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Trade Disclosures Shake Faith in Troubled Energy Markets Mitchel Benson, Chip Cummins and Jathon Sapsford, Staff Reporters The Wall Street Journal, May 13, 2002

Concerns that power producers inflated the apparent size of their business with bogus trades are hammering the industry's stocks, disrupting its finances and raising new questions about the already-shaken credibility of deregulated energy markets.

The latest events, in the aftermath of the December bankruptcy-protection filing by the power industry's best-known player, Enron Corp., are likely to renew calls for greater government oversight of the freewheeling market.

On Friday, Reliant Resources Inc. felt compelled to cancel a $500 million private debt placement under urging from its underwriters, after the company disclosed that it had sold and simultaneously bought back power from an unnamed trading partner. Earlier in the week, The Wall Street Journal reported that the Securities and Exchange Commission was investigating Dynegy Corp. because of a similar arrangement with CMS Energy Corp. CMS said Friday that the SEC had included the company in the probe and said it would cooperate fully; Dynegy had also said it would cooperate.

Following the move by Reliant, other companies active in the wholesale power-trading market said they had not deliberately inflated the size or number of trades they had conducted. Mirant Corp. of Atlanta took the unusual step of issuing a public statement to that effect. But stock and bond prices throughout the industry dropped sharply on investors' fears of more such disclosures to come. Already the disclosures of the last week have implicated four firms in such trades, in an industry dominated by big players.

It's not clear why firms would have made the trades, or whether they may have broken any laws. The SEC is likely to investigate whether companies fraudulently claimed revenue from trades that didn't net any profits. If not aimed at booking extra revenue, such trades also could have helped companies exaggerate their market share in a drive to be perceived as bigger players and bring in more business. Dynegy, for its part, said its trade with CMS was only intended to test the movement of large volumes of energy; Reliant declined to give any details about its trades until a conference call with analysts scheduled for Monday.

Exaggerated Growth?
More broadly, the latest revelations about trading behavior suggest that the torrid growth in the three-year-old wholesale electricity market, which underpinned huge revenue growth and fat profits at these companies through much of 2000 and 2001, could have been exaggerated -- no one knows by how much. The revelations also are renewing suspicions among federal and state investigators that bogus trades may have been at least partly behind electricity prices soaring as much as 900% in California early last year.

It's not clear how this kind of trading activity may have influenced market prices. Traders say that it is possible to use such "round-tripping" trades, in which the same amount of energy is swapped in both directions, to help set a higher benchmark price for a particular contract so that other or future buyers would have to pay more. It can also be used to make the market for a contract look more liquid than it actually is. It's also unclear how prevalent the practice was. The electricity trading market isn't transparent -- it consists of a handful of big players doing business amongst themselves.

What is clear is that the wholesale electricity market grew exponentially in very short order. Sales of megawatt hours nearly doubled from one billion in the fourth quarter of 2000 to 1.966 billion in the same period of 2001, during which Enron filed for bankruptcy protection.

Some observers believe fresh damage may be done to the credibility of electricity deregulation, which was supposed to bring consumers more choice and lower prices. At this point "the arguments against markets are clear," says Federal Energy Regulatory Commission member William Massey: "California is strike one, and Enron is strike two. My God, we don't need strike three."

A "third strike," adds Mr. Massey "is if consumers and state policy makers lose confidence in the market-based approach and feel like there are a lot of funny games going on in the market that they don't understand."

"Round-tripping" in the wholesale power market does seem to have been fairly common, according to traders and consultants. "We always presumed that this was going on," says Frederick H. Pickel, vice president at Los Angeles consulting firm Tabors Caramanis & Associates. But he adds that it is "impossible" to estimate how much of the industry's overall volume results from these kinds of trades. "The real answer is, nobody knows," Mr. Pickel says.

The vast growth in electricity trading is a recent phenomenon. Prior to the mid-1990s deregulation of wholesale markets at the national level and retail deregulation at the state level starting in 1998 in California, electricity was mainly a local affair. Regulated utilities traded power among themselves to meet shortfalls in supply. But as deregulation kicked in, some of these utilities and other independent power producers and traders such as Enron set about creating a national trading market, theoretically to efficiently allocate electrons where they were needed most.

Several companies including Enron and Dynegy set up their own online exchanges to trade power. Other firms grouped together in consortiums with names like TradeSpark and the Intercontinental Exchange to do the same. Because there was no central market to trade these contracts, each of these "market platforms" sought to dominate trading at the expense of the others.

Right out of the gate, trading volumes shot through the roof. Companies like Enron, Dynegy, Reliant Resources and Mirant trumpeted the huge growth in their "merchant" energy businesses, saying that the increasingly liquid national electricity market was allowing them to make the kind of profits that old style utility operations -- with their highly regulated pricing -- never could. Wall Street loved the story; several utilities spun off their unregulated units in lucrative initial public offerings. Several independent producers and big trading operations like Enron and Dynegy saw their stock prices shoot higher.

In trading electricity contracts that called for physical delivery of power months or years down the road, these companies had lots of leeway in how they valued the contracts. Using so-called mark-to-market accounting, the energy companies booked a profit or loss on the value of contracts they held based on the market price at a given moment. When electricity prices shot upwards in the Western U.S. in the first half of 2001 due to supply shortfalls in California, the companies reaped huge gains.

The opaque nature of these accounting practices were taken on faith when times were good but came under intensified scrutiny as Enron collapsed; now creditors and investors get spooked quickly when questions about trading practices are raised publicly.

That's apparently what happened at Reliant Resources, which claims to be one of the top five energy traders in the U.S. The Houston-based company would say little beyond its terse one-paragraph statement that it was canceling its debt placement "in response to news reports" Thursday about Dynegy's trades with CMS. The offshoot of Reliant Energy Inc. said that it is undertaking a review because it believes it had "similar transactions" with another undisclosed energy trading firm. Reliant Resources spokeswoman Sandy Fruhman said the company had decided "the prudent cause of action was to postpone the bond offering."

The postponement was unusual because the deal had already been "priced," meaning that the underwriters had already tested investor appetite and set the terms. Bankers familiar with the deal said the underwriters -- Deutsche Bank AG, Barclays Capital and Bank of America Corp. -- had concerns after learning the SEC was looking into the Dynegy-CMS trades, and were worried about liability if after the bond sale Reliant was found to have used questionable trading strategies or misleading accounting that could spark lawsuits. Spokesmen for the banks involved in the underwriting declined to comment.

Ms. Fruhman said the cancellation of the bond offering wasn't critical for Reliant Resources because the funds were intended to repay part of a bridge loan due in February 2003 that the company took out to complete its purchase of rival Orion Power Holdings Inc. Reliant paid $2.9 billion for Orion last February, assuming around $2 billion of its debt as well.

It's not good news for the company, though. Spun off to hold the unregulated units of Reliant Energy Inc. last year, Reliant Resources has made good profits -- posting net earnings of $97 million in the first quarter of 2002, up from $82 million the previous year -- but has been dogged by controversy. It's one of the companies being sued by California Attorney General Bill Lockyer for charging "unfair and unjust" prices during California's energy crisis. In April, the company announced that it was the subject of an informal SEC investigation after it restated earnings upwards by $134 million for the second and third quarter of 2001 due to a change in the way it accounted for certain trading transactions.

Big questions remain too at Dynegy, whose stock and bonds fell sharply in the wake of the disclosure of internal trading documents last week. The documents showed that on 10:08 a.m. on Nov. 15, 2001, Dynegy sold CMS 15,000 megawatts of energy capacity for the duration of a month. At the same moment, it bought back the same amount of electricity from CMS on the same terms. Twenty minutes later, the two companies conducted two more simultaneous trades, but this time for a years' worth of 5,000 megawatt hours of capacity. The total value of the two deals, according to a person familiar with the trade, was $1.68 billion.

Both Dynegy and CMS say that the trades produced no profit for either company and that they weren't included in income or revenue statements. Dynegy President Steve Bergstrom said in a conference call last week the trades were conducted "to stress test" Dynegy Direct because the platform had been "having problems with large transactions."

Analysts question the explanation. Art Gelber, a former energy executive who now runs the Houston consulting firm Gelber & Associates, say such trades are typically done to create the impression that a given company -- and in this case, a trading platform -- is drawing more activity than others. At the time of the trades, Enron was sinking fast and a number of different platforms were seeking to capture the business once held by its subsidiary EnronOnline. "It's a question of looking like the busiest guy around," said Mr. Gelber, who calls the practice "competing for brag-a-watts."

Such "round-tripping" isn't illegal in power markets. On regulated stock and futures exchanges, where the practice is known more commonly as "wash" trading, it is specifically restricted. For years, regulators have prosecuted traders who have sought to inflate trading activity in a security for the sake of manipulating the price or creating the false impression that the security is trading in a liquid market.

Several other big traders on Friday gave interviews saying they hadn't engaged in the practice of artificially boosting their trading volumes. Among them were San Jose-based Calpine Corp., Baltimore-based Constellation Energy Group Inc. and Tulsa-based Williams Cos.