August 2002

"Doggone"

by Roger Feldman  --   Bingham, Dana L.L.P.
(originally published by PMA OnLine Magazine: 2002/11/27)
 

The dog days of summer have arrived. At the flicks, it’s Scooby Doo. In the serious tabs, it’s the cry for market "watchdogs." Canine-mania seems to extend to the quality of politicians’ performances regarding restoration of faith in markets’ operations and accounting numbers.

Everyone says they want a watchdog now for some facet of the economy’s operation. Recent events have led commentators (and, evidently, the investing public) to the radical conclusion first articulated by Adam Smith and resurrected last by the New Deal: markets need oversight, if they are to maintain the credibility needed to be effective capital allocators. A subset of this principle in the deregulated energy industry is: market participants need the specificity of a detailed oversight approach, if those markets are to perform in the public as well as the private interest. But energy companies already have a watchdog – the regulators put in place to watch the regulated industries. Right? Maybe, wrong.

At the core of the promise of electricity deregulation was the role of trading markets, making possible far greater movement of power than had been the case when wholesale utilities periodically accommodated their respective needs through inter-regional wholesale trades. Improved reliability, price reduction, and smoothing of rates were all results to be anticipated. The confluence of electronic trading capability with deregulation was further touted as enhancing their trends, as well as making possible new wealth creation through financial products trading. One of the ongoing rhetorical cornerstones of deregulation proponents – post-Enron – has been that market liquidity gaps were quickly closed after the demise of the largest player.

Now, however, the vision of electrons being virtually moved in time and in response to true market needs has begun to fade. "Energy Woes Drain Online Power Trading" announces the Wall Street Journal, citing the demise of additional major trading players like Dynegy, and the sharp pull-back of many of the market leaders. The resulting switch back to older trading outlets – and lower tech trading modes – in turn promises to bring a new level of unpredictability of energy prices, as a diminishing number of trading outlets scramble for business.

In addition, the possibility of significant takeovers within the industry has been raised, as many of the familiar leading players in trading face deep market discounts and the prospect of a wave of takeovers is presented. Balance sheet pressures and executions of asset sales programs seem likely to create additional uncertainties.

In short, absent restoration of market operations, deregulation faces less liquidity, potential greater possibilities for control of markets by a few parties, and more volatile prices.

With these present and looming threats in mind, we turn with anticipation and concern to the response of the mother of deregulation – the Federal Energy Regulatory Commission. Its capabilities were most recently assessed in a GAO study entitled "Concerted Actions Needed by FERC to Confront Challenges that Impede Effective Oversight" (the "Study").

What we learn from the Study might, without exaggeration, be summarized as follows: FERC

Incidentally, the Study insightfully confides, some of its difficulties also reside in the absence of suitable legislation for carrying out these missions. The Study makes a few important constructive observations, which it reiterates several times in different forms (either its authors are paid by the word or were mesmerized by a college rhetoric teacher regarding the power of repetition):

Finally, at the heart of the Study’s matter, are its "Recommendations for Executive Action." The suggestions are, as they relate to the trading function, at once so fundamental and yet so seemingly out of reach of the agency as to raise a real sense of what Winston Churchill referred to as his "black dog" (i.e., depression). Picture the state of the securities world, if a GAO report or the SEC felt compelled to recommend measures such as these, which it commends to the FERC:

• "Update the agency’s strategic plan to include outcome measures that can be used to assess how well FERC is doing in achieving its strategic goals and objectives for overseeing competitive energy markets."
   

• "Develop an action plan for overseeing energy markets, in particular for electricity, until the transmission organizations’ market monitoring units become fully operational and FERC can implement a comprehensive oversight approach for these markets."

It should not be surprising that, in light of the Study’s findings, Congressional reconsideration of the Feinstein derivatives trading regulation bill re-introducing the CFTC to the energy trading picture is receiving attention. Nor that the Congressional effort to cause FASB-reform of "market to market" accounting procedures is not focused on that agency, whose regulated commodity is the one whose trades are the ones to be marked to market. What would one expect relative to an agency unable and unwilling to monitor swaps and eliciting the comment from the Study that, unless it opts to do so and compares simultaneous behaviors of participants in other markets, it would be difficult to identify instances of market manipulation.

Meanwhile, the screens blink off across the energy trading map and liquidity of available power returns as an issue, particularly as the heat of the summer dog days beats down, rekindling memories of summer shortages past. The realization dawns that, while there may be times to teach an old watchdog new tricks, there also are times to consider whether trading is a dogfight to which the current watchdog is well suited at all. Unfortunately for the unregulated trading power industry, the latter conclusion offers no friendly hydrant to stop at. The industry must offer up oversight alternatives that are credible. And in this political season where watchdogs are in and lapdogs are out, if such suitable action is not taken, industry trade proponents may find themselves between a Rottweiler and a closed kennel place. A possibility that seems to be closing in.

ROGER FELDMAN, Co-Chair of Andrews Kurth LLP Climate Change and Carbon Markets Group has practiced law related to the finance of environmental and energy projects and companies for 40 years.  In particular, he has analyzed and executed a wide variety and substantial value of project financings.  He chairs the American Bar Association’s Committee on Carbon Trading and Finance, serves on the Board of the American Council for Renewable Energy, and has been a senior official in the Federal Energy Administration.  He is a graduate of Brown University, Yale Law School and Harvard Business School.