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

by Bethany McLean

  One trend was that the California economy had gone through a tremendous boom in the 1990s, a boom that had included an enormous expansion of computing power, thanks in part to the rapid growth of Silicon Valley. As computer companies and dot-coms grew, they used more power. At the same time, though, the state’s strict environmental laws prevented major new power plants from being built. In other words, Belden believed, demand was growing and supply was not keeping up. Perhaps more important, Belden also believed that California had begun to rely far too much on an abundant supply of hydroelectric power. According to his analysis, hydro accounted for some 40 percent of the resources used to produce power throughout the West. What would happen if there were a dry year? Because of the way the California market was structured, with the utilities forced to buy most of their power on the spot market, any shortage could send prices spiraling upward. The result wouldn’t be the panic selling the deregulation gurus had envisioned; it would be panic buying.

  Acting on Belden’s theory, the West Coast trading desk took a huge long position in electricity in late 1999. By the spring of 2000, Belden’s prediction began coming true. Unseasonably warm weather boosted power needs. At the same time, because of lower snow pack, or snow density, there was less hydroelectric power available from Oregon.

  Almost overnight, the surplus became a shortage, and California needed every megawatt it could get its hands on. Soon, the ISO, which was just supposed to balance supply and demand around the edges, was providing 20 percent to 25 percent of California’s total energy needs and paying increasingly higher prices for power. On May 12, 2000, Belden e-mailed a colleague in Houston: “We long. Pricing keep going up. So far so good.”

  On May 22, 2000, the ISO was forced to declare a Stage 1 emergency, because its power reserves had dropped below 7 percent. Before May, prices had averaged $24 to $40 per megawatt hour; now they quickly hit the price cap of $750 per megawatt hour. Industry experts were in a state of shock: it wasn’t even summer yet, and supply and demand were not wildly out of whack. Why was the price of electricity going up so much?

  It became frighteningly clear that May 22 was no isolated event. All through June, power prices remained at sky-high levels. Emergencies became increasingly common; the ISO wound up declaring 55 emergencies in 2000 and another 70 in 2001, compared with just 17 in 1998 and 1999 combined. Suddenly, utilities were bleeding money because they were forced to pay far more for their power than they could collect from customers, who were still paying regulated rates.

  In mid-June, as temperatures in the Bay Area topped 100 degrees, Pacific Gas & Electric was forced to declare rolling blackouts—the first since World War II in California—in part because a plant that it sold to Duke Energy (as the new rules required) was taken offline for maintenance. Entire neighborhoods saw their power shut off for an hour to two hours at a time—at which point their power was turned back on and another neighborhood went dark. In just that one month, the total wholesale cost of electricity topped $3.6 billion, roughly half of what power had cost for all of 1999. The ISO, in search of a solution, lowered the cap on the price it would pay for power generated in California from $750 per megawatt to $500 and finally to $250.

  And so it went, all summer long. In San Diego, the one city where consumer rates had been deregulated (that’s because the local utility had earned back all its losses from those onerous long-term contracts), power prices doubled between May and August. Small businesses had to shut their doors because they couldn’t pay their bills. State officials pleaded with companies and consumers alike to turn down their air conditioners and dim their lights. Schools that had obtained lower rates by signing contracts under which their power supply could be interrupted—never thinking that such a thing could happen—had to send students home because their electricity was shut off. Companies with similar contracts had to turn off their air conditioning entirely, even though it was approaching 100 degrees outside. The big California utilities were suddenly in deep financial trouble. People were enraged. Protests sprang up all across the state. By the end of the summer, California was in full-crisis mode.

  And Enron was taking full advantage: Belden and his West Coast trading desk were booking profits the likes of which they’d never seen before, some $200 million just between May and August of 2000, according to a presentation Enron later gave to Moody’s. That was roughly four times the profit the desk had made in all of 1999, according to the government.

  But why? Why was this happening? To hear Enron and the other power sellers describe it, the whole debacle was California’s fault. The state needed to build more power plants; that was the only way supply and demand would get back into balance. And it needed to stop trying to keep an artificial lid on prices, which only made things worse. Indeed, to Enron, the two issues were intertwined. As Belden put it in an e-mail to the ISO, “prices need to reflect market conditions in order to incent new generation.”

  Later, Belden addressed an industry conference, which was covered by the Los Angeles Times. “Is there scarcity?” he asked. “Is there a smoking gun? We still don’t know. How did we get here? Well, first, these complex markets were designed by economists and engineers. If you want to trade power in California for Enron, the minimum requirements are, you need to have a law degree and a Ph.D. in engineering. You need to have done significant research in market theory and game theory.” At which point, the audience laughed.

  California regulators and politicians found such comments utterly infuriating. To them, the problem was simple: the big power companies, including Enron, were manipulating the market for their own benefit. And state officials wanted the federal government to do something about it. San Diego Gas & Electric filed a complaint with the FERC, requesting lower price caps. On August 10, the ISO issued a report, blaming the crisis on the exercise of market power; on August 17, representatives from the California utilities presented a detailed list of alleged trading abuses to the FERC, including the intentional creation of congestion and “megawatt laundering.” The FERC denied San Diego’s request, citing a lack of evidence. But on August 23, the FERC, under political pressure, did order an investigation.

  At the time, the FERC was deeply unsympathetic to California’s complaints. Most of the FERC commissioners were fundamentally proderegulation—that was the ethos of the times. They tended to agree with the power-trading companies that California had botched deregulation. On August 24, representatives from a group of power marketers met with the FERC to defend their actions. Enron sent Mary Hain, a regulatory affairs lawyer. The message she laid out—“The high prices in California were the result of scarce supply” and the FERC should be “discouraged . . . from taking any action that would hurt the vibrant wholesale market in the [sic] California and the rest of the West . . . ,” as she later wrote in an e-mail—fell on receptive ears. That was what the FERC already believed.

  Despite the FERC’s willingness to side with the energy traders, the company had no illusions about what was coming. “We knew we were going to get sued,” says Richard Sanders, who was head of litigation for Enron North America. “There was no way we weren’t going to get sued.” To steel itself for the coming legal battle, Enron assembled a team of outside firms, including Stoel Rives, a Northwest firm that specialized in energy regulations, and Brobeck Phleger, which had trial expertise in complex business litigation.

  On October 3, 2000, the entire team—more than a dozen lawyers and regulatory experts—convened in Portland to get a handle on the problem. “We are not your lawyers,” Sanders and the Brobeck lawyers warned Belden when the meeting started. “We are the company’s lawyers.” The message, of course, was that if Belden said anything incriminating, they would be looking to protect the company’s interests, not his. Belden was unflustered. He quickly went to the white board at the front of the room and began sketching out in minute detail the strategies he and the West Coast trading desk had been employing.

  For the next two hours, he went through them
all. He explained how his traders employed Ricochet to move power out of California, then back in again at much higher prices. He detailed Fat Boy and Death Star and Get Shorty, too. “No one can prove, given complexity of our portfolio,” he said at one point, according to handwritten notes taken by Mary Hain. (In a deposition she later gave, she said that she did not think this reflected chicanery, just the traders’ belief that regulators wouldn’t be able to figure out what was going on.) Far from being ashamed of what his group had done, Belden was proud of it. “I don’t think they ever thought they did anything wrong,” Sanders said later. “To them it was a big video game. . . . He [Belden] thought it was all just part of working the system to make us as much money as possible.”

  Sanders, however, was horrified. He didn’t understand everything he was hearing—it was very complicated stuff—but those nicknames sent chills up his spine. Fat Boy? Death Star? Ricochet? To Sanders, it scarcely mattered whether the strategies were legal or not. He was a litigator; California was in crisis; people were furious. He knew exactly how these nicknames would sound in court. “Is it too late to change the names?” he asked plaintively. “Can’t you just call them Puppy Dog and Momma’s Cooking?”

  There was another issue, too. Enron had gotten requests from both the CPUC and the California attorney general’s office, which wanted to know, among other things, exactly how much money Enron had earned in the state’s power market. The profits that Belden ascribed to the short-term strategies—$5 million here, $3 million there—were small. (The FERC later estimated that Enron earned a mere $60 million from “congestion revenues” and that it was “highly unlikely” that the impact of Belden’s strategies on spot prices “accounted for a substantial portion of Enron’s total revenues.” But as the ISO has also noted, it is impossible to gauge the “indirect and cumulative impact of these strategies on overall market prices and outcomes.”)

  But the company was making a fortune on Belden’s long position. Enron executives, knowing how poorly that would play, were desperate to avoid disclosing the figures. Hain said she heard from higher-ups that Enron would “die on the Hill rather than provide that information.” She also said: “They didn’t want anybody to know how much money they were making.”

  Yet despite all of this—the certain outrage that would result from the discovery of the company’s mammoth California profits; the legal headaches that would arise from exposure of the trading strategies’ names; indeed, the possibility that the strategies were illegal—nobody told the traders to stop. With one exception: at Belden’s request, Sanders did talk to a trader who had figured out that if he scheduled megawatt sales in fractions—say, 22.49 megawatts—the ISO would round down to 22 megawatts for the delivery and round up to 23 megawatts for payment, enabling Enron to skim the difference. Sanders told him to send the money—some $15,000—back.

  Belden argued that all Enron’s competitors were employing similar strategies, which was true. (In fact, other companies made much more than Enron did. But they were smart enough to avoid the headline-grabbing names like Deathstar.) He also blamed California’s real problems on the companies that owned the power plants, a group that did not include Enron. Belden insisted that some strategies were even beneficial to the market. For instance, because the state’s big utilities routinely underestimated their demand for the next day to force prices down, Fat Boy, which was a way of overestimating demand, made the system more reliable.

  Mostly, though, he claimed that while his traders’ strategies took advantage of badly designed rules, they didn’t break them. In the energy trading world, “talking your book”—lying about your position in order to get the market to move your way—was common practice. That these practices made a mockery of Ken Lay’s exhortations about Enron’s high ethical standards was irrelevant. So was the long-term damage the traders were doing to Enron’s larger goal of nationwide deregulation.

  In trying to be so smart, Enron’s West Coast traders were doing something incredibly stupid. But inside the Enron cocoon, they simply couldn’t see that. “The attitude was, ‘play by your own rules,’ ” says a former trader. “We all did it. We talked about it openly. It was the school yard we lived in. The energy markets were new, immature, unsupervised. We took pride in getting around the rules. It was a game.”

  • • •

  When Richard Sanders returned to Houston, he promptly went to see his boss, Mark Haedicke, the general counsel for Enron North America. “We have a problem,” he said.

  They certainly did. Gary Fergus and Peter Meringolo, two of the Brobeck lawyers who attended the session with Belden in Portland, noted that there were already at least six investigations into California energy practices and spelled out the potential consequences of the West Coast traders’ actions in a memo to the Enron legal department.

  “If Enron is found to have engaged in deceptive or fraudulent practices, there is also the risk of other criminal legal theories such as wire fraud, RICO, fraud involving markets, and fictitious commodity transactions. . . . In addition depending upon the conduct, there may be the potential for criminal charges prosecuted against both individuals and the company,” they noted. “We believe it is imperative that Enron understands in detail what evidence exists with respect to its conduct in the California electricity market as soon as possible.”

  At the end of October, the two in-house lawyers, Sanders and Haedicke, along with two of the top executives in the Wholesale division in Houston, Dave Delainey and John Lavorato, held a conference call with Belden so that the Houston executives could hear firsthand about Belden’s strategies. When he heard the nicknames for the schemes, Delainey could only shake his head. No one suggested shoving the problem under the rug—but, once again, no one said to stop, either.

  On November 1, just days after the conference call, Enron got some good news: the FERC issued the results of its investigation. The investigators had only had three months and lacked subpoena power, so they had no way of knowing about Death Star and Ricochet. The FERC did note that rates were “unjust and unreasonable” and proposed a number of remedies. But the report largely exonerated the power trading companies, including Enron. While the FERC said that “certain market rules do interfere with the functioning of the market and, taken together, may permit sellers to exercise market power,” that was as much a slap at California as it was the companies. And in any case, the investigators concluded that there was insufficient data to “support findings of specific exercises of market power.” The FERC also declined to order immediate refunds to California as San Diego Gas & Electric was demanding. The report was met with fury in California. One consumer group said that the “FERC is fiddling while consumers are burning.”

  If not for what happened next, Belden’s little tricks might have stayed a secret forever. On December 6, two lawyers—Christian Yoder from Enron and Stephen Hall from Stoel Rives—sent a memo to Richard Sanders and Mark Haedicke. Both had attended the meeting in Portland where Belden had laid out the traders’ schemes and were deeply troubled by what they’d heard. Neither of the recipients had requested a memo, but according to one person involved, Yoder wanted to make sure that Haedicke, who had a reputation for being slippery and political, couldn’t disavow knowledge of the Portland problem.

  Using phrases like “the oldest trick in the book” and “dummied up” demand, Yoder and Hall walked through Fat Boy, Death Star, and the other techniques. When they got to Ricochet, Enron’s strategy of exporting lower-cost California power out of the state then bringing it back in when the ISO was desperate, the lawyers wrote: “This strategy appears not to present any problems, other than a public-relations risk arising from the fact that such exports may have contributed to California’s declaration of a Stage 2 Emergency yesterday.”

  By this time, Haedicke had California first on his list of the top ten legal risks that Enron faced, says Sanders. (LJM was also on his list: “Increased SEC scrutiny might lead to restatement of earnings,” he noted.
) The Brobeck lawyers soon drafted another memo, trying to soften the harsh language Yoder and Hall had employed. They noted that Yoder and Hall had made a number of errors and that the lawyers still didn’t really understand what the traders were doing. But the damage was done. The Yoder and Hall memo, given to the FERC by Enron’s board months after Enron’s collapse, gave California the proof it had long sought that Enron had manipulated the market. Indeed, it caused many people to blame Enron for creating the California crisis.

  But that came later. All winter long, as Enron’s lawyers were grappling internally with their discovery of the West Coast trading schemes, California’s power problems continued to escalate. The state, by then, was desperate for power. It didn’t matter whether the weather was severe or not; the shortages were chronic, the declaration of emergencies more frequent. The ISO asked people not to turn on Christmas lights to save electricity. (“I know everybody says we’re the Grinch that stole Christmas,” said a spokesman, “but we’re trying to keep power on in their homes.”) Companies cut back on capital investment because they needed to make sure they had enough cash to pay their energy bills. Some factories were calling workers in at 2 A.M., so they could operate the plant when electricity was less scarce—and conserve it during peak hours.

  At the same time, PG&E and Southern California Edison were drowning in debt. Lacking long-term contracts—and unable to pass on their soaring costs to customers, who, as a result, had no motivation to conserve energy—they were reduced to sending out pathetic press releases begging consumers to “turn off PCs, monitors, printers, copiers, and lights when not in use.”

  Stunningly, the companies that had bought the generation plants from the utilities—companies like Mirant, Duke, Dynegy, and Reliant, which also traded energy—were taking them off line for maintenance. By-mid November, nearly a quarter of the state’s generating capacity was idle for maintenance or emergency repairs, nearly three times the outtage rate of a year earlier. In fact, from May 2000 through June 2001, plants owned by the major generators ran at just over 50 percent of capacity, according to industry consultant Robert McCullough.