California Scheming

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Enron board members testified last week at a Senate hearing

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.

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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.

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