May 14, 2002
The Honorable Pat Wood, III
Chairman
Federal Energy Regulatory Commission
888 First Street, N.E.
Washington, DC 20426
Dear Mr. Chairman:
The Senate Governmental Affairs Committee is
conducting a broad inquiry into whether the federal agencies
charged with overseeing the activities of Enron Corp.
appropriately discharged their regulatory responsibilities. As
you know, the Federal Energy Regulatory Commission (FERC) is
among the agencies whose activities we have been reviewing.
I write to express deep concern about
information revealed during the course of our investigation. As
discussed further below, our inquiry to date raises serious
questions about whether FERC appropriately discharged its duties
to monitor and regulate energy markets, followed through on
warranted reviews of Enron's energy trading business, and heeded
important warning signs of problems in Enron's business
activities.
Specifically, the Committee’s investigation
has discovered that FERC launched an internal inquiry into
Enron’s electronic energy trading activities in May 2001—an
inquiry that asked some of the right questions about Enron’s
market practices, but ultimately settled for incomplete,
unconvincing, or incorrect answers to those questions. Equally
disappointing, FERC failed to follow up on some of the most
serious concerns raised in the course of its inquiry. All this
occurred at a time when internal Enron documents uncovered
during the Committee’s investigation show the company placed a
high priority on maintaining the unregulated status of its
electronic trading activities. In the end, the 2001 FERC inquiry
is ultimately more noteworthy for what it overlooked than for
what it scrutinized, leaving consumers unprotected.
Going forward, these events add to the
numerous warning flags already flying in FERC’s view. As new
energy markets emerge, the nation’s consumers have the right to
expect their government regulatory agencies to be as aggressive
in protecting and promoting their interests as energy companies
are in exploiting new markets. We simply cannot accept anything
less than proactive and energetic efforts by FERC to understand,
monitor and, where necessary, regulate changing market
developments. Our inquiry thus far suggests that FERC has yet to
prove it is up to this challenge. While we cannot at this point
conclude that a more proactive FERC inquiry would have sounded
the alarm about Enron’s shaky financial condition, a better
investigation may well have exposed the cracks in Enron’s
foundation sooner. At a minimum, a more searching inquiry into
Enron’s opaque trading practices would, we hope, have led FERC
to question whether it truly was discharging its duty to
maintain just and reasonable energy rates.
The troubling story of FERC’s 2001 inquiry
into Enron Online is laid out below. I would appreciate your
reviewing the information contained in this letter and providing
the Committee with assurances that FERC has a plan in place to
redress the institutional failures that story reveals. I intend
to call FERC before the Committee to review the matters
discussed in this letter, as well as other issues currently
under review by Committee staff.
For the past 15 years, FERC has played a
central role in transforming the wholesale natural gas and
electric sectors from highly regulated systems dependent on FERC-approved
cost-of-service rates to loosely regulated, highly competitive
markets. This changing environment has given rise to new
participants and market platforms as well as new corporate
models -- such as the Enron Online trading service used by Enron
Corporation -- seeking to take advantage of the new business
opportunities it presented. Throughout this process, FERC has
been required to play multiple roles: (1) continuing its
traditional regulatory role in those cases where cost-of-service
rates and regulatory approvals are still required, (2) taking on
the new responsibility of leading the design and approval of
untested market-oriented policies and institutional structures,
and (3) maintaining throughout this period its statutory
obligations to ensure that wholesale rates are just and
reasonable, as required by the Natural Gas Act and the Federal
Power Act and related statutes.
As evidenced by the catastrophic failure of
the California electricity market, regional price spikes in both
electricity and natural gas prices, and most recently the
precipitous collapse of Enron – the nation's largest energy
marketer – navigating the waters of this transition continues to
be a complex and difficult process. It is this very complexity
and difficulty that requires a new sense of vigilance on the
part of FERC, the leading federal agency in this arena. While
FERC has taken on such a proactive role in revising natural gas
and electricity regulations to create new market-based utility
practices, it has taken a decidedly reactive approach to
fulfilling its obligations to ensure that rates are just and
reasonable each and every day for America's businesses and
consumers in these new, complex, and still evolving markets.
Despite the fact that deregulation of energy
markets had opened the door for companies like Enron to create
entirely new marketing models, such as Enron Online, and rapidly
capture a sizable percentage of the market, it appears that
FERC’s efforts to understand and adjust its regulatory approach
to these new entities was, and is, severely lagging. As recently
released internal Enron memoranda make clear, that company
sought to manipulate California's energy market and engaged in
abusive trading practices during the 2000-2001 energy crisis in
California and other Western states. Yet FERC apparently waited
nearly two years after the first allegations of market
dysfunctions arose before launching a formal inquiry into the
potentially abusive actions of individual companies.
In May 2001, FERC's General Counsel did
initiate a related, staff-level inquiry – one into the status of
electronic trading in the electric power and natural gas
markets, in general, and the role played by Enron Online, in
particular. A report discussing electronic trading
and Enron Online's operation and the significance of its
dominant share of these markets was completed on August 16,
2001.
The report found that, unlike some online
trading platforms which operate as third-party, "many-to-many"
exchanges matching willing buyers and sellers, Enron Online
appears to have operated as a proprietary extension of Enron's
trading units, including entities regulated by FERC. In other
words, an Enron trader was a party, either as a buyer or seller,
to every trade on Enron Online. Therefore, only Enron would know
valuable information about the actual volumes and prices
transacted on its trading platform – and, of course, how the
prices charged in any particular transaction were set or how
they compared to those charged in other, similar transactions.
The report also observed that Enron Online
simply served as a trading platform for other Enron
subsidiaries, shouldering no financial risk on its own. In other
words, the financial risk of all the trades conducted through
Enron Online remained with these other subsidiaries. This meant
the solvency of Enron as a whole was important to the viability
of Enron Online and to Enron’s trading activity.
With that observation in mind, the report
asked whether financial problems at Enron would threaten the
energy markets. The report answered the question in two ways.
First, it concluded that Enron did not have sufficient market
share to disrupt the energy market if it failed. According to
the report, Enron accounted for 16 percent of gas trading and 13
percent of electric power trading in North America, with the
majority of Enron’s trading transacted through Enron Online. In
the report’s view, the energy market could continue functioning
smoothly absent Enron’s market share. Second, the report
concluded that, in any event, the chance of Enron failing
financially was remote. The report provided little support for
this conclusion.
Finally, the report found that Enron Online
gave a competitive advantage to Enron’s own trading units by
reducing their transaction costs, giving them wider access to
the market, and providing them better market intelligence.
In short, though the report identified a
number of areas that ought to have troubled FERC as the federal
government’s lead energy regulator, it found no reason for
concern and no cause for action. This, I am afraid, was a
critical mistake.
First, though FERC staff identified the
potential risk inherent in (a) a trading model that exposed the
corporation to very large financial risks, and (b) the company’s
dependence on its corporate credit worthiness to maintain its
trading capability and to fulfill its trading commitments, staff
failed to take the logical next step to thoroughly understand
the significance of this finding. Instead, they conducted only a
cursory analysis of Enron’s financial standing, concluding that
Enron was unlikely to fail as a result of overextending credit
to its trading customers. This was obviously a mistake; although
the scenario imagined in the report did not come to pass, in
fact Enron was financially unstable, and within two months, had
collapsed completely.
Second, the analysis that led to the
conclusion that Enron’s market share was insufficient to
negatively impact the market in the event of the company’s
failure was far too cursory. The report based its conclusion
upon limited industry-supplied data that looked only at the
national picture. FERC should have based its conclusion on more
thorough data from actual regional markets, where market
concentration would likely have been of greater concern.
Third, while FERC concluded that it need not
worry about the competitive advantage that Enron Online provided
to Enron traders, Congress has received testimony that this
arrangement may well have been unfair. In fact, Enron had a
dominant position in the market through Enron Online, and the
system gave Enron traders exclusive access to valuable
information about market conditions unavailable to other
participants. The extent to which Enron took improper advantage
of this opportunity is unknown, but recent disclosures,
contained in internal memoranda provided to FERC detailing
potentially abusive Enron trading practices in 2000 and 2001 in
the California and Western energy markets must lead to a review
by FERC of the possible use of Enron Online by Enron's traders
to facilitate such abuse.
Fourth, FERC staff failed to follow up on
many of the issues raised by the report. Most troubling, given
the concerns identified in the report related to Enron's
financial risk, it appears that there was never any formal
process established within FERC for monitoring the financial
status of Enron - North America's largest energy trader - not
even following the unexpected resignation of Enron CEO Jeffery
Skilling on August 14. This was a key red flag that occurred
just days before the final report was transmitted to FERC
managers and helped persuade staff at the Securities and
Exchange Commission (SEC) to begin that agency's investigation
into Enron's financial condition. Even once the full magnitude
of Enron's financial problems began to take shape in mid-October
following Enron's restatement of earnings and public
confirmation of the SEC's investigation of the company, there
appears to have been no formal effort within FERC to monitor the
financial condition of the company or assess possible market
impacts. FERC even failed to follow the recommendation made in
the August 16 report that the team that prepared it continue to
monitor effectively developments at Enron Online and other
electronic trading platforms. There appears to have been no
effort made at the agency to ensure that this recommendation was
heeded.
The significance of FERC’s failures to pay
more attention to Enron’s financial condition is underscored by
the agency’s reaction, late last year, to news of Enron’s
collapse. When Enron's demise became evident in November 2001,
FERC officials were apparently troubled enough about the
potential impacts of the collapse on the energy market – the
very concern dismissed in their August report – to raise these
matters with representatives of the Federal Reserve, the White
House National Economic Council, and Enron itself.
Another troubling facet of the August 2001
report is that it was apparently not distributed to you or to
any commissioners prior to, or during, Enron's collapse to
inform your decision-making, and it is unclear at what point any
of the information contained in the report may have been
provided to you or other commissioners. In other words, a report
that might have served as a warning wound up being little more
than a footnote in the story of Enron's collapse.
Even though FERC initiated this report
examining Enron Online and other electronic trading platforms –
suggesting some level of concern within the agency about their
growing influence – and found that, in fact, the use of online
trading platforms and their trading volume were expected to grow
dramatically, the agency has fallen far short of giving these
mechanisms the scrutiny they deserve.
In fact, an important task related to the
Enron Online inquiry -- the preparation of a comprehensive legal
memorandum analyzing FERC's jurisdiction over online trading,
including Enron Online -- was begun, but never completed. This,
in my mind, is akin to the Food and Drug Administration (FDA)
utterly failing to scrutinize the development of a major new
class of drugs, so this effort should be quickly resurrected and
completed. Completion of such a memo is also needed to clarify
the jurisdictional boundaries between FERC and the Commodity
Futures Trading Commission (CFTC) regarding energy trading
activities and products, including online trading, and to better
define the two agencies' respective market monitoring
responsibilities in these developing markets. I also urge FERC
to include examination of the role of electronic trading in its
ongoing investigation into manipulation of the Western electric
and natural gas markets.
These trading platforms are precisely the
sort of emerging market institutions that one would expect FERC
to anticipate, to understand, to monitor and to address as the
federal government's lead regulatory agency as the natural gas
and electricity sectors transition to open, competitive markets.
To date, the Committee's investigation has
shown that many institutional watchdogs failed completely in
their obligations to alert the public to the precariousness of
Enron's business. The American people have every right to expect
that federal regulatory agencies they fund with their tax
dollars will act only on behalf of the public interest. It is
therefore of great concern to me that FERC, having identified
the specific red flag of Enron's credit and financial exposure
and its potential risk to U.S. energy markets, not only
concluded that such a failure was unlikely, but apparently took
little action to ensure that this conclusion remained valid in
the face of significant new developments – developments that
prompted a sister agency to initiate first informal, and later,
formal investigations. FERC's job is not simply to promote
market changes, but to anticipate and monitor new developments
and problems, and to protect the consumer against abuse. That
latter role seems to have been neglected.
In order to further the Committee's inquiry,
please provide answers to the following questions no later than
May 28 , 2002:
1) Has the Commission reviewed the August 16,
2001 report and the circumstances leading up to and following
it? Do the Commissioners believe they received the information
contained in the report in a timely manner? If the Commissioners
did not receive the information in a timely manner, what steps
will you take as Chairman to ensure that relevant staff
investigations and work products are provided to the
Commissioners?
2) What conclusions has the Commission
reached regarding the way staff handled the August 16 report and
the follow-up anticipated by that report?
3) In light of the fact that we now know the
August 16 report’s conclusion regarding Enron’s financial
condition has been proven false, has FERC reevaluated its
policies or approach to conducting financial evaluations? Does
FERC have adequate statutory and regulatory authority to
ascertain the financial condition of regulated entities and
parent corporations, such as Enron? Does FERC have adequate
requirements to ensure the creditworthiness of energy marketers?
4) Why did FERC apparently fail to implement
the recommendation in the August 16, 2001 report to direct the
inquiry team to continue to monitor Enron Online and other
trading operations? What plans does FERC have for monitoring the
development and operation of online trading platforms, as
recommended by the August 16, 2001 report, including plans to
coordinate such activities with CFTC?
5) Given the finding that Enron's trading
model entailed significant financial risk, why did FERC take no
formal action to monitor the financial status of Enron after the
August 16 report, especially given changing circumstances?
6) Records provided by FERC show that there
were interagency meetings with CFTC and with the SEC to discuss
electronic exchanges, data collection, and market monitoring
activities at the same time the inquiry that produced the August
16 report was underway. At the same time, FERC was also
conducting an investigation into energy prices in the Northwest
and a proceeding to determine whether the citizens of California
were entitled to refunds from marketers like Enron. Were these
apparently interrelated efforts coordinated?
7) Why was the legal analysis of the
jurisdictional issues surrounding online trading abandoned? Does
FERC intend to complete the legal analysis of the jurisdictional
issues surrounding online trading originally initiated as part
of the Enron Online inquiry and identified in the August 16,
2001 report? If so, when?
Thank you in advance for your cooperation.
Sincerely,
Joseph I. Lieberman
Chairman
PRESS RELEASE
Energy
Regulators Negligent In Investigating Enron
2001 Ferc Inquiry Found No Cause For Concern
Lieberman Investigation Shows
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