California Decontrols Electricity

As on many other topics, California moved ahead of the rest of the nation on decontrolling electricity. Since the 1930s, electricity generation and distribution had been a heavily regulated industry. Electric companies were viewed as “natural monopolies.” This meant that competition was likely to be cutthroat and inefficient, but allowing unrestrained monopoly would grant too much pricing power to the utilities. So, they were heavily regulated. In the typical model, a utility was granted a monopoly in a service area. A Regulatory Commission then set power prices to allow the utility to make a modest but secure return on equity. Utilities borrowed lots of money to leverage up their returns while paying regular dividends to shareholders. Power prices tended to be stable, except for fuel costs which varied with economic cycles.

Starting in the late 1970s, governments across America began to decontrol regulated industries. Airlines and trucking were two examples. However, the blockbuster decontrol occurred in telecommunications; there, venerable ATT was broken up, setting off a competitive free-for-all that delighted consumers with lower prices, more choice and rapid technological innovation. It was only a matter of time before this decontrol wave reached the regulated monopolies in electric power.

California sought to lead but was influenced by its volatile political system. Not only were consumers potent and organized; a referendum system was well established. Under this system, if organizers could collect enough names in support of a proposition, the proposition was put on the ballot. If the measure passed with majority support, it carried the force of law. This referendum system bypassed the legislative process and indeed could overturn existing laws. California’s state government had seen its tax base abruptly shrunk by a proposition that cut property taxes. In its wake, California’s politicians learned to walk carefully, not giving referendum organizers juicy targets to shoot at.

This political environment was to hamstring California’s plans to decontrol electricity. The state’s plan was based on the assumption that competition would drive down wholesale electricity prices. Accordingly, the plan architects forced a separation of power generation from electricity distribution. California’s well-known utilities, Pacific Gas & Electric Southern California Edison, and San Diego Gas and Electric, retained their distribution networks, but gave up their power plants to independent producers or out of state investors. Then, to promote competition, these distribution-utilities were prevented from entering into long-term electricity purchase contracts. Instead, they were required to purchase power in the daily spot market. Each day electricity suppliers would participate in an auction process to allocate supplies and set prices. California’s Public Utilities Commission (CPUC) expected that daily tendering for power would put intense competitive pressure on suppliers, who because of their high fixed costs would cut rates to assure that their power got placed.

To implement the daily power auctions, the CPUC created the California Power Exchange (California PX). This agency ran daily auctions for next day delivery. To handle last minute the imbalances, CPUC formed another agency, the Independent System Operator (ISO). Charged to monitor the reliability of the state’s power grid, the ISO also bought and sold electricity to manage supply/demand imbalances. Topping off this convoluted set of rules, the ISO was authorized to pay power providers fees to decongest power lines, this despite the fact that the agency had no ability to determine whether, in fact, lines were actually congested.

California launched this version of decontrol in 1998. Peering through the complex rules, this decontrol attempted to unleash cutthroat competition at the wholesale level so that power costs would stay under capped retail prices. The CPUC was so sure power costs would drop substantially that they lowered retail power rates 10% and then froze them for five years. This price freeze was intended to assure that California’s voters saw benefits from decontrol. However, it created a byzantine form of decontrol, one where prices to the ultimate consumer could not adjust to changes in the marketplace. This would lead to dire consequences within two years of the new system’s startup.

Throughout the decontrol process, Enron intensively lobbied California’s legislators, regulators and planners. The end product fell far short of Enron’s recommendation, which was complete decontrol. Disappointed but not surprised, Enron’s traders began to look at California’s new rules in a new light—as an opportunity for profitable gamesmanship.

Enron’s ‘Star Wars’ Gambits

Tim Belden and the other Enron traders didn’t like the decontrol model California had launched. But, setting that disappointment aside, they began to assess whether California’s decontrol might offer opportunities to produce trading profits. If exploiting the rules served to illustrate California’s folly, that was so much the better.

Enron’s traders analyzed the flaws in California’s system as follows. First, the regulatory model was predicated on the existence of surplus power. Only if there was surplus electricity looking for a customer did it make sense to force California’s utilities to buy spot power on a daily basis. Running daily auctions would then encourage providers to bid low to assure their power supplies were placed. However, if the market ever tightened, marginal suppliers would quickly discover that they had pricing power. Daily auctions would provide constant price feedback that supplies were tightening. Then, the suppliers’ incentives would reverse. By withholding supplies, they could force the “clearing price” ever higher. Under California’s auction system, this would raise the price for all electricity purchased each day. The state’s transmission utilities would then suffer the consequences, as their margins were crushed between frozen retail prices and rising wholesale power costs.

A second flaw involved the fact that California was dependent on imported power from other states. Environmental and other controls had led to a shortage of generation capacity in the state. As of 1998, surplus power did exist west of the Mississippi. California had to make sure they were able to attract it to the state, so the CPUC left the price paid for imported electricity uncontrolled. Power generated within the state was capped at $750 megawatt/hour. Most important, the CPUC did not prohibit power exports, reasoning that two-way flows were established patterns of load balancing.

Another noteworthy flaw concerned power transmission. Because California’s transmission utilities could not contract for term supplies, they could not plan an orderly use of their transmission lines. Instead, each day they would have to hope that the power offered at auction could somehow be routed through their grid lines. It was to help make this happen, that the ISO was authorized to pay suppliers for decongesting overcrowded lines. Since the ISO had little or no ability to monitor the power nominations, this system crucially rested on the good will of the power suppliers to match nominations to the California grid.

Perhaps the most massive flaw in California’s system was that it discouraged construction of new power generation. California’s decontrol was built around driving down the price of wholesale power by fostering cutthroat competition. To the extent that the auctions worked, they would drive wholesale prices down towards marginal costs. In electricity generation, marginal costs are essentially the cost of fuel. Since power generation also involves high capital and fixed costs, California’s auction system thus offered little prospect of prices that would allow for capital recovery and investment returns. In this way, California’s “decontrol” sowed the seeds of its own destruction. By insulating the state’s retail customers with a price freeze, then betting on competition to force prices down in a surplus market, it set in motion forces that would ensure the tightening of supply relative to demand. And, when that tightening occurred, the transparency of the daily auction system and the absence of any committed term supplies would set the stage for suppliers to realize they could ask almost any price for their “juice.”

Enron’s traders spotted the flaws in California’s deregulation early on. This led to an interesting test case. The state’s new rules went into effect on April 1, 1998. Three months later, Enron observed that Dynegy was able to extract a price of $9,999/megawatt hour for offering standby power at a time when few other suppliers had capacity. Enron waited until May 24, 1999. Then, it submitted an attractively priced bid to supply 2900 megawatts, enough to supply a medium sized city. Upon learning that its bid was successful, lead trader Tim Belden informed the ISO that the supplies would be routed over the Silverpeak transmission line, which could only handle 15 megawatts. Too late, the PX learned it would not have the supplies it counted on for the next day. The ISO then had to scramble for emergency power, paying a 70% premium over the average baseload price for that day. California’s authorities later investigated Enron’s actions for over a year. Eventually, head trader Greg Whalley signed a settlement agreement. In exchange for no charges being filed and making no admission of guilt, Enron paid a $25,000 fine and agreed not to “engage in substantially the same conduct.”

Basically unrepentant, Enron then adopted both short- and long-term trading strategies to capitalize on California’s mistakes. In the most fundamental sense, they watched the market carefully, waiting for the moment to “go long” on electricity. As California’s demand continued to grow rapidly, Enron saw the supply balance tighten to the point where “temporary factors.” e.g., plant outages or weather, could tip the market into a shortage. By early 2000, Enron’s traders had concluded that such tightening had occurred. Enron then went “very long,” buying electricity for future delivery throughout the western U.S.

Meanwhile, Enron developed tactical trading gambits to exploit California’s regulatory scheme. The first of these, called “Death Star,” capitalized on the ISO’s need to decongest transmission lines. Enron would purposely channel nominations to lines known to be crowded and then accept fees from the ISO to cancel its nominations. Knowing ahead of time that it planned to accept fees for canceling, Enron did not bother to line up actual supplies behind its paper nominations.

A second scheme, “Get Shorty,” was launched as California began to pay higher prices for out-of-state power. The ISO, increasingly concerned about supply shortages, began to line up backup power. Enron would nominate such reserves knowing that other suppliers planned to offer enough power at the auctions to assure that the backup supplies would not be needed. Consequently, Enron never actually arranged any backup power.

The third scheme was known as the Forney loop (for the trader who conceived it) or Ricochet; it involved buying lower cost power in California, exporting it from the state, passing it through a series of western utilities, and feeding it back into California at the uncontrolled auction price. Since the outflow/inflow into California netted out, no electrons actually left the state or came back. Instead, the out-of-state suppliers simply recorded profits from arbitraging the controlled in-state and uncontrolled out-of-state prices.

These various schemes proved lucrative. By the middle of 2000, Enron had earned approximately $60 M via these strategies. As impressive as these gains were, however, they paled in comparison to what Enron was making on its big bet, the “long” electricity position. Enron had read the market correctly. Surplus supplies had been absorbed, and then California suffered a combined heat wave and drought. The former drove up electricity demand for air conditioning. The latter cut in-state supplies from hydro-generating capacity. Clearing prices at the auctions sky-rocketed. By July 2000, California PX was paying $750 megawatt/hour for auction power even as the state’s retail prices remained frozen at ~$50–80/mwh, depending upon location. Enron was booking tens and later hundreds of millions in gains per month, while California’s transmission utilities headed towards bankruptcy.

Political Fallout in California

By August 2, 2000, California was in the midst of a “Stage-two” power emergency. Customers were voluntarily shutting off their electric power; rolling “brownouts” accomplished the rest of the load balancing. Governor Gray Davis received a CPUC report indicating that the state had paid $1 billion more for power in June/July 2000 than during the same period in 1999. Davis also noted another section of the report, which identified “enough evidence” of questionable trading to warrant the state opening an investigation. Davis then asked the state’s Attorney General to investigate possible manipulation of the state’s electricity market.

On August 10, the ISO issued a report blaming the crises on the exercise of market power by suppliers. On August 17, California’s utilities presented the Federal Electric Regulatory Commission (FERC) with a detailed list of supplier trading abuses, including the intentional creation of congestion and “megawatt laundering.” On August 23, FERC agreed to investigate.

Shortly thereafter, Mark Haedicke and Richard Sanders launched their efforts to prepare for possible litigation. Their move seemed prescient when, in late September, the CPUC served Enron with a subpoena seeking a large volume of the firm’s trading and financial records.

Enron Legal Investigates

On October 3, Richard Sanders visited the Enron trading room at their Portland General Electric utility. Christian Yoder and SR’s Stephen Hall joined him. They had come to hear what the traders had been up to in California. They made it clear they represented Enron and not the traders as individuals.

John Forney, inventor of the ‘Forney loop,’ declined to participate. The rest of the traders were then asked to leave before Tim Belden outlined “Death Star”, “Get Shorty,” “Ricochet” and other schemes on a whiteboard. The attorneys were dismayed. The various schemes were possible violations of several state laws, including anti-gouging and antitrust. Serious legal troubles were a real possibility.

Sanders could also see legal defenses for Enron’s actions. For example, the exporting of California power could be defended on the grounds that prices were higher outside the state. The submission of nominations on crowded lines looked bad, but Enron could argue it actually had done nothing wrong. If the state had demanded that Enron deliver power on those lines, it would have been obligated to do so. The fact that the state instead paid it to cancel deliveries was the state’s decision, not Enron’s.

Still, the effectiveness of these defenses would depend a great deal on the climate surrounding any trial. California juries were unlikely to be sympathetic. It would be crucial whether they ultimately directed their ire toward the out-of-state suppliers or the government who had designed the regulatory scheme. Managing the media stories around the California crisis would be as important as the quality of Enron’s legal defense.

With this in mind, Sanders ordered the traders to cease their trading gambits, including a new one wherein Enron got paid for fractional megawatt hours it never delivered. Back in Houston, Sanders briefed Mark Haedicke; together they went to see Enron’s general counsel, Jim Derrick. Sanders detailed the various trading schemes, including the trader names attached to each. Derrick inquired about possible “causes of action” that California’s government and consumers might bring. Sanders responded:

“Potentially antitrust violations. Some of the strategies I’m not too worried about. But I am worried about the congestion-management strategies.”²

Derrick inquired about whether Enron had the right outside lawyers for the matter. Sanders and Haedicke were reassuring.

The first formal legal complaint against Enron was filed on November 29. Derrick had not shared any of the Sanders/Haedicke briefing with either COO Jeff Skilling or CEO Ken Lay.

SR Produces a Legal Opinion

Once the trading games had been shut down, discussions between Enron Legal and the Portland-based traders went quiet. Christian Yoder began to be concerned that Enron senior management was not sufficiently aware of the legal threats they faced.

Yoder visited Stoel Rives and asked them to write up their findings in a legal opinion. He told them he needed it to brief Enron senior management. SR produced the draft opinion on December 6 (see executive summary, Attachment 2). Despite being on Stoel Rives letterhead, it listed Yoder as one of the authors. Yoder thought about it and decided to leave his name on the document, the better to strengthen the message of concern from Enron’s West Coast attorneys.

Once Sanders and Haedicke got over their initial shock, they turned to the question of what to do with SR’s opinion. Sanders had quickly pulled together his thoughts on Attorney-Client privilege. The bottom line was that the Federal government had recently developed effective pressure tactics to induce defendants to waive privilege. In several cases, attorney-client documents had been voluntarily handed over to federal prosecutors. Worrisome as this history was, it didn’t mean that Enron was fated to do so in a California lawsuit. For one thing, as long as Enron decided to fight, its privileged documents would remain confidential. For another, it was unclear that lawsuits in state courts would lead to the kind of “pressures” that had induced parties to waive privilege. Still, the existence of a memo from Enron’s own lawyers that all but declared the firm guilty was a dangerous document to have in the files. What if the California dispute eventually turned into a Federal matter?

Haedicke also reflected that he would have to decide what, if anything else, should be communicated up the line. Haedicke’s visit with Jim Derrick had, he thought, delivered the matter of briefing Enron management into Derrick’s hands. Did the arrival of the SR memo change anything here?

Haedicke told Sanders to collect all copies of the SR opinion and put them in a file to be kept in Haedicke’s safe. Once all the copies had been secured, he would decide what was to be done with them.

Author’s Note

This case asks students to step into Mark Haedicke’s shoes in September 2000 and consider Enron’s coming legal troubles in California. Haedicke faces a basic business problem of having to assess the extent of Enron’s potential liability. Outside attorneys can identify possible liabilities, but Haedicke must weigh their input against Enron’s available defenses. Underneath both of these points lies the more basic question of whether Enron has actually done anything wrong. Even if Haedicke concludes that Enron’s exposure is small, he must still assess the likelihood of the company being sued. Should he conclude that the probability here is high, he will want to organize a strong defense, one that does not give Enron’s opponents any unnecessary advantages.

Against this business backdrop, the Stoel Rives draft legal opinion arrives as a bombshell. It is forthright about both the likelihood of Enron being sued and about its potential liabilities. It takes a clear stance on the critical issues. However, its language is strong, almost recklessly so. The document is privileged and potentially useful for getting management to take the California legal risks seriously. Yet if the letter were to ever be made public, it would probably serve Enron’s opponents as a “smoking gun.” Haedicke wonders whether to use or destroy the opinion.

The case draws upon accounts of Enron’s California trading activities provided in Power Failure, The Smartest Guys in the Room and Conspiracy of Fools. The Smartest Guys in the Room provides the most detailed account of California’s “decontrol” scheme and the trading strategies Enron developed to capture profits under its rules. Conspiracy of Fools provides material covering Richard Sanders meeting with the Portland-based traders and his and Mark Haedicke’s initial reaction to the Stoel Rives opinion.

Attachment 1 is a Historical Recreation based upon input from a senior in-house legal counsel at a Fortune 50 firm. There is no public evidence that Mark Haedicke specifically weighed the risks of Attorney-Client privilege being compromised when he decided to collect all copies of the SR opinion. However, his actions were consistent with concern over the document entering the public domain. In fact, the Thompson memo was written after Enron had collapsed. However, corporate attorneys were already aware of government pressures on Attorney-Client privilege, and frequently counseled their clients to exercise appropriate caution. Attachment 1 documents events which further elevated the concern levels of in-house legal counsels regarding the sanctity of their communications, and gives students the opportunity to ponder the implications of DOJ’s tactics.

Attachment 2 is also a Historical Recreation. Stoel Rives obviously did produce a legal opinion, which ultimately did become public and did serve as a “smoking gun.” In the interests of concentrating the essence of its advice, Attachment 2 has combined its most eye-catching comments with advice given around the same time by another Enron outside counsel, Brobeck, Phleger & Harrison. Together they provide a composite of the views Sanders and Haedicke were getting as regards the legal risks raised by Enron’s trading strategies and the specific legal theories which the government might use to pursue them. Students should weigh Attachment 2 carefully as they consider whether to forward SR’s opinion to senior management, retain it in the Law Department files, insist that SR revise it, or have all copies destroyed.

Students thus face a combination of issues in this case. When a governmental entity issues a regulatory framework which your firm considers flawed, and there are opportunities to profit by exploiting the rules as written, should the firm impose ethical constraints on capturing those opportunities? If subsequently, in-house legal counsel discovers these opportunities have been exploited in ways that could violate state laws, what obligations do they owe to the firm, to senior management and to the law? Finally, if external counsel provides an opinion whose conclusions constitute a serious warning but whose language could prove embarrassing and damaging if released to the public domain, should the opinion be used within the firm, hidden away, rewrittenor destroyed?