Power Companies and Regulators Must Take Steps To Avoid Spread of California Power Virus: Andersen Analysis.

Business/Energy Editors

WASHINGTON--(BUSINESS WIRE)--April 24, 2001

A "new virus spawned in California" poses formidable challenges requiring new strategies on the part of power companies, regulators and policymakers to contain and reverse its damage, according to "Energy Crisis in the Western United States: Lessons for Navigating Regulatory and Market Minefields," a new Andersen report released today.

"The implications for the development of competitive energy markets go far beyond the Western United States," Andersen's national utility practice head Matthew D. Smith told a Washington briefing. "Unfortunately, California has taught the nation that regulatory and political barriers can create and sustain an energy crisis."

"California has demonstrated that the risks in the electricity industry, if not properly acknowledged and managed, can simultaneously and profoundly impact all market participants. To be effectively managed, these risks need to be exposed, assumed or shared, measured and monitored. When they are hidden or ignored, all parties can potentially suffer. A shared, integrated view of these risks, and a strategy for their assumption and management, is critical to avoiding rapid value destruction within the energy market," Smith said.

An Andersen survey of senior utility executives outside California, also released at the briefing, indicates most utility companies believe they inoculated themselves against the California virus so that it is unlikely to affect their operations beyond slowing the pace of deregulation and increasing investor scrutiny. However, based on the potential implications it sees of the California situation, Andersen believes a series of booster shots are advisable for power companies and regulators. "To deliver reliable service at a predictable cost in today's environment, companies must focus on market integration by developing new and innovative relationships between suppliers, customers, employees and investors -- while working with government officials and regulators to chart a smoother transition to a deregulated power market," according to Smith.

Eight Implications

The Andersen report identified eight overriding implications emanating from the Western energy crisis that are shaping the longer-term operations of the Western grid, the regional and national economy, domestic energy policy and the industry's evolution:

1. Increased deregulation uncertainty and risk -- Tension and

differences between state and federal regulators raise the

specter of repeating the regulatory and political conundrum

California's investor-owned utilities have faced. If federal

initiatives open wholesale markets while retail markets remain

regulated, a crucial question is raised: Will state regulators

pass-through higher wholesale costs if they should

materialize? Tensions between state and federal regulators

over policies on deregulation will grow if states delay or

abandon retail competition.

As wholesale markets are deregulated and RTOs begin operating,

the prudence principles that state regulators have used for

many years may have to be changed. For example, if FERC and

RTO monitors determine that deregulated wholesale markets

operate fairly, prices derived from those markets must be

considered reasonable. If so, these costs should be allowed

into state-regulated retail rates without regard to the

prudence principles state regulators have used for years.

Therefore, utilities' traditional burden of proving costs are

or are not justifiable shifts to regulators.

2. Reduced investor confidence -- Prior to deregulation,

stringent prudence review and disallowance of generation costs

in the rate base made regulatory risk largely uncontrollable,

killing IOU interests in most new investment. A major purpose

of deregulation was to create an environment in which risk

could be managed, but California's political and regulatory

environment provides only a limited ability to manage risks.

The confidence and perceptions needed to support investment

decision-making will be slow to return given the approach of

the state to remedy the crisis.

3. Contributing factor in economic softening -- Uncertain energy

reliability and higher costs can drive-out marginal

businesses, cause healthy companies to constrain expansion,

and lead new entrants to question whether to make new

investments. As such, an extended energy crisis contributes to

inflation pressures and may slow economic growth.

4. Increased pressure on the Western grid -- Even as capacity

increases and demand reductions work to resolve the California

crisis, these solutions have long-term implications for the

Western Grid. These include a realistic possibility of

California becoming an "energy island" as a result of

near-term reduction in available regional resources for export

to California; increased emphasis on security control to

protect against overall Western grid failure as sub-regions

have problems; RTO requirements to strengthen locally

available supplies to bolster overall system reliability;

longer-term development of new plants using plentiful coal

resources and clean coal technology will alter the pattern of

imports into California; and the emergence of Mexico as a

major supplier to southern California and Arizona,

contributing to a bifurcation of the Western Grid into

northern and southern markets.

5. Unbundling failures that push companies back to portfolio

strategies -- For California investor-owned utilities,

unbundling has achieved neither the least-cost solution sought

by regulators nor value maximization targeted by investors.

This necessitates a reevaluation of portfolio management

strategies potentially involving generation, transmission,

power trading and marketing, and retail businesses in multiple

geographies serving multiple markets.

6. Ineffectiveness in changing siting and development

restrictions -- California's retail price caps and multiple

explanations for the crisis have left accelerated siting

processes and environmental standards changes open to

challenge by various interests. In addition, limiting

application of new siting orders only to small generators

contributes to uncertainty and investor hesitancy.

7. Procurement management that alters user-utility negotiating

leverage -- Competitive markets compel participants --

suppliers, marketers, large industrial buyers, etc. -- to

strategically manage procurement as a critical value-driver.

Because risk is explicitly shared and always has the potential

of shifting advantage to either seller or buyer, the

sophistication of negotiations and contracts increases as

competitive markets evolve.

8. Increased emphasis on distributed generation and new

technologies -- California's reliability and price challenges

have triggered a re-emergence of energy crisis measures from

the 1970s. End-users are investing in solutions they control,

and the distributed generation market is being aggressively

developed among large retailers, industrial users and

residential customers. This makes possible the development of

microgrids connecting consumers in local areas and related

changes in traditional grid systems, from modifications in

interconnection agreements to changing definitions of reserve

margins and system reliability.

Industry Executives' Response

Senior executives from sixteen non-California utilities with a combined market capitalization over $120 billion and $145 billion in revenues responded to an Andersen survey with their views of the implications of the California power crisis for their companies and for the industry. The survey, conducted between February 19, 2001 and March 2, 2001 by Knowledge Systems & Research, Inc. of Syracuse, found that the companies are observing the California situation carefully, expect a slowing -- but not a turnaround -- of deregulation, and believe their internal plans and preparations are on-target for the changing environment:

-- Deregulation -- Nearly all executives believe recent California events will
slow the pace of deregulation over the next five years for states that have not
begun or finished writing restructuring legislation. None believe that it will
cause advanced states to re-regulate markets, although many states will review
their legislation to assess their risk of duplicating California's current
situation and make any changes necessary to avoid it.

-- National legislation -- Few executives suggest the situation will initiate
national energy policy/legislation; others believe it will be a continuing
issue but, because of state-to-state variances, Congress will be unable to pass
any comprehensive measures or force states to a restructuring timeline. Some
expect additional state-level legislation.

-- Company strategies -- Most do not see any changes to their business models
or strategies for generation, distribution or supply procurement as a response
to the situation in California. However, many have expanded their risk
management programs, reduced spot market purchases, begun emphasizing long-term
supply contracts, planning new power generation capacity, and started hedging
with futures trades. Those facing price caps are rethinking their stance on
them.

-- Investor scrutiny -- Many executives indicate their shareholders are aware
of the situation and investors -- particularly institutional investors -- are
more heavily scrutinizing their actions. Many say news coverage has prompted
retail, commercial and industrial customer skepticism of industry
restructuring.

-- Transmission deregulation -- Many executives agree the California situation
will increase interest in FERC's regional transmission organizations (RTO)
deregulation effort.

Utility Company Action Items

Both to guard against a sudden California cascade and as a potentially powerful competitive thrust, forward-thinking utilities should bolster their basic preparedness with a variety of tactics -- or inoculations -- specifically aimed to combat a potential California power virus, according to Andersen partner Mark Moskovitz:

-- Improve procurement management and risk management

capabilities -- To manage exposure to volatile supply and

demand shifts, organizations must be sure that comprehensive

and clear supply procedures, controls, decision points, risk

limits and communications are in place.

-- Plan and design innovative rate and pricing structures --

Companies and regulators must focus on communicating price

signals that create value for both the customer and the

provider. Innovative rate and pricing structures that more

closely tie the customer's price to the real cost of supply

will better signal the value of the service as well as

providing more accurate information upon which both end user

and supplier can make decisions.

-- Increase emphasis on demand side management (DSM) strategies

-- In addition to new pricing strategies to help achieve and

maintain supply-demand equilibrium, companies must now focus

on employing more extensive and innovative demand side

management programs. These programs may offer significant

benefits with limited risk to both the customer and energy

supplier.

-- Assess the supply and generation dynamics in adjacent

jurisdictions -- Companies must take a broader view -- beyond

typical geographic market definitions -- of the economics of

generation and related business decisions in an increasingly

volatile market in which supply will follow the best prices.

-- Develop contingency plans for the continued deferral of new

generation capacity -- In the face of potential ongoing

generation capacity shortages, companies and regulators must

be prepared to move with a portfolio of strategies to meet

demand, including for example DSM, flexible pricing and

distributed generation. In addition, they should explore

efficiency-improving upgrades to existing facilities and seize

any opportunity to accelerate near-term construction plans.

-- Proactively address potential organizational disruption -- As

regulatory and economic changes continue to churn the industry

waters and companies adjust and/or restructure, they must be

highly cogniscent of, sensitive to, and directly address

employees' concerns with information about the company's

future and theirs'.

Industry/Regulatory Lessons

There are also a number of broad primary lessons the electric power industry -- nationally and internationally -- should take away from its first major domestic test case in deregulation and restructuring, according to Andersen principal David O. Jermain:

-- Simplify market design.

-- Build a continuing role for regulators.

-- Maintain communications with multiple constituent interests.

-- Prepare contingency plans for extreme stress conditions.

-- Couple real-time retail pricing with transparently priced

wholesale competition.

-- Provide special incentives for RTO investment, formation and

development.

-- Break down regulatory and political barriers to market signals

and responses.

Andersen is a global leader in professional services. It provides integrated solutions that draw on diverse and deep competencies in consulting, assurance, tax, corporate finance, and in some countries, legal services. Andersen employs 85,000 people in 84 countries. Andersen is frequently rated among the best places to work by leading publications around the world. It is also consistently ranked first in client satisfaction in independent surveys. Andersen has enjoyed uninterrupted growth since its founding in 1913. Its 2000 revenues totaled US$8.4 billion. Learn more at www.andersen.com.

Copies of the "Energy Crisis in the Western United States: Lessons for Navigating Regulatory and Market Minefields" report can be obtained at www.andersen.com/energyandutilities.

A PDF copy of the report can be obtained by contacting Melanie Fahey at 713/222-1600 or [e-mail]