California Scheming

By Chris Taylor/San Francisco

When Federal regulators last week released internal memos that showed how Enron squeezed cash out of energy-hungry California, it was hard not to notice how many of the energy traders' secret strategies borrowed names from the state's most famous products. Hollywood was saluted with Get Shorty and Ricochet, while Marin County's George Lucas got a nod with Death Star. Some of the schemes operated in a manner that many Californians found disturbingly familiar: Enron made money hawking electrons that didn't exist. That's a business plan some former dotcom millionaires can remember well.

If it was all meant as an ironic joke, California isn't laughing. It's seething. The energy crisis of early 2001 forced the state to solve its rolling-blackout problem by signing a humiliating $40 billion in long-term energy contracts, the cost of which was passed on to consumers on a sliding scale. Bills today are as much as 67% higher than in 2000. Ever since the ink dried on the deals, lawmakers and grass-roots groups have been trying to recoup their losses at the bargaining table, find closure in the courtroom and persuade the Federal Government to step in and reregulate a market that has been "deregulated" in a partial and haphazard fashion for barely four years.

What many Californians now seek is proof that the situation was not their fault, that neither insufficient supply nor excessive demand caused the energy crisis and that neither conservation nor power-plant construction would permanently fix it. Many Golden State residents, including Governor Gray Davis, believed that traders had manipulated the complex rules for maximum profit regardless of the effect on consumers. And now they have evidence. Documents from Enron's Portland, Ore., law firm describe schemes so commonly used that they had their own lexicon. The documents brazenly admit that if those schemes became known, the result would be a p.r. disaster.

"This does not constitute the smoking gun," says California attorney general Bill Lockyer, "but it is strong ballistics evidence." The internal memos seem to portend more Enrons--one of the strategies, the memos state, was "now being used by other market participants." The Federal Energy Regulatory Commission (FERC) last week asked 150 energy companies whether they had engaged in trading schemes like Enron's. Three firms--Calpine, CMS and Dynegy--last week revealed they are the subjects of SEC investigations. Davis is leaning on the Justice Department to open a criminal investigation.

Wall Street seems to think the West Coast will get its vengeance. Shares of energy companies with big stakes in the California market dropped last week. Dynegy fell 33%, Calpine 12%, Mirant 27%, Williams 11% and Duke 2%. But the financial world wonders, How much of what Enron did was illegal? Get Shorty, for example, was based on the principle of short selling, something sophisticated investors do every day. (In Enron's version, however, there appears to have been some false documentation.) The trading system Enron exploited was full of holes. "Everything the power traders did followed the rules in California," a former Enron trader says--with perhaps a touch of hyperbole. "The state and government people were just too stupid to see it." Should Enron, already under fire for its accounting practices, be further punished for being too successful?

The answer is buried deep in the tangle that is California's energy crisis. Here's how it started: Back in 1996, lobbied by Enron and other energy interests, the state (under then Governor Pete Wilson, a Republican) decided to loosen its hold on electricity production. Responsibility for matching supply and demand was handed over in 1998 to an Independent System Operator (ISO), which would buy from providers (like Enron, Calpine and Dynegy) and sell to middlemen (companies like Pacific Gas & Electric) as necessary, even paying providers to take excess electricity out of the state at times when supplies were flush. And if the markets got too rough? Never fear; price caps were in place.

A major assumption was that the providers would play nice. "It never occurred to us in our innocence that something so vital to society would be treated like a casino," says Davis' top energy adviser, David Freeman. "We thought somehow the hand of Adam Smith would be benign."

But the bard of capitalism would scarcely recognize what California created as a "free market." The rules remained complex and rife with perverse incentives. The benefits to be gained from the system--taking advantage of its loopholes and stretching them wider--are all too obvious. Mike Aguirre, a San Diego lawyer who specializes in fraud and is representing California in one of its suits against Enron, took an energy-trading course in Houston last year in an enterprising bid to understand what the other side was being taught. There he learned Megawatt Laundering, or how to sell California its own electricity for a higher price by pretending it came from out of state. He also learned the Daisy Chain Swap, or how to form a temporary cartel with other traders to inflate prices. "It's clear these companies were signaling among themselves using a vernacular," he says.

The strategies multiplied, and traders were rewarded for coming up with new ones. "You always wanted to stay one step ahead of everyone else," says Stan Cocke, who worked as a power trader pulling 12-hr. shifts in Enron's Portland, Ore., office in 2000 and 2001. "Folks were quick to catch on. People were getting more savvy. We were definitely encouraged to be innovative, to be aggressive." Once a trader found a formula that worked, he or she would send an e-mail around the office, and staff members would toss around proposed nicknames for the idea until one stuck.

It was in this fertile ground that Death Star, Get Shorty and their kin were planted. These two strategies were particularly devious. In the former, Enron was being paid for taking away excess energy that it never really put in, while in the latter, it was buying and selling commitments it never made. This kind of trade, known as "gaming" the market, is prohibited by the California ISO's regulations, but because there were seven different energy markets the ISO had to keep tabs on and because it is so difficult to pin down whether a company has the energy it says it has--who has ever seen a megawatt hour?--the trades were able to slip by.

By December 2000, with prices rising amid a cold snap in Oregon and Washington that made those states want to hold on to excess energy, the ISO was even less inclined to investigate whether Enron was telling the truth about its supply. "When you're 30% short, you're looking for every megawatt," says ISO chief Terry Winter. On Dec. 8 of that year, Winter's stamina was exhausted. He wrote to the FERC asking for price caps to be lifted. Result: the price of a megawatt hour, which was $43.80 at the beginning of 2000, skyrocketed to $292.10 by the end of it. Death Star had struck.

The FERC imposed price caps again in June 2001, which allowed Davis to renegotiate those long-term contracts. But the caps are temporary, and if the FERC decides to remove them this year, there is nothing to stop other energy suppliers from following Enron's strategies. "It's like a cheap Western movie," says Harvey Rosenfield, president of the Foundation for Taxpayer and Consumer Rights in Santa Monica, Calif. "The outlaws come to town. They loot the town. The sheriff comes in. They head to the hills with their loot. As soon as the sheriff disappears, it's going to be the Wild West all over again."

That is why it is such a propitious time for these memos to arrive--and why a legal solution, which could take years, is less important to California than a political fix. Even Davis is sidestepping the question of whether Enron did anything illegal. "It doesn't matter to me if this conduct rises to criminality," the Governor told reporters last week. "The feds' responsibility is to make sure rates are reasonable and just."

Also, putting the matter in federal hands avoids the question of how much California is to blame for a system that effectively created a casino. Nevertheless, the lawyers behind these memos and the chairman of the FERC will appear before Congress this week, and West Coasters can feel that something is being done about their energy costs. This is how California likes to deal with those who mock it--by putting them on television.

--With reporting by Cathy Booth Thomas/Houston, Jyoti Thottam/New York, and Elaine Shannon and Adam Zagorin/Washington

With reporting by Cathy Booth Thomas/Houston, Jyoti Thottam/New York, and Elaine Shannon and Adam Zagorin/Washington