Putting deregulation in focus after Enron

David Walls
Arthur D. Little, Inc.

The recent collapse of Enron triggered concern about the long-term outlook for electric deregulation in North America. If the largest energy trader in the world could not make a go of it, how could anyone else? But as the dust settles, the reality of the situation is getting clearer. The evolving Enron story points to some combination of faulty business decisions, inadequate financial reporting and auditing standards, as well as overly optimistic projections of market opportunities and inadequate risk management. Deregulation was not the culprit, nor is the Enron fiasco likely to have a long-term impact on the deregulation process. Quite the contrary. The lessons learned will sharpen how companies look for and understand risk in future transactions and business deals.

Several concerns raised over recent months called into question the future of deregulation: Would the collapse of the largest wholesale energy trader affect the liquidity of the market? Would questions of market power, price manipulation and abuse undermine confidence in the ability to structure markets that will facilitate a level playing field and sustainable competition? Would the collapse of a major retail energy provider affect the emergence of competitive retail markets?

When these issues first surfaced, each appeared potentially problematic. But now we can begin to understand that they hold little risk for deregulation’s long-term prospects. Market liquidity has not been compromised following the demise of EnronOnLine. Many other successful wholesale energy traders have picked up the displaced volume. And major issues related to price manipulation are connected to California’s market problems of the past year and flaws in the market structure, not to an individual energy trader. Though fully functioning and competitive U.S. retail markets are likely to take much more time to develop than earlier predictions suggested, the reasons are tied to market structure issues, establishing adequate supply, overcoming transmission and distribution constraints, and price transparency-rather than to the success or failure of market participants.

Important Lessons

A number of lessons were there to be learned well before Enron’s collapse. They involve a solid grasp of market risk and a fuller understanding of the time required to make fundamental changes in complicated markets. The U.S. power market’s transformation is likely to take several decades. Realistically, players will face trials and failures as we work toward fully functioning, competitive markets.

Underlying all of this is risk: market risk, regulatory risk, technology risk, and financial risk. Though it has long been understood that deregulated energy markets involved risk, over the past 10 years we have seen little evidence of significant risk. In fact, the relative success of early independent power projects (IPPs) and wholesale trading markets, along with the apparent success of other commodity trading markets, led many participants to feel that these new markets represented relatively low risk. As a result, many deals were structured using off-balance-sheet financing. Frequently, large fees were extracted at the time the deal was completed, and there was a general sense that after that point, the risk was relatively low. This applied to power projects as well as the sale of fiber-optic cable capacity. However, as markets move toward increased deregulation, expect to see more volatility-i.e., price, market and volume volatility. This will create greater risk for participants along the value chain, including consumers, energy generators, and traders. Thus, we will see some failures along the way; performance will not always meet market expectations.

An important take-away from Enron’s failure is the growing recognition that making money upfront on the deal does not necessarily represent a viable long-term business model. Extracting fees is a nice perk if a company’s key strength is structuring deals, but this is not likely a predictable, stable method of earning revenue. And, if markets are to behave efficiently and provide the benefits intended to both consumers and participants, there must be a transparency in the transactions. Well before Enron’s collapse materialized, financial analysts were raising questions about transparency in the complexity of its businesses.

In light of Enron, companies across industries have been watching closely to understand the implications for market and business risk in their own organizations. In the energy markets, we believe the following are among the greatest lessons to be learned:

  • Deal-making is a legitimate and important business process but should not be depended on as a significant source of revenue. Instead, think about balancing the rewards for completing the deals with longer-term metrics for projects and business activities.
  • Deregulated energy markets will have more financial risk for participants than traditional regulated utility businesses. But, how you manage risk and balance your portfolio will determine your long-term success and ability to ride out a storm.
  • Deregulation and development of attractive competitive markets is going to take longer than anyone anticipated-though we should have known from experiences in the airline and telecom industries. But, companies that balance their portfolios of new higher-risk activities (that will take longer to evolve) with traditional and proven business activities will move forward fastest.
  • Hockey stick market projections should be carefully scrutinized because they rarely materialize. One approach to assessing market opportunities that works well for many companies is to use alternative market scenarios to evaluate the impact of a range of forecasts.
  • De-coupling assets from trading businesses can lead to unbalanced risk/reward relationships. It is increasingly obvious that energy-trading businesses must be balanced with assets that will cover a significant portion of the trading conducted.

The time is right to get on with the hard work of deregulation and create a truly competitive North America power industry. Already, companies are focusing on using their strengths to build new power plants and transmission capacity. Other companies are reviewing their portfolios and selling plants in regions where they have excess. There is more focus on balancing asset portfolios with trading businesses. And, as we look back in 10 years, we will likely see that the Enron collapse empowered the industry to rethink what was important to strengthen the industry: assets to back trading businesses and more transparent information about risks.

Walls is associate director of advanced energy systems with Arthur D. Little Inc. He can be reached directly via telephone (617-498-6649) or e-mail (walls.d@adl.com).

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