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Enron's Long Shadow

May 16, 2002

Tags Big GovernmentThe EnvironmentU.S. History

"[T]he arguments against markets are clear. California is strike one, and Enron is strike two. My God, we don’t need strike three." --Federal Energy Regulatory Commission member William Massey

All fads start in California, or so they say. Unfortunately, this appears to apply equally to alarming trends, from low-rise jeans to socialization of industry.

Let’s look at the utility industry, where the fallout from the Enron scandal continues to have effects. Last month, California lawmakers accused Enron of power trading back and forth with its affiliates in the state, taking advantage of the energy crisis at its height. In the process, Enron was able to drive up the wholesale price of electricity in a vain effort to forestall its inevitable collapse.

"They were essentially trading among themselves," Loretta Lynch, president of the California Public Utilities Commission, told a Senate consumer-affairs subcommittee last month in Washington. "This was truly a Ponzi scheme."

According to Lynch, Enron initiated a series of deals in December 2000 between itself, four affiliates, and a second firm with which it was closely allied, involving trades of more than 10 million megawatt-hours of electricity at ever increasing prices. The trades "created the illusion of an active, volatile market," Lynch said. In reality, they were "sham transactions."

This news is a godsend to California lawmakers who devised the regulatory regime that made activities such as this possible. At the time of the crisis, their credibility was strongly attacked. The state of California spent $20 billion of its taxpayers’ money both to keep lights on in the state and to hold off a political revolt against its authority in the face of rolling blackouts and the exodus of firms to more stable business environments.  


The state’s politicians were eventually rescued by the incoming Bush administration, when it imposed price caps on Western power markets (an action that forced energy consumers in non-Western states to pay higher prices), thus relieving California taxpayers the brunt of the burden caused by their politicians’ policies.

It was only a matter of time before the Feds realized that political capital could be created from this mess. Now, the Federal Energy Regulatory Commission is investigating all electricity sellers for evidence of similar pricing schemes employed during California’s energy crisis.

The FERC's Web site posted a notice to all energy traders doing business in California to preserve documents detailing trading strategies that are similar to those of which Enron is accused.  In true Soviet-like fashion, the FERC has issued a deadline by which suspected firms must "admit or deny" their complicity in engaging in spurious pricing schemes during the time period.

The result has been a crash of stock prices throughout the wholesale industry, as investors assume that any energy firm that has business in California will be considered a fair target by government regulators. Wholesalers such as Reliant Resources, Dynegy, and CMS Energy Corp. have now been implicated in schemes that, if true, would have exaggerated their firms’ reported profit margins.

There are several things wrong with this still-developing episode.  Let’s list a few.

First, California’s actions may very well have the effect of chasing out investment capital into the state that otherwise might have been used to provide dearly needed electrical generation. If this indeed happens, then it will be easier, from a political perspective, for the state to impose its designs on socialized energy production in the state. In the process, it legitimizes efforts to further socialize energy production on a national basis. Besides discrediting any future efforts to engage in real deregulation of any market, the true endgame of the Enron saga may be complete state control of energy production.

Second, California Gov. Gray Davis, who first proposed the idea of the complete socialization of energy production, was once dead in the water, both to his political enemies and friends. By trumpeting Enron’s supposed manipulation of California’s energy laws today, politicians can now divert attention from their own complicity in the affair in an election year, and Davis can once again be touted as a possible presidential candidate.

Third, it is important not to lose sight that the energy crisis in the state was created by the state itself when its notion of deregulation mixed price caps on consumer markets with more fluctuating prices in wholesale markets. The result was predictable and horrendous. Consumers had little incentive to conserve their use of electricity or to search out substitute goods.  In the face of such over-consumption, power providers compensated in the wholesale markets, where prices predictably skyrocketed.

Since rising relative prices attract suppliers to any market, many firms entered California’s wholesale market. It is ironic that these firms are now under the glare of FERC regulators.

Fourth, if California were a separate country, it would have to live with the effects of its economic policies. However, in the current political climate, states with bad economic policies have an incentive to impose them on neighboring states. For instance, in the event that Arizona implemented an electricity deregulation plan that avoided all price controls, then one wouldn’t expect energy shortages, blackouts, or unusual discrepancies between retail and wholesale prices in that state. The dichotomy would be obvious to everyone, including voters.

Faced with this situation, politicians in California have two choices. They can either remove price controls in their state, or they can press the federal government to force all states to implement similar rules to its own.  Since the state has been trying to get the federal government involved in its self-created energy problems for several years, it is obvious which choice has been made.  

Fifth, it is not clear that Enron, or any firm that might have engaged in power trading, violated any law at all. The fact that there is little evidence of firms engaging in such activity outside of California reflects the pressure that firms in this market inherited in the face of price controls.  Whether these firms may have violated ethical norms is beside the point.  Price controls clearly encourage such activity. Therefore, any solution to this problem that involves a heightened regulatory burden will fall short.

Besides, we certainly would not expect firms to be successful in driving up prices in the long run in a less regulated setting that implies freer entry and exit. Just as it is impossible for monopoly prices to be charged in the long run without extra-market forces protecting the monopolist, so it would be impossible for energy firms to manipulate energy prices in the long run without extra-market forces protecting them. This is because the firm that can force higher wholesale prices simply attracts to the market other firms that will be able to provide electricity at lower prices.

The media, as well as the state’s court intellectuals, love the Enron scandal and its continued fallout. It allows them the opportunity to broadcast on a daily basis the myth of market failure so as to justify ever increasing levels of government intervention in our lives. Yet, this scandal was fueled by government intervention, not by market forces, and continuing this intervention because it furthers the cause of the political class simply lays the groundwork for greater debacles in the future. Is anyone listening?

Christopher Westley is an assistant professor of economics at Jacksonville State University and co-author of "Enron: Market Exploitation and Correction" in Journal of Financial Decisions. See his Mises.org Articles Archive and send him MAIL.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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