The Schwarzenegger Energy Policy?

The Schwarzenegger Energy Policy?

December 01, 2003

Although Arnold Schwarzenegger only took office in California on November 17, it is not too early to speculate about the implications of the new regime for energy markets in general and the project finance community in particular.

This article has three parts.  It looks first at the broad political landscape that Schwarzenegger must navigate because that landscape will limit his options when it comes to energy policy.  Then it explains the state budget crisis that will have to be the new governor’s first priority and that could force him to spend political capital that he could otherwise use to address energy issues.  Finally, it discusses the governor’s energy strategy as outlined during his campaign.  Putting these pieces together, the article offers some insights into how the energy industry may develop in the new Schwarzenegger era.

Political Landscape

The political landscape facing the Schwarzenegger administration is complex and sets limits on any California governor’s ability to govern.

California has a multicultural society that gives rise to wide-ranging political philosophies.  Term limits have produced inexperienced legislators and strengthened lobbyists’ role in the legislature.  State budget passage requires a two-thirds majority, leading to recurring annual deadlock in Sacramento.  Primaries favor each party’s more extreme candidates, leaving moderate politicians locked out of the general elections.  A progressive legacy inflates the role of the state’s residents through initiative, referendum, and the recall process that brought Schwarzenegger into office.

Democrats currently control both houses of the California legislature, giving Republicans little or no meaningful voice in the legislature.  Only on budget issues, taxes, and urgent legislation, all of which require a two-thirds vote to pass, do the Democrats need a few Republican votes to pass legislation.  Not surprisingly, an initiative to reduce the number of votes required to pass a budget or raise taxes has qualified to be on the ballot in next spring’s election.

The ballot initiative adds another layer of complexity.  Under California’s constitution, petition drives can place initiatives directly on the ballot.  In fact, voter initiatives are quite common.  Periodic “grass root” outbursts have resulted in major policy shifts such as the limitations on property taxes and the establishment of term limits.  Now Californians can also point to their first successful recall of a governor.  The legacy of voter initiatives includes an increasingly dysfunctional state government that responds to crises with inaction and photo opportunities.

Budget Mess

Key Democratic leaders realize that Schwarzenegger has received a strong mandate from California’s electorate to shake up Sacramento and the political status quo.  Nevertheless, they are likely to challenge this political neophyte.  The budget crisis may present Democrats with their best hope for tripping up the new governor, just as it proved the undoing of Gray Davis.  Unpopular spending cuts or tax increases could quickly eliminate the political capital with which Schwarzenegger entered office.

In the late 1990s, California received an unprecedented budget windfall as the dot-com boom brought new revenue into the state coffers.  Rather than reduce taxes or establish an expanded reserve, Gray Davis and the legislature squandered most of this one-time windfall by increasing spending on politically popular programs.  Expenditures in the 2000-2001 fiscal year rose 20% over the previous year.  However, when the economy fell into recession the windfall was lost.  In the summer of 2002, legislators had to overcome a $23 billion deficit to reach a balanced budget for fiscal year 2002-2003.  The governor and the legislature used a series of accounting tricks, short-term loans, and raids on special funds to paper over the problem rather than cut programs or increase taxes — painful actions to take in an election year.

By the summer of 2003, Governor Davis and the legislature faced a two-year budget gap of $38 billion, an amount equivalent to one-third of general fund spending.  One month after his re-election, Governor Davis claimed that it was time to address the budget deficit with a mixture of spending cuts and tax increases.  A special session of the legislature generally ignored his proposals and adopted a budget that included a tripling of the vehicle license fee, a proposed $1.9 billion bond sale to pay on-going pension obligations, and another bond issue of $11 billion to finance the deficit.

Predictably, tax increases proved unpopular.  Following through on a campaign pledge, Governor Schwarzenegger repealed the unpopular vehicle license fee on his first day in office.  The deficit reduction bond measures are already being challenged in court on the grounds that the state constitution requires voter approval.  Schwarzenegger says he will ask voters to approve a deficit finance bond measure of as much as $15 billion, but his proposal has already run into opposition in the legislature.

Schwarzenegger also has proposed mid-year budget cuts and state workforce reductions, although specific details are not yet available.  He must propose a detailed budget for 2004-2005 to the legislature in January and convince the legislature to enact it.  Given his expressed desire to limit cuts in social programs, he has a difficult balancing act ahead.  Clearly, California’s budget challenges dwarf the fictional foes faced by action hero Schwarzenegger.

So far it has been unwise to underestimate Schwarzenegger the politician.  He ran a brilliant and unconventional recall campaign.  He attracted a respected group of economic advisors, including Warren Buffet and George Schultz.  Schwarzenegger has pledged to make direct appeals to the public and use the power of reform initiatives if blocked by the legislature.  Given his unconventional route to the governor’s office, that strategy may work, particularly since polls show the legislature and its career politicians are even less popular than ex-Governor Davis.

Energy Policy

Against this backdrop of fiscal crisis and political volatility, fixing California’s energy policy and regulatory environment will be a cornerstone of Schwarzenegger’s initiative to improve California’s business climate.  Schwarzenegger needs to get the right policies in place soon for several reasons.  First, energy is likely to be a key campaign issue in the 2006 elections.  Second, California appears to have a small window of opportunity to attract needed investment that can forestall an energy shortage predicted for the end of the decade.

Energy policy has been highly politicized in California since well before the energy crisis in late 2000 and early 2001.  Indeed, California’s energy morass stems from the restructuring framework enacted during the previous Republican administration.  However, it was the combination of high prices and apparent market failure during 2000 and early 2001 that made electricity restructuring a public issue and branded the Davis administration as hesitant and indecisive.

Every politician with ambitions for higher office has his or her own energy policy agenda.  State Senator Joseph Dunn, supported by California’s trial lawyers and eyeing the attorney general job, would “end energy deregulation rather than mend it.” State Treasurer Phil Angelides, a potential gubernatorial candidate in 2006, supports a resurgence in public power.  Another likely candidate for governor, Attorney General Bill Lockyer, emphasizes the litigation his office led before the Federal Energy Regulatory Commission and in civil courts against the energy “market manipulators”.

The best guess today is that California will need significant additional generating capacity by the end of this decade.  Given project lead times in California, there is a limited window of opportunity to re-establish the necessary prerequisites for attracting investment in energy infrastructure.

Investment in California’s energy infrastructure is hampered by a litany of woes: a lack of creditworthy buyers and sellers, unclear market rules, a flawed wholesale market design, and the operational and economic impacts of the portfolio of expensive and inflexible power contracts signed by the state Department of Water Resources, or “DWR,” during the California power crisis in 2001.  Topping off this list, key members of the legislature are hostile toward anything that could be characterized as deregulation.

Just as in many other parts of the US, a large number of efficient gas-fired power plants were built in California in the last few years, and the state now has adequate reserve margins.  DWR’s contract portfolio and California’s successful demand-side-management programs have left California generally long on capacity.  However, the state still faces a capacity shortfall during periods when demand peaks simultaneously in California and neighboring western states.  In addition, some geographic areas, such as San Francisco and San Diego, have inadequate transmission capacity that has created a need for additional local generation or expanded transmission.

The legislature adopted an aggressive renewable portfolio standard to add diversity to California’s generation mix.  This requires the investor-owned utilities to enter into long-term contracts for renewable resources to meet the new standards.  It increases pressure on merchant power plants that have not locked in buyers for their output.  Particularly hard hit are older, inefficient power plants that were mostly divested by the investor-owned utilities in the late 1990’s.  Partially completed new projects without power purchase contracts have been put on hold, and less efficient power plants are being mothballed.  A dry year that causes hydroelectric plants to reduce output, significant power plant shutdowns, or a resurgence of load growth could bring new power shortages.  The chart above shows forecasts of demand in relation to supply by the California Energy Commission.  Supply is expected to be adequate through 2007, but there is at least a one-in-ten chance that supply will fall short during this period.

To shape a new energy policy, Schwarzenegger will need to not only work with the Democratic legislature but also with Davis appointees.  For example, no new seats on the California Public Utilities Commission will open up until early 2005 (unless a sitting commissioner steps down before the end of his or her term).  Schwarzenegger will have an opportunity to appoint a new commissioner to the California Energy Commission in early 2004. The Senate must confirm appointments to either agency.  Both agencies are governed by five commissioners, so it could take two or three years for Schwarzenegger to appoint a working majority.  He may need to rely extensively on line-item budget vetoes to reshape these agencies.  Or he may pursue a more aggressive agency consolidation approach, discussed below.

Predictions

Governor Schwarzenegger is expected to bring a needed infusion of fresh thought to the state’s energy policy, which has been driven by reaction to the failures that led to the power crisis in late 2000 and early 2001.

Schwarzenegger’s campaign stance was notable for reliance on market strategies rather than a continued railing against the problems of the state’s deregulation to date.  His administration also professes a willingness to learn from successful deregulation efforts elsewhere in the country.  At the same time, he faces the constraints described earlier on his ability to act.

Some of Schwarzenegger’s policies should be fairly uncontroversial with the legislature and the holdover Davis appointees.  The following five policies fall into this category.

1.  A strong commitment to the environment.  One of the new governor’s first appointments was Terry Tamminen, a longtime conservationist and a political independent, as secretary of the Environmental Protection Agency.  Tamminen is expected to try to streamline California’s permitting and regulatory review processes, allowing certain “green” objectives to be achieved more efficiently.  Environmental issues are likely to continue to be a strong element of policy in this green-friendly state.

2.  Support for demand-side management programs and renewable energy.  Schwarzenegger wants an increase in the renewable portfolio standard to 30%, a very aggressive goal.  This is good news for investors in such resources, but it may prove a constraint on other generation development.

3.  Investment in California’s energy infrastructure, in particular natural gas transmission projects and new generation, as a key to stabilizing the energy markets.  The governor also wants advanced meters that would allow for better pricing signals through “real-time” pricing.

4.  Consolidation and pruning of California’s energy regulatory agencies.  An early candidate for elimination is the California Power Authority, which was created in the middle of the energy crisis and has been searching for a role ever since.  Rationalizing the state’s energy regulatory structure could reduce the regulatory risk in generation and transmission development.

5.  DWR contract restructuring.  Schwarzenegger wants to rewrite some contracts that the DWR signed in 2001, but his options may be limited because many of these contracts were renegotiated in some fashion under Governor Davis.  He may try to involve the utilities more directly, instead of relying primarily on DWR and its consultants and legal advisors.  The utilities could consider a broader range of restructuring tools, such as contract buy-outs rather than simply trying to shorten the contract terms.

In other areas the new administration will face greater opposition from the legislature and from Davis holdovers and separatelAnchory elected constitutional officers in the executive branch.  There are four policies where such opposition is expected.

aCore/Non-core retail structure.  Since the suspension of third-party options in 2001, large customers and their suppliers have supported a return, perhaps limited, to a retail market that offers choice to consumers.  Recent proposals focus on core and non-core approaches that would afford choice to large, presumably more sophisticated customers.  Opposition by key members of the legislature is fierce, and this may be one of the early energy battlegrounds for the Schwarzenegger administration.

bCPUC revenue allocation and rate design have moved strongly in recent years toward protecting small consumers.  A more pro-business Schwarzenegger policy orientation may push this pendulum back toward rate design that takes economic development and business retention concerns into account.

cState-federal confrontation.  Schwarzenegger would like to end the Davis administration’s bitter confrontations with the federal government on all fronts.  A return to the Republican fold would seem to point to a new rapprochement between Sacramento and Washington.  However, the state attorney general is expected to pursue his energy litigation with the Federal Energy Regulatory Commission through every possible appeal.  In the near term, Schwarzenegger will have limited influence on the California Independent System Operator, the California Public Utilities Commission and the California Energy Commission, each of which has its own differences with its federal counterparts.

dRegional cooperation.  Given how interconnected western power and gas markets are, it would be wise to work with the Federal Energy Regulatory Commission and the other western states to achieve a regional, competitive wholesale market.  However, we expect other western states to harbor continued mistrust of California, attempting to erect a “firewall” around California, even though most politicians in neighboring states will be much more interested in working with Schwarzenegger than they were with Davis.  The Pacific Northwest is vigorously opposed to the “standard market design” proposed by the Federal Energy Regulatory Commission.  It could easily take five years or more to achieve any truly regional approaches.

To sum up, California was already taking steps to restore confidence in the energy regulatory and investment climate before the election.  Personnel changes at the CPUC and CEC were obvious examples of that movement.  The Schwarzenegger administration will continue in this direction if it is not distracted or stymied by the state budget mess.  The state was singed if not scorched by the inept way in which it deregulated electricity supply in the 1990’s and then responded to the electricity crisis.  Schwarzenegger appears to want to resume the push toward true deregulation.  It could be at least two years and maybe longer before anyone can tell whether he will succeed.