Energy Trading: Out of Power?

For years, electricity trading has been described as the future of the power business. Now companies can't get out of it quickly enough.

Any business in which the now-fallen Enron Corp. was considered a trailblazer would seem likely to be suffering tough times at the moment. But recently a wave of developments has raised serious questions about the direction of the entire power-trading industry.

Consider this:

In recent weeks, major energy traders like El Paso and Williams have announced they are cutting their trading operations dramatically.

The government is looking into allegations of price-fixing stemming from California's power crisis.

Some firms, including Dynegy and Reliant, have acknowledged swapping quantities of electricity with each other to boost revenues.

And many states pondering electricity deregulation — a crucial aid in helping the trading business grow — have dropped the idea.

On top of all that, stricter government regulation of energy trading is on the way. The General Accounting Office, the federal government's watchdog office, issued a sharp report Wednesday calling for the Federal Energy Regulatory Commission to monitor the business more closely and further regulate a business once thought to represent the cutting edge of the free-market system.

"The industry is hemorrhaging right now," says Jim Walker, an analyst at Forrester Research in Cambridge, Mass.

A Commodity Like Any Other

It's all a far cry from the vision described by former power company executives like Kenneth Lay, the ex-Enron CEO, who told Congress in 1996 that deregulating the electricity business would "bring it into the modern age, and give American consumers the equivalent of one of the largest tax cuts in history."

Energy trading, while complicated in its details, operates via the same principles as other types of older commodities trading, from wheat to gold or oil. Companies like Enron — the industry pioneer in the United States — would try to anticipate fluctuations of the energy supply and demand around the country and trade quantities of power accordingly.

For instance, if Enron anticipated power shortages in Oklahoma, it could arrange to sell electricity to the local utilities in the future at a fixed price. Enron would then find a power producer elsewhere in the country with excess capacity, buy a contract guaranteeing the required amount of electricity, and have it shipped to Oklahoma.

Proponents of the concept, like Lay, argued prices would be lowered due to industry competition, and lobbied Congress vigorously to ease restrictions on shipping electricity around the country.

The Ups and Downs of Trading

The energy-trading business, however, has turned out to be as difficult as any other trading business when it comes to generating steady returns — like investment banks, for instance, which can see large year-to-year fluctuations in their trading profits (or losses).

That's not what the energy traders used to claim: Enron, for one, maintained its soaring revenues in recent years were mostly due to increases in the trading business.

Since Enron's fall, however, it has become clear that a substantial chunk of industry revenues were based on so-called mark-to-market accounting, in which future contracts are counted as current revenues. While this is not uncommon, analysts and investors have become wary of companies that heavily engage in this practice.

And in the last few months, Michigan-based CMS Energy, Houston-based Dynegy and Reliant, also of Houston, have admitted making "wash" trades — swapping electricity to pump up revenues.

Shares Plunging, Some Firms Limiting Trading

Share prices have plummeted across the industry, and some big names are reducing their energy trading.

In late May, the El Paso Corp., based in Houston, announced a "strategic repositioning" in which it would "limit its investment in and exposure to energy trading." And the Williams Companies, headquartered in Tulsa, Okla., said on June 10 it would be "reducing its financial commitment" to "providing energy risk management services."

Translation? Less trading and a greater concentration on the hard assets — pipelines, power plants — that industry leaders deemed old-fashioned until the Enron implosion occurred. Although that doesn't mean the trading business will evaporate altogether.

"Energy companies still need to trade," says Walker. "The question is, to what extent will they trade to make short-term gains because of arbitrage price opportunities, as opposed to business reasons to help a power plant they own or a customer they need to serve."

That means fewer companies may try to exploit short-lived differences in energy prices, the way a stock trader would try to profit from brief changes in stock prices. Instead, they may take a more defensive approach to trading, doing it simply to ensure a steady supply for the facilities many of the companies also own.

States Shun Deregulation

Another long-term impediment to the industry's growth, however, is the stalled movement toward deregulation after the California power fiasco of 2000 and 2001. Currently 16 states have deregulated their electricity supplies to some extent, but that number does not figure to grow soon.

"It is unlikely that additional states will move forward with deregulation," says Adam Goldberg, a policy analyst at Consumers' Union in Washington, D.C. "Everything is going to be on hold."

Then too, greater federal oversight could put a damper on the trading business as well. This week's GAO report calls for FERC to drastically improve its oversight of the energy traders: "FERC lacks assurance that today's energy markets are producing interstate wholesale natural gas and electricity prices that are just and reasonable."

In an attempt to address those problems, FERC is demanding that energy traders disclose basic information about their activities — including volumes, prices and deal dates — with a first filing date of July 30.

"We would love to see transactions of energy transmission made in a similar manner to prices on the stock market, with prices being quoted and record, so everybody knows what the going price is," says Goldberg.

"Sellers and traders don't like to share their information," adds Walker. But between the market's skepticism about energy traders and the promise of new regulations, he adds, "at this point in time, they don't have a choice."

Can Consumers Benefit?

Ultimately, the future of energy trading may depend on the extent to which consumers can be shown to benefit from the practice.

In his 1996 appearance before Congress, Lay said "every household and business that pays utility rates could save 30 to 40 percent on their utility bills" because of deregulation.

A Consumers' Union study of deregulation in six industries released last week, however, concludes it is too early to tell whether or not electricity deregulation has helped lower the bills of ordinary citizens. To this point, the study claims, the most meaningful rate drops in deregulated states, of about 20 percent, were simply dictated by the deregulation guidelines of those states.

Goldberg, for one, thinks deregulation could work if accompanied by strict enforcement, prices based on the costs of the energy companies, and measures to ensure a reserve supply of power. With those measures in place, he claims, states would then be able to see if energy trading really could help customers.

"Deregulation does not mean no oversight," says Goldberg. "It means regulation that allows for competition and competitors to thrive in a fair market."