Enron Chairman and CEO Kenneth L. Lay got in a few shots at theelectric industry in general, and the California marketspecifically, during a conference earlier this week that was calledto address spiraling winter gas prices.

While he conceded some of the problems plaguing the power marketare due to the fact that it’s in the “early stages” ofderegulation, Lay believes federal and state regulators got therules wrong. “The rules aren’t right on interstatetransmission…and obviously they’re still not right at the statelevel as you get down to the retail [market],” he told a crowd ofgas executives and regulators at the “Governors’ Natural GasSummit: Responding to the Looming Energy Crisis” Wednesday inColumbus, OH.

This has lead too much higher margin spreads for tradingelectricity, he noted. While margin spreads in natural gas marketshave dropped 75%, resulting in average trading spreads of “about apenny” at the Henry Hub, the margins in the electricity market havereached as high as 17 cents, he estimated. “That is mainly becausethe system isn’t working.” The difference between a penny and justa 10-cent spread is about $2.5 billion a month, or about $30billion a year, of “lost efficiency” for the electricity industry,Lay said.

He criticized the California power market for its dependence onthe spot gas market. The state’s electric system was designed under”the conclusion or assumption [that] the spot market would alwaysbe the cheapest market…..It even was set up in a way to greatlydiscourage people like Sempra and others from trying to hedge [gas]prices,” said Lay, who noted that gas could have been hedged at$2.79/Mcf earlier this year.

At the core of California’s problems is its shortage ofgeneration capacity. During the past four years, power demand hasrisen about 12% (by 5,500 MW), while new generation capacity hasonly increased by about 672 MW, Lay noted.

But “the lack of capacity is not because people are notproposing to build plants.” He said about 11,000 MW of new capacityhas been proposed for California by various companies, includingEnron. But “it’s very slow in getting the permits to build,” hesaid, adding that it takes about 3 1/2 years to get a newgeneration facility constructed in California.

In contrast, Lay noted Enron was able to build 1,300 MW of newgeneration capacity in less than a year in other markets in 1998,and 1,600 MW in less than a year in 1999. “That shows what you cando if the rules are right.”

He made clear his distaste for any kind of price regulation orprice caps for electricity and natural gas, referring to suchaction as the “regulatory death spiral” for the markets. “When westart off with a tight supply, resulting in a price surge orincrease, we put on price caps, [then] we get less supply and moredemand, leading to regulated shortages, and then to brownouts andblackouts. It’s a very predictable cycle,” Lay said.

“It behooves all of us…..to make sure that doesn’t happen, tomake sure, in fact, that we do continue to let the market forwholesale natural gas work, and it is working well…..and [that]we get the improvements in the wholesale electricity market thatare needed, particularly on open-access transmission….., and[that] we not go back to try to re-regulate.”

While he believes there’s the potential for a backlash byresidential customers to the high gas prices this winter, Lay saidthat gas – once prices are adjusted for inflation – still will beone of the best buys around. On a real-price basis, “the pricethat we’re looking at for this winter for residential consumers ofabout $8.80 [at the burner-tip] is back to just about where theprice was in 1986.”

Overall, he noted that all classes of natural gas consumers havesaved about $174 billion since 1984 when deregulation got underway.But the cost savings to consumers would have been only $350 millionto $400 million if the price controls that were enacted under theNatural Gas Policy Act were still in force today, Lay said.

He noted that industry experts anticipate that wellhead gasprices will moderate over the next two years, providing furtherrelief to customers. They expect prices to “probably drop fromabout $5.30 this winter to $4.30 next winter, [and] to $3.75 thewinter after. That’s a 30% reduction in two years.”

Lay said experts also anticipate the tight supply situation”probably will bottom out this winter,” and then begin to rise inresponse to the increased drilling activity, “probably growing atleast a Bcf a day or more…..[over the] next several years.”

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