Competition in the Electric Industry: Emerging Issues, Opportunities, and Risks for Facility Operators (1996)

Donald M. Black

Enron Capital and Trade Resources

My company, Enron Power Marketing, is the nation's largest power marketer and its third largest wholesaler of electricity, behind the Tennessee Valley Authority and the Bonneville Power Administration. Enron is a company with $9.2 billion in revenues and assets of $13.2 billion. Enron's electric power marketing business and trading activity in electricity began in June 1994 and has developed quickly. Last year Enron bought and sold about 7.8 million megawatt-hours, and it is on pace to exceed that amount in 1996. At this pace of growth, Enron could conceivably be the largest utility in the country in a few years.

The wholesale market for electricity is about $90 billion annually. That makes electricity by far the nation's largest commodity business. By comparison, the natural gas market is around $30 billion. Even more impressive is the retail market for electricity, which is in excess of $200 billion. There is a tremendous amount of money at stake here.

Enron is in the business of structuring long-term custom energy contracts designed to lower customers' costs. Enron trades natural gas, gas liquids, and now electricity as commodities. Our trading activity is conducted on a trading floor that is very similar in appearance to a typical securities trading floor on Wall Street. Our hourly traders deal in the real-time market, buying and selling the commodity hour-to-hour and day-to-day. Mid-market traders focus on transactions and opportunities within the next year, such as selling into scheduled outages of generating units or arranging seasonal exchanges between utilities in different parts of the country. Long-term marketers, of which I am one, focus on longer term,

more sophisticated transactions. These professionals include power marketers, gas marketers, an independent power producer (IPP) group (New York and California are two of our favorite locations for IPP activity), and an industrial services group which concentrates on the energy requirements of key industries in the United States, such as metals, paper, and petrochemicals. Enron is also very active in finance and currently has more than $1 billion in loans and other financial assets closed. Recently we started looking at financing activities including equity positions in end-user companies (i.e. retail load) to supplement activities in power and gas contracts.

Enron is a power marketer, not a power broker. Unlike a broker, it takes title to the commodities it sells. Its profit is the difference between the bid (to buy) and the offer (to sell). Brokers, on the other hand, arrange transactions, matching buyers with sellers and taking fees without taking positions. Enron's business entails entering into and managing risk positions. A broker takes no risk.

Enron is a commodity dealer, trading in electricity and natural gas and managing the risks of doing so. Information is the vital element of any commodity business, and whatever entity can accumulate the most information and act on it most quickly will have a competitive advantage. The trading floor is designed to let Enron's professional traders assimilate and act on information quickly. At any moment, they know exactly where power prices are trading throughout the country. Enron's traders also monitor moment-to-moment wheeling costs and availability and the locations of bottlenecks in the transmission system, so they can take advantage of arbitrage opportunities as they occur and generate market liquidity. The market for energy is developing to the point that power follows price signals, and Enron believes that at some price it will always be able to buy the necessary capacity and energy to meet its requirements.

Enron's lack of a reliability track record is one issue I face routinely as I pursue business. We have been in this business less than two years; most of the competition has been in the business far longer. When

one of our counterparts enters into a contract with Enron, they are assuming the risk of whether Enron will be there to meet its obligations during the term of that contract. Why, then, do energy users buy from Enron rather than their traditional utilities, which have been in existence for decades?

One reason is that Enron has been in the natural gas business for more than 10 years, with an excellent record. Second, it has been absolutely reliable as a power supplier over our two years of power marketing activity. Most important, perhaps, is the fact that there is no longer any guarantee that the traditional local utility supplier (Enron's competition) will be in business over the term of any contract they may sign either. Every single utility is transforming itself, and many are trying to operate the way Enron does. Finally, nearly every U.S. utility trades with Enron. They are beginning to recognize us as a reliable source, so why should other customers not?

Timing is everything in commodity markets. I believe now is a good time to enter into long-term contracts for power. The American power market is in oversupply in relation to demand, partly because the franchised utilities have built an infrastructure that was designed to be 100 percent reliable. As a competitive market for capacity and energy evolves and the distinctions between utility service territories begin to blur, that infrastructure begins to overlap between utilities and become redundant. With open access to the nation's transmission grid now guaranteed through the Federal Energy Regulatory Commission's (FERC) Notice of Proposed Rulemaking, power can now go anywhere, and the transmission necessary to wheel power must be made available. As a result, the spot market is trading on a marginal cost basis. Power marketers and other market driven participants can offer contracts for far less than it would cost to build generating capacity. Over time, we know the imbalance will correct itself, in part because little new capacity is being built. However, we do believe most of the capacity that will be built in the next decade will probably be natural gas-fired plants located near load centers.

The spot market for power is becoming increasingly liquid. Out of the liquid spot market will come a more liquid longer term market. Therefore, I believe that buyers have an opportunity over the next two years or so to take advantage of long-term contracts for portions of their

requirements. I don't suggest that customers "bet the farm," but instead that they would be wise to think of their power supplies as a portfolio, with some long-term, some mid-term, and some short-term positions.

The largest market for long-term wholesale deals is the nation's municipal systems. Enron is pursuing this market aggressively. So are the investor-owned utilities, which have spent the past year or more trying to arrange long-term contracts with these wholesale loads. The utilities know they must shore up their customer bases as they reengineer their companies in preparation for deregulation. But the utilities still have trouble binding themselves to 10-year fixed price contracts. So far I have seen the utilities offer fixed prices for 3 to 5 years, but thereafter prices typically float according to an index of fuel costs or other standards. Enron today offers fixed-price contracts out to 20 years for baseload, intermediate load, and peaking firm energy and/or capacity, along with a variety of ancillary services that will become available as the transmission-owning utilities file their tariffs for unbundled services.

As retail competition in the power markets becomes a reality, these same evolving markets will allow the formation of service companies that aggregate load and provide power for retail customers. Such a firm could hire a few traders to buy, in real-time, the cheapest energy available from moment-to-moment. In that way, a household could take advantage of spot prices from whomever is selling at the lowest price at the time.

As the spot market continues to develop and market indexes are created, an active financial (not physical) market will arise. That market will help buyers and sellers hedge their risks without having to purchase the actual commodity. With indices, power marketers will be able to set caps on a buyer's energy prices, permitting a buyer, for example, to deal in the spot market until the price reached a preestablished cap. Or an energy user could sell a power marketer a floor on prices, so the price would float until it reached the floor. On an energy user could buy a collar, which allows the price to float within an interval. The variety of such products is limited only by the demand for risk.

Enron has arranged a contract with Oglethorpe Power Corporation in Georgia under which Enron meets Oglethorpe's entire load, at a fixed price that is lower than Oglethorpe would have otherwise charged itself.

Enron is dispatching the system according to the momentary market price, running Oglethorpe's generating units only until the market price is cheaper and then buying from the market. In essence, Oglethorpe has hired Enron to run their system, and appears to be very pleased with the results.

Unfortunately, federal agencies cannot yet take advantage of these opportunities. Section 8093 of the 1988 Department of Defense Appropriations Act, in essence, forbids federal installations from buying power against state laws that typically set franchise rights for utilities. Tremendous savings would be available to the agencies, and ultimately the taxpayer, if this barrier were lifted.

In general, I warn you to beware of delaying tactics designed to slow the opening up of power markets to competition. One potential argument for delay is the need to conduct adequate technical assessments on the impacts of deregulation. Technical assessment is appropriate, but if assessment is used as a veiled delaying tactic to give utilities a chance to shore up their balance sheets and prepare themselves to compete, then it is not in consumers' interest. Again, timing is everything, and the time to move is now.