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By the time voters go to the polls in November, two to three energy companies could join Enron in bankruptcy. With the public furor over declining stocks and corporate greed already at a high pitch, these new failures could bring about a new round of re-regulation to the energy sector.
House Minority Leader Richard Gephardt (D-Mo.) has described headlines about corporate bankruptcies as “daily evidence of what happens when the drive to deregulate succeeds as it did over the last seven or eight years.” When questioned about Gephardt’s indictment of the Republican agenda, Senate Minority Leader Trent Lott (R-Miss.) essentially agreed that deregulation was to blame, but made sure to note that such ill-conceived polices “had to be signed by the president or they didn't go into law.”
Oddly, Clinton used to be criticized for adopting Republican causes for political purposes. Now he is chastised for not putting the breaks on these same initiatives.
Both Gephardt and Lott are correct to blame the bankruptcies on the partial deregulation of wholesale power markets. Before liberalization, these markets were dominated by monopoly utilities that willfully submitted to regulation so long as they were guaranteed a tidy profit. These companies could not go bankrupt because they faced no risk; state and federal regulators underwrote their entire operation.
This system produced such inefficiency that once certain markets were liberalized, investment came gushing in. Energy merchants and traders, like Enron, Williams, Dynergy, Reliant, and Duke succeeded in garnering billions in funding because incumbent utilities were so stodgy and inefficient that it seemed possible to dramatically undercut their prices and earn high profits at the same time.
These greedy corporate interlopers raised billions of dollars to invest in more efficient electricity generation, more streamlined delivery platforms, and robust trading operations. In 2000, more than half of the world’s 150,000 megawatts of power equipment purchases came from American businesses. By the end of 2001, the entire US gas and power industry was saddled with $450 billion in debt, much of it issued by new entrants whose debt increased by 110 percent over the past three years.
Economists have long recognized that liberalized energy and gas markets tend towards boom and bust cycles where companies over-invest when prices are high and under-invest when prices are low, or artificially constrained by government.
But this boom turned to such a bust – this year, American energy companies are expected to purchase equipment for only 5,000 to 10,000 megawatts of new capacity – because investors did not properly discount for the industry’s political risk. Robust competition between these new well-financed energy firms pushed wholesale power prices well below forecasts, but it was political obstacles that shrank the market, undermined returns, and persuaded these companies to massage their earnings.
Incumbent utilities successfully blocked competition in more states (most of the southeast) to place artificial political constraints on the traders’ growth. Then California successfully lobbied federal regulators to place peak price caps on the Western grid. With markets smaller than forecast and power prices bound by politics, energy traders could not generate the cash flow necessary to support their hefty debt burden and credit rating.
When life was good, the Enrons of the world only exposed themselves to trading partners of investment grade credit ratings. With so many counterparties to its forward swaps, Enron did not want to deal with companies it could not count on for delivery or payment. Enron’s bankruptcy was a product of this preoccupation, as a credit downgrade triggered repayment clauses Enron could not honor.
Yet federal and California state law mandated that these credit-sensitive traders must sell power to California utilities spiraling towards bankruptcy. The two largest utilities, PG&E and Southern California Edison, were not only legally prohibited from negotiating long term power contracts to hedge against temporary price spikes, they were also unable to pass increased power costs onto consumers.
Needless to say, the credit sensitive traders were concerned about the utilities’ ability to pay and charged sky-high power prices to reflect that risk. Now the greedy corporate raiders are more likely to end up in liquidation than collecting on the money. Ironically, the state, which assumed the utilities’ role as power purchaser in 2001, continues to refuse to pay these debts because power prices were so high. But the reason power prices were so high was to account for the risk that the state would refuse to pay.
Energy traders “of the future” failed because they were too optimistic, not too greedy. Their business was trapped in a political universe light-years from the trading operations they envisioned. To commodity traders obsessed with efficient operations and capitalizing on the thinnest of margins, political rules made little sense.
The rationality of the political markets and the energy markets are two very different things. Investors who believed political barriers would fade away because of their irrationality discovered that the political rules are designed to ensure reelection, a completely different type of rational decision-making.
The unfortunate lesson for investors is that it would be better to model Congressional and state legislature voting patterns than consumer demand if they are to avoid getting burned in the power market.