Special Presentation

The California Crisis and the Enron Debacle

Will Deregulation Survive?

IEEE

Luiz Maurer

São Paulo, SP

March 22, 2002

Deregulation of power sector in 2001

Focus of this presentation

California and Enron in a snapshot

Enron involvement in the California crisis

Can we blame it on deregulation?

Have deregulation and Enron created any value?

Relevance of this discussion to Brazil

In conclusion

AGENDA

DEREGULATION OF THE POWER SECTOR IN 2001

DEREGULATION OF THE POWER SECTOR HAD MANY SETBACKS IN 2001

California crisis

Enron collapse

Spillover effects on perceived “Enronites” – e.g. Calpine, losing US$ 2 billion

PG&E bankruptcy in San Francisco

Energy shortage in Brazil

VERDICT HAS BEEN SIMPLE: BLAME IT ON DEREGULATION

“Deregulation is a failed experiment” California, first state to fully introduce

wholesale + retail competition – was also the first one to fail

Enron, the champion of deregulation, following a death spiral which led to Chapter 11

Therefore: General skepticism from the public PUCs delaying retail competition FERC more prudent in setting up RTOs More discussions on how electricity should be

traded, transmitted and paid for

WHICH RAISES SEVERAL GENUINE QUESTIONS

Why did those things happen? Points in common?

Could it happen again and again? Is deregulation something evil? What are the alternatives? Go back to the old good days of cost plus

regulation and central planning? Should states put an end on customer

choice?

FOCUS OF THIS PRESENTATION

FOCUS OF THIS PRESENTATIONWHAT IS COVERED WHAT IS NOT COVERED

Competition in power generation

Other industry dynamics and deregulation

Market based prices New accounting rulesReduced barriers to entry New disclosure

requirementsSecond stage: retail competition and customer choice

Regulation in energy derivatives

Contestable provision of electric services

Pension fund regulations (401k)

How to make market forces work: design of power pools

Stock options and executive compensation regulations

CALIFORNIA AND ENRON IN A SNAPSHOT

CALIFORNIA IN A SNAPSHOT Started full deregulation in 1996 First problems in 2000 – price spikes directly

affecting customers, reflecting supply-demand mismatches and T constraints

Winter widespread rolling black-outs Financial distress imposed on utilities, forced to

buy on a spot basis Finger pointing – Enron as the scapegoat -

personal issue between Mr. Gravis and Mr. Lay Proposed solutions: State role as a buyer Last season – problem mitigated, with customer

response and [stranded] contracts (?) Discussions on US$ 9 bi refund from cowboys

ENRON IN A SNAPSHOT (I) Reported losses in October, with significant

write-offs Raised investment community eyebrows, but

explanations far from convincing SEC investigation – need to report retroactively Stock prices declining, triggering clauses of

financial derivatives Cash badly needed, stocks in a death spiral Frustrated attempt to merge with Dynegy Chapter 11 filing in early December, followed

by massive corporate layoffs

ENRON IN A SNAPSHOT (II) Frustrated attempt to sell trading floor and EOL at

a large premium Class actions, Congress hearings, Powers Report Scandals of all sorts, particularly related to special

entities and Enron CFO Key executives and board members fired AA – criminal charges for obstruction of justice Investigations on the way and will continue for

months to come After all, the largest bankruptcy in America

ENRON INVOLVEMENT IN THE CALIFORNIA CRISIS

ENRON IS PERCIEVED AS A SCAPEGOAT IN THE CALIFORNIA CRISIS

The most active proponent on deregulation Learned the “tricks of the trade” to manipulate

the wholesale market Making money on gas and electricity – and

created artificial constraints Not the only one – but played a leading role Strong proponent on no caps on spot prices Gov. Davis: Where do I go to get my money

back?

ENRON DOES NOT DESERVE THE BLAME

Does not own generation facilities (except wind) If claimed refund had merits -- < 0.5% 1994 Hearings – warning that the proposed

system would be capricious and lead to high pricing

State rejected Enron’s offer of long term power in 2001; later, sold to state at prices lower than average (US$ 181/MWh vs. US$ 243/MWh)

Intrastate pipelines are filled to capacity – 5,530 mcf versus 6,150 mcf entering the state

Enron is a net buyer – indeed to receive refund And a lot of high prices reflect scarcity in supply

or T constraints

CAN WE BLAME IT ON DEREGULATION?

CALIFORNIA IS NOT DEREGULATION Several design problems – some anticipated D/Cs not allowed to sign long term contracts And were exposed to spot price volatility But in most cases consumer rates frozen,

creating imbalances for D/Cs, and financial distress

In places where rates reflected spot prices, lack of hourly metering did not help in peak shaving

Extremely complex market design – some rules conducive to price gouging

ISO stakeholder board not capable to change Usually referred as a “botched deregulation”

ONE CAN NOT HONESTLY BLAME ON DEREGULATION FOR ENRON’S DEMISE “Trading Natural gas and electricity, the core

businesses, were solid ventures on deregulated markets” – from nothing in 94 to 900 TWh now

Many failed attempts to enter into new regulated businesses, mostly overseas

No modesty to admit they had different KSFs with diverse industry dynamics

Bulk of non-core assets under-performing – “less than decent rates of return”

Even decent rates of return would not have satisfied investors appetite – based on expected P/E ratios

“Company managed to hide from investors and regulators its bad management and possibly corruption by shamelessly promoting its image”

HAVE ENRON AND DEREGULATION CREATED ANY

VALUE TO SOCIETY?

“ENRON WAS MOSTLY RIGHT ABOUT ONE THING: DEREGULATION”

“Moving aggressively, it became the largest trader of electricity and gas derivatives

Enron had real insight into the role of new types of securities in deregulated power markets

Enron’s actions, while self-serving, were generally good for the economy as a whole

The company promoted greater competition in electric power. Enron battled against entrenched state and local electric power companies that opposed deregulation to preserve their monopolies

Enron’s total expenditures on political influence were tiny compared with the potential benefits to consumers from competition”

“TESTAMENT TO THE FLEXIBILITY OF THE U.S. ENERGY MARKET” “Enron could fail without disrupting gas or electric

supplies” There were no price spikes, electricity outages Enron’s trading functions immediately assumed by

others “Part of the reason the markets adjusted so

smoothly to the Enron collapse was the liquidity and risk allocation provided by the wholesale markets Enron had helped create”

For most regions of the US, there is significant market liquidity with multiple buyers and sellers meeting consumer needs

DEREGULATION HAS BROUGHT SIGNIFICANT BENEFITS TO US CONSUMERS Recent study by Boston Pacific Co. indicates that

1985-99 adjusted prices declined on average by 30% for residential and 36% for large customers

Despite not being the sole factor, large prices decreased occurred when competitive pressure was greatest

Recent study from the US Federal Trade Commission indicates that retail marketing is in a transition period

“In this hybrid environment of regulation and competition, many of the expected benefits have not emerged …

Nothing that has happened so far indicates that competition will not produce additional benefits to electricity customers”

AND THERE ARE MANY SUCCESS STORIES OUTSIDE OF CALIFORNIA AND ENRON

Well functioning power pools in the US do not receive the same publicity as California PJM – considered one of the most dynamic New York New England MISO

55.000 MW installed last year mostly in competitive environments

Other countries/regions have also developed vibrant markets Europe – Nordic countries, UK Australia, New Zealand Argentina

RELEVANCE OF THIS DISCUSSION TO BRAZIL

Embarked on a restructuring program in 1998, towards privatization and deregulation

Alleged lack of incentives for expansion leading to a major rationing crisis

State companies not allowed to expand; private sector not comfortable with risks entailed by the new model

Supply demand imbalance, lack of investments, drought, demand growth, environmental problems, transmission constraints, etc.

On the surface, it bears a strong resemblance to California

Point in common: deregulation

ONE WAY OF TELLING THE STORY

Model designed for Brazil is significantly different from California’s (Appendix)

Most reasonable observers agree that Brazilian reform is half-way through

The issue hinges on implementation, not design It is widely known that some incentives are not in

place, or still entail significant risks to investors – e.g. VN, FX, D/Cs willingness to sign PPAs

Less conspicuous but probably more important – penalties for under contracting Penalty is MAE price exposure This assumes that contracts among consenting

adults will be honored, with no bail-outs Rationing illustrated how sensitive the subject is

THE FLIP SIDE OF THE COIN

The way the rationing program was designed illustrates how market forces may help allocate a scarce resource

Quota system with penalties for those who exceeded this baseline – or bonuses for low income consumers

Penalties linked to MAE price – to avoid the California effect and affect utilities’ finances

Large clients allowed to exchange quotas 9 months of rationing with minor black-outs Recognized as a success story. Brazil saved US$ 10

billion by avoiding rolling black-outs Demonstrable possibility to leverage demand elasticity Customer choice created more appetite for retail

competition, to be introduced in 2003

THERE ARE SUCCESS STORIES ON THE USE OF MARKET FORCES

IN CONCLUSION

For many, California should not be called deregulation – it is a “botched” re-regulation

Deregulation did not kill Enron – the deadweight of regulated businesses did – but no excuses to actions of management

Not fair to blame on Enron for California crisis Enron collapse suggests need for greater financial and

pension fund regulation – but never back to the old days of cost plus regulation in the power sector

Deregulation, particularly in the wholesale market, has worked in many countries/regions and has brought many benefits to customers

There are also good lessons to be learned when designing wholesale and retail competition

Brazil may leverage on those and on the lessons drawn from the market-based rationing program

IT IS NOT FAIR TO BLAME IT ON DEREGULATION

APPENDIX

DEREGULATION MODELS

IN BRAZIL AND CALIFORNIA

DEREGULATION MODELS IN BRAZIL AND CALIFORNIA

BRAZIL

(DURING INITIAL CONTRACTS = CI’s)

CALIFORNIA

RATIONALE CONTRACT AS THE BASIS FOR COMPETITION

CONTRACT PROXY FOR RE VERTICALIZATION

IMPLEMENTATION HALF-WAY THROUGH IMPLEMENTED LEVEL OF CONTRACTING FOR LSE

HIGH MANDATORY

VIRTUALLY NILL HIGHLY RESTRICTED

COMPLEXITY OF WHOLESALE MARKET

LOW – ONE PRODUCT (MWh)

EX-ANTE DECLARATIONS LONG TERM CONTRACTS

FOR ANCILLARY SERVICES

HIGH – SEVERAL PRODUCTS BOTH EX-ANTE AND REAL TIME

DECLARATIONS ANCILLARY SERVICES

PROCURED REAL TIME

ENERGY COST PASS-THROUGH

RESTRICT TO VN SAME FOR SPOT

PURCHASES

TOTAL, AFTER RECOVERY OF STRANDED COSTS

UNCERTAIN BEFORE NATURE OF SHORTAGE AND MARKET POWER

HIGH PEAKING CAPABILITY – LACKING “FUEL”

MINIMAL UNDER TIGHT POOL REGIME

VERY LOW DURING INITIAL CONTRACTS

BASICALLY SHORT ON CAPACITY (PEAK MW)

ALLEGED AS HIGH FOR G “THIN” MARKET FOR

ANCILLARY SERVICES