term procurement policies.

In January 2004, the CPUC issued a decision stating that the utilities should use a formal RFP process to secure future long-term generating capacity resources and seek to obtain portfolios of short-term transactions, new utility-owned power plants, and long-term PPAs. However, the CPUC provided no definitive guidance as to the combination of these resources each utility should employ; how the utilities should evaluate the merits of competing proposals; or what ratemaking treatment generation capacity additions and PPAs would receive. The CPUC did impose certain non-resource specific adequacy requirements on the utilities including that they:

• Maintain operating reserve margins of 15-17 percent, to be phased in between now and 2008;
  
  
• Contract 90 percent of their summer load a year in advance;
  
  
• Limit spot-market purchases to 5 percent of their energy needs; and
  
  
• Resubmit long-term power procurement plans for CPUC review.

The CPUC is currently considering proposed decisions by an Administrative Law Judge and by Commission President Michael R. Peevey that would authorize San Diego Gas & Electric Company (SDG&E) to execute five separate agreements for the purpose of meeting SDG&E’s near-term and long-term grid reliability needs. The proposals emanate from an RFP issued by SDG&E in May 2003 and include one demand response program, purchase by SDG&E of two turnkey power plants (one of which is being developed by SDG&E affiliate Sempra Energy Resources), and long-term PPAs with two independently owned power plants.

Notwithstanding the fact that in its January 2004 decision advocating the use of RFPs the CPUC made “permanent” its pre-existing ban on procurement transactions between the utilities and their affiliates, both the approved Mountainview transaction and the SDG&E RFP pending approval include transactions with a utility affiliate.

Four factors highlight the urgent need for definitive and clear policy decisions on utility reliance on long-term PPAs. Policy direction is required to create a stable power market that will enable power plant developers to obtain financing for the construction of new power plants:

• Lack of New Power Plants: No new large power plants have completed construction in California in the last year, and none are scheduled to come on-line over the next year. The absence of contracts and financing is causing even plants that have been fully licensed to have construction deferred.
  
  
• Advantages of Retirement of Older Units: California power plants with 900 megawatts of capacity have been retired over the last two years. Given the aged status of the California power plant inventory (40 percent of California’s thermal power plants are more than 40 years old) and the higher operating costs and environmental emissions associated with these plants, it should be expected, and would be desirable, that a substantial number of additional plants cease operating within the next several years.
  
  
• Increase in Power Usage: There has been a surge in home-building in high energy consumption areas of California and increased economic activity statewide, increasing overall demand for electricity.
  
  
• Decrease in Energy Conservation: Californians are conserving less energy than they did during the summers of 2001 and 2002, when retail electricity rates were at their highest and the state government actively promoted conservation programs.

The issues on which policy direction is needed include:

• Will California’s load-serving utilities be permitted to once-again build and own gas-fired generation or will they be required to procure power in the marketplace, through long-term contracts? Can the independent generation market be expected to remain viable if utility affiliates are allowed to compete? If regulators believe that the promotion of both utility-owned generation and independent third-party generation represents good policy, how do regulators insure that the process is sufficiently transparent and fair so that independent generators will commit the necessary resources to compete against the utility affiliates?
  
  
• Notwithstanding its statement of support for a portfolio of resources that includes long-term PPAs, will the often 3-2 divided CPUC actually allow utilities to enter into long-term PPAs and thus be able to flow through to ratepayers the benefits such longer-term commitments may offer; or will they restrict utilities to less attractive shorter-term commitments on the theory that shorter terms “preserve options” and provide downside protection?
  
  
• What showing of “need” will regulators demand as a precondition of authorizing utilities to commit to any new generation sources? Will they restrict utilities to purchasing incremental power supply on an inventory “just in time” basis; or will they recognize the “insurance” benefits of erring on the side of committing to power acquisition levels slightly in excess of actual needs?
  
  
• Will regulators be able to develop a process that provides for full public input on utilities’ proposed incremental power supply, but does not, and at great expense, increase the uncertainties in, and extend the timeframes for, power development and thus increase development risk, deter entrants and drive up prices?
  
  
• What rules for cost recovery will utilities operate under for utility-owned generation and for purchased power? Will and how will the CPUC address the debt-equivalence impact of long-term PPAs on the utilities’ financial ratings and provide appropriate relief?
  
  
• What role will utilities play in demand-side management, energy efficiency, and distributed generation?
  
  
• What load-serving role remains for direct access and community choice aggregation?

The CPUC has 10 different proceedings underway to develop policy on related industry issues. It initiated a rulemaking in early April in which it promises to adopt long-term procurement plans for the electric utilities and coordinate the other nine proceedings. Davis Wright Tremaine is participating in and monitoring these proceedings. The subjects of those proceedings include:

• Adoption of long-term procurement plans for the utilities
  
  
• Demand response programs
  
  
• Energy efficiency programs
  
  
• Distributed generation
  
  
• Renewable portfolio standards
  
  
• Community choice aggregation
  
  
• Electric transmission assessment and planning
  
  
• Avoided cost and Qualifying Facility pricing
  
  
• Natural gas supply

In a positive development, Governor Arnold Schwarzenegger sent a letter to Commission President Peevey on April 28 expressing strong support for the CPUC to develop a transparent, competitive power procurement process. In his first significant expression of energy policy, the Governor reaffirmed the state’s commitment to energy efficiency and renewable energy, but his strongest message was for the CPUC to include in its power procurement policy upfront rate recovery standards that will provide the utilities the assurance they need to enter into long-term PPAs. The Governor’s letter may provide the impetus needed to advance the development of needed power procurement policies by the CPUC. The presently pending proposed decisions which would approve the results of SDG&E’s RFP offer the CPUC an immediate platform to act on the Governor’s message.

For more information, please contact:

Steven F. Greenwald San Francisco, CA (415) 276-6528 stevegreenwald@dwt.com

This Energy Advisory is a publication of the Energy Department of Davis Wright Tremaine LLP. Our purpose in publishing this Advisory is to inform our clients and friends of recent developments in energy law. It is not intended, nor should it be used, as a substitute for specific legal advice as legal counsel may only be given in response to inquiries regarding particular situations.

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