[Senate Hearing 107-458]
[From the U.S. Government Publishing Office]
S. Hrg. 107-458
ENRON CORPORATION'S COLLAPSE
=======================================================================
HEARING
before the
COMMITTEE ON
ENERGY AND NATURAL RESOURCES
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
TO RECEIVE TESTIMONY ON THE IMPACT OF THE ENRON COLLAPSE ON ENERGY
MARKETS
__________
JANUARY 29, 2002
Printed for the use of the
Committee on Energy and Natural Resources
U.S. GOVERNMENT PRINTING OFFICE
79-753 WASHINGTON : 2002
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512-1800
Fax: (202) 512-2250 Mail: Stop SSOP, Washington, DC 20402-0001
COMMITTEE ON ENERGY AND NATURAL RESOURCES
JEFF BINGAMAN, New Mexico, Chairman
DANIEL K. AKAKA, Hawaii FRANK H. MURKOWSKI, Alaska
BYRON L. DORGAN, North Dakota PETE V. DOMENICI, New Mexico
BOB GRAHAM, Florida DON NICKLES, Oklahoma
RON WYDEN, Oregon LARRY E. CRAIG, Idaho
TIM JOHNSON, South Dakota BEN NIGHTHORSE CAMPBELL, Colorado
MARY L. LANDRIEU, Louisiana CRAIG THOMAS, Wyoming
EVAN BAYH, Indiana RICHARD C. SHELBY, Alabama
DIANNE FEINSTEIN, California CONRAD BURNS, Montana
CHARLES E. SCHUMER, New York JON KYL, Arizona
MARIA CANTWELL, Washington CHUCK HAGEL, Nebraska
THOMAS R. CARPER, Delaware GORDON SMITH, Oregon
Robert M. Simon, Staff Director
Sam E. Fowler, Chief Counsel
Brian P. Malnak, Republican Staff Director
James P. Beirne, Republican Chief Counsel
Shirley Neff, Staff Economist
Howard Useem, Senior Professional Staff Member
C O N T E N T S
----------
STATEMENTS
Page
Bingaman, Hon. Jeff, U.S. Senator from New Mexico................ 1
Cantwell, Hon. Maria, U.S. Senator from Washington............... 59
Domenici, Hon. Pete V., U.S. Senator from New Mexico............. 51
Johnson, Hon. Tim, U.S. Senator from South Dakota................ 2
Makovich, Lawrence J., Senior Director and Co-Head, North
American Energy Group, Cambridge, MA........................... 43
McCullough, Robert, Managing Partner, McCullough Research,
Portland, OR................................................... 38
Murkowski, Hon. Frank H., U.S. Senator from Alaska............... 4
Newsome, James E., Chairman, Commodity Futures Trading Commission 23
Nugent, William M., President, National Association of Regulatory
and Utility Commissioners...................................... 18
Schumer, Hon. Charles E., U.S. Senator from New York............. 63
Seetin, Mark, Vice President, New York Mercantile Exchange....... 7
Shelby, Hon. Richard, U.S. Senator from Alabama.................. 3
Thomas, Hon. Craig, U.S. Senator from Wyoming.................... 50
Viola, Vincent, Chairman, New York Mercantile Exchange........... 30
Wood, Patrick, III, Chairman, Federal Energy Regulatory
Commission..................................................... 8
APPENDIXES
Appendix I
Responses to additional questions................................ 75
Appendix II
Additional material submitted for the record..................... 79
ENRON CORPORATION'S COLLAPSE
----------
TUESDAY, JANUARY 29, 2002
U.S. Senate,
Committee on Energy and Natural Resources,
Washington, DC.
The committee met, pursuant to notice, at 9:30 a.m. in room
SH-216, Hart Senate Office Building, Hon. Jeff Bingaman,
chairman, presiding.
OPENING STATEMENT OF HON. JEFF BINGAMAN,
U.S. SENATOR FROM NEW MEXICO
The Chairman. The hearing will come to order. The purpose
of this hearing is to receive testimony on the impact of the
Enron bankruptcy on energy markets and the interaction of
Enron's activities with energy markets over a period of time.
The problems of accounting misrepresentations, lost pension
funds, potential tax abuses, those, of course, are the subject
of other hearings which various other committees are
participating in.
Irrespective of the various financial issues regarding
Enron's corporate structure, the company played a significant
part in the Nation's infrastructure and markets. In addition to
its energy trading operations, Enron owned and operated several
major interstate pipelines, including one that traversed my
home State of New Mexico, and they also own the largest
electric utility in the State of Oregon. The trading operations
have been suspended, but the pipelines and the utility continue
to operate and to provide reliable service.
Before its failure, Enron Online was the largest fiscal
marketplace for energy products in the United States. I also
understand Enron traded unregulated financial instruments
called SWAP's, and over-the-counter instruments. The role of
Enron and other energy traders in the highly volatile gas and
electricity markets in California had come under increasing
public and congressional scrutiny.
In 2001, the committee held four investigative hearings to
evaluate the natural gas and electricity markets in California
and the implications for other States in the West. In the first
hearing, which we had January 31, 2001, the need for
transparent markets--both with respect to pricing and
capacity--was identified as one of the most pressing
requirements for well-functioning electricity markets.
Enron's trading activities were different from those of a
regulated exchange. Enron Online did not match buyers with
sellers. It contracted with each separately, so that Enron was
on the other side of every deal. Enron provided little or no
market transparency. That is, parties were not given
information as to the price and volumes that were offered to
others.
Market transparency is essential to efficient and
competitive energy markets, both in the short term and over the
long term. Over the long term, the market must signal the need
for additional capacity and new fuel supplies to ensure
reliable and affordable energy services. Whether adequate
capacity was available or not in the West last year should have
been apparent in the market before the crisis appeared. As we
understand the actual events of this past fall, when Enron's
financial situation became known, many parties who had been
trading with Enron shifted to other fiscal markets. NYMEX, the
New York Mercantile Exchange, also served as a major source of
stability. In the end, it is my impression Enron's demise did
not have a major impact on short-term energy markets.
The proposed energy legislation that we have introduced in
the Senate as S. 1766, Senator Daschle introduced and I
cosponsored the bill, tries to ensure transparency and real-
time reporting of trades. The FERC has increased its oversight
of individual companies. It has created a new market-monitoring
function which we hope to hear about today. The States also
have a critical role in ensuring adequate supply, planning, and
procurements.
We look forward to hearing the testimony of the witnesses,
and engaging in a thorough discussion on these issues. Senator
Murkowski, why don't you go ahead with your statement.
[The prepared statements of Senators Johnson and Shelby
follow:]
Prepared Statement of Hon. Tim Johnson, U.S. Senator From South Dakota
Mr. Chairman, this is an important hearing we are holding today.
The demise of Enron has been well-documented and its impact is being
considered in many venues, including other committees in the Senate.
The scrutiny of the company is proper: Enron is a major entity of the
nation's energy system and was one of the most profitable companies in
the nation. The effect of Enron's fall on both its internal operations,
its employees and its effect on markets needs to be examined thoroughly
to determine the root of the problems and so that we can learn lessons
for the future.
The Energy Committee is properly looking into the effects of this
situation on the nation's energy markets. Over the last couple of
years, we have seen many ups and downs in energy prices and in the
wholesale energy markets, where Enron made the bulk of their profits.
It seems, for the most part, that the market has responded well to the
Enron's demise and picked up the slack. Fortunately, there have been no
disruptions in service. But had this occurred last year when there were
rolling blackouts in California and when there was poor weather, the
effect could have been catastrophic.
The market also responded partially because many of Enron's
contracts were above current market prices, which its competitors were
rightly eager to pick up. Had the contracts been below market prices,
there could have been greater disruption in the system. In addition,
many other generators and trading entities, while still profitable,
have seen their stock prices drop since the Enron demise. This may make
it more difficult for the market to adjust to changes in the future.
I do not believe that Enron should be blamed for every issue that
arises or is now present in the energy field and many of the problems
with Enron are largely because of its improper accounting and financing
practices rather than its trading operations. But because Enron was the
largest operator in a somewhat volatile area, we need to examine
closely the role of the energy trading markets and how they effect
energy service. Having a robust market is good for the nation. But it
is largely unregulated, at least when compared to other trading
markets. I am not prepared to say at this juncture that any changes are
needed to the system but it is clear that we must take a closer look.
Moreover, it is also clear that Enron's role in the energy
legislation needs to be examined. In particular, it is my hope that the
Vice President and his task force will be more amenable to turning over
information about the meetings that occurred and the process that led
up the issuing of its report. Reforming our energy system is an
important matter and we must do so in an open manner as this committee
has done in holding dozens of hearings on energy legislation. Every
citizen of the nation is affected by energy services and it is
important for the Administration to be as open as possible in
addressing these concerns.
Thank you, Mr. Chairman, and I look forward to the testimony of the
witnesses.
______
Prepared Statement of Hon. Richard Shelby, U.S. Senator From Alabama
Thank you Mr. Chairman for calling this hearing today and I wanted
to thank our witnesses for being here to offer their perspective into
the collapse of Enron.
Mr. Chairman, the collapse of Enron offers a very interesting story
for all of those willing to invest the time and energy to investigate.
I believe that the story is just beginning to unfold and in the weeks
to come we will learn even more about the rise and fall of this energy
giant. It is certainly unnerving to hear of the significant losses that
were encountered by hundreds of Enron's stockholders and company
employees. But the bright spot in all of this, as I believe we will
hear today, is that our energy markets and energy consumers came out of
this relatively unscathed.
Experience has taught us that we should not judge before all of the
facts are before us. It is my hope that we do not pre-judge this event
and rush to take legislative action before we know all of the facts.
Enron received a number of exemptions to certain important laws. It is
also becoming very apparent that Enron's business and accounting
practices were not above board--they were not honest, they were not
forthright, and most importantly they were not transparent. I believe
that we must wait for all of the facts to come to light and the
investigations to be completed before we begin to make legislative
recommendations, if any, about the appropriate course of action to
prevent another ``Enron debacle''.
Today's hearing is intended to focus on the impact of Enron's
collapse on energy markets, but the witnesses were also asked to
consider existing statutory authorities and changes proposed by S.
1766, including the repeal of the Public Utilities Holding Company Act
(PUHCA). After reviewing the testimony of our witnesses, it appears
that many of you have some interesting thoughts on repeal and/or reform
of PUHCA and I am anxious to discuss that in more detail with each of
you.
Mr. Chairman, it is no secret that I am a strong advocate of
reforming the Public Utilities Holding Company Act. In my opinion, the
law is antiquated, duplicative, and has outlived its usefulness. I
believe, and the Securities and Exchange Commission (SEC) has
suggested, that since PUHCA's inception, a comprehensive system of
investor protections has been developed that obviates the need for many
of the specialized provisions included in PUHCA.
Over the years, as the restructuring debate has evolved, utilities
and the SEC have called for reform or repeal of PUHCA, asserting that
PUHCA has achieved what it was designed to do and that in the current
evolving energy marketplace, PUHCA discourages competition. In 1982 the
SEC recommended to Congress that PUHCA be repealed. In a 1995 study of
the regulation of public utility holding companies, the SEC called for
a conditional repeal of PUHCA. And in recent testimony before the House
Committee on Financial Services, Isaac C. Hunt, Jr., Commissioner of
the U.S. Securities & Exchange Commission stated, ``. . . because much
of the regulation required by PUHCA is either duplicative of that done
by other regulators or unnecessary in the current environment, the SEC
continues to support repeal of PUHCA. As the SEC has testified in the
past, however, we continue to believe that repeal should be
accomplished in a manner that eliminates duplicative regulation while
also preserving important protections for consumers of utility
companies in multistate holding company systems.''
Mr. Chairman, as I mentioned at the beginning of my statement, I
think that it would be misguided for us to walk away from today's
hearing believing that we have all of the answers. As the investigation
into Enron's activities progresses and as more and more government
regulators are called upon to testify in various committees of
jurisdiction, I believe that a complete picture will emerge. The
Securities and Exchange Commission and the Department of Justice are
currently investigating Enron's collapse to determine if there were
violations of existing laws. I think we should begin to make
recommendations and changes to guarantee the stability and transparency
of our energy marketplace after the investigations give us a clear
picture of what happened.
STATEMENT OF HON. FRANK H. MURKOWSKI, U.S. SENATOR
FROM ALASKA
Senator Murkowski. Thank you very much. Good morning, and
let me wish all the members a belated Happy New Year.
I think it is fair to say that Enron's collapse appears to
be a story of lies, deceit, shoddy accounting, corporate
misconduct, cover-up, etc.
Unfortunately, Enron's employees and stockholders have been
devastated by this action. We have seen a thousand people
unemployed, billions lost, retirement funds wiped out.
Therefore, we cannot forget that this is a business failure,
not an energy market failure. I think it is important to
reflect on that, because I think it is accurate. Today's
hearing can be useful if we explore the impact of Enron's
collapse on energy markets, on price and supply, as the title
suggests. However, if the hearing is used to set the stage to
speak about the need for additional Government regulations of
the energy market, then we will not have a very productive
hearing.
A number of committees are holding hearings on accounting.
You have heard from the chairman indicating that a number of
other committees are meeting as well. Commodity regulations,
these are not matters of our jurisdiction or expertise.
I will focus on the subject of this hearing, the impact of
Enron's collapse, and its collapse on energy markets. It is
clear that energy markets are working well, despite Enron's
failure. Enron was responsible for about one-quarter of the
wholesale electric and natural gas markets in this country, but
notwithstanding Enron's dominant position in the market. Its
bankruptcy had little impact on energy markets or on price and
supply. We saw that the lights stayed on and retail electric
prices did not spike. Gas furnaces did not go out. Why? I think
the answer is simple. Deregulated markets work. When market
forces are allowed to work, when government does not
micromanage the marketplace, markets match supply and demand.
Take a look at this chart. When Enron failed competing
companies swooped in and immediately filled the Enron void.
Consequently, no shortage or price spikes were seen, which this
chart points out. You can see that the big price spike was
associated with California activity, but there were no
significant trends, as evident in the chart. Enron's collapse
did not have any significant impact on natural gas either.
There was an effect on the stock prices of other energy
companies, and certainly a chill on generation. This investment
was primarily the result of concerns about credit quality and
exposure to deals with Enron.
Now, compare Enron's collapse with what happened in
California last summer. California is a poster child, an
example of how government command and control prevents markets
from working. Thus, creating shortages and price spikes.
California tried to micromanage the marketplace, capped retail
prices, forced divestiture of generation, required all power
purchase from the stock market, prohibited utilities using
long-term contracts, and made new construction virtually
impossible. They spent billions of taxpayer's money to pick up
the pieces after they broke the market.
The results we now know. Last year, the slightest twitch in
the California power market, such as; hot weather, and
powerplants needing maintenance, created black-outs or price
spikes. My point is, government micromanagement of the
California market hurt the consumers it was trying to protect.
So the story we ought to be hearing today is, deregulation
benefits consumers while government market manipulation hurts
consumers. I fear the story we might hear instead is that we
need more Federal interference in the market, that FERC needs
more authority to tinker with the market, that we cannot repeal
PUHCA and instead we need super-PUHCA, that we cannot trust the
free market but we can trust regulators.
I pose a question. If Enron's competitors had to go to FERC
or the SEC for prior approval, how quickly could they have
stepped in to replace Enron? How long would the lights have
been out? Well, we do not know the answer to those questions.
We can only speculate.
I look forward to hearing from today's witnesses about
these issues, about the merits of Federal interference in the
day-to-day operation of the market. I also look forward to the
Senate creating a national energy policy that enhances domestic
energy supply, makes that supply more reliable and affordable,
and reduces our dependence on foreign oil. We need to foster
our regulatory and investment climate, encourage new energy
sources of all types. This includes: oil, natural gas, nuclear,
coal, electricity and renewables, encourage construction of
energy infrastructure, including transmission lines.
I think this is what the administration stands for. It is
what I believe, and I know that it is what the American people
expect Congress to do. We may need to deal with how
corporations keep the books and how employee pension programs
are operated. But let us keep corporate mismanagement in
context with the operation of energy markets. I know in my
banking career, the Comptroller of Currency would not allow
directors to purchase stock and put it in the their own
retirement business portfolios. That was a matter of simple
regulation.
Let me conclude by turning to some of the politics of
Enron. It appears that politics in both Houses are trying to
create a political issue out of Enron's failure. Some are not
particularly interested in the hard-core facts. They are not
particularly interested in protecting consumers or
stockholders. Just look at some of the wild claims we have
seen. At one point the administration has been castigated for
not helping Enron, castigated for proposing an energy policy
that helps Enron. How can you have it both ways?
It is true that many elements of the administration's
policy are consistent with the views of Enron. It is also true
that far more elements of the Clinton administration's energy
policy were consistent with the view of Enron.
Let me refer to my own experience in this area. In my time
as chairman of this committee, I met with Mr. Ken Lay just
once. My contact with their Washington Office was very limited.
They simply did not call, and I can see why when I read the
Washington Post on January 13, 2002, and I quote.
At Lay's meeting with Pena on February 20, 1998, he spoke
of restructuring the U.S. electric market in ways that would
benefit Enron. Lay pressed the administration to propose
legislation that would assert Federal authority over the
national electric markets. Now, what does that mean? That means
they were asking for a date certain for retail competition, and
wanted FERC to preempt the States to make it happen. In other
words, one size fits all.
I quote again, according to a company's version of the
meeting, Lay and Pena agreed that a go-slow approach to the
deregulation advocated by Senate Energy Committee Frank
Murkowski was unacceptable. Pena asked Enron officials to keep
the Energy Department staffers posted on developments in
Congress, and solicited comments on the administration's draft
of its comprehensive national energy strategy. An Enron
document said Lay felt that the draft was headed in the right
direction except for a few points, the document said, end of
quote.
I guess we didn't see eye to eye about how best to ensure
America has an affordable and reliable energy supply.
In conclusion, I think it is also true that many elements
of the current Senate Leader's energy policy are straight out
of the Enron playbook. It is put together without any public
input, through members of the Energy Committee, which was a
tragic mistake on behalf of Senator Daschle, and I think he is
aware of that.
It should be pointed out that Enron has never wanted to
deregulate electricity. It said it wanted to federalize
electricity. Enron wanted different regulation, not
deregulation. I indicated from a certain date under
deregulation for everybody to come in at once for retail
competition. They wanted FERC to preempt the States to make it
happen, create a one-size-fits-all system that benefits
national markets here such as Enron. The system would ignore
local concerns and interests, and Enron wanted special
provisions of particular benefit to Enron.
Unfortunately, this is reflected in the Daschle bill. Just
a few examples: One, FERC authority to restructure electric
power industry. Two, FERC open access on all transmission
lines, including Federal. Three, uniform liability standards
under FERC control; and four, transmission information
disclosure that would have benefitted Enron's trading
activities, special transmission access and benefits for wind
generation--Enron owns a wind generator company--a renewal
portfolio standard that benefits wind generation, Federal
preemption of States and consumer protections. FERC is given
exclusive authority over electric reliability, and Nation-wide
uniform interconnection standards.
So in my opinion, as they say, those that live in glass
houses should not throw stones, or those that live in glass
houses perhaps should not take baths.
In any event, I look forward to hearing from today's
witnesses. Thank you, Mr. Chairman.
The Chairman. Thank you. Before we start, we have six
witnesses here today, and before we start with their testimony
I have asked Mark Seetin, who is the vice president of the New
York Mercantile Exchange, to give us about a 4-minute summary
of some of the definitions that we are going to be talking
about today, just as a refresher course, and then we will start
with testimony.
My intent would be to have each of the witnesses testify
for about 8 minutes, and then have panel members here asking
questions, give each one 7 minutes to make any statements they
wish, and ask whatever questions, and then we will have
additional rounds as appropriate.
Mr. Seetin, why don't you go right ahead.
STATEMENT OF MARK SEETIN, VICE PRESIDENT, NEW YORK MERCANTILE
EXCHANGE
Mr. Seetin. Thank you, Mr. Chairman. I will indeed try to
be brief, but as you rightly stated, the terms of art sometimes
get lost in the discussions.
First of all, the risk management marketplace, particularly
with energy and metals, has an regulated and unregulated side.
On the regulated, are overseers, the CFTC, as Chairman Newsome
represents here today, that the instruments offered are futures
contracts, and options on futures contracts. On the unregulated
side, in which instruments that really have much the same
function as the futures side but yet are under no regulatory
purview, forward contracts, over-the-counter or SWAP
instruments, and over-the-counter or OTC options.
A futures contract is a binding obligation to make or take
delivery of a specified quantity and quality of a commodity at
a specified location and time. The key is uniformity. Every
NYMEX oil contract is for 1,000 barrels with American Petroleum
Institute standards, so every time you trade a NYMEX contract
you know exactly what you have in that regard.
An option is a second step back from the futures contract
in that it is a contract between a buyer and a seller where the
buyer has the right but not the obligation that they have in
the futures contract to buy or sell the underlying commodity at
a fixed price over a specified period of time in exchange for a
one-time premium payment. It is a little bit like a deductible
insurance premium payment. If you buy insurance on your car,
you take a $500 deductible. That is quite similar to the way
options operate, and you have regulated options, those that are
listed on exchanges like the New York Mercantile, and options
that are offered over-the-counter in the unregulated
marketplace.
What is a forward contract? A forward contract is a
contract in which a seller agrees to deliver a specified cash
commodity to a buyer sometime in the future. In contrast to
futures contracts, the terms of forward contracts are not
standardized. Forward contracts are not traded on Federal
exchanges.
When I was farming, I would go to the elevator and get a
forward contract for 10,000 bushels of corn to be delivered in
December. That was a contract between myself and the green
elevator to be delivered at a forward time, not regulated.
What is an OTC or a slot contract? This is an agreement
whereby a floating price is exchanged for a fixed price over a
specified period. It is an unregulated financial arrangement
which involves no transfer of physical energy. Both parties
settle their contractual obligations by means of a transfer of
cash. The agreement defines volume duration and a fixed
reference price. Differences are settled in cash over specific
periods, maybe monthly, maybe quarterly, maybe over a 6-month
period.
So it is an arrangement between the hedger and the provider
of that OTC slot, and they say, we will use NYMEX, for example,
as the base price. Every month, if your price is above, I will
pay you. If the price is below the NYMEX price, you pay me.
That does the same thing, in essence, as a futures contract. It
allows one party to lock in the price.
What is a derivative? A financial instrument traded on and
off exchange, the price of which is directly dependent on the
value of one or more of the underlying securities, commodities,
or other derivative instruments, or any agreed-upon pricing
index, and the reason I put this last is because all of the
previous instruments that we talked about are considered
derivatives. Derivatives is a very encompassing term.
And with that, Mr. Chairman, I have completed, and look
forward to the testimony today.
The Chairman. I think that is useful background, and a
refresher for many of us. I appreciate it very much.
Let me start with Pat Wood, who is the Chairman of the
Federal Energy Regulatory Commission, and who has substantial
responsibility on a lot of the issues we are trying to
understand here. Why don't you give us your testimony, and
indicate the most important things you think we ought to be
aware of as we try to move forward.
STATEMENT OF PATRICK WOOD, III, CHAIRMAN,
FEDERAL ENERGY REGULATORY COMMISSION
Mr. Wood. Thank you, Mr. Chairman. I will break my
introductory remarks into two parts, what we perceive happened
from the FERC, and what we have done in the general arena to, I
guess, the issues that are raised by market monitoring.
Enron's collapse, just to cut to the chase, certainly as
one who comes from that State, and a lot of friends of mine
worked with the company and are invested in it, or were retired
from it, it is a human tragedy. But I think from our
perspective in this hearing today is to look at more soberly
the impact on the market, that I think Senator Murkowski
correctly praised as being vibrant and supportive of a lot of
healthy interaction among market participants, but the collapse
itself has had little perceptible impact on the commodity at
wholesale of electric and gas markets in the country, which are
the primary responsibility of the FERC. These energy markets
adjusted quite quickly to Enron's collapse, particularly when
you consider that Enron accounted for 15 to 20 percent of the
trades in these aggregated markets.
Our monitoring of energy markets to date has indicated
there has been no immediate damage to the energy trading in
both gas or electric, or certainly in the underlying physical
energy supplies. As can be expected, there has been some
volatility in these markets, with the swift exit from them of
trading that has impacted liquidity in the markets, and so the
ranges have traded--and our staff is actually investigating
that, and I will be glad to share with the committee as we get
to some conclusions on that, but with few exceptions in the
physical market, very few exceptions. In fact, I just got a
letter on the first one, a small company in Missouri, but
people have been able to rearrange their physical deals without
any impact, or perceptible impact with the underlying deals
that they had executed with Enron.
On the day that it was announced that there was a formal
investigation by the SEC into Enron, the commission staff began
to immediately monitor the spot markets and contact market
participants to evaluate what impact this significant
announcement could have on the trading in the Nation's energy
markets. Again, as I mentioned, the volatility increased, but
as I think Senator Murkowski's aggregated chart shows, and the
charts that are more closed in on 2 months that are attached on
the back of my testimony, in both power and gas markets the
general trends in prices due to both the weakened economy and
to oversupplies of both gas in storage and of power and the
rapid increase of new powerplants across the country, generally
were unaffected by that. That downward trend that we saw going
prior to Enron continued through the Enron collapse and
continued on into what has been a very mild winter, so the
weather is still primarily the key driver in these commodity
prices, much as I think Chairman Newsome will mention they are
for just about everything else, but that was no exception here.
At the point we began to monitor Enron Online, the online
trading faction much more closely--as I mentioned in my
testimony in some detail, it is a trading platform where Enron
is a party and many providers can come to it as buyers or
sellers--we looked at that particularly in comparison to other
markets which have multiple buyers and sellers coming together
to ascertain if the spreads in Enron Online and the spreads in
the other markets were comparable and, in fact, throughout the
entire 60-day period they were, so we are looking and continue
to look at that as an issue.
To Commission staff in talking to market participants
throughout this period, it became very clear that these market
participants were readjusting their business deals with Enron.
They were what we called flattening the books, which is to kind
of be neither long nor short on the future deals that they had
with each other, but to kind of basically exit Enron from the
transaction and stick the market participants in a place that
did not include Enron.
So the positioning that the parties did helped the calmness
in the market. Certainly there was not a frenzied reaction from
I think folks on our side of the fence or on your side of the
fence, that time gave people the opportunity to restructure
their business deals, and to basically reflect the fact that
Enron may not be the party they wanted to do business with any
more.
Enron is more than just an energy trader. It owns a
pipeline, a set of pipelines which we regulate. Those have not
filed for bankruptcy. We continue to monitor those. We set the
rates for those. The safety issues for those are overseen by
the Department of Transportation. Of course, safety is much
focused on in light of the September 11 events, and from
everything that we oversee and that we do, the pipeline
industry there looks fine.
PGE, which is a large electric utility in Oregon, is also
an owned subsidiary of Enron. It was announced prior to Enron's
collapse that that utility would be sold to Northwest Natural.
That proceeding is pending before the FERC and other regulatory
authorities, and I expect will move forward on its traditional
track unaffected by the filing for bankruptcy at Enron.
The commission has done a number of things in the interim,
mostly prior to the Enron events, to improve our ability to
monitor markets, to oversee markets, not to re-regulate
markets, but to oversee them to give buyers and sellers
information that they need to ascertain what the proper price
that they ought to pay for delivery of gas or delivery of power
ought to be.
We have set up, as you mentioned, Senator Bingaman, a new
Office of Market and Oversight and Investigation, as I have
testified before the committee my intention to do so. We have,
in fact, posted for the director of that office, and met with
our staff to discuss how this office would work within the
context of our statutory mission, and I look forward to
actually some superior candidates from across the country that
are interested in making markets work that want to see this
continue and I have had some very, I think, attractive
candidates for not only the top job but for people that want to
participate in that, and I think that is a healthy transition
from the whole cost of service world that we were good at to a
market referee, market oversight world that I think we can be
very good at.
We have the assets and facilities to do that. I expect that
as we develop these things I will be visiting with the
committee more if there are any issues that we need with regard
to reporting requirement authority. I mentioned some certainly
in regard to Senator Wyden's transparency language that we are
moving forward on that effort, but I think certainly any time
we ask for information we are challenged. I expect as part of
asking for new information we will also quit asking for old
information. I think that is what agencies need to do.
The OMB is pretty good about reminding us that we need to
clear out the underbrush when the world changes, and we expect
to do that, but in the new world of markets the need for
information is very important. It is, to me, disclosure and not
re-regulation. I think it is important to kind of keep that in
balance, but we have looked at that. Staff has worked forward
since September a very strong proposal about what the data
needs are going to be at the commission. I look forward to
moving forward on that.
We have also interestingly--and I see my time is out--have
asked for comments on a number of rulemakings at the commission
revising rules that have been on the books for a number of
years to reflect the new market. One of them in September we
put out actually asked if we should regulate or require
affiliate standards of conduct to be applied to activities such
as Enron Online, much as the SABRE data base was discussed
during the American Airlines litigation with the Department of
Justice. That is out there.
We have also asked if there should be additional accounting
requirements that we have historically exempted power marketers
from. If the SEC has a better solution there, and they may have
published one last week, as I reference in my testimony, we
certainly would not see the need to do that.
So we are moving forward on a number of fronts. I guess in
closing my final, I guess, plea and concern is, this industry
is one that requires a tremendous amount of capital on a daily
basis to build powerplants, to build gas pipelines, to build
power transmission lines, to build the local distribution
companies, to put meters on pipelines and houses and
businesses, and I think if I would just ask anything on behalf
of the need to continue that capital flow, it is that we do
keep these issues focused, as I think what I have heard in your
public statement so far, that we focus on what is really the
issue here, and the issue so far has not been that energy
markets had anything to do with it. In fact, I would say energy
markets are what saved the country from the collapse of this
country being so dramatic. It is a large player. It is a big
company. For it to have been digested so efficiently through
the market is quite a testimony to the efficiency of the market
that that company and many, many others have advocated for the
better part of the decade.
I look forward to answering your questions.
[The prepared statement of Mr. Wood follows:]
Prepared Statement of Patrick Wood, III, Chairman, Federal Energy
Regulatory Commission
i. introduction and summary
Mr. Chairman and Members of the Committee: Thank you for the
opportunity to testify on the implications of Enron's collapse on
energy markets.
The bankruptcy of one of the largest energy providers in the
country has stunned both the energy and investor communities, and many
employees and retirees saw their savings accounts all but vanish.
But the collapse of Enron has not caused damage to the nation's
energy trading or energy supplies. In the aftermath of Enron's
collapse, prices in energy markets remained stable, trading within
expected trading ranges, and, importantly, neither electric nor gas
deliveries have been disrupted. The Federal Energy Regulatory
Commission (Commission) has monitored the effects of Enron's collapse
on energy markets and has not found any substantial spillover effects.
The nation's electric and natural gas markets' resilience following the
swift collapse of one of its major participants indicates a high degree
of robustness and efficiency.
I disagree with those who claim that the Enron collapse sounds the
death knell for competition in energy markets or justifies nationwide
reimposition of traditional cost-based regulation of electricity. The
facts available to date indicate that Enron's failure had little or
nothing to do with whether energy commodities and their delivery to
customers are monopoly regulated or competitive. Rather, Enron appears
to have failed because of its questionable non-core business
investments and the manner in which it reported on its financial
position to its owner-investors and to the broader business community.
Based on the facts as they appear now, Enron's actions would have led
to the same result whether its core business focused on energy, grains,
metals or books.
ii. enron's impact on gas and electric markets
Enron's collapse had little perceptible impact on the nation's
commodity (wholesale) electric and gas markets, which are FERC's
primary regulatory responsibility. Energy markets have adjusted quickly
to Enron's collapse. The Commission's monitoring of energy markets
indicates that there has been no immediate damage to energy trading or
energy supplies. Although Enron transactions comprised 15 to 20 percent
of wholesale energy trades, its demise has had negligible effects on
trading. With a few exceptions, parties were generally able to
rearrange the deals they had executed with Enron.
Market Monitoring and Reactions
From late October 2001, when news of a likely formal investigation
of Enron and its auditors by the Securities and Exchange Commission
(SEC) first became known, to early December 2001, after Enron's
declaration of bankruptcy, spot market data indicates that there was no
change in natural gas or electric wholesale prices that could not be
attributed to weather or other fundamentals. (See Figures 1 and 2 in
the Appendix for graphs of spot market prices).* As may be expected,
Enron's swift exit from trading may have increased volatility somewhat.
Our staff is currently investigating this concern more thoroughly.
---------------------------------------------------------------------------
* The appendix has been retained in committee files.
---------------------------------------------------------------------------
Following the news of a formal SEC investigation of Enron in
October 2001, Commission staff contacted market participants to learn
whether any supply obligations might be in jeopardy. Staff began
monitoring EnronOnline more closely, particularly any changes in the
margins between the bid-ask prices on EnronOnline, as a widening of
these bid-ask spreads might signal less liquidity in the market; but
there was no significant change in the margin between the bid and ask
prices on EnronOnline.
Commission staff also contacted counterparties and received
assurances from them that they were adjusting to Enron by
``shortening'' their positions and not entering into longer-term
arrangements with Enron. In mid-November, when it appeared that the
Dynegy merger with Enron might be jeopardized, staff observed no
significant change in the margin between the bid and ask prices on
EnronOnline; at the same time, there was a marked increase in the
volume traded on other online trading platforms, such as Dynegydirect
and Intercontinental Exchange (ICE). Commission staff again contacted
energy traders to determine whether major supply disruptions in
wholesale markets were occurring, and was informed that Enron had
``flattened its books,'' i.e., made its portfolio of trades neither
long nor short so that it could more easily ``step out'' of
transactions and not cause disruption. As events unfolded in late
November and early December, other market participants stepped into
these deals. With the exception of certain lightly-traded points, it
appears that Enron's competitors have filled the void left behind by
Enron.
The reason for this overall calmness in commodity prices is basic.
Although Enron was a significant player in electric and gas markets--as
a pipeline, as a commodity trader, as a futures contract trader, and as
a market maker--there were many other players in these large,
established commodity markets, and a great deal of market diversity.
Once it became apparent that Enron might not be a stable counterparty,
its trading partners began to systematically adjust their positions and
practices in the marketplace, moving to other trading platforms and
partners. A similar process occurred among the counterparties to
Enron's longer-term, untraded gas and electric contracts. Thus, over
only a few weeks time, the gas and electric markets systematically
minimized Enron's role in the marketplace and the likelihood that a
company-specific failure could significantly affect the underlying
commodities. I believe the calm but vigilant reaction of the
Commodities Futures Trading Commission, among others, during this
period allowed time for this unwinding to take place.
The flexibility of today's energy markets allows a buyer losing its
supply to replace the energy in real-time (at least briefly) through
imbalance services offered by transportation providers. With more time,
such as an hour or more before a supply will be lost, a buyer generally
can arrange alternative supplies from a wide range of sources. Thus,
the risk of a buyer having insufficient energy because of a seller's
default appears to be manageable, as evidenced by the recent experience
with Enron.
The more substantial risk in these circumstances is the loss of an
advantageous contractual price for energy. Even this risk, however,
depends on market conditions. When a seller defaults, market conditions
for buying energy may be better or worse than when a buyer entered into
its contract with the seller. If better, the buyer actually may benefit
from not having to buy under the existing contract and instead being
able to buy at lower prices elsewhere.
Enron's Market Role
Enron's role in the gas and electric markets was primarily in the
trading of financial assets (commodity and futures contracts) rather
than physical assets (with the exception of its natural gas pipelines,
which continued operation relatively untouched by the events affecting
the parent and affiliated companies). Less than 10 percent of the
contracts traded in these markets involve the initial producer or final
wholesale customer for the product--well over 90 percent of commodity
contracts and futures are between intermediate holders who are managing
risk and facilitating connections between initial producers and
ultimate customers. Adjustments in the financial asset marketplace--as
to the length of a contract or the identities of the counterparties--
rarely affect the flow of the physical gas and electricity underlying
those contracts. Thus, while the commodity markets were shortening the
length of contracts and moving more trade to non-Enron partners, gas
and electric deliveries continued unaffected.
Enron does control a number of natural gas pipelines, but its
financial failure has had little apparent impact on their operations.
But even if it had, it is worth noting that the gas and electric
markets have demonstrated their ability to react to and manage around
problems that could affect their ability to deliver electricity and
gas. When a pipeline breaks, a compressor station fails, a transmission
line collapses, or a large power plant goes off-line, the parties in
the market adjust immediately to acquire other supplies and delivery
routes. Having a sufficiently robust energy infrastructure makes this
so. In these instances, prices may well rise and, occasionally,
deliveries to retail customers may be slowed but the wholesale market
reacts swiftly and minimizes the impact to wholesale and retail
customers alike.
In response to the Enron crisis, Moody's has raised the credit
standards for generators and traders. This has forced energy concerns
to rebalance their debt-to-asset ratios, forcing many to reduce debt
and cut back investments in new gas processing, pipelines and power
plants. During December 2001, stock prices of several energy companies
hit yearly lows. Enron's problems, in combination with the recession
and reports of potential overbuilding, appear to have eroded
confidence, making investors more cautious about putting money into the
energy industry. This slowdown in infrastructure investment could be
problematic in some regions as the economy recovers and demand for
energy grows. For that reason, the Commission has accelerated its
efforts to complete the transition to a more competitive wholesale
power market in order to provide investment certainty.
Enron and Competition
The markets' reaction to Enron's collapse demonstrates what good,
working competitive markets do best--a diverse group of market
participants with adequate market information about the players and
commodities act individually to produce a result that works for all.
The nation's wholesale electric and gas markets showed great resilience
and swift reaction time, and demonstrated that they are much stronger
than any individual player in the marketplace.
Some claim that Enron's demise is due to the failure of
deregulation and competition in the electric industry, of which it was
one of many supporters. I strongly disagree. Wholesale competition in
the gas industry has spurred gas production, encouraged pipeline
construction, driven down commodity prices for the past decade and
lowered retail prices accordingly. In the electric sector, wholesale
competition, although it is in its infancy, has enabled the
construction of thousands of megawatts of new power plant capacity
across the country, resulting in lower commodity and retail electric
prices in most regions, and in a cleaner generation fleet.
iii. the commission's regulation of enron subsidiaries
The Commission does not regulate the parent corporation, Enron
Corporation, as it does not engage in activities which are under FERC
jurisdiction. FERC does regulate eleven of Enron's approximately 100
subsidiaries. Our authority, and the specific names of the Enron
subsidiaries subject to our jurisdiction, are described below.
The Commission has jurisdiction over sales for resale of electric
energy and transmission service provided by public utilities in
interstate commerce. The Federal Power Act includes energy marketers
and traditional vertically integrated electric utilities in its
definition of public utilities. The Commission must ensure that the
rates, terms and conditions of wholesale energy and transmission
services are just, reasonable, and not unduly discriminatory or
preferential. FERC also is responsible for reviewing proposed mergers,
acquisitions and dispositions of jurisdictional facilities by public
utilities, and must approve such transactions if they are consistent
with the public interest. We also regulate the issuance of securities
and the assumption of liabilities by public utilities not regulated by
States.
The Commission also has jurisdiction over sales for resale of
natural gas and transportation. However, FERC jurisdiction over sales
for resale is limited to domestic gas sold by pipelines, local
distribution companies, and their affiliates, (including energy
marketers.) Consistent with Congressional intent, the Commission does
not prescribe prices for these sales.
Figure 3, in the Appendix, illustrates the distinction between
physical and financial assets in the energy sector and highlights the
market segments of several Enron subsidiaries. It further identifies
which subsidiaries and market segments fall under FERC regulation.
A. Energy Marketers
Competitive trading of energy by ``marketers'' generally began
about two decades ago. Marketers do not usually own physical
facilities, but take title to energy and re-sell it at market-based
rates. Natural gas marketing began with the deregulation of the price
of natural gas in 1978 and expanded with the Commission's 1992 open
access rule for natural gas pipelines, Order No. 636. In the decade
since Order No. 636, natural gas marketing has developed into a large,
robust activity with many marketers. The Commission lacks jurisdiction
over sales of natural gas by many gas marketers. To maximize
competition we have granted ``blanket authorization'' for those
marketers under FERC jurisdiction so they do not have to file for and
obtain individual approvals to sell gas at wholesale.
In the electric arena, wholesale power marketers began selling
electric energy as early as 1986. The Energy Policy Act of 1992, and
the Commission's 1996 open access rule for electric transmission owners
and operators, Order No. 888, further spurred the development of
competitive electric power trading.
The Commission regulates the following power marketers affiliated
with Enron: Enron Power Marketing Inc., Enron Sandhill Limited
Partnership, Milford Power Limited Partnership, Enron Energy Services,
Inc., and Enron Marketing Energy Corporation.
EnronOnLine
Before its collapse, Enron was the largest marketer of natural gas
and electric power. Enron's Internet-based trading system, EnronOnline,
was until recently the dominant Internet-based platform for both
physical energy (electricity and natural gas products) and energy
derivatives. (Derivatives are financial instruments based on the value
of one or more underlying stocks, bonds, commodities, or other items.
Derivatives involve the trading of rights or obligations based on the
underlying product, but do not directly transfer property.) Although
EnronOnline was the leading Internet-based trading platform for natural
gas and electric power, it faced competition from other Internet-based
trading platforms, such as Dynegydirect and Intercontinental Exchange
(ICE).
Traditional exchanges, like the NYSE and the NYMEX, determine price
by matching the buy and sell orders of many traders in a many-to-many
trading format. In contrast, EnronOnline uses a one-to-many trading
format, where an Enron affiliate is always on one side of each energy
transaction, either as a seller or a buyer. The price of a commodity or
derivative on EnronOnline is determined when a buyer or a seller
accepts an offer or bid price posted by an Enron trader. In the wake of
Enron's downfall, the many-to-many platforms such as ICE have helped to
fill the void, and create a more robust market by reflecting the bid
and offer values of myriad different energy buyers and sellers.
Market-based Rate Authorization
To sell electricity at market-based rates, public utilities
(including power marketers) must file an application with the
Commission. The Commission grants authorization to sell power at
market-based rates if the power marketer adequately demonstrates that
it and its affiliates lack or have mitigated market power in the
relevant markets. FERC conditions market-based rate authority on power
marketers submitting quarterly reports of their purchase and sales
activities and complying with certain restrictions for the protection
of captive customers against affiliate abuse. There are currently 1200
electric power marketers authorized to sell energy at market-based
rates.
The Commission generally grants waiver of certain regulations to
power marketers which receive market-based rate authorization. For
example, these marketers do not need to submit cost-of-service filings
because the rates they charge are market-based. The Commission also
exempts power marketers from its accounting requirements, because those
requirements are designed to collect the information used in setting
cost-based rates. In addition, unless others object, FERC grants power
marketers' requests for blanket approval for all future issuances of
securities and assumptions of liability.
Because the Commission's reporting and accounting requirements are
designed to address a limited set of concerns, and apply only to the
jurisdictional subsidiary at issue, it is unlikely that requiring power
marketers to comply with these requirements could prevent a future
Enron-like failure. Nevertheless, in our current rulemaking proceeding
on accounting rules, we have invited comments on whether the current
exemptions for power marketers from such requirements remain
appropriate.
B. Electric Utilities
A few years ago Enron acquired Portland General Electric (PGE), a
vertically-integrated utility subsidiary of Enron that handles
electricity generation, purchase, transmission, distribution and sale
in eastern Oregon. PGE's retail rates and practices are under the
jurisdiction of the Oregon Public Utility Commission. PGE also sells
energy to wholesale customers in the western United States. FERC has
granted market-based rate authorization to PGE for certain wholesale
sales. Although the Commission waives some of its reporting
requirements for power marketers, it requires continued reporting from
franchised electric utilities such as PGE, so we can monitor whether
its wholesale transactions are inappropriately favoring its affiliates
or harming its captive customers. Although Enron's collapse has had
tragic impacts upon PGE's employee retirement accounts, we have not yet
seen any negative impacts on PGE's ability to meet its obligations to
customers as a result of the Enron bankruptcy. I should also observe
that the sale of PGE to Northwest Natural, announced prior to Enron's
collapse, is pending before FERC and other regulatory bodies.
C. Gas Pipeline Subsidiaries
The Commission has limited jurisdiction over sales for resale of
natural gas in interstate commerce. The Commission has jurisdiction to
regulate only sales for resale of domestic gas by pipelines, local
distribution companies (LDCs), and their affiliates. Consistent with
the Congressional goal of allowing competition in natural gas markets,
the Commission does not prescribe the prices for these sales.
The Commission has authority over the rates, terms and conditions
for pipeline transportation in interstate commerce of natural gas and
oil. The Commission regulates several natural gas pipeline affiliates
of Enron, namely, Florida Gas Transmission, Midwestern Gas
Transmission, Northern Border Pipeline Company, Transwestern Pipeline
Company, and Northern Natural Gas Company.
D. Transactions and Activities Not Regulated by the Commission
The Federal Power Act does not give the Commission direct, explicit
jurisdiction over purely financial transactions, such as futures
contracts for electricity or natural gas. The Commission has asserted
jurisdiction over such transactions only when they result in physical
delivery of the energy which is the subject of the financial contract,
or when such transactions or contracts affect or relate to
jurisdictional services or rates (e.g., financial contracts affecting
firm rights to interstate transmission capacity or the pricing of such
capacity).\1\ While Enron and its subsidiaries engaged in many
electricity futures contracts and other energy-related derivatives, it
does not appear that these transactions have played a significant role
in Enron's demise.
---------------------------------------------------------------------------
\1\ In 1996, the Commission addressed the issue of whether an
electricity futures contract approved for trading by the CFTC would
fall under its jurisdiction, pursuant to the FPA. New York Mercantile
Exchange, 74 FERC para. 61,311 (1996). The Commission found that the
CFTC possessed exclusive jurisdiction over the trading of such futures
contracts, and that the Commission would assert jurisdiction, pursuant
to the FPA, only if the electricity futures contract goes to delivery,
the electric energy sold under the contract will be resold in
interstate commerce, and the seller is a public utility. Id. at 61,986.
---------------------------------------------------------------------------
iv. ferc initiatives in energy markets
In response to rapidly evolving energy markets, the Commission has
implemented a number of new initiatives to improve its market-
monitoring abilities. The Commission's new strategic plan, adopted
September 26, 2001, encompasses three major areas of activity in
overseeing the energy industry:
Infrastructure--working with others to anticipate the need
for new generation and transmission facilities, determining the
rules for cost recovery of new energy infrastructure,
encouraging the construction of new infrastructure, and
licensing or certificating hydroelectric facilities and natural
gas pipelines;
Market rules--ensuring clear, fair market rules to govern
wholesale competition that benefits all participants, and
assure non-discriminatory transmission access in the electric
and natural gas industries;
Market oversight and investigation--understanding markets
and remedying market rule violations and abuse of market power.
This last, third strategic goal is new, and reflects the present
Commission's commitment to ensuring that markets continue to work for
customers. The strategic plan is available on our website at
www.ferc.gov.
To give substance to this third strategic goal, the Commission is
creating a new Office of Market Oversight and Investigation (MOI),
which will concentrate the Commission's market-monitoring resources
into one workgroup and enable the Commission to better understand and
track wholesale energy markets and risk management by analyzing market
data, measuring market performance, investigating compliance
violations, and, where necessary, pursuing enforcement actions. MOI's
work will provide an early warning system to alert the Commission of
potentially negative market developments and let us act more
proactively to address any problems that may arise. We are currently
taking applications for the Director of this Office, who will report
directly to me.
In mid-2001 the Commission created the Market Observation Resource
Center (MOR) to better observe market developments and to enable us to
grasp quickly the significance of changes in market conditions. MOR's
computer hardware, software and subscription web services give us
access to historical and real-time data about energy markets.
The Commission has launched several other initiatives within the
past year to ensure vigilant and fair oversight of the changing energy
markets. In July 2001, the Commission proposed in a rulemaking to amend
the filing requirements for public utilities. The proposal would
require all generators, public utilities and power marketers to file
electronically with the Commission and post on the Internet an index of
customers with a summary of the contractual terms and conditions for
market-based power sales, cost-based power sales, and transmission
service. These companies would also have to report transaction
information for short-term and long-term market-based power sales and
cost-based power sales during the most recent calendar quarter. This
proposal will give the Commission and the public more complete and
accessible information on jurisdictional transactions.
In September 2001, the Commission proposed in a rulemaking to
revise its restrictions on the relationships between regulated
transmission providers (such as Portland General Electric) and their
energy affiliates, broadening the definition of an affiliate to include
newer types of affiliates, such as affiliated trading platforms (e.g.,
EnronOnline).
Also, in September 2001, the Commission staff began a comprehensive
review of the information the Commission needs to carry out its
statutory obligations in the current and evolving markets in
electricity and natural gas. Presently, much of the information we
require relates to the historic rate-setting functions of the agency.
The review so far indicates that some of this may no longer be
necessary, while other information is now more essential to provide
transparency in a competitive marketplace.
In December 2001, the Commission proposed in a rulemaking to update
the accounting and reporting requirements for jurisdictional public
utilities, natural gas companies and oil pipelines. FERC proposes to
establish uniform accounting requirements and related accounts for the
recognition of changes in the fair value of certain security
investments, items of other comprehensive incomes, derivative
instruments, and hedging activities. The proposal is aimed at improving
the visibility, completeness and consistency of accounting and
reporting changes for these items. It invites comments on whether
entities that are currently exempted from these accounting and
reporting requirements, such as power marketers, should be subject to
these proposed regulations.
While I have an open mind on whether the Commission should continue
to exempt power marketers from its accounting requirements, our
accounting requirements are not aimed at the kind of activities
allegedly undertaken by Enron. Based on our historical
responsibilities, FERC's accounting requirements are focused on
providing useful and accurate information for determining cost-based
rates. Cost-based ratemaking encourages utilities to maximize their
claimed costs and minimize their expected revenues, to justify the
highest possible rates. The Commission's accounting rules and auditing
are designed to ensure that utilities with cost-based rates do not
overstate costs or understate revenues. On January 22, 2001, the
Securities and Exchange Commission proposed additional accounting-
related disclosures from a broad universe of companies, including those
exempt from FERC's reporting requirements. Adoption of that proposal
could eliminate the need for the FERC to alter its reporting
requirements in this regard.
v. additional statutory authority
Before we can understand how to prevent another Enron-like
collapse, we must first understand what internal actions and external
events caused Enron to fail. That effort is now underway by this
Committee and elsewhere. Then we must ask whether those actions and
events can and should be prevented in the future.
Whether the Commission needs any additional statutory authority
depends on the role Congress intends for the Commission. Historically,
the Commission's economic regulation has focused on ensuring that
energy markets deliver adequate energy at reasonable prices. The demise
of Enron has had little or no effect on the supply or price of energy.
Instead, Enron's collapse has primarily harmed its investors and
employees. Since it appears that few of Enron's problems affected the
narrow scope of wholesale energy markets, it is not clear that giving
the Commission additional authority within its current scope would
prevent further Enron-like problems.
To encourage greater efficiencies in the energy markets and to
ensure that wholesale competition expands its ability to deliver
reasonably priced, adequate energy supplies to more customers, the
Commission is moving forward to complete its effort to create
competitive national wholesale power markets as it did with natural gas
markets in the late 1980s and early 1990s. Congress endorsed wholesale
power competition in the Energy Policy Act of 1992 and further
endorsement of this effort would certainly be helpful. In particular,
Congress should give the Commission explicit authority to require
regional transmission organizations (RTOs) where it finds RTOs to be in
the public interest. RTOs will broaden regional energy markets,
allowing greater market efficiencies and limiting possible
discrimination in grid operations. Congress should also remove tax
disincentives to transferring transmission assets to RTOs and to use of
public power transmission lines.
Price Transparency
Greater price transparency will help improve the efficiency of
energy markets, by providing buyers and sellers with better information
about market conditions. The creation and operation of broad regional
energy markets with a widely-traded set of energy products will do much
to make this happen. Once RTOs over broad regional markets are
established, operating under fair, clear, stable market rules, price
transparency will improve significantly, even without a Congressional
mandate. This has already happened to an extent in the regions now
served by Independent System Operators (ISOs).
The Commission is moving forward with further transparency, as
discussed above. Without question, Congressional endorsement of this
effort would be helpful. Proposed Senate legislation, S. 1766, would
improve market transparency through better electronic dissemination of
information about trades in the energy markets and the transfer
capabilities of the transmission infrastructure. These measures will
help the Commission establish sound competitive wholesale markets by
validating and broadening the agency's authority to compel such
reporting and information dissemination. They will also help FERC and
financial market regulators and players to better monitor individual
companies' participation and diminish the ability of any individual
player to misbehave or misrepresent in the marketplace.
I offer two cautions, however:
First, while the transparency provisions of S. 1766 address
actual trades, they do not appear to address at least two of
the issues at the heart of Enron's situation--how they handled
and reported the risks and valuation underlying the trades they
were conducting, and how they represented the value of the
trades flowing through their platforms as corporate revenue.
Those are broader financial reporting and regulation issues
that are outside the scope of FERC's jurisdiction.
Second, there is a difficult balance between information
that must be disclosed to make markets work and information
that is commercially proprietary. It is clearly to the public
benefit to implement rules that disclose more information and
improve market transparency, but it is not always easy in
practice to find the appropriate point between reasonable
information disclosure and protection.
But these reservations do not detract from the value that a
provision like Section 208 of S. 1766 may bring to the nation's energy
markets, and I support adoption of an appropriate transparency
provision.
Creditworthiness
The responsibility for ensuring creditworthiness of participants in
wholesale energy trades lies primarily with the parties involved in
those trades. Creditworthiness provisions are included in some
contracts or tariffs filed at the Commission to date, and the
Commission is likely to include some broad creditworthiness provisions
in the standard tariffs that will be developed for all transmission
providers and customers (to prevent the use of individual
creditworthiness terms as discriminatory measures in narrow geographic
areas or against specific players). But, market participants seem best
equipped to develop sophisticated risk management measures and narrow
creditworthiness concerns, and those provisions may be subject to
Commission review for justness and reasonableness.
To the extent creditworthiness issues are raised before the
Commission, we act expeditiously. For example, shortly after Enron
declared bankruptcy, the Participants Committee of the New England
Power Pool (NEPOOL) sought to implement alternative payment and
financial assurance arrangements with Enron Power Marketing Inc., Enron
Energy Marketing Corporation, and Enron Energy Services, Inc. Within a
week of the date of filing, the Commission accepted and suspended these
arrangements (subject to review of the finalized agreement), to protect
NEPOOL participants while enabling the Enron subsidiaries to stay in
the market and continue serving their customers. I do not think there
is any need to legislatively address creditworthiness issues specific
to energy markets.
Public Utility Holding Company Act
If Congress' policy goal is to promote wholesale energy competition
and new infrastructure construction, then reform of the Public Utility
Holding Company Act of 1935 (PUHCA), supplemented with increased access
by the Commission and state regulators to certain books and records,
will help energy customers. Energy markets have changed dramatically
since enactment of PUHCA, and competition, where it exists, is often a
more effective constraint on energy prices. In the 65 years since PUHCA
was enacted, much greater state and federal regulation of utilities and
greater competition have diminished any contribution PUHCA may make
toward protecting the interests of utility customers. State and federal
ratemaking proceedings, for example, are very effective in ensuring
that activities of unregulated businesses do not increase regulated
rates. For this reason, the provisions of S. 1766 which give broad
access to a regulated company's holding company's books and records is
important if PUHCA is to be repealed. But some have argued that certain
provisions of PUHCA may remain valuable in protecting the interests of
shareholders and employees in other regards, and I defer to others on
that point.
As always, I will be happy to provide further information or answer
any questions you may have and offer the services of my colleagues and
staff to the Committee's efforts.
The Chairman. Well, thank you very much. Next let us hear
from Mr. William M. Nugent, who is the president of the
National Association of Regulatory and Utility Commissioners,
as to the perspective from State commissions. Please.
STATEMENT OF WILLIAM M. NUGENT, PRESIDENT, NATIONAL ASSOCIATION
OF REGULATORY AND UTILITY COMMISSIONERS
Mr. Nugent. Thank you, Mr. Chairman, members of the
committee. I am not only the president of NRUC, I am also a
commissioner in Maine. I will present views from my perch in
Maine, and where possible, that of my colleagues across the
country, but I will tell you this has blown up so recently that
our members have not gotten together, chewed it over, and come
up with a particular policy on this.
Maine offers suggestions to FERC, or is pleased to comment
on these issues, because I do not think there is any State
across the country that has got a greater interest in the
success of the wholesale electricity markets than does Maine.
We opened our markets to competition 2 years ago, and since
that time our consumers have been directly and often
immediately affected by changes in New England's wholesale
electricity prices. As much as any jurisdiction we cut the
ties, the regulatory tie between electricity supply and
delivery by requiring utilities to completely divest themselves
of generation. I have brought for the committee's work, and we
can provide this to you for staff, it is a very recent annual
report on electric restructuring in the State, and I also offer
a blueprint which we previously provided to the FERC as to how
we can move expeditiously to create a Northeast regional
market.
We do this work because we believe that competition in
electricity markets is likely to be fairest and most successful
when transmission and distribution utilities have no reason to
favor any one competitor over another. Now, the model we have
chosen to open our State to competition apparently has found
acceptance in the energy community. 14 energy companies are
actively selling in Maine and have won customers, including
Enron, which by our estimate serves fully a quarter, an
estimated 450 megawatts of Maine's load, or at least it did so
prior to its recent troubles. I know that to the extent they
are meeting standard offer, provider of last resort
obligations, they continue to provide it as of this morning.
They are doing it.
Our interest in the success of the wholesale markets is
further rooted in our decision to forego artificial price-
controlling devices such as price caps or long-term fixed
supply contracts that insulate customers from the prices
revealed in wholesale markets. Our standard offer is provided
at prices that are set by competitive bid. The effect of our
approach to restructuring has been dramatic. The incumbent
investor-owned utilities no longer supply generation. Virtually
all of Maine's generation is supplied by competitive providers,
and 44 percent of our load has departed standard offering, and
is served by retail suppliers, and I have the data on that to
give you as well.
Our adoption of the competitive model came at a price. The
prices paid by Maine consumers are, perhaps as much as any in
the country, subject to the vagaries of the wholesale market
and, accordingly, we have worked very hard to avoid or minimize
the impacts of any events which will impair competition or
unfairly injure consumers, residential or business and thus
far, I am relieved to report, both Maine and New England have
apparently avoided significant injury from Enron's recent
financial collapse.
Most feared were threats to the reliability of supply, and
to prices paid by Enron's customers. Supply continued without
discernible disruption, and because of very careful management,
particularly by the ISO New England and participants in the New
England Power Pool, NEPOOL, there was no instability in the
markets, and apparently no major financial losses. Enron's
collapse did not cause a reliability problem because Enron does
not own most of the generators. It does not own any of the
generators in New England. The generation owners' interest
remained unchanged. Run the generators and sell the output.
Customers continued to want that output. Loads did not change,
generators did not go anywhere, so reliability was unaffected.
And in this environment, the stressed and ultimately
bankrupt Enron continued, and continues, as I mentioned a
moment ago, to meet its contractual supply obligations in
Maine, most, if not all of which were profitable in today's
energy market. Those contracts required customers to pay a
higher price than the current market price. It has been a
falling energy price environment.
Nevertheless, companies who owned the generators, fearing
that Enron might not pay for its power, opted out of contracts
when possible and instead sold into a spot market, and new
arrangements had to be found. Enron now settles each day for
the trades accounted for 3 days ago, as opposed to the previous
situation, which was a 30-day settlement, which the other
providers continue to enjoy, a change, by the way, which was
proposed on very short order in the wake of the collapse, and
was approved within about 7 days by the FERC, something we very
much appreciate.
Outcomes like the one in Maine and New England just
experienced frequently lead to the oft-used phrase, we dodged
the bullet, and a big sigh of relief. True, the bullet did not
hit us, but it was not because we were smart enough or nimble
enough to escape its blow. We were simply and profoundly lucky.
We are, and have been for many months, in a falling energy
price market, one in which suppliers with a fixed price can
profit from declining prices. Had these same set of events
occurred against the backdrop of rising energy prices,
suppliers would have had an extraordinary incentive to escape
their obligations. Now, Maine has had some experience with that
in two particular instances, and if you want to we can go into
that later.
Had Enron's implosion occurred in a rising market, Maine's
ratepayers could have taken a hit in excess of $50 million,
perhaps $100 million, and remember, Maine is a State of fewer
than 1.3 million people. If Enron had captured as much of the
market across New England as it has in Maine, and we were in a
rising energy price market, the comparable hit on ratepayers
across New England could have been more than $1 billion.
This is not to say that the markets would not have worked.
Prices change because markets are functioning, and I think
reliability would have been met, but the rising prices would
largely reflect a more constrained supply situation and there
would have been some travail for consumers.
For ratepayers there is a certain heads-you-win, tails-I-
lose aspect to the energy market. If a customer signs a
contract with an energy supplier, and market prices fall, the
customer is stuck with paying the now higher-than-market price
for its energy. This remains true even if the supplier, as
Enron, goes bankrupt.
The contract is a valuable asset of the bankrupt, one which
the bankruptcy court will seek to use on behalf of other
creditors, but if a customer has a contract with an energy
supplier, market prices rise, and the supplier for whatever
reason goes bankrupt and defaults on the contract, the
customers must buy new supply in the higher priced energy
market and take its place in line with all the other creditors,
with little hope that the protections a customer negotiated in
its supply contract will provide sufficient relief.
This is not an argument for eliminating the market. It is a
very deep reason why we have to ensure that we have healthy
players in the market, and it goes as much to the business
considerations here as to changes in market design.
I see my time is up. You have written copies of my
testimony in advance. I will be happy to answer your questions
as they come, Mr. Chairman. Thank you for this opportunity.
[The prepared statement of Mr. Nugent follows:]
Prepared Statement of William M. Nugent, President, National
Association of Regulatory and Utility Commissioners
Good morning, Mr. Chairman, members of the Committee.
Thank you for this opportunity to report to the Committee on the
effects of the Enron Corporation's recent decline on the electricity
market in one state (Maine) and New England. I am William M. Nugent, a
commissioner on the Maine Public Utilities Commission (MPUC) and
President of the National Association of Regulatory Utility
Commissioners (NARUC). I will present my own views and, where possible,
those of NARUC. But the Enron matter has developed so recently that our
members have yet to meet and develop specific policy in response to it.
To aid the Committee's work on restructuring the electricity
industry (S. 1766 and related bills), I have brought copies of the
Maine Commission's very recent 46-page Report on Restructuring in our
State. I am also providing a ``Blueprint for Establishing a Northeast
RTO,'' suggestions as to how we believe the Federal Energy Regulatory
Commission it can best aid the development of a Northeast RTO, while
ensuring the efficient operation of the current markets for as long as
those markets exist. Maine offered these suggestions to the FERC
because Maine has an enormous stake not only in the health of the
current markets but also in the further development of broader, deeper,
more liquid energy markets.
No state has a greater interest in the success of the wholesale
electricity markets than Maine. In the two years since we opened our
retail markets to competition, Maine's consumers have been directly and
often immediately affected by changes in the wholesale prices in New
England. As much as any jurisdiction, Maine cut the regulatory tie
between electricity supply and delivery by requiring its utilities to
completely divest themselves of generation. We did so because we
believe that competition in electricity markets is likely to be fairest
and most robust when the transmission and distribution utility, the T&D
utility, has no reason to favor any one competitor over any other.
Apparently energy companies agree; currently 14 of them have competed
and won customers in Maine, including Enron, which--by our best
estimates--serves fully one quarter (an estimated 450 megawatts) of
Maine's load--or at least it did so prior to its recent troubles).
Maine's interest in the success of the wholesale electricity
markets is further rooted in our decision to forego artificial price-
controlling devices such as price caps or long term fixed supply
contracts that insulate consumers from the prices revealed in the
wholesale markets; even Maine's Standard Offer (default or provider of
last resort) supply is provided at prices that are set by competitive
bid. The effect of Maine's approach to restructuring has been dramatic:
the incumbent investor-owned utilities no-longer supply
generation service;
virtually all of Maine's generation is supplied by
competitive suppliers, and
44 percent of the total electric load in Maine has departed
the standard offer (the provider of last resort) and is served
by retail suppliers.
Maine's aggressive adoption of the competitive model, however,
comes at a price. The prices paid by Maine's consumers are--perhaps as
much as any in the country--sensitive to the vagaries of the wholesale
market. Accordingly, we have worked hard to ensure that the wholesale
market reflects the economics of supply and demand, and does not
provide either inadequate incentives for efficient investment or
opportunities for gaming and the exercise of market power. We have
tried to avoid or minimize the impact of any events which will impair
competition or unfairly injure consumers--residential or business.
And, thus far, I am relieved to report, both Maine and New England
have apparently avoided significant injury from Enron's recent
financial collapse. Most feared were threats to the reliability of
supply and to the prices paid by Enron's customers. Supply continued
without discernible disruption. And, because of very careful
management, particularly by the ISO-New England and participants in the
New England Power Pool (NEPOOL), there was little instability in the
markets and apparently no major financial losses.
Enron's collapse did not cause a reliability problem because Enron
does not own the generators. The generation owners' interest remained
unchanged: run their generators and sell the output. Customers
continued to want that output. Loads did not change. Generators did not
go anywhere. So reliability was unaffected.
And in this environment the stressed and ultimately bankrupt Enron
continued--and continues--to meet its contractual supply obligations,
most--if not all--of which were profitable in today's energy market.
Those contracts required customers to pay a higher price than the
current market price.
Nevertheless, companies who owned the generators, fearing that
Enron might not pay for its power purchases, opted out of contracts
when possible and instead sold into the spot market.
NEPOOL's old financial assurance policies allowed the organization
to rescind membership in the Pool, but did not allow NEPOOL to cut off
a company from trading in the energy markets in response to a situation
like that posed by Enron. NEPOOL and ISO-New England's new policy will
automatically restrict a company's trading in the pool if its credit
rating falls below a certain level.
The sudden Enron disintegration impaired its ability to arrange
bilateral contracts with generators. In response, Enron bought more and
more from the Pool each day. When Enron declared bankruptcy, it was
carrying a large, negative financial balance with the Pool (pre-
bankruptcy-petition debt). There are two possible remedies for this
pre-petition debt. The bonds that Enron was required to post to
establish credit with the pool may cover the debt; and if not, NEPOOL
has filed a claim in the bankruptcy proceeding.
Enron fought to avoid giving up its trading activities. In lieu of
the 30-day settlement process accorded healthy energy trading
companies, Enron negotiated a new 3-day-rolling-average payment
arrangement with the Pool (administered by the ISO). Enron now
maintains a 3-day cash balancing account with the ISO. At the end of
each day, the ISO withdraws enough money to cover the transactions that
occurred three days previously. Enron has agreed to wire-transfer to
the ISO--by the end of the next day--enough money to replenish the
account. In December this arrangement and term sheet were submitted to
the FERC for emergency approval. The FERC promptly approved it.
There was further concern in the New England market that, because
parties with bilateral contracts to supply Enron could terminate those
contracts because of the bankruptcy but Enron could keep buying what it
needed in the spot market, Enron's resort to the spot market could
produce over-reliance on it (similar to what happened in California),
sharply increasing spot-market prices. While that did not happen in
this instance, it remains at least a theoretical possibility in the
event of the financial collapse of another big player.
Outcomes like the one Maine and New England just experienced
frequently leads to the oft-used phrase ``we dodged the bullet.'' True,
the bullet did not hit us. But it was not because we were smart enough
or nimble enough to escape its blow. We were simply and profoundly
lucky.
We are, and have been for many months, in a falling energy-price
market, one in which suppliers with a fixed price can profit from
declining prices. Had the same set of events occurred against a
backdrop of rising energy prices, suppliers would have had an
extraordinary incentive to escape their obligations. (Maine has had
direct experience with such circumstances.)
Had Enron's implosion occurred in a rising market, Maine's
ratepayers could have taken a ``hit'' in excess of $50 million, perhaps
$100 million. And, remember, Maine is a state of fewer than 1.3 million
people. If Enron has captured as much of the market across New England
as it has in Maine and if we were in a rising-energy-price market, the
comparable ``hit'' for ratepayers across New England could have
approached $1 billion.
For ratepayers, there is a certain ``heads you win, tails I lose''
aspect to the energy market. If a customer signs a contract with an
energy supplier and market prices fall, the customer is stuck with
paying the now higher-than-market price for its energy. This remains
true even if the supplier--as has Enron--goes bankrupt; the contract is
a valuable asset of the bankrupt, one which the Bankruptcy Court will
seek to use on behalf of other creditors.
But if a customer has a contract with an energy supplier, market
prices rise, and the supplier (for whatever reason) goes bankrupt and
defaults on the contract, the customer must buy new supply in the high-
priced energy market and take its place in line with all the other
creditors with little hope that the protections the customer negotiated
in its supply contract will provide sufficient relief.
Maine tries to minimize such risk to the state's Standard Offer
electricity customers by requiring licensed suppliers to provide
evidence of their financial soundness, either by posting a substantial
bond or (in the case of companies whose guaranteeing parent has a
minimum credit rating of BBB+ or equivalent) by providing us a
corporate guarantee that the supplier will meet its obligations.
But even if we had required and Enron had provided a bond to
protect Maine's Standard Offer customers, we would have had little
meaningful protection--at least sooner than the conclusion of very
protracted litigation. Reportedly Enron had purchased surety bonds to
guarantee billions of dollars of natural gas and crude oil to two
offshore companies. Enron declared bankruptcy in November, ostensibly
leaving its guarantors with the bill.
Enron's failure (perhaps amplified by large claims associated with
Kmart's failure) supposedly represents one of the largest payouts ever
for the surety industry, about $2 billion, according to experts.
Reportedly, it is comparable to the effect of the September 11th
terrorist attacks on the property and casualty insurance industry, and
the magnitude of these losses may force some bonding companies out of
the surety-bond business.
As a result, bond companies likely will raise prices, require
collateral, tighten underwriting standards, and cancel some policies.
Thus, it could be more difficult for some companies to obtain bonds,
thereby reducing the number of competitive providers and making
competition less vigorous. Energy market prices may reflect these
additional cost burdens.
In conclusion, well-structured, well functioning energy markets can
bring substantial benefits to consumers and opportunity to ethical,
well run businesses, and strengthen the U. S. economy. Benefits will be
realized regardless of whether a state or states open their markets to
retail competition.
The keys to a well structured, well functioning market are rules
that allow all players to compete fairly, based on the underlying
economics of what they bring to the competition, and on the integrity
of the players. Absent the latter, competitive energy providers will
not enjoy the confidence of investors (hence their financial support)
or other players in the market (making it harder for them to bring
valuable products to the market).
Energy providers, consumers, and investors very much need reforms
that will restore confidence in markets. By themselves, states cannot
protect against a incompetence or purposeful cheating by a major
national company. Apart from the costs and limited effectiveness of the
protections mentioned earlier (e.g., surety bonds, corporate
guarantee), unscrupulous players can avoid state-designed and enforced
protections by doing business only in states with the least restrictive
protections. The specific reforms of this nature must be national in
scope and carefully designed to balance the price of that protection--
both financial and regulatory--against the value of the additional
assurances received.
The Chairman. Thank you very much. Next, let us hear from
Mr. Newsome, James Newsome, who is the chairman of the
Commodity Futures Trading Commission.
STATEMENT OF JAMES E. NEWSOME, CHAIRMAN, COMMODITY FUTURES
TRADING COMMISSION
Mr. Newsome. Thank you, Mr. Chairman, members of the
committee. I appreciate the opportunity to testify on behalf of
the Commodity Futures Trading Commission, and because this
committee may be a little less familiar with the role of the
CFTC, I have detailed in written testimony the oversight role
of the CFTC and for the sake of time will abbreviate those
comments this morning, but would respectfully ask that my
written comments be included in the record, Mr. Chairman.
The Chairman. We will include your written comments in the
record.
Mr. Newsome. Thank you, sir.
I would like to begin by saying, as both a regulator and a
citizen, that I have great sympathy for the people who were
harmed by incomplete, misleading, and inaccurate financial
information. I share the concern of many that appropriate
inquiries be made to ensure that investors, creditors, and
others who rely on the accuracy of financial disclosures by
publicly held companies can continue to do so with the fullest
of confidence.
I would like to take a moment to complement Mr. Viola, to
my right, his staff and members of the New York Mercantile
Exchange, as well as those at the New York Board of Trade, for
their remarkable reactions to the September 11 attacks. The
fact that NYMEX and NYBOT were up and running within only days
after the attack helped avert the possibility of further
economic disruptions, and should give us all great confidence
in the resilience and strength of those institutions.
I would like to share with you today the important role of
the futures markets in our economy and the role of the CFTC in
overseeing those markets, particularly with respect to the
energy markets, and how that role changed with the passage of
the Commodity Futures Modernization Act of 2000.
The commission perceives its mission as twofold, to foster
transparent, competitive, and financially sound markets, and to
protect market users and the public from fraud, manipulation,
and abusive practices. While the stock markets provide a means
of capital formation, a way for new and existing businesses to
raise capital, the futures markets provide producers,
distributors, and users of commodities with a means of managing
their exposure to price risk. Futures contracts based on
nonagricultural fiscal commodities like metals or energy
products, and on financial products such as interest rates,
foreign currencies, or stock market indices, now serve the risk
management needs of businesses in so many sectors of the
economy that trading in these new contract areas is now many
times larger than that of agricultural contracts.
Although the primary purpose of the futures markets is risk
management, many futures markets also play an important price
discovery role in which many businesses and investors that are
not direct participants in futures nonetheless refer to the
quoted prices of futures market transactions as reference
points or benchmarks for other types of transactions or
decisions. To fulfill its responsibilities, the commission
focuses on issues of market integrity and pursues a multi-
pronged approach to market oversight. We seek to protect the
economic integrity of markets against price manipulation
through direct market surveillance and oversight of the
exchanges' surveillance efforts.
The heart of our direct surveillance is a large trader
reporting system under which commodity brokers called futures
commission merchants, or FCM's, and foreign brokers file daily
reports with us that aggregate positions across FCM's and
accounts to give a truer view of large trader presence.
Commissioners are apprised of market activity and possible
problems at weekly surveillance briefings. To protect the
financial integrity of the markets, our priorities are to avoid
disruptions of the clearing and settling system, and to protect
customer funds entrusted to FCM's. As an oversight regulator,
the commission reviews the audit and financial surveillance
work of the exchanges, and also monitors the health of FCM's
directly. We also review clearinghouse procedures for
monitoring risk and protecting customer funds.
To protect the operational integrity of the markets, the
commission requires extensive record-keeping, appropriate
customer disclosures, fair sales and trading practices, and
training of industry professionals. The CFTC Division of
Enforcement aggressively investigates and prosecutes violations
of the CEA and of commission rules.
We oversee on-exchange trading of futures and options
contracts based on things such as crude oil, natural gas,
heating oil, propane, gasoline, and coal. The overwhelming
majority of on-exchange energy transactions are executed on
NYMEX. Please note that the CFTC does not regulate trading of
energy on products in the cash or foreign markets, which are
excluded from our jurisdiction by the Commodity Exchange Act.
Because Enron was a large trader on the NYMEX, its on-
exchange activities have been regularly monitored by the CFTC.
At this time, we have no indication that manipulation of any
futures market was attempted by Enron. However, the rapid
financial deterioration of Enron presented a separate concern
for the commission. Could its positions be unwound without
price volatility or reduced liquidity?
In fact, these markets proved to be quite resilient. When
Enron's positions were closed out, prices did not spike up or
down, nor did liquidity suffer. When Enron's financial troubles
became known last fall, our staff worked closely with the NYMEX
clearinghouse and the FCM's that were carrying most of its
positions to monitor and manage the winding down of those
positions. By adjusting margins and other appropriate measures,
the clearinghouse was able to accomplish a very smooth landing
while protecting the FCM's and their customers.
By mid-December, all of Enron's positions on the regulated
exchanges had been liquidated. I believe this episode was an
example of success for the financial controls in the on-
exchange futures markets.
In 1999, the President's Working Group on Financial Markets
released its report on over-the-counter derivatives, which
recommended providing legal certainty for off-exchange
derivatives transactions. Congress considered these
recommendations and ultimately codified many of them, together
with substantial reforms of the regulatory regime for exchange
trader futures, in the Commodity Futures Modernization Act of
2000.
With respect to energy-based futures, the CFMA exempted two
types of markets from much of the CFTC's oversight. The first
is bilateral principal-to-principal trading between two
eligible contract participants which includes sophisticated
entities, for example, those with assets of at least $10
million.
The second is electronic multilateral trading among
eligible commercial entities, which include eligible contract
participants that can also demonstrate an ability to either
make or take delivery of the underlying commodity, and dealers
then that regularly provide hedging services to those with such
ability.
The CFTC, as part of the President's Financial Working
Group, is now participating in a review of corporate disclosure
issues that may yield valuable suggestions for how both
industry and the Government may seek to prevent a repeat of the
Enron situation. Within the commission, we are currently
implementing a reorganization of the CFTC divisions that will
consolidate our market oversight functions into one division to
help improve an already excellent program.
Mr. Chairman, as a regulator, I believe that it is
important to constantly review current policies and procedures,
especially given today's dynamic marketplaces, to ensure that
appropriate regulatory levels are maintained. The significance
of the Enron situation and its ramifications deserve study and
recommendations for improvements.
Some of those responses will come from Congress, others
from regulators, and still others from industry participants.
Having said this, I was a supporter of the CFMA because I
sincerely believe that a one-size-fits-all approach to
regulation was outdated, especially with all of the business
and technological innovations that we have seen in recent
history. Tailoring regulations to the nature of the
participant, product, and trading facility seemed in my view to
be appropriate concepts on which to define the Federal
regulatory interest.
To date, I have seen no evidence to the contrary. However,
we will continue to monitor the markets within our
jurisdiction, and we will continue to utilize all authorities
given to us by the Congress to aggressively pursue CEA
violations. The commission stands ready to work with this
committee, the Congress, and other regulators to find the
appropriate responses.
Thank you, Mr. Chairman, for the invitation to be here, and
I will be happy to answer any questions at the appropriate
time.
[The prepared statement of Mr. Newsome follows:]
Prepared Statement of James E. Newsome, Chairman, Commodity Futures
Trading Commission
Thank you, Chairman Bingaman, and members of the Committee. I
appreciate your having given me the opportunity to testify here today
on behalf of the Commodity Futures Trading Commission and to contribute
to the discussion of important issues you have raised.
I would first like to say--both as a federal financial regulator
and as a citizen--that I have great sympathy for those who were
misinformed by incomplete and inaccurate information they may have
received. I also share the concern that appropriate action be taken to
ensure that investors, creditors, commercial counter parties, and
others who rely on the accuracy and completeness of financial
disclosures by publicly-held companies can continue to do so with the
fullest confidence. I commend the Securities and Exchange Commission
for having opened an investigation into these matters.
I would also like to take a moment to commend Mr. Viola and all the
people at the New York Mercantile Exchange, as well as their friends
and colleagues at the New York Board of Trade, for their remarkable
reactions to the September 11th attacks. Their courage, tenacity, and
foresight in quickly restoring market operations in the face of
unprecedented challenges and terrible personal tragedies deserve the
gratitude of every business, investor, and consumer because these
markets can play critical roles in the U.S. and world economies. For
example, the West Texas Intermediate Crude oil contract traded on NYMEX
is relied upon as a price benchmark around the globe. The fact that
NYMEX and NYBOT were up and running within only days of the attacks
helped avert the possibility of economic disruptions across the economy
and should give us all great confidence in the resilience and strength
of these institutions.
With your permission, I would like to tell you a little bit about
the important role of the futures markets in the U.S. economy and the
role of the CFTC in overseeing those markets. I will describe how the
Commission responded to the Enron situation last fall. I will also
discuss our role with respect to the energy markets and how that role
changed with passage of the Commodity Futures Modernization Act of
2000. Finally, I would like to offer some thoughts on how the
Commission might make a contribution as we move forward.
background
The Commission was created by Congress in 1974 to oversee the
nation's commodity futures and options markets. The Commission
perceives its mission to be two-fold: to foster transparent,
competitive, and financially sound markets, and, to protect market
users and the public from fraud, manipulation, and abusive practices.
There are important differences between the futures markets and the
stock markets. While the stock markets provide a means of capital
formation, a way for new and existing businesses to raise funds, the
futures markets provide producers, distributors, and users of
commodities with a means to manage their exposure to commodity price
risk. Historically, commodity futures and options were traded on
agricultural products. And while contracts based on agricultural
products are traded as actively today as ever, a great many futures
contracts are now based on non-agricultural physical commodities like
precious metals or energy products and on financial commodities like
interest rates, foreign currencies, or stock market indices. Because
they serve the risk management needs of businesses in virtually every
sector of the economy, the volume of trading in these financials and
non-agricultural physicals is now nine times that in agricultural
contracts. While farmers and ranchers continue to use futures contracts
to effectively lock in the prices for their crops and herds months
before they come to market, manufacturers now can also use futures
contracts to plan their raw material costs and to reduce uncertainty
over the prices they receive for finished products sold overseas.
Mutual fund managers can use stock index futures to protect against
market volatility and effectively put a floor on portfolio losses. And
electric power generators can use futures contracts to secure stable
pricing for their coal and natural gas needs.
These producers, distributors, and users of commodities (whether
physical or financial) are called hedgers. The futures contract
positions that hedgers put on are referred to as covered positions. For
example, a power generator's obligation to purchase natural gas will be
covered by its ability to use that natural gas in its electricity
generation. There are other participants in the futures markets who
take uncovered positions in the hope of making profits rather than
mitigating risks. These individuals and firms are known as speculators
and they contribute to the smooth operation of a futures market by
increasing its liquidity. Because the needs of different hedgers for
long or short positions may not always be perfectly balanced, the
presence of speculators increases market effectiveness by better
ensuring that hedgers will be able to put on positions they need.
Although I have described the primary purpose of futures markets as
tools for risk management, it should be noted that many futures markets
play another important role in the economy, that of price discovery.
Many businesses and investors that are not direct participants in the
futures markets nonetheless refer to the quoted prices of futures
market transactions as reference points or benchmarks for other types
of transactions and decisions. This is particularly important in many
agricultural markets where no other means of price discovery exists
outside of the quoted futures prices but it is also true in other
sectors, including many energy markets.
how the cftc performs its mission
In seeking to fulfill its mission to foster transparent,
competitive, and financially sound markets and to protect market users
and the public from fraud, manipulation, and abusive practices, the
Commission focuses on issues of integrity. We seek to protect the
economic integrity of the futures markets so that they may operate free
from any fraud or manipulation of prices. We seek to protect the
financial integrity of the futures markets so that the insolvency of a
single market participant does not become a systemic problem affecting
other market participants or financial institutions. We seek to protect
the operational integrity of the futures markets so that transactions
are executed fairly, so that proper disclosures are made to existing
and prospective customers, and so that fraudulent sales practices are
not tolerated.
The Commission pursues these goals through a multi-pronged approach
to market oversight. We seek to protect the economic integrity of the
markets against attempts at manipulation through direct market
surveillance and through oversight of the surveillance efforts of the
exchanges themselves. The heart of the Commission's direct market
surveillance is a large-trader reporting system, under which clearing
members of exchanges, commodity brokers (called futures commission
merchants or FCMs), and foreign brokers electronically file daily
reports with the Commission. These reports contain the futures and
option positions of traders that hold positions above specific
reporting levels set by CFTC regulations. Because a trader may carry
futures positions through more than one FCM and because a customer may
control more than one account, the Commission routinely collects
information that enables its surveillance staff to aggregate
information across FCMs and for related accounts.
Using these reports, the Commission's surveillance staff closely
monitor the futures and option market activity of all traders whose
positions are large enough to potentially impact the orderly operation
of a market. For contracts which at expiration are settled through
physical delivery, such as in the energy futures complex, staff
carefully analyze the adequacy of potential deliverable supply. In
addition, staff monitor futures and cash markets for unusual movements
in price relationships, such as cash/futures basis relationships and
inter-temporal futures spread relationships, which often provide early
indications of a potential problem.
The Commissioners and senior staff are kept apprised of significant
market events and potential problems at weekly market surveillance
meetings, and on a more frequent basis when needed. At the weekly
market surveillance meetings, surveillance staff brief the Commission
on broad economic and financial developments and on specific market
developments in futures and option markets of particular concern. At
least one energy product market is usually discussed and officials of
the Energy Information Administration of the Department of Energy
periodically attend such meetings.
If any indications of attempted manipulation are found, the
Commission's Enforcement Division investigates and prosecutes alleged
violations of the CEA and Commission regulations. Subject to such
actions are all individuals that are (or should be) registered with the
Commission, those who engage in trading on any domestic exchange, and
those who improperly market commodity futures or option contracts. The
Commission has available to it a variety of administrative sanctions
against wrongdoers, including revocation or suspension of registration,
prohibitions on futures trading, cease and desist orders, civil
monetary penalties, and restitution orders. The Commission may seek
federal court injunctions, restraining orders, asset freezes, receiver
appointments, and disgorgement orders. If evidence of criminal activity
is found, matters may be referred to state authorities or the Justice
Department for prosecution of violations of not only the CEA but also
state or federal criminal statutes, such as mail fraud, wire fraud, and
conspiracy. Over the years, the Commission has brought numerous
enforcement actions and imposed sanctions against firms and individual
traders for attempting to manipulate prices, including the well-
publicized cases against Sumitomo for alleged manipulation of copper
prices and against the Hunt brothers for manipulation of the silver
markets.
In protecting the financial integrity of the futures markets, the
Commission's two main priorities are to avoid disruptions to the system
for clearing and settling contract obligations and to protect the funds
that customers entrust to FCMs. Clearinghouses and FCMs are the
backbone of the exchange system: together, they protect against the
financial difficulties of one trader from becoming a systemic problem
for other traders or the market as a whole. Several aspects of the
oversight framework help the Commission achieve these goals:
(1) requiring that market participants post a performance
bond, referred to as ``margin,'' to secure their ability to
fulfill obligations;
(2) requiring participants on the losing side of trades to
meet their obligations, in cash, through daily (and sometimes
intraday) margin calls;
(3) requiring that FCMs segregate customer funds from their
own funds and protect these customer funds from obligations of
the FCM; and
(4) monitoring the capitalization and financial strength of
intermediaries, such as FCMs and clearinghouses.
The Commission works with the exchanges and the National Futures
Association (NFA) to closely monitor the financial condition of FCMs.
The Commission, the exchanges, and the NFA receive various monthly,
quarterly, and annual financial reports from FCMs. The exchanges and
the NFA also conduct annual audits and daily financial surveillance of
their respective member FCMs. Part of this financial surveillance
involves looking at each FCM's exposure to losses from large customer
positions that it carries and one way in which such positions are
tracked is through the large trader reporting system. As an oversight
regulator, the Commission primarily reviews the audit and financial
surveillance work of the exchanges and the NFA but also monitors the
health of FCMs directly, as necessary and appropriate. We also
periodically reviews clearinghouse procedures for monitoring risks and
protecting customer funds.
As with attempts at manipulation, the Commission's Enforcement
Division investigates and prosecutes FCMs that are alleged to have
violated financial and capitalization requirements or to have committed
other supervisory and compliance failures in connection with the
handling of customer business. Such cases can result in substantial
remedial changes in the supervisory structures and systems of FCMs and
can influence the way particular firms conduct business. This is an
important part of the responsibility of the Commission to ensure that
sound practices are followed by FCMs.
Protecting the operational integrity of the futures markets is also
accomplished through the efforts of several divisions within the
Commission. The Division of Trading and Markets promulgates
requirements that mandate appropriate disclosure and customer account
reporting, as well as fair sales and trading practices by registrants.
Trading and Markets also seeks to maintain appropriate sales practices
by screening the fitness of industry professionals and by requiring
proficiency testing, continuing education, and supervision of these
persons. Extensive recordkeeping of all futures transactions is also
required. Trading and Markets also monitors compliance with those
requirements and supervises the work of exchanges and the NFA in
enforcing the requirements.
And, as with the Commission's efforts to protect the economic and
financial integrity of the futures markets, the Division of Enforcement
also plays an important role in deterring behavior that could
compromise the operational integrity of the markets. Enforcement
investigates a variety of trade and sales practice abuses that affect
customers. For example, the Commission brings actions alleging unlawful
trade allocations, trading ahead of customer orders, misappropriating
customer trades, and non-competitive trading. The Commission also takes
actions against unscrupulous commodity professionals who engage in a
wide variety of fraudulent sales practices against the public.
the cftc's role in the energy markets and our response
to the enron situation
The Commission oversees on-exchange trading of energy-related
futures and options contracts based on such things as crude oil,
natural gas, heating oil, propane, gasoline, and coal. Several U.S.
exchanges are designated to trade energy product futures and options,
but the overwhelming majority of on-exchange transactions are executed
on NYMEX, where contracts in each of the products I mentioned are
actively traded. Please note that the CFTC does not regulate trading of
energy products on the spot (cash) market or forward market (non-
standardized contracts), which are excluded from our jurisdiction by
the Commodity Exchange Act (CEA). However, the Commission can, for
example, look at the spot market under our anti-manipulation oversight
authority if we believe the spot market in a commodity that underlies a
futures contract has been manipulated and we want to determine whether
manipulation of the futures market for that commodity has been
attempted.
Because Enron was a large trader of energy-based contracts traded
on the NYMEX, its on-exchange activity has been monitored by our market
surveillance over the years. At this time, we have no indication that
manipulation of any on-exchange futures market was attempted by Enron.
However, the rapid financial deterioration of Enron last year presented
an additional concern about the markets: Could its on-exchange futures
positions be unwound without sudden price volatility or reduced
liquidity? As it turned out, although Enron had a significant presence
in these markets, the company was but one of many participants in what
are very large and liquid markets. When its financial difficulties
became known and Enron wound down its activities, energy futures price
showed remarkably little reaction: The markets for energy-related
futures were not roiled and prices did not spike nor did liquidity dry
up.
As would the financial difficulties of any large futures customer,
Enron's difficulties also raised concerns about the ability of the FCMs
that carried Enron's on-exchange futures positions to successfully
close out those positions if Enron were to fail to meet margin calls.
When Enron's financial troubles became known last fall, staff from our
Division of Trading and Markets worked closely with the NYMEX
clearinghouse and the affected FCMs to monitor and to manage the
winding down of these positions. By appropriately adjusting margin
requirements, the clearinghouse was able to ensure that adequate Enron
funds remained on deposit at the FCMs, which both provided additional
security for the FCMs and their customers and gave Enron a strong
incentive to reduce its positions as quickly as possible.
The winding down of Enron's on-exchange positions was accomplished
quickly and smoothly so that, by the time of Enron's bankruptcy filing,
the risks to which FCMs were exposed had dropped by 80% from only a
week earlier. By mid-December, all of Enron's positions on the
regulated exchanges had been liquidated. (Enron also owned a small
subsidiary FCM, Enron Trading Services, that carried no positions for
other customers and only a very small portion of Enron's own on-
exchange positions. At all times, ETS had regulatory capital several
times the required level. By mid-December, ETS had transferred its
customers to other FCMs.) I believe that this episode was a success for
the system of financial controls in the on-exchange futures markets.
There were no disruptions to the system of clearance and settlement.
Enron met all its obligations. No customer lost any funds entrusted to
any FCM.
how the commodity futures modernization act changed things
In 1999, the President's Working Group on Financial Markets--which
is chaired by the Secretary of the Treasury and includes the Chairs of
the Federal Reserve, Securities and Exchange Commission, and CFTC--
released a report entitled ``Over-the-Counter Derivatives and the
Commodity Exchange Act.'' The report recommended changes to the CEA to,
among other things, create legal certainty for off-exchange derivatives
transactions, such as swaps. Congress considered these recommendations
and ultimately codified many of them, together with substantial reforms
of the regulatory regime for domestic exchange-trading of futures and
options, in the Commodity Futures Modernization Act of 2000 (CFMA).
With respect to the energy markets, the CFMA exempts two types of
markets from much of the CFTC's oversight. Such markets are described
in Section 2(h) of the CEA, as amended by the CFMA. The Act defines
exempt commodities as, roughly speaking, all commodities except
agricultural and financial products. This category, which for the most
part represents futures contracts based on metals and energy products,
may be traded on the two types of markets covered by Section 2(h). The
first is bilateral, principal-to-principal trading between two eligible
contract participants, which include sophisticated entities such as
regulated banks or insurance companies and well-capitalized companies
or individuals (for example, those with assets of at least $10
million), among others. The second is electronic multilateral trading
among eligible commercial entities, which include, among others,
eligible contract participants that can also demonstrate an ability to
either make or take delivery of the underlying commodity and dealers
that regularly provide hedging services to those with such ability.
While the Commission does not directly regulate these transactions, we
do retain anti-fraud and anti-manipulation authority. The public policy
issues implicated by such trading among sophisticated entities were
addressed by Congress during passage of this important legislation.
suggestions on moving forward
I would like to first note that the CFTC, as a member of the
President's Working Group on Financial Markets, is participating in a
study of corporate disclosure issues relating to auditing and
accounting which may yield valuable suggestions for how both industry
and the government may seek to prevent repeats of the Enron situation.
Within the Commission, we have recently proposed a reorganization of
the CFTC that will consolidate our market oversight functions into one
division to help improve what is already an excellent program.
Mr. Chairman, as a government regulator, I believe that it is
important to constantly review current policies and procedures,
especially given today's dynamic marketplaces, to ensure that
appropriate levels of regulation are maintained. The significance of
the Enron situation and its ramifications generally deserve study and
recommendations for improvements. Some of these responses will come
from the Congress, while others will come from regulators, and still
others will come from the industry. Having said this, I was a supporter
of the CFMA because I sincerely believed that a one-size-fits-all
approach to regulation was outdated, especially with all of the
business and technological innovations that we have seen in recent
history.
Tailoring regulations to the nature of the participant, the
product, and the facility on which it is traded seemed, in my view, to
be appropriate concepts on which to define a federal regulatory
interest. To date, I have seen no evidence to the contrary in my
agency's initial analysis of the Enron situation. However, we will
continue to monitor the markets within our jurisdiction, and we will
continue to utilize all authorities given to us by the Congress to
aggressively pursue CEA violations.
The Commission stands ready to work with this Committee, the
Congress, other regulators, and the industry to find appropriate
responses. Thank you for the invitation to appear before your
Committee. I will be happy to answer any questions you may have.
The Chairman. Thank you very much. Next, let us hear from
Mr. Vincent Viola, who is the chairman of the New York
Mercantile Exchange. Thank you for being here.
STATEMENT OF VINCENT VIOLA, CHAIRMAN, NEW YORK MERCANTILE
EXCHANGE
Mr. Viola. Thank you. On behalf of the members of the New
York Mercantile Exchange, Mr. Chairman and members, I
appreciate the opportunity to participate in this hearing. My
remarks will briefly summarize our written testimony. I would
like to make five principal points before the panel this
morning, if I may.
NYMEX is, simply put, the largest energy marketplace in the
world, and it is a federally regulated marketplace where risk
management is conducted through the expertise of market
surveillance and open, transparent price discovery. The
critical component that makes NYMEX unique is its unique
neutrality to the marketplace. The exchanges market and
oversight rules identify potential problems that the exposure
of the unregulated marketplace to Enron's positions may
possibly have, and stepped in immediately to stabilize the
marketplace from our perspective, and our marketplace's
actions.
Using data and reports from the complete trading year of
2001 and to date reports for the trading year of 2002, the
notional value of NYMEX energy trading volume is substantially
larger than that of Enron and Enron Online. In fact, we are a
factor of 5 to 1 larger in terms of notional value of the
volumes traded on our marketplace as compared to Enron Online.
Transparency is an important component of a truly competitive
and open marketplace, but rules and procedures which forced a
true competition are critical to maximizing the benefits of
transparency.
While the facts to date do not indicate that the failure of
Enron was related to rules or the absence of rules governing
trading in energy contracts, had Congress enacted legislation
supported by Enron and a number of over-the-counter market
participants to remove nearly all Federal oversight from the
energy markets, and platforms would have caused a market
disruption that could not, I think at this point, be
contemplated in terms of the end effect upon the consumer.
In addition to the openness and transparency of its trade
execution operations, NYMEX's clearinghouse protects all
participants against counter-party credit risks. It functions
simply as a central banker for all participants in the energy
marketplace, and that credit risk really is simply the risk of
failure of either one of the two parties to a transaction to
enact that transaction. Over-the-counter or off-exchange
transactions of the type engaged in by Enron and its counter-
parties do not carry this level of protection.
Enron Online was, prior to its parent's financial failure,
a marketplace for the physical delivery of energy products and
also for unregulated financial instruments called SWAP's, and
which, as explained earlier, function as over-the-counter
instruments that look and perform identically to NYMEX-
regulated contracts, with several key exceptions, and I would
like to point them out distinctly, if I may.
The counter-parties in an over-the-counter environment bear
the credit risk of each other in a bilateral capacity. These
transactions currently are not cleared. NYMEX and other forums
currently plan to shortly introduce the clearing function and
the anonymous central counter-party credit mechanism of
clearing to these products. Pricing is not transparent to the
public on a system such as Enron Online, because the system is
geared and participated in by professional traders. The
transactions simply are not regulated.
Typically, over-the-counter market participants utilize
NYMEX as the ultimate source of the most efficient liquidity,
and liquidity for the purpose of this testimony is simply
defined as the difference between what someone is willing to
pay or bid for a set volume of energy and what someone is
willing to sell that energy for at any given instant. The
energy marketplace, there is a very substantial interaction
between NYMEX and the unregulated, physical and over-the-
counter energy markets. The interaction was clearly apparent in
the case of Enron.
I would like to share a little bit of the tactical
perspective of the New York Mercantile Exchange on market
structure and pricing dynamics as the Enron situation unfolded.
In the early stages of Enron's difficulties in the fall of
2001, NYMEX's market surveillance and risk management staff
alerted the exchange's management of the potential problems,
and immediately the exchange implemented a number of measures
that are classically typical of regulated environments.
Margin requirements on natural gas contracts were
immediately increased, approval was sought from--and I must
personally thank the leadership of the CFTC, because we were
granted immediate approval of the use of an instrument
described as an exchange of futures for SWAP's, which basically
this instrument allows for a participant in the cash market to
migrate the exposure of that position immediately to the
regulated credit mechanism of our exchange clearinghouse by
simply choosing to use that instrument, so an over-the-counter
unregulated instrument immediately becomes regulated, and
therefore credit-protected.
The exchange policies to reduce exposure to Enron's credit
risk by NYMEX traders were implemented. Indeed, as the measures
were enacted we witnessed a remarkable, what we call flight to
quality, quality of liquidity as market participants moved to
the NYMEX, where financial performance is guaranteed as the
depth and breadth of liquidity from moment to moment can be
easily identified in the centralized and physical marketplace.
Based on the information available at this time, it does
not appear that the failure of Enron was related to rules or
the absence of rules governing trading in energy contracts.
Although limited information is available concerning the volume
done through the Enron system, Enron Online, SEC filings by
Enron for the first two quarters of 2001 indicate that the
notional value of trades on Enron Online, the electronic
marketplace operated by Enron for various over-the-counter
products, averaged just under $2.8 billion per day notional
value. The average daily notional value of trades on the New
York Mercantile Exchange for all of the year 2001 averaged $13
billion per day, approximately 4.6 times the daily average
volume reported on Enron Online. These numbers suggest that
energy companies chose NYMEX over Enron Online for a large
majority of their business.
Related to the issue of Federal market oversight, I would
simply like to point out the perspective of the exchange, the
New York Mercantile Exchange relative to the Commodity Futures
Modernization Act of 2000. NYMEX actively expressed concerns
centered on a provision which appeared in both the House and
Senate versions of the legislation. This provision was actively
pushed by Enron, principally by Enron and other prominent
participants in the over-the-counter market and would have
exempted energy and metals futures contracts traded on the
electronic trading platforms from nearly all regulatory
oversight and thankfully, Mr. Chairman, with your and other
members of this committee's very distinct efforts, there was a
recognition of a serious flaw in that sort of policy
perspective, and extreme deregulation was not really achieved,
and I think the markets are better for it.
Quite courageously, this committee challenged Enron and
others, preventing it from becoming law in its most draconian
form, and I want to repeat, I think the marketplace, one of the
reasons the marketplace functioned as efficiently as it did in
Enron's unraveling was because of the metered and risk
management perspective of the regulation.
To this day, we fail to understand the distinction, the
Mercantile Exchange fails to understand the distinction between
an exempt exchange doing business electronically and a physical
exchange doing business in an open trading environment. The
energy market conditions arising from Enron's bankruptcy could
have been far different had the unwise proposal to nearly
completely eliminate regulatory oversight of energy and metals
futures and options contracts traded on electronic trading
platforms been adopted as it was originally proposed. As it
turned out, market participants availed themselves of the
safety and credit enhancement provided for by the regulated
marketplace.
As Congress moves forward in the examination of the complex
issues arising from the bankruptcy and in consideration of how
the benefits of transparency and market oversight and enhanced,
open and fair competition can be extended to the broader energy
marketplace, including that of electricity, where I think it is
dearly needed, these lessons should be remembered as future
legislation is developed and considered.
Once again, Mr. Chairman, I want to humbly thank you for
the opportunity to appear, and look forward to answer any
questions put forward by the panel.
[The prepared statement of Mr. Viola follows:]
Prepared Statement of Vincent Viola, Chairman, New York
Mercantile Exchange
Mr. Chairman, my name is Vincent Viola. I am the Chairman and Chief
Executive Officer of the New York Mercantile Exchange (``NYMEX'' or the
``Exchange''), which is the world's largest forum for the trading and
clearing of energy contracts. NYMEX is a federally chartered
marketplace, fully regulated by the independent federal regulatory
agency, the Commodity Futures Trading Commission (``CFTC'' or the
``Commission''). On behalf of the Exchange, its Board of Directors and
members, I want to thank you and all the members of the committee for
the opportunity to participate in today's hearing to study the impact
of the collapse of Enron on the energy marketplace. As you and the
members of this committee are painfully aware, the Enron bankruptcy has
had a far reaching impact on employees, consumers, stockholders,
regulators, elected officials, and energy market participants. The
shocking swiftness with which Enron's failure occurred and the lack of
transparency of the reasons for the failure are necessary topics for
thorough Congressional review.
Our comments and observations today will focus primarily on the
market impact and other issues, including regulatory matters, arising
from the bankruptcy, and the effect it has had on the marketplace,
market participants and consumers. Our remarks today will be presented
in the following order:
The Energy Marketplace--The Role of NYMEX
NYMEX is Regulated by the Commodity Futures Trading
Commission
The Marketplace Reacted to the Enron Collapse Swiftly, and
Minimal Damage Occurred
Transparency is a Critical Component of a Competitive
Marketplace
Statutory and Regulatory Issues
the energy marketplace--the role of nymex
The New York Mercantile Exchange, Inc., was established in 1872,
and has grown to become the world's largest exchange for energy and
precious metals. As a regulated commodity futures and options exchange,
NYMEX has served as a diverse domestic and international customer base
by bringing price transparency, competition and efficiency to energy
markets, and provides businesses with the financial tools to deal with
market uncertainty.
Although NYMEX is a marketplace for commercial participants in the
energy realm to hedge risk and discover prices on large volume
transactions, the benefits of this marketplace accrue to the consumers
of energy who receive prices based on open and fair competition. In
addition to prices being competitively arrived at, the Exchange also
assures that the prices for all transactions occurring on its floor are
transparent. They are disseminated world-wide immediately upon
execution via the market ticker, and are accessible real-time through a
variety of market data services.
The transparency of NYMEX prices, and the integrity of its markets,
makes NYMEX a visible and reliable benchmark for energy pricing which
is vital to our economy. The visible and highly competitive daily
transactions of energy futures and options on the exchange provide a
true world reference price for each of the commodities traded. In the
aftermath of the collapse of Enron, NYMEX has played a leading role in
insuring against a broader financial adversity in the energy
marketplace through its secure liquid market, also served once again in
its role as a safe haven that we have served during other episodes of
market uncertainty.
In addition to price transparency, the Exchange is used and relied
upon as an open forum for hedging energy price risk. Risk shifting, in
the secure liquid markets that NYMEX provides, allows commercial
interests to ``hedge'' the risk of price fluctuations that could affect
planning of their business operations, and consequently profitability,
by using futures and options contracts to ``lock in'' energy costs. For
the commercial participant, the result is a form of risk insurance
against the financial adversity that can result from volatile energy
prices. The primary instruments used are futures contracts and options
contracts:
A futures contract is a binding obligation to make or take
delivery of a specified quantity and quality of a commodity at
a specified location and time.
An options contract is a contract which gives the holder the
right, but not the obligation, to purchase or to sell the
underlying futures contract at a specified price within a
specified period of time in exchange for a one-time premium
payment.
In addition to the openness and transparency of its trade execution
operations, NYMEX's clearinghouse protects all participants against
counterparty credit risk, which is simply the risk of failure of either
one of the two parties to a transaction (the buyer or the seller) to
pay such funds as they become due to his counterpart as a result of the
trade. Through a system of cross guaranties among the brokerage firms
and banks that comprise NYMEX's clearinghouse, credit risk is removed
from each participant, because financial performance is guaranteed by
the Exchange and backed by its clearing members. Customer funds are
held by the Exchange and its clearing members in trust accounts which
are fully segregated from the exposure and funds of the clearing firm
or the Exchange itself. Over-the-Counter, or off-Exchange, transactions
of the type engaged in by Enron and its counterparties do not carry
this level of protection against credit exposure.
nymex is regulated by the commodity futures trading commission
The federal government has long recognized the unique economic
benefit futures trading provides for price discovery and managing price
risk. In 1974, Congress created the Commodity Futures Trading
Commission (``CFTC'' or ``the Commission''), giving it authority to
regulate commodity futures and related trading in the U.S. A primary
function of the CFTC is to ensure the economic utility of futures
markets as hedging and price discovery vehicles--encouraging
transparency, competitiveness, efficiency, and market and trade
practice integrity and fairness. Regulated markets must file all terms
and conditions of contracts, and contract changes, with the CFTC. The
Commission also oversees registration of firms and individuals who
either handle customer funds or give trading advice. It conducts and
monitors rule enforcement at U.S. futures exchanges.
As part of the federal mandate, NYMEX performs many self regulatory
functions, and its rule enforcement program is under the jurisdiction
and watchful scrutiny of the CFTC. NYMEX expends considerable resources
to maintain a compliance function, including market and financial
surveillance, as well as a disciplinary process for those who might
violate any of the Exchange's rules.
Unregulated Physical and Financial Markets Also Provide Risk Management
Another component of the energy marketplace is comprised of
exchanges and intermediaries not falling under the jurisdiction of the
CFTC, which thus are unregulated. These markets are frequently referred
to as over-the-counter (``OTC'') markets. The trading subsidiary of
Enron, EnronOnline (``EOL''), was, prior to the parent's financial
failure, a marketplace for physical delivery of energy products
(meaning that buyers and sellers actually intended to make or take
delivery of the commodity bought or sold), and also for unregulated
financial instruments called ``swaps,'' which are OTC instruments that
look and function similarly to or identically to NYMEX' contracts with
several key exceptions:
The counterparties bear the credit risk of each other--these
transactions are not cleared;
Pricing is not transparent to the public; and
The transactions are not regulated.
An over-the-counter or OTC deal is a standardized or customized
contract usually arranged with an intermediary such as a major bank or
the trading wing of an energy company, as opposed to a standardized
contract traded on a futures exchange. A swap is generally defined as
an agreement whereby a floating price is exchanged for a fixed price
over a specified period, thus allowing a buyer or seller of energy
products to ``lock in'' a specific price, and avoid the risk of
floating prices. The financial purpose of an OTC transaction,
therefore, is usually the same as the financial purpose of a NYMEX
transaction. The swap is a financial arrangement which involves no
transfer of physical energy; both parties settle their contractual
obligations by means of a transfer of cash. The agreement defines the
volume, duration and fixed reference price (which for most contracts in
the U.S. for oil or natural gas is the NYMEX price). Differences are
settled in cash for specific periods--monthly, quarterly or six-
monthly.
Typically, OTC market participants utilize NYMEX not only as a
price reference, but also to hedge their own price exposure resulting
from the swap agreements or physical contracts that they have entered
into. Thus, in the energy marketplace, there is a substantial
interaction between NYMEX and the physical and OTC energy markets.
the marketplace reacted to the enron collapse swiftly,
and minimal damage occurred
In the early stages of Enron's difficulties in the fall of 2001,
some observers feared that Enron's substantial position in the OTC
marketplace could pose serious problems for a significant number of
market participants. Although it is still too early to know for sure,
it appears that these fears did not come to pass, although they were
well-founded. Enron's counterparties appear to have realized the risk
in being paired against a company in ever-worsening condition and made
alternative arrangements, including transferring positions to the
NYMEX.
During that same period, NYMEX market surveillance functions, using
the established tools such as large trader reporting, position limits,
and position reporting, alerted staff and management to potential
problems. To address issues arising from the Enron situation, the
Exchange implemented a number of measures:
Margin requirements (cash required as a guarantee of
fulfillment of a futures contract) on natural gas contracts
were increased.
Approval was sought from, and granted by, the CFTC for the
use of EFS (``Exchange of Futures for Swaps'') instruments for
natural gas to allow market participants to migrate their
positions from the OTC marketplace to NYMEX, where financial
performance is guaranteed.
Exchange policies to reduce exposure to Enron's credit risk
by NYMEX traders were implemented.
Indeed, as the measures were enacted, we witnessed a remarkable
``flight to quality,'' as market participants moved to the NYMEX where
financial performance is guaranteed by the safety and soundness of a
federally overseen clearinghouse.
transparency is a critical component of a competitive marketplace
Market transparency has sometimes been defined as ``the ability of
market participants to observe and obtain information on the trading
process.'' Transparency has many dimensions because a market has many
kinds of participants and many types of information. In the case of
Enron, concerns on transparency have ranged from corporate reports in
compliance with securities law requirements, disclosure to stockholders
and employees, and in the nature of the market utilized by the
company's energy trading arm. We are not inclined to comment on
securities law related issues, or on corporate governance. We will
direct our observations to transparency issues related to the
functioning of the energy marketplace.
Mr. Chairman, through your legislative efforts and public
statements, you have promoted the notion that energy markets are in
need of greater transparency. More than merely paying ``lip service''
to the issue, you have translated your opinion into action.
Specifically, H.R. 2884, the ``Energy Act of 2000'' (Attachment 1) *
included an important provision which you sponsored, and which directs
the Secretary of Energy to study how government agencies, consumer
cooperatives and others can learn about and utilize heating oil futures
to protect consumers and government budgets from energy price
uncertainty. Expanding the knowledge and use of market instruments
directly enhances market transparency.
---------------------------------------------------------------------------
* The attachments have been retained in committee files.
---------------------------------------------------------------------------
Even now, the Department of Energy's Energy Information
Administration (``EIA'') is evaluating comments on their proposal,
following an initial review by the Office of Management and Budget
(``OMB''), to provide a weekly report on the volume natural gas in
storage. This report, which had been done by the American Gas
Association until the AGA announced that it would cease reporting in
the spring of 2002, is a critical component of transparency in the
natural gas marketplace. NYMEX strongly supports the EIA's efforts, but
we feel it is absolutely critical that the data be released at a time
when the market is open and has the largest number of participants--we
have argued for a release time of 10:30 a.m. on the day of release
(Thursdays). Some comments received during the OMB Review of EIA's
proposal suggest that the report should be released in the late
afternoon, or just prior to the weekend, so the data can be
``digested,'' and would not cause as much volatility in the
marketplace. While the intentions of those proposing after hours
release may be chaste, they would have the opposite effect sought.
Energy markets today trade 24 hours per day. However, the participants
trading outside of the traditional ``open outcry'' daytime market tend
to be very large and sophisticated entities. Those large entities would
have a distinct advantage if the data were to be released when the most
active market is closed. In essence, they would be in a position to
utilize information when many market participants could not. While not
exactly the same issue as ``insider trading,'' the benefits of the
natural gas survey data in enhancing energy market transparency would
be greatly diminished if the data is not released during a time when
the largest number of participants are active.
Transparency Lessons Learned From the California Electricity Disaster
The most recent, and telling, lessons on market transparency come
from California. While striving to develop a competitive and
transparent electricity marketplace to facilitate the implementation of
California's ``deregulation'' legislation in the mid 1990's, the
efforts of federal and state agencies overseeing the attempt failed
miserably. In the name of ``transparency'' a government mandated
monopoly market, the California Power Exchange (``PX'') was created
which eliminated competition and forced the market into a ``spot'' or
day ahead marketplace which is typically the most volatile in energy
markets. Making things even worse was the fact that the transmission
system remained, for all intents and purposes, under the monopoly
control of the utilities, thus stifling yet another avenue for
competition. The fact that the PX reported prices in the name of
transparency was of little use in developing a truly competitive
market. When a monopoly owns a road and controls all access, price
reporting, or ``transparency'' is of little use to the driver in need
of that road. In spite of all the benefits of controlling a monopoly
market, the PX filed for bankruptcy last March.
The goal of building and enhancing a transparent electricity market
is a good one. However, without rules and policies which facilitate
true competition--an environment where many sellers compete with each
other for buyers, and non-discriminatory access to the transmission
grid, ``transparency'' will not develop in a manner that maximizes the
public good. Another potential difficulty lies in the area of committee
jurisdiction. One agency with expertise and experience in competition
and transparency is the CFTC. As this committee moves through the
difficult legislative process, we urge that consideration be given as
to how the market oversight knowledge of the CFTC might be utilized to
further the goals of enhanced competition and transparency in the
electricity markets.
statutory and regulatory issues
Based upon the information available at this time, it does not
appear that the failure of Enron was related to rules, or the absence
of rules, governing trading in energy contracts. Until all the facts
are in, we cannot say with any certainty which of several possible
causes brought about the bankruptcy, but we do not believe the cause to
have been the regulation or deregulation of energy trading. Based on
what we now know, we are not recommending or calling for significant
changes in the way the over the counter markets are regulated. However,
as detailed in the following paragraphs, we still do not believe the
differences in regulatory oversight between energy and metals futures
contracts traded on electronic platforms, as opposed to those traded on
an ``open outcry'' manner which resulted from legislation passed in
2000, are justified on an economic or policy basis.
Episodes like this one, where a major market participant fails,
heighten the awareness that the Exchange is a safe haven, and that the
benefits to doing business on a regulated marketplace hold enormous
appeal, or should, to any corporation with credit or price exposure to
energy. We believe that corporate boards and treasury offices should
become more involved as a matter of their fiduciary obligations to
their employees and shareholders to learn about the differences between
regulated and unregulated marketplaces. However, we do not believe that
business should be compelled to use NYMEX by virtue of a regulatory or
legislative fiat.
Although limited information is available concerning the volume of
business done through the Enron system, SEC filings by Enron for the
first two quarters of 2001 indicate that the notional value of trades
on EnronOnline (the electronic marketplace operated by Enron for
various OTC products) averaged just under $2.8 billion per day. The
average daily notional value of trades on NYMEX for all of 2001 is $13
billion, or more than 4.6 times the daily average volume reported for
EnronOnline. These numbers suggest that energy companies chose NYMEX
over EnronOnline for a large majority of their business. It was NYMEX,
not Enron, which represented the largest forum for the trading of
natural gas, crude oil, and other energy products, by a wide margin,
notwithstanding (or perhaps because of) the vastly uneven regulatory
schemes governing our respective conduct. It is worth pointing out that
NYMEX remains solidly in business.
Recently, a number of publications have reported that the Exchange
was ``unhappy'' with the Commodity Futures Modernization Act of 2000
(the ``CFMA''). Specifically, while we were supportive of, or neutral
to, much of the legislation, our major concerns centered around a
provision which appeared in both the House (H.R. 4541) (Attachment 2)
and Senate (S. 2697) versions of the legislation as introduced in May
of 2000. This provision was actively pushed by Enron, among others, and
would have exempted energy and, in the House version, metals futures
contracts traded on electronic trading platforms from nearly all
federal regulatory oversight.
Thankfully, Mr. Chairman, you, Senator Charles Schumer, and
Senators Richard Lugar and Tom Harkin (Attachment 3) with the Senate
Agriculture Committee, as well as number of members of congress
including Congresswoman Carolyn Maloney, Congressmen Peter King, John
Dingell, and others recognized the serious policy flaws with this
extreme deregulatory measure, and quite courageously challenged Enron
and others, preventing it from becoming law in its most draconian form.
The final version of the legislation passed by Congress in December,
2000, (H.R. 5660) (Attachment 4), contained a modified version of the
provision which added the following provisions:
An exempt electronic exchange would be subject to anti-fraud
and anti-manipulation provisions of the Commodity Exchange Act.
Authority for the Commission to prescribe rules, if
necessary to ensure timely dissemination by the electronic
trading facility of price, trading volume, and other trading
data should the Commission determine that the exchange performs
a significant price discovery function.
Obligate the exchange to maintain records for five years.
An exempt electronic exchange would have to provide the
Commission with access to the facility's trading protocols and
electronic access to the facility, and information relating to
data entry and transaction details sufficient to enable the
Commission to reconstruct trading activity on the facility
conducted in reliance on the exemption.
NYMEX had opposed the exemption from its inception, and had
supported its elimination from both the Senate and House versions of
the CFMA. To this day, we fail to understand the distinction between an
exempt exchange doing business electronically, and one doing business
on an open-outcry trading floor.
The risk management/price discovery business has undergone a
dramatic evolution over the last fifteen years. Many of those changes
have been both the cause and the effect of legislation passed in 1992.
Specifically, the growth of the over-the-counter (``OTC'') markets
whether in financial or commodity swaps, Brent oil forward contracts,
or other new instruments was the driving force that led to the dramatic
change in commodity oversight that the 1992 amendments to the Commodity
Exchange Act embodied. No longer were all futures contracts required to
be executed on or subject to the rules of a contract market. For the
first time, the CFTC was granted the authority to exempt from the
exchange trading requirement, agreements and transactions that may
otherwise have been subject to the Act. The CFTC exercised that
exemptive authority shortly after the passage of the 1992 amendments,
and, as a result, the growth of the over-the-counter markets greatly
accelerated.
In many respects, NYMEX, as a marketplace for contracts that
require physical delivery of a commodity, has been a beneficiary of the
regulatory flexibility embodied in the 1992 legislation. It has
fostered the growth of energy price risk management by parties that
otherwise lack the ability to utilize optimally standardized physical
delivery contract because they need to manage the price risk in the
commodity in a more customized manner. Regulatory flexibility has
enabled these parties to structure transactions with a selected
counter-party to suit their needs. To the extent that energy price risk
is transferred to a willing counter-party, that party can protect
itself through the use of the futures market for the generalized
commodity price risk and accept the balance of the price risk (for a
cost the parties agree to) or attempt to otherwise balance it off.
Congress and the CFTC must provide the flexibility to exchanges to
innovate--to continue to serve the commercial needs of the community,
whether oil producers, refiners, farmers, or financial institutions--
free of the regulations which micro-manage, yet within a statutory
framework that maintains public confidence.
In testimony presented over the past decade, NYMEX has consistently
supported and advocated the need for the market oversight (position
limits, large trader reporting and surveillance) that the centralized
markets provide. We believe that CFTC oversight is appropriate and
beneficial in areas that provide oversight and uniform standards aimed
at protecting the ongoing financial integrity, market integrity and
trade practice integrity of the marketplace. We believe that correct
emphasis has been placed on the financial integrity and trade practice
protections that the self-regulatory structure of this industry has
always provided. The deepest, most liquid markets--that provide the
most efficient price discovery and risk shifting--occur on the
centralized market, i.e. NYMEX, where market and financial integrity
oversight is a routine part of doing business.
The Energy Marketplace Has Dealt With the Enron Bankruptcy
Chief among the lessons to be taken from the Enron bankruptcy is
the value provided by the federally chartered, regulated commodity
marketplace in supplying market oversight and credit enhancement. The
ability of market participants to move from largely unregulated trading
platforms to the Exchange where transparency, liquidity, and market
oversight are the watchwords, proved to be of critical value in
avoiding broad ranging disruptions as Enron's problems became known.
The situation could have been far different had the unwise proposal
to nearly completely eliminate regulatory oversight of energy and
metals futures and options contracts traded on electronic trading
platforms been adopted as originally proposed. As it turned out, market
participants availed themselves of the safety and credit enhancement
provided by the regulated marketplace. As Congress moves forward in the
examination of the complex issues arising from the bankruptcy, and in
consideration of how the benefits of transparency, market oversight,
and enhanced competition can be extended to the broader energy
marketplace, including that of electricity, these lessons should be
remembered as future legislation is developed and considered.
Once again, Mr. Chairman, thank you for the opportunity to
participate in this important discussion.
The Chairman. Thank you very much for your testimony.
Mr. Robert McCullough, managing partner of McCullough
Research in Portland, Oregon.
STATEMENT OF ROBERT McCULLOUGH, MANAGING PARTNER, McCULLOUGH
RESEARCH, PORTLAND, OR
Mr. McCullough. Thank you, Mr. Chairman, thank you, members
of the committee for the opportunity to speak today. Now, I am
a practitioner, a fact provider and, to be blunt, I am a tiller
of the fields that are managed and regulated by the fine
gentlemen who have spoken before. I am going to be very brief.
The bottom line is that the Enron collapse had tremendous
impacts throughout the industry. Luckily, it was not spot
prices.
He really brought up the central issue, which is
transparency. That is an economist term, openness, and that
openness is critical to the working of a competitive market.
There are three feet to the stool, financial, commercial,
operational. On the financial side, the issue of blame really
is not central here. We really do not care at this exact
moment, in this exact panel, who is at fault, but we care
critically that the Enron collapse raised the cost of capital.
For those of you who are conversant with this, it has
shifted the choice of resources away from renewables towards
fossil fuels, because renewables are capital-intensive. We will
live with that choice for many years.
Now, how did it change the cost of capital? Simply because
we do not understand the Enron statements. How do you get even
the most minor understanding of the Enron statements? Well, a
simple question. Who owned LJM, that led, precipitated the
collapse? Well, first you need computer resources, you need a
high-speed Internet connection to the SEC, you need 48 hours to
download this force generation data base with real-time access,
and at the end of it what you find is that on November--I am
sorry, October 20, 2000, Enron stated that LJM was owned in
part by Credit Suisse and Greenwich Net West.
Now, the critical issue there is, how can an investor
possibly invest in these markets without knowing who the
central owners of these vast enterprises are? This is a logical
question. Because that information is not available, the
financial markets are not transparent, the cost of capital will
be higher. The change will end up in the resources we are
served by in years to come, and certainly by consumers.
Next, let us talk about the impact on commercial
businessmen, trading. A simple fact of the matter is, we have
very little information on commercial arrangements. Some of the
new institutions, like the California ISO, are very, very
secretive. They were lobbied from the beginning by players in
that market to set commercial data availability rules that were
very restrictive. You required the intervention of the
regulatory commissions of all the Western States, the
Governor's office of many of the major utilities simply to find
out which resources were running in 2000 and 2001 in
California.
We still have very little understanding about who dominates
many of these hubs. We have very little information about the
critical long-term forward markets. The chairman of FERC is
entirely correct, we did not see a lot of spot price changes,
but we were appalled to find that at the moment of Enron's
bankruptcy the 2003 and 2004 forward prices in the critical
hubs in the Pacific Northwest changed, were reduced downward by
30 percent.
We cannot explain that coincidence, because the data is not
available. Moreover, it is not simply a question of one trader
making money and another trader losing money. Those are prices
that directly impact consumers.
The Bonneville Power Administration across this period was
forced into a major rate increase. They had very unpleasant
financial results. Preliminary review of what data is available
in the case that Enron may possibly be the largest single
commercial partner for the Bonneville Power Administration.
Again, that will be sorted out in days to come. The bottom line
is that we need much more commercial information available.
My firm and my clients have fought efforts at FERC and the
North American Electric Reliability Council and at the EIA to
make less information available. That is the wrong path.
Now let us get to the most important issue. It is actually
system operations. When all is said and done, we are a wealthy
country. We can afford the tremendous bills we saw out of the
California market fiasco. It was not pleasant. Two of our major
industrial clients went bankrupt, one major utility is
bankrupt, but reliability is not something you can fix later on
by moving around money.
In the winter of 2000, 2001, the lack of system operations
information from California led to a major policy error. The
Secretary of Energy, doing the best he could--and this is not
an error on his part. It is an error on the policymaking part--
decided to direct all of the utilities in the Northwest to draw
down that scarce storage battery, the Columbia River, to keep
the lights on in California. I do not think he could have made
any other decision, but we know from the research done by the
Northwest Regional Planning Council that he brought us within
20 percent of long-term interruptions in the Northwest.
We are not talking an hour a day, we are talking homes and
stores and churches, factories being without lights for 8, 16
hours at a time for weeks. The bottom line there is, we needed
that operational data. We still need it. We still, by the way,
do not have an easy flow of it.
Our firm actually receives that data from the Oregon Public
Utility Commission. It then passes it back to California State
authorities like the AG's office and the California Public
Utility Commission. That is how makeshift that information flow
is.
The bottom line, gentlemen, is that transparency, openness
is a far better tool than regulation. If we know what is going
on, we know what we need to fix. At that point, the excellent
job of the regulators can focus in on the actual problems.
Before that, we are trying to operate competitive markets in
the dark, and unfortunately I am not kidding. We came close, in
the winter of 2000-01, to actually running the largest single
integrated electric system in the world in the dark.
Thank you very much.
[The prepared statement of Mr. McCullough follows:]
Prepared Statement of Robert McCullough, Managing Partner,
McCullough Research, Portland, OR
Mr. Chairman and Members of the Committee:
Good morning. Thank you for this opportunity to speak on the need
for transparency in energy markets.
I would like to start by telling a short historical tale with
enormous relevance to today's situation. Seventy years ago a pioneering
electric and natural gas firm collapsed. The bankruptcy, the largest
one in U.S. history at the time, destroyed the retirement savings of
millions of Americans. Thankfully, due to the primitive technology of
the time, interconnections between systems were rare and the collapse
had few operational implications--the lights stayed on.
As everyone in this room is aware, I am speaking of the Insull
Trust. Sam Insull, Edison's secretary, had built a huge empire known
for its lack of transparency. Even given the weak financial reporting
standards of the time, Insull's structure was shrouded in secrecy.
Ownership relationships were so tangled that it took twenty years to
untangle the web of interlocking directors and pyramided debt and
equity financings.
The collapse of the Insull Trust created an enormous public outcry.
Reforms directly traceable to the collapse are the genesis of our
current regulatory structure--the SEC, the Federal Energy Regulatory
Commission, and a variety of other mechanisms like the Public Utilities
Holding Company Act. Even the North American Electric Reliability
Council likely owes its existence to the tangled industry structure
bequeathed to us by Sam Insull.
Seventy years later we are re-enacting the same drama with Enron.
Not only are the financial details frighteningly similar, but we are
realizing that our regulatory framework has failed to protect investors
and consumers from exactly the same abuses.
In a sense we are lucky that the two largest collapses in U.S.
history have occurred in firms that had little operational
significance. Our situation would have been far worse off if Enron had
actually achieved the level of hegemony over retail markets that they
often boasted about. In practice, both failures ended up hurting
investors more than consumers. We need to recognize that this will not
always be the case if reforms are not enacted.
The common theme between these two disasters is transparency.
Transparency is an academic's name for openness. In everyday English it
simply means the ability of investors, traders, and operators to
understand what is going on in the electric and gas industry. Unique in
the economy, our energy infrastructure is central to the health of
society on an instantaneous basis. Failures in electricity and gas open
the specter of the lights actually going out in large areas of North
America. Transparency allows policy makers, regulators, investors,
entrepreneurs, and consumers to make intelligent and well founded
decisions about their energy supply. A refrain we hear often repeated
is that competitive markets don't operate very well in the dark. If we
fail to set the right policies, we may actually get to experience this
first hand.
Transparency is critical in three different, but closely related,
arenas.
financial transparency
The first of these is financial. Both Enron and Insull were
characterized by a bewildering corporate structure and very sketchy
financial reporting. Insull pioneered abuses in interlocking
directorates, pyramided securities, and self-dealing. As the weeks pass
after Enron's Chapter 11, we are hearing exactly the same allegations.
One of the ironies of the Enron debacle is that if Representative
Sam Rayburn, one of the authors of the 1935 Public Utilities Holding
Company Act, had had his way, Enron would have been a registered
utility holding company. The stringent reporting and regulatory
requirements would very likely have allowed us to avoid Enron's
implosion. Every arcane financial transaction would have been on the
record. Every major decision (and most minor ones) would have been
subject to SEC review.
Now we all know that PUHCA is complex, difficult to apply, and
technologically outmoded. In practice, applying PUHCA has been like
gardening with a chainsaw--possibly effective but difficult to control.
I am not proposing that we can easily rehabilitate this tool today. The
key is that the detailed reporting required under PUHCA would have
provided the transparency that the investors desperately needed to
protect themselves from Enron's hidden risks.
The investor--even those aided by sophisticated Wall Street
analysts--simply did not have the data to make an informed choice. Our
detailed dissection of just one of Enron's Special Purpose Entities
(SPEs) required massive computer resources, many years of experience on
the ground in the industry, and thousands of hours of professional
effort.
Whitewing, the asset holder that supported the investments at Enron
and Osprey, is now worth no more than $2 billion dollars against a book
value of $4.7 billion. No matter how creative the bankruptcy court is
in the unraveling of Enron's Chapter 11, investors will lose $2.7
billion dollars from just this one SPE.
The required reforms are straightforward. Off-balance sheet
financing does not mean stealth financing. Whitewing's income and
balance sheets needed to be part of the reports available to investors.
Massive, billion dollar shifts were frequently made in Whitewing's
structure and only reported with a line or two in Enron's 10Qs and
10Ks.
Equally dangerous was Enron's use of mark-to-market revenue and
earnings accounting. Enron apparently calculated the proceeds from
multi-year transactions based on values from forward markets that are
thin at best and non-existent at worst. One industry pundit called
depending on forward markets in electricity as pricing by rumor. If
mark-to-market is used, the assumptions behind the calculations must be
open for review.
commercial transparency
Commercial transparency is also a problem. FERC's previous
chairman, Curt Hebert, recently appeared before this committee and
stated that ``In today's competitive markets, however, confidentiality
of price and customer information can be critical to a utility's
success.'' One of the lessons of the California market failure and
Enron's collapse is that he cannot have been more wrong.
One of the ironies of the California crisis is that the theoretical
pursuit of transparency through the establishment of centralized
markets at the California ISO and Power Exchange led to the filing of a
tariff at FERC that made almost all commercial information secret. The
logic is that commercial data availability would make gaming the
centralized markets easier and, therefore, in order to protect the
competitive process, government must intervene to suppress the
distribution of market data.
In practice, the secrecy enforced by the ISO has made their markets
completely opaque. Another irony is that in the course of the many
investigations currently under way as well as numerous FERC cases, all
commercial information is now readily available to market interests.
Only policy makers, the press, and consumers do not have access to
market data.
Restriction of market information weakened the negotiating position
of consumers and made high prices far more likely in these markets.
Even today, weak reporting of marketers to FERC and restrictive
information rules by ISOs make concentration and abuse in market hubs
difficult to monitor. Enron, for example, doesn't include market hub
information in their quarterly marketing report to FERC, even though
many other marketers do. Our only way to know the degree of market
dominance Enron had achieved at certain hubs is to ``reverse engineer''
reports from marketers who do report such data in order to calculate
Enron's share of transactions. In doing so, we now know that Enron had
achieved a share of greater than 30% of transactions at the California-
Oregon Border.
The relevance of such information is critical. On December 3rd,
Enron went into Chapter 11. At the same time, forward markets on the
West Coast fell by 30%. No other changes in operations, hydroelectric
supply, or fossil fuel prices took place at that time. The clear
implication is that Enron may have been using its market dominance to
``set'' forward prices.
The negative impacts of these policies are not only felt by
consumers. Bonneville Power, an agency of the Energy Department, posted
$337 million in losses last year--losses that reflect a cost in the
short term to the U.S. Treasury. One possible reason is the large
degree of transactions between Enron and Bonneville during this period.
Transparency, simply put, requires open information for consumers
and policy makers. In the absence of open information market failures
are easily disguised and corrective measures are painfully delayed.
operational transparency
The third area where transparency is critical involves system
operations. Marketers have been lobbying FERC, NERC, and the Energy
Information Administration to restrict information in the name of
competition.
While their arguments seem specious to long time market
participants such as myself, their energetic advocacy often disguises
the weakness of their arguments. Where system operations are concerned,
granting their demands may well be catastrophic.
NERC and the regional reliability councils were established in
response to the massive blackout along the eastern seaboard in November
1965. The idea was to promote reliability by coordinating information
between parties. All information was open to the public and accessible
to policy makers.
Until 2000, the system worked very well. In 2000, the system
foundered. California emergencies, we now generally believe, had a
strong component of market failure. In December of 2000, our utility
clients on the West Coast simply did not know whether that the
emergencies were true or not.
When the California crisis started, on May 22nd, 2000, the question
of whether the high California prices were due to withholding by
California generators or a real capacity shortage was of critical
importance to the neighboring systems. Upon investigation, we found
that the California ISO had effectively classified all of their
operating information. We were unable to understand why the California
ISO's official reports to the Western System Coordination Council
showed a healthy surplus--15%--but they were declaring capacity
emergencies every few days. A critical issue was whether the major
thermal units in California were actually being dispatched. The
California ISO was distributing this information to the WSCC, which in
turn was making it available to market participants within California.
Access, even by WSCC members, outside this small group was
energetically opposed by marketers and the California ISO. When we
finally raised this issue publicly in October of 2000 and gained access
for Pacific Northwest utilities, the regulatory Commissions in Oregon
and California, and a variety of California state agencies such as the
California Energy Commission and the California Oversight Board, the
California ISO responded the following day by ceasing to provide this
information, citing, in part, access to information by Oregon state
regulators.
How did commercial transparency create this 180 degree reversal of
public policy? The answer comes from a lack of understanding about
competitive markets and the importance of information to consumers. The
fundamental fact that the ISO overlooked is that freedom of information
makes markets more efficient. The ISO had no real way of judging
whether they were actually facing a capacity shortage or a problem in
their markets once they had forestalled open debate by classifying
virtually all operational information.
Today, we know that plant operations in 2000 among the five major
generators only averaged 50%. Comparable resources--by age, fuel, and
size--operated at over 90% in surrounding states over the same period.
In passing, the historical average availability for comparable
equipment, by age, fuel, and size is 84%.
As an historical aside, FERC gradually came to understand the
importance of this data and established a ``must offer'' rule for the
California generators as part of their repair package at the California
ISO. This rule, combined with a price ceiling, returned the California
market to competitive levels. It also appears to have reduced thermal
plant outages from 50% to 10% in a matter of weeks.
The lack of reliable operational information brought the system
very close to disaster. The hydroelectric reservoirs in British
Columbia, Oregon, and Washington are finite. Water stored in these
reservoirs are the last insurance policy against system collapse. If
the California emergencies really reflected a capacity shortage rather
than a market failure, it would have been critical to maintain this
insurance policy.
As it turned out, the Secretary of Energy, on the basis of
insufficient information, directed the U.S. systems to draw down this
insurance policy in order to serve everyday loads in California. If
winter weather in British Columbia, Oregon, and Washington had turned
harsh, blackouts of substantial duration might well have resulted.
The fault was not with the Secretary of Energy. The fault was in an
ISO tariff that restricted the information available to policy makers.
In the absence of data, we cannot have an informed debate. In the
absence of an informed debate, we can and often do make the wrong
decisions.
The first two forms of transparency discussed above, financial and
commercial, only affect dollars--losses to investors and overcharges to
consumers. The loss of transparency in the area of system operations
was vastly more critical. We came close to shutting off light and heat
to millions of consumers in January and February 2000--only a year
ago--because we drew down our reserves several months too early.
The right policy direction is to guarantee transparency to
investors, consumers, and operators. The result of the collapse of the
Insull Trust in 1932 was to make information available to policy makers
and the public. The implications of the Enron collapse of 2001 is that
we have allowed the resolve of our parents and grandparents to
dissipate.
If we fail, and the evidence from the Enron debacle is that we are
failing, we may really get the chance to explore competitive markets in
the dark.
Thank you.
The Chairman. Thank you very much.
Our final witness this morning is Dr. Lawrence Makovich,
who is the senior director and co-head of the Northern American
Energy Group in Cambridge, Massachusetts. Dr. Makovich, thank
you for being here.
STATEMENT OF DR. LAWRENCE J. MAKOVICH, SENIOR DIRECTOR AND CO-
HEAD, NORTH AMERICAN ENERGY GROUP, CAMBRIDGE, MA
Dr. Makovich. Thank you. The collapse of Enron, America's
largest electricity trader on the heels of the California power
shortage creates a crisis of confidence in deregulation of
power markets. Therefore, it is quite important to ask this
question, what was the impact of this company's collapse on
power markets across the United States?
Now, to answer this question we must realize that power
markets are a set of interconnected markets. There are regional
spot markets for energy, there are ancillary service markets,
energy futures markets, forward markets, capacity markets, and
retail power markets. The impacts of Enron's collapse range
from negligible to significant across these markets.
In the spot markets, Enron's collapse had little impact on
spot markets. An examination of the daily spot market prices
over the past year show no discernible impacts on electric
energy prices on critical dates surrounding the Enron collapse,
including December 2, when they declared bankruptcy. Therefore,
Enron's collapse did not distort the price signals that
determine the efficient utilization of powerplants in regional
markets across the country.
In ancillary service markets, Enron's collapse did not
significantly collapse these markets that involve transactions
for commodities like voltage support, reactive power, and
spending reserves. Enron's collapse did not close down critical
energy supply infrastructure, did not threaten electric
reliability, nor increase the likelihood of brownouts and
blackouts.
In futures markets, it is important to realize that the
spot markets, the volatility we see there is telling us the
power business is a very risky energy transformation business.
As a result, it is very important that this business has
futures and forward markets that are structured to work well to
provide necessary risk management, and of course the most
significant impact derives from Enron's position as America's
largest power trader.
Enron's bankruptcy forced many power contracts to unravel
at a significant cost to Enron counter-parties. Similar
nonperformance problems surfaced during the 1998 defaults by
bankrupt traders and bankers in the Midwest power markets and
during the California power crisis that required counter-
parties to write off hundreds of millions of dollars. Such
write-offs are necessary again in the wake of Enron's collapse.
Consequently, many Enron counter-parties may suffer value
declines in capital markets, at least for some period of time.
However, there is an important caveat. Although Enron's
collapse forced market players to scramble to replace contracts
to mitigate risk exposures, the collapse occurred with enough
warning to avoid a shock to energy futures prices.
Some of this stability is due to the futures exchanges
themselves. These exchanges are run by neutral third party
entities such as the NYMEX that were in a position to intervene
for Enron's nonperformance and maintain market liquidity.
Enron's collapse did affect forward power markets. The
forward power markets involve nonstandardized bilateral
contracts for power delivery in the future, usually of a longer
term than the monthly futures contract. However, unlike futures
markets, no neutral third party entity organizes these markets.
As a result, Enron filled this void in power markets by being a
market maker in forward power markets.
To do this, Enron set up a many-to-one trading platform,
Enron Online, to facilitate these transactions. To make it
attractive, Enron provided market liquidity by ensuring
continuous transactions as an intermediary. This was one of the
major reasons why Enron operated as a buyer and seller in
roughly one-quarter of all electric trading activity.
Enron's collapse suggests that it was a mistake to allow a
significant market buyer or seller to be the market maker
without any oversight. As a market maker, Enron created
information asymmetry by providing all buyers to buy from Enron
and all sellers to sell from Enron. As a result, even though
Enron aided the market by providing more price information
liquidity, Enron was also in a position to be consistently
among the first to know about most forward market transactions.
In the extreme, information asymmetry becomes insider
trading, and such flaw has a potential to destroy confidence in
the market. However, even well short of that situation, lesser
information asymmetries can also create potential problems. To
see this, imagine the temptations facing a market maker/player
to take large speculative positions in forward markets,
believing that their information advantage will allow reversal
of the position ahead of others if the market moves against
them. Such information asymmetry puts other market players at a
disadvantage, and even puts investors in a position of being
the last to know about the speculative position of trading
companies they own.
An information advantage market maker/player has the
potential to create a destabilizing trader collapse if the
information advantage is not perfect, and eventually results in
a big, wrong, inescapable bet. Allowing the largest buyer and
seller in the market to be the market maker without oversight
is also a mistake, because such conditions create dangerous
incentives when a market maker also tries to function as the
objective arbiter of forward power prices.
This potential problem arises when the market maker/player
uses mark-to-market accounting for their forward power
positions and, as a result, they are not indifferent to the
forward power price. Clearly a dangerous incentive arises,
because the market maker/player has either a net long or a net
short position, and has the incentive to shade reported forward
prices to increase reported earnings. Therefore, oversight is
essential when a major market player is clearly not indifferent
to the forward price, and yet fills the role of objective
arbiter of forward prices.
Enron's collapse may have a positive impact on capacity
markets. Capacity markets involve the trading of dispatchable
megawatts to ensure long-run supply and demand balance in power
markets. Enron was an influential stakeholder in power market
design, and an opponent of capacity markets. Enron believed
that forward markets alone could keep supply and demand in
balance in power markets over the long run. As a result,
Enron's demise may help build the consensus that forward power
markets alone cannot fulfill this function, and capacity
markets are needed.
Such capacity markets are a common element in the power
markets that evolved from tight power pools, the ones that seem
to be working better right now, and it is part of the reforms
suggested in the California market design to include these
going forward.
In retail markets, Enron's collapse does contribute to a
crisis of confidence in power market deregulation. That
significantly impacts State legislation and implementation of
retail market reform. The well-publicized collapse of Enron on
the heels of the California crisis is slowing or reversing the
move from regulation and towards the market by overshadowing
the positive evidence and lessons from the evolving power
markets that are working in several regions in the United
States.
In conclusion, Enron's collapse had significant impacts on
some power markets, but does not threaten the U.S. power system
in the near term. Enron's collapse does create this crisis of
confidence. Of course, it will take a year or more to find out
if the problems of lack of oversight, distorted market player/
maker incentives, or asymmetry of information played a role in
Enron's demise, or whether the collapse was primarily driven by
quite different factors connected to partnerships and debt.
Nevertheless, such a daunting investigative task simply
highlights the need for greater oversight and transparency in
forward power markets as part of the ongoing structure of power
markets.
Thank you.
[The prepared statement of Mr. Makovich follows:]
Prepared Statement of Dr. Lawrence J. Makovich, Senior Director and
Co-Head, North American Energy Group, Cambridge, MA
implications for energy markets of the enron collapse
The collapse of Enron--America's largest electricity trader--on the
heels of the California power shortage creates a crisis of confidence
in the deregulation of power markets. The regional power markets across
the United States are a set of interconnected markets--spot energy
markets, ancillary service markets, energy futures markets, forward
power markets, capacity markets, and retail power markets. The impacts
of Enron's collapse on these evolving power markets ranges from
negligible to significant. Few impacts are found in the spot, ancillary
service, futures and capacity markets. Significant impacts are found in
forward power markets in the short run and retail markets in the long
run.
Electric Energy Spot Markets
Enron's collapse had little impact on spot energy markets--the
trading of megawatt-hours in real time. An examination of daily spot
market prices over the past year shows no discernable impacts on
electric energy prices on critical dates surrounding the Enron
collapse--including around December 2 when Enron declared bankruptcy.
Therefore, Enron's collapse did not distort the price signals that
determine the efficient utilization of power plants in regional markets
across the country.
Power Ancillary Service Markets
Enron's collapse did not significantly impact ancillary service
markets that involve transactions for commodities including voltage
support, reactive power, and spinning reserves. These markets are
necessary because buyers and sellers of power cannot simply contract
for power flows without confronting thermal, voltage and stability
constraints of moving power through a network of high voltage lines.
Physics dictates that power flows along the path of least resistance
and not along the contract paths dictated by market transactions. As a
result, simple bid and offer negotiations cannot determine supply nor
can they clear fast enough to balance electric supply and demand
reliably in real time. Thus, power markets involve rules and
institutions to create markets or contract terms to provide these
commodities. Enron's collapse did not close down critical energy supply
infrastructure and thus did not threaten electric reliability nor
increase the likelihood of brownouts or blackouts.
Power Futures Markets
The power business is a risky energy transformation business. Thus,
futures and forward power markets are necessary to provide risk
management. For example, energy futures markets involve trading of
standardized power contracts for energy delivery at future dates. Such
a futures contract allows a buyer to purchase electric energy at a
fixed price ahead of the delivery date. As such it provides a hedge
against high spot energy prices in the future. The counterparty to this
purchase is typically a power supplier who runs the opposite risk of
low spot energy prices. Power suppliers face this risk because they
typically commit to multi-month contracts for fuel supply and thus face
the risk that future power prices may be too low to cover locked in
fuel costs and quantities. Thus, a futures transaction brings together
parties with opposite risk exposures to mitigate their risk. The
futures exchanges are set up around liquid spot trading hubs because
although few futures contracts involve physical delivery, such physical
delivery has to be possible in order for the hedging activity to take
place. A settlement of the futures contract occurs based upon the
difference between the futures contract price and the actual spot price
of electricity on the due date.
The most significant impact derives from Enron's position as
America's largest power trader. Enron's bankruptcy forced many power
contracts to unravel--at a significant cost to Enron's counterparties.
Similar nonperformance problems surfaced during the 1998 defaults by
bankrupt traders and brokers in the Midwest power markets and during
the California power crisis that required counterparties to write-offs
hundreds of millions of dollars. Such write-offs are necessary again in
the wake of Enron's collapse. Consequently, many Enron counterparties
may suffer value declines in capital markets, at least for some period
of time.
However, there is an important caveat: Although Enron's collapse
forced market players to scramble to replace contracts to mitigate risk
exposures, the collapse occurred with enough warning to avoid a shock
to energy futures prices. Some of this stability is due to the futures
exchanges themselves. These exchanges are run by neutral third party
entities such as the NYMEX that were in a position to intervene for
Enron's nonperformance and maintain market liquidity.
Power Forward Markets
Enron's collapse affected forward power markets. Forward power
markets involve non-standardized bi-lateral contracts for power
delivery in the future usually of a longer term than the monthly
futures market contract. Such contracts are necessary because the
standardized contracts of power futures markets are appropriate to
manage some but not all of the risk in the power business. However,
unlike futures markets, no neutral third party entity organizes these
markets. As a result, Enron filled this void in power market by being a
market maker in forward power markets.
As a market maker, Enron set up a many-to-one trading platform--
Enron On-line--to facilitate transactions. To make it attractive, Enron
provided market liquidity by insuring continuous transactions as an
intermediary. This was one of the major reasons why Enron operated as a
buyer or seller in roughly one quarter of all electric trading
activity. Enron's rapid collapse put pressure on forward market players
to scramble and adjust their contract positions as Enron collapsed. As
a result, other power traders were able to expand activity and fill the
void left by Enron's collapse.
Other traders have filled in for Enron in forward markets. Enron's
collapse suggests that it was a mistake to allow a significant market
buyer or seller to be a market maker without oversight. As a market
maker, Enron created information asymmetry by requiring all buyers to
buy from Enron and all sellers to sell to Enron. As a result, even
though Enron aided the market by providing more price information and
liquidity, Enron was also in a position to consistently be among the
first to know about most forward power markets transactions. As a
result, this critical enabling software in forward power markets did
not maximize market transparency concerning interactions between buyers
and sellers but instead, Enron-Online may have allowed the company to
gain an advantaged information position. Of course, this remains to be
examined as the investigation into Enron goes on, however, such
information asymmetries can create a serious market flaw.
In the extreme, information asymmetry becomes insider trading and
such a flaw has the potential to destroy confidence in a market.
However, even well short of that situation, lesser information
asymmetries can also create potential problems. To see this, imagine
the temptations facing a market maker/player to take large speculative
positions in forward power markets believing that their information
advantage will allow reversal of the position ahead of others if the
market moves against them. Such information asymmetry puts other market
players at a disadvantage and even puts investors in a position of
being the last to know about the speculative positions of the trading
companies they own. An information advantaged market maker/player has
the potential to create a destabilizing trader collapse if the
information advantage is not perfect and eventually results in a big,
wrong, inescapable bet.
Allowing the largest buyer and seller in a market to be a market
maker without oversight is also a mistake because such conditions
creates dangerous incentives when a market maker/player also tries to
function as an objective arbiter of forward power prices. This
potential problem arises when the market maker/player uses mark-to-
market accounting for their forward power positions and as a result,
are not indifferent to forward power prices.
To see this flaw in allowing a major player to also be the market
maker without oversight, suppose a market maker/player buys power under
a ten-year contract from a supplier. The market maker uses this
transaction, along with other similar transactions that it acts as an
intermediary for, to establish the forward power price curve at that
time. This requires the application of some judgment because these
transactions are not standardized. As time passes, other transactions
occur that provide the basis for the market maker to reset the forward
price curve. If the forward price curve increases then the value to the
power buyer of the ten-year power sales contract at the fixed price
increases. On the other hand, if the forward price curve decreases then
the value to the power buyer of the ten-year power purchase contract
declines.
Mark-to-market accounting allows the buyer to record this change in
contract value as current period earnings. Clearly, a dangerous
incentive arises because the market maker/player that has either a net
long (purchases exceed sales) or net short position (sales exceed
purchases) has the incentive to shade reported forward prices to
increase its own reported earnings. Therefore, oversight is essential
when a major market player is clearly not indifferent to the forward
price and yet fills the role of objective arbiter of forward power
prices.
Power Capacity Markets
Enron's collapse may have a positive impact on capacity markets.
Capacity markets involve the trading of dispatchable megawatts to
insure the long run supply and demand balance in power markets. Enron
was an influential stakeholder involved in power market design and an
opponent of capacity markets. Enron believed that forward market
contracts would keep supply and demand in balance in power markets over
the long run. As a result, Enron's demise may help build a consensus
that forward markets cannot fulfill this function and capacity markets
are needed. Such capacity markets are a common element in the power
markets that evolved from tight power pools and the reforms in the
California market design include a plan to create capacity markets.
Retail Power Markets
Enron's collapse contributes to a crisis in confidence in power
market deregulation that significantly impacts state legislation and
implementation of retail energy market reform. The problem is that
retail markets are linked to wholesale markets and power markets cover
large multi-state regions. Thus, seven years into power industry
deregulation, less than half of the electricity customers in the US
have choice of power suppliers and only a small fraction of demand is
liked to market price signals. This loss of momentum in power
deregulation perpetuates a volatile mix of uncoordinated markets and
regulation into the future.
The well-publicized collapse of Enron is slowing or reversing the
move from regulation and toward the market in power industry
restructuring by overshadowing the positive evidence and lessons from
evolving power markets that are working in several US regional markets.
conclusion
Enron's collapse had significant impacts on some power markets but
does not threaten the US power system in the near term. Enron's
collapse on the heels of the California power crisis does create a
crisis of confidence that may affect the course of industry
restructuring in the long run. Of course, it will take a year or more
to find out if the problems of a lack of oversight, distorted market
player/maker incentives or asymmetry of information played a role in
Enron's demise--or whether the collapse was primarily driven by quite
different factors, connected to partnerships and debt. Nevertheless,
such a daunting investigative task simply highlights the need for
greater oversight in forward power markets as part of the ongoing
structure of power markets.
The Chairman. Thank you very much. I think all of this
testimony has been very useful. Let me just start. We will do
7-minute rounds here.
Let me just start with the question that occurred during
your testimony, Dr. Makovich. You indicate that you believe
that allowing the largest buyer and seller in the market to be
a market maker without oversight is a mistake. What kind of
oversight do you think is required, and who should perform that
oversight, and what, in addition to just oversight, are we
talking about?
Dr. Makovich. By the term oversight I am not suggesting
micro-management of these markets. What I am talking about here
are the kind of very standard disclosure requirements on
positions, the kind of transparency in market prices that a
many-to-many exchange that provides, that provides no one with
an advantage, advanced information advantage, so this really is
about transparency and reporting requirements. It does not mean
that forward contracts have to be public knowledge, but we do
need some third party entity.
Now, whether that is NYMEX expanding their business into
this area, that can analyze these contracts and publish the
necessary information for these markets to know where they are
on a real-time basis.
The Chairman. Let me ask Mr. Newsome, do you agree that the
additional oversight or openness that both Mr. McCullough and
Dr. Makovich talks about is required, and if so, how do we get
to it?
Mr. Newsome. Well, I think that transparency and disclosure
are kind of like talking about apple pie and mom. Everyone is
in favor of that.
But I think as we look back over the last couple of years,
there has been a very full debate and airing of the issues.
When Congress was determining the Commodities Futures
Modernization Act, that is certainly an area that was looked
at.
I think based upon debate that took place during that time
period, because of the type of trading there, Congress
certainly did not choose to require at that time that those
markets disclose, and I think it bears out some difference.
In the energy exemption there are basically two levels. The
bilateral level of eligible contract participants, there is no
requirement there for disclosure,because it is one entity doing
business with another single entity without any multilateral
type competition.
The Chairman. Does anybody else have a point of view on
this? Mr. McCullough, I gathered from your testimony you
believed that it was a mistake for Congress to exempt these
trading activities in energy commodities from these
requirements for disclosure.
Mr. McCullough. This has been like a mechanic who just
pulled his head out from the guts of a car, to say what you
should do to fix all cars in the future. We do not really have
very deep and liquid electric markets. We do not really
understand the price as well. Our only discovery in 2003-04
electric prices in the largest electric market in the world is
through surveys conducted by the press. This is a very weak
tool upon which to base the planning for an entire half of the
North American continent, and we have even weaker tools in some
of the other areas.
The Chairman. Mr. McCullough, just reading from an article
that was in the Energy Daily this morning--where you are quoted
or referred to as saying that Enron could have been driven to
more and larger long-term deals in order to generate increasing
amounts of market-to-market paper profits needed to hide its
losses on earlier short-term deals that other money-losing
operations--the thrust of the article as I understand is your
suspicion at least, your belief that there is a possible
manipulation that was taking place on these forward contracts
that we have not yet become aware of. Is that an accurate
statement? Would you want to elaborate on that?
Mr. McCullough. Yes, sir. What we have is such a thin
market that Enron Online taking a position in these forward
markets could easily have become the basis for the mark-to-
market accounting. In a sense, the value of Enron's financial
statement would have become the chicken and the egg.
Now, we have had some clarification of that hypothesis
recently in the Tribune, and the Houston Chronicle, I believe,
where we have traders off the record saying that their deals
did not seem to pencil out, but they were directed to go on
ahead. If so, that would be highly consistent with this
outcome. The problem is more than simply losing the investors
in Enron money. The problem is that those forward market
disturbances might become the basis of power purchasing for
utilities like Seattle City Light, or Governor Gray in
California, in which case we might be talking about distortions
that will take years to work out.
The Chairman. I think my time is up.
Senator Thomas.
Senator Thomas. Thank you, Mr. Chairman. I would like my
statement, along with Senator Domenici's statement, to be put
in the record.
The Chairman. We will include that statement in the record.
[The prepared statements of Senators Thomas and Domenici
follow:]
Prepared Statement of Hon. Craig Thomas, U.S. Senator From Wyoming
Thank you, Mr. Chairman, for holding this hearing. To say the
demise of Enron was a shock to all of us is an understatement. I was
deeply disappointed at the collapse of this energy giant and equally
concerned when the actions of the company's top management came to
light.
However, as the Senate Energy Committee, we are not here today to
discuss the demise of Enron, but whether or not its collapse has had
affects on the energy market. Ironically, what happened to the company
is unrelated to Enron's trading business--that is the side of the
company associated with deregulation. Unfortunately, some will try to
link what happened to Enron to the electricity restructuring debate,
the natural gas markets and maybe even the overall energy debate.
Enron's problems were less about energy and more about poor investments
and unconventional, for lack of a better term, accounting practices.
Fortunately, market participants were sophisticated enough to fill
in the blanks and energy markets have not been significantly affected.
Both the wholesale electric and natural gas markets continue to
function smoothly. Sadly, for many shareholders, Enron's collapse has
had severe implications on the capital markets in this sector. Since
the company's demise, there was a huge collapse in investor confidence
and many companies have seen enormous losses with respect to stock
prices.
I hope we learn from this hearing that Enron's collapse, though a
tragedy for the company and its employees, has had no real impact on
energy markets. The company's failure should not influence the energy
legislation that this committee or, in our case, this Congress, might
pass in the future but, should influence the securities legislation we
might pass down the road. What has happened at Enron should not
influence the debate regarding energy policy, but make us raise serious
concerns over corporate accounting and disclosure of corporate
information.
I look forward to hearing from the witnesses.
______
Prepared Statement of Hon. Pete V. Domenici, U.S. Senator
From New Mexico
Mr. Chairman, I understand that this hearing was called, and I
quote from the briefing memorandum prepared by your staff, to probe the
``impact of the Enron bankruptcy on energy markets.''
As more and more details emerge about the demise of Enron, and its
effects on employees and shareholders, there can be no question that we
must learn a great deal from this collapse and strengthen our financial
and reporting policies so this can't happen again. The impact of this
fiasco on the retirement plans of countless employees is also an
extremely serious situation, The federal government may need to
implement new policies to ensure that this kind of debacle can not,
again, destroy the future plans of so many dedicated employees.
From the briefing materials prepared by your staff, Mr. Chairman, I
note the conclusion that the demise of Enron had, and I quote, ``little
impact on energy markets.'' Analysis of the Republican staff confirms
the same fact. Testimony from the Chairman of FERC states that ``the
collapse of Enron has not caused damage to the nation's energy trading
or energy supplies.''
So, Mr. Chairman, while we have much to learn from the collapse of
Enron from regulatory and financial transparency and securities and
retirement plan perspectives, it appears that the simple answer to your
goal for this hearing, as stated by your staff, is that the Enron
collapse had little impact on energy markets.
Some would argue that the collapse of Enron presents an argument
against deregulation of electricity markets. I do not agree, any more
than I would agree that the recent fiasco in the California energy
markets is an indictment of deregulation.
I think it's far too early to judge the success of electricity
deregulation, but it's also far too early to condemn it as a failure.
The California situation arose from some ridiculous constraints on
market prices and costs--a rational analysis of their approach to
deregulation would have easily shown it that it was an over-constrained
attempt to manipulate the market. It was anything but an attempt to
apply free market principles to the electricity sector.
Several states are in the midst of much more successful
deregulation ventures. We need to give them time to develop their
approaches and evaluate lessons learned from their experiences. Above
all, we need to be sure that the federal government does not overly
constrain the ability of states to deregulate. I think it's safe to bet
that states, after studying the California problems, will also be
careful to ensure that a true market economy thrives in their state if
they choose to pursue deregulation.
America built its economic engine by providing free and open
markets, with a transparent financial system to allow evaluation by
consumers and shareholders. We have prospered tremendously from
allowing the free market system to work. Deregulation may be a boon for
consumers, but only if it's done in the context of a free market system
with full respect for the rights of individual states.
Before closing, Mr. Chairman, I also want to note that some are
arguing that Congress should delay action on a comprehensive energy
bill while all the lessons of the Enron situation are analyzed. I've
already noted my support for learning all we can from this situation
and applying those lessons to improved federal controls. But I want to
state that the Enron situation absolutely should not be used as still
another excuse to delay action with serious and credible debate on an
energy bill.
As President Bush has noted on many occasions, energy security is
part of national security and it is a vital component of homeland
defense. Where we can take actions to lessen our dependence on foreign
energy producers, especially those from unstable parts of the globe, we
should be doing so.I hope such discussions will be part of a floor
debate on an energy bill, since the most unfortunate decision was made
by the Senate leader to strip this Committee from its jurisdiction over
this bill.
In closing, in the rush to study the Enron collapse, Congress is
launching hearing after hearing. Many of those hearings may uncover
critical new opportunities to improve federal systems, but I don't
think that will be the outcome of this hearing. Instead, Mr. Chairman,
I suggest that we allow states to continue to experiment with
deregulation of electricity markets, while benefiting from the
experiences of other states.
Senator Thomas. Let me follow up on your last comment
there. I guess you said Enron's deals would set the price. I do
not quite understand that. You have generators, you have a
price, you know what the price is. If you have transmission to
move it, why would Enron's deal set the price?
Mr. McCullough. Mr. Senator, the problem is that we have a
very deep short-term market. The hourly market is huge. The
long-term market is bilateral. There are only a few players out
there. Recently, we put together a long-term deal for a large
Northwest industrial, a huge smokestack industry. There were
only four bidders, so Enron simply being a player in that has
enormous ability to swing those forward markets, and because
they are not regulated they are in an organized market like
NYMEX. We only find out what those bids are.
Senator Thomas. But if you had a regulated market you would
not be doing that.
Mr. McCullough. I meant regulated in the sense that we
would have CFTC or NYMEX oversight, or NYMEX acting as the home
for that market, and so what happens is, we only find out by a
survey and, in fact, we are pricing by rumor, and when we
discovered that plan's energy trader, one of the leading
journals in the nuts and bolts side of the business, showed
this major shift in forward prices on the day of their
bankruptcy, that came as quite a shock to us.
Senator Thomas. I guess it is a little hard, the
uncertainty of futures is true in most any commodity, and so
that is up to the buyer to make that judgment, it seems to me.
But Mr. Wood, you covered a lot of things. Just in a word
or two, what would you suggest as a result of this be done by
the Congress, or by the FERC, or have you gotten to the point
that you are ready to say?
Mr. Wood. I think watching this whole event unfold, it is
clear that there is a lot going on here, other than the issues
that these bright people--and I am honored to be in their
midst, quite frankly. I have learned more here than I have in
probably the last 4 months in my job, just listening to these
smart guys talk, but there is a lot more going on in this
story, and I would just suggest, as I mentioned at the end of
my opening remarks, that there is some wisdom to be had from
listening, and I know there are a number of other committees
looking at this. Before you see what the Enron deal can teach
us, what is interesting is there are some broader stories here,
and some of which, a lot of which were going on before the
Enron event happened regarding, I know, the issue on price
transparency.
Certainly, I know Commissioner Brownell and I talked about
that at our confirmation hearing before you all back in May, I
guess it was. Transparency for markets is critical. The gas
markets--we have talked a lot about the power markets, but not
so much about the gas. They have been around about 10 years
longer. They are much more deep, they are much more liquid. The
forwards go a lot farther out into the future. They are a lot
more competitive.
Enron Online was one-fourth or one-fifth of that market, so
people felt they were getting a raw deal from Enron Online.
They have got plenty of other alternatives to go to to do
forward trading. The power markets are a lot thinner.
And I am sorry, you asked me to do it in a word or two. I
guess a word or two, I think steady as she goes on opening up
the power markets. Congress has been supportive of the
commission's efforts to do that thoughtfully and do that
assertively to get the power markets to a health and depth and
liquidity that the gas markets are.
Senator Thomas. You have all talked about transparency. The
question is, how do we do that? Does Congress need to do that,
or can you do that?
Mr. Wood. As I mentioned in my testimony, Senator Thomas,
we have started on that effort at the commission. I think we
will get--as pointed out here by Dr. Makovich, we will get, I
guess, the traditional push back from folks that do not want
certain information to be disclosed into the market. Enron was
always good about arguing that, about how much they did not
want out there in the public marketplace for information, and I
expect that others will fill their shoes and then we will have
to deal with that.
Senator Thomas. There has been some increase in generation
capacity, but that has been one of the problems, is the
uncertainty, I think, of investment in generation. What do you
think this Enron thing has as an impact on that, any of you?
Mr. Wood. Moody's did change after one of the accounting
issues came up with regard to the Enron story. Moody's did
really go after, and I believe the others have joined them, go
after what the reporting requirements are for all of the other
people who, unlike Enron, are very asset-heavy. But I mentioned
in my testimony I am a bit worried about the overreaction to
other people's books that the Enron story precipitated and what
that might do to the availability of capital in the short run
with the generators, particularly people building powerplants,
putting it on the ground, putting cleaner plants in place than
the ones they are replacing.
Senator Thomas. What is your reaction, any of you, to
transmission? It seems to me if you are going to have market
generators you have to move power, and obviously if you want to
have a marketplace in the generation area you have to have more
transmission, do you not?
Mr. Wood. Amen to that.
Mr. Nugent. Senator, I think you clearly need more
transmission to make the market flow and function better. I
will say that solution seemed to be coming forward. Some have
not even been presented yet to us, but therefore strengthening
the capacity over certain routes, seeking some novel new routes
to markets, and there are some cost pressures that are building
that may overcome some opposition to transmission in certain
areas.
I think particularly of southwest Connecticut, for example,
where there is a real difficulty in getting power into that
area. I would say that these are not easy things to solve. They
balance a lot of issues in the environmental area or in the
acceptability in neighborhoods. We are working to solve those
as they come forward.
Senator Thomas. Would you think that an interstate grid
with RTO's off of it would be the direction we ought to be
moving?
Mr. Nugent. Well, Maine has voiced its support of that, and
the question is how to get from here to there, but stronger
ties among that to enable trading are important.
Senator Thomas. Doctor, I do not know where you are with
the resistance to doing away with PUHCA, but are there not a
lot of things that still remain of service in more than one
State if PUHCA was removed?
Dr. Makovich. Well, the holding company act is really
designed to prohibit very large, multi-State ownership in this
business, and the question of sizing this business today is a
little bit different. What we do have is large, multi-State
transmission networks that really define these markets, so the
real question is, is anybody too big within any one of these
regional power markets that you are worried about them having
undue influence?
It is actually an advantage for companies actually to
stabilize their earnings. If we do allow them to diversify
across several of these regional power markets we do not want
companies that have all their eggs in one basket, so that when
you get a boom-and-bust cycle in power prices we get tremendous
variation in their earnings, so the question of size really now
I think needs to focus on making sure the markets are not
dominated, these regional markets, and actually it is probably
a good thing if we have companies that can diversify the risk
of these power markets across regions.
Senator Thomas. Thank you, Mr. Chairman.
The Chairman. Thank you.
Senator Wyden.
Senator Wyden. Thank you, Mr. Chairman.
Mr. Wood, I appreciate you noting that I have been trying
to lift the cloak of secrecy surrounding energy markets for a
long time. I think the public ought to be able to obtain basic
information about what is going on out there, and I want to
emphasize, we are just talking about basic business
information. We are talking about transmission capability,
generating capacity, plant outages. That is what we ought to be
getting out. That is what is in the bill that I introduced, the
bipartisan bill with Senator Burns, and we are going to stay
with this until it gets done.
Now, the testimony today indicates that following Enron's
bankruptcy, forward markets, the forward energy markets on the
west coast dropped by 30 percent. That was testimony, I believe
from Mr. McCullough. Does that suggest that by keeping secret
key information, that Enron was able to artificially inflate
the west coast prices by 30 percent?
Mr. Wood. Again, I think we have heard the very nonliquid
markets, there are not many trades that are that far out. You
remove one guy from it and there is going to be a big change.
Now, the drop, I am not sure I could drop all the point and
say that the drop in those prices automatically means there was
some untoward activity by Enron when there is not that many
places in the market in the first place, but it certainly is
worth following up on.
Senator Wyden. My concern is, there were no other changes
on the west coast, no changes in hydro supply, fossil fuel
prices. People were in the dark, and I am not sure that the
country can conclude that Enron was not manipulating the energy
markets on the west coast.
Mr. Wood. The time frame you are talking about, Senator
Wyden, was when?
Senator Wyden. Right at the time of the filing on December
3, Enron went into chapter 11, at the same time, forward
markets on the west coast fell by 30 percent, no other changes
occurred, and I want to be clear about that--because you have
said that it really does not seem to have been any dramatic
price ramifications as a result of what was going on in Enron
and, of course, people did not have the information. I am not
sure that it is possible for the country to conclude that Enron
was not manipulating the market with their energy trading to
the detriment of my constituents and Senator Feinstein's
constituents and others.
Mr. Wood. I think that is fair. I would like to say that
what I focused on in my testimony were the markets we do watch,
which are the physical markets that are the real exchange of
power, and not these markets that were referred to, the forward
markets, which are not regulated anywhere, so I wanted to make
sure my testimony was clear on that.
Senator Wyden. I think your point is fair as well. I would
like you to follow that up.
Mr. Wood. I would be glad to.
Senator Wyden. Because, given that situation, that
certainly raises questions about whether Enron was manipulating
the west coast market, our constituents. You have got three
west coast members here who have a lot of folks hurting, and I
would like you to get back to us on that.
Mr. Wood. I will do that.
Senator Wyden. Thank you.
Mr. McCullough, a question for you. In your prepared
testimony, you said, and I believe you are the first witness
now to say to the Congress that if the Public Utility Holding
Company Act had been enforced it could have been used to avoid
a portion of this horrible debacle for our constituents. How
did it happen that Enron was not regulated under the Public
Utility Holding Company Act?
Mr. McCullough. I can certainly imagine the FEC was
unwilling to donate massive resources, or even knew how the
donate the resources in a very changed market, but if we were
under registered utility rules, every one of those SPE special
purpose entities would have had to have been reported to the
SEC. They would have been public. We would have known that
there were $4.7 billion at risk in White Wing, and certainly
anyone who lives in Portland knows hundreds of people who have
lost their life savings, and so it sounds pretty credible to me
at the moment. that law was written for the Insull Trust 17
years ago, and I think it is possible the rules and regs could
be regulated.
Senator Wyden. Was Enron granted an exemption from the
Public Utility Holding Company Act?
Mr. McCullough. Yes, sir.
Senator Wyden. They were granted an exemption, and when was
that that they were granted an exemption?
Mr. McCullough. I am sorry, I do not have that information.
Senator Wyden. Were there public hearings? I guess I am a
little incredulous. You told us now that they were actually
granted an exemption from the Public Utilities Holding
Companies Act. Were there public hearings, or is there any
record on this point?
Mr. McCullough. I am not an expert on SEC activities, but
it is my understanding that it was a letter as opposed to a
full hearing.
Senator Wyden. Mr. Chairman, I would like to insert into
the record at this point a letter from a number of consumer
groups raising questions about the exemption that Mr.
McCullough has talked about, and again, this was the first time
I had ever heard about this, but I think this is another area
that when we have a chance to review the documents and to look
at this, it is important.
I do not have any further questions, Mr. Chairman.
The Chairman. Thank you very much. Just to clarify, I am
informed, and the witnesses can contradict me if I am wrong
here, but there is a regulation that the Securities and
Exchange Commission issued sometime ago, 17 CFR 250.2, which
essentially says that unless otherwise required by the
commission, a holding company, which is a subsidiary of a
registered holding company, need file only the initial
statement, and essentially Enron took advantage of that
regulation to just file a statement when they acquired the
Portland utility to say that they were not covered. I believe
that is the way it occurred.
Senator Wyden. My understanding is, and this is what I
would like to have clarified, Mr. Chairman, is apparently there
are some reports that there was a subsequent March 1997
exemption--and I guess we will have to take a look whether that
is the PUHCA statute or the Investment Company Act statute, and
I think you were talking about them receiving an exemption, is
that right?
Mr. McCullough. Yes, sir. I apologize for not being an SEC
expert, but it is my understanding the SEC did not pursue Enron
under the PUHCA rules.
Senator Wyden. Mr. Chairman, I want to be clear. Again,
this is an area I have heard about for the first time, and I
think we ought to look very carefully at both the Investment
Company Act of 1940 and the PUHCA statute and review them both,
because, given the fact that this has not been talked about,
and apparently there has been an exemption from one of these
statutes that might have protected my constituents and people
on the west coast, I would like us to look at that.
Senator Thomas. Mr. Chairman, I asked that question a
little while ago. Based upon the fact that you operate on one
State, apparently there is an exemption, at least a statutory
exemption, so that is probably where we need to look.
The Chairman. We will try to get this clarified. This is a
good line of inquiry, and we need to understand it better.
Senator Feinstein.
Senator Feinstein. Thanks very much, Mr. Chairman.
Mr. Chairman, earlier I handed you a letter asking that we
hold a follow-up hearing to learn more about Enron's online
transactions, and how they affected California and the Western
energy market from May 2000 to June 2001. I believe, Mr.
Chairman, that this is a Pandora's Box, and that it must be
opened.
I would like to begin my comments with some quotes from
yesterday's Los Angeles Times, and I quote: ``the entire
electric restructuring agenda on a national level was an Enron
agenda,'' said State Senator Steve Peece, who led the
legislature's effort in 1996, California legislature, to shape
deregulation. They had such control and influence over Federal
regulators that in turn put California in a place where we had
no choice.
This is sort of a follow-up of what Senator Wyden just made
very clear. The PUC under pressure set out in 1993 to overhaul
its 80-year-old system of regulating the monopolies of Pacific
Gas & Electric, Southern California Edison, and San Diego Gas &
Electric.
The fact that Skilling was in PUC meetings was an
indication of how important we thought this was, said David
Parquet, an Enron vice president who has been with the company
in California since 1993. Most of the ones that would later
come to dominate the California market, Reliant, Duke, and
Mirant, for example, did not hire lobbyists or begin giving
campaign contributions until after 1997, when they bought the
powerplants that PG&E, Edison, and San Diego Gas & Electric
were forced to auction under deregulation.
Enron did spend a lot of money on this, said Robert
Michaels, an economics professor at Cal State Fullerton, who
has worked as a consultant for the firm. Enron was essentially
the only company, other than the utilities, that had the
resources and motivation to send lawyers and experts to
thousands of working groups and hearings. Enron was very, very
insistent on what came to be called the market separation rule,
said Paul Joskow, a Massachusetts Institute of Technology
economist who worked for Edison as a consultant. Those of us
who participated warned the commission that there were
significant potential dangers there.
Mike Florio, senior attorney with the Utility Reform
Network and a member of the board that Overseas Cal-ISO, said
he is convinced that a more integrated approach would have
spared California the worst of the soaring prices that lasted
from June 2000 to 2001. With the ISO and the power exchange
being separate, he said, none of the market monitors could see
the whole picture, so it was possible for people to play games
much more easily without being detected.
Now, this is important, and I want to go now into the
online aspects of the Enron business, because two companies
have taken up that online trading with no transparency, and a
third has taken up that online trading with transparency,
namely, Intercontinental Exchange with transparency, Dynergy
and Williams with no transparency.
Let me make this point. In 1999, the entire cost of
electricity for the State of California was $7 billion. In
2000, it was $27 billion, and in 2001, it was $26.7 billion.
This was a massive transfer of wealth from California's
investor-owned utilities from consumers to a handful of energy
companies, and this is just the electricity portion of it.
Let us take a quick look at spot prices for natural gas,
which everyone knows drives the price of electricity. This is
November 2000. The red are spot gas prices in southern
California, the blue spot gas prices in northern California. It
goes right up to here, and this narrow black line is the
benchmark for the rest of the United States.
Ladies and gentlemen, you clearly see what has happened. We
are told by analysts that Enron Online may have controlled up
to 50 to 70 percent of the trading market for natural gas
deliveries into southern California, 50 to 70 percent. There
was no price transparency. There was no regulatory oversight
because Enron's trades were bilateral, and natural gas prices
drive up electricity prices.
Keep in mind that many of the generators had gas contracts
and did not buy on the spot market on the graph, but they used
spot market prices to justify the higher electricity prices,
and this is why I think this is so critical, that we look very
deeply into this.
On December 12, 2000, the spot price of natural gas
delivered to the southern California border was $59.12 a
decatherm. Well, it was $10.12 a decatherm in nearby San Juan,
New Mexico. Know that it costs less than $1 to deliver the gas
from San Juan to the California border. On December 12, there
was $48 a decatherm unaccounted for. As you can see from the
graph, the problem lasted well into the springtime.
To keep this in perspective, today's gas price average is
$1.91 for most of the country, and $2.05 for California, so
there is a lot of money unaccounted for, while at the same time
Enron and other energy marketers are announcing record profits
during that quarter.
These exorbitant gas prices helped drive up electricity
prices in California to more than 10 times higher than they
should have been, and we still do not know why the price of
natural gas was so much higher in California than in
neighboring States. Again, Enron Online, I am told, could have
controlled 50 to 70 percent of the natural gas trades in
southern California, and all this time, because Enron Online
was engaged in bilateral trading, nobody except Enron knew the
prices that were being bid.
Last January, I introduced legislation to ensure there
would be at least transparency in the delivery of natural gas.
I am pleased with Senator Wyden and Senator Bingaman's interest
in this subject and the fact that there is a transparency in
the Democratic energy bill introduced by Senator Daschle in
November. Now that Enron is out of the online energy trading
business and companies like Dynergy and Williams have stepped
in to fill the void, there is no transparency, if there was not
the cap and the intervention, finally, by the FERC, this could
all happen again.
I am really starting to believe that Congress needs to
ensure that a regulatory agency is willing to step up to the
plate and protect consumers from a repeat crisis. Energy
deregulation proponents argue that deregulation benefits
consumers by increasing their choices and lowering their
prices. You would have a hard time finding a California
consumer that believes that today, so FERC indeed has a lot of
work to do, and I want to begin by asking Mr. Wood this
question.
The Chairman. Senator Feinstein, you have run out of time.
Why don't we go ahead to Senator Cantwell.
Let me just advise we are told there will be a vote here in
just a few minute, so we will hear from Senator Cantwell, and
then we may adjourn for a short period to go vote and come back
and continue.
Senator Cantwell. Thank you, Mr. Chairman, and I think I
will enter a longer statement into the record, if I may.
[The prepared statement of Senator Cantwell follows:]
Prepared Statement of Hon. Maria Cantwell, U.S. Senator
From Washington
i. introduction
Thank you, Chairman Bingaman, for holding this important hearing on
the implications of the Enron bankruptcy for our nation's energy
markets.
It is our duty as policymakers to take a close look at the factors
that contributed to this company's collapse.
We have an obligation to shine a light on what one Enron executive
last year called a ``regulatory black hole,'' a vortex consisting of
lax oversight, loophole ridden accounting practices and potentially
criminal acts on the part of corporate executives. A black hole that
Enron itself was proud to help create. After all, it was central to
Enron's business strategy.
Mr. Chairman, as the Senate prepares to debate an energy bill, I
must add that I am deeply troubled by the Bush Administration's refusal
to turn over the records of its energy policy task force to the General
Accounting Office.
At a time when Enron's collapse has illustrated in graphic detail
the need for transparency in our nation's energy policy, the
Administration's refusal to turn over those records smacks of
insensitivity toward the many Americans whose lives have been touched
by this debacle, if not outright obstructionism.
Enron's bankruptcy has touched the lives of hundreds of thousands
in our country.
The effects are being felt most directly and most painfully by the
families of Enron's rank and file employees--many of whom lost not just
their jobs but their retirement savings.
ii. washington state impacts
Even the residents of Washington state, who may seem far from the
epicenter of this scandal, are feeling its impacts.
Already the Washington Attorney General has filed suit on
behalf of the State Investment Board, seeking to recoup more
than $100 million in lost shareholder value.
A 64-year-old construction firm that employs 600 in Bothell,
Washington--purchased by Enron in 1997--was left in limbo when
its assets were swept into Enron's central cash management
system and locked up in the bankruptcy proceeding.
A Washington-based insurance company has reported a $20
million loss--a 10 cents per share earnings hit--as a result of
its Enron bond holdings.
And a number of our utilities--among them Seattle City
Light, which has already experienced an almost 50 percent rate
increase over the past year due to the Western energy crisis--
are owed money by Enron.
Viewed within the sweeping, multi-billion dollar collapse of this
company, these losses may seem small. But I assure my colleagues that
they make a difference to Washington state retirees, investors and
utility ratepayers--many of whom have already been affected by
recession, the tragic events of September 11 and this past year's chaos
in Western energy markets.
For many of my state's residents--who have seen double-digit power
rate increases over the past year--the first questions that comes to
mind in view of Enron's collapse is, quite simply: Where did all of our
money go?
My initial response to this question might be: down the regulatory
black hole that Enron helped create, along with the retirement savings
of many working families and a good deal of investors' confidence in
the integrity of our financial markets.
To be sure, this is a question to which the Senate will demand a
more complete answer during the course of its ongoing investigation
into the factors that contributed to Enron's downward spiral.
iii. market transparency
And while we are still in the process of unwinding Enron's complex
web of corporate shell games, I believe a lesson extracted from the
financial debacle is equally relevant to this Committee's hearing
today. That is, much as the disintegration has pointed to a need for
greater coherence and consistency in corporate accounting practices, it
has underscored the need for transparency in our nation's energy
markets.
We will hear testimony today that Enron's collapse has caused
almost surprisingly little disruption in wholesale energy markets.
But I believe there remain a number of unanswered questions--
brought into sharp relief for me by the Western energy crisis--that it
is the duty of this Committee to examine.
In particular, I think it is a great relief that the collapse of
such a dominant trader as Enron--which handled up to 25 percent of our
nation's wholesale energy transactions--had such a small impact on both
energy supply and price.
But the question foremost in my mind remains:
What if Enron's collapse had occurred in the midst of the Western
power crisis, when chaos in the markets reigned, rolling blackouts had
become a fact of life in California and appeared imminent in the
Northwest, due to a drought of historic proportions?
While energy in the West is now plentiful and prices remain low--
due in part to recession, mild, wet weather and loss of load, not to
mention jobs in energy intensive industries--how would the market have
responded when energy ran $3,000 per megawatt and utilities were
scouring for all possible sources of generation?
Mr. Chairman, while I'm glad that the impacts to energy consumers
have been negligible thus far, my fear is that no one really knows the
answer to this question. And the reason, in my view, is a troubling
lack of transparency in our nation's energy markets the very same lack
of transparency that has many energy analysts, regulators and consumers
scratching their heads over the seemingly incongruous set of factors
that gave rise to the past year's Western energy crisis.
v. conclusion
As the Senate prepares to consider comprehensive energy
legislation, I think it is imperative we keep in mind one of our
primary goals: fostering reliable and efficient markets, which require
accurate and timely information for participants, regulators and,
ultimately, the consumers themselves. I again thank you Mr. Chairman
for holding this important hearing on the lessons we can learn from
Enron's collapse.
Senator Cantwell. But Mr. McCullough, I appreciate your
testimony this morning. Also, I find some of the comments and
statements very disturbing as to what it means to Northwest
citizens who were far more concerned about this energy crisis
before the events in December, because they had actually seen
the effects of high energy prices, and even though we have
started to recover from what has been a drought, we still have
people in the Puget Sound area and various parts of the State
who are paying 50 percent rate increase in their electricity
rates, and to think that perhaps, that that 50 percent rise in
electricity might have been caused by some of these forward
contracts is a very disturbing concept.
I am not shooting the messenger. I appreciate your
comments, but when you say that no other charges in operation
and hydroelectric supply took place at this time, three is
clear implication that Enron may have been using its market
dominance to set forward prices. This, to Northwest consumers,
seems to be what they have been thinking all along, that where
there is smoke there is fire, and in this particular case they
have been gouged.
My first question is, how do we get more information on the
forward contracts? How does this committee obtain more
information on the forward contracts, and what do you think the
implications are for those forward contracts today, given the
structure of the bankruptcy? Will some of these entities still
have to live up to those forward contracts if, in fact, energy
is delivered?
Mr. McCullough. Well, the second question is the easiest.
Yes, Northwest utilities' industrial customers will have to
live by the deals they made, and they are stuck with these
higher prices for years to come. We know that each of the
utilities buys a portfolio. Bonneville, City Light, Portland
General, Puget Sound Energy, all have had exposure to those
market changes, and they have all had cost.
The first question is harder. To the degree that utilities
really operate in forward markets, this is a very critical
issue. We have had debates in front of FERC about whether
markets should be viewed as hourly or daily or monthly. To an
extent, an hourly market is like the neighborhood bodega. You
go down once in a while to buy some milk, but most of us
actually buy our food at Safeway or even Cosco. We buy in the
future, not simply the present.
So forward markets are very, very important to us. Our
industrial and utility clients are far more likely to be in the
monthly/yearly markets than they are in the hourly markets, and
so any information the committee can provide, both on the
current Enron crisis and hopefully through their leadership
into changing of the rules that will give us transparency in
those forward markets is going to be absolutely critical.
It requires an enormous amount of work to discovery that
Enron had a 30 to 50 percent position in the critical mid-
Columbia market. It is not easy in the moment. The only good
information we have is from FERC's quarterly marketing reports,
and thank you, Mr. Chairman, for having those, because that is
all we have, and we really do need to know who is carrying the
simple positions so we can judge whether they are far markets
and fair prices.
Senator Cantwell. Mr. McCullough, do you believe those
markets, an entity should have to live by those forward
markets, if, indeed, Enron is found to have been manipulating
the market?
Mr. McCullough. I am an economist rather than a lawyer.
Contracts are pretty sacred to economists even when they are
wrongful. Certainly the Attorney General and his fellow
Attorneys General up and down the coast have been looking into
that question, and if they find wrongful behavior, I suspect
then we could find some protection for the customers in the
coastal States, California through Washington.
Senator Cantwell. Thank you. Mr. Wood, do you have a
response to that question? Do you think utilities, if Enron has
been found to be manipulating the forward contracts, do you
think that utilities should have to live and be stuck with
those prices?
Mr. Wood. I think a court could probably make the call, or
the State commissions could determine that there are sufficient
facts to void--in general, it is hard to conclude yes or no,
but I think that a court is pretty good at saying that is a
voidable contract and therefore we should not be required to be
paid. That is what we use courts for.
I think there is also, depending on the jurisdiction and
the ability of our commission or State commission to do the
same.
Senator Cantwell. Mr. Wood, I have been enthusiastic about
your appointment to FERC. I think I even told one of the local
newspapers that this is exactly what the FERC needs, is the new
energy and smarts of Patrick Wood.
I have a question, though, because obviously part of this
going through my constituents' mind and I think the general
public's is just this right to know, on SEC filings and
corporate earnings reports, on campaign finance disclosures, on
even public policy documents, and I guess my question is, since
FERC is this quasi-judicial entity and there is some sort of
firewall, you do have communications with the administration, I
am sure, on their energy policies, and you do have some
communications, or I would assume--and this is probably
proceeding prior to you taking over as chairman.
You do have some communication with, obviously, these
various entities like Enron. Would FERC make those documents
available to the public, your communications either between the
administration on energy policy and your communications, or
potential communications that may have occurred prior to your
being the chair of FERC, related to Enron?
Mr. Wood. I would be glad to, Senator, as I think I have
been asked for the press for the latter, particularly. I think
much to everyone's surprise besides mine, because I can tell
you Enron has not been in to see me or my staff at all since I
have been here, and plenty of other people have, but that is a
pretty short list, but I would be glad to give you what we have
had.
Senator Cantwell. But your communication with the
administration, or prior to your taking over, because obviously
that is new, but the FERC's communication to the administration
in the early part of the year on energy policy. Again, while my
constituents were saying, we are getting gouged, and yet there
was not disclosure. There was not real disclosure on the
formation of what the energy policy was by the administration.
Those kinds of communications between FERC and the
administration on that energy policy, would those
communications be available?
Mr. Wood. I would be glad to look into that, if any exist.
I know from my experience in the State government there was a
pretty clear definition up front about the distinction between
an independent agency as opposed to an executive agency, and
the administration, so I will look into what exists before I
came, but I do not believe there has been anything since I came
there.
Senator Cantwell. Well, we appreciate FERC's willingness to
make documents public.
Mr. Wood. We are a public agency, answerable to the
Congress.
Thank you.
The Chairman. With that, we have this vote that has already
started. Why don't we take a 15-minute break and vote.
Senator Schumer. Mr. Chairman, I just have one question.
Can I get that question in?
The Chairman. We will go ahead and defer to Senator Schumer
for that question.
Senator Schumer. Thanks, Mr. Chairman. I would ask my
statement be read into the record. I know we are trying to get
over to the vote.
[The prepared statement of Senator Schumer follows:]
Prepared Statement of Hon. Charles E. Schumer, U.S. Senator
From New York
Good morning. I would like to begin by thanking the Chairman for
holding these hearings, which I feel are part of this committee's
significant and necessary role in evaluating the performance of post-
Enron energy markets.
Within the scope of the energy market, the collapse of Enron has
demonstrated the damage and dysfunction that can result from a lack of
transparency and oversight, and how a transparent market can be a
stabilizing and steadying force. In this case, we have a market that
had been dominated by Enron, in which participants and observers were
unable to gain a clear and total picture of the markets within which
they operated, markets that by and large existed outside of adequate
oversight.
During the debate regarding the CFMA, I was greatly concerned about
the similar effects that granting electronic trading facilities an
exclusion from CFTC oversight would have had on the market, and fought
hard against such an exclusion. Exempting electronic trading facilities
from CFTC oversight would have resulted in regulatory arbitrage,
essentially meaning that all trading commodities would be exempt from
CFTC oversight. There would have been no anti-market manipulation
rules, among others, to protect the markets. Those of us who were
concerned about the ramifications of an ETF exemption fought that
provision and won.
Today, as a result of Enron's collapse, what we're seeing is
exactly the opposite of regulatory arbitrage. We are seeing a flight to
quality. The stable, transparent markets have absorbed the market share
that Enron had enjoyed without missing a beat. The fact that the
largest energy trader in the United States could undergo a rapid
collapse without disrupting supplies or creating price shocks is a
testament to the strength of U.S. markets. However, it also
demonstrates the importance of regulation in ensuring the integrity of
our markets.
Although the markets have performed admirably, we cannot afford to
simply breathe a sigh of relief that in the short term the energy
markets have been able to move on. We have a responsibility to fully
evaluate the long-term implications of the Enron collapse on the future
performance, and on how government fulfills its regulatory role.
Today's hearing should serve an important role in guiding the Senate as
we move toward considering comprehensive energy legislation that
includes significant regulatory reforms.
Contained in S. 1766 is the repeal of Public Utility Holding
Company Act. In order to fill the void, a number of the regulatory
procedures established under PUCHA, including merger authority and
guaranteed access to books and records are passed to FERC and State
regulators. We need to explore the question of whether or not these
transfers or authority are adequate, or whether, and in what fashion
they need to be augmented. We also need to explore where opportunities
may exist for state regulators to work in concert with FERC to create a
safe and stable climate for deregulation.
In my estimation, the most significant contribution we can make
toward the long term well-being of America's energy markets, and as a
result, America's prosperity, is to create a regulatory climate that
will allow open markets to function with transparency and security for
all participants.
Senator Schumer. I would just ask, as some of you know, I
was particularly interested in the attempt to totally
deregulate electronic trading facilities, and was heavily
involved in trying to stop that from happening when it
happened, and so I guess what I would ask the witnesses, and
particularly Mr. Newsome and Mr. Viola, who is here along with
Mr. Seetin, is this.
Do you think that in general since the Enron problems there
has been a flight to quality to large and more transparent
markets in electronic trading, or do we have to worry about the
fractionalization of the markets, and people going into little
corners and trading into nontransparent platforms and, related,
what actions need to be taken to prevent a chain reaction of
little mini-Enrons if the potential for such--and does the
potential for such reaction exist?
I guess Mr. Newsome first, then Mr. Viola.
Mr. Newsome. Thank you, Senator. As we spoke about a little
earlier, obviously there was a full airing and debate by
Congress as they deliberated the Commodity Futures
Modernization Act. I think that debate was certainly warranted,
and very useful information, and a proper regulatory regime
came from that debate.
As we look at the CFMA, as we look at the flight to quality
and protection, one of the things that was included in the CFMA
that has not been discussed here is the allowing of clearing
four these OTC instruments. That is an area that I know that
NYMEX is planning to move into, and I certainly think there is
a lot of positives that can come from that, because when you
get the credit controls that you currently have on exchange
offered and utilized off-exchange, that is something that could
give all of us more comfort, and so I think there are already
some things in that act that currently are not being utilized,
that because it is such a new act, it is just being
implemented. I think market participants are starting to move
in that direction and will offer some controls.
Senator Schumer. So you have a little more confidence than
you would have before the act?
Mr. Newsome. Yes, sir.
Senator Schumer. Mr. Viola.
Mr. Viola. Senator Schumer, I think clearly the last minute
efforts at sort of not having complete deregulation and
exemption occur in the CFMA helped greatly in keeping markets
stable through what would have been a very much more disruptive
period, and I think that has to be made very clear. The efforts
on behalf of this committee were instrumental in keeping market
structure and price dynamics stable in the unraveling of Enron.
I think a flight to quality is being experienced in the
regulated environments. The players do not want to
fractionalize, they want to converge on the central counter-
party risk and anonymous clearing function of the regulated
exchanges like NYMEX. The point that we at NYMEX want to repeat
is that the standard for regulation should be the same between
an electronic platform and open auction outcry public forum
where the trades are physically executed by traders. That is
the one point we want to make.
In the one study that we have done, and observed the one
migration from a pit environment to an electronic environment--
that was the German bond market that moved to a completely
electronic environment--we see that beyond the first one or two
months, the first quarter of trading, the market does
fractionalize, and it clearly becomes opaque, and it becomes a
broker-dealer market. There is not that centralized liquidity
you have in the public forum of a trading pit, and even though
people may seem to think electronic media creates efficiency
because it is digitized and quicker, in fact it starts to
fractionalize liquidity.
So those are the points I think from an exchange
standpoint. There is going to be a convergence. There will be
over-the-counter clearing provided by exchanges like the NYMEX
and the Intercontinental Exchange, but clearly the standard for
regulation should be converged to the same.
Senator Schumer. Thank you, Mr. Chairman. I appreciate
that.
The Chairman. You are certainly welcome. We will take a 15-
minute break, and then have a second round.
[Recess.]
The Chairman. Let me ask everyone to take their seat. We
will start the hearing again.
Let me ask a few additional questions, and I know Senator
Feinstein has got additional questions. I do not know if other
members will return or not to ask questions, but we will try to
do 5-minute rounds at this point just so that we can get
through as many questions as possible.
Let me try to paraphrase what I think I am hearing as a
result of some of the testimony and the questions of Senators
also, and that is a concern that Enron was the major player in
many of these forward contracts, or markets for electricity in
particular, but also natural gas, and that as the major player
they had the ability to set the price, or substantially impact
the price that those markets would require people to pay if
they wanted to enter into those forward contracts.
And then the implication is that perhaps either individual
traders or someone in the company might have artificially
inflated those prices or required higher prices than the market
otherwise was requiring in order to gain the profit from that,
presumably, but that the effect of this might have been to
cause California and some of the other entities that were in
these long-term markets, these forward markets, to lock
themselves in at much higher prices than they otherwise would
have had to.
Is that a fair paraphrase of what you believe might have
occurred, or did occur, Mr. McCullough.
Mr. McCullough. Yes, Senator.
The Chairman. Is there anybody else who has a point of view
on whether or not this did occur, or might have occurred, or
does this sound like an implausible scenario, based upon other
factors?
Yes, Dr. Makovich.
Dr. Makovich. I think what I have testified to is that you
do not want to put somebody in the position, because the
forward market is not very liquid and is nonstandardized, you
do not want to put them in a position where they have to add
judgment to say, well, here is what the forward price is, and
also then have that impact their earnings.
Now, the question about, was there manipulation, for a
trader, depending upon their position, whether they are in a
net short or net long position, they can benefit from having
prices move down as well as having prices move up, so it is not
clear what Enron's position would have been in the Northwest,
whether they would have actually benefitted from a drop in
price.
What we did see last year across the United States is all
forward power markets dropped significantly about mid-point in
the year, and you saw that very clearly in the futures strip,
which does go out for about a year or so into the future.
If the forward markets are thin, then it takes a while for
the forward markets to reflect that as well. The liquidity of
the futures market is that much greater, and so there was just
a general downward movement in forward pricing across all power
markets in the United States last year.
The Chairman. So what you are basically saying is, you
think there may not have been an incentive for Enron to
artificially inflate the price in the forward markets.
Dr. Makovich. Because of their position and because of
disclosure. We do not know what their position was. If they are
short or long, they can benefit by the price going up or down,
and so the testimony is, we do not want to put people in the
position of having to have a judgment to say, here is where the
market is, and that affect the valuation of those positions in
the future.
The Chairman. Let me ask one other question. This is about
the online trading issue.
Mr. Viola, you have raised this issue, saying that you do
not think there is a justification for a different standard for
electronic trading versus trading in the pit. What is the
current state of law on that, or the current state of law with
regard to oversight and regulation of online trading, and what
do you believe that law should be?
Mr. Viola. Well, I think to reduce my answer to as simple a
statement as possible, the current state is that the standards
of compliance and disclosure and position reporting, those
three principal areas are less onerous for an electronic
trading platform that is exempt, as applied to the compliance
disclosure and oversight standard for a pit-traded environment,
and I think that those two standards need to converge so that
the liquidity provided in a physical environment can be
competitive from a structural standpoint, market structure
standpoint.
The Chairman. Mr. Newsome, do you have an opinion on that?
Mr. Newsome. Yes, sir. I think there are some differences,
and those differences are why the CFMA looked at a different
regulatory scheme versus regulating both the open outcry and
the electronic systems exactly the same.
When you look at different tiers of regulations, it is
based upon several criteria, and one difference in that
criteria is real time audit trail that is available to a
regulator through an electronic system which is not available
to a regulator through an open outcry system in which you have
to put together that audit trail through a manual method.
Another difference was the types of traders who are using
the system. If you operate in an open outcry system, then
basically you have access to both sophisticated and retail
types of traders. Obviously, in a market in which you have
retail trade, there is a higher need for regulation. If you are
operating in a market in which there are solely sophisticated
operators, the intent was felt that there was a less regulatory
need there than there was with retail participation, and so I
think there are some reasonings of why there is a difference
between regulation at the two levels.
The Chairman. And the assumption that you have there is
that there will be less sophisticated traders involved in pit
trading than there will be in online trading?
Mr. Newsome. No. There is an opportunity to--even if an
electronic system wanted to open up to a retail customer base,
then they would have to assume a higher level of regulatory
responsibility. The exchange in a pit-trader system has an
opportunity to operate in a less-regulated environment if it
wants to limit its market base only to those sophisticated
customers.
At this point the CFMA, most of the exchange-traded
contracts had decided to stay at the highest-regulated level
because of having access to the full customer base, so there is
a flexibility to the market participants who have different
levels of regulation, depending upon what customer base that
they want to operate with and what type of system they want to
utilize.
The Chairman. So in your view the key distinction is not
between being online and being physically trading in the pit.
The distinction is how sophisticated the people are who have
access to the market to trade.
Mr. Newsome. Correct.
The Chairman. Let me call on Senator Feinstein.
Senator Feinstein. Thanks very much, Mr. Chairman.
Mr. McCullough, I mentioned in my statement that analysts
had told us that Enron controlled about 50 to 70 percent of the
gas trades that went into California. Would you agree with that
number?
Mr. McCullough. Yes, Senator, with the caveat that since we
have no open discovery on Enron Online, it is purely anecdotal.
Senator Feinstein. Thank you, and you also say in your
written remarks that on December 3, when Enron went into
Chapter 11, at the same time forward markets on the west coast
fell by 30 percent, and then you say, unlike what Mr. Makovich
just said, no other changes in operations, hydroelectric supply
or fossil fuel prices took place at that time. The clear
implication is that Enron may have been using its market
dominance to set forward prices.
Mr. McCullough. Yes, Senator. Let me clarify. I do not
believe Dr. Makovich and I were disagreeing. We had two major
west coast shifts. He completely correctly described the mid-
year shift that occurred throughout the markets, but the shift
I am referring to is actually a December 3 shift, not December
2, because I remember that was a Sunday, was it not, but
actually on the trading days we had that dramatic shift, and
that was in addition to the price shifts that Dr. Makovich was
describing.
Senator Feinstein. Thank you, Mr. McCullough. That would
indicate to me, Mr. Wood, that there was, in fact, a distorted
market, and I would like to ask you to take a look at
California's bilateral electricity contracts. If, in fact,
Enron transactions have distorted that market, and Governor
Davis signed those contracts, there is a good argument that
those generators should be forced to renegotiate those
contracts, so I am making that request of your commission.
Mr. Wood. Yes, ma'am. We will do that. I think it would
actually be, we have not--encouraged I guess is a strong word,
but we have answered when the California commission has
attempted to kind of get at these issues, that they could
certainly file at the commission a formal complaint so that we
can bring the full tools of discovery, and I shared that with
President Lynch, and I am not sure what their status is on
doing that.
Senator Feinstein. Has such a complaint been filed?
Mr. Wood. Not from California. One has been from Nevada.
Senator Feinstein. Well, I will see that one gets filed,
then.
Let me ask you this question. My understanding is that at
the break you related to the press that you did not think Enron
was responsible for California's natural gas spikes. If it was
not Enron, the only two main suspects would be El Paso and/or
SEMPRA through southern California gas. I would like to ask
what went wrong. I would like very much to get your view.
Mr. Wood. The question that was asked related to the short-
term markets, which I have been kind of differentiating on
today because we do not have, as was pointed out here today,
focus on the long-term markets, particularly on gas, which are
quite competitive, although the fact you raised about the 50 to
70 percent certainly raised my eyebrows. That is a pretty high
number for one to assume that it is competitive.
So with that caveat, which we will look into, because it
certainly is something we are supposed to look into, there are
two other players. One of those is certainly subject to the
pending complaint you and I visited about in this forum before,
and we did just reopen the record in El Paso and attempt to
fully flush out the record and understand what happened on
capacity on that key pipeline going into the State.
I am not saying they did something right or did something
wrong, but just making sure we understand fully what the facts
are there, so I am a little reluctant to opine on that, but I
would be happy to once we do get a record back from our judge.
Senator Feinstein. But you are prepared to give me your
assurance that you are going to look into this?
Mr. Wood. Yes, ma'am.
Now, as to December, we have got a jurisdictional issue
between us and the State. Once the runs get to the State,
California is not unique, but certainly there are only a very
few States where the State commission takes over the regulation
of the natural gas and the physical facilities of a pipeline,
once it gets to the State borders, and we have visited with you
all about that before, but there is a bit of--I would call it
not a dislocation, but a difference as to how regulatory
treatment of the line that we regulate coming into California
and the line that the CPUC regulates, which takes over from
that point to get to the generator plant, or get to the final
customer.
That jurisdictional line has been certainly something we
have worked through informally with the commission to try to
get around these issues.
I do know that they took some actions in the recent months
to change what many have identified as being a tariff problem,
that people could not buy power all the way through from, say,
Utah to a point on the coast, and now I think the commission
has addressed that at the State level, so that should help.
Senator Feinstein. I do not want to use all my time. I have
got one very important question.
Mr. Wood. But certainly on the El Paso one I will answer
when it is appropriate, and we will find out what we can about
SEMPRA and talk to you about that.
Senator Feinstein. Does FERC have the authority to regulate
online trading presently?
Mr. Wood. We in September, before this all came up, put out
revisions to our standards of conduct which are kind of code
words for, if you have got a regulated company and a
competitive company under the same umbrella, we want to make
sure that the regulated company does not do something to
benefit its competitive cousin to the detriment of somebody
else out there in the market.
Senator Feinstein. Is the answer yes?
Mr. Wood. We asked the question on online, should we go
forward and treat online as though it were a pipeline company,
so that is out there. We would not have asked it if we did not
think we could answer yes, so the answer is yes.
Senator Feinstein. Very interesting.
Second question. Do you have the expertise to do it?
Mr. Wood. Honestly, no. That is why I mentioned a moment
ago I put out the job announcement for director of this new
office, and then a number of new people coming on it. The
Congress was kind enough to give the Commission additional
funds and positions to use for the enforcement and
investigation purpose, and I fully intend to utilize those.
Senator Feinstein. If you went along those lines, since
energy trades can change hands dozens of times, do you think
that FERC should be able to regulate all energy trading
platforms all over the counter, energy trades? How would you
see that?
Mr. Wood. If the Congress wants us to do that, Senator, we
will do that. I would aver that there might be a more expert
agency to do that, but whatever you all want us to do is what
we do.
Senator Feinstein. Well, let me ask, my understanding is
that the CFTC does not want that responsibility. Is that
correct?
Mr. Newsome. Well, I do not think the CFTC has ever made
that determination of whether they wanted it or did not want
it.
Senator Feinstein. Then that is not correct, so are you
open to it, and would you have the expertise to do it?
Mr. Newsome. Well, certainly we are open to whatever the
Congress chooses for us to do. I think if the Congress decides
that there needs to be more regulatory oversight into that
area, I think the CFTC would be a proper place to look for that
regulatory oversight.
Senator Feinstein. Mr. Wood, how do you feel about that?
Mr. Wood. I would concur.
Senator Feinstein. So your preference would be that any
regulatory authority be vested with the CFTC rather than FERC?
Mr. Wood. I differentiate between the physical market,
which is where we have expertise, and then the financial
trading market, which again is used to handle risk of the
physical market. If we make sure the physical market works
well, and that those are transparent and open and known and
liquid, then the rest of the transactions that Jim and his
group work with work much more effectively, and I think are
subject to whatever oversight is appropriate for that activity.
Senator Feinstein. Thanks very much.
The Chairman. Senator Cantwell.
Senator Cantwell. Thanks, Mr. Chairman. I would like to
follow up on a couple of my earlier points, and the point
Senator Feinstein has been making, and obviously, Mr. Chairman,
I think we should think about what information this committee
does seek to further shed light on these forward contracts, but
Mr. Wood, I wanted to ask a question.
I believe that the Supreme Court has previously found that
FERC has the authority to negate bilateral contracts if it
finds that the terms or conditions of those contracts are
unjust or unreasonable, and I know that your comment earlier,
when I asked the question, was about the court, and I know we
are talking about what we are going to do moving forward, and
what is the proper authority, but would you use the authority,
your authority in this case if we find that these contracts
signed during the height of this crisis show that they were
manipulating the forward markets?
I do not think I have to again emphasize how important this
is to my State, given the fact that there are many entities--
and again, I am not 100 percent clear, but I think some of the
contracts that Enron might have had with individual businesses
might have had an escape clause so they got out of that
payment, but I do not think the utilities, again the ratepayers
of those utilities are going to get out of those increases and
forward contracts.
Mr. Wood. And I did mention earlier--I am sorry if I
mumbled it--but that the court or a commission, whether it be
us or a State commission, would have similar authority, and
yes, ma'am, we have that under section 206 of the Federal Power
Act, that authority to look at those contracts.
I guess my only caution would be if those contracts did
reflect a true scarcity price that reflected the lack of or the
reduction of hydropower and relative more expensive fossil
fuel----
Senator Cantwell. But I think the point is being made----
Mr. Wood. If it is market-power related, then I think that
is a different type of hearing than just one of true scarcity.
I think that is the only difficult thing I would put out there
for you to understand before these cases would come to the
commission, if they do, that that is probably the line of
inquiry. If it would be as a result of market power, then you
would go one route. If it is the result of scarcity, then you
probably would be more uninclined to reform those contracts.
Senator Cantwell. But again, my constituents are asking who
is this FERC entity, as they were getting gouged for higher
prices, and what are they going to do to mitigate this impact,
and yes we had a drought, but going out and buying on the spot
market at a time when the partial deregulation caused all sorts
of problems, now they are hearing maybe these forward contracts
are unjust, what is FERC gong to do to investigate those
forward contracts in a manner that will give us some answers
that I think the public deserves to have.
Mr. Wood. Well, as you know, as we talked about, I think
the first time we met, there is a pending complaint about a
number of contracts under this section 206 before the
commission. I believe it is finishing up briefing at this
point, and has had a judge's opinion on it.
Senator Cantwell. Do you think Mr. McCullough's point that
things that--I mean, because that investigation started and is
researching information back to December 1999, and now we are
talking about isolating--and I have queried FERC before on
these forward contracts, and whether they should be rolled into
this investigation, and oftentimes people have responded yes,
it is of interest, but not a clear commitment that these
forward contracts should be investigated in the detail that I
think this morning's hearing is saying that they should.
Mr. Wood. Are you requesting that the Commission do a
section 206 investigation in the long-term contracts?
Senator Cantwell. Yes. I think I would like to know what
documents you are going to seek that would clarify whether, in
fact, this 20 or 30 percent increase that happened during this
time period is because of manipulation by Enron. I think the
public--again, ratepayers in my State are paying a 50-percent
increase in our utility rates and want to know.
Mr. Wood. And we will get them an answer that answers it
one way or another, and I will commit to doing that for you,
Senator.
Senator Cantwell. Thank you.
Mr. McCullough, do you have any other input on what
documents we might be seeking, or that FERC should be seeking
or this committee should be seeking that would help shed light
on this?
Mr. McCullough. Yes, Senator. Very clearly, we do need to
know Enron's position in these markets, as Senator Feinstein
has said. FERC apparently--and it is anecdotal. When I say
that, it does not mean it is not true. It means we cannot tell
for sure if Enron did have a 30 to 50 percent share of these
markets, which appears to be the current anecdotal evidence, in
electricity, then they have a tremendous ability to shift those
prices.
So I think it is important for these forward positions to
become public, and it is very important as well in terms of the
financial investigations to know what these forward positions
were, because again in market-to-market they were being used as
the center point of Enron's valuation, so I think throughout
the entire nexus, we are very interested in this specific
question.
Senator Cantwell. Again, Mr. Chairman, obviously Senator
Feinstein has asked for more hearings and clarification, and I
support that. I think it is critically important that we
understand it, and again the difference is between how some
individual businesses in this bankruptcy may be getting out of
these forward contracts, and yet utilities, which ratepayers
are impacted by, may not be.
The Chairman. Let me ask, to just clarify for my own
understanding, there is a difference between forward contracts
and long-term firm power contracts, and the contracts that
consumers are currently having to pay under, and that utilities
in California are having to pay under, are these long-term firm
power contracts, as I understand it.
Now, the concern here that Mr. McCullough has raised and
others have raised is that these forward contracts--which are
unregulated and which are really a hedging device to hedge
against risk as you go forward into the future--the prices of
these forward contracts were artificially inflated, and the
artificial prices there were affecting in adverse ways one of
the prices that people entered into with long-term power
contracts. Is that a correct understanding of what we are
talking about here?
Mr. McCullough. Yes, Mr. Chairman. If I could describe it
very simply, we do not have a book, a Bible we can open and see
the future. When Governor Gray's team made these long-term
contracts, when my clients or utilities and industries in the
Northwest make these long-term contracts, they do it by the
simplest possible way. They pick up the phone and they ask the
vendors--and Enron was a very important vendor--what the prices
are in 2003, 2004, 2005, and in Governor Gray's case, all the
way out to 2010. Then once they have that price discovery, then
they will actually sit down and sign that long-term contract.
If the evidence we have from this very narrow test at the
beginning of December, which was designed to avoid issues on
hydro or drought, because it was so short that we just saw this
one event, and we could see the sudden reaction, if those
affected everyone's perceptions on long-term prices, then we
might in fact have had a serious distortion that would show up
all the way through the power prices in Seattle and San
Francisco and San Diego, even beyond our authorities in
Edmonton, Alberta, and all the way down to Tijuana. This could
have affected the markets throughout the entire West Coast for
long-term contracts.
The Chairman. So that these forward contracts, those are
the contracts the price of which dropped 30 percent on 3
December, the forward contracts.
Mr. McCullough. Correct.
The Chairman. And that drop in your view is evidence that
those forward contracts were artificially high prior to
December 3, and many of these long-term fixed contracts, power
contracts that California and others were entering into, may
well have been artificially high as a result.
Mr. McCullough. Yes, Mr. Chairman. The Governor Gray
contracts were higher than the cost of building a new
powerplant. They were very, very high at the time, but they
were the only contracts apparently his team were able to
negotiate. We did not know whether that was scarcity--we do not
even have the data today to know whether it was scarcity or
market failure. Most of us presume it was market failure,
because the crisis has dissipated.
But where we are now is, we see this sudden single test,
this experiment with this sudden change, and it really does
gives us some reason to doubt whether or not that forward
market was deep enough to get the right economic answers.
The Chairman. So if, in fact, these forward contracts had
as big an impact as we are here speculating on the price of
long-term fixed contracts, then the obvious question is, why
are forward contracts in this unregulated column on that chart
that Mr. Seetin put up earlier, why are forward contracts not
in some way or another regulated so that people have a better
sense of where they are and how they can be justified.
Mr. McCullough. Yes, Senator. Now, I am not a person who
opposes markets. I am a price theory economist, but at the very
least we need to have discovery. We need to have open pit
outcry that enables us to check how deep the market is, and we
need to find out if there is only one person in the pit, if
there is only one person in the pit that we know to proceed
with caution. We do not have that information in front of us
today.
The Chairman. We are halfway through another vote here. Let
me just ask Senator Feinstein, Senator Cantwell, did you want
us to do another round and come back after this vote, or do you
have a final question we can finish up with?
Senator Cantwell. I think, Mr. Chairman, we can submit any
further questions.
Senator Feinstein. I would like to submit some in writing.
The Chairman. We will submit some additional questions in
writing. We thank you all very much. I think it has been a very
useful hearing, and we will adjourn the hearing.
[Whereupon, at 12:30 p.m., the hearing was adjourned.]
APPENDIXES
----------
Appendix I
Responses to Additional Questions
----------
U.S. Commodity Futures Trading Commission,
Washington, DC, February 8, 2002.
Hon. Jeff Bingaman,
Chairman, Committee on Energy and Natural Resources, U.S. Senate,
Washington, DC.
Dear Chairman Bingaman: Thank you for the opportunity to appear
before the Committee on Energy and Natural Resources on January 29.
Enclosed please find my response to the extra questions supplied by
Senator Feinstein as a follow-up to the hearing.
Sincerely,
James E. Newsome,
Chairman.
Responses to Questions From Senator Feinstein
Question. Can you explain why energy transactions, and specifically
Enron's bilateral energy trades are exempted from CFTC regulation?
Answer. The Commodity Futures Modernization Act of 2000 (CFMA) was
signed into law by President Clinton on December 21, 2000. It amended
the Commodity Exchange Act (the Act or CEA) to, among other things,
provide legal certainty for over-the-counter (OTC) derivatives
products. The CFMA added to the CEA a new exemption in Section 2(h)(1)
for some types of bilateral transactions between sophisticated parties
in certain non-agricultural and non-financial commodities, including
energy products. Other types of bilateral energy trades are beyond the
scope of our regulatory authority under the Act by virtue of the
statutory exclusions of forward contracts in Section 1a(19) and swap
transactions in Section 2(g).
Question. I suspect that Enron On-line didn't just happen to fall
through the cracks, so what was the rationale for this exemption? Do
you think this was a mistake?
Answer. Congress enacted the CFMA after a number of hearings were
conducted by our House and Senate oversight committees (in the context
of reauthorizing the CFTC) that covered issues related to evolving
markets. I believe Congress appropriately recognized that OTC
derivatives markets, which provide valuable risk management tools to
commercial counterparties and other sophisticated users throughout the
economy, do not necessarily require the same level of regulation as
markets that serve retail participants.
Question. I understand that the CFTC investigated Enron On-line and
concluded that there was no market manipulation. Did you have all the
information you needed to make this determination? How much more
information would you have had if Enron was performing multi-lateral
rather than bilateral trading?
Answer. The Commission has not initiated a formal investigation of
Enron On-line. However, the CFTC's market surveillance staff regularly
monitors the regulated futures and options markets, including those for
exchange-traded energy contracts, to identify activities or price
relationships that might indicate attempted manipulation or other
threats to the orderly operation of these markets. We receive daily
reports of large trader positions. Commissioners and senior staff are
kept apprised of significant market events or potential problems at
weekly surveillance meetings. Staff from the Energy Information
Administration of the Department of Energy are invited to participate
when energy markets are on the agenda. Thus, because Enron was often a
large trader of energy-based contracts on the New York Mercantile
Exchange (NYMEX), its on-exchange trading activities were monitored by
our market surveillance staff and we have no indication that Enron ever
attempted to manipulate any on-exchange futures or option market.
If an electronic trading facility operates multilaterally pursuant
to Section 2(h)(3) of the CEA,, the CFTC has authority under Section
2(h)(4) to prescribe rules to ensure the timely dissemination by the
facility of price, trading volume, and other trading data where the
CFTC determines that such facility serves a significant price discovery
function for transactions in the underlying cash market. The Act does
not provide the CFTC this authority with respect to bilateral
transactions entered into pursuant to Section 2(h)(1).
Question. What regulations governed the hedging instruments that
Enron sold? Some have alleged that Enron sold hedge funds which
rewarded Enron when gas prices were high and volatile? Can you respond
to these claims?
Answer. If by hedging instruments, you refer to futures or options
traded by Enron on the NYMEX or another regulated exchange--which, like
other derivative instruments, can serve risk management (hedging)
purposes--then Enron's positions would be subject to a full range of
CFTC regulations, including the large trader reporting requirements
discussed above. If, however, you are referring to transactions which
may be conducted over-the-counter under the CFMA amendments of the Act,
then the exemptions and exclusions discussed above would apply.
Hedge funds, on the other hand, are a form of pooled investment
vehicle, which typically cater only to sophisticated investors. Some
hedge funds, if they participate on a regulated futures exchange, must
register with the CFTC as commodity pool operators. We are not aware of
Enron having ever marketed interests in any hedge fund, commodity pool,
or other pooled investment vehicle.
______
Federal Energy Regulatory Commission,
Washington, DC, February 14, 2002.
Hon. Jeff Bingaman,
Chairman, Committee on Energy and Natural Resources, U.S. Senate,
Washington, DC.
Dear Mr. Chairman: Thank you for your January 31, 2002 letter
enclosing questions from Senator Richard C. Shelby and Senator Gordon
H. Smith for the record of your Committee's January 29 hearing on the
impact of Enron collapse on energy markets.
I have enclosed my responses to Senator Shelby's and Senator
Smith's questions. If you need additional information, please do not
hesitate to let me know.
Best regards,
Pat Wood, III,
Chairman.
[Enclosures]
Responses to Questions From Senator Shelby
Question 1. Chairman Wood, in your testimony you state that:
``Enron appears to have failed because of its questionable non-core
business investments and the manner in which it reported on its
financial position to its owner-investors and to the broader business
community. Based on the facts as they appear now, Enron's actions would
have led to the same result whether its core business focused on
energy, grains, metals, or books.''
This leads me to believe that regardless of the level of regulation
imposed upon Enron, you believe that they would have failed, is this
the case?
Mr. McCullough makes the argument that had Enron been a registered
holding company all of this may well have been avoided, do you agree
with this assessment?
Answer. The full details of Enron's accounting practices are not
yet clear. Until further information is available, I cannot say whether
additional regulation, or what types of additional regulation, might
have prevented Enron's collapse. The excerpt quoted from my testimony
was intended to mean that Enron's problems did not depend on the fact
that Enron's core business is in the energy industry. The accounting
principles at issue appear to apply to all domestic companies, and are
not unique to the energy industry. In response to Mr. McCullough's
assertion, I believe that until we have a comprehensive understanding
of the facts, it would be premature to judge whether Enron's collapse
may have been averted if Enron had been a registered holding company.
Question 2. Chairman Wood, in your statement you mention that in
``December of 2001, the Commission proposed a rulemaking to update the
accounting and reporting requirements for jurisdictional public
utilities, natural gas companies and oil pipelines.''
Could you please explain to the Committee, the current accounting
and reporting requirements for these entities, and if you could detail
the differences in those requirements for registered holding companies
and non-registered holding companies?
Answer. The Commission's current accounting requirements for
jurisdictional public utilities, natural gas companies, and oil
pipelines are encompassed in the Commission's Uniform System of
Accounts, 18 CFR Parts 101, 201 and 352 (2001). The Uniform System of
Accounts generally requires these jurisdictional entities to establish
and maintain a systematic and complete accounting for all of their
costs. The Uniform System of Accounts is aimed primarily at ensuring
that the Commission has reliable and comprehensive information to
verify that cost-based rates are just and reasonable.
The Commission has established a number of reporting requirements
for jurisdictional companies. The most important one is that public
utilities, natural gas companies and oil pipeline companies must file
an annual report, which generally contains a balance sheet, a statement
of income, a statement of retained earnings and a statement of cash
flows--all kept in accordance with the Uniform System of Accounts.
Marketers typically would be exempt from these accounting and
reporting requirements, since the requirements are intended to elicit
cost information and are not relevant to the market-based rates allowed
for marketers. However, power marketers must file quarterly reports
concerning their recent power transactions.
The Commission's accounting and reporting requirements do not vary
based on whether the company is or is not part of a registered holding
company. Although the Commission in certain circumstances imposes
restrictions on public utilities that are part of registered holding
companies, with respect to pricing for non-power goods and services,
the basic accounting and reporting requirements applicable to a
jurisdictional company are not affected by whether or not that company
is owned by a registered holding company. Public utilities in holding
companies must abide by the Commission's accounting requirements as
well as those of the Securities and Exchange Commission.
Question 3. Chairman Wood, continuing along those lines, it is my
understanding from the minimal account of information that we now have
that Enron may have violated the rules of the Financial Accounting
Standards Board--essentially, they may have violated existing
accounting rules. In your opinion, would these new accounting and
reporting requirements that FERC is proposing provide an extra layer of
protection for consumers and investors?
Answer. No. The Commission's proposed accounting and reporting
requirements are intended to make accounting for jurisdictional energy
companies more consistent with existing accounting requirements for
non-jurisdictional companies. The Commission's proposal would not have
prevented Enron's apparent noncompliance with existing accounting
requirements or standards.
The proposed accounting and reporting requirements would establish
uniform accounting requirements and related accounts to recognize
changes in the fair value of certain security investments, items of
other comprehensive income, derivative instruments, and hedging
activities, consistent with certain Financial Accounting Standards
Board protocols. The new accounting requirements would apply to those
public utilities, natural gas companies and oil pipelines required to
comply with the Commission's Uniform System of Accounts. For these
companies, the proposed rules are intended to improve the accuracy and
completeness of the accounting information available to the Commission,
customers and others.
As noted above, power marketers are not required to comply with the
Uniform System of Accounts. Thus, the proposed new requirements would
not apply to power marketers. However, the Commission did ask for
comments on whether the exemption of power marketers from the existing
and proposed accounting requirements remains appropriate. These
comments are due to be filed by March 11, 2002. The Commission will
evaluate this issue carefully after receiving all of the comments.
Responses to Questions From Senator Gordon Smith
Question 1. The Pacific Northwest wholesale generation and
transmission system provides reliable, low-cost electric service to
consumers in the region. The predominant cause of transmission
constraints is not service for regional loads, but marketers and others
wheeling power out of and through the region. What problems would you
be solving for electricity consumers in the Northwest by mandating an
RTO and national market standards?
Answer. In my view, all uses of the transmission grid are equally
valid. With most Load Serving Entities (LSEs) dependent on some amount
of generation remote from their loads, I cannot conclude that regional
exports rather than native load are the cause of transmission
constraints. In general, RTOs will achieve greater efficiencies in
power markets and limit opportunities for discrimination in grid
operations. They will promote greater competition in regional wholesale
markets, which will benefit customers by lowering delivered electricity
rates. RTOs will also conduct regional transmission planning, expedite
reasonable cost grid expansions, and eliminate transmission rate
pancaking. A standard market design would help remove barriers to
regional trade and facilitate regional coordination in performing key
industry functions.
I recognize that the electric infrastructure in each region of the
country has unique operational characteristics and needs. As the
Commission continues developing RTOs and market design, I will remain
mindful of the need for balance between the efficiencies of a seamless
national market and regional flexibility.
To this end, the Commission has provided a number of opportunities
for representatives from each region of tire industry to express their
interests and concerns on these issues, either in writing or in public
meetings. The Commission will continue its extensive outreach efforts
as we adopt and implement new policies and requirements on RTOs and
market design. The Commission is also preparing cost-benefit studies to
ensure that any actions we may require on these issues are in fact
likely to benefit customers. I assure you that whatever policies and
requirements the Commission ultimately adopts will be based on our goal
of producing additional savings for customers.
Question 2. Given that FERC still regulates wholesale power and
transmission, what are the limitations of market-based solutions to
ensuring adequate power generation and adequate transmission
infrastructure?
Answer. Market-based solutions are an important step to ensure the
adequacy of our electrical infrastructure. Investors will not provide
the capital needed by the electric industry unless they believe they
will be compensated adequately compared to other investment
opportunities. Thus, a good market structure with some assurance of
sound rulemaking and revenue recovery is essential to assure that new
generation and transmission are built.
However, as you suggest, market-based solutions are not sufficient,
by themselves, to ensure development of needed infrastructure. Siting
issues often can delay or prevent such development. Of course, we must
meet our need for energy infrastructure without unduly impairing our
Nation's environmental assets. However, siting problems are sometimes
driven by the fact that the benefits of proposed infrastructure would
go to one state or region while the costs (economic or environmental)
would go to another. We must find ways to ensure that everyone's
interests are considered adequately and that the benefits and burdens
of development are distributed as fairly as possible. The Western
states, through the Western Governors Association and the Committee on
Regional Electric Power Cooperation, have recognized the importance of
sound Western energy infrastructure expansion and are developing
methods of cooperation to better handle these siting issues across
states. Here too, having an RTO-led regional planning process would
help achieve regional infrastructure solutions.
Question 3. My constituents rely on their long-term Bonneville
contracts to move federal generation from its source to their loads.
How are those rights going to be accommodated and protected in an RTO?
Answer. Bonneville is not a public utility and thus the contracts
under which it provides service are not subject to the Commission's
direct jurisdiction under sections 205 and 206 of the Federal Power
Act. The same concerns you express, however, have been expressed by and
on behalf of public utilities. In that context, two key issues raised
in the Commission's rulemaking on market design are: (1) whether an RTO
transmission tariff should apply to bundled retail transmission; and
(2) whether existing transmission contracts (e.g., contracts in effect
before formation of an RTO) should be grandfathered. In the
Commission's Order No. 888, the Commission did not assert jurisdiction
over bundled retail transmission. That issue is now pending before the
U.S. Supreme Court. Also in Order No. 888, and in the formation of
certain Independent System Operators, the Commission grandfathered
existing transmission contracts. However, grandfathering existing
contracts may not be the most efficient approach to RTO formation. We
have received a number of constructive suggestions on these points in
our standard market design proceedings and will carefully consider the
interests of all affected parties before making any decision on the
these issues in our pending rulemaking.
Appendix II
Additional Material Submitted for the Record
----------
Consumers for Fair Competition,
Washington, DC, January 25, 2002.
Hon. Jeff Bingaman,
Chairman, Committee on Energy and Natural Resources, Dirksen Senate
Office Building, Washington, DC.
Dear Chairman Bingaman: For years, the Securities and Exchange
Commission (SEC), private utilities and others have argued that the
Public Utility Holding Company Act (PUHCA) was a redundant,
anachronistic law.
As detailed in the attached paper, the financial collapse of Enron
underscores the continued importance of regulating the conduct,
financing and structure of utility companies to facilitate effective
regulation, protect consumers and investors and support fair
competition. Absent receipt of an SEC staff ``no action'' letter, Enron
would have qualified under PUHCA as a registered holding company. Such
a determination would have resulted in significant restrictions on
Enron's broadband and foreign utility investments, as well as inter-
affiliate transactions, and required SEC pre-approval of Enron
securities issuances and direct oversight of books and records.
Effective administration of PUHCA could have prevented, minimized
or provided ``early warning'' of the events that precipitated Enron's
collapse.
Enron's corporate empire, according to recent reports, includes
roughly 5,800 affiliates and subsidiaries--including 821 located
offshore. Simply providing limited access for the Federal Energy
Regulatory Commission and state utility regulators to review holding
company books and records, as provided in S. 1766, is clearly
inadequate to safeguard consumers and investors and prevent the
corporate and accounting shell-game employed by Enron to disguise the
true nature of its investments, financial condition and affiliate
relations. Yet, with repeal of PUHCA, every utility company in the
country--companies vested with responsibility for provision of an
essential service--could mimic the corporate structure employed by
Enron, thereby shielding itself from effective regulatory scrutiny and
exposing consumers and investors to significant risks.
Consumer for Fair Competition--an ad hoc coalition of consumer
representatives, public power organizations, industrial customers and
small businesses--believe Congress should strengthen, not weaken, the
nation's laws that protect consumers and investors and promote fair
competition. We urge you to delete repeal of the Public Utility Holding
Company Act from your pending legislation unless adequate, additional
protections are provided.
Sincerely,
Marty Kanner,
Coalition Coordinator.
Collapse of Enron Highlights the Need to Strengthen, Not Weaken,
the Nation's Electricity Laws
The sudden and dramatic financial collapse of Enron, the world's
largest electricity and natural gas trader, highlights the need to
strengthen, not weaken, the nation's electricity laws to ensure that
consumers and investors are protected and fair competition advanced.
On December 12, 2001, testimony before the House Energy and Air
Quality Subcommittee, SEC Commissioner Isaac Hunt outlined the abuses
that led to passage of the Public Utility Holding Company Act of 1935
(PUHCA): ``inadequate disclosure of the financial position and earning
power of holding companies, unsound accounting practices, excessive
debt issuances and abusive affiliate transactions.'' Commissioner Hunt
asserted that enhanced and expanded regulation by the SEC and the
states--as well as changes in the accounting profession--rendered the
protections found in PUHCA ``duplicative and unnecessary.''
The Enron collapse underscores the failure of the remaining fabric
of regulatory oversight to uncover the abuses that starkly parallel
those that led to enactment of PUHCA. Repeal of federal statutes, such
as PUHCA, removes important tools that could be used to prevent future,
similar collapses in the energy industry and associated investor and
consumer harm.
PUHCA is intended to regulate the structure, financing and
operations of utility holding companies to prevent complicated
corporate structures, affiliate transactions and consolidations that
prevent effective regulation and cause investor or consumer abuse.
Following is a summary of key provisions of PUHCA and their
implications in the Enron debacle:
1. Utility ownership restriction. If a company owns one operating
utility, it is precluded from purchasing another unless the acquired
utility can be physically and operationally integrated with the
original utility. In addition, if the resulting acquisition creates a
multi-state utility, then the holding company must become a
``registered'' holding company under PUHCA, with additional
restrictions on financing and diversification. The effect of this
restriction was to limit Enron to owning a single operating utility--
Portland General Electric. Had additional, non-integrated utility
acquisitions been allowed, the consumer impact of Enron's collapse
could have been significantly magnified. PUHCA repeal would allow a
small number of companies to acquire a large number of utilities, not
for reasons of economic and physical integration but for reasons of
cash flow. This trend toward concentrated utility ownership will
magnify the harm to energy consumers from the financial failure of any
one of these companies. Recently, a federal court held that the SEC
erred in approving a merger between two large utilities because their
systems were not integrated. This shows the need for more vigorous
regulatory oversight--not less.
2. Finance and Accounting. PUHCA requires registered holding
companies to secure SEC approval prior to the issuance of stock and
provides for SEC--not just private accounting firm--auditing of company
books and records. Had Enron been a registered holding company, and
PUHCA been effectively administered, these requirements could have
prevented or provided ``early warning'' of Enron's use of stock as
collateral and payment to a variety of limited partnerships.
3. Diversification restrictions. PUHCA is supposed to limit each
registered holding company holdings to a single integrated utility
system, plus only those businesses that are ``necessary or incidental''
to that system. In short, holding companies must stick to their core
business, and operate it efficiently. One of the primary contributing
factors in Enron's collapse was its diversification into broadband,
water utilities and foreign utility investments. Had the SEC
effectively administered PUHCA, Enron would have been classified as a
registered holding company \1\ and its investments in broadband would
have fallen under the 1996 Telecommunications Act restrictions
requiring prior state commission approval, investment disclosure
requirements and access to books and records, capitalization, and
pledging of utility assets.\2\ In addition, Enron's investments in
foreign ventures would have faced tighter restrictions. Repealing PUHCA
will remove the restrictions on holding company diversification and
conditions on holding company investment in telecommunications and
foreign utility. This action could potentially lead to other utilities
making risky investments that lead to financial ruin.
---------------------------------------------------------------------------
\1\ The Federal Energy Regulatory Commission (FERC) determined that
Enron's electricity trading operations qualified Enron as a ``public
utility''. As noted in a January 21, 2001, Wall Street Journal article,
the SEC staff issued a ``no action letter'' in January 1994,
determining that Enron's energy marketing and brokering activities did
not constitute ``facilities'' within the mean of an electric or gas
utility that would require Enron to become a registered holding
company. Had the SEC staff made the same determination as the FERC,
Enron would have become a registered holding company under PUHCA with
the associated restrictions.
\2\ By restricting the pledging of utility assets, captive
ratepayers would not be at risk for failed diversification ventures,
and those ventures could be more limited in scope to do the absence of
collateral.
---------------------------------------------------------------------------
4. Affiliate transactions. PUHCA stipulates terms for financial and
commercial transactions between affiliates that, if properly enforced,
should prevent corporate shell games that hide the true financial
condition of a company. PUHCA repeal will remove one check on
complicated corporate structures that could hide similarly looming
catastrophes. Because of the increasingly multi-state nature of such
transactions, additional statutory protections are needed.
5. Restrictions on consolidation. In the wake of Enron's collapse,
numerous other ``merchant'' power companies have had their credit
downgraded and seen stock prices plummet. This financial situation, by
weakening smaller newcomers, is likely to lead to increased
consolidation, as healthier incumbent market participants acquire their
weaker competitors. While such consolidation may be financially
beneficial to the acquiring and acquired companies--it will certainly
reduce the number of market participants and reduce competition. PUHCA
requires that any proposed merger produce economic and operational
efficiencies and be in the public interest. Rather than utilizing this
``net benefits'' test, FERC policies call for approval of any merger
that does not cause obvious harm. Repealing PUHCA will lower the
standard for utility mergers and acquisitions and lead to increased
consolidation and reduced competition in the industry.
______
Statement for the Record of the American Public Power Association
Before the Senate Energy and Natural Resources Committee Hearing on the
Impact of the Enron Collapse on Energy Markets
The American Public Power Association (APPA) is pleased to submit
testimony to the Committee on the impact the collapse of Enron has had
upon energy markets and the defects and regulatory deficiencies in
energy markets that led to the collapse. APPA represents the interests
of more than 2,000 publicly owned electric utility systems across the
country, serving approximately 40 million citizens. APPA member
utilities include state public power agencies and municipal electric
utilities that serve some of the nation's largest cities. However, the
vast majority of these publicly owned electric utilities serve small
and medium-sized communities in 49 states, all but Hawaii. In fact, 75
percent of our members are located in cities with populations of 10,000
people or less. Further, most publicly owned utilities are not
generation self-sufficient but depend on wholesale power purchases to
meet the retail loads of the communities they serve.
When Enron filed for Chapter 11 bankruptcy protection on December
2, 2001, it became the largest bankruptcy in U.S. history. Enron's
collapse has affected thousands of Enron employees, many of whom lost
their life savings as well as their jobs. Enron stockholders lost
countless millions as Enron stock rapidly crumbled from approximately
$90 a share to less than a dollar per share this year. In Texas, the
Teachers Retirement System and Employees Retirement System lost a
combined $59.7 million as a result of investments in Enron stock. In
addition, banks that loaned Enron money may not be repaid, causing
instability among lending institutions.
The collapse of Enron has consequences for energy markets as well.
Independent power producers nationwide have seen their stock prices
drop as a result of weakened investor confidence. The negative investor
sentiment lingering from the Enron debacle has eroded the price of
Calpine Corporation stock, the country's largest independent power
producer, to a one-year low.
Appropriately, the Department of Labor, the Securities and Exchange
Commission and the Department of Justice have launched investigations
into Enron's collapse. In addition, numerous congressional committees
have stated their intent to hold hearings on issues related to Enron.
We believe it is particularly appropriate for this committee to
examine Enron's collapse because of the serious implications this event
has for the electric utility industry and electric industry
restructuring legislative initiatives. We commend Chairman Bingaman and
members of the Committee for holding this hearing today. Information
that comes to light as a result of this hearing, as well as other
ongoing investigations, could help shape electricity legislation and
protect consumers, as well as investors, from the questionable
practices that caused Enron's bankruptcy.
Unfortunately, the Enron debacle is more than a case of greed and
accounting failures. The collapse of Enron represents a colossal
regulatory failure.
In 1935, the Public Utility Holding Company Act (PUHCA) was enacted
to regulate the structure, financing and operations of utility holding
companies to prevent complicated corporate structures, affiliate
transactions and consolidations that prevent effective regulation and
cause abuse of investors or consumers. PUHCA directs the Securities and
Exchange Commission (SEC) to regulate the activities of large, multi-
state electric or gas utility holding companies and to limit their
diversification into non-utility businesses. In fact, PUHCA was created
to prevent precisely the kind of utility holding company structure--
with nearly 1,000 affiliates--that Enron became.
Under PUHCA, the SEC enforces: special accounting requirements;
limits on utility mergers and expansion; and tough restrictions on
affiliate relationships. To date, 35 companies are regulated by the SEC
under PUHCA. It is interesting to note that despite arguments PUHCA is
perceived by companies as a major problem, the number of companies
choosing to be regulated under PUHCA by the SEC has doubled over the
past 10 years.
Enron was clearly intent on avoiding regulation under PUHCA. In
1993, Enron obtained a ``no-action letter'' or waiver from the SEC
exempting their wholesale power-selling unit, Enron Power Marketing
Inc., from registering under PUHCA. Some have argued that the SEC would
have been within its authority to require Enron Power Marketing Inc. to
register under PUHCA and that the SEC issued the waiver without
addressing the legal issues in the application. Conversely, when faced
with a similar decision the Federal Energy Regulatory Commission (FERC)
determined that Enron's electricity trading operations qualified Enron
as a ``public utility.''
Had the SEC applied the same criteria, Enron would have become a
registered holding company under PUHCA with the associated
restrictions. Restrictions that would have been in place had Enron been
a registered holding company include: SEC approval prior to the
issuance of stock; SEC auditing of books and records; limits on
diversification; and terms for financial and commercial transactions
between affiliates. The restrictions, had they been appropriately
administered, could have prevented, or provided ``early warning'' of,
Enron's collapse. Appropriately, the SEC is now reviewing the 1993
staff ruling to award the waiver; however, this will provide little
comfort to the Enron employees and shareholders who suffered great
personal and financial loss.
Further evidence of the lengths Enron would go in order to avoid
PUHCA regulation can be found in Enron's 1997 acquisition of Portland
General Electric (PGE), a deal specifically structured to avoid placing
Enron under the strictures of PUHCA. In fact, in a July 1996 article in
The Electricity Daily Ken Lay, Enron's CEO at the time, stated in
reference to the PGE deal and their efforts to avoid PUHCA regulation
``. . . clearly there are (PUHCA) constraints in other deals. We think
the Act should be repealed.'' Ironically, had these constraints not
been in place, additional, non-integrated utility acquisitions would
have been allowed and the consumer impact of Enron's collapse would
have been significantly magnified.
Ultimately, the repeal of PUHCA will allow a small number of
companies to acquire a large number of utilities, not for reasons of
economic and physical integration but for reasons of cash flow. This
trend towards concentrated utility ownership will magnify the harm to
consumers from the financial failure of any one of these companies.
In addition to the waiver from PUHCA, Enron was able to obtain a
SEC exemption from the Investment Company Act of 1940. This waiver
allowed Enron to shift the debt of their foreign operations off their
books and permitted Enron executives to invest in partnerships
affiliated with the company.
Clearly, having regulations in place is not enough--these
regulations must be strictly enforced in order to be effective. At
least in terms of PUHCA, a deficiency in SEC enforcement contributed to
the Enron debacle. This enforcement deficiency may be related to the
SEC's belief that PUHCA should be repealed or the fact that there are
currently proposals pending in Congress that would repeal PUHCA.
Ironically, it was a similar deficiency in enforcement, at FERC in
this instance, which prolonged and contributed to the energy crisis in
the West. In California and throughout the West, we believe that FERC
was so focused on promoting competition that it completely lost sight
of its obligation under the Federal Power Act to permit only just and
reasonable wholesale rates and its responsibility to ensure that
consumers are protected from abuses of market power. Rather than
relying upon assumed competition to regulate wholesale electricity
markets, FERC should have taken immediate steps to control electricity
prices in the West.
Over the next several months much information will be gleaned and
many lessons will be learned from the hearings and investigations in
the Enron collapse. Congress should proceed cautiously on comprehensive
restructuring legislation until such time that those lessons can be
assimilated into legislation. Proceeding on comprehensive electricity
legislation without the benefit of information that comes to light as a
result these hearings and investigations ultimately is likely to cause
more harm than good. In order to better protect consumers, shareholders
and the integrity of energy markets from similar ``Enron'' collapses in
the future, Congress should undertake an examination of current laws
and regulations on the books and ensure that those laws and regulations
are being adequately enforced. Further, Congress should consider, when
appropriate, strengthening existing law as a means of closing
potentially exploitable loopholes.