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July - Duke Energy Employee Advocate
Deregulation - December, 2001 - Page Seven

“Enron was a major player during the utilities deregulation debate, for which Bush lobbied actively, and
in ‘tort reform,’ making it harder to sue corporations for the damage they do” - San Jose Mercury News

Agencies Crack Down on Utilities

The Wall Street Journal – December 30, 2001

(12/19/01) - Credit-rating agencies were asleep when California's deregulated energy market imploded. They were slow to act when Enron Corp. plunged, for fear of hastening its demise. Now, they have made an about-face and are being tougher than ever on power companies, telling them to slash debt or else.

Downgrades of Dynegy Inc. and Calpine Corp. -- both coming as apparent surprises to the companies' chief executives -- function as a shot over the bow of an entire industry that has been borrowing like crazy. Companies involved in energy marketing and trading have to recognize they are in a "confidence-sensitive industry" that can create sudden needs for cash collateral, says John Diaz, energy analyst for Moody's Investors Service Inc.

After Enron's Chapter 11 bankruptcy-court filing early this month, the rating agencies want to see more cash on hand. The message: The market is more worried about risk than it is excited by the prospect of profits from deregulated markets.

Underscoring this new reality, companies on negative credit watch from Standard & Poor's Ratings Group or Moody's include Allegheny Energy Supply, a unit of Allegheny Energy Inc.; Calpine; Duke Energy Trading and Marketing LLC, a unit of Duke Energy Corp.; Dynegy; NRG Energy Inc. and Reliant Resources Inc. Moody's has said it will issue an opinion tomorrow on several of these companies, as well as AES Corp. and Edison Mission Energy, a unit of Edison International.

Ratings downgrades make it more difficult and more expensive to borrow money. That is true for all companies. But a low credit rating can be especially troublesome for energy-trading companies because they often operate on slim margins, and a higher borrowing cost can wipe out profits. More important, most energy firms require trading partners to be credit-worthy in order to enter into contracts. A firm that slips can be required to post large amounts of cash collateral that can cause a liquidity "death spiral" such as Enron experienced.

The speed of Enron's collapse has caused the credit agencies to be more vigilant, reflecting criticism that they have both been slow to sense change and that they have permitted "ratings inflation" during recent years. "I don't know if the problem was grade inflation as much as a willingness to downplay the exposure that was off balance sheet," says Jeffrey Holzschuh, an investment banker for the power industry at Morgan Stanley. "It's not just credit-rating agencies. The whole market was overheated."

At Moody's, Mr. Diaz says his agency now routinely asks companies, "Assume you're downgraded to below investment grade. Do you have sufficient liquidity to run your business?" It is equivalent to asking the average worker, assume you lose your job, do you have enough savings to pay the mortgage? "Companies haven't focused on this possibility at all," he says.

Now, says Alan Spen, a credit analyst at rating agency Fitch Inc., "banks are fearful to put more money into the sector" and it is making credit analysts nervous, as well. The smart companies, he says, are the ones that voluntarily "get their balance sheets in line" and then "let the market know they're in charge of their destiny . . . since the market clearly has the heebie-jeebies."

It isn't the message energy companies were getting a few months ago. In fact, the ability to borrow heavily was touted as one of the central advantages of the national push toward deregulated power markets since the mid-1990s. Historically, regulated utilities were permitted to borrow only a dollar for every dollar of equity they invested because ratepayers ultimately bore the risk of any failure. But so-called merchant generators of electricity, often affiliated with utilities, could borrow as much as their credit ratings and banks would permit. Calpine, the fastest-growing power-plant builder in the country, has borrowed two dollars from banks and bondholders for each dollar of equity, for instance.

Capital markets are "very fickle" now, says Mr. Holzschuh of Morgan Stanley. "From week to week, the judgments can be different and it's extremely selective."

Nine months ago, the energy business was promoting itself as a colossal "growth story" that could pick up where the dot-com meltdown left off. The price-to-earnings ratios of the stocks of flashier companies in the sector, such as Enron and Calpine, were huge, signaling investor confidence in ever-rising earnings.

That view started to dim early this year when problems in California's deregulated energy market pushed the state's largest private utility, PG&E Corp.'s Pacific Gas & Electric Co., into bankruptcy court. The jitters turned into panic when Enron collapsed in a shocking six weeks, amid questions over its accounting practices.

Now, there is a heightened sense that "we're the ultimate guardians of financial markets," says Mr. Spen of Fitch. "People are looking to us for a higher degree of guidance since we have special access to inside information about these companies."

Their tougher line is having a big effect. Even companies with stocks trading near their 52-week lows now appear prepared to issue new stock to bolster equity. Dynegy and gas-and-electricity seller El Paso Corp. both say they are willing to take lumps from common shareholders for diluting them rather than risk the wrath of the rating agencies. Executives of Mirant Corp., a recent power-generation spinoff of Atlanta's Southern Co., have been barricaded in their offices preparing to unveil details on the company's capital restructuring later in the week.

All the belt-tightening spells bad news for continued development of the nation's energy infrastructure. Companies that can borrow more money and stretch their dollars, quite simply, can build more plants and equipment. Companies that are increasingly dependent on equity financing -- particularly in a bear market -- can do less. Already, Dynegy, NRG and others have said they will slow development projects. If enough follow, it could put the nation in a tight spot when the recession ends and energy demand surges. It was a point made in a recent analyst call by Calpine Chairman Pete Cartwright. "We're building a portfolio of the best plants it's possible to build with a working life of 40 years or more," he said, with evident exasperation at souring investor perceptions of his company's health. "America needs this power…"

Enron Fallout

The Atlanta Journal-Constitution – by Matthew C. Quinn – December 30, 2001

Dec. 18--Shares of Mirant Corp. plunged another 15 percent Monday after two Wall Street investment houses lowered their ratings on the stock in the ongoing fallout from Enron Corp.'s collapse.

The shares closed at $13.35, down $2.35, despite company assurances Friday that Mirant expects to have $1 billion in cash and credit lines available at the end of the year and to maintain its investment-grade credit ratings.

It's part of a general downward spiral that has hit unregulated energy companies since industry trendsetter Enron declared bankruptcy Dec. 2.

"We underestimated the effect that Enron's failure would have on the industry," said Christopher Ellinghaus, an analyst with Williams Capital who reduced ratings for both Mirant and Houston-based Dynegy. "The white hot light of intense scrutiny has focused on the liquidity and balance sheets of the industry."

Ellinghaus reduced his ratings for Mirant and Dynegy to "neutral" from "strong buy." He also reduced his earnings-per-share projection for Mirant by 10 cents for 2002. Bank of America reduced its ratings on both companies to "buy" from "strong buy."

Dynegy later announced plans to sell shares and assets and reduce expenses by $1.25 billion to reduce debt. Moody's Investor Service on Friday cut credit ratings for both Dynegy and California-based Calpine Corp. "The credit ratings for the energy marketers are the cornerstone of their business, and the risk of further ratings reductions is palpable," Ellinghaus said.

Mirant plans a conference call with analysts Thursday to discuss the crisis that has hit the entire unregulated power sector. Chief Financial Officer Raymond Hill has said Mirant expects to maintain its investment-grade credit ratings and has contingency plans in place to slow growth in order to do so. Those assurances did not stop the stock from falling to another all-time low Monday…

Enron/Deregulation Collapse

Dallas Morning News – December 30, 2001

(12/15/10) - WASHINGTON--The collapse of Enron Corp. is reinvigorating the critics of energy deregulation. But many in Washington have a slightly different message.

Deregulation works, they say. What's needed, according to federal agencies and many in Congress, is tougher policing of corporate behavior, in the energy industry and elsewhere.

Free markets, in other words, aren't the same thing as a free-for-all.

"Enron is now the most miserable corporate symbol of energy deregulation in the world," said William Massey, an Arkansas Democrat who is a member of the Federal Energy Regulatory Commission. But whatever Enron's shortcomings, the lights stayed on, he said. And Mr. Massey and his commission colleagues want to press on with national electricity deregulation, which depends on the markets Enron pioneered and once dominated.

Chairman Pat Wood III, the Republican who formerly headed the Texas Public Utility Commission, agrees that what's needed is a tougher FERC to keep corporate behavior in bounds.

Somebody's got to watch over the market, to be the cop, the anti-trust regulator," he said in October. "Right now, we're not particularly good at it. We have to beef up and get like the [Securities and Exchange Commission]."

"The postmortems under way on Enron already have identified numerous trouble spots in the Byzantine worlds of corporate accounting and commodities trading.

Politicians and regulators, for example, are looking anew at the question of consumer protection in the energy trading business.

It went unaddressed when the industry began growing in the 1990s, because Enron and its peers were far removed from residential customers. No more, as California's myriad power woes proved this year.

And eyebrows in Washington are arching over "special purpose entities" and "mark-to-market accounting" -- bookkeeping practices that inflated Enron's earnings and share prices and kept stockholders in the dark about the company's true financial picture.

Enron created a number of SPEs, including some with its own executives, while keeping the liabilities off its corporate books.

Now seeking bankruptcy protection, Enron has denied any illegality.

But even as chairman Ken Lay assures creditors that the company could re-emerge from Chapter 11 in a year, even as Enron asserts that it discovered and reported the financial irregularities itself, small and large investors are reeling. Enron shed $70 billion in shareholder value this year.

Rep. Paul Kanjorksi, D-Pa., was exasperated after hearing testimony this week from the SEC's chief accountant, Enron's auditor and a critic of stock market analysts.

"Aren't you outraged?" he demanded. "I mean, if this system is so broke that the seventh-largest corporation in the United States can play these silly games and everybody comes and just says, `Well I didn't know, or we didn't understand, or we had these complications' -- are we any different than any other nations that are having problems with transparency?"

Critics of energy trading markets share Mr. Kanjorski's complaint about obscure corporate accounting.

Rep. Billy Tauzin, R-La., who chairs the House Energy and Commerce Committee, said he does not want a repeat of the mysteries and suspicion that surrounded California's soaring prices and rolling blackouts. "When we looked at the California energy crisis, the first thing we noticed was that the trades were not only unregulated, they were not transparent," he said.

Mr. Tauzin said he and Rep. Joe Barton, R-Ennis, tried to require transparency for energy trades with legislation specific to California's crisis, but the bill did not get out of committee.

Energy trading emerged with the deregulation of energy pricing. In the oil business, trading in futures and spot purchases of crude oil undercut the power of OPEC to fix prices across the globe.

Since these trades were mainly between corporations and large wholesalers, consumer protection seemed of small importance.

The Commodities Futures Trading Commission, chaired by Wendy Gramm, followed congressional guidance and in 1993 chose not to extend its regulatory oversight to energy, according to commission officials.

Soon after, Mrs. Gramm, who is married to Sen. Phil Gramm, R-Texas, left the commission and became a member of Enron's board of directors, where she is a member of the audit committee.

The same deregulation rationale prevailed last year when Congress passed the Commodity Futures Modernization Act.

That measure exempted trading markets for oil, natural gas and electricity from the commission's oversight. Enron lobbied for the bill, which was sponsored in part by Mr. Gramm.

California's electricity crisis heightened concern about energy trades from the perspective of consumers. Mr. Tauzin said Congress "may have made a mistake" when it exempted energy trading from CFTC regulation.

Several members of Congress are also wondering if Enron's handling of SPEs, where some of its own executives profited handsomely, point to a need for reform.

The accounting industry already sees a storm ahead and has promised to hold corporations to a stricter standard for what stays on their books and what goes off to the side.

Rep. Richard Baker, R-La., said Enron's use of SPEs smacked of "self dealing."

Such practices beg for federal oversight, Mr. Kanjorski said.

"The business interests in this country seem to make the most compelling case in the world that we need heavy regulation, and that sort of offends me," he said. "I felt that ... the professions aiding these corporations and the corporate executives would be using the highest moral and ethical standards." Joseph Berardino, CEO of Enron auditor Andersen LLP, said the accounting industry recognizes the problem and wants more disclosure of such transactions by its corporate clients.

Another obscurity of energy trading called "mark to market" accounting is coming under scrutiny as well. This practice leaves it up to the energy trading companies themselves to determine expected future profits for ongoing energy contracts.

Optimistic assumptions can boost current earnings and a company's share price. The mathematical models for determining future profits are so complex that accounting standards give companies a pass on independent audits.

Mr. Berardino said the accounting industry would try to clarify for securities regulators how auditors can keep corporations from reporting misleading information with mark to market accounting.

"We are fully prepared, as a profession, to try and get some guidance out for this year end, as companies are ending their years Dec. 31, so that there will be more clarity this year than there might have been last year," he told Congress.

Investors are giving other energy companies the message. Shares in energy traders Dynegy Inc., El Paso Corp. and others have been under pressure since Enron's meltdown.

El Paso, a Houston corporation that owns the nation's largest natural gas pipeline network, says it will restructure to get rid of off-balance sheet financing.

"It has become clear in the last month that the market now expects energy companies to maintain lower leverage and more simplified balance sheets," the company said in a statement.

Mr. Tauzin's House committee is gathering documents and interviews for a sweeping investigation -- "as wide as the sky," he said -- of Enron's collapse.

"My guess is we're going to find we have to legislate and improve both the regulatory side and the legislative side of this matter," he said.

Enron’s Books

The Wall Street Journal – December 30, 2001

(12/14/01) - In addition to acting as Enron Corp.'s outside auditor, Arthur Andersen LLP also performed internal-auditing services for Enron, raising further questions about the Big Five accounting firm's independence and the degree to which it may have been auditing its own work.

That Andersen performed "double duty" work for the Houston-based energy concern likely will trigger greater regulatory scrutiny of Andersen's role as Enron's independent auditor than would ordinarily be the case after an audit failure, accounting and securities-law specialists say.

It also potentially could expose Andersen to greater liability for damages in shareholder lawsuits, depending on whether the internal auditors employed by Andersen missed key warning signs that they should have caught. Once valued at more than $77 billion, Enron is now in proceedings under Chapter 11 of the U.S. Bankruptcy Code.

Internal-audit departments, among other things, are used to ensure that a company's control systems are adequate and working, while outside independent auditors are hired to opine on the accuracy of a company's financial statements. Every sizable company relies on outside auditors to check whether its internal auditors are working effectively to prevent fraud, accounting irregularities and waste. But when a company hires its outside auditor to monitor internal auditors working for the same firm, critics say it creates an unavoidable conflict of interest for the firm.

Still, such arrangements have become more common over the past decade. In response, the Securities and Exchange Commission last year passed new rules, which take effect in August 2002, restricting the amount of internal-audit work that outside auditors can perform for their clients, though not banning it outright. "It certainly runs totally contrary to my concept of independence," says Alan Bromberg, a securities-law professor at Southern Methodist University in Dallas. "I see it as a double duty, double responsibility and, therefore, double potential liability."

Andersen officials say their firm's independence wasn't impaired by the size or nature of the fees paid by Enron -- $52 million last year. An Enron spokesman said, "The company believed and continues to believe that Arthur Andersen's role as Enron's internal auditor would not compromise Andersen's role as independent auditor for Enron…"

Free Business Lessons From Enron

Washington Post – by Allan Sloan – December 30, 2001

(12/4/01) - In the spirit of the season, Enron Corp. has given us an early holiday gift. No, it's not sending goodies to our homes or money to our bank accounts. Rather, it's giving us an amazing tale of corporate downfall and hubris. And it is providing lessons ranging from the mercilessness of markets to the dangers of forcing people to tie their living and retirement to the same company.

Enron, created in 1985 when Houston Natural Gas combined with a gas-pipeline company, swaggered through the 1990s. It claimed it would revolutionize life and commerce by substituting the efficient hand of the market for the clumsy hand of government regulation.

But Enron's leaders proved to be every bit as bungling as any government bureaucrat. Sift through the financial debris, and you see that Enron lost about $7 billion on four dumb investments (details below.) However profitable Enron's other businesses might have been, paying for those turkeys stretched Enron to the breaking point. And it broke. Some $60 billion of stockholder value has been wiped out this year. Shares that opened the year at $83 closed Friday at 26 cents. Bankruptcy looms. You wonder if Enron Field, home of the Houston Astros baseball team, will be renamed Chapter 11 Field. Or maybe House of Cards.

Adding another dimension to the debacle is the intimate relationship between Enron and the White House. Enron, which for years has tried to ride roughshod over state and federal regulators, has ties throughout the Bush administration. For starters, Enron and its chairman, Kenneth Lay, were among George W. Bush's biggest and most important contributors in his Texas and presidential campaigns. And according to public records, Bush intimates ranging from economic adviser Larry Lindsay to political adviser Karl Rove (who owned $100,000 to $250,000 of Enron stock) to Trade Representative Robert B. Zoellick had been on Enron's payroll before moving to Washington. Army Secretary Thomas White Jr., a former Enron executive, had stock and options worth between $50 million and $100 million.

In a different environment -- remember Whitewater? -- the combination of big losses and White House ties would have long since produced cries for a special prosecutor to see what (if anything) Enron's buddies have done on behalf of the company. The upcoming hearings in the Republican-controlled House should be fascinating, and there will doubtless be more hearings in the Democratic-controlled Senate.

"We've had no contact with the White House" since Enron's meltdown started, says company spokesman Mark Palmer.

"I'm not aware that there have been any requests [from Enron] for anything," a White House spokesman says.

Even though Enron shareholders have been essentially wiped out, Lay isn't going to the poorhouse. Unlike Enron employees whose retirement accounts have been vaporized because they consisted largely of Enron stock the company wouldn't let them sell, Lay has plenty of wealth left. Last year alone, he made $123 million of profit on stock options, according to Enron filings. This year he has made an additional $25 million or so. Note: on Friday, with its stock at around 30 cents, Enron changed its policy and allowed employees to sell it.

Ironically, what brought down Enron from its lofty perch on the Fortune 500 list (No. 7) is that the markets, whose virtue it preached, lost faith in it after it disclosed funny dealings with a partnership run by its chief financial officer.

And now, let's proceed to the syllabus of Enron 101:

1. Bubbles Didn't End When Dot-Coms Bombed

Enron, a major trader of electricity and natural gas, grossed $200 billion a year and had $60 billion of assets, but it turned out to be a bubble. Its business depended on borrowing lots of money. People lined up to lend as long as Enron seemed healthy. When suspicions arose six weeks ago after the company revealed its partnership problems, money trickled away. Then it started leaving in a flood. As Enron tottered, it lost trading business. Its remaining customers began to gouge it -- that's how trading works in the real world. Don't blame the usual suspects: stock analysts. Rather, blame Arthur Andersen, Enron's outside auditor, which didn't blow the whistle until it was too late. (Andersen says it's far too early for me to be drawing conclusions.)

2. Deregulation Can Be Dangerous

It's clear that the cozy world of utility monopolies needed to be shaken up, given huge losses on nuclear plants and other problems. Besides, breakthroughs in turbine technology made it feasible for big users such as manufacturing plants to set up their own generators and drop off the electric grid. Letting them go would have raised prices for everyone else. But dereg has caused lots of problems. In 1998, the Midwest had huge spikes in the price of electricity and rolling blackouts: Some utilities had sold power outside their service areas, and the traders they were relying on to replace that power didn't deliver. Upstarts have dropped in and out of retail markets in several states, sticking established players with big costs. And, of course, there's California, which got caught with too little energy in the spring (helping Enron and others make big profits) and now is stuck with too much expensive energy. This has crippled the state's finances, driven its biggest utility into bankruptcy and clobbered customers. Leaving vital necessities such as electricity and natural gas to the tender mercies of the market is risky. Especially when a big player such as Enron can vanish overnight.

3. Beware Your Own Hype

Enron pioneered trading in electricity and natural gas, and it was the primo player in that field. But it came to believe that it was good at everything. It wasn't. Some of the debacles: losses of $2 billion each in the water and telecommunications businesses, and another $2 billion lost in a Brazilian utility investment. It blew an additional $1 billion on an electricity-generating plant in India. Hence, I think, the need to obscure rising debt levels and less-than-stellar results by dealing with so-called off-balance-sheet partnerships with "Star Wars" names such as JEDI (for Joint Energy Development Investments) and Chewco (as in Chewbacca, the Wookiee). The fact that Enron executives were involved in these partnerships and made money while the company got clocked didn't help.

The Summary

The Enron Affair reinforces two of the oldest lessons there are. To wit: When someone tells you he's changing the world for the better and getting rich at the same time, hold onto your wallet. And when something sounds too good to be true, it probably isn't true.

Arizona Cautious of Deregulation

Associated Press – December 30, 2001

PHOENIX - The head of the Arizona Corporation Commission wants to reevaluate the state's deregulated electricity market, which allows most residents to shop for competitively priced power.

Commission Chairman William Mundell said he continues to support the development of competitive markets and acknowledged voting in favor of the rules that deregulated the market.

But, he said, "the California experience has given me reason to pause and rethink the concept of restructuring the electric market." After power shortages, rolling blackouts and skyrocketing prices over the past year, California has backtracked on deregulation.

Mundell wrote in a letter distributed to the commission Wednesday that while he's not ready to "pull the plug" on his votes and previous positions, "I want to take a closer look at the direction of current Arizona policy."

The other two commissioners, Jim Irvin and Marc Spitzer, said they would support such a move. Arizona's electric market became substantially deregulated in January, when most residents were able to shop for cheaper power.

But traditional utilities were the only sellers.

Arizona Public Service Co., which has 850,000 electric customers in Arizona, is now asking the commission to modify an agreement that requires it to seek competitive bids for half its electricity beginning in 2003.

Instead, it wants to buy all of its electricity from its own parent company, Pinnacle West Capital Corp. The deal represents a partial return to regulation in that it would guarantee Pinnacle West a buyer for its electricity and a way to recover the $1 billion it is investing in new power plants.

Pinnacle West would be able to pass along the cost of the plants to APS, which would then pass the costs to customers. The commission, which regulates utilities, would determine whether the rates were fair. Pinnacle West said it needs the change to guarantee consumers a stable supply of electricity at reasonable prices.

But competitors such as Duke Energy, Pacific Gas & Electric and Reliant Energy argue the change would undermine competition.

Deregulation - December, 2001 - Page 6