Free Lunch (24 page)

One day the Snohomish officials learned that the government had tapes of every call placed by Enron
traders. They asked for the tapes and were denied. They fought to get the tapes until they won. Then they spent $800,000
transcribing them. What they showed was worse than even Inslee imagined.

Traders talked
about money they “stole from those poor grandmothers in California.” They shouted with joy when a brushfire let off so much heat
that the volume of electricity on a major transmission line had to be reduced, allowing Enron traders to jack up prices. “The magical
word of the day is ‘Burn Baby Burn,'” one trader exulted.

Other traders talked openly about
how, when Wood imposed the minimal price caps, they got around them by selling electricity made in California to Arizona or
Nevada and then selling it back into the state to evade the caps. They talked about how the new president from Texas would be
good for Enron.

When the Snohomish district made its transcripts public, the responses were
revealing. Enron, gasping its last in bankruptcy, said it was cooperating with investigators. Wood's spokesman stuck to the Bush
administration line that the crisis was a tale of California politicians failing to do their job without quite making the accusation.
Ignoring the guilty pleas already made by several Enron traders accused of fraud and other felonies, Wood's spokesman, Bryan
Lee, said: “The bottom line is, was this crisis all manipulation? Or was there an actual shortage that resulted in the supply and
demand already being tight?”

Once the evidence of Enron's systematic criminal behavior
became overwhelming, the Federal Energy Regulatory Commission appeared to finally act with regard for some interest other than
Enron's. It ruled that Enron could be required to give up all of the profits it earned since 1997. The operative word turned out to be
“could.”

Wood's successor as commission chairman, Joseph T. Kelliher, said that any firm
that extracted profit through market manipulations on his watch would be forced to disgorge all profits. That turned out to be more
hollow than promise.

What seemed like a routine settlement came before the commission for
approval in June 2006, two years after the transcripts showing Enron's trading desk was a vast criminal conspiracy. It involved
Enron's claim that it was owed about $160 million by two small nonprofit utilities. To end the dispute, Silicon Valley Power, an
agency of the City of Santa Clara, California, paid Enron $36.5 million for power it had agreed to buy but that Enron never delivered.
Valley Electric Association, a cooperative in the rural desert west of Las Vegas, paid $14 million. Both payments settled issues from
the period when Enron was engaged in criminal fraud.

What about Chairman Kelliher's vow
that on his watch any profits from manipulations would be disgorged? Lee, his spokesman, said that policy remained in force. But,
he explained, the settlement involved not profits, but a dispute over termination fees. Whether “the termination fee is an unjust
profit,” Lee said, “is something the commission has not weighed.”

Congressman Inslee was
incensed. “It's the equivalent of Bonnie and Clyde, having been arrested, demanding that the banks refund the money they stole
and the government making the banks give them the money.” Senator Maria Cantwell, a Washington Democrat, said the
commission “has abdicated its responsibility” to protect consumers and taken the side of Enron and its creditors, “instead of
looking out for the public interest.”

The settlement also drew complaints from a cement
company that has been billed $4.2 million for electricity that Enron will never deliver to its Montana kiln operation. Jack Ross,
general counsel for Ash Grove Cement Company, said he was at a loss to understand why the commission staff agreed to the
settlement. “We thought FERC would be an advocate for the consumer and we are an energy consumer,” Ross said. “We felt the
staff decision was more aligning itself on the Enron side and we were very surprised that they were so cozy on the Enron
side.”

The settlement with the two small municipal electric systems contained a provision that
showed just how cozy Kelliher's commission was on the Enron side. It removed from the public record all of the notes, letters,
e-mails, and audiotapes that documented Enron's crimes. Paragraph 12 of the settlement said that the commission staff agreed “to
release the Enron Parties from all existing and future claims under any legal theory or cause of action that: (1) Enron charged,
collected, or paid unlawful rates, terms or conditions for electric energy, ancillary services, or transmission congestion or natural
gas in the western markets; (2) Enron manipulated the western electricity or natural gas or associated markets in any fashion, or
otherwise violated any applicable tariff, regulation, law, rule, or order relating to the western markets; (3) Enron was unjustly
enriched.”

So there it was, five years after Cheney had told Inslee he did not understand
economics. What the Bush administration did understand was that it could help its friends get rich, even if they were too clever by
half and lost it all. First Cheney could deny a problem existed, and decline to inquire. Then the administration could create the
appearance of an investigation while taking care to make sure nothing untoward would be found. And finally, when the evidence of
wrongdoing came out anyway, it could just seal the record, promising to never ask a question or speak of these unpleasant
matters again.

But wait. There's more.

Among the
documents withdrawn from the public records under the settlement were notes taken by an Enron lawyer named Mary C. Hain. She
worked at the hub of Enron's electricity trading operation. That was in Portland, Oregon, where Enron owned its only operating
company, Portland General Electric. While far from conclusive, the notes indicate that Hain knew about wrongdoing or, at a
minimum, considered a strategy to counter any serious investigation. Hain wrote:

What makes these notes interesting is that the Federal Energy Regulatory Commission never questioned
Hain under oath about her notes. Instead, it hired Hain as a lawyer in its office of administrative litigation. When word of Hain's
hiring got around, Senators Dianne Feinstein, a California Democrat, Cantwell, and others asked questions.

Chairman Kelliher insisted there was no issue because Hain would not work on any Enron matters. Hain told
the
Los Angeles Times
, which asked about her hiring, “I'm an extremely ethical
person. I've felt that I've been that way my entire career, including the time I was at Enron.” The value of the statement can be
weighed in the context of the mob boss Joseph Bonanno, who in his autobiography boasted about what a moral and ethical man
he was, at least in his own eyes. Hain said her notes were the product of two meetings in which she hardly knew what was being
talked about because she was a regulatory lawyer and the others were traders.

Robert
McCullough, whose fax showed that a third of power plants were offline when prices soared, said her hiring should raise a
question about why the commission could not find someone else among all the legions of regulatory lawyers in America who was
at least as good, if not better. “Apparent indifference to corruption,” he said, “seems like a very poor qualification as a
regulator.”

Today Enron is gone. So is Lay, dead in July 2006. His fatal heart attack came after
his fraud conviction, but before his sentencing. That means the record in his case, like the record before the energy regulatory
commission, will be changed. His conviction will not stand. As for the market manipulations that cost energy customers tens of
billions of dollars in electricity charges alone, and left California with debt it will take two decades to pay off, officially whatever did
happen will never be spoken of again by regulators under the settlement.

Despite this, the
story is not over. The damage Lay and Enron caused was not limited to criminal acts. Enron had laws written to suit its schemes.
Those laws remain on the books. They continue to enrich the wealthy few at the expense of the many through auctions that are
called markets but, as we shall see, act instead like bid-rigging systems approved by government.

A
T THE CORE OF THE ARGUMENT THAT MARKETS ARE BEST LIES
ADAM
Smith's observation that, in a free market, prices will fall to the lowest level at
which proprietors can stay in business. Professor Sarosh Talukdar of Carnegie Mellon University decided to look into how this
applies to the auction markets for electricity.

Talukdar created an ideal market. His simulated
market had ten electricity generating companies, each of equal size, selling power; and ten utilities, also of equal size, buying
power. The sellers seek the highest prices, while the buyers want to pay the lowest prices possible. There was more than enough
capacity to supply the market.

In this idealized market, prices would be expected to fall as
buyers took only the lowest bids. Instead, prices rose. And as time passed and more trades were made, the prices the buyers had
to pay rose higher and higher. The results astonished Talukdar, so he ran four variations of the market experiment to test the
findings. The results were always the same. Prices rose.

This pattern of rising prices suggests
strongly that the sellers were colluding. The classic way to raise prices is for sellers to meet in secret and agree to fix prices at
higher levels than the market would set.

But in Talukdar's experiment, collusion was
impossible. The sellers could not have met in secret to fix prices because they were not people, but simple computer programs
called learning algorithms. The programs were so simple that high school students with a knack for software could have written
them.

What the experiments showed was that sellers could jack up prices in this market
because the buyers are forced to buy. If the price of a share of stock or a piece of land is too high, buyers can walk away. Not so
electricity, where the utilities that distribute the power are required to supply it. In this auction, the sellers all paid attention to the
prices offered by other electricity sellers, then raised their own prices to higher and higher levels. So long as no one broke ranks
and undercut the market, the sellers overall got higher prices and fatter profits than they would in a competitive
market.

This unstated coordination gave the producers of electricity what economists call
market power,
which means the ability to set prices higher than a competitive market
would allow. Within less than a hundred rounds of bidding, Talukdar's experimental auctions resembled not so much a competitive
market as a cartel, in which many sellers obtain monopoly power by coordinating their actions to artifically inflate prices. That is
what OPEC, the Organization of Petroleum Exporting Countries, does openly when members collude on setting the price of oil by
limiting production.

“Collusion is a crime,” Talukdar noted, “but learning is not. My studies
show it is easy to learn from the signals given by others how to get the benefits of colluding without breaking the
law.”

Professor Talukdar is a computer scientist, not an economist. He thinks as an engineer
thinks. “In building complex systems, whether it is a manufacturing process or a jetliner,” he said, “you have to have rigorous
verification to see if what you designed actually works the way you intended. But that is not the practice with economists, who do
not verify the design of trading markets. Economists have this faith in markets, that markets are always a good
thing.”

Defenders of the electricity auction system, especially the owners of power plants,
insist that the system has produced lower prices than the old regulated system, whose rates covered costs and provided a virtually
guaranteed profit to the utilities. But the figures they point to show that prices fell, not because of market forces, but due to the rate
caps and freezes that government imposed. Numerous studies found no benefit to consumers. One Cornell University study
concluded, “There is no evidence to support the general expectation that deregulation would result in lower electricity prices.”
Instead, the evidence points to competition resulting in the higher prices that Talukdar's experiment found.

Talukdar said that his experiments show that “the design of markets matters a great deal and the design must
be verified to see if it really works as a free market.” Frank Wolak, a Stanford University economist who favors competitive markets
for electricity, said Talukdar is right. The design of markets matters a great deal, Wolak said, because “even small flaws in the
design of markets can cause enormous harm to consumers in very little time.”

The damage
was, and is, huge. Marilyn Showalter, an advocate for publicly owned power systems, analyzed Department of Energy data. The
data showed that in the 12 months ending in May 2007, electricity in states that adopted Enron-style laws cost $48 billion more than
the average cost in states that retained traditional regulation, which ties prices to the costs of production. That is $132 million per
day in excess costs that act like a tax on the customers paying the bill.

In adopting Enron's
recommendations to create electricity markets, state legislators did not take into account many unique aspects of electricity that
affect its suitability for market auctions.

In markets for stocks, pork bellies, airline tickets, and
houses, potential buyers have the option to walk away if the prices are too high. A stock can be bought on another day. Bacon is
not required for breakfast. A trip can be deferred, and so can plans for a new house. But utilities in California, Connecticut, Illinois,
Maryland, Texas, and a dozen other states must buy power every day. Many corporate-owned utilities, under laws Enron drafted,
were required to sell their own generating plants. They are forced to buy power in the electricity markets since they no longer
produce electricity themselves, but are still required to supply all that customers want.

Unlike
the stock market, where vast numbers of strangers buy and sell, the electricity markets involve a relative handful of buyers and
sellers. In New Jersey, for example, just 10 generators won bids in 2006 to supply a third of the state's base load of power for the
next three years.

In many markets, the buyers and sellers are related companies under a single
corporate umbrella. When regulated utilities sold their power plants, the buyers were often unregulated sister companies owned by
the same corporate parent. In such arrangements, if the unregulated company that owns an electric power plant gouges the utility,
the result is big profits for the parent company, creating a perverse incentive to raise prices.

Finally, electricity trades repeat each day. Power is sold for specific time periods, often an hour or quarter
hour, a day or two before it is needed. The short periods allow prices to be affected by changing demand from customers as they
turn on air conditioners on hot afternoons or flip off lights at bedtime. Because auctions occur so often, those who generate power
for sale can get an idea of what the market will bear by studying the weather report and historic patterns of demand. This is where
the analysis of trading patterns that drove up prices in Talukdar's experiment comes into play.

Moreover, electricity markets operate in government-imposed secrecy. Individual stock investors can make
sure they got a fair price by checking the prices paid just before and after their trade. But the Federal Energy Regulatory
Commission and the electricity exchanges it authorizes stamp many trading records confidential, though some records are made
public months or years later. Many times even this knowledge is misleading, however, as the markets include not just the owners
of power plants, but brokers who act as fronts.

Finally, the very nature of electricity means that
it must be produced, transmitted, and consumed in an instant. Automakers can cut production when vehicles do not sell. Investors
who hold too much of a particular stock can sell it in blocks over time to get the best price. But electricity cannot be held in
inventory.

There is one other crucial difference between electricity and stock markets. In
electricity markets, every seller gets the highest price—
even when it is higher than the price at which
they were willing to sell.
That is the rule in the electricity auction market: the highest winning bid sets the price for
all.

Contrast this to the stock market. Someone who wants shares of a company buys them at
different prices, perhaps $10 a share to start, and then, as word gets around that someone is accumulating shares, paying $20. The
average of these prices may be $15. Not so with electricity. In electricity markets, everyone gets the highest price that is accepted. It
is as if the stock market buyer had to pay $20 for every share, even the ones offered for sale at half that price.

Giving every seller the high price for the day, hour, or other time period creates a huge incentive to hold
generating stations offline to restrict supply and thus drive up prices. This was exactly what was shown in the fax that Vice
President Cheney refused to examine when he told Representative Jay Inslee, “You just don't understand economics.” This
system also creates incentives to apply what is learned, as Professor Talukdar showed, to rig prices.

Consider what happened on March 2, 2003, in the Texas electricity market. Power was being auctioned off in
quarter-hour segments for the next day. Some power was offered for free, presumably by nuclear power plants, which must run at
the same rate around the clock. Several dozen bidders then offered power at various prices.

The average of the bids required to supply all the power that was needed came to $83 per megawatt hour. But
the bid that cleared the market, the bid that provided the last megawatt of power needed to meet demand, was more than $200.
Under the rules for electricity markets, every generating company was paid the high bid of more than $200 per megawatt hour. The
difference between the individual prices that the sellers offered and the price actually paid was $150,000. That money was extra
profit for all but the top bidder.

In the auction for the next quarter-hour period, the bidding
pattern changed. There were still generators offering power for free. But the high bid for the last few megawatts of power needed
by customers was $990. Every owner of a generating plant got that price, even those offering power for free. The extra profit? More
than $800,000 in just fifteen minutes.

The industry calls these inflated prices “hockey stick”
bids because, when plotted on a chart, the prices show a long handle that rises slowly with a spike at the end like the blade on a
hockey stick.

Official state reports identified only as “Company C” the bidder who set the price
at nearly $1,000. Years later it was identified as TXU, which owns both the regulated Dallas electric utility and, through a sister
company, a host of power plants. Although historically stocks of utilities were reliable but slow to appreciate, TXU has been one of
the best-performing large company stocks between 2002 and 2007, showing just how valuable the pricing manipulations of
“Company C” were to its bottom line.

The system was a perfect arrangement to get, not the
lowest possible prices, but a free lunch through inflated prices, served up by government rules. Any one of the many TXU
generating plants could make a high bid that produced windfall profits for the others. Because the power was sold to regulated
utilities, which by law must provide whatever power customers demand, the price was just passed on. But customers had no idea
that in some quarter-hour segments they were paying exorbitant prices. Why? Because all customers get is a monthly statement
that adds up the prices paid for every fifteen-minute period into a single total.

Technology
allowing residential and small-business customers to know what price they pay each moment for electricity has been available for
decades. In the seventies, utility regulators in California and some other states said they would make it widely available to
encourage people to reduce their use of power during periods of peak demand. Somehow, though, it just never happened. And
without that knowledge of prices at each instant, customers cannot know when their pockets are being gouged.

The supposed markets for power enable price gouging in still other ways. California has 1,400 power plants,
which ought to be more than enough for a vibrant market and, as Adam Smith observed, should drive prices down to the lowest
level at which the businesses can afford to continue operating. But ownership of those California plants is so concentrated that
just six generating companies can set an artificially high price for electricity virtually all the time, research by Carnegie Mellon
University shows.

New Jersey and Illinois are among the states that conduct annual electricity
auctions. In New Jersey, just 10 generators won contracts to supply a third of the state's base load of power through 2009. The
price? It was 55 percent higher than the previous year's three-year bid.

In Illinois, prices also
soared. Among the winning bidders to supply power? An unregulated sister company of Commonwealth Edison, the Chicago
utility, both of which are owned by Constellation Energy. In essence, this is a system in which an unregulated company earns
outsized profits from a regulated company, which in turn earns virtually guaranteed profits and, by law, can pass on the prices it
pays for electricity to its customers. Think of this as the anti–Adam Smith policy.