Paper Trail Points to Roots of Energy Crisis

TIMES STAFF WRITERS

One fall day in 2000, in the midst of the California energy crisis, S. David Freeman found himself debating by telephone with Enron's Kenneth Lay, chief executive of the then highflying Texas energy firm.

Freeman, head of the Los Angeles Department of Water and Power at the time, had joined other California officials in pushing the federal government for price controls as a means to rein in a runaway wholesale market.

Government intervention, Lay warned Freeman by telephone, would not work. Extended price caps would keep the market from correcting itself, and frighten away future investment in power plants. Lay, as Freeman recalls it, ended the conversation with this parting shot:

"Well, Dave, in the final analysis, it doesn't matter what you crazy people in California do, because I got smart guys out there who can always figure out how to make money."

Looking back on it now, amid revelations about "Death Star" and "Get Shorty" and other colorfully named tactics concocted by Enron traders, Freeman figures he should have paid more attention: "What he was telling me, in a sophisticated way, was that they were going to game the system."

Over the last few weeks, internal memos, notes and other energy industry materials have kept popping into public view, suggesting in sometimes vivid detail just how the "smart guys," as Lay called them, worked to manipulate the California energy market in 2000 and 2001.

The paper flow, which began in early May with the release of a set of so-called "smoking gun" memos from Enron, has prompted regulators, politicians and other industry figures to begin reexamining the root causes of the crisis and even to consider anew that most fundamental of questions: Was there, in fact, a shortage at all?

Federal regulators, who long maintained that the mess was one of the state's own making--and who, in turn, were maligned by California leaders as cops asleep on the beat--seem to have executed an about-face.

Patrick H. Wood III, the former Texas regulator who late last year was appointed chairman of the Federal Energy Regulatory Commission by President Bush, said that initially he considered the California debacle the result of a flawed deregulation plan. Now he's not so sure.

"I didn't walk in here thinking we needed to do a names, numbers, times and dates and 'Who's your alibi?' investigation of the California market, and now I do," Wood said in an interview. "That kind of analysis is something that we really do need to do ... to get the definitive understanding of what happened in the California market."

While Wood and others say the evidence on manipulation is not yet conclusive, California officials who contended all along that the crisis was artificial are no longer being dismissed as conspiracy theorists. There is more at work now than sorting out the spin and revising history.

Although the crisis faded away a year ago, the Enron memos and subsequent disclosures have given a push to state efforts to retrieve some of the fortune spent to keep the lights on.

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Seeking to Revise Long-Term Contracts

California officials have demanded nearly $9 billion in refunds from power companies on the grounds that wholesale electricity rates violated a federal requirement of "just and reasonable" prices. They have also sought a restructuring of long-term contracts negotiated with generators--often at steep prices--to keep electricity flowing.

At a minimum, the disclosures have poked a hole or two in the vapor of mythology that enveloped the crisis almost from the start. Bottlenecks on the north-south transmission lines, air quality rules, drought in the Pacific Northwest, overworked plants, the demands of the burgeoning California computer culture--all these and more were blamed at various times for driving California's electrical system to the edge of collapse. Even Christmas tree lights had a moment in the defendant's dock.

In testimony before a U.S. Senate committee, state Sen. Joseph Dunn (D-Santa Ana) described what he called the "evolution of excuses" this way: "Prices skyrocket and consumers are told they are suffering the short-term 'pain' of deregulation. Prices remain high, and generators falsely explain that California is a victim of its own demand--despite ranking 48th among the 50 states in per capita energy usage and a demand growth of just 4%, year after year.

"Then we are told there is an outright shortage--a myth that persists today. Next they tell us that the crisis is the result of bad rules, the generators' and traders' way of justifying manipulative behavior. The Enron memoranda and the recent admissions by other market participants reveal the truth about the cause of the energy crisis:

"Certain market participants gamed the system to reap excess profits on the backs of Californians."

Robert McCullough, an Oregon-based energy consultant and early advocate of the view that market manipulation, not scarcity, was propelling the runaway prices, cited several other myths he would like to dispel, including:

* A Pacific Northwest drought depleted hydroelectric supplies, an important source of California energy in summertime peak hours. Hydro supplies were just slightly below average in the summer of 2000, when wholesale prices started to soar, he said. Oddly enough, when the prices declined in mid-2001, hydro supplies were much worse than they had been the previous summer.

* Plants were so overworked that they kept going down for repairs just as they were needed most. On the contrary, McCullough said, citing Environmental Protection Agency data, power plants operated in California by AES Corp., Duke Energy, Dynegy, Mirant and Reliant ran at only 50% of capacity from May 2000 to June 2001. Plants of similar construction and vintage outside of California, he said, were working much harder.

* Congested power lines caused six days of blackouts, and dozens of near misses, in early 2001. McCullough, citing Bonneville Power Administration reports, said that transmission lines from the Pacific Northwest to California were never fully loaded at those times.

"A lot of what was going on," McCullough said, " ... just didn't pencil out."

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Energy Generators Insist No Gouging Occurred

Experts still disagree over just how big a role manipulation played in the crisis. Private energy generators still insist that California dug a hole for itself by not building enough power plants and by bungling its deregulation effort. And what Californians call "gouging," they tend to describe as playing by the rules as the state wrote them.

Indeed, many of the so-called industry "myths," as McCullough and others describe them, do have some basis in truth. There was a drought in the Northwest. Plant construction did slow down for a time in California, as it had across the West. There were clogs in the transmission system and flaws in the electricity market design.

"Every charlatan starts with a kernel of truth," state Sen. Steve Peace (D-El Cajon) said in an interview. "Everything that they pointed to had some kernel of truth to it, some credibility to it. That was the trouble with arguing your way through this thing. Everybody wanted a simple, philosophical, cut-and-dry answer. As opposed to the reality, which is that all these things they point to combine to create an environment that allows unethical, crooked people to take advantage of the circumstances."

In recent weeks, however, new kernels of truth kept emerging.

Last week, a state Senate committee produced a "blueprint" for gaming the California market, a document that it said had been developed by Perot Systems. Perot Systems denied any wrongdoing.

Another industry document, produced by FERC's expanded investigation into market manipulation, caught the attention of Wall Street analysts last week. It contained telephone transcripts in which traders appeared to be discussing assorted ways to manipulate the California market and maybe even share profits.

"We are deeply concerned," noted the analyst, Christopher Ellinghaus of the Williams Capital Group, "that the unveiling of additional documentation related to the California issue will continue to be bombshells for this industry."

So far, though, the most provocative discovery to come to light has been a Dec. 6, 2000, memo from outside attorneys for Enron. It was written after they debriefed traders in the fall of 2000 about their conduct in the California market. In the memo, made public in early May, the lawyers laid out a catalog of trading "strategies." These included laundering megawatts in and out of state and the creation of false congestion on the transmission grid.

The language can be wonderfully accessible. For example, in describing a congestion gambit known as "Death Star," the attorneys wrote: "The net effect of these transactions is that Enron gets paid for moving energy to relieve congestion without actually moving any energy or relieving any congestion."

And a tactic by which electricity was bought by Enron and then exported from California to markets willing to pay even higher prices was defended this way: "This strategy appears not to present any problems, other than a public relations risk arising from the fact that such exports may have contributed to California's declaration of a Stage 2 Emergency yesterday."

As for the colorful names attached to the tactics, it was explained: "Enron's traders have used these nicknames with traders from other companies to identify these strategies." In another document, a set of a lawyer's handwritten notes from the debriefing, a public posture for the firm is proposed should the tactics become the subject of investigations: Answer questions, say nothing ... finger others.

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Only the Price of Power Changed

Some state officials and energy experts contend that the main value of these documents has been to popularize a point they had attempted to make all along--that the steep increases in wholesale prices went beyond what could be expected in the normal fluctuations of a working market. They regret not coming up with catchy names like "Fat Boy" and "Ricochet" themselves.

Said Freeman, who left the DWP during the crisis to become a key energy advisor to the governor: "For a lot of people, all of the sudden, it just clicks. The light bulb turns on."

However compelling the internal documents may be, many California officials insist the best evidence that the crisis was, as Freeman put it, "ginned up" has been there all along, simple and empirical. Demand for electricity was not significantly higher during the crisis period than it had been in previous years. Supply was not drastically lower. All that changed, and changed dramatically, was the price being paid for the electricity.

What happened, according to their scenario, is that in the late spring of 2000, for a variety of reasons, the market began to tighten up. There was still enough juice--by and large the lights did stay on--but the cushion of excess supply shrank. This gave generators and traders what is called "market power," the ability to demand and receive excessive prices over an extended period of time.

Market power traditionally occurs when two or three suppliers control vast portions of a given market.

In California's electricity market, however, such dominance wasn't necessary. With supply and demand curves running more closely together, a small amount of generation offered at just the right time also would do the trick.

Frank Wolak, a Stanford University economist and chairman of the market surveillance committee for the California Independent System Operator, which runs the grid, explained: "Say 10 firms each own 1 megawatt and demand is 9.5 megawatts. There's no shortage, but you're going to have prices at the price cap. Why? Because each firm knows that you need half a megawatt from me no matter what my competitors do to meet demand."

Peace said federal regulators failed to recognize this nuance: "You don't have to have 40% of the overall market to exercise market power. You only need to control the right electrons at the right time. And that's what these guys did."

Anjali Sheffrin, director of market analysis for the independent system operator, has churned out chart after chart tracking demand and price for California electricity since 1998, when the state began its transition away from a regulated energy model. The lines stay relatively flat month after month, until May 2000.

At that point, like the wild scratching of a polygraph machine when the suspect begins to tell fibs, the wholesale price curve starts to shoot upward. It peaks in December 2000, a month when wholesale prices were running 10 times higher than they had the year before--even though demand was virtually unchanged. The price line finally flattens out again at what had been normal levels in June 2001--after FERC essentially rewrote the market rule book for California and the entire Western grid, imposing price limits and closing loopholes.

Sheffrin has reworked her numbers many times to incorporate all the supposed forces behind the rising prices. Each time, in examining the price spike, she has found the same thing: "A significant portion of it--even after you accounted for cost of production, emission, everything--occurred because suppliers were demanding high prices."

And getting them: "In all my reports," she said, "what I show is that whenever supply and demand get real close, even though you're not in a shortage situation, then suppliers can name their price. That's what market power is."

In this context, questions of whether plants were shut down needlessly for "unscheduled maintenance" or traders shipped California electricity out of state take on added importance.

Ongoing federal and state investigations are exploring whether generators withheld supply--either by idling plants, or through manipulations of the bidding process--to preserve their market power and strike only when prices were at their highest.

As the crisis unfolded, other oddities were noticed. Prices for wholesale electricity during off-peak hours--early Sunday morning, say--began to climb nearly as fast as those of the busiest afternoon hours. There was a wintertime spike in natural gas prices, the fuel needed to run many California plants; gas prices were high everywhere in that period, but the increases in California exceeded those registered in other states many times over.

Of the half-dozen rolling blackouts that finally did materialize, most occurred not in the summer, when demand for electricity tends to be at its peak in California, but in the cooler months.

Wolak, for one, finds this remarkable: "That says to me, these guys figured out [they're] the only game in town. Declare enough forced outages, and you will be able to jack the price up through the roof."

Traders and suppliers, of course, spun a different story throughout. In October 2000, about the time Lay was debating price caps with Freeman on the telephone, and energy companies were posting huge boosts in third-quarter earnings, and Enron traders were telling the lawyers about Death Star and Get Shorty and the rest of their tricks, a leading Enron trader, Tim Belden, addressed his colleagues at a conference on volatile energy prices.

He said he was baffled by it all.

"We sit here, we listen to everybody talk," Belden said. "Each side is compelling. You scratch your head. You maybe say, 'I have no idea.' Is there scarcity? 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 PhD in engineering. You need to have done significant research in market theory and game theory."

At this point, the audience laughed.

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A Bleak Time for Energy Industry

Of course, laughter in the energy industry has been in short supply of late--and not an artificial shortage either. The fortunes of outside energy companies dealing in California tended to follow the lines on Sheffrin's price chart. And now, seven months after the collapse of Enron, the merchant-energy industry is suffering one of the bleakest periods in memory.

Of the 123 industry groupings in the Standard & Poor's 500 blue-chip stock index, the Multi-Utility category--made up of Duke Energy, Williams Cos., Dynegy, Mirant, Calpine and AES, California players all--finished dead last for the month of May, with an aggregate decline of nearly 23%.

Every day, it seems, brings another damaging revelation, another investigation launched, another executive resigned. In California, there's talk among industry leaders about establishing voluntary codes of conduct for traders. And even some of the best allies of the energy generators express disappointment in the mind-set revealed by the Enron memos.

"It's personally offensive to me," said Jan Smutny-Jones, executive director of the Sacramento-based Independent Energy Producers, which represents power plant owners, "as someone who's spent a lot of time working on markets in California ... to have someone creating congestion in order to get paid for fixing it."

He pointed to a window in his Sacramento office.

"This window doesn't have a sign on it that says do not throw a rock through it, but most people have a common sense that you don't throw rocks through windows. If we need to put a sign on every window that says don't throw rocks through it, that's fine."

Meanwhile, the investigations proceed.

Dunn, whose committee has smoked out some of the most damaging documents, sat in his office the other day surrounded by 33 yet-to-be explored boxes of internal Enron paperwork.

"The tip of the iceberg" is how he described what has transpired so far. He recalled the long stretches early on when the investigation into possible market manipulation often was dismissed as something of an Oliver Stone production: long on conspiratorial theory, short on the goods.

"At some level," he said, "there's relief that what we suspected for a long time has proven to be true. But economists said that you can't have this sort of wealth transfer going on without something having gone wrong in the market. They were right. When you saw the transfer of wealth we had in so short a time, something's wrong."

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Times staff writers Ricardo Alonso-Zaldivar, Richard Simon, Thomas Mulligan and researcher Maloy Moore contributed to this report.

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