Te disarray in the California power market has the potential to bankrupt the utilities, engulf neighboring states, and put the state government in the business of generating and transmitting electricity. The following are excerpts from a panel discussion in New York in late January about the implications for independent power companies and for banks that have loaned money to finance their facilities.

The panel included Dr. Robert B. Weisenmiller, one of the leading experts on the California electricity market and a founder of MRW & Associates, Inc. in Oakland, California, Lynn Hargis, former assistant general counsel for electricity utility  egulation at the Federal Energy Regulatory Commission, Howard Seife, the head of the bankruptcy practice at Chadbourne, Robert F. Shapiro, who has negotiated numerous “qualifying facility” contracts and tolling agreements and been involved in a large number of projects in California, Chaim Wachsberger, head of the Chadbourne project finance group, Bruce Rader, an experienced bank lawyer, and Bill Monsen, a former utility economist for the Pacific Gas & Electric Company who is  currently with MRW & Associates. The discussion was moderated by Keith Martin from the Chadbourne Washington office.

MR. MARTIN: This is a story that has more twists and turns than the Florida recount. Bob Weisenmiller, everyone has read in the newspapers about how the situation came about, but I think it helps to state for the record that there are three things California did to itself and two external factors that are also contributing to the mess. What are they?

DR. WEISENMILLER: First, there is a retail rate freeze. The utility is essentially acting as the balancing point between the wholesale price and the frozen retail rate and, as a consequence, the utilities collectively have run up deficits of $12 billion. That is the difference between what they must pay to purchase power and what they are allowed under the rate freeze to charge their customers. Next, the California utilities are buying — on average across all three — about one-third of their electricity in the spot market . . . . [U]nder the California structure, the utilities are not allowed to sign long-term contracts to buy electricity and have no ability to hedge against price volatility. Third, no major new power plants have been built in  California in 10 years. This was during a period when demand for electricity increased dramatically. 

MR. MARTIN: What about external factors?  

DR. WEISENMILLER: California is on the margin a gas-based system Gas prices have gone up substantially. Gas prices have gone from what used to be $2 or $3 at the California border to somewhere between $8 and $15 on the forward
markets, and some of the daily prices have been as high as $50. Gas prices have gone up by at least a factor of three. That would have translated into a much higher price for electricity whether or not California had deregulated. Southern California has very strict pollution control laws. The price for tradeable emission credits for NOx emissions has gone from approximately $2 a pound to something like $40 or $50. This translates directly into higher electricity prices in the south. 

The third point is California has always imported a lot of its power. Approximately 25% to 30% of its electricity comes from out of state — much of it from the Pacific northwest. The Pacific northwest is short itself — due primarily to low water levels in  ivers — and has less electricity to export. This has had to be replaced with more gas generation in California, and has led in part to the escalating cost of emissions credits. 

MR. MARTIN: So in assessing whether this problem can happen in other parts of the country, one needs to understand that the mess is due partly to things California did to itself and partly to external factors. 

There is a conspiracy view held by some people. What is this conspiracy view, and what is your assessment of it? 

Conspiracy Theories

DR. WEISENMILLER: There are two variations on it. Probably the better discussion is a paper by Paul Joskow and Eddie Kahn. Joskow is an economist at MIT. They looked at the operating levels of the different divested plants and tried to pick
hours when it would be economic for those plants to operate. Some of the analysis that has been done on the topic of withholding has not looked at whether the market price was above or below the operating cost of the projects. However, the
Joskow paper corrected for this and found that during some high-priced periods — when prices were over let’s say $125 a megawatt hour — plants were not operating even though their variable costs would have been covered. 

There are several reasons why this could have occurred. The plants could have been down for maintenance. The plants could have reached air emission limits. It could have been a time when the transmission lines running between southern
and northern California were congested. Or the plants could have been withholding power to result in a higher price. They could not tell from their data which of those four factors was leading to the undergeneration. 

One aside: the week that report came out, AES was assessed a record fine for running its power plants in California at levels above its emissions limits. The Joskow/Kahn report identifies the AES plants as some units that may have been withholding.

Similarly, Duke was also identified in the Joskow report as another generator who may have been withholding. Yet Duke reports that its plants in California are producing 70% more power this year than the year before, and the plants generally are operating at the second or third highest level for the 30 or 40 years of their existence. 

The point is it is difficult to untangle things. This will probably be in litigation for years. You have plants that are 30 to 40 years old, that should be operating at an intermediate or peaking level, that are being operated a lot more than before, and that are running into more outages. The question is: is it outages or is it strategic gaming or what?

MR. MARTIN: You told a story of a day in the life of an AES plant operator. Tell us that. 

DR. WEISENMILLER: One of the plant operators was trying to explain to his people what it was like operating in California. The company had a bomb threat at its plant. They were trying to figure out whether to shut the plant down to look for the bomb or to keep operating. It’s a very stressful environment. There is remarkably poor communication and suspicion between the regulators and independent generators and also between the regulators and the utilities. The distrust and lack of communication among all the parties are staggering.

MR. MARTIN: Power prices have gone up. One of the biggest problems is that the utilities have to pay more for power, but they can’t pass through the cost to their ratepayers. Is there any evidence that power prices have been pushed up
artificially or is it all driven by rising gas prices? 

DR. WEISENMILLER: Certainly when you go through the fundamentals and look at how much of the increase is coming from higher gas prices, how much of it is coming from higher air credit costs, and various other pieces, the runups are not 
explained entirely by the increase in production costs. 

MR. MARTIN: Of course, rising prices may be a function simply of too little supply and too much demand. There is no conspiracy; it is just the way the market works? 

DR. WEISENMILLER: The FERC staff report suggested it is impossible to untangle how much of the increase this summer was due to scarcity and how much to market power. You will hear a lot of allegations that it is market power. You will
see numbers thrown around for the amount. The figures always assume a world where the plants only charge their variable costs of operation, or at least the market-clearing price is always set just by the variable cost of operation, which then  leads to the question how peaking or intermediate units cover their fixed costs. It’s a very strict standard. No market reaches that or matches that standard. 

Measuring the Problem

MR. MARTIN: The measure of the problem: the problem at heart is utilities pay more for power than they can pass through to their customers. Edison and PG&E buy how much of their power in the spot market? 

DR. WEISENMILLER: If you look  at the three utilities in the aggregate, a rough rule of thumb is they buy a third of their power in the spot market. They get about a third of their power from QFs. They generate about a third of their power  themselves. Across the three utilities, those percentages obviously differ. 

MR. MARTIN: Another measure of the problem is that PG&E and Edison still have rate freezes, do they not, while San Diego can pass through?

DR. WEISENMILLER: Special legislation was passed last summer that put in place a rate freeze for core customers of San Diego Gas & Electric of 6.5¢ a kWh. There is no freeze for noncore customers. And for core customers with 6.5¢, the
California Public Utilities Commission has not resolved whether San Diego will be able ultimately to pass those rates through or be forced to absorb them or what happens to the shortfall. For PG&E and Edison, there is a hard freeze. For PG&E, it is 5.5¢ or 5.7¢. The public utilities commission just gave them an extra penny,  taking it to around 6.5¢ or 6.7. Edison was 6.2¢. The extra penny takes them to 7.2¢. You have 7.2¢ relative to a spot market price that was on the order in December of 25¢ to 30¢.

MR. MARTIN: Just an anecdote: one of the Chadbourne associates in Washington went home  to San Diego for Christmas. His parents live in a condo that has two bedrooms. Their electricity bill for November — when the air temperature during the day was 75 degrees — was $550. What’s the situation with QFs who supply electricity to these utilities? When did the various utilities stop paying them? 

Payments to QFs

DR. WEISENMILLER: I believe QFs selling to San Diego are still being paid. Edison defaulted on payments to QFs for their November power production. PG&E paid for November. However, PG&E has just recently sent letters to QFs claiming force majeure will prevent future payments. 

MR. MARTIN: The state is making an effort to reduce the revenue that is being paid to QFs. Before you address that, let me just mention that most of these QF contracts are in a so-called cliff period. The contracts set the price for electricity
during the first 10 years. After that, prices move with the market.

DR. WEISENMILLER: During the cliff period, prices move with the short-run avoided cost. The short-run avoided cost is based on a formula that basically starts with electricity prices in the year California deregulated and indexes this price to
the border price of gas. QFs also could elect to receive a price tied to the PX, or spot market, price. A number of QFs in northern California chose the PX price. The PX is winding down, and the volumes are dropping. The question is what
happens to QFs that made this election. The price they are supposed to be paid under their contracts is now unclear.

MR. MARTIN: There is a negotiation going on between Edison and its QFs and PG&E and its QFs. What is that all about? 

DR. WEISENMILLER: FERC put out the notion that a reasonable price for bilateral contracts between the generators and utilities would be 7.4¢ a kWh. The California Public Utilities Commission grabbed that number, backed out the inflation  adjustment, and said — based on that — it believes there should be a cap of 6.7¢ a kWh for QFs. The commission was prepared last week to adopt that number and say no QF — whether it is gas-fired and the border index is 16¢ or it elected to receive the PX price — will be paid more than 6.7¢. Under that gun, the QFs began negotiating with the utilities to try to agree on a different approach. 

At the same time, from the utility or state perspective, if one-third of your power is coming from QFs and you are in a stage 3 emergency with shortage problems, the last thing you want to do is to shut down the QFs. So, there have been
attempts to negotiate among all parties something, although the negotiators appear to want the legislature ultimately to bless those agreements. 

MR. MARTIN: Is this a single negotiation with all QFs or do the utilities do a deal with one QF at a time?

DR. WEISENMILLER: Generally they have been with all, although it has been like herding cats. It has been a fairly fluid negotiating environment. MR. MARTIN: If the negotiations fail, will the CPUC reduce the revenue QFs receive under their
contracts to 6.7¢ a kWh? 

DR. WEISENMILLER: My understanding is there are votes at the commission to put out the draft decision. The commission has held it in abeyance to see what the negotiations produce. 

MR. MARTIN: This means a reduction in revenue for QF projects measured against today’s high prices. Is it a reduction if one looks at what the QFs were being paid six months ago? 

DR. WEISENMILLER: Generally it is above the numbers six months ago, but it would leave gasfired cogeneration projects with too little revenue to cover their fuel costs, let alone other expenses.

MR. MARTIN: Gas-fired QFs are what percentage of the market?

DR. WEISENMILLER: About two thirds of QFs are gas fired and one third use renewable fuels. 

MR. MARTIN: So, if the CPUC follows through on its threat to set the price for QFs at 6.7¢ a kWh, gas-fired QFs may find themselves unable to produce because they lose money at that level?

DR. WEISENMILLER: Exactly.

MR. MARTIN: Lynn Hargis, a question for you. Does California have the authority to tinker with prices under QF contracts or is this power reserved to the federal government?

MS. HARGIS: The CPUC said in its order that the avoided cost paid to QFs would be based on adjusted gas prices. The CPUC clearly has authority to decide the avoided cost. However, the CPUC went on to suggest that it has also an obligation to ensure that the amounts paid to QFs are “just and reasonable.” 

The CPUC used a FERC order as a benchmark for what would be “just and reasonable.” The federal government decides whether the prices charged are “just and reasonable.” The CPUC will exceed its authority if it insists QFs must be
paid a price that is below the avoided cost on grounds that to pay them a higher price would be unreasonable.

MR. MARTIN: At the end of the day, California probably has the authority to push down QF revenues in this manner?

MS. HARGIS: No. If a QF sued California, it would probably win. However, the case would take a couple of years to move through the courts.

MR. SHAPIRO: I would say California has the authority administratively to set a new short-run avoided cost. However, the arbitrary nature of picking a number that is so clearly below the cost for gas-fired QFs or the utilities to produce electricity is so suspicious that a court would probably overrule the CPUC.

California Government’s Plan

MR. MARTIN: Let’s go back to Bob Weisenmiller. California’s response to these problems — what is it doing?

DR. WEISENMILLER: The governor has essentially three objectives. Number one: he does not want the utilities to go bankrupt. Two: he does not want any increase in retail rates above the penny per kWh that has already been approved by the CPUC. Three: he doesn’t want to bail out the utilities.

MR. MARTIN: This is a magnificent failure of self government.

DR. WEISENMILLER: It is hard to achieve all three at the same time. 

The state legislature is considering legislation that would do a variety of things. The utilities still have valuable hydro systems and transmission grids. There is a thought that the state should grab these assets before they fall into the hands of creditors in a utility bankruptcy proceeding. 

The thought is the state might issue or guarantee bonds to cover the $12 billion undercollection with repayment of the bonds to occur over 10 or 12 years. The quid pro quo — so that this is not considered a utility bailout — is that the state would get the hydroelectric and transmission systems. Obviously, the end result is the state would become much more involved in the power
business. A state power authority might be set up. The state might move into the business of generating electricity. There is talk even of acquiring all the generation and transmission in California through condemnation proceedings. 

The state also has an RFP out today for power. The idea is the state would enter into bilateral contracts with generators to buy electricity and give it or resell it to the utilities. Bids are supposed to come in by noon today. The political situation is very unstable. Things could go in a couple of different directions depending on what sorts of bids the state gets in the RFP. 

One thing is clear: the situation will be very bad next summer unless we get a lot more rain in California and the Pacific northwest than we have now.

MR. MARTIN: The power shortages this winter will look mild by comparison to what is possible next summer?

DR. WEISENMILLER: Exactly. 

Generators May Be Ordered to Pay Refunds

MR. MARTIN: Let me move to Lynn Hargis. As you can imagine, this crisis has led to a blizzard of litigation. Let’s talk about what the lawsuits are aimed at doing before I ask the big question, which is, “Will any of these lawsuits matter at the
end of the day or will everything be decided ultimately in the bankruptcy court?”

Last fall, the Federal Energy Regulatory Commission announced a “soft” price cap and also put generators on notice that they might be ordered to refund some of their profits. What was that all about?

MS. HARGIS: In a December 15 order, FERC refused to set any kind of real price caps on the market. FERC still believes in letting the market work. But it did tinker with the market. For example, it freed utilities from having to sell electricity
they generate themselves into the PX and buy it back at spot prices. FERC said the utilities could sell this electricity directly to their customers. That’s when it suggested a benchmark price of 7.4¢ a kWh might be considered reasonable.

MR. MARTIN: Is this the “soft cap”?

MS. HARGIS: The soft cap was a little different. The soft cap was 15¢ a kWh for sales into the ISO or PX. The generators were assured that sales at that price would not be examined. However, sales above that price would be examined. The
generators presumably would have to justify the higher prices later to FERC and might have to make refunds if the higher prices were found subsequently not to be “just and reasonable.” The only problem is that FERC has admitted several times that it doesn’t know what is “just and reasonable” in the context of a free market. 

MR. MARTIN: Back up one step. FERC told generators it will not order retrospective refunds, but it put them on notice that there might be refunds going forward from what date? 

MS. HARGIS: October 2, 2000. 

MR. MARTIN: Until when?

MS. HARGIS: Until the end of 2002.

MR. MARTIN: But the only guidance it gave on what standard it might use to decide whether to order refunds is the prices at which generators sell electricity must be “just and reasonable,” and nobody knows what that means? 

MS. HARGIS: They said there is a zone of reasonableness. The bottom end of the zone is the rates are confiscatory, and the top end is that they are excessive.

MR. MARTIN: These refunds might be ordered only on sales to the ISO or into the PX — not on sales under QF contracts? 

MS. HARGIS: Not on sales under QF contracts. FERC did say that generators would be allowed to cover at least their costs, plus a reasonable return, and maybe an opportunity cost. Thus, there should not be a concern that if refunds are
ordered, they would leave generators with too little revenue to cover their costs. The hard part is to determine what cost is.

MR. MARTIN: Would refunds be ordered only by generators selling into the California market or does the warning about possible refunds apply to other parts of the country? 

MS. HARGIS: This applies only to generators selling to the California ISO or into the California PX. 

Lawsuits Challenging Rate Freeze

MR. MARTIN: Another set of lawsuits is aimed at forcing the California Public Utilities Commission to let the utilities pass through their costs of buying electricity to their customers? 

MS. HARGIS: Both PG&E and Edison have gone into federal district court to argue that the doctrine of federal preemption requires the CPUC to pass through wholesale rates that have been accepted by the federal government. Traditionally, under normal law, that is correct. Bob Shapiro has argued this very forcefully in the Freehold case. But there is nothing traditional or typical about what is happening in California. I think there is little chance of the utilities getting the relief they are seeking retroactively because they not only agreed several years ago when the state deregulated to the rate freeze, but it was also part of an overall package that — as some of the parties have pointed out — FERC itself approved.

Going forward, there is a rule of preemption that FERC-accepted wholesale rates must be passed through in retail rates. 

MR. MARTIN: The federal government has control over wholesale rates, and the state has control over retail rates, or the rates charged to consumers, but the federal government has an interest in requiring that the retail rates reflect the wholesale rates? This is a federal-state dynamic that President Bush may not have grasped yet when he said the federal government will not become involved? [Laughter] 

MR. SHAPIRO: You don’t have to answer that. 

MS. HARGIS: Traditionally, about 10% of all electricity rates are wholesale rates and 90% are retail rates. What happened in California is, by deciding to run all electricity sales through the PX, all electricity sales became wholesale sales in
interstate commerce, giving the federal government jurisdiction over essentially 100% of the rates in California. That’s why Edison went immediately to court to ask for a writ of mandamus ordering FERC to decide what are “just and reasonable” rates, asserting that FERC has admitted the market is not setting such rates and, therefore, if FERC has no other plan, it should go back to setting rates based on cost of service. If FERC does not change something on rehearing of its order in the California case, it will certainly be sued on this issue.

MR. MARTIN: How long does a case like this take to work through the courts?

MS. HARGIS: Normally, it would take a couple of years. 

US Order to Generators to Sell

MR. MARTIN: Another area of legal controversy is the federal government has ordered generators to sell electricity to California. That order was renewed yesterday for another two weeks. Can you elaborate a little more on that? 

MS. HARGIS: These are really emergency war powers. They were set up in 1935 for a crisis like war in which there just wasn’t enough electricity. Secretary Richardson first invoked them in December. When the California ISO says it is short electricity, generators are required to sell. There is an equivalent order on the gas side that was invoked for the first time last week because PG&E said its suppliers were not selling it natural gas. 

MR. MARTIN: Generators must sell. Is there anything in the order about the price at which they must sell? 

MS. HARGIS: The buyer and seller must agree on a price. If they cannot, then FERC will set the price for electricity. 

MR. MARTIN: These orders are aimed solely at dealing with the credit problems of the utilities? Generators are reluctant to sell because they are not sure they are going to be paid?

MS. HARGIS: At this point, that seems to be one of the main problems. But there may be an actual shortage of gas.

Market Abuse Investigations

MR. MARTIN: Another area of legal process is the investigations into market abuses. I suppose these could lead ultimately to criminal charges and to racketeering, or RICO, charges. Where are those occurring — at the federal or state level? 

MS. HARGIS: A number of cases have been brought. I think mostly in state court. There are two kinds of cases. One set of cases charges that the gas pipelines have created an artificial shortage by selling to affiliates. On the electricity side,
the city of San Francisco, a number of water districts and others have alleged that there was an exercise of market power by generators in order to withhold supplies and drive up prices. Those may be more political than legal. 

Can QFs Suspend Contracts?

MR. MARTIN: Let me move now to the entire group, but with a heavy bankruptcy input. This is a question for Howard Seife, but the rest of the group should feel free to weigh in. Assume for a moment the utilities in California do not file for bankruptcy. The QFs are not being paid. Can QFs suspend deliveries of electricity and sell their power elsewhere?

MR. SEIFE: That’s an analysis that QFs are doing now. Some QFs have not been paid since November. A lot of these are facing cash shortages. They have bills coming due for gas. One thing such a QF could do would be to declare a default on its power sales contract with the utility. 

Can the QF go further and terminate the contract? I think there is a very strong argument that failure to pay two months running, plus an announcement publicly that there is an inability to pay, is a material breach under the contract.

That would entitle the QF legally to stop supplying power. 

There is an alternative solution, and that is to suspend performance. However, there is a question under California law whether such a right exists. That’s because it has not been established under California law whether the delivery and
sale of electricity are covered by the Uniform Commercial Code. To be covered, electricity must be a “good.”

MR. MARTIN: What difference does it make if electricity is a “good” under the Uniform Commercial Code, or UCC?

MR. SEIFE: The UCC provides very clear remedies for breaches of contracts involving sales of goods. One of the remedies is to suspend performance. A generator would be able to suspend performance without terminating the contract.
Many QFs are reluctant to terminate their contracts because the contracts are valuable assets.

MR. MARTIN: Bruce Rader or Bob Shapiro, any other views on whether the QFs can walk away from their contracts?

MR. SHAPIRO: Obviously, the UCC question is a very big issue. However, on top of that, you have a threat every day of blackouts. If a large group of QFs was to suspend performance, it would create a worse blackout situation and probably leave the Bush administration with no choice but to invoke section 202(c) of the Federal Power Act to force QFs to continue to serve. 

DR. WEISENMILLER: One other point — many of these QFs have long-term contracts with capacity payments that run for as long as 30 years. If a QF were to terminate now at year 12, it would have a substantial liability for the capacity
overpayments that have been made to date. The contract would have to be viewed as a 12-year rather than a 30-year contract. That’s a very strong deterrent against termination. 

MR. SHAPIRO: Another complicating factor is that the standard offer contracts typically in use in California were negotiated, political documents. Consequently, they lack certain key provisions — for example, default and termination
provisions. [Laughter] Ordinarily, one would read the default section to find out what is a default and what the cure rights are and what happens after a cure period. The contracts are silent on this subject.

What Happens In Bankruptcy

MR. MARTIN: Let’s move to a slightly different topic — bankruptcy. Howard Seife?

MR. SEIFE: The utilities could find themselves in bankruptcy in one of two ways. One would be involuntarily. All it takes are three creditors who together are owed more than $10,000 in claims, and all they need to allege is the company is not
generally paying its debts as they come due. The companies have already admitted as much in their public filings. Thus, we are faced with a situation where any three creditors could — as we speak — run to the courthouse and put the utilities into an involuntary bankruptcy. 

Another scenario would be a voluntary bankruptcy. The implications of a voluntary bankruptcy are significant. Number one, the utilities would be able to resume borrowing and, thus, have the cash to pay their bills. It sounds contrary 
to common sense that, by filing bankruptcy, one gains access to the credit markets, but that’s exactly what happens.

The banks are already lining up to offer DIP financing, or debtor in possession financing. Before any utility puts itself voluntarily into bankruptcy, it would want to be assured that such financing is available and locked in so that it would have access to the credit markets the day after filing.

MR. MARTIN: Back up. Aren’t there a couple of other things that happen in bankruptcy? One is creditors cannot continue to pursue collection of past debts?

MR. SEIFE: There are several potential benefits to the utilities from filing for bankruptcy. 

One is what you just mentioned, which is an automatic stay. Your creditors are enjoined, or stayed, from taking any enforcement actions against you. They can’t sue you. They can’t attach your assets. They can’t even harass you.

MR. MARTIN: Is another effect of a bankruptcy filing by the utilities that the QFs would be obligated to continue performing their contracts? 

MR. SEIFE: Yes, to the extent the QFs have not terminated their contracts before a utility bankruptcy, they are going to be locked in. They are going to have to continue to supply power under those power purchase agreements. That is one of
the protections that the bankruptcy code gives to the utilities.

MR. MARTIN: At what price would they be required to continue performing? 

MR. SEIFE: That raises an interesting question. 

The normal rule is that, if a debtor still wants to get the benefits of a contract, he must continue to perform according to the terms of the contract. So in this case, if the utilities want to continue to be supplied with power the QFs, they would have to
pay for it according to the contract terms. 

There is one exception that I don’t think has been focused on to any significant degree. If the QFs are determined to be “utilities” for purposes of the bankruptcy code, then the rules change. It it not hard to imagine some smart lawyers  representing utilities are going to argue that the QFs are themselves utilities.

MR. MARTIN: What happens if they are utilities?

MR. SEIFE: If they are utilities, then number one, the QFs are required to continue to supply power. Number two, you don’t necessarily look at the contracts to determine the rates that the QFs must be paid for their power. You look at something  that’s more akin to a market rate. A QF could be better or worse off, depending on what its contract provides currently.

MR. MARTIN: The newspapers are full of reports that bankruptcy might be a good idea because a bankruptcy judge could order the CPUC to allow the utilities to pass through their costs. Could a bankruptcy judge do that?

MR. SEIFE: Some of the headlines in the papers have intimated that a bankruptcy judge can unilaterally impose new rates. I think that’s far from the case. Bankruptcy courts are very reluctant to step on a regulator’s toes. They generally defer to the regulators. You are not going to see a bankruptcy judge unilaterally setting rates. 

However, what the bankruptcy court can do is bring all the parties together, give a focus to all of competing claims, and really start imposing some moral suasion and pressure to get a deal done. A bankruptcy judge will not determine what is a fair
and reasonable rate.

MR. MARTIN: Is there any reason to believe that these parties — who have already met in one room with the Secretary of Energy, the Secretary of the Treasury, the FERC chairman, and the California governor — are going to be any more likely to reach an agreement in a bankruptcy court than they have already?

MR. SEIFE: I would think not. But it does buy time, and it may diffuse the crisis atmosphere. The utilities will be able to resume borrowing. They will be able to pay future bills. This will buy time.

MR. MARTIN: This is an odd situation for bankruptcy. Normally when a company files for bankruptcy, it starts over with a clean slate. But here, with every electron the utilities buy, they lose more money. How would they be able to borrow going forward in that circumstance?

MR. SEIFE: The magic of bankruptcy is the new lenders will have first priority. They will be the first ones to get repaid on any process. So this is generally a safe loan. MR. MARTIN: Only if the bank is willing to take assets for repayment. The utilities are losing — and will continue to lose — a million dollars an hour.

MR. SEIFE: There will be cash flow. MR. MARTIN: If a bankruptcy judge cannot order the regulators to increase retail rates, is there a risk in bankruptcy that he could order the QFs to accept less?

MR. SEIFE: If the QFs are determined to be utilities, then the judge could try to fix rates. Apart from that, the utility will not get immediate relief from the rates that it is being charged by the QFs.

During the bankruptcy process, the utilities will able to decide whether they want to assume contracts, including these PPAs, or reject them. If they assume the QF contracts, they will have to cure all the back payments. If the utilities think electricity can be purchased elsewhere at better rates, they can reject the contracts. Then the QFs will be left with general unsecured claims.

MR. MARTIN: If the bankruptcy judge rejects the QF contracts, won’t this be an ironic outcome? The utilities have been trying to buy them out for several years. Do the QFs get any compensation if the contracts are rejected?

MR. SEIFE: The QF will get to stand on line with all the other creditors. They will have prepetition general unsecured claims, and it will be up to the bankruptcy court to determine the contract damages.

MR. MARTIN: What about the value of the contract itself going forward?

MR. SEIFE: That will be part of each QF’s prepetition claim.

MR. MARTIN: At this point, I would like to bring in the rest of the panel. One way to get into bankruptcy is for the generators to force the utilities into it. Do generators have any interest in doing this? Do they gain or lose? 

MR. SEIFE: One ironic benefit for the QFs if the utilities go bankrupt is payments will resume under their contracts. The utilities will be able to borrow money. A bankruptcy judge will require the utilities to pay currently for power being supplied by the QFs.

MR. MARTIN: Are there downsides?

MR. SEIFE: The flip side is the risk for QFs that their contracts will be rejected. QFs also have to deal with their own lenders. Each of these QFs has its own bank debt. A bankruptcy filing by a counterparty to the power purchase agreement will be a default under the QFs own financing agreements.

MR. MARTIN: Any other views on the panel?

MR. SHAPIRO: I don’t see any of this as realistic. If the state will not allow the utilities to pass through their costs of electricity, the utilities will continue to lose money. Eventually, one will have a situation where the generators must either stop serving or declare bankruptcy themselves. There will have to be a political solution that involves some combination of utility bailout and rate increases. Bankruptcy provides no ultimate solution.

MR. MARTIN: So in your view, there is nothing to be gained by bankruptcy?

MR. SHAPIRO: No. Eventually, you will end up in the same place.

MR. MARTIN: Any other views on the panel?

MR. SEIFE: The advantage of the bankruptcy is to buy time for the utilities. A political solution is not in view. This crisis cannot go on much longer in its current mode. I think a bankruptcy is virtually inevitable.

DR. WEISENMILLER: Can utilities shield their unregulated businesses from the bankruptcy court by erecting a “ring fence,” or will the bankruptcy ripple out to these affiliated companies?

MR. SEIFE: That’s a key question. Will this work? S&P and Moody’s think it will because they have given investment grade ratings to these companies that have moved over behind the ring fence. Will it be challenged in a bankruptcy court? I think probably it will be.

What QFs Should Do

MR. MARTIN: If you are a QF and expect the utility to whom you sell power to file for bankruptcy, is there anything you should be doing now in anticipation of this?

MR. SEIFE: If I think I might lose the ability to sell or want to terminate my contract, I would start looking now for another buyer for my electricity.

DR. WEISENMILLER: In California, a QF — under very limited circumstances — can sell on the retail market without becoming a utility, but the sale must be just over the fence. Therefore, I would say over 99% of QFs would have to look at the wholesale market. You then look at the ISO and PX. If you were to try to participate in them now, there would a time lag of maybe 60 days. Obviously, one can’t predict whether the PX will be around in 60 days. So, you are looking at the wholesale market — municipal utilities and wholesale entities — trying to figure out if you have any way to get your power to them either through the ISO or through any pre-existing transmission agreements they have. I am not sure “dismal” is the right word, but it is a complicated analysis. I fear most people will find themselves trapped.

MR. MARTIN: One effect of a utility bankruptcy is the QFs become locked into supplying power. Some QFs have talked about filing for bankruptcy themselves. This would set up a dueling bankruptcy scenario. What would happen? Why would a QF do this?

MR. SEIFE: One benefit for a QF to file for bankruptcy is the ability to reject its power purchase agreement. It would get out of the obligation the utility bankruptcy imposes to continue supplying power. Obviously, this would entail a lot of risk. A QF would only do it if it wasn’t getting paid and knew it could enter into a long-term agreement to sell to someone else.

MR. MARTIN: If a QF waits to file for bankruptcy after the utility does it, would it be released from its obligation to continue serving or is it too late?

MR. SEIFE: I would think it would still be obligated to deliver power to the utility, even though it filed for bankruptcy. However, you would have a conflict between two bankruptcy judges, one of whom wants to do everything possible to protect the utility and the other who wants to do everything possible to protect the QF.

MR. MARTIN: Are there other effects of a utility bankruptcy? Is this an automatic default for QFs under their own bank loans?

MR. RADER: Clearly it is. One other thing we should mention is QFs are looking at forbearance agreements with the utilities as a way of forestalling any utility bankruptcies. The QFs are hoping to get forbearance agreements back to back with gas suppliers and then also with their lenders.

MR. MARTIN: A forbearance agreement is what?

MR. RADER: It is an agreement that the QFs would forebear from trying to collect from the utility for past debts. The utility could suspend payments — namely the next two payments under the PPA. The utility would pay the QFs on April 1 with some concept of default interest built in.

MR. MARTIN: So, suppose a generator expects a utility bankruptcy. What ought it to be doing? Bob Weisenmiller mentioned looking for other outlets for the power. We talked about the possibility of the QF itself filing for bankruptcy. We talked about forbearance agreements. One should probably also let one’s lenders know the situation because this could be an automatic default under the QF’s financing agreements. Are there other things that QFs ought to be doing now?

DR. WEISENMILLER: This is a major political poker game in Sacramento. QFs ought to make sure that they are represented at the table.

MR. SEIFE: One of the issues that QFs are struggling with is whether to shut down. Right now they are incurring huge costs for gas, and they are not getting any revenues in. That hole just gets deeper and deeper. One of the things they are considering is going dark.

MR. MARTIN: That seems suicidal given the current political environment.

MR. SEIFE: It depends whose suicide you are talking about. [Laughter] One of the issues for the bankers in the audience is what do you do when your borrower — the QF — sends you a notice that it is out of cash, its utility hasn’t paid it in two months, and it can’t afford to buy more gas to operate. There is very little banks can do. This is not mismanagement. It is not malfeasance. The banks are not going to be able to take over the facilities and run them any better than the QF can. Everyone has to sit on his hands until the political solution is sorted out.

MR. MARTIN: Twenty to 30% of independent generators are selling through power marketers into the spot market or selling their power under tolling agreements. Are generators who are doing this in the same fix that the QFs are? Bob Shapiro?

MR. SHAPIRO: Generators that have tolling agreements with creditworthy offtakers are okay. They are not selling directly into the spot market. There is no regulatory out clause in those contracts. They are protected to the extent that the power marketers to whom they sell power remain creditworthy. The power marketers and tolling gas companies are the ones with the problem.

MR. MARTIN: Are those power marketers and tolling gas companies putting the credit of the parent company on the line or were these contracts signed by special-purpose subsidiaries?

MR. SHAPIRO: In every case where there is a project financing, the toller has to be itself creditworthy or have a guarantee by a creditworthy entity.

What Banks Should Do

MR. MARTIN: Let me ask Chaim Wachsberger, since you often represent banks, what ought a lender to be doing at this point?

DR. WACHSBERGER: I have to be a little careful in answering that because we have clients who are lenders and developers. The starting point is to know what your loan agreements say. Many of the possible QF actions discussed today will require lender consent.

However, at the end of the day, this is probably one of the most difficult scenarios you could have dreamt of. It’s very complicated. It’s big. It’s in flux. You take a look at some of the power companies in California — these are some of the best companies this business has ever seen. I have to believe the bankers in the audience are thinking I should look at what my rights are, but if these guys can’t figure out other options this week, I’m not sure I can figure it out any better. It’s not a question of mismanagement. I think it is healthy to know what your borrower is doing and thinking. Keep a close eye on what’s going on. Once the situation changes enough so that people begin to have options, you try at that point to have your say.

Risk of Expropriation

MR. MARTIN: Let’s move on. There has been talk about the possibility of San Francisco and other municipalities taking over the power plants or seizing capacity. Let me ask Bill Monsen, is this a very likely scenario?

MR. MONSEN: A number of cities in California have been looking at this. The reality is they don’t really have any generating assets located within city limits. As a result, it would be very difficult for them to become municipal utilities.

DR. WEISENMILLER: One of the issues the state is facing with its RFP for power is whether it has good enough credit to support long-term contracts. A municipality that goes into the power business would have the same issue, particularly if the only assets nearby to municipalize are distribution lines so that it would still have to buy power in the wholesale market. It is surprising to see the city of San Diego — a very conservative city — looking at municipalization.

In all of the California chaos, the municipal utilities have been isolated from the problems. However, it is a very simplistic solution to say that if Los Angeles — which is served by the LAPD — has done so well, why not do the same thing on a statewide level or at least for the city of San Francisco. The first question is where do you get the excess generation. The heart of the problem in California is there is too little supply in relation to demand. Does the city of San Francisco want to allow the siting of new power plants in San Francisco?

Is California Unique?

MR. MARTIN: One big question, can this happen elsewhere?

DR. WACHSBERGER: It never could have happened here. [Laughter]

MS. HARGIS: I think that’s the answer. One of the problems in California is the utilities are not allowed to pass through the high prices they are having to pay for wholesale power. These high prices can be found in other parts of the country. Indeed, GPU in Pennsylvania has a rate cap, and it said recently in a regulatory filing that it has run up $42 million in excess costs for power that it has been unable to pass through. I think California is the worst case, but a fair number of states are starting to feel discouraged about whether deregulation reduces electric rates. ​

MR. MARTIN: Other views on whether this can happen elsewhere? 

MR. SHAPIRO: A number of states that have gone far down the road in restructuring have done a much better job than California. In many of those states — for example, Nevada and Ohio — the selloffs of generation have been accompanied by transition power sales agreements back to the utilities that essentially match in price the retail rates the utilities are allowed to charge during the freeze period. There won’t be the situation that occurred in California in these states. The real question is going to be is there enough incentive — are the markets robust enough and is the climate good enough —- for new generation so we won’t get into a capacity crunch as California has done. To the extent regulators and governments in other states understand the need to encourage new generation and for supply to grow with demand, over the longterm the pricing will reach equilibrium.

MR. MARTIN: Other views? Bob Weisenmiller?

DR. WEISENMILLER: If you think back to what I identified at the start as the five or six factors that contributed to the situation in California, I think you can find one or more of these problems in other parts of the country, but not the whole combination. You can find jurisdictions that have rate freezes. You can find jurisdictions that have a high reliance on gas or imported electricity. So, you will certainly have rate spikes in other states with utilities being caught at least temporarily in the middle, but I don’t think you have quite the same sort of perfect storm where everything goes wrong at the same time.