Francis Kimberly thinks he knows a thing or two about what’s wrong with corporate America.
As an original investor in Northern Natural Gas, the firm that later became Enron Corp., he watched as the company was transformed from a stable, regulated natural gas pipeline business into something so complex that few people understood what it did, much less how it made money.
“If you bought Northern Natural Gas in 1950 it was just like buying IBM or General Motors,” said Kimberly, 73, who began purchasing the stock soon after joining the company at age 23. “It was a `widows and orphans’ blue-chip stock.”
Kimberly retired in 1984, shortly before the then Omaha-based business merged with Houston-based Enron and the focus of the business became, as he put it, “trading floors and all that junk.”
Enron ended in catastrophic failure, when the energy concern filed a $49.8 billion bankruptcy late last year. Revelations of the company’s web of mysterious off-balance-sheet partnerships, failed far-flung investments and manipulation of the distressed California power market underscored the growing realization that something in this newfangled business was fundamentally wrong.
Enron has been followed by a steady stream of corporate accounting scandals that extend beyond the energy industry, including those at three telecom giants, WorldCom Inc., Qwest Communications International Inc., and Global Crossing Inc., and at the manufacturing conglomerate Tyco International Ltd.
But the fact remains, observers say, that the energy business is a case study of what could–and did–go wrong in American business over the past decade. A parade of “new-breed” energy companies, many with roots as regulated utilities, rushed into the seemingly lucrative business of power trading. They loaded up on debt, bought power plants and other utilities, expanded into overseas energy exploration and began frenetically swapping power among themselves and with the states and municipalities that needed it. All the while, they booked incredible–and, in hindsight, impossible–profits on their complex webs of transactions.
Now, one after another, many of them are fessing up to severe problems in the way they did business and watching their stock prices plummet.
Enron’s implosion shook the banking industry and the financial markets to their cores, costing investors billions of dollars. CMS Energy Corp., Reliant Resources Inc. and Dynegy Inc., which owns downstate utility Illinois Power, all confessed to executing “wash” trades, dummying up power transactions to inflate their revenue.
Nicor, provider of natural gas to nearly 2 million Illinois residents, admitted accounting problems and is being investigated by the Illinois attorney general’s office, the Illinois Commerce Commission and the state police.
Ripe for mischief
“The energy business opened up enormous opportunities for mischief,” said Robert McCullough, a Portland, Ore.-based energy analyst and former executive at Portland General Electric, one of Enron’s power company acquisitions. “Not only was it more complex than other businesses, it was less regulated. The business was complicated and conducted largely behind closed doors, and that led to a situation that was rife for corruption.”
To a certain extent, these scandals are a byproduct of the 1990s’ bull market, when many industries went through profound transformations, morphing into new entities eager to win Wall Street’s favor by reporting ever-higher profits.
But the roots of the industry’s problems don’t lie merely in what Federal Reserve Chairman Alan Greenspan recently called an “infectious greed” that had invaded certain regions of the American business landscape. Rather, the source of the changes stretches back to the 1970s, when the industry started on the path to deregulation.
Back then the electricity industry was balkanized into territorial monopolies, which by and large did everything, including generation, transmission and distribution of power. There were minor connections among utilities that allowed them to sell small amounts of excess power to help each other out in the occasional power crunch.
“In the good old days … utility cash flows were considered to be rock solid,” said Jon Kyle Cartwright, senior energy analyst with brokerage firm Raymond James. “Utilities were in the business of building power plants, issuing bonds to pay for the construction and raising rates to pay for the bonds. Those days are over.”
Population shift plays role
As the U.S. economy expanded and the population started to shift from northern areas to southern cities and states, a dramatic imbalance in electricity started to build. In order to deal with that problem, the government started to deregulate the industry.
“In the 1970s, you get a gradual separation of production from shipping,” said Sam Peltzman, a professor at the University of Chicago Graduate School of Business. “You get the development of a wholesale electricity market and the shipping of electricity for thousands of miles.”
Once that happened, an electric company in Montana was able to sell electricity to Los Angeles, whereas before every utility was usually self-contained.
What followed was deregulation of power markets by a succession of states and a series of congressional and regulatory actions that encouraged power transmission and trading.
Since then, the power industry has become increasingly separated into producers (or generators) of power, known as the merchant energy industry, and the distributors of power, which are generally local regulated utilities that have monopoly ownership over the wires that transport electricity to homes and businesses.
“These businesses are more risky than they used to be; there’s no doubt about it,” Peltzman said. The power-generation companies face risks: They have to find customers and they have to take bets on construction, what to build, when and how to finance it.
Firms that have decided to stay regulated distribution businesses face their own set of risks: They have to secure power. Although they can hedge that risk with long-term contracts that allow them to lock in power supplies at set prices, they run the risk of locking into a long-term contract, then taking a loss if electricity prices plummet on the spot market, Peltzman said.
As deregulation progressed, the need for energy-trading “platforms” like Enron and Dynegy’s widely touted electronic systems, called Enron Online and Dynegy Direct, became apparent.
“The reason you have all the trading is that large chunks of the production are now traded into a spot market context that didn’t exist in the 1970s,” Peltzman said. “It started as a way for the incumbent regulated monopolists to trade among themselves. Now you have this merchant industry that speculates on the spot market and huge chunks of the industry operating on the spot market basis. In that situation, you have people willing to assume risks and others wanting to lay off risks.”
One principal problem for shareholders of energy companies, especially those that started as regulated utilities, was that they were in the dark about how the industry had changed.
“It appears that a large portion of the analysts, ratings agencies and investors didn’t seem to understand what was going on,” Cartwright said. “We didn’t realize how bad the lack of understanding was until Enron. Enron was evolving effectively into a brokerage firm. You can argue that it may not have even been an energy company when it blew up.”
Herd mentality
Paul Healy and Krishna Palepu of Harvard Business School theorize that a large segment of the investing community may not have acted on the knowledge of how drastically the energy business was reshaping itself, even if they had been better informed.
Most mutual fund managers, for example, are rewarded on the basis of their fund’s size and performance, relative to comparable funds. Enron was one of the hottest stocks of the late 1990s, and any fund manager who chose not to buy it probably would have underperformed his or her peers.
“This structure leads to herding behavior on the part of investors,” Healy said.
A deeper and more difficult question is how the remade energy firms of the 1990s became havens of questionable accounting. McCullough, the Oregon energy analyst, blames weak regulation by the Federal Energy Regulatory Commission, the Commodity Futures Trading Commission and the Securities and Exchange Commission, which he says allowed the firms to keep what they were really doing hidden from investors.
“To this day,” he said, “we still have an astonishingly opaque market. Almost everything is secret. For example, for 100 years the industry has had to file reports on their long-term contracts with the FERC. The companies still are required to do so, but there is an incredible effort to keep those reports secret. Less and less information is open to public view.”
Greed took over
Francis Kimberly, the Northern Natural Gas retiree who spent 32 years with the pipeline company, working in Iowa, Texas, New Mexico and his native Nebraska, is inclined to view the industry’s transformation from a sociological perspective.
“Many of our people were mayors and members of the town boards where we worked,” he said. “We’d build swimming pools for the communities where we operated. Everybody said we had the greatest company in the world. We did have a beautiful company, until it was overrun by greed.”
