Kochland Page 34
Figuring out the cost of electricity was only part of the equation. The Koch traders also had to figure out the legal parameters of the California market in the bill passed by Stephen Peace.
The bill created a new market on which Koch’s traders could buy and sell megawatt-hours: a market called the California Power Exchange. It was basically a wholesale market where utilities bought power, thousands of megawatt-hours at a time, to meet their customers’ needs.
There was a wrinkle in this exchange that would later cause calamity. The prices on the Power Exchange could float with market conditions. But the prices that utilities could charge their customers for the power they bought on the exchange were frozen. The utility companies had pressed to freeze customer rates at high levels as a way to recoup the $20 billion to $30 billion in power plant upgrades the utilities made before the new law forced them to sell those same power plants. The state agreed to freeze electricity rates—at a price that was higher than wholesale power—so the utilities would be guaranteed a comfortable profit margin for the first few years of deregulation.
When everything went south later, trading companies like Enron, who were actually breaking the law, would scapegoat the rate freeze and call it a “price cap,” using it as evidence that California had created a distorted marketplace that was simply begging to be exploited. In fact, the rate freeze was not a cap at all but a floor—a guarantee that prices would be high enough for the utilities to recoup their sunk costs. It appears that virtually no one in 1998 believed that wholesale electricity prices might actually go higher in the age of deregulation. The law did not contain a clause that would unfreeze rates and allow them to rise if wholesale prices spiked.
There was one more vital piece to the California law that would cause problems later. This was the emergency system put into place to make sure that the utility companies wouldn’t lose power if nobody was selling megawatts on the Power Exchange. To make sure the system was reliable, California created a new nonprofit authority called the California Independent System Operator, which was based just outside Sacramento. This agency was like an air-traffic control tower—it was staffed with engineers and operators who made sure that the electrons were flowing on time and in proper volume. The Independent System Operator, or ISO, only came into play once trading was finished on the open Power Exchange.
The Power Exchange was a “day ahead” market, meaning that utility companies shopped there for electricity they planned to use the following day. After trading closed on the exchange, the traffic controllers at the ISO made sure there was ample supply for the following morning. If things started to look haywire for the next days, the ISO operators could buy the emergency supplies it needed to keep the lights on. These operators also had a special authority that didn’t get much attention in 1998—they could buy electricity at the last minute, at high prices, to shore up the grid if it looked like there was going to be a shortage. This was designed to be a safety net, and one that would be rarely used. The market was set up in a way to ensure that the Independent System Operator barely purchased any electricity.
Steve Peace, for one, believed that only a tiny fraction of electricity would be bought in emergency markets by the Independent System Operator. As it turned out, the higher prices on the emergency ISO market turned out to be too strong of a lure for the new traders at Enron and Koch to ignore.
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When Melissa Beckett started her day on Koch’s trading floors, she bought and sold electricity contracts in the same way other Koch traders bought and sold crude oil futures. But this time, her customers were the large utilities in California that had been stripped of their power plants and forced to buy megawatts on the open market. Beckett and her team of megawatt traders were one of the most important players in California’s new market.
Her trading desk wasn’t glamorous. It looked like the desk of a telemarketer. The traders sat shoulder to shoulder in their stations, speaking into black microphones, checking their computer monitors, occasionally glancing up at the large television screen suspended from the ceiling that gave them minute-to-minute headlines. Their desks were covered in drifts of papers and file folders, littered with empty coffee cups and boxes of Kleenex tissue perched on top of files.
Through the course of an average morning, Beckett called traders, brokers, and customers west of the Rocky Mountains. She greeted them by name—“What’s going on, Billy?”—and began to haggle with them over the cost of a megawatt-hour. She sounded casual, but Beckett was trading based on information, analytics, and the projections produced by Koch’s elaborate West Power Clearing Model.
California’s new electricity markets were ambling along peacefully during their first years of operation. Prices were relatively low, as legislators like Steve Peace had expected them to be, and the market was relatively stable. Most of the power was bought and sold in the day-ahead Power Exchange and very little power was traded in the emergency hourly markets, where prices were much higher.
But then, during the first days of January in 2000, the West Power Clearing Model began to produce some very strange numbers. It seemed that there was a supply crunch looming in California. The state had not built a new power plant in about a decade, and demand had been rising steadily. Water reservoirs were getting low, thanks to a dry year with little rainfall. A hot summer seemed to be on the way. Demand was high and supplies were tight, which meant that prices would soon be rising. This was essentially the same analysis that Brenden O’Neill was seeing on the natural gas desk. There would be a spike in both gas and electricity prices, which were closely connected.
There was a small problem, however. California’s day-ahead market on the Power Exchange had a price cap on it. This created a potential distortion in the market: the real price of power might float higher than the capped price, which would force producers to trade at a loss. There seemed to be some gaming going on in this market in response to the price caps—it looked like some utility companies were intentionally underscheduling their loads in the day-ahead market to try and evade the price caps. The traders believed that California’s new system was imperfectly deregulated because of the price caps, and they also seemed to believe that the state’s political leaders were too dumb to recognize the fact or change it. The traders weren’t sympathetic to the idea that they should abide by the price caps if the market dictated otherwise.
The thinking of Enron traders was captured in recorded phone calls, later obtained by investigators, which included gems such as: “Grandma Millie, man . . . now she wants her fucking money back for all the power you’ve charged . . . jammed right up her ass for fucking two hundred fifty dollars a megawatt-hour.”
It would be up to the traders, then, to figure out how to make the markets work in spite of California’s jerry-rigged system. In the spring of 2000, these traders were looking to do one thing—they were looking to “gain length,” as Beckett put it. They were looking to own megawatts and sell them at a price higher than the state-imposed price caps on the California Power Exchange. The only way to get a higher price for the megawatt-hours was to sell them in the small emergency market on the day that power was needed: the ISO market. But Koch was prohibited from doing this—only companies that owned a power plant and could promise to deliver the power on a given hour could sell into the ISO market. Koch needed to find a way to break into the hourly markets, regardless of what the rules said. Or, as Darrell Antrich would later put it when questioned by federal investigators: “We thus concluded that we were more likely to be profitable on our positions if we had the flexibility to carry our long positions into the real-time power market.”
Antrich discovered a pathway into the pricier ISO market almost by accident. He was meeting with a salesman for a power plant company named Tom Nesmith, who pitched Antrich a novel idea. It was called “parking.” It would deliver Koch the profits it desired in California. Federal regulators later determined that the trading technique violated the law.
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Antrich wasn’t looking for a new trading technique when he first met with Tom Nesmith. He just wanted information. There was one critical piece missing in Koch Energy Trading’s intelligence network. Koch Industries didn’t own any power plants, so it didn’t have access to the kind of inside information that made its energy trading desks so successful. Antrich was on a quest for such information, and he tried to get it by forming information-sharing systems with utility companies that owned the plants.
Antrich approached one such utility outside California: Public Service Company of New Mexico, or PNM, as most people called it. The company owned a power plant in Arizona that sold electricity into California. This meant that PNM could sell into the coveted ISO market. Antrich wanted PNM to sign a deal that would give Koch’s traders access to PNM’s inside information, such as information on plant outages, its own weather forecasts, and other data that could give Koch a head start on responding to changes in the market. In return, PNM would get access to Koch’s trading analysis, its secret in-house weather projections, and its forecasts on natural gas markets, among other things.
Antrich and his team drew up a consulting agreement for PNM that spelled out the information-sharing agreement, and he pitched it to Tom Nesmith. The salesman was interested in this arrangement. But he wanted to pitch Koch on a special opportunity: the parking trading strategy that Koch could execute in partnership with PNM. The strategy was apparently dreamed up by traders at Enron, and it was later judged to be illegal.
Enron traders seem to have invented the parking scheme sometime in the late 1990s. To execute a parking trade, a trader at Koch or Enron sold electricity from a power plant in California to a customer outside the state, like PNM in Arizona. This sale was made in the day-ahead market, where prices were capped. But the sale was bogus. The next day, when power was supposed to be delivered from California to PNM, the utility would suddenly sell the exact same amount of power from Arizona into California, and into the much pricier ISO hourly market. The two sales would be orchestrated to cancel each other out: 100 megawatts out of the state to PNM, and 100 megawatts into the state from PNM.
Here’s why the scheme was fraudulent: the electricity never made the round-trip journey that the paper trail would indicate. Instead, the power was generated at the original point inside California, and then sold to a customer in California the next day without ever leaving the state. It was only a paper game between PNM and Koch that made it look as if Koch had moved electricity from California to Arizona, and then back into California again. In reality, the power had just gone from point A to point B inside California. The reason this is so important is that, under the arcane rules of California’s system, the power from Arizona was allowed into the pricey ISO market, while the power from California was not.
Once PNM learned how to park power, it started pitching the service to trading companies. One trader was hesitant to sign up because he was worried he might get stuck having to actually deliver electricity across state lines. But Nesmith assured this trader by saying: “[L]uckily, you’re the guy with the hand on the throttle in this case.” Federal experts would later interpret that remark as showing that PNM always considered the parking transactions to be little more than a ploy on paper.
Nesmith understood that a company like Koch could make huge profits by parking power. Accordingly, PNM charged a high price for the service: according to Koch’s agreement with PNM, Koch paid an up-front fee of $345,600 to participate in the parking strategy. Koch also paid an additional fee of $1 for every megawatt-hour it traded through the parking deal.
On February 28, 2000, Koch Energy Trading signed a contract with PNM to park power in the coming months. The deal essentially allowed PNM to rent out its status as an out-of-state utility company, and allowed Koch to buy its way into the pricey hourly market in California.
Koch’s agreement with PNM allowed Koch’s traders to start parking power in July. But they began much earlier than that. Electricity prices spiked in May, thanks in part to the supply crunch that Koch saw coming through its supply-and-demand models. When prices spiked, parking allowed Koch to capture the opportunity. “I am excited about practicing in the next few weeks, as well as the opportunities the parking gives us for this summer,” Antrich wrote.
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On May 22, 2000, Koch Industries executed one of its first parking transactions. On that Monday, Koch sold 950 megawatt-hours of power into California’s Power Exchange. The price on that day-ahead market was high: Koch was paid $108.99 per megawatt-hour—average prices that month were about quadruple what they had been one year before. An unusual heat wave had driven up power prices sharply as businesses and residents cranked up their air-conditioning.
The state was facing a shortage of electricity and the Independent System Operator declared a stage 2 power emergency because reserves were below 5 percent. This meant that the agency could start initiating blackouts if demand stayed high, and the administrators were desperate to find backup sources of power to keep the lights on.
Koch’s parking arrangement allowed it to take advantage of this desperation. On the same day that it sold electricity into the Power Exchange, Koch’s traders “parked” 650 megawatts of power with the Public Service Company of New Mexico. This meant that Koch informed the state of California that it was planning to export the 650 megawatts to PNM the following day, even though Koch had no intention of doing so, according to federal investigators. The reported export was essentially a sham—Koch knew that when it came time to export the power, Public Service Company of New Mexico would report to the state it was sending the same amount of power into the state. This paper game allowed Koch’s traders to sell electricity in emergency markets that were otherwise off-limits to traders like Koch.
Of the 650 megawatt-hours that Koch parked with PNM, Koch was able to sell 50 megawatt-hours directly to the Independent System Operator at a price of $336.40 per megawatt-hour. Then it sold 450 megawatt-hours to the Power Exchange’s “day of” market for $539.95. Koch sold another 125 megawatt-hours of parked power to a utility company for $625. It sold the rest to Enron for $320.
The transaction yielded $315,788 in profit. Investigators would later say that this kind of deal came at a dear cost to the state. By parking power, electricity traders were diverting power from the day-ahead Power Exchange and forcing the Independent System Operator to pay exorbitantly high prices for the power, a cost that was passed on to the utility companies.
Gaming the system was creating dire, real-world effects. Power was cut at the Orange County government building, forcing employees to go home early. In the Santa Clarita Valley, north of Los Angeles, the school district paid emergency prices to keep students in session, including penalty payments of up to $10,000 an hour. On June 14, Koch’s traders executed another remarkably profitable and complex parking transaction that yielded $874,523 in profits.
On June 15, Darrell Antrich e-mailed an old friend named Brian Arriaga, who had previously worked for Koch’s trading office. Arriaga had since moved on to a new job, but the friends bantered back and forth during the workday.
Arriaga e-mailed Antrich at two in the afternoon to comment on the remarkably warm weather in California, which had pushed electricity prices to record highs.
“Isn’t it a little too early in the summer for the Santa Anna [sic]winds?” Arriaga wrote. “I hope you guys were long!!”
Antrich, who was presumably busy that afternoon, did not reply until 5:19 that evening, long after the markets had closed.
“I can’t even begin to tell you how well things have been going,” he wrote. “We have been doing parking with PNM and have made over 2 million in the last 2 weeks. WHEE!!”
On June 14 and 15, temperatures rose above 100 degrees in many parts of California. It was 103 in San Francisco and 109 in San Jose. Air conditioners kicked on in millions of homes and businesses throughout the state. The heavy load bogged down transmission lines and sapped pow
er plants. Prices skyrocketed.
Lights blinked on the wall-sized electronic maps and screens inside the cavernous control room of the California Independent System Operator, just outside Sacramento. Traders there looked at spreadsheets on their computer monitors and desperately called from broker to broker, looking to buy supplies to keep power running. These traders were frantic with good reason: the technology of the modern power grid dictated that demand had to be met exactly at all times. If the supply was not met, even for a matter of moments, it could cause a system of cascading and uncontrolled blackouts that could leave millions without power.
By the afternoon of the fourteenth, it became clear that the ISO might fall short on its power supplies. Power reserves fell below 7 percent, so the state declared a phase 1 emergency, giving it the authority to begin rolling blackouts. At 1:22 in the afternoon, San Francisco’s utility company, Pacific Gas and Electric, started cutting power to blocks of thirty-five thousand customers at a time, leaving them in the dark for between sixty and ninety minutes and then shifting the blackout to other neighborhoods. The lights went out at a microbrewery on Haight Street. People who worked from home got in their cars and took their PowerBook laptops to coffee shops in nearby cities where the lights were still on.