Tuesday, January 31, 2006


Low energy

Remember Enron?

The criminal trial of top Enron executives, former Chairman Kenneth Lay and CEO Jeffrey Skilling, began yesterday in Houston. They're being charged with several counts of fraud and conspiracy for their wild run in what turned out to be a sham money-losing company that fraudulently booked profits for several years, making Wall Street look very stupid and ruining lives of thousands of employees who lost their retirement savings. Oh, yeah, and Lay and Skilling sold their own stock just before Enron's collapse to the tune of $500 million.

I just watched The Smartest Guys in the Room, a feature-length documentary on the Enron collapse. While I was disappointed insofar as the film didn't help me understand the intricacies of how Enron's business worked and what the fraud was, the film did a good job of putting across atmospherics of the case.

Three things are clear to me, having seen the film:

1. The Enron collapse, and the hundreds of millions of dollars made in essentially a stock swindle by Enron executives while its company was losing money, is the corporate crime of the century.

2. Enron basically "raped" (the word used by a commentator in the film) California. (See here and here, for background.) In 2001, Enron traders made manipulative trades of power resources to move electric power out of California, and they pressured power companies to shut down plants on phony excuses. The resulting artificial power shortage caused the price of energy to skyrocket, at which point Enron traders sold the power back into the state of California at huge profits. (The one time the company actually made money.) In the film, you get to hear these Enron traders with Texas accents joking about stealing $1 million a day from customers like "Grandma Millie" and saying charming things like:
"Just cut 'em off. They're so f----d. They should just bring back f-----g horses and carriages, f-----g lamps, f-----g kerosene lamps."

3. Enron and Ken Lay were thick as theives with both George H.W. and George "w" Bush. Both as governor and as the boy President, younger Bush received huge campaign contributions from Ken Lay and pushed Enron's agenda to deregulate the power markets so they could do things like manipulate energy prices in California.

If 9/11 hadn't basically pushed all domestic news and policy issues to the back burner, I think Enron would have been more of a continuously powerful story that would have seriously tarnished the Bush administration. Just another way in which the Bush presidency has perversely benefitted from the fact that our country was victimized by a terrorist attack early in his term of office.

I understand the book goes into more detail on the structure of the fraud. It's the sort of thing I'll put on the reading pile once I've settled down enough after reading The Republican War on Science.

More remarkable is the prospect that Lay and Skilling might more-or-less get off, which if I follow the arguments at Conglomerate, boil down to some combination of the near-total fecklessness of certain provisions of corporate law and Houstonians' willingness to stick it to The Man #1 by forgiving swindles by The Man #2.
I just watched Enron: The Smartest Guys in the Room. I can't believe the lengths that the executives went to in the name of greed. I would highly recommend the movie for anyone who would like to get in depth information about the case before the trial. It was also just nominated for an Oscar.
The "intricacies" of Enron's swindle was pretty simple, really. Accounting rules are based on objective valuations; you can't record the value of your car based on your own opinion, but you can record a gain if you sell it to a third party. So, Enron would create assets, and "sell" them to limited-liability corporations actually owned by Andy Fastow, Enron's CFO (who already pled guilty to stealing tens of millions in "fees" from Enron through this personal ownership). Fastow would bully Enron's banks to provide large loans to the LLC's to pay inflated prices to Enron, and Enron recorded large profits on these sales (things like Venezuelan power barges and joint-ventures with Blockbuster to sell movies over Enron's fiber optic lines). But in reality, the banks weren't idiots, and demanded collateral for these loans; the loans were backed by Enron, either in the form of stock warrants (we'll print millions of shares to make good on the loan) or price guarantees (you can sell it back to us in 6 months at a modest but guaranteed profit). In some instances, these LLC's did meet technical accounting rules that 3% of their "capital" came from non-Enron parties, but in some they did not. In all instances the clear intent of the transaction was to pad Enron's income statement or hide losses, or hide debt from its balance sheet. Enron's "fall" came when the true size of its debt load was disclosed, and lenders ran, which dried up the liquidity (access to cash) required by the only truly profitable arm of the company - the gas and energy trading operation. Very good book by the lead WSJ reporters, Emshwiller and Jones, if you want more of the gory details.
Thanks, Eric, that's a clear explanation. There was also "mark to market" accounting, in which the company was allowed to book anticipated future profits, which turned out to be highly speculative and always far in excess of actual returns.

But what the movie failed to convey was what their actual business was supposed to be. How could they "trade" power assets out of California, among other things.
The power market rules for California were set by the state Pub. Util. Comm., run by a former UC Davis law professor (Daniel Fessler). With all deference to the legal profession... the rules were a mess, and literally an invitation to gaming, due in part, no doubt to Enron's lobbying (and Skilling's repeated personal appearances at the CPUC and Calif. Legislature, extolling the virtues of "markets"). Basically, all parties had to sell all their generation into a state Power Exchange. The PX set a single "clearing" price for all generation, so if you owned 3 generating plants, you could low-ball 2 bids and get them dispatched, then set the 3rd bid very high to produce a high "clearing" price which all 3 plants get paid. Or, shut down one plant so the other 2 can effectively name their price. The market rules also ignored physics, so you could "send" power out of state, then "send" it back and avoid price caps. Also, Enron would "schedule" power transactions to overload transmission lines, then offer to "solve" this congestion problem and get paid for unwinding fictional transactions. The idea of taking a commodity that cannot be stored, and forcing all the major consumers to procure 100% of it in the spot market rather than contracting long-term for any of the commodity, sounds insane on its face, but that's what we (I live in CA) did.
Trading power assets is neither an issue nor, in itself, a problem.

Assume you have a generator in Barstow (CA) that can generate (easy numbers) 1G of electricity per hour.

Assume the local demand (including Apple Valley and all other environs) is 800B per hour.

You have 200B/hr excess capacity. You can either (1) operate at 80% capacity or (2) sell that excess to any place accessible on the power grid that has a shortfall.

So long as MC.LT.MR, it makes sense to generate (and sell) that energy to UT, NV, AZ, or wherever it can be delivered.

"mark-to-market" accounting is commonly used throughout all industries. If you make reasonable assumptions about the discount rate (or cost of funds) and future expenses (MC again), there won't be a problem, assuming you are a continuing entity (and that all or most of your competitors are).

What can happen, though, is that you can artifically inflate/deflate the price of relatively illiquid assets. (Think thinly-traded stocks; if I tell you XOM is worth $40, you have plenty of evidence contrariwise; a penny stock or tightly-held company, otoh, doesn't trade every day.) But that should be relatively easy to prove as well.
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