It ain’t over

We knew the prices were high, but a new study shows the terms of the state’s long-term energy contracts could also be disastrous

Senator Steve Peace called the contracts “extortion” by power generators.

Senator Steve Peace called the contracts “extortion” by power generators.

Courtesy Of Steve Peace

The energy crisis ended last year, or at least that’s the conventional wisdom in California. Skyrocketing wholesale electricity prices fell. We’ve emerged from the darkness, as even Governor Gray Davis proclaimed in last week’s State of the State speech: “We confronted the challenge and kept the power flowing to our homes and businesses “cities and farms.”

Yet a strikingly different picture is painted by a little-noticed state audit that was released over the holidays, as well as in a little-covered legislative hearing last week that examined the report.

At issue are the long-term energy contracts negotiated on behalf of state consumers by the Department of Water Resources (DWR), contracts which were for months shielded from public scrutiny by the Davis Administration. Once they were revealed, the media reported that the contracts locked in higher prices for each megawatt than analysts expected in the future.

Blame for the situation could fall on the Legislature, which ordered the buying spree with Fred Keeley’s Assembly Bill 1X. Or it could be put on the generators, whose price-gouging forced the crisis. Or the federal government for refusing to institute wholesale price caps.

But ultimately, it was Davis appointees at DWR who cut the deals, so it’s the administration that has been criticized by Republicans, consumer and taxpayer groups and the media for the bad deals, and has searched for ways to renegotiate the contracts, unsuccessfully so far.

But the average price per megawatt may not be the worst aspect of the contracts. As the 258-page audit and last week’s hearing detail, the frantic rush to sign these contracts last February resulted in many contract provisions that hurt the state, and which are unheard of in such agreements.

As such, many of the contracts could ultimately diminish the state’s power supply, worsen its air quality, compromise its regulatory authority and increase its costs, this summer and for years to come.

Devilish details
During a crisis of rolling blackouts and ten-fold wholesale energy price increases, DWR officials last year signed 57 long-term power contracts obligating the state to pay at least $42.6 billion over the next 10 years. Forty of those contracts—or about 80 percent of the total power purchased—were signed during a 30-day period beginning in February.

So it’s no wonder the DWR—whose negotiators largely lacked the legal and technical expertise they faced across the bargaining table—ended up agreeing to contract terms lacking key safeguards of price, reliability of supplies and who bears the burden if the promised power doesn’t come through.

“Although the department was in a weak bargaining position because of the financial crisis in the electricity markets, its rush to ease the electricity crisis by locking in power supply through long-term contracts weakened its position even further,” the audit read. “In its request for bids, the department did not request contract terms and conditions that are standard in the power industry for entities that must ensure reliable delivery of power.”

Some examples of problematic contract terms:

” Most contracts specify only how much power is to be provided over the course of the year, rather than amounts at peak-demand hours, leaving the state at risk of blackouts or the mercies of the volatile spot market during hot summer days.

” In many contracts, the state assumes the risk for when power can’t be provided by a generator because of delays in building any promised new plants or when plants go out of service due to mechanical difficulties. Few contracts even explicitly allow DWR officials to inspect plants that aren’t operating to see if the generators are being truthful about breakdowns.

” Most contracts contain no opt-out provisions that could release the state from its financial obligations, even in cases where the generators repeatedly fail to deliver promised power supplies.

” Generators are the beneficiaries of improved market conditions in most contracts. Purchases made from natural gas plants contain no provisions for the price to fall as the price of natural gas falls as predicted.

” Most contracts are “nondispatchable,” meaning the state has to pay for contracted supplies whether it needs them or not. And DWR contracted for more power than it is expected to need in Southern California throughout 2004.

” Many of the contracts make the state liable for increased costs of doing business, such as complying with environmental laws, even those enacted by the federal government.

As veteran energy contract attorney Louise Thomas told the Joint Legislative Audit Committee last week, “I have never seen [many of] these provisions before.”

Triple whammy
With several months to study the contracts, Bureau of State Audits investigators delved deeply into some of their more troubling aspects, such as provisions that place California on the hook for the cost of state and federal environmental regulations, creating a disincentive to effectively regulate the power plants.

“Three of the largest long-term contracts (Calpine, Williams and Dynegy), all of which were executed quite early in the contract negotiation process, contain a number of troubling provisions,” the report concluded.

Contracted to sell the state 145,700 gigawatt-hours for $9.8 billion, Calpine is the top contracted supplier, while Williams is fourth after Sempra and Allegheny, contracted to sell 56,500 gigawatt-hours of electricity over the next 10 years at a cost of $3.8 billion.

Calpine is the California company praised last year by Davis administration officials as the reasonable exception to the gouging “pirates,” praise that later haunted the administration when it was revealed that many of the state’s negotiators owned Calpine stock or had other connections to the company.

In the Dynegy contracts, broad language making the state liable for a wide range of increased business costs could, according to the audit, not only make the supply less reliable and more expensive than it appears on the surface, but it could actually require the state to help the company meet its obligation to other customers.

“This means that if Dynegy’s ability to produce and supply power is restricted in any way or any reason related to performance of its contracts with the department, the department must provide power to Dynegy (rather than receive it) for an undetermined period of time after the end of the contracts,” it read.

Provisions of the Dynegy and Williams contracts also make the state liable for buying air emission credits, which companies now must pay for when they exceed air pollution thresholds, when such costs are incurred during the course of supplying power to the state.

“The contracts with Williams, for example, expose the department to between $400 million and $688 million in potential emissions credit pass-though costs over the life of their contracts,” estimated the audit.

The Calpine contracts also transfer to the state some of the financial risks involved as to whether new peaker plants get built on schedule. In addition, the state must make annual “capacity payments” of $80 million to $90 million to Calpine, to reserve some of the plants’ capacity just in case it needs it.

“The department is obliged to make those capacity payment regardless of whether Calpine actually delivers the power to the department.”

DWR may have signed some bad deals, but members of the Joint Legislative Audit Committee bristled at the notion that it made mistakes. Rather, legislators said California was desperate and at the mercy of generators.

“It might have been extortion, but it wasn’t a mistake,” Senator Steve Peace said. “They were in a war, under attack, out-gunned and out-manned and abandoned by their federal government.” Or as Assemblywoman Hannah-Beth Jackson said, “We had a gun to our head in this deal.”

To solve the problem, the committee is considering a wide array of options, from the state filing a lawsuit to have the contracts voided, to pursuing policies and deals that could mitigate the risks in the contracts, to the state simply walking away from them and letting the generators sue, to the more diplomatic approach of trying to renegotiate their terms.

The latter option has been pursued by the Davis administration, which has met with representatives from Dynegy, Sempra, and Calpine.

“We are in the midst of renegotiating the contracts to get more favorable terms and prices,” said Davis spokesman Steve Maviglio, who said he expects to make an announcement in coming weeks that some new deals have been cut.

Yet erasing the damage may not be easy because the state still has little leverage over the generators. As contract attorney Thomas told the committee, “As a practical matter, I don’t think you can drop a nuclear bomb and get rid of all these contracts.”