Abuse of Power: How Manipulative Trading Undermined Energy DeregulationPublished: June 05, 2002 in Knowledge@Wharton
At its height, Enron dominated – and arguably even helped create – the energy trading industry. Its lobbying helped push states from New Hampshire to California to eliminate utilities’ monopolies and open up their retail electric businesses to competition. After the dot-com bubble deflated, Enron’s chairman and CEO remained cover-boy favorites for business magazines desperate for upbeat stories: EnronOnline, the energy trading platform the company touted as the biggest e-commerce site in the world, was cited as proof that the Internet truly had been revolutionary. In the energy capital of Houston, Enron traders walked with the swagger of the biggest, baddest gunslingers in a town filled with testosterone-pumped cowboy traders. The company’s headquarters towered over the city’s skyline and the company was expanding so fast it was building another skyscraper across the street. “The evil empire,” others called it, with a mixture of respect, envy – and fear.
So perhaps it should come as no surprise that Enron’s demise is creating as many waves as its successes. Already, the disclosure of off-balance sheet partnerships that allowed the company to hide billions in debt has led to renewed calls for reforms of accountants, securities analysts and rubber-stamp boards of directors. It caused the ruin of Arthur Andersen and a contagion of skepticism that has dampened the stocks of companies from General Electric to Tyco and cut the debt ratings of numerous other energy trading firms.
Last month, federal regulators’ release of memos outlining how Enron’s traders profiteered from loopholes in California’s energy market, along with disclosures by six energy trading companies that they had inflated trading volumes with fictitious trades, set off a new round of recriminations and Congressional hearings. These disclosures have revived calls for tighter regulation of energy trading and will likely further slow retail energy deregulation. Democrats hope to make the disclosures an issue in the 2002 campaigns, citing the Bush administration’s close ties to Enron and energy interests, and its refusal to protect consumers in California and neighboring states from price gouging.
The revelations of market manipulation in California’s wholesale market and the evaporation of promised savings for retail consumers elsewhere in the U.S. have undermined arguments for replacing traditional cost-of-service utility regulation, say Wharton professors Paul Kleindorfer and Witold Henisz.
Although 24 states have opened their retail markets, consumers in those states have found few competitors to choose from and negligible savings. “Most observers these days, whatever their previous position [on deregulation] might have been, would argue that there isn’t very much gold in them thar woods,” says Kleindorfer. “For those states that have not embraced deregulation, we will certainly see a much more careful attitude on their part.”
Henisz, a professor of management who has studied political risk to companies that have built power plants in developing nations, says he fears the abuses could result in a government overreaction that could lead to energy shortages in the future.
“There’s going to be a big call for government re-regulation of the sector. It might go further than is needed to limit market power abuses and give rise to more substantial government involvement in the energy sector,” Henisz says. “Once you get this government intervention going it’ll be very difficult to stop at the right place. The cost of that is generators won’t build power plants. We have to balance the short-term desire for cheap power with the long-term need for sufficient capacity.”
The power industry differs in several fundamental ways from other deregulated industries such as trucking, airlines and telecommunications. For one, regulators have to rethink ways of assessing market power. The Herfindahl-Hirschman index, a commonly accepted measure of market concentration, doesn’t work in the electric industry, where generators with as little as a 5% market share can send prices soaring by withholding supplies. Because electricity is a vital necessity with inelastic demand, and because it cannot be stored in substantial quantities, its price is extraordinarily volatile. Thus, when policymakers make mistakes in deregulating the industry, the consequences can be breathtaking.
California’s power crisis of 2000-1 was set in motion by an ill-conceived plan that forced utilities to sell most of their power plants and prevented them from signing long-term contracts to insulate them from the spikes of the spot market. Other contributing factors included high natural gas prices, a drought that cut hydroelectric supplies from the Pacific Northwest, and state environmental regulations that made it difficult to site new power plants.
The result: wholesale energy prices shot up tenfold and supply shortages forced repeated rolling blackouts. The crisis forced the state’s biggest utility, Pacific Gas and Electric, into bankruptcy and pushed another, Southern California Edison, to the brink. In desperation, California Gov. Gray Davis signed long-term contracts for $48 billion worth of power – prices two to three times today’s market rate.
The crisis spread beyond California’s borders, forcing the closing of aluminum plants in the Pacific Northwest and saddling ratepayers in Utah and Washington states with rate hikes of up to 88%. Nevada’s biggest utility says it may go bankrupt because regulators have refused to let them recover all its costs from the crisis.
President Bush and Vice President Dick Cheney rebuffed California’s calls for relief, saying the state was to blame for failing to build enough power plants to meet its growing demand. Market forces, they insisted, should be allowed to return the market to equilibrium. Prices did not drop until mid-2001, the result of mild weather, falling natural gas prices, and a regional price cap reluctantly imposed by the Federal Energy Regulatory Commission.
Calif. Gov. Davis, a Democrat who is seeking re-election this year, has been attacked by his Republican challenger over his handling of the crisis. When the Enron memos were released this month, Davis seized on them as vindication of his claims that the state was the victim of market manipulation. Davis has demanded $9 billion in refunds from the energy companies.
The memos, drafted by Enron’s lawyers preparing a defense against anticipated refund demands, described how the company’s traders sought to exploit flaws in California’s system. When California imposed a price cap on power generated within its borders, for example, Enron traders circumvented it with a technique they called “Ricochet.” They bought power under the cap within the state, sold it to another company in a neighboring state, and purchased it back from the company for resale into California – now exempt from the cap.
Enron traders also received payments by artificially creating congestion in power lines. "Enron gets paid for moving energy to relieve congestion without actually moving any energy or relieving any congestion," the lawyers wrote. "Because the congestion charges have been as high as $750 per megawatt-hour, it can often be profitable to sell power at a loss simply to be able to collect the congestion payment." In functioning markets, power typically trades for $20 to $40 per megawatt-hour.
The lawyers told a Senate committee last week that they had concluded that the tactics were "potentially criminal." FERC Chairman Patrick Wood 3d told the committee that one tactic described in the Enron memos appeared to be "deliberate misrepresentation of information; that might be a longer way of saying fraud." FERC ordered other power suppliers to provide records and affidavits documenting whether they had engaged in any similar practices.
In addition to the Enron memos, the industry has been roiled by disclosures last month that at least six companies had engaged in paper transactions known as “round trip” trades – simultaneous purchases and sales of power or natural gas at identical prices and volumes – that inflated their trading volumes but generated no profits. Such “wash” trades, which can increase prices and create the appearance of liquidity in a market, are illegal on regulated commodity markets, but not prohibited in energy markets.
Reliant Resources canceled a $500 million bond offering after acknowledging fictitious trades had inflated its reported revenues by 10% in 1999-2001. Reliant also acknowledged its traders had taken part in two of the gambits outlined in the Enron memos. Dynegy, another company that engaged in round-trip trades, also disclosed it was under investigation by securities regulators for questionable accounting techniques that boosted its cash flow. Meanwhile, The New York Times reports that energy traders frequently trade “ahead” of their customers – buying energy for their own accounts before executing purchases for clients that they knew would drive up prices – another practice prohibited in regulated commodities and securities markets.
Under lobbying from Enron, Congress last year passed futures trading legislation that exempted Internet energy trading platforms like EnronOnline from oversight by the Commodity Futures Trading Commission. The revelations have put FERC chairman Wood, a deregulation advocate appointed by Bush to the agency last August, under the microscope. A former Texas utility regulator, Wood was among those on a list of recommended FERC nominees that Enron chairman Ken Lay submitted to Cheney.
Enron was one of Bush campaign’s largest contributors. Cheney and Bush already have drawn fire for their ties to the energy industry and Cheney’s refusal to release records of the industry-friendly energy task force he headed. Industry experts says it was uncertain how much of an impact these trading tactics had on California’s prices and whether the revelations would help the state’s bid for refunds. But they say it puts additional pressure on Wood’s agency to prove that consumers won’t be gouged in the future.
Indeed, California is not the only example of misbehavior by the industry. Regulators in Texas have identified Enron and Reliant as among six energy firms under investigation for improperly profiting from that state’s nascent competition. A $20 million fund that Texas created to compensate providers for clearing transmission line congestion, expected to last 18 months, was exhausted by traders in two weeks.
In the mid-Atlantic power grid, which FERC has cited as the model for the rest of the nation to follow, Pennsylvania regulators are investigating allegations that PPL Corp. forced competitors out of the retail market in the state by raising some wholesale prices to six times normal levels. Pennsylvania consumers, who initially saw savings as high as 20% by switching suppliers, now have few choices and virtually no savings. PPL has denied any wrongdoing.
While a growing number of critics now say deregulation was a bust, Dow Jones energy columnist Mark Golden disagrees. “Merchant energy companies are in an oversupplied, very competitive industry. They haven’t been able to budge prices much higher than about 4 cents a kilowatt-hour for months, nor will they be able to do so for the foreseeable future… That’s good news for consumers, who historically have paid more than 4 cents for power. Without deregulation and the free market it requires, that 4-cent power just wouldn’t be available.”
Thus far, consumers in most deregulated states have been protected from higher prices by retail price caps. But when those caps expire over the next several years, consumers could find themselves facing the worst of all possible worlds – an unregulated monopoly.
Even if the political furor subsides as quickly as a price spike following a heat wave, the turmoil in the industry could have far-reaching effects. For one, the new scrutiny from Wall Street and credit rating analysts that was prompted by the Enron accounting scandal has caused a plunge in stock prices and cuts in the credit ratings of energy trading companies. When Standard & Poor’s released a list of 15 companies that could face a cash crunch if their debt ratings were cut last week, all but three of them were energy companies. Several companies that had wowed Wall Street a year ago with ambitious plans to expand their generating capacity now are canceling new plants and planning to sell assets to shore up their balance sheets. If new plants are not built, older, dirtier plants may remain in service far longer, threatening the nation’s ability to meet tougher pollution standards. Moreover, the Cheney task force estimated the nation needs to increase its generating capacity by 25% over the next decade to keep pace with demand.
Henisz says government officials could exacerbate the problem if new policies make companies doubtful they will earn a sufficient return on new investment. “I think that the right prescription is to have very general antitrust laws and a lot of information – transparency – to observe the patterns that would indicate market power abuse,” he adds. “That will be a tough sell in an election year. People are suspicious that those laws will be enforced. They’ll want more tight handed regulation.”
Kleindorfer says energy traders risk a backlash unless they adopt ethical standards that prevent a recurrence of market abuses. “The facile explanations of these companies leave everyone with the sense that there is probably much more that remains to be revealed,” he says. “Functioning markets are based on trust in the institutional foundation of those markets. There must be transparency … or we’re not going to have energy markets.”