Exorcising the Ghosts of Enron
Crisis is a potent catalyst for policy change. The most infamous electric industry crisis was the 2000-2001 Western Energy Crisis. In the public eye, it was largely pinned on the actions of Enron. The policy response led to a mix of institutional development and deconstruction that fundamentally shifted the course of the industry. The ghosts of Enron still haunt policymakers’ confidence in power markets today. But it is time to put those ghosts to rest; expanding and improving power markets unquestionably elevates social welfare.
In the 1990s, California made the first attempt to adopt competitive electricity markets, known as “restructuring.” Competition came at two levels—wholesale and retail—and replaced cost-of-service monopolies for generation and retail services. The restructuring movement was a product of economic research and consumer advocacy in the 1980s and 1990s that theorized a strong value proposition of moving to competitive markets. This manifested in a series of federal and state reforms in the 1990s.
Momentum froze in 2000, when California’s attempt at restructuring induced the Western Energy Crisis. The behavior of Enron, including market manipulation, took center stage. Among other things, Enron engineered an artificial supply shortage to inflate prices. In response, states immediately backtracked on their restructuring plans without understanding the root causes of the crisis. In hindsight, California’s mistake was poor implementation, not the normal operation of restructured markets.
Today, the structure of wholesale and retail power institutions varies by state. R Street identified three common combinations: restructured, traditional (full monopoly), and hybrid (competitive wholesale markets with predominantly monopoly-owned generation and retail services). By this definition, we consider California hybrid, and the remainder of the West traditional but considering a move to the hybrid model.
Over the past decade, wholesale markets have expanded considerably but unevenly. Retail markets have remained relatively static. Recent resurgence in power demand is accelerating business consumers’ pursuit of wholesale markets and reinvigorating interest in retail choice, with proposals emerging in various states.
Currently, competitive wholesale markets serve the vast majority of domestic customers, yet only about one-third of states have substantial retail competition. The only lower 48 states without wholesale or retail competition reside in the Southeast and West. The greatest momentum for wholesale market expansion currently resides in the West, with competing proposals in various stages.
The West, understandably, is also the region haunted most by the Western Energy Crisis. For example, state regulators and non-governmental stakeholders have expressed concerns that western wholesale market expansion threatens another “Enron-like” energy crisis. Misunderstandings of Enron have even undermined confidence in the benefits of existing markets, such as mischaracterizations of the Texas market in the documentary JUICE. Such concerns underscore the value of explaining the root causes of the western crisis; how contemporary institutions and policies manage these concerns today; and why policymakers best serve the public interest by expanding and improving markets.
Unpacking the Western Energy Crisis
California instituted its competitive wholesale and retail markets in March 1998. The markets worked “fairly well” for a year and a half. Beginning in the summer of 2000, electricity prices surged and generation capacity shortages induced power outages. By January 2001, the institutions set up to administer the markets, the California Power Exchange (PX) and the California Independent System Operator (CAISO), ceased to function effectively.
The economic fallout was extraordinary, including orders of magnitude escalation in electricity prices, repeated rotating blackouts, and severe financial problems for California’s utilities. The crisis was accompanied by, but did not cause, the dramatic collapse of Enron. Political responses matched the severity of the event. States halted restructuring and Congress passed three pieces of major legislation that gave the Federal Energy Regulatory Commission (FERC) and other federal agencies unprecedented authority to rectify electric and natural gas market manipulation.
The initial autopsy by FERC, expert practitioners, and academics centered on supplier market power and design flaws in the PX and CAISO markets. In energy markets, suppliers can exercise market power by physically withholding supply, or economically withholding it by offering supply at a price far exceeding its marginal cost (i.e., at a large premium to what they would offer if competitors had ample supply to offer). Indeed, Enron and other suppliers engaged in physical and economic withholding that contributed to the crisis. FERC’s procedures failed to mitigate this behavior.
Beyond market power, FERC’s approved rules at the time failed to even mention manipulation. The Western Energy Crisis exposed not only the inappropriateness of antitrust approaches to mitigate electricity market power, but the gulf between rule-based market power mitigation and principle-based prohibitions on fraudulent behavior. Enron’s behavior was famously tied to fraudulent schemes that enabled widespread manipulation of energy markets.
The public nature of the trials of Enron’s executives led to a misleading narrative that the crisis simply resulted from a few nefarious masterminds. Other mischaracterizations contended that the crisis was an inherent piece of competitive electricity markets, while others implied the result was pure government failure. Rather, the behavior of Enron and other suppliers resulted from market and government failure. Bad regulation encouraged bad behavior. The crisis specifically exposed failed market design rules, improper market power mitigation policy, and a lack of market oversight and manipulation prevention.
Most of Enron’s trading strategies were demonized in the public eye but ironically corrected distortions by enhancing economic efficiency. Enron’s economically harmful behavior was, for the most part, a rational response to exploit blatant market design flaws. Other firms engaged in both types of behavior. This is not to downplay that Enron also engaged in illegal behavior, notably fraud, but to underscore that severe public policy flaws caused the Western Energy Crisis, not a single manipulative firm. Importantly, the market design flaws that firms like Enron exploited were flagged by economists before the Western Energy Crisis, with neglect from policymakers resulting in a “disaster waiting to happen.”
The Western Energy Crisis was not a simple case of over- or under-regulation. Both were at fault. One instance of government overreach was the use of retail price controls, namely rate caps or freezes, which caused a severe disconnect between wholesale and retail markets. Another was an effective ban on long-term hedging. The primary lesson from Enron in the economic literature is to remedy regulatory flaws, not search for scapegoats.
Inadequate regulation was also evident. The power industry, given unique physical and economic characteristics, presents a complex set of market failures that even surpass those of other network industries. These include high barriers to entry; large information asymmetries and transaction costs; exceptionally dynamic market power; and profound network externalities. Thus, laissez-faire competition is not possible, and capturing the substantial benefits of competition requires careful attention to detail, such as market design rules. This necessitates a nuanced approach to regulation that facilitates competition, which contemporary institutions have evolved to accomplish.
Market Institutions Today
Electric market institutions have transformed in the decades following the Western Energy Crisis. FERC established its Office of Enforcement in 2002. The Energy Policy Act of 2005 enhanced FERC’s tools to oversee energy markets and assess civil penalties for market manipulation and rules violations. FERC’s “just and reasonable” standard now takes a strict regulatory stance against physical and economic withholding. CAISO and its six peer institutions, known as regional transmission organizations (RTOs), have expanded and overhauled market rules under FERC’s purview. FERC also established new independent institutions, known as market monitoring units (MMUs), to evaluate market performance, mitigate market power, report misconduct, and identify market design flaws and remedies.
By the mid-2010s, the literature found that despite early isolated failures of competition, domestic electricity markets were “reasonably competitive” based on various empirical measures. Generally, RTO markets have remained competitive to date based on the RTO-specific reports of the MMUs. For example, the most recent annual assessment for CAISO found that “wholesale energy prices were about equal to competitive baseline prices” estimated by the MMU.
Altogether, RTOs have demonstrated robust economic, reliability, environmental, and transparency benefits, with those in restructured states showing the best performance. This advantage should grow as the economics of the power industry become more conducive to market competition, especially with the advent of energy storage, variable generation plants like wind and solar, customer-sited generation, and flexible demand. Market power, opacity, and other consumer concerns are more evident in the “bilateral-only” exchanges that exist outside RTOs. Contrary to the Enron narrative, the evidence backs competition as an antidote to bad behavior when examining the full history of electricity industry cronyism and scandals, which tend to result from the perverse incentives of monopoly utilities.
The contemporary benefits of competition reflect, in large part, improvements to market design. Crucially, domestic markets use granular, nodal pricing to reflect grid congestion and permit long-term contracting that supplements RTO spot markets. This avoids core flaws behind the Western Energy Crisis, which used broad, zonal pricing and prevented long-term contracts. For example, when Texas converted from zonal to nodal design in 2010, it reduced operating costs by 4 percent in the first year. These widely adopted market design features instill confidence that Western Energy Crisis lessons have staying power domestically. Lessons like nodal-pricing benefits are even applied abroad.
The decline in problematic market participant behavior in part reflects an aggressive FERC enforcement apparatus that deters manipulation and other rules violations. From 2007-2013, FERC enforcement negotiated $858 million in civil penalties and $584 million in disgorgement. Problematic conduct among market participants has trended toward small and sophisticated infractions like “gaming” rules. Given the growing codependence of electric and natural gas markets during winter storm events, some enforcement practices may need refinement to detect supplier withholding in both industries.
While proper market design and contemporary enforcement has proven effective in mitigating schemes like Enron’s, unclear enforcement practices have evolved to undermine market performance. FERC frames “its anti-manipulation rule broadly, rather than articulating specific conduct that would violate the [r]ule.” Thus, FERC relies on legal settlements to establish compliance, where market participants must infer what constitutes permissible behavior based on previous enforcement cases. Furthermore, FERC’s opaque investigation process may not comport with basic aspects of due process. Former top FERC enforcement economists and lawyers have made convincing arguments that current enforcement practices deter economical behavior and are a procedural quagmire in need of reform. As power markets become more dynamic with unconventional resources, unclear and inaccurate FERC interpretations of economic withholding based on “opportunity cost” may become particularly problematic.
Proper Policy Responses
The last quarter century has demonstrated that the proper role of generation and retail regulation is to facilitate—not substitute for—competition. This explains why energy consumers seek to continue the expansion of competitive markets alongside consumer protections, namely “robust independent market monitoring and dynamic mitigation and enforcement practices.” Policymakers should appreciate the demonstrated and growing economic, reliability, and environmental advantages of markets.
Policymakers in the West and Southeast would achieve the best results by firmly committing to wholesale markets rather than piecemeal market expansion. Wholesale competition requires complex sets of institutions and rules that are optimally implemented in a coordinated fashion, which also reduces the unintended consequences of piecemeal markets. Wholesale markets perform best when paired with retail competition. States must resist the temptation to use price controls and interfere with generation investment, which contributed to the Western Energy Crisis and remains a concern in California today. However, the core regulatory flaws behind the Western Energy Crisis were abandoned over a decade ago. Given mounting problems with monopoly utility service, the riskiest option is forgoing the proven competitive market model.
Facilitating electric competition requires unusually sophisticated market institutions. These must be designed and calibrated to address the market failures that make electricity uniquely vulnerable to exercises of market power and manipulation. Independent market monitoring, dynamic market power mitigation, and appropriate enforcement are necessary.
Government failure must also be minimized. In particular, FERC’s enforcement practices prevent bad behavior effectively, but also stymie productive behavior. Prudent reforms include adopting a clear, economic-efficiency based anti-manipulation definition as well as a transparent and open process with safe harbors. Such reforms would retain consumer safeguards while enhancing the benefits of markets for all participants.