Illustration by Melinda Beck

ENRON CEO JEFF SKILLING TOOK IT from all directions when he traveled to San Francisco last June to address the white-glove crowd at the Commonwealth Club.

First the announcement came early that week that the Federal Energy Regulatory Commission would extend price caps to any companies selling energy on California's wholesale market. Then the stock market reacted, with Enron shares slipping to a 52-week low of $43.07. The low price was devastating for Enron; the company now would have to devote additional shares to keeping its off-the-books partnerships afloat.

Outside the Commonwealth Club, protesters gathered, outraged by the continuing sky-high prices Californians were paying for energy. One tossed a berry-cream pie, striking Skilling in the side of his head.

Altogether a rough week, but Skilling had it coming. He and Enron had helped lay the groundwork for the energy crisis. When millions in Western-market dollars flowed across their balance sheets, Skilling and Enron exulted. Now the party was ending in the same place it had started. Within a month, Skilling would resign from Enron, jumping ship just as the Fortune 500 conglomerate began to slip beneath rising tides of bankruptcy.

For California, meanwhile, the damage is still being tallied. Cost estimates of the state's energy-market meltdown range upward from $40 billion. The state owes $10 billion for power it bought to keep the lights on last year, and another $45 billion in long-term contracts, which is close to double the market value of the electricity California will receive. Also figure in the state budget, which went from a heady surplus to a $15 billion deficit in the space of one crisis-wracked year, and the wreckage of two of the state's century-old utilities, both in bankruptcy proceedings.

Not surprisingly, the state's elected representatives want someone to hang for all the mayhem. Senator Dianne Feinstein has been the most explicit in her critique of Enron, asking the Senate Energy Committee to hold a special hearing “to pursue what role Enron had in the California energy crisis with respect to market manipulation and price gouging.”

It's an easy enough charge to make. Enron was one of six new energy firms that played a major role during the crisis. All have been accused — and four sued by the state of California — for scheming to drive prices up, and each reported record profits in 2000 and early 2001. But the other five firms are power generators who bought California plants after the state moved to deregulate markets.

What sets Enron apart is that Enron helped design the market that ultimately melted down. The Houston energy company dispatched top executives to testify at scores of hearings in California where the new electricity system took shape, leaning on key public officials in 1994 and 1995. A close review of the record and interviews with veterans of the state's energy war show that when it came to winning critical changes in market structure, Enron carried the day.

Enron's hand in shaping California energy policy makes the question that much more interesting. We can see that we were robbed — certainly there were some who made out like bandits — but were we set up? Did Enron manufacture the state's energy crisis to reap huge profits?

The answer is not simple. There were myriad factors at work in designing California's groundbreaking venture into deregulated electricity, including scores of major stakeholders, billions of dollars and the peculiar physics of one of the largest electricity markets on the globe. Still, Enron was there at the beginning, it reported spectacular earnings during the months of spiking prices, and it fought to extend the crisis when the clamor rose for government intervention. Did Enron chairman Ken Lay rig the California market and then clean out the state treasury, or did fate simply take its course, the ball bouncing first his way, and then the other direction?

Part of the answer lies in the company's history, and its first foray into California, long before anyone could sense approaching doom.

AN ECONOMIST BY TRAINING BUT ALSO THE SON of a Baptist preacher, Ken Lay espoused a fervent belief in the virtues of free-market competition. His convictions were honed during a series of government jobs, first as an official in the Nixon administration at the Department of the Interior, and then at the Federal Energy Regulatory Commission (FERC).

He got his chance to put those ideals to work in 1985, when Lay was drafted to helm the merger of two natural-gas pipeline companies in a deal financed by junk-bond king Michael Milken. The new company boasted the nation's only coast-to-coast interstate natural-gas pipeline, but it also carried massive debt. There was little chance the company could survive in the traditional mode of shipping gas from wellhead to utilities and power plants — the fees simply wouldn't cover the debt service.


Lay had a plan, rooted in his regulatory work at the FERC. The same year he stepped in at Enron, the FERC changed the rules governing natural gas, allowing utilities and producers to trade in an open market. Enron responded by issuing an offer to transport other firms' gas for a fee and to arrange retail delivery. Today all gas is moved that way, but in 1985, it was a radical departure.

To help develop his new market, Lay drafted Skilling, a brash Harvard Business School graduate. Skilling quickly positioned Enron Gas Marketing to serve as a go-between for staid utilities and the energy firms that served them. By 1992, the firm was grossing $6.2 billion in revenues, and Enron set about seeking new realms to conquer.

Electricity represented a natural progression, a $300 billion annual market operating under close state and federal oversight. But Enron's move into energy would be more complex than with natural gas. While the FERC had endorsed deregulation, scores of utility commissions and other state-level agencies across the nation still had a hand in energy matters. For Enron to realize full profit potential, it would have to carve out markets state by state.

California became a proving ground. As a party-line Republican, Governor Pete Wilson had made commitment to free markets a litmus test for his administration's loyalties, and in 1993 the state Public Utilities Commission endorsed the idea of deregulation. It was just the sort of break Enron was looking for. “They were involved in discussions all across the country,” recalled Dick Ratcliff, a veteran Sacramento lobbyist retained by Enron in 1992 to help on a pipeline project. “But they saw that California began to wiggle a little bit, and that got their attention.”

Still, California was hostile territory. Enron was distrusted for its obvious self-interest, and it was quickly dismissed by the Legislature. “They were disliked,” observed Dan Kirshner, an analyst and lobbyist with Environmental Defense in Oakland. “Enron was always from Texas.”

But Enron's people were smart, and understood that the critical decisions would be made long before the Legislature affixed its stamp of approval. “Their sense was that this was a regulatory matter,” Ratcliff says. “To their mind, you really didn't need or want the Legislature to be involved.”

THE DEBATE OVER THE NEW, DEREGULATED ENERGY market quickly turned to the question of design: How do you replace century-old utilities with a system that keeps prices in check and deliveries on time? Two camps quickly emerged. One represented an elite group of professionals, experts in economics and engineering who had helped design new power systems in places as far-flung as Norway and New Zealand. They were led by Bill Hogan, an electrical engineer trained at the U.S. Naval Academy in Annapolis who was a professor of public policy at the Kennedy School of Government at Harvard. Enron led the opposition.

Hogan advocated a “pool” design where all the state's electricity would be bought and sold in a single market. The pool model — dubbed “PoolCo” — represented disaster for Enron. With buyers and sellers meeting in a single open market, no middleman would be needed, leaving Enron and its traders out in the cold. Enron's alternative was “bilateral trading,” where buyers and sellers would make their deals independently. There would be a central grid operator, but it would be neutral, like air-traffic control or a stock market.

That was fine in theory, Hogan and other experts answered, but it didn't take into account the unique nature of electric power, with its huge generating facilities and elaborate delivery grid. “Electricity is a little different from other commodities,” Hogan says. Since there's no way to store it, supply and demand must match precisely and by the minute, he said, with purchase and delivery orders cleared and coordinated through an orderly exchange.

Enron was not alone in opposing PoolCo. Generators and consumer advocates alike were concerned that a central exchange would lend a built-in advantage to established utilities or a convenient avenue for government control. “Many of us were highly suspicious of that model,” said Jan Smutny-Jones of the Independent Producers Association. “There were more than a hundred different parties intensely interested in what was happening,” added Don Garber, a lawyer with San Diego Gas and Electric. “Many of them were wary of intervention by regulators” through a central power exchange.

Enron gave the opposition credibility by offering an opposing theory for how the electric system might function. “They claimed to understand how markets would work,” Garber said. “A lot of these people had no idea how to set up an electricity market,” said Larry Ruff, another energy consultant at the PUC workshops. Enron didn't either, but they insisted that they did. “Skilling was talking nonsense,” Ruff said. “But he was very influential. He was so full of hot air, he would dominate the hearings.”


Besides, Enron was espousing the dominant ideology of the day — the virtues of the free market versus the evils of regulation. The company executives were young, confident and forward-looking, an attitude that infused the whole state venture into deregulation. “They were the new kids on the block,” said lobbyist Ratcliff. “They had very sharp people; they were scooping up new grads out of Harvard. Unfortunately, being very sharp doesn't make you wise.”

IN LATE 1995, AFTER A SERIES OF PRIVATE MEETINGS, the anti-pool coalition proposed a far more elaborate model. It called for two separate power markets — the Power Exchange, where utilities were to buy most of their electricity, and the Independent System Operator, to handle late, spot bids and to dispatch energy throughout the state grid. Most business would be conducted outside the central market through a constellation of “schedule coordinators,” which would independently buy and sell power before making deliveries to the larger system.

Enron didn't win its “pure” market model, but it didn't lose, either. The splintered market meant that utilities, generators and major consumers would all make their own transactions through the schedule coordinators, and then submit the prices to the central exchanges, meaning plenty of action for the traders and derivatives specialists at Enron.

Hogan immediately denounced the split-market approach, which he dubbed the “separation fallacy.” “This is a seriously flawed idea. No commercial or technical case can be made” for such a scheme, Hogan wrote in the December 1995 edition of The Electricity Journal. “There are, by contrast, very compelling reasons for keeping these functions together. These reasons explain why there is no competitive electricity market in the world” that operates without a unified, central exchange.

Those sorts of objections stalled the move to open markets in states across the country, leading Ken Lay in August 1997 to launch what he called “an attack on a consensus-driven process” that produced “halfway” reforms. In one state, however, Lay was able to report “good news”: “We have the ear of the market-oriented commission in California.” Later that year, state officials submitted a hybrid market design for final approval by the FERC.

Eric Woychik, an MIT-trained energy consultant to TURN, the San Francisco­based consumer group, made one last effort to raise a red flag. In testimony before the FERC, Woychik and two colleagues called for “substantial revisions to the proposal . . . in order to create a truly competitive market structure.” Otherwise, they said, “Decentralized markets enable market players to achieve price discrimination, game markets, arbitrage price differences, and to avoid the increased competition that results from uniform pricing.” It was a concise outline of what was to follow.

CALIFORNIA INAUGURATED ITS NEW ENERGY MARket in March of 1998, and for a time it seemed to work. Prices sank as generators underbid competitors for a share of the market. A year later, however, prices began drifting higher. And by June of 2000 they were spiking. Electricity that cost between $20 and $40 to produce was selling for as much as $1,000, with average prices hovering over $100. The crisis was on.

Caught between sky-high prices and regulated rates, the state's utilities quickly ran through their reserves and were forced into bankruptcy. Political leaders headed by Governor Gray Davis demanded price caps to bring the market under control, but federal regulators, echoed by generators in California, denounced excessive demand and the failure to build new power plants. “It's easy to blame people from out of state,” said Steve Kean, the Enron vice president. “The real underlying cause was that you had rapid demand growth and you didn't have enough supply.”

It has since become clear that Kean was wrong on both counts. Robert McCullough, a Portland-based economist who specializes in energy issues for clients in the U.S. and Canada, conducted a thorough survey of the Western market and presented his findings in testimony before Congress in January. “The industry was in better load/resource condition in the summer of 2000 than it had been in some time,” McCullough told the House Subcommittee on Energy and Air Quality in January. “Peak loads were lower and total resources were higher than in previous years.”

Just how large a share of Enron's business derived from California remains in dispute. But McCullough reports that a sample of interstate traffic between California and Oregon shows that Enron handled one-third of those transactions. The company itself disclosed in court filings last year that it was owed $570 million by PG&E, and Enron was named to the creditors' committee for the bankrupt utility. And some Enron executives made unguarded statements that contradicted the company line. “We've probably bought and sold more power than any other market maker in the West,” Steve Kean told reporters early last year.


Besides, Enron did much more than simply deliver power. “I know what Enron likes to say, that they were bit players, that they did less than 10 percent of the business in California,” said state Senator Joseph Dunn. “That doesn't really tell you that much.”

A plainspoken Democrat from Orange County, Dunn spent much of the past year making inquiries as chairman of the Senate Committee To Investigate Price Manipulation of the Wholesale Energy Market. Dunn explained that the actual sale of power to a utility is simply the last step in a complex process, and that the price hikes in California were actually set well before final delivery. “The sale from the wholesale market to the utility is one small act in a whole series of events,” he says. “A single megawatt is traded 20 to 25 times before it is sent.”

Most of those trades took place on the private exchange at Enron, where as many as 1,500 young traders bought and sold contracts at the company's state-of-the-art Houston trading floor, with scores of flat-screen price/quote boards and piped-in rock & roll to keep things jumping. In 2000, Enron was the nation's largest wholesale buyer and seller of electricity, as well as its largest trader in natural gas, a key component in the price of power. In California as well, Dunn says, “Enron was a huge player in the market.”

While Enron consistently declined to break out its California business in its corporate statements, the state's energy crisis coincided with an explosion in the volume of business the company reported. In the year 2000, profits from Enron's Commodity Sales and Services division leaped by $1 billion, from $628 million, an increase of 160 percent. Its trade receivables, derived largely from transactions in energy and natural gas, rose from $3 billion to $10.4 billion. And its “assets from price risk management activities” — the swaps and derivatives in which it specialized — shot from $2.2 billion to more than $12 billion.

Much has happened since those figures were issued, of course, and Enron's numbers cannot be taken at face value. But nobody has challenged the surge in actual volumes transported by the firm, nor the doubling in commodity transactions. And for all the various enterprises the company was pursuing — retail energy services, broadband data transmission, even a deal with Blockbuster to deliver movies online — Enron never claimed substantial profits outside its core energy businesses. Says Frank Wolak of Stanford: “They made a boatload of money in California.”

Certainly Wall Street thought so. Enron stock jumped 86 percent in 2000, reaching a high of $90.75 on August 23. Enron quickly recognized that California's misfortune had brought a windfall. In January 2001, with energy prices continuing to climb, Lay, Skilling and other executives rewarded each other with millions of dollars in bonuses, augmented by personal sales of stock that brought $1 billion more.

AS THE TURMOIL IN THE MARKETS deepened, Ken Lay and Enron did all they could to forestall government intervention, touting Lay's free-market gospel to anyone who would listen.

In California, Lay engaged in a series of meetings with Davis, whose run for the state house he had backed with contributions of $75,000. The meetings were cordial despite the obvious policy differences, according to Davis spokesman Steve Maviglio. “Ken Lay is extremely charming,” Maviglio says.

More important, Lay saw his friend George W. Bush elected president. Taking advantage of unparalleled access to the new administration, Lay held meetings with the new secretaries of Energy and the Treasury, huddled with Bush in Texas and in Washington, and was appointed to the committee advising Vice President Dick Cheney on energy policy. Clearly he was getting his message across. A day after a private meeting with Lay on May 17, Cheney told reporters: “Price caps are not a help. They take us in exactly the wrong direction.”

But Lay's easy access to the administration soon turned into a liability for Bush. In California, Governor Davis was denouncing the Houston energy combine as “pirates” and “snakes.” In February, the governors of eight of 11 Western states, most of them Republican, voted to endorse caps on wholesale energy prices. In May, Representative Vic DeFazio summed up the mood in remarks to Congress: “This is the great new thing the Bush administration wants to bring to all of America: more profits, rolling blackouts, price gouging, and a mandate from the Republican administration that every state be subject to this sort of case. Now, this is because of Enron, the largest energy conglomerate in the world.”


The economic hemorrhaging from the nation's largest state could no longer be ignored. The Bush administration quietly stepped aside, and on June 18 the FERC voted to cap the wholesale prices of electricity in the Western market. Energy prices immediately began to sink across the West, as did stocks of energy producers and traders like Enron.

The impact was magnified at Enron by the unusual financing arrangements with subsidiary partnerships it had used to shift debt off the company books. The debt in those partnerships was guaranteed by shares of Enron stock — so long as the shares held up, the deals would as well. But with share value slipping below $50, the partnerships would backfire. Enron accountant Sherron Watkins spelled out the bind in her now-famous memo to Ken Lay. “If Enron stock did well, the stock issuance to these entities would decline and the transactions would be less noticeable,” Watkins wrote. Instead, she observed, “All has gone against us.”

Seen from California, Enron's demise takes on a tinge of irony. “They were betting on enormous windfall profits to keep the house of cards up,” said Larry Drivon, an attorney with Joe Dunn's Market Manipulation committee. “They waited for another spike — they waited and waited, and when it didn't come, it was kaput.”

HALF A DOZEN DIFFERENT COMMITtees of Congress are now sorting through the wreckage, along with investigators from the Securities and Exchange Commission and the Department of Justice hunting for evidence of administrative or criminal misconduct.

The leading suspects include Lay, Skilling and Andrew Fastow, one of the executives who profited so handsomely by creative accounting and in-house partnerships. But as brazen as their acts look in hindsight, it's hard to tell whether they're guilty of chicanery or mere hubris.

Remember, these were people who believed they were harbingers of a “New Economy,” that they would spread enlightenment — and profits — simply by applying their focused attention. Consider a few lines from Enron's 1999 annual report: The key to Enron's success was “innovation, driven by a quest to restructure inefficient markets, break down barriers and provide customers with what they want and need.” That drive came from within. “Enron has been and always will be the consummate innovator because of our extraordinary people,” the report explained. “Move our assets to another company and the results would be remarkably different.”

That attitude may be the best defense for Enron executives against charges by financial regulators that they drained the assets of an enterprise they knew to be living on borrowed time.

For California, that question goes to the heart of determining what went wrong in the state's disastrous experiment with deregulation.

“There are two explanations,” offers the Kennedy School's Bill Hogan. “Most people — and that means just about everyone I talk to who sat across the table from them — most people believe that Enron was manipulative and cynical. That they believed that if a market were poorly designed it would create more opportunity for them to make more money.”

Hogan's view is different. He believes Ken Lay and the other Enron executives bought into their free-market vision, and simply weren't interested in addressing the unique complexities inherent in operating a modern-day electrical grid. Jeff Skilling in particular struck Hogan as a classic ideologue, “often wrong but never in doubt.” Once the system was in place, Hogan acknowledges, “I don't think there was any doubt people were gaming at some point.” But to Hogan, the rise and fall of Enron speaks more to delusion than to good and evil. “They believed the free market can solve any problems that might arise. I believe they were victims of their own moonshine.”

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