Energy Deregulation - Troubled Past Portends Scary Future
My earlier ND20 article outlined the deregulation of energy commencing in the 1990s. Unleashed from government constraints, the industry was to serve the public’s energy needs efficiently and economically. Free market forces were to supplant the waste and unwarranted burden of governmental oversight, forcing down prices and improving operations.
I must report that things did not work out very well. Everyone is aware of the Deep Water Horizon oil spill and the Upper Big Branch Mine explosion. The costs in human life, environmental damage, jobs and financial loss have been enormous. It was all the direct result of the subversion of regulation by the oil and coal industries, a form of deregulation known as “regulatory capture.”
Far less understood are the consequences of deregulating the other two energy sectors, natural gas and power. After 60 years, price regulation of wholesale markets was ended by Congress and the regulators. Vertically integrated power utilities divested many of their generating assets to unregulated Independent Power Producers to take advantage of the new free market. Derivatives trading in these markets was then deregulated, allowing the banks and big oil firms to dominate price hedging.
Consumer prices were supposed to fall as fierce competition and unfettered trading improved efficiency. That did not happen. For the decade commencing in 2000, when the last phase of deregulation was completed, power prices increased 40% more than the rate of inflation. Natural gas price performance was worse. In 2009, gas prices plummeted as demand evaporated with recession. Before that year, gas prices increased 110% more than inflation for the period.
No doubt, competition drives down prices. But if the costs of creating competition increase prices more, the net result is just a bad business deal.
Energy is a capital intensive industry. Before deregulation, most capital investment was made by price-regulated businesses, such as gas pipeline companies and vertically integrated utilities operating within protected franchise territories. Regulated utilities and pipelines had extraordinarily low capital costs because of low risk. The new unregulated businesses were much riskier because they were exposed to market price changes. For the consumer to benefit from deregulation, savings from competition had to overcome higher capital costs of the riskier companies.
This problem has gotten progressively worse since full deregulation. Price risk was seen to be an unacceptable credit exposure for the unregulated companies. Prices had to be hedged through derivatives transactions for the companies’ credit standing to be acceptable. Today, when energy companies present themselves to investors and ratings agencies, they feature their hedging strategies prominently to justify higher share value.
Most energy firms are not well-equipped to secure hedges in the conventional trading markets. Derivatives positions require ready access to cash, and a lot of it. Values change abruptly and the swings can be very large. Adverse moves must be covered immediately with cash collateral posted to clearinghouses and counterparties.
Whipsawed by the need to hedge and the intolerable cash requirements of hedging, energy companies have turned to devices created by banks which can be used to avoid liquidity demands. These devices involve risks and costs that the energy companies often do not understand (or, perhaps, care to understand). As long as they have access to hedges and the costs and risks are obscure, their businesses can survive.
Incidentally, the energy companies fought hard to secure the “end user” exemption in the financial reform legislation largely to preserve these devices. If the cost of hedging were to become transparent under the reforms, share values would be lower.
The weakness and high capital cost of unregulated energy are illustrated by the bankruptcy of three of the largest unregulated power companies since 2003 - Calpine, Mirant and NRG. In 2008, Constellation went to the brink of bankruptcy, only to be bailed out by a cash infusion of $1 billion by Warren Buffet and the sale of a 49.9% interest in its nuclear facilities to Electricite de France for $4.5 billion. Constellation was considered the most sophisticated unregulated producer since it was staffed largely by former Goldman Sachs personnel. Ironically, it almost failed because of a recordkeeping error related to trading.
The bankrupted companies and Constellation represent power generating capacity sufficient to serve all of the needs of New York, New Jersey, Pennsylvania and New England.
There is much, much more. The effect of predatory bank energy trading of energy is the subject of a forthcoming article. In addition, several notorious events in the recent past were rooted in energy deregulation. Four are described below. Remedial action was taken in each case, but the stories should not end there. Sharp minds are still hard at work seeking unfair advantages which endanger the system. We must expect similar disasters and scandals if regulatory controls are not somehow re-imposed.
California Energy Crisis. Anticipating deregulation, the state established a set of rules for the economic allocation of wholesale demand among competing power suppliers. A continuous auction process set prices during each day at levels necessary to secure supplies. In the summer of 2001, as demand peaked, suppliers implemented strategies to game the system. There were many complex strategies with ominously named, as if the traders were playing video games. (Enron’s “Death Star” was most notorious.) Generally, they were designed to withhold supply, drive up prices and then sell at enormous premiums, all within short timeframes. The utilities commission refused to allow the power distributers to pass along the costs to customers. After suffering brownouts, $45 billion in losses and the bankruptcy of Pacific Gas and Electric (which serves most of northern California), the Federal Energy Regulatory Commission and the state combined to force an end to the crisis using price caps.
Round Trip Trading. Unregulated electronic trading on the Intercontinental Exchange offered a major opportunity for manipulation. Traders at two firms could collude to transact at a price and then execute a reversing transaction later so no one lost money. Energy markets are really collections of small markets based on specific delivery points. Round trip trades artificially moved the price of gas and power at specific delivery points for the advantage of the participants. As an added incentive, ICE had a program of granting stock warrants (tremendously valuable in an IPO) based on customer volume which was inflated by the rigged trades. When round trip trades were discovered in 2003, it became apparent that the practice was widespread.
Amaranth. This hedge fund put on a massive, highly leveraged position betting on the spread between natural gas prices for deliveries in March and April in each of the years 2007 and 2008. It was the idea of Brian Hunter, a 30 year old trader who was later dubbed by the DealBreaker blog as “the destroyer of all worlds.” In 2006, the trades lost $6.8 billion and Amaranth (a symbol of immortality in Greek mythology) collapsed. Energy markets were massively disrupted. To put this in perspective, Long Term Capital Management lost “only” $4.6 billion in 1998. However, LTCM was integrated into Wall Street and the Fed stepped in to force a takeover by several banks to bail out investors. Does this sound familiar?
Financial Transmission Rights. The theorists behind deregulation of the power markets had a problem. Power delivered to the grid nearer the site of demand and transmitted along uncongested paths is more valuable than the alternative. Power could not be priced efficiently in daily auctions without accounting for this value. Predictably, the experts came up with a market-based solution. Rights to transmit from point to point would be periodically sold at auctioned by system operators to provide price signals. But too few parties were interested in such rights to assure a valid auction. The theorists proposed mechanisms to attract outside, financially interested bidders. To a cynical, market-savvy observer, this was a recipe for speculation by traders in a highly volatile derivative instrument without having to post margin to cover risks. In 2007, unsurprisingly, a few thinly capitalized shell companies which faced transmission rights losses to PJM (the system operator for the Mid-Atlantic region) simply walked away. PJM members had to kick in $100 million or so to cover the loss. While this loss pales in comparison with Amaranth’s, the episode illustrates how deregulation of complex markets can have perverse and unpredicted consequences. If the members had refused to pick up the tab, claiming that PJM was inept and the risks were undisclosed, the largest power system in the United States might have financially failed. In truth, this alternative appealed to many members. We are lucky that the loss was small enough so that they paid up after a short struggle.
Some may say that the chicanery and ineptitude outlined above should not trouble us. After all, remedies and firewalls have been put into place. Do not believe it. The deregulated energy sector is complicated, fast moving and large. It bristles with tempting opportunities to make a quick buck by manipulating the system. For deregulated energy, the past portends the future.
Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.