Empire of the Sun: An Economic Interpretation of Enron’s Energy Business

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The collapse of Enron Corporation has beenportrayed as the result of accounting fraud andgreed. Not everything that Enron did, however,was wrong or fraudulent. Fraud contributed tothe timing of Enron's failure but was not theroot cause of that failure. In analyzing Enron, itis critically important to distinguish what Enrondid wrong from what it did right.

Enron's basic business strategy, known as"asset lite," was legitimate and quite beneficial forthe marketplace and consumers. By combining asmall investment in a capital-intensive industrysuch as energy with a derivatives-trading operationand a market-making overlay for that market,Enron was able to transform itself from a small,regional energy market operator into one ofAmerica's largest companies.

Enron contributed to the creation of the naturalgas derivatives market, and, for a while, it wasthe sole market maker, entering into price riskmanagement contracts with all other market participants.Its physical market presence, as a whole-salemerchant of natural gas and electricity, placedthe Houston-based company in an ideal positionto discover and transmit to the market relevantknowledge of energy markets and to make thosemarkets more efficient.

When Enron applied that same strategy in othermarkets in which it had no comparative informationaladvantage or deviated from the asset-litestrategy, it had to incur significant costs to createthe physical market presence required to rectify itsrelative lack of market information. The absence ofa financial market overlay in several of those marketsfurther prevented Enron from recovering itscosts. It was at that point that Enron abusedaccounting and disclosure policies to hide debt andcover up the fact that its business model did notwork in those other areas.

For its innovations, Enron should be commended;for their alleged illegal activities,Enron's managers should be prosecuted to thefull extent of the law. But under no circumstanceshould Enron's failure be used as an excuse toenact policies and regulations aimed at eliminatingrisk taking and economic failure, becauseunless a firm takes the risk of failure, it will neverearn the premium of success. As was demon-stratedin the case of Enron, markets--not politicians--are the best judges of success and failure.

Christopher Culp and Steve H. Hanke

Christopher L. Culp is adjunct professor of finance at the Graduate School of Business at the University of Chicago, a principal at Chicago Partners LLC, and senior fellow in financial regulation at the Competitive Enterprise Institute. He is coeditor with William A. Niskanen of Corporate Aftershock: The Public Policy Lessons from the Collapse of Enron and Other Major Corporations, forthcoming in June. Steve H. Hanke is professor of applied economics at the Johns Hopkins University, a principal at Chicago Partners LLC, and a senior fellow at the Cato Institute.