For once smooth-sailing power generators and traders, each day seems to bring a horrific Jaws-like sequel. Just when investors think it's O.K. to wade back in, another shark surfaces in waters that haven't been safe since Enron Corp.'s implosion last fall. "I've been in this industry for 30 years, and it breaks my heart to see it in such a mess," says Sally Hunt, special consultant at National Economic Research Associates Inc.
In the past six weeks, revelations of questionable accounting and trading maneuvers at Dynegy Inc., market manipulation in California by Enron, and phony trades and inflated revenue at Reliant Resources Inc. (REI ) have roiled jittery markets. William F. Hall, senior vice president for energy policy and strategy at Duke Energy Corp. (DUK ), blames "immature players who aren't managing their businesses well" for "casting a big cloud of suspicion over all." But the fallout will go well beyond battered stock prices and reputations.
Federal and state regulators are sure to exert more oversight and demand increased disclosure. A capital-constrained industry plagued by regulatory uncertainty will find it harder to get the money to build plants and pipelines. That could pave the way for future energy shortages. Some players are considering leaving the trading business. And the road to broad deregulation of the power markets appears blocked for years. "It's a mistake for people to assume that deregulation in the power business is simply inevitable," says Lawrence J. Makovich, a senior director at Cambridge Energy Research Associates.
The extent of the fallout depends to some degree on how widespread the market manipulations turn out to be. After internal memos showed that Enron traders may have boosted profits by overstating demand and creating phony congestion in the California power market, the Federal Energy Regulatory Commission (FERC) moved to see if others engaged in similar tactics. The agency has asked more than 130 companies to provide details on their 2000-2001 trading practices by May 22.
Sure, it's a giant fishing expedition spawned by political uproar. But the inquiry is "a real test for [the pro-market] FERC," says agency Chairman Patrick H. Wood III. He vows to release an interim report on the probe this summer.
Yet even if widespread abuses are found, the agency, which has been criticized by California Democrats for foot-dragging, has limited tools at its disposal. It has civil statutory authority, so any criminal activity that turns up would be handled by the Justice Dept. FERC can levy fines, but they would be mosquito bites to power giants. Violations get fines of $500 a day fine, and a willful violation is limited to $5,000. The White House has asked Congress for hikes to $25,000 a day and $1 million, respectively, but there's no change yet.
FERC is also working on rule changes to make electricity transactions more transparent. It recently proposed a rule requiring traders to submit more details about who they're trading with and for how much. Industry lobbyists oppose it, saying it would force them to reveal too much detail to rivals. But FERC officials say this "sunshine" approach would prevent future abuses. FERC can order refunds, which agency insiders say is the most likely outcome.
And that could play into the hands of deregulation opponents and California politicians such as Governor Gray Davis, who's trying to renegotiate $36 billion in long-term power contracts and is seeking refunds of $9 billion from marketers and generators.
Certainly, better safeguards will be needed before deregulation's prospects improve again. In the 17 states that have begun to open competition for retail customers, there has been no huge backlash yet. But those that haven't acted won't move forward now. And state regulators are stepping up their vigilance, even though their market structures don't share California's fatal flaws. One reason: Even supposed success stories such as Pennsylvania and Texas have found their systems open to abuse. "I don't think any energy market is immune to manipulation of this kind," says Joe Bowring, market monitoring unit manager for PJM Interconnection LLC, the operator of the mid-Atlantic grid that includes Pennsylvania, Maryland, and New Jersey.
Indeed, the revelations about Reliant and trading partners CMS Energy Corp. (CMS ) and Xcel Energy Inc. (XEL ) raise questions about broader abuses. On May 10, Reliant pulled a $500 million private debt placement amid news that its traders had pumped up revenues 10% in the past three years with so-called "round-trip" trades. Reliant blamed "misguided" employees for trades in which the company would buy and sell the same commodity at the same price with the same partner. While there was no impact on profits, the fake trades inflated revenues and volumes. It's unclear if such moves affected prices, but the probe is heating up.
Optimists say the problems aren't as bad as they appear to be. But others suspect the trading games were widespread in the rush to impress Wall Street. "There's overall investor disgust with this sector now," says one analyst. No wonder Dynegy (DYN ) stock is down 65% since Jan. 1, Reliant is off 47%, and Mirant (MIR ) has lost 46%.
Many power players are trying desperately to appease skittish rating agencies and lure capital. Williams is in talks with what it calls "strong financial houses," such as Berkshire Hathaway Inc., for new investment. Gerald Keenan, an energy expert at PwC Consulting, figures merchant energy companies must refinance $50 billion in bank loans over the next two to three years. "The problem is that the financials on which those loans were made now seem fanciful," he says. "It wouldn't surprise me to see some of these folks simply stop by the bank on the way out of town and leaving the keys to the plant."
Customers in this confidence-sensitive business are demanding more, too. William E. Hobbs, CEO of Williams Energy Marketing & Trading Co., says some of his clients want additional collateral, while others are signing one- or two-year deals instead of five-year pacts. That will mean lower profit growth in the near term.
Financial woes are also prompting the demise of ill-conceived power projects--though that could end up boosting profits. Economist Kemm C. Farney of DRI-WEFA Inc. thinks half of more than 320,000 megawatts of proposed U.S. capacity will be canceled next year. He and others see that as the necessary end to a building boom that created overcapacity. But some worry about aftershocks in two or three years. "You could certainly see some regional shortages in certain commodities," says Hobbs. California, he notes, is "far from out of the woods."
A shakeout is also expected in the trading sector, where hundreds of players buy and sell power and related products to utilities, industrial users, and other big customers. Reliant says it's calling a "time-out." Dynegy says it could exit the business--15% of its operating and equity earnings. It says its "round-trip" trades under question were never included in volumes or revenues, unlike Reliant's. "We still like our business model and think it makes sense, but right now, the market's not giving us any value for it," says President Stephen W. Bergstrom.
Some compare the industry's pains to those seen in banking, telecom, and airlines in the early stages of deregulation. "The growth prospects for the industry are still there," says Gary J. Morsches, a senior vice-president at Atlanta-based Mirant Corp. But first, the industry will have to slog through the long and painful process of rebuilding the confidence of investors, regulators, and consumers.
By Wendy Zellner, with Stephanie Anderson Forest, in Dallas, Laura Cohn in Washington, Dean Foust in Atlanta, and bureau reports