Electricity, Contract Rules, and the Environment: Welcome to the Hotel California

Steven Ferrey

Steven Ferrey is Professor of Law at Suffolk University Law School and Professor of Law (Adjunct) at Boston University School of Law, both in Boston. Among his 5 books (and more than 50 articles) are THE LAW OF INDEPENDENT POWER (West Publishing 2001), a 3-volume treatise now in its 18th edition, THE NEW RULES (Penwell Publishing 2001), a book on navigating through the deregulated electric market, and ENVIRONMENTAL LAW: EXAMPLES AND EXPLANATIONS (Aspen Publishing, 2d ed. 2001). Professor Ferrey has served as legal counsel or an expert witness for many private and government clients on energy and environmental issues. He has represented some of the largest and most active power market participants in asset acquisition and sale, siting, and operation of facilities. He also has consulted for various federal energy and environmental agencies, as well as for the state of California and other government entities. He consults for the World Bank on power sector privatization globally. He holds degrees in economics, law, and environmental planning, and was a post-doctoral Fulbright Fellow in London, England. Copyright 2001 Steven Ferrey.

[Editor's Note: This is the first of two Articles by Professor Ferrey on the California electricity crisis. In the January 2002 issue, Professor Ferrey will, in light of the California experience, examine the unresolved question of whether the common law or the Uniform Commercial Code governs disputes concerning deregulated electric markets.]

[31 ELR 11475]

One of the major news stories of this year is the implosion of California's electric power restructuring. The most capital-intensive industry in the United States, in the largest state in the Union, which itself is one of the largest economies in the world, came completely unglued. This focused attention on how we produce, distribute, and consume electric power and its profound implications, not only for social welfare, but for the environment.¹

The problems in California resulted in a rash of litigation and administrative proceedings of every conceivable stripe and hue. Every party involved is suing others over every conceivable dispute as the California system struggles to equilibrate. What is clear is that private contract rights—and legal suits regarding those rights—have replaced the traditional role of regulation. The courts will have to decide more, and the regulators less, of the rules of the newly deregulated electric marketplace.

Until now, a fundamental issue that will profoundly shape the outcome of these lawsuits has been ignored.² In electricity deregulation and restructuring, the "sleeper" issue is characterization of electricity as either a "good," which is a movable "thing," or as a service, which is not a tangible "thing." This technical question is one that, in the past, few lawyers worried about. But with a fundamental shift from regulated monopolies to restructured competitive markets, what electricity "is" will determine the legal rules by which participants in the market must play. How we adjudicate rights in the inevitable move to a partially deregulated, restructured electric environment is of critical economic, environmental, and strategic importance.

Different legal rules apply to different commodities or services in the deregulated marketplace. As the various state common laws of contracts replace traditional regulation as the interpretive determinant of electricity transactions, legal rights and obligations, in part, will depend on how individual states treat electricity. First, let's survey the unbelievable twist of California choreography.

The California Electric Experience

In late calendar year 2000, California's restructured electric power market imploded. What happened? The facile answer is that demand exceeded supply. But there is much more to it than that.

The Choreography

In 1998, California became the third state in the nation, after Massachusetts and Rhode Island, to restructure its electric sector, allow retail competition, and force or incentivize its investor-owned utilities (IOUs) to sell their generating assets. Power supply was bid to the Independent System Operator (ISO)³ daily, with the last/highest price accepted setting the price for all sales of power during that period.⁴

After deregulation, the California Energy Commission no longer assessed the state's need for power. Market participants, subject to regulatory siting approval, were responsible for supply. The utilities were required by regulatory authorities to buy a substantial amount of their power requirements on the "spot" market—day to day—rather than through forward-hedged contracts. To some extent California's [31 ELR 11476] difficulties were made more complex by unregulated companies and their affiliates controlling both some of the natural gas supply and a significant share of deregulated wholesale electric power producers. Some of the gas supply companies declined to sell natural gas to the integrated electric and gas utility companies in California that were required by law to serve residential and other natural gas customers. This drove the price of natural gas higher, and therefore the cost of power produced at wholesale by natural gas-fired power generation technologies. The utilities were unable to store sufficient amounts of natural gas because the state regulatory commission had discouraged investment in pipeline and in-state storage assets to be owned by the gas distribution companies. California's reservoirs were down to minimal levels, which left little energy capacity from these hydroelectric resources in the system.⁵

Most consumers did not switch to competitive suppliers, instead remaining with their utilities. When spot market prices of wholesale power increased dramatically due to shortfall, this caused the ultimate cost of power needing to be passed on in retail rates or otherwise recouped to increase correspondingly. In response to ratepayer protest, the state ordered retail rates frozen at 5.5 cents/kilowatt hour ([cent]/kwh). Many of the retail IOUs were purchasing power at substantially higher wholesale spot market prices, but allowed to pass on much less than the acquisition cost in retail rates under the retail rate cap.

The revenue-strapped regulated California distribution utilities were unable to pay on time for their wholesale power acquisitions, because of dwindling cash resources. The utilities teetered on the verge of bankruptcy. Over time, an increasing amount of total load was served through real-time spot market purchases, which reflected panic situations. The ISO was allowed to purchase power from out-of-state suppliers at any price.⁶ A phenomenon known as "megawatt laundering" occurred, in which out-of-state suppliers sold power to neighboring states, the electricity then resold to the ISO at inflated prices.

In the California market, where there was a shortage of power, efforts to make various installed generating units be available most of the time caused them to exceed their air emission limitations. Certain generators were constrained because of annual emission limits or local limitations on combustion turbines within city limits.⁷ Some of the plants had to shut down late in calendar year 2000 or late in a particular quarter during 2001, so as not to exceed their emission thresholds. The ISO rejected efforts of some of those plants to shut down, directing them to purchase additional emissions allowances from other generators. In some instances, air emission credits can be purchased, if available, to allow additional generation, at a potential cost of millions of dollars. Exceedances result in fines from the environmental authorities; the resulting shortage in California power led to dramatic increases in deregulated wholesale power prices at the margin; the last price accepted set the price for all power sales.

Rolling blackouts were imposed on consumers during the off-peak winter and spring months of 2001. California air regulators subsequently allowed those plants to come back online, in return for paying daily fines for exceeding their allowances. Only about one-half of the affected capacity responded to this permission. Gov. Gray Davis (D-Cal.) subsequently signed an executive order temporarily allowing some of the most polluting California power plants to operate as long as they wish during times of power scarcity, without violating air rules, in return for paying a fee, and without counting against their emission limits in the future.⁸ This permission to operate was challenged by the city of San Francisco and environmental groups.⁹

In June 2001, Governor Davis issued an emergency order allowing all natural gas-fired units to operate irrespective of emission limits in their permits and without imposition of fines or penalties through summer 2001, without counting such excesses against permit limits (as could occur under the previous order), as long as mitigation fees are paid to the state. The justification was that extra generation from cleaner gas-fired units eliminated the need to start up dirtier oil-fired units. Such units are required by the order to sell all power to the state, which could violate the exclusive federal control over wholesale power sales. This action, if legal, preempts regional air quality regulators, could violate the state implementation plan for air quality maintenance, and fills state coffers with payments from the generators.

In addition, by an emergency order in December 2000, the Federal Energy Regulatory Commission (FERC) authorized California Qualifying Facilities (QFs) to generate at full capacity, exceeding the federal small power producer fuel use requirements,¹⁰ without losing their QF status. Therefore, it appears that the political concern to maintain adequate supplies of energy took precedence over environmental and QF regulatory concerns in that market.

One geopolitical and environmental residue of the California crisis is that independent power companies are scrambling to establish power generation facilities just south of California along the Mexican border. Mexican power generation facilities are not exposed to the same stringent environmental regulations as are California facilities. Power can be exported to California pursuant to the North American Free Trade Agreement and FERC permission. Some of the airborne pollutants may also drift into southern California. As such Mexican plants are constructed and their power sold into California, this will raise new choice of law issues, not only involving whether the product sold is a "good" or "service," but whether Mexican or California law will apply to the transactions.

[31 ELR 11477]

Wholesale Litigation

Amidst this implosion, litigation rose instantly from the ashes.¹¹ California utilities fell hundreds of millions of dollars in arrears in paying for purchased wholesale power. The parties most owed were those who had purchased former regulated utility generating plants and had continued to sell power on the wholesale market. There followed numerous claims and suits involving the supply, failure of supply, pricing, and reliability of wholesale power supply and fuel supply in California:

. Wholesale power suppliers litigated the slow or nonpayment of power previously purchased by utilities. A court rejected a motion by FPL Group, a wholesale supplier, to place a lien on utility company assets to secure amounts owed.

. Suits were pending against the California Power Exchange regarding its calculations of exchange transactions of wholesale power. In addition, the Imperial Irrigation District asked the D.C. Circuit Court of Appeals to review whether it can be forced to sell its power through the ISO, or could remain independent.

. Reliant Energy Services (Reliant), an independent power generator, sued to enjoin an ISO order mandating suppliers to continue to sell power to the state even if payments for the power were not forth-coming. Power was purchased by the state from Reliant, when cheaper alternatives appeared to be available. In turning down Reliant's preliminary injunction request, the judge found that unregulated power suppliers must continue to supply power that they did not otherwise choose to supply because the state's energy crisis, one "of catastrophic proportions," had created a public health and safety emergency. Separately, a state court ordered Reliant to sell emergency power to California, notwithstanding that such wholesale power sales are wholly jurisdictional to FERC. Reliant argued that this will shift California's problems to other western states, characterizing the requirement as "economic protectionism." Appeal was taken to a federal forum.

. The California Senate issued subpoenas to major power generators and marketers for allegedly confidential business data, which several of the parties resisted.

. There will be contract claims that a supplier did not provide "firm" capacity and energy for sale during the California energy crises, as opposed to supplying just nonfirm energy.

. Based on confidential data, the ISO filed a report with FERC in March 2001, accusing power suppliers of overcharging the state by nearly $ 6.2 billion, representing 30% of wholesale power costs (the ISO claimed that power suppliers overcharged by $ 500 million during December 2000 and January 2001). These prices of power were accepted at arm's-length by the ISO. In return for dropping the charges against it, Williams Energy Services (Williams) agreed to refund $ 8 million to the ISO, corresponding to a shutdown of two Williams plants in 2000, which had caused the company to sell power from more expensive units. FERC's matter was not successfully mediated, and remains pending. An appeal of initial FERC decisions was launched in the Ninth Circuit by the California Public Utilities Commission (PUC).

. The city attorney of San Francisco sued Dynegy Power Marketing, Inc. (Dynegy) as did Ruth Hendricks on behalf of herself and other similarly situated people in a class action suit. The Sweetwater Municipal Water District and the Padre Dam Municipal Water District also sued Dynegy (however, this was not a class action). Pier 23 Restaurant in California, on behalf of itself and others similarly situated, sued Pacific Gas and Electric Energy Trading (PG&E). Pamela Gordon brought a class action and private attorney general action versus Reliant. These suits contain basic allegations of conspiracy to fix prices and of "gaming" the auction process in California.¹²

. The city of San Francisco filed suit regarding three Mirant peaking plants of 156 megawatt capacity which exceeded their emission allowances.

Threats of criminal and civil action followed. California Attorney General Bill Lockyer (Democrat) offered tens of millions of dollars (as a percentage of any recovery that is made in actions against wholesale suppliers) to "anyone who provides information leading to the successful prosecution of a false claim action." In Lockyer's estimation, California law would allow an informant, likely from inside one of the wholesale suppliers, to collect in the "hundreds of millions of dollars" if proffered information led to a successful recovery of monies from a supplier. However, the Lockyer's investigation had, by mid-2001, concluded that no criminal activity had occurred; no prosecutions followed. Lockyer did, however, convene a grand jury investigation.

Rep. Bob Filner (D-Cal.), in April 2001, urged FERC to revoke the market-based rate authority of 18 companies selling power in California, alleging that Williams, Reliant, Dynegy, Duke Energy Trading and Marketing (Duke), and Southern Company effectively control the California wholesale market. However, these five provide only about 25% of California wholesale power. California Lieutenant Gov. Cruz Bustamante (Democrat), said that unregulated [31 ELR 11478] companies which were successful in selling wholesale power to California utilities at higher than anticipated prices should pay restitution and fines and their top officers should be thrown in jail.

Federal Intervention

The situation in California became so extreme that former President William J. Clinton used a statute reserved for national emergencies, or when the national defense is threatened by foreign powers, in order to try to keep the lights on in California. Declaring a "natural gas supply emergency," and using the 1950 Defense Production Act, which was enacted at the commencement of the Korean War to keep supplies flowing to the government, the president compelled unregulated out-of-state natural gas companies to keep selling gas to California utilities who were not able to pay for it and which were on the verge of bankruptcy. The Clinton Administration justified this action by claiming that if such an order had not been issued, California IOUs could have seized other gas in the pipelines to serve residential customers, thus cutting off federal military and National Aeronautics and Space Administration facilities.

This was an extraordinary exercise of national defense powers in peacetime in order to cause private companies to act contrary to their market interests. President George W. Bush allowed this order to expire after extending it once. Governor Davis, seeking to regain his political footing, urged President Bush

to stand up to your friends in the energy business and exercise the federal government's responsibility to ensure energy prices are just and reasonable…. What's going on here, pure and simple, is unconscionable price-gouging and market manipulation by the big energy producers and marketers—most of them, incidentally, located in Texas.¹³

During the first five months of 2001, however, only about 10% of power sales to the state were from Texas-based companies. Former Gov. Pete Wilson (R-Cal.) countered that then-Lieutenant Governor Davis did not offer "a peep" during the original California deregulation debate.¹⁴

FERC next became embroiled in the California imbroglio. The commission entertained numerous investigations, complaints, and applications:

. California contested wholesale pricing and price cap issues at FERC, involving all of the competitive wholesale suppliers as respondents. Governor Davis stated: "We are going to Washington with one goal, and that is to bring back $ 9 billion. The fact is that people have taken advantage of the market, the system, and ripped people off."¹⁵ FERC eventually imposed a so-called soft cap on wholesale prices, and then extended it to the western system in June 2001.

. In March 2001, FERC ordered 13 wholesale electric suppliers to justify that the rates they charged in the unregulated California market were "just and reasonable." FERC focused on January price sales by Dynegy, Duke, Reliant, Williams, and Enron's Portland General Electric Company (Enron). FERC, in March 2001, ordered refunds of wholesale prices charged by wholesalers during California stage three power emergencies, amounting to 1% to 2% of wholesale power costs. The utilities countered that FERC was engaged in secret ratemaking. Dissatisfied with FERC's progress, Governor Davis charged that FERC had shown little regard for consumers and vowed a court appeal.

. The Northern California Power Agency, representing municipal and public systems, complained formally to FERC that the ISO was discriminating against its member customers in two regards: by allowing the IOUs more lax credit standards than the power agency, thus forcing the power agency to shoulder some of the credit support for the IOUs, and second, by imposing rolling blackouts on power agency member customers to make up for deficient generating assets among the IOUs.

. Reliant asked FERC to order the ISO not to attempt to dictate when Reliant's independent generators would perform maintenance or operate.

. Sens. Joseph Lieberman (D-Conn.) and Jean Carnahan (D-Mo.) petitioned the U.S. General Accounting Office in April 2001, to investigate whether FERC had been derelict of its regulatory duties regarding California's wholesale market.

. Congressmen challenged the use of the federal Defense Production Act to force natural gas sales on unregulated suppliers.

. Two California lawmakers, Senate Speaker John Burton (Democrat) and Assembly Speaker Robert Hertzberg (Democrat), sued FERC in federal court, alleging that the commission neglected its duty to cap wholesale power costs during the power crunch. The Ninth Circuit Court of Appeals dismissed the mandamus action in May 2001.

Buying Retail

To date, California consumers have seen an average 9% electric rate increase in January 2001, and a 37% boost in March 2001. The Federal Reserve Bank of San Francisco (FRB) calculated that the power costs for the typical California household would increase by $ 750 annually, plus an additional $ 200/year for natural gas, for a total 38% increase in total energy costs. The average California bill increased by 36%, according to J.D. Power and Associates. The extra cost of extricating California from its power debacle was estimated by the FRB, in terms of direct costs for electricity and gas, as well as higher ultimate costs of goods and services produced using more expensive electricity and gas, to reduce California household income by an average of 1.5% for the typical family.

The implosion upset the business community, which was the major beneficiary of restructured retail competition to date, as well. A poll by the National Federation of Independent [31 ELR 11479] Business found that small businesses could be forced from the state by the energy crisis. The Intel Corporation, citing uncertain power reliability, announced that it would curtail plans for future chip and semiconductor manufacturing expansion in the state. California officials sought to expedite review of proposed new power plants, and appointed a task force to expedite plant construction. However, even more generation, alone, will not solve the constriction along the 84-mile San Joaquin Valley Path 15, the congested transmission corridor which limits the flow of power from the southern to the northern parts of the state. The federal government proposed expanding this transmission capacity as part of President Bush's national energy strategy. This $ 300 million 500 kilovolt expansion could take up to four years to complete.

PG&E, the nation's biggest utility, initiated a federal lawsuit to seek an order directing the California PUC to allow the recovery of all wholesale power costs in retail rates. SCE Corp., the parent company of Southern California Edison, sought and obtained in federal district court a declaratory order that it is entitled under law to recover all of the wholesale power costs from its retail ratepayers. The judge qualified his ruling by requiring a subsequent trial for SCE Corp. to demonstrate as an issue of fact that all of its power purchases from the California Power Exchange and the ISO were prudent pursuant to state law.¹⁶ A similar rash of litigation has and will ensue regarding the retail provision of power to end-use customers:

. California ratepayers are litigating over their increase in retail rates.

. Power marketers and brokers are involved in claims regarding their failure to supply contracted power to clients.

. The University of California and the California State University initiated, but subsequently dismissed, suit involving contract claims against Enron, a private wholesale energy supplier that withdrew from supplying retail power in California.

Regional Spillover

No state, particularly California—which imports power from 11 other states and Canada—is an island. This is especially true regarding electrons moving almost at the speed of light.

The Clinton Administration required neighboring western states to export power to California to limit California blackouts. This spread some of the concern over the operation of deregulated markets to several of the states that export power to California.

As low-cost federal hydropower was exported to California, wholesale power costs for residual power in the Northwest rose. In the Pacific Northwest, the Bonneville Power Administration raised rates by 75%. Retail electricity prices in the state of Washington increased as much as 50% due to the ripple affects of Northwest power being diverted to California under federal order and lower hydroelectric capacity. Louisiana-Pacific Company had to close facilities; corporate energy concerns were voiced by Boeing and Microsoft. Other states in the West threatened lawsuits for monitoring damages for injuries resulting to their states from the California restructuring debacle.

Governor Davis sought additional federal intervention. FERC refused to restrain the operation of the market that California had created, other than initially to continue wholesale power sale "soft" price caps, and eventually to approve, in June 2001, a cap on spot market prices for all western power transactions occurring when reserve margins fall below 7%. Nonetheless, power was "laundered," by being first sold out-of-state to marketers at prices above the soft cap, and then resold at market prices to or in the state.

FERC ordered public power systems in the West to be subject to the same transmission constraints as regulated public systems, even though FERC does not have jurisdiction over them and they were not necessarily part of the problem. This mandate was imposed as a condition on use of the transmission system. Gary Ackerman of the Western Power Trading Forum concluded that this was self-defeating regarding additional supply: "Any plant developer will have serious second thoughts about building a power plant in the West."¹⁷

The Washington State attorney general alleged the negligence of California in setting in motion a situation requiring the federal government to order the diversion of power from other regions to California. Instead of initiating suit immediately, attorney generals in Oregon and Washington conducted an investigation prior to a decision on litigation. Other litigation has spilled over California's borders like the plague:

. FERC, in April 2001, launched an investigation of potential overcharging for wholesale power in the West.

. Suits between and among western states will be spawned. While retail electricity prices in Washington State increased by as much as 50%, California initially held California ratepayer increases to 10%, before being forced higher.

. Sierra Pacific Resources backed out of a planned sale of $ 1.7 billion of power generating assets in Nevada to NRG Energy and Dynegy because of the crisis in California. This could spur litigation.

. The cities of Los Angeles and Long Beach, in March 2001, filed lawsuits accusing several gas companies of conspiring in a Phoenix hotel room in 1996 to block construction of gas pipelines so as to limit supplies and drive up prices of natural gas. Executives of Southern California Gas Company admitted to the meeting, but denied its purpose.

The Legislative Response

In a matter of a few months, the restructured California environment created a $ 14 billion shortfall for the state purchasing power on behalf of its essentially insolvent IOUs, a loss that would have to be subsidized and recouped over a decade by taxpayers and ratepayers. The cost of the California bailout, while publicly projected by Governor Davis to cost only $ 10 billion, was estimated by several of his cabinet [31 ELR 11480] members to likely cost up to $ 23 billion in the next two years alone. This would leave customers paying approximately 50% more for electricity—in addition to the 10% to 15% increase in year 2000, and another 10% increase already scheduled for 2002—and would completely wipe out the state's tax surplus.

There is a certain irony in that all of the formerly regulated utility generating plants were sold for approximately $ 3 billion in capital costs, while the state within a mere few months has been forced to pump an additional $ 14 billion into power purchases from these and other facilities. It would appear that the facilities have returned, quite amply, to their new unregulated owners.

California came up with a complex legislative solution. The legislation empowers the state's Department of Water Resources (DWR) to pay for the difference between acquisition by that agency of electricity and the retail price for which it is eventually resold. The interim solution in California was a $ 10 billion bond issue to allow the state to purchase long-term wholesale power, which could be sold to utilities for their retail resale. The bonds are to be retired from tax revenues over a 10-year period. State energy costs are paid before any surplus is repaid to the state general fund.

There are also provisions in the legislation that will prevent commercial and industrial energy users from walking away from long-term contract deals with the DWR when their long-term contracts expire and lower rates are available elsewhere in the market. This is an instant formula for litigation—major market players in a deregulated market are singled out to have their normal market choices constrained so as to cross-subsidize other user groups.

Moreover, this law locks all current utility customers into place with their current utility. This basically stops all the retail power shopping that the restructuring law allowed. The measure effectively terminated direct retail access in California, which was at the core of deregulation. Mack Seetin of the New York Mercantile Exchange alleged that consumers were first forced to "pay the ransom of the stranded costs" and then "pay off the bonds" prior to direct access.¹⁸

Blackouts ensued nonetheless across California in the first half of 2001. Ten thousand customers plead for exemption from rolling blackouts, including oil refineries, sports venues, and municipal entities not served by the power-short private utilities. The California PUC decided that any circuit that can reduce consumption by 15% will be exempt from future rolling blackouts imposed in the state. This provided perverse incentives for keeping power consumption high, so they could subsequently show a 15% reduction. The PUC agreed to exempt all hospitals, where initially it had tentatively decided to only exempt large hospitals. Mass transit systems and oil refineries also were exempt.

New authority is provided in the legislation to increase the rates for electric power paid by residential customers whose power use exceeds 130% of an administratively set "baseline" consumption. The formula for calculating baseline usage will vary in different locations throughout the state, and be sensitive to weather conditions, usage patterns, and other variables. The newly authorized so-called Power Police were empowered by a gubernatorial order to prosecute businesses in larger cities that use outdoor lighting when they are not open. The use of outdoor lighting during nonbusiness hours can result in fines of as much as $ 1,000 per day. This could spawn a host of lawsuits over the interpretation of this differential pricing scheme for the same electric energy commodity to different consumers. California's past experience with water rationing does not bode well for a smooth implementation of this system. The political deal in California is fraught with exceptions and one can anticipate many challenges.

California might solve its energy shortfall by deploying some of the estimated 30 gigawatt of privately owned backup and emergency generators already installed in the state.¹⁹ This generation capacity is almost equal to California's total peak demand. However, this would require examining environmental restrictions placed on the units,²⁰ in some cases improving or deploying interconnections, and most importantly, revising regulatory systems and incentives to make it worthwhile for the owners of decentralized generation to sell power to the grid. In the near-term, this did not happen.

To pay for power, in March 2001, the PUC increased rates by an additional 40% to 50% (3 [cents]/kwh), the largest hike in state history. California Controller Kathleen Connell, stated that even this was not enough to prevent a state deficit.²¹ Moreover, with residential rates effectively capped by legislation during the transition period, indications are that the PUC will pass larger rate increases disproportionately onto larger volume customers, including larger volume residential customers. This would create a conservation incentive but may not be cost-justified in terms of cost of service.²² Should this occur, there are likely to be legal challenges regarding noncost-based allocation of rates to larger volume customers.

There is evidence that requests for voluntary conservation were heeded by California consumers. In addition, there are calls for a political consumer revolt to overthrow state decisionmakers and return the state power sector to regulation. The possible litigation scenarios:

. Fines assessed against high consumption ratepayers by the "Power Police" under the governor's order will be contested.

. Claims will ensue over differential pricing of power to certain users. A coalition of large commercial and agricultural users, including Silicon Valley manufacturers, formed to oppose the new rates.

. A ratepayer revolt, conducted by initiative measures placed on the 2002 California ballot, is threatened by southern California and San Diego area ratepayers, linked to other efforts to "derail" the new legislation.

. Sen. Don Perata (D-Cal.) is asking Governor Davis to check into so-called price gouging by the Los [31 ELR 11481] Angeles Department of Water and Power in selling power to the IOUs. Senator Perata said "it's one thing to have some Texas guy ripping you off but it's another thing to have a public agency in your own state …. I think they ought to give the money back."²³

. The California Chamber of Commerce, the California Manufacturers and Technology Association, California State University, and the University of California are crying "foul play" regarding the emergency legislation, which locks them into remaining with their current utility supplier through the crisis, regardless of supposed ability to shop for other retail suppliers under the restructuring legislation.

Bankruptcy and More Legislation

The new legislation did not end the problems. PG&E, the nation's largest utility, filed for Chapter 11 bankruptcy protection in April 2001, voicing a lack of faith in California's legislative and executive response. The utility had incurred approximately $ 9 billion in purchased-power costs since June 2000, with no prospect of recovering these past costs in real time. Governor Davis had refused to deal with the utilities unless they dropped lawsuits filed against the PUC for refusing to let them pass through high wholesale purchase costs in retail rates. The PG&E bankruptcy was meant to stem ongoing losses exceeding $ 300 million/month. Said PG&E Chairman Robert Glynn: "We heard a lot of the words [spoken by Governor Davis] but we've not seen actions…. Doodling with the numbers will not fix the problem."²⁴

The federal bankruptcy court could override PUC jurisdiction, and could abrogate existing contracts, including QF power purchase contracts. The PUC asserted that it is sovereign and immune from bankruptcy court orders. In the last 20 years, only four other utilities have filed for bankruptcy protection (including Public Service of New Hampshire, Tucson Power, and E1 Paso Electric).

Other bankruptcies followed. The California Power Exchange filed for Chapter 11 protection in March 2001. It blamed a slew of lawsuits by power generators as the cause for seeking bankruptcy protection. Mindful of the failure of the purchasing utilities to pay, the Los Angeles Department of Water and Power threatened to halt sales of surplus electricity to the ISO unless payment was made in cash or letter of credit was tendered in advance of the transaction. The ISO itself subsequently filed for bankruptcy protection.

Nor did legislative initiatives end there. Lawmakers proposed windfall profits taxes (Senate Bill 1x and Alternative Bill 2xx) to attempt to confiscate supernormal earnings of wholesale generators (designated at rates greater than $ 80/megawatt hour (MWh) and $ 60/MWh, respectively, by the bills). The bills exempted the DWR, which purchases power on behalf of the state. Such taxes could discourage the construction of new generation essential to adequate supply in the California market.

Legislators in California also considered seizing the California utilities' hydroelectric assets and transmission grid assets, to backstop the bailout obligations incurred by taxpayers. Other legislators looked at taking a forced equity ownership in the utilities. State Senate President Pro Tem John Burton introduced legislation to force the legislature to back the governor if he sought to seize power plants or contracts (Senate Resolution 1xx) and to prevent the PUC from automatically increasing retail rates (Senate Bill 85xx). These various measures, if implemented, will undoubtedly spawn litigation.

In February 2001, Governor Davis used his emergency power to seize forward power contracts of two of the large utilities that were held by the California Power Exchange, minutes before the exchange was due to liquidate them, so as to prevent the exchange from doing so in order to pay the utilities' outstanding bills. The value of these contracts was worth $ 150 million. Having seized these, Governor Davis then disputed the invoice price under these forward contracts. Both the seizure and the dispute over pricing mechanisms in the contracts will end up being litigated. In July 2001, Reliant sued California to recover $ 337 million owed under these long-term contracts. A hailstorm of legal action has encircled the exercise of governmental intervention and response, and shows no signs of early resolution.

As might be expected, the pendulum swings back: legislation was proposed (Senate Bill 23x) to promote municipalization of IOU systems. The bill would reduce the ability of private utilities to challenge municipal condemnation²⁵ and prohibit local land use planning agencies from vetoing the formation of local utility districts.²⁶ Another bill (Alternative Bill 48x) would foster municipal aggregation. The California legislature created a state public power authority to finance construction of power plants and transmission facilities (Senate Bill 6x). The authority would issue bonds, take property by eminent domain, and finance new projects. Any seizing or other acquisition of assets by the state will be litigated, notwithstanding that the governor has implied that the state could operate the transmission assets more efficiently than the utilities.

County and municipal budgets have been devastated by higher than expected electricity rates, for which state government may be claimed to be responsible. Republican law-makers sued Governor Davis to get access to secret Department of Water and Power contract files with wholesale power generators. The California state Senate found Enron and Mirant in contempt for their refusal to provide subpoenaed internal documents.

There will be actions by state or local government officials asserting that utilities have been negligent or have not honored their franchise obligation to provide reliable service (Republican Mayor Rudolph Guiliani in New York and Democratic Mayor Willie Brown in San Francisco have initiated such actions). Such claims could allege inadequate system design, inadequate maintenance, or failure to prepare for weather-related events.

Legislation advanced to move the 22 previously utility-owned but now privately held unregulated generating plants to the state's tax assessment rolls from their traditional [31 ELR 11482] place on municipal assessment rolls. This would allow dramatic increases in the tax assessment of these plants, avoiding the state Proposition 13 2% annual increase limitation on municipal tax rate increases. Such a punitive move also would discourage new plant construction. Municipalities also sought preferential payment of their normal franchise fees from the PG&E bankruptcy court.

The Owners

As the difficulties were evident, FERC approved PG&E's petition, submitted on an emergency basis, to transfer stock, thus changing its corporate structure to protect most of its unregulated assets from the credit problems affecting their regulated electric distribution utility. This immunized certain assets of the company from any possible bankruptcy of the subsidiary retail electric utility company. Stockholder and owner derivative suits could be part of anticipated litigation:

. Attorney General Lockyer asked the federal Securities and Exchange Commission (SEC) to probe the transfer of assets to PG&E's parent company prior to the PG&E bankruptcy filing.

. Attorney General Lockyer also asked the SEC to open an insider trading investigation into the activities of energy consultants hired by Governor Davis.

. Stockholders seeing dividends and stock prices plummet could initiate suits against the distressed IOUs. One such class action suit against PG&E alleges securities fraud under the Securities Act of 1934 for failure to divulge prospective operating losses.

. Bankruptcy Court Judge Dennis Montali, presiding in the PG&E bankruptcy proceeding, originally approved a $ 17.5 million bonus payout to senior managers, then subsequently asked for a more complete explanation. On July 13, 2001, he again approved the payout so as to retain key employees. The payout was opposed by the U.S. Trustee and retired former PG&E executives.

. There could be shareholder derivative suits against directors and officers of utilities and other publicly held companies operating in the deregulated marketplace, alleging negligence, fraud, and failure of fiduciary duty to properly steer the company.

. Recent purchasers of stock in publicly held companies, including utilities, could allege that lack of full disclosure caused them to purchase and over-pay for their shares in the company.

. Bondholders also could initiate suit to the degree that their security is compromised by the California legislation or administrative orders.

. There also is threatened administrative regulatory action, and possible lawsuits, over prior decisions of the PUC to allow the three major California electric utilities to diversify into unregulated businesses, and to restructure their assets. The Northern California Power Agency called the reorganization of PG&E "unconscionable" and accused FERC of assenting to a "stealth filing" which "also smells of an insider preference, a solution barred by the bankruptcy laws," and of the creation of a "ring fence." The California PUC is determining whether California's large IOUs violated rules allowing them to diversify into unregulated businesses.

Qualifying Facilities

Renewable energy producers and cogeneration facilities were particularly hard-hit during the California crisis. There are more than 600 QFs in California, which provide about 15% of the total state power.²⁷ It was estimated that California QFs were owed approximately $ 1.5 billion in back payments by utilities as of March 2001, rising to $ 1.8 billion by mid-2001. Because the fossil fuel-fired cogenerating QFs had not received payment for the power output, they were unable to purchase additional fuels to keep operating their facilities. Consequently, about 110 QF energy producers, representing 3,000 MW, shut down their facilities because of nonpayment. Many of these QF units were threatened with bankruptcy as a consequence of cessation of power production and power sale activities. Some simultaneously ceased paying property taxes to their local communities, causing a ripple effect to municipal coffers.

Heads of California's utilities responded that this nonpayment was not a choice, but was a function of economic necessity and insolvency. Governor Davis accused the utilities of conduct "irresponsible" and "immoral" for not paying QF power producers.²⁸ A California court freed hundreds of QFs from requirements that they supply wholesale power to major California retail electric utilities, if they were not being paid for that power as required by contract. SCEC had not paid approximately $ 140 million for power purchased from QFs between November 2000 and February 2001. After this ruling, SCEC agreed to resume payments to the QFs, and to make advance payments before future power is delivered. In June 2001, the PUC authorized SCEC to pay 15 cents on the dollar for past QF power purchases, assuming the QF demonstrated a need for the funds, with the balance paid later, as well as incentive payments if the QF generates surplus power in the future.²⁹ Past amounts due would be paid at a 10% rate, although this could be challenged as preferential.

An opposite approach was taken by PG&E, which threatened suit if it was forced to pay for QF power prior to a guarantee that it would recover such wholesale power acquisition costs in its retail rates. Simultaneously, legislators sought to legislatively reduce the price that QFs were allowed to receive, pursuant to federal law,³⁰ for their power by changing the gas fuel index used for setting avoided cost, [31 ELR 11483] even though the QFs could not procure gas at the place or price of this northern California index.³¹

PG&E then filed for bankruptcy court protection. The bankruptcy judge refused to allow QFs to abrogate their contracts even though they were not being paid for power sales to utilities, and refused to interfere with the new lower avoided cost prices imposed by the PUC. In July 2001, PG&E signed five-year agreements with 131 QFs with existing contracts, agreeing to pay back amounts owed plus an average energy price of 5.37 [cents]/kwh going forward.

A requested lien against utility assets filed by an unpaid QF was denied. A QF owned by CalEnergy Corporation was granted permission by a California superior court to temporarily suspend performance under its Public Utility Regulatory Policy Act supply contract with its utility, and sell power (at higher prices) to more solvent third parties. Looking toward the future, the California Assembly passed an emergency bill to create a $ 25 million loan guarantee program to fund new renewable energy projects (Alternative Bill 38x). Eligible projects would have to be 1 MW or greater, and the loans would primarily benefit solar photovoltaic and wind turbines, as the preferred technologies.

1. It is estimated that electric power plants are responsible for: 66% of sulfur dioxide (SO₂) emissions, 29% of nitrogen oxide (NO_x) emissions, 35% of carbon dioxide emissions, and 21% of mercury emissions. See CLEAN AIR NETWORK, POISON POWER: HOW AMERICA'S OUTDATED ELECTRIC PLANTS HARM OUR HEALTH AND ENVIRONMENT (1997). Statistics complied by the U.S. Department of Energy, Energy Information Administration, show even higher percentages for SO₂ and NO_x emissions attributable to generating plants. See generally ARNOLD W. REITZE JR., AIR POLLUTION CONTROL LAW: COMPLIANCE AND ENFORCEMENT (Envtl. L. Inst. 2001).

2. The only two treatments of this issue to date are found in 1 STEVEN FERREY, THE LAW OF INDEPENDENT POWER § 10.05[4] (West Publishing, 17th ed. 2001) [hereinafter FERREY, INDEPENDENT POWER] and STEVEN FERREY, THE NEW RULES: A GUIDE TO ELECTRIC MARKET REGULATION ch. 13 (Pennwell 2000) [hereinafter FERREY, NEW RULES], from which some of the case law treatment herein is adopted.

3. The ISO is an independent organization composed of various stakeholders in the California energy market. It establishes the market and coordinates all sales of wholesale power into California. The California Public Utilities Commission is the state-established regulatory authority with jurisdiction over retail power sales and service, as well as distribution (but not transmission) of power. The California Energy Commission is an advisory government agency responsible for the approval of new power generation facilities and transmission and distribution facilities.

4. For a discussion of the experience and efficacy of this so-called second-price auction, see FERREY, INDEPENDENT POWER, supra note 2, at vol. 1, ch. 9.

5. In re PG&E, No. 01-30923DM (N.D. Cal. filed Apr. 6, 2001).

6. S.A. Van Vactor & F.H. Pickel, Money, Power, and Trade, PUB. UTIL. FORT., May 1, 2001, at 41. As power sellers in Oregon and Washington became nervous about selling through multiple jurisdictions into southern California, the financial risk began to decrease the trade from a north-to-south direction on the West Coast. The deregulation legislation required all of the utilities to purchase their loads over a four-year transition period from the California Power Exchange, which was prone to purchasing power at spiked prices.

7. Pasadena, for example, limited certain combustion turbine operation to 300 hours per year on 226 megawatts (MW) of oil-fired and gas-fired capacity. Even if units were allowed to run, the expense of obtaining additional emission credits in the heavily regulated California substantially increased the cost of peak generation. Id. at 40.

8. The mitigation fee is $ 7.50/per pound (lb) for NO_x and $ 1.10/lb for carbon monoxide. The U.S. Environmental Protection Agency concurred on this waiver.

9. San Francisco v. Mirant Potrero LLC, No. C012356 (N.D. Cal. filed June 19, 2001); Communities for a Better Env't & Bayview Hunters Point Community Advocates v. Mirant Potrero LLC, No. C012348 (N.D. Cal. filed June 19, 2001).

10. See 16 U.S.C. § 824a-3, 18 C.F.R. 292.300 et seq.; FERREY, INDEPENDENT POWER, supra note 2, at vol. 1, ch. 4; FERREY, NEW RULES, supra note 2.

11. The following sections are meant to illustrate the possibilities of litigation when a complex deregulated energy system implodes, including pending, as well as possible, claims and litigation.

12. The legal authority for plaintiffs' claims is found in California's Cartwright Act, the California Business and Professions Code §§ 16720 et seq., and the California Business and Professions Code §§ 17200 et seq. The former provides treble damages similar to the federal Sherman Act. Single damages are measured by what the prices would have been without a conspiracy. Joint and several liability is provided for all damages. Indirect purchasers, i.e., consumers of power, are granted standing to sue. The latter statute outlaws "unlawful" business conduct, which is defined as conduct that violates some statute other than the Unfair Business Practices Act. Misleading conduct, which is not fraudulent, might be sufficient without regard to whether a consumer actually detrimentally relied. "Unfair" business conduct has been described as anything constituting immoral, unethical, aggressive, or unscrupulous conduct. The lawsuits allege anticompetitive bidding techniques. Claims for relief are equitable in nature, seeking the disgorgement of profit, restitution, and a civil penalty.

13. Richard Simon et al., Bush Energy Plan Seeks More Nuclear Power, Aid for Poor, L.A. TIMES, May 17, 2001, at A1, A20.

14. Robert Salladay, Energy Crunch: Power Players Blame Deregulation, Creators Defend Their Actions, S.F. CHRON., June 24, 2001, at A1.

15. Lynda Gledhill & Christian Berthelsen, The Energy Crunch: $ 9 Billion Showdown Over Power State Delegation Seeking Refunds, S.F. CHRON., June 25, 2001, at A1; Megan Garvey, Power Regulators to Determine State Refunds, L.A. TIMES, June 25, 2001, at B7.

16. The California PUC had repeatedly held in the past that purchases made through the California Power Exchange and the ISO were, by definition, prudent and reasonable.

17. ELECTRIC UTIL. WK., June 25, 2001, available at http://www.archive.mhenergy.com/cgi-bin/archive/index_main.html (last visited Sept. 21, 2001).

18. See ELECTRICITY DAILY, June 29, 2001, at 1.

19. See Mark Lively, Saving California, PUB. UTIL. FORT., June 15, 2001, at 14.

20. Many of these units utilize oil as their fuel, and face operating restrictions.

21. Rebecca Smith, Power Costs Still Bode Ill for California, WALL ST. J., Mar. 29, 2001, at A3; James Sterngold, California Controller Calls Rate Increase Inadequate, N.Y. TIMES, Mar. 29, 2001, at A12.

22. For a discussion of cost-of-service retail ratemaking principles, see FERREY, INDEPENDENT POWER, supra note 2, at vol. 1, ch. 5.

23. Perata Calls for Investigation of LAWP, Calif, Speaker's Office of Member Servs., Issue No. 22, Mar. 8, 2001, at 1.

24. PLATT'S ELECTRIC UTIL. WK., Apr. 9, 2001, at 1.

25. For a discussion of these topies, see FERREY, INDEPENDENT POWER, supra note 2, at vol. 1, ch. 6.

26. This had occurred in 2000, when the city of Davis attempted to municipalize its utility system.

27. For a discussion of QF requirements and case law, see FERREY, INDEPENDENT POWER, supra note 2, at vol. 1, ch. 4; FERREY, NEW RULES, supra note 2.

28. ELECTRICITY DAILY, Mar. 26, 2001, at 1.

29. In re Southern Cal. Edison Co., Cal. PUC A00-11-038 (June 13, 2001). In March 2001, the PUC ordered the utilities to pay all QFs for power purchases within 15 days of power sale, even though this could be a preferential transfer. Cal. PUC Letter No. 3508 (Mar. 2001). In April 2001, it began investigating whether QFs violated their contractual obligations to supply power to the retail utilities. Cal. PUC Letter No. 10104 (Apr. 19, 2001).

30. 16 U.S.C. § 824a-3.

31. The former index was toprock at the Southern California-Arizona border. This was changed to the Oregon-California border gas index. Cal. PUC Letter No. 01-03-067, R.99-11-022 (Mar. 27, 2001). New five-year contracts were offered at 5.37 [cents]/kwh. Additional payments could be authorized if the QF demonstrated that this price did not cover fuel costs. Such a change raises issues of FERC precedent, the Filed Rate Doctrine, and the Supremacy Clause, as well as possible Public Utility Regulatory Policy Act violations. See FERREY, INDEPENDENT POWER, supra note 2, at vol. 1, ch. 7.