By Alan Jenkins and Mark Perry
June 4, 2003 — A recent announcement by Entergy-Koch Trading L.P. that it has suspended all price reporting to avoid regulatory risk indicates how far the energy market has come in responding to regulatory risk.
Such awareness comes only after many energy companies were simply run over by the regulatory semi-truck that lurked in the blind-spot of the late-90s energy autobahn. The challenge now is to create a regulatory model that not only spots regulatory risk but understands and minimizes such risk. The first step toward a successful regulatory model is to recognize why the prior model failed.
The Enron model was specifically designed not to recognize regulatory risk
The Enron model supplanted the stodgy cost-of-service regulated utility model that had dominated the energy industry for at least the last half of the 20th century by commoditizing energy. As Enron developed advanced market and risk analysis models largely borrowed from non-energy financial markets, its traders could quickly recognize profit opportunities and its back office personnel could lock in profits.
Indeed, Wall Street traders and back-office personnel with little or no experience in the energy field flourished in the Enron environment as they acted quickly to exploit gaps in the commodity market unrestrained by “old utility thinking.”
However, these same employees were largely oblivious to the continued applicability of regulatory power to “unregulated” transactions. Further, the risk models relied on by traders took no account of the regulatory risk facing market players in a deregulated energy marketplace. Similarly, many energy companies trying to catch up to Enron began to conduct generation and marketing activities isolated from the internal regulatory and legal oversight that had formerly typified the regulated utilities.
Fundamentally, Enron and its business clones were wildly successful at spotting business opportunities but failed to recognize that the trading or generation entity is not, in fact, unregulated. While the entity’s cost structure may not be subject to direct state or federal oversight, its myriad transactions are subject to post hoc government scrutiny.
Simply put, the business model these companies followed was designed not to recognize regulatory risk.
It’s hard for a regulator not to regulate
In one respect, energy company personnel cannot be faulted for failing to recognize the “blind spot” because the term “deregulation” itself implies, at a minimum, less regulation. However, as former FERC Commissioner Vicky Bailey put it: “It’s hard for a regulator not to regulate.” 20 Energy Law Journal 1 (1999).
As Enron entered into deregulated markets, no regulator reviewed Enron’s cost of doing business. Price volatility, market inefficiencies and deregulation growing pains, however, soon led to public dissatisfaction that echoed back to regulators who of course owe their jobs to public favor.
These regulators, though they may no longer have had the ability to regulate energy provider costs, still possessed a number of legal tools to scrutinize energy companies. In the past five years regulators have imposed price caps, codes of conduct, new accounting standards, and standards of service on energy providers.
Government bodies have also used certificate authority, securities law and commodities law to scrutinize the myriad transactions of energy companies.
Some government bodies have even abrogated contracts or pressured energy companies to enter into or modify power contracts. Finally, some have used the press as a weapon to “regulate” unregulated providers. None of these regulatory risks was captured adequately by the Enron risk models and thus, when the risks materialized, many energy companies found themselves unable to sustain the unexpected financial blow.
Adjusting the Mirrors
As reported recently by Dow Jones newswires, Entergy-Koch Trading suspended “all price reporting until there is further clarity and certainty around industry expectations and the government regulators’ guidelines.”
Of course, many other energy trading operations have simply closed up shop altogether. To be successful, the new regulatory model must not only be able to spot regulatory risk, it must also advise trading and generation arms on how to proceed in the current energy marketplace while minimizing that regulatory risk.
This model must include in-house or outside personnel that are specifically tasked to identify specific regulatory risks faced by energy companies, work with on-the-ground or trading floor personnel to develop strategies for minimizing such risks, work with back office personnel to internalize regulatory risk in risk models, and keep directors and officers informed as to the progress of such efforts.
In short, such personnel must adjust the mirrors to reduce or eliminate the regulatory blind spots.
About the Authors:
Jenkins is a partner with McKenna Long and Aldridge LLP. Jenkins represents clients in the natural gas, electric power and communications industries. He is actively involved in advising energy clients on how to deal with regulatory risks associated with regulated and deregulated markets. Jenkins represents utility companies, energy traders, independent power producers, commercial users and other clients on how to structure proposed projects, securing regulatory and financing approvals for such projects, and drafting and negotiating key project and power supply agreements. He has also represented energy clients before a number of state and federal regulatory agencies, and appellate courts. Jenkins received a Bachelor of Science degree magna cum laude from the State University of New York and a Juris Doctor degree with honors from the University of North Carolina/Chapel Hill.
Perry is a graduate of the University of Tulsa with degrees in urban planning and economics. Beginning in 1979, Perry has been involved in oil, gas, natural gas liquids and power trading with Vesta Energy and subsequently his own company providing testimony at the FERC concerning jurisdiction over liquids sales, processing agreements, and the conversion of firm sales certificates by companies with expired sales agreements. Since 1996, Perry has been involved in several investigations of royalty and working interest owner fraud, and reviewed the trading policies and procedures of several of the largest traders. He also was one of the instructors for Enron and Genesis Training System program teaching Enron Capital & Trade executives “Strategic Alliance Sales.” The program was designed to provide the traders with the skills to sell all forms of energy products to a customer or group of customers. Perry is a member of the Association of Certified Fraud Examiners (ACFE) and has been a member of the Natural Gas Associations of Oklahoma, Houston, North Texas and New Orleans and well as NESA.