Enron's Power Play
On this cold January day in Houston, Enron President Jeffrey K. Skilling could easily play the pirate that California consumer groups are casting him as these days. After two weeks of sailing with his three children in the Virgin Islands, Skilling's face is slightly sunburned, and he sports a rakish post-vacation beard. But the CEO-elect isn't buying the buccaneer image that some have slapped on his company. He clearly thinks Californians should be thanking Enron, not castigating it, for its role in trying to push open the state's power markets. "We're on the side of angels," he says. "We're taking on the entrenched monopolies. In every business we've been in, we're the good guys."
Alas, the nation's largest energy merchant is garnering no such accolades from California's great deregulation experiment. Soaring power prices have pushed the state's utilities to the brink of bankruptcy and forced Third World-style blackouts across the world's sixth-largest economy. Enron and other electricity marketers and generators are being investigated by the state attorney general and sued by consumers amid accusations of profiteering and market manipulation. "Every trading company in the country has been feasting on California, and Enron is the shrewdest of them all. They are like sharks in a feeding frenzy," says Michael Shames, executive director of the Utility Consumers' Action Network in San Diego. Enron, an early critic of California's deregulation plan, hotly denies those charges.
FRICTIONLESS? The glaring spotlight on California's botched attempt at deregulation casts Enron in the uncomfortable role of defending its radical business model. Though often grouped with utilities, Enron produces little power itself and owns relatively little in the way of hard assets. Instead it has pioneered the financialization of energy, making the company more akin to Goldman Sachs than Consolidated Edison. Its impressive profits stream is squeezed out of a torrent of often low-margin trades, in which it buys and sells a dazzling variety of contracts. The more buyers and sellers, the better for Enron, which is now twice the size of its nearest competitor.
Enron executives paint this as nothing less than a holy war on inefficiency. When the power giants are busted up, scrappy Enron believes it can thrive by delivering just the products and services particular customers want most. And they're thinking way beyond just energy. Skilling, a former McKinsey & Co. director, is now applying the model to a slew of new markets, including data storage, steel, even advertising space. He believes the company can thrive as a market maker. "Whether it's Enron or not is almost irrelevant," says Skilling. "It's going to happen."
For now, though, California's crisis has abruptly slammed the brakes on efforts to deregulate U.S. retail electricity sales, which are under way in nearly 25 other states. Moreover, that mess may prove to be the death knell for industry hopes that retail deregulation would spread far beyond the 20% of U.S. businesses and homeowners who now can name their own electricity supplier. "Deregulation has lost a lot of momentum," says Kemm C. Farney, vice-president for electric power at consulting firm WEFA Inc. "It's hard to argue that this has resulted in lower bills." Even in overseas markets, where Enron is counting on huge future gains, supporters are watching nervously. Big utilities, particularly in the south of Europe, "want to use California to slow down liberalization," says Jan van Aken, secretary general of the European Federation of Energy Traders.
It's not hard to see why. Sure, the old regulated system was expensive, but at least we knew the lights would turn on when we flipped the switch. However, Skilling and others argue that the battle in California has obscured the reasons for pushing deregulation in the first place. The old utilities, he says, "were incredibly expensive and provided horrible service to their customers." Under the regulated model where utilities could simply pass on costs to customers, they lacked incentives to utilize capacity more efficiently or to offer innovative services. In California, for instance, business leaders pushed for deregulation because they were paying 50% more for power than their counterparts in other parts of the country. At the same time, the utilities themselves were operating high-cost plants with little access to capital to fix their problems, says Farney. The upside of deregulation? "We have a tremendous amount of new construction. It's a direct result of the industry having new access to capital markets," he says.
One of the biggest problems now is that the nation is in a muddled state between regulation and deregulation. For instance, freezing retail prices for consumers and businesses in California while deregulating the wholesale market where utilities shop left the power companies unable to cover their skyrocketing energy costs and pushed them near the brink of financial collapse. Paul W. MacAvoy, a professor at the Yale School of Management, compares that to the blunder that regulators made in the 1970s with the savings and loan industry. The S&Ls were restricted to investing in long-term assets, like mortgages, while paying volatile market rates on shorter-term deposits. "There's a widespread opinion in the academic world that regulation is bad, but partial and phased-in deregulation is much worse," says MacAvoy.
Skilling argues that Enron's exposure to fallout from California is minimal. Its biggest business is in the wholesale market, serving utilities and big industrial customers who under federal law already have the right to choose their electricity suppliers. And wholesale markets in Europe and Japan are rapidly opening their doors. That explains why most observers believe that Enron will emerge with its earnings engine intact. "We do not expect the California situation to have any significant impact on Enron's financial outlook," says Skilling, who is set to take over the CEO title from Enron Chairman and CEO Kenneth L. Lay on Feb. 12. In the fourth quarter, Enron's core wholesale trading and services business reported income of $777 million before interest and taxes, nearly triple that of a year earlier. Enron's total net income excluding nonrecurring items shot up 32% for all of last year, to $1.27 billion, on sales of $100.8 billion, up 150%. Physical volumes of gas and electricity delivered jumped 59%, boosted in part by EnronOnline, the company's year-old Web-based trading operation.
POWERFUL ALLIES. Under a new Republican Administration and a President with strong ties to Lay, Washington isn't likely to derail deregulation. If anything, Enron will be using the crisis to push for more favorable federal rules for moving electricity from state to state, which could boost its flexibility and trading options. Certainly, Curt L. Hebert, the new chairman of the Federal Energy Regulatory Commission (FERC), is a free-market advocate friendly to Enron's views. "I don't think California is going to be any lesson that stops America from wanting choice. It's going to be a lesson that allows America to learn what not to do," he says.
Still, Skilling and Lay will have to spend precious time and energy on a deregulation battle that Enron seemed well on its way to winning. Already, Oregon, Arkansas, and Nevada are considering a slowdown in their deregulation plans, while northeastern states have put in place wholesale price caps. Some Western governors want Congress to force regional price caps on the wholesale electricity market. And Representative Peter A. DeFazio (D-Ore.) is ready to introduce an "energy re-regulation" bill that would overturn the 1992 U.S. Energy Policy Act. "Electricity is not a commodity fit for the competitive marketplace. Private investors don't have public safety in mind," says Doug Heller, consumer advocate with the Foundation for Taxpayer & Consumer Rights in Santa Monica, Calif., which is pushing for a referendum to have California take over much of the power system.
If that kind of radical sentiment spreads beyond the California border, Enron could find its growth prospects, even in the $220 billion wholesale market, sharply curtailed. And it would surely be bad news for Enron's latest effort to crack the retail market: a separately owned company formed last May with then-America Online Inc. and IBM called the New Power Co. Enron tried four years ago to enter the residential market in California but quickly backed out when it found the state's new rules wouldn't let it turn a profit.
The hyperconfident Skilling is unrepentant about his company's long role as a deregulation crusader. Enron benefits from volatility, not high prices, he says. In California, where Enron doesn't own power plants, the company insists it is dealing in thin margins. "Depending how markets are swinging around day to day, we're either making a little money or losing a little money on that," says Lay, although he won't break out specific figures for California. If anything, says analyst Donato J. Eassey of Merrill Lynch & Co., operating margins are getting thinner--in the entire wholesale business they were 2.4% last year, vs. 3.7% in '99 and 3.6% in '98. That's O.K., says Eassey: "I'll take that margin pressure with a 72% earnings growth rate on that [wholesale] business."
In its gleaming Houston office tower, Enron has seven floors of some 1,500 traders making markets in gas, electricity, metals, bandwidth, and other products. Enron, for example, posts prices for an array of energy contracts. With the click of a mouse, utilities caught short on supply can make a deal. Likewise, generators with excess capacity can find prices Enron is willing to pay. Enron pockets a spread on the deal. The traders are supported by a back-office team that schedules pipeline and transmission capacity to actually deliver gas and electricity, checks credit, and handles billing. Each desk of two or three traders used to handle about 100 transactions a day when doing their business by phone. Now a desk handles 800 to 900, mostly on EnronOnline.
Enron's success has not gone unnoticed, but it has a few advantages that competitors would be hard pressed to match. First is its expertise; it pioneered the model. It has dozens of PhDs in mathematics, physics, and other disciplines, and even hired a former shuttle astronaut to schedule satellite time. Enron also has built a huge network of buyers and sellers with a wide range of commodities to trade. With its deep pockets Enron has plenty of capital to keep its markets liquid.
A big part of the value Enron provides is helping companies manage risk, especially the risk of big price swings or delivery snafus. One example: In 1999, Peoples Gas, Light & Coke Co. of Chicago, a local distribution company, signed a five-year gas procurement deal with Enron. Enron took over Peoples' scheduling of gas pipelines and storage, assets that Enron then could use to meet commitments for a broad array of other customers. In the meantime, it procures gas daily as Peoples needs it, provides working capital, handles accounts receivable and payable, manages storage, and finances the gas in storage. "This is our distinctive competence--bringing the whole thing to the table," says Skilling. "No one's our equal in that." And Enron has pioneered contracts to manage other kinds of risk too, including weather.
Enron's deregulation roots reach back to the early '70s, when Lay, an economist by training, began promoting opening gas markets as an Under Secretary of the Interior in the Nixon Administration. In 1986, Lay took over Enron, the product of a merger between two pipeline companies. He warned federal regulators that pipelines like his were in danger of sinking under rules that crippled their ability to compete with low-priced oil. The FERC finally changed the rules starting in 1985, freeing utilities to shop for gas and the pipelines to search for customers. Enron embraced the changes with gusto, rapidly becoming the largest buyer and seller of gas in North America. It then pushed just as aggressively to open wholesale and retail electricity markets, to the chagrin of the nation's entrenched utilities. In Ohio, it offered consumers coupons for free electricity to build political support for deregulation. In California, it fielded an army of regulatory attorneys to battle the state's utilities over the rules of engagement.
SERIOUS FLAWS. The seeds of California's energy debacle were planted long before deregulation set in, though. Thanks to environmental concerns, poor planning, and uncertainty about the rules of deregulation, California's power supply in recent years has been growing far slower than demand, which was driven by an expanding population and its increasing use of energy-sucking technology. The badly flawed 1996 deregulation scheme--some terms of which Enron and others fought from the start--only exacerbated the problems. It included a pricing system that prevented utilities from locking in long-term supplies at fixed prices and from passing on higher fuel costs to customers. Without rising prices, consumers had no incentive to reduce demand and utilities couldn't pay their soaring wholesale power bills. That scared away some power suppliers and created the financial crisis from which the state is still trying to dig out.
By now there is nearly universal agreement that the biggest flaw in California's deregulation plan was the decision to force utilities to buy all of their power needs one day in advance from a newly formed entity called the California Power Exchange. The theory was that the exchange would provide the most transparent prices, since every buyer and seller had to operate through it. Whatever power didn't get bought through the exchange would be purchased on a last-minute basis the following day by another entity called the Independent System Operator (ISO).
But many observers believe this two-step setup encouraged generators to offer less power to the exchange and instead to wait until the last minute to sell power to the ISO, which out of desperation would have to pay higher prices. In three lawsuits, consumer groups, municipal water districts, and the City of San Francisco allege that Enron and other electricity marketers engaged in unlawful market manipulation. Several investigations so far have failed to prove collusion by Enron or others. But one study said that the soaring prices couldn't be explained by such factors as high demand and rising fuel and environmental costs. "We concluded that power was being withheld inexplicably, at the exact time at which prices were most vulnerable to manipulation," says Edward Kahn of the Analysis Group/Economics, a co-author of one study backed by the parent of utility Southern California Edison. Adds co-author Paul L. Joskow, a professor of economics at Massachusetts Institute of Technology: "It was bad regulation, bad market design, bad luck, and greed."
NOT ROLLING OVER. Enron dismisses the study as flawed and slanted to favor the utility that paid for it. Meanwhile, the attorney general's office, state Public Utility Commission, and FERC are all continuing to investigate. California's current plans to fix the problem involve the state becoming the lead buyer, through long-term contracts that take the uncertainty out of pricing. The Power Exchange is being phased out. Enron applauds that move. And even some of the hardest-hit power users in California haven't given up on deregulation. California Steel Industries Inc., a Fontana (Calif.)-based steel producer, lost power 14 times in January, costing it millions of dollars. Yet Lourenco Goncalves, its president and CEO, is not advocating a return to regulation: "Deregulation is a good idea," he says. "We just need to treat this like a business and fix what went wrong."
The energy crisis comes just as Enron is vigorously pushing its promise of efficiency and lower prices into a slew of new commodities. "Look at pulp and paper. Look at all those salesmen who play golf all day. For a commodity, for crying out loud. You don't need to play golf to sell a commodity," blurts Skilling in his typically blunt style. In these new arenas, Enron won't face the kind of regulatory obstacles it must eliminate in energy. But it's no wonder that many players will resist what they see as an arrogant and menacing middleman. The California experience gives them new ammunition. Enron and other traders "sure as hell haven't done a very good job of protecting the American public from the rising price of natural gas or electricity. I don't see that they bring any real value to the steel marketplace," says Daniel R. DiMicco, CEO of Nucor Corp., one of the nation's leading steelmakers.
In one of his first big bets outside of the energy patch, Skilling is attacking the telecommunications industry. In the past year, Enron has spent nearly $500 million to create its own high-speed fiber network. But the goal is not to be a traditional telecom player. Instead, Enron wants to create a vast spot market for high-speed communications capacity, and ultimately a futures market. Consider its deal with Blockbuster Inc. The two signed a 20-year pact for Enron to deliver movies-on-demand to Blockbuster customers, a service that's now in four test markets. Instead of having to build its own network and coordinate a multitude of agreements with local high-speed communications providers, Blockbuster turned the whole thing over to Enron. It pays Enron per movie, getting only the capacity it needs, when it needs it. For now, those movies are moving mostly on Enron's 13,500-mile fiber network. But as a robust market for trading bandwidth develops, Enron could pluck the capacity it needs from other communications companies. It may even sell its fiber network when it no longer needs the physical capacity to ensure delivery to its customers. "The minute I don't need it, it's gone," says Skilling.
Indeed, Enron's new CEO has already demonstrated that he doesn't linger over troubled assets. To help fund its vast ambitions, Enron expects to shed more than $2 billion in plants and other properties around the world this year, including a gas production plant in India and a wind-power company in California. In the fourth quarter, the company took a $326 million aftertax charge to cover problems at Azurix Corp., its failed water business that's likely to be busted up. Under Skilling, Enron is essentially abandoning its once-ambitious plan to build power plants, pipelines, and other facilities around the globe.
Now, Enron will build assets where they clearly support the trading operations, including places like Spain and Japan. Rival energy marketer and producer Dynegy Inc. of Houston questions just how competitive Enron can be without a significant physical presence in its new commodities "to give you that incremental intelligence," says CEO Chuck Watson. Without that, "you don't really have a competitive advantage." But investors don't seem worried. Indeed, Enron's stock is up about 175% in the past two years. "One thing about Enron is they're incredibly well managed, very smart, and entrepreneurial," says portfolio manager Robert L. Shoss of shareholder AIM Capital Management Inc. "They've proven they deserve the benefit of the doubt."
As Enron gets bigger, maintaining its entrepreneurial culture and stiff risk-management controls will surely prove a bigger challenge. And more competition from strong rivals, like Dynegy, means "a lot of the margins are going to go away," says one utility analyst. "Early entrants get generous margins that attract other competitors." One of the biggest risks is that Enron simply can't create the open markets it needs. California stands as a stark reminder of that. If the state goes back to a "cost-of-service" utility model, where utilities simply pass through their costs to consumers, "that would cause us trouble," says Skilling.
But Skilling and other industry players don't think that's likely to happen, as other states such as Pennsylvania prove their deregulation models can work. Indeed, some believe that the nation's muddled effort to move toward deregulation is the best of all worlds for Enron. "If the market were really open and very, very efficient, there isn't a lot of need for these trading intermediaries," says Lawrence J. Makovich, a senior director of electric power research for Cambridge Energy Research Associates. Luckily for Skilling and Enron, that's one vision that's likely to remain a pipe dream for some time.