[Senate Hearing 107-156] [From the U.S. Government Publishing Office] S. Hrg. 107-156 RESTRUCTURING OF ENERGY INDUSTRIES ======================================================================= HEARINGS before the COMMITTEE ON GOVERNMENTAL AFFAIRS UNITED STATES SENATE ONE HUNDRED SEVENTH CONGRESS FIRST SESSION __________ JUNE 13, 2001 ECONOMIC ISSUES ASSOCIATED WITH THE RESTRUCTURING OF ENERGY INDUSTRIES JUNE 20, 2001 THE ROLE OF THE FEDERAL ENERGY REGULATORY COMMISSION ASSOCIATED WITH THE RESTRUCTURING OF ENERGY INDUSTRIES JUNE 28, 2001 THE IMPACT OF ELECTRIC INDUSTRY RESTRUCTURING ON SYSTEM RELIABILITY __________ Printed for the use of the Committee on Governmental Affairs 75-477 U.S. GOVERNMENT PRINTING OFFICE WASHINGTON : 2002 ____________________________________________________________________________ For Sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpr.gov Phone: toll free (866) 512-1800; (202) 512�091800 Fax: (202) 512�092250 Mail: Stop SSOP, Washington, DC 20402�090001 COMMITTEE ON GOVERNMENTAL AFFAIRS JOSEPH I. LIEBERMAN, Connecticut, Chairman CARL LEVIN, Michigan FRED THOMPSON, Tennessee DANIEL K. AKAKA, Hawaii TED STEVENS, Alaska RICHARD J. DURBIN, Illinois SUSAN M. COLLINS, Maine ROBERT G. TORRICELLI, New Jersey GEORGE V. VOINOVICH, Ohio MAX CLELAND, Georgia PETE V. DOMENICI, New Mexico THOMAS R. CARPER, Delaware THAD COCHRAN, Mississippi JEAN CARNAHAN, Missouri ROBERT F. BENNETT, Utah MARK DAYTON, Minnesota JIM BUNNING, Kentucky Joyce A. Rechtschaffen, Staff Director and Counsel David M. Berick, Professional Staff Member Hannah S. Sistare, Minority Staff Director and Counsel Paul R. Noe, Minority Senior Counsel William M. Outhier, Minority Investigative Counsel Darla D. Cassell, Chief Clerk C O N T E N T S ------ Opening statements: Page Senator Lieberman...................................... 1, 61, 163 Senator Thompson....................................... 3, 63, 165 Senator Carnahan........................................... 35, 96 Senator Collins............................................ 38, 85 Senator Voinovich.......................................... 42, 94 Senator Carper............................................. 46, 92 Senator Durbin............................................... 83 Senator Torricelli........................................... 87 Senator Bennett.............................................. 89 Senator Domenici............................................. 99 WITNESSES Wednesday, June 13, 2001 Hon. Barbara Boxer, a U.S. Senator from the State of California.. 5 Hon. Larry E. Craig, a U.S. Senator from the State of Idaho...... 7 Hon. Dianne Feinstein, a U.S. Senator from the State of California..................................................... 10 Alfred E. Kahn, Ph.D., Robert Julius Thorne Professor of Political Economy, Emeritus, Cornell University................ 13 Severin Borenstein, Ph.D., Director, University of California Energy Institute and E.T. Grether Professor of Business Administration and Public Policy, Berkeley's Haas School of Business, University of California............................. 16 William W. Hogan, Ph.D., Professor of Public Policy and Administration, Center for Business and Government, John F. Kennedy School of Government, Harvard University............... 18 Paul L. Joskow, Ph.D., Director, Center for Energy and Environmental Policy Research, Massachusetts Institute of Technology..................................................... 21 Lawrence J. Makovich, Ph.D., Senior Director and Cohead, North American Energy Group, Cambridge Energy Research Associates.... 23 Frank A. Wolak, Ph.D., Professor, Department of Economics, Stanford University............................................ 25 Wednesday, June 20, 2001 Hon. Frank H. Murkowski, a U.S. Senator from the State of Alaska. 66 Hon. Patty Murray, a U.S. Senator from the State of Washington... 69 Hon. Maria Cantwell, a U.S. Senator from the State of Washington. 71 Hon. Barbara Boxer, a U.S. Senator from the State of California.. 74 Hon. Gray Davis, Governor, State of California................... 75 Hon. Judy Martz, Governor, State of Montana...................... 106 Hon. John Hoeven, Governor, State of North Dakota................ 110 Hon. Christine O. Gregoire, Attorney General, State of Washington 117 Roy Hemmingway, Chairman, Oregon Public Utility Commission....... 120 Hon. Curt L. Hebert, Jr., Chairman, Federal Energy Regulatory Commission (FERC).............................................. 127 Hon. Linda K. Breathitt, Commissioner, Federal Energy Regulatory Commission (FERC).............................................. 132 Hon. Nora Mead Brownell, Commissioner, Federal Energy Regulatory Commission (FERC).............................................. 134 Hon. William L. Massey, Commissioner, Federal Energy Regulatory Commission (FERC).............................................. 135 Hon. Patrick H. Wood, III, Commissioner, Federal Energy Regulatory Commission (FERC)................................... 138 Thursday, June 28, 2001 David N. Cook, General Counsel, North American Electric Reliability Council............................................ 167 Phillip G. Harris, President and CEO, PJM Interconnection, L.L.C. 169 Kevin A. Kelly, Director, Division of Policy Innovation and Communication, Federal Energy Regulatory Commission............ 171 Irwin ``Sonny'' A. Popowsky, Consumer Advocate of Pennsylvania, on behalf of the National Association of State Utility Consumer Advocates (NASUCA)............................................. 173 Alphabetical List of Witnesses Borenstein, Severin, Ph.D.: Testimony.................................................... 16 Prepared statement........................................... 194 Boxer, Hon. Barbara: Testimony.................................................... 5, 74 Breathitt, Hon. Linda K.: Testimony.................................................... 132 Prepared statement with an attachment........................ 462 Brownell, Hon. Nora Mead: Testimony.................................................... 134 Prepared statement........................................... 484 Cantwell, Hon. Maria: Testimony.................................................... 71 Cook, David N.: Testimony.................................................... 167 Prepared statement with attachments.......................... 509 Craig, Hon. Larry E.: Testimony.................................................... 7 Davis, Hon. Gray: Testimony.................................................... 75 Prepared statement........................................... 391 Feinstein, Hon. Dianne: Testimony.................................................... 10 Gregorie, Hon. Christine O.: Testimony.................................................... 117 Prepared statement........................................... 415 Harris, Phillip G.: Testimony.................................................... 169 Prepared statement with attachments.......................... 526 Hebert, Hon. Curt L., Jr.: Testimony.................................................... 127 Prepared statement with an attachment........................ 430 Hemmingway, Roy: Testimony.................................................... 120 Prepared statement with an attachment........................ 423 Hoeven, Hon. John: Testimony.................................................... 110 Prepared statement........................................... 825 Hogan, William W., Ph.D.: Testimony.................................................... 18 Prepared statement with attachments.......................... 200 Joskow, Paul L., Ph.D.: Testimony.................................................... 21 Prepared statement with an attachment........................ 351 Kahn, Alfred E., Ph.D.: Testimony.................................................... 13 Prepared statement........................................... 191 Kelly, Kevin A.: Testimony.................................................... 171 Prepared statement........................................... 533 Makovich, Lawrence J., Ph.D.: Testimony.................................................... 23 Prepared statement........................................... 365 Martz, Hon. Judy: Testimony.................................................... 106 Prepared statement........................................... 821 Massey, Hon. William L.: Testimony.................................................... 135 Prepared statement with an attachment........................ 494 Murkowski, Hon. Frank H.: Testimony.................................................... 66 Murray, Hon. Patty: Testimony.................................................... 69 Popowsky, Irwin ``Sonny'' A.: Testimony.................................................... 173 Prepared statement........................................... 545 Wolak, Frank A., Ph.D.: Testimony.................................................... 25 Prepared statement........................................... 371 Wood, Hon. Patrick H., III: Testimony.................................................... 138 Prepared statement........................................... 504 APPENDIX June 13, 2001 Chart entitled ``California Day-Ahead Power Prices'' (submitted by Senator Thompson)........................................... 551 Chart entitled ``The Big 5 Energy Generator's Profits'' (submitted by Senator Boxer)................................... 552 Chart entitled ``Closed for Maintenance?'' (submitted by Senator Boxer)......................................................... 553 Article by Robert J. Samelson, Washington Post, dated June 13, 2001, entitled ``Short-Circuiting Supply and Demand'' (submitted by Senator Craig)................................... 554 Letter from Wayne D. Angell, Senior Managing Director and Chief Economist, Bear, Stearns and Co., Inc., dated June 11, 2001 (submitted by Senator Thompson)................................ 556 William C. Dudley, Chief U.S. Economist, Goldman, Sachs and Co., prepared statement............................................. 558 Marcia Baker and John Hoefle, EIR News Service, prepared statement...................................................... 561 June 20, 2001 Report entitled ``Meeting the Energy Challenge: How the State of California is Taking Charge of the Energy Future'' (submitted by Governor Davis)............................................. 569 Chart entitled ``Total Wholesale Cost of Electricity in California'' (submitted by Governor Davis)..................... 742 Chart entitled ``1999 Per Capita Electricity Consumption'' (submitted by Governor Davis).................................. 743 Chart entitled ``Table 1: Average Monthly Bill By Sector, Census Division and State, 1999'' (submitted by Senator Collins)...... 744 Prepared statements for the record: Hon. John A. Kitzhaber, M.D. Governor, State of Oregon....... 746 Jerry Ellig, Ph.D., Senior Research Fellow, Mercatus Center at George Mason University, with an attachment............. 749 Vernon L. Smith, Ph.D., Economic Science Laboratory, University of Arizona...................................... 774 John M. Quain, Chairman, Pennsylvania Public Utility Commission................................................. 786 Question for the record and responses from: Governor Davis............................................... 788 S. David Freeman, Sr. Energy Advisor to Governor Davis....... 800 Chairman Curt L. Hebert, Jr.................................. 802 Commissioner Linda K. Breathitt.............................. 810 Commissioner William L. Massey............................... 812 Commissioner Patrick H. Wood, III............................ 815 June 28, 2001 Chart entitled ``Bundled'' (submitted by Senator Lieberman)...... 819 Chart entitled ``A Fully Unbundled Electric Industry Model'' (submitted by Senator Lieberman)............................... 820 ECONOMIC ISSUES ASSOCIATED WITH THE RESTRUCTURING OF ENERGY INDUSTRIES ---------- WEDNESDAY, JUNE 13, 2001 U.S. Senate, Committee on Governmental Affairs, Washington, DC. The Committee met, pursuant to notice, at 9:33 a.m., in room SD-342, Dirksen Senate Office Building, Hon. Joseph I. Lieberman, Chairman of the Committee, presiding. Present: Senators Lieberman, Durbin, Cleland, Carper, Carnahan, Thompson, Stevens, Collins, and Voinovich. OPENING STATEMENT OF CHAIRMAN LIEBERMAN Chairman Lieberman. Good morning and thank you all very much for coming. Since this is our first hearing since the transition within the Senate, I wanted to begin by just saying what a great honor it is for me to become Chairman of the Senate Governmental Affairs Committee. This is a Committee with a proud history, and I hope and believe on a bipartisan basis we can make its future as proud. It is an honor for many reasons for me to become the Chairman, but perhaps the most meaningful is that one of my childhood heroes and later one of my mentors, Senator Abe Ribicoff of Connecticut, served as Chairman of this Committee back in the 1970's. Under his leadership the Committee did what was right to protect the interests of the American taxpayer, and that is a legacy that I hope all of us will carry on. I want to particularly thank my friend and colleague, Senator Fred Thompson of Tennessee, for the distinguished and thoughtful leadership he has given this Committee over the past several years. Though we are switching seats today, I know that Fred and I will continue our very strong working partnership in pursuit of the fulfillment of the responsibilities of this Committee, which, as I see them, are to make sure that the people that we represent have the most responsive, efficient, ethical, and economical government that we can provide them. Sometimes fulfilling this responsibility will lead to producing legislation, but I think uniquely within the Senate Governmental Affairs Committee more often it will involve oversight. Over the course of the next 2 weeks, we will be paying particular attention to the economic interest of the taxpayers as consumers of electricity and natural gas. As a Committee charged with oversight, it is our job to make sure that Federal agencies are doing their job to fairly and appropriately protect the interests of the American people. America now faces an array of serious energy problems. Whether it is the price of gasoline in the Midwest, shortages of heating oil in the Northeast, consumers and businesses struggling to pay their natural gas bills, or electricity blackouts and price spikes in California, energy price and supply problems are becoming regular events from one end of the Nation to the other. I think that if we ignore these problems, we put our economy at risk. California accounts for 15 percent of the U.S. economy. If you add its Western neighbors Oregon and Washington, which are also part of this most recent crisis, we are talking about the health of roughly one-fifth of the American economy. And earlier this spring, the North American Electric Reliability Council issued warnings not only about California and the Pacific Northwest but New England and New York City as well. So none of us should say of the West's problems today that we will not face them in our part of the country tomorrow. What the Federal Government does in this situation out West, I think, will set a precedent for what it will do in the next energy crisis elsewhere in America. So today and again next Wednesday, when we will hear from the members of the Federal Energy Regulatory Commission, Governor Davis of California, and another witness that Senator Thompson will call, we will be looking at the role of the Federal Government in addressing the issues of energy price and supply. In particular, we are going to be looking at the effects of deregulation on the energy market and how FERC has carried out its responsibility to oversee these changes. FERC was created in 1977 under the Department of Energy Organization Act and charged with the same responsibility as its predecessor, the Federal Power Commission, to set just and reasonable wholesale energy rates. But I doubt that there is any among us today that would say that California's energy costs are now just and reasonable. In 1999, the State spent $7 billion--that is all of the consumption of electricity energy, $7 billion on energy. Last year the number multiplied to $27 billion, and estimates for this year go as high as $70 billion, even though Californians are conserving and using 11 percent less energy today than last year. In fact, last fall FERC itself said that electricity prices in California were not just and reasonable. Like most of our expert witnesses today, in fact, I think maybe all of them, I am a fan of free markets. I do not believe in price controls or price caps or other economic contrivances that inhibit the free marketplace, but the energy market in California and the West is not free today. It may not even be functional. So we need to examine, I think, the appropriate role for regulators when the market does not work. This is a matter about which we may differ, but the differences should not be, and I do not believe are, partisan or personal. In fact, the primary legislative response to the crisis in the West that has been proposed is bipartisan, the legislation authored by Senators Feinstein and Gordon Smith, and I hope that our deliberations in this Committee will focus on finding a solution rather than on finding a scapegoat. We are fortunate to have a distinguished panel of nationally renowned economists to help us understand the changing nature of the energy markets and how consumers have been affected by the transition from the regulation of electricity and natural gas at the State and Federal levels to an unregulated, more market-oriented system. The fact is that 25 States and the District of Columbia have moved to deregulate their electric utility systems, but the recent experience of California in both electricity and natural gas markets and the price hikes in the Midwest in 1999 and the Northeast last spring have very serious doubts about this new world of spot markets, electricity futures, and open access to natural gas and electricity transmission systems. Several States on the verge of regulation, including two of California's Western neighbors, New Mexico and Nevada, have blinked and put the brakes on deregulation, and that is understandable considering what has been happening in California. So I think that if the Federal Government doesn't find a way to provide temporary price relief out West now, the natural and, I think, desirable trend toward deregulation across the country will come to a halt. So I look forward to the testimony of our witnesses. I hope they will help us learn the lessons we need to learn from what is happening in California and in the Western grid and outline for us the role they think the Federal Government needs to play in these new markets. I hope they will tell us what we can do when, as in the case of California, good intentions go painfully off course. I am now going to call on Senator Thompson. I do want to say in this first hearing that I have the privilege to Chair that I am going to borrow some of the procedures that I have learned on the Armed Services Committee, with the indulgence of my colleagues, and just have Senator Thompson and myself give opening statements but extend the time for questioning in each round by the Members of the Committee to 10 minutes, so that if they wish to make an opening statement they can do so during that 10-minute time. And we will call on Senators in order of arrival, switching parties as we go along. Senator Thompson. OPENING STATEMENT OF SENATOR THOMPSON Senator Thompson. Thank you very much, Mr. Chairman, and you know, as the old saying goes, if it had to happen, it couldn't have happened to a nicer guy. I look forward to working with you as we have in the past. We went through some interesting and trying times a couple of years ago, and throughout all of that and up until now, we have had a good working relationship. You have been very cooperative with me in every respect, and I intend to be the same with you. So I am looking forward to it. The energy troubles that have plagued the State of California and the West over the past year are well known to all Americans. Most are probably as aware of the problem from stories about blackouts as they are from stories about fingerpointing and placing blame. I think it is important to know that California's problems did not begin on January 21, 2001. Efforts to place blame on the current administration, to hire consultants at $30,000 a month to spin the issue, or to pit one State against another are not only misplaced, but do not help arrive at a solution. In truth, there appear to be many causes of the problems now faced in the West. The restructured energy system in California had flaws. There was evidence of mounting problems a couple of years ago, but the State was reluctant to address them. The State was slow to react when prices rose sharply last summer. It has shied away from passing rate increases along to consumers sufficiently to affect demand, and it resisted the kind of long-term contracts that could have mitigated the current crisis. In addition, natural gas prices have risen sharply, increasing the cost of producing energy. A lack of rainfall in the Northwest has decreased the available hydro power in the region, and the best way to head off this problem, building new generations, has been difficult given the State's burdensome requirement for building new plants. In sum, California has not provided an energy supply that could meet the demand of its growing economy. The question we face now is what should be done to address the short-term problem of power shortages and certain blackouts this summer and the long-term problem of ensuring sufficient supply to the West in the future. The long-term answer appears more clear: More supply. New generation is being built, and some estimate a sufficient amount will be online within 18 months. In addition, signing long-term contracts could help provide stability to the region. The short-term solution is more difficult, particularly because it is so late in the game. Prices exploded last summer and stayed high all winter. Now Governor Davis has asked the Federal Government to step in and fix the problem now that it is too late for anyone to prevent rolling blackouts. Some suggest temporary price controls through early 2003. While that may get us through the next election, temporary price controls have rarely stayed temporary, nor have they worked. President Nixon's wage and price controls, oil price controls in the 1970's, and rent control in New York City are just a few examples of temporary fixes that lasted far longer than intended and actually did more harm than good. And governments do not have very much credibility with investors when it comes to talk about temporary price controls. Many economists, including two that we will hear from here today, believe that introducing price controls into the current situation would do more harm than good. Setting price controls could provide a disincentive to new generation and drive suppliers to other markets, creating more shortages and blackouts over the summer. In addition, it is difficult to know how workable these solutions are. One option which will be discussed today is a cost-based price control. Under this scheme, government officials would set plant-by-plant price rates which are unrelated to the marketplace. This raises a host of practical implementation problems given that there are hundreds if not thousands of operators providing power in the Western energy market. In addition, if you only impose price controls on investor- owned power, then half the electricity in the Western market escapes. That creates market distortions and loopholes for evasion. And with regard to the possibility that by delaying FERC action we are in some way delaying reform in other States, my concern is we may set back the case for real reform if we lead other States to believe they can take the same measures that California did and FERC will come in and bail them out. What FERC has done is to institute a market-based price mechanism on price levels during level one, two, and three emergencies within the State. Since that order, prices have dropped below $100 per megawatt hour for the first time since the crisis began 1 year ago.\1\ FERC has taken action, and that may be working. However, the State of California has a responsibility, too. If the governor truly believes that price controls are the answer, he has the authority to set the price that the State will pay. He can also take steps to fix the broken system in his State to prevent these types of problem in the long run. --------------------------------------------------------------------------- \1\ Chart entitled ``California Day-Ahead Power Prices,'' appears in the Appendix on page 551. --------------------------------------------------------------------------- I look forward to hearing from our witnesses today as to what possible solutions there are for the problems in the West and what the Federal Government could and should do. Thank you Mr. Chairman. Chairman Lieberman. Thank you, Senator Thompson. When we put out a notice that we were going to convene this hearing, we had a request from three of our Senate colleagues to testify, Senators Boxer, Craig, and Feinstein, and two of them are here and I would like to call on them and ask them to begin their testimony. And I believe Senator Feinstein may be on the way. Why don't you come to the table? Let me also note the presence here in the room of Congresswomen Jane Harman and Anna Eshoo. These members of the House serve on the House Energy and Commerce Committee and have been very involved in fashioning a response to the crisis in their State. Obviously, this is a topic of enormous importance to the people of California, and the presence of these two distinguished colleagues from the House testifies to their very deep and active interest, and I thank them for being here. Senator Boxer. TESTIMONY OF HON. BARBARA BOXER, A U.S. SENATOR FROM THE STATE OF CALIFORNIA Senator Boxer. Thank you Mr. Chairman. I want to give the largest thank you to all of you, Republicans and Democrats alike, from my constituents, 34 million of them in California. This is really the first hearing we have had on our emergency situation. We have had emergencies before. We have had earthquakes, floods, fire, and everything else, and you have always been there for us. This one took a little longer because it is not as obvious an emergency. But trust me, it is an emergency. So thank you very, very much. Today you are going to hear from economists about the cost- based pricing. I give it another name, Senators. I call it anti-gouging pricing, and I hope you will think of it in that light. And I called for such pricing by FERC last August, and last September I introduced a bill with Representative Filner of San Diego. Those are the people that felt this first. We called for such pricing. California is facing price gouging by the electric generators. The generators' profits increased on average by 508 percent.\1\ I have a chart here. We go through the various large generating companies. We average them out at 508-percent increase, and at that time that they were making the 508- percent average increase, demand was going up by 5 percent. So, Senators, I have to tell you, when you see this, it makes your stomach turn. --------------------------------------------------------------------------- \1\ Chart entitled ``The Big 5 Energy Generator's Profits,'' appears in the Appendix on page 552. --------------------------------------------------------------------------- I have to also tell you one of these companies, who was just advertising in Roll Call and all the other--the New York Times--I have a copy of the advertisement here. I want to just hold it up. It is bragging about keeping the lights on in California, reliant energy. Their profits went up, Mr. Chairman, 1,685 percent during that period. This is the ad. It says, ``Helping California keep the lights on, reliant energy.'' What they did not say is ``and gouging California consumers at the same time.'' They left out that part. It is very, very disheartening and discouraging. One of the primary causes of price gouging in my opinion-- and I leave this to you to ponder--is the generators' holding back supply. So when you talk about a free market, I say to my friends, you cannot hold back supply if it is really a market that is working. We will show you this amazing chart.\2\ The blue shows you how much power was taken off-line for maintenance last year. And this is how much power was taken off for maintenance this last year, current year, in the yellow. It is hard to imagine that suddenly you would have this great disparity in how much power has to be pulled off-line. --------------------------------------------------------------------------- \2\ Chart entitled ``Closed for Maintenance?'' appears in the Appendix on page 553. --------------------------------------------------------------------------- I am going to be quick--because I know you have so many folks--and make a couple more points. If the average price of milk went up the way the average price of electricity went up, we would be paying $190 a gallon for milk from $3. I want you to think about that. It is just stunning. And I want to leave with you this point, Mr. Chairman, and your Ranking Member and all of you good Members who care a lot about people. We are getting letters from businesses. I have a letter from John Odaman of San Marcos, California. He wrote to President Bush and sent me a copy. He said, ``I am a father and a husband in a single-income family. My wife and I very carefully planned our family economics in order to give our daughter the benefit of having a full-time parent at home. We are currently spending money on electricity bills that should be going into family investments for college and retirement planning.'' Mr. Odaman and other Californians have less disposable income. I have other letters. I have another letter from a California farmer, Ann Zack. Ms. Zack wrote to me asking for help. She writes, ``Our family has owned and operated an alfalfa ranch since 1965. Our crop is irrigated in the summer with water pumped from wells by electric pumps. We have been informed by Edison that our power rate will double this summer, will possibly be raised beyond that in the future. Since we have narrow profit margin''--their profit margin is not 508 percent, Mr. Chairman--``this will effectively put us out of business.'' So my question to you is: How can these electric generator executives go to sleep at night? I honestly to God do not know. They are hurting real people. This is not right. We all want our businesses to operate at fair profits. God knows that is the essence of our system. But gouging is something that must be stopped. I met with the Vice President yesterday. It was a cordial meeting, Mr. Chairman. We did not make too much headway on this issue of caps, but I hope he will rethink it, and I hope that you will help us by getting FERC to understand that their job is to protect us from unfair and unjust and unreasonable prices and to stop the gouging now. Thank you, Mr. Chairman, for your concern about California. Chairman Lieberman. Thank you, Senator Boxer, for your concern and for your testimony this morning. Chairman Lieberman. Senator Craig, we just had the second run of bells goes off, but we have got a good 8 to 10 minutes left. Thanks for being here this morning. TESTIMONY OF HON. LARRY E. CRAIG, A U.S. SENATOR FROM THE STATE OF IDAHO Senator Craig. Mr. Chairman and Members of the full Committee, thank you very much for an opportunity to come and visit. This is the fifth hearing on the California energy crisis I have participated in since it began well over 6 months ago. I also asked for and convened a hearing of FERC in Boise of the 11 Western States to examine what is truly a broken energy system in the West. So it is not the first time that the Congress has focused on--and I am guessing it will not be the last time that we will focus on this issue. But my message today, Mr. Chairman, is that with the energy crisis in the West, we pay closer attention to the facts and move away from a great deal of the political myths involved. There has been much too much distortion and rhetoric in this debate. In part, I guess it is understandable. Like other serious and complicated problems we face, the Western energy crisis is laced with both emotion and I believe now some partisanship. This is clearly evident in the statements on the crisis of high prices that have been charged for the wholesale electricity in California. In this debate, Mr. Chairman, there have been many for their own purposes engaged in what I believe is an intentional distortion and misstatement of the facts. They say that there is no lack of supply in the West. They say that there are plenty of power plants and transmission lines to meet all of the demands for electricity. And they say that small groups of companies, based primarily in Texas, have conspired to withhold electricity from the market in order to drive prices up to an unreasonable, indeed unconscionable level. It is they who are, I think, the unconscionable crowd in this rhetoric. They are either unconscionably ignorant because they have not looked at the reality of what is going on out there, or they are unconscionably and deliberately distorting facts. Now, Mr. Chairman, in all of these kinds of situations, I think we have some who are always in search of a conspiracy. And as you know, Mr. Chairman, conspiracy theorists are always around at the right time, despoiling and oftentimes using public discourse in a variety of critical ways. Conspiracy theorists reject what most of the rest of us view as plain and real. Instead, they search and usually find villains and conspirators. Some of these conspiracy theorists engage in the craft full-time. I must tell you that, as I have listened to the rhetoric of the Governor from California, I am frustrated in trying to understand where he is. Since 1990, there has been a 26-percent increase in the demand for electricity in the State of California. During that time, not one major new power plant was constructed. I repeat, not one. Even Governor Davis, who has led in what I believe is misdirected and politically inspired assaults on independent generators in his own State, has repeatedly alluded to the fact that California has been derelict in new generation. In other words, it appears that he is working full-time to be on both sides of this issue. Governor Davis in a prime-time speech delivered last spring said that the major problem facing the State in this crisis was a lack of available generating capacity. Despite a chronic shortfall in electrical capacity to meet peak demands, Californians have until recently been able to get bailed out of their blackouts and their price spikes, and here is why. They have relied on the hydro power of the Pacific Northwest, but now, as you mentioned, and as I think Senator Thompson mentioned, the Pacific Northwest is suffering from what is probably the worst drought since 1930. Our reservoir levels are the lowest since the 1930's. In addition, the economic growth in the Pacific Northwest, in Arizona, and in Nevada have caused power plants in these areas to dedicate more of their output to their own localities and less to California. To be specific, peak summer demand in the West has increased at an annual rate of 8 percent in Arizona, New Mexico, and Nevada, 3.2 percent in California, 2.8 percent in the Rockies, 2.4 percent in the Pacific Northwest. Yet, from 1991 to 1998, the growth rate of new generation capacity additions in that whole region was less than 1 percent. All of these factors have resulted in a stark exposure of the electrical supply deficiency within California. California has been subsisting off the surplus of its neighbors, and now those neighbors have no surplus, and they have to take care of their own. Another important part of the reality in California has been the high prices of natural gas and of securing necessary emissions credits. The cost of both have soared through the roof. The reality of the charts that have just been shown in many instances are real. This has created enormous upward pressure on the price of electricity and generating capacity of old gas-fired plants. A shortage of electrical generating capacity, a regionwide drought causing reduction in imported power and high natural gas and emission credits, these are all fundamental causes of the electricity crisis. Any of these factors could cause or would have caused the problem. All of them combined have probably crippled the market. Now, I believe that is the big picture, Mr. Chairman, and frankly I believe that is the true picture. How do we deal with it? And that is, of course, part of what you are looking at today. And how do we deal fundamentally with our electric and gas utilities? I know now that the spot market in California is lower than the long-term contract prices that Governor Davis negotiated. Why? Because California recently began to expose the consumer in California to the real market price and the consumer in California began to make real choices. It is also happening across the West as our power rates go up. Is conservation the only solution to our problem? Absolutely not. But there are no blackouts in California at this moment, and one of the reasons why is that there is an 11 percent conservation that has now taken hold in the State of California. The major utilities of California have stated that during deregulation, conservation almost stopped altogether because the consumer knew the price was fixed. Those were the realities of the situation. Chairman Lieberman. Senator Craig, forgive me. We are down to about 2 minutes left on the vote. Senator Craig. Then I will conclude. I must tell you that Governor Davis has moved swiftly. While I criticize him, I must also recognize the fact that 5,000 new megawatts of power are going to come online next spring in California and 5,000 within a year, and that is an effort at reducing and changing regulation and process, and the governor ought to be applauded for that. Let me quickly refer to FERC and what I think FERC is doing now in a very responsible fashion. Out of the Boise hearing came the new order, and that new order largely says all of those in the market have to supply capacity to that market on a full-time basis. That has helped bring those prices down. Satisfying political preserve by choosing price caps, is not a way to fix the market. Investment is rushing to California at this moment to supply a need. They are rushing there because they believe the market is becoming more free and will be allowed to operate in a more unfettered fashion. Let me ask that you allow to be part of the record an op-ed by Robert Samuelson this morning in The Washington Post. I would recommend it for your reading. It is called ``Short- Circuiting Supply and Demand.'' \1\ --------------------------------------------------------------------------- \1\ The article referred to by Senator Craig appears in the Appendix on page 554. --------------------------------------------------------------------------- Chairman Lieberman. Without objection. I have noticed that the Ranking Member has been reading that op-ed here at my side this morning. I thank you Senator Craig and Senator Boxer. I think the two of you in some ways have framed the discussion that will go on here in the coming weeks. We are going to recess now. We will come back and hear Senator Feinstein and then proceed with the witnesses. Thank you. [Recess.] Chairman Lieberman. The hearing will reconvene. I apologize to our witnesses and others here for the interruption which was necessitated by two votes on the floor of the Senate. We are privileged now to have the third of our colleagues who asked to testify before this hearing and lead co-sponsor of the legislative proposal responding to the price crisis in California and the West, Senator Dianne Feinstein. Thank you for being here. TESTIMONY OF HON. DIANNE FEINSTEIN, A U.S. SENATOR FROM THE STATE OF CALIFORNIA Senator Feinstein. Thank you very much, Senator Lieberman, and Senator Collins, and I saw Senator Carper. He is over here. I want to thank you for this opportunity. I have been carefully watching as a member of the Energy Committee now what has been happening with the deregulation in California, and I have watched the problems spread to seven other Western States. So California is no longer alone. I must tell you, Mr. Chairman and Members, that I have really come to question whether deregulation of electricity and natural gas can work. You know, when we deregulated airlines, individuals had a choice of airlines. If they did not like one, they could go to another. When we deregulated telephones, individuals had a choice. If they did not like one service, there was another. In the area of natural gas and electricity, the consumer has no choice. You get your bill. You cannot change companies if you do not like it. What I have also seen is that it is a broken market, caused in part by California's not having adequate generation. However, having said that, I have got to make a point. Californians have been conserving. In January, the State consummed 5 percent less energy than the previous year. In February, the savings was 7 percent. In March it was 9 percent. And in April, Californians saved 7 percent. The energy savings last month was 11 percent, and the cost of all electricity for California in 1999 was $7 billion. The cost in 2000 was $28 to $30 billion, and the costs this year are predicted to be $50 to $65 billion. In that milieu, you have had two big investor-owned utilities, the middlemen, buying the power on the wholesale market, selling it to the consumer, go into bankruptcy. One is in bankruptcy. Southern California Edison, if it does not work out an arrangement with the State, will be in bankruptcy. And you have the State so far this year having spent $8 billion buying electricity to try to keep the price low. As recently as 2 weeks ago, electricity prices in California were almost 10 times higher than they were a little more than a year ago. Now, the Federal Power Act clearly states that if FERC, the Federal Energy Regulatory Commission, finds prices to be unjust and unreasonable, FERC must regulate and set those rates. They did find the rates unjust and unreasonable last November. They have really refused to move aggressively to set those rates, and I and many other Californians have tried to sound a consistent drumbeat to move to do that. In late April, FERC issued a limited--what is called price mitigation order, which would cap wholesale costs during stage one, two, and three emergencies. And it now appears that on Monday, FERC may extend this order to the entire Western energy market and may ensure that the order stays in place at all times--in other words, going to 24 hours a day, 7 days a week, and requiring power generators in the entire Western region to sell electricity back into the grid. That is another step forward. The question I have about it is manipulation. Because this is tied to the least efficient megawatt, so it is tied to the dirtiest, most polluting plant. Now, I ask this question: Is that then an incentive to keep dirty plants in order to drive up price and produce profitability for clean plants? And we are going to have to see. I called the head of the independent systems operator-- known as the ISO--yesterday, Terry Winters, and he agreed that this could be manipulated. He agreed that we do not have enough information yet to know whether, in fact, the acute drop in prices over the past week or so is a result of the April FERC order, whether it is a result that the generators now feel that the heat is on, whether it is a result of the Senate having changed power, whether it is a result that Senator Smith's and my bill now has a markup date in June which would set Western regional caps, we do not really know yet what the case is. But we do know a couple of things, that just a few days ago one generator admitted to selling electricity into California at $3,000 a megawatt hour, 5,000 megawatts at that price, and that another generator fessed up to $1,900 a megawatt. So what we still have out there is a ribald, unregulated marketplace. The natural gas issue has been an interesting one because natural gas is three times higher in California than anywhere else in the United States. FERC is looking into this. There is no transparency when it comes to natural gas. It is very hard to tell what is going on. But when you have three times the price, when the transportation cost of natural gas should be between 50 and 70 cents a decatherm and the gas is selling, instead at $3 or $4, $12 to $15, you really come to question what is going on. Let me give you a couple of examples of what has happened. We have one sugar refinery in my backyard. It is in Crockett, California, C&H Sugar. They employ about 1,200 people. Their normal cost of natural gas to produce steam is $450,000 a month. It has risen to $2 million a month. They have had to lay off people. They have had to close down the plant. They have had to try to get bridge financing. I can tell you about California steel industries with the costs escalating literately millions of dollars. Now, that is not restaurants. That is not others that use electricity as well. You should know that yesterday the Attorney General of California announced that he will convene a criminal grand jury to investigate whether power generators illegally manipulated energy prices. The investigation will begin shortly after July 1 when a new 19-member Sacramento County grand jury is seated. As Mr. Lockyer said, this does not indicate we have reached a conclusion. It is a process to get at the truth. This is the beginning of the criminal focus. So the belief is among many of us--and I am one--that the generating community has made use of the problems in California, quite simply stated, to manipulate the market and gouge prices. John Bryson, CEO of Southern California Edison, testified before the Energy Committee, in answering a question of mine, that when they divested of generating facilities and sold those facilities to out-of-State generators, I asked this question: What were you selling a megawatt hour power from the facility when you owned it? The answer was $30. Then the next question was: When it was divested, what did the company that took over ownership charge? The answer was $300 a megawatt hour. So, in other words, power that had been selling at $30, when the facility was sold, they had to buy that same power back at 10 times the price. One of the reasons they are close to bankruptcy today. I am sure Senator Craig mentioned the concerns in Idaho. I am sure Senator Burns and others can mention the concerns in Montana where you have got a mine closing where people are losing their jobs, and in these seven Western States where it is anticipated that there will be rate increases from a low of 14 percent to a high of over 100 percent. So the situation is changing dramatically and I thank you, Mr. Chairman. I wrote you a letter urging that you take a look at some of the relationships between the big generating companies and the regulatory agency that is supposed to be regulating these very companies. We see no semblance of really meaningful regulation yet, and particularly in the area of natural gas, there is very deep concern. My bill will be marked up, I believe, on June 27. Whether we can get it to pass the Senate or not, let alone get it to pass the House, I do not know. I should tell you, when Senator Smith and I went to see Congressmen Tauzin and Barton, they were not very sympathetic. I now think that is changing in the House, and instead of the word ``control,'' the word ``mitigation'' is being substituted. Whatever you call it is fine with me, as long is it works. Thank you very much Mr. Chairman. Chairman Lieberman. Thank you, Senator Feinstein, for very thoughtful testimony. I want you to know that we are in receipt of the letter you referred to, and we are looking into the questions that you have raised. I am going to call now on the panel of economists who I think will begin to answer some of the questions that Senator Feinstein and others have posed. We have a very distinguished panel of economists who were asked both by myself and Senator Thompson, and I appreciate the trouble that they took to come and be with us. I have read the papers they submitted. In my opinion, though they are more accustomed to grading than I am, they all deserve high grades. They are very thoughtful and very thought-provoking. It had been my intention to call people in alphabetical order, but since this is the Senate where we follow the seniority rule, I wonder if his colleagues would mind if I call Dr. Kahn first. Mr. Kahn. No one is more senior than I, sir. Chairman Lieberman. Well, we do have Senator Thurmond here. But among the witnesses you are definitely the most senior. Dr. Kahn has certainly been, I guess I would say, if you will allow me the liberty, the father of the modern deregulation movement in our country, perhaps best known for his work as Chair of the Civil Aeronautics Board during the 1970's. He is currently a professor emeritus of political economy at Cornell University, and I am delighted that he was able to be with us today. We are going to run this clock and ask you to try to stay within 5 minutes for your opening statements, although your full statements will be entered into the record. And then it will give each of my colleagues here an opportunity to engage in discussion for a greater period of time. Dr. Kahn, thank you for being here. TESTIMONY OF ALFRED E. KAHN, PH.D.,\1\ ROBERT JULIUS THORNE PROFESSOR OF POLITICAL ECONOMY, EMERITUS, CORNELL UNIVERSITY Mr. Kahn. Thank you, sir. It is an honor to be here. I should begin by recognizing that the only reason I am here is that I did play an important role in deregulating the airlines, trucking, railroads, and telecommunications, and I do not offer myself as an expert on the electric power industry. In point of fact, I have tried to stay away from the electric one because it frightened me. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Kahn appears in the Appendix on page 191. --------------------------------------------------------------------------- I agreed partly because there are around me people who know much more about the electric industry generally, and, after all, one of them is a former student of mine, so he has been very well trained, and I urge you to listen to him carefully. Just one other introductory remark. The discussion of the California situation has become so deplorably simplistic, if not ideological, and again I am hoping that by my having decided that I wanted to subscribe to the letter that Professor Wolak started, that we can de-ideologicize it, if you will, and I have all sorts of examples that I would be happy to cite, but I am not going to waste your time because you have encountered them as well. I think perhaps I will merely quote that eminent economist William Safire, who referred to ``the demagogic call for energy price caps, always politically satisfying, populist interference with the market's self-correction that would lead to worse shortages and rationing, to inflation and wage control.'' I suppose Mr. Safire deserves a good grade for the first 2 weeks of elementary economics, but from there on he flunks. I hope he, however, and others like him will be satisfied that all the sybarites in California with their hot tubs and the politicians and militant consumer advocates who promised them the benefits of free markets but without the risks of being exposed to the free market--I hope the opponents of putting caps on will be satisfied that those parties have been sufficiently rewarded for their opportunism. I have in a paper I have written--and, in fact, Paul did the same--about the opportunistic nature of the move for deregulation. Nobody was in favor of deregulation of electric power in the 1950's and 1960's when real rates went down. No one was in favor of deregulation in the 1970's and 1980's when it looked clearly as tough regulation was holding rates below competitive levels. It only became a bonfire movement when in the middle 1990's, because of mistakes that had been made in the past, it looked as though prices would go all the way down. Of course, we should have realized that since the big errors were made in the past, we should have realized that this one, too, was based on an unrealistic assessment of the future. But, in any case, here we are in the situation that has been described so well by other people, and moving beyond the first 2 weeks of Economics 101, let me just mentioned the factors that have induced me to sign on to this letter, apart from the fact that I have great confidence in the other people who signed. First, when you have extreme inelasticity of supply and demand, when prices can go up 5-fold, 10-fold, 15-fold and not induce a substantial response in demand, very largely because these prices operate in spikes by particular times of day and particular days of the year, and consumers do not have meters that tell them those prices. So demand is highly inelastic. But, similarly, when you have a highly inelastic supply, you reach a certain point, if you look at Severin Borenstein's figures at the end, where supply just suddenly turns vertical, and you do not get any more supply as the prices double, treble, and quadruple. Markets do not work very well, to put it mildly. And that leads me to the second point that everybody who talks about wage and price controls in the past or caps in the past have interfered with supply, and there is a letter by some very eminent economists who apparently know even less about the electric power industry than I, who say there are all sorts of plants, higher-cost plants that will come online as prices go up. I ask you to pose that question particularly to the people who know what is going on in California. It is simply not true. The supply--no matter how inefficient the plants, there is ample reason for them to be operating if the price gets above the incremental cost of operating, and yet we have a virtually totally vertical supply curve. In those circumstances, this equilibrating character of free markets just doesn't work very well. Third, it is true that the elasticity response was prevented by the ridiculous freezing of retail prices. That was one of these cases of ``we will give you all the benefits but you will not have to bear any of the risks.'' And the increases that have come since have been grudgingly inadequate. But since the extreme shortages, producing 10-, 20-fold increases in wholesale prices, have been the spikes and consumers do not have meters that tell them when those spikes occur, you are not going to get the demand response. And, therefore, you can say, well, you would not have blackouts if you let the price go up to whatever extent necessary, but that extent necessary is reckoned in terms of not doubling but increasing 10-, 20-, or 50-fold. Then you have to say as against the possible benefit of a 10-fold increase in prices in getting a better balance of supply and demand, you have to realize, first of all, the income distributional consequences of that and, second, the macroeconomic consequences. I had the misfortune to be adviser to President Carter on inflation just when we had the increase in OPEC prices from $10 a barrel to $40 a barrel on the East Coast, and we know that that extraction of those dollars from the pockets of consumers had a major role in promoting the stagflation from which we were all suffering. Well, look at what is happening to the California economy and the widespread distress that it is causing to a lot of innocent people, without eliciting increased supply, without bringing about re-equilibration. Fourth, the spectacular cases in history where price controls have done more harm than good cited by all the opponents, and correctly so, particularly in the 1970's when we held the price of crude oil below marginal costs--marginal cost was the cost of imports, and so we held the domestic prices below that. Of course, that interfered with supply, and the same thing was true with the case of caps on the price of natural gas. That clearly did interrupt supply. But the notion that caps automatically interfere with the increase of supply in the electric industry is absurd. It ignores the whole history of regulation. Look at my ``Economics of Regulation.'' There must be 50 pages on the fact that regulation of the electric industry through this entire history has not interfered with expansion of capacity. The major criticism has been that it has led to overexpansions of capacity because it guaranteed the investors a return on their capital and they made money by investing more. So it is simply historically incorrect that regulation, recognizing the full costs of additional capacity, necessarily interferes with supply. Moreover, one can make certain of that. The problem is that we are not going to get any new plants for 2 or 3 years. Make the caps temporary. Make them automatically sunset in the 2 to 3 years. Make them not apply to new power. There is no shortage of people interested and willing to build new power plants, and for that they do not have to have $1,000 a megawatt or $1,500 or $2,000 a megawatt. That is Economics 101.1, and I wish Mr. Safire would come back and learn it. So we must not interfere with the fundamentally required correctives. We must press ahead with time-of-day metering or something like that. We must be willing to let retail prices go up more than the grudging amount by which they have. But where the demand and supply response takes years, it is simply sadistic to insist that elementary economics tells you that price controls do not make any sense. Thank you. Chairman Lieberman. Thanks, Dr. Kahn. You got us off to a very good beginning, a provocative beginning. Dr. Severin Borenstein is a professor of public policy and business administration at the University of California's Haas School of Business. He has focused on electricity deregulation, market formation, and competition. In addition, he is the director of the University of California Energy Institute and a member of the Governing Board of the California Power Exchange Corporation. So he is right in the middle of the California crisis. Thanks for being here, Doctor. TESTIMONY OF SEVERIN BORENSTEIN, PH.D.,\1\ DIRECTOR, UNIVERSITY OF CALIFORNIA ENERGY INSTITUTE AND E.T. GRETHER PROFESSOR OF BUSINESS ADMINISTRATION AND PUBLIC POLICY, BERKELEY'S HAAS SCHOOL OF BUSINESS, UNIVERSITY OF CALIFORNIA Mr. Borenstein. Thank you, Senator Lieberman. I just want to start out by talking for a few seconds about how we got here, into the crisis that California now faces, and understanding what the problems are and, more importantly, what the problems are not. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Borenstein appears in the Appendix on page 194. --------------------------------------------------------------------------- There is no question that demand has grown rapidly in the Western United States and that we are now in a situation where there is a real tight market in the entire Western grid. There is also no question that that creates a real supply-demand mismatch. That has two effects. One is the effect that you learn in the first 2 weeks of Economics 101, which is when demand shifts out and supply does not keep up, the price goes up. The second effect, which is just as easy to understand if you sat through the first 6 weeks of Economics 101, is that when you are a seller and you are in a market where there are few substitutes for your product on the demand side and the other sellers are unable to expand their supply because they are already at capacity, you can raise your price without losing much in sales. Economists do not call this market manipulation. They call this exercising market power. This is not illegal under U.S. antitrust laws, and it is, in fact, what businesses do. When Microsoft decides how much to sell its software for, it is not basing it on its cost. It is trying to figure out how much money it can make, how many sales it will lose as it raises its prices. That's what the sellers in the California electricity market are doing. The problem is that we have set up a market where they can raise prices quite a bit without much demand response at all and, because of the technology of electricity, without other sellers able to expand their output. Let me address two myths about how we got into this. The first myth is that the California crisis is the result of rabid environmentalism in California that blocked the building of new power plants. There is a lot of environmental consciousness in California, and there is no question that the permitting process in California takes a bit longer than it takes in most other States, on the order of months. But this is not a case that California just closed its eyes and refused to build new power plants when they were necessary. The reason no new power plants were built or started between 1995 and 1998 is because nobody applied to build new power plants during that time. And they did not just apply in California. They did not apply in Arizona. They did not apply in Nevada. They did not apply in Montana or Wyoming or the other parts of the Western grid. The fact was that the sellers in the Western grid in 1996, 1997, and 1998 believed that the prices in Western United States were going to be low, that there was not going to be a shortage, and that there was not going to be a need for this capacity. They did the economic calculation and they found out that it did not make sense to build power plants at that time. By late 1998, they figured out they were wrong. Demand was growing and we were facing a tighter market. By the way, most of the demand growth was not in California. It was outside California, but it was all part of the Western grid. And so the market tightened up, and at that point there were plenty of applications. Firms started building power plants. They started trying to get power plants sited. Unfortunately, the process of getting from starting to build a power plant to having the power online is a 4- or 5-year process, and that is why we are still 1 or 2 years away from solving that problem. The second myth is that wholesale price caps caused these problems in California. California has had wholesale price caps. They were at $250 throughout most of the market. They were $750 for a period from October 1999 to June 2000. They were not frequently hit, and during that time, if you look at the rate of return on owning these power plants, it was astronomical. These firms have made plenty of money. There was no period essentially until November 2000 where you could possibly argue that the price caps actually deterred production. In November 2000, we actually did see this happening. In November 2000, the price of natural gas skyrocketed in California, and there was a period of time where it cost $400 to buy the gas for which you could then sell the power for $250. That is the bad old problem with price caps. That is exactly what we had in natural gas. That is exactly what we had in gasoline in the 1970's. That is the danger of price caps. It can happen. But prior to that, it did not happen and suggesting that firms were not building plants or firms were not producing from those plants is just not supported in the data. So California now faces two issues, and I think it is important to keep the two issues clear and separate from one another. California and the entire Western grid faces a longer- run problem of building power plants, of getting investment in the West. The market is solving this problem. I think this really is not a major issue. This is the problem of power in summer 2004, and I think the problem of power in summer 2004 is going to solve itself. The question we are facing now is the problem for power in summer 2001, and telling California at this point to build more power plants is not a solution to that problem. Power plants are not going to get built for this summer. There are only two areas where California can help itself or be helped to get through this summer. One is conservation, and the State has been way too slow to get its conservation plans going. They are now moving on them. We have been way too slow to get real-time pricing in place so that particularly large commercial and industrial consumers would actually see those high prices on hot summer afternoons and would have an incentive to scale back their consumption. We have not sent price signals and we have not done enough to encourage voluntary conservation. We are moving. We are getting some results. We need a whole lot more results to get through this summer without a major economic crisis. The other area is the area of price controls. As Professor Kahn said, price controls can be used in a way that would prevent a massive transfer of wealth from consumers to producers without having the adverse effects. The idea of dismissing price controls because they were used, frankly, extremely badly and without much analysis in the 1970's is as silly as the idea of dismissing electricity deregulation because California electricity deregulation has gone awry. Price controls can be used well and carefully. It has to be done extremely carefully. And electricity restructuring can work successfully. We cannot dismiss it based on California's bad experience. However, I have to say, listening to some of the testimony this morning reminds me of the dangers of price controls. That is, once we go down this road, we are going to have to be careful to recognize what price controls do effectively is control market power. What price controls do in a damaging way is attempt to just control the transfer of wealth in a regular competitive market. In the 1970's, we tried to control that transfer of wealth in a very competitive market, and we ended up completely screwing up the market and causing shortages. What we need is the analytic capability to tell the difference. Unfortunately, the Federal Energy Regulatory Commission, which came into this deregulation as a legal-oriented process, has not shown the policy skills to do that sort of analysis and as a result has been blindsided by a lot of the economic operation of this market. I think if they had the policy skills to do it, they could implement price caps in a way that would be very carefully done, that would not solve all of the problems--a lot of the problem is a real shortage and real scarcity--but that would solve a significant amount of the problem without causing the sort of damage that price caps did cause in the 1970's. Thank you. Chairman Lieberman. Very interesting. Thanks, Dr. Borenstein. Dr. William Hogan is a professor of public policy and administration at Harvard's Kennedy School of Government, also a research director for the Harvard Electricity Policy Group, which is exploring the issues involved in the transition to a more competitive electricity market. Professor Hogan has also held positions dealing with energy policy analysis in the Federal Energy Administration. We are delighted to have you here, and I look forward to your testimony now. TESTIMONY OF WILLIAM W. HOGAN, PH.D.,\1\ PROFESSOR OF PUBLIC POLICY AND ADMINISTRATION, JOHN F. KENNEDY SCHOOL OF GOVERNMENT, HARVARD UNIVERSITY Mr. Hogan. Thank you very much, Mr. Chairman. I have a prepared statement which I would like to submit for the record, but in the few minutes that are available I will summarize the highlights of the initial points I would like to make. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Hogan appears in the Appendix on page 200. --------------------------------------------------------------------------- I would emphasize three ideas. First, echoing the comments of my colleague, the diagnosis of what the problems are in California should be the first thing we do in order to understand the recommended policies, because different diagnoses lead to different policies. Second, I would say a few words about the price caps debate, which I think has motivated much of this hearing and the discussion, and to re-emphasize the theme that the details matter. People are talking past each other on this subject. The third point would be to return to the question of what should be done about market design, which is the long-term and continuing problem in California. I have some suggestions that I will summarize. The problems in California are quite serious, and they had been serious well before last summer. It is not apparently widely known, but the Federal Energy Regulatory Commission found that the many design features of this market were fundamentally flawed, in their words, in late 1999. So this is not a new problem, but it became much more serious when the prices increased. Essentially, because of the problems that developed after the summer and the collapse of the market earlier this year, things fundamentally changed as people stopped paying their bills. Market participants were not paying for the power they were taking. Some of the utilities got in financial trouble. One of the utilities went bankrupt. I think the diagnosis of that problem is widely accepted. This situation was unsustainable and it also tells us what needs to be done to deal with it. First, California should pay its bills in order to re-establish the credibility of transactions. No system can work without creditworthy buyers; and then, further, to provide incentives for conservation, retail prices for incremental energy electricity should be raised to market levels, at least for commercial and industrial customers. Changing the rules and metering to support demand responses would help on many fronts, and I agree with my colleagues on that matter. Other topics are more controversial, about in particular whether or not the principal cause of the high prices is scarcity or the principal cause is strategic withholding by generators in the exercise of market power. There is a debate about this issue, and unfortunately, this is one of the areas where the debate tends to lead to different policies. It is not so obvious what to do. Broadly speaking, I think we are talking past each other when we talk about price caps. I would identify three broad ideas that have been suggested. One is a uniform price cap, just setting a cap on the price that will be paid. Second is traditional cost of service regulation where you have a different cost for every plant and you pay them according to those traditional costs. And third comes what are known as bid caps, where you set limits on what each individual plant can bid. It may be different for different plants in different hours, but then everybody gets paid the market-clearing price. There also is a requirement for people to bid. I will not go into the details now, but I believe uniform price caps would be counterproductive for all the usual reasons. As far as traditional cost of service regulation, trying to reimpose that on the system, it is far from clear how this kind of administrative process could facilitate the market or be implemented in a way that would not exacerbate the immediate problems in the West. However, to the extent that the problem of high prices results from withholding of supply in order to raise prices, the better solution would be to go to the bid cap approach, which is already in use in other parts of the country as authorized by the Federal Energy Regulatory Commission in PJM, New York, and so on. Under a bid cap generators are required to bid and they cannot bid more than a certain level, which is related to their cost. But unlike with the price cap, the generators would still be paid the market-clearing price. The requirement to supply works in support of a competitive market and would counteract the effect of market power. On the other hand, to the extent that the problem is scarcity, bid caps will not do much to reduce prices. But if scarcity is the problem, then administrative action to reduce prices would probably make conditions worse, not better. If we are going to intervene, the best of this bad bargain would be to do so with bid caps. This is basically the direction that the Federal Energy Regulatory Commission went to at the end of April with the order that they presented at that time. And I think that is the right direction. There are some fixes that you could put that to make it work better but, nonetheless, I think basically what they are doing is in the right direction. The problem that I emphasize in my prepared remarks is not dealing with the symptoms of prices and rolling blackouts. The problem that I would emphasize is that the Federal Energy Regulatory Commission has not gone far enough or fast enough in dealing with the market design problems, how to change the basic rules of how the market operates in the West. The details I summarized in my prepared remarks reduce to a simple prescription. Namely, the market for the West should be set up to emulate that which is working so well in the East, in the PJM system, in New York, and is soon to be adopted in New England. These systems are not perfect, but they are the best systems that we know about, and they are much different than what California adopted. Market design is not necessarily the cause of the high prices, but it constitutes another set of problems which are fundamental and have been ignored or delayed, as everybody is worried about the symptoms of high prices and blackouts. It is time to move on, because we are running out of time if we want to see electricity restructuring work. Thank you. Chairman Lieberman. Thanks, Dr. Hogan. I feel like I am going back to Economics 101. It has been very helpful, and this brings me logically to Dr. Joskow, who is engaged in teaching and research at the Massachusetts Institute of Technology in the areas of industrial organization energy and environmental economics and government regulation of industry. Dr. Joskow has been focused on the competitive electricity markets for over 20 years and in that time has published five books and over 100 articles and papers. Senator Thompson, in the interest of full disclosure, I do want to reveal that while a graduate student at Yale in 1970, Dr. Joskow was a very important volunteer in my very first campaign for the state Senate. [Laughter.] Is that where you learned your economics? Chairman Lieberman. That is why I mentioned Economics 101. Dr. Joskow, nice to see you. TESTIMONY OF PAUL L. JOSKOW, PH.D.,\1\ DIRECTOR, CENTER FOR ENERGY AND ENVIRONMENTAL POLICY RESEARCH, MASSACHUSETTS INSTITUTE OF TECHNOLOGY Mr. Joskow. Thank you, Senator Lieberman, Senator Thompson. It is a pleasure to be here. Actually, my job on that campaign was to be a poll watcher and make sure that people who died in the past 2 years did not vote. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Joskow with an attachment appears in the Appendix on page 351. --------------------------------------------------------------------------- Senator Thompson. We should have had him for our prior hearing. Chairman Lieberman. You are a very valuable witness in most matters this Committee is interested in. Mr. Joskow. I have a prepared statement that covers a number of issues related to FERC's responsibilities and performance across the country. In my oral remarks, however, I would like to focus on California. The causes of California's electricity crisis are complex, reflecting a combination of bad market design, bad regulatory decisions, unanticipated changes in gas prices and other supply and demand conditions, credit problems, and, I believe, supplier behavior which rationally took advantage of opportunities created by these conditions to further increase market prices above competitive levels. I would like to agree with Senator Thompson. These problems did not start on January 21, 2001. Indeed, they did not start in 2000. The first problems in California's markets began to emerge as early as July 1998, and in my view, the events of the past year were an accident waiting to happen. Some progress has certainly been made in the last year. However, I continue to believe that both Federal and State officials can and should do more to deal with the immediate problems and to make longer-run reforms in California's wholesale and retail market institutions. While wholesale electricity market problems have been most severe in California, they are not unique to California. I think it is important for the Committee to understand that. There have been market performance problems requiring a variety of reforms and mitigation measures in the new wholesale markets in New York, New England, and the Pennsylvania-New Jersey-Maryland pool as well. And this should not be surprising. Electricity has unusual physical attributes that make the design of well-functioning competitive wholesale markets a significant technical challenge. Spot markets perform especially poorly when supplies are tight, demand is completely inelastic, and a large fraction of demand is served out of the spot market. Midcourse corrections have frequently been necessary after competitive electricity markets first go into operation. Price caps, bidding rules, cost-based contracts, and a variety of other mitigation mechanisms have been used and are being used in most new wholesale electricity markets in the United States and other countries. I must say some of the recent discussion about ``price caps'' is a bit of a mystery to me because we have been using them for several years. In this regard, the term ``price caps'' has become so ideologically loaded and means so many different things to different people, I think we should just use a different term. My concern is not that wholesale prices are high per se. My concern is that prices are significantly above competitive levels because of a variety of market failures. What I would like to see is a comprehensive, short-run market failure mitigation program, not rigid uniform price caps, combined with a longer-term program to fix market design and regulatory flaws. You can call it anything you want--price mitigation, since Fred Kahn is here, let's call it a banana. The issue is to move forward. Of course, we need to be sensitive to the possibility that mitigation measures can make things worse rather than better if they are poorly designed. Of course, we want to use mitigation mechanisms that do not discourage new investment in generating facilities. Of course, the proper long-run strategy is to fix the market and regulatory institutions that are broken. But we also must be concerned about the interim cost to consumers and the economy of unmitigated market failures. Despite the recent break in wholesale prices in the West-- and I would be happy to answer questions about that if you have questions--I remain concerned that hot weather plant breakdowns, reduced hydroelectric supplies, and remaining market design flaws are likely again to present conditions that create the incentive and opportunity for suppliers to engage in behavior that increases prices significantly above competitive levels this coming summer. It is this potential problem that should be the focus of immediate mitigation efforts while we continue to focus on longer-term fixes. As Senator Thompson observed, the summer is now upon us. The practical mitigation options for this summer are, therefore, quite limited. FERC did put in place a supply and price mitigation protocol in California on May 29, and I will not call it price caps, price mitigation. Let's see if we can build on it. I would like to see FERC extend the number of hours to which these mitigation rules apply to all summer hours, 7 by 24. I would like to see it identify and close remaining loopholes available to re-sellers, and I think very importantly to find ways to integrate suppliers in other Western States into this mitigation program. I do not think this is going to be easy. I do not think it will be successful if FERC follows its usual course in applying these mechanisms. But I think it can be done if FERC staff and the control area operators in the West work together to make it happen. I also would continue to urge California officials to continue their efforts to remove unnecessary barriers to the construction of new generating plants, if any still exist, to raise retail prices to reflect wholesale market prices, to implement real-time pricing, to restore credit to the system, and to continue energy efficiency and conservation efforts. Thank you. I would be happy to answer any questions you have. Chairman Lieberman. Thank you, Dr. Joskow. Thank you very much. Right on time, too. Dr. Lawrence Makovich is senior director of Cambridge Energy Resource Associates, an energy consulting firm started by Daniel Yergen, who many of us have been pleased to know and worked with over the years. Dr. Makovich is an expert on electricity markets regulation, economics, and strategies, the author of several reports and articles on the future of the electric power business, and a lecturer on managerial economics at Northeastern University's Graduate School of Business. A pleasure to have you here. Senator Stevens. Mr. Chairman, do we have a copy of his statement? Dr. Makovich. I did submit a copy of the statement, yes. Chairman Lieberman. He did. We can get you one. Go right ahead, Dr. Makovich. TESTIMONY OF LAWRENCE J. MAKOVICH, PH.D.,\1\ SENIOR DIRECTOR AND COHEAD, NORTH AMERICAN ENERGY GROUP, CAMBRIDGE ENERGY RESEARCH ASSOCIATES Mr. Makovich. Power prices in California are too high because the power market has a real shortage caused by serious structural flaws in the market design and in its implementation. California did not follow the example of other power markets that use rules to create a market for capacity. In addition, California's complex siting and permitting processes have created formidable barriers to the development of new generating capacity that the State so badly needs. Quite simply, California ran out of capacity because it did not set up a market to pay for it or a process to enable it. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Makovich appears in the Appendix on page 365. --------------------------------------------------------------------------- A third flaw in the California market design was the use of price caps in retail power rates. As scarcity drove up wholesale power prices in 2000, the majority of customers in California continued to consume power at price levels frozen at 1996 levels. The retail price caps distorted the market by increasing demand and driving price spikes higher. Yet utilities remained obligated to provide all the power people wanted at capped prices. As a result, price caps had the unintended consequence of driving Pacific Gas and Electric, California's largest utility with $22 billion of assets, from an A credit rating to bankruptcy court in less than 4 months. Of course, the bankruptcy also distorted the market by making suppliers reluctant to buy fuel and produce power to deliver to someone who was not likely to pay for it. Price caps, although well intentioned, usually distort the market and create unintended consequences. We have already seen this in California, and the history of price controls is a record of distortion and unintended consequences. Price caps may sound simple in theory, but, in fact, they are anything but simple. The bureaucracy to administer them always becomes many more times complicated than originally expected. Now, many people want price caps because they believe that power suppliers are withholding capacity to drive up prices. If this were true, then price caps would limit their gains. Further, this argument goes, if we could just get them to knock it off, then this artificial shortage would end and power prices would drop back down to reasonable levels. Why do so many people want to believe in market power? Putting the blame on suppliers diverts blame from the basic design flaws and weaknesses in the current California power market. An examination of the California power market does not support the market power hypothesis. Power generators have market power if they can act to set prices; however, high prices alone can occur for many other reasons as well. The California power exchange began operation in 1998. In anticipation of this, we developed a computer model in CERA to analyze the interaction of supply and demand in the determination of prices. When we simulate the Western power markets in 1998 and 1999 and compare the results to the actual market-clearing prices, the evidence is quite compelling. During this period the California power market was in a demand and supply balance, and we observe that wholesale power prices cleared at the level of short-run operating costs--fuel, environmental costs---- Chairman Lieberman. What time periods was that, Doctor? Mr. Makovich. This is 1998 and 1999. Chairman Lieberman. Thanks. Mr. Makovich. Fuel, environmental costs, and other operation and maintenance costs. Over this time frame, the California energy market was doing just what it ought to do: Efficiently determining the utilization of power plants to meet demand at each hour with price signals reflecting the operating costs of rival producers. We must confront the fact that the industry structure that delivered a competitive outcome in 1998 and 1999 did not change in 2000. What did change was the demand and supply balance. Since no significant generation additions were made, demand finally outstripped supply. Any market with a severe shortage of a commodity that customers value highly and have few substitutes for will end up with buyers' bidding up scarce supply--in other words, a shortage or scarcity premium. We must recognize that when supply and demand were in balance, the competitive energy market in California produced prices with a level and volatility that was half of what was necessary to support new power plant development. During 1998 and 1999, the annual wholesale power price of power was between $14 and $30 a megawatt hour. The evidence is clear. The energy market alone in California did not provide a timely price signal for new investment. As a result, the shortage was both predictable and preventable, and as early as April 1997, CERA published a report predicting just that. Other markets have capacity markets along with energy markets--like Texas and New England--and they have been able to attract more than enough power investment in just a few years to avoid similar shortages. We must face the fact that California competes with other power systems around the world to attract power plant investment and price caps discourage investment. Remember, the power business is one of the most capital-intensive businesses in U.S. economy. California remains a highly flawed power market in which the only way to recover costs above short-run operating costs is through a periodic shortage premium. By adding price caps to the current flawed California market design, investors will see no way to recover the full cost of power investment through the market. California cannot afford to continue to bring forth power development by guaranteeing payment through long-term power purchase contracts from the Department of Water Resources. The State's record in long-term power contracting is abysmal. Remember, half the stranded costs in California that drove the State to deregulate were due to long-term power contracts the State mandated under the Public Utility Regulatory Policy Act. California has not fixed its market to create a positive investment climate for power development. To assist California, the FERC should insist on a minimum set of structural elements in its wholesale market design. It will be a mistake to make price caps the centerpiece of a Federal response to the California power shortage. They would make a bad situation worse, and they do nothing to fix the flaws that so desperately cry out for solution. Thank you. Chairman Lieberman. Thanks, Dr. Makovich. Thanks for your testimony. And, finally, Dr. Frank Wolak, whose impressive credentials I will describe now. Dr. Wolak specializes in industrial organization and economic theory at Stanford University where he is professor in the economics department. His recent work studies methods of introducing competition into infrastructure industries and assessing impacts of this competition policies on consumer and producer welfare. Dr. Wolak is also notably the chairman of the Market Surveillance Committee of the California Independent System Operator and, therefore, again, right in the middle of the California crisis. Thanks for being here. TESTIMONY OF FRANK A. WOLAK, PH.D.,\1\ PROFESSOR, DEPARTMENT OF ECONOMICS, STANFORD UNIVERSITY Mr. Wolak. Thank you very much. I would like to focus my remarks on a specific issue, and that is really the design of what I will call--Paul Joskow called it bananas. I will call it regulatory interventions required under the Federal Power Act to protect consumers from unjust and unreasonable wholesale electricity rates. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Wolak appears in the Appendix on page 371. --------------------------------------------------------------------------- First, I would like to state the two goals of regulatory intervention, and then I will briefly explain why I believe that the plan recently implemented by the Federal Energy Regulatory Commission will fail to achieve these goals. And, finally, I will just summarize the plan that has been proposed by the Market Surveillance Committee in its December 2000 report to FERC, which I do believe satisfies the goals. The first goal of market power mitigation is to reduce the average wholesale price that California pays to a level that would occur in a competitive electricity market, given California's current supply and demand conditions and the cost of input fuels. And any successful market power mitigation plan has to guarantee that it can at least satisfy this goal. The second goal of a market power mitigation plan is also, I think, very important, to alter the incentives faced by the market participants so that it will no longer be profit maximizing for generators to essentially withhold capacity from the spot market by bidding substantially in excess of the variable cost of producing electricity from their facilities. The idea is essentially to alter the rules in such a way that, post-intervention, spot market functions in a manner that is consistent with the competitive market in the vast majority of the hours. I believe the market power mitigation plan that has been recently implemented by FERC is very unlikely to achieve these goals. In the first place, the plan provides for no mitigation during hours without system emergencies, and unfortunately, as has been noted by a study prepared by the Department of Market Analysis at the ISO as well as my own work with Severin Borenstein and Jane Bushnell at the University of California Energy Institute, the majority of overpayment due to the exercise of market power occurred during the hours when there were no system emergencies. Consequently, this market power mitigation plan currently fails to address the greatest source of the unjust and unreasonable prices in the California electricity market noted by the Federal Energy Regulatory Commission is its November and December 2001 orders. So even if this mitigation plan was extended to all hours, it still has the potential to be virtually ineffective at mitigating market power. For example, the plan only requires generators give all their uncommitted capacity into the ISO's real-time energy market at what is called a proxy bid price, which is computed by ISO to essentially account for the heat rate of the unit, the price of natural gas, and the price of other inputs that the firm might use. However, a very straightforward way for generators to avoid this requirement, is simply to sell its energy in advance to a power marketer, and then even if this firm sells its energy to an affiliated power marketer, that will satisfy the condition that FERC now has to saying the capacity is committed, and therefore not subject to the mitigation measure. So this aspect of the FERC plan creates a very simple strategy for a generation owner to essentially obtain higher prices. The firm simply sells its energy to an entity located outside the State on a day-ahead basis. This effectively commits the capacity, so it is no longer subject to the real- time bid rule. Then in real-time market approaches, the ISO discovers it is short of electricity in California, and must find some out-of-state producer to sell into the market. Under these circumstances, the out-of-state suppliers can effectively bid whatever they wish into the ISO's real-time energy market, because they certainly have the option of not supplying energy into California if they do not receive the price they want. And through this process, a generator located in California can effectively achieve significantly higher prices than what are certainly seen to be envisioned by the mitigation plan by selling outside of the State at a high price, knowing that in all likelihood, this power will be sold back into the State in real time when the ISO calls the out-of-state supplier to produce more energy, because as all market participants know, California is a net importer of energy, and this is particularly the case in the summer months. And to give some idea of the potential profitability of this activity, it is not unusual for a megawatt delivered to California to trade between 5 to 10 times in the forward market before it is actually consumed. So a second aspect of the order that I think will render it ineffective, even if it is applied to all hours, is that generators still have the ability to receive their justifiable costs, rather than the market- clearing price computed by the ISO using the generator's proxy big prices. So, for example, if a generator's proxy bid price is computed by the ISO to be $50, and if this unit is necessary to serve demand and it bids its cost-justified bid of $150, if the bid is necessary to serve demand, the generator will be paid its bid for $150 for the energy supplied, not the $50 per megawatt proxy bid market clearing price. So, consequently, even though the market-clearing prices posted on the ISO website would say $50, generators can receive substantially in excess of this market clearing price if they are willing to cost justify their bids in the ISO's real-time energy market. And given FERC's unwillingness to order significant refunds from generators and their use of a methodology that is exceedingly generous to generators in determining the recoverable production cost, it is no surprise that right now many generators are currently submitting bids that are accepted and paid as bid at prices significantly higher than the market-clearing price set by FERC under its recently implemented market power mitigation plan. So this provision for paying as bid for energy is very similar to the $150 soft-cap policy, which was implemented in 2001. This policy said that all bids in excess of $150 had to be cost justified, and if necessary to serve demand, they would be paid as bid. And during the period July 1, 2001 to May 1, 2001, even though there was $150 soft price cap in place, average prices in the ISO's real-time market were in excess of $250 per megawatt hour. So this guarantee by FERC in its former soft-cap regime, and in this recently implemented mitigation plan to pay as bid any cost-justified bids, as I think the best illustration of the point that cost of service regulation, which is essentially what the soft-cap policy is, without a prudency requirement, is the equivalent to no regulation at all. Unless FERC seriously investigates the prudency of these claims cost, something it did not do during the former soft-cap regime, the current mitigation plan will once again return California to a world without effective market power mitigation. And the final aspect of the FERC mitigation plan is that if it were applied to all hours, and even if these two problems described above were solved, it is extremely unlikely to achieve the second goal of market power mitigation, because it just does nothing to alter the incentives of generators to bid aggressively in the spot market and to maintain their units in top working order. This is effectively the point made by Senator Feinstein. In fact, on the contrary, the plan creates strong incentives for generators to declare forced outages and planned outages of their low-cost units so these units will not set the market-clearing price, but instead, their higher cost units will more frequently set the market-clearing price that is earned by all the units. And, so, moreover, this mitigation plan creates incentives for generators both in and out of California to sell outside the State for the reasons discussed above, so consequently, the FERC plan has the potential of creating the worst of both worlds for California, a less reliable grid, because generators do not want to sell into California and have little incentive to maintain their plants, and high prices because it is very easy to cost justify virtually anything with no serious prudency review on the cost incurred. And just to finish up, the December 1 Market Surveillance Committee Report presents a plan which I think can achieve both of these goals, and this remedy does not impose a soft cap on the spot market, but it does require FERC to make a one-time regulatory intervention that results in just and reasonable rates in California for the next 2 years. The essence of this plan is that all sellers in California would be ineligible to continue to receive market-based rates only if they offer 75 to 80 percent of their expected annual sales in the form of a 2- year forward contract at a price set equal to the perfectly competitive benchmark over this time period. This after all is market-clearing price that the FERC no-market-power standard explicitly stated in its competitive market requirement for a participant to receive market-based rates. So consequently, with this mitigation measure in place, the firm still has a significant upside potential, but California consumers are protected from the significant volatility in the spot market for at least 75 percent of their sales, and moreover, this plan will create the incentives for generators to be aggressive competitors in the spot market, to maintain their plants in top working order, and the other advantage of it is, it is simply a one-time intervention, and has no danger of essentially, once implemented, remaining in place. Thank you very much. Chairman Lieberman. Thank you Dr. Wolak. Thanks to all of you for very interesting and thoughtful and helpful testimony. You have come from different places. In fact, four of you were asked by the majority, two by the minority. Generally speaking, it sounds to me that though there may be some disagreement on what action FERC should take, just about all of you agree there should be some price mitigation action, although I do want to give you a chance to clarify, Dr. Makovich, because at the end of your statement, you spoke out strongly against price caps. Do you think there is any role here for FERC to play in what Dr. Joskow and others have called price mitigation in the Western markets now? Mr. Makovich. The price mitigation idea, as Dr. Wolak has said, there is this opportunity to get around it with the power traders. There is also a problem here that half of the power produced in the west is not under FERC jurisdiction. So on a practical basis, it is hard to imagine that this kind of bid capping or price mitigation is really going to work, given the reality of the jurisdiction limits out there and the ways to end run this set of regulations. Chairman Lieberman. So what would your answer be to folks in California who say that prices are too high; in a year and a half, supply is going to equal demand because of the power plants that are coming online; we have done all we can in California; the power plants are moving again; conservation is working, we are 11 percent down; but we need the Federal Government, through FERC, to come in and do something for us in the short-term, temporary price leash. What would you say in response to somebody from California who asked you that? Mr. Makovich. Well, there is a number of things that needed to be done in the short run, some of which were not done. So the price increases that we have seen were important, but they are very uneven. We have yet to---- Chairman Lieberman. Things not done by FERC, you mean? Mr. Makovich. The retail pricing pieces. What has not been done in the short run is there should have been more done to bring additional supply in for this summer. And people say, well, it takes 4 years to build a power plant. But the truth is, I know people that can build barge-based emergency power systems in the Houston ship channel, and within several months could have that power plant--they could have hundreds of megawatts of additional supply in various locations through California. There were proposals to do that last year. Those proposals were denied. There are, according to the California Energy Commission, 5,000 megawatts of emergency backup generation that we have never taken the legal and environmental restrictions off temporarily to coordinate that supply to have it available for this summer to help meet these demands. So there are a lot of things that can still be done in the short run, short of price caps, to help mitigate the blackouts that are coming. Chairman Lieberman. Dr. Borenstein, would you like to respond to that? Mr. Borenstein. Yes, I would like to respond to a number of things. First of all, I think Dr. Makovich did not hear the news, that in the last couple of days, there has been a lifting of a lot of the environmental restrictions, and so a lot of those backup generators are going to be allowed to run. Chairman Lieberman. By the State. Mr. Borenstein. By the State. They are heavy polluters and that is certainly not the way I would go. If I ever asked beyond price caps what the State should be doing, is pushing much, much harder on conservation than we are pushing. We still have buildings air conditioned to the point that people need sweaters, and that is just crazy, given the situation. I think it is really not accurate or at least not relevant to say that half of the power produced in the west is not FERC jurisdiction. Most of that is public power. In the case of municipals, who produce their own power, those are not--they generally are not ones exercising market power. It depends on their net import or net export position. Most of that power is produced by public utilities who are just consuming their own power. So I think the argument that there is a lot of power you could not control, is not a reason to implement price mitigation. It is true that demand has outstripped supply, but I really have to say, if Dr. Makovich's company is advising companies and telling them that you cannot exercise market power in this market, they need a refund, because if you are in this market, and you own 4,000 megawatts of capacity in California, and you cannot exercise market power, you are not paying attention. It is really pretty straightforward. It is something that many of us pointed out before the market even opened. It is something that we have interacted with people at these companies, who are certainly aware of their ability to do it. They have argued that they are not doing it, but I think that if that is the case, it is out of benevolence, which is not how capitalist systems actually work well. Chairman Lieberman. Let me ask one or more of the five of you, who have advocated some sort of price relief by FERC on a temporary basis, to respond--there was some mention of it, but I would like to hear a little bit more about it--to respond to the argument that price relief or price caps--although that is a bad term; price relief or mitigation is better--if they are imposed, they are going to cut off supply by reducing the incentive for new power and new power plants by intervening in the market in that way. Dr. Kahn, what is wrong with that argument? Mr. Kahn. The whole history of regulation of the electric power industry has been one in which the effective regulation on capacity has always been deemed to be one of encouraging excessive expansion of capacity. There is no reason why, if you set rates that insure an operator return on investment that is sufficiently high to do so, that it will discourage construction of new capacity. And it seems to be it is very useful to look in history. People just say it and say it and say it, but I was never aware of any contention--I was chairman of the New York Public Service Commission and studied this for 50 years--that anyone has ever argued that had the effect of retarding investment. On the contrary, it is a very well-known phenomenon, which Paul Joskow has studied, and it is not always empirically demonstrable, but I have never seen anybody argue it had the opposite effect. The only thing that had the opposite effect was, of course, the uncertainty in the 1990's about what was going to happen. Mr. Joskow. Senator Lieberman, let me take a crack at this. I think the greatest danger right now to new investment in California and the rest of the west is the continuing chaos in the markets out there and the uncertainties about public policy. The price mitigation programs that have been proposed by a variety of different people, yield prices that make it very profitable for new efficient generating plants to enter the market. Those plants lined up for permits back in 1998 when prices were very low. The new plants are 30 percent more efficient thermally than the existing plants. They emit a tenth of the nitrous oxide of the existing plants. There are just enormous incentives, once those plants can get licensed, to come in to the market, and many of them are being built in California, and in Arizona, and in Nevada. So if this is done effectively I think it will in fact, make it easier for investors to commit resources to the west because they will have a stable market and regulatory environment against which to shoot at. Chairman Lieberman. Let me just say it is an important point, because we hear this in a host of different economic areas here in Congress. The business community is always asking for stability, predictability to base their judgments on. But as both of you are saying, obviously, a price mitigation will, under anybody's vision of it, preserve a healthy profit margin for the producer. So, presumably the market will still be there, sufficient to encourage them, particular with the stability and predictability we are talking about, to get into the business, which they are. Mr. Joskow. Yes, indeed, and there is a very good study that has been done by an economist at the California ISO, Eric Hildebrand, which looks at exactly this question, if we kept prices at the competitive levels that a number of us have simulated, there is still a very healthy margin for new investors. I would like to get us out of the game of placing blame, of demonizing the suppliers, to recognize we have to do something in the short run to keep the system from going out of control, make long-run fixes, but to provide a stable regulatory and economic environment for new investors to invest in. I think that is substantially more important than continuing what I think will be continuing chaos and the blame game over the next 18 months if we do not take effective action now. Chairman Lieberman. Dr. Wolak, did you want to say something? Mr. Wolak. I just wanted to add something following up on what Paul Joskow said. I think it is very important to bear in mind the time lag that it effectively takes in a decision maker deciding whether or not to build new capacity. What he is interested in is not the prices right now, not the prices a year from now, not the prices even 18 months to 2 years from now, but the prices after the period when the plant is in the ground and producing. So following on what Paul Joskow said, if what we--the fear I think of many firms is, what will happen in California if we go through this summer and it is a complete implosion, then it will be public power or whatever strange solution comes out of the California initiative process and that will be the sort of thing that I think will chase all investment away, because of the fact that it takes 2 years to build a power plant. So high prices now do nothing to signal new investment to come into the market. It is the expectation of high prices 2 years from now to 3 years from now, when that plant is in the ground and operating, that cause me, as a rational firm, to invest in the market. All you are doing by mitigating prices within the interim 2-year period, is simply just not distorting any investment decisions, but just reducing essentially the punishment, as Professor Kahn said, that consumers have to bear during that period. Chairman Lieberman. Thanks. My time is up. Senator Thompson. Senator Thompson. Thank you very much Mr. Chairman. This is a great panel, because we have so many people who are so much more knowledgeable than we are, and it is always good when we are struggling to try to keep up. I think maybe we are making progress. But on that point of investment, and listening to you talk about that, it sounds like a rosy scenario compared with some of the things we have heard from some people involved in the activity. In a June 11 letter,\1\ Bear, Stearns' senior managing director and chief economist Wayne Angell writes that price controls are a recipe for disaster. He goes ahead and makes the usual points, I guess, concerning price control, but he says the confidence in the investment community has already been severely damaged by California's regulatory policies, and it will take time to repair the damage and regain credibility with investors. The worst thing regulators could do at this time would be to impose still more controls. A prepared statement of June 13 from William C. Dudley,\2\ chief U.S. economist, Goldman, Sachs; he says that price caps would deter the type of investment in electric power generation and transmission capacity that the State of California seeks to encourage. The risk would rise because the imposition of price caps is by nature arbitrary as to level, timing and duration. If caps were imposed, this would increase investor anxiety that the caps could in the future be lowered, broadened, extended, in terms of duration. He says, ``In my view, the solution to the California energy crisis lies not in price caps, but in encouraging the installation of additional electric power generation and transmission capacity, and imposition of price caps work against this.'' We may be comparing apples and oranges here, but I would ask that these two statements to be made a part of the record here. --------------------------------------------------------------------------- \1\ Letter from Wayne D. Angell, Bear, Stearns and Co., Inc., dated June 11, 2001 appears in the Appendix on page 556. \2\ Prepared statement from William C. Dudley, Goldman, Sachs and Co., appears in the Appendix on page 558. --------------------------------------------------------------------------- Chairman Lieberman. Without objection. Senator Thompson. People in the community are concerned about the attractiveness of California in the current environment as far as future investment is concerned. It seems to me that it is important to understand the nature of the problem, complex in some respects, not so complex in others, perhaps. It seems from all of you have said, and other experts have said, that we do in fact have a system, that is not working and from the very beginning, had inherent flaws: Retail caps, which went against our need for conservation; utilities with no ability to enter into long-term contracts, had to operate on the spot market, which looked good at the time, and, well, looks good today, as I understand. Now that California has gone to long-term contracts, the spot market is down. So they are buying high and selling low in both respects. Insufficient capacity, perhaps insufficient infrastructure, weather, all these problems come together. But in looking at all of that, and listening to these comments, would anyone disagree with the proposition, that as a part of this mix, California needs to allow retail prices to rise more and be more consistent with the actual cost? Mr. Kahn, if I understood you correctly, you referred to ridiculous freezing of retail prices. Mr. Borenstein, you talked about the need for conservation. I do not see how we can get there without that. Does anyone disagree with California's need to do that? Mr. Wolak. I think it is important to make the distinction between the cost, prices that reflect cost versus prices that reflect what people offer the power at. So I do not think anyone would disagree that prices that reflect cost should be passed on to consumers. The big debate is over exactly the extent to which the prices that are currently being charged in the market, are reflective of cost, because of the fact that there is the standard under the Federal Power Act that says that rates must be just and reasonable, and one way to obtain just and reasonable rates is rates that recover costs, and as I said with the various studies that have been done by the various members of the panel here---- Senator Thompson. Even if the retail prices were what you feel like they ought to be, without the influence of market power, would you still not agree that the idea of retail caps was a bad one? Mr. Wolak. I think the other thing to remember with the retail caps is this is not something that is unique to California. This exists in every market that has been restructured in the United States. The other thing that I think is important to remember from the retail caps---- Senator Thompson. Retail caps, letting alone the wholesale prices---- Mr. Wolak. Fluctuating wholesale prices and---- Senator Thompson [continuing]. And caps along these lines? Mr. Wolak. Yes, it exists in PJM, New England, New York. It is just the only difference is, is the extent to which there is an outstanding position on the part of the retailer to sell the power to purchase from the spot market. And the other markets, the extent to which they have to--if you like their net short for energy--is much less. They own significant amounts of generation capacity to meet their own loan obligations, whereas California, because of the divestiture, had large amounts of net short, and that really is a major source of the problem. Senator Thompson. These other States that have deregulated, for example, have allowed long-term purchases, have they not? Mr. Wolak. Yes. California did as well. It is just that-- the unfortunate thing is that California allowed the investor- owned utilities to do that. It is just that the incentives that the investor-owned utilities faced at the time were such that it was a good deal not to engage in long-term contracts, so it is not an explicit prohibition. Senator Thompson. Mr. Kahn, would you comment about the efficacy of these price caps? Mr. Kahn. Yes. Two things. One, looking at it now, of course, it is clear that the imposition of rigid retail caps was a mistake. At the time, it may have seemed a reasonable bargain, because you will remember that 4 or 5 years ago, the main concern was that the distribution companies, the big electric utilities, would be left with stranded costs. That is, the cost of over investment in capacity, the cost of those huge contracts that they were forced to buy at artificially-set prices, and so at the time, it looked like a bargain. You give us the assurance that we will be able to recover our stranded costs. In exchange, we will freeze retail prices. So we have to be a little bit gentle. The fact is, after the fact it has proved to be a catastrophe from the point of view of the companies who in effect---- Senator Thompson. There comes a point in time in which public officials, theoretically, should be able to perceive that it was a bad idea. Mr. Kahn. I think that is right. Senator Thompson. Mr. Makovich, do you have a comment? Mr. Makovich. Well, I think the idea that this problem can be solved simply by long-term contracting is one that is also a fairly dangerous idea. There is a couple of problems there. One is, suppose we got 80 percent of people to voluntarily contract long run of their demand in California. If then we rely on the spot market to supply the rest of it, and people will not build on the basis of the spot market, which we have already seen, and we come up short again. We do not have the capability to cut off the customers that are covered under long-term contracts versus those that are not. So there is an enforcement problem here, because when we shed electric customers in a blackout situation, we shed circuits. We do not differentiate one customer to the next. Second, if long-term contracts are the solution, and they keep the market in balance because the price is high enough to cover all the cost of a new power plant, power marketers are going to attack them because they are going to be able to buy on the spot market that clears on short-run costs, and they are going to be able to have a short position, sell long term---- Senator Thompson. You are getting a little down into the weeds for me. [Laughter.] Mr. Makovich. Right. Senator Thompson. I am not making a case for long-term or spot. I assume you need both. What I am trying to get at is a decent analysis of the structural situation that underlies this and presents the problem. Mr. Makovich. Suffice it to say, long-term contracts alone will not solve the problem we have in California. Mr. Borenstein. If I can answer on retail rates, I very much agree with you, and we were very slow in California to raise retail rates, and I am fearful that as the bills arrive in the next few weeks, particularly residential customers are going to find out their bills did not go up very much because they did not on average. But I think it is important to recognize that electricity is not a storable good. The cost of providing electricity is something that varies hour to hour tremendously, even in a completely competitive market. Senator Thompson. So these great spikes we see, I understand, are just momentary. Mr. Borenstein. Right. We have deregulated the supply side of the market and have not deregulated the demand side of the market in the way we really need to to make that work, and that is with real-time pricing. That is, prices that are sent through reflecting the rate, the real rates. If all we do is just raise the flat retail price you are going to be facing an incredibly high price in the middle of the night which is way too high, and the same price on a hot summer afternoon when it is way too low. What the real mistake California did on the retail rate is not the freeze, I would say, although I think that is a big part of the problem, it is that we did not get to pricing on the retail side that really reflects the scarcity. Senator Thompson. Can I impose on the Chairman, and ask Mr. Joskow to respond to that also? Chairman Lieberman. Sure. Mr. Joskow. I agree completely with Mr. Borenstein, who by the way, was my student. I think California was too slow in increasing retail rates, but I also think it is important to make these markets work, that at least some significant fraction of demand be on real-time prices. Just to give you an example from June 2000. On June 8, the demand was low and the price was $50. On June 13, 2000, demand spiked and the price went up to $750. You cannot respond to that if you are not seeing those prices, and if you get your bill a month later that tells you that you paid that. One of the things that makes markets work is that consumers can say no when they see a high price. If you go into a restaurant and you see on the menu that a hamburger is $85, you say I am not going to have a hamburger. I will have a tuna sandwich, or I will have a salad. You cannot do that now in these electricity markets, and they are just not going to work until we implement these kinds of strategies. We have made a lot of mistakes. There is a lot of blame to go around, not just in the west. In New England, in New York and PJM, this was much harder to do than a lot of people thought. We need State and Federal regulators to work together to fix these problems, not just in California, but elsewhere in the country, and I think that really is the big issue, not finding blame. There is plenty of blame to go around. But to get FERC, to get the State commissions, to get the reliability councils together to make the system work in the short run and the long run. I think we can mitigate prices in California this summer if we take that approach. I agree with Frank Wolak. It would have been better if they had followed advice that was given to them by the Market Surveillance Committee last summer. But FERC essentially ignored the Market Surveillance Committee. But here we are. It is June 13. The summer is upon us. We have got to work quickly together to get us through this summer and probably next summer, while we do not forget that we need to fix the longer run problems as well. Mr. Kahn. This is not a new idea, 25 years ago the price of electric power on Long Island was 5 cents a kilowatt hour, morning, afternoon, evening, summer, fall, winter, and spring. By the time I left, we had all big commercial and industrial consumers on time-of-day meters, and the prices ranged from 2.5 cents at night to 30 cents when the thermometer got above 84 degrees. That was 1976. Mr. Joskow. Fred was being modest when he said he knew nothing about electricity. He was the chairman of the Public Service Commission in New York, and in fact, implemented these ideas in New York State. Chairman Lieberman. Thank you both. Senator Carnahan. OPENING STATEMENT OF SENATOR CARNAHAN Senator Carnahan. Yes, thank you, Mr. Chairman. I realize that our topic today is about energy in California, but I want you to know that the people of Missouri are very concerned about the energy picture as well. They have watched as the crisis has unfolded in California, and they have worried also as their own fuel prices have spiraled. I have heard from a number of people whose natural gas bills have doubled, and in some cases tripled, just since last winter. Many of them are seniors on fixed incomes and working families who are barely making ends meet. So as we talk about the economics of the electricity industry today, we should be mindful that this discussion is about far more than just competing theories. And it is about more than beliefs in free markets. It is about the everyday lives of real people and the impact that our decisions have on them. The price spikes in many States, combined with the crisis in California, and the current debate about a national energy policy, have caused confusion and anger all across America. In the past, most of us purchased our electricity from a single regulated utility. State agencies determined the utility's cost in producing the electricity, added a reasonable profit, and set the price charged to consumers. Changes in the electricity industry, including technology, have allowed us to consider new deregulated systems. Under such a system, consumers would choose from whom they wished to buy electricity. Many have argued that competition should lead to lower prices, but California's experiment with deregulation has caused serious doubts among many Americans. Whatever the original cause, California's problems have been compounded by the hands-off approach of FERC. Instead of vibrant competition, California has suffered from shortages and skyrocketing prices. Does this mean that deregulation is bad policy? No. We may very well conclude that the best interest of the American people are served by deregulated electricity industry, but I think we must ask a very fundamental question. Is a deregulated market the same thing as a competitive market? I think California's experience shows us that the answer is clearly no. Obviously, the deregulation must be approached with caution. The transition from a regulated industry to a competitive model is a process that will require a willingness to make adjustments. When the initial approach proves unworkable, corrections must be made. During that transition, we must ensure that someone has both the legal authority and the will to look out for the purchasers of electricity. Thus far, the sellers have proved adept at protecting their own interest. Undoubtedly, as academics, each of you will continue to study the wisdom of California's approach to deregulation for some years to come. However, one thing is clear today: The responsibility for insuring just and reasonable prices in the wholesale electricity marketing in California and around the Nation lies with the Federal Government and particularly FERC. As you may know, Senator Lieberman and I recently wrote to the General Accounting Office to express our concern about recent reports that market power has been abused in California. It is alleged that this, in turn, has contributed to the spiraling cost of electricity in the State. We have asked the GAO to use its oversight authority to review whether FERC is up to the task of ensuring just and reasonable rates. The recent debate has centered on whether FERC should take measures to help ease the pain during the transition to a competitive market, and I hope that today's discussion will continue to shed light on that question. I believe that part of the long-term solution to California's problems lies in additional infrastructure--more generation and additional transmission capacity. Some have argued that any transitional efforts by FERC would disrupt much needed investment. I must tell you that I am not entirely convinced by that argument. Pennsylvania is often held up as an example of how to manage the transition to a competitive market correctly. I find it interesting that there are price caps on both the wholesale and retail markets in Pennsylvania during the transition. I understand the need to protect incentives for investment. However, I must question how much incentive is required. It seems to me that the profits of the energy companies are more than adequate incentives to be a part of this industry. For example, last year the operating income of Enron, a Houston- based energy company, rose 140 percent from the previous year, from $802 million in 1999 to $1.953 billion in 2000. By comparison, Anheuser-Busch is a Missouri-based Corporation with a reputation for being a very well managed company. Last year, they experienced outstanding sales and growth. Their operating income grew by 8.4 percent, compared to Enron's growth of 140 percent. Last year, the S&P 500 declined by 9.1 percent. Anheuser-Busch outperformed the index with a return of 30.5 percent, but Enron surpassed the S&P 500 with a whopping 89 percent return. This level of return indicates that the incentives to invest in the energy sector are firmly in place. I believe we can reasonably conclude that this will result in additional supply. Once this additional supply is in place, I would hope the market would level out. So my concern is how we protect the interest of the consumers during the intervening period. As we make the transition to a truly competitive market, who will ensure that prices are just and reasonable? Thus far, FERC's response has been timid. In my view, this will not do. I hope that today's questions and answers will provide insight into how the Federal Government can play a constructive role in relieving this temporary but extraordinary crisis. Mr. Chairman, I am having to leave in just a moment, but I would like to ask Mr. Borenstein one question before I do. As you know, many States are examining the deregulation proposals now. These States may continue to believe that competitive electricity markets can provide long-term benefits to consumers. However, they are concerned about what is happening in California. You have researched the situation in California extensively, and based on your research of what is happening there, what lessons can States like Missouri--that have not yet moved to deregulation--what can we learn? What guideposts should States use as they design a deregulation process? Mr. Borenstein. Well, there are a number of things that I think we can learn from the California experience. And they almost all fall under the general notion of making sure that there is the infrastructure support for having a competitive market. If you are going to move to a competitive market, you have to make sure that the supply side of the market will be competitive. To do that you have to have analytical tools that will let you look into the structure of the market and what sort of prices it will yield. In fact, these tools were around in 1995, and many of us were suggesting FERC use them, and FERC ignored them, and went ahead using a completely antiquated approach of simply looking at the market share of each player. But if you use the right tools, you can see how much divestiture into separate companies would be necessary to get a competitive market. At the same time, you have to have price responsiveness. You have to be willing to let people see the prices, and as I said to Senator Thompson, you have to be willing to let the people see the prices in a way that reflects in real time what is going on so they have an opportunity to respond to those prices. Then of course you have to have the infrastructure to actually carry the power around. One of the mistakes that California made, which has not really come to the fore yet, but will in the next few years, is that we deregulated without having a real vision of how to invest in transmission capacity in a deregulated market, and transmission investment, as a result, has virtually come to a halt. So we really do need to have a system that will beef up transmission and will then price power appropriately at each location in the system. If you do that, if you make sure you have a competitive supply in the market, if you make sure you have a demand that can respond to prices, I think you can go forward with electricity restructuring that can really work. At the same time, you do want some fall-back position, and the way you get that is as you enter restructuring, you have long-term contracts in place or ownership by the regulated utilities, that are effectively a hedge. One of things I pointed out in Pennsylvania is Pennsylvania has had huge price spikes. It is just that Pennsylvania buys very little power on the spot market because they have effectively hedged, because the utilities continue to own almost all of their capacity. But I think if you follow that recipe, it is still a recipe for success and eventually for benefits to consumers in electricity markets. Senator Carnahan. Thank you very much. Chairman Lieberman. Thanks so much, Senator Carnahan. I just want to indicate that I appreciate that you were one of the first to draw this subject to my attention anyway. I know our staffs have met with GAO, and we hope for some kind of interim report in the next three or 4 weeks to our request. Thank you. Senator Collins. OPENING STATEMENT OF SENATOR COLLINS Senator Collins. Thank you very much Mr. Chairman. I have really enjoyed this hearing today and the chance to hear such a distinguished panel of economists present their divergent views on this issue. I think that the competition that we have seen among ideas here is as important as the competition that we hope to see among electricity generators. I do want to take advantage of this opportunity, as the Chairman has suggested, to share with the Committee some of my thoughts on this issue. Many of our States, including my home State of Maine, are striving to promote more competition in electricity markets. Maine was one of those States that pioneered this and plunged very early into the brave new world of deregulation. Competition in properly functioning markets, should, over the long term, result in cheaper prices, better service, and more innovative products for our consumers. Since price caps limit competition, they should be avoided in properly functioning markets. Unfortunately, however, electricity markets do not always function properly, and, as we have seen, California is a clear example. California's electricity markets are not functioning correctly because they were not set up correctly. When you do not allow retail prices to rise in the face of electricity shortages, you are setting up a flawed system. It is clear to me, based on the testimony we have heard today, that California needs to restructure its market to remove artificial barriers that inhibit the marketplace. Even in an electricity market without the kinds of major design flaws that we have seen in California, however, there are still some factors inherent in the nature of electricity that can cause the market to function improperly. Because electricity is generated and consumed simultaneously, and cannot be meaningfully stored or inventoried, there are essentially 8,760 hourly electricity markets each year. Even if the markets work most of the time, there may be hours when, because of an imbalance between supply and demand, they are not workably competitive. This can lead to incredibly high prices. Since it is impossible for most consumers to respond to high hourly prices, the sellers of electricity can raise their prices an unlimited amount for short periods. I want to give you an example that affected my State last year. During a few hours last May in Maine and the rest of New England, the price of electricity in the spot market went to $6,000 per megawatt hour. That is more than 100 times its usual level, and, as Dr. Kahn and others have pointed out today, very few customers saw this price spike in a timely way. They could not adjust their demand. They could not respond by turning off their air conditioners for a few hours, or waiting until later to do their laundry. So in this instance, in my judgment, the market simply did not work. Subsequent to this price spike, FERC imposed a price cap of $1,000 per megawatt hour in New England during periods of significant supply shortages. Given its limited applicability and the extremely high level, this cap seems to me to be a reasonable response. Furthermore, there is no evidence at all that it is deterring new plant construction in our region. I want to emphasize that ultimately our goal by speaking is to alert the consumers, not just in California, but in the Nation as a whole. In Maine, homeowners and businesses alike are burdened by some of the highest electricity rates in the country. In fact, one of the reasons that Maine jumped into deregulation early was the hope and the elusive promise that it would lead to a lowering of electricity rates since we have always been at a competitive disadvantage compared to other regions in that area. Households are seeing their electricity and other energy costs eat up more and more of their incomes, and many businesses, particularly manufacturers, are seeing smaller and smaller profit margins as more money goes to purchase energy. Some businesses in Maine are even threatening to move to other regions where electricity prices are lower. I hope that we can succeed today in helping to identify solutions for California, but I also hope that our goal is to identify ways to lower electricity prices in the rest of the Nation. We need to look closely, and we have looked closely, at the lessons that we can learn from California, and we also need to be careful that we do not blindly apply California-size solutions to New England, which has been by and large very successful in avoiding California-size problems. In fact, we have had a number of new generating plants come online, and yet we are still experiencing these distortions in the market. In the final analysis if we are firmly committed to competition, as I believe that we should be, we cannot seek government intervention whenever the prices are high. But on the other hand, we must recognize that electricity markets have unique characteristics which may cause them to not work competitively at times. Thus, in dealing with electricity issues, I think we need to combine competition with common sense. Finding the right mix, that which will lower electricity prices for all Americans, is no easy task, but this hearing provides a basis for us to try to strike the right balance. I do want to ask Dr. Kahn a question, since I agreed with so much of what you said in your statement. Mr. Kahn. That is funny, Senator. I was going to say I wish I had written what you just said. Senator Collins. The approach you have suggested makes much sense to me, as does the idea for short term carefully constructed price caps. My one concern is that we have seen price caps that were intended to be temporary, become permanent. We have seen these results. And I like what you have suggested about having them designed to be temporary, to automatically sunset them and to make them inapplicable to new capacity coming online. But, can you give us some more guidance on what you think should trigger the expiration of the price caps in the kind of scheme that you have described? Mr. Kahn. There are only two ways that occur to me, both of which I have mentioned. I like the idea of automatic sun setting; that is to say, one makes a reasonable estimate of what it takes for new capacity to come online and then requires a reenactment, rather than requires an explicit repeal. So that was the one that I suggested. We have been through a period 30 or 40 years ago where we tried to differentiate caps on old and new sources of supply in the case of natural gas. And I think we would have to say that was not a success, to put it mildly. Whether that is feasible in these circumstances, I truly do not know. Certainly, it is not a good long-term expedient. Power is power is power, and it is absurd to have discrimination in charges to different people. But some way of making absolute the guarantee that new investment will not be subject to any kind of--even if it is an arbitrary cap. The only other observation follows partly from what I have said. In electric power we have not had a problem of shortage under regulation. On the contrary, regulation, by assuring an adequate return on investment, has tended if anything, to encourage gold plating of service, and having excess capacity. Senator Collins. Which is why everyone thought it was going to be this boon to consumers. Mr. Kahn. That is why we thought we had such enormous excess capacity, including by the way, the inflated prices that the electric distribution companies were forced to pay to independent generators. I think Dr. Makovich mentioned the ridiculous prices under the Public Utility Regulatory Practices Act. It has all been in the direction of encouraging excess capacity. That is why I kind of bristle when people say yes, but price controls always restrict supply. You have to look at the particular situation. That is not true historically. But other than that, I am really repeating what I said, different ways of ensuring automatically that new capacity coming online will not be subject to these. Senator Collins. Thank you. Dr. Joskow, do you have anything to add to that? Mr. Joskow. Yes, Senator Collins, very briefly. By the way, I would love to subscribe to your statement as well. Let me talk about New England just to move across the country. I remember those $6,000 megawatt hours very well, and I think I paid for them in August. In New England I think we can establish a relatively small set of criteria for when the market is sufficiently reformed to remove price controls, except perhaps for these kinds of damage control price caps at very high levels, so that the price does not go to $1 million a megawatt hour. So in New England right now we are in the process of a major market redesign. There are specific items that have to be completed. When they are completed, we should be in much better shape in terms of operating the spot market and dealing with congestion management. We have a number of power plants in Maine, New Hampshire, Massachusetts and Rhode Island that are in the process of being completed. The New England ISO has a target minimum reserve margin. We are going to reach that I hope next summer. That is another criterion. Third, I think contract cover is important, that retail customers and the entities that serve them, have substantial contract cover. We are pretty good at that in New England right now, and I think we need to stay at around 70 percent. Finally, I would like to see us get about 10 percent of the load in New England on real-time prices, really, some of their demand, so they in fact, can see and respond to the $6,000 a megawatt hour prices if they emerge again. I see those structural fixes being in place over the next 18 months, and I am hopeful that the markets in New England will really be working well then, and that we can take off any of the heavy-handed regulation and rely on continuing very, very light-handed regulation to ensure that the markets work competitively. Let me note that since last summer I have had more calls from State officials in New England than I think I have the rest of my life. Five of the six States in New England have restructured radically. They did many of the same things California did, and the people there are scared. We cannot do what they can do in Missouri, which has not moved forward, and I have been very, very pleased to see the kinds of cooperation that the market participants, the ISO, the kind of cooperation they have gotten from the public utility commissions in the region, from the Governors of the States, from the attorney generals. I really see people working together in New England in a very, very constructive way, and I must contrast that with the atmosphere in California. Maybe we are just more civilized in New England. I do not know, but---- Senator Collins. I have always thought so. Chairman Lieberman. We show a bipartisan agreement on that. Senator Collins. That is right. Mr. Kahn. I think it shows we can do a lot better if we work together, rather than just screaming at each other. Thank you. Senator Collins. Thank you. Thank you very much. I really enjoyed your testimony. It was very interesting. Thank you, Mr. Chairman. Chairman Lieberman. Thank you, Senator Collins, and thanks for asking some questions about New England. Senator Voinovich. OPENING STATEMENT OF SENATOR VOINOVICH Senator Voinovich. I, too, have enjoyed the testimony this morning. It may come as a surprise to you that Ohio is the third-largest energy dependent State in the Nation behind California and New York, and back in March 1999, in my first State of the State address as Governor of our State, I called for a comprehensive energy strategy to keep the lid on energy and utility costs for our citizens, and to try and stay competitive with other States that I was concerned would be taking some of our businesses away because of the lower cost of energy, particularly the State of Pennsylvania, which was one of the first States to restructure. As a result of that effort, we proposed and published the energy strategy report. That was back in 1994, and we started to discuss the whole issue of restructuring and did not pass the legislation until 1999, but a lot of the heavy lifting in anticipation of it was done during the 3 years prior to my leaving the governorship. One of the major provisions in the restructuring effort was that rates were capped during the first 5 years of energy restructuring to protect our consumers, but we were careful in terms of the rate because we had to recover stranded costs, and we tried to get a reasonable return for our utilities, and it has worked out, and we have had new energy producers come online, several thousand megawatts, and have another 13,000 or 14,000 in the pipeline. The thing that bothers me about the new facilities coming on is that they are all powered by natural gas, and because of some environmental concerns, a new source review and lawsuits that were filed by some folks in the northeast, they have turned away from the use of clean coal technology for our coal, and of course we are all aware of the fact that we could be doing a much better job in terms of taking advantage of nuclear energy in this country. But the fact is that we have a crisis in California, and everybody's wringing their hands, and I think California did it the wrong way. They separated the major functions of the generation transmission and distribution system. Three of California's major utilities were required to divest large portions of their generating capacity. They precluded major utilities from entering into long-term contracts for electricity supply and required that they sell their remaining capacity on the spot market. I do not think they did it right, and now the chickens have come home to roost, and they have a problem. The question I have for this panel is this: Does Congress need to get into this and start passing legislation to deal with this problem, or should we let this problem be worked out through the traditional ways? Now FERC is involved. They got in a little bit late, but they are involved in the process. Do we need Federal legislation to deal with this, or should we leave it to the system that we have in place? You were talking, Dr. Joskow, about the governors and the utility commissions getting together and working together. FERC is now involved. What is your opinion about that? Should the U.S. Congress get involved? Mr. Joskow. Senator, I think that is a very good question. Ideally, I think no. I think FERC should enforce the law, and if I could recommend anything, it would be perhaps a letter from the U.S. Congress to remind FERC the Federal Power Act has not been repealed, Congress has not just deregulated wholesale power markets, that their job is to ensure that they work well and to continue to oversight, of FERC, to get them to do their jobs. I think in the longer run there are some questions in my mind as to whether FERC is currently structured, both in terms of personnel and its conception of its missions and its procedures, to oversee the development of well-functioning competitive electricity markets. I would like to see FERC evolve more into an agency that is involved in monitoring, identification of market failures, and mitigation. It is structured as an agency that for almost 50 years basically did rate cases when investor-owned utilities sold power to municipal utilities. I think the agency needs to change. It has got to be more like the SEC in monitoring these markets, and I think that would be a very productive thing for Congress to look at and to explore whether amendments to the Federal Power Act are necessary to make that happen. FERC's responsibilities are now very different from what they were only 5 years ago in terms of the quantities of electricity, the amounts of money and the nature of the industry. I think it does make sense to revisit whether that agency is properly structured and whether its objectives are properly focused on the new world rather than the old world. Senator Voinovich. Thanks. Dr. Hogan. Mr. Hogan. Senator, I think this is a very good question. Legislation by the U.S. Congress at this point would be premature, and I think it is because the problems that you are dealing with here are so complex, that trying to prescribe the solutions that are going to be applicable for California and the rest of the country, cannot be done through legislation. We have an example of that going on in the discussion here today. When Fred Kahn introduced into economist lexicon the term ``banana'', because of the difficulty of getting the ideas across, he was talking about, as I recall, a situation where he wanted the same idea but a different name, because he wanted to be able to talk about it politically. I think what is going on here is we are talking about different ideas and putting them all under the same name, and people are very confused as I have heard it in the discussion today. For example, Senator Lieberman said that five of us were in favor of price mitigation. But I think, at least for part of the discussion, when I heard Paul Joskow talking, he was talking about market failure mitigation, and that is a helpful contribution to this discussion. I am in favor of market failure mitigation, and I described a mechanism, the bid cap scheme, that FERC has been pursuing that is directed at that problem. It may lower prices. It may not lower prices. It is not targeted at price mitigation. That is not the objective, and I do not think it should be the objective. I think correcting the market failures as quickly as possible should be the objective and that is something that is not a good thing for the Congress to try to do. That is something you need FERC to do. And then when you look at FERC--I agree with Paul Joskow's observation. I do not have any question in my mind about it. I do not think that the commission is able to deal with these problems at the moment, and I think they have been going in the wrong direction. FERC's responsibilities have changed in reality, if not in their perception, and their responsibility has to be to design, and make sure that people adopt the rules for effective markets, the kinds of market infrastructure that Severin Borenstein has been talking about. They have been very slow to do that, partly because they feel confused by these very complicated problems. And if they are confused by these complicated problems, imagine what it would be like trying to write legislation. So the real challenge is to beef up the FERC staff and change their mindset. Senator Voinovich. One of the issues that this Committee has been dealing with, and I have been addressing in the Subcommittee on Oversight of Government Management and Restructuring, is the human capital crisis that we have in the Federal Government. I would be interested in your observations. If it is like some of the other agencies, such as the Nuclear Regulatory Commission, for example, the number and quality of people really needs to be punched up if we expect it to do the job that it is supposed to be doing. Mr. Hogan. They have some very good people at FERC, but they do not have enough, and they need more, particularly people trained in markets and able to deal with market design issues. They increased the size of that staff to reorient the agency and to make the Commission take it on that it has a new job--market design. Mr. Joskow. And let me give you a couple of good examples. The Federal Trade Commission has a large economic staff that is fully integrated with the lawyers and others in enforcement and investigations. It is considered to be a prestigious place to spend a couple of years if you are an economist. The Antitrust Division of the Justice Department is a similar type of arrangement. FERC has lost some very good people in economics and markets, and they never really had enough. I really think that we should look at other agencies that have been successful, like the Federal Trade Commission and the Antitrust Division, to see if we can bring the best skilled people to bear with the appropriate focus. I do think there are compensation issues that have to be addressed. It is one thing for me to come and spend a couple of years, take a leave from MIT and spend a couple of years. It is another thing for a civil servant to spend his or her whole life in the agency. We need to recognize and compensate these people, as well as to make it a rewarding professional experience for them. Senator Voinovich. Dr. Wolak. Mr. Wolak. I guess on your first question, what I would say is, I think that the same fundamental problem is going to arise again and again in competitive electricity markets until the following issue is addressed, is that competitive markets do not, by their very nature--or markets, rather, by their very nature, do not yield just and reasonable prices. And having in the Federal Power Act, a standard that rates wholesale electricity prices must be just and reasonable, is really in some sense incompatible with a market, because it creates, I think as Senator Thompson said, ``this sort of incentive of OK we will do what we do, but if things go really bad because of the just and reasonable rate standard, we will get bailed by the Federal Government.'' So if I was going to say the one thing that would be necessary is to essentially either get rid of it, of that standard in the Federal Power Act, and say, look, in a market, prices will be what prices will be, so you need to take the precautions necessary in advance to make sure that those sorts of eventualities do not occur, and then I think the market will work. But if you create the sort of circumstance where there is this just and reasonable rate standard, then you always have this problem that I always have the recourse, and in some sense, that is to me the fundamental incompatibility between a competitive market and this just and reasonable rate standard. Senator Voinovich. Any other comments? Mr. Borenstein. I had one comment. I know personally of a couple of economists who have gone to the FERC, and compensation is an issue, but I think the much bigger issue is the mindset. The economists and the policy analysts at the FERC have not really had enough influence on decisionmaking. I was a staff economist at the Civil Aeronautics Board during airline deregulation. I was lucky enough to work under Professor Kahn, and I was lucky enough to work at a time when we were going through deregulation and we were spending many days sitting around, saying, ``Well, if I were an airline and these were the rules, what would I do trying to make as much money as I can?'' And just walk through that analysis. Had the FERC had people who were doing that and were being listened to in 1996, we would not be here today because there were many people telling the FERC, ``If I were a generator and you set up these rules, here is what I am going to do.'' Unfortunately, FERC did not have that mindset. FERC had the mindset of, ``We have a legal process we go through. People file documents. We read them, etc.'' FERC really needs to get the staff, and to listen to the staff, who are going to do that sort of policy analysis. And if they do that, I think they can be quite successful. Senator Voinovich. Thank you. Chairman Lieberman. Dr. Makovich. Mr. Makovich. My final comment on that. I think what you see here is a general consensus that the California market was set up flawed. Because it was so complicated and difficult to do, it was not done well. What we have also, I think, agreed on here, is it has not been fixed, and price caps are a Band-Aid, not a solution to the problems there. So the role of the Federal Government, either through FERC or legislation, is to provide leadership here on how power markets have to be set up right, and there are a minimum set of structural requirements that we have to have in all power markets to avoid the market failures that we have been talking about. Chairman Lieberman. Thanks, Senator Voinovich. That was a very interesting series of questions, and they really go right to the heart of the Committee's oversight role, because what we are really overseeing here is not the California or Western energy crisis that happens to engage us, but it is what is FERC doing about it? And I appreciate the comments you made about the role of staff within the agency, and there is no question-- may be one of the unexpected results of this crisis is that bright, young economists will think about going to work at FERC. Mr. Borenstein. Well, bright, young economists did in the last few years, and they were there for a year, and they left. Chairman Lieberman. That has to change then. Senator Thompson. Speaking of the jurisdiction of the Committee, I am reminded of the fact that it is very relevant to another subject we spend a lot of time on, and that is federalism. Here you have the classic question of what should government do and at what level should it do it? We have got a State responsibility and a Federal responsibility, and they overlap somewhat. Each is trying to cast responsibility on the other side, and each wants perhaps the best of all worlds. It is a fascinating federalism issue. Chairman Lieberman. True. Mr. Kahn. A very brief answer, if I may, to Senator Voinovich is, that this is an oversight committee, and I have had 6 years of experience in two places with oversight committees, and legislation, I do not think you could get any agreement right now what the legislation would be. But inducing the kind of discussion and thinking that is going on, or should be going on here, I think that is where you all play a very essential role. Everybody seems to agree with that. Chairman Lieberman. That is certainly my hope here. I would rather that we not have to go forward with the legislation, that FERC provides a response that is adequate to the occasion, whatever that might be. So thank you. Senator Carper. OPENING STATEMENT OF SENATOR CARPER Senator Carper. Mr. Chairman, I apologize to our panel and to my colleagues. I have been presiding over in the Senate during the debate on education, and I have missed, with the exception of Dr. Kahn's comments, I have missed all of your comments, and I will not ask you to repeat yourself, but I will ask you to do one favor for me, and sort of provide us with a benediction. I like to say sometimes when I am speaking to a group, I try to tell them what I am going to tell them, I tell them, and then when I finish, I tell them what I told them. And we are at that point where I am going to ask you to tell us what you told us. What I want to do is this. I am going to ask each of you to take maybe a minute, tell me where you agree. Tell me, throughout this panel, where you agree and what is the appropriate role for us in the Federal Government, in the Senate, where is the consensus? And I will just start with you, Dr. Borenstein. Mr. Borenstein. You want to specifically focus on what the appropriate role of this Committee is? Senator Carper. The Federal Government, where is your consensus? No, where is your consensus of the role of the Federal Government? Mr. Borenstein. I think the consensus is that California is in the midst of a crisis this summer, that a lot of it needs to be done at the Federal level. I think there is near consensus that the FERC can do something to help mitigate prices for this summer, and I think there is widespread consensus that that should not be a long-run tool that the FERC should be using. Senator Carper. Is part of that consensus that the FERC has every authorization that they need to proceed without our legislating? Mr. Borenstein. I am not an expert in that area, but it is certainly my impression that the FERC, if they wanted to step up to the plate, would have all the powers they needed to. Senator Carper. Thank you very much. Dr. Hogan. Mr. Hogan. I think there is also a consensus that there are a number of things that have to be done in California that have not been done or done fast enough to raise prices to retail customers, put in metering, get the demand side included in this marketplace, and that is an urgent matter. It has been for a long time, and it continues to be. This is something FERC has relatively little control over, but it is something that California has a lot of control over. And then fixing the market design, which has been a problem since day one of operation of this market, not just this last year, should be completed, and that is a problem not just in California. It is a problem in the west. It is a problem in the midwest, the southwest, the southeast. About the only place that has, I think, a workable market design is the northeast. Senator Carper. Good. Thank you, sir. Chairman Lieberman. Here here. Senator Carper. When I was leaving, Dr. Kahn was saying that there was somebody on the panel who was his former student. Is that you? Mr. Joskow. It was me. Senator Carper. I noticed when he spoke, your lips moved. [Laughter.] Chairman Lieberman. In the interim, Tom, Dr. Joskow indicated that Dr. Borenstein in turn was his student. Senator Carper. And Dr. Borenstein then told us that he worked for Dr. Kahn at the CAB, so it is a little bit--pretty incestuous, is it not? Mr. Joskow. Senator, I think there is actually a lot of agreement on this panel. We all agree that the markets in California and the west are broken. There is a lot of blame to go around. We agree that there are both long-term problems and short-term problems. We agree that FERC has the authority and needs to do a better job in fixing both short-run and long-run problems. I think a majority of us agree that mitigation options exist for this summer that are important both to protect California consumers as well as to convince other States that are on the path to restructuring competition, that Federal officials will not abandon them if they have problems. We agree that these mitigation methods have to be designed sensibly, that they can be designed in a way that does not deter investment in new generating capacity, and I think on all of those things, I think most of us agree. We have some differences as to exactly what is wrong, exactly how much of the price increase is due to market failures, market power, and how much is due to higher gas prices and higher demand, and higher NOX credit prices and so on. But I think what you are hearing from this panel is that FERC needs to step up to the plate, they need to become informed, they need to do something. And I would add my personal view, just looking at this over the--I do not know if there is agreement--over the past year, there has been too much screaming and too much paper flying back by Federal Express written by lawyers, back and forth between Washington and Sacramento. And I really would like to see the technical people at FERC be able to get together with the technical people at the ISO, with some of the economists in California, have a series of technical conferences and work out some fixes for this summer. I think this is not as hard as everybody has made it. We need to have a more cooperative spirit here, and as I said when you were out, there is plenty of blame to go around, and let us all accept the blame and let us move forward. I just think we can do much better. Senator Carper. Well, as one who was trained as an economist, not as a lawyer, I do not take any umbrage to which you just said here. Dr. Kahn. Mr. Kahn. I really do not have much to add to what the people on my right have said. I do not think that legislation is necessary. You have got the provisions of the Federal Power Act now. It seems to me that the oversight function of getting FERC here and saying, ``OK, there are your responsibilities, what are you doing about it?'', is terribly important. You are never going to get complete agreement about in what respect these designs were perfect or imperfect, so there is a very wide range of agreement. I am curious that no one has raised the question about whether it was wise totally to require the generating companies to divest their--I mean the distribution companies to divest their generation. Mr. Borenstein. I think there is agreement it was not wise. Mr. Kahn. Obviously, it was not undertaken lightly. No one has raised it. Obviously, if you still owned all the generation and you were still regulated at the distribution level, the situation would be very different. The one area in which we may not have come sufficiently close to agreement, but we have never really encountered, is that there have been studies by people like Dr. Borenstein and Professor Joskow, which purport to find definitively that there has clearly been evidence of withholding, of exercising market power, and I have not seen anybody directly challenge that except The Wall Street Journal, which published an editorial saying he left out five other causes--the price of natural gas, the cost of NOX emissions--well, read his letter in The Wall Street Journal today. As Paul says, I looked at every one of those things. I mean, The Wall Street Journal is still trying to get President Clinton impeached. It paid no attention to the fact that he had done all these things, and so I have been acting in part on the belief, and I think Frank Wolak has done the same thing, that there have been people who have found that there has been a market power problem here. Well, mitigation of that is surely something you have the right to demand of an agency that operates under your jurisdiction. Senator Carper. Mr. Chairman, thank you. I really want to thank you for being here today and for your good work over the last several decades, as well as training a whole new generation of economists. Please. Chairman Lieberman. Senator Voinovich, did you have something you wanted to say? Senator Voinovich. I was just going to comment that I think that Dr. Kahn, as one who has observed this whole area for many many years, has two students, or one student and one indirect student here, has made a great suggestion, and probably the most positive thing that you could do as Chairman of this Committee is to bring FERC in here and have a hearing and have them respond about what they are going to do about it. Chairman Lieberman. And in fact, they are coming in next Wednesday on the 20th. Senator Voinovich. Good. Chairman Lieberman. That is exactly what we would want to do. And I do want to repeat, I hope that FERC will act in a way that the move to have legislation adopted here ends, because it is not the best way to do it, particularly in the short-term case here where everybody is saying what is needed is temporary relief. Those who are saying that any relief is needed, say it is temporary relief, so I look forward to having them in--all five commissioners will be here next Wednesday. Senator Carper. Two more witness, please, if you would just conclude. Go ahead. Thank you. Mr. Makovich. I think there is a consensus here that power markets are very complicated, and as a result, we have got multiple flaws as we look to the California example in particular, which means that there is no simple solution including price caps, that it is difficult to fix in the short run, and that there are however, examples of people that have done things far better than California, like New England, and Pennsylvania, New Jersey, Maryland, the way they set up their markets. Senator Carper. PJM? Mr. Makovich. Yes, PJM. Senator Carper. Glad you mentioned that. Thank you. Mr. Makovich. This can be done right. Just to differ on-- there is not a consensus here that market power is the problem. It harkens back to, for example, when we had the blackout in 1965, 9 months later The New York Times ran an article about the record births at Mt. Sinai Hospital, and there were experts that had testified or had reported to The New York Times that there was reasons to expect that the blackouts had lead to people become amorous. And it was 5 years later---- Senator Carper. I am anxious to see where you are going to take this. Chairman Lieberman. I may have to exercise the gavel on my first day as Chairman. Mr. Makovich. It was 5 years later in August 1970, that there was a study done by the School of Public Health at the University of North Carolina that went through all the data and debunked the notion that there was a boomlet of births after the blackout. Mr. Kahn. How disappointing. Mr. Makovich. Some of this outage data, we have to be careful, that we may be misinterpreting it right now. It is complicated. Senator Carper. Thank you, sir. Chairman Lieberman. This might have led to an appeal for more blackouts, and we would not want to have that adverse market effect. Mr. Wolak. The advantages of being last is you do not have much to say, but the only thing I would say is, to follow-up on what Paul Joskow said, as the chairman of the Market Surveillance Committee, which was, believe it or not, established by FERC to be, if you like, the eyes and ears in the California market, it was shocking to me that in sort of-- when the crisis sort of first started, there was absolutely no communication with the Committee, despite the fact that we had prepared over the intervening 2 years, numerous reports, had analyzed the bid data, the production data, etc., so I really think that, exactly, rather than the lawyers talking it out, a very good thing would be a discussion among the staff at FERC, as well as the market monitoring committee, as well as the department of market analysis at the ISO, to essentially work to formulate a solution that will help to make things work, and I think there are a lot of very good and capable people at the ISO that I think could very much help FERC do its job very well. Senator Carper. My thanks to each of you. I again apologize for missing much of your testimony. Mr. Chairman, thank you for indulging me and I am delighted to hear, in response to what Senator Voinovich said, that we have got all five commissioners coming in next week, and we will look forward to that. Sounds like a great idea. Chairman Lieberman. Thanks, Senator Carper. That was very helpful to do that. I think Senator Thompson and I at least, and maybe Senator Voinovich, want to ask a few more questions. So that was a great summary of what has happened. I appreciate the focus on FERC, and it is interesting that as this discussion was going on today. It was noticeably different, and one of the reasons I think is that we have been thinking at least here in very legalistic terms, because after all, FERC operates under a law and we have been talking about just and reasonable rates and what powers they have and should have to exercise them. I think there has been a lot of common sense here at the table. I am curious about whether so much experience and good thinking around the table--are any of you ever consulted by FERC in what they do? Dr. Borenstein. When FERC did their investigation last summer, I am on the governing board of the California Power Exchange and director of the UC Energy Institute, and I called Scott Miller, who was the person--I guess one of the people running that, and never was called back. Chairman Lieberman. Dr. Joskow. Mr. Joskow. When the California markets were being set up, FERC, at that time in 1996 and early 1997, had a series of technical conferences, and they invited me to speak. Indeed, one of them involved setting up a market surveillance committee at the ISO, and what data they should collect. And so one of the great mysteries to me in all of this, is why they set up these entities which were supposed to be independent, and then for 2 years, ignored them. I thought that was a brilliant idea, to sort of decentralize the monitoring, that Frank Wolak, Carl Shapiro, who has been the chief economist in the antitrust division is now at Berkeley. Al Klevorick was on the PX, and I think it is a worthwhile question to ask FERC. You set up these market monitoring entities. They have got great people on them, they do good studies. Why do you not build on that and work with them? And I have asked them that, and I do not understand the answer. Chairman Lieberman. We will ask. Let me ask another question. I think I will ask Dr. Wolak this one, and invite anyone else who wants to respond. There has been some concern, as you know, that even though FERC determined last November that the prices in the California market were not just and reasonable, that they have done not enough regarding examining past overcharges and providing refunds to wholesale customers, which might make up for some of the high costs. Do you have a reaction to that? Mr. Wolak. I very much agree with that. Chairman Lieberman. Excuse me. Dr. Kahn, you have to depart, am I right? Mr. Kahn. In a few minutes. Chairman Lieberman. Thanks very much for being here. You contributed---- Mr. Kahn. I apologize. Chairman Lieberman. No, not at all. Mr. Kahn. The people who deregulated those dammed airlines. [Laughter.] Chairman Lieberman. Thanks very much for coming. Mr. Kahn. I am awfully sorry. Chairman Lieberman. Not at all. We are going to wind up soon. You were a great help. Mr. Kahn. Thank you so much. Chairman Lieberman. Dr. Wolak. Mr. Wolak. I guess as I said, I definitely agree with the viewpoint. In fact, I would go even further to say that effectively FERC said that if there is market power, then we will essentially order refunds of any rates that reflect the exercise of market power. Unfortunately, effectively in my entire 2 years, almost 3 years on the Market Surveillance Committee, FERC has never determined what constitutes the exercise of market power, in other words, what prices would reflect the exercise of market power? What behavior on the part of the generator would result in prices that reflect the exercise of market power? So in many ways it is sort of looking for something that you do not know what it is. So what we have had to do, as well as Professor Joskow has had to do, is essentially say, well, we will use the standard definitions from economics to determine what are the payments in excess of competitive prices and what reflects the exercise of market power. But as far as FERC is concerned, even despite numerous meetings with FERC staff and conferences with FERC commissioners, a definition for what constituted market power and what constituted prices that reflect the exercise of market power, that definition was never given. So in some sense, it makes it very simple never to have to confront that issue. Chairman Lieberman. Anyone else want to speak to the question of refunds? Dr. Makovich. Mr. Makovich. The question of just and reasonable prices is a difficult one for many reasons, but right now, the prices in California with the shortage are too high, and that is why the finding of just and reasonableness by FERC was that these are too high. But we have to remember, when the California Power Exchange opened, on its first day, there were hours when the price of power cleared at zero. And it continued. That is something that we have seen through time, that the price will clear at zero. Is zero an unreasonable or unfair price to a producer? And the point that has been made here, is if there is a 4-year lead time on building power plants, the prices are too high right now but this is not the right time to give somebody a signal to build. It was 4 years ago that we had to give people the expectation that if they build a power plant, they could make money. And if the explanation was, sure, prices clear at zero. They are averaging $14, but in the year 2000 and 2001, there will be an extreme shortage, and you will be able to make all your capital costs back within just 2 years, although you will be vilified as the cause of the problem, I do not think you would have got a lot of investment. So there is fundamentally still a problem here on investment incentives and just and reasonable prices. Capping them now neglects the fact that they are too high now because they were too low previously. Mr. Wolak. May I just respond to that? I think it is very important to bear in mind that the zero prices he is referring to were not really paid to anyone. They may have been paid to small, small, small amount of capacity sold, but primarily most of the times when those prices of zero occurred, these were in a capacity that is called ``must take'' and is being paid under a different contractual arrangement as primarily setting the price. So the other, I think, I want to also correct a few more misunderstandings here is the statement that these prices were too low. The average price for 1998 was not $18, it was above $30. And, moreover, generators in California also have the opportunity to earn ancillary service payments, which are payments to provide reserve capacity that roughly average on the order of about 7 to 10 percent more revenues to their facilities. Moreover, generators in California also have the opportunity to sign up for reliability must-run contracts, which pay them large amounts of money in payments to provide local reliability service, in addition to the prices that they receive for energy. So, I think we want to be very clear on all of the sources of revenue for generators in California. Chairman Lieberman. We seem to be replicating the ``Cross Fire'' show on television. Mr. Makovich. Just a quick one---- Chairman Lieberman. Just a quick one because I want to ask one final question, though it is a good exchange. Thank you. Mr. Makovich. The $30 level is an average on-peak price. Mr. Wolak. No, it is not. Mr. Makovich. Well, even if it is across all hours---- Mr. Wolak. Yes, it is across all hours. Mr. Makovich. You need something closer to $50 to justify building a power plant, and not everybody gets ancillary services. It depends on location. Mr. Wolak. That is not true, either. Mr. Makovich. The fact that nobody built power plants in California has to make one wonder, if they built them in Texas, and they built them in New England and did not build them in California, maybe there was a problem with the investment incentive. Chairman Lieberman. Yes. Let me move on because I was really asking about refunds, and we got off a bit. The final question is the effect of what is happening. We are all focused on California, but they are part of a regional grid, and I know seasonally power generating facilities in other States have fed into California. I was in Washington State, where, I am sure you all know, they tell me some of the aluminum plants have stopped because they are selling their electricity and making more than they could making aluminum, and people are out of work. So it is serious. I wonder whether you think that FERC should be including the other Western States in its response to the problems in California and its regulatory response to the problems in California. Dr. Joskow. Mr. Joskow. Senator Lieberman, if I might, I think to make the mitigation program that I mentioned before, which is extending the protocol FERC put into effect on May 29 to all hours, it is essential that it apply to the rest of the region, as well. This is the only way to deal with some of the problems that Frank Wolak mentioned, involving essentially daisy- chaining the power from one reseller to another. So I would strongly recommend that if that is the approach that FERC takes that, in addition to extending the number of hours, that it include at least the other major control areas: Arizona Public Service, Tucson; Nevada, Bonneville; Public Service in New Mexico, in this program, and that is going to be the only way to tag the power plants that are supplying the power and applying their marginal cost base mitigation plan. Chairman Lieberman. Dr. Borenstein. Mr. Borenstein. Yes, I agree with Dr. Joskow that we really do need to do this on a regional basis because there are a lot of loopholes that can easily be exploited. I think it is also important to recognize, when we get onto this investment subject, I should also say, as director of the Energy Institute, I do not do consulting for any private companies in the business. So I have no financial interest here. It really concerns me when we start talking about the need to give firms capacity payments in order to get them into the market. Economics tells us pretty clearly that if you have competitive prices all of the time, you will get the right investment. Now it is going to be pretty disruptive in the electricity industry if you do not have a demand that can participate, and that is why you want to have long-term contracts and that is why you want to have demand responsiveness. But we need a regionwide approach to this, and we need to recognize that the goal here is not the lowest prices in history. The goal here is competitive prices that will ultimately serve consumers, and sometimes those competitive prices will be very low, and sometimes they will be high. The goal is to make sure they are the competitive ones. Senator Joskow. Could I add a note of history to this? When I was at Yale, I taught economic history. The Federal Government induced California to build long transmission lines to link them with the Northwest in the 1960's: Two AC lines, one DC line, and then in the 1980's a third AC line for the municipal utilities, and they were encouraged to rely on the Northwest for power and for the whole region to operate as an integrated system. One of the things that has happened as a result of this crisis is that every State is trying to grab onto its power supplies, which is just the opposite of what we hope to emerge in competitive wholesale markets, and abandoning would have been one of the best examples of regional cooperation anywhere in the United States, and I really think that we do not want to go back to a system where every State think it has to be energy self-sufficient. It would be a terribly, terribly costly mistake. Chairman Lieberman. My time is up, but, Dr. Hogan, I want to give you a chance to respond. Mr. Hogan. On this question of extending the FERC order to around the clock and to around the region, there are a number of things you have to be very careful about in doing this. It is not so simple. The FERC order includes a requirement that people bid in, under these bid caps that they have put in place, and it is one thing during these emergency hours. But it would be another thing during all hours. For example, there is the credit worthiness problem. They also are going to require that they be paid, and right now a lot of the problem is that people are not being paid, and that is why they do not want to produce. And if the Federal Government is going to mandate that you produce, they have to address that problem. Second, there is the problem of dealing with facilities that have cumulative limits because of environmental restrictions or any other kind of constraints, hydro facilities and the like, where the amount that you can produce over the year is limited, even though in any particular hour it might not be. And right now the order punts on that because they did not know how to deal with that problem, but they were only dealing with it during shortage hours so it did not matter so much. But if they go around the clock, this is going to become a big problem that they are going to have to address. Right now they have a system where they have discriminatory pricing rules for inside California and imports and power that is coming from outside California. That creates the opportunity for the marketers to get around the rules, as they perceive them, which I think is a good thing. The way to solve that problem is to simply go to a single-market clearing price. As Fred Kahn said earlier, when the imports are the marginal supply, then you should use those to set the marginal cost, not trying to set multiple prices for different markets. If they extend to the rest of the rest, they are going to have to deal with the problem of reserves. Do you want to draw down the reserves in Idaho in order to satisfy California and create reliability problems? These are not trivial issues and they are going to have to be worked out. There are solutions to these problems. They are going to have to get demand-side participation into the system somehow, which so far they have not been able to get in California, and that should be done across the whole West, if they can get to it. Chairman Lieberman. Thanks very much. I will think about your answer. Senator Thompson. Senator Thompson. Thank you very much, Mr. Chairman. I think it is good that we have FERC in, but least we spend all of our time concentrating on what they might could do with what I read is about 50-percent of the power that we will be dealing with, I think we need to understand that we are in the midst of a political issue. I mean, this is something public officials are going to have to decide, and I think until then, we need to take a close look at what FERC's proper role in this should be. But until we have some acknowledgment that California will allow its consumers to pay a little closer to what their energy costs really are, instead of relying on other forces and outside forces to do that for them, I think politically you are going to have great difficulty on shifting responsibility all on FERC. I just do not think that when you look at all of the factors that everyone acknowledged played a part: The structural situation that they set up, the insufficient capacity to meet the demand, the infrastructure problems, the weather problems--you are just not going to get most people to believe, I do not think, that all of this is because of wicked suppliers in Texas. So we need to look at a whole part of the picture. The governor will be here, and hopefully we will be able to see whether we could get the State and the Federal entities to agree that everybody needs to do a little something here and have a more likely solution. I want to ask one question, but I want to lead into it a little bit. I want to ask about the risk of not getting this cap situation right. In the first place, Dr. Hogan, do you agree that there is near unanimity with regard to the role of market power in this problem or do you think that is questionable? Mr. Hogan. I do not agree with that. I have looked at the analyses of this study, and I have done some independent analysis of some of the data that we can get in the public domain. My position on it at the moment is that it, with the information that we have in the public domain, which is insufficient, it is not possible yet to make a determination; in other words, that the margin of error is larger than the size of the effect we are trying to estimate. Senator Thompson. But we have, I presume, somewhat of a disagreement on the panel. At least two of you have questions with regard to the significance of market power playing into this price. Assuming that it does play a part or a large part, I want to address the difficulty in getting the caps right--the unintended consequences, the deciding of who, what, where, when, and how. I also want to address the complexity, if it is going to be a cost-based situation, of having hundreds or I guess thousands of suppliers and trying to determine what their individual costs are so you can determine what they are going to be allowed to charge. Also there is the issue of FERC only covering half the system and having two tiers, new entrants who are not covered, and old entrants who are. You know, we are reminded of Marc Rich back in the oil cap days. That is the way he made his money, apparently, with those two tiers and playing them against each other. Obviously, it is different with electricity, but it comes to mind. The point being the investors. You say in a perfect world here is the way it could work. You put it on at the right price, not too high, not too low. Have it administered correctly. Then you take it off at the right place, knowing that there is nothing that the government does that cannot be undone, causing credibility with regard to potential investors. My point being that it seems to me, and I think maybe several of you have acknowledged on both sides of this issue, that this is a complex proposition. It is a complex proposition, perhaps not impossible, perhaps something that cannot be done. But I want to ask what if, in fact, it turns out that this is not primarily a problem of market power? What if, in fact, and let us say there is maybe even a 30- to 40-percent possibility that it is not primarily a market power problem, that it is a supply and demand problem, and we impose these price caps or controls? From what I can understand of this, there is a tremendous risk that we would have substantially greater problems than we would otherwise have, and the blackouts would be more pervasive than they otherwise would be. First of all, Dr. Hogan, I will start with you. Is my premise correct? That is, that if we are incorrect about our assumption, basing all of this on the significance of market power and it turns out to be other things, are the risks of imposing caps into those circumstances great? Mr. Hogan. I think the answer is yes. That is why I made the point earlier that I think the diagnosis of what the problem is, is critical in deciding what to do. Senator Thompson. Excuse me, but as I understand it, if, in fact, it is market power, then they are right. If you impose caps, then the inducement to hold back is not there any more, so you will come across with the electricity. Again, my concern is are we that certain that this is the cause, that we can go in this direction? And if we are wrong, what are the consequences? Mr. Hogan. Well, I think there are many causes, and I am not certain about which is the dominant effect here. That is why the proposal that the FERC is pursuing, this bid cap proposal, is attractive if we are going to do anything at all. That is because a bid cap is the most robust policy with respect to the problems that you are talking about. To the extent that it is scarcity and you have a competitive market out there, and it is not market power, the bid caps effectively become redundant. It is a complicated process to get it put in place, but they effectively become redundant. And if you have market power out there and people are withholding, the bid caps target that problem exactly, and that is what they are trying to do to eliminate it. This is a very delicate business because when you are trying to do this, there are many ways to get it wrong, but this is, I think, the most robust mechanism. That is why it is so important to be careful about trying to target the market failures, rather than just worrying about making prices lower, because our objectives should not be just to make prices lower. Senator Thompson. If I understand what you are saying, you sound to me like you are somewhere in the middle between market caps, on the one hand, and what FERC is doing today. Mr. Hogan. I would not characterize what FERC is doing today as a price cap, in the traditional sense. I think it is different, and the term of art is a bid cap mechanism. It does not determine what the market price will be. The market price can go up and down and varies with conditions at every hour and depending what plants are running and what is happening to the water in the Northwest. You do not have to decide those things before the fact. It adapts it the same way, trying to emulate what the competitive market would do, and so it targets the market failure. But it does not guarantee--you have to be candid about it--it does not guarantee that prices will be low because if there is a scarcity problem, prices will be high. Senator Thompson. Dr. Joskow. Mr. Joskow. Thank you, Senator Thompson. There is one thing I would like to make crystal clear. Nobody who has done the studies of market prices, market behavior and market power in California in year 2000 has concluded that the dominant source of the price increases was market power. We have all recognized gas prices went up, demand went up, imports went down, NOX credit prices went up and have tried to take that into account in our analysis. Merely $5 to $6 billion out of $27 billion, I think that is the average of the various studies, are due to market power. I think that is a lot of money. It would be a lot of money to me. I have done a study with public data, the ISO has done a study with confidential data. Frank Wolak, Severin Borenstein, and Jim Bushnell have done a study with public and some confidential data, and they basically all come to the same conclusion. There is evidence of market power driving prices up above what would have already been high prices. And Mr. Hogan wrote a very thoughtful paper criticizing some of these studies, and I am about to finish a response that recalculates our numbers. I would be happy to provide it to the Committee. I hope it will be done in a week. So that is my first point. Senator Thompson. Is it fair to say, and do not let me keep you from your second point---- Mr. Joskow. Sure. Senator Thompson. Is it fair to say that the confluence perhaps of all of these circumstances in this history put California in a situation where market power could come into play? Mr. Joskow. Absolutely. This is not a conspiracy issue. This is a result of the conditions in California that provide suppliers with opportunities to maximize profits that lead to prices that are above competitive levels. The second point I would make is that FERC is already applying a price mitigation program. We can call it whatever we want. I will not use the term ``price caps,'' but it does effectively cap prices at a certain level when it is implemented. I agree with Mr. Hogan that is the appropriate framework because it is targeted on trying to simulate competitive prices. I would like to see us at least explore whether we can expand the number of hours, and more importantly close some of the loopholes in the current program by bringing other States into the program as well. And the final point I would make is that we have a lot of experience with applying mitigation mechanisms around the country. You would think from the public discussion of this that this is some new thing that has never been done before. It has been done. We have had bid caps and PJM for 6 months. We have had price caps in New York and in New England. It has not discouraged investment, it has not led to shortages. It has given folks the confidence that they can fix what were pieces of broken markets without unreasonable economic consequences. So I think we have a lot of experience. If they bring knowledgeable people to the table to fix this problem, we can do it in a way that minimizes the concerns, the legitimate concerns that you have, and we need to recognize that none of these schemes are going to be perfect. We need to do the best we can in an imperfect world. Senator Thompson. Thank you. Before I call on Dr. Makovich, we always or oftentimes go back and get the statements of experts or academics and cross-examine them with them. I want to turn the tables a little bit here and point out that Dr. Makovich wrote, in April 1997, an analysis of the California market, and said, ``There is no reliable mechanism in California to pay for the fix and operating costs of new generating facilities, since the means for doing so, that is, long-term contracts and high ancillary service payments are unlikely to be widely available for several years, given the rate for these and above-noted trend toward low PX prices. This is likely to lead to extended periods of low prices, followed by periods of very high prices, as supply shortages and surpluses develop. Price volatility will not be conducive to a smooth transition to competition.'' Congratulations, Mr. Makovich. Not only apparently was this foreseeable by some, it was foreseen. I understand the folks at Bonneville, in early 1999, pointed out that it looked like there was going to be some hydro shortages in the Northwest. So that is a parenthetical. I do not want you to move too far away from the question I ask, and that is the consequences of getting it wrong. Mr. Makovich. Right. Well, I think the consequences of getting it wrong are very serious. For example, it has been mentioned today it would be a good idea to exempt new supply from any kind of price cap proposal, but it is important to realize, as we look back over the decade of the 1990's, a major source of new supply in this country, if not the majority of new supply over the first half of that decade, came from the refurbishment and investment in existing power plants. And so we are either going to create a disincentive to investing in power plants and improving efficiency, and availability and capability, or we are going to create a very complicated review process, where people are going to have to try to argue what percentage of my plant is now new capacity versus old capacity. We have already seen, within the past week, an announcement that 500 megawatts are not going to be developed in California by a major supplier who had a site that was permitted, and they were ready to go on construction. And, finally, with this idea, there is a bit of a circular argument here with withholding capacity. The conditions of the very inelastic supply and demand curves only exist in a shortage so that the only way it is rational to withhold is if you have got a shortage. So to argue the shortage is caused by withholding is a bit of a circular argument, and there are problems with the basic data. People are running these power plants far harder this year and last than they ever did before. So the basic data here is something that has to be looked at far more carefully to come to the conclusion because it is a very dramatic accusation to somebody that they are withholding capacity and supply from this market---- Senator Thompson. You could ask why they did not withhold in 1998 and 1999, I suppose. Mr. Makovich. It would have been worth a lot more to them to do so. Senator Thompson. My time is up, but obviously---- Chairman Lieberman. Do you want to have the last word? Mr. Borenstein. Well, actually, it would not have been worth a lot more to them to do so. In 1998 and 1999, there was a lot more supply, and the economics of withholding were much less attractive in 1998 and 1999. Put simply, the right question to ask is, when you put yourself in a position when the ISO is near a blackout, they have 2-percent reserves left, and you own 6 percent of the capacity in the State, what do you bid? And the answer is whatever you can get away with, and that is not to demonize the generators. They are out there trying to make money. That is what they are supposed to do. Our job is to create markets where when they try to make as much money as they can, they end up helping consumers. But it is a fantasy to say that this is a market in which generators cannot exercise market power. It is a serious issue. I do want to respond to Senator Thompson's question that it would be a major disaster to set the price caps too low. We saw that last November when we had this 250 price cap, and the price of natural gas went too high, and generators did the rational thing and shut it off. That is exactly the 1970's all over again, only worse. However, it would also be a major disaster to simply walk away and pretend there is not a problem here. Because at those times of peak demand, if we have no price mitigation, we will have billion-dollar prices. There is just nothing to stop it. Chairman Lieberman. Thanks, Dr. Borenstein. Thanks, Senator Thompson, and thanks to all of you. It has been a long hearing, but it has been a very productive hearing. I think we have all learned a lot about the situation in California, and frankly about FERC, and you have helped us to get ready to ask some constructive questions of FERC. I do think that there is agreement that the rates in California now are not just and reasonable, that FERC has some role to play here, although there is a disagreement as to what the role is. The other thing I have heard is that no one thinks, in spite of the drop in prices out there in the last few days, that the crisis is over or that everything is going to be OK this summer. So this calls on us all to continue to work together. And I hope that some of the kinds of discussions among technical people can occur that many of you described, and that may get us some way forward. Anyway, thanks for taking the time to come here. Thanks for sharing your expertise with us. It has been a very productive morning. The hearing is adjourned. Thank you. [Whereupon, at 1:19 p.m., the Committee was adjourned.] THE ROLE OF THE FEDERAL ENERGY REGULATORY COMMISSION ASSOCIATED WITH THE RESTRUCTURING OF ENERGY INDUSTRIES ---------- WEDNESDAY, JUNE 20, 2001 U.S. Senate, Committee on Governmental Affairs, Washington, DC. The Committee met, pursuant to notice, at 9:35 a.m., in room SD-106, Dirksen Senate Office Building, Hon. Joseph I. Lieberman, Chairman of the Committee, presiding. Present: Senators Lieberman, Durbin, Torricelli, Carper, Carnahan, Thompson, Collins, Voinovich, Domenici, and Bennett. OPENING STATEMENT OF CHAIRMAN LIEBERMAN Chairman Lieberman. Let me ask everyone to take their seats and we will begin the hearing. I appreciate very much the presence of all of our witnesses and guests. I wish you good morning and I thank you for joining us today as the Senate Governmental Affairs Committee continues its hearings into how the Federal Government has conducted itself in response to the deregulation of the U.S. energy industries, with a particular emphasis, of course, on the cost and supply of electricity in California and the Western United States. Last week, we heard from five economists, including Alfred Kahn, the father of deregulation himself. They agreed that the California market was so dysfunctional that the Federal Government needed to intervene and temporarily regulate. On Monday, the agency that oversees electricity rates, the Federal Energy Regulatory Commission, which is known here in Washington by the acronym FERC, agreed to take action. Today, we are going to hear about FERC's latest order and whether or not it adequately carries out the Commission's statutory responsibility to provide just and reasonable rates for electricity consumers in California and the West. I must say that I am relieved that the Commission has asserted itself more aggressively to address the severe problems in Western power markets, although I remain concerned that even at this late date it has not done all that it could. The price limits established by FERC may still be too high, and ratepayers in California and in other Western States may still deserve substantially greater refunds for overcharges that have previously been imposed for them. We are very fortunate today to have most of the key participants in this complex matter as witnesses before the Committee, including Governor Gray Davis, the Governors of North Dakota and Montana, Representatives from the State Governments of Oregon and Washington, the five members of FERC, as well as three distinguished colleagues here in the Senate. To put this hearing briefly in historical context, let me say that Federal oversight of wholesale electricity sales began in 1935 when Congress passed the Federal Power Act mandating that prices for electricity be just and reasonable. Originally, those oversight duties were assigned to the Federal Power Commission, which in the 1977 reorganization of the Department of Energy became FERC. The Federal Power Act remains, however, the primary statute governing FERC oversight of wholesale electricity sales. And the law requires that all rates in connection with the transmission or sale of electric power under the Commission's jurisdiction shall be, ``just and reasonable and not unduly discriminatory or preferential.'' FERC is authorized upon outside complaint, or its own initiative, to investigate prices that appear suspect. And if the rates are found to be unjust or unreasonable, the Commission is obligated to take remedial action, including the ordering of refunds to customers. Traditionally, FERC has met its obligation to ensure just and reasonable rates by ordering rates that provided for cost recovery plus a margin of profit, in the same manner that most State public utilities authorities or commissions have done for generations. More recently, FERC has allowed market-based pricing or proxy pricing, such as it ordered Monday, to be the standard for just and reasonable. No matter what the methodology, FERC remains responsible for ensuring that the wholesale markets operate competitively and that the rates they produce are just and reasonable. As the Committee heard last week, in 1996, California enacted legislation to deregulate its electricity markets beginning in 1998. To put it mildly, it has not been an easy transition, either for California or other Western States, because of record prices for electricity, supply shortages, rolling blackouts, and price spikes for natural gas. The transition to deregulation prompted the bankruptcy and near bankruptcy of major investor-owned utilities, and in an extraordinary development, the State of California has now assumed responsibility for wholesale power purchases. So as I see it, the question today is: Has FERC responded adequately to this crisis? What is the record? Last July, almost a year ago, FERC began a staff investigation into electricity problems in the West and a formal investigation into California prices. In a December 15 order, FERC concluded that the California market was deeply flawed, which, when combined with other factors, caused electricity prices to be neither just nor reasonable. So the Commission ordered changes in the California market and established a procedure for refunding excessive charges. Yet in March and April of this year, as the Commission began implementing that procedure, it also significantly limited the number of transactions subject to refund and the circumstances under which prices would be mitigated. In April, the Commission also initiated a formal Federal Power Act investigation of the Western electricity market. Two days ago, FERC expanded those actions by setting a soft cap on energy prices, around the clock, and regionwide. In my opinion, the Commission's record in this matter raises serious questions about whether it will, and has, adequately overseen newly deregulated energy markets. It has been very slow in responding to this real and painful crisis. While the Commission by its own admission has had the authority to intervene to ensure just and reasonable rates, it has been surprisingly reluctant to do so. It did not initiate a formal investigation of the Western market outside of California until April of this year. In the past, when it has intervened in response to California's problem, the result has fallen short of what the public interest required. I, of course, hope that Monday's order will be more successful, but I continue to have substantial concerns. I believe the order addressed the matter of refunds for electricity in California in an unsatisfactory manner, and it did nothing for refunds for consumers elsewhere in the West. Monday's order will constrain some price spikes and close some loopholes in the previous FERC order, and that, of course, is all to the good and appreciated. But will it ensure that electricity prices in California and throughout the West are just and reasonable? That is not only the bottom-line question, it is the law. And it is that question that I hope our witnesses will address this morning. Senator Thompson. OPENING STATEMENT OF SENATOR THOMPSON Senator Thompson. Thank you very much, Mr. Chairman. I think it is obvious to all of us that California is in a state of crisis. Two of its largest utilities have gone under or one has taken bankruptcy. California bonds have been downgraded on two occasions. Producers, suppliers, who the State is going to have to depend upon for additional supply in the future, are expressing concerns. Some projects now have been delayed. We have seen blackouts, and we are told that, apparently regardless what happens from here on out, we are locked into future blackouts this summer. It is of concern to all of us, not only from a humanitarian standpoint but from an economic standpoint. California, of course, is extremely important to the rest of the Nation from that standpoint. So we are addressing the question of what to do about it at this stage of the game and who is responsible. I am reminded, as I look at this, of the wisdom of the Founding Fathers and the system of federalism that they created, and that was that we should have responsibility at two different levels of government, and one of the reasons for that was to assess accountability. And if there was ever a place where we do not have federalism, it is here. We have a split system where the State is responsible for the retail market, as it were, and a Federal system where the Federal Government has some responsibility in terms of wholesale prices with regard to private suppliers. And it ensures that no one will really have to accept accountability when things go wrong, and that is one of the reasons, of course, we are seeing all of the finger- pointing and the blame-gaming that we are seeing now. But it is true that this hearing today has been focused on FERC. I think it is unfortunate. I see we have five panels here, and a certain thing in some businesses they refer to as ``prime time,'' and FERC's appearance is not in it. And I certainly hope that we have at least a semblance of the interest in hearing the FERC testimony, which is supposed to be the primary subject of this hearing when they come on sometime probably mid-afternoon. But they do have a responsibility in certain areas, and part of that has to do with just and reasonable prices, whatever that may be. The idea of a Federal agency deciding what is just for something as important as this would be laughable in any other context, but that is the law, and that is what we operate under. That has led many to call for hard caps. Constituents and elected leaders, after thoughtfully mulling over this for long periods of time come down on the side of lower rates instead of higher rates. But we know that in any long-term sense, anyway, that generally speaking caps do not work when supply is the problem. And neither the FERC while President Bush is President or the FERC while President Clinton was President has thought that hard caps were a good idea. In fact, the prevailing opinion is that when supply is the problem, they make a bad situation worse. Now we are told that this is different, this situation is different, that we can apply a Goldilocks test to this one and we can get the rates not too high, otherwise, they would be ineffective; not too low, otherwise, we would drive supply out of the market; and we would lift it just at the right time and all of that would work out, although I see no model for that in history anywhere. There are a lot of very credible people who think that that is the way to go. So there has been tremendous pressure on FERC because of that. They have taken several actions. I was reading a summary of the written testimony of FERC Commissioner Linda Breathitt. She says that since last August, FERC has issued 50 orders implementing important remedial measures and price mitigation, instituted investigations into rates and market design flaws, established programs to maximize electricity supply and delivery and demand reduction, and directed sellers to provide refunds. And, of course, those refunds, rebates, are an important part of this process. It does not shock me to find out that in a matter involving this much money and this many people and this many suppliers that there probably have been some out there who have not behaved as they should, even though I see no allegations of criminal activity--at this point, anyway. Those investigations are ongoing, and they should be ongoing. But for most people, the idea that this problem was caused solely or even primarily by that is far-fetched, to say the least. So let that play out as it may. Let's acknowledge that that might be a part of the mix. FERC, on April 25, of course, entered into a price mitigation system. Prices have dropped since that time. Now we are switching somewhat from a blame game to a credit game, and everybody is scrambling to claim credit for the recent drop in prices in California, and we will watch that play out with some interest. But now they have expanded the price mitigation system. It is not a hard price cap, and it is not price controls in the normal sense of the word, I would think. But it has been expanded to all of the Western grid and to an around- the-clock operation. However, some people believe that this problem has to do with more than just a Federal agency fine-tuning wholesale prices, and I am one of those. And some people believe that to determine where to go, it is good to consider how we got here in the first place. Now, for Governor Davis, the answer is simple. A bunch of Texas cowboys got down at the corral and decided they were going to take advantage of helpless California, and we are seeing the results of it. In fact, we have seen no shortage of villains. The governor at one time or another has blamed Federal regulators, State regulators, the President, suppliers, the former governor, and a bankrupt public utility. However, I think we need to cast our net a little wider. Clearly, there are other factors at play. We know, for example, that we had a drier Northwest during crucial periods of time that cut back on the hydropower that the West normally sent down during the summer months and that California depends on. We had an inordinately hot summer. We had an inordinately cold winter. During all of this, we were experiencing increased demand throughout the West, and especially in California because of the growth of that part of the country. It was clear that California was becoming more and more dependent upon imports. Surely, none of us can blame anyone for those factors, but the other interesting point about that is none of those factors were secret developments. One would have thought that State officials might have noticed those things as they were occurring, especially since they were getting warnings as early as early 1999 with regard to the problems in the hydropower situation, at least. Other factors, of course, enter into play, and that has to do with the policies of California, the policies of the Public Utility Commission, and the governor. No power plants in 10 years. The governor is not responsible for most of that. But capped retail rates at a time when the utilities were locked into spot markets, which everybody acknowledges was a mistake. When deregulation came about, we had a supply surplus of about 30 percent in California. That situation, as we saw, rapidly changed, but the policies did not change with it. So PG&E was paying 30 cents and selling for 3 cents and, of course, ultimately went bankrupt as they were saying last year that they needed relief and others were saying they needed relief. No relief was coming. So no additional power, capped retail rates, locked into spot markets, a siting process that was longer than apparently anybody else's made it very difficult to put new power online. And then even more warnings from experts who were talking about the storm clouds that were looming, and then, of course, we saw shortages in May 2000. So all of the policies that were clearly a part of the problem were locked into place and kept there until the problem became a disaster. I think that it is instructive to look at other States around the country that have deregulated, that have not had similar problems. They did not have some of the natural problems either that California had, in all fairness, but they did not have some of the policies or adhere to them the way that California did either. Now, after blackouts are inevitable, apparently, according to the experts, some changes have been made. California now enters into long-term contracts, but apparently they are paying very high rates for the contracts, higher than spot markets. So when spot market prices were higher than long-term contracts, they were paying spot market prices. Now that long-term contracts are higher than spot market prices, they are paying long-term prices. A policy of buy high, sell low. And we do not know exactly what prices they are paying because California has not been willing to release the prices that California citizens are paying for the long-term contracts for municipalities, which, of course, continue to be large suppliers of power. So I do not want to rain on anybody's parade here today as we bring FERC to task, but I guess, as Paul Harvey would say, perhaps we ought to look at the rest of the story and, before the day is over, perhaps a more balanced view we will have not only as to what should be done at the Federal level but as to how we got here in the first place. Thank you, Mr. Chairman. Chairman Lieberman. Thank you, Senator Thompson. It is a long hearing. We do have serious questions to ask. I assure you I will be here when FERC comes on, regardless of what hour it comes on. And in some sense, the morning testimony will pose questions which I think will be fair and reasonable both to those who are in the morning and to those who will follow in the afternoon. As is our custom, we will now go to Members of the Senate who asked to testify this morning, though I do note the presence of a growing number of members of the California delegation. I do want to welcome them here. I see Congresswoman Jane Harman, Ellen Tauscher, Hilda Solis, Anna Eshoo, Joe Baca, Lois Capps, and Lynn Woolsey. And I thank you. Obviously your presence here is an expression of your concern about the ongoing problems regarding electricity rates in your State and your hope that we and FERC together can bring some relief to citizens and businesses in your State and to the economy of the State generally. I am pleased to have three colleagues with us. I can go in alphabetical or seniority order. Do you have a---- Senator Murray. Seniority order. Chairman Lieberman. This is most encouraging. Your two colleagues from Washington State, acknowledging that you are obviously much older than either one of them, Frank, have yielded to you. So, Senator Murkowski, ranking member of the Senate Energy Committee, we thank you for being here and look forward to your testimony. TESTIMONY OF HON. FRANK H. MURKOWSKI, A U.S. SENATOR FROM THE STATE OF ALASKA Senator Murkowski. Thank you, Mr. Chairman, and let me thank the two gracious ladies on either side of me. I am most appreciative that you included Energy and Natural Resources Committee representation here at your hearing. Everybody seems to want to get in on the energy crisis at this time. There are many chairmen holding hearings, and that certainly is the prerogative. Some are even involved in spinning away their responsibility associated with the crisis in California. We have heard criticism of our President, of our Vice President, for being chummy and cozy with big oil, criticism that indeed the higher costs associated with the shortage are the responsibility of the administration. It strikes me, Mr. Chairman, that if you have a sickness-- and we have a sickness right here with the gentleman that just turned the chart over. It is upside down. [Laughter.] He is relatively highly paid--or I mean he was. Chairman Lieberman. Of course, there was some chance that we were upside down and the chart was right side up. Senator Murkowski. Well, we have been accused of that, too. Senator Thompson. I am glad we noticed. Senator Murkowski. But the point I wanted to make relative to the criticism of the President and the Vice President for being too chummy and out of the oil patch and part of the bad guys from Texas, I think somebody did a calculation that suggested that Texas-owned companies contribute about 12 percent of the energy that California consumes. But, ordinarily, if you have a sickness or a crisis of some kind, you address it with some degree of expertise as opposed to holding a public hearing. And I think the energy situation in this country is a sickness. You need people who know something about it, how to correct it, and how to bring about change. And I think both our President and our Vice President fit that category. Now, we know something about energy as well, Mr. Chairman. We have held 24 hearings, Senator Bingaman and I. We have had 164 witnesses. And what we found is very simple: We must increase production, we must develop alternatives and renewables, and we must improve conservation. It is just that simple. And those that suggest it is more complex are leading you down either goat or rabbit trails, as the case may be. We had a hearing in this room yesterday. We had FERC here. We had all five commissioners. And it was rather interesting because they did reach a conclusion. All five concluded that Congress should not legislate price control legislation or wholesale price caps, as the case may be. I would also remind you that FERC is just recently up and running. They just obtained the last two members, and now they have a five-member commission. Further, both sponsors of the price cap legislation, Senator Smith and Senator Feinstein, have indicated they will not push for legislation to a markup on their proposed wholesale cap bill, which I think is relative to the action that FERC has taken and their belief that FERC is doing the job that they were set up to do. Now, I commend the President and the Vice President for staying the course, staying the course against wholesale caps. This is the only way the energy supply will increase. If you put caps on, you will not get investment. We heard testimony given yesterday by the investment community relative to the fact that if you have tight caps, there is not the incentive for investment. And the investment can go a number of places. I think it is also important to point out that under the Bush Administration, FERC has taken their responsibilities seriously, somewhere between 30 and 50 orders, as Senator Thompson indicated, since they took over. Now, where was FERC before that? Well, they were running pretty lean. But, nevertheless, the crisis did not occur beginning in January. The crisis in California was in effect beyond that. And why FERC did not act, why, perhaps you could pursue that. Their just-issued West-wide order will further help both California and the entire Western United States. Now, we do have the chart now right side up, and the point I want to make with that chart is that it is working.\1\ What you are looking at is California's price structure relative to the peak power costs. And you will see it is down now to somewhere in the area of $48, and when you compare it to what it was, nearly $550 or $600, I think you can see that it is moving in the right direction. --------------------------------------------------------------------------- \1\ The chart entitled ``California Day-Ahead Power Prices,'' appears in the Appendix on page 551. --------------------------------------------------------------------------- Now, basically, that FERC has done its part, the question is what must California do, and I think that is an important reflection on the responsibility of the Congress. California, of course, has driven one investor-owned utility into bankruptcy and has put the other two on the brink of bankruptcy. The governor once said that he could solve California's problems in 15 minutes if he just let the true cost of electricity be passed on to the consumer. Well, you can ask him about that. But it appears that California has continued to try and hide the true cost of power by having the State now pay for it instead of the utilities. This puts the taxpayer of California on the hook for somewhere in the area of $47 billion. My question is: What is the difference between the ratepayer and the taxpayer? I find little difference. Although California officials accuse investor-owned power as being ``pirates,'' they have done little to protect California consumers from power sold by municipally owned utilities that are within California's own authority. A recent Los Angeles Times article reported that the city- owned Los Angeles Department of Water and Power was one of the largest moneymakers in the California spot market and made $17.8 million. And I would remind you that is owned by the city of Los Angeles. Further, California's problem is not lack of regulation. It is really a lack of generation. California bet it could stop building new power plants and instead import power from outside the State. California ordered its investor-owned utilities to divest their fossil fuel generation but exempted the municipal utilities. Why would they exempt one and not the other? Well, you can ask the governor. California prohibited its investor-owned utilities from using long-term contracts for power and forced them to rely on the spot market. This strategy can work for a time when there is excess in that spot market. But it did not work when that excess was removed. California has taken steps to expedite power plant construction. It has let a lot of permits. But the question is: How many of those permits have firm take-outs from financial bodies that are prepared to back them without a degree of certainty on the rates that those investments are going to amortize? So I think the jury is still out whether the California investor will want to build in California given the investment climate the State has created. As we look at the issue, Mr. Chairman, of those that are alleged of profiteering, I am going to ask that this be included in the record, the ``Top 10 in Profits.'' According to the California independent systems operator say that they total $505 million. Two-thirds of that are associated with British Columbia Power Exchange, $176 million, Mr. Chairman; Bonneville Power, $30 million; Los Angeles Department of Water and Power, $17.8 million. There you have a significant portion of those overcharges, and they are municipally owned. In the case of BC Power, they are outside. Finally, in conclusion, the solution to California's problems is more power plants of all types, natural gas, nuclear, renewables, and incentives for conservation. And you provide that incentive for conservation when you pass on the true cost of power to the consumer. Then the consumer will conserve, go down and buy a new refrigerator or whatever. FERC's order clears the way for Congress to focus on the national energy crisis that is affecting millions of families from coast to coast, not just California. Before the recent change in the Senate, we were on a course to bring President Bush's task force legislation to the floor, Senator Bingaman and I in a bipartisan package. As I have indicated, we have had the hearings. Senator Lott said at that time the energy legislation would be the next order of business after the Senate finished education. But under the new Senate schedule, energy has slipped on the Senate schedule. That is unfortunate in view of the fact that polling indicates that energy is the number one issue in the country at this time. So now is really the time for action on a comprehensive energy legislation to bring about a long-term and meaningful solution to the Nation's real energy problems, and I am convinced that the time for talk is behind us. The time for action is now. Thank you for the courtesies extended to me. I would ask to be excused. I have another hearing on the Energy Committee at this time. Chairman Lieberman. Thanks, Senator Murkowski. Thank you for being here. Senator Murray. TESTIMONY OF HON. PATTY MURRAY, A U.S. SENATOR FROM THE STATE OF WASHINGTON Senator Murray. Thank you very much, Mr. Chairman and Members of this Committee, for calling this hearing. In my home State of Washington, there is no more important issue than the energy crisis today. Two days ago, after months of delay, the Federal Energy Regulatory Commission finally woke up and took action against alarming energy rates. FERC, as all of you know, put in place price controls that are similar to what Senator Lieberman and I and Senator Cantwell and others have been urging for months. I am glad that FERC finally came around, helping us bring some order to this volatile energy market, but this one step is not going to solve the energy crisis. The energy crisis is very real, Mr. Chairman. It is not going away, and the Federal Government needs to do its part to help our communities. Today, I want to share with this Committee how the energy crisis is hurting Washington State, and then I want to offer six things that the Federal Government must do to protect our people and our economy. Let me begin with the impact in Washington State. We have already lost thousands of jobs because of rising energy rates. Entire industries could be idle just to prevent massive rate increases. According to one estimate, Washington State could lose another 42,000 jobs over the next 10 years unless we take action. Not only are there economic costs, but there are environmental impacts as well, including our ability to recover endangered salmon. I want to share with you a typical letter I received from a constituent in Washington State. Mrs. Valeria Mesler of Okanogan, Washington, wrote to me: ``I am a 91-year-old widow living on my Social Security check each month, which is small. I cannot afford any increase in the cost of my electricity. I am sure there are many like me and also younger families on low incomes.'' Mr. Chairman, she is right. There are thousands like her. Today, the energy crisis is hitting our pocketbooks, and unless we act, tomorrow it will threaten our prosperity. Even Washington State schools are feeling the impact. Nancy Olson, who is the superintendent at the Ocean Beach School District wrote me that energy costs will add another $200,000 to their budget. As a result, they are going to have to lay off the equivalent of 3.5 teachers. According to Superintendent Olson, ``We have no extras anywhere in our budget. We will now have to resort to cutting teachers, which means increased class sizes.'' They are even, Mr. Chairman, considering going to a 4- day week in that school because of the costs. Energy is impacting everything from our kids' education to jobs in our economy, to every family's personal quality of life and finances. We in Washington State are doing our part. We are conserving and we are cutting our energy use. Several of Washington's public utility districts have worked with consumers and have agreed to cut back on the amount of power they receive from Bonneville Power Administration. Last week, the Benton County PUD agreed to reduce its energy load by 10 percent. Recently, Clark Public Utilities, Franklin, and Ponderay and Grace Harbor PUDs have signed load reduction agreements as well. People are changing their habits and buying more energy- saving products. In fact, in many parts of my State, you cannot even find a compact fluorescent light bulb on store shelves because they are all sold out. We are also bringing new energy sources into service, especially renewable sources like wind. We have a 300-megawatt wind field being developed near Walla Walla and another 150- to 500-megawatt wind field planned for Prosser. We have a company in Kelso, Washington, that takes plastic from landfills and turns it into high-octane, low-sulfur diesel fuel. We are doing our part. But we need the support and the leadership from this administration. I, of course, am not saying that this administration caused this crisis. It did not. But I have believed that it has stood in the way instead of providing us the help that is critically needed. First, they identified it as just a California problem. Then, instead of urging conservation, they decried it as simply a personal virtue. And later, when we introduced bipartisan price cap legislation, the administration said no. Instead, they sent us an energy plan that focuses too much on drilling for oil and gas with very little support for alternative and renewable sources of energy. Throughout, FERC has not done anything to help Washington State consumers get relief from predatory pricing. This week the administration's FERC appointees finally came around and accepted what we have been telling them all along, that we need price caps, temporary price caps, to protect consumers from outrageous rates. Frankly, I think the bipartisan legislation we have pushed has helped them make that decision. Mr. Chairman, this administration has minimized this crisis for months, and people across my home State of Washington are paying the price. We are doing our part to conserve and to generate new, clean energy in Washington State. Now it is time for the Federal Government to do its part, and I want to quickly outline six steps I think we need to do at the Federal level. First, we need a disaster declaration so that hard-hit small businesses can get low-interest loans from the Small Business Administration. Second, we need real Federal support for conservation. Third, we need to diversify our energy sources. Fourth, we need to site new plants. Fifth, we need FERC to keep its word and investigate price gouging in Washington State and other Western markets. If prices have been unjust, there have to be swift refunds. And, finally, we need to make sure that as we expand our energy infrastructure, our oil and gas pipelines are safe. Mr. Chairman, those are the steps we need to take at the Federal level to keep this crisis from getting worse. I hope that this administration will see the wisdom of acting now to protect our economy, our communities, and our citizens before it is too late. Thank you, Mr. Chairman. Chairman Lieberman. Thank you, Senator Murray, for that testimony. Senator Cantwell, good morning and thanks for being here. TESTIMONY OF HON. MARIA CANTWELL, A U.S. SENATOR FROM THE STATE OF WASHINGTON Senator Cantwell. Thank you, Mr. Chairman and Senator Thompson. I thank you for this opportunity to testify before the Committee today and for your leadership on this important issue. The Senate Energy Committee, of which I am a member, has had numerous hearings on this issue, and I want to applaud Chairman Bingaman for the leadership and commitment that he has brought to this issue, and to Senator Murkowski for the number of hearings that we have, in fact, held for his attention to this issue. Today's hearing focuses on a subject that I believe Congress must explore fully and, more importantly, be prepared to act on: The role of FERC. Our Nation's top energy regulator probably has never been more important than today. As the energy crisis has evolved, I have had an opportunity to get to know all the FERC Commissioners and am pleased that we now have a full contingent of commissioners with two new members, Commissioner Pat Wood and Commissioner Nora Brownell. Today, the FERC is in the unenviable position of being on the Congress' radar screen. I think it is important to keep in mind that this agency is in transition, responding to a brave new energy world. But as our recent experience in the Northwest has shown, the FERC has a long ways to go in its transition. I am concerned about two things. I am concerned that the agency has been slow to respond, and even when it has responded, it has not always acted with equal vigilance from State to State. One cannot, as Senator Murray pointed out, open up newspapers in Washington State without finding stories about the energy impacts on our State, families, businesses, and community. As perhaps too few people realize in the midst of these bright lights shining on California, this really has been a crisis from which the Pacific Northwest has suffered. Yes, it has been exacerbated by a drought that has been the worst drought in 30 years. But, nonetheless, our need to go out and buy power on the spot market left us subject to rates 11 times what they were a year ago today. The results have been devastating and have touched every part of our economy, from traditional energy-intensive industries such as aluminum and paper, to small businesses, farmers, and even technology companies. Thousands of people have already lost their jobs and plants have been shut down. A hospital in Washington State has experienced probably $1 million in additional energy costs that will come off of their bottom line. Small businesses as diverse as grocery stores and hotels have already started adding energy surcharges. And this is despite an effort by most of these businesses to curtail their energy consumption by over 30 percent. Governor Locke has issued a challenge for people and business in Washington to conserve 10 percent. Many businesses are reaching far beyond that and still seeing rate increases that are the same amount as what they paid for their entire energy bill last year. Our State's LIHEAP caseload is expected to rise by over 50 percent this year due to skyrocketing energy prices. These facts point to an inescapable, common-sense conclusion--that the Western power markets have been dysfunctional for quite some time and that the electricity prices in the Northwest have been neither just nor reasonable. Like many of my colleagues, I want to say I appreciate the steps that the FERC Commissioners took on Monday, June 18, to help mitigate the impacts of the Nation's energy crisis and rein in the runaway electricity prices in 11 Western States. I am hopeful that these actions will help address the crisis in the Northwest. However, during the hearing before the Senate Energy and Natural Resources Committee yesterday morning, I had an opportunity to ask the FERC Commissioner and the FERC's general counsel about my concerns given that we had not had a chance to read the order. In response to my questions, I found one piece of information very troubling. That is, Mr. Chairman, despite a year of skyrocketing prices throughout the Northwest and other Western States, the FERC admits that it will not provide a mechanism for those in the Western States outside of California to seek refunds--this is a very important issue--other than refunds that would occur after July 2, 2001. On the one hand, FERC has offered long overdue relief to Washington State consumers who are staggering from these high energy prices. But, on the other hand, it has taken away an opportunity for us to get these refunds. With the support of Senator Murray and other Senators from the Northwest, I am sending a letter to FERC Chairman Curtis Hebert today asking for a rehearing on the Commission's December 15 order in which FERC denied Puget Sound Energy's complaint regarding the West, outside California. We are asking FERC to set a refund effective date consistent with Puget Sound Energy's October 2000 filing. Mr. Chairman, whether this refusal to consider consumer refunds outside of California is an oversight or an accident, it is certainly the latest in a series of FERC actions that have elicited questions and concerns from many people in my State. Over the last year, people in Washington State have endured many impacts from this energy crisis, and I think it is very important that FERC go further in addressing this issue of repayment. Mr. Chairman, obviously this Committee and the Congress in general, as policymakers, need to ferret out the many causes of FERC's slow-to-act performance in the face of this crisis, whether it is lack of a clear mandate arising from dramatic changes in the energy industry, a lack of necessary information or resources to do its job, or simply just a lack of will. But as we work to prevent such crises in the future, we also need to focus on how to correct the mistakes that have been made. We know that there are Pacific Northwest communities that have been devastated by plant closures and job loss due to an unprecedented run-up in electricity prices and FERC's inactions and omissions. It is simply unacceptable that the Federal agency charged with ensuring that consumers are protected does not meet that responsibility. With this in mind, Mr. Chairman, I hope that FERC heeds our calls to reverse its decisions on issues of retroactive refunds for Northwest consumers and applies the same standards of fairness to the constituents of my State as they have to ratepayers in California. I thank the Committee for this opportunity to speak on this issue, which is important to so many people in Western States, and I thank the Chairman for holding this hearing and look forward to your continued oversight of this commission. Thank you. Chairman Lieberman. Thanks very much, Senator Cantwell, and we will be sure to ask the members of FERC this afternoon some of the very relevant questions you have raised here this morning. I note the presence of another member of the California House delegation. I am delighted to welcome not only to this hearing but to the Congress Congresswoman Diane Watson. Thank you for being here. Before the Committee calls the Hon. Gray Davis, Governor of the State of California, Senator Boxer, our colleague, has asked to very briefly introduce Governor Davis. TESTIMONY OF HON. BARBARA BOXER, A U.S. SENATOR FROM THE STATE OF CALIFORNIA Senator Boxer. Mr. Chairman, Senator Thompson, thank you so much for inviting my governor here. I promised you that I would make a minute, a minute-and-a-half introduction, and I will because I know how many people you have yet to come. But I want to say that in California we need the help of everyone on this Committee. The reason we have such a beautiful delegation sitting behind me here is because of their deep concern. They have got many other issues on their plate. I think it shows and demonstrates that we are all speaking with one voice, that we need relief for our consumers, and our governor has been fighting this fight in the middle of a crisis that he did not make. And he has been doing everything he can to heed what Members of this Committee have said, which is to bring sources of power online to push the State toward energy efficiency and conservation, which we are succeeding at--we really are--and also to call attention to the gouging. And if I might say, that is the only word I can use, and I think when you hear the governor, you will understand why we use the term ``gouging.'' Mr. Chairman, I think this Committee is key for us. You are an investigative committee. You are a Committee that is an oversight committee. It is very appropriate that you oversee the FERC. I believe with your leadership, Mr. Chairman, and others on both sides of the aisle, we have seen FERC finally look at their charter, which says they must protect against unjust and unreasonable prices. We have seen them take action. We in California welcome that action, and at this time, it is really my honor to introduce a man who has been working on this crisis day and night. It is a lonely and difficult thing, many times, and he has really done everything within his power to keep the power on in our State. Thank you very much for welcoming him here, and thank you for your deep concern, Mr. Chairman, and also Senator Thompson. Chairman Lieberman. Thanks, Senator Boxer. Governor Davis, I am honored to welcome you here. I appreciate very much that you took the time to come out and share your thoughts and your experiences with us. This is a hearing room that is often used by another committee. I am privileged to be a member of the Senate Armed Services Committee, and it does strike me that there are some parallels here. I feel like I do when we had leaders of our military come in from areas of battle to report on how the battle was going. It is not quite that serious, but you face a serious crisis that was not of your making. You have been tested. I think some of the improvement that is reflected in the charts that we have seen from Senator Murkowski you deserve some credit for. I am delighted to hear from you now, and I suppose the question is: How goes the battle? TESTIMONY OF HON. GRAY DAVIS,\1\ GOVERNOR, STATE OF CALIFORNIA Mr. Davis. Well, we are making progress, and thank you very much, Senator Lieberman, and Ranking Member Senator Thompson. Thank you for inviting me as well. I want to thank our junior Senator, Barbara Boxer, for her friendship and for her introduction, and our senior Senator, Dianne Feinstein. They both worked very hard on price relief for California and the West, and I want to thank all of our Congress people that have been staunch allies in this. You have mentioned their names, but I would like to repeat: Congresspersons Tauscher, Harman, Solis, Eshoo, Baca, Watson--have I missed any?--Lois Capps and Lynn Woolsey. Did I miss anybody else? And there are many others who are not here. They are very busy, and I appreciate their taking their time to be here today. Obviously this is an important issue. That is why so many people have come today. I applaud the Committee for having this hearing. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Davis appears in the Appendix on page 391. --------------------------------------------------------------------------- I want you to know that California is doing its part to meet the energy challenge. As you know, there are two constructive things the State can do: Build more plants, conserve more power. We have approved 16 plants since I have been governor starting the fourth month I was in office. Ten are under construction, more than at any time in our State's history. We are also the most electricity-efficient State in the Union, as that chart, based on U.S. Department of Energy figures shows, and we are not resting on our laurels. It is in our self-interest to become even more electricity efficient as the summer proceeds. Those two goals--building plants and conserving--are the major prongs of a long-term energy plan that we have put together for every Member of this Committee. Long-term contracts are also a big part of that, and I want to thank David Freeman, who is with me today, formerly of the Department of Water and Power--he helped negotiate those--and Michael Kahn who is president of our ISO, who is also with me in attendance today. Let me just elaborate for a second on the building of power plants and conservation. As was noted earlier, for the 12 years before I was a governor, not a single major power plant was built in our State. Not one. But we began earnestly to right the ship, and as I said, we have licensed 16. Ten are under construction. Four will be online this summer. The first one a week from today will come online in Bakersfield. Two more will come online by July 7. Those three plants will provide roughly 1,200 megawatts of power. In addition, we have sited 10 peakers. Through my emergency powers, I have cut the permitting process to 21 days to site peakers. They represent more than 800 megawatts of power. Part of our effort to get more plants online involve reducing the time to site permits. That was mentioned earlier. We have cut that in half from a year to 6 months, and I have reduced that even further through my emergency powers to 4 months. So the combination of the plants online plus additional renewables, distributed generation, and re-rating of existing power plants we believe will provide 4,000 megawatts of power by the end of September. Then we have 5,000 megawatts coming online in each of the next 3 years for roughly 20,000 megawatts by the end of a 4-year period. Suffice it to say, at no time in the history of the State have so many plants been under construction in California. On conservation, we are not resting on that laurel. I signed the bill for $850 million, which encourages more efficiencies in people's homes and places of work. Plus we signed an executive order which gives people and businesses a 20-percent rebate if they reduce their electricity by 20 percent any of the 4 months--June through September--of this summer. Plus we have signed agreements with 137 companies, including the Bank of America and Wells Fargo, Hilton Hotels, for them to reduce their consumption by 20 percent from June to September of this year. We have signed agreements with 225 municipalities, special districts, for them to achieve between 10 and 20 percent conservation. So all across the State, Californians are pulling together to build plants and to reduce electricity usage. I think the proof is in the pudding. In May, it was reported that Californians had reduced electricity usage over last year by 11 percent and by 10.4 percent during peak periods. I think that is a remarkable contribution, but we are going to do even more. So I think it is fair to say on long-term contracts, which have reduced our dependency on the spot market by roughly 40 to 45 percent, on building plants, more than any governor has done before, and on conservation, California is doing its part. The one mission element, at least until Monday, was any efforts to regulate the wholesale price of electricity. As the Chairman correctly pointed out, that is exclusively the function of the Federal Government. The State has no control over that, even if it wanted. Our only power is the power to advocate, testify, occasionally to shame, to make sure that action is taken. As the Chairman also said, the Commission is responsible to see that rates are just and reasonable. That comes as a great shock to some people who think that market forces should take hold no matter what. I am going to speak to that a little later. But that is not the law. As Ranking Member Thompson pointed out, the law does require just and reasonable rates be enforced, and FERC by its own admission has allowed those rates to remain in effect, even though they made a finding November 2000, reiterated in December 2000, reiterated again in April 2001, that our rates were not just and reasonable and our market was dysfunctional. Under law, the Commission must order refunds once they make a finding that a marketplace is dysfunctional and rates are not just and reasonable. Under law, if rates are not just and reasonable, they are by definition unlawful, and the ordering of refunds is not a matter of discretion. It is a matter of law. Yet at every point where the Federal Energy Regulatory Commission could have restored some sanity to wholesale prices, it failed to do so. I have done my best for approximately a year to advocate, to urge, and to encourage appropriate Federal action. I have testified before the Federal Energy Regulatory Commission. I have written countless letters. I have spoken personally to Presidents Clinton and Bush. Our electricity oversight board, the independent service operator, and the PUC have made at least 100 filings for relief. But in every case, even in the face of mounting evidence in support of our position, our requests have been denied or ignored. Two days ago, the Federal Energy Regulatory Commission did bow to public pressure and took a step in the right direction. But here is what the Commission's inaction over the last year has yielded, and I refer you to the chart on the right where it says ``Total Wholesale Cost of Electricity in California.''\1\ In 1999, Californians paid roughly $7.4 billion for electricity. In the year 2000, with demand up only 4 percent, we paid $27 billion, roughly a 400-percent increase in electricity costs. This year, we are on track to spend between $50 and $60 billion, even though we are reducing our electricity usage by roughly 9.5 percent each month. And as I explained to President Bush when we had a nice visit in Los Angeles, a functioning market in which the consumer is reducing use by 9 to 10 percent a month should produce a reduction in prices, not a doubling. So we are looking at ratepayers' paying 700 to 800 times more for electricity than they did just 2 years ago. --------------------------------------------------------------------------- \1\ The chart referred to by Governor Davis appears in the Appendix on page 742. --------------------------------------------------------------------------- You will not be shocked to hear that Duke Energy Company acknowledged not too long ago that they charged the State about $3,800 a megawatt in January. Reliant, I pointed out, charged us $1,900 a megawatt on 2 successive days a month ago. So it is clear that the energy companies have exerted extreme power over our market and are driving up prices dramatically. That is why Governors Locke, Kitzhaber, and I, some time ago proposed cost- based pricing which would allow for a reasonable profit on a temporary basis until more plants could come online. A number of noted economists, including Alfred Kahn, the proponent of airline deregulation, came before this Committee last week and spoke to the wisdom of temporary price relief for California and the West. On Monday, the Federal Energy Regulatory Commission again refused to impose cost-based pricing. I want to thank Commissioner Massey for his long effort in that regard. I believe to this moment that that is still the most effective way to restrain prices and provide a reasonable profit. Again, my thanks to our two Senators for their long efforts and our congressional allies, not just in California but throughout the West, who have worked night and day for price relief for the West. On Monday, with two new commissioners, the Federal Energy Regulatory Commission did grant some price relief. I thank them for that. The commission did correct the most obvious errors in its April order, but it was months too late and there is much more for FERC to do. The California ISO estimated that from May 2000 to February 2001, power generators charged Californians $6.7 billion more than a competitive marketplace would otherwise warrant. They have recently updated those figures through May, and the overcharges are now $8.9 billion. To date, however, Mr. Chairman, not a single penny in refunds has been returned to California. I believe it is unconscionable if generators are allowed to keep these egregious overcharges. Mr. Chairman, FERC must move quickly to enforce the law. FERC must order these energy companies to give us back our money. Then, finally, Mr. Chairman, FERC must turn its attention to natural gas. Until very recently, California natural gas prices were 2 to 3 times higher than the national average, and for a while they were 8 times higher. That was due in part to the fact that El Paso Natural Gas controlled a significant portion of the major pipeline into Southern California. It was not until that contract expired and was divided essentially to 30 other energy companies that the price started to come down and get close to what the rest of the country is enjoying. So, clearly, FERC must be--I would suggest this commission could do a useful service in urging FERC to exercise its responsibility to enforce laws against manipulation on interstate pipelines to California. Mr. Chairman, in conclusion, California will continue to do its part, building all of the plants California needs and setting an example for the rest of the country on conservation. With the greatest of respect, I would ask this distinguished body to do its part by joining us in holding the Federal Energy Regulatory Commission's feet to the fire. It is unconscionable that the commission look the other way while energy companies bilk Californians out of $9 billion. Californians are due billions of dollars in refunds. Together we have made progress on price relief. Now it is time to move forward on refunds, not just refunds for California but refunds for the entire West. Again, I thank you for the privilege of being here. I know there were a couple of questions earlier that were raised about California's activities, and if it is appropriate to respond to those questions, I will. Chairman Lieberman. Thanks very much, Governor Davis, for that excellent testimony. I think the record does make clear, as you have documented, that the State of California and the people of California have taken very significant steps forward in a most difficult situation which no Member of this Committee would want to have their State go through, to try to make things better. That says the obvious. I would say no governor of one of our States would like to have that State go through that either. Both in terms of bringing more power online through the State, but also in the very impressive conservation figures that are coming out now from California, which means that individuals, families, businesses understand the crisis and using less electricity, progress is being made. We are focused, because we are Federal an oversight committee, on the Federal Energy Regulatory Commission. And as you said, and I said before, that is the group that we have been asking to do what you cannot do and no one else can do-- that is, the State cannot do, and that is to deal with the wholesale price of electricity. I wanted to ask you a few questions about the order that came out on Monday. The first is this--I am going to get to the nature of the price relief in a moment, but in its order, FERC provided price relief until the end of next summer, September. And my question to you: Is that enough time? In other words, can we expect that by that time enough of the power plants that are now in the process of being constructed will be online, and conservation will be sufficient so that supply and demand will be equivalent or that supply will surpass demand and we can have a genuinely competitive market? So is September of next year sufficient time for the State at this point? Mr. Davis. Well, as I said, I think the Commission's action is a step in the right direction. They will have to be vigilant to make sure that there are not too many loopholes and that the order is enforced. We will not have, however, about enough power to meet our demand until sometime late in 2003. Alan Greenspan has said on a number of occasions that electricity deregulation really does not work unless you have 15 percent more power than demand. We will not get to that point until sometime late in 2004. So, optimally, the order should extend at least until we get enough power online to bring demand and supply into equilibrium, and that will not be until late 2003. Chairman Lieberman. I will ask that question of the FERC Commissioners this afternoon, why they limited the order to the end of next summer and whether they are open to extending it if conditions suggest that they should. My second question goes to this matter of refunds. In my own review of the law, it does seem to me that the statute is clear that if FERC decides that rates are unjust and unreasonable, not only that they have to take action prospectively but they have the power to act in a just manner, which is to order refunds. In the order that came out on Monday, as has been testified to earlier, nothing was said about refunds for the overcharges outside of California along the Western grid. And I was struck, as Senator Cantwell or Senator Murray said this morning, that their electricity prices in Washington State have gone up 11 times, by a multiple of 11 in the last year. FERC's new plan issued Monday, as I get it, is for a 15-day settlement conference presided over by an administrative law judge. So I wonder if you have had enough time to give a response to that as an adequate forum in which to try to obtain the refunds necessary for the State. And if you do not, what other avenues do you have available to you? Mr. Davis. Well, as you suggest, there does not appear to be much guidance to the administrative law judge as to what to consider and how to proceed. Obviously, I believe California should have a seat at the table. So should the other States who believe they have been overcharged. And we would present information from the California ISO that is advised by many of the economists that you had testify before you last week and have come to the conclusion that Californians are owed at least $9 billion in overcharges. Again, the FERC itself came to that conclusion on three separate occasions, but it has taken no action to put money back in the pockets of Californians. So they have suggested that about $120 million might be subject to refund, but there is an ongoing process that allows the companies to rebut that and put in evidence to the contrary. The bottom line is no money has yet come back to California. I do not know if 15 days is enough time to resolve this issue, but I do believe the FERC should get a clear signal from this Committee that refunds are part of its function. Yes, they have provided some relief going forward. It is not exactly what we wanted, but there is no question that it will have a downward impact on prices, on the real-time market. But that is only half the job. The other half of the job is to give us back the money that was wrongly taken from us. The Commission made the determination it was wrongly taken from us. They just did not follow through and order refunds. What I would suggest is that at the end of the 15-day period, you call the FERC back to this hearing and ask what has happened, how much progress has been made, have States had a chance to make their case, and what is, in fact, going to happen on refunds. Refunds--I mean, as you know, there is really no justice if you have a right but no remedy. We have a right to $9 billion, but there has been no remedy. Chairman Lieberman. Thank you. I agree with you. And let me just say that it is my intention, though the Committee has a lot on its agenda, that this is an important enough crisis, and it is a crisis, obviously, that affects the West, but it sets a precedent for how energy price and supply crises will be responded to by the Federal Government. So I intend to continue to exercise, on an ongoing basis, the oversight authority of this Committee with regard to FERC. And I hope that will be helpful to them and to people throughout the country. Mr. Davis. If I may, Mr. Chairman, I might suggest that you put those questions to Commissioner Wood. I have had three conversations with him. I find him to be a very reasonable person. He suggested to me that he thought a more aggressive approach to refunds might be in order. So I think he might be sympathetic to---- Chairman Lieberman. I will do that this afternoon. Thank you. Senator Thompson. Senator Thompson. Thank you very much. Governor, welcome very much. Mr. Davis. Thank you, sir. Senator Thompson. Governor, you heard my opening comments, and they will lay the basis for some questions I have. I started off by saying that I admire you in many respects. I wouldn't wish your problem on my worst enemy. You certainly were not responsible for many of the things that occurred, certainly as they developed before you became governor a couple years ago. I was especially impressed by the fact that you said you had seen all my movies. [Laughter.] Chairman Lieberman. Late at night. Senator Thompson. Which makes two of us, now that I have calculated. Perhaps you can talk to the Chairman about salutary effects of that. But you have made some pretty pointed comments concerning other people. You have made some here today. I have made some. And I am sure that you understand from one elected official to another that it is appropriate that we get into some of the history of this and some more pointed comments and questions. And I appreciate the fact that you do not shy away from that and you come here today and present yourself for some of those questions. So having said all that, I want to ask you how it was that you seemed to let things get totally out of hand. My information is that back as far as 1998, the California Energy Commission warned of possible energy shortages as early as 2000. In February 1999, Bonneville put out a warning concerning the problems as far as hydropower in the Northwest. In July 1999, the CEC once again warned of short supplies. All this time, of course, you are becoming more and more aware, and, of course, last summer, a hotter summer than normal, the lack of moisture in the Northwest, all of the other factors that we have mentioned concerning increased demand--I think your electric power demand from 1996 to 2000 increased by about 24 percent. You were obviously becoming more and more dependent on imports for your power. May 2000 spikes, shortages, California's first two-stage alert. January of this year, a letter from 20 prominent economists saying it would be a fateful mistake to proceed with current policies such as the price caps and the spot contracting. All of those things obviously developed over a period of time, it looks like a couple of years. But they were there for anyone to see. Did you see these developments as they were occurring? Did they cause you concern? If not, why not? And if you did, why didn't you act sooner? Mr. Davis. In my testimony, I made clear, Senator, that we started licensing plants my fourth month in office. I became governor in January 1999. We talked about electricity usage increasing from 1996 to 2000. I came in in 1999. We started approving plants in April. That first year of 1999, before this matter was really--had not really been chronicled, it certainly was not in the newspapers with the regularity it is now, we approved six new plants. When the matter worsened in 2000, particularly in San Diego, which experienced the full frontal effect of deregulation, we passed appropriate legislation to relieve the problem there, and I began testifying in front of the FERC in the fall of 2000 after a San Diego meeting. So I have spent an inordinate amount of time on this issue. It is obviously important to the growth of the economy in the West and in California. But just to put a couple things in perspective, according to the U.S. Department of Energy, 85 percent of the growth of electricity in the West in the last 5 years has been outside of California. We have, as you can tell, a very enviable record on conservation, and that is not just the product of the work that I have been engaged in with our legislature. But for 20 years, we have been requiring energy-efficient buildings, appliances, all kinds of things which have reaped benefits for our State. So we have been working on this for a very long time, and to suggest otherwise is simply not accurate. Senator Thompson. Well, I see my time is up. I would ask you, though, to--I want to ask one more question. You can answer it now or later, if I might. Mr. Davis. It depends how hard it is. Senator Thompson. I will just take a few seconds. I take note of what you said, but in the eyes of many people, many more fundamental problems were not addressed, for example, the lifting of the retail caps. Mr. Kahn, who, as you correctly pointed out, testified here last week in favor of caps, said that the idea of keeping these retail caps on was ridiculous. You acknowledge yourself that you could probably solve the problem if you wanted to raise rates. So you have the combination of keeping the retail caps on, forcing the utilities to buy on the spot market, which was great when the spot market was not, not good when it became high. The approval process, the siting process, you addressed after the blackouts occurred, I believe. These are fundamental structural things, I think, which all investment advisers--we have had Bear, Stearns, Goldman, Sachs and others testify--say that these were structural things that clearly, regardless of who was responsible for how you got to that point, that clearly had to be addressed. And now they are being addressed at a price that is much greater than you would have had to have paid had you addressed them last year, last summer, when the crisis was obvious to everyone. So do you not claim--or do you not accept any responsibility for not having addressed these structural problems that were inherent in your system that obviously had to be changed when so many of the circumstances were changing, especially in light of your emergency powers, if you needed to exercise them? Mr. Davis. First of all, it is nice for us to sit back here and talk about passing on the true price of electricity. But let me assure you, if I passed on a 700-percent increase to the citizens of California, there would be an outrage the likes of which you have never seen, and electricity deregulation in this country would not benefit from the---- Senator Thompson. I do not think anybody is suggesting a particular price here today. Mr. Davis. Well, but I do not know that--I do not think you have, Senator, but I believe I have heard many people say why didn't we pass on the true price of electricity. The legislature and I believe it is important not to shock our economy into recession, and so we have phased this out over about a 10-year period. The highest residential user this year will get about a 45- to 50-percent rate increase. We did increase rates in January of this year. They went up again 2 or 3 months ago. There are also a number of incentives for conservation no matter what your rates are, and the people who are the most efficient, who just use 130 percent of baseline usage, do not see their rates go up. But we are trying to manage a system which, as your question suggests, was basically flawed. The bill that passed in 1996 unanimously, with every Democrat and Republican voting for it, and the previous governor signing it, deregulated the wholesale market but not the retail market. The flaws of that did not become crystal clear until sometime in 2000, and we began earnestly taking steps above and beyond the steps we had done in 1999 to improve the siting process and to put new plants online. So, everybody benefits from hindsight, but I make no apologies for the aggressive efforts we have taken to correct situations that we inherited. I did not, as you suggest, cause the electricity problem. President Bush did not cause it. Obviously it is on our respective watches. We have to try and manage it as best we can for the people of our State. And I think we are doing that. Senator Thompson. Thank you. Chairman Lieberman. Thank you, Senator Thompson. Let me just say for the record that it is my understanding that in almost all States that have deregulated electricity prices, retail caps, caps on retail prices for a temporary time period are the rule, the custom. That is the norm, usually. And so what was adopted here I know had an adverse effect because of all the other things that went wrong. But I would just make the point that if, in fact, California electricity customers were forced to pay the true price of electricity as it was being fed into the State, I think unfairly, very unfairly, it would have not only been a jolt to your economy and the American economy, because you are almost 15 percent of the national economy, but I honestly think it would have terminated the movement toward energy deregulation. I mean terminated the deregulation of energy which is occurring across the country, and is, generally speaking, I think the way to go. So I think what is on the line here in your response to this crisis and FERC's response is not only how this Federal agency is doing, but whether we are going to continue to enjoy the benefits of deregulation. Senator Thompson. Mr. Chairman, if I may just point out, I think that the issue is not a very good solution versus a very bad one. I think the issue is a choice between two bad solutions and whether or not by allowing more of the true price to be passed on we are creating a larger problem down the road. Chairman Lieberman. This dialogue could go on a while, but I think we will hear more of it as the other Senators question. I am going to call on Members as they arrive, going from Democrat to Republican. Next is Senator Durbin. OPENING STATEMENT OF SENATOR DURBIN Senator Durbin. Thank you, Mr. Chairman. Governor Davis, thank you for joining us. Mr. Davis. Thank you, sir. Senator Durbin. I have listened to your plight with great interest. You would think that if you are from Chicago or Illinois, far away from California, it would just be an academic endeavor. It is not. We have faced natural gas price increases, home heating cost increases over the last winter that are at record levels in Illinois. We have just seen a run- up in gasoline prices, which mercifully are starting to come down again. And it has sensitized people across my State and I think across the Nation to the fact that this is not just California's problem. This is a national energy debate. Sadly, your State and the people living there have been the first victims of some of the worst things that have occurred here. But what I find interesting is that the debate usually centers on whether or not there is an understanding of market forces. And those who want to explain away what has occurred in my State and yours say you just do not understand supply and demand. I think behind that statement is the suggestion that we can trust supply and demand, that we can trust the market forces when it comes to energy. And yet for a long time here in Washington, we have come to the opposite conclusion. In 1935, when we created the Federal Power Administration, we basically decided that energy was so important to our Nation's future and that the energy corporations so unpredictable that they could not go unguarded or unsupervised. So from 1935 forward, we said we as a government, as a people, will regulate this market, this industry. It is just too important to ignore. And I think that brings us to where we were a few years ago and where we are today. In 1996, as States like your own embarked on deregulation, before you were elected governor, I can tell you that repeatedly the folks from the industry came to us and said, Washington, get out of the way, we do not want you involved in this. Every State is going to come up with its own solution. One size does not fit all. This is not a national thing to do. Let the States do it. And as you have noted, and Senators Thompson and Lieberman, in 1996, when Governor Wilson came forward with his plan, it passed unanimously in the California General Assembly, which is probably a rare occurrence on an issue of this complexity. And so those who were second-guessing whether that California deregulation was smart or not so smart have to understand that in the context of 1996, virtually all the parties to the debate said this is the way to go, setting the stage for what happened to California and to your administration just a few years later. I think that is a background which we should not lose sight of. As we look at this today, we should be reminded that 66 years ago, this Congress created the precursor to the Federal Energy Regulatory Commission and said: Watch this market, watch energy in America. There are things here that can happen that are devastating. California sadly today is on center stage as we look at the results. Let me ask you about a couple things in particular. First, you have suggested that California should have a seat at the table in this discussion. I wholeheartedly agree. I think the residents of all the States should have a seat at the table. Sadly, this debate comes down to a face-off between the energy giants and the giant bureaucracies, and there seem to be some groups that are absent here, including families and businesses and others that are going to get nailed if we let the market run amok. I have proposed a consumer energy commission that will involve all three, not only the producers and the regulators but also the consumers, so that they could have a voice at the table about the need not only for generation and conservation but also, as in your remarks--and I thought this is critical from where I live--stabilization so that there is predictability, so a business knows from month to month or week to week the parameters of potential energy increases. I would like to have your comment on that, and particularly I would like you to address your repeated suggestion, which I can surely understand, about this need for a refund. FERC has the authority to give refunds. They have not addressed this issue. As I sit here I do not know if historically they have ever considered doing that. But I would like you to comment on that refund question, what it would mean to your State and whether there is any precedent that you are aware of at FERC for such a refund. Mr. Davis. Well, first of all, I appreciate your description of the background to the situation we currently face in California. It was accurate and well done. Obviously, refunds are a primary way of policing the market, and if the Federal Energy Regulatory Commission is supposed to be a watchdog for the consumers--and that was the original notion back in 1935--then their primary vehicle is to provide relief, not just prospectively but retroactively. It is one thing if--well, I was going to give an analogy, but I will not. So it is helpful to know that maybe we will not reach $60 billion this year, although we are halfway through it, in expenditures for electricity--a little shocking when you realize it was just $7 billion 2 years ago--but that does not fully balance the equities since we have shelled out far more money for electricity than would be the case. All I can say is that whether or not there is a precedent for refunds of this magnitude, they are owed, they should be paid, and this oversight committee I believe, and with respect, should hold FERC's feet to the fire and ensure they issue the orders to give us back our money. That is the only message the energy companies will understand. If they have to reach in their pocket and write a check back to Californians, they will think long and hard before they take advantage of the market again. And in response to your question, Senator Lieberman, I consider myself a marketplace Democrat. My parents were actually Republicans. But this is a special market. You cannot store electricity, unlike any other commodity. The user has to have it on the day they need it, whether you are on a fixed income, whether you are a police station or a hospital, and the seller has to sell it on that day. And so you do need some kind of buffering situation, and the umpires in this contest, if you will, are the Federal Energy Regulatory Commission. They need to see themselves as the--again, another analogy--circuit breaker to make sure they step in when there are problems. And the best remedy, I think, is refunds. That sends a very clear message. Senator Durbin. Thank you, governor, and I just in closing would say to the Committee here, your tragic experience in California has taught some national lessons, and I think particularly in the area of conservation. You have given us some real guidance as to what we can do as a Nation to deal with energy and view conservation as more than just a personal virtue. Thank you. Mr. Davis. Thank you, sir. Chairman Lieberman. Thanks, Senator Durbin. Senator Collins. OPENING STATEMENT OF SENATOR COLLINS Senator Collins. Thank you, Mr. Chairman. Governor Davis, I would like to join my colleagues in welcoming you this morning. Although Maine and California are far apart geographically, we actually have quite a few things in common. We each have beautiful coastlines. We were each early movers in electricity restructuring. And both of our States have citizens that recognize that women make great Senators, although California has not gotten the party affiliation right yet. There are also, however, some major differences, particularly with how our States have handled electricity restructuring. Maine has been steadily building new power plants. California went a decade without building any. Perhaps most important, Maine did not make California's fundamental error of artificially capping retail rates. Fixing retail rates, even in the face of power shortages and escalating wholesale rates, has clearly been a disaster for your State. You cannot expect the benefits of a free market if you have a market which is not free. Nevertheless, as I said at last week's initial hearing, electricity markets are not like other markets. By its very nature, electricity is a unique commodity. It cannot be stored or inventoried. It is sold continuously on the spot market at prices that may vary widely. We had a case last summer in Maine where the spot price for a megawatt of electricity went to $6,000, which is more than 100 times its usual rate. And, obviously, it is very difficult, if not impossible, for most consumers to respond to price spikes by turning off air conditioners or doing the laundry at a different time. So it seems to me that while it is fundamental that electricity markets must first and foremost be structured properly, they can also create instances where they do not operate in what FERC calls a workably competitive manner because consumers are not aware of price spikes. Therefore, I believe that FERC's actions to mitigate prices appear to be reasonable. But while it is important that FERC take action in the clearly dysfunctional California market, I would caution the Governor of California to be careful about what you ask for. While it may be tempting to ask FERC to exercise even more control of the California market, I know from our experience in New England that there may well come a day when you will wish that FERC would exercise less control. In New England, FERC decided that we needed to give generators more incentives to build capacity, so FERC increased what is known as the installed capacity fee. This is a fee that is paid by consumers to generators to encourage additional generation. What was really striking was that FERC ordered a 50-fold increase in the I-cap fee over the level agreed to by a supermajority of the members of the New England Power Pool and recommended by the New England independent system operator. It is ironic that FERC ordered this increase despite the fact that FERC's own report shows that New England already had plenty of capacity, and it is even more ironic that FERC ordered this fee in New England when the region with the biggest capacity problems, California, has no I-cap fee at all. Governor, with better planning, your State will eventually be where Maine is today. You will have adequate generating capacity to meet the needs of your State. Generators will eventually charge lower rates, although, as in Maine, they still are unlikely to be cheap. But if you ask FERC to exercise more authority over your market today, how will you ensure that FERC does not exercise unwanted authority over your markets tomorrow. If you call for FERC to set prices today, how do you know that at some point in the future FERC will not set prices, or at least some components of that price, at a level that Californians will almost universally agree is too high? And, finally, if your answer is going to be that only FERC has jurisdiction to act on these issues and questions, are you recommending that we change the allocation of authority between State and Federal regulators? Mr. Davis. Well, I appreciate your comments, Senator, about the flip side of asking for assistance. FERC has been such an omnipresent factor in our market, ever since I became governor, that I never contemplated a day without FERC, even though it is probably worth a few minutes' contemplation. I do want to make one comment. You touched on it, Senator Lieberman touched on it. Electricity deregulation might work efficiently if there is more power than demand. That is the key. And to States considering electricity deregulation, I would discourage them from doing so unless they first acquire more power than demand, because otherwise you are at the mercy of market forces that will extract every dime FERC allows them to from your citizens. I think it is fair to say, Senator, if you were in my shoes and facing the extraordinary price increases that our citizens have, you would feel, as I do, that our first obligation is to fight back and try and get some relief from those price increases and assure people that the markets will stabilize and that henceforward they will not be subject to these rapid price spikes. So, yes, I am asking for assistance. What we got on Monday was not perfect but is a step in the right direction. And I am hoping that this Committee will ensure that refunds are forthcoming. I think that will have a very sobering influence on the behavior of energy generators in the future. I want them to make money, I want them to be profitable, but not at the expense of driving our economy into a recession, which will have an adverse consequence on the American economy. Chairman Lieberman. Thank you, Senator Collins. Senator Torricelli. OPENING STATEMENT OF SENATOR TORRICELLI Senator Torricelli. Thank you, Mr. Chairman. Governor, welcome to the Committee. Governor, I do not know that it is productive to engage in partisan blame in this matter. People in California simply want this problem solved. But I do have a sense of what is fair. Some things have been said about you and your administration that simply do not bear scrutiny. But the fact is your predecessor did not build power plants. You are building or planning 28. You claim that that is more than your predecessors or more than at any time in California history. You suffer from unnecessary modesty. That is not simply more than at any time in California history. That is more power plants ever built by any State at any time in any comparable period. And the record should reflect it. It has been said, indeed, that conservation should be part of this equation. Indeed, at no time in American history has demand fallen by comparable levels. California is not simply now exercising conservation. You have the most efficient use of electricity of any State in the Nation. Indeed, if the State of Maine were to become the model, every citizen of California would have to double their consumption next month to follow the Maine model. On the question of whether or not there is responsibility for the current flawed deregulation plan, it should be noted that you did not write it, you did not design it, you did not vote for it, and you did not sign it. You just inherited it. And now you are fixing it, and that is to your credit. Now, I do not think that matters to people of California. They just want this solved. But fair, nevertheless, is fair. And I think you have handled this very well. Now, second, let me say something to the people on the FERC board. This Senate in confirming Presidential nominations looks to integrity and it looks to competence. Speaking only for myself, I want to make clear for FERC members who come before this Senate again, I am going to look for something else: Whether in this moment of crisis for the people of California they were responsive. FERC has been late. Its response has been inadequate. I am glad they have acted. But unless or until this response carries the State of California through this building program until you have adequate supply, their response is not adequate. And I hope every member of the board who intends to return to this U.S. Senate listens very carefully to those words. This is now a Democratic majority Senate. It will remain so for some years, and we are watching how the people of California are treated, and we are watching very closely. Third, let me say there are those who, I think, are genuine in wanting to help your administration. But there is a partisan overlay that perhaps separates the fate of California from what is happening with the rest of the country. That might be true with some States. It is not true with your State. If the economy of the State of California suffers, this country will follow. There is no separating your economic performance from that of the Nation as a whole. Everybody has a stake in how this evolves and whether or not this is solved properly. Then, finally, let me add to you it is my observation that if this Committee were meeting on the price of corn or cotton or housing prices and we were witnessing falling demand, increased supply, and a 700-percent increase in prices, we would not be citing the laws of economics. We would be citing the criminal laws, because it is against the law. There is a prima facie case that there must be some collusion. Prices are being set. The free market is not working. And this is one of the greatest examples I have ever seen in the history of our country, watching what is happening with these projections. I, simply for my part, because you have answered so many of these questions, wanted to offer my compliments and to say that there is a public perception because of the national debate, that some people are talking only about increasing supply, other people are talking only about the controls of pricing and what we are doing about consumption. Indeed, you have set records in both directions: The greatest reductions in consumption with the greatest conservation and the largest building program in American history for supply. Everybody else may have run to their extremes. It appears to me, you, if you alone, have struck a balanced program. I hope the people of California in this difficult moment have the patience to see this through. There clearly is an answer on the horizon. And I hope, also, Members of this Committee and the administration will realize that those numbers of $60 billion for consumption, what is behind those numbers. Every rise in that cost represents a family that cannot meet a mortgage, cannot educate a child, is taking from their retirement income to pay electricity bills. These are not some abstract numbers. It is people's quality of life and the future of their children that are being impacted. And so when we talk about rebates from these energy producers, when we talk about the need to control their prices, this is not vengeance against some unnamed corporate entity. It is preserving the quality of life of individual families in California who are paying with their futures and their children's futures by this unconscionable taking advantage of this situation. So, governor, I am glad you are here. You may have noted there is not a question in there, but, nevertheless, I thought there were some things that you might have been unwilling to say on your own behalf that needed to be said. I suspect I have no time, but if I do, it is yours. Thank you. Chairman Lieberman. I was going to advise you, governor, that after Senator Torricelli's statement, you could rest your case. [Laughter.] Mr. Davis. Thank you, Senator. Chairman Lieberman. Thanks, Senator Torricelli. And now, Senator Bennett. OPENING STATEMENT OF SENATOR BENNETT Senator Bennett. Thank you. Don't get too comfortable. [Laughter.] I lived in California for 12 years. I was there while you were Chief of Staff to Governor Brown and I welcome you to the Committee now. I am delighted to have you say that President Bush did not cause this. I would hope you advise your political consultant of that fact. I will just leave it at that, but you saw the piece in the Wall Street Journal, as did I, as to how your political consultant tries to write economic policy by focus groups. I hope you will tell him, and then through him the people of California, that President Bush did not cause this. Now, having said that, let me note that by virtue of what you have done, you have effectively nationalized the power industry in California. If California were a separate country, you have taken action similar to action taken by the parliament in Great Britain when the Socialist Party, the Labor Party, took it over, and have started doing things yourself as the chief executive of California which previously were done by private entities. You are entering into long-term contracts on behalf of the State, taking out of the hands of the private entities the right to make those kinds of price decisions. Let me review, therefore, the record from California with respect to your administration's ability to do this. I do this as a cautionary note. I have a quotation here from the Wall Street Journal. That is seen as a right-wing newspaper, so I will stay with newspapers in California and the comments that they have made about your stewardship in this area as you now step up with a nationalized program. This is from the San Francisco Chronicle, not known as a right-wing newspaper. This is last February. ``Governor Gray Davis was slow to respond to the economic realities of California's power crisis despite warning signals from legislators, regulators, and utility executives stretching back to last summer. Indeed, documents and interviews with industry insiders, regulators, and lawmakers show Davis may have contributed to the meltdown of the State's two largest electric utilities by neglecting a repeatedly suggested strategy for stabilizing wholesale prices.'' ``In addition, a top former Federal regulator said he told the governor's advisors and State Public Utility Commission officials as early as July that a key Davis proposal, to lower wholesale price caps, wasn't likely to solve the State's power problems. `The Governor resorted to a log-rolling strategy to get us to do things that we understood at the outset were not going to be real solutions,' said James Hocker, an appointee of President Clinton's, who stepped down in January as the Chairman of the Federal Energy Regulatory Commission.'' Now, moving to March and to the Sacramento Bee, Dan Walters, ``Crisis Also One of Leadership.'' I will not quote all of it, but he says, ``It is evident that it would have been a relatively minor bump in the road had Davis not frozen last summer when the first indications of price spikes arose. Had Davis done what private utilities, power suppliers, and others urged him to do then, adjust power rates slightly and allow utilities to sign long-term contracts with energy brokers and generators, the major crisis could have been averted.'' Now, going to a source outside of California but one of the leading left-wing newspapers in this country, The Washington Post yesterday says, and I quote---- Chairman Lieberman. We will note that the laughter was coming from the media table. [Laughter.] Senator Bennett. Well, if I am going to refer to the Wall Street Journal as a right-wing newspaper, I have to be even- handed and refer to The Washington Post as a left-wing newspaper. Quoting from The Washington Post, ``The Senate will hold hearings on California tomorrow.'' This appeared yesterday. ``Governor Gray Davis, having won the argument on price caps, plans to use that occasion to demand billions of dollars in refunds from generators for the period when price caps were not in place. This is not a smart way to persuade generating companies to invest in new power plants in California, and without investment, blackouts will return to California sooner or later.'' Now, as I said, governor, you have nationalized the industry in California. You have just entered into a contract for 8 years with Constellation Energy Group that would put a peak of $154 per megawatt and off-peak of $58 per megawatt. That is the decision you have made. The State has entered into that contract. I would point out that Enron, who has come in for a good degree of criticism in California politically, last summer with the utilities offered them 5 years at $50 per megawatt. You have just entered into a contract that is worse than the one that could have been obtained a year ago on the free market, and that raises questions in my mind about your ability to handle the nationalization of energy in the State of California. I am assuming we will have a second round, Mr. Chairman, so I have laid the predicate for where I am on this first round, and either now or during the second round, we can get the governor to respond, because I do not want to unfairly put him in a position where he cannot respond. But I think the actions California has taken here are unprecedented, and in the second round, I will quote the assumption about those actions that are in both the Los Angeles Times and the Wall Street Journal and I think we ought to explore that very carefully. Chairman Lieberman. Senator Bennett, it had been my desire that there not be a second round, but if the Members want it, we will have a brief one, only because we have two other governors and the Attorney General and the Public Utilities Commission and the five members of FERC. But I wonder, Governor Davis, if you want to take a moment to respond to the statements that Senator Bennett has made. Mr. Davis. Yes, Senator. I mean, I readily acknowledge I have a number of critics and you have quoted some of them. I do want to pick up on a couple other things you have mentioned. I have given President Bush credit for expediting Federal approvals that have allowed us to license 16 plants. I thank him for the extension of a couple emergency orders at the beginning of his term, and I believe in giving people credit when they do what I believe to be the right thing. As to why the State stepped in in January of this year to buy power, it was very simple. These prices have brought PG&E to its knees. Edison was deemed uncreditworthy, and in a meeting here in Washington, the generators told me, we are not going to sell any more power to your utilities. So you either find us a creditworthy buyer or your lights are going out. The State decided to become a creditworthy buyer and has done our best to keep the lights on, the power flowing, and to spread out the Herculean rise in prices over a lengthy period of time, which ensures all the power costs are fully paid, but we don't shock our economy into recession, which I suggest would not do well for your economy or for the economy of this Nation. If you want to get into the details, if there is a second round, I brought David Freeman with me. He oversaw the contracting process and is more familiar with it than I. But I have total confidence in his work. He ran the New York Power Authority. He ran the Tennessee Valley Authority. He ran SMUD. He ran the Department of Water and Power. Some people think he can't keep a job, but he has actually done a good job in all those places and he had to negotiate with these energy companies starting in late January when we had no leverage, prices were running $1,500, $1,600, and $1,700 for a megawatt of power, and I think he did a good job, not just in getting a good price for the State over 5- and 10-year period, but in shrinking the spot market, without which we would have seen higher prices than we are currently seeing this summer in our purchase on the spot market, because we have shrunk it to the point, through long-term contracts, where the price has started to come down. Chairman Lieberman. Thank you. Senator Carper, you are next. OPENING STATEMENT OF SENATOR CARPER Senator Carper. Thanks, Mr. Chairman. I want to say to my old colleague, Governor Davis, it is great to see you and I warmly welcome you to this place. When I was running for the U.S. Senate a year or so ago, I asked a sitting Senator who had been a governor, what is the difference between being a governor and U.S. Senator, he used a football analogy. He said, when you are the governor, you are the quarterback on the field calling every play. When you are the U.S. Senator, you are the athletic director sitting in a box watching the game. It is easy for us to sit here in the box watching the game to be critical of you and the other quarterbacks calling the plays and trying to move the team down the field. Senator Torricelli has already spoken, and I think eloquently, about your efforts, and I would just say to my colleagues, we could find pundits in our own States and throughout the country who would question our votes and our steps and missteps just as questions have been raised about some of the actions of Governor Davis. I applaud the efforts that you have undertaken and hope for you and for the people of California that the end will be a good one and a satisfactory one. I want to ask you, if I may, to take the lessons that you have learned in California with respect to electricity deregulation and with energy conservation and to share with us what applicability there is for the rest of the country for our national policy, particularly with energy conservation. What are the lessons for us as a Nation derived from your experiences in California for electricity deregulation and for energy conservation? Mr. Davis. In terms--I shared earlier one of my thoughts about electricity deregulation. States who have not yet decided to go down that road, in my judgment, should not do so until they acquire more power than their project demand. That will then give them leverage and allow them to say no to prices that are unduly high. We look forward to being there someday, so when someone offers us power at $400 or $500 or $600 a megawatt hour, we can say, well, we will just turn on one of our peakers, or thank you very much, if you want to offer it to us for less than $100, we will talk to you, and you have the leverage, they know you have the leverage, and you come to a reasonable resolution of that issue. On conservation, this has been very exciting because it is something we had to do. It is not a question of whether we wanted to do it, it is a question of necessity for us to improve upon the conservation gains that had been built into the system before I got there, and it is just exciting to see what people are willing to do. When the President was in town, before my meeting, we met with technology companies. One company is making a flat-screen computer which reduces electricity usage by 75 percent. Intel is making a new chip that makes your computer much more efficient on ``sleep mode,'' so it can receive information and still conserve about 60 percent of electricity. We just tell people in their daily lives, if you are not in a room and no one else is in the room, turn out the lights. Turn up the thermostat two or three degrees. I believe in personal example. My wife has taken this cause of conservation to new heights. When you come into my house at night, it is like entering a tomb. There is no light, none, except a little crack of light under whatever door in the room she is in, and she has replaced all the lights with fluorescent lights. In the winter, the temperature was down to 55 degrees, so it was--I went to bed with a sweatshirt on. But her bill the first month was down 36 percent, last month, 63 percent. So it is amazing what you can do if you are determined to reduce electricity, plus it is exciting to see some of the technology gains that will be on-line, not just for us but for the rest of the country, because no matter how much excess power you have today, you will get to a point when you don't have it and you will want the benefit of these technology improvements, which our crisis is forcing us to develop, and obviously, we will share them with everyone. Senator Carper. You mentioned, in fact, you described here and earlier the actions that the FERC announced on Monday as a step in the right direction. What might be some appropriate further steps in the right direction, one, for the FERC, and two, for us in the Congress? Mr. Davis. Well, I think they have to look closely at there is still some potential for manipulation. Everything is geared to the least-efficient unit in the State. Everything keys off that. Chairman Lieberman. Governor, can I interrupt you? Congresswoman Susan Davis was here from San Diego and I know she has to leave now. Before she leaves, I want to note her presence for the record. Thank you for being here. Mr. Davis. Thank you very much for being here. Thank you so much for staying. I lost my thought---- Senator Carper. We were talking about steps in the right direction, appropriate next steps, one, by the FERC, two, by us in the Congress. Mr. Davis. We believe what FERC has done will offer us some price relief. I notice that Mr. Hebert was suggesting that the order that he implemented on May 29 was responsible for some falling prices in California, and it may well have been for 2 days, the 30th and 31st. But we haven't had a stage one alert since then, so that order only affected us 2 of the 22 days it has been in effect. So now, by making it applicable across the board during any purchases, real-time purchases of power, it should have a downward impact on prices. I don't know all the potential for manipulation, but the people in the energy business are smart folks. They have got trading floors that compare favorably with the New York Stock Exchange. They have teams of meteorologists. They have media operations that would shame a network, and so I am sure they will do their best to find whatever loopholes are there and we need to be vigilant. This Committee needs to be vigilant, and so does FERC, to make sure that the thrust of its order is, in fact, carried out and the relief that is intended is made available to us and, hopefully, to the rest of--in terms of refunds, to the rest of the West. Senator Carper. The last half of my question. What appropriate steps are in line for the Congress? What should we be doing? Should we simply be monitoring the actions of the FERC, holding hearings like this, conducting oversight operations? Mr. Davis. There are many things that obviously compete for your attention. I tried not to give you too long a laundry list. I mentioned two. The President, when we met with him, and again, I thank him for the meeting. Even though we didn't agree on price caps, we agreed on this. There was no reason that the price of natural gas should be significantly higher in California than in the rest of the country, particularly natural gas coming from Texas, and he was open to the possibility, because I ran this by him twice and he said, ``Yes, you can say this,'' he is open to the possibility that the tariff should be reimposed on the transportation quotient of natural gas. Natural gas is deregulated, but there used to be a fixed price you could charge for transporting it. That is one possibility to reexamine. So the two things that I would suggest this Committee focus on in terms of its dealings with FERC are the potential for manipulation on the natural gas issue, because natural gas is not only a cost in and of itself but a huge part of electricity costs, and what I think is the necessity is providing refunds to Californians and other citizens in this State who have been unduly victimized by extraordinary electricity prices. Senator Carper. Again, welcome. Thanks. Mr. Davis. Thank you. It is a pleasure to see you in your new capacity. Senator Carper. Thank you. Chairman Lieberman. Thanks, Senator Carper. Next, we will go to Senator Voinovich. OPENING STATEMENT OF SENATOR VOINOVICH Senator Voinovich. Welcome. I was just thinking that nobody knows the trouble a governor has unless they have worn the shoes of that governor. I went through the minefields of deregulation while I was governor of the State of Ohio. The deregulation legislation finally went into effect a year after I left. I have looked at your deregulation and I think that it ought to be revisited, and I think that some of us that came in afterwards learned some lessons from California. Last week, we had five outstanding economists come here to speak before us and the question to them was, do we need a legislative solution to the problems that you are dealing with in California. Their answer was, no, FERC already has authority to handle the situation, although they did admit that FERC has been slow to take on new responsibilities that have come with deregulation, and that they probably needed some more people and expertise. As you know, FERC has recently adopted a system of price controls that allow for all generating units that provide energy to California to recover their costs plus a reasonable profit. That is what we did in Ohio. We created a restructured electric utility system that recovered stranded costs while also allowing for a reasonable profit for generators. That, in turn, encouraged greater investment in new generation. In fact, by 2007, governor, we are going to have 18,000 new megawatts of on-line power because we had a 5-year cap, but it took into consideration that companies have to make a profit and recover their costs. I think that FERC's decision this last week is going to provide some short-term relief for you. But I do not think there is any quick fix. The point I am making is that price caps will not solve supply shortages in California. In fact, price caps that are set too low discourage investment, as you know. I think Robert Samuelson noted in the Washington Post last Wednesday that the root cause of your problem is demand outran supply, and for California to avoid the constant worry over the ability to provide power, investment in new power generation has to be encouraged, including the implementation of a streamlined siting process that protects public health and the environment, and I think that you perhaps ought to look at your deregulation law again. Other States, and this is something that is really significant, have worked through deregulation issues on a cooperative regional basis. By contrast, the California situation seems to be extremely polarized, with California insisting that Western States take definitive positions for or against price caps. The question is, at what point will California be willing to become part of a regional solution, as called for by FERC, rather than insisting on its own independent governance structures to run the electric grid? Instead of a single State operator of the transmission grid, I think the opportunity exists for a regional transmission organization to be established, just as we did in the Midwest when I was governor. We had a multi-State ISO. What do you think of going to a more regional approach instead of your current handling? Mr. Davis. As you know, the next largest State in America, Texas, is not under FERC jurisdiction because they have not yet separated generation from distribution. The next two States, Florida and Texas, have submitted to the FERC permission to be their own ISOs because of the size of their economies. Because we are the fifth--at least last year, we are the fifth largest economy on the planet, I think at least for the foreseeable future, we should be our own ISO, as well. Now, I certainly believe that until we get to a situation where we have more power than demand. This has been, as I am sure you can tell, being a former governor, one of my least favorite things to do, occupying a great deal of my time, and I think it is just imperative that we stay the course on building new power plants, on conservation. I am pleased that there is some response from FERC on price relief prospectively. I am hoping that with your assistance, there will be response on price relief retroactively. So I would not be open to the State joining a regional ISO--I would not be open at all until we reach the point where we got to 15 percent more supply than demand. Then I would be willing to revisit it. That is not to say I don't have great respect for our neighbors in the West. We have a particularly friendly relationship with the neighbors that border us, be it Arizona or Nevada or Oregon and also with Washington, and a sharing relationship with our neighbors to the Northwest. Senator Voinovich. Being next to California is like being in bed with an elephant, and you have had a dramatic impact on your regional area. Ohio is the third-largest user of electricity in the United States of America. We had a regional ISO and we have found it to be beneficial. I would suggest, governor, that you look at that. I know FERC has recommended that. I would appreciate, as a member of this Committee, that you seriously review that issue again and I would like to talk to you more about it. Mr. Davis. As a courtesy to you, Senator, I will do that, and I would be pleased to have a discussion with you. If I could just make this final point, until Monday, despite a year of effort on my part and all the agencies that I work with in California, we did not have a satisfactory response from FERC on any matter. As a matter of fact, we think their lifting our price cap in December 2000 was responsible for blackouts because there were no blackouts when we had a price cap in effect, none, and it was only when the price cap was lifted there became an incentive to withhold until the last minute. Gaming became a great prospect. And while I quickly acknowledge that price caps on a long- term basis don't make economic sense, I also want to acknowledge that 12 of the 16 plants that we have licensed submitted their application when the hard price cap was in effect of $250. So they must have thought that was sufficient, offered sufficient return on their investment. And in terms of conservation, there is nothing that will discourage us from improving upon our conservation because we have to do that to minimize the potential for blackouts and disruption. So while theoretically I acknowledge that price caps do not--they may well discourage conservation and discourage investment, our experience in California, given the situation I have described, is to the contrary. Senator Voinovich. I have learned in my life that when things go wrong, so often what we do is point to other people as being responsible for our problems. I have found that it is good to look to one's self and see if there are things that one can do to improve the situation, and I believe that is the attitude that you and your State should have and work with FERC and everyone else. But I think that the finger-pointing ought to end and we ought to figure out how to get this job done, because it is not only affecting your State, but the entire country, including my State. Chairman Lieberman. Thank you, Senator Voinovich. Senator Carnahan. OPENING STATEMENT OF SENATOR CARNAHAN Senator Carnahan. Thank you, Mr. Chairman. Welcome, Governor Davis. Mr. Davis. Thank you, Senator. Senator Carnahan. I have appreciated the forthright manner in which you have responded today. I realize that our topic is primarily the situation in California, but Missourians are very concerned about the energy picture, as well. They have watched the crisis unfold in California and they have been worried about their own energy bills and how they, too, have increased steadily. It is important to focus on the proper role of Federal regulators as we restructure the electricity industry. As we consider future policies at the national and State level, we should learn from the problems of the past. We are told that a fully-functioning deregulated market should lead to lower prices, and, of course, this is a very appealing argument. But for all of the initial optimism about lower prices, California's experiment with deregulation has caused me to question how future transitions should be managed. If the deregulation is to continue, we must have the structure in place for a successful transition. Public confidence is an important component of any successful market, but competitors must also feel that there is a level playing field and that markets are not designed in ways that unfairly benefit some players while creating barriers for others. This brings us to FERC's role in the process. There is certainly no shortage of opinions on the merits of the order FERC announced last week. But the question in my mind is even more fundamental. What is the appropriate role for the Federal Government to play as more and more markets move from regulation to competition? Regardless of our views on the merits of FERC's order, the fact remains that FERC's action came long after the market was found to be dysfunctional, months after the rates were found to be unjust and unreasonable. Like many other States, my home State of Missouri is considering deregulation. If Missouri deregulates, assuring just and reasonable rates for Missouri consumers will be entirely in the hands of FERC. FERC's performance in California does not inspire confidence. This week, FERC finally began closing the door on rate gouging in California, but only after letting a $50 billion horse out of the barn. Missourians deserve assurances that if our State deregulates, we won't be stampeded by runaway prices. I am sure that leaders in California have spent countless hours considering what mistakes they have made in the past and what they can do in the future to improve the situation. Now, I would hope the Federal Government would conduct the same sort of analysis. In April, Senator Lieberman and I wrote to the General Accounting Office asking that it conduct an independent review of a number of matters relating to FERC. Specifically, we requested that the GAO study whether FERC has fulfilled its mandate to ensure just and reasonable prices. FERC played a very different role when they were Federal caretakers over an often stodgy regulated industry. But I am coming to believe that a new approach will be required to oversee what has become a very dynamic industry. FERC must seriously reexamine its role in light of recent experiences. This Committee must aid that effort. If we find that FERC is not living up to its mission, or if it simply cannot live up to this mission because of limited resources or other factors, we must determine the most effective and efficient remedy. Otherwise, I believe that a truly competitive market for electricity may well be a long time coming. To instill public confidence in our energy markets, FERC must prove capable and willing to assert its authority by closely monitoring markets and better anticipating potential problems, and perhaps most importantly, it must be prepared to take swift corrective action when there is evidence of flawed markets or abuse of market power. This is a duty we owe to the American people. I want to thank you for being here today. I admire your courage and your willingness to take on this very tough problem. I have just a couple of questions I would ask you at this time. From your experience, do you believe that FERC is equipped to fulfill its responsibility to ensure just and reasonable prices as we transition from a regulated to a deregulated energy market? Mr. Davis. I think the jury is still out on that. Clearly, we feel we have been denied relief, at least from November 2000 until Monday, and then the relief we have received is prospective in nature. The true test of their leadership on this issue and whether or not they are going to fulfill the mandate of the Federal Power Act will be seen on how they deal with the refund question. So I can't answer that question any more clearly. I know it is customary for witnesses to sort of break down on partisan issues, but the commission did not take a positive step until the two Bush appointees joined it. I don't know if that means they will take a positive step on refunds or not. It remains to be seen. I hope they do. Senator Carnahan. And one other question. Recently, we have seen some individual transactions where prices were abnormally high and some have argued that this has resulted from manipulation in the market and abuse of market power. Should FERC be more aggressive in its investigation of abnormal transactions to determine if market power, in fact, has been abused? Mr. Davis. I think the answer to that is unequivocally yes, Senator. In our State, we have logs that indicate plants were shut down per marketing division. Now, in and of itself, that may not be conclusive, but you have to ask yourself why the marketing division would have an interest in telling a plant to shut down. The maintenance of our plants, admittedly old ones, some 30 and 40 years old, averaged 3,000 megawatts in each of the years of 1999 and 2000, averaged about 11,000 to 15,000 megawatts the first 5 months of this year, and the figures I gave you before were a comparison, April through May of 2000. In 1999, it was about 3,000. This year, it started at 11,000 and went up to 15,000. I mean, we can't prove that they withheld power in order to drive up the price, but it does seem kind of odd that so many megawatts were out of service. So I think that is at least one area that the FERC could be more aggressive in ensuring that the market is not manipulated and that consumers are not unduly charged with excessive prices. Senator Carnahan. Thank you very much. Mr. Davis. Thank you. Chairman Lieberman. Thanks, Senator Carnahan. Senator Domenici OPENING STATEMENT OF SENATOR DOMENICI Senator Domenici. Thank you very much, Mr. Chairman. Governor, it is good to be with you. Mr. Davis. I, as well. Senator Domenici. I want to just talk about one area that concerns me, and I have difficulty understanding what happened and why it happened, and that has to do with the absence of long-term contracts during most of this crisis. I have tried my best to go through a chronology of events with dates and I have been able to come up with 11 opportunities at different times. Starting in mid-June 2000, there are 11 times when a U.S. governor was either offered the opportunity to enter into long- term contracts or you were urged by some committee or group that was advising you about the problem, where long-term contracts were recommended but that recommendation went unheeded. So let me go through a few and you tell us what happened. In mid-June 2000, Southern Cal met with you, according to what we have here, and the top advisors, and they warned that electric prices in San Diego could soon go sky high and that his company would have to take on significant debt. I understand at that opportunity, at that event, the suggestion was that long-term contracts be entered into. If that is the case, why was that ignored at that time? Mr. Davis. I would like to ask if I might bring David Freeman with me, who helped negotiate some of these long-term contracts. Could I ask him to come forward? Chairman Lieberman. Sure. Mr. Freeman, why don't you come up, take the seat next to Governor Davis, and just identify yourself for the record. Don't tell us all you have done in your life because we do not have enough time. Mr. Freeman. I am Dave Freeman and I am the senior energy advisor to the governor, I think I am the oldest guy around. Chairman Lieberman. That is a good sign. Senator Domenici. The oldest guy around, where, in California or up here? Mr. Freeman. Both. [Laughter.] Senator Domenici. Let me say to you, as the advisor, I prefer to ask these questions of the governor, but if he needs help from you, that is fine with me. I understand that. Mr. Davis. I understand that. Senator Domenici. Let me take two or three of them and then you can answer together. I just gave you one, mid-June, Southern Cal meets with the governor--I assume you are aware of this meeting--and the recommendation was that prices were going to go sky high in the San Diego area and that that company was going to have to take on significant debt. On that occasion, the idea of long-term contracts was broached, entered into, and nothing was done about it. Mr. Davis. I can answer that question. That was before the State got into the business of buying power in early January 2001. The PUC did give approval to the three utilities to enter into long-term contracting. The PUC insisted that it keep its prudency review, which only makes sense because a utility could enter into a contract for 3,000 or 4,000 megawatts an hour and then the consumer would be obligated to pay that. Some of the utilities took advantage of those long-term contracting opportunities, others didn't, but the PUC did act, I believe, in August to allow all three utilities to enter into long-term contracts. Senator Domenici. OK. Well, let me move---- Mr. Freeman. Senator, that is correct, and they just didn't. Senator Domenici. Please? Mr. Freeman. I think the utilities who were then purchasing their own power just failed to enter into long-term contracts. If they were here, they would say that they weren't sure that the PUC would approve them, but they did not try. Senator Domenici. Well, let me go on to a couple of other dates and tie two dates together. July 21, 2000, PG&E files an emergency motion seeking authority and guidelines to sign long- term contracts with electricity suppliers. On July 27, the governor calls on FERC to extend wholesale electric price caps. Now, it seems to me he must not have been supporting long-term contracts at that point and I want to know---- Mr. Freeman. No, sir. The two actions---- Senator Domenici [continuing]. Were they not good? Mr. Freeman [continuing]. Are not inconsistent at all. Senator Domenici. Is there something wrong with long-term contracts? Mr. Freeman. No, sir. The two actions are not inconsistent at all. The price caps were to control a runaway spot market that was literally taking the money out of the pockets of the people of California. The long-term contracts were designed for the future, to establish a just and reasonable market rate. But the caps were needed not to control long-term contracts---- Senator Domenici. No, I know that. Mr. Freeman [continuing]. But to control the spot market. So the two actions were completely consistent. Senator Domenici. I understand they are different, but it seems to me that I have ten instances when the governor had a chance to support long-term contracts and didn't. On a number of occasions, instead of doing that, shortly around that time, he suggested caps. It seems to me that is what he wanted all along, was just caps. That was his proposal. Mr. Davis. Senator, the Public Utilities Commission met in August and granted all three utilities the right to enter into long-term contracts. Some utilities took advantage of that, some didn't. As David Freeman correctly points out, they will complain that they had to be subjected to a prudency review, but every PUC commission in the history of our State that has granted long-term contracts has always insisted on an opportunity to review the prudency of that contract for the reasons I suggested earlier. So we did--I can't just say, you have long-term contracts. That is not within my power. The Public Utilities Commission, then consisting of three members appointed by Governor Wilson and two by me, did agree to grant that permission in August, the month after the question arose. Mr. Freeman. Senator, if I could just add, the minute that this governor had the authority to enter into long-term contracts, that is when we started doing it, almost the very day, in fact, a few days before the statute was actually enacted by the legislature. It wasn't until January 2001 that the State began buying power. Before that, it was the utility's responsibility and the dates that you are mentioning are all before Governor Davis and the State got into that business. But the minute we did, we negotiated $42 billion worth of long-term contracts in several weeks, the largest exercise of that kind in the history of this country. Senator Domenici. Well, let me just generalize and then ask two more questions. Are you suggesting here before our Committee that you, governor, and if you are his advisor, you can answer that, you promoted and encouraged and wherever you had authority, you actually pursued long-term contracts during all of this crisis? Were you not at some point against entering into long-term contracts? Mr. Davis. No. There are two separate periods in question. First is a period when the utilities were buying power, and was a period when we were buying power. We started buying power January 18, 2001. I asked David to start buying power, was it before the month was out? Mr. Freeman. Yes, sir. It was---- Mr. Davis. We asked within a matter of days after the State started buying, and net short, for the State to secure long- term contracts because we wanted to wean ourselves from total dependency on the spot market. Now, the earlier phase, when the utilities were buying power, at various points, they did raise to me the issue of long-term contracts, something, I might add, that FERC discouraged in 1995, 1996, and 1997. I advised the Public Utilities Commission, in my judgment, it made sense--they had to schedule the meeting, they have 30 days' notice, they gave permission in August 2000. I think two of the three utilities took advantage of that opportunity to obtain some long-term contracts, but all three were given permission to do it. Senator Domenici. If you have another chance, I will ask another question. Chairman Lieberman. Yes. Thanks, Senator Domenici. Governor, some of my colleagues on the Committee have asked for a second round, and because of the importance of the issue, notwithstanding that we have a couple of governors, attorney general, etc., waiting, I am going to go ahead and do that. I am going to ask my colleagues to stick to 5 minutes. I do want to ask you, would you like to take a brief break? Mr. Davis. If I could take a 5-minute break, I would appreciate it. Chairman Lieberman. This reminds me. Once before, a few years ago, I was going to meet with President Assad of Syria and probably the most significant advice I got, excuse my explicitness, was to go to the restroom before the meeting because I could expect it to go on for a long time. This apparently is also true of testifying before a Senate Committee. So we will take a 5-minute break. [Recess.] Chairman Lieberman. Let us reconvene. I am sure not just Governor Davis, but all of us benefitted from the break and an opportunity to stretch our legs a bit. I thank you very much. It has been a very productive and interesting morning. I want to say to my colleagues, though we are going to go to a second round, I hope everyone knows they do not have a constitutional or legal obligation to ask questions on this round. Senator Bennett. Yes, we do. [Laughter.] Chairman Lieberman. I will now call on Senator Thompson. Chairman Thompson. Thank you very much. Governor Davis, I think that one of the increasing concerns that we all have is whether or not these plants that may be in the process of being licensed are actually going to get built. There are several who have expressed reservations about investing in new generation in California. Merit, for example, a spokesman said that--well, this is from the San Francisco Chronicle, June 2, 2001. An Atlanta company that just got approval to build a power plant in Antioch is holding off construction, citing California's push for Federal price controls and rhetoric about possible seizures of power plants. The Charlotte Observer, April 27 of this year, says even though Duke Energy Corporation is building one, the Power Star, of California's biggest power plants, top executive Rick Prowery said the company would hesitate to build more California plants because the State's energy economy resembles that of a third world. Reliance expressed some similar concerns. ``Ridgewood Power said generators find it more predictable and less risky to operate in third world companies than they do in the State of California,'' griped Marty Quinn, Executive Vice President and Chief Operating Officer. Of course, obviously, some of these folks have their own axes to grind. There is no question about that. But we have also heard from investment bankers, as I indicated earlier, about this. You can't get away from comparing that with the rhetoric that has come out of California. These power suppliers have been subjected to all manner of description. You have an Attorney General there who apparently wants to introduce the head of Enron to your President so that he can be introduced to a fellow named Spike. Assuming that these energy executives don't want to meet Spike, I wonder what that is doing to the atmosphere when you are going to threaten to seize plants. What is that doing to the atmosphere when you are going to have to be, I think, in the future--we are talking about short-term solutions here right now primarily. You are going to have to be dependent upon substantial new investment at a time when the regulatory environment is very uncertain for these people to start with, and now they are finding a very hostile political environment. Is that a wise strategy at this time? Are you concerned about the completion of plants and suppliers who are expressing these serious reservations? Mr. Davis. Well, Senator, with all due respect, the people I represent are mad. They don't like paying 700 percent more for electricity. Small businesses in San Diego don't exist anymore because they had to face this problem in the year 2000 and they want us to fight back, and that is what we are doing. This is a rough business. You know these energy companies. Many of them have a wildcatter mentality. My grandfather had something to do with the oil business and I know what that attitude is like. California has been a cash cow to a lot of energy companies around this country who have done extraordinarily well, and occasionally some harsh words get exchanged. But my job is to fight back and say we are not going to take it, and I suggest to you, if it were not for a good deal of what you might consider political hyperbole, we might not have the attention of the Federal Energy Regulatory Commission that stiffed us for almost a year. Chairman Thompson. Do you think that FERC responded to your Attorney General suggesting that the head of Enron be thrown in jail with Spike, or do you think FERC responded because you called the suppliers pirates and words of that nature? It may make you feel better, and it may be understandable in responding to your constituency. We all have the temptation to do that from time to time. You are not alone in that respect. The only difference here is, you are going to be very dependent on these same people. Regardless of the past, it looks to me like you have to look to the future. Is it the responsible thing to do to create an environment for the very people who are in the process of looking at California for future investment, and sometimes have requested license applications, who are now doubtful because of the regulatory and the political environment in your State when you are the head of that State? Mr. Davis. Well, first of all, as Senator Torricelli pointed out, we are building more power plants than anyone has ever built. Chairman Thompson. How much has come on-line in the last 2 years? Mr. Davis. It takes about 2 years to build a plant, but as I said in my initial comments, there will be three plants on- line between now and July 7, representing about 1,200 megawatts. There will be ten peakers representing about 800 megawatts. And there will be a total, when you count distributive generation, additional renewables, re-rating power plants, approximately 4,000 megawatts by the end of September. We anticipate 5,000 megawatts for each of the 3 years following that for a total of 20,000 megawatts. Now, obviously, we want the State to be an attractive place for investment, but we don't want companies walking all over our citizens. We want--responsibility is a two-way street. We understand the obligation to be responsible and we expect corporations that operate in our State to be responsible, and by and large, they are. Chairman Thompson. Thank you, Mr. Chairman. Chairman Lieberman. Thanks, Senator Thompson. Senator Bennett. Senator Bennett. Thank you. I want to go in the same direction, Governor, as Senator Thompson. Last time, you said I quoted your critics. This time, I will quote you, and it is interesting that Mr. Freeman is sitting next to you, because here is a circumstance where the two of you may have said different things. Here is a quotation, a release from the Office of the Governor on May 31, 2001: ``I met with the municipal utilities about 3 weeks and I was very disappointed to learn that they were charging us more for power than the generators. Here we have been maligning the generators, properly, because they have been selling us power at 600 to 700 percent what we paid for it just 2 years ago. I find out the munis are charging us even more. So I said, listen, you are going to sell us your excess power this summer at a cost-plus basis, roughly 10 to 15 percent over cost, or I am going to seize it from you and I am going to make sure that we get that power at an attractive rate.'' ``I gave them a couple of weeks to negotiate with the Department of Water and Resources. The first day they had to negotiate was this Tuesday. We will see what happens in 2 weeks, but if they don't come through with contracts, I am going to seize the power because they are creatures of the State legislature. They are supposed to provide power on a cost-of-service basis, not make a zillion dollars by charging more than these out-of-State generators who set the Guiness Book of Records for greed themselves. The munis are doing even more.'' And then, Mr. Freeman, you are quoted in the Los Angeles Times, not specifically in response to the Governor's statement, but generally. `` `These charges go under the heading, there is no good deed that goes unpunished in this State,' Freeman said, noting that DWP Power helped avert more blackouts across the State. He did acknowledge, however, that the agency has charged high prices for surplus power at the 11th hour, but said that was only because it cost more to produce. `We have consistently charged Cal ISO our cost-plus 15 percent,' he said. `It is not as though we are up there peddling a bunch of power to jam it down their throats.' '' Now, my question--first, if you want to challenge the statements, that is fine, but my question is, you are here asking for refunds and rebates from those whom you say gouged and bilked Californians. Are you planning to ask of that from California munis? Mr. Davis. I believe everybody that unduly took advantage of this situation should be required to make rebates. Californians expect people to treat us fairly. We expect to treat them fairly in return. The statement you quoted from me was accurate. I was appalled to find out that these municipal power authorities, which were creatures of the legislature, we gave them permission to exist, because they were not supposed to be competing with the free market, they were supposed to provide cost-of-service power, had, in fact, charged us roughly $360 a megawatt hour while the generators had charged us about $310 a megawatt hour, and I found that out about 30 minutes before the meeting we had with the munis. So my job is to protect all the citizens of this State from getting a raw deal and it doesn't matter to me if the raw deal comes from a generator from Houston or a municipal power authority in Los Angeles. Senator Bennett. Mr. Freeman, the governor has asked you to the table. Do you feel that you gouged the State while you were running the muni and charging cost-plus 15 percent? Mr. Freeman. No, sir, and your researcher overlooked one relevant fact, which is that the day after I left the Department of Water and Power, that board of commissioners changed their policy to start charging market prices for power, and it was that market price policy that Governor Davis correctly was criticizing. They have since then backed off and they have now agreed to sell at cost. So the governor is entirely correct, but I think that I was accurate when I said that our policy when I was there was to sell at cost-plus 15 percent. Senator Bennett. Do you feel that---- Mr. Freeman. But if there is any investigation that shows that we charged more than that, the muni should refund the money just like anyone else and the governor is being consistent. Indeed, he should be congratulated for being just as hard on the municipalities in California as he is on the other generators. It seems to me that this is just more evidence that he is standing up for the consumers across the board. Senator Bennett. I appreciate that clarification. Just one last comment, Mr. Chairman, if I might. Your $50 to $60 billion projected figure does not coincide with the earlier chart that Senator Murkowski put up that shows that prices are, in fact, coming down. I would appreciate it if you would supply information for the record as to whether or not you are prepared, after examining where prices are, to lower that projection or if you stand by it. We don't have the time to go through it here, but we have had two separate charts that show different projections for the future and I would appreciate whatever further clarification you could give to that.\1\ --------------------------------------------------------------------------- \1\ Chart entitled ``California Day-Ahead Power Prices,'' appears in the Appendix on page 551. --------------------------------------------------------------------------- Thank you, Mr. Chairman. Chairman Lieberman. Thanks, Senator Bennett. Just real briefly, I do want to quote with regard to the impact of price relief or price mitigation questions. Fair questions have been raised about the impact of that on the willingness of power producers to come into the California market. The Los Angeles Times, which I will not describe according to any particular ideological inclination, says today, headline, ``Curbs Won't Halt Plants.'' First paragraph, reports reporters Nancy Vogel and Thomas Mulligan, ``The expanded electricity price limits approved by Federal regulators could squeeze big energy traders but will probably not discourage power plant construction in California, electricity producers said Tuesday.'' ``But the companies,'' I go on, skipping a paragraph, ``the companies generally asserted Tuesday that the order would not deter them from investment in the vast power-starved Western region, though they have often raised such a prospect in arguing against price controls.'' So that is certainly an encouraging dispatch or independent report. I think I am going to control myself and not ask any more questions because you have been on a long time. Governor Davis, you have been tested generally in this crisis. You have been tested this morning. But by my judgment, you have passed the test very, very well. I appreciate your testimony and I appreciate not only the fact that you have become an expert in something you probably weren't an expert in a couple of years ago, but the tone in which you have spoken. I think you were quite right. You said that neither you nor President Bush was there at the origin of this problem. The question is, what do we all do about it now, and that is the question that we are asking FERC. This is not a partisan matter, by any means. This is just a question of a genuine crisis, not of your making, not of the President's making, but so genuine that it threatens the economy. And I have noted now, California's economy is now the fifth largest, if it were a country, in the world, and it is critically important that we all do our share to overcome the crisis. I think, as you have testified very directly and eloquently today, the State of California, the legislature of California, the people of California have done their part and FERC has finally come into the arena and done some things to be helpful. I have concerns, as I stated at the outset, about how fully effective it will be. I share your concern about the inequity of not ordering refunds to go to electricity customers in California and the West because they suffered damage here. When you have a right, as you said, without a remedy being offered, that undercuts our system of justice. And, it does not deter future behavior of that kind by energy wholesalers or anybody else who would take advantage of a consumer. So we are going to ask that question of FERC this afternoon and we are going to stay on the case until we feel that we have done as much as we can by way of our oversight to make sure that the Federal Government plays an appropriate role here, or at least that we have adequate public discussion of the role that it is playing. I thank you for the time you took in coming out here. You have contributed substantially to our understanding of the problem and I wish you well. Mr. Davis. Thank you very much. Thank you, Senator Thompson. Chairman Lieberman. Thank you. We will now call the Hon. John Hoeven, Governor of the State of North Dakota, and the Hon. Judy Martz, Governor of the State of Montana. According not just to the tradition but the rules of the Committee, we try to conduct these hearings and our deliberations generally in a bipartisan fashion. Senator Thompson requested that these two governors be called and I am delighted that you two have taken the time and made the effort to be here. Your presence obviously punctuates the fact that we have all been testifying to, that though California may have been most extremely impacted by this energy price and supply crisis, that certainly other States in the West, let alone States throughout the country, have an interest in this. So we look forward to your testimony. Governor Martz, do you want to proceed first? TESTIMONY OF HON. JUDY MARTZ,\1\ GOVERNOR, STATE OF MONTANA Ms. Martz. Sure. Thank you very much. Thank you, Mr. Chairman, and thank you, Senator Thompson and Members of this Committee. My name is Judy Martz and I am the Governor of the Big Sky State of Montana. I appreciate the interest this Committee has shown in the struggles of Western States to deal with an electricity crisis. I may, as Vice Chairman Thompson said, rain on a parade. --------------------------------------------------------------------------- \1\ The prepared statement of Ms. Martz appears in the Appendix on page 821. --------------------------------------------------------------------------- We are here to discuss the role of the Federal Energy Regulatory Commission associated with the restructuring of energy industries. However, the real issue seems to be what went wrong in California and could it happen elsewhere? Let me try to answer this question. The facts show that the primary responsibility for the electricity crisis in the West lies within the State of California. A series of mistakes made by the State and the failure by the State to take corrective action once problems first arose more than a year ago led directly to the crisis we are in now. This crisis, I believe, could have been avoided if California had taken timely action. Instead of acting, I believe the State, unfortunately, engaged in a prolonged exercise of blame shifting. I don't say this to be disagreeable. I really don't. I say this from the perspective of a State that has been hurt by the California electricity crisis. I also say this to make sure that other States do not make the same series of mistakes California made in the recent years. We all want to do our share, but it is killing us. Montana has been hit hard by the very same issues that Washington State has. As a result of the California electricity crisis, Montana industrials have gambled on declining future power prices that have been hurting us as a result of the power prices rising. We have seen several closures in Montana, a State whose economic base cannot afford to lose even one single job. But because we are tied to the Western grid, any excess energy is pooled to other States and we face higher rates ourselves. Industries that chose to shop for energy found their traditionally low rates of about $30 per megawatt rise to as high as $300. Much of the pain that my State and others have felt could have been avoided if California had not shied away from making tough decisions when they were called upon last year. Let us review how we got here today. California was the first State to open its retail electricity markets to competitive markets in 1996, with Pennsylvania following quickly on its heels. The California electricity law is often described as deregulation, but it was nothing of the kind. California did not deregulate electricity markets but merely exchanged one set of State regulatory rules for another, which led to disaster. We did better than that in Montana. The 1996 law had a number of unusual elements. It forced California utilities to divest much of their electricity generation. It required utilities to rely completely on volatile spot markets to buy all of their power, something no other State did. It also imposed regulatory rules governing spot market sales that increased wholesale market prices. It froze retail rates. One provision missing from the 1996 law was reform of the State siting law. It can take up to 7 years to build a power plant in California, and on the average period, it is 4.5 years, nearly twice the average as in Texas. This was a crucial mistake. Since California retained a siting process suitable for long-term planning by regulated utilities with 10- or 20- year planning horizons, but completely unsuitable for a competitive market where independent power producers build virtually all power plants using much shorter planning horizons. The failure to address siting reform was, I believe, a major mistake. Independent power producers moved quickly to meet California's growing electricity demands, filing applications to build 14,000 megawatts of new generation beginning in 1997. Because of the failed State siting process, none of these power plants are operating yet. Montana did not make that same mistake. We revised our siting laws to exempt generation facilities. It is important to note that the supply shortage in California did not occur overnight. It developed over a 5-year period when electricity demand rose by 6,300 megawatts. Incredibly, over this same period, electric generating capacity in California actually declined. As I indicated earlier, California took a big gamble by forcing its utilities to buy all their power through a volatile spot market. It took an even bigger gamble by not ensuring that electricity supplies were adequate to meet the needs of consumers and businesses. It doesn't take a panel of economists to know that supply shortages and spot markets are not a good combination. They produce the sky-high prices that California and the West have been paying now for the past year. California has had price caps for the wholesale power sale since 1998. Last year, California experimented with four different price caps, starting with a hard cap of $750 per megawatt hour. This year, FERC changed tactics, approving price mitigation that reflects gas costs and other costs. That approach seems to be working, and FERC earlier this week expanded the scope of its price mitigation plan. Price caps exacerbated California's supply problems last year. Since the caps did not apply to the Western markets and State power producers often chose to sell electricity outside of California at prices higher than the hard cap, as a result, power exports from California rose 85 percent and California's electricity supply fell by 3,000 megawatts. By the end of the year, when the hard cap had been lowered to $250, the price cap was seriously exacerbating California's electricity supply problem, since prices in an uncapped market had risen to more than $400. Ultimately, California had to ask to lift the price caps on the grounds that it was causing serious supply problems. On December 8, 2000, the California ISO filed an emergency petition to waive the $250 hard cap, which FERC approved. At their request, FERC set a soft cap. Price caps last year did not control high prices. Each time prices were lowered, average monthly prices rose. The experience last year showed that price caps failed to control high prices and exacerbated supply problems. The lessons California apparently drew from the failure of price caps last year was to expand the scope of price caps to encompass the entire West, notwithstanding the opposition expressed by eight of the 11 governors in the region, and I repeat that. Eight of the 11 governors in the region opposed price caps. The main cause of the California electricity crisis is a supply and transmission shortage. It is each State's responsibility, not the Federal Government, each State's responsibility to license power plants and to get us moving. It has been clear for a long time that California's siting process is broken. Although it has made cosmetic changes, the State has shied away from making meaningful reforms to the siting process. The secondary cause of high prices is the disastrous regulatory rules imposed on the electricity market by the State. Unfortunately, the State has simply refused to act in a timely and effective manner. The California electricity crisis, in large part, is a result of inaction over a crucial 9-month period after the price spikes and supply shortages began in May 2000. This inaction forfeited the last chance to prevent a crisis. State rules barred California utilities from recovering wholesale power costs from retail rates, forcing utilities to buy power at 30 cents per kilowatt and resell it for 3 cents. It was those rules imposed by the State of California that destroyed the financial health of the utilities and drove Pacific Gas and Electric into bankruptcy. If the State had allowed cost recovery, the utility's credit would not have been destroyed. PG&E would not have gone bankrupt, and the State would not be spending its surplus buying electricity and bailing out the very utilities whose credit is destroyed. The bankruptcy of PG&E could have been avoided if the State had allowed cost recovery. Perhaps the most serious mistake made by the State was forcing the California utilities to rely entirely on the volatile spot markets for all of their power, even after wholesale prices had risen tenfold. If the governor had allowed the utilities to enter into bilateral contracts last year, electricity prices would be a fraction of what they are now. The State only recognized the need for bilateral contracts after the financial health of utilities were destroyed and the State assumed the burden of buying power for Californians. Once the State was paying the bills, it realized reliance on volatile spot markets was foolish and began to enter the bilateral contracts. Ironically, the contract prices California has announced, and much of this remains secret, indicated that they agreed to pay up to three times higher than what Duke Energy offered them last year. The State's indecision on raising retail rates was another major mistake, one that led to higher rate increases than were necessary. Last fall, the utilities requested a modest rate increase. The State refused to consider this proposal, which directly led to the PG&E bankruptcy. In the end, the State ended up approving a much larger rate increase than was necessary if it had acted in a timely and effective manner. We governors have a lot of power. It is called executive power, and I truly believe that could have been used in this case. Nine months after the beginning of this crisis, Governor Davis began to take action. In February, he announced an emergency plan to build 5,000 megawatts of new generation by July 1. According to recent reports, only 1,300 megawatts of plants that were under construction before his announcement will be available on that date. Governor Davis announced a conservation plan to lower demand by 3,000 megawatts. I understand that plan also is falling short and may produce less than 1,000 megawatts in demand savings, which is a good savings, but nowhere near what the demand was. The governor's plan to restore the financial health of Southern California Edison appears to be languishing in the State legislature, and I am glad the State is taking this action, but regret they only acted in response to a crisis, instead of trying to prevent one. Threats by the governor and others to seize power plants and impose punitive taxes, which we did not do in Montana ultimately, will discourage what is needed most, investment in new generation. California has seen at least two power plants on hold now because of uncertainty about regulatory stability in California. As Senator Thompson said and one other power company said, ``I have more confidence in regulatory stability in Brazil than I do in California.'' If the governor takes a rash step, investment in new generation in California will come to a complete halt. The State will find itself in the business of generating and transmitting electricity on a permanent basis. The State will continue to spend billions of dollars on electricity instead of on schools. The power plants and transmission infrastructure will slowly degrade. And California's neighbors, Montana included, will find that they must continue to supply the power that California needs, since California refuses to provide it for itself. The time has come to quit shifting the blame, quit shifting it to the Federal Government. We as governors have, as I said before, tremendous power to take advantage of our own destiny. FERC has taken strong actions to mitigate high prices in California. The time has come for the State to buckle down and do its job, ensure adequate electricity supplies for California consumers and businesses. So please, I am asking you, do not put caps on the utilities of the Western States like Montana. It will be the same as inflicting foot-and-mouth disease on our agriculture industry. It will discourage construction of generators, it will discourage transmission, and it will surely discourage people from conserving, and it does not encourage us anymore. I liked what Senator Carper said, that we are like the quarterback on a team and that you are maybe the athletic directors, but I tell you what. If the athletic director doesn't work right, the team is out of business, and I really see if you put price caps on us right now, if Governor Davis wants that for California, then I would advise him to do that for California. He has the power to. But do not inflict it by FERC on the rest of the States because it will kill us. Thank you. Chairman Lieberman. Thanks, governor. I have the feeling this morning that we are down on the field now. [Laughter.] Ms. Martz. That is right. Chairman Lieberman. We are no longer athletic directors. Governor Hoeven, thank you for being here. I look forward to your testimony. TESTIMONY OF HON. JOHN HOEVEN,\1\ GOVERNOR, STATE OF NORTH DAKOTA Mr. Hoeven. Chairman Lieberman, thank you for the opportunity to testify. I must say that I admire the diligence of both you as Chairman and the Ranking Member, Senator Thompson, for conducting these hearings and sitting throughout. I appreciate it very much. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Hoeven appears in the Appendix on page 825. --------------------------------------------------------------------------- I have to say this. I do not know if I should, or not, but Senator Thompson, I really did enjoy your movies. Chairman Thompson. I knew I would find somebody. Chairman Lieberman. Do not let this go to your head. [Laughter.] Mr. Hoeven. My comments today, and I will be brief, which I am sure you will be pleased to hear, my comments today will focus on the President's leadership in setting the right direction for energy policy. His plan calls for a market-based approach that will stimulate supply, promote conservation, and enable North Dakota and other States to meet this country's energy needs. North Dakota exports 75 percent of the electricity generated in our State. We are encouraging the construction of new and efficient generation and the development of environmentally friendly renewable energy. We have also developed one of only two coal gassification plants in the world, converting coal into natural gas, and as you know, there is a tremendous need for natural gas right now, which will be a big benefit to California as they continue to site new power plants that utilize natural gas. This diverse and growing energy portfolio will serve North Dakota's needs for a long time in the future while allowing the excess energy to be exported and help serve other parts of the country, like California. We are also one of the low-cost energy producing States in the Nation, using clean coal technology, natural gas, and hydro, a fact that we are very proud of. We have worked hard to ensure that we have enough electricity to meet the demands of our consumers and businesses, and our citizens recognize that you cannot maintain economic growth if you lack the electricity infrastructure needed to encourage economic development and continued growth. We also see energy generation as an important job creator for our State's economy, while helping to meet a national need. In order to assure economic growth, our State has a partnership called Vision 21, investing $10 million with any company that undertake feasibility studies for new clean coal technology generation plants. This program will seek to access the clean coal program in the President's energy policy, if it is authorized by Congress, creating a Federal, State, private sector partnership for new energy generation. For America to move forward and ensure our energy independence, our Federal Government must utilize market-based policies that will encourage new and efficient infrastructure. We must stimulate private investment in new generation and transmission in order to develop a vibrant, regional wholesale market. To do this, I believe the Federal Government has two roles. One is leadership, and the other is to provide market and regulatory certainty. President Bush and Vice President Cheney have shown our Nation the leadership necessary to ensure our future energy independence. President Bush has developed a long-term national energy policy while also directing his administration to take steps that can help address short-term problems like that of the California energy crisis. The President's initiatives to help solve the California energy crisis include: Two days after taking office, the Bush Administration extended emergency orders giving the State time to enact legislation authorizing it to buy power on behalf of Californians. A month after taking office, the President issued an executive order directing Federal agencies to expedite permits needed to increase electricity supply in California. In order to reduce demand, the President issued an executive order directing Federal facilities in California to maximize conservation this summer. And at the governor's request, Secretary Abraham asked FERC to extend a waiver for qualifying facilities from PURPA fuel requirements, a request that FERC granted. Finally, 4 months after taking office, the administration took the first steps towards removing a transmission constraint, the Path 15, that has caused repeated blackouts. For a long-term energy independence, the President developed and released the administration's National Energy Policy. Not all of the recommendations are popular, but they all should be considered as part of a comprehensive national energy policy. America cannot depend on other countries to meet our energy needs. In order for new investment to begin in some parts of the country and continue in others, we must ensure that there is regulatory certainty at both the State and the Federal level. State legislative and executive agencies must show they can assure the investment community that rules will be set and followed in an expeditious manner. We must ensure that agencies will make tough decisions, however unpopular, that benefit the good of the entire State and the region. The Federal Government, both Congress and the Executive Branch, must move expeditiously to change the laws and promulgate the rules necessary to move our energy and electric industries forward. The Congress must quickly decide what laws need to be repealed and modified to ensure a vibrant and efficient market. The FERC, EPA, Interior, and other agencies must implement sound, market-based rules and enforce them to ensure that market participants are playing fair while not gaming the system. The FERC took a step in that direction on Monday. It remains to be seen if that order will work as designed, but we do know that all of their orders and rules must encourage new investment in electricity generation and transmission. Development of new transmission will require a reasonable return on investment and reasonable access to the infrastructure. In closing, given the right type of Federal and State regulatory environment, private industry will make the large investments and long-term commitments necessary to build our energy generation and transmission infrastructure. President Bush has provided a road map for the Federal Government's role, a market-based approach that will help States provide industry with the regulatory certainty needed to move forward. Though there will continue to be bumps in the road, we are making progress. The challenges are great, but by working together, I am confident we can develop dependable, affordable, and environmentally sound energy for our future. Thank you, Mr. Chairman. Chairman Lieberman. Thank you, governor. Governor Martz, in your statement, you put a lot of the blame for the crisis on inaction or mistakes by the State of California, by the Government of California, but let me ask you this. I do think that Governor Gray Davis was asked most of the questions that you asked, so I think he has given his answers for the record. Part of his response, apart from his response to the specifics, was that the State of California, the people are doing what they can now, as much as they can do now, but because they are so adversely affected by the price they are being charged by the producers outside the State who are wholesaling electricity into the State, that they need help from FERC because only FERC can do anything to mitigate those prices. It is probably hard to imagine. We were joking before about what if this had been Montana that had been affected by this crisis. But if it had been and you felt you were at a point, leaving aside what the causes were, at a point where you had done everything you could, wouldn't you also be appealing to us for the Federal Energy Regulatory Commission to help protect you from being unfairly treated by out-of-State wholesalers? I am coming to your point that governors have great power. That is absolutely right. But they don't have the power, in this case, to regulate or at all affect, really, certainly the price charged by out-of-State producers of power. Ms. Martz. That is a very fair question, Senator, and I don't believe I would be coming to the Federal Government for help. I really believe that I would, if I had the emergency powers that Governor Gray Davis does, I would be ordering facilities being built so that we could start to speak to our own energy needs. You talk about them having to pay high prices. Because they are buying our markets, they are causing us to have to pay those high prices. They are not doing anything that we are not having to do because of them. So I don't believe I would. You don't know until you are in those shoes, but I really believe this is something States should solve on their own and I really do think that he has some powers that he hasn't used yet. Chairman Lieberman. I know you criticized the State and the governor for not building enough power plants. I am sure you know that he was elected in 1998 and took office in 1999. It was pretty hard, I think, but let me ask you to respond, to have built enough power plants to have been on-line in that short of a time to deal with the price spikes that began to occur about a year ago. Ms. Martz. Well, I think he could be having power plants on-line right now. He has got 6,300, I think, ordered. He has got 1,300 coming up, and they are not there yet. Each of us in our own States has to do what we have to do. We are looking at wind, we are looking at solar, we are looking at biodiversity, we are looking at coalbed methane, we are looking at coal, and we are going to be building as quickly as we can, also. We have enough power in our own State--people say, well, you haven't built in your State, either. We haven't because we never needed to. We export almost as much as we use in our own State out of State. So we didn't need to build until California's crisis came upon us. Chairman Lieberman. Let me ask you this. I have a copy of a letter dated April 6 of this year that a number of governors in the West, I believe all Republicans, sent to the Chair of the Federal Energy Regulatory Commission, and the two of you signed it. In it, it says, ``Your resistance''--this is to Mr. Hebert--``your resistance to the considerable pressure to impose `penny wise and pound foolish rate controls' has served a long-term interest of our region.'' I wonder, now that FERC, most recently, 2 days ago, has acted to impose what some call price mitigation, some call price relief, some call price control, some call soft price caps, how you feel about FERC's action in light of your earlier request to the Chairman that they not impose, as I read it, any form of price controls. Ms. Martz. In our State, already, meetings with the utility companies, we have a transition advisory committee working on these energy issues. Already, some of the utilities have concern over that. So we are going to have to see how that plays out. We did not have the full document. We had the press release from FERC that tells basically what that does, but we don't have the full document to be able to read that yet, so we will have to see how that plays out in our State. It may not be a healthy thing for us. We do not want price caps. We want the market to play itself out. Chairman Lieberman. Your 5 minutes is up, but I do want to give you a chance, Governor Hoeven, to give me your reaction to what FERC did on Monday. Mr. Hoeven. On the ruling? Well, I view it as price mitigation, designed to make sure there is no price gouging or overcharging. If it works that way and still allows the market to operate so that, again, we stimulate the increase in supply that we need, particularly in the Western area power pool, and at the same time encourage conservation, then it may work, and I think that is what remains to be seen. And I think that is the point that I am trying to make. FERC has to set rules of the game that are certain so that industry can come in and make long-term commitments and make investments and know that not only are they going to be able to recoup that investment, but they are also going to have access to transmission lines they build and so forth so that they can do business and truly solve this problem for the consumers of California and other States. Chairman Lieberman. Governor Hoeven, am I right, North Dakota is not on the Western grid, is that correct? Mr. Hoeven. Right. We are in the mid-America power pool. Now, we are members of the Western Governors' Association and we sell power, of course, to a variety of other States. Chairman Lieberman. Right. So it is both as a seller of power, but also generally interested in electricity and energy issues, that you are here today. Mr. Hoeven. Ironically, this is an incredible opportunity for our State. We need development in rural North Dakota, in Western North Dakota. We have oil, we have gas, we have hydro, we have clean coal technology, we are converting coal to natural gas, we have bio-diesel, we have ethanol. We are busting at the seams trying to export energy to the markets that need it, but we need help from the Federal Government in terms of the rules of the game so that our companies can invest in transmission and get that power to market, not only in terms of recouping their investment, but also in terms of access to the line they have built. They might build a transmission line and not even know what access their company is going to have on that line under the rules that FERC has because it is so much in transition and there is so much uncertainty. Chairman Lieberman. Thanks. Senator Thompson. Chairman Thompson. Thank you, Mr. Chairman. Governor Hoeven, I think you have hit right directly upon the nature of the problem when we try to look at FERC's actions, and I think you have the right solution, and that is certainty. I mean, that is what we look for across the board in our country. It is called the rule of law. You may have good laws, bad laws, indifferent laws, some kind of good, some kind of bad, but the main thing for business and for individuals is to know what the deal is, know the game that you are playing. So now we are launching off under this great pressure. We are launching off into something that has something to do with the business' costs, figuring out all these suppliers, utilities, I suppose, what their real costs are and what is just. And we put FERC in the position of deciding, somebody withholds power and they say, well, we need repairs and what not. Well, what is really on your mind? Why are you really doing this? We put them in a position of deciding what is just. So if I were thinking about building new power sources, I would have to wonder how certain is this. I mean, is somebody going to wake up some day and look at this thing totally differently? I think that is the problem. It is not that we can sit here and say that it is a good idea or a bad idea. I think hard caps are obviously a bad idea, but that is the problem. Carrying it further, part of the problem with hard caps is that it is, as I said, a Goldilocks formulation, not too hot, not too cold, just right, and if we do this and if we do that and that works out, and we lift the caps when we say we are going to. What supplier believes government when they tell them that? There is no reason for them to believe. So it is uncertainty, again, and that is why you are seeing, I think, a lot of the comments you are seeing from potential suppliers in California. I think, also, you are right when you say the prices are high, therefore, what are we going to do? We have got to look at that, and that is what we are looking at, but we also have to look at the front end. Why did prices get so high? How did it come about that we developed this supply problem? Governor Martz, how is Montana affected by being a part of the Western grid when California is in the shape that it is in and urging the things that it is urging? All the talk is about California, as I am sure you know. All the concentration is about California. The lead-off witness, in effect, was the Governor of California. We spent all morning, just about, with the Governor of California. You other States are out there, too. And I might point out, as you said, eight of the 11 governors are Republicans and the three who are for price caps are Democrats. All three of those States will be represented here today, by the way, but eight of the 11 governors oppose price caps. Why is that and how is your State as a part of the grid affected by all the attention and the pressure that is being brought to bear on behalf of California? Ms. Martz. Well, thank you, Senator, for the question. In the morning, when California wakes up, say if they are down 3,000 megawatts in the morning and they have to go out on the spot market and buy, we can't even buy power in Montana. Right now, we have tried--we are a regulated market until 2002 for our homeowners. Twelve major companies went off of that regulated market when we deregulated, had the opportunity to go off of the market. They are having a terrible struggle now buying power, even finding power to fill their need because most of the power is bought up at a higher price. We can't buy power. It is contracted out. We are looking at power, when the 2002 market comes up, we can't even satisfy the full load that we need for our homeowners because of what is happening in California. They are paying such high prices for it, so it is driving our prices up. Chairman Thompson. And, of course, we only know part of the story. I can't figure out yet what has been released and what has not been released because the State of California has resisted, and relented, I think, partially now on releasing to the taxpayers of California and the ratepayers of California how much they are actually paying. And I think they still haven't released what the municipals are paying. And you have suppliers out here who don't want to reveal the high prices they are charging. You have purchasers in California who don't want to reveal the fact that they are paying several times more than they would have paid last year if they had done what everybody was urging them to do. So we know they are paying higher prices. We don't know how much because of that. I have a note here that you need to leave right away, and I think that is probably--well, my time is up. How convenient. [Laughter.] Chairman Lieberman. Thanks. I am going to let you go, but I cannot help but say you taught us something. You created part of a record here that we haven't had before, which is obviously that anybody on the grid is affected by what is happening in California, so that if the price goes up there, it makes it harder to purchase in Montana. But it also brings me back to the fact that, though I know you are opposed to any form of price mitigation or relief control, that if FERC imposed some sort of order here and lowered the price of electricity in California, wouldn't that help the folks in Montana? Ms. Martz. No, because we then cannot even build more generation to keep in the State at all. Chairman Lieberman. Oh, well that is the tipping point. Ms. Martz. See, what FERC did, it is important to remember, the only thing that they did, the only thing you can do to prevent blackouts is increase supply and reduce demand. Those two things, you can do. Yesterday's ruling doesn't address either of those. Price caps won't address getting more power. Chairman Lieberman. That is correct. Of course, these are only--I am going to let you go, but these are only temporary. I mean, there is no question that, conceptually, you could certainly reach a point where price caps were so severe that you would discourage supply. Nobody wants to get there. But what I am suggesting as I hear you is that some temporary price relief until supply can overcome demand in California actually would help folks in Montana, too, because once the price is lowered there, you are not going to have to pay so much more to buy it off the grid. Ms. Martz. But Senator, FERC admits this themselves. Anytime they have ever put a price cap, it has never been removed. So we are not looking at consistency for the producers at all, and, boy, if I owned it and I am a small business person, I would not invest. That is all I can say. And maybe some people can wait a year. Montana can't. We cannot lose any more jobs. Chairman Lieberman. I look forward to that oversight hearing, hopefully, in the not-too-distance future, when we press FERC as to why it has not removed the price cap. Ms. Martz. Thank you. Chairman Lieberman. Because supply has---- Chairman Thompson. I thought you already guaranteed it would be temporary. Chairman Lieberman. Just listening to the governor, I said, if they do not remove a price cap, we will be back here when supply exceeds demand to ask that they do that. Thanks so much for making the effort and taking the time to come out here and I wish you both well. Ms. Martz. Thank you very much. Mr. Hoeven. Thank you very much. Chairman Lieberman. The next panel is the Hon. Attorney General of the State of Washington, Christine Gregoire, and Roy Hemmingway, Chairman of the Oregon Public Utilities Commission. I thank you both for your patience. I thank you for coming out. I was honored to become Chairman of this Committee recently and I said I was feeling like I was Attorney General again, which was definitely six great years of my public service career. Of course, one thing I missed when I came here was that nobody called me ``General'' anymore. Anyway, General, it is nice to have you here. We welcome your testimony. TESTIMONY OF HON. CHRISTINE O. GREGOIRE,\1\ ATTORNEY GENERAL, STATE OF WASHINGTON Ms. Gregoire. Thank you, Mr. Chair, Senator Lieberman, Senator Thompson. Thank you for the opportunity to come before you today and testify. --------------------------------------------------------------------------- \1\ The prepared statement of Ms. Gregoire appears in the Appendix on page 415. --------------------------------------------------------------------------- Let me also publicly thank both of our Senators from the State of Washington, who came before you this morning, for their support and their hard work with regard to the energy crisis facing the State of Washington. I am here this afternoon primarily in my role as chief enforcer of the State and Federal antitrust and unfair business practice laws for the State of Washington. But I also come to speak on behalf of my colleagues from the State of Oregon and California regarding the multi-State law enforcement investigation that we began recently. First, let me say that I am pleased that FERC recognized that this is a West-wide crisis involving all 11 Western States. Consumers in my State have been paying extraordinarily high prices for the last year. These issues are not just about legalities and economic theory, but about, fundamentally, the day-to-day lives of people, our businesses, our schools, and our environment. Let me share some of the impact this crisis has had on the people of the State of Washington. Our utilities, especially our publicly-owned utilities, have paid hundreds of millions of dollars for power over the last year. For example, Seattle City Light paid $312 million to buy power on the open market this past year compared to a normal year in which it spends about $50 million. Seattle consumers' rates were raised 42 percent since January of this year, and there is another expected rate increase of 22 percent in October. These increased costs reverberate throughout our economy and our society. Our schools have diverted funds from needed educational programs to purchase power, and we have idled or shut down major industries. Georgia Pacific shut down its Bellingham plant and idled 420 workers, citing power costs as the reason. Let me turn now into the multi-State investigation into unlawful business practices. The multi-State investigation launched by the attorneys general of Washington, Oregon, and California focuses on the causes of the exorbitant prices charged to utilities serving the West Coast consumers. We are concerned that the energy prices and supply in the past year do not appear to be the result of natural market forces. In the past year, let me tell you what we have observed that has led us to this investigation. First, the wholesale market rates for a megawatt hour of electricity skyrocketed from about $30 to $300, sometimes even as much as $3,000. Were these massive price hikes caused by some form of unfair business practice or collusive activity among the generators and the marketers? Second, sudden, unplanned maintenance outages at generating plants in California, to the point where 40 percent or more of the generation capacity has been consistently off-line, compared to historical averages of about 10 percent. What caused so many competing generating plants to suddenly go off- line at the exact same time? Third, prices remaining high 24 hours a day, even though power is being purchased for off-peak hours. Why can prices stay so high when demand has been reduced? Fourth, transmission capacity restraints during crucial times, further exacerbating the high prices and the availability of power. Were the companies exchanging confidential data in a joint effort to create transmission problems? And fifth, suspicious activity in the California natural gas market, including claims that companies may have collusively agreed to suppress competition or otherwise engage in illegal activity. If we ultimately find evidence to support a violation of Federal or State antitrust or unfair business practice laws, we will seek restitution, injunctive relief, civil penalties, and our costs for investigating the matter. In California, a criminal grand jury is being convened in early July to determine if criminal activity has taken place. That grand jury will be exploring State, RICO, or other criminal violations, including false claims under California law. Let me note something else about our investigation. We are having difficulty getting access to power generators' records. California issued civil investigative demands on these generators in February. It is now June and these three States still do not have the documents that we requested. Some of the power generators are simply not cooperating, and this has delayed our antitrust investigation. They do this despite their public claims of full cooperation. Where is the cooperation with the chief law enforcement officers of these States? My question for the companies is, what do they have to hide? If you have not done anything wrong, let us see. Let us see the records on an unconditional basis in a way that is timely and responsive to our questions. Let the truth be the judge. Now let me return to my role as public counsel for the ratepayers of the State of Washington. I understand how very complex this issue is both for FERC and for Congress. However, among all the complexities is a very simple, straightforward principle. FERC has a statutory duty to ensure that rates in the wholesale market are ``just and reasonable.'' Though I am very disappointed that FERC did not act earlier to address the problem on a West-wide basis, I am pleased that it has now expanded its most recent order to provide relief West-wide. It is a step in the right direction. I remain concerned that the order does not provide remedies for all of the harm that has been suffered by Washington State citizens, and I want to see if, in fact, at the end of the day, it does address the problems prospectively. For those reasons, I would like to encourage this Committee in its oversight role to do the following. First, monitor carefully the implementation of FERC's order. Judge its effectiveness by FERC's statutory duty to ensure just and reasonable rates. Second, ensure FERC has the resources and the guidance to continually monitor the market and investigate rates that may be unreasonable, to enforce its order and any subsequent orders designed to make the markets work, and to provide appropriate refunds to all consumers, including those in California. Third, if this order does not appear to be working, FERC must take immediate, decisive, corrective steps to ensure that the rates are just and reasonable. In addition to protecting ratepayers, FERC must be vigilant to make sure that energy efficiency and protection of the environment is an essential part of any solution, both short- and long-term. Again, these competition and FERC issues, are not just about legalities. They are not just about money. They implicate the day-to-day lives of our citizens, our businesses, our schools, and our environment. As we move forward, we must keep these interests, truly the public interests, in the broadest sense, in mind. In conclusion, this energy crisis has had a tremendous impact on my State's citizens, its business, its economy, and its environment. It is a West-wide problem and has been going on now for a year. Although we will continue with our law enforcement investigation, FERC really is uniquely situated to monitor this energy market and to provide the appropriate remedies to all who have been harmed by unjust and unreasonable rates. We ask this Committee to make sure that, in the end, FERC fulfills its mandate that energy rates be just and reasonable at all times for consumers. Thank you again for allowing me to testify. Chairman Lieberman. Thank you, General, for that testimony. Mr. Hemmingway, welcome. TESTIMONY OF ROY HEMMINGWAY,\1\ CHAIRMAN, OREGON PUBLIC UTILITIES COMMISSION Mr. Hemmingway. Thank you, Mr. Chairman and Senator Thompson. I am speaking today as the Chairman of the Oregon Public Utility Commission. At the beginning, I want to make three points clear about Oregon's position. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Hemmingway appears in the Appendix on page 423. --------------------------------------------------------------------------- First, Oregon believes in competition in markets. We have begun a gradual and flexible opening of our retail electricity markets to larger customers, but due to the Western power crisis, even this go-slow approach is in political trouble and I cannot predict its future in the Oregon Legislature at this time. Second, Oregon believes in sending appropriate price signals to retail consumers. We have passed on prices to consumers, as have some publicly-owned utilities in Oregon, and this crisis has not been brought about by the failure to pass on higher prices. Passing on to consumers unjust and unreasonable prices at 1,000 percent above cost will not alleviate this crisis. Third, Oregon does believe that there is a shortage of electricity in the West. Some of this, a good deal of it, is caused by the fact that we have had a drought year in the Pacific Northwest. If we had had the rainfall we had in 1998 and 1999, we would not be here today. There would be plenty of electricity and our plans to build new generation would come on-line just in time. I say all this to emphasize that we who advocate serious Federal intervention in the Western power markets have been doing our part to augment supplies. We are not against market competition in the electricity business. We are not advocating repeal of the laws of supply and demand. We are simply asking that the Federal Government undertake its historical role in regulating electricity marketplaces when they are characterized by high prices and inadequate numbers of competitive suppliers. The principal argument that FERC has given for not imposing serious wholesale price controls is that they will work against bringing increased supply to the market. FERC seems to confuse here long-term supply issues with the immediate need in the Western market for power supply. There is no way, as I think other witnesses have indicated, that the amount of supply that would create a truly competitive market that could be built in time to significantly temper the prices that utilities have been paying in the wholesale market in the last year. The lead time is simply too long. Oregon, for instance, has under construction 1,500 megawatts of new generation, and we have in a plant in the permitting stage 3,000 megawatts of new generation, and in the planning stage even more. This is in a State with 5,500 average megawatts of consumption, 10,000 megawatts of peak, so this is an extraordinary amount of generation that is under construction. But only one of these plants of about 400 megawatts will be on-line by July to meet the summer problem. Not enough generation is likely to be able to be brought on- line this summer to alleviate the real and contrived shortages in the Western market. In summary, the high prices supported by FERC are simply not needed to stimulate investment in long-term generation because--long-term investment in generation, because that is occurring, and they cannot magically bring in new supplies in time to deal with the crisis this year. Theoretically, high wholesale prices should stimulate suppliers to bring on generation in the short term that would otherwise not come to market. But in truth, the unfettered wholesale market favored by FERC has done little to increase supply. Over the last year, the California market, in particular, has been characterized by record levels of plant outages, despite these stratospheric prices. The high prices have had a perverse effect. Owners of generation do not need to bring new supplies to the market in order to make record profits, which almost all the energy suppliers in California have done, if you look at their balance sheets. Without colluding, energy suppliers can figure out that not bringing every kilowatt to the market will boost prices and create profits. Only as power prices have declined in recent months have we actually seen lower plant outage rates. The shortage has given incentive to suppliers not to bring all their supplies ready to the market because it has meant that they get higher prices. I would like to turn now to the June 18 order that FERC issued this week. I believe this order is a step in the right direction, but I want to make clear that it is a small step and it will not end the worst abuses that have characterized the Western power market this year. The order remains flawed in fundamental ways. It allows all sellers, no matter what the cost of their generation, to get the price of the highest cost resources operating at the time. While marginal cost pricing of this kind is appropriate for commodities in a competitive market--I think any economist will tell you that--in a market where consumers have choices, electricity in the Western power market has not yet reached that point. Electricity is a commodity for which there are no immediate substitutes and there are no technically feasible ways yet to send immediate retail price signals when wholesale prices are high. High wholesale prices on a hot July day do not mean that consumers will get that signal at the right time to reduce consumption and reduce the costs to the utility system. Worst of all, the new FERC order still provides incentive for gaming of the system by suppliers. All power sold in the market gets priced, as I said, at the cost of the highest and most expensive resource running at the time. As a result, there is still incentive for suppliers to ensure that there are not enough efficient resources running and that the inefficient price-setting resource does operate. With supplies tight in a small number of suppliers, a non- competitive market results where individual suppliers can anticipate the actions of others. FERC has not yet shown that high wholesale prices in a non-competitive market will deliver equal or more short-term supply than in a fully-regulated market. In fact, recent history suggests the opposite. FERC is still acting as if electricity in the West were like wheat or pork bellies, where buyers can find substitutes and respond to high prices and no one supplier can affect the market or anticipate how other sellers into the market will respond. None of these conditions is true. In the current Western power market, we do not have a competitive market. For over 60 years, FERC and its predecessor, the Federal Power Commission, oversaw conditions that created a stable power market that brought electricity to utilities and consumers at affordable prices and rewarded investors with reasonable rates of return. FERC's recent ideological devotion to free-market principles in a market that is anything but free and competitive has shattered the public's faith in the Federal Government's willingness and ability to ensure an adequate and affordable supply of power. FERC's actions threaten to bring a political end to appropriate deregulation initiatives around the country, such as Oregon. This is a sad legacy, indeed, which I hope will be remedied as swiftly as possible by the Congress. Thank you. Chairman Lieberman. Thanks, Mr. Hemmingway. You touched on something fundamental to the FERC order that I want to ask the commissioners this afternoon, because although it is a step forward, there remains the question from our perspective, how much of a step forward? And it does seem to me, as you said, and I appreciate it, because you are a regulator, a utility regulator, that they have created a system here, the so-called proxy pricing, which stated in complete layman's terms does peg the price to the highest price obtained in a given period on the market and it allows everybody to come up to that price. As I understood it, in the off-peak hours, they can charge up to 85 percent of that high price. So it is a ceiling, and I suppose it will, therefore, protect consumers from the most extreme price hikes, but it is a pretty tall ceiling. What would you have done if you were a one-man FERC in this case? Mr. Hemmingway. Mr. Chairman, I would have looked for the possibility of reimposing cost-plus price controls. You can provide plenty of incentive and reward for investment with a cost-plus arrangement without allowing a supplier to get 1,000 percent greater than its costs when selling into the market. Chairman Lieberman. And that is what we traditionally have thought of as utility regulation. Again, we are all for--not all, but I am certainly for deregulation with competition. It does strike me that the cost-plus system--the idea that you get your money back that you spent plus some reasonable profit--is also easier to apply than this system. It is certainly easier to understand, for me, than this system that FERC has adopted. Am I right from a regulator's perspective or not? Mr. Hemmingway. Well, there is the problem that there are hundreds of transactions that are going on and these have to be tracked. Chairman Lieberman. Right. Mr. Hemmingway. But FERC is experienced at this. After all, it did it for over 60 years, so I think they could go back to that. And I am for competitive markets and believe it is a better way to price a product than is regulation, but you need to have a fully competitive market with multiple suppliers in it in order to get to that point where you can say that that kind of pricing is appropriate and I do not think we have that in the Western power market today. Chairman Lieberman. Right. General Gregoire, obviously, the FERC order is good news for Washington State and the rest of the West in that it both extends the previous FERC order to 24 hours a day, 7 days a week, but more importantly for you, it extends the order throughout the Western grid, including your State. The bad news for your State, obviously, is that there is nothing said regarding refunds that you think you are entitled to. So let me ask you, what, if anything, the State can do to right that wrong, and if you have any counsel for this Committee or for FERC, I suppose, as to how to deal with the question of refunds that electricity customers in Washington State may be entitled to. Ms. Gregoire. Well, thank you, Mr. Chair. I am one who believes that there have been unjust and unreasonable rates beginning about June 2000 and that needs to be corrected and refunds are in order, and you heard from both of my Senators this morning speaking to that issue, as well. FERC has suggested that it does not think it has the legal authority in that the Federal Power Act would call for it to be able to give refunds only 60 days after it had opened its investigation, and that would, for purposes of this particular instance, for the West-wide investigation, didn't occur until April 26. The problem with respect to that is we have been asking for a West-wide investigation for some time. California utilities first approached to FERC in August. It was joined by Washington in October. FERC declined to do a West-wide investigation in December. A motion for rehearing was brought in January, supported by Washington. We went to the D.C. Circuit to ask the D.C. Circuit to order FERC to open up a West-wide investigation, and that was declined. At the end of the day, our consumers may be with no redress if they have to turn to FERC. I think that is fundamentally wrong. At the end of the day, our antitrust investigation may provide a remedy, but I am not optimistic that will be done soon given the lack of cooperation with the generators. Sometimes that takes years to accomplish. So if, in fact, FERC says it has no jurisdiction and we are unable in reconsideration to convince them otherwise, I would ask this Committee to take that issue up so that we do not find this situation occurs again in the future. Chairman Lieberman. So the current procedure is that you are not entitled to refunds until the period covered 60 days after an investigation---- Ms. Gregoire. Is opened. Correct. Chairman Lieberman. I know this should be clear to me, but it is not. Has FERC reached a conclusion for parts of the Western grid outside of California that the rates charged are now unjust and unreasonable? Ms. Gregoire. Correct. They did in their order on Monday. Chairman Lieberman. On Monday. Ms. Gregoire. So it only goes back the 60 days from the time they opened that investigation, which would put refunds due to the rest of the West to begin in July. Chairman Lieberman. Yes. Ms. Gregoire. That is fundamentally unfair, since our consumers have been harmed now for a year with unjust and unreasonable rates. Chairman Lieberman. Yes, I agree with you. It is very unfair. So you are suggesting that the Committee may want to look, assuming that you will do everything you can to try to obtain refunds through litigation and other means, appeals to FERC, that the law itself is flawed and we ought to, as one result of these oversight hearings, deal with how to correct that inequity so it doesn't happen again? Ms. Gregoire. We would ask you to do so, yes. Chairman Lieberman. My light is flashing. My time is up. Thank you. Senator Thompson. Chairman Thompson. Thank you, Mr. Chairman. Mr. Hemmingway, Governor Davis has been critical of the amounts charged by the Bonneville Power Administration, which, of course, is big in your State. Do you believe that Bonneville has engaged in price gouging? Mr. Hemmingway. Senator Thompson, no, I don't believe they have been. They have been selling into the ISO market and been a price taker in that market, and I think that they have been able to resolve their issues with Governor Davis on that. I mean, we can check with him. They have not been able to set the price of the power that they sell into that market. They merely take whatever the market clearing price is of that day. Chairman Thompson. So you would disagree with the governor with regard to that particular entity, anyway. Mr. Hemmingway. [Nodded head up and down.] Chairman Thompson. General Gregoire, with regard to your investigation, you were talking about the generators and, of course, you and I both know that saying, ``I am from the government and if you don't have anything to hide, turn over your records,'' is not the standard, of course, that we normally use in court or anywhere else. In fact, civil libertarians would have a hard time with that if it were anybody else except power generators. But having said that, you say you have issued subpoenas. How many generators have you subpoenaed? Ms. Gregoire. We have issued civil investigative demands, and what that provides for those companies, by the way, is absolute confidentiality, and to date, the companies that have not complied are Duke, Mirant, and Reliant. We have had cooperation, on the other hand, from AES and Dynergy. We have yet to issue with regard to a couple of the other companies and we are in the process of doing so now. Chairman Thompson. How many have you issued so far? Ms. Gregoire. Well, we have sent ones to Mirant, Reliant, Dynergy, Dynergy Inc., Dynergy Energy Services, Duke Energy Corp., Duke Energy Trading and Marketing, Duke Energy Power Services, and AES. Chairman Thompson. How many of them own generation facilities in Washington? Ms. Gregoire. None of them do. They sell into Washington State. Chairman Thompson. What percentage of the wholesale market do these generators supply to Washington? Ms. Gregoire. Well, let me give you an example. In Washington State, for example, the purchases last year to Washington companies by AES was $15 million, by Enron was over $1 billion, by Dynergy, $195 million, Mirant, $283 million, and Reliant, $224 million. Chairman Thompson. Generally, what percentage of the wholesale market would that be? Ms. Gregoire. I don't know that. Chairman Thompson. Well, it seems as if it would be a very small percentage of your overall wholesale market. Ms. Gregoire. We do not rely--most of our power comes from Bonneville. Chairman Thompson. Well, that was---- Ms. Gregoire. We cannot rely on these generators. Chairman Thompson. That was going to be my next question. What are the largest wholesale suppliers, electricity suppliers, in your State, Bonneville? Ms. Gregoire. Correct. Chairman Thompson. Who else? Powerey? Ms. Gregoire. We have some coal, we have some nuclear, and we have these generators, primarily. Chairman Thompson. What about BC Hydro or Powerey? Ms. Gregoire. We have some, yes. Chairman Thompson. That is electricity generation, of course. Bonneville is electricity. Ms. Gregoire. Right. Chairman Thompson. Have you issued subpoenas to them to investigate their role in this? Ms. Gregoire. We have had full cooperation by Bonneville. We have not yet issued anything to any of the generators in BC Hydro. Chairman Thompson. So I suppose if I was a generator out there, when you are talking about compliance, I would wonder why you would be issuing these subpoenas or requests, whatever you call them, for those companies that have very little--have no presence in your State, supply what seems to me to be a small percentage of the wholesale market, on the one hand, and you really haven't done the same thing with regard to those generators who supply a much larger percentage of your market. Ms. Gregoire. Well, Senator, it is a multi-State investigation involving all three States, and, of course, these generators are located in California and have not cooperated with California at all, as well. They have refused to provide documents to California and, in fact, have brought a protective order motion in court to ensure that whatever documents they get, they cannot be released to either Washington or Oregon. Chairman Thompson. Of course, that is normal when a governmental subpoenas documents that they are not put on the public record unless there are further legal proceedings. Whether or not a company is cooperating, of course, begs the question, whether they are properly exercising their legal rights that any company or any citizen has in this Nation. So the fact that they are or are not cooperating, of course, begs the question. You will have to resolve that, as to whether or not they are not cooperating for appropriate reasons. But again, if I were one of them, I would be wondering why you are going after all these out-of-State folks and not going after the ones that are supplying most of the power. I have nothing further. Chairman Lieberman. Thanks. Very brief factual questions. Earlier, one of the Senators from Washington State said that she thought that the increase in electricity costs in the State was a multiple of 11 times in the last year. Is that right? Ms. Gregoire. That is correct. Chairman Lieberman. And what would be a comparable figure for Oregon? Mr. Hemmingway. Mr. Chairman, it would be a comparable figure for companies that are buying in the wholesale market. We have a number of utilities which are largely publicly-owned utilities which have bought a percentage of their power at those prices and they have had to raise their retail rate as a result by 20 to 40 percent. Chairman Lieberman. Is it possible to state what percentage of that in each of your States, roughly speaking, is derivative from the problem in California and what percentage is more home grown, if you will? If you can answer that, fine. If you cannot, then we will let you think about it and submit a written answer. Mr. Hemmingway. Mr. Chairman, it is one grid, and so it is very difficult to separate out the problem as a result of the drought from the problem in California. Chairman Lieberman. That is what I was thinking. Mr. Hemmingway. As I said before, if we were not having a drought, even California would not be having a problem, in my opinion, because we export so much power from the Pacific Northwest in good water years to California that it--that is the reason, essentially, these problems started to creep up in the year 2000, was that the first year that we did not have, in a long time, really large exports to California. Chairman Lieberman. General, a final question. In light of your multi-State investigation, to the best of your knowledge, is the Antitrust Division of the Justice Department investigating this matter at all? Ms. Gregoire. No. To my understanding, the U.S. Department of Justice is not involved. We have asked them to join with us in the investigation and they have not joined us as yet. It is a three-State multi-State investigation. Chairman Lieberman. How about the Federal Trade Commission? Do you know of any---- Ms. Gregoire. No. Chairman Lieberman. No active investigation? I do not have any other questions. I thank you for coming out, for your patience. Your testimony was very helpful. I appreciate it very, very much and wish you a safe trip back home. Ms. Gregoire. Thank you. Chairman Lieberman. Senator Thompson, it is my inclination now to take a half-hour break to allow everyone who must be here to stretch their legs and get some lunch and we will be back at 2:15 with the five members of the Federal Energy Regulatory Commission. The Committee stands in recess. [Recess.] Chairman Lieberman. The hearing will come back to order. I thank the five members of the Federal Energy Regulatory Commission, at times in its history little known, I would say now probably at one of its highest points of visibility with all the attendant responsibilities thereto. I think you know that this Committee is an oversight committee. And the hearings we are conducting here are pursuant to that authority, to make a judgment as to how your commission has been responding to the general subject or matter of energy deregulation with particular regard, of course, to the electricity markets in the West, and most especially in California. We heard testimony last week from some leading economists. We heard testimony today--perhaps you followed it-- from Governor Davis, Governor Hoeven, Governor Martz, Attorney General Gregoire of Washington State, the Chairman of the PUC from Oregon, Mr. Hemmingway, and members of Congress. I know that you have some prepared testimony. Mr. Hebert, I want to start with you and we will give each of the members a chance after that. We have been running a 5-minute clock on the witnesses. Mr. Hebert, if you go a little longer, I do not think we will physically eject you from the room. And then Senator Thompson and I will proceed with some questioning. Thank you for your understanding about the time pressures today and keeping yourselves available. I appreciate it. It is important business and you are right at the heart of it, so we thank you for being here. Mr. Hebert, it is all yours. TESTIMONY OF HON. CURT L. HEBERT, JR.,\1\ CHAIRMAN, FEDERAL ENERGY REGULATORY COMMISSION (FERC) Mr. Hebert. Thank you, Chairman Lieberman. Thank you for the opportunity to appear here to discuss the Federal Energy Regulatory Commission's role in restructuring of the electricity markets. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Hebert appears in the Appendix on page 430. --------------------------------------------------------------------------- The Commission's experience in regulating electric and natural gas utilities and, indeed, the Nation's experience in pricing and allocating vital goods and services have taught us an important lesson. Consumers are better off if supply and pricing decisions are based on market mechanisms rather than bureaucratic fiat. Thus, the Commission is committed to helping move this country toward open, competitive energy markets. At the same time, we recognize we must ensure that broken and dysfunctional markets are fixed. This poses challenges, particularly in California and the West, where there is a substantial imbalance of supply and demand. In response to these challenges, the Commission has been working aggressively to reform market structures and to enhance consumer welfare in California and the West. The Commission has not lost sight of the point that the best way to lower wholesale electricity prices and to keep them low is to promote investment in badly-needed supply and delivery infrastructure and to encourage demand reduction. The Commission's task remains to balance these goals to ensure that short-term measures do not undermine long-term priorities. My written testimony, which I submitted Monday morning, describes the dozens of orders the Commission has issued in recent months addressing California and Western energy markets. The Commission has done everything that it can within its jurisdiction to extract every last drop of electricity out of existing resources and to free up additional megawatts from demand reduction initiatives. Moreover, the Commission has been no less active in its efforts to investigate and lower the price of natural gas in and bring additional pipeline capacity to Western markets. In my limited time this morning, I would like to focus on action undertaken by the Commission on Monday afternoon after the filing of my written testimony. By a unanimous 5-0 vote, the Commission expanded the scope of a market monitoring and price mitigation plan for California and the West. An earlier version of that plan went into effect on May 29 of this year. Since that date, as we all know, prices of electricity and natural gas in both spot and forwards markets have plunged dramatically. Energy prices in California and the rest of the West are lower than at any time in the past year and are coming close to prices in the rest of the country. Building on that success, the Commission voted unanimously to expand its price mitigation plan for California's spot market sales to all hours of the day. The Commission also extended the limitations on spot prices to all 11 States in the Western System Coordinating Council. The details of the Commission's plan are many. For this reason, I have submitted for the record the Commission's 60-page order which was issued yesterday afternoon and a 7-page press release on the order which was issued Monday afternoon. In a nutshell, the price mitigation ordered for the West and applicable during all hours is based on the market clearing price concept adopted in the Commission's April 26 order. The market clearing price is based on the bid of the highest cost, least-efficient unit in California that is called upon by the California ISO to serve load during any day in which available reserves dip below 7 percent. Sellers other than marketers have the opportunity to justify individual prices above the market clearing prices based on their costs. I am very proud of the Commission's approach toward reforming California and Western electricity markets. The Commission's mitigation plan manages what many said could not be accomplished, restraining prices while encouraging investment. The key is that price mitigation is based on market forces. The market clearing price is not a blunt, arbitrary figure that bears no resemblance to market conditions and is subject to political pressures and whims. That is what was tried in California just last summer, Mr. Chairman. The ISO lowered the price cap last summer from $750 per megawatt hour to $500 per megawatt hour and then $250 per megawatt hour. All this did was cause an increase in the average electricity price and a reduction in the ability of the ISO to procure emergency power. Indeed, last December, the ISO, the California ISO, begged the Commission to allow it to remove the cap, explaining that it was impairing the ISO's ability to meet demand and undermining the reliability of the electrical grid, what we knew all along. Also, the mitigation price is not based on the cost of individual generators. A return to traditional regulation would entail months and perhaps years of administrative and appellate litigation over cost structures and reasonable rates of return. This type of delay and uncertainty is simply unacceptable at this critical juncture. The other point that certainly needs to be made is that under that scenario, Mr. Chairman, the most inefficient units would be guaranteed profits probably at levels that they will not get under our plan. Even more disturbing, regulation based on cost would provide no incentive for the various suppliers to become efficient and to reduce their costs and thereby lower prices for consumers. The Commission's plan, on the other hand, provides every incentive for suppliers to reduce their costs and improve their efficiency. Nothing is now guaranteed. A generator or a marketer now makes money by increasing the efficiency of production. Its profit is determined by how much of a differential there is between its own cost of production and the cost of least-efficient, last-dispatch unit. A generator is now able to recover its fixed costs, but the extent of its capital recovery and the size of its profit is determined by the very efficiency of its operations, Mr. Chairman. In this manner, a generator will find it profitable to retire old, dirty, inefficient units and replace them with new, cleaner burning, more efficient units. I am very proud of the green initiatives of the Commission's plan. The best way to clean our air, as we all know, is to never pollute it in the first place. And finally, through enhanced monitoring and coordination of generator outages, along with additional tools to act against withholding and other forms of anti-competitive behavior, the Commission has removed any doubt in that we are committed to ferreting out and remedying any form of market manipulation and behavior no matter when it occurs, 24 hours a day, 7 days a week. As Monday's order makes clear, anti-competitive behavior simply will not be tolerated by this Commission. Indeed, in Monday's order, the Commission directed Duke Energy to make refunds for the period earlier this year when it charged California consumers approximately $3,800 per megawatt hour for electricity. In other orders this year, the Commission has directed the refund of over $130 million for past overcharges and manipulative behavior and has ordered an expedited hearing into allegations of affiliate market power abuses concerning the transportation of natural gas to the California border. Other investigations are underway, as well. There should be no doubt that this Commission is actively pursuing refunds and other appropriate remedies for past behavior. Frankly, I believe that the best way for California consumers to be made whole is, if possible, to have the parties themselves negotiate a fair and comprehensive settlement of all outstanding refund issues. The Commission is not ducking these issues. Rather, it is giving the parties, including the State of California, 3 weeks, which is not a lot of time, to do what is best for the people of California. I hope that all parties will come to the table. I hope that all parties themselves will spare consumers the pain and uncertainty of protracted litigation over past market behavior. If, however, these parties are unable to reach agreement, the Commission stand committed to act quickly and decisively to resolve these issues. As for the rest of the West, the Commission's refund authority presently extends from July 2 of this year, the earliest refund effective date allowed under the Federal Power Act. I understand the pleas for an earlier refund effective date, and this is a matter that the Commission is currently considering on rehearing of its December 15 order of last year. In that order, the Commission denied a complaint brought by Puget Sound Energy which sought an investigation into rates charged, not for the entire West, but rather one limited to the Pacific Northwest. I can state, however, that Western parties outside California are not shut out of the settlement discussions scheduled to commence next week, as of Monday. To the contrary, those discussions are open to all entities which are parties to the proceeding that was the subject of Monday's order. Those parties include Puget Sound Energy, the City of Seattle, various Pacific Northwest utilities and industrial companies, and the Bonneville Power Administration. In conclusion, the Commission has been doing a great deal of work to help ease the present energy problems in California and the West. The Commission's efforts have contributed to the recent decline in Western energy prices. Monday's order, issued by a unanimous Commission, improves upon a plan that is good for California, good for the Pacific Northwest, and good for the entire West. It is a plan that respects market forces and that attempts to restrain prices, while at the same time offering incentives for investment in supply and delivery that is the only real solution for the West's immediate energy problems. It represents an effort to provide relief now, while making sure that mitigation is short-lived. The Commission's goal remains to fix dysfunctional markets and to ensure that markets regain their competitive footing as quickly as possible. There has been a lot of talk about the past and I would like you to know, Mr. Chairman, Senator Thompson, and the Committee, that this Commission--I can't speak for a previous Commission, I can't speak for a Commission prior to January 22. I had no control over that agenda. But I will tell you, sirs, that we have been engaged. We have issued over 60 orders for the State of California. We have issued a price mitigation plan. We have improved upon that plan. We have issued refunds that no other Commission has done. We are moving forward quickly. We are trying to resolve gas issues, asking for transparency. We are committed, and I assure you, sirs, I assure the members of this Committee that I know in my educated mind and I truly believM in my heart that we are well on our way of improving this marketplace and getting them on their feet while bringing the consumers reasonable prices, but at the same time attracting necessary investment. I read in today's issuance of the Wall Street Journal, and I brought up websites that say, under this order, they remain bullish and are bringing opportunities into California, and I think we have done it right and I am committed to it. Thank you, sirs. Chairman Lieberman. Thank you, Mr. Chairman. Just as a point of clarification, I appreciate your testimony. I think you said some things there that are directly responsive to questions that were raised by the witnesses this morning. I just want to clarify what you said, and then I will go on to the other Commissioners. You said that once the 15-day period that is called for in the order, Monday's order, in which parties will work together under an administrative law judge on the question of refunds, that if that does not reach a solution that is satisfactory to the Commission, that the Commission might--or satisfactory to the parties, that the Commission would consider reentering on those matters. Mr. Hebert. Let me take 15 seconds. One, I did not get to see this morning's hearing. As you know, we are busy. Chairman Lieberman. Right. Mr. Hebert. But I will tell you that the process is there is 15 days for the parties to reach settlement. If not, this Commission by a vote of 5-0 has instructed the administrative law judge to recommend to us a settlement within 5 days of that--I am sorry, 7 days of that. Chairman Lieberman. OK. Mr. Hebert. So 22 days, and then this Commission can act. Chairman Lieberman. And just on the second point, which was obviously of concern to people in Washington State and Oregon who believe that their quest for refunds is not within the purview of the administrative law judge, did I hear you correctly to say that, as you understand it, that they are wrong, in other words, that the judge will consider their request for refunds, as well? Mr. Hebert. You are going to require me to be very careful here, and let me do it. Chairman Lieberman. I am not meaning to put any words in your mouth. Mr. Hebert. No, you are not. Chairman Lieberman. I just wanted to make sure I understood what you were saying. Mr. Hebert. This is a very delicate situation because I have the December 15 order, which speaks to that, under rehearing at this time, so I do not want to conflict myself out on that case, so I have to be very careful in my answer. The beauty, I believe, as an attorney who has been involved in settlement processes, I will tell you that there are two things that settle issues and cases, uncertainty and deadlines. You trade certainty for uncertainty and there is a deadline that closes it out. We did not define the parameters of the settlement process. We left it open. That is, in fact, the beauty of the process. They are parties to that process. They will be in the room. It will be up to them to negotiate what they believe to be in the best interests of them and the parties that they represent. Chairman Lieberman. Well, that is very heartening. I just saw a copy of a letter that is on its way to you--maybe you have received it already--from some of the Congressional delegation from Washington State asking these questions, so they will be grateful for that. I will hold my additional questions. Commissioner Breathitt, welcome. Thank you. TESTIMONY OF HON. LINDA K. BREATHITT,\1\ COMMISSIONER, FEDERAL ENERGY REGULATORY COMMISSION (FERC) Ms. Breathitt. Thank you, Mr. Chairman and Members of the Committee. I appreciate this opportunity to appear before you this afternoon to discuss the role of the Federal Energy Regulatory Commission regarding the restructuring of California's electricity market and its implications for other States and regions. --------------------------------------------------------------------------- \1\ The prepared statement of Ms. Breathitt with an attachment appears in the Appendix on page 462. --------------------------------------------------------------------------- The problems that have been experienced by consumers in the West have been the primary focus of the Commission for almost a year now. What we have learned through our investigations and inquiries is that the causes of the present energy situation in California and other Western States are highly complex and multifaceted. I am sure you heard a lot of that this morning. I believe the Commission has taken bold and decisive actions within our jurisdiction to remedy the extreme distortions in the California markets and to address the instances of potential market power abuses. Since last August, the Commission has issued over 50 orders--I think the Chairman said 60 now--implementing important remedial measures and price mitigation mechanisms, instituting investigations into rates and market design flaws, establishing programs to maximize electricity supply, delivery and demand reduction, directing sellers to provide refunds of excess amounts charged for certain electric energy sales. Our actions are starting to have a dampening effect on prices in California and the West. Prices have decreased significantly since our market monitoring and price mitigation plan for California took effect on May 29. For instance, during the week of June 9, prices for spot purchases of power at Western trading hubs fell to less than $55 per megawatt hour from a high of about $170 per megawatt hour earlier in the week. The low prices continued into the next week, and equally important to me, the price for the longer-term contracts has also come down dramatically. We have seen forward contracts drop for 2003 to $41 per megawatt hour in the past month. We have long stressed--the Commission has long stressed the importance of long-term contracts to minimize the reliance on the volatile spot market, and I believe we are down to about 20 percent from 100 percent when we started issuing our orders. In my pre-filed testimony, I highlight several of the major orders that we have issued and I hope that you will note those when you are going through the testimony. It is important for your Committee to understand the breadth and the scope of our myriad actions in the Western energy crisis. Critics have said we have done nothing and that is simply not true. My testimony also discusses the relationship between the problems we are experiencing in Western energy markets and those in natural gas markets and I point to numerous impediments in natural gas markets that must be addressed. I have a deep concern about the impact of the prolonged periods of high natural gas prices on industries and communities in the West and particularly the impact on the electric generation costs, since so many of the units in California use natural gas. But this afternoon, I would like to focus on our most recent action. On Monday, the Commission instituted a market monitoring and price mitigation plan for the entire Western United States. These new procedures build on our April 26 order, which implemented similar orders just in California, and we initiated the investigation that has made it possible to cover the entire Western United States back in April. The plan that we announced is designed to reduce prices in all hours that are just and reasonable and to emulate prices that would be present in a competitive market. The purpose of the plan is to stabilize the market in the short term and permit California and the Western States to repair dysfunctional market mechanisms. The mitigation plan is intended to provide breathing room for the markets to self- correct. Importantly, the plan will apply to all sellers, including marketers and non-public utilities across California and the balance of the United States portion of the Western States Coordinating Council. I fully support the premise of this order, which is that all sellers in the West should be treated similarly to remove the incentive to sell into one area versus another, so-called megawatt laundering. While I wholeheartedly encourage conservation and embrace demand reduction, we need to acknowledge that natural gas and electric infrastructure needs to be expanded and upgraded. I believe this market-oriented approach that we took in Monday's order will provide the price mitigation needed and it is my hope that it will not discourage necessary investment. I would also like to note before concluding that I attached a concurrence to express my views about one aspect of the order that I didn't fully endorse, and that was a section that instructs the ISO to impose a 10 percent creditworthiness surcharge to the market clearing price. I believe that the imposition of such a surcharge virtually conceded to the ISO the issue of whether or not the ISO must implement our creditworthiness standards, and I thought that was premature. And finally, I wanted to state my support for the settlement conference. You brought that up, Mr. Chairman. I am keenly aware of the difficulties that the parties face and the compromises that will need to be made to fashion a very comprehensive settlement. I have long been an advocate of negotiated resolutions and I encourage all the parties, including the State--I believe I heard the governor this morning say that his delegated officials would be parties to the settlement, and I was very pleased to hear that, and I hope that all these parties work very hard at the daunting task of settling past accounts and structuring new arrangements. Mr. Chairman, I had a few final remarks, but I will stop there by saying that I think that all of these goals work within a market-oriented framework and that is an approach that I have endorsed. Thank you. Chairman Lieberman. Thank you, Commissioner Breathitt. Commissioner Brownell, welcome. TESTIMONY OF HON. NORA MEAD BROWNELL,\1\ COMMISSIONER, FEDERAL ENERGY REGULATORY COMMISSION (FERC) Ms. Brownell. Thank you. Thank you, Mr. Chairman, Senator Thompson. --------------------------------------------------------------------------- \1\ The prepared statement of Ms. Brownell appears in the Appendix on page 484. --------------------------------------------------------------------------- Chairman Lieberman. Do you think it was a friendly act to appoint you to the Commission at this point? [Laughter.] Ms. Brownell. Well, it is full employment. I don't have any boring moments in my day, or night, I might add. Chairman Lieberman. That is for sure. Welcome. Thank you. Ms. Brownell. In fact, I would like to start out by saying that I am pleased to be here and I think that my first experience in getting out this order suggests a culture at the Federal Energy Regulatory Commission that has not been largely recognized. There was a sense of urgency, there was open and honest communication, and there was innovation in the development of this order. All of my colleagues and the staff worked very hard to address a number of concerns raised by stakeholders, and I think we responded responsibly. We have created a road map to bring certainty for the next two summers so that we can all get down to the business of creating markets that work, that work for market participants, but most importantly that work for consumers. I would like to talk a little bit today about what we experienced in Pennsylvania and what we learned, lessons learned that I think we can bring successfully to the way we do business at the FERC. First of all, we were asked to define the differences between California and some of the States, and I think you know them well, and I do not say that judgmentally. There are just fundamentals that it takes for a market to work--good market design, appropriate capacity, an independent system operator, and I emphasize that, and sufficient infrastructure. But while we have, in fact, had great success in Pennsylvania, there were things that didn't work and things that we needed to do to transform our Commission to successfully respond to market changes. Markets are transitional. You don't declare them open 1 day, declare victory, and walk away. They don't happen overnight. They are fragile and they need nurturing. And they need more work with the regulatory process than I would have anticipated, frankly, when we started. But they can't use the standard regulatory responses. Markets don't wait for answers. Markets need certainty. They need quick responses. People are making business decisions. Consumers are making buying decisions. So we designed successfully in Pennsylvania several flexible approaches that I believe address the issue of transforming markets. All of our restructuring decisions went to settlement processes that took no longer than 30 to 45 days to resolve. What did that accomplish? All of the stakeholders knew what the rules were. The market participants were not exposed in the capital markets for an undue period of time. And we did not have to wait for the standard litigation process, to wait 1, 2, or 3 years. We were able to bring the benefits of a retail market to Pennsylvanians, who saved in the first 3 years almost $3 billion. That only would have happened if we had not used these new flexible approaches. In the early stages, we had a lot of operational issues that traditionally would have had to wind their way through a rulemaking or some other process that would have taken 8 to 9 months. We had an operational SWAT team that met, in some cases, every day in the early stages. The rules were, no lawyers, no lobbyists, no commissioners. We had a staff person who led a team of operations experts who brought instant solutions so that there were no market delays, billing problems, or other kinds of impediments to the market. The second thing we learned was that market monitoring is, indeed, a critical issue in managing the transformation and in building the credibility of the market. It is something I think we are all learning. I am suggesting to my colleagues that we bring in some outside experts who do this kind of thing for a living. We have been rate makers. We have not been market monitors. And I think the staff is the first to say that they have worked very hard to design a system that works, but they would love some advice from the FCC, from the FTC, and from the SEC. So I would like to move forward with that because I understand that you, your colleagues, and all of our constituents need the confidence that we are going to take a good look at these markets and that there will be transparency and honesty and equity. The third thing I think we realized and is more critical today than ever before are regional solutions. We need to reach out to the stakeholders in the regions, the States, the creation of RTOs, listen to what they have to say, listen to what their experiences are. Yesterday, we had a hearing on seams issues for RTOs and I think it made a big difference in informing us on how we must move forward. Our order called for a technical conference on technology in the introduction in demand-side management that will bring new technology to the market, I hope, as soon as we can. We are reaching out to learn things and to listen to stakeholders to learn. I think this can be very successful. So I understand why there are concerns, but now that we have moved beyond the crisis, let us move to solutions that will work for the longer term and create the credibility and the confidence that we all need to introduce the benefits of competition to all Americans. Thank you. Chairman Lieberman. Thanks, Commissioner Brownell. Commissioner Massey, thank you for being here. We look forward to your testimony. TESTIMONY OF HON. WILLIAM L. MASSEY,\1\ COMMISSIONER, FEDERAL ENERGY REGULATORY COMMISSION (FERC) Mr. Massey. Thank you, Mr. Chairman. Mr. Chairman, and Senator Thompson, our June 18 order brings dramatically expanded price controls to a broken Western market. I supported the order because it adopts measures that I have been championing for the past 8 months. Price controls are now extended to the entire Western interconnection, thereby eliminating the megawatt laundering problem that has vexed the mitigation programs adopted by the Commission and the ISO over the past year. Cost-based price constraints are now extended to all hours, not just those of reserve deficiency. We have long needed 24-hour-a-day, 7-day-a-week coverage, and now we finally have it. These caps will remain in place until September 2002, giving the market two full summers to correct. I endorse these measures. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Massey appears in the Appendix on page 494. --------------------------------------------------------------------------- While better late than never, I wish this Commission had taken effective action sooner. Until this order, the Commission had stubbornly refused to implement full-time price constraints despite rather clear evidence that prices were not just and reasonable. Businesses have closed down, putting thousands out of work and hurting the Western economy, and all because of a broken electricity market. By acting 12 months ago, we could have prevented much of the economic carnage in the Western interconnection that has occurred over the past year, and I regret that we did not. Given that the Commission adopted measures that I have long advocated, however, I am tempted to declare victory and let it be, but I cannot. There are some aspects of the order that I have strong reservations about. One aspect is the addition of a 10 percent surcharge to the market clearing price to reflect credit uncertainty. I do not see the need for this. The Commission has issued orders in the past few months instructing the ISO to abide by the creditworthiness requirements of its tariff. I am concerned that the adder may diminish the ISO's enforcement of those requirements. Moreover, it is my understanding that, recently, all sales into the ISO markets have been backed by a creditworthy party--recently, all sales, not until recently. Instituting this surcharge does have a modest bright side, however, I must admit. Generators may no longer attempt to justify bids on the basis of credit risk above what is provided for in the cost-based clearing price methodology. This was a major flaw in the old, ineffective $150 benchmark in our earlier mitigation program announced in December. Eliminating that ground for high prices is a positive development. Second, the order should have provided guidance to the parties that will participate in this massive settlement conference that we order. I believe we are avoiding our responsibility under the Federal Power Act to set just and reasonable prices by requiring parties to settle a multitude of issues with a price tag of billions of dollars without at least 2 cents' worth of guidance. Third, I do not agree with the rhetoric in this order that characterizes cost-of-service pricing as irrelevant and perhaps even downright harmful on the theory that it would discourage new supply. I do not understand the need nor the logic of this language. We have made a choice in the order to strike a balance between strict generator-by-generator cost-of-service regulation and a blind reliance on the market. The mitigation program puts in place important cost-based price caps while relying on market-based pricing. The order sets out reasons for this balanced choice and articulating them is all that is needed to support our decision. Make no mistake, this is a cost-based program. The maximum price is limited to the costs of the last generator dispatched. I strongly disagree with the statement in the order that a cost-based inquiry alone would not be sufficient to fulfill our statutory duty under the Federal Power Act. I do not read the Federal Power Act and the relevant court decisions so restrictively. I have aggressively supported this movement to markets, and I still do, but there is still an important role for cost-of-service regulation where markets melt down and prices are not just and reasonable. What is curious about this aspect of the order is that the concern is to avoid discouraging new supply. However, as well respected economist Alfred Kahn recently said of our long reliance on cost-of-service regulation, and I believe he said it before this Committee, ``If the literature agrees on anything about that experience, it is that cost-based regulation as traditionally practiced has encouraged the gold- plating of service and the very excess capacity that seems to promise such enormous benefits to consumers during the past decade if rates were deregulated.'' Mr. Chairman, I notice the red light is on. May I have 2 more minutes, please? Chairman Lieberman. Indeed. Go right ahead. Mr. Massey. Thank you. Dr. Kahn, therefore, believes that cost-of-service regulation may lead to too much supply. Thus, I do not understand the order's logic concerning cost-based regulation discouraging supply adequacy. There may be legitimate reasons against cost-based regulation, but discouraging new supply is not one of them, at least according to Dr. Kahn. These concerns notwithstanding, I supported the order and the price protection plan it puts in place. To ensure that this price protection plan is successful, the Commission must exercise all of its statutory powers to keep natural gas prices in the West at just and reasonable levels. Virtually all of the formula, all of the formula except a $6 O&M adder, is tied to the cost of fuel. For the marginal unit, that will be natural gas. Thus, the success of the plan we adopt in lowering prices depends in large part on fluctuations in the price of natural gas. If natural gas prices stay reasonable, our plan will provide reasonable price mitigation. Today's price protection plan gives California and the West breathing room while the markets are brought back to health. A number of items need to be addressed in the next 15 months. There must be substantial amounts of new generation capacity brought on-line, a more balanced supply portfolio must be developed as California moves away from over-reliance on the spot markets, a robust demand response program must be implemented through demand bidding and accurate price signals, the transmission constraints must be relieved. Without these measures, which must be implemented over the next 16 months, I would be concerned about whether the markets in the West can be brought back to health. Thank you, Mr. Chairman. Chairman Lieberman. Thank you, Commissioner Massey. And finally, Commissioner Wood, welcome to you. TESTIMONY OF HON. PATRICK H. WOOD, III,\1\ COMMISSIONER, FEDERAL ENERGY REGULATORY COMMISSION (FERC) Mr. Wood. Thank you, Chairman Lieberman and Senator Thompson. I would just ask that my written comments represent my views here. I am the fifth guy of five, so I won't belabor you other than to say, from my own experience as a State regulator in Texas, I share a lot of Commissioner Brownell's perspective on these issues and recognize that it is so important that the Federal Commission be perceived and be in reality a co-player in regulating these very important infrastructure industries, electricity and natural gas. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Wood appears in the Appendix on page 504. --------------------------------------------------------------------------- One of the important aspects of competition, the only reason that competition works, and as we have seen the counter case in California, is that there are good market rules in place and a sufficient infrastructure, infrastructure being a broad word, meaning supply side and demand side, resources meaning the delivery that gets them there, whether that be gas transportation pipelines or electric transmission lines. It doesn't work well--it doesn't work at all if the infrastructure is not in place. I think one of the lessons learned by this Commission is that our historic reliance on individual States or on private industry organizations to oversee that sort of reliability is, I think, a thing of the past. I do think that is a role now that clearly ought to move to this Commission and ought to be a constant oversight for us as we determine that the competitive infrastructure is in place before we move to a deregulated era. So that is what I hope we will do. I think we probably are going to need some resources to do that and we will be, I think, reviewing that in the appropriate way with the Chairman and with our oversight committees, as well. But in addition to people and financial resources, I think also one of the things that are important for regulators to have are big sticks, not that they ever need to be used, but when they hang from your belt, the people who you are trying to regulate understand. Certainly, the ability to revoke a certificate, or as my colleagues here recommended, at times to go from a market-based certificate to a cost-based certificate may be perceived as a penalty of sorts. I think administrative fines, certainly ordering refunds is one issue, but to order refunds with an administrative penalty attached to those would be perhaps a useful tool for the Commission to have in its tool shed. I think perhaps we were asked if there were treble damages, much as exists in antitrust lawsuits. We found that we did not have the statutory authority to do that in this order that was issued yesterday, but that again may be an important tool for the Commission to have. Those do not exist today, but I think if we are going to be a vigilant market cop, we need to make sure that our bite can match our bark. So I look forward to working with you, Chairman Lieberman, Senator Thompson, your Committee, Committee staff, and my colleagues on making sure that this Commission is fully equipped to do the job that I know you want us to do well. Chairman Lieberman. Thanks, Commissioner Wood, for that statement, very interesting statement. I have been thinking as I have been listening to the testimony today. This picks up a thought that you just articulated, which is that the market is a magnificent mechanism for stimulating, facilitating economic growth, thereby general well-being, and through competition getting people the goods or services they want at the best possible price. I am paraphrasing somebody, maybe famous, maybe not. The market, notwithstanding its great attributes, its positive attributes, has no built-in conscience so that if there is not genuine competition, then there arises in a market without the pressure of competition, the genuine need--you just uttered the word, for what I would say a cop on the beat, to bring back the conscience, to bring back a sense of right and wrong, and limits. Otherwise, people will suffer. And I do think in the environment we are in now, both in terms of deregulation of certain elements of the energy industry and then more broadly the grave national concern about fluctuations in energy pricing, that this is a role that various agencies and departments in the Federal Government have to play. And I appreciate what you said. I think that there will be a way in which this Commission, I hope, has crossed a bridge to a new chapter in its history through this period of time. So I appreciate what you have done. As I said this morning, I think the order that was issued on Monday was a real step forward and I appreciate it. I have some questions about it, both in terms of the formula chosen and the means chosen as well as questions about refunds which, in part, Mr. Hebert, you answered. But let me go to the formula. Once you decided last December that the rates in California were not just and reasonable, and I gather on Monday in the order made the similar decision for the rest of the Western grid. The question then is what relief to provide. I am from a State Government background. I was Attorney General. My office represented the Public Utilities Commission, control authority as we call it in my State. So the notion of a cost-of-service-plus--some reasonable profit seemed much more simple and certain, and I suppose easier to administer to me. As I look at the system you have chosen, I want to ask this question. It seems to, as one of you said, peg the acceptable price in California to the last price offered during the period of time, the highest price, and, therefore, arguably the least- efficient price, the least-efficient company setting the price. Then they can charge up to 85 percent of that in the off-peak hours. So there is no question that this system will impose some constraints on pricing to the benefit of electricity consumers, energy consumers in California and now throughout the West. But considering that the standard of law is just and reasonable rates, how can you feel comfortable that this system will guarantee just and reasonable rates? In other words, you have put on a ceiling here, but because it is being set by the highest price, the last price charged, the highest price, it can be a pretty darn high ceiling and there still can be a lot of latitude for unjust and unreasonable pricing underneath that ceiling. Mr. Hebert. Let me speak to that as quickly as I can, and that is really the crux of what we are trying to accomplish here. One, and I know you understand this, while we were trying to put this together, our goal was to bring prices to a reasonable level while at the same time attracting adequate investment so we can get the supply there, we can build the deliverability up so that we can deliver that supply, therefore keeping prices down in the long term for consumers. We weren't really looking for the easiest way to get there. We were, in fact, looking for the best way to get there. I think that is what this plan is. I have heard many people on this Committee, Mr. Chairman, I have certainly heard you speak on green issues and making certain that we have a green environment. Through driving the efficiency, we do two things. One, we bring down prices. Two, we strive to never make our air dirty through bringing in the cleaner units. If the most inefficient unit that clears the market is setting the price at which other people may take, then you are going to drive everyone's efficiency, and the secret is this. As they enter the bid stack, no one knows which units are going to be called and which is going to be the last unit, so there is no way to predict or manipulate which is the most inefficient unit and which one is going to be called last. There would be some people who would suggest, well, it is going to keep the dirty units on for the long term. Well, that is not true, because if they are what is clearing the market and if their costs or their market inputs is what is setting that price, then their profit is much lower than anyone who has got a 7,500 heat rate system as opposed to a 40,000 heat rate system. So what they are trying to do is, hopefully, we will retire these dirty systems. They will go away. We will bring in the newer 7,500, and even under compressed situations, 4,500, heat rate systems. They will be much more efficient and they will clean the air. Now, that is better for consumers in two aspects and it meets the balance of bringing prices to a reasonable level while at the same time attracting investment and providing for clean air. Chairman Lieberman. Let me ask you and any other commissioners who want to respond, why is that better than having gone to a more traditional cost-plus-reasonable-profit system, such as has existed traditionally at the State level? Mr. Hebert. I will give you the brief answer and I would like to give each of my colleagues an opportunity to answer it. One, we have come up with a plan that I think we are going to be able to move forward with as we move towards cost-based. We have seen the litigious nature of that, the appellate review of it, the indecision that ever comes from it. We need something. California and the West needed immediate results. They needed a problem solved today. Cost-based does not do that. And the other thing that cost-based does is it does exactly the opposite. It would guarantee a profit at maybe 10, 12, or 13 percent return on these inefficient units and you would keep them around a very long time and we need those units off. Chairman Lieberman. Do any of the other commissioners wish to respond? Yes, Commissioner Breathitt? Ms. Breathitt. Mr. Chairman, I would like to make a point, that this plan is only covering 20 percent of the electricity sales occurring in California. The number that we have gotten from State officials in California is that they have been able to secure 80 percent of their sales in fixed price contracts. So we are only talking about this plan mitigating prices for 20 percent of the energy purchases, and I think that is an important factor. It is not 100 percent. The plan also is a market-oriented plan that has incentives as we believe that will incent new investment, but at the same time, you can call them price caps, you can call them price controls, you can call them a price mitigation, it does put in price controls that have proven to be effective from our March 29 order, and if this continues to hold forth, it is going to be effective all hours, all the time. Chairman Lieberman. I do want to note for the record that two of you have used the term ``price control.'' I was expecting Groucho's duck to come down from the ceiling. [Laughter.] Ms. Breathitt. I will say price cap. Chairman Lieberman. You are truly bold. Chairman Thompson. I wish the governor had stayed around to listen to this. He ought to be here. Chairman Lieberman. Commissioner Brownell, do you want to add anything? Ms. Brownell. I will try and dodge the issue of calling it anything as long as it works, frankly. Chairman Lieberman. Yes. Ms. Brownell. I would add simply that I think it is pretty clear from other markets that you do not get innovation when you have monopolies and cost-based kinds of pricing, that the kinds of opportunities that capital flows to are created by markets where people can make economic choices and to make choices based on other kinds of preferences. We saw almost 20 percent of the market in Pennsylvania choose green power. For the first time, we actually had investment in a number of green plants, many examples of economics that work, but an example, I think, that will prove true over time. I also think that the commentary by the investment community yesterday and this morning would indicate that it also satisfies some of their concerns, so you will have stability both for the incumbents to the extent that they deal with their other issues and the market players. I think that is important, as well. Mr. Massey. Mr. Chairman, my preference was to return temporarily to a system based upon the cost of each individual generator in the market. I think that would have been a more effective time out and I would have exempted any new generation from that. I hope my colleagues are right that a cost-based system tied to the least-efficient generator will actually encourage the retirement of those generators. A lot of economists believe that it will. Others believe that it may provide an incentive to keep some of those old dogs around so that the market clearing price can be pegged rather high. So I don't have 100 percent confidence that this is the right approach, but it seemed to me that it was a dramatic step forward. Chairman Lieberman. Commissioner Wood, I thought I heard you say in your opening statement that you have left the door open to situations where the Commission might want to temporarily order a cost-of-service-plus rating system. Mr. Wood. I think that is always an option, Senator. Some perspective on this. The State in 1996 put forward a plan that FERC approved that said they wanted to move away from it as part of their restructuring plan. The Commission, wanting to work with the States, in fact, approved that. That moved the procurement of almost all the power by the major investor-owned utilities to the spot market mechanism where you take the last unit's price. Back in that day of surplus and prior to the drought, that incremental unit was cheaper than the average unit, and I think had that world continued for forever, people would have continued to be better off under the deregulated plan than the regulated plan. But the drought, which hydroelectricity is a big part of the energy picture in California and in the Northwest, the drought and the lack of investment in anything new caught up with the State and with that region last summer, and in the fall, the Commission moved in its December order to really preempt the State plan and say, this will not work anymore. We have got to get you guys out of the spot market and move you to a contract-based market. So that is when, as Commissioner Breathitt pointed out, we are now down from 100 percent to 20 percent of the power plants playing in this hourly marketplace, and so that has meant quite a bit of difference. As I mentioned yesterday, and I am sorry I do not have my crude drawing skills as at the Energy Committee, but in response to Senator Feinstein's proposed legislation with Senator Smith, what we have found is that the units that are playing in this spot market pool are largely the older gas- fired plants, we call them the old dogs, and they are largely about the same heat rate. They are about the same level of inefficiency. So because of that unique situation, it seems to me that cost-of-service ratemaking in that spot market might actually cost the customers of California more than what the Commission adopted. Now, that may not always be the case, and it is a tool, as your question asked, Senator, that is a tool in the regulatory toolshed, that if a cost-of-service rate is the best way to get to a just and reasonable rate, it certainly is in the statute and it is certainly something the Commission can do. I do think for the reasons stated that it may be advisable to move toward ones that are more incentivizing than we have had in the past. Chairman Lieberman. Thanks. My time is more than up. I appreciate your answers. I think I understand better why you made the decision you did on Monday. I must say that I am left with a question about whether the system you have chosen will ultimately fulfill the statutory responsibility to maintain just and reasonable rates, but I think the answer to that is that we are not going to know until we see for a while how this system you have chosen works. So we will all, hopefully, be following it with open minds and learn from the experience. Senator Thompson. Chairman Thompson. Thank you, Mr. Chairman. I appreciate the Commission being here and the work that they are doing. I imagine you feel somewhat like a center on a football team. Nobody notices much what you do until something goes wrong. But I think people are beginning to realize more and more the work that you have been doing, the 50 to 60 orders that you have put out, the addressing of this issue. Just because you do not do what people want you to do, one side or the other or both, does not mean that you are not addressing the issue. I think, if nothing else, you have disabused the two extremes, and these are the people who say that FERC has no role in this and the others who say all you need to do is cap retail prices and wholesale prices and prices will be low and everybody will be happy. So, hopefully, we have moved away from both of those. I think one thing that we have learned is that if we have prices that wind up driving the demand up and the supply down, you are going to have problems. And we can't just look at the problem today and what we do about it in the short run because we run the risk of exacerbating an already troublesome situation. It does seem to me like this is, in many cases, short-term versus long-term consideration. Something that might be helpful in the short term and pleasant, or more pleasant, might not be the right thing to do in the long term, and those are the balances that you have to make. I think the more we learn about it, the more we see the complexities of it. I do not think, for example, you can talk about the March order and whether it is successful or not. Until we get a way down the road, you may have gone not far enough, you may have gone too far. I don't think anybody knows. I mean, that is the nature of the situation, and especially the nature of electricity, it seems to me. If there was an answer--we have brilliant people here now for the second day on both sides of the issues. If there was an answer, we probably would have discovered it. So we have to do the best we can and learn as we go along. One of the things that puzzles me is what are we going to do, and I know the tremendous pressure that this Commission has been under, but the Department of Energy, Senator Murkowski testified today and he pointed out that the Department of Energy has pointed out that, as I understand it, that there will be blackouts in California. Now, you know what is going to happen. There is going to be a hue and cry that the Commission didn't go far enough. That will be definite proof that the Commission didn't go far enough, and the pressure that you see today will be magnified many times over. My question is, what are you going to look at? I know you are not going to just respond to the public opinion polls. What are the factors that you will look at when that happens? Are you going to look at what has happened since this order and conclude that that can tell you what the sound policy is for the future, or will your analysis at that point be the same analysis that you have today. That is, you consider all of the factors that you ought to consider and you put this down for time enough to see whether it works, however long that might take. But it seems to me that from a, I do not want to use the word ``political'' standpoint, but that is something we have to consider if you do not, but you are buying into a tough hand here because you are coming up with a policy in your considered judgment--some of you have some reservations about it, but in your considered judgment is the way to, knowing that if it works as well as it can possibly work, you are going to have blackouts. How are you going to handle that when the time comes? Mr. Hebert. Senator Thompson, I will tell you that you are exactly right as to the politics and the pressure, there has been a lot of pressure applied by the Senate and the House and State leaders. The important thing is that this is an independent agency, hopefully not susceptible to pressure. I want to thank my colleagues for taking a bold move by believing in this and saying we believe this will work. We cannot, ``we'' being FERC, control blackouts. It is outside the realm of our ability to change. The reason for that is we can't site generation. We can't build generation. We can't cite intrastate gas pipelines that supply fuel that, quite frankly, is constrained right now in California. There are things that are outside the realm of opportunity for us, and that means we need help and we need California to help. We will just have to continue to believe in what we need, and that is to call balls and strikes. Part of the beauty, I think, of this Commission of five, Commissioner Wood brought it up about two State Commissioners. Actually, you have four State Commissioners, previous State Commissioners, I think three of which, including myself, that were previous chairmen of State Commissions. So we are sympathetic to the needs and plight and understand the political pressures that are on State leaders, as well, in this regulatory environment. There are mechanisms that we are going to continue to pay attention to. This plan stays in effect through the end of September 2002. There have been lots of questions come up, is that long enough? How long should you go? Well, the end of September is an educated guess based on what we are being told is going to be brought to the marketplace in California and the West as far as generation. Now, there was a release in April of this year by the State of California, perhaps it may have been the governor's office, I can't recall, that there was going to be around 5,000 megawatts brought on-line by the end of this summer, which is very important to this Commission and certainly important to the people of Commission. Chairman Thompson. By July. Mr. Hebert. Right. The newest numbers that are out are suggesting to us that 2,309 megawatts are going to actually be what is going to be what is on-line. That is less than half of what we are told. If those megawatts are not brought on-line, the blackouts will continue and they will be harsher because demand is increasing. We have no control over droughts. We have no control over outages, although we are trying to inject ourselves there to make sure we understand the schedules. The short answer is, I don't have an answer for you, Senator Thompson. I wish I could tell you that politics are not going to play a role in this and I wish I could tell you that I know and I am willing to bet my life on this plan. This is an evolution that we are going through. We are learning this process. I think right now it is the right move and I believe it will bring down prices and at the same time bring in new supply. But I remember when I got this job on January 22, the California crisis was right in the middle of our face and I was asked about it by some reporter, ``What are you going to do about it?'' and I said, ``Well, we are going to work hard and we are going to be committed. I did not start this fight, but I am going to try to finish it.'' And that is what we are doing. Chairman Thompson. Does anyone else have a different observation or additional--Mr. Massey? Mr. Massey. Senator, my view is that this order does about all that we can do at the Federal level, this order and previous orders, to prevent blackouts this summer. The ISO is skillful and has adequate tools to keep the system in balance if there is enough supply. There is a ``must offer'' provision that requires all generation in the Western interconnection that is not committed to native load or wholesale contracts to be offered in every hour of every day. The ISO in California will supervise maintenance schedules and outages within the State to ensure that the maximum supply is available. We have, by imposing these price controls, I think, eliminated any incentive to withhold generation to drive up price. That strategy is simply not available anymore because it won't work. So that is about all we can do. There will still be blackouts this summer in California because there is just not going to be enough supply in some hours, and I am not sure what this agency can do about that at this point. Chairman Thompson. Thank you, Mr. Chairman. Chairman Lieberman. Thank you, Senator Thompson. Senator Collins. Senator Collins. Thank you, Mr. Chairman. Mr. Chairman, before I question our witnesses this afternoon, for the honor of my State, I have to correct a wrong statement that was made this morning by Senator Torricelli after I had left. It is my understanding that the Senator from New Jersey made comparisons about Maine's per capita energy use versus California and implied that Maine was much higher. That is incorrect, which does not surprise me. And I would also note, though I am sorry he is not here to hear this, that the residents of New Jersey use 35 percent more electricity per household than do the residents of conservation-minded Maine. I thought it was very important for the record that I set that straight, and I would ask unanimous consent that a table doing a State-by-State comparison of average monthly bills be included in the record.\1\ --------------------------------------------------------------------------- \1\ The chart entitled ``Average Monthly Bill By Sector,'' appears in the Appendix on page 744. --------------------------------------------------------------------------- Chairman Lieberman. Without objection. Chairman Thompson. How does Connecticut fare? [Laughter.] Chairman Lieberman. Actually, I think we do pretty well, don't we? You don't have to give me the answer now. Senator Collins. I am sure that you would be interested in that---- Chairman Lieberman. The thrifty New England Spirit. Senator Collins. That is right. Mr. Chairman, I very much appreciate the opportunity to discuss with our FERC Commissioners this afternoon some issues that are of great concern to the people of Maine, and since I have been in touch with many of them on the issue I am about to raise, I am sure it will not be a surprise to them. I first want to congratulate the two new members, Commissioners Brownell and Wood, on their recent appointment and tell you that I checked you out with the members of the Maine Public Utilities Commission, on which a former counsel to me serves. They speak very highly of you and I am confident that coming directly from State regulatory commissions that you will be especially sensitive to how your decisions affect consumers, particularly those who have little or no control over what they pay for electricity. I would like to pose some questions about the charges for installed capacity, the so-called ICAP fee, which has been a very controversial issue in my State. I realize there may be some limits on your ability to respond, and I will respect those limits. To provide some background to my colleagues, Maine leads the Nation in the percentage of its electric load served by competitive providers with numbers that recently passed those for Pennsylvania and that continue to grow. Unfortunately, what appears to be good news on the surface is the result of a less- happy development, mainly that our consumers pay very high prices for standard offer or default service. This is because of the interest in promoting competition. We have done more than any other State to expose our consumers, especially our business consumers, to current market prices for power. That obviously contrasts dramatically with the approach taken in California. And it is a tribute to the people of Maine that they have largely accepted these price increases with stoicism, if not silence. But it would be unfair and unwise to abuse their patience with additional government-imposed costs that cannot be absolutely justified. The market is already making them pay dearly for energy, and in my judgment, the Federal Government should not be adding to this burden through high capacity charges. I appreciate the importance of providing incentives for new generation, but unlike California, it is difficult to see that New England has any kind of problem on that front. More significant, we should be very careful that in our eagerness to create incentives for new generation, we do not want to create incentives for voters to pull the plug on electric competition. Against that backdrop, I have two questions. First, to what extent has FERC considered the appropriateness of using a deficiency charge for capacity that was developed during a time of fully regulated, vertically integrated utilities in a time when power is sold in a competitive market? To be more specific, in the prior world, utilities sold each other energy based on their actual costs. Most owned substantial generation, and government could ensure that the proceeds of any capacity charges were used for new construction or otherwise benefitted consumers. Now in States like Maine, energy prices are based on what the market will allow. Companies that sell power to consumers often have to buy all of their capacity in the market and capacity charges are simply another cost imposed on consumers with no guarantee that they will be used to improve reliability. Should these dramatic changes in the nature of the industry alter how FERC sets deficiency charges for capacity and how the proceeds are allocated, and if so, how? Mr. Hebert. Mr. Hebert. You are well-educated on an issue that you should not be required to be educated on. Senator Collins. I agree with that. [Laughter.] Mr. Hebert. I want to remind my colleagues that this is a pending matter. This is a remand back to us from the First Circuit, so, therefore, we have jurisdiction of it at this point. I would ask the Senator's permission to very carefully draft you an answer in writing as opposed to giving you anything orally that may cause me to recuse myself. That is a pending matter. Mr. Welch and I are friends, as well, and I hear you, heard him, and we will be acting. Ms. Breathitt. Senator, I think that is why you saw us all sort of shifting back and forth and talking among ourselves. We have had this before us for a while. It went to the court. The court remanded it back and I hope we will be acting soon. Ms. Brownell. Senator, I would just like to add that you asked the right questions. The questions are not only being asked in New England, but in PJM and throughout the country, both by the market participants and the ISOs. So it is an issue that we will be dealing with and I think we are cognizant that a transforming market requires new looks at everything. I would also like to suggest it would be a great thing if you could lead a conservation competition among all the States. It would be the fastest way to get demand-side management to the market that I could think of. Mr. Massey. Senator, I have no idea whether we got that $8.75 charge right or not. I think our decision was reasonably well motivated. We want load-serving entities to come to the market meeting their requirements plus some measure of reserve, and if they fail to meet that reserve capacity requirement, the question is, how do you create incentives for them to meet that capacity reserve requirement and should they be penalized if they fail to meet that requirement? That is really what this is all about. And if they should be penalized, what should the level of penalty be? That is what is before us. The Court of Appeals said to us, you can retain the $8.75 per kilowatt month penalty if you choose to, but if you choose to, you have to provide a much better explanation of why you made that choice, or you can move off of that choice. We now have before us a new proposal from New England about how to calculate that fee, and I won't comment on the wisdom of it because I haven't reviewed it, but I know it is before us. But I do think one of the issues this Commission is struggling with generically, and frankly, it rose out of the California debate, there was no capacity market in California and no reserve requirement and not enough generation being built and---- Senator Collins. But New England is not California, and that is part of our---- Mr. Massey. That is true, but one of the reasons New England is not California is there is this capacity requirement, and the question is, if the load-serving entities don't meet it, to what extent should they be penalized? That is really the issue before us. I am sensitive to your concerns. I am glad you raised it and we will try to do the right thing on rehearing. Senator Collins. Mr. Wood, did you want to add anything? Mr. Wood. I think, as kind of a general matter, because this was really the last piece of unfinished business on the agenda when I left the Public Utility Commission of Texas, which like New England and unlike any other place in the country both have in excess of 20 percent excess capacity looking at this summer and next, one would think in a market- based scenario, in a market that is slightly overbuilt, that the costs of buying social insurance for excess capacity would be relatively low, if not zero. In a market that is really tight, if you were buying social insurance for capacity, like in California, maybe that would be a relatively expensive purchase. So philosophically, the answer to your question is that a market would price things different than a regulated area. How it does so is going to be, again, subject to this proceeding that is coming up. But I think it is a critical question to get right, because as I mentioned before, relying on external sources to make sure we have enough capacity in future years is something that the Commission can no longer do. We have to ensure that mechanism is something that is ordered by this Commission, if it doesn't already exist. Senator Collins. Mr. Chairman, I am wondering if you would indulge me with one more question---- Chairman Lieberman. Go right ahead. Senator Collins [continuing]. Since it involves New England. Chairman Lieberman. That was a very craven appeal to my partisan, or my regional, parochial, regional interests. There are only three of us, so you should see the red more as a cautionary yellow light. Senator Collins. Thank you. [Laughter.] My second question is this. The independent system operator of New England recently submitted a proposal to FERC which provides that sellers of capacity must agree to bid their energy into the market at a price that is capped at $1,000 a megawatt hour. I earlier talked about a situation we had in New England last May when there was a price spike that went to $6,000 per kilowatt hour, more than 100 times the usual rate. I won't ask you to comment on the specific proposal, because I understand the constraints you are under. But in general, should a generator who receives capacity payments have any limits on the prices that it charges for energy? Mr. Hebert. Mr. Hebert. As you know, we do have a matter pending before us and, therefore, I am going to be precluded from answering that. I will tell you that this Commission, I think, has been very clear that we are conscious of rising prices, we are conscious of problems that markets that are not fully designed and fully functioning create, and that we are willing to do what is necessary to make certain that those markets are working and on their feet. Senator Collins. Let me ask just one final question that is not related to a matter that is pending before you. But I have to tell you that those matters that are pending before you are of extraordinary importance to my State and have caused a great deal of consternation, and whenever I go to a manufacturing plant, it is the first issue that comes up. In fact, you would not believe the number of people in Maine who know what ICAP means. That is really frightening. Let me switch gears for a moment. It seems clear to me that given the short-term inelasticity of electricity markets, that there are periods when at least some sellers can know with certainty that their output will be purchased no matter what the price. Now, during these periods, what steps do you think we can take to constrain prices--I know the $1,000 cap has been one approach--that will preserve public confidence and still provide sufficient incentive for capital investment in generation? And one particular matter I would like you to comment on, in addition to price mitigation or price caps that could be imposed, is whether or not we should be looking to develop a real-time demand response, and whether you have any thoughts on how such a response could be incorporated into the market structure. When we had that $6,000 spike, consumers didn't know that at that time they should turn off their air conditioners or delay doing laundry or curtail their use of electricity. They don't have any way of knowing when we have hourly electricity markets what the prices are for that particular time. Mr. Hebert. Mr. Hebert. Actually, what the Commission has done is we certainly, I believe, have a full understanding that we have to be committed to a wholesale marketplace that works. What you are talking about is fluctuations in a marketplace from time to time that get price spikes. I will tell you, individually myself, not speaking for the entire Commission, I understand price spikes, but what consumers truly feel are average prices. A price spike every now and then may give some certainty to the investment community as to where they need to send their dollars to invest, to build new generation, perhaps to deal with congestion or bottlenecks. Through our Order 2000, this Commission believes that if we set up regional transmission organizations, which we are in the middle of right now, we can somehow get the free flow of electrons. The end state hopefully will be flow-based rates that will give us some opportunity to make certain that all consumers get the benefits of a market that works. We are not there yet. We are in the middle of that process. It is a part of the evolution, but we are continuing to go down that road. We are working with State regulators. I mentioned to you Mr. Welch. We are trying to make sure that all State regulators understand the need in us working together with the regional transmission organizations to get these grids to work. Ideally, we would love to have one North American grid. That is not going to happen. We have got the interconnection difficulties, but we are trying to get it down to a lower level than we have currently got. We need investment in infrastructure. We need investment in supply. And the Order 2000 will bring about that, I believe. Senator Collins. Commissioner Breathitt. Ms. Breathitt. Senator, I would like to add that if there is sufficient supply in your area, in your State, that that expensive bid for power may not ever be needed to be called upon by your grid operator. So one thing that can be focused on in your area is if there is the right planning process to site new needed generation, and because of the installed capacity program in your area, there should be the incentive in place to ensure that there always is a reserve margin. The other thing that is in place in the area that Commissioner Brownell comes from, and we have seen it in ISOs to the north, Pennsylvania, New Jersey, Maryland, is the circuit breaker concept that you mentioned of $1,000. The few times it has been used in the PJM control area, I think we asked recently and they have only gotten up to $1,000 under six times. So it is rare that it gets up there, but it is a circuit breaker if sales do reach it. So adequate infrastructure, climates that allow for that, and a circuit breaker approach works. Ms. Brownell. Senator, I would simply add that another issue is you have to have the rules in place that make sure you know what is going on in that market and why that spike took place, and you have to have appropriate things like congestion pricing that is responsive to the market. So I think those are things that we are working on and they are important. We do have a $1,000 cap in PJM and I think it just sends a signal. But critically, you have to know why that spike was there. On demand side management, in our order on Monday, we called for a technical conference in two phases. The first phase will actually bring in technology providers--it is really extraordinary what is out there--and learn what is available, and then in the afternoon probably talk about implementation issues. The reality is, I think customers are a whole lot smarter than we think they are and I think if we can encourage the development of technology, we can bring down costs and let everyone from large business to small business to homeowner begin to use the tools that are available. So we are committed to doing that and we do understand that is a reality, an important reality, in any market. Mr. Massey. Senator, I think it is a wonderful question. You have really put your finger on an issue that I think we have grown to believe is extraordinarily important in any electricity market. Electricity markets aren't like other markets where a purchaser simply decides not to purchase if the price gets too high. In other markets, that has a substantial price dampening effect, as you point out. But in electricity markets, we simply don't have that yet, but we are working on it. It requires, I think, a strong Federal role and an even stronger State role to make that happen. But because of the nature of electricity, I think it is important that price volatility be minimized to the extent possible. It is simply not acceptable in electricity markets. We need to implement demand response programs, working with State Commissions. It will require a substantial portion of the load actually seeing a price signal in real time, I think, having the tools to respond to that price signal to cut back on usage. I think the technology is available to do that. This conference that Commissioner Brownell played a leadership role in establishing, I think could be a watershed event in this Commission moving forward to understand the relationship between the wholesale markets and the retail markets, particularly as they relate to the demand side, so I very much appreciate your question. Mr. Wood. I guess the only thing I would add, Senator Collins, is that unlike buying gasoline or milk or a new car, you get a bill 30 days later and it is a little hard to change your behavior because it has already happened. The big customers tend to have real-time meters on their premises, and when, as we move to hourly markets, as you all have in the Northeast, hourly prices are then corraborated with the usage of the plant, the manufacturing plant that you mentioned in your question, that those folks are pretty cognizant of what the prices are, as you know, and have the ability to respond to them. Actually, 30 percent of the market, which would be the commercial and industrial, the large guys, if those people have the ability to react in real time by cutting off their power usage in whole or in part and getting paid for it, which is what the demand side mechanism that Nora and Bill just talked about are all about, i.e., if you are going to pay $6,000, I will take $3,000 to shut off. This guy will take $2,000. This guy will take $1,000. We will get down below that $1,000 cap pretty quick. These people will take some money to get shut off. Interruptibility has a price. Then that really becomes another player in the market, just as good as building a new power plant. So it is a critical silver bullet to solving this market- based transition that we are in and I am glad to hear you are interested in it, too. Senator Collins. Thank you. Thank you, Mr. Chairman. Mr. Hebert. If I might add one thing on the demand side, Mr. Chairman---- Chairman Lieberman. Sure. Mr. Hebert. Senator Collins, a couple of things. The demand side issue is something that has certainly been in front of FERC, that we have been engaged in. Actually, the first time I think we supported it together was March 15. We had it in our March 15 order. We had it in our April 26 order. And now, the 5-0 vote of the Commission the first time we have been able to get together on it. But I will tell you, understanding, and this is, again, where I think it is important to have four former State Commissioners engaged in this, the demand issues are State issues and they extend beyond our jurisdiction here at the FERC. But what this Commission, through removing obstacles and impediments, is willing to do is complement the services of States that are willing to get into demand issues. We are willing to help them when and where possible in looking for ideas and answers. Thank you. Senator Collins. Thank you very much. Thank you, Mr. Chairman. Chairman Lieberman. Thanks, Senator Collins. I have a series of questions about the order on Monday, just to clarify on some questions that have come up. The first is on the question of refunds, which there was a lot of concern about this morning. I think I understand, Mr. Hebert, what you established and what your understanding is regarding the California--the 15 days before the administrative judge-- parties will discuss the settlement, the judge has 5 days or 7 days thereafter then to recommend to the Commission, and there is some latitude there to begin a process. You also indicated, I was pleased, that there is some way in which Oregon and Washington can become parties to that process. Additionally, those two States expressed a concern, and the letter that I mentioned before is from the four Senators from the States, Senators Wyden, Smith, Murray, and Cantwell, to the Commission, which undoubtedly will be waiting for you when you return. The question is the law and the fact that they need to wait 60 days after the investigation is opened to enjoy any benefits of refund, which would not in this case, in their case, occur until early in July of this year, and that is the law. Because that seems like an inequitable situation to me, and my question is, is there any way to work around that within the law? Mr. Hebert. I like that question. Chairman Lieberman. The reason I ask that is---- Mr. Hebert. As a lawyer, I love it, but---- Chairman Lieberman. The Attorney General of Washington suggested that if there is not, one of the things the Committee ought to do, working with the Commission, is to see if we cannot find a way to change the law, and I do not mean with regard to these cases, but in the future. Mr. Hebert. Well, obviously, the Federal Power Act is the law that we go by in regard to this, and certainly Congress can amend and change and whatever law is passed down to us, we will follow. We have to follow the law and that is what we are doing. Sixty days after the notice is exactly right. That is why it is July 2, and I think that is the case you are talking about. As I told you, there is a pending matter before us in dealing with Puget Sound and we will have to be very careful in any comments we make due to that, because I nor anyone else wants to be recused. We all want to sit on that case. But I will tell you at the same time, as I shared with you a little bit before, I think that is the beauty of the settlement process that we set up through this order that we issued on Monday, and that is that there are entities from the Northwest, the Pacific Northwest, that are parties to this California settlement. Chairman Lieberman. Because they are suppliers into California. Mr. Hebert. And I will tell you that we have, I believe, one of the best settlement judges around, our chief judge that is going to handle this matter. Now, this Commission felt it was important to leave the uncertainty there. What this judge ends up doing within the confines of that hearing room, I don't know nor can I give direction to, legally or ethically. But I will tell you, I believe that is the beauty of the settlement process. My guess is that through this settlement process, there are many issues within our jurisdictional grasp--``we'' being FERC--that will be settled. As with most settlements that I have ever seen or been a part of, my guess is there are some issues that are outside of our jurisdictional grasp that will be settled, as well. What are those? I have no idea. Chairman Lieberman. I appreciate your answer. It was artfully done. Mr. Hebert. Thank you. Chairman Lieberman. I am not going to push any further. I think it does leave some hope here for the folks in Oregon and Washington that there may be some possibility of refunds, but that is my conclusion, not---- Mr. Hebert. I am not going to draw any conclusions, but you are certainly welcome to, sir. Chairman Lieberman. Thank you. Let me ask this question by way of exercising our oversight function. For the moment, let us assume that--well, we do not have to assume anything. The fact that the ability to obtain refunds is contingent on the date on which an investigation is opened obviously puts a premium in that way and many other ways on a swift response to complaints. One of the criticisms of FERC in this matter, and I will ask it now as a question, the criticism generally is that the Commission has acted too slowly here. Price increases began in California last spring or summer. I guess the Commission pretty quickly opened an investigation in July, but it was not until December that the decision was made that the rates were not just and reasonable. Then, incidentally, no investigation was opened until the end of April regarding non-California States on the Western grid, particularly in this case, Oregon and Washington. So the question is, or the allegation is, that until Monday, in some sense, until last Monday, that the Commission has been sort of dragged along more by events and rising anxiety about economic impacts of prices in California than it has taken control of the events--until Monday. So I want to pose that question to you, Mr. Hebert. How would you respond to it? How would you defend the Commission's behavior? And then particularly that question about Oregon and Washington and why did you wait until late April to get into that? Mr. Hebert. I will defend it by my record, Mr. Chairman. I would tell you that I think the record of this commission since January 22 has been solid. Chairman Lieberman. In fairness--excuse me--you did not arrive until January 22. Mr. Hebert. I did not become chairman until January 22. Chairman Lieberman. I am sorry. You didn't become chairman until then. Mr. Hebert. I was a commissioner, and actually, if you talk about proceedings and the ability to get proceedings before this Commission, under the previous chairman, the El Paso case has been one of the big cases that so many people have talked about and questioned about why we moved so slowly. I actually issued a concurrence in the El Paso case under the previous chairman that we had made enough procedural and discovery calls and it was time that we made decisions on the substance of the matter with the El Paso case and moved forward. And one of the first things we did when I became chairman of this Commission is to move forward with the El Paso case. A lot of people said, why did it take you a year? Well, it was the same question I was asking, and I actually issued in a concurrence prior to being chairman. We did study not only California and look at and try to make good balls and strikes calls when it comes to the Northwest, as well. I think if you look at January 22, getting through that process, getting what we had to be done at the staff level to get adequate information, to call the right balls and the right strikes, I don't think April is that bad, actually. I think that is actually pretty good. And if you, and I know you do, know as much about a government as anybody, that is a pretty quick call. And at the same time, most people do not understand, we were working with a commission of three that, quite frankly, was left with a backlog of 2,000 cases. We have reduced that backlog by about 25 percent now while at the same time dealing with California, issuing refunds that had never been done before. So I feel very good about our record and I think we are going to continue to move in a strong, fast, and furious, but reasonable and legal, manner. Chairman Lieberman. I want to yield to my colleagues in a moment. I could ask this as a question, but I am just going to make a statement on it. Just when you mentioned the backlog it came to mind that under Monday's order, FERC is taking on some very significant responsibilities to monitor energy markets in the West on a 24/7 basis. The question, and it is a larger question for another day, is how are you going to do it as a matter of process and organization? Do you have the personnel that will enable you to carry that out? Mr. Hebert. I would like to quickly try to answer it, if that is all right, Mr. Chairman, because I think I do have an answer for you. Chairman Lieberman. Yes. Mr. Hebert. Several things. One, this Commission saw that early on, actually through our Order 2000. We believed it was important through the regional transmission organizations to give them a monitoring role, to try to give them some shared responsibility. So that is a part of Order 2000 and that will help us monitor those markets. At the same time, and I don't want to speak for my colleagues, I want to give them an opportunity, but if I recall correctly, there were some organizations, one including one division of FERC that was put together, that we all disagreed with. When I became Chairman, I reassessed our resources. I looked at those resources and I split that division back up, which was the litigation division. We had around 150 people. We needed at least half of those people, the technical people, to be involved in monitoring those markets. So we sent them to the division that properly would handle that through those markets and we sent the others to OGC to handle the legal situation at hand. So I think we have taken our resources. Do we need additional resources in the future? We will see. Again, we are in an evolution mode, but I will tell you, we are moving forward with monitoring efforts. We probably don't have everything we need at this point. What will that include in the future, I will be glad to keep you abreast of. Chairman Lieberman. Yes, I would appreciate that, because that is part of our oversight role, as well. One last final question, and a quick answer, I hope. We have talked about the order that you issued on Monday being effective through September of next year, 2002, which would take us, as a few of you have said, through the two summers, give time for this to settle out, and I think that is all good. There is another perspective on it, not negative to what I have just said, which is that the folks in California have projected that supply will not be in any equilibrium with demand until about a year later. I will ask if any of you want to comment on it, but real quickly if you would, in deference to my colleagues, will you be open to extending the order beyond September of 2002 if that seems appropriate? Mr. Hebert. I think it is important that we set a deadline, and as I said earlier, there are things out of our control--the siting of generation, making certain that generation comes on- line, dealing with Path 15, dealing with the intrastate network on natural gas. All these things are problems in California. If they get resolved, and they should be, then yes. If not, perhaps they do not get in 7 percent reserves. Perhaps they stay within 10 or 11 percent. My suggestion will be that, yes, the plan should change. To what extent, we can't make that call at this point. Chairman Lieberman. Does anybody else want to add to that? Mr. Wood. Mr. Wood. I think if the market rules are fixed and the infrastructure sufficient, then competition can work. Deregulation can follow from competition. And I think it is our job to make sure that the infrastructure is in place. Chairman Lieberman. OK. Thank you all. Senator Carnahan, I think you were here first, if that is OK with Senator Carper. Senator Carnahan. Yes. Thank you. I have a question for Commissioner Massey. You said previously that you do not believe that FERC has met its responsibility to assure just and reasonable prices in the wholesale market. Given the experience in California, how might FERC reconsider its approach in the future to better reflect the current realities in the energy market? Mr. Massey. Senator, I have supported the movement to markets for electricity with one caveat, and that is it must benefit consumers. And so it seems to me that we have to ensure that the markets are structured in a way that they produce just and reasonable prices all of the time, and if they don't, we have to intervene. There are a number of things that we can do. First of all, we have granted market-based pricing to over 900 sellers using a screen that literally everyone passes. A market power screen that every seller passes is no screen. We may as well just issue a rule saying everyone passes. So I think we need to come up with a screen that is sensitive enough to actually measure market power in the marketplace and deny market-based pricing to those that have it. Second, we need to get very serious about market design. We need to ensure that the rules are in place in the market so that the market will produce just and reasonable prices in all hours. That is a big job in the California market right now. Perhaps the market should be redesigned to include an installed capacity market, a reserve requirement. We need to move dramatically away from over-reliance on the spot market. Progress has been made in that area. We need to do a lot of work to ensure that there is a robust demand response, in other words, consumers deciding not to consume electricity when the price gets too high. If we can achieve that goal, it will have a substantial price mitigating effect. And the markets need adequate supply. Our experience in California makes me wonder whether we should have markets where we know that the supply is inadequate. What should we do? What protections should we build in if we know it is a capacity- short market and that prices will soar? So those are my thoughts on it. Senator Carnahan. When you think of beefing up FERC's enforcement, I have heard from many that SEC might be able to serve as a model. The SEC closely monitors the market and it proactively investigates anything that seems unusual. Do you think that is a good idea? Mr. Massey. It is a good idea if Congress is willing to fund it. It seems to me that to be the tough cop on the beat, I have come to believe that we need more resources than we have and we probably need more people involved in effective market monitoring. We need to attract--we have excellent economists and investigators, but we need to attract more, it seems to me. Perhaps we should look at the SEC model, but I think the SEC devotes about half of its staff to investigations. It is a large percentage. I don't know what percentage ours is, but it is probably a small percentage of our staff. So I think we perhaps will need to retool, because whenever--despite our best efforts to structure good markets, there may be problems, there may be market power, there may be abuses, and we have to be willing to investigate those effectively and step in. Senator Carnahan. Thank you. My next question is for Mr. Hebert. In your prepared testimony, you listed numerous actions taken by FERC over the past several months, and I understand that you have taken those actions based on your best judgment of how to help. In your view, have the prices in the wholesale market in California been just and reasonable? Mr. Hebert. I think the mitigation plan that we put into effect April 26, that actually was effective as of May 29, and I believe the plan that we put into effect on Monday that will actually take effect tomorrow, is and will bring down prices to more reasonable levels. This Commission has spoken in its December 15 order to say, in fact, that we have found and believe rates to be unjust and unreasonable at certain times under certain conditions. That was my belief then. That continues to be my belief, and that is why we have taken the action we have taken, to bring reasonable prices to the consumers of California and the West while at the same time attracting investment in supply and infrastructure that will continue to bring them better opportunities and, therefore, lower prices in the future. Senator Carnahan. In the future, how do you feel FERC might play a more constructive role earlier in the process to better meet its statutory obligation to assure just and reasonable prices when additional States now are undertaking deregulation, such as my home State of Missouri? Mr. Hebert. I have said before, and I will say again, that FERC probably made a mistake--not probably, FERC did make a mistake in giving too much deference to the State of California in waiting too long to intervene and step in. We hate for government to intrude in any time that they don't need to, but clearly, we had a dysfunctional market. We needed to step in. We have done so now and I think the record will speak for itself that we are doing a good job of that. So many people want to look in the rear-view mirror and talk about what happened last year and the year before. I wasn't the umpire at that point, so I am not going to go there. But I will tell you, I believe that we are moving in the right direction. Things are going to be better. In saying that, I think it is only fair to say right now, since the Commission has been trying to move California away from its reliance on the spot market, and we are very proud of where they have moved. They have got around 20 percent-- Commissioner Breathitt had talked about that--in the spot market at this point. Whereas we do want to move them away from reliance on that spot market, when we talk about forward markets and them moving towards the forward markets, I want to be very clear that there are forward markets that are reasonable and there are forward markets that, quite frankly, are very risky. It is my thought and my belief that once you start getting outside of 5 years, if you get beyond that on signing contracts, I would tell you that those are very risky contracts, especially given the volatility of energy. Senator Carnahan. Thank you very much. Mr. Hebert. Thank you. Chairman Lieberman. Thanks, Senator Carnahan. Thanks for your interest in this subject. Senator Carper. Senator Carper. Thanks. I was here earlier today, and I don't know if you folks were in the audience then or not, but these hearings are broadcast on C-SPAN. Sometimes they show them at night and people might be seeing this around the country around 3 o'clock in the morning someplace. They are waking up from a little nap and say, what is this all about, FERC? I just think, a month or two ago, most people had probably never heard of FERC, and now you are getting to be a household word, almost like Lieberman. [Laughter.] Mr. Hebert. We preferred, or at least I preferred the secrecy of FERC. Senator Carper. Well, you are a secret no more. Mr. Hebert, you were saying that you became the chairman back in January but you served on FERC prior. How long? Mr. Hebert. Since 1997. Senator Carper. All right. And Ms. Breathitt, how long have you been there? Ms. Breathitt. I joined the Commission in November 1997. Senator Carper. All right. And Ms. Brownell, you are pretty new, aren't you? Ms. Brownell. A week that seems like a thousand years, Senator. [Laughter.] Senator Carper. You are a brave soul to take this on. Mr. Massey, how long have you been on this team? Mr. Massey. Eight years, Senator. Senator Carper. Eight years, wow. Mr. Wood. Mr. Wood. Two weeks. Senator Carper. Two weeks. OK. Let me just ask, for people that might be watching this around the country and are waking up in the middle of the night wondering what is this all about, could you just explain for them and for this late-arriving Member of the Committee--and I am going to ask our newest members to do this--just explain to folks who might be tuned in, what did you all actually agree to and announce on Monday of this week? Mr. Wood. What we agreed to do, Senator, was to take action, perhaps a little delayed action, but action nonetheless, to help repair a broken market out West. There is an electricity market that was deregulated through State initiatives in 1996, or 1995 time frame. That worked pretty well at the beginning, but it quit raining and the State depends for about 30 percent of its power supply on the hydroelectricity. There was no new investment in new gas-fired plants or other kind of plants to keep the infrastructure in place. That confluence of bad weather and lack of investment and a deregulated market meant that prices went up. The step that the Commission took this week was what it could do to help mitigate the economic impact of those events, but unfortunately, no step we could have taken or can take will make up for the fact that there are more megawatts being demanded than will be available to be used this summer. So we did not promise that it would be a panacea. I think, quite frankly, we want to make sure that we mitigate not only the price, but mitigate the expectations that things are going to be rosy this summer in the West Coast. They will not. There will be blackouts. But I think what we wanted to take a step on was to make sure that those blackouts, the insult of those wouldn't be accompanied by the injury of a very high and unjust bill for the power. Senator Carper. Thank you. Ms. Brownell, do you want to add or take away anything from that? Ms. Brownell. I would never take away from my colleague, only to add---- Senator Carper. Unlike us. [Laughter.] Ms. Brownell [continuing]. Just a little bit. And that is, I think that we laid out a road map. We took a number of steps. We laid out a road map that will give certainty to consumers, to the State of California, to the participants in the market there about what will happen through the next two summers so that we can begin to deal with the broader issues of a longer- term plan of how to site more generation, create market rules that actually work, and that will provide for just and reasonable rates in the long term. We took the surprise of the day out of the market so that people now know what is going to happen. I think the second thing we did was respond very positively to the stakeholders from California's issues and reached out to the State of California to work with them, because we all have a role to play and it is critical that we each do our part. So I think we could give you 25,000 details, but most importantly, we took a lot of steps and we now have a plan, a map, and some certainty, and that is important. Senator Carper. All right. Ms. Breathitt and Mr. Massey, if I could ask you two the next question, and that is how do you know if what you have agreed on unanimously to do, how will you know that it is working or not working? Ms. Breathitt. We have a several-week trial of this plan having worked in what we call emergency conditions, when the grid operator in California says reserves have diminished to 7 percent. Our plan kicked into effect in late May and we have evidence that that methodology worked. What we did was extend that methodology to all hours rather than just triggering when there was an emergency condition called by the grid operator. So we have some evidence that it worked the times that we were in an emergency, and we tweaked it slightly for the 24- hour condition to actually even limit more the market clearing price for the non-emergency hours. So we think that it will work. We have some evidence that it is working and what we did was extended the plan to all hours and we covered the rest of the Western States. So we now have it in 11 States. Senator Carper. Mr. Massey, do you want to answer? Mr. Massey. Senator, I think the answer to your question is we don't know for certain whether it will work or not so we have to pay attention and---- Senator Carper. What will tell you that it is working or not working? Mr. Massey. For me, the real question in whether it is going to provide substantial price relief is tied to the costs of the last generator to be dispatched. It could have been tighter than that, but we know the price won't be higher than that in the market. That last generator to be dispatched will probably be a natural gas-fired generator most of the time. About 95 percent of the dollars in the formula for determining the market clearing price under our order will depend upon the price of natural gas. That is it in a nutshell. If the price of natural gas remains reasonable, this plan will produce reasonable prices. If the price of natural gas skyrockets in California, the price for electricity will skyrocket. And so I think we still have a lot of work to do to ensure that prices for natural gas are just and reasonable, as well. Senator Carper. Mr. Chairman, I have one last question I would like to ask of Mr. Hebert, if I could do this as a follow-on. You have explained, and I think very nicely, what you agreed on and you have given us a pretty good notion of how you will know and maybe we will know if it is working. Let me just ask, when Governor Davis was here today, he described the unanimous step that you took, he described it as a step in the right direction. Let me just ask, and this I would ask of you, Mr. Chairman, if the kind of success you are looking for and hoping for doesn't occur, what would be an appropriate next step? Mr. Hebert. First, let me say that Governor Davis and I agree on that. It is a step in the right direction. What do we do from here? I think it depends on what we learn from here. My experience in government and regulation and energy markets, and I have been involved in legislating and regulating energy since 1988, my experience is it is important to listen and learn before you lead and I think that is what this agency has done. I believe we have done that wisely, responsibly, and in the best interests of the consumers by looking at not only short- term benefit of bringing down prices and making them reasonable, but at the same time focusing on supply and deliverability and making certain that we have got an infrastructure that will work and will, in the long term, bring better prices and more choices to the people of California and the West. What do we do beyond that? Some of it, as I have said, is outside of our control. We can't site one generating unit in California. The leaders in California can, and I believe and I hope that they are committed to that. We are going to look at this plan again on several opportunities. In the plan, we talk about looking to make certain that the generation that has been discussed and scheduled does come on-line in California, also that there is less and continued to be less reliance on the spot market. So we are going to continue to monitor these markets. We are evolving through that process. We have got additional people working on that right now, as I have said. I have taken the resources at our agency and moved them around and taken half of those 150 people who were doing nothing but litigating and got them now monitoring these markets. We are going to have the regional transmission organizations through Order 2000 monitoring markets along with us. I believe we will be successful. If we have learned anything in the meantime that says we made a mistake or says that we need to change something we did, we will, in fact, do that. Senator Carper. Good. Mr. Chairman, I wish I could have been here for the whole hearing. This has been quite a hearing and we are grateful to each of you for being here today and for your service. You come to your positions, a couple of you, in a very exciting time, and Mr. Massey, for 8 years. For you, no purgatory, straight to heaven. [Laughter.] Chairman Lieberman. That was not a power of the Committee that Senator Carper was talking about. That is individual authority. [Laughter.] Thanks, Senator Carper, for coming back, and for your thoughtful questions. I thank the members of FERC for very good testimony. This has been a long day, very interesting to me and an important day, and I think ultimately an encouraging day. I mean, we have a real problem that occurred in California. There are a lot of reasons for it. I have the impression that everybody is now trying their best to make it better, and by your own judgment, last December, the rates for electricity were and are unjust and unreasonable and it required action by yourselves and, of course, other kinds of actions by the State. Though occasionally, because these are important matters and we are all in politics, there gets to be an edge to the back and forth. These are not ultimately partisan matters. We may have different ideological points of view. We may have different jobs to do. We may have different authorities. But these are real problems that cry out for solution and I appreciate the efforts you made. The Committee is going to remain involved here. We think this is important. We would like to work with you. As I said, we not only are going to press you and ask you why you did this or why you did that, but sometimes we are going to ask you, what do you need to do th things we are asking you to do? And then, we will try to become your advocates. I do think, as Commissioner Wood said earlier, the fact is that the Commission is at a new chapter in its history. The very fact that you have two new commissioners and you are now up to full strength says that. But also, I believe that, and you are more expert at this than I, but from what I know of FERC, that this has been a--we tend to use the term ``defining moment'' too much in our Senatorial lives, but it seems to me this has been one of those defining moments in the life of this Commission and that what follows will be different. And we need you to be actively involved because of the obvious central effect that energy pricing (that you have some authority over) has on the lives of individual Americans, but also on the vitality of our economy. So I thank you very much for your service, for your patience today, for your outstanding testimony, and we look forward to seeing you again soon. The hearing is adjourned. [Whereupon, at 4:20 p.m., the Committee was adjourned.] THE IMPACT OF ELECTRIC INDUSTRY RESTRUCTURING ON SYSTEM RELIABILITY ---------- THURSDAY, JUNE 28, 2001 U.S. Senate, Committee on Governmental Affairs, Washington, DC. The Committee met, pursuant to notice, in room SD-342, Dirksen Senate Office Building, Hon. Joseph I. Lieberman, Chairman of the Committee, presiding. Present: Senators Lieberman and Thompson. OPENING STATEMENT OF CHAIRMAN LIEBERMAN Chairman Lieberman. Good morning, and welcome to our witnesses and our guests. We thank all of you for being here. Two votes are going to occur in the Senate at around 9:50, so we can probably at least go until about 10 o'clock before we have to break for a while and then return, for which I apologize. This morning, I am pleased to continue this Committee's examination of the Federal Government's response to the deregulation of the energy industry. This is the third hearing we have held on this issue in as many weeks. In our first two hearings, we focused on the problems of electricity deregulation in California and the West and the need for more vigorous oversight and intervention by the Federal Energy Regulatory Commission. Fortunately, last week, the Commission did step up its role in addressing the Western power crisis. This Committee will continue to keep watch on those efforts to determine whether they bring adequate price relief to besieged energy consumers. Today we turn to a related concern, and that is the reliability of the electric grid. The grid is our energy lifeline, a vast network of transmission lines that carry electricity from a myriad of energy producers, large and small, to the utilities and ultimately into our homes and businesses. It is a lifeline that we take for granted every time we switch on the lights, sit down at a computer or open the refrigerator. The national electric grid is vital to our lives and to our livelihoods, and it has been greatly affected by the deregulation of electric utilities. So today, we are going to ask who is operating the grid, and who is watching what is happening on the grid on behalf of electricity consumers, and who is it that keeps the lights on--or, as people in California no doubt have been asking, who is to blame when the lights go off. Not long ago, that was an easy question to answer. Local electric utilities ran the show top to bottom. They produced the power for homes and businesses in their service areas, made sure there was enough of it, and saw to it that the electricity ran in the proper voltages and frequencies to be transported and used safely. Local utilities built and ran the transmission lines to get power from their plants to their customers, and they built interconnecting lines to neighboring utilities that allowed for modest trading in times of shortage. That diagram is roughly meant to show how neat things were before deregulation.\1\ --------------------------------------------------------------------------- \1\ Chart entitled ``Bundled,'' appears in the Appendix on page 819. --------------------------------------------------------------------------- But the deregulation of electricity markets has scrambled this picture.\2\ Utilities no longer make the power they sell to retail consumers. Instead, electricity generators compete on the market to sell to utilities and sometimes even directly to retail customers. --------------------------------------------------------------------------- \2\ Chart entitled ``A Fully Unbundled Electric Industry Model,'' appears in the Appendix on page 820. --------------------------------------------------------------------------- Nor do local utilities anymore always control the interstate transmission lines. In several regions of the country, independent system operators, known as ISOs, act as electricity traffic cops, routing power from sellers to buyers. That means that the ISOs are responsible for keeping the system up and running. So what was once a relatively sleepy, largely local network has been transformed into a fast-moving and extremely congested national electricity delivery superhighway. While deregulation obviously offers potential economic benefits, the new arrangements it has brought to the national electricity grid also pose some risks to the reliability of the grid. In fact, a Department of Energy task force concluded in 1998 that the current configuration, devised in an age of far less usage of the transmission grid and far more regulation of the utility industry, is clearly ``unsustainable in the newly decentralized and competitive electricity industry.'' In fact, problems have already occurred. A November 2000 Staff Report by FERC describes a disturbing incident in July 1999 when power was tight and prices were high. As I understand it, engineers monitoring the Midwest electricity grid noticed something unusual and troubling. Some of the electricity that should have been in the system just was not there. What happened? According to a later FERC report, Cinergy, a large Midwestern utility, just took power off the grid, which apparently it had no right to, in order to supply its own customers rather than disconnecting them or buying the extra power it needed, which would have been at significantly higher prices. Another account of the incident which appeared in the Wall Street Journal notes that the utility put power back into the system later, but only after demand and prices had dropped. The utility was never punished for this behavior because the system has historically depended on voluntary industry standards rather than a regime of Federal regulation and enforcement. Grid reliability has also been an issue in California, where the grid is managed not by the local utilities but again, by one of the new independent system operators. To fulfill its responsibility to keep the lights on in the spring of last year, the California independent system operator contracted to buy extra power in times of shortage from what is known in the industry as an RMR, ``reliability must run'' unit. But as an April 2001 FERC Order describes it, when the California ISO needed the backup supply last spring, some of these power plants did not cooperate. In other words, the ``reliability must run'' units were not reliable and did not run. According to the FERC Order, to keep the lights on, the ISO was forced to scramble to fill demand on the spot market, obviously at much higher prices. FERC subsequently investigated that case and approved a settlement, with generators paying for the $8 million difference in price. Although FERC has jurisdiction over the interstate transmission system under the Federal Power Act, it has not historically regulated reliability. Instead, FERC has deferred this responsibility to regional voluntary Electric Reliability Councils, which include all of the electric systems in the continental United States, Canada, and part of Mexico. Industry has relied upon the voluntary standards set by these councils through their governing body, the North American Electric Reliability Council, or NERC. With the changing structure of the electric industry, however, we now need to ask whether the Federal Government should play a more active role in maintaining and policing the national electricity grid. Indeed, Congress has actively considered amending the Federal Power Act to require FERC to establish reliability standards and a system for enforcement, although no such proposal has yet been enacted. That is the issue that we are going to explore today. Some of the questions that I would like to ask include: Does the shift from heavily-regulated utility systems to deregulated competitive markets threaten reliability of the grid? If so, does FERC have adequate statutory and regulatory authority to protect the public interest in a reliable electricity transmission grid? And what is the proper division of responsibility between Federal and State regulators concerning electricity reliability overall? I look forward to hearing our witnesses answer these and other questions, and I thank them very much for joining us this morning. Senator Thompson. OPENING STATEMENT OF SENATOR THOMPSON Senator Thompson. Thank you very much, Mr. Chairman. Our topic today is less controversial than the two energy hearings that we held previously, but this one is important. We have seen demand for electricity grow across the country, and we are watching as new generation is being built to try to keep pace. What may be lagging behind, however, as you point out, is the new transmission and proper enforcement of standards to maintain the reliability of our grids. Prior to restructuring, integrated utilities were responsible for generating, transmitting, and delivering electricity from the power plant to the consumer. The reliability standards in place have been voluntary, established by the North American Electric Reliability Council, and when there is a violation, there is no penalty, even if the violation threatens the integrity of the grid, possibly resulting in blackouts. In recent years, we have seen dramatic change take place. The electric power industry is dividing itself into different components. As a result, there is no single entity that is responsible for overall reliability. We have seen over the years instances, some of them serious, of individual actions that have adversely affected reliability. So, as the electric power industry restructures, we need someone made responsible for ensuring reliability and someone who has enforcement authority. We should note that the problem is not simply one of enforcement but also of investment. A greater demand on long- distance sales will require more transmission. I am pleased that the President recognizes this fact and included in his National Energy Policy Report the need to streamline the siting process to allow for construction of more lines. While the country moves down the road toward restructuring and competition, it is important not to leave any key component of our electricity system behind. The good news is that we as a Senate have addressed this issue. The Energy Committee has held hearings on this topic, including one last month; I believe Mr. Cook testified at that hearing. In addition, in the last Congress, the Senate passed by unanimous consent a bill to establish an organization to set reliability standards and to take disciplinary actions when those standards are violated. That legislation did not pass the House, but it has been reintroduced this year. Earlier this year, Senator Lott had planned to have an energy bill ready for the President's signature by July 4. Unfortunately, despite the urgency and need we have seen for some action, it does not appear that there will be discussions about the timing of such a bill until after the July 4th recess. Perhaps at that point we will address the energy issues which are becoming more and more critical every day and which are the focus of your well-timed hearings, Mr. Chairman. They of course will include the issue of the reliability of our system. Mr. Chairman, I want to apologize in advance. As you know, we have the patient bill of rights on the floor, and my amendment is up as we speak, so I am going to have to break away. It has to do with exhaustion of administrative remedies; it is very exciting, and I am sure that you will want to be a part of that as soon as the hearing is concluded. Chairman Lieberman. And I am going to try not to be exhausted by it. Thanks, Senator Thompson, for coming by. I appreciate it very much. Let us begin with David Cook, who is General Counsel of the North American Electric Reliability Council, to which Senator Thompson and I both referred. This is one of those hearings for which preparation educated me greatly, and I think the hearing will continue that process. Mr. Cook, please. TESTIMONY OF DAVID N. COOK,\1\ GENERAL COUNSEL, NORTH AMERICAN ELECTRIC RELIABILITY COUNCIL Mr. Cook. Thank you, Mr. Chairman and Senator Thompson. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Cook with attachments appears in the Appendix on page 509. --------------------------------------------------------------------------- NERC welcomes the Committee's attention to the critically important issue of the reliability of the bulk electric system. As you indicated, NERC is a not-for-profit organization formed after the Northeast blackout in 1965 to promote the reliability of the interconnected bulk electric systems. NERC comprises of 10 Regional Reliability Councils that account for virtually all of the electricity that is supplied in the United States, Canada, and a portion of Baja California Norte, Mexico. For more than 30 years the industry has followed a system of voluntary reliability standards. Those standards have worked very well, and we have had an extremely reliable electric system. As you indicated, the reliability standards have no enforcement mechanism. Peer pressure has been the only means available for achieving that compliance. As good as that system has been, the voluntary system will not serve us well for the future as the electric industry restructures. Here is why. The grid is now being used in ways for which it was not designed. There has been a quantum leap in the number of hourly transactions and in the complexity of those transactions on the grid. Transmission providers and other industry participants who formerly cooperated willingly are now competitors. Rate mechanisms which in the past permitted utilities to recover the costs of operating systems reliably are no longer in place or are inadequate given the increased risks and uncertainties they face. The single, vertically-integrated utility that formerly performed all reliability functions for an area is being disaggregated, meaning that reliability responsibilities are being divided among many participants. Some entities appear to be deriving economic benefit from bending or violating the reliability rules. Construction of additional transmission capacity has not kept pace with either the growth in demand or the construction of new generating capacity, meaning that the existing grid is being used much more aggressively. The result of all this is that the transmission grid is being increasingly stressed, and that stress shows up in two ways. NERC is seeing more congestion on the grid for more hours of the day, and NERC is seeing increased violations of its reliability rules. Not changing the way we deal with the reliability side of the business as the electric industry restructures would be like an airline switching to jet airplanes without increasing the length of the runways. Not having everyone follow a common set of rules for how the interconnected international system is operated would be like allowing individual airlines to choose their own routes and altitudes at which they fly. NERC and a broad coalition of State, consumer and industry representatives have developed and are actively pursuing consensus legislation to convert the voluntary reliability guidelines into mandatory and enforceable rules. The goal of that legislation is to set mandatory and enforceable rules for all operators and users of the international interconnected bulk power system in North America. It would be fairly developed and fairly applied by an independent industry self-regulatory organization with oversight in the United States by FERC and similar oversight by governmental authorities in Canada. It would have respect for the international character of the interconnected transmission system, and regional entities would have a significant role in implementing and enforcing compliance with those common reliability standards. Because of FERC's limited jurisdiction and authority, because of the international character of the North American grid, and because of the technical expertise required to develop and oversee compliance with bulk power system reliability standards, this is not a job that can simply be given to FERC. Nor can we simply have regional organizations set and enforce their own rules in their own way. Having an independent international industry self-regulatory organization develop and enforce reliability rules under government oversight recognizes the interconnected and international nature of the bulk electric systems, takes advantage of the huge pool of technical expertise that the industry currently brings to bear on the subject. That combination of industry technical expertise to work on the substantive reliability rules and government oversight, FERC and the United States, provincial regulators in Canada, to assure fairness in due process, is an effective and efficient way to address these issues. As you indicated, the Senate passed a version of the NERC- supported reliability legislation last year. The bill died in the House. That legislation is before the Senate again this year, both in Senator Bingaman's bill, S. 597, and Senator Murkowski's bill, S. 389. Your letter inviting NERC to testify specifically asked us to address the issues of the role of independent system operators and regional transmission organizations in maintaining reliability as well as the role of State commissions. In the pending legislation, ISOs and RTOs are defined as system operators. As such, they must comply with the reliability rules established by the independent SRO. I would add that having the potential for RTO development is important. It is a positive development in being able to address reliability issues, because I think it will enable us to deal effectively with some of the issues that we are facing. If those RTOs develop all across the country, with the full scope and authority that FERC has envisioned for them, it will greatly facilitate dealing with some of the issues we face. Nevertheless, since the actions of any one system operator can affect the result of the interconnected transmission grid, RTOs will still need to follow a common set of reliability rules independently established and administered by an international self-regulatory organization. NERC commends the Committee for focusing on this critical issue of assuring the continued reliability of the interconnected bulk power system as the industry undergoes restructuring. Legislation now pending would allow for timely creation and FERC oversight in the United States of that needed industry SRO. The reliability of North America's interconnected transmission grid need not be compromised by changes taking place in the industry provided that reliability legislation is enacted promptly. Thank you, Mr. Chairman. Chairman Lieberman. Thank you, Mr. Cook. That was very helpful and interesting testimony about the impact of deregulation on the grid, and I suppose I should say that it is not every day that we have a representative from industry coming to Congress, asking for regulation. So it is a measure of the new landscape in which you are operating. Thanks. Chairman Lieberman. Mr. Harris, welcome. TESTIMONY OF PHILLIP G. HARRIS,\1\ PRESIDENT AND CEO, PJM INTERCONNECTION, L.L.C Mr. Harris. Thank you, Mr. Chairman. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Harris appears in the Appendix on page 526. --------------------------------------------------------------------------- I have prepared testimony that I would like to submit for the record if I may. Chairman Lieberman. Without objection, your testimony will be entered in the record. I have gone over the testimony that each of you have submitted, and I appreciate it very much. It is very thoughtful and very helpful to the Committee, and all testimony will be entered into the record of this proceeding. Mr. Harris. Thank you, Mr. Chairman. As you know, the critical test of any law or economic concept is the test of use. I come to you today from the Mid- Atlantic region where, for 4 years, we have been operating the world's most successful competitive wholesale energy marketplace. We have over 200 buyers and sellers and traders in our marketplace, and we have an arrangement with five States and the District of Columbia wherein the States are active in the participation of this market development. We have an arrangement where the environmental groups are active and participate in our marketplace and have meaningful input into the rules and practice and procedures that we follow in the Mid-Atlantic region. We also have active participation by all of those who have an effective interest in our planning. We have a total regional planning protocol. As a matter of fact, we are the only region in the Nation that has a regional protocol. That has resulted in over 40,000 megawatts of generation being planned. Currently in the Mid-Atlantic region today, we have nearly 7,000 megawatts of generation under construction. Additionally, we have over $700 million of transmission under construction to support that generation, so that over the next 10 years, we believe that we will not have a reliability problem. We have many buyers and sellers and traders in our marketplace. What we have seen over 4 years of rolling up our shirtsleeves and actually doing it is that reliability has increased in the Mid-Atlantic region and that competition has worked. Mr. Chairman, we have had over 70 different countries visit our area to ask questions about why is it working here and what are some of the root elements that we are engaging in, what are some of the presumptions that we made several years ago that have born fruit today. It is from that perspective that we would like to share some thoughts with you today. I think the first and most important thing that this Committee should do for the Federal Energy Regulatory Commission is ensure that it keeps its focus. The second thing is to ensure that the Federal Energy Regulatory Commission achieves ``end'' solutions. As the Chairman mentioned, there are many needs that are important. You must meet the environmental needs. You must meet the State needs. You must meet the local needs. Having ``end'' solutions that achieve reliability and competition is what it is all about, ultimately. The third thing is to ensure that the Federal Energy Regulatory Commission promotes a national energy marketplace. If I may, I would like to talk about each one of these. First, ensure that the Federal Energy Regulatory Commission keeps its focus. The Energy Policy Act which was promulgated in Federal Energy Regulatory Commission Order 888 and FERC Order 2000 had one purpose, and that was to ensure that customers have the benefit of competitively-priced electricity. If we lose sight of the fact that the customers are the ones who are supposed to benefit from this change in the energy marketplace, we lose sight of the objectives of the Energy Policy Act that this Congress established and what it is all about. We must ensure that we have the appropriate form over function. FERC Order 2000 delineates certain functions that are necessary to ensure that the customers will have the benefit of competitive price generation, and ensuring that the Federal Energy Regulatory Commission is true to those functions--that they do not ``dummy them down,'' that they insist on regional planning protocols, for example, so we can coordinate among regions to ensure that there is sufficient generation for reliability and ensure that the differences between regions are adequately addressed is absolutely imperative, and FERC should have that authority. Second, ensure that FERC truly achieves ``end'' solutions. As the Chairman has mentioned, electricity touches the very fabric of our lives. We know that price is important, and it is important that pricing be done appropriately. Electricity is a speed-of-light ecological system. It is the only product in the world that, at the very instant someone wants to consume it, it is produced. You turn on the light switch, and nominally, you are controlling a nuclear plant. That process goes far beyond just the bulk system. It affects the distribution system, which the States are responsible for; it affects local delivery to the home, because it is an instantaneous, speed-of-light product. In truth, there really are no pure reliability/economic principles. They all overlap and are intertwined. What we are seeing today with the wonderful network information technologies which PJM has employed quite successfully to enable these competitive marketplaces through technology is that these things are blending and merging. So it is very difficult to say this is reliability, and this is not. We would recommend that this Committee ensure that the Federal Energy Regulatory Commission assert its authority over all the things to achieve these ``end'' solutions. Third, we think that you have to have national energy marketplaces. We have seen competition work, but the electricity grid is like a giant synchronous motor. The Eastern connection is 650,000 megawatts; there is not another motor like that in the world. The West is a 125,000-megawatt motor. It needs to work well together, and the Federal Energy Regulatory Commission should take the lead in ensuring that we have a true national marketplace that can meet the focus of the Energy Policy Act, and that is to ensure that customers have the benefit of competitively priced generation. Thank you, Mr. Chairman. Chairman Lieberman. Thanks very much, Mr. Harris. That was excellent testimony. We will recess briefly now so that I can go over and vote, and then I will come back. The Committee stands in recess. [Recess.] Chairman Lieberman. The hearing is reconvened. I apologize to the witnesses and others here. We ended up having two votes on the Senate floor; hopefully, there will now be a reprieve from floor action for a while. Mr. Harris, thank you for your testimony. We will go on now to Kevin Kelly, who is the Director of Policy Innovation and Communication at FERC. Thank you, Mr. Kelly, for being here. TESTIMONY OF KEVIN A. KELLY,\1\ DIRECTOR, DIVISION OF POLICY INNOVATION AND COMMUNICATION, FEDERAL ENERGY REGULATORY COMMISSION Mr. Kelly. Good morning, Chairman Lieberman. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Kelly appears in the Appendix on page 533. --------------------------------------------------------------------------- My name is Kevin Kelly, and I am Director of the Division of Policy Innovation and Communication within the Federal Energy Regulatory Commission's Office of Markets, Tariffs, and Rates. I am appearing here today as a Commission staff witness, and I do not speak for the Commission itself or for any individual commissioner. Thank you for the opportunity to speak on how the reliability of electric service is being affected by the industry's restructuring and the Commission's role in ensuring the reliability of electric service. The Commission's fundamental role in the electric utility industry is to regulate public utilities with respect to the sale of electric energy at wholesale in interstate commerce and the transmission of electric energy in interstate commerce. In short, the Commission serves as an economic regulator. Since the electric power industry began, reliability has been primarily the responsibility of the customer's local utility as overseen by State and local regulators. Increasingly, electricity trading over large regions leaves many matters affecting reliability outside the exclusive control of the local utility. So it is more important than ever to have reliability rules that everyone follows. But the Commission has no statutory authority to promulgate and enforce mandatory reliability rules. One approach to ensuring reliability is to enact Federal legislation. In May, the administration released its National Energy Policy Report, calling on the Secretary of Energy to work with FERC to improve the reliability of the interstate transmission system and to develop legislation providing for its enforcement by a reliability organization, subject to Commission oversight. I believe that a legislative approach is preferable to another approach that some have been trying in the absence of legislation, that is, to ensure reliability through contractual commitments. Congress should understand, however, that mandatory transmission reliability rules alone are not enough to ensure reliable electric service. Senator Lieberman, you asked who is watching the grid. We believe it should be RTOs, and partly for reliability reasons, the FERC has strongly encouraged the formation of Regional Transmission Organizations. These RTOs would eliminate many of the reliability problems caused by the highly Balkanized way in which the interstate transmission grid is now operated. In adopting its RTO rule, called FERC's Order 2000, in December 1999, the Commission set out at length the need for an RTO in each region to ensure reliability. The needs include coordinated operation and maintenance of interconnected transmission systems, improved determination of transmission system throughput capability, and unified regional planning of necessary grid additions. The Commission required in particular that a RTO must have the authority to ensure the short-term reliability of the regional grid and also must be responsible for planning and arranging necessary transmission expansions and additions that will enable it to provide efficient and reliable transmission service. But reliability requires more. It also requires adequate generating resources. A current issue, for example, is whether those who sell power to retail customers all over the country must maintain a specified level of generating reserves. Reliability also requires that generation support transmission in certain ways, and the Commission required in its ``open access rule'' of 1996, called Order 888, that all public utility transmission owners must offer generation-related ancillary services to their transmission customers, including the provision of minimum levels of generating reserves. Senator Thompson pointed out in his opening remarks that to further ensure reliability, we also need to find ways to encourage the construction of new transmission facilities. Market and regulatory rules must be designed to elicit sufficient investment in new transmission. For example, to provide transmission owners with an incentive to meet the needs of transmission users, the Commission could adopt performance- based rates reflecting the reliability of a transmission owner's system. The Commission already had authority to adopt such rates under the Federal Power Act. In closing, restructuring of the electric power industry makes it necessary to consider new means of ensuring the reliability of electric service. The Commission has only limited authority to address reliability, and the need for new approaches is clear. Federal transmission reliability legislation is one such approach but alone is not sufficient. The Nation must also develop regional transmission organizations for reliable grid operation and must develop its transmission and generation infrastructure. Again, thank you for inviting me to testify this morning. Chairman Lieberman. Thanks, Mr. Kelly. That was very thoughtful and very helpful. Mr. Popowsky--how did you get the name ``Sonny''? TESTIMONY OF IRWIN ``SONNY'' A. POPOWSKY,\1\ PENNSYLVANIA CONSUMER ADVOCATE, ON BEHALF OF THE NATIONAL ASSOCIATION OF STATE UTILITY CONSUMER ADVOCATES (NASUCA) Mr. Popowsky. I think it is because the first two children born to my parents were both daughters, and my father was determined that the next child would be a son and was determined to call me ``Sonny'' regardless. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Popowsky appears in the Appendix on page 545. --------------------------------------------------------------------------- Chairman Lieberman. That is a good reason. Mr. Popowsky. The other reason it stuck is because my real name is ``Irwin'' and that speaks for itself. [Laughter.] Chairman Lieberman. Understood. Well, ``Sonny'' seems like a good name to have for someone in your line of work. Thanks for being here. Mr. Popowsky. Thank you, Chairman Lieberman. I am the Consumer Advocate of Pennsylvania. I am also past President of the National Association of State Utility Consumer Advocates, or NASUCA. From 1997 until earlier this year, I also served as the representative of small utility consumers on the board of trustees of the North American Electric Reliability Council. I am testifying today on behalf of NASUCA. NASUCA is an organization comprised of offices from 40 States and the District of Columbia, charged by our respective State laws to represent utility consumers before Federal and State regulatory commissions and the courts. Our members' primary interest is the protection of residential and other small utility consumers. In your letter of invitation, you asked NASUCA to address ``the challenges to electric system reliability resulting from the restructuring of the electric industry and its increasing reliance on competitive markets.'' In my opinion, there is no more important issue facing the electric industry and its consumers today. There remains great disagreement across the Nation regarding the relative costs and benefits of electric restructuring, but I believe there is little disagreement that if the road to restructuring leads us down the path of severely deteriorated reliability, then we will have accomplished little as a Nation and will indeed have set ourselves back, both economically and in terms of basic human welfare. Today, I would like to discuss the role of the States, the NERC, the FERC, and the Regional Transmission Organizations in ensuring that the American public will continue to receive reliable electric service. In my view, each State must continue to play an important role in ensuring reliability for its consumers. In practice, most day-to-day outages and reliability problems that affect retail consumers occur on the local distribution system, which has been and remains under State jurisdiction. States have long experience addressing these issues, and Federal involvement here would be duplicative and less effective than the current State efforts. Nevertheless, it is obvious that electric reliability problems can affect more than one State. Indeed, NERC itself was formed in response to the blackout of 1965 that cascaded across the Northeast with no respect for State boundaries. In my opinion, NERC and its member Regional Reliability Councils have done an outstanding job of developing standards and tools to operate an extremely reliable electric network. But as you have already heard, NERC is a voluntary organization that has traditionally had no ability to enforce its rules through anything more than peer pressure. To its credit, I believe that NERC has done almost everything that it can do, first, to open its doors to organizations like NASUCA that are outside the traditional utility industry, and more recently, to establish a fully independent board of trustees. NERC and some of its regional councils have also attempted to develop contractual enforcement mechanisms to put more force behind their rules and standards. But NASUCA agrees with NERC that more is needed, and we fully support the legislation that would establish a self- regulatory industry organization that would continue to develop reliability standards but whose standards would be fully enforceable and ultimately subject to the review of the FERC. I believe this proposal is essential in a world of increased competition. The players in this game can no longer also serve as the referees, and the referees must be able to do more than just issue warnings to the players who violate the rules. What else can FERC do? I hope that FERC will turn its attention as soon as possible to completing the task of establishing a set of Regional Transmission Organizations across the United States. These organizations will play a vital role in the reliable operation and planning of the electric network. These RTOs in turn must coordinate their activities closely with their respective Regional Reliability Organizations and with any new national reliability organization. Ultimately, every reliability standard will have effects on the economics of many transactions, and any economic transaction could have an effect on reliability. RTOs and reliability organizations must work together on wholesale bulk power issues, but ultimately, they must both answer to a single entity, which I believe for interstate purposes must be FERC. I would like to close with a personal observation if I may about the electric restructuring experiences in California and my own experience in Pennsylvania. Viewing the California situation from 3,000 miles away, I would have to say that even if wholesale prices had not spiked to absurd levels, and even if major utilities had not been thrown into financial disarray, the reliability impacts alone of the recent electricity crisis in California were totally unacceptable. I never thought I would see the day when such a large segment of the American public could not be confident that their lights would stay on from 1 day to the next. A few years ago, some people questioned whether there would be adequate generation supplies at reasonable prices in a restructured electric industry, but they were assured that ``the market would provide.'' Well, the market did not provide in California. The question our Nation must face is whether the past year's failure of the California market was the result of a ``perfect storm'' of events in which everything that could go wrong, including the weather, did go wrong or whether California was the ``canary in the mine shaft,'' giving the rest of the Nation a warning that we should turn back from this path as soon as possible. In contrast, when I look in Pennsylvania at the current PJM market, I generally see reliable service, supply keeping up with demand, and prices that, at least most hours of the year, are close to what one would expect in a competitive market. The PJM market still has several flaws and is far from perfect, but at least the staff and independent board of PJM, as well as many PJM members, recognize these flaws and are taking steps to try to remedy them. In closing, I am hopeful that our experience in PJM to date will turn out to be closer to the rule and that the recent California experience will turn out to be the exception. But I think we first need to ensure that entities such as the newly reconstituted North American reliability organization, the FERC, and the hopefully independent RTOs will have the tools to create enforceable reliability rules and market structures where the benefits of competition can be secured for all Americans in a reliable and economic manner. Thank you. Chairman Lieberman. Thanks, Mr. Popowsky, for your very interesting testimony. Let me begin my questions by following up on the questions that you raised at the end of your testimony. They join the first two hearings, that we held on the California crisis, to this hearing. How do you--and you have had some experience in this-- answer the questions that you raised? In other words, how do you explain why reliability of electricity has become in doubt for this summer; and even though the prices are now, fortunately, moderating, there is still concern about blackouts. How do you explain why it happened? Mr. Popowsky. It is easier for me to try to explain why it has not happened in PJM, so if I could start with that, I think that if you have rational market rules where people can come in and build power plants and know they can be interconnected to the system in a rational manner and that they will participate in a market that actually works, you do not need ridiculously high prices in order to get people to build power plants and have the supply meet demand. I think again, from afar, in California, it appears that for whatever reasons, generators whom one would think should have been flocking to California to build needed generation did not do so, and there was a fundamental mismatch of supply and demand. As I said, I do not see that happening in PJM, but I think you have to have the market structure and the rules in place, and they have to be understood in order for the market to have any chance of working. Chairman Lieberman. So if a big part of the problem was simply that the industry was not building new generating facilities, looking back at it, who should have done what to avoid the crisis that has occurred in California? That is a big question, but I am curious whether you see that there was a role for the government here. This part of reliability is the adequacy of supply, really, and what is coming onto the grid, if I hear you correctly, as opposed to whether the grid can handle it and whether it is being policed adequately. Mr. Popowsky. Yes, I think that that is right, and that is why I raised the question, which is in theory, the market should provide the incentives to build the adequate generation. In PJM, the theory gets a little thumb on the scale. If you would agree, Mr. Harris--there is a requirement in PJM that the parties which are called ``load-serving entities,'' the parties or companies that serve load, have to have enough generation to serve their load plus a reserve margin in terms of capacity that they must have in addition to what they think they might need in their peak hour. So there is actually a requirement within PJM that requires participants in the market to have additional capacity over and above what they think they will need. Chairman Lieberman. Who sets that requirement? What is its origin? Mr. Popowsky. I believe it is set by PJM in cooperation with the Regional Reliability Council, the Mid-Atlantic reliability council. Chairman Lieberman. Mr. Harris. Mr. Harris. I have just a couple things to add to Sonny's comments. I think we get back to some very elemental things here. In the Mid-Atlantic region, the questions you are asking were considered so important that we insisted that we had to have a regional planning protocol before we began commercial operations in our competitive marketplace. We spent the years 1994 to 1996 negotiating with five States and the District of Columbia, consumer advocate groups-- Sonny's group participated--and environmentalists to come up with a regional planning protocol. So we are the only area that has a regional planning protocol in place before we begin competitive marketplaces. This is absolutely crucial to ensure that you will have capacity to meet demand. Chairman Lieberman. Was that one pursuant to some governmental authority or requirement, or was it just done voluntarily within the industry? Mr. Harris. No, sir. To credit the political and other leadership in the Mid-Atlantic region, the States, they determined that this was such a crucial point that they wanted to have this in place. It took us 2 years to negotiate the protocol so that all five States and the District of Columbia, consumer advocates, environmentalists and others joined in this process. We filed that to begin operation as an independent system operator. The second thing is a point which you made, that prices are important, and it is important to get prices right. So we developed a system that would make public transparent spot prices. We publish prices, every 5 minutes, on the electrical grid, and everyone can see the price, and transparent spot prices enable you to have appropriate competitive behaviors and enable people to determine when and if they want to build generation. Chairman Lieberman. Just talk a little more about that. That is very interesting. So that every 5 minutes, you are publishing the prices in that period of time from the various sources of electricity coming onto the grid. Mr. Harris. That is correct. And if you want it, we can give it to you every few seconds. As a matter of fact, information transparency is so important to having a competitive energy marketplace that we have created a program which we call ``E-data,'' and your staff and yourself can get on that program, and you can see these prices. Any individual can see what the prices are at any point in time, and then you can make your decisions based on that price transparency. Chairman Lieberman. Do people actually buy--what is the smallest unit of time that you can buy? In other words, how quickly can you change your purchases? Mr. Harris. You can change with 30 minutes' notice, actually. We have hundreds of traders in any given hour. On hot days where the system is getting tighter, we have actually had 400 to 500 changes an hour in the marketplace. So another thing you need to have in your market is many buyers and sellers, which gets you back to the importance of having regional solutions when you move forward. Chairman Lieberman. Let me step back a little bit and go back to what the problem is and see if you can illustrate it before we get to some of the solutions. As I hear you, and understand from what I have read and studied, part of the problem, or a big part of it, is the significant transition we have made to deregulated electricity markets, and the fact that the electricity grid, which was largely local or regional in the old model of a particular local utility building a power plant, arranging for the lines to get to its customers, creating some backup possibility where it connected a transmission line to neighboring utilities--now you have a very active deregulated market in which every 5 minutes, even every couple of seconds if you want, buying and selling is occurring over this grid, which was for the most part not built for this kind of traffic, so there are both congestion and reliability problems. I cited two examples that we found as we were going over this. One was the Cinergy case, where they basically took some power which they were not entitled to; and the second was the California case where the backup units did not fulfill their obligation to come on in time of need. I would just like to ask all four of you if there are other examples that you have of the problems which have come with the transition we have made to deregulated markets, just as a way of illustrating what we are dealing with here. Mr. Cook. Mr. Cook. Another kind of situation--I think the congestion issue that you mentioned, with the limits on how much power we can transfer from one part of the country to another, is a very critical one. Chairman Lieberman. And of course, once that happens, it then goes to the very heart of deregulation, because it limits competition. Mr. Cook. It can limit competition. It means that power cannot move into an area that might be less expensive, so people need to resort to more expensive generation, and in some instances, transactions need to be curtailed, because there simply is not enough ability to serve that load. That is one of the things that we are seeing, and it gives rise to the need that we have talked about to have a more robust transmission system. Chairman Lieberman. Mr. Harris. Mr. Harris. Thank you, Mr. Chairman. First of all, the two problems that you elucidated could not have happened in the Mid-Atlantic region simply because we are administered by an independent entity that has no financial interest in the marketplace. We have 10 different transmission- owning companies and hundreds of traders, and it is independently administered so it would not have occurred. Chairman Lieberman. Take those two cases and tell us how your region would have prevented them from occurring, or why they would not have happened. Mr. Harris. It would not have happened because the operation of the power grid is done by an independent entity that has no financial interest in the marketplace. We have many companies. Cinergy was one company, vertically integrated, with everything under its control. We operate and direct the operations of the power grid neutrally and independently from all market participants. Chairman Lieberman. So what would happen in the case where Cinergy took the power off the grid that it was not entitled to? Mr. Harris. Well, again, it would not have happened in our area. We saw the power change, because the frequency dropped, because there was not enough generation to serve load, and we were asking questions about who was not playing by the rules. That is how it came about. Chairman Lieberman. OK. Mr. Harris. Two things that I think are problematic and symptomatic that this Committee could certainly look into are, first, the fact that electricity does get consumed the instant it is produced. It does not say this is only wholesale. It does not say it is only retail. It does not say it is just in this State. It travels at the speed of light. So the solutions that FERC needs to have need to be ``end'' umbrella solutions where you look at the whole thing. As Sonny was saying, things are not pure--pure reliability or pure economics--they blend. So it is extremely important to have a holistic view of the problem. The second thing is in the way that institutions are getting approved. We have institutions now that have spot market authority. There are certain RTOs that do not administer spot markets, and that creates difficulties, as you saw. We need to come to the national energy market with common designs so that we can solve these problems much more quickly and robustly as we move forward. There are other things coming out--the gas industry recently proposed an energy industry standards board. Some of the things that they proposed are interesting. They recognize that there is a nexus between natural gas and electricity, and there must be ways to resolve those issues as we move to the future. So we are learning, and the process we have followed, we call ``little steps, little feet.'' It is very complicated. We take little steps. We learn, pilot, take the next step, learn, and increment our way to the future. Chairman Lieberman. Thanks. Mr. Kelly, do you have any examples of reliability problems on the grid that might help illustrate the problem that we are trying to solve? Mr. Kelly. There are many, but let me give you two--one, illustrating difficulties with incentives to build generation, and one with difficulties in incentives to build transmission. You were asking Mr. Popowsky about California earlier. One thing that is rarely mentioned that I think is very important is that the West Coast is heavily dependent on hydro power. You have the Cascade Mountains down through Washington and Oregon, and the Sierra Nevadas through California; and starting around the time of World War I, they started developing the hydro resources there heavily. I think California is about 30 percent dependent on hydro. They had unusually heavy rainfalls in 1998 and 1999, that created a surplus of electric energy in the West, which created a disincentive for people to come in and build generation right away. And then, they had 2 years of drought. It is my personal belief that with or without deregulation in California, the West would have been stressed over the last 2 years. With the old world of regulation, however, there were reserve margin requirements, as Mr. Harris has talked about. The California market design chose not to have such a requirement, at least of the old sort. It was not built into their system as it is built into the East Coast systems. The FERC asked the California ISO and the California parties last November to consider having such a requirement. It is my personal belief that a reserve requirement of some sort is needed to incent generation construction in a market environment and to prevent the cyclical boom and bust of inadequate and surplus generation that can cause price swings. Let me turn to a transmission story. We are seeing a lot of gas-fired generation being sited along the Gulf Coast right now in Mississippi, Louisiana, and Texas, probably much more than can be consumed in the area. Many of those generators, I am told, intend to sell up in the Upper Midwest, Chicago, and States to the east and west of that. There really is just not enough transmission capacity to move the power up there, and it is not being built, in part because many of the traditional utilities that own generation and transmission, I think, see themselves getting out of the transmission business--they would rather put their money into generation--but in part because there are old, antiquated grid rules that make things difficult. Just for example, somebody who wants to move power from, say, Louisiana up to Chicago is likely to look at a path going through Tennessee and find that there is no capacity available. So it will look for an alternate path and find one that exists on paper that goes up through Arkansas and Missouri and gets into Illinois through that route, and it will reserve that path. But unfortunately, the electrons still flow through Tennessee, tending to overload the grid in Tennessee. You might say, well, the solution is for the utilities in and around Tennessee, primarily TVA, to build more transmission. The trouble is they do not have a transmission customer. The utilities that have the customers are the utilities in the Arkansas-Missouri area. So those are two examples, Senator. Chairman Lieberman. Those are very interesting examples. I don't want to break the trend here, but it leads me to ask for the record for those who are watching, just to help us understand--in the normal course, who decides whether additional transmission capacity will be built? Is that totally a market judgment where somebody has to come along and see an opportunity and decide to build--because that is a fascinating example. Plants are being built in Louisiana, more generation than the region needs, big markets up North, and how do you get the electricity there? Mr. Kelly. In the old world, it was the individual utility that was building transmission primarily to distribute its own power around its own area, and it built some interconnection with its neighbors for reliability purposes. In the new world that I have just described, I do not think that model will work. You need a large regional organization that encompasses all the utilities along all the flow paths from Mississippi to Chicago to decide when and where transmission should be built to meet the aggregate needs of the region. Hence the RTO. Chairman Lieberman. OK. So the vision that FERC has of the RTOs is that the RTOs would play that role. Mr. Kelly. Yes. Chairman Lieberman. And how would they do it? Would they actually do the building of the transmission lines themselves? Mr. Kelly. They would certainly do the planning and come out with a plan that meets the needs of a large region and have some role in either directing or carrying out the building. In our rules, we allowed some flexibility to how an RTO would do that, because there are different flavors of RTOs. One, for example, might be a pure transmission company that would build and own it itself. But in another region, you might have utilities that are owned by government. TVA is one example, and the cooperative utilities in Missouri, for example, who feel that they cannot turn their transmission over, either by law or custom, to another entity. There could be protocols where those utilities could build transmission in response to a plan by the RTO and a compensation scheme devised by the RTO and subject to FERC approval. Chairman Lieberman. Mr. Cook, does NERC play a role, the reliability councils, in trying to make sure that there is enough transmission capacity to handle the electricity that wants to move? Mr. Cook. Not in actually building the systems. NERC does do an assessment on a regular basis of the generation adequacy and transmission adequacy so that information is available about where the problem spots are and the kind of things that need to be taken on. Chairman Lieberman. Mr. Harris, what about PJM; what are you doing with regard to the need for new transmission liens? Mr. Harris. As I mentioned, we do have a regional planning process which is independently administered. We believe that the person who is doing the planning should not own the transmission; it should be those who are in the transmission business. We look at things regionally and ask what is the least-cost solution to ensure that generation will meet load over all five States. That is why we have approved and now have $700 million worth of transmission under construction. Chairman Lieberman. Who is doing that? Mr. Harris. My office is doing that. Chairman Lieberman. I mean, who is actually building the lines? Mr. Harris. Each individual utility is building the lines that go through their particular territories. Chairman Lieberman. And how did you get to that point? In other words, you saw the need, and you planned, but how did you make sure they would go ahead and build the lines that were needed? Mr. Harris. I think it was the maturity and the development of our marketplace. The companies got together and said this is going to be the reality of the future, and if we have a neutral and independently derived plan from somebody with no financial interest in the outcome, we will obligate ourselves to build and construct in accordance with that plan. That is what they agreed to back in 1996, and that is what we are following today. Chairman Lieberman. In the new deregulated market, are those generating companies, or what I used to call the utilities that are actually selling to the customers, who are building the lines? Mr. Harris. They are the utilities. In our market, someone could come in in a merchant capability if they so desired and do it if they wanted to; they are not precluded. The intriguing question that Mr. Kelly raised does bring up an interesting point as to how you get the broad interregional needs. With RTOs that have the planning functions, the key is making information available to those who have a commercial interest and can achieve an appropriate economic solution. In many instances, transmission is competing with generation to come up with the same solution. The problem they all have is how do I get the information so that I can make an informed decision. Chairman Lieberman. Mr. Popowsky, let me come back to the earlier question about whether you had in your work, either in Pennsylvania or information from your colleagues, illustrations of what the problem is with the grid now as a result of deregulation. Mr. Popowsky. Again, in our area, we have not seen the kind of reliability problems arising as a result of market failure. I do think, however, that we have seen some instances where it would have been a lot better if we had had more and different generating companies on the system. For example, the market for capacity--as I said, capacity is very important in PJM to make sure we have enough available. On the other hand, it is not a very liquid market, and if we look at the prices this past winter, they went from zero to $177 a kilowatt-day and stayed at $177 for 2 months. And two summers ago when we had a heat wave, the energy price actually went up as high as $900, which is really unprecedented and, fortunately, I do not think has happened again. But as I said, in PJM, we are making strides so that when things like that happen, the PJM Market Monitoring Unit and the PJM board can look at those things and either try to reach a resolution itself or come to the FERC with resolutions, as they have done over the last few months, to try to correct these remaining market flaws. If I could just mention one other thing about the Cinergy example, as Mr. Harris indicated, it is not a question of what PJM would have done at that point if that happened; it is that if you have a truly independent system operator who is operating the system, that will not happen. And my recollection is that when it did happen, I think the NERC board and the regional council were able to basically send a nasty letter saying ``Do not do that again.'' That is why we need the legislation so that FERC can follow up on that nasty letter with a little more authority. Chairman Lieberman. ``Strong action to follow.'' Mr. Popowsky. Yes. Chairman Lieberman. Just to summarize what you have said, as I recall in the statements you submitted, Mr. Kelly and Mr. Cook, you both indicated that the number of violations of reliability rules are increasing in the deregulated market nationally, and I assume nobody on the panel would disagree with that. Mr. Cook, did you want to add something? Mr. Cook. Just to reaffirm that statement, that we are seeing more of that as the system is being stressed more; yes. Chairman Lieberman. Let us talk now about what to do about it. As I listened to the first two witnesses, Mr. Cook and Mr. Harris, I thought that I heard a difference of approach, and please correct me if I am wrong. I thought, Mr. Cook, that you were talking about the desirable answer here being to establish independent authority through NERC, through the North American Electric Reliability Council, with some oversight from the Federal Energy Regulatory Commission. But I thought, Mr. Harris, that you were focusing more on having FERC do this themselves, without a separate, independent group overseeing. Did I hear it correctly, and if so, can I invite the two of you not to get into a crossfire here, but to elucidate your points of view. Mr. Cook. The first point is that the panel report that you quoted from in your opening statement--NERC had an independent panel of experts come in about the same time to look at how ought we be treating reliability as we go forward. Both of those groups came to two conclusions. One was that we needed to have the rules be mandatory and enforceable. Then the question is what is the best way to accomplish that? Both the Secretary of Energy's panel that you quoted from and NERC's own panel of experts came to the conclusion that the best way to do that was to use an industry self-regulatory organization modeled after the SROs that are presently in operation in the securities industry. That is a way to have the industry expertise brought together and have government oversight there to make sure the process is fair and open. It is also a way to deal with the international character of the grid. As Mr. Harris said, the interconnection is one big machine. The map that I attached to my testimony indicates the scope of that machine, including the provinces in Canada as well. It is necessary for that machine to operate under a single common set of rules. If FERC was to set the rules for that, in effect they would be dictating what the rules would be in Canada as well. Having the international organization set those rules, Canadians participate now extensively in NERC activities, and that would carry forward into this new organization. That is a way to deal with that international issue as well. Chairman Lieberman. I was going to ask you if there is a model existing for what you propose, and from what you are saying, I gather that it is in securities regulation. Mr. Cook. In the securities regulation area, where you have the stock exchange and the NASD take on the role of setting rules for their marketplaces and how the broker-dealers are to be handled, under oversight by the SEC. The exchanges develop their rules, they are filed with SEC, and that gives them the legal authority to enforce them. SEC has independent authority to carry out its own enforcement activities if it sees a need to do that. Those features are really built into the legislation that is before you now. It is the same model that we have used. Chairman Lieberman. Mr. Harris, what is wrong with that? Mr. Harris. What we have learned over 4 years of looking at how do you get to competitive marketplaces and ensure you have the reliability necessary is that it is a learning curve. I also served on the NERC board of trustees, and I am the regional manager of the Mid-Atlantic Council, so I am very close to these issues and the genesis and the development of them. But we have made over 110 changes to our rules since we started by incrementally learning and growing. What we are seeing now in this industry is that we really need to deal with the realities. I think you said it very well--we have to address all the needs. There are environmental needs, there are State needs, there are local needs. And how we develop those is going to be extremely important to ensure that we do not have any more huge unintended consequences and missteps. So as we look at what is necessary to make sure those things happen, it should definitely be this Committee's oversight of the Federal Energy Regulatory Commission to ensure that the total holistic solutions are met, and met reliably. FERC has to have oversight. We are also finding the convergence of industries. Gas is important to what happens in electricity, as you have heard today. We were somewhat intrigued by the gas industry's proposal to solve this problem with an energy industry standards board where the current NERC would have a meaningful role in that process. This needs to have more thought, and it needs to be looked through. So our suggestion is that it needs to have FERC oversight, and the simplest way to do it would be to have the Federal Energy Regulatory Commission determine what is a necessary reliability organization and have the Federal Energy Regulatory Commission determine the scope and extent of that organization. Then we can get into the details without bothering the Committee. But I think this Committee should ensure that the Federal Energy Regulatory Commission puts forth some organization that allows that to take place, and we should learn from our experiences as we grow. Chairman Lieberman. Interesting. So if I am hearing you correctly, you are saying that the Federal Energy Regulatory Commission ought to make this decision, and not to presume that NERC is going to play that role, but obviously, that would be one of the options that FERC would consider. Mr. Harris. Yes, sir, that is correct. Chairman Lieberman. Mr. Cook. Mr. Cook. I was just going to say that under the legislation, the Federal Energy Regulatory Commission would be making that decision. That is, FERC would make the decision on what organization is going to carry forward once that legislation passes. The organization would submit a proposal to FERC saying ``We propose to take on that function and here is how we propose to meet it, and here is what we would do.'' So that feature really is built into the legislation. Chairman Lieberman. Mr. Kelly, what is your reaction on the FERC to this question of how to best organize a legislative response? Mr. Kelly. In terms of the differences that Messrs. Harris and Cook have expressed, if there are real differences, I do not see them as 180 degrees apart; to me, they are 5 or 10 degrees apart. Mr. Harris wants to put a greater emphasis on the coming RTOs than he perceives NERC is placing. NERC has drafted a bill that puts emphasis on NERC and regional councils. In my personal view, when we get right-sized RTOs and right-sized regional councils, the councils will be coincident with the RTOs, and most of the differences that they may think they have will disappear. Chairman Lieberman. Mr. Popowsky. Mr. Popowsky. I would agree, and I think that is what the legislation is intended to do. There is a discussion of what the role of the States is through a savings clause. There is a discussion of coordination with Regional Transmission Organizations. I think, though, the bottom line is that both of the final decisions should come down to FERC. But that does not mean that FERC staff have to be sitting there, trying to develop reliability standards. That is better done by the new NERC or NAERO group, I think. Even today, they have a tremendous staff who focus on reliability. That is their area of expertise, and they should be working with the RTOs, coordinating their activities, and then, ultimately, it should be up to FERC to make those tough calls as to how much to emphasize reliability versus economics and how to reconcile those. Chairman Lieberman. Do any of you want to add anything about the legislation that is before us? We have both the Murkowski and the Bingaman proposals. Mr. Cook. On the reliability piece, Mr. Chairman, those bills are the same. Chairman Lieberman. Right. So that, basically, your request would be to get one of them adopted, but certainly that part of them adopted, and there is no real difference between them on reliability. Mr. Cook. That is correct. Chairman Lieberman. Mr. Popowsky, the National Association of State Utility Consumer Advocates which you represent here today filed comments with the Department of Energy, as I believe you know, that argue quite forcefully that FERC needs to act on reliability whether or not Congress passes additional legislation, and also argue that FERC has the authority to do so. I wonder if you are in a position to talk a little bit more about that now and if so, prior to the legislation, since we know that is hard to predict around here, what would you like to see FERC do? Mr. Popowsky. In light of what has happened over the last several months starting with the realignment--in other words, in February 2001, NERC did turn over its trusteeship to the new independent board of trustees. In addition, they began to establish contractual enforcement activities. Our first preference is certainly to pass legislation. If legislation is not passed, then FERC can certainly go back and try to eke out whatever authority it does have to address reliability matters. I personally think that is by far a second-best or much worse solution to giving FERC the actual authority to review reliability rules that would apply to all actors in the market and not just those who are under FERC's jurisdiction already. So that would still be by far the lower priority, and as I look at it, a better use of FERC's resources now would be to really get the RTOs in place, because the RTOs also have a reliability role, and to make sure that we have a national set, a complete set of RTOs that also have reliability authority, and that, clearly, the FERC has the ability to do. That would certainly be my preference at this point. Chairman Lieberman. You kind of anticipated my next question. Mr. Kelly, one of the points you made in your statement is that FERC does not have jurisdiction over a number of the utilities that control parts of the transmission grid, such as Federal power administrations or municipally owned utilities. I was interested in the fact that the recent order that FERC set regarding the Western power markets includes conditions on every utility that sells into the federally- regulated transmission system out West, including the Federal power administrations and the municipally owned generators. So I wonder, prior to the legislation, if it is possible for FERC to act on reliability concerns throughout the system, including both the Federal and municipal parts of the system. Mr. Kelly. I suppose it would be possible, Senator, with a great stretch on our authority, but there are difficulties. The California situation, I think, caused the Commission to desire to act quickly and forcefully and to put a solution in place, by interpreting its jurisdiction just about as broadly as it could, probably more broadly than it would going into a new area. There is a real question, I think, if you are building reliability for the future--such an important topic that affects all 50 States and our neighbors in Canada and portions of Mexico--if you would want to build such an important enterprise on what might be an untested legal foundation. In addition, I might add, we were imposing conditions on generators who were using the transmission system that was jurisdictional to us, and imposing those generation pricing conditions as a condition of using the grid that was jurisdictional to us--I am not sure we could quite use the same rationale to impose conditions on transmission systems that were not jurisdictional to us. And one-third of the transmission in the United States is not FERC jurisdictional. Chairman Lieberman. Say the last sentence again, please. Mr. Kelly. One-third of the transmission in the United States is not FERC jurisdictional. When you look at TVA, Bonneville, the Western Area Power Administration, and add in the State-owned systems like the New York Power Authority, the whole State of Nebraska, which has publicly-owned transmission and utility systems, and all the major municipalities, and then add in the large cooperative utilities that are financed by the rural utility service and hence, when so financed, are not subject to FERC jurisdiction, it is fully one-third of the transmission lines. Chairman Lieberman. That is interesting. Does everyone on the panel agree that one of the most important parts of legislation would be to make sure that there would be one set of standards and one enforcement mechanism since, if there is anything that I have learned from this hearing, it is that everything is interconnected. Do you agree? Mr. Cook. Yes, sir. The letter that I attached to the testimony that we sent to the members of the Senate Energy and Natural Resources Committee included a long list of folks who are supporting the legislation, and on that list are the coops, the public power people, folks that, normally, you would not think would be suggesting that jurisdiction be extended over their members. But for purposes of the reliability bill, they have all signed on, if you will, and are supporting that effort. Chairman Lieberman. Are there any other responses? Mr. Kelly. Mr. Kelly. Well, I would agree, maybe adding a footnote that NERC's rules themselves do recognize there may be regional differences; for example, some of the rules as applied in a hydro-dependent region might be different from the rules in a wholly coal-fired region. So NERC has a standard rule, but the rule itself allows for variation. So with that footnote, I would agree with the statement. Chairman Lieberman. Mr. Harris. Mr. Harris. One additional footnote is that we just cannot ignore the physics. It is consumed the instant it is produced; it is a speed-of-light product; it does not know State boundaries; it is the consumer from the generating plant and the fuel behind it. So we cannot just carve out the wholesale business from the retail business. You cannot just carve out the States. You cannot carve out the environmental. It is a separate problem. The Federal Energy Regulatory Commission needs to have holistic authority to ensure that this thing will work together as a single, synchronized motor. Chairman Lieberman. It is really quite remarkable, and I do not know that I fully understand it--one of you referred to it before--about the example of the Louisiana utility trying to get its power to Chicago. But in a regulated market where utilities, conceptually, should be able to buy from generators anywhere on the national grid--at one point, I remember having a conversation where it was suggested that customers actually might--that is, business customers or even residential, ideally--would be able to choose where they wanted their power to come from based on a competitive model. The conceptual difficulty is in visualizing how this happens. It is one thing, as I said to my staff the other day, for me to understand that if I want to buy shirts from a particular mail order house, I have a series of choices to make, and then I know that they are going to find their way, either by airline or by truck, to Federal Express or UPS or whatever, to my house. But how does one envision how those units of electricity get instantaneously from a generator that may be halfway around the country to my utility in Connecticut, let alone to me? What I have been told is that they do not--is that right? In other words, somebody is adding to the pool, and what my utility is taking out is probably not part of that even though I am paying at a rate based on what that generator has added to the transmission grid. Mr. Harris. I appreciate your comment. That is the beautiful thing about moving to competitive electricity marketplaces. We now have over 100 different companies trading on the market in any given hour, from Florida, Texas, and Canada, all trading into the PJM marketplace. The Federal Energy Regulatory Commission has approved a pilot program this summer where we have economic incentives for individual customers to buy and make choices based on the spot price of electricity. Chairman Lieberman. Not utility companies--but customers. Mr. Harris. No, sir. Individual customers to make economic decisions based on that spot price. What we are seeing is the beautiful things about network information technology--the power and speed of processors, the broad bandwidth capabilities that will enable competitive enterprise to work down to the individual level. While it may be complex in administration, one of the things that we have found, again through these technologies, is that we can actually make the life of the customer more simple and more convenient through the use of these technologies. It is also something, I might add, that the Committee might want to ensure that the Federal Energy Regulatory Commission has, and that is the appropriate technology and tools to have oversight over this vast network of process. That can happen; they can understand what is going on in prices to see if it is an anomaly over a broad scope, and technology will enable that today. Chairman Lieberman. And the truth is that without technology, you could not do it; you could not monitor it. Too much is happening too quickly. Mr. Harris. That is correct. We can do things now that were impossible a year ago, and the technology keeps growing rapidly so that we can take this speed-of-light product and really simplify the life of the consumer and add value to the economy in these ways. Chairman Lieberman. Now that we are on this fascinating subject, just very briefly, how is the individual customer going to tap into the information that will allow him or her to decide where they will buy the electricity to their--are we talking about to their house, or to their office building, or-- -- Mr. Harris. If the individual customer wanted to do that to their house, they could. Remember that we are developing our program ``little steps by little feet,'' so we have a pilot program that we are running that we call an ``economic program.'' It is interesting--we filed the program, and the Federal Energy Regulatory Commission approved it for this next season, and in that program, we negotiate a way where individuals, customers or small businesses, can see that spot price and then make decisions on whether they want to isolate to the grid, i.e., buy megawatts, or where you would actually pay them to come off the grid at their choice---- Chairman Lieberman. And they see it on their personal computers, for instance? Mr. Harris. It is seen through some type of networking tool that would allow that information to be there. Again, this is a pilot program, but what it shows is the promise of the future. I think that one of the sad things about the California situation is that it masks the wonderful opportunities that we now have in a networked information economy, and somehow, we need to get back to that. Chairman Lieberman. Yes. Mr. Popowsky. Mr. Popowsky. In terms of residential consumers, I think most of the participants will be larger commercial and industrial customers, at least initially. Mr. Harris. Yes, we have some small commercial, but there is nothing that precludes a residential if they wanted to play. Mr. Popowsky. But there are other things that can be done. To get back to your first example, I think one of the positive developments in Pennsylvania is that consumers who wish to do so can buy green power, that is, power developed from renewable resources. Now, as you indicated, it is not that you can get the power all the way from the windmill, two States away, into your toaster oven; but by patronizing with that market or with that company, that company will put more of the wind power onto the grid. So it is not that you get those kilowatt hours, it is that you contribute. Chairman Lieberman. People feel good about it? Mr. Popowsky. We found in Pennsylvania that people are even willing to pay more, like they buy recycled paper goods at the supermarket. They are willing to pay more, and I believe they understand that they are not literally getting those kilowatt hours, but they are contributing to getting more of those kilowatt hours onto the grid. Chairman Lieberman. Very interesting and very exciting. I thank all of you. From the testimony that you have offered, I would conclude that dramatic changes have occurred, both in the markets, in the deregulation of electricity markets around the country, and of course in the increasing demand generally as our economy has grown, and as a result of the extraordinarily developments in technology, the grid as it exists now has reliability vulnerabilities to it and that the market and government and private groups have tried to react to those. But the general feeling I get from listening to you is that the current approach does not adequately fit the new reality of competitive markets and technology. Also, there seems to be general agreement by one path or another that the buck has to stop at FERC, that this is an area in which FERC has to receive new authority, that the ideal is if Congress were to clarify FERC's role here. There are details that still need to be resolved about how the actual organizational structure will be built and will operate, and it is not clear, as I hear from you, in the absence of legislation, although some would argue on one side or another, what steps FERC should take except to continue to pursue its vision of the RTOs. So I think some things are happening here. I think we do have a problem, and California is obviously the extreme example of it for a lot of reasons. But it is also clear that unless we act to improve the national electricity grid, consumers will not be able to achieve the maximum benefit from deregulation, and at worst, the lights will go off occasionally, or there will be unfair practices along the grid because there is inadequate monitoring and policing. So I think it is critically important that we act on this legislation on which there seems to be general agreement. And Members of this Committee will do our part to make sure that is so, and we will continue to monitor FERC's oversight of these matters. For me, it has been a very informative hearing. I will continue to be interested in it. As Senator Thompson said at the beginning, it is not quite as controversial or dramatic as the current crisis in California, yet this is all about prevention. This is all about taking the steps necessary to make sure that we do not have more Californias, more blackouts, and more pricing of electricity that is higher than it would be if we had a grid that was up to handling the generating capacity that will be coming on and to the opportunities that technology provides. We will leave the record of this hearing open for a week if any of you want to submit additional testimony or if any Members of the Committee who could not be here today want to submit questions for you. But in the meantime, I thank you all, not only for your testimony, but for what each of you is doing to assure the reliability of the national electricity grid. I thank you. The hearing is adjourned. 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