In hindsight, California's energy crisis was caused by some fundamental factors and some market manipulation. It was prolonged into a big financial crisis by the refusal of regulators to intervene at various stages.
High prices in the California market were driven by a number of factors that reflect simple supply and demand, and that have the ability to induce price spikes and volatility in any energy commodity market.
First, electricity demand had grown very rapidly throughout the Western US in the late 1990s and early 2000s. The summer of 2000 was particularly hot. Remember that California was dependent on other states for roughly one-third of its electricity supply. So rapid population and economic growth in places like Phoenix and Las Vegas meant that there was less surplus electricity to sell to California.
Second, in the year 2000 there was a drought in the Pacific Northwest, whose hydroelectric dams were another source of supply for California. Less water going through those dams meant less power to send to California.
Third, in 2000 there was a major natural gas supply disruption in California. One of the three pipelines serving the state exploded in the summer of 2000 and its owner (El Paso Energy) took many months to bring the pipeline back into service. You might be interested to know that FERC later found El Paso to have been guilty of delaying the pipeline repairs to artificially increase the price on gas flowing through its other pipelines in the western US. Since natural gas is a major fuel source for power plants in California, this had the impact of raising costs and prices for electricity in California's market.
Fourth, California had a cap and trade system called "RECLAIM" for oxides of nitrogen (NOx), which is a power plant pollutant that can cause ground level ozone to form, harming the health of people with respiratory problems. The summer of 2000 coincided with a decline in the number of tradable permits issued under RECLAIM (this was by regulatory design). Emissions costs alone for some plants were more than $100/MWh ($25/lb of NOx).
Fifth (which we have already discussed), there were some fundamental problems with California's market design. The state failed to recognize the problematic level of exposure to the PX spot market and was too slow to try to allow the utilities to sign long-term contracts. The state also refused to allow retail prices to rise when PX market prices started to skyrocket.
Finally, there were many attempts at outright manipulation of California's electricity market. Declaring generation plants "out of service" and pulling them out of the market was one simple way to raise prices. More sophisticated ways took advantage of some peculiarities of California's market rules.
Many of these more sophisticated manipulation techniques (sometimes referred to as "gaming" since they weren't all technically against the rules) were pioneered by a company called Enron, whose logo ironically looked kind of like a crooked letter E. Enron began as a pipeline company in the Midwest, but its employees began to use modern techniques of financial engineering and risk management in the 1980s to hedge fluctuations in the newly deregulated natural gas market. The company lobbied heavily for the creation of electricity markets in California and other places, and until its collapse in 2001 it was judged to be not unlike many technology companies from Silicon Valley - both highly innovative and highly ruthless.
While Enron is known most widely for its attempts to manipulate California's electricity market, it actually created a number of the institutions and practices that we now take for granted in the energy world. Hedging fuel costs using futures and options was basically pioneered by Enron. The idea of using mark to market accounting to value energy assets was another Enron innovation (though its accountants certainly abused this practice). The world's major online platform for energy commodities trading, the Intercontinental Exchange (ICE) was created by Enron.
Enron got a lot of the blame for the collapse of California's electricity market, although they were one of a number of companies that had figured out how to manipulate California's markets. Part of the problem was that California's market rules were so complex and oversight was initially so lax that clever companies like Enron could figure out how to bend the rules without always technically breaking them. This was sometimes called "gaming," since it involved taking advantage of loopholes in the market rules. Whether this gaming behavior was illegal was not always clear, but it was infuriating to politicians in California and the California ISO.
The first such example of gaming came to be known as the "Silver Peak Incident." Silver Peak is the name of a transmission line that connects California and Nevada. It is a small line, with a capacity of about 15 MW. In 1999, an Enron trader named Tim Belden cleared around 3,000 MW in the PX market and scheduled ALL of it on the Silver Peak line. Remember that this was how the California market worked - electricity was cleared through the PX without any regard to the capacity of the transmission system. Reconciling any transmission congestion fell to the California ISO.
So, Tim Belden submitted a schedule that would have sent 3,000 MW on the Silver Peak line, which had 15 MW of capacity. This triggered the congestion adjustment bid process from the California ISO that we met earlier in the lesson. Belden, believing correctly that no one would be paying attention to what was happening on a small transmission line, then submitted an adjustment bid to the California ISO at a very high price.
Enron was thus paid a high price to relieve transmission congestion that it had caused with its initial schedule on Silver Peak. Remember that there was no actual physical power flow here - Enron created a fictitious flow and then canceled it out with an offsetting transaction for which it got paid. Basically what it had done was to create an arbitrage opportunity for itself, not entirely unlike short-selling a stock. Enron created a position for itself with the initial schedule on Silver Peak, and then closed that position with the congestion adjustment offer that effectively canceled the Silver Peak flow.
This strategy, which Enron coined "Death Star" and was used dozens of times, certainly seems sneaky. But nothing Enron was doing technically violated any of the market rules in California. This illustrates a crucial and often overlooked point about electricity markets - they have to be immensely complicated because the power grid is immensely complicated. But creating a complicated market worth tens of billions of dollars gives clever companies all sorts of incentives to use those rules to their advantage. If you happen to see parallels with the US tax system, then you are thinking in the right direction!
Death Star was just one of several gaming strategies used by Enron. Here are a few others - many of them had very colorful names.
Wheel Out was a bizarre strategy related to Death Star. This involved scheduling power flow on a transmission line that was out of service for maintenance or repairs. It is not clear why the California ISO allowed Enron or any market participant to schedule flow on a line that could not carry any power.
Fat Boy was a strategy under which artificial demand was created, which Enron then got paid to serve. It worked in two steps. First, Enron would arrange with a partner or subsidiary to submit an inflated demand forecast for an area of California. This made overall demand in the state look higher than it really would be. Enron would then schedule a large quantity of power for delivery into that particular area of California. So the partner made up some fake electricity demand, and then Enron made up some fake electricity to serve the fake demand. Physically, the fake transactions canceled each other out so it created no actual power flow.
Ricochet was a strategy to skirt the price caps in California that did not apply to other states. Remember that any power generated in California was subject to a price cap, but power imported into California was not. What Enron would do was sell generation from within California to a third party outside of the state, creating an export from California. This third party would then re-sell that power back into California at a price above the cap. Since the owner of the power was from outside of California, the price cap did not apply. This strategy also came to be known as "megawatt laundering" and was supposedly created not by Enron but by the Los Angeles Department of Water and Power.