What’s Really Under Indictment?

July 9, 2004 • Commentary
Reprinted from The Wall Street Journal © Dow Jones & Company, Inc. All rights reserved.

The grand jury indictment of former Enron CEO Ken Lay opens the final act of a political morality play that may well influence who sits in the Oval Office next January. For, in truth, the particulars of the indictment against Mr. Lay regarding the corporate governance at Enron are of little consequence compared to the particulars of the indictment against what Enron is believed to represent: unregulated markets run amuck and unrepentant corporate greed. While it’s too early to say whether the indictment against Mr. Lay has merit, it’s not too early to pass judgment on each of the two counts of the indictment against the economic policies of the last several years.

First, is Enron what happens when markets are unsupervised and regulators are asleep at the switch? No, Enron is what happens when politicians believe they can create robust, well‐​functioning markets out of whole cloth and efficiently manage competition via regulation.

California’s restructured electricity market was, in fact, the furthest thing from a capitalist jungle imaginable. The government forced electric utilities to sell‐​off most of their power plants and discouraged them from buying electricity outside of a complicated state‐​managed spot market. Furthermore, the electric utilities were forced to open their power lines to anyone who wanted to use them – like Enron – under tightly regulated terms and conditions.

The day‐​to‐​day management of the grid was likewise taken from the utilities and given to state regulators. While wholesale electricity prices were deregulated, retail prices remained tightly controlled – a combustionable combination. In sum, the state was more heavily involved in the restructured market than it was in the old system we all grew up with.

It shouldn’t come as a surprise to learn that companies like Enron figured out how to game the system with colorfully named strategies such as “Death Star,” “Get Shorty,” “Fat Boy” and “Ricochet.” All involved exploiting arbitrage opportunities offered by the fact that California’s electricity market was actually four separate markets: 24 separate “day‐​ahead” markets (one for each hour of the day) overseen by the state managers of the spot market; a transmission congestion relief market mirroring the 24 day‐​ahead markets; a reserve market managed by the state grid operator; and a real‐​time market overseen by the same.

In a well‐​functioning market, the prices for day‐​ahead, reserve, and real‐​time energy during each hour would be equal in all areas of the West, including California. But because of transmission congestion, price controls, and the fact that each of those market auctions occurred at different times, uncertainty reigned and prices varied widely. Enron, as well as others figured out all kinds of schemes – most of which are perfectly legal – to buy low and sell high within this Byzantine system.

Enron’s strategies were more attractive than they otherwise might have been for two reasons. First, no matter how much they charged for power, retail prices were frozen by law and demand would thus not be effected. A market where price increases do not decrease demand is a dream walking for those selling electricity. Second, the highest priced electricity accepted in the day‐​ahead market established the price for all electricity bought that hour. Because the state allowed a company’s power offer to be broken down into many differentially priced increments, suppliers had an incentive to hold back some power for sale only at exorbitant prices. If the offers were rejected, fine – the volumes of electricity typically offered at those very high prices weren’t so great. If they did get their asking price for any of these small unit offers, however, it was as if everyone in that particular hourly market won the lottery.

Because he did not eschew such strategies, most hold up Ken Lay as the ultimate avatar of endemic corporate greed, the second count of the political indictment at issue. But corporate executives have a fiduciary duty to their stockholders to maximize profit. Moreover, consumers are better off in the long run when market actors exploit arbitrage opportunities because it assists in the efficient allocation of electricity assets across time and space.

Regardless, it is not clear whether Enron was either the largest or even the most aggressive firm involved in such arbitrage. It’s worth noting that during the 2001–2002 crisis, Enron was charging less for electricity on average than were most of the municipally owned public utilities in the Pacific West.

No, if a charge of unconscionable greed is going to be leveled at Enron for its activities during the California electricity crisis, it ought to be leveled on two altogether different counts.

First, Enron was not a passive bystander when this bizarre market was imposed in the form of California Assembly Bill 1890. The company actively lobbied for and aggressively promoted the market structure it eventually exploited. While many well‐​meaning people embraced the reforms (the law, after all, passed the California legislature without a single vote in opposition and was widely embraced by academic economists and all parties to the new system), there’s reason to believe that Enron at least sensed that this brave new world would provide ample profit opportunities given all its problematic imperfections.

Second, Enron apparently broke the law in pursuit of profit within the new system, but to what extent that occurred is unclear. The line between clever arbitrage and actions that violate the rules laid down for the California market is difficult to discern. Still, Enron misrepresented some of those transactions to state regulators and fraudulently reported others.

More serious is evidence found in recently released taped conversations between Enron traders suggesting that electricity was intentionally withheld from the California market to drive up wholesale prices. Now, one can make a reasonable argument that this shouldn’t be against the law (if I own a power plant but can’t decide when it runs and when it remains idle, who really owns the plant – me or the government?), but the fact remains that doing so to jack up electricity prices was well understood at the time to be illegal.

Does all of this add up to a convincing indictment against the market? No. Even those economists like MIT’s Paul Joskow who are most convinced that illegal market manipulation played a major role in the California meltdown continue to support the introduction of (better designed) markets to the electricity sector. Other economists are of the opinion that market design ought to be left to trial and error in the context of more complete deregulation rather than to some template drafted by experts who think they can know a priori how electricity markets could best be organized.

It’s instructive to remember that the accounting shenanigans that eventually led to Enron’s downfall and the indictment handed down yesterday were brought to light not by diligent regulators but by investors who smelled a rat. Enron survived as long as it did because those very same market forces that brought the company down were largely exiled from the California electricity market. Whether that particular narrative is as compelling as the alternative may well influence the course of politics for years to come.

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