UNITED STATES OF AMERICA

BEFORE THE

FEDERAL ENERGY REGULATORY COMMISSION

Public Utilities Commission of the State of California, Complainant, v. Allegheny Energy Supply Company, LLC, Alliance Colton LLC (aka Colton Power) CalPeak Power, Calpine Energy Services, L.P., Clearwood Electric Company, LLC, Constellation Power Sources, Inc., Coral Power, L.L.C, Dynegy, El Paso Merchant Energy, L.P., Fresno Cogeneration Partners, L.P., GWF Energy LLC, High Desert Power Project, LLC, Imperial Valley Resource Recovery Co., L.L.C., Mirant Americas Energy Marketing, L.P., Morgan Stanley Capital Group, Inc., Pacificorp Power Marketing, Inc., Primary Power International, PG&E Energy Trading-Power, L.P., Sempra Energy Resources, Soledad Energy, LLC, Sunrise Power Company, LLC, Wellhead Power, L.L.C., Williams Energy Marketing & Trading Company, and All Sellers of Long Term Contracts to the California Department of Water Resources, Respondents.

Docket No. EL02-___-000

SECTION 206 COMPLAINT

VOLUME I

GARY M. COHEN
AROCLES AGUILAR
SEAN H. GALLAGHER

JONATHAN BROMSON

ELIZABETH M. MCQUILLAN

LINDSAY BROWN

Attorneys for Public Utilities
Commission of the State of California

505 Van Ness Avenue, Room 5124
San Francisco, California 94102
(415) 703-2059

UNITED STATES OF AMERICA

BEFORE THE

FEDERAL ENERGY REGULATORY COMMISSION

Public Utilities Commission of the State of California, Complainant, v. Sellers of Long Term Contracts to the California Department of Water Resources, Respondents.

Docket No. EL02-___-000

SECTION 206 COMPLAINT

Pursuant to Section 206 of the Federal Power Act ("FPA") and Rule 206 of the Rules of Practice and Procedure ("Rules") of the Federal Energy Regulatory Commission ("FERC"), the Public Utilities Commission of the State of California ("CPUC") hereby files this Complaint against specified sellers who are counter-parties on long term contracts with the California Department of Water Resources ("CDWR") for violations of the FPA and certain rules, regulations and orders promulgated thereunder, and requests the initiation of refund proceedings pursuant to § 206 of the FPA, and for other relief as FERC deems appropriate.

Respondent sellers are listed in Appendix A. The challenged contracts are listed in Appendix B and attached hereto as Exhibit Nos. 1 through 34.¹ Certain challenged contracts include more than one transaction. Certain sellers entered into more than one contract with CDWR. The Complaint thus addresses 44 transactions embodied in 32 contracts with 22 sellers.

The CPUC submits that each of the contracts challenged herein must be abrogated. Each challenged contract is unjust and unreasonable. In addition to unreasonable pricing, the non-price terms and conditions of each contract are unjust and unreasonable, and warrant abrogation of the contract. Abrogation of the contracts should be implemented in an orderly fashion which will enable California to obtain such replacement contracts as are necessary at reasonable prices and on reasonable terms. In the alternative, FERC must reform the challenged contracts to provide for just and reasonable pricing, reduce the duration of the contracts, and strike from the contracts the specific non-price contract terms and conditions found to be unjust and unreasonable, including each of the provisions discussed herein.

SUMMARY OF COMPLAINT

In January 2001, at the height of the California market dysfunction, the California Department of Water Resources ("CDWR") was thrust into the position of embarking on an unprecedented program of power procurement. In attempting to procure the "net short" load² of the IOUs, CDWR faced a market environment dominated by the exercise of market power. Sellers' market power in the forward markets had been enhanced rather than restrained by FERC's initial orders seeking to mitigate the price and supply crisis in California. In this environment, despite its best efforts, CDWR was forced to pay unjust and unreasonable prices, and to agree to onerous, unjust and unreasonable non-price terms and conditions, in order to secure the power necessary to ensure that the lights stayed on in California. In many instances, CDWR was forced to accept high-priced power for 10 or even 20 years in order to obtain any power at all for the two to three year period in which it sought to focus its efforts.

The contracts challenged herein must be rejected as in violation of the applicable statutory standard. The prices, terms, and conditions in each challenged contract are tainted with the exercise of market power, rendering each challenged contract unjust and unreasonable in violation of § 206 of the FPA. The attempt in certain contracts to require that any FERC review utilize the more stringent "public interest" standard should be rejected. However, to the extent applicable, the challenged contracts must be rejected as not in the public interest as well.

The CPUC's preliminary calculations indicate that collectively, the challenged contracts are priced at levels exceeding just and reasonable prices by some $14 billion. In addition, the unjust and unreasonable non-price terms and conditions in the challenged contracts include provisions providing for: (1) priority over bond repayment; (2) attempted evasion of FERC review; (3) asymmetrical credit treatment; (4) "most-favored nation" treatment; and (5) mitigation and termination.

For instance, many of the contracts attempt to preclude FERC review of the contracts altogether. One version of this type of provision would require CDWR to pay any amounts determined by FERC to be unlawful, apparently in addition to the FERC-determined lawful price. Virtually all of the challenged contracts provide for asymmetrical credit treatment, requiring the State of California to maintain a certain rating or risk default and termination payments, but imposing no risk or penalties on suppliers who fail to maintain an investment grade credit rating. Other examples of terms and conditions which reflect the market power of the sellers in the negotiations which resulted in the challenged contracts abound and are described in greater detail below.

Because the challenged contracts are, in whole and in part, unjust, unreasonable, and violative of § 206 of the FPA, the challenged contracts must be abrogated in their entirety. In the alternative, at a minimum the unjust and unreasonable price terms in the challenged contracts must be reformed to just and reasonable levels, and the contracts must be reduced in length. In addition, the unjust and unreasonable non-price terms and conditions in the challenged contracts must be stricken from any contracts which are not abrogated.

COMMUNICATIONS AND COMPLAINANT DESCRIPTION

The names and addresses of persons to whom communications in this docket should be addressed are:

Sean H. Gallagher Fay Fua

Public Utilities Commission Public Utilities Commission

of the State of California of the State of California

505 Van Ness Ave., Room 5035 505 Van Ness Ave.

San Francisco, CA 94102 San Francisco, CA 94102

(415) 703-2059 (415) 703-2481

Arocles Aguilar Jonathan Bromson

Public Utilities Commission Public Utilities Commission

of the State of California of the State of California

505 Van Ness Ave., Room 5128 505 Van Ness Ave., Room 5128

San Francisco, CA 94102 San Francisco, CA 94102

(415) 703-2969 (415) 703-2362

The CPUC is a constitutionally-established agency charged with the responsibility for regulating natural gas and electric corporations within the State of California. In addition, the CPUC has a statutory mandate to represent the interests of natural gas and electric consumers throughout California in proceedings before the FERC.

COMPLAINT

I. BACKGROUND

A. THE CALIFORNIA ELECTRIC CRISIS

California's restructured electric markets opened on March 31, 1998. For the first two years of their operation, the PX and ISO markets worked fairly well, although market power concerns necessitated the imposition of price caps by FERC in the ISO markets.³ Nonetheless, energy prices in both the ISO and PX markets for 1998 and 1999 averaged approximately $33/MWh. Price caps set during most of this period at $250 were rarely reached.

In May 2000, however, problems began to appear. Average PX prices in May 2000 were 100% higher than prices in May 1999. In June 2000, prices reached previously unthinkable levels-and stayed there for a year. The total estimated energy and Ancillary Services cost for the month of June was $3.6 billion, or $166/MWh, compared to total energy and Ancillary Services costs for the entire 1999 calendar year of approximately $7.4 billion. July spot market prices averaged $118/MWh, with total costs estimated at $2.55 billion. August spot market prices averaged $180/MWh, and total costs for the month exceeded $4 billion. September 2000 prices averaged $126/MWh, compared to September 1999 prices averaging $38/MWh. October 2000 prices averaged $104/MWh.⁴ The CPUC estimated that generators charged some $4 billion in excess of competitive baseline prices in the June-September period.⁵ Subsequent calculations by the ISO estimated potential refunds owed due to the charging of unjust and unreasonable prices during the period prior to October 2 at $2.9 billion. The higher summer prices were accompanied by declining reliability. The ISO was forced to declare 55 system emergencies in calendar year 2000, compared to only 11 in 1998 and 1999 combined.

The crisis did not subside with the arrival of cooler weather in the fall. Although California peak electricity usage declines by roughly 25%-33% in the cooler months, California-based generation owners physically withheld their supply from the "markets" by declaring the units out of service for maintenance or other reasons, or simply by refusing to bid into the PX's Day-Ahead or Hour-Ahead markets. Outages persisted at 3-4 times historical rates throughout the late fall and into the spring. Prices continued to rise rather than fall.

November prices averaged $161/MWh. December 2000 prices were the highest yet seen, averaging $317/MWh. Wholesale power costs for the month of December for energy and Ancillary Services totaled $6.15 billion, despite the fact that December is one of the lowest demand months in California. Costs for calendar year 2000 totaled $27 billion, compared to $7 billion in 1999. January 2001 total energy and Ancillary Services costs amounted to $5.34 billion with prices averaging $278/MWh. February prices increased to $363/MWh.

Prices remained astronomical into the spring, driven by continued high levels of generation outages and the exercise of market power. Real time prices in March averaged $313, despite "visible conservation efforts" by consumers. Demand in the ISO control area in March and April was down over 5% from the prior year, when prices had been on the order of $40/MWh. Real-time prices in April nonetheless rose to $370/MWh. Real-time prices in May 2001 averaged $250/MWh.

If there was any doubt about the causes of the exorbitant prices in the spring of 2001, they were eliminated by the acceptance by the ISO of a bid from Duke Energy of $3,880/MWh for real time energy. Although Duke sought to explain its bid by stating that it was composed largely of a "credit premium," the simple fact that Duke was able to make a sale at this price demonstrates the ability to abuse market power. See San Diego Gas & Electric Co. et al., 95 FERC ¶ 61,418 at 62,565 ("We will not tolerate abuse of market power or anticompetitive bidding or behavior. Emblematic of these practices is the now well-publicized bid of $3,880/MWh by Duke Energy. This bid resulted in total revenues for Duke Energy of $11 million").

B. THE ROLE OF CDWR

The electric crisis in turned spawned a financial crisis for California's investor-owned utilities, in particular Pacific Gas & Electric Co. ("PG&E") and Southern California Edison Co. ("Edison"). On December 14, 2001, the Secretary of the Department of Energy, acting under section 202(c) of the Federal Power Act,⁶ ordered that certain suppliers provide electricity to California utility companies when the ISO certified that there was inadequate electrical supply. Subsequent orders extended this requirement to February 7, 2001. On January 16, 2001, Moody's and S&P lowered the credit and debt ratings of Edison to junk or "near junk" status. On January 16 and 17, 2001, these rating services downgraded PG&E's credit and debt ratings to junk status.⁷

On January 17, 2001, California's Governor Gray Davis issued an emergency proclamation giving CDWR authority to enter into arrangements to purchase power in order to mitigate the effects of electrical shortages in the state. CDWR began purchasing under this authority the next day. See Exhibit 36. On January 19, 2001, the Governor signed a bill appropriating $400 million from the General Fund for CDWR's purchases for sale to Edison and PG&E.⁸ On February 1, 2001, Governor Davis signed a bill, AB 1X, providing for expanded authority for CDWR to purchase energy on behalf of the retail customers of the state's IOUs.⁹ On February 14, 2001, FERC issued an order later interpreted to prohibit the ISO from purchasing energy in real time on behalf of PG&E and Edison unless such purchases were backed by a creditworthy party such as CDWR.¹⁰

Pursuant to its new statutory authority, and in light of the credit problems facing PG&E and Edison, CDWR embarked on a power procurement program unprecedented in the annals of either the electric industry or state-sponsored procurement programs. Although CDWR had some experience in the power markets as a result of its operation of the State Water Project, that experience paled in the face of the challenge presented to CDWR in January 2001. CDWR commenced procuring the "net short" load of the California IOUs, that is, the gap between the IOUs' retained generation (including production under QF contracts) and the total energy demanded by their customers. Thus CDWR was required to immediately commence purchasing approximately 6,000,000 MWh/month, or some 8,000 MWh/hour, every hour of every day, in a market acknowledged by FERC to be wholly dysfunctional. See Exhibit 37 at 4. CDWR attempted to meet these needs by assembling a portfolio of short and long-term energy contracts and short-term transactions.

C. MARKET POWER

The conditions under which CDWR found itself in seeking to obtain the energy supplies necessary to keep the lights on in California were far from enviable. CDWR commenced implementation of the Governor's emergency order on January 17, 2001. On that day and the following day, California experienced its first two days of rotating outages resulting from shortage of supply in the state's history. Moreover, by the time that CDWR's role commenced, FERC had found that the California markets were in disarray and were infused with the abuse of market power. FERC has repeatedly reiterated that the California energy markets were not workably competitive into the summer of 2001, and did not produce just and reasonable prices,¹¹ and has conducted proceedings to determine the refunds due with respect to the California spot markets.

FERC's November 1 Order found that unjust and unreasonable rates had been charged in the California markets, and that "there is clear evidence that the California market structure and rules provide the opportunity for sellers to exercise market power when supply is tight and can result in unjust and unreasonable rates under the FPA."¹² FERC further found that the tight supply conditions persisting in California conferred market power even on small suppliers, and acknowledged that market power in the spot markets drove up forward market prices:

This leaves California vulnerable to price spikes caused by even small suppliers who, under tight supply conditions, can affect the PX and ISO market clearing prices. These conditions can allow the exercise of market power. These higher spot market prices in turn affect the prices in forward markets.¹³

FERC declined to impose a remedy, however. Instead, FERC proposed a package of "structural" remedies for the California markets, and proposed to implement a $150 "soft" price cap effective January 1.¹⁴ Suppliers who sold at prices above $150 would receive their bid price rather than setting a market clearing price, and would be required to report certain information to FERC. The centerpiece of FERC's proposal was to require buyers to increase their forward market purchases and decrease their spot market purchases. To enforce this, buyers who procured more than 5% of their requirements in the real time market would be assessed an "underscheduling penalty" of $100/MWh. ¹⁵

The CPUC demonstrated that the "soft" price cap was no price cap at all and would permit the continued exercise of market power. The CPUC further demonstrated that the combination of unrestrained spot market prices as proposed by FERC plus the underscheduling penalty would increase market power in the forward markets, thus rendering the FERC proposal's reliance on forward purchases ineffective to ensure just and reasonable rates.¹⁶ The independent Market Surveillance Committee ("MSC") concluded that the remedies proposed "are likely to be ineffective to constrain market power and, in fact, could exacerbate California's supply shortfalls, and, thereby, increase wholesale energy prices." The MSC also predicted higher prices resulting from the implementation of the underscheduling penalty, without any reduction in underscheduling.

FERC's December 15 Order "reaffirm[ed] its findings that unjust and unreasonable rates were charged and could continue to be charged unless remedies are implemented."¹⁷ FERC found that it had "no assurance that rates will not be excessive relative to the benchmarks of producer costs or competitive market prices."¹⁸ FERC recognized that if "rates do not behave as expected in a competitive market, the Commission must step in to correct the situation."¹⁹

Yet FERC's December 15 Order implemented its November 1 proposals largely unchanged. It implemented the $150 "soft" price cap-which is to say, no price controls at all-on the spot markets.²⁰ It eliminated the prior $250 bid cap. It provided no mechanism to ensure just and reasonable rates in the forward contracts which it hoped would relieve pressure on the spot markets. It implemented the underscheduling penalty which would increase pressure on prices in the forward markets.²¹

The MSC later filed comments in response to the March FERC staff proposal that provided further evidence that the unrestrained spot market prices permitted by FERC's December 15 Order had caused forward market prices to similarly explode. ²² This was true because "no profit maximizing firm will voluntarily give away market power that it possesses without an up-front payment that exceeds the increased profits available from exercising this market power."²³

FERC forced California into the forward markets, but failed to take any measures to ensure the reasonableness of forward contracts. Such efforts were necessary because forward markets are influenced by spot markets. When spot market prices are inflated by the exercise of market power, forward prices track those inflated prices. As the CPUC argued prior to the issuance of the December 15 Order:

Under current market conditions, any plan which seeks to mitigate spot market pricing by relying, as FERC's proposal does, on forward contracting, must also address the reasonableness of forward markets.²⁴

Indeed, FERC itself recognized in the November 1 Order that "higher spot prices in turn affect the prices in forward markets."²⁵ Yet FERC stated in its December 15 Order, despite overwhelming evidence to the contrary, that it "do[es] not agree" that "prices in the forward markets will be affected by last summer's spiraling spot prices."²⁶ FERC later reversed course again in the June 19 Order, conceding there that forward markets and spot markets are linked.²⁷

FERC's purported remedial program announced in the December 15 Order included several elements that increased the pressure in the forward markets, thus increasing opportunities for sellers to exert market power in negotiating forward contracts. First, FERC forced California to procure enormous volumes of energy in the forward markets all at once. Second, FERC eliminated the existing price cap on the spot markets. Third, FERC imposed a $100/MW penalty on load procured in the only spot market that remained.²⁸ The combined effect of these measures enhanced sellers' market power in the forward markets. As the CPUC stated:

This is a recipe for continued unjust and unreasonable prices and effectively punishes the victims of high wholesale prices.²⁹

In its June 19 Order, FERC again reaffirmed that unjust and unreasonable prices continued to be charged for the six months following the December 15 Order, and recognized that its prior orders had been insufficient to remedy the market power producing unjust and unreasonable prices.³⁰

FERC has thus found that market power extant in the spot markets was producing unjust and unreasonable prices, has found that forward markets are impacted by spot markets, and has imposed purported remedial measures which increased demand in the forward markets, thus increasing market power in those markets. FERC then forced California to procure energy in the forward markets or face penalties of $100/MW.³¹ In fact, forward market prices increased steadily as the crisis deepened. CDWR was forced to make purchases at these exorbitant prices, or face the hyperinflated spot market, plus the $100/MWh penalty.

CDWR, too, recognized that FERC's failure to impose effective price mitigation had resulted in the exercise of market power in the forward markets. For instance, in an affidavit executed on April 23, 2001, and submitted in Docket No. EL00-95-012, CDWR's Deputy Director Raymond Hart stated that "at present, power sellers have significant incentives to withhold power from forward contracting in day ahead or longer markets" due to sellers' knowledge that in the real time market "in most cases, all bids will be accepted," whatever the price. See Hart Declaration, attached hereto as Exhibit 38. Mr. Hart concluded that FERC needed to take additional measures to move sellers to offer supplies at reasonable prices in the forward markets. Id.

FERC's recent order in AEP Power Marketing, Inc., 97 FERC ¶ 61,219 (2001) recognized that effective spot market price mitigation can have a positive effect on prices in forward markets. FERC stated that:

Applying mitigation to spot market transactions will also result in mitigation of generation market power in longer term (forward) markets by creating a kind of competitive "standard offer" service for customers. If sellers attempt to charge excessive, non-competitive prices in forward markets, customers can avoid them by waiting to purchase in the real-time market. This puts market pressure on sellers to offer competitive prices in the forward markets. And when sellers offer competitive forward prices, many buyers will prefer to purchase in the forward markets in order to gain price certainty.

In California, however, FERC eliminated the possibility of avoiding "excessive non-competitive prices in forward markets by waiting to purchase in the real-time market" by failing to impose effective price mitigation on the California spot markets, and by imposing the $100/MWh "underscheduling penalty."

Experience in California since FERC finally imposed effective price mitigation measures in its June 19 Order further demonstrate that the market power in the spot markets infected forward markets. Since last summer, forward prices at California and western trading hubs have tended to converge with forward prices nationally, including PJM, and in some instances contracts for summer 2002 now stand below PJM prices.³²

FERC's conclusion that spot market prices have been unjust and unreasonable, along with its concession that spot prices affect forward prices, necessarily lead to the conclusion that forward prices agreed to this spring were affected by market power and thus were not just and reasonable.