The Enron Rip-off

The energy crisis that cost California as much as $40 billion in 2000 and 2001 did not, in fact, result from a shortage of electricity, according to testimony by state officials before Congress last week.

Instead, it was an economic crisis brought on by manipulation of the wholesale energy market. And the key player in that market, experts and California officials said, was Enron.

It‘s been five months since the Senate first convened hearings on how misconduct and failed oversight led to the collapse of the Houston energy giant, but last week the Senate Commerce, Science and Transportation Committee took the first detailed testimony on the role Enron played in the crisis that forced California’s two largest utilities into bankruptcy, and cost the state billions in bloated costs for power.

The hearing was convened by Senator Barbara Boxer, who wanted to show that “the financially shaky Enron bled California to keep the price of its stock high so that insiders could cash their stock out.” And while the four witnesses called by the committee had little to say about the fluctuations of Enron stock, they had plenty to say about bleeding California.

S. David Freeman, the former director of the Department of Water and Power in Los Angeles and now an adviser to Governor Gray Davis, emphasized in testimony that he was not “singling out Enron and ‘piling on’ just because they are in trouble for other reasons.” As a former staff member of the same Senate committee he was addressing, Freeman said, “It is important that Congress understand that a rich and famous company can succeed in achieving terrible results for consumers.”

Or several companies. In California, according to Loretta Lynch, president of the state Public Utilities Commission (PUC), Enron helped drive prices up in California by conducting “sham transactions” between as many as five separate subsidiaries. Each “sale” brought a higher price, which convinced power generators and other marketing firms to follow suit. Consequently, state utilities paid $20 billion more for energy in 2000 than they had the year before.

Yet the California officials said that federal rules make it impossible to produce the sort of smoking gun that would prove a case of market manipulation. “Because Enron as a trader could hide behind a curtain of secrecy, no one knew the full extent of how much they profited, and we may never know,” Freeman said.

That uncertainty may explain why the hearing got little attention from the media either in Washington or in California. And because four of the five witnesses were Democrats or appointees of Governor Davis, some dismissed their statements as partisan potshots. But the expert testimony provided fresh insight into how, as Freeman put it, “Enron and their fellow gougers [were] picking the pockets of Californians to the tune of billions of dollars.”

The first step to understanding the state energy crisis is to realize that, contrary to news reports at the time, there was always plenty of energy. “There has never been a ‘power shortage’ in the state of California,” said state Senator Joe Dunn, chairman of the Select Committee to Investigate Price Manipulation of the Wholesale Energy Market. “What California experienced in 2000 and 2001 was not a crisis in electricity, it was a crisis in economics,” Dunn said.

That testimony was supported by Robert McCullough, a Portland-based consultant who was the sole committee witness from outside California. McCullough cited data from the Western Systems Coordinating Council to show that the ratio of generating capacity to energy demand never slipped below standard operating margins during the crisis. In fact, McCullough testified, “The situation was far better in 2000 than the situation the WSCC faced from 1991 through 1998.” The difference, state officials agreed, was deregulation.

Of course, not all efforts to roll back government oversight results in such spectacular market failures. But in California, the experiment with an unfettered electric market was, to a significant degree, designed by lobbyists and executives at Enron. Freeman emphasized, “At every step in the rule-making for deregulation in California from 1996 until today, Enron, more than anybody else, used their enormous resources to urge the most extreme positions that resulted in maximum secrecy and lack of accountability.”

State Senator Dunn was succinct on the same point. “Enron‘s sophisticated lobbying efforts helped create the very market it would later exploit.”

Key to Enron’s strategy was to ensure that it could operate in secret. It accomplished this goal, not in California, but through lobbying in Washington, via the offices of the Commodity Futures Trading Commission. There, in 1992, commission chairwoman Wendy Gramm, the wife of Texas Senator Phil Gramm, wrote rules to exempt energy companies from normal financial accounting rules. Six weeks after the rules were approved, Gramm left the commission and joined the Enron board.

Enron was active in California as well, working to make sure the new electricity market would operate outside of the central exchange where officials matched supply and demand on an hourly basis. That allowed major players to influence prices in myriad ways.

Loretta Lynch of the PUC described Enron‘s greatest innovation -- the creation of its own electricity marketplace, with its own set of rival firms, where prices were set before the energy was shipped to the central exchange. “In the fourth quarter of 2000,” Lynch said, when energy prices were spiking, “five Enron affiliates -- Enron Energy Services Inc., Enron Power Marketing, Inc., Enron Energy Marketing Corp., the New Power Co., and Portland General Electric -- bought and sold 10,167,782 megawatt-hours of electricity to and from each other, at prices as high as $1,100 per megawatt-hour (more than 10 times the cost of generation). These trades were not only among affiliated companies; the same individuals were managing all these companies.

”These ’trades‘ were in fact sham transactions -- Enron was selling the same megawatts back and forth to itself, causing the price to rise with each sale -- all under the rules it had helped to create . . . This was truly a Ponzi scheme.“

There were other players in the market, of course, but they soon realized it was in their interest to go along with Enron’s games rather than undercut the inflated prices. McCullough testified that the five independent generators who bought into California on the eve of deregulation -- the energy firms Duke, Dynegy, Reliant, Mirant and AES -- each ran their power plants at just half their rated capacity through the months of the crises, helping create the appearance of shortage.

Enron had no actual capacity, and so found more creative ways to exploit the California market. Aside from sham transactions, Lynch said Enron was a leader in the practice of ”megawatt laundering,“ whereby a firm would sell California power to out-of-state customers, creating artificial shortages at home. ”Exports from California quadrupled from 1999 to 2000,“ Lynch said.

Still another market ruse was to create ”congestion“ on the state‘s transmission grid. That is, by committing to ship more energy than a particular line could handle, Enron could, under the rules in California, force the state to pay a premium to keep the power off-line. Senator Dunn described one early episode in which Enron traders bought the right to sell 2,900 megawatts over a 16-hour period, and then scheduled all that juice over a 15-megawatt line. State regulators fined Enron $25,000 when the ruse came to light.

The California energy crisis ended when federal regulators moved to impose caps on wholesale electricity prices in June of 2001. And while ”Obviously Enron had many other problems,“ Freeman observed, ”it is beyond dispute that as a trader, Enron made money buying and selling when prices were high, and as prices settled down so did their profits.“

Those price caps are set to expire this September. Freeman warned that, unless federal regulation continues, the energy crisis could well resume. ”California is still vulnerable,“ he said.

Lynch took a broader view. Drawing parallels between energy and the telecommunications industry, which is now seeing ”cross-country mergers, bankruptcies, high-technology affiliates and other changes,“ the PUC president called for renewed commitment to government regulation of the free market. Said Lynch, ”Congress must keep it simple, keep it clear and keep regulation and enforcement strong.“