BOOK 3: ENRON ASCENDING: THE FORGOTTEN YEARS, 1984-1996

Chapter 5 Internet Appendix

5.1 Transwestern vs. FERC Cost-based Regulation
5.2 Marketing Affiliate Rule (FERC Order No. 497)
5.3 On the Formation of Gas Bank
5.4 Global Warming and Greenhouse Gases
References for Chapter 5 Appendix

5.1 Transwestern versus FERC Cost-based Regulation

Jim Rogers, the chief strategist and decision-maker for Enron’s interstate pipelines in the 1986–88 period, sought to move the Federal Energy Regulatory Commission (FERC) away from cost-based regulation. Given an environment where competition required rate discounting for at least part of the time, it was natural to lobby federal regulators to allow a pipeline the flexibility to charge rates above the regulated maximum—at least to offset rate discounting.

The rationale for rate flexibility, within or above a cost-based revenue requirement, was stated by Dan Alger and Michael Toman in reference to interstate pipelines under FERC regulation:

Slow-moving traditional regulation cannot respond to the quick changes…. [Regulated] rates generally misprice services: in peak periods services are not allocated to the highest valued uses, in off-peak periods the pipelines are often not used as fully as they could be, and administratively set rates fail to provide proper signals for entry and exit decisions (p. 263).

In 1987/88, Transwestern Pipeline worked with outside consultants to make a case that its market was “workably competitive”—and thus suitable for rate liberalization under the “just and reasonable” standard of the Natural Gas Act of 1938, as interpreted by FERC.

While this initiative failed with regulators, Transwestern debated its own consultants over the nature of competition and economic efficiency to justify a departure away from cost-based rates. At issue was the neoclassical theory of competition and efficiency—something on which Transwestern’s consultants (Ph.D. economists all) and the FERC based their theory.

As against “nirvana economics” (a term used by economist Harold Demsetz and borrowed by the present writer while at Transwestern), interest developed to judge Southern California’s gas market by a more realistic real-world standard. Thus, a rival theory to neoclassical economics, market-process theory (from the Austrian school of economics) was pushed by Transwestern. This theory viewed competition as entrepreneurial discovery, whereby pure profit, even at levels above cost-based rates, propelled improvement. It also conformed to the commonsense notion of rivalry; after all, industry analysts considered Transwestern’s market the most competitive in the nation. “Nowhere does gas-on-gas competition exist more strongly than in the California market,” noted one (Crowley, p. 4).

Otherwise, Enron considered commodity unbundling and mandatory open-access as deregulatory, not re-regulatory. Stated Enron’s 1987 Annual Report (p. 17):

Enron supports the move toward deregulation as evidenced by the fact that three of its affiliated interstate pipelines demonstrated a willingness to compete in a deregulating gas market, but they have also have been key proponents for completing the industry’s transition to a market-based rather than a regulated environment.

The year before, the chairman’s letter stated a goal to “become even more market oriented in each [core area]” (Enron, 1986 Annual Report, p. 5).

The theme of Enron as a pro-deregulation and free-market company would be part of Ken Lay’s imaging—and an effective diversion from the reality of Enron as a political, pro-intervention company. “I believe in God, and I believe in free markets,” Lay stated in 2001, the final year of Enron’s active life (quoted in Capitalism at Work, p. 3).

 

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5.2 Marketing Affiliate Rule (FERC Order No. 497)

On August 7, 1986, Hadson Gas System Inc., an independent marketer not affiliated with an interstate pipeline, petitioned FERC to “examine various pipeline business practices which portend serious harm to competition in gas sales markets and to explore what expedited procedures may be created to resolve complaints concerning violations of Order No. 436 transportation tariffs” (quoted in Allison). At issue were the practices of pipeline gas-marketing affiliates, whose operation began with FERC-authorized special marketing programs (SMPs), starting in 1983. (Transco Energy, and its president, Ken Lay, was at the forefront of released pipeline “spot” gas intended to increase sales and reduce take-or-pay liabilities with producers [Bradley, Edison to Enron, pp. 339, 344, 347, 348].)

Independent marketers complained that their pipeline-affiliated rivals received preferential rates and terms of service—or just strategic information to capture the deal in-house. Nonaffiliated marketers had to transport on the interstate pipeline, yet the interstate’s own marketing affiliates were going after the same business off its pipeline. One participant analogized the preferential treatment thus: “When I look for somebody to cut my grass, my son has a real advantage over the kid next door” (quoted in Valdez, “Gas Industry Squabble,” p. 4).

Hadson’s complaint, spearheaded by its president Vinod Dar, would be supported before FERC by other marketing independents, such as Yankee Resources and Natural Gas Clearinghouse—and their newly formed trade association, Independent Marketers Group. Also supportive were gas producers represented by the Independent Petroleum Association of America, IPAA’s regional affiliates, and the Natural Gas Supply Association (representing the majors). End-user groups such as the American Gas Association also saw benefit from greater firm-to-firm rivalry from marketing affiliate rules.

FERC initiated a notice of inquiry, in November 1986, in which interstate pipeline companies and their trade association, the Interstate Natural Gas Association of America (INGAA), argued against regulation on two grounds. First, pipeline marketing affiliates were necessary to sell released gas in order to reduce take-or-pay exposure and should not be regulated away. Second, competitive abuses (favoritism, discrimination) were “anecdotal,” not widespread.

Evidence exists that Enron’s treatment of outside-versus-inside transportation requests was relatively fair compared to other pipeline affiliates, making it a “very classy operation” according to one independent marketer (quoted in Valdez, “Pipeline Marketing Affiliates,” p. 4). Enron’s Jim Rogers, testifying before FERC, posited that that Enron’s interstates provided nondiscriminatory transportation as “good business practice” (Foley).

Nonetheless, FERC ruled in favor of Hadson et al. with Order No. 497 (effective July 14, 1988) that functionally separated—but did not divorce—a company’s interstate pipeline from its marketing affiliate(s). The required “standards of conduct and reporting requirements intended to prevent preferential treatment of an affiliated marketer by an interstate pipeline in the provision of transportation services” led to a Chinese Wall between pipeline and marketing operations of the same company.

In response, Enron published a 43-page compliance paper for its employees, “Procedural Guidelines for Enron Corp’s Compliance with Order No. 497” (no date: copy in the author’s possession). Enron’s pipeline affiliates—PAMI (Transwestern), Northern Gas Marketing (Northern Natural), and Panhandle Gas (HPL) were merged into EGM. Employees such as George Wasaff, who marketed in California for both Transwestern and PAMI, pre-Order No. 497, had to go one way or the other. (Wasaff chose Transwestern [Wasaff interview, p. 22]).

FERC Order No. 497 was an outgrowth of Order No. 436 and would be followed by Order No. 497a, Order No. 497b, Order No. 497c, and Order No. 497d. Such are the dynamics of government intervention into the marketplace, where initial intervention has predicted and unpredicted results leading to further government involvement (Bradley, Edison to Enron, pp. 493–98).

 

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5.3 On the Formation of Gas Bank

Jeff Skilling of McKinsey is often credited with the Gas Bank idea. However, Gerald Bennett, head of Enron’s intrastate gas activities, was as instrumental in getting the idea to a workable, executed business innovation. Bennett recalls:

The interesting thing that came out of all this was something called the Gas Bank. And it was probably late 1988/early 1989 that I was trying to figure out how to put term to some of our contracts because everything at that point in time had gone through spot….

Enron Gas Marketing was the major source of contracts to some of the utilities. It was obvious that the customers we were competing with, predominantly the utilities, wanted a longer-term gas supply and since all of our dedicated supply had really almost gone to spot at that time. [But as] we were unsuccessful in getting producers to commit to a price, we were trying to figure out how to take that margin in between.

I sat down with Skilling in my office late one afternoon [to explain an idea]. The one thing that I learned from my Texas oil and gas experience, and this is really interesting, when we sold gas to a customer, we did it on a dedicated reserve basis. And we would say, “we’ll sell you up to 20 million cubic feet a day of gas from this reserve,” and we would take specific gas contracts, aggregate them, aggregate all their deliverability to equal that 20 million cubic feet a day. And then, a big part of my job when I was with TXO Delhi was continuing to put gas supply behind them.

So, as we would see the deflation in some of those contracts, we would go back in and we would dedicate new contracts to that one sales contract. So, I told Skilling: “You know, part of the problem is you buy gas like this, you sell it like this…. [T]here’s got to be a way that as we go out and we buy this gas supply.”

So, what we ended up coming up with was slicing the production decline curve into components of 10 years, 5 years, 3 years, and 2 years, and going out and selling a blend of contracts to the utilities. Then what we had to do was really work on that part of the curve that didn’t quite fit in that square…. So, that was really the concept of the Gas Bank.

What role did McKinsey and Skilling play in creating the “gas bank” idea?

We used McKinsey to do two things. One was to help us with the pricing parameters to figure out what risks we were taking as we ended up contracting out to some of the utilities compared to the production costs that we were putting under contract. And the other part of that is Harry Stout and I probably contacted almost every producer in Houston and we couldn’t buy any reserves.

I mean, the first thought was put it on reserves…. [given] a change in the tax laws … [to allow] reintroducing production payments to some of the producers… [where] we took a lot of the risk out of that curve by going in and just buying their production for them.

I mean, if we wanted 20 million a day, we bought 20 million a day. And let them take the risk on the decline curve of trying to get through the rest of the gas. So, you know, we were making adjustments to the concept from day 1.

It was interesting . . . McKinsey had all these Harvard guys in here running the pipeline . . . we had – I can’t remember the individual’s name – we had one guy that we got from Amoco who was a University of Chicago PhD, and he really was the architect of the pricing for the gas market. We used him every time. We had meetings every morning and we’d look at where we were with supply and where we were with sales and we would adjust that model every day and say O.K., we can’t sell . . . if we sell a three-year contract, it’s got to be at this price….

Ken Rice actually was running the operation, our sales group, out of the northeast. He was the one negotiating with Elizabethtown and Brooklyn Union and others. So, we would get that whole group of people with our supply people together and say, “O.K., we’ve got this sales potential. What’s the supply opportunity and how do you price it?” So, it was a dynamic process that was going on, I mean, almost every day. Like I say, we would be there at 7:00, 7:30 every morning and there would be 15 people in the room going through the daily status. That is the reason I kind of got drained.

Jeff helped put the initial pricing model together and, you know, I would say that McKinsey’s scare model [of John Sawhill] was a selling tool with the utilities. But [Jeff] was a consultant at McKinsey at the time. He didn’t have the authority to do anything.

 

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5.4 Global Warming and Greenhouse Gases

Climate change, as documented in James Fleming’s Historical Perspectives on Climate Change (1998), has been a societal and intellectual issue for far longer than the global warming scare of recent decades.

The 1945–75 global cooling inspired informed conjecture of a coming Ice Age. In the Preface of Lowell Ponte’s The Cooling (1976), climatologist Reid Bryson opined (p. xi) that many specialists expected a long-term cooling, not warming, trend. A man-made component to global cooling, sulfur dioxide (SO₂) emissions from coal-fired power plants, was implicated. (SO₂ would be central to the acid-rain controversy that resulted in 1990 amendments to the Clean Air Act.) The head of the Climate Project for the National Center for Atmospheric Research, Stephen Schneider, was a notable coolist.

Beginning in the mid-to-late 1980s, global warming replaced global cooling as the focus and fear of the climatology community. There was an ecological bias at work from the nature-is-optimal, man’s-influence-cannot-be-good perspective. This dominance has been questioned in light of the “Pause” of global warming that began in the late 1990s and continued for two decades.

 

1. Carbon Dioxide

Carbon dioxide (CO₂) is the major anthropogenic (man-made) greenhouse gas (water vapor is the predominant greenhouse gas overall). While having less forcing properties than methane (CH₄), CO₂ lasts far longer in the atmosphere. In terms of recorded global warming potential associated with emissions between 1750 and today, CO₂ constitutes 60 percent of the basket of man-made greenhouse gases. (This section is taken from Bradley, 2003, pp. 72–75).

CO₂, a natural by-product of mineral energies, has known positive properties. It classically has not been categorized as a pollutant but as a building block of a living and vibrant biosphere. There is a well-documented positive relationship between airborne carbon dioxide concentrations and plant growth and productivity. Plant respiration, water-use efficiency, and the ability to handle weather stress are enhanced by elevated CO₂ in the amounts experienced or projected in the carbon energy age. As CO₂ concentrations rise, the temperature optimum for most plants increases as well.

Optimum atmospheric CO₂ level for biosphere productivity from enhanced photosynthesis has been estimated at between 800 and 1,200 parts per million volume (ppmv). In this range, experiments indicate that plant growth is stimulated to maximize vegetative and biological productivity, other things equal.

The mid-point of 1,000 ppmv can be compared with today’s estimated level of 405 ppmv and two projected levels by 2100. Using the most recent 25-year average increase (1.54 ppmv per year) leads to a projected level of 522 ppmv; the IPCC-projected increase to approximately 715 ppmv. An unhealthy CO₂ level for humans is around 15,000 ppmv, which is conceivable inside a deep coal mine but not out in the open air.

Today’s CO₂ level, approximately one third greater than in the mid-nineteenth century, is estimated to have increased plant and crop biomass and productivity in the agriculture and forestry sectors by 10 percent or more. Carbon fertilization and related anthropogenic effects are a reason why global food production is at record levels.

A doubling of CO₂ from today’s level is expected to increase biomass and economic yield by 10 per cent for “C4 plants” like corn and sugar cane, and as much as 33 per cent for “C3 plants” like rice, wheat, potatoes and vegetables. This fertilization effect could also spur undesirable plant growth and pest populations, problems that improving technology can be expected to address.

Continued carbon-energy usage in future centuries could bring atmospheric CO₂ levels into the optimum range. The climate effects (warmer nights, increased precipitation) associated with such elevated CO₂ concentration would have benefits for plant growth and productivity as well.

 

2. Key Questions

In the context of energy sustainability, anthropogenic (man-made) climate change has become the major issue confronting the modern carbon energy economy. Other energy “sustainability” issues such as depletion, pollution, and reliability (security) have proven amenable to market incentives, technological progress and, in some cases, government regulation.

Key questions are: What does atmospheric science (climatology) currently conclude about the anthropogenic influence on global and regional climate? What does the relatively new specialty of climate economics, or more broadly climate political economy, conclude about the future benefits and costs of the human influence on climate? And, most important, what public policies towards greenhouse gas emissions are supported by the balance of evidence presented by climate science and climate economics?

Answers to these questions point towards climate optimism and policy restraint. The human influence on climate—tending towards warmth, moisture, and carbon fertilization—promises significant benefits to offset anticipated costs. The evidence to date of the anthropogenic influence has been moderate and benign. Climate models suggesting a far worse future have trouble squaring this with the past and depend on highly simplified physical representations of climate. Such simplification is prone to being falsified by more realistic (and complicated) climate processes that are now becoming better understood.

Turning to public policy, government intervention to “protect the climate” or “slow climate change” has a surprisingly limited impact on overall carbon emissions and a predictably large negative impact on energy availability, dependability, and affordability. The panacea of renewable energy is problematic on environmental and non-environmental grounds upon close inspection.

 

3. Industry Notice

Enron’s notice and amplification of the global warming issue reflected the urgency of the issue in the mainstream press and in the energy trade. Then-Senator Timothy Wirth (D-CO), for example, told the Natural Gas Roundtable in Washington in mid-1988 that natural gas would “play an important role in dealing with the greenhouse effect, since natural gas emits far less carbon dioxide than do other fossil fuels” (“Wirth Says”). At the World Gas Conference, the head of Ruhrgas AG of West Germany embraced gas as helping make “the transformation from the fossil fuel age to the era of non-fossil fuels in the next century” (quoted in McConnell).

The legion of groups and journalists reporting on environmental issues, for whom gas wore the white hat among the fossil fuels, led Mick Seidl to reminisce (Berger):

At Enron, we always had a sensible environmental ethic. We tried to be as green as possible. We were pushing natural gas as an alternative to diesel fuel and coal, which are heavier polluters. We always cared and talked about the environment because we thought it gas us a competitive advantage.

Seidl added:

I’m not an apologist for capitalism, not am I an apologist for the environmental movement. I’m an apologist for good common sense.

 

 

 

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References for Chapter 5 Appendix

 

Alger, Dan, and Michael A. Toman. “Market-Based Regulation of Natural Gas Pipelines.” Journal of Regulatory Economics 2, no. 3 (1990): 262–80.

Allison, W. V. “Request for Rulemaking—Hadson Gas System, Inc., Enron Interoffice Memorandum, August 26, 1986 (copy in the author’s possession).

Berger, Kevin. “The Superfund.” San Francisco Magazine, June 29, 2006.

Bradley, Robert, Jr. Climate Alarmism Reconsidered. London, UK: Institute for Economic Affairs, 2003.

Bradley, Robert, Jr. Capitalism at Work: Business, Government, and Energy. Salem, MA: M & M Scrivener Press, 2009.

Bradley, Robert, Jr. Climate Alarmism Reconsidered. London: Institute for Economic Affairs, 2003.

Bradley, Robert, Jr. Edison to Enron: Energy Markets and Political Strategies. Hoboken, NJ: John Wiley & Sons; Salem, MA: Scrivener Publishing, 2011.

Bryson, Reid. Preface to Lowell Ponte, The Cooling. Englewood Cliffs, NJ: Prentice-Hall, 1976. pp. xi–xii.

Crowley, Lawrence. “Enron Corporation,” Rauscher Pierce Refsnes. March 5, 1993.

Enron, Annual Reports, various.

Fleming, James. Historical Perspectives on Climate Change. Oxford: Oxford University Press, 1998.

Foley, Cheryl. “FERC Conference on Marketing Affiliate Rule,” Enron Interoffice Memorandum, October 22, 1987 (copy in files).

McConnell, Beth. “Congress Responds to Greenhouse Gases.” Natural Gas Week, August 15, 1988, 2.

Valdez, William. “Gas Industry Squabbles Again Over Marketing Affiliates Issues,” Natural Gas Week, October 26, 1987, 1, 4.

Valdez, William. “Pipeline Marketing Affiliates Rile Independent Gas Brokers,” Natural Gas Week, September 8, 1986, 1, 4–5.

“Wirth Says Gas Plays Role in Cooling Greenhouse Effect.” Natural Gas Week, June 20, 1988, 7.

Interviews

Bennett, Gerald. Interview by Robert L. Bradley Jr., Houston, TX, May 13, 2006.

Wasaff, George. Interview by Robert L. Bradley Jr., Houston, TX, March 7, 2001.