The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (49 page)

THE
BEWILDERED
ISO
SCHEDULER
:
Cause, I mean, it’s—it’s—it’s a—I mean . . . it’s a pretty interesting schedule . . .

BELDEN
:
It—it’s how we—it makes the eyes pop, doesn’t it?

It did indeed. Because there was no way for Belden’s power to be delivered, the PX didn’t have the supply it thought it had. And so the ISO, which handled such emergencies, had to hustle to find replacement supplies. Because the agency was forced to buy a substantial amount of power at the last minute, prices in California shot up by more than 70 percent, resulting in a cost of as much as $7 million to users. There was nothing subtle about Belden’s gambit. “Someone played a game yesterday,” reported a newsletter called the
Energy Market Report
. Almost immediately, complaints from other market participants triggered an investigation.

The investigation dragged on for almost a year. Belden’s essential defense was that he wasn’t trying to break the rules; he was simply performing an experiment. In fact, he claimed, he was doing the state a favor by pointing out such a huge flaw in its regulations. Enron’s hypocrisy was stunning: Ken Lay wrote to the Cal PX in November 1999 that Enron “believes in conducting business affairs in accordance with the highest ethical standards . . . your recognition of our ethical standards allows Enron employees to work with you via arm’s length transactions and avoids potentially embarrassing and unethical situations.”

Enron’s arrogance was equally stunning. Greg Whalley, Belden’s boss, flew to California to argue Enron’s position. In a meeting with a Cal PX economist, he went up to a white board and filled it with supply-and-demand charts, explaining all the while why the California market was flawed. “It was like Whalley was a college professor, lecturing him,” recalls an Enron lawyer who was there. Whalley’s position was that it wasn’t Enron that was at fault; the problem was the foolishness of the rules, which were so easy to take advantage of. His argument was a little like an eight year old telling his parents that it was their fault he’d done something wrong because they weren’t watching him closely enough.

In April 2000, the Silverpeak case was settled. Enron neither admitted nor denied the allegations that it had violated the market rules, but it agreed to pay a fine of $25,000 and promised to not “engage in substantially the same conduct.” The agreement was signed in large, upright handwriting by Greg Whalley. “This ‘experiment’ clearly demonstrates a disregard for the Cal PX’s primary goal of maintaining efficient and fair markets,” concluded the Cal PX investigators. If Enron had really been worried about a flaw in the system, they added, “the appropriate response would have been to bring the matter to the attention of appropriate policy makers at the Cal PX rather than disrupt the market for its own education.” But no changes were made to market rules. And internally, Belden wasn’t even reprimanded for Silverpeak, though he had hardly been upholding “the highest ethical standards.” Then again, why would Enron reprimand him? He was making money for the company.

In fact, even as Whalley was signing the settlement agreement, Belden and his team were busy devising similar schemes. These were subtler than the Silverpeak experiment—now that it was for real, it seems that the traders didn’t want to get caught—but the purpose remained the same: to manipulate the rules and make money in the process. In one scheme, Enron submitted a schedule reflecting demand that wasn’t there. The West Coast traders called that one Fat Boy. Another was a variation of the Silverpeak experiment: Enron filed imaginary transmission schedules in order to get paid to alleviate congestion that didn’t really exist. That was called Death Star. Get Shorty was a strategy that involved selling power and other services that Enron did not have for use as reserves, with the expectation that Enron would never be called upon to supply the power or would be able to buy it later at a lower price. The point of Ricochet was to circumvent California’s price caps. For instance, Enron exported power from California and brought it back in when the ISO was desperate and had to pay far higher prices. (This strategy, which was used by all the power traders, was more widely known as “megawatt laundering.”)

When a trader found a formula that worked, he would send an e-mail around the office. On May 5, 2000, for instance, an Enron trader named Michael Driscoll sent an e-mail to his fellow traders. “The
FINAL
PROCEDURES
FOR
DEATH
STAR
 . . .” read the subject heading. The e-mail, which contained detailed instructions on how to replicate the strategy, noted that “project deathstar has been successfully implemented to capture congestion relief across paths 26, 15 & COI.” The e-mail concludes with “
THANKS
AND
GOOD
LUCK
.
” (Driscoll’s year-end list of accomplishments in 2000 noted that he had also “implemented the Round the West trade strategy—taking California power out in the Southwest, up the Rockies . . . and back into California” and that he was an “innovative trader.”)

One advantage the traders had in playing their games was the use of Enron’s own utility, Portland General. It wasn’t long before the utility’s transmission lines became a part of the company’s machinations. For example, as Portland General later told the Federal Energy Regulatory Commission (FERC), some of the transactions it did during this time “may have resulted in the company purchasing power from the Cal PX and reselling power from its portfolio of supplies at prices higher than those paid to the Cal PX.”

The U.S. Senate Committee on Governmental Affairs also says that transcripts of Portland General employees reveal transactions where the apparent purpose was “to assist Enron in exporting power from California with the intention of reimporting it back to the state at higher prices.” It’s not clear how complicit Portland General was, but several transcripts make it sound as if the old-line Portland General employees, unlike the West Coast traders, hated what they were being told to do. On an April 6, 2000, transcript of Portland scheduling calls, one Portland employee responsible for scheduling power transmission tells another: “I’ll sure be glad when we’re sold and they can’t pull this [expletive] anymore.” At other times Portland General transmission workers describe Enron deals as “messed up,” “stupid,” “the weirdest junk,” “convoluted,” and “bogus.” Another says, “This is a scam and you know it.” Even an Enron trader acknowledges that certain deals are “kind of squirrelly” and “nasty.”

Indeed, Enron couldn’t have pulled off many of its strategies without the help of third parties, which had access to generation and transmission lines that Enron itself didn’t control. But that turned out to be not much of a problem; many competitors, as well as out-of-state utilities and power suppliers, were only too happy to oblige. There was money in it for them as well. According to a later FERC report, an undated Enron document notes that the traders were pursuing a strategy of “gaining control of a variety of small resources or capabilities around the west.” By 2000, Enron had agreements with Montana Power, Powerex, El Paso Electric, and others. (“These prices provide extraordinary opportunities,” Enron wrote to El Paso in July 2000.) An Enron Services Handbook contained a list of various market conditions that might arise, which of the “partners” to call, what steps to follow in order to take advantage of a particular situation, and an explanation of the profit-sharing arrangements.

“El Paso wants to play again,” wrote an Enron trader in one e-mail. “They are willing to . . . profit share (fat boy) into the ISO. . . .” Over time, Enron noted, it would “store operational data” from its partners. It wanted, the handbook said, “to lock customers in—if they leave . . . their data stays here.” This strategy of enlisting other players gave Enron more information, more market share, and more access to power generation and transmission. Under the rules, it was supposed to report resources it controlled to the FERC. The FERC says it didn’t. It seems that the Enron traders simply didn’t believe any outsider would ever be smart enough to connect the dots.

 • • • 

In addition to his short-term schemes, Belden had a long-term outlook on electricity. Despite Enron’s predictions that prices would fall after deregulation, he had a different view. He had become convinced that the economics of power in California were such that prices were going to rise. His calculation didn’t have much to do with gaming the rules of deregulation; it was rooted instead in his reading of several larger trends.

One trend was that the California economy had gone through a tremendous boom in the 1990s, a boom that had included an enormous expansion of computing power, thanks in part to the rapid growth of Silicon Valley. As computer companies and dot-coms grew, they used more power. At the same time, though, the state’s strict environmental laws prevented major new power plants from being built. In other words, Belden believed, demand was growing and supply was not keeping up. Perhaps more important, Belden also believed that California had begun to rely far too much on an abundant supply of hydroelectric power. According to his analysis, hydro accounted for some 40 percent of the resources used to produce power throughout the West. What would happen if there were a dry year? Because of the way the California market was structured, with the utilities forced to buy most of their power on the spot market, any shortage could send prices spiraling upward. The result wouldn’t be the panic selling the deregulation gurus had envisioned; it would be panic buying.

Acting on Belden’s theory, the West Coast trading desk took a huge long position in electricity in late 1999. By the spring of 2000, Belden’s prediction began coming true. Unseasonably warm weather boosted power needs. At the same time, because of lower snow pack, or snow density, there was less hydroelectric power available from Oregon.

Almost overnight, the surplus became a shortage, and California needed every megawatt it could get its hands on. Soon, the ISO, which was just supposed to balance supply and demand around the edges, was providing 20 percent to 25 percent of California’s total energy needs and paying increasingly higher prices for power. On May 12, 2000, Belden e-mailed a colleague in Houston: “We long. Pricing keep going up. So far so good.”

On May 22, 2000, the ISO was forced to declare a Stage 1 emergency, because its power reserves had dropped below 7 percent. Before May, prices had averaged $24 to $40 per megawatt hour; now they quickly hit the price cap of $750 per megawatt hour. Industry experts were in a state of shock: it wasn’t even summer yet, and supply and demand were not wildly out of whack. Why was the price of electricity going up so much?

It became frighteningly clear that May 22 was no isolated event. All through June, power prices remained at sky-high levels. Emergencies became increasingly common; the ISO wound up declaring 55 emergencies in 2000 and another 70 in 2001, compared with just 17 in 1998 and 1999 combined. Suddenly, utilities were bleeding money because they were forced to pay far more for their power than they could collect from customers, who were still paying regulated rates.

In mid-June, as temperatures in the Bay Area topped 100 degrees, Pacific Gas & Electric was forced to declare rolling blackouts—the first since World War II in California—in part because a plant that it sold to Duke Energy (as the new rules required) was taken offline for maintenance. Entire neighborhoods saw their power shut off for an hour to two hours at a time—at which point their power was turned back on and another neighborhood went dark. In just that one month, the total wholesale cost of electricity topped $3.6 billion, roughly half of what power had cost for all of 1999. The ISO, in search of a solution, lowered the cap on the price it would pay for power generated in California from $750 per megawatt to $500 and finally to $250.

And so it went, all summer long. In San Diego, the one city where consumer rates had been deregulated (that’s because the local utility had earned back all its losses from those onerous long-term contracts), power prices doubled between May and August. Small businesses had to shut their doors because they couldn’t pay their bills. State officials pleaded with companies and consumers alike to turn down their air conditioners and dim their lights. Schools that had obtained lower rates by signing contracts under which their power supply could be interrupted—never thinking that such a thing could happen—had to send students home because their electricity was shut off. Companies with similar contracts had to turn off their air conditioning entirely, even though it was approaching 100 degrees outside. The big California utilities were suddenly in deep financial trouble. People were enraged. Protests sprang up all across the state. By the end of the summer, California was in full-crisis mode.

And Enron was taking full advantage: Belden and his West Coast trading desk were booking profits the likes of which they’d never seen before, some $200 million just between May and August of 2000, according to a presentation Enron later gave to Moody’s. That was roughly four times the profit the desk had made in all of 1999, according to the government.

But
why?
Why was this happening? To hear Enron and the other power sellers describe it, the whole debacle was California’s fault. The state needed to build more power plants; that was the only way supply and demand would get back into balance. And it needed to stop trying to keep an artificial lid on prices, which only made things worse. Indeed, to Enron, the two issues were intertwined. As Belden put it in an e-mail to the ISO, “prices need to reflect market conditions in order to incent new generation.”

Later, Belden addressed an industry conference, which was covered by the
Los Angeles Times
. “Is there scarcity?” he asked. “Is there a smoking gun? We still don’t know. How did we get here? Well, first, these complex markets were designed by economists and engineers. If you want to trade power in California for Enron, the minimum requirements are, you need to have a law degree and a Ph.D. in engineering. You need to have done significant research in market theory and game theory.” At which point, the audience laughed.