Optimism, ambition, and a few red flags.
By 1998, California's electricity restructuring was the most ambitious in American history. The state had:
The goals were clear: competition would drive down prices, innovation would flourish, and California's electricity market would become a model for the nation. The state's legislature was so confident in the outcome that it capped retail electricity rates at 10% below their 1996 levels — locking in the savings they expected from competition before the market had even proved itself.
The first year or so went reasonably well. Wholesale prices were moderate. A few competing electricity providers entered the market. The lights stayed on. Reformers declared victory.
But experienced market watchers were uneasy. Several design flaws in California's market structure were already visible to those who knew where to look.
First, the utilities were required to buy power through the spot market rather than through long-term contracts. This left them completely exposed to real-time price spikes.
Second, the demand side of the market was essentially inelastic. Retail prices were frozen, so customers had no incentive to reduce consumption when wholesale prices spiked. There was no price signal to ration demand.
Third, California had retired or sold off much of its "peaking" generation — the older, less efficient plants that only run during high-demand periods. The state's reserve margin was thin.
Fourth, CAISO's market rules had gaps that sophisticated traders — particularly Enron — were already probing for profit opportunities.
Through 1999, none of these flaws had been catastrophic. Prices were volatile at times, but manageable. The grid stayed balanced. Californians paid their bills and mostly didn't notice that a complex financial crisis was quietly incubating in the wholesale market.
Then came the summer of 2000. And everything fell apart.
Sacramento, September 23, 1996. Assembly Bill 1890 passed the California Senate 37 to 0 and the Assembly 66 to 9. Every yes vote was a statement of confidence: that market competition would lower electricity prices, that the Independent System Operator would neutrally dispatch the grid, and that the four-year rate freeze would protect consumers during the transition. The bill simultaneously created CAISO, required the three major utilities to divest their fossil generation, launched retail choice, and established the Competition Transition Charge to compensate utilities for stranded costs. Not a single legislator voted against the provisions that would prove most consequential — the requirement that utilities buy spot power in real time or the cap on retail rates that prevented prices from rising to clear the market. California's design flaws were not obvious to anyone in 1996. The near-unanimous vote is a precise measure of how confident a room full of intelligent people can be when they are wrong.
IMF Finance and Development — "Lessons from California's Power Crisis," September 2001