July 21, 1997
Jonathan Jacobs
Manager of Market Evaluation
Pacific Gas and Electric
77 Beale Street
San Francisco, CA 94177


Dear John:

I am sending this to you via the fax because it may contain information that
would require you to destroy it or to black out selected sections after you have
read it. (I can edit it as you may request and then send an email version.) As
is noted in the report I sent you, we have "verified" the inevitable dynamics of
deregulation by using our models to correctly predict the evolution of events in
the UK (where I spent the year in Cambridge developing the European energy
analysis capabilities for the European Commission), South America, Australia,
and the US (were we have not only compared the results to published events, we
have modified the model to take out the computer's decision algorithms so that
humans - utility executives and commissioners - can make the decisions and
change the rules - only to show the resulting same set of events). This note
indicates that we know how to take advantage of those events over the full
spectrum of subtle to extreme gaming tactics. We have a methodology that
directly considers the uncertainty in competitor and regulatory
actions/responses. It determines any underlying patterns and can automatically
produce an certain-to-win but continuously changing portfolio of tactics based
on the actual market conditions it sees and analyses.

To put this proposal in perspective, the transition from a regulated to a
deregulated market presents a tumultuous time for all the companies that
prospered under the "old" rules. Regulators attempt to provide an orderly
transition from the past to the future that protects existing rights and
commitments while simultaneously clearing the way for new free-market
activities. These two demands are in economic opposition and new rules
necessarily contain ambiguities and market distortions. Physical constraints to
the system insure that any definition or rule will become ambiguous under some
operating condition @unt 1996, p. 61) and thereby allow competitors to respond
in way that dramatically changes the expected character of the future market
place2 (Newbery 1996, p. 64). In


' Sally Hunt and Graham Shuttleworth, Competition and Choice in Electricity,
John Wiley and Sons, 1996, p.61.

2 David M. Newbery, "Regulation, Public Ownership and Privatisation of the
English Electricity Industry" in International Comparison of Electricity
Regulation, Richard Gilbert, and Edward Kahn, ed., Cambridge University Press,
1996.







California, significant efforts were made to ensure the market acted as the
regulators deemed appropriate. This not only causes market distortions that can
be advantageous to some and detrimental to others, it also means that the rules
probably will have effects contrary to the desired effect. As Richard Tabors of
MIT notes:".. .the market rules cannot be gotten right on the first try if the
goal is a pre-designed supervised market. The regulatory interference has
prevented the types of market mechanism ... normally seen in a commodity type
market"3 (Tabors 1996, p. 47). From electricity deregulation experience in other
parts of the world, "the message .. is clear. It was incorrectly assumed that
the new commercial entities would continue to operate by the intent of the
rules, even if not formally stated, when the new structure began. But commercial
markets are commercial markets, profits are profits and any commercial advantage
will be taken" (Tabors 1996, p. 49). The dynamics of deregulation as they relate
to how competitors may act toward each other are documented further by Wolak4
and Backus.5

My work has focused on the games people play during the transition from the
regulated to the deregulated environment. During this period, the optimization
tools typically used by utilities cannot provide adequate answers. Not only do
the uncertainty in rules and competitor responses invalidate the assumptions of
the analysis, I can show that an optimal "player" is the one that is easiest to
defeat in a readily-producible "gaming" situation. The comprehensive gaming we
address necessarily includes strategic, tactical, operational, real time
components. Wars are not won with a singe one-shot battle using a single tactic
and a single weapon.

We simulate (with the needed validation and confidence bounds): dynamically
changing own and competitor financial strength, tactical sequencing, repetitive
and non-repetitive tactics, portfolios of tactics, misinformation efforts,
gambits, bidding, diversions, third-party tacit cooperation, counter-responses,
counter-measures, over/under booking, availability strategies, protocol
ambiguity/rule conflicts, congestion tactics, must-run/take tactics, market
separation effects (e.g., day versus hour versus ancillary), market isolation
(region and segment), combined customer/suppler distortions, signaling,
financial instruments/hedging, financial restructuring/asset placement,
divestiture re-direction, affiliated marketers, affiliated generators,
exacerbating weather effects, new rule "guidance," legal restraining orders/law
suits or any other categories that become recognized. If required, we can keep
the gaming below regulatory thresholds or hide it in the noise of the market.

Some "desirable" tactics could be blatant to cause a rule to be changed to hurt
a competitor more than PG&E, or to help PG&E more than it helps the competitor.
We also show the advantage of both the regulated and unregulated segments of the
company

3 "Lessons from the UK and Norway," Richard D. Tabors, IEEE Spectrum, New York,
pp. 45-49. 4Frank A Wolak and R.H. Patrick, "The Impacts of Market Rules and
Market Structure on the Price Determination in the England and Wales Electricity
Market, Stanford University Department of Economics Working Paper," April 1997.
Available on www-path.eecs.berkeley.edu/UCENERGY. 5 George A. Backus, The
Dynamics of US. Electric Utility Deregulation, U.S. Department of Energy, Office
of Utility Technology, Washington D.C., August 1996.





having the tool so that efforts are coordinated - but without direct
communication. "Perversities" in the market dynamics exist such that the
unregulated marketing arm can, under an orchestrated game plan, be most useful
helping adversaries take away UDC market share. Similarly, generation may want
to over-sell to old grandfather contracts even if the power "goes" to an out-of
state supplier. We can determine and coordinate the comprehensive set of moves,
from real-time to long-term end-game, that maximize income or any other measure
of company success. The highly convoluted rules of the California system, by
nature, produce abundant but highly convoluted gaming moves.

We call what we are proposing a "Real-time Competitive Response System." The
system, however, does and must include the financials simulation of all
California market players as well as the full simulation of all the North
American gas and electric energy suppliers. This allows both short-term and the
long-term analysis of merger, acquisition, take-over, bankruptcy and market
entry activities. In additional to the financial simulation capabilities, the
model contains the plant, electric transmission, and gas transmission physical
detail. The detailed aspects of the PX and ISO will be included as they change
AND are expected OR preferred to change. It also includes the all-fuel, end-use
simulation of demands. Very realistic (and accurate) retail-wheeling and
marketing dynamics/impacts are intrinsic to the model.

Gaming may be a dirty word to FERC and the California commission, but the sooner
the market clears out the distortions, the better it works for everyone. The
"gaming" defeats the flaws in the system and ultimately removes the players or
features that lead to market distortions. There may be ethical issues related to
"the end justifying the means" but there is a large region of opportunities
between what is ethically viable (profitable) and ethically dangerous (illegal).
It is prudent to understand the full spectrum of possibilities, and through the
understanding of market dynamics that it provides, to select that appropriate
subset of strategies which best serve the long-term interests of PG&E.

In 1986 (not 1996), Policy Assessment Corporation (PAC)and Systematic Solutions
Incorporated (SSI) developed the Competitive Industry Gaming Model (CIGMOD) to
analyze the dynamics of deregulation for the State of Illinois. The model was
based on the ENERGY 2020 model used in 40 states and provinces in North America
by the energy industry and regulators. Versions of ENERGY 2020 are the US
National Energy Policy Model (FOSSIL2/IDEAS) and the Canadian government's
National Energy Planning Model (ETPM). ENERGY 2020 was selected to analyze the
energy and environmental evolution of Western Europe. The model is extensively
used in Eastern and Central Europe to address the severe dynamics of both
economic and energy deregulation there. We are currently initiating the invited
efforts to assist Brazil in its deregulation process. The model is also being
used by the US and Canadian governments to provide analytical support for the
international greenhouse gas negotiations.

When the conventional models used in the UK to analyze deregulation failed to
reproduce the unfolding events, it was the re-parameterized US CIGMOD model that
reproduced the gaming dynamics, the re-regulation activities and the merger
processes within the UK.





Most observers would argue that the UK experience has little to do with the US.
The CIGMOD "experience" turns this view on its head and goes so far as to say a
"market is a market" in all languages and countries. The work of Sally Hunt as
referenced above, later corroborated that conclusion.

Our combined efforts with the Perot System's (PSC) staff working on the ISO
(primarily those familiar to PG&E: Paul Gribik, Ali Vojdani and Dariush
Shirmohammadi) have shown a large number of additional gaming opportunities that
their unique experience with the PX, ISO and the PX/ISO interface allow. These
opportunities are not only in the design of the PX and ISO itself, but also in
the data transfer, settlement, and physical response issues.

Thus, my associated organizations (PAC and SSI) along with PSC provide a
capability that is not even remotely available elsewhere. What we would propose
to PG&E would be specific tasks that adds the California ISO/PX simulation to
and modifies the structure of the deregulation dynamics model developed by
Systematic Solutions, Inc., to faithfully reflect the specific rules and
protocols associated with the California market as they change from now until
the end of the transition.

The Project

The proposed effort could tentatively be divided into three or more phases to
verify that each current phase indicates the success of the next phase. This
hypothetical proposal is provided for exemplary purposes only. An entirely
different effort, more or less ambitious, could be readily accommodate. Careful
consideration of the system's design strongly indicates minimal technical risk
under all hypothesized conditions. We have all the tested parts to the system
except the real-time PX/ISO data acquisition software. The parts do need to be
modified to reflect the specific and continuously changing, California
regulatory conditions, PG&E priorities, and the calculation times needed to
provide real-time response. The changing ground of the California deregulation
process, however, also indicates that certain tasks may not be needed, that some
tasks may need to be redefined and that other tasks may need to be added in
Phases II and I. For example, recent (June) modifications to the PX protocols
would require that our PX simulation model be modified accordingly for the
interim PX operations. This example proposal provides for the testing of the
complete system in Phase I, followed by two other phases contingent on the
expectations of the PX/ISO release of specifications, an exhaustive model
testing regimen, and PG&E staff training needs. This phasing also allows PG&E to
gain confidence in the system and approach prior to using it in the actual
market place to help facilitate up to $12 million in transactions per day.

Phase I

The first phase, called the "functional model phase," reviews all the
information of the California ISO and PX as well as any other relevant
commission rulings to determine any areas where PG&E or competitors could find
opportunities. These are translated to





strategies and incorporated into the existing strategy options within the
current deregulation model framework. The simulation of the way that the actual
PX/ISO operates is also incorporated into the model. Perot Systems Consulting
(PSC) has help designed these tools for the actual PX/lSO and are thus the most
capable to make sure this project provides valid simulations of actual PX/ISO
operations. Further, PSC's intimate knowledge of PX/ISO protocols has a
particular advantage for this project.

The deregulation framework contains detailed demand, energy, financial and
physical representations of all the known potential players in the California
market. (Unanticipated entities can be added as needed.) The short-term
forecasts for California and local competitors demands are determined
endogenously so that the generation available to serve the California market can
be correctly ascertained. Phase I provides the integration and testing of all
critical components as well as determines what protocols and rules have
relevancy to future market conditions. PG&E staff will use this framework to
learn the modeling system plus gain confidence in its usage as an operational
tool. The human interface will also be modified as needed to maximize the
efficacy of using the model for bidding and other strategies. The real-time data
available from the PX/ISO will not have been determined during Phase but will be
the focus when it becomes available for Phase II. Nonetheless, the ability of
the model to simulate basic competitive strategies against human players will be
tested in Phase I to ensure that the model performs as expected.

Phase II

The second phase is the "operational model phase." In this phase the project
team determines the available and actual real-time data from the ISO/PX and adds
the analysis capabilities to take advantage of that data stream within the
model. Advanced statistical methods (primarily associated with the technical
analysis of commodity time series and cointegration) will be added to the model.
These sub-systems will determine the statistical qualities of the prices,
supplies and demands in order to understand the underlying direction of their
variance and averages. Depending on the intelligence data available PG&E
pursues, the software will be able to detect any pattern in a competitor's
actions that may be detrimental to PG&E operations or whether competitors are
somehow directly tracing any PG&E efforts.

In Phase I below, neural networks may be advantageous for the short-term
forecasting of price and demand. Neural nets, however, do require specific data
structures that would not yet be understood in the early days of the
deregulation.

Both Phase II and Phase III use a sophisticated confidence/validity package
called HYPERSENS. It can search essentially all the possible options to find
those real-time strategies that ensure PG&E is not disadvantaged by the
behaviors of competitors. HYPERSENS cannot only accommodate the uncertainty in
competitor behavior, generator availability, and hourly demands, it can
determine the set of options available that best meet PG&E goals.






Because the modeling system of Phase II will have the capabilities to analyze
hourly data, test data sets will be generated for PG&E staff to use as a means
of learning and gaining confidence in the system. Any uncovered limitations will
be mitigated as appropriate. Model testing with PG&E Staff is a significant part
of the project to insure that the model does well under anticipated and
unanticipated conditions. Synthetically produced data streams that approximate
what is actually expected during the first quarter of 1997 will be used in the
testing.

Phase III

The third phase is the "real-time implementation phase." Only after January 1,
1998 will real data be available for both analysis and real-time decision-making
purposes. The modeling system described here will need to be monitored to insure
that it produces the. information PG&E expects. The system will contain software
that notifies staff of any anomalies that may jeopardize the result's validity.
Further, fail-safe" positions will be included that limit any financial exposure
during the time interval before adequate data have become available to fully
validate the system's operation. The algorithms will be "tuned" as appropriate
and enhanced features are added as required. The model will also be benchmarked
against "reference" assumption to determine its success rate compared to
equilibrium conditions. The model methodology will, by default, certainly have
the ability to determine the best bidding strategy given market information. The
only area where added care and testing must be taken is in those strategies that
respond directly to the aggressive actions of a competitor.

Optional Follow-on Phases

The data flows during the transition may be overwhelming to PG&E operations. We
also have the ability to provide the data-visualization (GIS) that clearly
delineates for PG&E staff the options and recommended actions. This activity
could constitute a Phase IV

As an intrinsic part of the system, the CIGMOD deregulation dynamics model will
allow PG&E to test the impacts of others entering the California market
(generation or marketing) or the impacts of (gas and electric) mergers,
acquisitions, and takeovers among competitors or by PG&E. This could represent a
Phase V consulting effort. The consolidation (or dilution) of the market changes
the strategies that a company must use to insure profitability. This effort
would extend the short term (hour-to-hour to monthly) analyses to longer time
frames, thereby providing company-wide analyses of the impacts of such
longer-term strategies on day-to-day as well annual operations and
profitability. This Phase can also test competitors' financial strategies which
could impact PG&E's operations/profitability.

The ISO/PX system in California is premised on the assumption that DC analysis
is adequate to determine system requirements and behaviors. Efforts of the
project staff indicate that the AC considerations lead to significant additional
opportunities for competitors to disadvantage PG&E operations. Some of the
advanced technical efforts to





increase the transfer capabilities within WSCC may make this area the most
crucial to insuring the real-time availability of PG&E generating units. Adding
AC considerations to the proposed modeling system could represent a Phase VI.

The specifics of these potential Phases IV through VI are not pursued further
here.

Attached is an example of what the tasks of a "real" proposal might look like. I
want to make this as concrete for you as possible so that your evaluation is as
easy as possible. Please contact me with any questions or concerns you may have.


Sincerely,




Dr. George Backus
President