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 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 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) 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. 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. 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 of the previous year. 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.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-than- normal 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 $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. 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. 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 high- demand 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. 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. 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 produced, because different generators use different types and amounts of fuel.