Monday, February 4, 2008

Energy: Learning From The Mistakes Of Others

Way back in 2000-01, when I was but a wee lad in my Freshman year at Pomona College in (the eastern border of) Los Angeles (County), my $36k/year school was hit with "rolling blackouts." I grew up in the mountains of Santa Cruz, and the power went down at least once a year. In elementary school, this was sufficient cause for school cancellation. In college, class was cancelled the first day, but alas, thereafter we were required to attend class in the dark. The blackouts had an upside, though, they forced us out of our rooms and into the emergency lighting of the dormitory halls. This probably did more for our camaraderie than any of the school's group spirit building activities. Eventually, the school bought an exemption and we returned to our rooms to hone our bridge skill on the internet for our regular contests of bidding for points above the line to secure our rubbers.

At the time, we were told that there was an energy crisis; there was a lack of energy. With time, it was discovered that a company called Enron had somehow manipulated the markets and the shortage was merely perceived. Supposedly, "deregulation" was at fault. This was my understanding of California's energy crisis until I took a course in Energy Law and Policy.

The U.S. energy industry has been on a steady path of deregulation. The only ones who have fought for regulation are the state-sanctioned monopolies and the, now defunct, monopsonies. Monopolies are safe and are guaranteed a return on investment according to the rates they are allowed to charge, and monopsonies just get to rake in money hand over foot. And, hell, it's always cool to be the only guy in town. Competition is important in all aspects of the energy industry because competition drives innovation in energy efficiency and energy price, competition encourages the construction of new generation facilities, competition encourages the building of energy transportation infrastructure, and competition was driving the growth of green energy by allowing energy retail consumers to choose energy providers and thereby creating a market for green energy. The Energy Policy Act of 1992, and the implementing FERC initiatives, started the U.S. on the road to energy deregulation because prices were too high, there were too few generation facilities, transportation infrastructure was poor, and consumers wanted to choose their retailers.

The problem was that in California, the deregulation did not go far enough. Prices on the wholesale spot market within California were deregulated, but retail prices to consumers were capped. By the authority of the Commerce Clause of the Constitution, the FERC chose to cap wholesale prices on energy sold from California to other states. This mix of regulation and deregulation allowed power marketers, such as Enron, to step in and manipulate the market.

Power marketers are necessary in a deregulated market because they create a futures market which helps to stabilize energy prices. Problems arise when power marketers start manipulating the market to their own gain at the bad faith expense of others.

Enron engaged in five primary market abuse tactics to drive wholesale energy prices up. They even went so far as to give each con scheme a cute name:
  1. Wash Trades: this is the sale of electricity to another company with a simultaneous purchase of the same electricity at the same price. This gives the appearance of both business and market activity, which results in both making the company look more financially healthy than it is, and in making the energy demand look more robust than it actually is pushing up price.
  2. Death Star: Enron would accept payment to relieve electricity line congestion. Due to the physical nature of the electron, it is impossible to relieve line congestion with a paper trade, and this just added to the cost of wholesale electricity.
  3. Fat Boy: Enron would schedule high MWs to its subsidiaries, and then only use a fraction. They paid for energy they did not need, to drive up the price of electricity.
  4. Get Shorty: There were several different markets, and Enron would make electricity deals on the day-ahead market, which it didn't have the ability to do, and then purchase the electricity for those deals on the more volatile hour ahead market.
  5. Ricochet: It is not completely clear that this scheme is illegal, but under the regulatory framework, Enron could purchase wholesale energy at the capped rate from California companies, and then sell that energy in other states with deregulated wholesale energy prices.
Enron wasn't wholly to blame, other power marketers and energy wholesalers were also withholding power from California energy retailers thus driving prices through limited supply. And, though these guys were acting like a bunch of jerks, California was also hotter than usual that year which placed a much higher than usual strain upon the energy grid due to increased AC use.

The effect was that after it was discovered how easily wholesale prices could be manipulated, wholesale prices shot through the roof. While wholesale prices soared, retail prices were capped, and wholesale prices quickly exceeded retail. Energy retailers began operating at a loss. Soon, the retailers' creditors grew unwilling to lend them money to purchase the necessary electricity on the spot markets. Without electricity, the retailers had to impose rolling blackouts upon Southern California because energy was simply too expensive. Eventually, the Department of Water Resources bailed us out with a bond initiative, which is attached to each of our electricity bills. And, the fight is on for proper deregulation sometime in the future.

What the heck does this have to do with China?

Well, China's currently in a remarkably similar situation to California in 2000-01. China is as uncommonly cold as California was uncommonly warm, which places great stress upon the energy grid. But the big similarity jumped out at me from the Financial Times article, Coal price debate at root of power shortage. The price of China's primary energy source, coal, is deregulated, while electricity prices are regulated by the government. The coal shortage is, apparently, not caused by manipulation, but by other external factors, and this shortage of supply drives up prices. If the electricity generation companies must pay higher prices for coal, but are required to charge the same rates for their energy, then they are being forced to operate at a loss, or at least a lower profit. Even in a Communist country, it can be too much to ask a power company to operate at a loss.

With worries over inflation in China, the deregulation of electricity is almost certainly a no go. However, deregulation combined with a robust electricity futures market might help alleviate problems. A futures market in both coal and electricity would help stabilize the price of both. A futures market in electricity would require deregulation that isn't there.

The final sentence of the article makes one wonder if there actually is some market manipulation similar to that conducted by Enron: "But Beijing appears equally furious at the brinkmanship of the power companies. Mr Brock said: “I think the power companies’ tactics have backfired.”"

A key component of vision is having the ability to learn not from your own mistakes, but from the mistakes of others. Those Enron guys were some slippery jerks, but they were named Fortune Magazine's "Most Innovative Company" for 6 straight years, defrauded West Coast utilities out of $1.8 billion, and cost tens of thousands of people around the world their jobs. And, they accomplished this in one of the most tightly regulated securities environments in the world. If China truly has vision, I hope they see the error of our ways, and prevent this abuse in their country. Ex post facto executions do not count.

More Reading on China's Energy and Weather Crisis

China's Power Crisis at All Roads Lead to China
Extreme Weather Affecting Operations in China & China Storm Update at Managing the Dragon
China leadership Winter 2008 tour at Imagethief
China's Weather Report: Because It Really Matters at China Law Blog
The Call of the Home at China Business Law Blog
Winter weather updates at CER


Bill said...

Haven't you heard that China is unique, and any solution must be suitable for the current situation in China, with Chinese characteristics ? Learning from someone else's mistakes is not possible.

Will Lewis said...


Thank you! I love starting my day off with a hearty laugh.