Myth, Corruption, Cap And Trade: The Next Big Derivative Disaster

Sacramento Bee columnist, Dan Walters, mounted an interesting dismissal of the significance of political corruption in California’s Capitol on Sunday, arguing that the real problem in state government is hastiness. Those darn legislators just take on problems too quickly, embracing poorly vetted solutions of “convenience” that later backfire on the public, he suggested.

It is an important observation because it comes from the Capitol’s seminal journalist. What Mr. Walters writes has a tendency to leak into the work of his colleagues and ultimately imbed itself into Capitol lore:

“The great enemy of the truth is very often not the lie — deliberate, contrived and dishonest, but the myth, persistent, persuasive, and unrealistic. Belief in myths allows the comfort of opinion without the discomfort of thought.” – John F. Kennedy

The ultimate example of such hastiness, says Mr. Walters, was the unanimous passage of the Electric Deregulation Bill (AB1890) in 1996. Sometimes these myths become a barrier to “the discomfort of thought”. But this colossal myth continues to have colossal consequence.

Here are the facts:

The PUC passed a binding deregulation order (more accurately “restructuring order”) in December of 1995 after more than four years of hearings and workshops. Before adopting their final rulemaking the PUC published massive documents covering the proposed changes –the final two known as the “Yellow Book” and the “Blue Book”.

The Wilson administration and deregulation advocates sponsored more than a dozen electric deregulation bills in the Legislature beginning in 1992. The bills were subjected to hundreds of hours of hearings between 1992 and 1995. None of them passed.

During this period the Federal Energy Regulatory Commission (FERC) continued to pressure for deregulation and promote the notion of a transition that would include “non recovery of stranded assets” This, of course, meant that no regulated utility would build a power plant for fear that they would ultimately not be allowed to recover their investment out of “unregulated” rates.

AFTER the PUC takes its action in December of 1995 and after the legislature is advised by the Attorney General and the Legislative Counsel that the PUC did in fact have the authority to unilaterally restructure without Legislative approval, Democrats (who overwhelmingly opposed the entire concept of deregulation and simply did not have the two-thirds vote necessary to override the Governor) move AB1890 along with other bills to a two-house conference committee in 1996.

The Conference Committee meets for almost 200 hours over a period of six months in televised public hearings held in the Capitol’s largest hearing rooms. All six members of the Conference Committee attend all meetings and the audience averages over 100 people in attendance throughout the process.

These hearings include many days in which meetings are held twice a day. Once in the morning, and again in the evening with staff working with language in between (in the hearing room open to the public). All language is vetted in detail in publicly televised hearings, including a final word-for-word public reading of the entire document in two successive televised hearings with the entire committee and a packed room in attendance.

Only a couple of weeks into the process, Mr. Walters complains privately about these evening hearings. He is told that because the committee members also serve on other committees, and because the Chair insists that committee members actually be present at the hearings, evening hearings are necessary (in fact preferable) to assure proper attention to a complex subject. These evening hearings also bring the added benefit of attracting significantly greater “general public” participation. The Committee encourages this by allowing testimony from numerous so-called “unrepresented” members of the public. Mr. Walters generally does not attend, but presumably monitors the proceedings on television.

The final product makes no changes in the PUC’s market design, despite heavy lobbying by Enron and its allies to eliminate the proposed Power Exchange (PX) in favor of a direct “bilateral market” in which energy traders would sell directly to retail consumers. AB1890 does however make two substantive changes to the PUC order that the Governor agrees to. First, it puts in place a statutory mechanism to preserve historical programs targeted at alternative energy and poor consumers. Second, it puts in place a temporary retail rate freeze and cap on the three utility companies’ ability to recover “stranded costs” (the purpose is to protect residential and small commercial ratepayers in the transition from potential volatility created by marketers). The balance of the bill essentially mirrors the December PUC order.

The process is praised by all of the participants, and by numerous editorials throughout the state, including the San Jose Mercury, which calls the process “thorough and exhaustive.”

The package of bills passes unanimously after a lengthy floor presentation. Many legislators who had firmly established records opposing deregulation vote yes and even co-author the bill. Why? Because not passing the bill would have meant the market would still open as directed by the PUC, but without the environmental protections and without the ratepayer protections included in AB1890.

The first evidence of market manipulation efforts is reported to FERC in the fall of 1998. FERC refuses to even open an investigation. Despite these early gaming efforts — much to the chagrin of energy traders –volatility in the transparent Power Exchange remains low, and rates to consumers are running well below expectations. This holds until the summer of 2000 when energy traders and natural gas suppliers, led by Enron and Sempra Trading, execute a coordinated attack on the California Power Exchange.

FERC hears evidence that energy traders are manipulating Western Energy markets. The testimony demonstrates that California is particularly vulnerable to such activity because of its growing dependence on imported power (ironically this dependence is largely the result of FERC’s own policies discouraging both new power plant construction and long-term energy contracts in favor of heavy reliance upon spot market (short-term) trades. FERC refuses to act.

Enron follows its market attack with a sophisticated and comprehensive PR strategy designed to keep the press and a term limited legislature focused on the entirely false contention that California’s problems are rooted in “failed market design”.

Enron and their allies use their clout at FERC to win in Washington what they could not win in Sacramento: FERC shuts down California’s transparent PX to lay the groundwork for the bilateral (dark) market Enron had always sought.

Led by the Enron Myth and by “free advice” from traders from Credit Suisse First Boston camped out in the Speaker’s office, the Capitol flails through a series of worthless exercises for a year until Enron’s corporate collapse reveals to the press the dimension of illegal activities that were actually behind the “California” Energy Crisis. (Interestingly, the corporate collapse is directly related to Enron’s California strategy, but no one ever makes the connection publicly).

In the meantime, because of AB1890’s rate freeze, PG&E and Edison are not allowed to pass the bloated wholesale energy costs on to residential and small business customers. This threatens both companies’ solvency but protects their millions of small customers. But for the AB1890 rate freeze, the entire state would have been hit with the devastating retail level impact that was experienced in San Diego where the Sempra owned SDG&E had already exited the rate freeze.

Throughout this period, the media repeats the Enron Myth as to the cause of the crisis and literally invents the idea that the Legislature had acted precipitously and in the dead of night on AB1890 to open electricity markets.

It takes more than five years for the Federal Courts to eventually rule that FERC had acted illegally in failing to stop the illegal trading activity. The evidence provided in court is the same evidence that had been provided to FERC in the beginning.

Turns out that the “crisis” wasn’t about energy at all. It was about derivatives and a trading ethic that depends upon the ability to create market volatility to make massive profits. Most of the court-ordered “recovered” ill-gotten gains come in the form of cancelled obligations from Edison and PG&E who, out of cash, had stopped paying wholesale suppliers. But for the AB1890 Rate Freeze, these costs would have long ago been passed on to consumers and never recovered.

By now, the Enron California narrative is inextricably woven into the AB1890 Myth. The PUC removes all documents related to the December 1995 Order from its website. The Power Exchange is never revived and the spin’s residual is the Capitols most demonstrably inaccurate Myth: “the problem with the legislature is Conference Committees, just look at AB1890.”

Folks in the Legislature who never put much stock in “process” recognize the opportunity to essentially abolish it. They simply stop having conference committees – the only official and transparent way to resolve differences between the two houses — in favor of backroom meetings between leadership staffs.

Unvetted language is routinely dropped into “hijacked” bills — totally bypassing the entire hearing process and rendering all but a few legislators irrelevant. Thanks to term limits, most do not even know what they miss.

So, in the end, the 1890 myth results in the elimination of transparency in both the California energy market and in the California legislative process. Enron’s Ken Lay dies under somewhat suspicious circumstances. Jeff Skilling goes to prison. Enron’s traders move on to new companies and new markets. Dan Walters keeps his day job.

As is often the case, there is a kernel of truth in Mr. Walters piece. There may be a bigger problem than corruption in California’s Capitol but it’s certainly not that things do not move fast enough. In fact, in general important things don’t move at all.

The problem is not “hastiness.” It’s “laziness.”

Important issues require a lot of work. Discussing them in public is hard and sometimes dangerous work when every word said in public is subjected to a cynical and presumptively negative spin by observers who have neither the time or the temperament to learn, let alone meet the challenge of distilling and sharing the complexities actually at the root of big problems.

So, we should not be surprised when legislators simply retreat to darkness when there is no reward for staying in the light of day.

The folks that cause problems like this simply move on like those traders at Enron; they had cut their teeth years before, profiting despite spectacular market collapses (see “When Genius Fails: The Story of Long Term Capitol Management”). Where did they go? They went to the housing market; destroyed it, moved on — profits in their pocket. And, now they are licking their chops over California’s new “Cap and Trade” market. Same people; just working for different companies; spinning the same old tale; still working in the dark of night.

It’s a pretty transparent trail, despite the night travel. A “new ethic” FERC is actually threatening to take action against JP Morgan energy traders allegedly caught scamming the California market earlier in the year. But, these guys keep moving, trolling for the next big score.

The Capitol media could do some much deserved public service time by simply drawing the obvious connections between the companies and the traders before they produce the next great “Derivative Disaster”. Long Term Capital Management. Enron, Credit Suisse, JP Morgan: different companies, same people, same ethic. These are not folks looking to make a living. They are folks looking to make a killing.

Great story. However, it requires some “discomfort of thought” and some night work.

Steve Peace (the author) is a former State Senator. He chaired the Conference Committee that produced AB1890 in 1996.