JANUARY 31, 2001


I. Enron


Enron develops and operates networks around the world, primarily in energy and communications. We combine physical assets and contract access to the physical assets of others to make markets in, among other things, energy commodities, pulp and paper, steel and other metals, and broadband capacity. Our primary products are contracts which protect end users and producers from price volatility.

Enron is the largest buyer and seller of electric power in North America and participates in power markets around the world. As a market maker in power markets, we post prices at which we will buy and prices at which we will sell.

Enron’s role as a market maker gives us a uniquely objective perspective on the problems in California.

- With the exception of a few megawatts of wind facilities, Enron is not a generator in the state of California.

- We sell protection from price volatility to both producers and end users. Consequently our interest in California’s power market (and the rest of the markets we operate in) is to ensure that the market works effectively. That’s what enables us to do business.

- We post both purchase and sales prices. To the extent a market participant thinks our price is too high, they can sell to us.


Contrary to what you may hear or read, our success is linked to efficient markets, not higher prices in California, or anywhere else for that matter. What we are interested in is competitive and well functioning markets. Our financial success is not built on California’s back. Our business grew dramatically around the world and across commodities in part because we migrated our market making activity to an online platform and because there is increased demand for risk management in many markets. Our volumes have grown and so have our earnings. We do not have uncommitted generation to profit from in California. But, for the first time, many market participants have begun to see the benefits of hedging against their commodity price risk. Many people purchased our products - - both producers and customers.

These distinctions are important ones because they uniquely position us to identify the facts and the solutions objectively.


II. California


A. The problem. California’s current crisis has very straightforward causes:


· Economic growth spurred growth in the demand for electricity.

· New supply additions did not keep pace with this growth in demand.

· The state placed excessive reliance on a state-created spot market, which meant that utility buyers were exposed to price fluctuations across their entire portfolio.

· The state did not deregulate; that is, the state did not enable new entry into the supply (generation) business and did not in fact give customers choices.


The combination of these factors squeezed utilities between a volatile spot market and regulated customer rates, leading at first to rapid recoveries for utilities (when wholesale prices were low) and later to gigantic deficits and near bankruptcy (when wholesale prices moved up).

B. The Solutions

Just as the problems in California are straight forward, so are the solutions.


· California must allow supply to catch up with demand. It generally takes 5-7 years to build new generation facilities in California. Enron and other companies have done it as quickly as 10 months in other states. California’s process must be streamlined. California needs more power now. It must become a state priority to rapidly site and interconnect new generation. Another way of getting at this same problem is approving and siting new and expanded transmission facilities.


· California must enable demand to respond when supplies are tight. In a true competitive market, buyers and seller are free to set mutually beneficial terms. In California’s regulated retail environment less than 1% of customers are served by competing suppliers (the rest are still regulated utility customers). A market place where buyers and sellers meet would change the demand picture in the following ways:

-- real time price signals would encourage conservation or shifting of demand to off peak times.

-- suppliers would offer products to encourage conservation (energy efficient equipment for example).

· Demand reductions at key times drive market prices down for everyone. To get a demand response, however, customers must see price signals from the marketplace. In the long run, prices must be allowed to reflect the market. In the near term, such prices would have to be introduced gradually and combined with “purchased demand reductions.” Paying for demand reductions makes sense. If utilities, the ISO, or the state, are willing to pay $500 for a megawatt, they ought to be willing to pay the same for a “negawatt.” New capacity cannot be brought on in time for this summer’s peaks. But, demand reductions could be purchased with a minimum of disruption to businesses, workers and the economy.

· Long term contracting: California has recognized the importance of reducing reliance on the spot market and has started an auction process designed to shift more of the state’s demand to long term contracts. This is sensible. Forward power prices are “backwardated,” meaning that power prices are lower for future deliveries than they are for current deliveries. This means that longer term contracts will produce average prices lower than today’s spot price levels, immediately reducing utilities’ costs. However, these markets are shallow and skittish today. Price caps and active government intervention in California’s power markets combined with financial uncertainty about the utilities’ ability to pay has built large risk premiums into bids in those markets. If California entered into forward contracts after an active program to site new transmission and generation, forward prices would be lower and more bidders would bid in greater supplies. The sequence of the reforms needed in California is therefore critically important: the institutions of the state must be financially stabilized and clear, credible steps must be taken to give the market confidence that new supplies will be brought on line. Forward contracting in that environment will produce better results.

· Financial stability: The creditworthiness of the state’s institutions must be reestablished. Without credit worthy buyers of power, it will be difficult to attract new generation and long term supply commitments. The sobering fact is this: unless the state is willing to cut off significant load in the state, it has only two “choices” – it can buy the power the state needs in the short term, or it can let the utilities become insolvent and then buy the power the state needs. Nothing is gained by letting the utilities in the state become insolvent. The state appears to be on the right track with recently introduced legislation designed to ensure collection of past amounts and provide support for future purchases.

The introduction of real price signals to bring supply and demand into balance can and should be tempered by phasing in rate increases and market pricing and by insuring that low income customers are protected through continuing subsidies.

Just as importantly, there are a number of proposed “solutions” which will not help the situation in California or the rest of the West.

· Price caps: price caps are bad for consumers, the economy and the environment. Price caps in the West have not worked and will not work. Price caps have led to the cancellation of peaking power projects which could have brought additional supply to California in the near term. [Attachment 1] Price caps have succeeded only in disrupting and bifurcating the market for power, sending the states’ institutions into the real time market to buy the power needed beyond the amounts purchased at or below the caps. Price caps merely export California’s problems to neighboring states, discourage investors from developing needed supply resources, disrupt the market, and force a last minute scramble for power which endangers reliability.


· State control of the power business: There is no reason to believe (and every reason to doubt) that governments will do a better job than private firms in rapidly constructing new facilities and operating those facilities efficiently. Competition in the generation sector has produced faster construction, more efficient facilities and has placed the risk of those facilities on investors not taxpayers or consumers. Government resources would be best focused on streamlining siting and interconnection rather than building and operating facilities with taxpayer funds.

· Repeal Choice: Consumers are never better off with fewer choices. The only consumers that were protected in San Diego were those who chose alternative suppliers. It would be a mistake to repeal choice.

III. Implications for the West and the rest of the US: the need for federal involvement.


California’s problems have already spilled over into neighboring states. California is a significant importer of power. As demand has grown so has its need for imported power, particularly from the Northwest. [Attachment 2] [Attachment 3] In past years, abnormally high hydroelectric capacity has masked some of the underlying supply/demand imbalance. [Attachment 4] [Attachment 5] Normal or even lower than normal hydro conditions mean that California’s demand is taxing Northwest resources.


Moreover, California is just the latest of several disruptions in U.S. power markets and, unless we act quickly, it will not be the last. Reliability problems and price spikes have occurred with increasing frequency across the country. Some of the underlying causes are the same (e.g. higher demand spurred by economic expansion throughout the country).


To prevent reliability and pricing of power from becoming a problem throughout the nation, policymakers must act now. Power plants are not built in a day.


The solutions which will prevent local emergencies from becoming a national disaster are straightforward:

· New generation must be built and interconnected.

· The interstate transmission system must be opened to enable power to move from where it is to where it is needed, reducing the need for new supplies.

· Customers must be free to choose. Choices mean not only lower prices but greater innovation in products and services which can reduce demand at critical times.


Policymakers need to remove the barriers which inhibit these solutions. Federal lawmakers should enact legislation to enable all Americans to have better access to reliable, affordable supplies of power, which can best be achieved by providing them with access to the nation’s interstate grid. In addition, the Federal Energy Regulatory Commission (FERC) should act. It should fully unbundle transmission service and provide for nondiscriminatory access to that service. It should ensure open access transmission through the “seams” (the administrative borders separating parts of the grid). It should also expedite the interconnection of new generation with clear rules and deadlines to prevent foot dragging by utilities who don’t want to connect with competitors’ generation. FERC should also require the nation’s transmission owning utilities to join Regional Transmission Organizations (RTO) which will ensure that this access and interconnection continue to occur on a nondiscriminatory basis.


The answer to the question: Can California happen again? is “yes it can,” though perhaps not in precisely the same way. What began as an effort to increase competition, customer choice and innovation ended as a heavily compromised and half-baked new regulatory regime. (This has happened in other states and jurisdictions as well.) California did not deregulate its power market. The FERC has not deregulated wholesale markets. Instead, policy makers have chosen (or are forced by political realities) to negotiate with incumbent monopolies over the terms of restructuring. The result is the worst of both worlds.


What is required is a rededication to introducing real competition into power markets. Access to transmission and customer choice should be a top priority. It must be swift and complete. The nation cannot afford to stand still on this issue. Electricity is too important. The needs of customers - - particularly in the high tech sector - - have outpaced the existing regulated monopoly model. Regulation in the old style does not work and California demonstrates that heavily compromised restructuring does not work. What is needed now, more than ever, is an unwavering commitment to an open and competitive power market.