By Rebecca Smith
Staff Reporter of  The Wall Street Journal

The unilateral move by the California Independent System Operator, or ISO, came at the end of a chaotic week in which energy prices spiraled out of control and the world's seventh-largest economy was threatened by blackouts. Originally meant to have a small role in the state's de-regulated market, the ISO, which guarantees electricity reliability, has lately found itself buying as much as one-third of the power consumed daily. In order to do so, the ISO has paid ever-higher prices for last-minute power purchases. On Monday, it spent $5 million. By Friday, the figure had climbed to $81 million.

Generators, which already had 30% of the state's power plants down for repairs after running them hard all summer, offered progressively less power to a computerized day-ahead market run by a state-sanctioned auction. They held back thousands of megawatts, offering the juice to the ISO only if prices got high enough. That put the ISO in the position of having to beg and haggle for power, despite the fact that actual demand wasn't anything extraordinary.

"My people were making phone deals - 10 to 15 an hour - when I needed them running the grid," said Terry Winter, ISO chief executive. "We had a gun to our head".

In the end, the ISO took the rogue action of abandoning its "hard price cap" of $250. It did so without advance approval of its governing board, Gov. Gray Davis, or even the Federal Energy Regulatory Commission, to which the ISO reports. Nevertheless, the four-member commission concurred with the move, at least temporarily, noting the "extraordinary circumstances occurring in California". The energy commission is expected to issue on Wednesday an important order on what is to be done with the California problem.

Mr. Winter said  he got tired of waiting around as politicians and bureaucrats debated a fix for California's broken energy market, which saw prices soar to record levels even before last week and which has put the state's main utilities at risk of eventual insolvency. "I wanted some accountability for these outrageous costs," Mr. Winter said.

Gov. Davis, who has come under fire from consumer groups for the sharply rising energy costs, immediately lambasted the ISO for what he called an "outrageous assault " on consumers. Gov. Davis, who favors a $100 price cap - a level that generators say is below their operating costs - threatened to "dismantle" the ISO in retaliation.

Generators and traders, on the other hand, said that by freeing up prices, the ISO is actually doing what is necessary to make sure the market works. They argue a better match of supply and demand should eventually bring down prices. "Price caps distort the market," says Kenneth Lay, chairman of Enron Corp., the nation's largest energy trader.

Even if that is the case, relief may not come quickly. A cold snap is increasing electrical demand throughout much of the west, soaking up juice that otherwise could be available to California. What's more, the price of natural gas - the fuel for many power plants - has shot up to unprecedented highs recently. Natural-gas prices, at $2 to $3 per million British thermal units a year ago, are now trading on the spot market at around $40 to $60, by far the highest level in the country.

The ISO action, though, should give the organization some breathing room. By promising generators they can offer energy at more then $250 per megawatt hour and not have their bids rejected outright, the ISO saw the amount of juice offered on Friday jump from nearly zero to 3,000 megawatts, giving it the biggest cushion it had all week. Some of the offers came in below $250.

By yesterday, more trading had shifted back into the day-ahead market run by a sister organization, the California Power Exchange. But that pushed up its average price for power to be delivered today to a record $611.80 per megawatt hour, nearly one and a half times the prior daily high. (WebEditor's Note: $611.80 - $250. = $361.80 = 1.56 x $250. But,  $611.80/ $250 = 2.44.  See published chart below:)

(WebEditor Note: In May, 2000, the Federal Electric Power Regulator of the Department of Energy in Order No. EA-179-A authorized the California Power Exchange Corporation (CalPX) to begin the export of large amounts of California electrical power to Mexico via the transmission facilities of San Diego Gas & Electric Company.)

The change in the pricing system is a risky one because generators may be able to justify sky-high  prices because of their natural-gas purchases. There are only a handful of generators serving California, and some buy their natural gas from affiliate companies, opening the door to sweetheart deals. "There's no arms-length relationship between the gas and electric companies," say Harvey Morris, an attorney at the state Public Utilities Commission who has filed an action against El Paso Energy, owner of a major gas pipeline serving California, alleging that contractual arrangements between its units have driven up gas prices. El Paso denies that is the case.

Under traditional cost-based regulation, such arrangements weren't allowed. Electric generators - utilities - were required to show they bought their gas at reasonable prices. Today, they are allowed to buy gas from anyone and at any price because the assumption was that a competitive electricity market would make it impossible for them to pass through inflated costs.

Energy experts say that the ISO's actions will only have a positive effect if the energy commission sets standards for permissible costs and then audits generators and traders aggresively."

1. "Export of Electric Power from California to Mexico".

2. "Export of Natural Gas from California to Mexico".

3. "California Investigates Power Companies' Finances".