Report to Congressional Requesters

United States General Accounting Office

GAO

June 2002 RESTRUCTURED

ELECTRICITY

MARKETS

California Market

Design Enabled

Exercise of Market

Power

GAO-02-828
Page i GAO-02-828 Restructured Electricity Markets

Letter 1

Results in Brief 4

Background 5

Suppliers Exercised Market Power during Periods of Tight Demand

and Supply Balances 11

Market Design in California Enabled Exercise of Market Power 18

Conclusion 21

Objectives, Scope, and Methodology 22

Appendix I Determining the Existence of Market Power and

Impact of CAISO Price Caps 24

Appendix II Key Events during Electricity Restructuring in

California 34

Appendix III Summary of Studies on Market Power 36

Appendix IV Bibliography of Selected Studies 38

Appendix V GAO Contacts and Staff Acknowledgments 43

GAO Contacts 43

Acknowledgments 43

Tables

Table 1: Studies of Market Power in California’s Restructured

Electricity Market 11

Table 2: Price Regression Results 26

Contents
Page ii GAO-02-828 Restructured Electricity Markets

Figures

Figure 1: Average Monthly Prices of Electricity in California, April

1998-February 2002 8

Figure 2: Baseline Relationship between Electricity Demand and

Prices (August through October 1998) 14

Figure 3: Comparison of Prices and Demand (Baseline and August

through October 2000) 15

Figure 4: Demand and Prices 30

Abbreviations

CAISO California Independent System Operator

FERC Federal Energy Regulatory Commission

MWh megawatt hour
Page 1 GAO-02-828 Restructured Electricity Markets

June 21, 2002

The Honorable Jay Inslee

The Honorable Peter DeFazio

House of Representatives

Electricity is vital to our daily lives and our national economy. The United

States’ electricity industry is in the midst of major change, and the results

of this change will affect all consumers. Historically, utility monopolies

have generated electricity and sold it to consumers at prices set by state

regulators. Now, in as many as 24 states, numerous private companies

compete to sell electricity at either the wholesale or retail level at prices

determined by the market forces of demand and supply. This change,

commonly referred to as restructuring, is being driven by federal

legislation and regulatory rules as well as by state actions. Restructuring is

intended to improve efficiency in the industry and ultimately lower

consumer prices.

California is part of a broader western market, and electricity is routinely

bought and sold across state and national boundaries. For example,

California has historically imported as much as 20 percent of its electricity

from surrounding states—such as Arizona, Oregon, and Washington as

well as from Canada and Mexico. In addition, California has exported

electricity during periods when supply has exceeded demand in the state.

As in other markets, private electricity suppliers will try to sell their

electricity in whatever location they can get the highest price. As a result,

if prices rise in one state, supply will flow into that state from surrounding

regions, and this potentially causes prices to rise in those regions as well.

California’s electricity industry began operating in a restructured market

in April 1998. As part of the state’s restructuring plan, the three privately

owned utilities1

 operating in the state—serving about 75 percent of

California’s customers—were encouraged to sell much of their electricity

generating capacity to private generating companies, referred to as

wholesale suppliers, to enhance competition in the wholesale electricity

market. To provide electricity to consumers, the three utilities then had to

rely largely on these wholesale suppliers. Wholesale market prices—the

 1

 The three utilities are Pacific Gas & Electric, Southern California Edison, and San Diego

Gas & Electric.

United States General Accounting Office

Washington, DC 20548
Page 2 GAO-02-828 Restructured Electricity Markets

prices utilities paid for electricity they sold to consumers—were

determined in an auction run by a “power exchange,” in which retailers

purchased electricity from wholesale suppliers, generally no more than a

day in advance of the delivery date. At the outset of restructuring, retail

prices charged by the utilities to consumers were still determined by the

California Public Utilities Commission. As such, retail prices were initially

frozen at a level 10 percent below the pre-restructuring rate, with full retail

competition and unregulated retail prices intended to begin later. Finally,

the plan set up the California Independent System Operator (CAISO), a

nonprofit, private corporation charged with managing the transmission

system in the state and balancing demand and supply, at the last minute, to

ensure reliability of supply. California’s market design was approved by

the Federal Energy Regulatory Commission (FERC), which has authority

over the design and operation of wholesale electricity markets.

For two years, the state had relatively low wholesale electricity prices.

Beginning in May 2000, however, wholesale prices rose dramatically in

California and stayed relatively high for about a year. Causes for the high

prices included fast-growing demand, slow-growing supply, and unusually

dry and warm weather in the region, which led to decreased availability of

electricity imported from surrounding areas to California.

State officials and others also claimed that wholesale suppliers were

exercising market power to raise prices above competitive levels. In this

context, market power refers to the ability of individual sellers of

electricity to charge prices above competitive levels. The competitive price

is, by common definition, equal to the additional costs that would be

incurred to produce an additional unit of electricity sold in the market. As

long as sufficient supplies exist, the competitive price is roughly

proportional to the fuel costs required to generate the next unit of power.

However, when supplies grow increasingly scarce, leading to a tight

balance between demand and supply, generating costs can rise

dramatically because they include the costs of running generating units at

higher than normal rates, thereby increasing the likelihood of breakdowns.

At the point that all available generating capacity is in use, the competitive

price will rise until demand equals supply at that price.

It is possible for market power to be acquired and used through legitimate

means. For example, a patent on a new medicine may enable a drug

company legally to charge prices above the costs of producing the drug, or

a gasoline station owner on a busy corner may be able to charge higher

prices than a competitor on a less traveled block, even if they pay the

same amount for the gas they sell. However, federal antitrust laws are
Page 3 GAO-02-828 Restructured Electricity Markets

violated if a company achieves, protects, or expands its market power

through anticompetitive business practices such as colluding with its

competitors to raise prices.

Because of concerns about market power, California officials appealed to

FERC to mitigate the high prices. FERC is responsible for ensuring that

electricity prices are “just and reasonable.” If FERC determines that prices

are not just and reasonable, FERC has authority to order refunds or make

market changes, such as temporarily capping wholesale prices. Such a

price cap would place a limit on the price suppliers could charge for their

electricity.

In summer 2000, California used its authority, granted by FERC, to

implement price caps in the wholesale market to mitigate the high prices.

Further, in December 2000, FERC imposed its own price cap in an attempt

to mitigate prices, although it allowed suppliers to sell at prices exceeding

this cap if they could demonstrate that their costs were high enough to

warrant such a price. All of the wholesale price caps imposed in 2000 were

set at levels far above the frozen retail prices. In winter and spring of

2001—after many months of paying high wholesale prices and selling the

electricity at much lower frozen retail prices—two of the three utilities

became insolvent and were unable to purchase sufficient electricity to

serve their customers. The state then began buying electricity from the

market in the utilities’ stead and eventually negotiated long-term contracts

with wholesale suppliers to provide electricity to the state over periods of

time as long as 20 years in the future.

Wholesale prices remained relatively high until about June 2001, when

prices fell. A combination of events—cooler than usual weather, increased

supply from the addition of new generating facilities, state conservation

efforts, long-term purchases of electricity by the state, and a new regionwide price cap imposed by FERC—has been credited by various state,

federal, and industry sources with causing prices to fall. The state is

currently reviewing and redesigning its electricity market in order to

ensure that the events that led to the high prices in 2000 and 2001 do not

reoccur. The state is seeking approval from FERC for the new design.

You asked us to determine (1) whether wholesale suppliers of electricity

exercised market power by raising prices above competitive levels after

restructuring, and if so, (2) what role, if any, the design of California’s

market played in facilitating the suppliers’ ability to exercise market

power. To address your questions, we performed statistical and other

analyses of electricity market data from April 1998 through October 2000;
Page 4 GAO-02-828 Restructured Electricity Markets

reviewed numerous studies; and interviewed academics, industry experts,

and analysts. Our analysis of market power is focused on the late summer

and early fall of 2000. Because we did not have access to detailed

company-specific data, we were unable to draw conclusions about the

behavior of individual wholesale suppliers in 2000. In particular, we did

not have data that would have enabled us to evaluate the effects of

recently revealed trading strategies by Enron, wholesale suppliers, or

other companies trading in electricity markets. Further, we did not assess

whether the high prices experienced in California were the result of

violations of federal antitrust or other laws relating to the sale of electric

power. Such assessments fall under the jurisdiction of state attorneys

general or federal entities such as the Department of Justice and the

Federal Trade Commission. A number of lawsuits have been filed

concerning various aspects of the California electricity market. Among

these, are pending lawsuits alleging antitrust, fraud, and other violations of

law. Appendix I provides a complete discussion of our methodology.

Our analysis and other studies found evidence that wholesale electricity

suppliers exercised market power by raising prices above competitive

levels during the summer of 2000 and at other times after restructuring.

Neither our analysis nor the other studies addressed whether any market

power exercised in California was in violation of federal or other laws

pertaining to the sale of electricity. However, our analysis and other

studies found that during some periods, prices did not follow patterns

consistent with prices under competitive conditions. For example, several

studies concluded that wholesale suppliers were able to exercise market

power by withholding electricity from the market, only making it available

at the last minute when buyers were desperate to acquire enough

electricity to meet demand and therefore willing to pay higher prices. As

part of our analysis, we also found evidence of increasingly tight balances

between demand and supply during the same period—a hot summer

caused demand to rise, while dry weather the previous winter meant that

hydroelectricity was in short supply. Because tight demand and supply

balances would also lead to higher than normal prices, even under

competitive conditions, we could not isolate how much of the relatively

high prices was due to the exercise of market power. Other factors, such

as environmental constraints on some electricity generators and higher

fuel costs, were also identified by the other studies as contributing factors

to the high prices.

The design of California’s electricity market enabled individual wholesale

suppliers of electricity to exercise market power. In addition, once prices

Results in Brief
Page 5 GAO-02-828 Restructured Electricity Markets

rose, in part as a result of market power, the design lacked effective

mitigation strategies to return prices to competitive levels. Prominent

experts on market design and industry experts generally agree that two

principal market design flaws increased wholesale suppliers’ incentive and

ability to raise prices above competitive levels: (1) retail prices were

frozen, and (2) with few exceptions, the California Public Utilities

Commission prohibited or discouraged long-term contracts between

utilities and wholesale suppliers. The experts and analysts concluded that

the frozen retail electricity prices in California made it more profitable for

suppliers to raise prices, because when they did, consumers did not

reduce their use of electricity. Because retail prices were frozen,

consumers had no financial incentive to reduce their demand when

wholesale prices rose in summer 2000. This is unlike most other markets,

in which consumers choose to buy less when prices rise. When consumers

respond to prices in this way, suppliers know that if they raise their prices,

they will lose some of their business. Concerning the lack of long-term

contracts between utilities and wholesale suppliers, the experts and

analysts concluded that this situation increased suppliers’ ability to

exercise market power because, without contractual obligations to

generate electricity, suppliers could withhold part of their supply. As a

result, electric utilities—required by design to serve all of consumer

demand in their service areas—had to compete to purchase increasingly

scarce electricity. Under these circumstances, wholesale suppliers were

able to raise their prices above competitive levels. Our analysis shows that

California’s market design also lacked effective price mitigation strategies

to be used once the exercise of market power was suspected. More

specifically, in 2000, price caps imposed by the California Independent

System Operator were ineffective in reducing prices to competitive levels,

allowing the high prices to persist. Other studies and expert opinion also

concluded that these price caps did not work, in part because they applied

only to the state of California, leading to problems getting needed

electricity into the state when electricity prices in other states rose above

the California price caps.

Prior to restructuring, the electricity industry in California was organized

around three regulated monopoly utilities, which were responsible for

ensuring that electricity demand and supply were balanced at all times in

order to maintain a reliable electricity system. The utilities owned and

operated the electricity generating facilities as well as the electricity

transmission system (i.e., the actual wires that carry electricity from

generators to final consumers). The utilities sold electricity to consumers

at prices determined by the state’s Public Utilities Commission—a state

Background
Page 6 GAO-02-828 Restructured Electricity Markets

regulatory agency. Charges to cover the costs of generating the electricity

as well as the costs of maintaining and operating the transmission system

were included in the retail electricity prices set by the commission.

Utilities were allowed to earn a “normal rate of return” on all approved

capital expenditures required to build generating facilities and the

transmission system itself.

Seeking to improve efficiency and reduce electricity prices, California

began restructuring its electricity market during the 1990s. As part of the

state’s restructuring plan, the utilities were encouraged to sell much of

their generating capacity to private companies. This divestiture was

intended to increase the number of competitors in the wholesale

electricity market. The plan also set up the California Independent System

Operator (CAISO), a private nonprofit corporation charged with managing

the transmission system in the state and balancing demand and supply to

ensure reliability of the system. Under the plan, the utilities would still

own some generating capacity and own and maintain the transmission

system. In the restructured market, which formally opened on April 1,

1998, private generators were able to sell electricity to the utilities through

the newly created California Power Exchange in daily and hourly auctions.

The power exchange was intended to be the primary market for wholesale

electricity sold in the state. To ensure that the power exchange was a

competitive market with many suppliers, the Public Utilities Commission

required the utilities to sell their remaining generating capacity into the

power exchange market. The Public Utilities Commission also limited the

utilities’ ability to enter into long-term contracts to purchase electricity

wholesale, which effectively required them to purchase almost all of their

electricity needs from the power exchange. As a result of these actions,

most electricity purchases occurred in the short term—generally, at most

one day ahead of when the electricity was needed.

Under restructuring, retail prices were frozen, while wholesale prices were

to be determined by market conditions of demand and supply. In an

attempt to ensure that consumers received some immediate benefits from

restructuring, California’s restructuring legislation required retail prices be

frozen for up to 4 years at a level 10 percent below the prices that were in

effect immediately prior to restructuring. Policy makers anticipated that

the reduced retail prices would be higher than wholesale prices and would

therefore allow the utilities to continue to recover costs they incurred in

the old regulated market and that had not yet been recouped. Wholesale

prices were determined in the power exchange market, and the CAISO

bought some electricity near the last minute to maintain a precise balance

between demand and supply. FERC’s authority was unchanged; the agency
Page 7 GAO-02-828 Restructured Electricity Markets

continues to monitor the functioning of wholesale markets and retains

responsibility for ensuring that wholesale prices are just and reasonable.

For the first two years of California’s restructured market, overall

wholesale prices were fairly low, averaging about $33 per megawatt-hour

(MWh)2

 compared with the frozen retail prices, which were set at about

$65 per MWh. However, overall wholesale prices rose significantly in May

2000 and remained very high through May 2001.3

 These overall prices

reached an all-time peak in December 2000 of $317 per MWh. Figure 1

shows the monthly average overall prices since April 1998, when the

restructured market began operating, through February 2002.

 2

 One megawatt-hour is enough electricity to serve the needs of 750 typical homes for an

hour.

3

 Overall prices are an average of prices paid in the power exchange markets and prices

paid by the CAISO for last-minute purchases.
Page 8 GAO-02-828 Restructured Electricity Markets

Figure 1: Average Monthly Prices of Electricity in California, April 1998-February 2002

Source: GAO’s presentation of data from CAISO.

As we reported in June 2001, average wholesale prices of electricity sold

through the power exchange during the months of May through December

2000 were between 2 and 13 times higher than prices in the same months
Page 9 GAO-02-828 Restructured Electricity Markets

of the previous year.4 In addition, there were frequent periods, especially

in the winter of 2000-2001, when the electricity system was in danger of

service disruptions, and there were a number of days when rolling

blackouts occurred. During this period, two of the state’s three major

utilities became insolvent and were unable to pay for their purchases of

electricity. The California Power Exchange ceased doing business in

January 2001 and later declared bankruptcy, as the state assumed

responsibility for buying electricity on behalf of the utilities. (See app. II

for a timeline of key events occurring in the California electricity market.)

Various factors have been cited as contributing to California’s high

electricity prices.

• Increased demand for electricity combined with a shortage of supply

created increased scarcity beginning in May 2000. As we noted in our June

2001 report, demand for electricity rose by as much as 13 percent from

1995 through 2000, while supply growth did not keep pace.5

• Imported electricity from the Pacific Northwest, which California

depended upon to meet its needs, was less available because an extremely

dry winter in 2000 had reduced hydropower generation. In addition,

imports from southwestern states were less available because higher-thannormal temperatures increased electricity demand in those states.

• Costs of generating electricity rose in 2000. In particular, prices of natural

gas—the fuel used to generate as much as 40 percent of California’s

electricity—rose in 2000 compared to 1998 and 1999 prices. Also the costs

of emissions permits, which some generating plants are required to own in

order to operate, also rose in 2000.

• California state officials and others cited the exercise of market power by

suppliers as a cause of the dramatically higher prices.

California officials attempted to mitigate high wholesale electricity prices

in several ways. The CAISO attempted to control wholesale price

increases by using a price cap to limit the maximum price it would pay for

electricity it purchased. During the summer of 2000, this maximum price

was lowered twice: from $750 to $500 per MWh in July and again from

 4

 U.S. General Accounting Office, Energy Markets: Results of Studies Assessing High

Electricity Prices in California, GAO-01-857 (Washington, D.C.: June 29, 2001) .

5

 U.S. General Accounting Office, California Electricity Market Options for 2001:

Military Generation and Private Backup Possibilities, GAO-01-865R (Washington, D.C.:

June 29, 2001).
Page 10 GAO-02-828 Restructured Electricity Markets

$500 to $250 in August. Despite the caps, overall wholesale electricity

prices remained higher than in the previous two years. As a result,

California requested assistance from FERC. In December 2000, FERC

implemented its own mitigation strategy that capped wholesale prices at

$150 per MWh, but allowed suppliers to charge higher prices if they could

demonstrate to FERC that their costs of generating the electricity

exceeded the price cap. Even after FERC’s actions, prices remained much

higher than normal through May 2001. In June 2001, FERC implemented a

region-wide price cap that effectively limited prices to a maximum of

about $92 per MWh in all western states.6

 The state also took steps to

expedite the siting of new power plants, promote energy conservation (in

part by raising retail prices), and to negotiate long-term contracts with

electricity suppliers.

In June 2001, overall wholesale prices fell dramatically and continued to

decline for several more months, eventually dropping to about $40 per

MWh as of December 2001. Numerous reasons have been advanced for

these decreasing prices, including the price mitigation efforts by the state

and FERC. In addition, demand was lower because of moderate weather

conditions, and electricity-generating costs fell due to lower costs for

purchasing natural gas.

Despite the current moderate electricity prices and estimates of enough

electricity to meet the state’s needs for the summer of 2002, California’s

electricity market faces an uncertain future for a number of reasons:

(1) FERC’s region-wide price caps are scheduled to expire September 30,

2002; (2) CAISO is still in the process of redesigning the electricity market

and will seek approval from FERC for their new design; and (3) California

officials are attempting to renegotiate many of the long-term contracts

they signed with wholesale electricity suppliers in early 2001 because the

prices they negotiated are much higher than current market prices.

Further, as we recently reported, many proposals for new power plants in

California have been cancelled because of factors such as the national

economic slowdown; lower electricity prices; and the increased risk of

entering a market where the market design and rules are uncertain.7

 6

 The FERC price cap is actually linked to costs of generating electricity. If costs rise or fall,

the cap will also rise or fall.

7

 U.S. General Accounting Office, Restructured Electricity Markets: Three State’s

Experiences in Adding Generating Capacity, GAO-02-427 (Washington, D.C.: May 24,

2002).
Page 11 GAO-02-828 Restructured Electricity Markets

Our analysis found that electricity suppliers exercised market power by

raising prices above competitive levels during some periods after the

restructured market opened. In particular, we found that in parts of 2000,

electricity prices did not follow the usual pattern of rising during the highdemand hours and falling during low-demand hours—rather, the highest

prices were not found in the hours of highest demand. In addition,

numerous studies conducted by prominent economists and other industry

analysts also found evidence that individual suppliers exercised market

power by raising their prices above competitive levels during certain

periods. In explaining the high prices, the studies pointed to other factors

as well, such as environmental constraints on some generators, higher fuel

costs, and a generally tighter supply-demand balance, which increased

suppliers’ costs and contributed to relatively scarce supply during 2000.

Table 1 summarizes our findings and the results of the other studies.

Table 1: Studies of Market Power in California’s Restructured Electricity Market

Study/Authors Period studied Methodology Results or findings

GAO analysis April 1998-October 2000 Estimated the relationship between

market price and total demand for

electricity during a baseline period.

Estimated the relationship between

price and demand in AugustOctober 2000 period—a high price

period—and compared it to the

baseline. Used other market data to

attempt to explain observed

differences. Remaining unexplained

differences attributed in part to

market power.

Prices across different levels of demand

were inconsistent with baseline

relationship between price and demand.

Other factors—including fuel costs and

levels of imported electricity, total

demand, and in-state generation—did

not explain the different pattern.

Price pattern was consistent with market

power being exercised in off-peak hours.

Berkeley/Stanford

study

June 1998-October 2000 Estimated the marginal cost of

supplying electricity and compared

this cost to market prices. Prices

greater than marginal cost were

deemed to imply exercise of market

power.

Market power was exercised in peak

demand periods in 1998 and 1999, and

more extensively in summer 2000. Fiftyone percent of total electricity

expenditures in summer 2000 were

attributable to market power.

MIT study June-September, 2000 Estimated competitive benchmark

prices. Compared actual market

prices with the benchmark. Prices

higher than benchmark were

deemed to imply exercise of market

power.

Prices far exceeded competitive levels

during study period. Fuel costs,

emissions permit prices, and other

factors accounted for some of high

prices. Market power accounted for the

rest.

CAISO-A study May-November, 2000 Reviewed individual suppliers’ offers

to sell electricity. Compared the

offered prices with estimated

marginal costs of generating power

for each supplier. Offered prices

higher than marginal costs were

deemed to imply exercise of market

power.

Some offers to sell were inconsistent

with competitive behavior. Evidence

indicates that suppliers withheld

electricity to drive up prices.

Suppliers Exercised

Market Power during

Periods of Tight

Demand and Supply

Balances
Page 12 GAO-02-828 Restructured Electricity Markets

Study/Authors Period studied Methodology Results or findings

CAISO-B study: April 1998-February 2001 Estimated baseline marginal costs

of generating electricity that would

occur under competition. Compared

market prices to these costs. Prices

higher than marginal costs were

deemed to imply exercise of market

power.

Suppliers exercised market power during

the study period. Overall costs to state

attributed to market power: $6.2 billion.

California State

Auditor Study

April 1998-December 2001 Reviewed other studies, interviewed

experts, reviewed bidding data.

Suppliers deliberately attempted to

manipulate prices. Suppliers withheld

supply, causing CAISO to pay high

prices to maintain system balance and

avoid blackouts.

Source: GAO’s analysis and GAO’s presentation of data from other studies.

To determine whether there was evidence that wholesale electricity

suppliers exercised market power in California, we evaluated data from

August through October 1998—a period of relatively low wholesale

prices—to establish a competitive baseline relationship between

wholesale electricity prices and the level of demand. We selected this

baseline period because previous studies indicated that prices during the

period were, for the most part, competitive. Then we compared the

baseline to the period from August through October 2000, when wholesale

prices were on average much higher, to determine whether the pattern of

prices was consistent for comparable situations in the two periods. 8

 Our

analysis used price data from the power exchange market and demand

data from CAISO.

Under competitive conditions, prices of electricity are expected to follow

a pattern in which high prices correspond to hours of the day in which

demand for electricity is high and low prices correspond to low-demand

hours. This pattern occurs because competitive electricity prices reflect

the changing costs of producing electricity. The competitive price of a

MWh of electricity is equal to the additional amount it would cost to

generate an additional megawatt-hour, once all current demand is met.

This additional cost is commonly referred to as the marginal cost. The

marginal cost of generating electricity rises as more electricity is

 8

 We chose these two periods after conducting a statistical analysis of price and demand

data from April 1, 1998, through October 31, 2000. This analysis indicated that the August

through October 2000 period differed significantly from similar months in 1998 and 1999,

when prices were relatively low. Therefore, we focused further on this period and

compared it to the same months in 1998.

Our Analysis Found

Suppliers Exercised

Market Power
Page 13 GAO-02-828 Restructured Electricity Markets

produced, because different generators use different types and amounts of

fuel. For example, hydroelectric and nuclear generating plants have very

low fuel costs, while natural-gas-burning plants have higher fuel costs.

Generating plants with low marginal costs generally operate during more

hours of the day than those with higher marginal costs—the highest-cost

plants operate only during the very highest demand hours and may even

sit idle most of the year. Therefore, under competition, the rising marginal

cost of electricity leads to high prices when demand is high and low prices

during low-demand periods.

Figure 2 shows actual average demand and prices for different hours of

the day from August through October 1998, the period that we used as our

baseline. As the figure shows, prices are generally lower during lowdemand hours and higher during high-demand hours.
Page 14 GAO-02-828 Restructured Electricity Markets

Figure 2: Baseline Relationship between Electricity Demand and Prices (August

through October 1998)

Source: GAO’s presentation of price data from the California Power Exchange and demand data from

CAISO.

Figure 3 illustrates the price and demand patterns we observed during the

baseline period compared to those for the period from August through

October 2000. In comparing this baseline relationship to the prices and

demand observed from August through October 2000, we found that

average prices were much higher during the 2000 period than in the

baseline. Other studies attributed part of this increase in prices to the

exercise of market power. In addition, we found that the relationship

between prices and demand observed during the 2000 period was not

consistent with what would be expected under competitive conditions.

Specifically, during the period analyzed, average prices during the heaviest

demand hours were actually lower than in surrounding, lower-demand

hours.
Page 15 GAO-02-828 Restructured Electricity Markets

Figure 3: Comparison of Prices and Demand (Baseline and August through October

2000)a

a

 The actual dates for the 2000 period are August 7 through October 31, 2000 to coincide with the

$250 price cap. The 1998 period runs from August 1-October 31. We refer to both periods as August

through October.

Sources: GAO’s presentation of price data from the California Power Exchange and demand data

from CAISO.

Figure 3 shows that the hours of highest demand—1 p.m. through 4 p.m.

and 5 p.m. through 8 p.m.—did not correspond to the highest average

price, as would be expected under competitive conditions. Instead, the

highest average prices came in the lower demand hours of—9 a.m. through

12 p.m. and 9 p.m. through 12 a.m. For example, in the highest demand

hours, 1 p.m. through 4 p.m., demand averaged about 33,300 MWh, and the

price averaged about $164 per MWh. In contrast, during the hours, 9 p.m.
Page 16 GAO-02-828 Restructured Electricity Markets

through 12 a.m., demand averaged about 27,600 MWhs and price averaged

about $182 per MWh.

We discussed the patterns of prices with CAISO staff and reviewed studies

to try to explain why the prices did not follow the expected pattern in

August through October 2000. According to CAISO staff, during this

period, some suppliers increased the proportion of their electricity

generation that they sold directly to CAISO, as opposed to selling in the

power exchange as the market design intended. CAISO staff explained

that, during this period, CAISO purchased some electricity at the last

minute at prices above the prevailing price cap in order to keep demand

and supply in balance and avoid blackouts. As a result, staff said, in-state

suppliers withheld some of their electricity from the power exchange

market and waited to sell at higher prices at the last minute. One recent

study of the California electricity market concluded that suppliers knew

that CAISO was unwilling to allow blackouts, even when prices were very

high.9

 Therefore, the study concluded, the price cap created a game of

“chicken” between suppliers and CAISO. Suppliers would wait until the

last minute to sell their electricity, in an attempt to see how much the

increasingly desperate CAISO would pay. The supplier behavior described

by CAISO staff and in studies we reviewed was consistent with the

exercise of market power, because the prices charged did not reflect the

marginal costs of generating additional megawatt-hours of electricity.

Rather, the behavior reflected an ability to charge higher prices by waiting

to commit the generation to a time when buyers were willing to pay more.

Other studies we reviewed analyzed the marginal costs of generating

electricity during this period and concluded that these costs were well

below the market prices we observed.

In addition to discussing our findings with CAISO staff and reviewing

other studies, we examined other market data to try to explain the

unexpected pattern of demand and prices observed from August through

October 2000. We found that the supply of electricity was scarcer during

that period than during the baseline period, owing in large part to a

reduction in available imports of electricity from other western states.

While greater scarcity can explain generally higher prices, it does not

explain the pattern of prices we found. Even when electricity becomes

 9

 Borenstein, Severin, “The Trouble With Electricity Markets: Understanding California’s

Restructuring Disaster,” Journal of Economic Perspectives, Volume 16, Number 1, Winter

(2002): pages 191-211.
Page 17 GAO-02-828 Restructured Electricity Markets

increasingly scarce, prices should be higher during high-demand periods

than when demand is lower, unless suppliers can, through the exercise of

market power, affect prices in lower-demand periods. Therefore, based on

our analysis and our review of other studies, we believe this pattern of

prices demonstrates that suppliers exercised market power by raising

prices above their marginal cost. Because we did not have specific cost

data and could not accurately measure the role of scarcity in determining

prices, we were unable to isolate the relative role of market power in

causing the high prices found during 2000.

The authors of the other studies discussed in table 1 found that suppliers

exercised market power by raising prices above marginal costs of

generating electricity. Although these authors used different

methodologies and studied varying time frames, they all reported that the

exercise of market power was a key factor contributing to higher prices in

the California market. The reported effect that market power had on

prices varied: while the California State Auditor made no specific estimate,

the authors of the Berkeley/Stanford study attributed as much as

51 percent of the price increases in the summer of 2000 to market power.

The CAISO-B study concluded that $6.2 billion in higher electricity prices

resulted from the exercise of market power by electricity suppliers during

May 2000 through February 2001. Additional details of these studies are

presented in appendix III.

The authors of the studies reported that other factors besides market

power, such as increased production costs and a tight supply-demand

balance, also contributed to higher electricity prices in California. Some of

the authors noted that higher production costs contributed to higher

prices in California during 2000 compared with earlier years. These costs

included costs to purchase natural gas, which had increased in price, and

costs of emissions permits required for some generators to allow them to

operate. Some of the authors reported that tight demand and supply

balances also affected prices. Demand increased because of unusually hot

weather, while supply was scarcer because of the reduced availability of

electricity imports from other states and a lack of new electricity

generation in California in the preceding years.

Other Studies also Found

Suppliers Exercised

Market Power
Page 18 GAO-02-828 Restructured Electricity Markets

California’s market design enabled wholesale electricity suppliers to

exercise market power. According to prominent experts and analysts, two

principal market design flaws increased suppliers’ ability to raise prices

above competitive levels: (1) retail prices were frozen, and (2) with few

exceptions, the Public Utilities Commission limited utilities’ ability to

enter into long-term contracts with suppliers. In addition, we found that

California’s market design lacked effective price mitigation strategies to be

used once exercise of market power was suspected.

A provision of California’s restructuring legislation froze retail prices for

consumers for 4 years or until the utilities recovered certain costs incurred

under the prior regulated market.10 Numerous authors of studies of the

California electricity market, including those studies discussed previously

in this report and others, noted that the retail price freeze meant that

consumers in California did not reduce their use of electricity when prices

began to rise in May 2000.11 Economists and other market design experts

commonly recognized that such insensitivity to price changes is a key

factor that enables suppliers to raise prices above competitive levels under

tight supply conditions.12 Therefore, the frozen retail prices in California

created a situation in which suppliers could charge high prices during

some periods without worrying that consumers would reduce their use of

electricity.

With few exceptions, the California Public Utilities Commission severely

limited the utilities’ use of long-term contracts until after electricity prices

increased in the summer of 2000.13 The Congressional Budget Office notes

that in California, as much as 50 percent of electricity purchases occurred

 10The retail price freeze was in effect for Pacific Gas & Electric Company and Southern

California Edison for the entire 4-year period. San Diego Gas and Electric Company

recovered its costs in 1999 and started charging consumers their full costs. When prices

rose in spring and summer 2000, California enacted legislation in September 2000 to again

freeze consumer prices for most customers of San Diego Gas and Electric Company.

11 See appendix IV for a complete bibliography of studies we reviewed.

12 For a discussion of the relationship between price sensitivity and the ability of suppliers

to exercise market power, see Jean Tirole, The Theory of Industrial Organization, The

MIT Press, 1988.

13 Even after the restrictions on long-term contracts were relaxed, the Public Utilities

Commission would not guarantee that utilities could recover what they paid for electricity

purchased in long-term contracts. Officials of one of the three main utilities told us that,

without such a guarantee, they believed the risk of signing long-term contracts was too

great.

Market Design in

California Enabled

Exercise of Market

Power
Page 19 GAO-02-828 Restructured Electricity Markets

immediately before electricity was needed to meet demand, compared to

10 to 20 percent in other states that had restructured their electricity

markets.14 Economists and other market design experts recognize that

when suppliers have signed long-term contracts to sell much of their

capacity at pre-determined prices, they have a much smaller incentive and

ability to exercise market power. For example, authors of a study of the

June 2000 price increases in California concluded that if the utilities had

signed long-term contracts for their expected demand for the months of

May and June 2000, average prices in the power exchange would have

been significantly lower.15 FERC also reported in November 2000 that

flawed market rules—especially frozen retail prices and limited long-term

contracts—contributed to unusually high prices in the summer of 2000 in

California.16 These studies and others concluded that the absence of such

contracts between California’s utilities and wholesale suppliers created

conditions under which these suppliers could and would exercise market

power.

In the course of our analysis, we found that the CAISO’s use of price caps

was ineffective in mitigating high prices and bringing them down to

competitive levels in 2000. Other studies and expert opinion also

concluded that these price caps did not work, in part because they only

applied to the state of California—when prices in surrounding states were

higher than the CAISO’s price cap, wholesale suppliers naturally tried to

sell to the highest location, which led to problems getting needed

electricity into California.

Our statistical analysis indicates that the CAISO price caps were

ineffective in bringing prices down; in fact, when they lowered the price

 14 Congressional Budget Office, Causes and Lessons of the California Electricity Crisis,

Washington, D.C., September 2001.

15 Frank A. Wolak, Robert Nordhaus, and Carl Shapiro, An Analysis of the June 2000 Price

Spikes in California ISO’s Energy and Ancillary Services Markets, a special report for

the Market Surveillance Committee of the California Independent System Operator,

September 6, 2000.

16 Federal Energy Regulatory Commission, Staff Report to the Federal Energy Regulatory

Commission on Western Markets and the Causes of the Summer 2000 Price

Abnormalities (Washington, D.C., Nov. 1, 2000).
Page 20 GAO-02-828 Restructured Electricity Markets

cap from $750 to $500 per MWh and again to $250, average prices rose.17

Specifically, prices during May and June—when the $750 price cap was in

place—averaged about $93 per MWh. During the period in which the $500

cap was in place—July1 through August 6—prices rose, averaging about

$143 per MWh. When the price cap was lowered again to $250, prices again

rose, averaging about $164 per MWh from August 7 through October 31.

Our analysis does not allow us to say whether the price caps caused the

increase in average prices, or if so, explain why that happened, but it is

clear that they were not effective in bringing prices down to competitive

levels.

We reviewed studies and interviewed experts to try to determine why the

price caps were not effective. There was general agreement that one major

flaw in the design of the price caps was that they did not apply to the

entire western region. As one expert put it, “California is part of a larger

western electricity market, and as a result, the CAISO price cap created an

incentive for suppliers to sell electricity outside of California whenever

prices were higher in surrounding states.” Another study concluded that

the implementation of the price cap was also flawed. The author of the

study noted that the CAISO did not commit to keeping a firm price cap,

because it was unwilling to impose blackouts on customers even when

prices increased a great deal. As a result, the author said, the CAISO was

put in a very weak position when it came to negotiating prices for

electricity at the last minute and suppliers were able to drive up prices

above the cap level.

The CAISO told us that as part of the design of California’s restructured

electricity market, the CAISO had limited authority to mitigate high prices

when it found they were caused by the exercise of market power. This

authority was largely limited to imposing prices caps on what the CAISO

would be willing to pay for electricity from in-state suppliers. These caps

did not apply to electricity purchased from out-of-state suppliers.

Moreover, if prices outside the state rose above the California price cap,

then in-state suppliers would have an incentive to export electricity,

thereby making electricity scarcer and placing a greater burden on the

CAISO to purchase more electricity at the last minute to balance demand

 17 Our analysis focuses on prices in the power exchange market and therefore does not

address the prices CAISO paid for electricity in last minute purchases. Price caps may have

affected the prices paid by the CAISO, but we did not have sufficient data to analyze this.

Nonetheless, the majority of electricity purchases during the period we analyzed were

made in the power exchange.
Page 21 GAO-02-828 Restructured Electricity Markets

and supply, sometimes at prices above the price cap. As a result, capping

prices in the state was ineffective in bringing down the total expenditures

on electricity.

FERC also implemented a mitigation plan in December 2000. FERC’s

mitigation plan reduced the price cap from $250 to $150, but allowed

sellers to receive higher prices for their electricity if they could justify the

higher prices by demonstrating that their costs of generating or acquiring

the electricity were higher than $150 per MWh. As mentioned previously in

this report, prices remained relatively high throughout the winter of 2000

and 2001 despite FERC’s mitigation efforts.18 While it would appear that

FERC’s December mitigation plan was not effective in bringing prices

down to competitive levels, there were other confounding changes in the

market environment, including sharp increases in natural gas prices and

increasing financial difficulties of the state’s three largest utilities, that

make it difficult to isolate the impact of FERC’s actions on prices.

Therefore, we were unable to evaluate the effectiveness of FERC’s

mitigation strategy.

As discussed in this report, a number of factors caused electricity prices to

rise in California in the summer of 2000 and at other times since

restructuring. Based on our analysis and studies by prominent economists

and other market analysts, the exercise of market power by wholesale

suppliers was clearly one of those factors explaining the high prices.

Further, the design of the California electricity market created almost

textbook conditions under which market power would be expected to

exist. As a result, electricity suppliers could withhold electricity from the

market until it was critically needed, and at that time, could raise prices

above competitive levels. Attempts by the CAISO to mitigate the resulting

high prices during 2000 were unsuccessful due to inadequacies in design

and implementation of the mitigation strategies. This experience in

California highlights the importance of properly designing competitive

electricity markets and the need for effective mitigation when restructured

markets do not perform as expected.

 18 In June 2001, FERC revised and expanded its mitigation plan, lowering the price cap

again and extending its scope to encompass all western states. Subsequently, prices fell

dramatically. As discussed previously, FERC’s region-wide price cap has been partially

credited by some for causing prices to fall. Other factors that may have led to lower prices

were cooler weather, increases in supply, conservation efforts, and the state’s long-term

electricity contracts with wholesale suppliers.

Conclusion
Page 22 GAO-02-828 Restructured Electricity Markets

To determine whether wholesale suppliers of electricity exercised market

power, we examined and analyzed market data on generation, demand,

and prices of electricity in California from April 1998 through October

2000. We did not analyze the period after October 2000 because there were

many changes to the market, that beginning in November 2000 made it

difficult to determine what competitive prices should be. Among these

changes were sharp increases in natural gas prices, increasing financial

difficulties for the state’s two largest utilities, and the eventual closure of

the power exchange. The data we used came from the California Power

Exchange, CAISO, and California Energy Commission. We performed

statistical analyses to determine whether there were changes in the

pattern of prices across different levels of demand during the summer and

early fall of 2000. We also assessed other possible explanations for the

high electricity prices experienced during 2000, including increased

scarcity of supply, higher than normal demand, natural gas fuel costs faced

by sellers, and the reduced availability of imports of electricity from other

states. Appendix I contains a complete discussion of our methodology and

analysis. In addition, we evaluated numerous other studies to determine

what other analysts had concluded about the existence and extent of

market power in the California electricity market. In particular, we

focused on five studies that covered a range of time periods and

methodological approaches and that addressed directly at least one of our

objectives. A full bibliography of the studies we reviewed is contained in

appendix IV. We did not have sufficient data to evaluate whether

individual companies exercised market power, or to determine how much

of the high prices experienced in California was the result of market

power versus other factors that may have led to tighter demand and supply

balances or to higher costs of generating electricity during this period.

To determine what role, if any, the design of California’s market played in

facilitating suppliers’ ability to exercise market power, we evaluated the

CAISO’s price mitigation efforts. Specifically, we performed a statistical

analysis of the relationship between prices and levels of demand,

controlling for the various price caps imposed by the CAISO. We

compared the periods in 2000—during which the CAISO lowered its price

caps twice, and prices were generally high—with previous periods in 1998

and 1999, during which prices were generally lower. We also reviewed

numerous studies by academics, industry analysts, and government

agencies. Further, we interviewed academics, industry experts, industry

participants, and officials from state and federal government, including the

CAISO, California Energy Commission, Electricity Oversight Board of

California, California Public Utility Commission, and FERC. In addition,

where applicable, we applied established economic concepts and theories

Objectives, Scope,

and Methodology
Page 23 GAO-02-828 Restructured Electricity Markets

to predict the likely effects of the CAISO’s market power mitigation plan

on prices and the supply of electricity.

We evaluated as well, FERC’s market power mitigation plan, implemented

in December 2000. Data limitations precluded us from evaluating the

effectiveness of the FERC plan, but we reviewed academic studies that

discussed FERC’s mitigation methodology.

We conducted our work from July 2001 through May 2002 in accordance

with generally accepted government auditing standards.

As arranged with your offices, unless you publicly announce its contents

earlier, we plan no further distribution of this report until 30 days after the

date of this letter. At that time, we will send copies to appropriate

congressional committees, the Federal Energy Regulatory Agency, the

Director of the Office of Management and Budget, and other interested

parties. We will make copies available to others on request.

If you or your staff have any questions about this report, please contact me

at (202) 512-3841. Key contributors to this report are listed in appendix V.

Jim Wells

Director, Natural Resources

and Environment
Appendix I: Determining the Existence of

Market Power and Impact of CAISO Price

Caps

Page 24 GAO-02-828 Restructured Electricity Markets

This appendix provides a detailed discussion of the analysis we used to

determine whether market power existed in California’s electricity market

in 2000 and also to estimate the impact of the CAISO’s changes to price

caps in July and August 2000. We conducted econometric analyses using

data on market prices in the forward electricity market operated by the

California Power Exchange and demand data from the California

Independent System Operator (CAISO). We also evaluated data on

imports, reserve electricity purchases, and other purchases at the last

minute by the CAISO to balance demand and supply.

In summary, the results of our econometric analysis are inconsistent with

the absence of market power and are not fully explained by other factors,

such as increased scarcity of supply or increases in costs of generating

electricity. Therefore, we have concluded that market power played a role

in the high prices experienced in California in 2000. Because we do not

have sufficient data to allow us to measure costs or scarcity with

precision, we could not estimate the extent to which the high prices were

attributable to these factors versus market power on the part of wholesale

suppliers.

We also found that the price caps imposed by the CAISO in an effort to

mitigate market power were ineffective in reducing average prices. In

particular, we found that when price caps were reduced in the summer of

2000—from $750 per MWh down to $500 on July 1 and from $500 to $250

on August 7—average prices actually rose. Other studies and experts we

interviewed pointed out flaws in the design and implementation of these

price caps that likely caused them to be ineffective. In addition to our own

analysis, we interviewed economists and other industry experts to get

their views on our methodology and results. Our findings are consistent

with other studies by academics, industry experts, and staff of the CAISO.

To determine whether the high wholesale electricity prices in summer

2000 were consistent with expected behavior in the absence of market

power, we developed an econometric model to estimate the relationship

between prices in the power exchange market and variables expected to

influence the price, such as the quantity supplied, time of day, and price

cap regulation. In this model, we estimated a regression in which the

quantity supplied is divided into two parts: the part that is served by instate generation, and the part served by imports. In general, greater

quantity supplied is predicted to lead to higher prices. However, in

discussions with experts on the California electricity market, we were told

that the availability of imports has a large impact on prices in the state. In

Appendix I: Determining the Existence of

Market Power and Impact of CAISO Price

Caps

Methodology for

Evaluating Electricity

Prices
Appendix I: Determining the Existence of

Market Power and Impact of CAISO Price

Caps

Page 25 GAO-02-828 Restructured Electricity Markets

particular, imports have a damping effect on prices, because costs of

generating electricity are lower in surrounding states than in California. In

addition, they said that the highest cost suppliers during most hours are instate generators, and it is these suppliers that set the market price for

California. Therefore, we expect to find a negative relationship between

imports and price and a positive relationship between in-state generation

and price.

The model included dummy variables for periods of time during which the

CAISO had imposed price caps.1

 We expected price cap variables to have a

negative or insignificant impact on prices based on the theory of supply

and demand. We also included dummy variables for different years,

months, days of the week, and hours of the day, to account for unobserved

variations in demand and costs over time. Finally, we included squared

and cubed in-state generation terms to account for a possible non-linear

relationship between price and quantity supplied of in-state generation.2

The final form of our regression is shown in the following equation.

ice = α + β Gen + β Gen + β Gen + β Netimports +γPcaps +φTimeperiods + ε v v 4

3

3

2

1 2 Pr ( ) ( )

In the equation, price is the hourly price set in the power exchange market

in an auction held one day ahead of when the electricity will be generated

and consumed. “Gen” refers to in-state generation in MWhs, and

“netimports” is the amount of electricity imported, minus the amount

exported, also in MWhs. “Pcaps” is a vector of dummy variables for

various price caps that existed in California between April 1, 1998, and the

end of our analysis, October 31, 2000.3 “Timeperiods” is a vector of dummy

variables for year, month, day of the week, and hour of the day.

The results of the ordinary least squares regression are shown in table 2.

 1

 A dummy variable takes a value of 1 if a certain characteristic is present and a value of 0

otherwise.

2

 It is important to note that we are not estimating either a demand or supply relationship.

3

 The price data are hourly market clearing prices from the power exchange day-ahead

market. Other variables are hourly data from the CAISO.
Appendix I: Determining the Existence of

Market Power and Impact of CAISO Price

Caps

Page 26 GAO-02-828 Restructured Electricity Markets

Table 2: Price Regression Results

Explanatory variablesaCoefficient estimate Standard error

Constant 51.42918 4.800264b

In-state generation 0.0019569 0.0006479b

(In-state generation)2 -4.14E-07 3.91E-08b

(In-state generation)31.26E-11 6.69E-13b

Net imports -0.0056135 0.0002955b

250 Price Cap (1998-1999) 0.2356245 2.067501

750 Price cap 6.352422 3.738449d

500 Price cap 56.09492 4.93126b

250 Price cap (2000) 72.7612 5.241998b

1999 19.03923 1.802957b

2000 33.93763 3.739452b

February -5.197752 1.957393b

March -7.083489 1.936569b

April 1.394583 1.8194

May -1.832361 1.864067

June 8.310609 2.029737b

July -14.03577 2.206409b

August 3.875315 2.309641d

September 22.55745 2.192674b

October 25.19806 2.469456b

November 22.89343 2.670744b

December 18.10554 2.6692b

Sunday -9.019749 1.392289b

Monday -1.399346 1.299002

Tuesday -1.486778 1.295473

Thursday -5.967485 1.295307b

Friday -8.301758 1.298334b

Saturday -8.434973 1.356632b

2 a.m. -4.364651 2.41029d

3 a.m. -5.185202 2.440988c

4 a.m. -7.350066 2.473241b

5 a.m. -6.126103 2.496086b

6 a.m. -0.0317145 2.497901

7 a.m. 7.907819 2.480037b

8 a.m. 17.78537 2.454051b

9 a.m. 18.97172 2.428454b

10 a.m. 22.8728 2.417118b

11 a.m. 26.67939 2.423078b

12 p.m. 27.99686 2.431365b

1 p.m. 20.62724 2.438165b

2 p.m. 27.76876 2.443315b

3 p.m. 28.13216 2.446393b
Appendix I: Determining the Existence of

Market Power and Impact of CAISO Price

Caps

Page 27 GAO-02-828 Restructured Electricity Markets

Explanatory variablesa Coefficient estimate Standard error

4 p.m. 24.37271 2.449033b

5 p.m. 20.00959 2.45096b

6 p.m. 15.99276 2.458588b

7 p.m. 14.57276 2.467717b

8 p.m. 10.16211 2.472744b

9 p.m. 17.10398 2.481656b

10 p.m. 15.11537 2.46666b

11 p.m. 6.660357 2.437887b

12 a.m. 1.924638 2.409756

Notes: Adjusted R-square: 0.4983

a

The dependent variable is price.

b

Significance at the 1-percent level.

c

Significance at the 5-percent level.

d

Significance at the 10-percent level.

The regression estimates indicate a positive relationship between price

and in-state generation, and a negative relationship between price and netimports as expected. The relationship appears to be somewhat non-linear,

although the non-linear terms are small in magnitude. The initial price cap

of $250 per MWh, which was in place from July 18, 1998, through

September 30, 1999, had no significant impact on prices. In addition, the

$750 price cap appeared to have only a weak if any impact on price.

However, lowering the price caps from $750 to $500 per MWh and again

from $500 to $250 was associated with increases in average prices. This

result is inconsistent with what would be expected under normal

conditions, where a price cap can only cause prices to fall and then only

during periods where the cap is lower than the market price.

In addition to the least-squares regression results reported, we also

performed various checks for robustness. First, we calculated standard

errors for the regression coefficient estimates that are robust to

heteroscedasticity (White, 1980)4

, and to serial correlation and

heteroscedasticity (Newey and West, 1987).5

 The statistical results did not

qualitatively change from the reported regression in that lowering the

 4

 White, H. “A heteroscedasticity-consistent covariance matrix estimator and a direct test

for heteroscedasticity.” Econometrica, 48, 1980, 817-838.

5

 Newey, W. and K. West. “A simple positive semi-definite, heteroscedasticity and

autocorrelation consistent covariance matrix.” Econometrica, 55, 1987, 703-708.
Appendix I: Determining the Existence of

Market Power and Impact of CAISO Price

Caps

Page 28 GAO-02-828 Restructured Electricity Markets

price caps from $750 to $500 per MWh, and then from $500 to $250,

resulted each time in a statistically significant increase in the market

clearing price.

Second, because the residuals of the least-squares regression indicated

first-order serial correlation, we estimated the regression controlling for

the serial correlation and obtained qualitatively similar results using both

least-squares standard errors and robust (White, 1980) standard errors.

Third, we analyzed the impact of extreme observations on the regression

results because, in least-squares models, the expected value of the marketclearing price and large deviations from the mean can disproportionately

affect the coefficient estimates. We estimated a bounded influence

regression (Kraskel, Kuh, and Welsch, 1983)6

 in which extreme outlying

observations are down weighted; the results of this regression were

similar to the least-squares regression although the $250 price cap had a

much larger positive effect on the market price. We also estimated a

quantile regression in which the median of the market price was modeled

because the median is not sensitive to extreme outliers (see Judge et al.,

1985, ch. 20);7

 the results of the median regression were similar to the

least-squares regression results, although the magnitude of the $250 price

cap was again larger.

On balance, the regression results indicate that when price caps were

lowered in 2000, average prices rose—a result that is potentially

inconsistent with competitive conditions but which does not directly

indicate the existence of market power. Average prices could have risen

due to changes in some other factors that influenced electricity prices and

coincided with the lowering of the price caps, but that are not accounted

for in the regression model. For example, the increase in prices could have

been caused by increases in costs that coincided with the lowering of the

price caps.8

 To determine whether there was evidence of market power,

 6

 Krasker, W. S., S. E. Kuh, and R. E. Welsch. “Estimation for dirty data and flawed models.”

in Z. Griliches and M. D. Intriligator (eds.) Handbook of Econometrics, vol 1, Amsterdam,

North Holland, 1983, 652-698.

7 Judge, G.G., and W. E. Griffiths, R. C. Hill, H. Lutkepohl, and T. C. Lee. The Theory and

Practice of Econometrics. New York, Wiley, 2nd Edition, 1985.

8

 Another possibility is that there were increases in prices of electricity in surrounding

states that coincided with the lowering of price caps in California. In this case, in-state

suppliers would be able to get higher prices in surrounding states, and this would cause

prices in California to rise as well.
Appendix I: Determining the Existence of

Market Power and Impact of CAISO Price

Caps

Page 29 GAO-02-828 Restructured Electricity Markets

we had to explore other possible explanations for the unexpected

regression results.

In order to explore the possibility that market power was being exercised,

we focused our attention on the period from July 1, 2000—the day the

$500 price cap was implemented—through October 31—the last date of

our regression analysis. This period encompassed the date the $250 per

MWh price cap was implemented—August 7, 2000. As discussed in this

report, prices did not follow the pattern expected under competitive

conditions during the period of the $250 price cap. In an attempt to

explore other possible explanations for the observed pattern of prices, we

compared two periods—the first from July 1 through August 6, 2000,

during which the price cap was set at $500 per MWh, and the second from

August 7 through October 31, 2000, during which the cap was $250. In

particular, we evaluated the increase in average prices and the change in

the pattern of prices that occurred when the price cap was lowered from

$500 to $250 per MWh. Figure 4 shows prices and total electricity demand

in the two periods in which the price caps were $500 and $250 per MWh,

respectively. While lowering the price cap was associated with falling

prices in the two highest demand periods, it was also associated with

rising prices in all other periods.

Determining the Existence

of Evidence of Market

Power
Appendix I: Determining the Existence of

Market Power and Impact of CAISO Price

Caps

Page 30 GAO-02-828 Restructured Electricity Markets

Figure 4: Demand and Prices

Source: GAO analysis of CAISO and California Power Exchange data.

As discussed in this report, the increased prices in the lower-demand

periods are not consistent with competitive pricing if all other factors are

held constant. However, we cannot conclude directly from this pattern

that market power was the cause of the increases in prices or changes in

the pattern of prices. Therefore, we evaluated numerous variables,

including imports of electricity from surrounding states, last-minute

purchases of electricity to balance demand and supply by the CAISO,

prices of natural gas (the principle fuel used by many of the in-state

generators), total demand, and total in-state generation. We found that

these variables were all changing over time, but in ways that should have

led to lower rather than higher prices or were of insufficient magnitude to

explain the price increase.
Appendix I: Determining the Existence of

Market Power and Impact of CAISO Price

Caps

Page 31 GAO-02-828 Restructured Electricity Markets

For example, imports and net-imports (imports minus exports) of

electricity into California were higher during low- and high-demand hours

in the $250-price-cap period than in the $500-price-cap period. Our

regression results indicate that higher levels of net imports are associated

with lower prices. Therefore, changes in net imports are unlikely to

explain the increase in prices during low-demand hours after the price cap

was lowered to $250 per MWh. In addition, levels of in-state generation are

also lower during low- and high-demand hours in the $250-price-cap period

than when the cap was $500 per MWh. Our regression results indicate that

lower levels of in-state generation are associated with lower prices.

Therefore, levels of in-state generation are unlikely to account for the

increases and change in pattern of prices after the cap was lowered to

$250 per MWh. Similarly, total demand was lower during low- and highdemand hours in the $250-price-cap period. As discussed in this report,

lower levels of total demand are predicted to be associated with lower

prices. Therefore levels of total demand cannot account for the observed

price changes.

Last-minute purchases of electricity to balance the system were relatively

unchanged over the two periods. In particular, purchases of regulation

electricity, spinning reserves, and non-spinning reserves were close in

both low- and high-demand hours in the two periods.9

Among the variables affecting electricity prices was the price of natural

gas, which rose over this period. While this increase would be expected to

cause electricity prices to rise under competitive conditions, prices would

likely rise in proportion to the change in natural gas prices. However,

electricity prices during low-demand hours rose by much more,

proportionally, than did average natural gas prices, which means that gas

prices are not likely to fully explain the increase in prices during these

hours.

In addition to evaluating these variables, we discussed our findings with

two economists with electricity market expertise. They agreed that the

pattern of prices we observed was not consistent with competitive

conditions. In particular, they said that the fact that prices rose so much at

the lowest levels of demand indicates that suppliers changed their

 9

 Regulation electricity, spinning reserves and non-spinning reserves are purchased by the

CAISO to balance demand and supply and maintain enough reserves of supply to keep the

system operating reliably as demand and supply conditions change.
Appendix I: Determining the Existence of

Market Power and Impact of CAISO Price

Caps

Page 32 GAO-02-828 Restructured Electricity Markets

behavior in response to the price cap. Both also agreed that the price cap

caused some suppliers to avoid the capped prices, either by withholding

some of their electricity from the power exchange and offering it directly

to the CAISO at the last minute and at higher prices or by selling it in

surrounding states, where prices were at times higher than $250. Further,

they said that this withholding of power from the capped market would

likely have caused other suppliers to increase their asking price for

electricity, knowing that they faced less competition. The economists said

that such a change in behavior is only consistent with the existence of

market power, because suppliers who do not have market power treat

prices as given and do not take actions designed to achieve a higher price.

We also discussed this period of time with staff of the CAISO. In

discussions with the CAISO, we were told that sellers were able to

partially avoid the price cap by selling some of their power outside the

state—perhaps to an affiliated company—and then buying it back to sell to

the CAISO at the last minute when the CAISO was desperate to balance

demand and supply and therefore willing to pay prices above the capped

rate.

We did not have data on specific transactions between suppliers and

buyers outside of the capped market, and we had no data on out of state

sales or prices. Therefore, we could not verify that supplier behavior

changed in the ways suggested by the economists we interviewed and

CAISO staff. However, we were able to look at aggregate levels of exports

of electricity from California to surrounding states. We found that monthly

exports were significantly higher from May through October 2000, than

they had been in these same months in 1998 or 1999. Specifically, monthly

exports from May through October 2000 were between about 40 and 230

percent higher than the same months in 1998 or 1999. Overall, exports

were about 200 percent higher from May through October 2000 than in the

same period in either 1998 or 1999.

In balance, the combination of the results of our econometric analysis, our

analysis of prices and other variables in the period surrounding the change

in the price cap from $500 to $250 per MWh, and the interpretation of the

economists and CAISO staff we interviewed provide evidence that

suppliers were able to exercise market power during the period after the

$250 price cap was implemented.
Appendix I: Determining the Existence of

Market Power and Impact of CAISO Price

Caps

Page 33 GAO-02-828 Restructured Electricity Markets

The results of our regression indicated that average prices rose when the

caps were lowered during summer 2000. This pattern was inconsistent

with our expectations about the impact of price caps. To explain these

inconsistent results, we reviewed other studies and interviewed

economists and other experts. There was broad agreement that flaws in

the design and implementation of the price caps led to their being

ineffective as tools for mitigating market power.

The flaws in design identified by studies and experts relate to the ability of

suppliers to avoid the price caps and sell at prices above the cap. In

particular, the cap was imposed by the CAISO to limit what CAISO would

pay for power in the last-minute markets. However, California is a part of a

larger western regional market, and the CAISO cap did not apply to other

states. Therefore, when prices in other states rose above the CAISO price

cap, suppliers in California had an incentive to sell their electricity to other

states. As a result, the CAISO found that it was forced to buy a larger share

of the total electricity consumed in a given hour during the last minutes

before it was needed to meet demand. CAISO was also faced at times with

paying prices higher than the cap to avoid electricity shortages and forced

blackouts for some consumers. According to one study, the inability of the

CAISO to commit to maintaining the cap, even at the risk of blackouts,

gave suppliers a bargaining advantage in setting their prices for sales to

the CAISO at the last minute.

Determining the

Effectiveness of Price

Caps on Market Power

Mitigation
Appendix II: Key Events during Electricity

Restructuring in California

Page 34 GAO-02-828 Restructured Electricity Markets

Appendix II: Key Events during Electricity

Restructuring in California
Appendix II: Key Events during Electricity

Restructuring in California

Page 35 GAO-02-828 Restructured Electricity Markets

Sources: Multiple news stories, public documents, and studies.
Appendix III: Summary of Studies on Market

Power

Page 36 GAO-02-828 Restructured Electricity Markets

The authors examined the degree of competition in the California

electricity market from June 1998 to October 2000. They compared market

prices, using pricing data from the power exchange, with estimates of

marginal costs of producing additional electricity. The authors tested

whether the overall market was setting competitive prices considering the

production capabilities of all suppliers in the market. The analysis

included such cost factors as fuel costs; maintenance costs; and costs for

emissions control, a regulatory requirement for some geographic

locations. Adjustments were not made for costs related to inefficient

transmission of power between geographic areas. Using the cost data, the

authors computed the perfectly competitive price for each hour for the

months in the sample period. The authors then categorized higher

expenditure for wholesale purchases of electricity during the summer of

2000 into increases in production cost, scarcity, and the exercise of market

power. The authors found that 51 percent of total electricity expenditures

in the summer of 2000 could be attributed to market power. They note that

market power was most commonly exercised during peak demand

periods.

The authors simulated competitive prices under various demand and

supply conditions that existed during the summer of 2000. They then used

public data on production on an hourly basis from EPA and other public

sources and compared the actual prices from this data with their

estimated competitive wholesale benchmark prices. The benchmark price

was the short-run cost of supplying electricity from the last unit that would

clear the market in each hour. Factors such as fuel prices and costs for

emissions control to meet environmental requirements were included in

the analysis. These authors found that wholesale prices far exceeded

competitive levels during the months of June through September 2000.

They noted that evidence supports the conclusion that power was

withheld from the market by electricity suppliers, which contributed to the

high prices during the summer of 2000.

Appendix III: Summary of Studies on Market

Power

Borenstein, Severin, James

Bushnell, and Frank

Wolak. “Measuring Market

Inefficiencies in

California’s Restructured

Wholesale Electricity

Market.” (unpublished).

February 2002.

Joskow, Paul, and Edward

Kahn. “A Quantitative

Analysis of Pricing

Behavior in California’s

Wholesale’s Electricity

Market During the Summer

2000: The Final Word.”

(unpublished). February 4,

2002.
Appendix III: Summary of Studies on Market

Power

Page 37 GAO-02-828 Restructured Electricity Markets

This CAISO economist evaluated electricity prices in California for the

period of April 1998 through February 2001. This study compared the

difference between actual wholesale prices in the CAISO system with an

estimate of baseline costs that would be incurred under competitive

market conditions. He included in this analysis the potential impacts of

emissions costs and price impacts from hours when supply was scarce.

The results of the analysis showed that market power was being exercised

for the period evaluated, between May 2000 and February 2001. The author

estimated that overall wholesale costs during that period had been driven

up by more than $6.2 billion by the exercise of market power and that over

30 percent of wholesale electricity costs during the year prior to his study

could be attributed to market power.

This CAISO economist reviewed bids from five large in-state non-investor

owned utility suppliers, as well as 16 importers selling electricity in the

real-time market of the CAISO for each hour between May and November

2000. She compared detailed bidding data in the real-time market to the

marginal cost of supplying energy and analyzed the level of mark-up for

each supplier. The author used real-time data from the CAISO market for

specific companies and generation units. She found bidding behavior that

was not consistent with competitive bidding. Further, she found that

wholesale suppliers displayed forms of physical and/or economic

withholding of electricity for the purposes of inflating prices. The author

concluded that large suppliers were actively engaged in bidding behavior

that had a direct impact on market prices, and she noted that this behavior

indicated systematic exercise of market power to maximize profits.

The California State Auditor reviewed the operations of the power

exchange and CAISO, including prices in the electricity market for the

period April 1998 through December 2000. Consultants for the State

Auditor reviewed reports and statistical and econometric models used by

various monitoring, and/or market analysis groups of the power exchange

and CAISO. They also interviewed respective members of these

organizations. The State Auditor concluded that market participants

adopted tactics to manipulate wholesale electricity prices in California.

The authors noted that bidding data from the last year prior to the March

2001 issuance of their report suggested that both buyers and sellers

deliberately attempted to manipulate electricity prices. Market

participants utilized bidding strategies that held back needed supply,

which then forced the CAISO to make purchases at exorbitant prices to

guarantee system reliability.

Hildebrant, Eric. Further

Analyses of the Exercise

and Cost Impacts of

Market Power in

California’s Wholesale

Energy Market. A special

study by the Department

of Market Analysis,

California Independent

System Operator, Folsom,

California, March, 2001.

Sheffrin, Anjali. Empirical

Evidence of Strategic

Bidding in California ISO

Real Time Market. A

special study by the

Department of Market

Analysis, California

Independent System

Operator, Folsom,

California, March 21, 2001.

California State Auditor.

Energy Deregulation: The

Benefits of Competition

Were Undermined by

Structural Flaws in the

Market, Unsuccessful

Oversight, and

Uncontrollable

Competitive Forces.

Sacramento, California,

March 22, 2001.
Appendix IV: Bibliography of Selected Studies

Page 38 GAO-02-828 Restructured Electricity Markets

United States General Accounting Office, Restructured Electricity

Markets: Three States’ Experiences in Adding Generating Capacity.

GAO-02-427. Washington, D.C.: May 24, 2002.

Stoft, Steven. “Power System Economics: Designing Markets for

Electricity.” IEEE/Wiley, 2002.

McCullough, Robert. “Revisiting Market Power After Two Years.” Public

Utilities Fortnightly, April 1, 2002

Joskow, Paul, and Edward Kahn. “A Quantitative Analysis of Pricing

Behavior in California’s Wholesale’s Electricity Market During the Summer

2000: The Final Word.” (unpublished). February 4, 2002.

Borenstein, Severin, James Bushnell and Frank Wolak. “Measuring Market

Inefficiencies in California’s Restructured Wholesale Electricity Market.”

(unpublished). February 2002.

Borenstein, Severin. “The Trouble With Electricity Markets: Understanding

California’s Restructuring Disaster.” Journal of Economic Perspectives,

Volume 16, Number 1, (Winter 2002): pages 191-211.

California Independent System Operator, Department of Market Analysis.

Third Annual Report on Market Issues and Performance, Market

Monitoring, Investigative, and Compliance Activities, JanuaryDecember 2001. Folsom, California, January 2002.

Harvey, Scott, M. and William W. Hogan. “Identifying the Exercise of

Market Power in California.” (unpublished). December 28, 2001

Harvey, Scott, M. and William Hogan. “Market Power and Withholding.”

(unpublished). December 20, 2001.

California State Auditor. California Energy Markets, Pressures Have

Eased but Cost Risks Remain. Sacramento, California, December 2001.

Harvey, Scott, M., and William Hogan. “Further Analysis of the Exercise of

Market Power in the California Electricity Market.” (unpublished).

November 21, 2001.

Morey, Matthew, J. Ensuring Sufficient Generating Capacity, During the

Transition to Competitive Electricity Markets. prepared for Edison

Electric Institute, Washington, D.C.: November 2001.

Appendix IV: Bibliography of Selected

Studies
Appendix IV: Bibliography of Selected Studies

Page 39 GAO-02-828 Restructured Electricity Markets

Borenstein, Severin, James Bushnell, Christopher R. Knittel, and Catherine

Wofram. “Trading Inefficiencies in California’s Electricity Markets.”

(unpublished). October 2001.

California Independent System Operator, Department of Market Analysis.

Second Annual Report on Market Issues and Performance. April 1999-

December 2000. Folsom, California: November 2001.

Wolak, Frank A. “Designing a Competitive Electricity Market that Benefits

Consumers.” (unpublished). October 15, 2001.

Joskow, Paul L. “California’s Electricity Crisis” (unpublished). September

28, 2001.

Congressional Budget Office. Causes and Lessons of the California

Electricity Crisis. Washington, D.C., September 2001.

California Energy Commission. California Energy Outlook, Electricity

and Natural Gas Trends Report. Staff Draft, Sacramento, California,

September 2001.

Hirst, Eric. “The California Electricity Crisis: Lessons for Other States.”

(unpublished). July 10, 2001.

Joskow, Paul and Edward Kahn. “Identifying the Exercise of Market

Power: Refining the Estimates.” (unpublished). July 5, 2001.

Taylor, Jerry, and Peter VanDoren. “California’s Electricity Crisis What’s

Going On, Who’s to Blame, and What to Do.” Policy Analysis, No. 406,

(July 3, 2001).

United States General Accounting Office. Energy Markets: Results of

Studies Assessing High Electricity Prices in California. GAO-01-857.

Washington, D.C.: June 29, 2001.

United States General Accounting Office. California Electricity Market:

Outlook for Summer 2001. GAO-01-870R. Washington, D.C.: June 29, 2001.

United States General Accounting Office. California Electricity Market

Options for 2001: Military Generation and Private Backup Possibilities.

GAO-01-865R. Washington, D.C.: June 29, 2001.
Appendix IV: Bibliography of Selected Studies

Page 40 GAO-02-828 Restructured Electricity Markets

Electric Power Research Institute. The Western States Power Crisis:

Imperatives and Opportunities, an EPRI White Paper. Palo Alto,

California, June 25, 2001.

Department of Market Analysis, California Independent System Operator.

Potential Overpayments Due to Market Power in California’s Wholesale

Energy Market: May 2000-2001. Folsom, California: June 19, 2001.

Rowe, John W., Peter Thornton, and Janet Bieniak Szcypinski.

Competition Without Chaos. Joint Center for Regulatory Studies, Working

Paper 01-07, June 2001.

Hogan, William W. Electricity Market Restructuring: Reforms of Reforms.

Paper presented at annual conference of Center for Research in Regulated

Industries, Rutgers University: May 23-25, 2001.

Harvey, Scott M. “On the Exercise of Market Power Through Strategic

Withholding in California.” (unpublished). April 24, 2001.

Hildebrandt, Eric. Impacts of Market Power in California’s Wholesale

Energy Market: More Detailed Analysis Based on Individual Seller

Schedules and Transactions in the ISO and PX Markets. A special study

by the Department of Market Analysis, California Independent System

Operator, Folsom, California, April 9, 2001.

Sheffrin, Anjali. Empirical Evidence of Strategic Bidding in California

ISO Real Time Market. A special study by the Department of Market

Analysis, California Independent System Operator, Folsom, California:

March 21, 2001.

Harvey, Hal, Bentham Paulos and Eric Heitz. California and the Energy

Crisis: Diagnosis and Cure. Energy Foundation, March 8, 2001.

Hildebrant, Eric. Further Analyses of the Exercise and Cost Impacts of

Market Power in California’s Wholesale Energy Market. A special study

by the Department of Market Analysis, California Independent System

Operator, Folsom, California: March, 2001.

Edison Electric Institute. Learning from California: Power Shortages and

Unique Market Rules Lead to Price Spikes. Washington, D.C.: March 2001.

California State Auditor. Energy Deregulation: The Benefits of

Competition Were Undermined by Structural Flaws in the Market,
Appendix IV: Bibliography of Selected Studies

Page 41 GAO-02-828 Restructured Electricity Markets

Unsuccessful Oversight, and Uncontrollable Competitive Forces.

Sacramento, California: March 22, 2001.

California Independent System Operator, Department of Market Analysis.

Report on Real Time Supply Costs above Single Price Auction Threshold:

December 8, 2000-January 31, 2001. Folsom, California: February 28, 2001.

Federal Energy Regulatory Commission, Office of the General Counsel,

Market Oversight and Enforcement and Office of Markets, Tariffs and

Rates, Division of Energy Markets. Report on Plant Outages in the State

of California. Washington, D.C.: February 1, 2001.

Joskow, Paul and Edward Kahn. “A Quantitative Analysis of Pricing

Behavior in California’s Wholesale Electricity Market During Summer

2000.” (unpublished). January 2001.

Borenstein, Severin. “The Trouble With Electricity Markets (and some

solutions). (unpublished). January, 2001.

Chandley, John, D., Scott M. Harvey, and William W. Hogan. “Electricity

Reform in California.” (unpublished). November 22, 2000.

Federal Energy Regulator Commission. Staff Report on Western Markets

and the Causes of the Summer 2000 Price Abnormalities: Part I of the

Staff Report on U.S. Bulk Power Markets. Washington, D.C.: November 1,

2000.

Puller, Steven L. “Pricing and Firm Conduct in California’s Deregulated

Electricity Market”. (unpublished). November 2000.

Marcus, William and Jan Hamrin. “How We Got Into the California Energy

Crisis.” (unpublished). November 2000.

Harvey, Scott, M. and William W. Hogan. “Issues in the Analysis of Market

Power in California.” (unpublished). October 27, 2000.

Barker, Dunn and Rossi, Inc. “The Electric Summer: Symptoms-OptionsSolutions.” A special report prepared for Edison Electric Institute,

October 2000.

Nordhaus, Robert, Frank A. Wolak, and Carl Shapiro. An Analysis of the

June 2000 Price Spikes in the California ISO’s Energy and Ancillary

Services Market. A special report prepared for the Market Suveillance
Appendix IV: Bibliography of Selected Studies

Page 42 GAO-02-828 Restructured Electricity Markets

Committee of the California Independent System Operator, September 6,

2000.

California Independent System Operator, Department of Market Analysis.

Report on California Energy Market Issues and Performance: May-June

2000, Special Report. Folsom, California: August 10, 2000.

California Public Utilities Commission and Electricity Oversight Board.

Summer 2000 Report for Governor Davis Regarding California’s

Electricity System. San Francisco, California, August 2, 2000.

Borenstein, Severin, James Bushnell, and Frank Wolak. “Diagnosing

Market Power in California’s Restructured Wholesale Electricity Market.”

(unpublished). August 2000.

Borenstein, Severin, and James Bushnell. “Electricity Restructuring:

Deregulation or Reregulation?” (unpublished). February 2000.

Bushnell, James, B. and Frank A. Wolak. “Regulation and the Leverage of

Local Market Power in the California Electricity Market.” (unpublished).

September 1999.

Borenstein, Severin. “Understanding Competitive Pricing and Market

Power in Wholesale Electricity Markets” (unpublished). August 1999.

Borenstein, Severin, James Bushnell, and Christopher R. Knittel. “Market

Power in Electricity Markets: Beyond Concentration Measures.”

(unpublished). February 1999.

Tirole, Jean. The Theory of Industrial Organization. The MIT Press, 1988.
Appendix V: GAO Contacts and Staff

Acknowledgments

Page 43 GAO-02-828 Restructured Electricity Markets

Jim Wells (202) 512-3841

Dan Haas (202) 512-9828

In addition to those named above, Art James, Randy Jones, Jon

Ludwigson, Cynthia Norris, and Frank Rusco made key contributions to

this report.

Appendix V: GAO Contacts and Staff

Acknowledgments

GAO Contacts

Acknowledgments

(360123)
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