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What was the Enron California Energy Crisis, and what effect did it have on Enron’s business and eventual failure?
The Enron California Energy Crisis occurred when Enron Online traders began taking advantage of California’s deregulated energy market. In this market, energy providers had to sell facilities and other assets to make money while customer still paid regulated prices. Eventually, the Enron California Energy Crisis got so bad that Enron’s lawyers halted trading.
What Happened During the Enron California Energy Crisis?
Meanwhile, the energy traders were making lots of money in the volatile markets. They were one of the few really profitable centers of the company, giving credence to Skilling’s vision of a next-generation, asset-light energy company.
In the early inefficient markets, traders used fundamental research to make smart trades – like finding dam water levels to estimate future water prices or using weather to estimate fuel prices. Money came so easily they were bewildered.
They made even more when they launched Enron Online – a virtual trading floor for energy futures. This eventually caused the Enron California Energy Crisis.
- Enron served as the marketmaker, representing both sides of the trades. This dramatically increased the capital requirements (the danger will become apparent later).
- Its dominant position, as well as proprietary info on what outside traders were doing on their platform, allowed Enron to possibly manipulate markets to move prices in its favor. Enron supposedly did 25-50% of the trades in gas futures and electricity.
- They justified manipulating prices as just mere supply and demand – “traders don’t determine long-term price. No one had to use EOL – it wasn’t their fault others couldn’t come up with anything better.”
Within Enron, the traders saw themselves as the intellectual elite and the salvation of the company, since they were actually making money.
Enron Trading and California’s Blackouts
Enron traders participated in California’s partial deregulation of electricity, becoming enmeshed in the controversy around California’s blackouts and emergencies. The Enron California Energy Crisis was driven by trading over this deregulation.
The regulatory change: California opened electrical grids to competition in a market, where electricity had previously restricted it to certain providers with controlled costs. Utilities had to sell off their generating facilities and buy power on the open market.
But the regulation was partial – price caps were instituted; rates to consumers were fixed; and utilities were precluded from longer-term agreements that might have allowed hedging and reduced spikes in prices.
- Other rules (made with good intentions): if a power line became congested, companies would be paid fees to relieve the congestion – even if there wasn’t enough demand to cause congestion in the first place.
Enron took advantage of the rules to manipulate markets, to the detriment of consumers:
- Energy producers kept power plants off to spike prices.
- Electricity rates were tied to the price of natural gas, which Enron was also in a natural position to control.
- Enron got paid for electricity through routes that didn’t have the bandwidth to transmit it. The utilities then had to hustle to find last-minute power at high prices.
- Enron submitted schedules reflecting illusory power demand.
- Enron would sell power as reserves without actually having it.
- Enron exported power from California and brought it back in desperate times (“megawatt laundering.”)
- The partners (out of state utilities, power suppliers) were happy to oblige because they made money too.
Ultimately utilities were forced to pay far more for power than they could collect from customers, who were still paying regulated rates. One incumbent went bankrupt.
Vicious cycle: because of this instability, power producers began refusing to ship to California. (Later the US Energy Secretary imposed a state of emergency, requiring marketers to sell to California.)
If Enron had a long-term view on the Enron California Energy Crisis, it would have seen that California’s experiment needed to do well to make bigger business for it later. But it held destructive short-term views, like “other people are doing this too” and “California didn’t fully deregulate like we suggested so it deserves what it gets.”
Free market supporters claim that California’s partial deregulation set up a worse scenario than total deregulation, and California didn’t do enough to create enough electricity supply (for example, by removing price caps to incent development or realizing that hydroelectric power was subject to risk from low rainfall).
Ultimately Enron lawyers told the traders to stop.
Enron’s Big (Failed) Bet
All the financial machinations around SPEs were meant as temporary measures while Enron bet big on its next two major businesses. Both of them, however, sustained massive losses. One was Enron Energy Services.
Enron Energy Services – Retail Utilities
In addition to Enron and California’s relationship with the energy crisis, Enron’s historical bread and butter was large wholesale contracts with commercial buyers. But it believed there was a coming wave of deregulation, where federal/state governments would release municipalities from local monopolies to allow the free market to drive prices down. Enron could then sell directly to businesses and homes.
In reality, the federal government wasn’t interested in intervening in state affairs, and only a few states started pilot programs toward deregulation (New Hampshire, Pennsylvania, California).
In the few hotspots it could work in, Enron campaigned aggressively to recruit consumer households to sign up, promising lower utility costs. However, the local suppliers fought back, pulling their political strings and running ads against the big guy coming into town.
In the end, few consumers really signed up for Enron’s services – 50k in California (1% of the market) and 300 in New Hampshire. Enron and California were not a good fit.
After the residential failure, Enron targeted businesses. This was enticing – a big company spends millions a year for light, heating, and cooling. Couldn’t Enron get a share of this?
The commodity part of this business was actually a money-loser – Enron’s hope was that it would make money on contracts to reduce energy costs and increase efficiency.
Regardless, this new TCV became the sought-after metric of the day, since it gave the appearance of Enron signing big business. As usual, Enron deal makers were given bonuses on total TCV and the projected profitability of the deal (which were wildly optimistic). Naturally, a lot of bad deals were signed very quickly.
The operational requirements of this new business put Enron and California out of its depth when it came to energy – servicing customers directly required customer service, attention to detail, and hard manual work that Enron executives referred to derisively as “butt crack” work
Enron tried to argue that efficiency improvements would help them make the deals profitable, but soon it became clear those efficiency improvements wouldn’t pay for themselves.
The Enron California Energy crisis actually made Enron money. While many other schemes failed to generate actual revenue, the Enron California Energy Crisis did, but proved to be an unethical business venture.
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Here's what you'll find in our full The Smartest Guys in the Room summary :
- How Enron rose to become one of the world's most promising companies
- How Enron management's greed led it to start cutting corners
- The critical failures that crashed Enron's house of cards to the ground
