A Deluge of Regulation by Chris Trayhorn, Publisher of mThink Blue Book, April 1, 2003 The casualties continue to mount in the devastated landscape of the post-Enron world. We know now that Enron was the beginning of the end of the euphoric, anything goes, expanding universe of energy, energy trading, and process of restructuring of electricity and natural gas markets — particularly if the restructuring initiative is motivated solely by a desire for unfettered competition. The parade of the 1990s is over, and much of the policy and legal effort is now devoted to the unpleasant cleanup. When the investigations and litigation are complete, when the bankruptcy proceedings grind to completion, and when the politics subside, lasting reforms will remain. The structure of those reforms across American business in general and the energy industry in particular are emerging. This paper notes important developments on two major fronts in response to the Enron denouement. These two partially parallel and ultimately intersecting worlds are: a general observation on the reform of the corporate oversight, accountability, and reporting rules; and key steps by the Federal Energy Regulatory Commission to reinvigorate compliance with and enforcement of the statutes FERC administers. So much has changed in the world of federal regulation of the financial activities of publicly traded companies, as well as in the federally regulated energy companies, that entire volumes could be written on these topics alone. This paper will touch on the highlights and point toward likely further trends, with a special emphasis on energy players, their activities, and regulation. New Mandate The massive reformation under the Sarbanes-Oxley Act of 2002 of the responsibilities of public companies, the function of boards of directors, and requirements for auditors and corporate attorneys continues to be implemented through the Securities and Exchange Commission. The mandate of Congress in the Sarbanes-Oxley Act has led the SEC to issue regulations embodying numerous sweeping changes to the American corporate scene — disclosures of deals, contractual obligations, and contingencies that previously lived in a luxury land off the balance sheet. Those halcyon days are over, as they are for the auditors and lawyers who created an environment in which fantasy islands rose from the sea of misleading financial statements. New, more vigorous standards of professional conduct are proliferating to meet new expectations in all aspects of their professional behavior. The pressure is building for all corporate professionals, and the process has already claimed high-profile victims in the maelstrom of political intrigue permeating Washington, including an SEC chairman. If these issues are so toxic as to be capable of forcing a respected longtime corporate lawyer out of the chairmanship, it is certain to be treacherous to those lesser mortals who cross into the forbidden zones that have been created by the post-Enron reforms. This new rigorous regime is for all of corporate America. Energy Sector Now, intensify the scrutiny, suspicion and skepticism about the basic integrity and transparency of a particular industry. Welcome to the problematic world of the energy industry. Beleaguered for years by regulation that was unpredictable except for its unpredictability, the energy industry had, like a newborn colt, just gotten up on its legs and was taking its halting free-market steps. Unfortunately, due to greed, confusion, disconnects between and among different industry segments, even in the same company, far-fetched nightmare became ugly reality. The much-ballyhooed energy trading business was deconstructed in a matter of months. Investigations by Congress, the Department of Justice, the SEC, FERC, the Commodities Futures Trading Commission (CFTC), the states, other governmental entities worldwide, and other players ensued and are still going at full force. Every paranoid, sweaty dream of the deregulation unbelievers about what might happen if the gas and electric industries were set free from regulation came true. FERC Under the Microscope The reaction from political quarters to FERC’s regulatory efforts over Enron’s empire “before the fall” have been critical. The General Accounting Office issued a report entitled “Energy Markets: Concerted Actions Needed by FERC to Confront Challenges that Impede Effective Oversight.” That report found that FERC faced key challenges in overseeing energy markets with respect to: changing the commission’s organizational structure to improve the effectiveness of its oversight program; defining and implementing an effective approach to overseeing competitive energy markets; and addressing human capital needs. In addition, the report found that new statutory authority and guidance from Congress would enhance FERC’s ability to develop, regulate, and oversee competitive energy markets. The Permanent Sub-Committee on Oversight and Investigations of the Senate Government Affairs Committee later issued a report after its investigation of the relationship between FERC and Enron. That report, one of several oversight reports on the Enron debacle, found that although FERC did not directly regulate Enron Corp. (essentially a holding company for the company’s many and diverse operating subsidiaries) as a corporation, per se, FERC had jurisdiction over many of Enron’s energy marketing, generation, and transmission subsidiaries and activities. Jurisdiction Entities In response to the committee’s request, FERC identified 24 electricity marketers, generators, or transmitters, 15 gas pipelines, and five oil pipelines that are or were Enron subsidiaries or affiliates and that either are so-called “jurisdictional entities” under the Federal Power Act, Natural Gas Act, or Interstate Commerce Act or are qualified facilities that must be certified by FERC under PURPA. In addition, Enron appeared to have several other electric affiliates subject to FERC’s jurisdiction or certification requirements. Not surprisingly, therefore, FERC had many contacts with Enron concerning Enron’s FERC-regulated subsidiaries and affiliates over the 10-year period examined by committee staff. The vast majority of these involved routine matters such as rate filings, reporting requirements, and system operation. Enron was aggressive about using, and seeking to use, the regulatory process to further its business goals and to protect its economic interests in matters within FERC’s purview, from the promotion of the deregulation of the electric and natural gas markets to FERC’s response to the California situation. Enron intervened in dozens, if not hundreds, of proceedings before FERC to this end. In investigating the role of FERC, the Senate’s investigation identified four specific areas of concern: • Enron’s sale and repurchase of certain wind farms. • The activities of Enron Online, theelectronic trading platform run by the company. • Transactions conducted between Enron and certain Enron-affiliated companies. • The impact of Enron on the California energy price run-up of 2000. FERC Criticized The oversight hearing found that FERC had, in the committee staff’s view, lacked determination to scrutinize the company’s activities. Further, FERC’s failure to structure the agency to meet the demands of the new, market-based system that the agency itself has championed was criticized. The concession was whether the disclosure of any of the individual activities would have prevented Enron’s collapse; that more proactive, aggressive action by FERC would have limited some of the abuses that appear to have occurred, raised questions about Enron’s trading practices and other business activities, and exposed at least some of the cracks in Enron’s foundation earlier. Perhaps scrutiny by FERC (or the SEC or others) would have also jolted the Enron board of directors and Enron itself into acting to change direction. At a minimum, investors, analysts, and other regulators may have looked more closely at Enron. As could be expected, FERC has begun to take major steps to prevent Enron-esque disasters in the future. FERC Probe In response to allegations that Enron may have used its market position to distort electric and natural gas markets in the West, the commission initiated a fact-finding investigation into whether any entity, including any affiliate or subsidiary of Enron Corp., had manipulated electric energy or natural gas prices in the West since the start of 2000. In conducting this investigation, FERC staff is coordinating closely with the Department of Justice, the SEC, the CFTC, and the Department of Labor. During August 2002, FERC staff released an initial report of its investigation. The report concludes that published indices of electricity and natural gas prices in or near California during the recent crisis may not be sufficiently reliable to be used in setting refunds for wholesale power buyers in California. Based on its staff finding, FERC requested comments on whether it should change the method for determining the cost of natural gas in calculating the refunds for power sales in California from October 2000 to June 2001, and if so, what method should be used. Investigation continues FERC pursued a comprehensive investigation of a variety of factors and behaviors that may have influenced electric and natural gas prices in the West during 2000-2001. The final report will include: • An explanation of Enron Online operations and the role they played in the energy markets. • An analysis of sales data collected from information requests. FERC staff will explain the results of the statistical analysis of such data, including findings of how, and to what extent, forward prices directly correlate with spot energy prices. • An analysis of wash trades in electricity and natural gas markets in the West. • A discussion of FERC staff’s findings on allegations that Williams Co. had attempted to manipulate natural gas markets in the West. • An analysis of the relationship between physical and financial natural gas and electric products. • Recommended standards and protocols for how to identify and deal with possible physical withholding. • Further analysis of the extent to which Enron’s trading strategies had an effect on other products, such as long-term physical and financial contracts. General Reforms at FERC In parallel efforts, FERC approved a final rule directing public utilities, licensees, natural gas companies, and oil pipelines to report changes in fair value of certain investment securities, derivatives, and hedging activities. The treatment is consistent with the reporting standards of the SEC and the Financial Accounting Standards Board (FASB) and is consistent with the rulemaking proposed by FERC. The commission severed from the final rule its inquiry whether independent and affiliated marketers and power producers should be available for waivers of certain accounting rules on a case-by-case basis. The final rule imposes more comprehensive reporting requirements that are intended to enhance the transparency of financial information and facilitate FERC’s knowledge of the nature and extent to which regulated companies use derivatives and hedging activities and how those transactions affected utilities’ reported financial condition. In recent years, the use of fair value measurements, which assist investors, creditors, and other users of financial data in making investment and credit decisions, have grown in importance. As regulated utility industries restructure, fair value will increasingly provide a relevant measure of economic effects for a growing number of transactions. The final rule is intended primarily to address reporting consistency needs, while entities such as the SEC and FASB search for better ways to estimate the current value of future instruments. Another step taken is a proposal by FERC to change its Uniform System of Accounts to establish more transparent, complete, and consistent reporting of liabilities associated with the retirement of tangible long-lived assets and related capital costs. An asset retirement obligation is a legal obligation associated with the retirement or decommissioning of a tangible long-lived asset that an entity is required to settle by virtue of a law, statute, ordinance, or contractual obligation. Current FERC regulations do not provide specific direction for the recording of these costs, which commonly include removing and/or dismantling the asset. The proposed changes would be consistent with current SEC reporting requirements. A New Office FERC also created a new Office of Market Oversight and Investigations (OMOI) reporting directly to the commissioners. The OMOI encompasses two units that function independently but work closely together. The Market Oversight and Assessment unit reviews developments in the market on a real-time and longer-term basis and spots irregularities. As problems arise and are identified, an Investigations and Enforcement unit will bring swift, decisive, and effective enforcement. The office will hopefully serve as an early warning system to alert FERC when market problems develop. The office is working with a variety of entities, including other federal, state, and provincial regulatory agencies, state consumer advocates, industry participants, academic institutions and think tanks, financial institutions (such as ratings agencies), and market monitoring units (MMUs) at regional transmission organizations and independent system operators, designed to let them know that FERC is developing a market oversight capability. The OMOI has more than 100 employees budgeted and has attracted sophisticated, dedicated players. Its impact is already being felt in the regulated community. Outside FERC FERC is building on the relationships established over several years of quarterly meetings with the Department of Justice and the Federal Trade Commission. FERC and CFTC staff have jointly deposed or interviewed more than 100 individuals in the Western market investigation. The two agencies have also jointly developed and shared discovery responses each has gathered from its respective regulated entities, a major jurisdictional leap. FERC has entered into information-sharing agreements with Justice, the SEC, and the CFTC with respect to the investigation, and these agencies are also coordinated under the Deputy Attorney General for the broader investigatory efforts of the president’s Corporate Fraud Task Force. FERC legal staff has coordinated with the CFTC regarding each agency’s respective jurisdiction over energy market activities. These are important steps to reestablish meaningful oversight of immensely complex businesses. Hopefully, FERC’s initiatives will lead to a restoration of faith in the industry by regulators, investors, and participants. It is a beginning, filled with promise and peril for all. Filed under: White Papers Tagged under: Utilities About the Author Chris Trayhorn, Publisher of mThink Blue Book Chris Trayhorn is the Chairman of the Performance Marketing Industry Blue Ribbon Panel and the CEO of mThink.com, a leading online and content marketing agency. He has founded four successful marketing companies in London and San Francisco in the last 15 years, and is currently the founder and publisher of Revenue+Performance magazine, the magazine of the performance marketing industry since 2002.