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The facts behind Palo Alto’s Energy Contracts

by Bern Beecham and published in the Palo Alto Daily News

Much has been said about the City’s purchase on May 7, 2001 of a 25 megawatt power contract
for electricity to be delivered June 2001 through January 2005 (about 15% of the City’s needs).
This summer, the City announced that the market value of this contract had fallen sharply, by
$44 million.

Opinions vary on whether this contract was a good decision or a mistake at the time (in
hindsight, it’s always easy to know when one should have bought IBM or sold Yahoo). The best
opinions are based on facts. Here is a summary of what happened to help you form your own
opinion.

The scenario in April, 2001
In the year prior to April, several major events created chaos in the California electric market.
•        The state’s deregulation scheme succumbed to its fatal flaws.
•        The Northwest was dryer than normal, leaving low reserves for generating electricity for the
West.
•        Loads in the northwest had also increased, reducing the available surplus for use in
California.
•        California had completed a decade of economic growth and increasing electric
requirements.
•        No major electric projects had been built in California in that decade.
•        Along with rolling blackouts, wholesale prices for electricity spiked to unheard of levels,
exceeding historical prices by a factor of 10 to 15.
The equivalent rise in gasoline would be prices averaging between $20 and $40 per gallon for 6
months with some days spiking to $100 and other days it just cannot be found at any price.

Industry estimates for summer 2001 projected hundred hours of blackouts throughout
California. These estimates were based on projected demand, availability of generation
resources and summer temperatures. At the same time, FERC (Federal Energy Regulatory
Commission) was adamant about letting the ‘free market’ establish wholesale prices.
Wholesale prices were charted to stay much higher than normal for another 3-4 years until
sufficient new power plants were built

Palo Alto, through Western (Western Area Power Administration), has a forty year contract with
PG&E to "integrate" Western’s power (i.e. provide a stable supply of electricity even though
Western’s supply fluctuates through the year based on available water behind its dams). This
PG&E contract provides 55% of Palo Alto’s electricity. The contract ends in December, 2004 and
has prices based on PG&E’s internal cost of producing the power, about $22/MWh.

The PG&E contract, along with our Western contract, insulated us from the chaos in the rest of
the industry. Until PG&E filed for bankruptcy on April 6.

PG&E’s bankruptcy put Palo Alto’s low, stable electric costs at tremendous risk.

At the time of bankruptcy, this contract was a $2 billion liability for PG&E since they were
obligated to provide 90 government agencies with electricity at PG&E’s internal cost of
production rather than skyrocketing market prices.

Industry legal and technical experts expected PG&E to attempt to void the contract. In bankruptcy
court, PG&E could request the judge to void the contract as an "executory" contract. If PG&E were
successful, Palo Alto would be buying over half its electric needs on the open wholesale market
at peak hour costs of more than $300/MWhr. Based on industry market projections of wholesale
prices, Palo Alto retail rates would go up almost 3 fold.

Experience at PG&E, Southern California Edison and San Diego made clear the effects of not
having long term power contracts.

On a parallel action, on March 29 PG&E filed with FERC to unilaterally change the contract to
charge us market rates instead of their internal costs. The effect on Palo Alto would be as bad
or worse than simply voiding the contract.

City Action
To prevent having to buy over half our electricity in the turbulent short term market, City staff
requested authority to purchase up to 75MW of electricity, starting as soon as possible for a
term of up to 10 years. This 75MW was expected to cover 100% of Palo Alto’s shortfall if PG&E
voided the contract. Council approved the purchase of up to 50 MW and set up a Standing
Oversight Committee comprised of four Council members to oversee the details of the staff
purchase strategy. Contract procedures were to be reviewed by the City Attorney and City
Auditor.

The SOC ultimately approved procuring 25MW for 3½ years.

The City issued an RFP and received responses from five qualified suppliers. After
negotiations, the City received the most favorable terms from Enron and signed a contract with
them on May 7th.

In advance of this action, and months prior to PG&E’s bankruptcy, the City looked for legal
counsel to assist Palo Alto in the eventuality of a PG&E bankruptcy. In January, the City began
working with a preeminent bankruptcy lawyer to advise the City on PG&E bankruptcy issues.

Because Palo Alto was one of the few agencies prepared for the case, the City was appointed to
the "Official Unsecured Creditors’ Committee" as its only local government member.

What’s happened since

Since May 7, the market value of the 25MW contract has fallen. And Palo Alto successfully
fought to preserve our rights under the PG&E contract.

Palo Alto continues to serve as a member of the Official Committee that negotiated with PG&E
over their recent reorganization plan. Although needing to operate under strict confidentiality
rules, Palo Alto’s legal team surely would have made clear to PG&E the importance of keeping
the contract. PG&E is aware of the strength of Palo Alto’s position and the City is confident they
will not attempt to void the contract.

In its parallel effort, PG&E proceeded with its FERC filing to change the contract to increase Palo
Alto’s costs to market costs. Palo Alto actively opposed this filing, joined by Western and other
customers. Based on our arguments and others, FERC rejected PG&E’s filing on October 24.
Today, the contract appears secure, although PG&E may develop further legal tactics.

Since spring, a number of independent factors have brought the market cost of electricity down
(although still above historical levels):
•        A slower economy reduced demand
•        Governor Davis’s bought long terms contracts to avoid spot market purchases.
•        FERC reversed its policy and has set rules effectively limiting prices.
•        Finally, Palo Altans and consumers throughout the state dramatically embraced
conservation, reducing usage by 15%.

Tomorrow
Of course there are no facts about what will happen tomorrow. Electricity prices have recently
risen but are far more stable than in the past year. The value of our energy contract has risen by
several million dollars but is still significantly below cost. For the moment, the PG&E contract
seems secure. In the end, Palo Alto’s lights will stay on.