The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron

by Bethany McLean

  In truth, for all Enron’s lobbying, the new rules accompanying California’s deregulation were a far cry from what the company had hoped to see enacted. As always, Enron had pushed hard for a completely deregulated marketplace, in which companies could cut whatever deals suited their needs. But there were so many powerful competing interests jockeying for advantage that the CPUC, which was in charge of designing the new rules, was never going to allow a completely free market.

  For example, the state’s three investor-owned utilities—Pacific Gas & Electric, San Diego Gas & Electric, and Southern California Edison—all had long-term contracts to buy power at high rates. If the state was no longer going to set electricity rates based on their costs, they wanted compensation for the losses that would inevitably ensue. Politicians, meanwhile, wanted guarantees that consumers would get their rates reduced. Otherwise, what was the point?

  The result was a convoluted mishmash of compromises featuring more rules and regulations than ever. The utilities were forced to sell off their generating facilities and buy their power on the open market. They were also forbidden from entering into any significant long-term contracts; instead they had to purchase power in the spot market every day. This was supposed to lead to panic selling, thereby driving prices down. At the same time, though, the rates consumers were charged weren’t deregulated, at least not in the short term. Instead, they were cut 10 percent, then frozen for five years. Because the CPUC was convinced that spot-market power prices would drop substantially more than 10 percent after deregulation, it wanted the utilities to be able to use the difference to recoup the losses on their long-term contracts. (Indeed, if the utilities recovered their losses before five years were up, consumer rates would be unfrozen. This actually happened in San Diego.)

  But the true nightmare—and the opportunity for traders like Belden—lay in the market itself, which was really a handful of markets layered together in incredibly complex ways. To some extent, the very nature of electricity made that necessary. Getting electrons to go where you want them to go isn’t a matter of loading them on a truck, driving them someplace, and letting the extra ones sit around until a buyer arrives. It’s an engineering feat, one involving something that’s essential to modern life. Supply has to be lined up ahead of time; and the path the electrons will take to get from Point A to Point B also has be planned ahead of time, because transmission lines have a limited amount of capacity. It’s also impossible to store electricity; electrons can travel only in real time. So there also has to be a way to make sure that supply and demand match at all times.

  This is complicated stuff to begin with, and California made it even more complicated. The state’s new rules created two quasi-governmental agencies. One was called the California Power Exchange (Cal PX). Its job was to set hourly prices for electricity through auctions conducted the previous day and on the day of delivery. Sellers received (and buyers paid) the highest price needed to satisfy all the demand in any given hour. The second agency, the Independent System Operator (ISO), was in charge of managing the state’s network of transmission lines to ensure reliability. It also conducted its own real-time auctions, which were just supposed to correct last-minute supply-and-demand imbalances and ensure adequate reserves.

  The logic behind many of the new rules could be difficult to fathom. One example: when the ISO purchased last-minute power that was generated in California, the price was capped in early 2000 at $750 per megawatt hour. But if the power came from out of market, there was no price cap. Of course, the price caps could also easily turn into price targets: people knew just what the ISO was willing to pay.

  Another example: if too much electricity was scheduled to flow on a transmission line—and the line became “congested”—the ISO would pay fees to whichever power company agreed to relieve the apparent congestion. There was no way to check if there was even enough real demand to cause the congestion in the first place. The potential for abuse was obvious. As early as 1996, a man named Eric Woychik, an adviser to the CPUC in the 1980s and later an ISO board member, wrote that gaming the market would be like “shooting fish in a barrel—not great sport, but lucrative.” Even Belden himself, in an internal presentation he gave in May 2000, noted that “the ISO and the PX have a complex set of rules that are prone to gaming.”

  The new rules went into effect on April 1, 1998. At first, deregulation seemed to be a roaring success. It did exactly what everyone hoped it would do: it caused prices to drop substantially. There was so much competition among suppliers that electricity was actually free between 1 A.M. and 2 A.M. For most of the next two years, wholesale costs averaged around $33 per megawatt hour—well below the old regulated rates. They also stayed safely below consumer rates, allowing the state’s big utilities to recover billions of dollars.

  But to those in the guts of the market, it was clear almost immediately that some suppliers were not going to play nice. On July 9, 1998, just three months after the new rules went into effect, ISO employees were stunned to see the price for reserve power, which had been a dollar, suddenly spike for no apparent reason to $2,500 per megawatt hour, then to $5,000. Four days later, it happened again: the price soared to $9,999 per megawatt hour.

  What had happened? Dynegy had simply offered to supply standby power at that price—and under the rules, since there were few other offers and the ISO was expecting high demand, the ISO was forced to take Dynegy’s price. Jeffrey Tranen, then the CEO of the ISO, later told the Sacramento Bee, “All of us saw those numbers and realized . . . there was nothing to stop someone from bidding to infinity.”

  By any objective measure, Enron had a powerful self-interest in seeing the California experiment succeed. It had preached for years that deregulation would cause prices to go down and make life better for everyone. The Enron belief was that once California deregulated and showcased the virtues of a free market in retail electricity to the rest of the nation, other states would have no choice but to follow suit.

  But if deregulation was a failure, Enron would be badly hurt. As an internal Enron memo put it, “If Enron doesn’t do well in California, Enron will have a difficult time convincing anyone outside of California that they are capable of and committed to providing power services.” Just as importantly, if the California experiment failed—no matter what the reason—other states were hardly likely to follow it into the abyss. A California failure could put an end to the push for broad, national power deregulation.

  Yet from Ken Lay on down, Enron executives simply refused to see that their best interest lay in helping the state succeed. That kind of larger consideration was utterly foreign to the company’s what’s-in-it-for-me culture. This was especially true of the traders, who viewed such thoughts as lacking intellectual purity. Besides, everyone at Enron was annoyed at the way California had put deregulation into effect; the state hadn’t followed the company’s long-held position that a completely free marketplace was the only thing that made sense. Having failed to listen to Enron, the state therefore deserved whatever it got.

  “If they’re going to put in place such a stupid system, it makes sense to try to game it,” says one former senior Enron executive, in a comment that perfectly summed up the prevailing attitude inside the company. That their actions might cause turmoil and hardship, that they might affect businesses up and down the state, well, from the point of view of the Enron traders, that was California’s problem, not theirs. “It was the traders’ job to make money, not to benefit the people of California,” says another former Enron executive.

  Thus, right alongside their rivals at Dynegy and elsewhere, Enron’s West Coast traders began searching for loopholes. There were ultimately a hundred West Coast traders; they operated out of the Portland World Trade Center, where the company had built a copy of its Houston trading floor, down to the plasma TV screens and Nerf footballs. Belden, who was leading the effort to find exploitable loopholes, put in 14-hour days learning the arcane rules of California deregulation. By
the spring of 1999, he thought he saw a flaw he could exploit. But first, he had to conduct his experiment.

  Here’s what Belden did: on May 24, 1999, at 6:10 A.M., he submitted four bids to sell a total of 2,900 megawatts—enough to run a city the size of Fresno for a day—to the Cal PX to meet demand in the peak hours the following day. At 7:01 A.M., the PX notified Belden that his bid was successful. At 7:29 A.M., Belden identified a transmission route called Silverpeak as the means for getting the electricity to the state.

  The transmission route Belden had chosen begins at the Beowave geo-

  thermal energy facility in Nevada, where steam is pulled from subterranean cauldrons into a huge turbine, generating electricity. The electricity is carried across Nevada to a terminal in Silverpeak, a ghost town in the desert, where lines then transmit it over the Last Chance mountain range into Southern Califor-

  nia. Here’s the key point, though: the Silverpeak transmission lines can only carry 15 megawatts at a time.

  In other words, Belden had scheduled 2,900 megawatts on a line that could only absorb a tiny fraction of that amount. Because the transaction was physically impossible, alarm bells went off in the offices of the ISO, which was responsible for both the transmission lines and for correcting supply-and-demand imbalances. At 11:17 A.M., an ISO scheduler called Enron to find out if there had been a mistake. Belden was expecting the call, which was immediately transferred to him.

  BELDEN: Um, there’s a—there—we, just, um—we did it because we wanted to do it. And I don’t—I don’t mean to be coy.

  THE BEWILDERED ISO SCHEDULER: Cause, I mean, it’s—it’s—it’s a—I mean . . . it’s a pretty interesting schedule . . .

  BELDEN: It—it’s how we—it makes the eyes pop, doesn’t it?

  It did indeed. Because there was no way for Belden’s power to be delivered, the PX didn’t have the supply it thought it had. And so the ISO, which handled such emergencies, had to hustle to find replacement supplies. Because the agency was forced to buy a substantial amount of power at the last minute, prices in California shot up by more than 70 percent, resulting in a cost of as much as $7 million to users. There was nothing subtle about Belden’s gambit. “Someone played a game yesterday,” reported a newsletter called the Energy Market Report. Almost immediately, complaints from other market participants triggered an investigation.

  The investigation dragged on for almost a year. Belden’s essential defense was that he wasn’t trying to break the rules; he was simply performing an experiment. In fact, he claimed, he was doing the state a favor by pointing out such a huge flaw in its regulations. Enron’s hypocrisy was stunning: Ken Lay wrote to the Cal PX in November 1999 that Enron “believes in conducting business affairs in accordance with the highest ethical standards . . . your recognition of our ethical standards allows Enron employees to work with you via arm’s length transactions and avoids potentially embarrassing and unethical situations.”

  Enron’s arrogance was equally stunning. Greg Whalley, Belden’s boss, flew to California to argue Enron’s position. In a meeting with a Cal PX economist, he went up to a white board and filled it with supply-and-demand charts, explaining all the while why the California market was flawed. “It was like Whalley was a college professor, lecturing him,” recalls an Enron lawyer who was there. Whalley’s position was that it wasn’t Enron that was at fault; the problem was the foolishness of the rules, which were so easy to take advantage of. His argument was a little like an eight year old telling his parents that it was their fault he’d done something wrong because they weren’t watching him closely enough.

  In April 2000, the Silverpeak case was settled. Enron neither admitted nor denied the allegations that it had violated the market rules, but it agreed to pay a fine of $25,000 and promised to not “engage in substantially the same conduct.” The agreement was signed in large, upright handwriting by Greg Whalley. “This ‘experiment’ clearly demonstrates a disregard for the Cal PX’s primary goal of maintaining efficient and fair markets,” concluded the Cal PX investigators. If Enron had really been worried about a flaw in the system, they added, “the appropriate response would have been to bring the matter to the attention of appropriate policy makers at the Cal PX rather than disrupt the market for its own education.” But no changes were made to market rules. And internally, Belden wasn’t even reprimanded for Silverpeak, though he had hardly been upholding “the highest ethical standards.” Then again, why would Enron reprimand him? He was making money for the company.

  In fact, even as Whalley was signing the settlement agreement, Belden and his team were busy devising similar schemes. These were subtler than the Silverpeak experiment—now that it was for real, it seems that the traders didn’t want to get caught—but the purpose remained the same: to manipulate the rules and make money in the process. In one scheme, Enron submitted a schedule reflecting demand that wasn’t there. The West Coast traders called that one Fat Boy. Another was a variation of the Silverpeak experiment: Enron filed imaginary transmission schedules in order to get paid to alleviate congestion that didn’t really exist. That was called Death Star. Get Shorty was a strategy that involved selling power and other services that Enron did not have for use as reserves, with the expectation that Enron would never be called upon to supply the power or would be able to buy it later at a lower price. The point of Ricochet was to circumvent California’s price caps. For instance, Enron exported power from California and brought it back in when the ISO was desperate and had to pay far higher prices. (This strategy, which was used by all the power traders, was more widely known as “megawatt laundering.”)

  When a trader found a formula that worked, he would send an e-mail around the office. On May 5, 2000, for instance, an Enron trader named Michael Driscoll sent an e-mail to his fellow traders. “The FINAL PROCEDURES FOR DEATH STAR . . .” read the subject heading. The e-mail, which contained detailed instructions on how to replicate the strategy, noted that “project deathstar has been successfully implemented to capture congestion relief across paths 26, 15 & COI.” The e-mail concludes with “THANKS AND GOOD LUCK.” (Driscoll’s year-end list of accomplishments in 2000 noted that he had also “implemented the Round the West trade strategy—taking California power out in the Southwest, up the Rockies . . . and back into California” and that he was an “innovative trader.”)

  One advantage the traders had in playing their games was the use of Enron’s own utility, Portland General. It wasn’t long before the utility’s transmission lines became a part of the company’s machinations. For example, as Portland General later told the Federal Energy Regulatory Commission (FERC), some of the transactions it did during this time “may have resulted in the company purchasing power from the Cal PX and reselling power from its portfolio of supplies at prices higher than those paid to the Cal PX.”

  The U.S. Senate Committee on Governmental Affairs also says that transcripts of Portland General employees reveal transactions where the apparent purpose was “to assist Enron in exporting power from California with the intention of reimporting it back to the state at higher prices.” It’s not clear how complicit Portland General was, but several transcripts make it sound as if the old-line Portland General employees, unlike the West Coast traders, hated what they were being told to do. On an April 6, 2000, transcript of Portland scheduling calls, one Portland employee responsible for scheduling power transmission tells another: “I’ll sure be glad when we’re sold and they can’t pull this [expletive] anymore.” At other times Portland General transmission workers describe Enron deals as “messed up,” “stupid,” “the weirdest junk,” “convoluted,” and “bogus.” Another says, “This is a scam and you know it.” Even an Enron trader acknowledges that certain deals are “kind of squirrelly” and “nasty.”

  Indeed, Enron couldn’t have pulled off many of its strategies without the help of third parties, which had access to generation and transmission lines that Enron itself didn’t control. But that turned out to be n
ot much of a problem; many competitors, as well as out-of-state utilities and power suppliers, were only too happy to oblige. There was money in it for them as well. According to a later FERC report, an undated Enron document notes that the traders were pursuing a strategy of “gaining control of a variety of small resources or capabilities around the west.” By 2000, Enron had agreements with Montana Power, Powerex, El Paso Electric, and others. (“These prices provide extraordinary opportunities,” Enron wrote to El Paso in July 2000.) An Enron Services Handbook contained a list of various market conditions that might arise, which of the “partners” to call, what steps to follow in order to take advantage of a particular situation, and an explanation of the profit-sharing arrangements.

  “El Paso wants to play again,” wrote an Enron trader in one e-mail. “They are willing to . . . profit share (fat boy) into the ISO. . . .” Over time, Enron noted, it would “store operational data” from its partners. It wanted, the handbook said, “to lock customers in—if they leave . . . their data stays here.” This strategy of enlisting other players gave Enron more information, more market share, and more access to power generation and transmission. Under the rules, it was supposed to report resources it controlled to the FERC. The FERC says it didn’t. It seems that the Enron traders simply didn’t believe any outsider would ever be smart enough to connect the dots.

  • • •

  In addition to his short-term schemes, Belden had a long-term outlook on electricity. Despite Enron’s predictions that prices would fall after deregulation, he had a different view. He had become convinced that the economics of power in California were such that prices were going to rise. His calculation didn’t have much to do with gaming the rules of deregulation; it was rooted instead in his reading of several larger trends.