07/19/2010 04:06 pm ET Updated May 25, 2011

The Stealthy Deregulation of Energy

A colleague with an encyclopedic knowledge of the economy told me recently that he did not have a good feel for energy deregulation. My friend thought its obscurity may have been planned by the industry. From my perspective, deregulation happens because the energy sector is treated as multiple sub-units by state and federal law: oil, coal, gas and electricity; fuel extraction and transportation; power generation, transmission and distribution; energy derivatives trading. For example, it's impossible to find government data on the size of the energy sector in relation to GDP. The regulatory framework, dismantled in the last two decades, viewed energy as a many separate businesses. Deregulation was not a single act, but several, taken a different times and affecting different agencies.

The industry, however, sees itself as integrated. At the strategically important hub of the industry are the large banks and oil companies. They exploit the relationships between the types of fuels and energy as well as the phases of the process, from fuel extraction to retail consumption. It is time that policymakers thought the same way. The various legislative and regulatory steps in deregulation need to be catalogued and tied together to understand the industry's perspective. In a follow-up post, I will examine a chain of disastrous consequences that grew out of deregulation, a window on our future if deregulation is not reined in.

The stakes are large. Viewed as a whole, energy is enormous and affects almost every component of the economy. An industry so large and fundamental can do much damage if allowed to run rampant. The opponents to regulation are the most powerful and politically influential corporations in the world. Remedies for deregulation must be muscular, and the politics must be aggressive and direct. It is simply not possible to meaningfully reform energy by seeking compromise and consensus.

Oil and Coal Deregulation

These fuels, developed more than a century ago, have been regulated primarily through safety and environmental rules at the point of extraction. Commercial activity is relatively unconstrained. In fact, the government encourages exploitation of the resources through tax incentives, a form of "anti-regulation."

Deregulation has been accomplished through subversion of the bureaucracies. Because of the British Petroleum oil spill in the Gulf and the Upper Big Branch Mine explosion, we are painfully aware of industry control of the Minerals Management Service and the flaunting of violations by Massey Energy and others. Given current events, further discussion is not required.

Natural Gas Deregulation

Commencing in 1938, all pricing in the natural gas business chain was regulated by the state and federal governments. The Federal Energy Regulatory Commission (the FERC) was given jurisdiction over pipeline companies. Federal law required that the producers sell to the pipeline companies who, in turn, sold to distributers. Prices at the wellhead and on the pipelines were regulated by the federal government. Prices paid by customers to distribution companies were controlled by state utilities commissions. The goal was to avoid exploitation of market power in the concentrated industry.

In 1985, Congress amended the law to allow pipelines to transport and store gas on behalf of producers. This allowed producers to sell directly to distributors, transactions outside FERC jurisdiction. Direct sales in the wholesale market were deregulated. FERC Order 636 issued in 1994 mandated open access to pipelines for producers, ending price regulation of the wholesale market completely.

Electricity Deregulation

The power industry originated as a collection of local enterprises. Power was generated, transported and sold within state-franchised regions. This made sense because power plants could be built near the customers to minimize transmission. In contrast, fuels were extracted at places where they could be found and transported over long distances. Consumer prices (except for prices charged by non-profit state entities and rural co-ops) were regulated state utilities commissions. Private utilities were allowed to price power sufficiently high to recover fuel costs, operating expenses and a fair return on invested capital, all subject to review and approval by the commissions.

As demand grew, utilities established interconnections between the franchised territories to serve customers more flexibly. The interconnected transmission evolved into the grid, owned separately by the utilities but operated under agreements governing cooperation. The FERC was given regulatory authority over the system to assure reliability.

The Energy Policy Act of 1992 mandated that the grid be opened up to allow access to all qualified marketers of power. The utilities resisted the mandate by imposing restrictions that stifled access. The FERC issued a series of Open Access Orders in 1996 which brought an end to resistance.

A more subtle form of deregulation which arose from open access was "disaggregation." Utilities could sell generating assets to unrelated parties or unregulated subsidiaries of utility holding companies. The new owners now had access to the grid. Returns on the invested capital would no longer be regulated by the state. Investment banks relentlessly marketed the idea to utilities and made enormous fees restructuring and recapitalizing the utilities and the independent generation companies, now known as "independent power producers" or "IPP's." On a worldwide basis, the most successful and aggressive IPP was a rather boring gas pipeline company which jumped into the business under a suitably modern name - Enron.

Trading Deregulation

Enron, the banks and big oil perceived an enormous new opportunity. Deregulation meant that there were new buyers and sellers of fuel and wholesale electric power. The new buyers and sellers no longer relied on the certainty of regulated prices. They now were exposed to layers of price risk and became customers for financial hedges. A new derivatives marketplace was born.

After a period of moderate success, it became clear that more deregulation was needed for a completely unfettered market. The Commodities Futures Modernization Act of 2000 (CMFA) contained provisions known as the "Enron Loophole" in honor of that company's immense effort to secure its passage by a skeptical congress. Over-the-counter energy derivatives trading and electronic trading platforms for energy were both exempted from the Commodities Exchange Act regulations.

Initiatives to exploit the new unregulated market sprouted like weeds during the debate on the CFMA. Enron Online was established in late 1999. Using internet-based screens, traders could transact with Enron without using (and paying) brokers. Enron made markets in all energy products (meaning it would respond to a bid at some price, even if no other trader would transact). If a trader used Enron Online, he or she was certain of getting a transaction done, even at obscure delivery points with uncertain prices. Enron Online quickly captured a huge market share and one year later its unregulated status was clarified by the CFMA. Enron profited from the fees for use of Enron Online; but the market power resulting from dominance of multiple energy price points was far more valuable.

The major banks and oil companies founded the Intercontinental Exchange, an electronic energy trading environment, in mid-2000. Using ICE, the sponsors and other traders could meet and transact physical contracts and derivatives. The brokers were cut out of more business. Like Enron Online, ICE was exempted from regulation under the CFMA. The sponsors could replicate the Enron strategy of exercising market power by becoming market makers for energy price points. The sponsors pumped business through ICE and eventually sold off their shares for a profit considered at the time to be outrageous.

The two banks in the forefront of energy trading were Goldman Sachs and Morgan Stanley. In those days, before energy was completely "derivatized," it was thought that traders needed access to the physical energy product to mitigate risks in these volatile and relatively thinly traded markets. In late 2001, Goldman partnered with Baltimore Gas and Electric to own an unregulated IPP. Goldman supplied the traders and BG&E supplied the physical product. The new energy trading firm called Constellation became wildly successful. Goldman dissolved the relationship in 2003, after becoming comfortable with naked energy derivatives.

So by the end of 2001, the second phase of deregulation of energy was completed with the emergence of a huge new and unregulated trading market for energy derivatives controlled by Enron, the banks and big oil. Alas, Enron did not enjoy the spoils of its victories for long. It soon exploded like a supernova and filed for bankruptcy. Enron was a victim of its own aggressive free market philosophy carried to the extreme of self-dealing and fraud by its officers and employees.