Author Archive Send to a Friend <% dim printurl printurl = Request.ServerVariables("URL")%>" target="_blank">Print Version

February 4, 2002, 8:00 a.m. Played in Regulation Time Played in Regulation Time.

he Enron debate has now shifted away from what caused the firm's bankruptcy to what the bankruptcy means to employees, executives, pensions, and Kenneth Lay's Aspen houses — in essence, to the more dramatic stories surrounding the demise of the "once great" company. The court battles will go on for years, and the outcome of those battles will largely help only the lawyers. But there are lessons to be learned, and we need to look at the economic conditions that fostered Enron's meteoric ascent and even faster demise.

Looking back, it's clear that a necessary condition for such a dramatic rise is "the sure thing" or "the one-sided bet." With just a short step back in history, you can easily find other companies that also found themselves looking at a sure thing, and, almost without fail, their stories ended unhappily. In nearly each of these episodes, the "sure thing" was the direct result of policy mistakes. Interestingly, the data also suggest that it is policy changes in the right direction that put a precipitous end to these "sure thing" or "one-sided bet" cycles.

So what led to the one-sided bet for Enron? It was NRO Financial's Larry Kudlow who first noticed the key. On his new TV program, America Now, he showed a chart of the Enron stock price versus a chart of a commodity price index. The fit was surprisingly tight. Larry's partner on the show — Jim Cramer — went ballistic when Larry pointed out that Enron, as a stock, had not done all that well until commodity prices firmed up. The implication of Larry's chart was that the positive trend in commodities presented Enron with a nice trading opportunity — or their one-sided bet.

Buying energy now and selling it in the future at a higher price would lead to nice profits. However, one can argue that if markets are reasonably efficient, they will eliminate the simple profit opportunities. This is where the policy mistakes come into play. It appears that California was, inadvertently, an enabler of Enron's meteoric rise and fall.

CALIFORNIA-STYLE “DEREGULATION”
In 1996, during the Pete Wilson administration, the California legislature enacted regulations that cut retail energy prices by 10% and froze them there for six years. Only wholesale electricity prices were deregulated and allowed to rise and fall with the market. The law forbade electricity companies from signing long-term power-supply contracts. In fact, the law explicitly required the electricity companies to buy electricity in a daily spot market. This was a key provision that allowed energy traders like Enron to make hay while the sun shined. Put another way, it afforded a favorable environment of rising energy prices. The California Power Exchange (CPE) and the Independent System Operator (ISO) were the two market makers in the "deregulated" California system.

The system was supposed to work as follows: Every day, suppliers would offer power in the form of bids to the CPE. The exchange then bought as much power as was needed for the day, starting with the lowest bid and continuing through higher bids until it filled the quota. The last successful bidder set the price for the whole market. The second market maker, the ISO, would step into the market to buy emergency supplies, paying whatever was necessary to prevent blackouts.

Looking at the history of California, it is obvious that regulation prevented the construction of new plants, especially base-type plants, since these would most likely be nuclear power plants. By not allowing base (nuclear) power to grow, state regulations have increased the dependency on more expensive, at-the-margin, domestic sources of energy.

The explicit prohibition against signing long-term contracts forces California energy suppliers to move away from base-type solutions into marginal energy-type solutions. During periods of excess national production (i.e., low energy prices), marginal plants will not be used to satisfy incremental demand. The cheapest alternative for California in this environment is to buy excess base production from other states. Hence, during energy gluts, the marginal cost of imported energy will be well below the average cost of producing energy. However, during times of high demand, base production will be consumed and suppliers will only produce at the margin if it is profitable. Hence, during those times, the cost of importing energy will be well above the average price.

With all this in mind, let's look at the events that led up to the Enron collapse.

In 1998, the system worked fairly well. Energy prices were low and supply was plentiful. Suppliers submitted low bids in hopes of having their plants utilized. They knew that if they were the lowest bid they would very likely receive the higher rate for that day. With plentiful energy, the system worked well, but these conditions gradually changed. During the second half of the decade, the U.S. economy grew at or near a 4% real rate annually. Energy demand grew even faster.

Hence, as the decade came to an end, the rising demand was pushing the economy up along its energy-cost curve. The glut conditions were slowly disappearing. The culmination of this process occurred during the spring of 2001. Low water levels in the hydroelectric systems serving California and rising natural-gas prices added to scarcity and energy prices rose.

That scarcity exposed the fragility and rigidity of the California energy policy. It provided the "one-sided bet" that a company like Enron could exploit. In the face of rising energy prices, every bid got snapped up. That led to a reverse speculative attack against the system. Suppliers had an incentive to further reduce the available supply to the system to insure escalating prices. This reverse speculation acted to reduce the available supply of energy, forcing the system to depend more on spot-market conditions.

For example, with energy shortages, power-plant outages would increase, in turn increasing the need for the ISO to enter the market to insure that there would be no blackouts. Also, knowing that the ISO would have to go into the market, energy suppliers had a no-lose situation: They could ask for higher prices from the CPE, and if the bid got accepted everyone would gain. If the bid was not accepted and not much was offered, then the ISO would enter the market to insure there would be no blackout.

The gaming of the system did not stop there. As regulation changed, new rules required electricity generators bidding in excess of $150 per megawatt hour to prove they had costs high enough to justify that price. Well, some suppliers with long-term energy/gas contracts could justify it. They sold their gas in the open market, making a profit on their long-term contracts, and then turned around and bought the gas in the open market to use in the production of electricity. That way they could justify the higher cost and thus qualify for the higher prices paid by California.

All of this, while perfectly legal, illustrates how regulations and controls were gamed in a way that produced higher prices and significantly higher profits for the providers.

In fact, looking at the process, as long as the regulations were in place and unchanged, the profit opportunities were almost risk-free. The one-sided-bet was on. The suppliers took advantage of the situation; they simply responded to the incentive structure set up by California's regulators. Viewed this way, California was an inadvertent enabler of Enron's meteoric rise.

California's governor reacted to the crisis in a very populist way. Without rehashing all the policy actions taken, California ended up taking a number of actions that varied in their effectiveness. Some of these actions actually hurt the state. However, there was one little and unnoticed action that reversed the trend. Neither policymakers nor Enron executives grasped the significance of this policy action. However, it proved fatal for Enron.

California significantly raised the energy price to consumers. Throughout the "deregulation period" prices to residential users were frozen. Hence, households had no real incentive to conserve energy. However, when energy prices quadrupled, California consumers found in their hearts the desire to conserve energy. Miraculously, as soon as prices quadrupled, the crisis subsided. Energy prices began to decline in California and so did Enron's profit margin.

And that's not all that happened. As the expression goes, when it rains it pours. The downturn in energy coincided with the economic slowdown and the Internet bubble bursting. In short, the volume and, to a large extent, the prices of everything that Enron made a market (and had positions) on, went down.

AFTER THE FALLOUT
The question now is how solve the problems that swim in the wake of the Enron collapse. There are two possible solutions: one is a government-mandated solution and the other is a continued reliance on market forces. It looks like we're going to get both.

The impetus for a government-mandated solution is quite evident. It seems that campaign finance reform is likely to pass as a result of Enron. The fallout could also result in new IRA regulations, too.

The market process will be relatively straightforward. If the issue was that investors had a tough time understanding the balance sheet of the company and the complicated accounting structure allowed Enron to do certain things they should not have done, the market will now punish firms with complicated structures. Those with fewer footnotes in their statements will become more attractive companies.

Yet, the last thing we need is a move toward more regulation — the condition that enabled Enron's gaming structure to thrive. The California example makes it abundantly clear that deregulation was not the culprit.

— Victor A. Canto and Peter Mork of La Jolla Economics