A Deluge of Regulation

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

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

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

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

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.