Published January 18 2002, 2:ooam EST

In the Eye of a Hurricane

SAN FRANCISCO-A year ago yesterday, Gov. Gray Davis said California would start buying power to keep electricity flowing to 26 million of the state’s residents. And it would be done through the state Department of Water Resources.

Most people then asked, the department of … what?

Ray Hart, deputy director of the DWR, laughed at the thought. After spending 24 years working for an agency that most people had never heard of, he knew exactly why Davis picked it for a job that would also included issuing $12.5 billion in power purchase revenue bonds, the largest–and by many accounts the most complex–municipal bond deal in U.S. history.

Though most of the preparations for the bond financing itself have been run by state Treasurer Phil Angelides, the department has had to nshow investors and the rating agencies that we have a business plan that works,” Hart said.

Since its rocky beginning in the power purchase business, all eyes have been on the DWR.

“It’s like living in a fishbowl,” Hart added. Before the state stepped in to buy electricity for the investor-owned utilities that no longer had the creditworthiness to buy power, the DWR was already California’s largest buyer and seller of electricity. The agency’s main job of building and operating the State Water Project –a system of dams, reservoirs, aqueducts, and pumping and power plants –included engaging in long-term contracts, short-term contracts, and energy purchases and sales on the last-minute spot market.

The DWR generated about 2,000 megawatts of electricity and purchased another 2,500 megawatts, according to Hart. But the energy shortages early in 2001 affected the project, which was asked to turn off pumps to save energy.

The state needed someone to buy power for the Pacific Gas & Electric Co., Southern California Edison, and San Diego Gas & Electric customers, spread out over about 130,000 square miles.

To put that in perspective, Los Angeles Department of Water & Power, the nation’s largest municipal utility, serves about 3.8 million customers in a 464-square-mile area.

The night before Davis’ executive order, Hart sat down with his staff to consider the task.

After some deliberation, “We thought, ‘This is doable,’ “he said.

The DWR brought in some experienced retirees to trade energy and new people to assist them.

“We put together an emergency action plan that day, and it was in operation that evening,” Hart said. “Rarely has government set up something this fast and this well.”

The energy group took over part of a government building in a suburban Sacramento shopping center used in other state emergencies such as floods. With about nine energy traders in a media access room that was quickly converted into a secure trading room, the DWR started purchasing energy on the spot market.

To differentiate itself from DWR energy purchasing operations for the State Water Project, staff picked the acronym CERS –California Energy Resources Scheduling, but it’s been slow to catch on outside of trading floors.

Pushing back against the well-documented sky-high prices of generators, CERS staff worked long hours trying to literally keep the lights on, Hart said.

“A number of us put in a year’s worth of work by the time June came up,” he said.

During the rolling blackouts last year, CERS had a staff of about 500 people; today, about 120 people run the energy operations. The peak times were last spring when supply was tight, in part due to transmission problems and in part because so many generators were offline for maintenance.

The DWR’s main role in the planned $12.5 billion bond financing plan is demonstrating that the energy procurement operation is sound. The payments to back that mammoth debt issue would be secured by a charge attached to customers’ utility payments for power purchased by CERS.

Last February, Angelides appointed the 32 underwriting firms, two financial advisers, and three legal counsel firms working on the deal from his financing pools. J.P. Morgan Securities Inc. is senior manager. Montague DeRose & Associates and Public Resources Advisory Group are co-financial advisers. Bond counsel is Hawkins Delafield & Wood, and Sidley Austin Brown & Wood is special counsel.

“Other than that, all the things have our name on it,” Hart said.

Although it was first anticipated to be sold last spring, the bond issue has been delayed by a conflict over rates between Davis and regulators at the state Public Utility Commission. Pressure has been building on officials to end the deadlock since the California will face a $8 billion to $14 billion budget shortfall even if the bonds sell before the end of the current fiscal year in June.

In order to meet that deadline, some agreement between representatives of the governor’s office –including his legal staff and outside professionals –and utility regulators is needed to at least start the wheels turning again, especially if any action is required by the PUC that requires public input.

The bond deal has been delayed since a power struggle heated up last summer between Davis, PUC president Loretta Lynch, and Senate President John Burton.

Under the law enabling the bond sale, power generators holding long-term contracts with the state get paid first from utility rates, and the DWR has sole authority to determine if its rates are fair. Under a proposal by Burton and supported by Lynch and a majority of commissioners, the department’s debt would be first in line for utility rates, and the PUC would have more oversight of the general operations of the DWR, including the long-term contracts. Lynch and Burton say the contracts are too expensive and agreeing to pay them first would prevent the state from renegotiating those contract terms, which Davis has been trying to do for months.

The deputy state attorney-general determined that Burton’s plan would impair the contracts, but the PUC’s legal counsel said it would be legal. Davis says he would veto Burton’s bill –which has never been sent to his desk–because it would violate the generators’ contracts and bring on extensive litigation.

Both Burton and Davis are Democrats, and Lynch was appointed by Davis.

Problems getting the bond deal done have more to do with state officials handling of the situation than the DWR’s operation of the power purchase program and forecasting future power needs and costs, some observers say.

“Davis and DWR’s projections of cost have been conservative throughout,” said Joseph Fichera, chief executive officer at Saber Partners who advised Davis on energy matters last year. “If people are critical of anything, it’s that the DWR was being overly conservative on power cost projections. All of our surprises have been good surprises.”

Separate from the high-profile energy bonds, the DWR has issued $5.8 billion in debt in 37 bond issues since 1968, according to Thomson Financial Securities Data. It most recently issued $261 million in water system refunding bonds in May. Those bonds, insured by Financial Security Assurance Inc., were priced to yield 5.40% in 2029.

The DWR was created by the California Legislature in 1956 to plan and guide the development of the state’s water resources. Back then the major challenge was to bring water to the arid regions of the fast-growing state. The department continued research started in previous decades to forecast future water supply needs, inventory existing water resources, and explore the potential to serve the state’s growing population. All this eventually led to a proposed Feather River Project in Northern California.

In 1960, California voters approved a $1.75 billion bond issue to begin building the State Water Project. The project was designed and constructed by the DWR. By 1973, the initial facilities were completed and water delivery to Southern California began. Today, the State Water Project is one of the largest water development and distribution systems in the nation. It includes 32 storage facilities, reservoirs, and lakes; 17 pumping plants; three pumping-generating plants; five hydroelectric power plants; and about 660 miles of open canals and pipelines.

CERS’ power purchase operation in several cases relied on DWR employees who helped run the State Water Project, including Pete Garris, the acting deputy director of CERS. He worked in various capacities at the DWR between 1976 and 1997, when he left to work with the Independent System Operator, the agency designated under the state’s new deregulation plan to coordinate power purchases throughout the state.

He returned to the DWR, expecting to manage the water project, last January.

“I know you’re laughing at me, not with me.” he said. “I thought I was coming back to manage the State Water Project through significant changing times. I didn’t think that was going to be an easy job in itself.”

Garris has overseen all procurement and energy-delivery activities since those early days last year. Keeping on top of everything was “like herding grasshoppers.” he said.

“We were working in a fast-paced, unstable environment … trying to push back at prices.” he said. “We battled to get enough of a portfolio to the point where we could say no to $600/megawatt-hours.” A megawatt is enough energy to power roughly 750,000 homes.

Over the summer, CERS purchased up to 17,000 megawatts, which is almost seven times what DWR was accustomed to purchasing. During the peak of the energy crisis last spring, the state in some cases paid more than $1,000/megawatt-hour. In December, the DWR paid an average of $69/megawatt-hour under long-term contracts and about $36/megawatt-hour on the spot market.

Through CERS, the DWR continues to buy about half of the power that customers of the investor-owned utilities need. The other half is generated by the utilities’ own plants or through smaller contracts allowed under the state’s deregulation plan. The department buys about 25% of customers’ needs through long-term contracts negotiated earlier this year and now at the center of the dispute holding up the revenue bond deal. The remaining 25% the agency buys using other vehicles, such as short-term contracts and spot-market purchases, Garris said.

The DWR has been criticized on all fronts last year. State and federal regulators wanted it to be more accountable, as did consumer advocacy groups unhappy with the prices negotiated by the state in some of its long-term power contracts. And most recently so did the independent state auditor.

But Garris said the department did the best job it could in a crisis situation.

“It was a do-or-die situation,” he said. “Not attempting was not an option. People in CERS work hard and are proud of what they do. No one ever says, ‘That’s not my job.’ They tried to see what they can do to make this work.”

“In some respects, the only thing that could happen, did happen,” Garris said.

Hart, DWR’s deputy director, thinks the department has played the hand it was dealt well.

“What would critics have called success last January? I’d say cheap spot-market prices, no blackouts over the summer, and a market that is functioning.

“At the end of the day, people are going to write master’s theses on this,” he continued. “I’m absolutely certain people will be amazed at what we pulled off. In some ways, we pulled off the impossible. Nobody dreamed there would be no blackouts over the summer.”

“I think eventually people will write what a good job has been done under the most