[Senate Hearing 107-458]
[From the U.S. Government Printing Office]



                                                        S. Hrg. 107-458
 
                      ENRON CORPORATION'S COLLAPSE
=======================================================================





                                HEARING

                               before the

                              COMMITTEE ON
                      ENERGY AND NATURAL RESOURCES
                          UNITED STATES SENATE

                      ONE HUNDRED SEVENTH CONGRESS

                             SECOND SESSION

  TO RECEIVE TESTIMONY ON THE IMPACT OF THE ENRON COLLAPSE ON ENERGY 
                                MARKETS

                               __________

                            JANUARY 29, 2002









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               Committee on Energy and Natural Resources


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               COMMITTEE ON ENERGY AND NATURAL RESOURCES

                  JEFF BINGAMAN, New Mexico, Chairman
DANIEL K. AKAKA, Hawaii              FRANK H. MURKOWSKI, Alaska
BYRON L. DORGAN, North Dakota        PETE V. DOMENICI, New Mexico
BOB GRAHAM, Florida                  DON NICKLES, Oklahoma
RON WYDEN, Oregon                    LARRY E. CRAIG, Idaho
TIM JOHNSON, South Dakota            BEN NIGHTHORSE CAMPBELL, Colorado
MARY L. LANDRIEU, Louisiana          CRAIG THOMAS, Wyoming
EVAN BAYH, Indiana                   RICHARD C. SHELBY, Alabama
DIANNE FEINSTEIN, California         CONRAD BURNS, Montana
CHARLES E. SCHUMER, New York         JON KYL, Arizona
MARIA CANTWELL, Washington           CHUCK HAGEL, Nebraska
THOMAS R. CARPER, Delaware           GORDON SMITH, Oregon

                    Robert M. Simon, Staff Director
                      Sam E. Fowler, Chief Counsel
               Brian P. Malnak, Republican Staff Director
               James P. Beirne, Republican Chief Counsel
                     Shirley Neff, Staff Economist
             Howard Useem, Senior Professional Staff Member








                            C O N T E N T S

                              ----------                              

                               STATEMENTS

                                                                   Page

Bingaman, Hon. Jeff, U.S. Senator from New Mexico................     1
Cantwell, Hon. Maria, U.S. Senator from Washington...............    59
Domenici, Hon. Pete V., U.S. Senator from New Mexico.............    51
Johnson, Hon. Tim, U.S. Senator from South Dakota................     2
Makovich, Lawrence J., Senior Director and Co-Head, North 
  American Energy Group, Cambridge, MA...........................    43
McCullough, Robert, Managing Partner, McCullough Research, 
  Portland, OR...................................................    38
Murkowski, Hon. Frank H., U.S. Senator from Alaska...............     4
Newsome, James E., Chairman, Commodity Futures Trading Commission    23
Nugent, William M., President, National Association of Regulatory 
  and Utility Commissioners......................................    18
Schumer, Hon. Charles E., U.S. Senator from New York.............    63
Seetin, Mark, Vice President, New York Mercantile Exchange.......     7
Shelby, Hon. Richard, U.S. Senator from Alabama..................     3
Thomas, Hon. Craig, U.S. Senator from Wyoming....................    50
Viola, Vincent, Chairman, New York Mercantile Exchange...........    30
Wood, Patrick, III, Chairman, Federal Energy Regulatory 
  Commission.....................................................     8

                               APPENDIXES

                               Appendix I

Responses to additional questions................................    75

                              Appendix II

Additional material submitted for the record.....................    79









                      ENRON CORPORATION'S COLLAPSE

                              ----------                              


                       TUESDAY, JANUARY 29, 2002

                                       U.S. Senate,
                 Committee on Energy and Natural Resources,
                                                    Washington, DC.
    The committee met, pursuant to notice, at 9:30 a.m. in room 
SH-216, Hart Senate Office Building, Hon. Jeff Bingaman, 
chairman, presiding.

           OPENING STATEMENT OF HON. JEFF BINGAMAN, 
                  U.S. SENATOR FROM NEW MEXICO

    The Chairman. The hearing will come to order. The purpose 
of this hearing is to receive testimony on the impact of the 
Enron bankruptcy on energy markets and the interaction of 
Enron's activities with energy markets over a period of time. 
The problems of accounting misrepresentations, lost pension 
funds, potential tax abuses, those, of course, are the subject 
of other hearings which various other committees are 
participating in.
    Irrespective of the various financial issues regarding 
Enron's corporate structure, the company played a significant 
part in the Nation's infrastructure and markets. In addition to 
its energy trading operations, Enron owned and operated several 
major interstate pipelines, including one that traversed my 
home State of New Mexico, and they also own the largest 
electric utility in the State of Oregon. The trading operations 
have been suspended, but the pipelines and the utility continue 
to operate and to provide reliable service.
    Before its failure, Enron Online was the largest fiscal 
marketplace for energy products in the United States. I also 
understand Enron traded unregulated financial instruments 
called SWAP's, and over-the-counter instruments. The role of 
Enron and other energy traders in the highly volatile gas and 
electricity markets in California had come under increasing 
public and congressional scrutiny.
    In 2001, the committee held four investigative hearings to 
evaluate the natural gas and electricity markets in California 
and the implications for other States in the West. In the first 
hearing, which we had January 31, 2001, the need for 
transparent markets--both with respect to pricing and 
capacity--was identified as one of the most pressing 
requirements for well-functioning electricity markets.
    Enron's trading activities were different from those of a 
regulated exchange. Enron Online did not match buyers with 
sellers. It contracted with each separately, so that Enron was 
on the other side of every deal. Enron provided little or no 
market transparency. That is, parties were not given 
information as to the price and volumes that were offered to 
others.
    Market transparency is essential to efficient and 
competitive energy markets, both in the short term and over the 
long term. Over the long term, the market must signal the need 
for additional capacity and new fuel supplies to ensure 
reliable and affordable energy services. Whether adequate 
capacity was available or not in the West last year should have 
been apparent in the market before the crisis appeared. As we 
understand the actual events of this past fall, when Enron's 
financial situation became known, many parties who had been 
trading with Enron shifted to other fiscal markets. NYMEX, the 
New York Mercantile Exchange, also served as a major source of 
stability. In the end, it is my impression Enron's demise did 
not have a major impact on short-term energy markets.
    The proposed energy legislation that we have introduced in 
the Senate as S. 1766, Senator Daschle introduced and I 
cosponsored the bill, tries to ensure transparency and real-
time reporting of trades. The FERC has increased its oversight 
of individual companies. It has created a new market-monitoring 
function which we hope to hear about today. The States also 
have a critical role in ensuring adequate supply, planning, and 
procurements.
    We look forward to hearing the testimony of the witnesses, 
and engaging in a thorough discussion on these issues. Senator 
Murkowski, why don't you go ahead with your statement.
    [The prepared statements of Senators Johnson and Shelby 
follow:]
 Prepared Statement of Hon. Tim Johnson, U.S. Senator From South Dakota
    Mr. Chairman, this is an important hearing we are holding today. 
The demise of Enron has been well-documented and its impact is being 
considered in many venues, including other committees in the Senate. 
The scrutiny of the company is proper: Enron is a major entity of the 
nation's energy system and was one of the most profitable companies in 
the nation. The effect of Enron's fall on both its internal operations, 
its employees and its effect on markets needs to be examined thoroughly 
to determine the root of the problems and so that we can learn lessons 
for the future.
    The Energy Committee is properly looking into the effects of this 
situation on the nation's energy markets. Over the last couple of 
years, we have seen many ups and downs in energy prices and in the 
wholesale energy markets, where Enron made the bulk of their profits. 
It seems, for the most part, that the market has responded well to the 
Enron's demise and picked up the slack. Fortunately, there have been no 
disruptions in service. But had this occurred last year when there were 
rolling blackouts in California and when there was poor weather, the 
effect could have been catastrophic.
    The market also responded partially because many of Enron's 
contracts were above current market prices, which its competitors were 
rightly eager to pick up. Had the contracts been below market prices, 
there could have been greater disruption in the system. In addition, 
many other generators and trading entities, while still profitable, 
have seen their stock prices drop since the Enron demise. This may make 
it more difficult for the market to adjust to changes in the future.
    I do not believe that Enron should be blamed for every issue that 
arises or is now present in the energy field and many of the problems 
with Enron are largely because of its improper accounting and financing 
practices rather than its trading operations. But because Enron was the 
largest operator in a somewhat volatile area, we need to examine 
closely the role of the energy trading markets and how they effect 
energy service. Having a robust market is good for the nation. But it 
is largely unregulated, at least when compared to other trading 
markets. I am not prepared to say at this juncture that any changes are 
needed to the system but it is clear that we must take a closer look.
    Moreover, it is also clear that Enron's role in the energy 
legislation needs to be examined. In particular, it is my hope that the 
Vice President and his task force will be more amenable to turning over 
information about the meetings that occurred and the process that led 
up the issuing of its report. Reforming our energy system is an 
important matter and we must do so in an open manner as this committee 
has done in holding dozens of hearings on energy legislation. Every 
citizen of the nation is affected by energy services and it is 
important for the Administration to be as open as possible in 
addressing these concerns.
    Thank you, Mr. Chairman, and I look forward to the testimony of the 
witnesses.
                                 ______
                                 
  Prepared Statement of Hon. Richard Shelby, U.S. Senator From Alabama
    Thank you Mr. Chairman for calling this hearing today and I wanted 
to thank our witnesses for being here to offer their perspective into 
the collapse of Enron.
    Mr. Chairman, the collapse of Enron offers a very interesting story 
for all of those willing to invest the time and energy to investigate. 
I believe that the story is just beginning to unfold and in the weeks 
to come we will learn even more about the rise and fall of this energy 
giant. It is certainly unnerving to hear of the significant losses that 
were encountered by hundreds of Enron's stockholders and company 
employees. But the bright spot in all of this, as I believe we will 
hear today, is that our energy markets and energy consumers came out of 
this relatively unscathed.
    Experience has taught us that we should not judge before all of the 
facts are before us. It is my hope that we do not pre-judge this event 
and rush to take legislative action before we know all of the facts. 
Enron received a number of exemptions to certain important laws. It is 
also becoming very apparent that Enron's business and accounting 
practices were not above board--they were not honest, they were not 
forthright, and most importantly they were not transparent. I believe 
that we must wait for all of the facts to come to light and the 
investigations to be completed before we begin to make legislative 
recommendations, if any, about the appropriate course of action to 
prevent another ``Enron debacle''.
    Today's hearing is intended to focus on the impact of Enron's 
collapse on energy markets, but the witnesses were also asked to 
consider existing statutory authorities and changes proposed by S. 
1766, including the repeal of the Public Utilities Holding Company Act 
(PUHCA). After reviewing the testimony of our witnesses, it appears 
that many of you have some interesting thoughts on repeal and/or reform 
of PUHCA and I am anxious to discuss that in more detail with each of 
you.
    Mr. Chairman, it is no secret that I am a strong advocate of 
reforming the Public Utilities Holding Company Act. In my opinion, the 
law is antiquated, duplicative, and has outlived its usefulness. I 
believe, and the Securities and Exchange Commission (SEC) has 
suggested, that since PUHCA's inception, a comprehensive system of 
investor protections has been developed that obviates the need for many 
of the specialized provisions included in PUHCA.
    Over the years, as the restructuring debate has evolved, utilities 
and the SEC have called for reform or repeal of PUHCA, asserting that 
PUHCA has achieved what it was designed to do and that in the current 
evolving energy marketplace, PUHCA discourages competition. In 1982 the 
SEC recommended to Congress that PUHCA be repealed. In a 1995 study of 
the regulation of public utility holding companies, the SEC called for 
a conditional repeal of PUHCA. And in recent testimony before the House 
Committee on Financial Services, Isaac C. Hunt, Jr., Commissioner of 
the U.S. Securities & Exchange Commission stated, ``. . . because much 
of the regulation required by PUHCA is either duplicative of that done 
by other regulators or unnecessary in the current environment, the SEC 
continues to support repeal of PUHCA. As the SEC has testified in the 
past, however, we continue to believe that repeal should be 
accomplished in a manner that eliminates duplicative regulation while 
also preserving important protections for consumers of utility 
companies in multistate holding company systems.''
    Mr. Chairman, as I mentioned at the beginning of my statement, I 
think that it would be misguided for us to walk away from today's 
hearing believing that we have all of the answers. As the investigation 
into Enron's activities progresses and as more and more government 
regulators are called upon to testify in various committees of 
jurisdiction, I believe that a complete picture will emerge. The 
Securities and Exchange Commission and the Department of Justice are 
currently investigating Enron's collapse to determine if there were 
violations of existing laws. I think we should begin to make 
recommendations and changes to guarantee the stability and transparency 
of our energy marketplace after the investigations give us a clear 
picture of what happened.

      STATEMENT OF HON. FRANK H. MURKOWSKI, U.S. SENATOR 
                          FROM ALASKA

    Senator Murkowski. Thank you very much. Good morning, and 
let me wish all the members a belated Happy New Year.
    I think it is fair to say that Enron's collapse appears to 
be a story of lies, deceit, shoddy accounting, corporate 
misconduct, cover-up, etc.
    Unfortunately, Enron's employees and stockholders have been 
devastated by this action. We have seen a thousand people 
unemployed, billions lost, retirement funds wiped out. 
Therefore, we cannot forget that this is a business failure, 
not an energy market failure. I think it is important to 
reflect on that, because I think it is accurate. Today's 
hearing can be useful if we explore the impact of Enron's 
collapse on energy markets, on price and supply, as the title 
suggests. However, if the hearing is used to set the stage to 
speak about the need for additional Government regulations of 
the energy market, then we will not have a very productive 
hearing.
    A number of committees are holding hearings on accounting. 
You have heard from the chairman indicating that a number of 
other committees are meeting as well. Commodity regulations, 
these are not matters of our jurisdiction or expertise.
    I will focus on the subject of this hearing, the impact of 
Enron's collapse, and its collapse on energy markets. It is 
clear that energy markets are working well, despite Enron's 
failure. Enron was responsible for about one-quarter of the 
wholesale electric and natural gas markets in this country, but 
notwithstanding Enron's dominant position in the market. Its 
bankruptcy had little impact on energy markets or on price and 
supply. We saw that the lights stayed on and retail electric 
prices did not spike. Gas furnaces did not go out. Why? I think 
the answer is simple. Deregulated markets work. When market 
forces are allowed to work, when government does not 
micromanage the marketplace, markets match supply and demand.
    Take a look at this chart. When Enron failed competing 
companies swooped in and immediately filled the Enron void. 
Consequently, no shortage or price spikes were seen, which this 
chart points out. You can see that the big price spike was 
associated with California activity, but there were no 
significant trends, as evident in the chart. Enron's collapse 
did not have any significant impact on natural gas either.
    There was an effect on the stock prices of other energy 
companies, and certainly a chill on generation. This investment 
was primarily the result of concerns about credit quality and 
exposure to deals with Enron.
    Now, compare Enron's collapse with what happened in 
California last summer. California is a poster child, an 
example of how government command and control prevents markets 
from working. Thus, creating shortages and price spikes. 
California tried to micromanage the marketplace, capped retail 
prices, forced divestiture of generation, required all power 
purchase from the stock market, prohibited utilities using 
long-term contracts, and made new construction virtually 
impossible. They spent billions of taxpayer's money to pick up 
the pieces after they broke the market.
    The results we now know. Last year, the slightest twitch in 
the California power market, such as; hot weather, and 
powerplants needing maintenance, created black-outs or price 
spikes. My point is, government micromanagement of the 
California market hurt the consumers it was trying to protect. 
So the story we ought to be hearing today is, deregulation 
benefits consumers while government market manipulation hurts 
consumers. I fear the story we might hear instead is that we 
need more Federal interference in the market, that FERC needs 
more authority to tinker with the market, that we cannot repeal 
PUHCA and instead we need super-PUHCA, that we cannot trust the 
free market but we can trust regulators.
    I pose a question. If Enron's competitors had to go to FERC 
or the SEC for prior approval, how quickly could they have 
stepped in to replace Enron? How long would the lights have 
been out? Well, we do not know the answer to those questions. 
We can only speculate.
    I look forward to hearing from today's witnesses about 
these issues, about the merits of Federal interference in the 
day-to-day operation of the market. I also look forward to the 
Senate creating a national energy policy that enhances domestic 
energy supply, makes that supply more reliable and affordable, 
and reduces our dependence on foreign oil. We need to foster 
our regulatory and investment climate, encourage new energy 
sources of all types. This includes: oil, natural gas, nuclear, 
coal, electricity and renewables, encourage construction of 
energy infrastructure, including transmission lines.
    I think this is what the administration stands for. It is 
what I believe, and I know that it is what the American people 
expect Congress to do. We may need to deal with how 
corporations keep the books and how employee pension programs 
are operated. But let us keep corporate mismanagement in 
context with the operation of energy markets. I know in my 
banking career, the Comptroller of Currency would not allow 
directors to purchase stock and put it in the their own 
retirement business portfolios. That was a matter of simple 
regulation.
    Let me conclude by turning to some of the politics of 
Enron. It appears that politics in both Houses are trying to 
create a political issue out of Enron's failure. Some are not 
particularly interested in the hard-core facts. They are not 
particularly interested in protecting consumers or 
stockholders. Just look at some of the wild claims we have 
seen. At one point the administration has been castigated for 
not helping Enron, castigated for proposing an energy policy 
that helps Enron. How can you have it both ways?
    It is true that many elements of the administration's 
policy are consistent with the views of Enron. It is also true 
that far more elements of the Clinton administration's energy 
policy were consistent with the view of Enron.
    Let me refer to my own experience in this area. In my time 
as chairman of this committee, I met with Mr. Ken Lay just 
once. My contact with their Washington Office was very limited. 
They simply did not call, and I can see why when I read the 
Washington Post on January 13, 2002, and I quote.
    At Lay's meeting with Pena on February 20, 1998, he spoke 
of restructuring the U.S. electric market in ways that would 
benefit Enron. Lay pressed the administration to propose 
legislation that would assert Federal authority over the 
national electric markets. Now, what does that mean? That means 
they were asking for a date certain for retail competition, and 
wanted FERC to preempt the States to make it happen. In other 
words, one size fits all.
    I quote again, according to a company's version of the 
meeting, Lay and Pena agreed that a go-slow approach to the 
deregulation advocated by Senate Energy Committee Frank 
Murkowski was unacceptable. Pena asked Enron officials to keep 
the Energy Department staffers posted on developments in 
Congress, and solicited comments on the administration's draft 
of its comprehensive national energy strategy. An Enron 
document said Lay felt that the draft was headed in the right 
direction except for a few points, the document said, end of 
quote.
    I guess we didn't see eye to eye about how best to ensure 
America has an affordable and reliable energy supply.
    In conclusion, I think it is also true that many elements 
of the current Senate Leader's energy policy are straight out 
of the Enron playbook. It is put together without any public 
input, through members of the Energy Committee, which was a 
tragic mistake on behalf of Senator Daschle, and I think he is 
aware of that.
    It should be pointed out that Enron has never wanted to 
deregulate electricity. It said it wanted to federalize 
electricity. Enron wanted different regulation, not 
deregulation. I indicated from a certain date under 
deregulation for everybody to come in at once for retail 
competition. They wanted FERC to preempt the States to make it 
happen, create a one-size-fits-all system that benefits 
national markets here such as Enron. The system would ignore 
local concerns and interests, and Enron wanted special 
provisions of particular benefit to Enron.
    Unfortunately, this is reflected in the Daschle bill. Just 
a few examples: One, FERC authority to restructure electric 
power industry. Two, FERC open access on all transmission 
lines, including Federal. Three, uniform liability standards 
under FERC control; and four, transmission information 
disclosure that would have benefitted Enron's trading 
activities, special transmission access and benefits for wind 
generation--Enron owns a wind generator company--a renewal 
portfolio standard that benefits wind generation, Federal 
preemption of States and consumer protections. FERC is given 
exclusive authority over electric reliability, and Nation-wide 
uniform interconnection standards.
    So in my opinion, as they say, those that live in glass 
houses should not throw stones, or those that live in glass 
houses perhaps should not take baths.
    In any event, I look forward to hearing from today's 
witnesses. Thank you, Mr. Chairman.
    The Chairman. Thank you. Before we start, we have six 
witnesses here today, and before we start with their testimony 
I have asked Mark Seetin, who is the vice president of the New 
York Mercantile Exchange, to give us about a 4-minute summary 
of some of the definitions that we are going to be talking 
about today, just as a refresher course, and then we will start 
with testimony.
    My intent would be to have each of the witnesses testify 
for about 8 minutes, and then have panel members here asking 
questions, give each one 7 minutes to make any statements they 
wish, and ask whatever questions, and then we will have 
additional rounds as appropriate.
    Mr. Seetin, why don't you go right ahead.

 STATEMENT OF MARK SEETIN, VICE PRESIDENT, NEW YORK MERCANTILE 
                            EXCHANGE

    Mr. Seetin. Thank you, Mr. Chairman. I will indeed try to 
be brief, but as you rightly stated, the terms of art sometimes 
get lost in the discussions.
    First of all, the risk management marketplace, particularly 
with energy and metals, has an regulated and unregulated side. 
On the regulated, are overseers, the CFTC, as Chairman Newsome 
represents here today, that the instruments offered are futures 
contracts, and options on futures contracts. On the unregulated 
side, in which instruments that really have much the same 
function as the futures side but yet are under no regulatory 
purview, forward contracts, over-the-counter or SWAP 
instruments, and over-the-counter or OTC options.
    A futures contract is a binding obligation to make or take 
delivery of a specified quantity and quality of a commodity at 
a specified location and time. The key is uniformity. Every 
NYMEX oil contract is for 1,000 barrels with American Petroleum 
Institute standards, so every time you trade a NYMEX contract 
you know exactly what you have in that regard.
    An option is a second step back from the futures contract 
in that it is a contract between a buyer and a seller where the 
buyer has the right but not the obligation that they have in 
the futures contract to buy or sell the underlying commodity at 
a fixed price over a specified period of time in exchange for a 
one-time premium payment. It is a little bit like a deductible 
insurance premium payment. If you buy insurance on your car, 
you take a $500 deductible. That is quite similar to the way 
options operate, and you have regulated options, those that are 
listed on exchanges like the New York Mercantile, and options 
that are offered over-the-counter in the unregulated 
marketplace.
    What is a forward contract? A forward contract is a 
contract in which a seller agrees to deliver a specified cash 
commodity to a buyer sometime in the future. In contrast to 
futures contracts, the terms of forward contracts are not 
standardized. Forward contracts are not traded on Federal 
exchanges.
    When I was farming, I would go to the elevator and get a 
forward contract for 10,000 bushels of corn to be delivered in 
December. That was a contract between myself and the green 
elevator to be delivered at a forward time, not regulated.
    What is an OTC or a slot contract? This is an agreement 
whereby a floating price is exchanged for a fixed price over a 
specified period. It is an unregulated financial arrangement 
which involves no transfer of physical energy. Both parties 
settle their contractual obligations by means of a transfer of 
cash. The agreement defines volume duration and a fixed 
reference price. Differences are settled in cash over specific 
periods, maybe monthly, maybe quarterly, maybe over a 6-month 
period.
    So it is an arrangement between the hedger and the provider 
of that OTC slot, and they say, we will use NYMEX, for example, 
as the base price. Every month, if your price is above, I will 
pay you. If the price is below the NYMEX price, you pay me. 
That does the same thing, in essence, as a futures contract. It 
allows one party to lock in the price.
    What is a derivative? A financial instrument traded on and 
off exchange, the price of which is directly dependent on the 
value of one or more of the underlying securities, commodities, 
or other derivative instruments, or any agreed-upon pricing 
index, and the reason I put this last is because all of the 
previous instruments that we talked about are considered 
derivatives. Derivatives is a very encompassing term.
    And with that, Mr. Chairman, I have completed, and look 
forward to the testimony today.
    The Chairman. I think that is useful background, and a 
refresher for many of us. I appreciate it very much.
    Let me start with Pat Wood, who is the Chairman of the 
Federal Energy Regulatory Commission, and who has substantial 
responsibility on a lot of the issues we are trying to 
understand here. Why don't you give us your testimony, and 
indicate the most important things you think we ought to be 
aware of as we try to move forward.

           STATEMENT OF PATRICK WOOD, III, CHAIRMAN, 
              FEDERAL ENERGY REGULATORY COMMISSION

    Mr. Wood. Thank you, Mr. Chairman. I will break my 
introductory remarks into two parts, what we perceive happened 
from the FERC, and what we have done in the general arena to, I 
guess, the issues that are raised by market monitoring.
    Enron's collapse, just to cut to the chase, certainly as 
one who comes from that State, and a lot of friends of mine 
worked with the company and are invested in it, or were retired 
from it, it is a human tragedy. But I think from our 
perspective in this hearing today is to look at more soberly 
the impact on the market, that I think Senator Murkowski 
correctly praised as being vibrant and supportive of a lot of 
healthy interaction among market participants, but the collapse 
itself has had little perceptible impact on the commodity at 
wholesale of electric and gas markets in the country, which are 
the primary responsibility of the FERC. These energy markets 
adjusted quite quickly to Enron's collapse, particularly when 
you consider that Enron accounted for 15 to 20 percent of the 
trades in these aggregated markets.
    Our monitoring of energy markets to date has indicated 
there has been no immediate damage to the energy trading in 
both gas or electric, or certainly in the underlying physical 
energy supplies. As can be expected, there has been some 
volatility in these markets, with the swift exit from them of 
trading that has impacted liquidity in the markets, and so the 
ranges have traded--and our staff is actually investigating 
that, and I will be glad to share with the committee as we get 
to some conclusions on that, but with few exceptions in the 
physical market, very few exceptions. In fact, I just got a 
letter on the first one, a small company in Missouri, but 
people have been able to rearrange their physical deals without 
any impact, or perceptible impact with the underlying deals 
that they had executed with Enron.
    On the day that it was announced that there was a formal 
investigation by the SEC into Enron, the commission staff began 
to immediately monitor the spot markets and contact market 
participants to evaluate what impact this significant 
announcement could have on the trading in the Nation's energy 
markets. Again, as I mentioned, the volatility increased, but 
as I think Senator Murkowski's aggregated chart shows, and the 
charts that are more closed in on 2 months that are attached on 
the back of my testimony, in both power and gas markets the 
general trends in prices due to both the weakened economy and 
to oversupplies of both gas in storage and of power and the 
rapid increase of new powerplants across the country, generally 
were unaffected by that. That downward trend that we saw going 
prior to Enron continued through the Enron collapse and 
continued on into what has been a very mild winter, so the 
weather is still primarily the key driver in these commodity 
prices, much as I think Chairman Newsome will mention they are 
for just about everything else, but that was no exception here.
    At the point we began to monitor Enron Online, the online 
trading faction much more closely--as I mentioned in my 
testimony in some detail, it is a trading platform where Enron 
is a party and many providers can come to it as buyers or 
sellers--we looked at that particularly in comparison to other 
markets which have multiple buyers and sellers coming together 
to ascertain if the spreads in Enron Online and the spreads in 
the other markets were comparable and, in fact, throughout the 
entire 60-day period they were, so we are looking and continue 
to look at that as an issue.
    To Commission staff in talking to market participants 
throughout this period, it became very clear that these market 
participants were readjusting their business deals with Enron. 
They were what we called flattening the books, which is to kind 
of be neither long nor short on the future deals that they had 
with each other, but to kind of basically exit Enron from the 
transaction and stick the market participants in a place that 
did not include Enron.
    So the positioning that the parties did helped the calmness 
in the market. Certainly there was not a frenzied reaction from 
I think folks on our side of the fence or on your side of the 
fence, that time gave people the opportunity to restructure 
their business deals, and to basically reflect the fact that 
Enron may not be the party they wanted to do business with any 
more.
    Enron is more than just an energy trader. It owns a 
pipeline, a set of pipelines which we regulate. Those have not 
filed for bankruptcy. We continue to monitor those. We set the 
rates for those. The safety issues for those are overseen by 
the Department of Transportation. Of course, safety is much 
focused on in light of the September 11 events, and from 
everything that we oversee and that we do, the pipeline 
industry there looks fine.
    PGE, which is a large electric utility in Oregon, is also 
an owned subsidiary of Enron. It was announced prior to Enron's 
collapse that that utility would be sold to Northwest Natural. 
That proceeding is pending before the FERC and other regulatory 
authorities, and I expect will move forward on its traditional 
track unaffected by the filing for bankruptcy at Enron.
    The commission has done a number of things in the interim, 
mostly prior to the Enron events, to improve our ability to 
monitor markets, to oversee markets, not to re-regulate 
markets, but to oversee them to give buyers and sellers 
information that they need to ascertain what the proper price 
that they ought to pay for delivery of gas or delivery of power 
ought to be.
    We have set up, as you mentioned, Senator Bingaman, a new 
Office of Market and Oversight and Investigation, as I have 
testified before the committee my intention to do so. We have, 
in fact, posted for the director of that office, and met with 
our staff to discuss how this office would work within the 
context of our statutory mission, and I look forward to 
actually some superior candidates from across the country that 
are interested in making markets work that want to see this 
continue and I have had some very, I think, attractive 
candidates for not only the top job but for people that want to 
participate in that, and I think that is a healthy transition 
from the whole cost of service world that we were good at to a 
market referee, market oversight world that I think we can be 
very good at.
    We have the assets and facilities to do that. I expect that 
as we develop these things I will be visiting with the 
committee more if there are any issues that we need with regard 
to reporting requirement authority. I mentioned some certainly 
in regard to Senator Wyden's transparency language that we are 
moving forward on that effort, but I think certainly any time 
we ask for information we are challenged. I expect as part of 
asking for new information we will also quit asking for old 
information. I think that is what agencies need to do.
    The OMB is pretty good about reminding us that we need to 
clear out the underbrush when the world changes, and we expect 
to do that, but in the new world of markets the need for 
information is very important. It is, to me, disclosure and not 
re-regulation. I think it is important to kind of keep that in 
balance, but we have looked at that. Staff has worked forward 
since September a very strong proposal about what the data 
needs are going to be at the commission. I look forward to 
moving forward on that.
    We have also interestingly--and I see my time is out--have 
asked for comments on a number of rulemakings at the commission 
revising rules that have been on the books for a number of 
years to reflect the new market. One of them in September we 
put out actually asked if we should regulate or require 
affiliate standards of conduct to be applied to activities such 
as Enron Online, much as the SABRE data base was discussed 
during the American Airlines litigation with the Department of 
Justice. That is out there.
    We have also asked if there should be additional accounting 
requirements that we have historically exempted power marketers 
from. If the SEC has a better solution there, and they may have 
published one last week, as I reference in my testimony, we 
certainly would not see the need to do that.
    So we are moving forward on a number of fronts. I guess in 
closing my final, I guess, plea and concern is, this industry 
is one that requires a tremendous amount of capital on a daily 
basis to build powerplants, to build gas pipelines, to build 
power transmission lines, to build the local distribution 
companies, to put meters on pipelines and houses and 
businesses, and I think if I would just ask anything on behalf 
of the need to continue that capital flow, it is that we do 
keep these issues focused, as I think what I have heard in your 
public statement so far, that we focus on what is really the 
issue here, and the issue so far has not been that energy 
markets had anything to do with it. In fact, I would say energy 
markets are what saved the country from the collapse of this 
country being so dramatic. It is a large player. It is a big 
company. For it to have been digested so efficiently through 
the market is quite a testimony to the efficiency of the market 
that that company and many, many others have advocated for the 
better part of the decade.
    I look forward to answering your questions.
    [The prepared statement of Mr. Wood follows:]
   Prepared Statement of Patrick Wood, III, Chairman, Federal Energy 
                         Regulatory Commission
                      i. introduction and summary
    Mr. Chairman and Members of the Committee: Thank you for the 
opportunity to testify on the implications of Enron's collapse on 
energy markets.
    The bankruptcy of one of the largest energy providers in the 
country has stunned both the energy and investor communities, and many 
employees and retirees saw their savings accounts all but vanish.
    But the collapse of Enron has not caused damage to the nation's 
energy trading or energy supplies. In the aftermath of Enron's 
collapse, prices in energy markets remained stable, trading within 
expected trading ranges, and, importantly, neither electric nor gas 
deliveries have been disrupted. The Federal Energy Regulatory 
Commission (Commission) has monitored the effects of Enron's collapse 
on energy markets and has not found any substantial spillover effects. 
The nation's electric and natural gas markets' resilience following the 
swift collapse of one of its major participants indicates a high degree 
of robustness and efficiency.
    I disagree with those who claim that the Enron collapse sounds the 
death knell for competition in energy markets or justifies nationwide 
reimposition of traditional cost-based regulation of electricity. The 
facts available to date indicate that Enron's failure had little or 
nothing to do with whether energy commodities and their delivery to 
customers are monopoly regulated or competitive. Rather, Enron appears 
to have failed because of its questionable non-core business 
investments and the manner in which it reported on its financial 
position to its owner-investors and to the broader business community. 
Based on the facts as they appear now, Enron's actions would have led 
to the same result whether its core business focused on energy, grains, 
metals or books.
             ii. enron's impact on gas and electric markets
    Enron's collapse had little perceptible impact on the nation's 
commodity (wholesale) electric and gas markets, which are FERC's 
primary regulatory responsibility. Energy markets have adjusted quickly 
to Enron's collapse. The Commission's monitoring of energy markets 
indicates that there has been no immediate damage to energy trading or 
energy supplies. Although Enron transactions comprised 15 to 20 percent 
of wholesale energy trades, its demise has had negligible effects on 
trading. With a few exceptions, parties were generally able to 
rearrange the deals they had executed with Enron.
            Market Monitoring and Reactions
    From late October 2001, when news of a likely formal investigation 
of Enron and its auditors by the Securities and Exchange Commission 
(SEC) first became known, to early December 2001, after Enron's 
declaration of bankruptcy, spot market data indicates that there was no 
change in natural gas or electric wholesale prices that could not be 
attributed to weather or other fundamentals. (See Figures 1 and 2 in 
the Appendix for graphs of spot market prices).* As may be expected, 
Enron's swift exit from trading may have increased volatility somewhat. 
Our staff is currently investigating this concern more thoroughly.
---------------------------------------------------------------------------
    * The appendix has been retained in committee files.
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    Following the news of a formal SEC investigation of Enron in 
October 2001, Commission staff contacted market participants to learn 
whether any supply obligations might be in jeopardy. Staff began 
monitoring EnronOnline more closely, particularly any changes in the 
margins between the bid-ask prices on EnronOnline, as a widening of 
these bid-ask spreads might signal less liquidity in the market; but 
there was no significant change in the margin between the bid and ask 
prices on EnronOnline.
    Commission staff also contacted counterparties and received 
assurances from them that they were adjusting to Enron by 
``shortening'' their positions and not entering into longer-term 
arrangements with Enron. In mid-November, when it appeared that the 
Dynegy merger with Enron might be jeopardized, staff observed no 
significant change in the margin between the bid and ask prices on 
EnronOnline; at the same time, there was a marked increase in the 
volume traded on other online trading platforms, such as Dynegydirect 
and Intercontinental Exchange (ICE). Commission staff again contacted 
energy traders to determine whether major supply disruptions in 
wholesale markets were occurring, and was informed that Enron had 
``flattened its books,'' i.e., made its portfolio of trades neither 
long nor short so that it could more easily ``step out'' of 
transactions and not cause disruption. As events unfolded in late 
November and early December, other market participants stepped into 
these deals. With the exception of certain lightly-traded points, it 
appears that Enron's competitors have filled the void left behind by 
Enron.
    The reason for this overall calmness in commodity prices is basic. 
Although Enron was a significant player in electric and gas markets--as 
a pipeline, as a commodity trader, as a futures contract trader, and as 
a market maker--there were many other players in these large, 
established commodity markets, and a great deal of market diversity. 
Once it became apparent that Enron might not be a stable counterparty, 
its trading partners began to systematically adjust their positions and 
practices in the marketplace, moving to other trading platforms and 
partners. A similar process occurred among the counterparties to 
Enron's longer-term, untraded gas and electric contracts. Thus, over 
only a few weeks time, the gas and electric markets systematically 
minimized Enron's role in the marketplace and the likelihood that a 
company-specific failure could significantly affect the underlying 
commodities. I believe the calm but vigilant reaction of the 
Commodities Futures Trading Commission, among others, during this 
period allowed time for this unwinding to take place.
    The flexibility of today's energy markets allows a buyer losing its 
supply to replace the energy in real-time (at least briefly) through 
imbalance services offered by transportation providers. With more time, 
such as an hour or more before a supply will be lost, a buyer generally 
can arrange alternative supplies from a wide range of sources. Thus, 
the risk of a buyer having insufficient energy because of a seller's 
default appears to be manageable, as evidenced by the recent experience 
with Enron.
    The more substantial risk in these circumstances is the loss of an 
advantageous contractual price for energy. Even this risk, however, 
depends on market conditions. When a seller defaults, market conditions 
for buying energy may be better or worse than when a buyer entered into 
its contract with the seller. If better, the buyer actually may benefit 
from not having to buy under the existing contract and instead being 
able to buy at lower prices elsewhere.
            Enron's Market Role
    Enron's role in the gas and electric markets was primarily in the 
trading of financial assets (commodity and futures contracts) rather 
than physical assets (with the exception of its natural gas pipelines, 
which continued operation relatively untouched by the events affecting 
the parent and affiliated companies). Less than 10 percent of the 
contracts traded in these markets involve the initial producer or final 
wholesale customer for the product--well over 90 percent of commodity 
contracts and futures are between intermediate holders who are managing 
risk and facilitating connections between initial producers and 
ultimate customers. Adjustments in the financial asset marketplace--as 
to the length of a contract or the identities of the counterparties--
rarely affect the flow of the physical gas and electricity underlying 
those contracts. Thus, while the commodity markets were shortening the 
length of contracts and moving more trade to non-Enron partners, gas 
and electric deliveries continued unaffected.
    Enron does control a number of natural gas pipelines, but its 
financial failure has had little apparent impact on their operations. 
But even if it had, it is worth noting that the gas and electric 
markets have demonstrated their ability to react to and manage around 
problems that could affect their ability to deliver electricity and 
gas. When a pipeline breaks, a compressor station fails, a transmission 
line collapses, or a large power plant goes off-line, the parties in 
the market adjust immediately to acquire other supplies and delivery 
routes. Having a sufficiently robust energy infrastructure makes this 
so. In these instances, prices may well rise and, occasionally, 
deliveries to retail customers may be slowed but the wholesale market 
reacts swiftly and minimizes the impact to wholesale and retail 
customers alike.
    In response to the Enron crisis, Moody's has raised the credit 
standards for generators and traders. This has forced energy concerns 
to rebalance their debt-to-asset ratios, forcing many to reduce debt 
and cut back investments in new gas processing, pipelines and power 
plants. During December 2001, stock prices of several energy companies 
hit yearly lows. Enron's problems, in combination with the recession 
and reports of potential overbuilding, appear to have eroded 
confidence, making investors more cautious about putting money into the 
energy industry. This slowdown in infrastructure investment could be 
problematic in some regions as the economy recovers and demand for 
energy grows. For that reason, the Commission has accelerated its 
efforts to complete the transition to a more competitive wholesale 
power market in order to provide investment certainty.
            Enron and Competition
    The markets' reaction to Enron's collapse demonstrates what good, 
working competitive markets do best--a diverse group of market 
participants with adequate market information about the players and 
commodities act individually to produce a result that works for all. 
The nation's wholesale electric and gas markets showed great resilience 
and swift reaction time, and demonstrated that they are much stronger 
than any individual player in the marketplace.
    Some claim that Enron's demise is due to the failure of 
deregulation and competition in the electric industry, of which it was 
one of many supporters. I strongly disagree. Wholesale competition in 
the gas industry has spurred gas production, encouraged pipeline 
construction, driven down commodity prices for the past decade and 
lowered retail prices accordingly. In the electric sector, wholesale 
competition, although it is in its infancy, has enabled the 
construction of thousands of megawatts of new power plant capacity 
across the country, resulting in lower commodity and retail electric 
prices in most regions, and in a cleaner generation fleet.
         iii. the commission's regulation of enron subsidiaries
    The Commission does not regulate the parent corporation, Enron 
Corporation, as it does not engage in activities which are under FERC 
jurisdiction. FERC does regulate eleven of Enron's approximately 100 
subsidiaries. Our authority, and the specific names of the Enron 
subsidiaries subject to our jurisdiction, are described below.
    The Commission has jurisdiction over sales for resale of electric 
energy and transmission service provided by public utilities in 
interstate commerce. The Federal Power Act includes energy marketers 
and traditional vertically integrated electric utilities in its 
definition of public utilities. The Commission must ensure that the 
rates, terms and conditions of wholesale energy and transmission 
services are just, reasonable, and not unduly discriminatory or 
preferential. FERC also is responsible for reviewing proposed mergers, 
acquisitions and dispositions of jurisdictional facilities by public 
utilities, and must approve such transactions if they are consistent 
with the public interest. We also regulate the issuance of securities 
and the assumption of liabilities by public utilities not regulated by 
States.
    The Commission also has jurisdiction over sales for resale of 
natural gas and transportation. However, FERC jurisdiction over sales 
for resale is limited to domestic gas sold by pipelines, local 
distribution companies, and their affiliates, (including energy 
marketers.) Consistent with Congressional intent, the Commission does 
not prescribe prices for these sales.
    Figure 3, in the Appendix, illustrates the distinction between 
physical and financial assets in the energy sector and highlights the 
market segments of several Enron subsidiaries. It further identifies 
which subsidiaries and market segments fall under FERC regulation.
A. Energy Marketers
    Competitive trading of energy by ``marketers'' generally began 
about two decades ago. Marketers do not usually own physical 
facilities, but take title to energy and re-sell it at market-based 
rates. Natural gas marketing began with the deregulation of the price 
of natural gas in 1978 and expanded with the Commission's 1992 open 
access rule for natural gas pipelines, Order No. 636. In the decade 
since Order No. 636, natural gas marketing has developed into a large, 
robust activity with many marketers. The Commission lacks jurisdiction 
over sales of natural gas by many gas marketers. To maximize 
competition we have granted ``blanket authorization'' for those 
marketers under FERC jurisdiction so they do not have to file for and 
obtain individual approvals to sell gas at wholesale.
    In the electric arena, wholesale power marketers began selling 
electric energy as early as 1986. The Energy Policy Act of 1992, and 
the Commission's 1996 open access rule for electric transmission owners 
and operators, Order No. 888, further spurred the development of 
competitive electric power trading.
    The Commission regulates the following power marketers affiliated 
with Enron: Enron Power Marketing Inc., Enron Sandhill Limited 
Partnership, Milford Power Limited Partnership, Enron Energy Services, 
Inc., and Enron Marketing Energy Corporation.
            EnronOnLine
    Before its collapse, Enron was the largest marketer of natural gas 
and electric power. Enron's Internet-based trading system, EnronOnline, 
was until recently the dominant Internet-based platform for both 
physical energy (electricity and natural gas products) and energy 
derivatives. (Derivatives are financial instruments based on the value 
of one or more underlying stocks, bonds, commodities, or other items. 
Derivatives involve the trading of rights or obligations based on the 
underlying product, but do not directly transfer property.) Although 
EnronOnline was the leading Internet-based trading platform for natural 
gas and electric power, it faced competition from other Internet-based 
trading platforms, such as Dynegydirect and Intercontinental Exchange 
(ICE).
    Traditional exchanges, like the NYSE and the NYMEX, determine price 
by matching the buy and sell orders of many traders in a many-to-many 
trading format. In contrast, EnronOnline uses a one-to-many trading 
format, where an Enron affiliate is always on one side of each energy 
transaction, either as a seller or a buyer. The price of a commodity or 
derivative on EnronOnline is determined when a buyer or a seller 
accepts an offer or bid price posted by an Enron trader. In the wake of 
Enron's downfall, the many-to-many platforms such as ICE have helped to 
fill the void, and create a more robust market by reflecting the bid 
and offer values of myriad different energy buyers and sellers.
            Market-based Rate Authorization
    To sell electricity at market-based rates, public utilities 
(including power marketers) must file an application with the 
Commission. The Commission grants authorization to sell power at 
market-based rates if the power marketer adequately demonstrates that 
it and its affiliates lack or have mitigated market power in the 
relevant markets. FERC conditions market-based rate authority on power 
marketers submitting quarterly reports of their purchase and sales 
activities and complying with certain restrictions for the protection 
of captive customers against affiliate abuse. There are currently 1200 
electric power marketers authorized to sell energy at market-based 
rates.
    The Commission generally grants waiver of certain regulations to 
power marketers which receive market-based rate authorization. For 
example, these marketers do not need to submit cost-of-service filings 
because the rates they charge are market-based. The Commission also 
exempts power marketers from its accounting requirements, because those 
requirements are designed to collect the information used in setting 
cost-based rates. In addition, unless others object, FERC grants power 
marketers' requests for blanket approval for all future issuances of 
securities and assumptions of liability.
    Because the Commission's reporting and accounting requirements are 
designed to address a limited set of concerns, and apply only to the 
jurisdictional subsidiary at issue, it is unlikely that requiring power 
marketers to comply with these requirements could prevent a future 
Enron-like failure. Nevertheless, in our current rulemaking proceeding 
on accounting rules, we have invited comments on whether the current 
exemptions for power marketers from such requirements remain 
appropriate.
B. Electric Utilities
    A few years ago Enron acquired Portland General Electric (PGE), a 
vertically-integrated utility subsidiary of Enron that handles 
electricity generation, purchase, transmission, distribution and sale 
in eastern Oregon. PGE's retail rates and practices are under the 
jurisdiction of the Oregon Public Utility Commission. PGE also sells 
energy to wholesale customers in the western United States. FERC has 
granted market-based rate authorization to PGE for certain wholesale 
sales. Although the Commission waives some of its reporting 
requirements for power marketers, it requires continued reporting from 
franchised electric utilities such as PGE, so we can monitor whether 
its wholesale transactions are inappropriately favoring its affiliates 
or harming its captive customers. Although Enron's collapse has had 
tragic impacts upon PGE's employee retirement accounts, we have not yet 
seen any negative impacts on PGE's ability to meet its obligations to 
customers as a result of the Enron bankruptcy. I should also observe 
that the sale of PGE to Northwest Natural, announced prior to Enron's 
collapse, is pending before FERC and other regulatory bodies.
C. Gas Pipeline Subsidiaries
    The Commission has limited jurisdiction over sales for resale of 
natural gas in interstate commerce. The Commission has jurisdiction to 
regulate only sales for resale of domestic gas by pipelines, local 
distribution companies (LDCs), and their affiliates. Consistent with 
the Congressional goal of allowing competition in natural gas markets, 
the Commission does not prescribe the prices for these sales.
    The Commission has authority over the rates, terms and conditions 
for pipeline transportation in interstate commerce of natural gas and 
oil. The Commission regulates several natural gas pipeline affiliates 
of Enron, namely, Florida Gas Transmission, Midwestern Gas 
Transmission, Northern Border Pipeline Company, Transwestern Pipeline 
Company, and Northern Natural Gas Company.
D. Transactions and Activities Not Regulated by the Commission
    The Federal Power Act does not give the Commission direct, explicit 
jurisdiction over purely financial transactions, such as futures 
contracts for electricity or natural gas. The Commission has asserted 
jurisdiction over such transactions only when they result in physical 
delivery of the energy which is the subject of the financial contract, 
or when such transactions or contracts affect or relate to 
jurisdictional services or rates (e.g., financial contracts affecting 
firm rights to interstate transmission capacity or the pricing of such 
capacity).\1\ While Enron and its subsidiaries engaged in many 
electricity futures contracts and other energy-related derivatives, it 
does not appear that these transactions have played a significant role 
in Enron's demise.
---------------------------------------------------------------------------
    \1\ In 1996, the Commission addressed the issue of whether an 
electricity futures contract approved for trading by the CFTC would 
fall under its jurisdiction, pursuant to the FPA. New York Mercantile 
Exchange, 74 FERC para. 61,311 (1996). The Commission found that the 
CFTC possessed exclusive jurisdiction over the trading of such futures 
contracts, and that the Commission would assert jurisdiction, pursuant 
to the FPA, only if the electricity futures contract goes to delivery, 
the electric energy sold under the contract will be resold in 
interstate commerce, and the seller is a public utility. Id. at 61,986.
---------------------------------------------------------------------------
                 iv. ferc initiatives in energy markets
    In response to rapidly evolving energy markets, the Commission has 
implemented a number of new initiatives to improve its market-
monitoring abilities. The Commission's new strategic plan, adopted 
September 26, 2001, encompasses three major areas of activity in 
overseeing the energy industry:

   Infrastructure--working with others to anticipate the need 
        for new generation and transmission facilities, determining the 
        rules for cost recovery of new energy infrastructure, 
        encouraging the construction of new infrastructure, and 
        licensing or certificating hydroelectric facilities and natural 
        gas pipelines;
   Market rules--ensuring clear, fair market rules to govern 
        wholesale competition that benefits all participants, and 
        assure non-discriminatory transmission access in the electric 
        and natural gas industries;
   Market oversight and investigation--understanding markets 
        and remedying market rule violations and abuse of market power.

    This last, third strategic goal is new, and reflects the present 
Commission's commitment to ensuring that markets continue to work for 
customers. The strategic plan is available on our website at 
www.ferc.gov.
    To give substance to this third strategic goal, the Commission is 
creating a new Office of Market Oversight and Investigation (MOI), 
which will concentrate the Commission's market-monitoring resources 
into one workgroup and enable the Commission to better understand and 
track wholesale energy markets and risk management by analyzing market 
data, measuring market performance, investigating compliance 
violations, and, where necessary, pursuing enforcement actions. MOI's 
work will provide an early warning system to alert the Commission of 
potentially negative market developments and let us act more 
proactively to address any problems that may arise. We are currently 
taking applications for the Director of this Office, who will report 
directly to me.
    In mid-2001 the Commission created the Market Observation Resource 
Center (MOR) to better observe market developments and to enable us to 
grasp quickly the significance of changes in market conditions. MOR's 
computer hardware, software and subscription web services give us 
access to historical and real-time data about energy markets.
    The Commission has launched several other initiatives within the 
past year to ensure vigilant and fair oversight of the changing energy 
markets. In July 2001, the Commission proposed in a rulemaking to amend 
the filing requirements for public utilities. The proposal would 
require all generators, public utilities and power marketers to file 
electronically with the Commission and post on the Internet an index of 
customers with a summary of the contractual terms and conditions for 
market-based power sales, cost-based power sales, and transmission 
service. These companies would also have to report transaction 
information for short-term and long-term market-based power sales and 
cost-based power sales during the most recent calendar quarter. This 
proposal will give the Commission and the public more complete and 
accessible information on jurisdictional transactions.
    In September 2001, the Commission proposed in a rulemaking to 
revise its restrictions on the relationships between regulated 
transmission providers (such as Portland General Electric) and their 
energy affiliates, broadening the definition of an affiliate to include 
newer types of affiliates, such as affiliated trading platforms (e.g., 
EnronOnline).
    Also, in September 2001, the Commission staff began a comprehensive 
review of the information the Commission needs to carry out its 
statutory obligations in the current and evolving markets in 
electricity and natural gas. Presently, much of the information we 
require relates to the historic rate-setting functions of the agency. 
The review so far indicates that some of this may no longer be 
necessary, while other information is now more essential to provide 
transparency in a competitive marketplace.
    In December 2001, the Commission proposed in a rulemaking to update 
the accounting and reporting requirements for jurisdictional public 
utilities, natural gas companies and oil pipelines. FERC proposes to 
establish uniform accounting requirements and related accounts for the 
recognition of changes in the fair value of certain security 
investments, items of other comprehensive incomes, derivative 
instruments, and hedging activities. The proposal is aimed at improving 
the visibility, completeness and consistency of accounting and 
reporting changes for these items. It invites comments on whether 
entities that are currently exempted from these accounting and 
reporting requirements, such as power marketers, should be subject to 
these proposed regulations.
    While I have an open mind on whether the Commission should continue 
to exempt power marketers from its accounting requirements, our 
accounting requirements are not aimed at the kind of activities 
allegedly undertaken by Enron. Based on our historical 
responsibilities, FERC's accounting requirements are focused on 
providing useful and accurate information for determining cost-based 
rates. Cost-based ratemaking encourages utilities to maximize their 
claimed costs and minimize their expected revenues, to justify the 
highest possible rates. The Commission's accounting rules and auditing 
are designed to ensure that utilities with cost-based rates do not 
overstate costs or understate revenues. On January 22, 2001, the 
Securities and Exchange Commission proposed additional accounting-
related disclosures from a broad universe of companies, including those 
exempt from FERC's reporting requirements. Adoption of that proposal 
could eliminate the need for the FERC to alter its reporting 
requirements in this regard.
                   v. additional statutory authority
    Before we can understand how to prevent another Enron-like 
collapse, we must first understand what internal actions and external 
events caused Enron to fail. That effort is now underway by this 
Committee and elsewhere. Then we must ask whether those actions and 
events can and should be prevented in the future.
    Whether the Commission needs any additional statutory authority 
depends on the role Congress intends for the Commission. Historically, 
the Commission's economic regulation has focused on ensuring that 
energy markets deliver adequate energy at reasonable prices. The demise 
of Enron has had little or no effect on the supply or price of energy. 
Instead, Enron's collapse has primarily harmed its investors and 
employees. Since it appears that few of Enron's problems affected the 
narrow scope of wholesale energy markets, it is not clear that giving 
the Commission additional authority within its current scope would 
prevent further Enron-like problems.
    To encourage greater efficiencies in the energy markets and to 
ensure that wholesale competition expands its ability to deliver 
reasonably priced, adequate energy supplies to more customers, the 
Commission is moving forward to complete its effort to create 
competitive national wholesale power markets as it did with natural gas 
markets in the late 1980s and early 1990s. Congress endorsed wholesale 
power competition in the Energy Policy Act of 1992 and further 
endorsement of this effort would certainly be helpful. In particular, 
Congress should give the Commission explicit authority to require 
regional transmission organizations (RTOs) where it finds RTOs to be in 
the public interest. RTOs will broaden regional energy markets, 
allowing greater market efficiencies and limiting possible 
discrimination in grid operations. Congress should also remove tax 
disincentives to transferring transmission assets to RTOs and to use of 
public power transmission lines.
            Price Transparency
    Greater price transparency will help improve the efficiency of 
energy markets, by providing buyers and sellers with better information 
about market conditions. The creation and operation of broad regional 
energy markets with a widely-traded set of energy products will do much 
to make this happen. Once RTOs over broad regional markets are 
established, operating under fair, clear, stable market rules, price 
transparency will improve significantly, even without a Congressional 
mandate. This has already happened to an extent in the regions now 
served by Independent System Operators (ISOs).
    The Commission is moving forward with further transparency, as 
discussed above. Without question, Congressional endorsement of this 
effort would be helpful. Proposed Senate legislation, S. 1766, would 
improve market transparency through better electronic dissemination of 
information about trades in the energy markets and the transfer 
capabilities of the transmission infrastructure. These measures will 
help the Commission establish sound competitive wholesale markets by 
validating and broadening the agency's authority to compel such 
reporting and information dissemination. They will also help FERC and 
financial market regulators and players to better monitor individual 
companies' participation and diminish the ability of any individual 
player to misbehave or misrepresent in the marketplace.
    I offer two cautions, however:

   First, while the transparency provisions of S. 1766 address 
        actual trades, they do not appear to address at least two of 
        the issues at the heart of Enron's situation--how they handled 
        and reported the risks and valuation underlying the trades they 
        were conducting, and how they represented the value of the 
        trades flowing through their platforms as corporate revenue. 
        Those are broader financial reporting and regulation issues 
        that are outside the scope of FERC's jurisdiction.
   Second, there is a difficult balance between information 
        that must be disclosed to make markets work and information 
        that is commercially proprietary. It is clearly to the public 
        benefit to implement rules that disclose more information and 
        improve market transparency, but it is not always easy in 
        practice to find the appropriate point between reasonable 
        information disclosure and protection.

    But these reservations do not detract from the value that a 
provision like Section 208 of S. 1766 may bring to the nation's energy 
markets, and I support adoption of an appropriate transparency 
provision.
            Creditworthiness
    The responsibility for ensuring creditworthiness of participants in 
wholesale energy trades lies primarily with the parties involved in 
those trades. Creditworthiness provisions are included in some 
contracts or tariffs filed at the Commission to date, and the 
Commission is likely to include some broad creditworthiness provisions 
in the standard tariffs that will be developed for all transmission 
providers and customers (to prevent the use of individual 
creditworthiness terms as discriminatory measures in narrow geographic 
areas or against specific players). But, market participants seem best 
equipped to develop sophisticated risk management measures and narrow 
creditworthiness concerns, and those provisions may be subject to 
Commission review for justness and reasonableness.
    To the extent creditworthiness issues are raised before the 
Commission, we act expeditiously. For example, shortly after Enron 
declared bankruptcy, the Participants Committee of the New England 
Power Pool (NEPOOL) sought to implement alternative payment and 
financial assurance arrangements with Enron Power Marketing Inc., Enron 
Energy Marketing Corporation, and Enron Energy Services, Inc. Within a 
week of the date of filing, the Commission accepted and suspended these 
arrangements (subject to review of the finalized agreement), to protect 
NEPOOL participants while enabling the Enron subsidiaries to stay in 
the market and continue serving their customers. I do not think there 
is any need to legislatively address creditworthiness issues specific 
to energy markets.
            Public Utility Holding Company Act
    If Congress' policy goal is to promote wholesale energy competition 
and new infrastructure construction, then reform of the Public Utility 
Holding Company Act of 1935 (PUHCA), supplemented with increased access 
by the Commission and state regulators to certain books and records, 
will help energy customers. Energy markets have changed dramatically 
since enactment of PUHCA, and competition, where it exists, is often a 
more effective constraint on energy prices. In the 65 years since PUHCA 
was enacted, much greater state and federal regulation of utilities and 
greater competition have diminished any contribution PUHCA may make 
toward protecting the interests of utility customers. State and federal 
ratemaking proceedings, for example, are very effective in ensuring 
that activities of unregulated businesses do not increase regulated 
rates. For this reason, the provisions of S. 1766 which give broad 
access to a regulated company's holding company's books and records is 
important if PUHCA is to be repealed. But some have argued that certain 
provisions of PUHCA may remain valuable in protecting the interests of 
shareholders and employees in other regards, and I defer to others on 
that point.
    As always, I will be happy to provide further information or answer 
any questions you may have and offer the services of my colleagues and 
staff to the Committee's efforts.

    The Chairman. Well, thank you very much. Next let us hear 
from Mr. William M. Nugent, who is the president of the 
National Association of Regulatory and Utility Commissioners, 
as to the perspective from State commissions. Please.

STATEMENT OF WILLIAM M. NUGENT, PRESIDENT, NATIONAL ASSOCIATION 
            OF REGULATORY AND UTILITY COMMISSIONERS

    Mr. Nugent. Thank you, Mr. Chairman, members of the 
committee. I am not only the president of NRUC, I am also a 
commissioner in Maine. I will present views from my perch in 
Maine, and where possible, that of my colleagues across the 
country, but I will tell you this has blown up so recently that 
our members have not gotten together, chewed it over, and come 
up with a particular policy on this.
    Maine offers suggestions to FERC, or is pleased to comment 
on these issues, because I do not think there is any State 
across the country that has got a greater interest in the 
success of the wholesale electricity markets than does Maine.
    We opened our markets to competition 2 years ago, and since 
that time our consumers have been directly and often 
immediately affected by changes in New England's wholesale 
electricity prices. As much as any jurisdiction we cut the 
ties, the regulatory tie between electricity supply and 
delivery by requiring utilities to completely divest themselves 
of generation. I have brought for the committee's work, and we 
can provide this to you for staff, it is a very recent annual 
report on electric restructuring in the State, and I also offer 
a blueprint which we previously provided to the FERC as to how 
we can move expeditiously to create a Northeast regional 
market.
    We do this work because we believe that competition in 
electricity markets is likely to be fairest and most successful 
when transmission and distribution utilities have no reason to 
favor any one competitor over another. Now, the model we have 
chosen to open our State to competition apparently has found 
acceptance in the energy community. 14 energy companies are 
actively selling in Maine and have won customers, including 
Enron, which by our estimate serves fully a quarter, an 
estimated 450 megawatts of Maine's load, or at least it did so 
prior to its recent troubles. I know that to the extent they 
are meeting standard offer, provider of last resort 
obligations, they continue to provide it as of this morning. 
They are doing it.
    Our interest in the success of the wholesale markets is 
further rooted in our decision to forego artificial price-
controlling devices such as price caps or long-term fixed 
supply contracts that insulate customers from the prices 
revealed in wholesale markets. Our standard offer is provided 
at prices that are set by competitive bid. The effect of our 
approach to restructuring has been dramatic. The incumbent 
investor-owned utilities no longer supply generation. Virtually 
all of Maine's generation is supplied by competitive providers, 
and 44 percent of our load has departed standard offering, and 
is served by retail suppliers, and I have the data on that to 
give you as well.
    Our adoption of the competitive model came at a price. The 
prices paid by Maine consumers are, perhaps as much as any in 
the country, subject to the vagaries of the wholesale market 
and, accordingly, we have worked very hard to avoid or minimize 
the impacts of any events which will impair competition or 
unfairly injure consumers, residential or business and thus 
far, I am relieved to report, both Maine and New England have 
apparently avoided significant injury from Enron's recent 
financial collapse.
    Most feared were threats to the reliability of supply, and 
to prices paid by Enron's customers. Supply continued without 
discernible disruption, and because of very careful management, 
particularly by the ISO New England and participants in the New 
England Power Pool, NEPOOL, there was no instability in the 
markets, and apparently no major financial losses. Enron's 
collapse did not cause a reliability problem because Enron does 
not own most of the generators. It does not own any of the 
generators in New England. The generation owners' interest 
remained unchanged. Run the generators and sell the output. 
Customers continued to want that output. Loads did not change, 
generators did not go anywhere, so reliability was unaffected.
    And in this environment, the stressed and ultimately 
bankrupt Enron continued, and continues, as I mentioned a 
moment ago, to meet its contractual supply obligations in 
Maine, most, if not all of which were profitable in today's 
energy market. Those contracts required customers to pay a 
higher price than the current market price. It has been a 
falling energy price environment.
    Nevertheless, companies who owned the generators, fearing 
that Enron might not pay for its power, opted out of contracts 
when possible and instead sold into a spot market, and new 
arrangements had to be found. Enron now settles each day for 
the trades accounted for 3 days ago, as opposed to the previous 
situation, which was a 30-day settlement, which the other 
providers continue to enjoy, a change, by the way, which was 
proposed on very short order in the wake of the collapse, and 
was approved within about 7 days by the FERC, something we very 
much appreciate.
    Outcomes like the one in Maine and New England just 
experienced frequently lead to the oft-used phrase, we dodged 
the bullet, and a big sigh of relief. True, the bullet did not 
hit us, but it was not because we were smart enough or nimble 
enough to escape its blow. We were simply and profoundly lucky. 
We are, and have been for many months, in a falling energy 
price market, one in which suppliers with a fixed price can 
profit from declining prices. Had these same set of events 
occurred against the backdrop of rising energy prices, 
suppliers would have had an extraordinary incentive to escape 
their obligations. Now, Maine has had some experience with that 
in two particular instances, and if you want to we can go into 
that later.
    Had Enron's implosion occurred in a rising market, Maine's 
ratepayers could have taken a hit in excess of $50 million, 
perhaps $100 million, and remember, Maine is a State of fewer 
than 1.3 million people. If Enron had captured as much of the 
market across New England as it has in Maine, and we were in a 
rising energy price market, the comparable hit on ratepayers 
across New England could have been more than $1 billion.
    This is not to say that the markets would not have worked. 
Prices change because markets are functioning, and I think 
reliability would have been met, but the rising prices would 
largely reflect a more constrained supply situation and there 
would have been some travail for consumers.
    For ratepayers there is a certain heads-you-win, tails-I-
lose aspect to the energy market. If a customer signs a 
contract with an energy supplier, and market prices fall, the 
customer is stuck with paying the now higher-than-market price 
for its energy. This remains true even if the supplier, as 
Enron, goes bankrupt.
    The contract is a valuable asset of the bankrupt, one which 
the bankruptcy court will seek to use on behalf of other 
creditors, but if a customer has a contract with an energy 
supplier, market prices rise, and the supplier for whatever 
reason goes bankrupt and defaults on the contract, the 
customers must buy new supply in the higher priced energy 
market and take its place in line with all the other creditors, 
with little hope that the protections a customer negotiated in 
its supply contract will provide sufficient relief.
    This is not an argument for eliminating the market. It is a 
very deep reason why we have to ensure that we have healthy 
players in the market, and it goes as much to the business 
considerations here as to changes in market design.
    I see my time is up. You have written copies of my 
testimony in advance. I will be happy to answer your questions 
as they come, Mr. Chairman. Thank you for this opportunity.
    [The prepared statement of Mr. Nugent follows:]
     Prepared Statement of William M. Nugent, President, National 
          Association of Regulatory and Utility Commissioners
    Good morning, Mr. Chairman, members of the Committee.
    Thank you for this opportunity to report to the Committee on the 
effects of the Enron Corporation's recent decline on the electricity 
market in one state (Maine) and New England. I am William M. Nugent, a 
commissioner on the Maine Public Utilities Commission (MPUC) and 
President of the National Association of Regulatory Utility 
Commissioners (NARUC). I will present my own views and, where possible, 
those of NARUC. But the Enron matter has developed so recently that our 
members have yet to meet and develop specific policy in response to it.
    To aid the Committee's work on restructuring the electricity 
industry (S. 1766 and related bills), I have brought copies of the 
Maine Commission's very recent 46-page Report on Restructuring in our 
State. I am also providing a ``Blueprint for Establishing a Northeast 
RTO,'' suggestions as to how we believe the Federal Energy Regulatory 
Commission it can best aid the development of a Northeast RTO, while 
ensuring the efficient operation of the current markets for as long as 
those markets exist. Maine offered these suggestions to the FERC 
because Maine has an enormous stake not only in the health of the 
current markets but also in the further development of broader, deeper, 
more liquid energy markets.
    No state has a greater interest in the success of the wholesale 
electricity markets than Maine. In the two years since we opened our 
retail markets to competition, Maine's consumers have been directly and 
often immediately affected by changes in the wholesale prices in New 
England. As much as any jurisdiction, Maine cut the regulatory tie 
between electricity supply and delivery by requiring its utilities to 
completely divest themselves of generation. We did so because we 
believe that competition in electricity markets is likely to be fairest 
and most robust when the transmission and distribution utility, the T&D 
utility, has no reason to favor any one competitor over any other. 
Apparently energy companies agree; currently 14 of them have competed 
and won customers in Maine, including Enron, which--by our best 
estimates--serves fully one quarter (an estimated 450 megawatts) of 
Maine's load--or at least it did so prior to its recent troubles).
    Maine's interest in the success of the wholesale electricity 
markets is further rooted in our decision to forego artificial price-
controlling devices such as price caps or long term fixed supply 
contracts that insulate consumers from the prices revealed in the 
wholesale markets; even Maine's Standard Offer (default or provider of 
last resort) supply is provided at prices that are set by competitive 
bid. The effect of Maine's approach to restructuring has been dramatic:

   the incumbent investor-owned utilities no-longer supply 
        generation service;
   virtually all of Maine's generation is supplied by 
        competitive suppliers, and
   44 percent of the total electric load in Maine has departed 
        the standard offer (the provider of last resort) and is served 
        by retail suppliers.

    Maine's aggressive adoption of the competitive model, however, 
comes at a price. The prices paid by Maine's consumers are--perhaps as 
much as any in the country--sensitive to the vagaries of the wholesale 
market. Accordingly, we have worked hard to ensure that the wholesale 
market reflects the economics of supply and demand, and does not 
provide either inadequate incentives for efficient investment or 
opportunities for gaming and the exercise of market power. We have 
tried to avoid or minimize the impact of any events which will impair 
competition or unfairly injure consumers--residential or business.
    And, thus far, I am relieved to report, both Maine and New England 
have apparently avoided significant injury from Enron's recent 
financial collapse. Most feared were threats to the reliability of 
supply and to the prices paid by Enron's customers. Supply continued 
without discernible disruption. And, because of very careful 
management, particularly by the ISO-New England and participants in the 
New England Power Pool (NEPOOL), there was little instability in the 
markets and apparently no major financial losses.
    Enron's collapse did not cause a reliability problem because Enron 
does not own the generators. The generation owners' interest remained 
unchanged: run their generators and sell the output. Customers 
continued to want that output. Loads did not change. Generators did not 
go anywhere. So reliability was unaffected.
    And in this environment the stressed and ultimately bankrupt Enron 
continued--and continues--to meet its contractual supply obligations, 
most--if not all--of which were profitable in today's energy market. 
Those contracts required customers to pay a higher price than the 
current market price.
    Nevertheless, companies who owned the generators, fearing that 
Enron might not pay for its power purchases, opted out of contracts 
when possible and instead sold into the spot market.
    NEPOOL's old financial assurance policies allowed the organization 
to rescind membership in the Pool, but did not allow NEPOOL to cut off 
a company from trading in the energy markets in response to a situation 
like that posed by Enron. NEPOOL and ISO-New England's new policy will 
automatically restrict a company's trading in the pool if its credit 
rating falls below a certain level.
    The sudden Enron disintegration impaired its ability to arrange 
bilateral contracts with generators. In response, Enron bought more and 
more from the Pool each day. When Enron declared bankruptcy, it was 
carrying a large, negative financial balance with the Pool (pre-
bankruptcy-petition debt). There are two possible remedies for this 
pre-petition debt. The bonds that Enron was required to post to 
establish credit with the pool may cover the debt; and if not, NEPOOL 
has filed a claim in the bankruptcy proceeding.
    Enron fought to avoid giving up its trading activities. In lieu of 
the 30-day settlement process accorded healthy energy trading 
companies, Enron negotiated a new 3-day-rolling-average payment 
arrangement with the Pool (administered by the ISO). Enron now 
maintains a 3-day cash balancing account with the ISO. At the end of 
each day, the ISO withdraws enough money to cover the transactions that 
occurred three days previously. Enron has agreed to wire-transfer to 
the ISO--by the end of the next day--enough money to replenish the 
account. In December this arrangement and term sheet were submitted to 
the FERC for emergency approval. The FERC promptly approved it.
    There was further concern in the New England market that, because 
parties with bilateral contracts to supply Enron could terminate those 
contracts because of the bankruptcy but Enron could keep buying what it 
needed in the spot market, Enron's resort to the spot market could 
produce over-reliance on it (similar to what happened in California), 
sharply increasing spot-market prices. While that did not happen in 
this instance, it remains at least a theoretical possibility in the 
event of the financial collapse of another big player.
    Outcomes like the one Maine and New England just experienced 
frequently leads to the oft-used phrase ``we dodged the bullet.'' True, 
the bullet did not hit us. But it was not because we were smart enough 
or nimble enough to escape its blow. We were simply and profoundly 
lucky.
    We are, and have been for many months, in a falling energy-price 
market, one in which suppliers with a fixed price can profit from 
declining prices. Had the same set of events occurred against a 
backdrop of rising energy prices, suppliers would have had an 
extraordinary incentive to escape their obligations. (Maine has had 
direct experience with such circumstances.)
    Had Enron's implosion occurred in a rising market, Maine's 
ratepayers could have taken a ``hit'' in excess of $50 million, perhaps 
$100 million. And, remember, Maine is a state of fewer than 1.3 million 
people. If Enron has captured as much of the market across New England 
as it has in Maine and if we were in a rising-energy-price market, the 
comparable ``hit'' for ratepayers across New England could have 
approached $1 billion.
    For ratepayers, there is a certain ``heads you win, tails I lose'' 
aspect to the energy market. If a customer signs a contract with an 
energy supplier and market prices fall, the customer is stuck with 
paying the now higher-than-market price for its energy. This remains 
true even if the supplier--as has Enron--goes bankrupt; the contract is 
a valuable asset of the bankrupt, one which the Bankruptcy Court will 
seek to use on behalf of other creditors.
    But if a customer has a contract with an energy supplier, market 
prices rise, and the supplier (for whatever reason) goes bankrupt and 
defaults on the contract, the customer must buy new supply in the high-
priced energy market and take its place in line with all the other 
creditors with little hope that the protections the customer negotiated 
in its supply contract will provide sufficient relief.
    Maine tries to minimize such risk to the state's Standard Offer 
electricity customers by requiring licensed suppliers to provide 
evidence of their financial soundness, either by posting a substantial 
bond or (in the case of companies whose guaranteeing parent has a 
minimum credit rating of BBB+ or equivalent) by providing us a 
corporate guarantee that the supplier will meet its obligations.
    But even if we had required and Enron had provided a bond to 
protect Maine's Standard Offer customers, we would have had little 
meaningful protection--at least sooner than the conclusion of very 
protracted litigation. Reportedly Enron had purchased surety bonds to 
guarantee billions of dollars of natural gas and crude oil to two 
offshore companies. Enron declared bankruptcy in November, ostensibly 
leaving its guarantors with the bill.
    Enron's failure (perhaps amplified by large claims associated with 
Kmart's failure) supposedly represents one of the largest payouts ever 
for the surety industry, about $2 billion, according to experts. 
Reportedly, it is comparable to the effect of the September 11th 
terrorist attacks on the property and casualty insurance industry, and 
the magnitude of these losses may force some bonding companies out of 
the surety-bond business.
    As a result, bond companies likely will raise prices, require 
collateral, tighten underwriting standards, and cancel some policies. 
Thus, it could be more difficult for some companies to obtain bonds, 
thereby reducing the number of competitive providers and making 
competition less vigorous. Energy market prices may reflect these 
additional cost burdens.
    In conclusion, well-structured, well functioning energy markets can 
bring substantial benefits to consumers and opportunity to ethical, 
well run businesses, and strengthen the U. S. economy. Benefits will be 
realized regardless of whether a state or states open their markets to 
retail competition.
    The keys to a well structured, well functioning market are rules 
that allow all players to compete fairly, based on the underlying 
economics of what they bring to the competition, and on the integrity 
of the players. Absent the latter, competitive energy providers will 
not enjoy the confidence of investors (hence their financial support) 
or other players in the market (making it harder for them to bring 
valuable products to the market).
    Energy providers, consumers, and investors very much need reforms 
that will restore confidence in markets. By themselves, states cannot 
protect against a incompetence or purposeful cheating by a major 
national company. Apart from the costs and limited effectiveness of the 
protections mentioned earlier (e.g., surety bonds, corporate 
guarantee), unscrupulous players can avoid state-designed and enforced 
protections by doing business only in states with the least restrictive 
protections. The specific reforms of this nature must be national in 
scope and carefully designed to balance the price of that protection--
both financial and regulatory--against the value of the additional 
assurances received.

    The Chairman. Thank you very much. Next, let us hear from 
Mr. Newsome, James Newsome, who is the chairman of the 
Commodity Futures Trading Commission.

  STATEMENT OF JAMES E. NEWSOME, CHAIRMAN, COMMODITY FUTURES 
                       TRADING COMMISSION

    Mr. Newsome. Thank you, Mr. Chairman, members of the 
committee. I appreciate the opportunity to testify on behalf of 
the Commodity Futures Trading Commission, and because this 
committee may be a little less familiar with the role of the 
CFTC, I have detailed in written testimony the oversight role 
of the CFTC and for the sake of time will abbreviate those 
comments this morning, but would respectfully ask that my 
written comments be included in the record, Mr. Chairman.
    The Chairman. We will include your written comments in the 
record.
    Mr. Newsome. Thank you, sir.
    I would like to begin by saying, as both a regulator and a 
citizen, that I have great sympathy for the people who were 
harmed by incomplete, misleading, and inaccurate financial 
information. I share the concern of many that appropriate 
inquiries be made to ensure that investors, creditors, and 
others who rely on the accuracy of financial disclosures by 
publicly held companies can continue to do so with the fullest 
of confidence.
    I would like to take a moment to complement Mr. Viola, to 
my right, his staff and members of the New York Mercantile 
Exchange, as well as those at the New York Board of Trade, for 
their remarkable reactions to the September 11 attacks. The 
fact that NYMEX and NYBOT were up and running within only days 
after the attack helped avert the possibility of further 
economic disruptions, and should give us all great confidence 
in the resilience and strength of those institutions.
    I would like to share with you today the important role of 
the futures markets in our economy and the role of the CFTC in 
overseeing those markets, particularly with respect to the 
energy markets, and how that role changed with the passage of 
the Commodity Futures Modernization Act of 2000.
    The commission perceives its mission as twofold, to foster 
transparent, competitive, and financially sound markets, and to 
protect market users and the public from fraud, manipulation, 
and abusive practices. While the stock markets provide a means 
of capital formation, a way for new and existing businesses to 
raise capital, the futures markets provide producers, 
distributors, and users of commodities with a means of managing 
their exposure to price risk. Futures contracts based on 
nonagricultural fiscal commodities like metals or energy 
products, and on financial products such as interest rates, 
foreign currencies, or stock market indices, now serve the risk 
management needs of businesses in so many sectors of the 
economy that trading in these new contract areas is now many 
times larger than that of agricultural contracts.
    Although the primary purpose of the futures markets is risk 
management, many futures markets also play an important price 
discovery role in which many businesses and investors that are 
not direct participants in futures nonetheless refer to the 
quoted prices of futures market transactions as reference 
points or benchmarks for other types of transactions or 
decisions. To fulfill its responsibilities, the commission 
focuses on issues of market integrity and pursues a multi-
pronged approach to market oversight. We seek to protect the 
economic integrity of markets against price manipulation 
through direct market surveillance and oversight of the 
exchanges' surveillance efforts.
    The heart of our direct surveillance is a large trader 
reporting system under which commodity brokers called futures 
commission merchants, or FCM's, and foreign brokers file daily 
reports with us that aggregate positions across FCM's and 
accounts to give a truer view of large trader presence.
    Commissioners are apprised of market activity and possible 
problems at weekly surveillance briefings. To protect the 
financial integrity of the markets, our priorities are to avoid 
disruptions of the clearing and settling system, and to protect 
customer funds entrusted to FCM's. As an oversight regulator, 
the commission reviews the audit and financial surveillance 
work of the exchanges, and also monitors the health of FCM's 
directly. We also review clearinghouse procedures for 
monitoring risk and protecting customer funds.
    To protect the operational integrity of the markets, the 
commission requires extensive record-keeping, appropriate 
customer disclosures, fair sales and trading practices, and 
training of industry professionals. The CFTC Division of 
Enforcement aggressively investigates and prosecutes violations 
of the CEA and of commission rules.
    We oversee on-exchange trading of futures and options 
contracts based on things such as crude oil, natural gas, 
heating oil, propane, gasoline, and coal. The overwhelming 
majority of on-exchange energy transactions are executed on 
NYMEX. Please note that the CFTC does not regulate trading of 
energy on products in the cash or foreign markets, which are 
excluded from our jurisdiction by the Commodity Exchange Act.
    Because Enron was a large trader on the NYMEX, its on-
exchange activities have been regularly monitored by the CFTC. 
At this time, we have no indication that manipulation of any 
futures market was attempted by Enron. However, the rapid 
financial deterioration of Enron presented a separate concern 
for the commission. Could its positions be unwound without 
price volatility or reduced liquidity?
    In fact, these markets proved to be quite resilient. When 
Enron's positions were closed out, prices did not spike up or 
down, nor did liquidity suffer. When Enron's financial troubles 
became known last fall, our staff worked closely with the NYMEX 
clearinghouse and the FCM's that were carrying most of its 
positions to monitor and manage the winding down of those 
positions. By adjusting margins and other appropriate measures, 
the clearinghouse was able to accomplish a very smooth landing 
while protecting the FCM's and their customers.
    By mid-December, all of Enron's positions on the regulated 
exchanges had been liquidated. I believe this episode was an 
example of success for the financial controls in the on-
exchange futures markets.
    In 1999, the President's Working Group on Financial Markets 
released its report on over-the-counter derivatives, which 
recommended providing legal certainty for off-exchange 
derivatives transactions. Congress considered these 
recommendations and ultimately codified many of them, together 
with substantial reforms of the regulatory regime for exchange 
trader futures, in the Commodity Futures Modernization Act of 
2000.
    With respect to energy-based futures, the CFMA exempted two 
types of markets from much of the CFTC's oversight. The first 
is bilateral principal-to-principal trading between two 
eligible contract participants which includes sophisticated 
entities, for example, those with assets of at least $10 
million.
    The second is electronic multilateral trading among 
eligible commercial entities, which include eligible contract 
participants that can also demonstrate an ability to either 
make or take delivery of the underlying commodity, and dealers 
then that regularly provide hedging services to those with such 
ability.
    The CFTC, as part of the President's Financial Working 
Group, is now participating in a review of corporate disclosure 
issues that may yield valuable suggestions for how both 
industry and the Government may seek to prevent a repeat of the 
Enron situation. Within the commission, we are currently 
implementing a reorganization of the CFTC divisions that will 
consolidate our market oversight functions into one division to 
help improve an already excellent program.
    Mr. Chairman, as a regulator, I believe that it is 
important to constantly review current policies and procedures, 
especially given today's dynamic marketplaces, to ensure that 
appropriate regulatory levels are maintained. The significance 
of the Enron situation and its ramifications deserve study and 
recommendations for improvements.
    Some of those responses will come from Congress, others 
from regulators, and still others from industry participants. 
Having said this, I was a supporter of the CFMA because I 
sincerely believe that a one-size-fits-all approach to 
regulation was outdated, especially with all of the business 
and technological innovations that we have seen in recent 
history. Tailoring regulations to the nature of the 
participant, product, and trading facility seemed in my view to 
be appropriate concepts on which to define the Federal 
regulatory interest.
    To date, I have seen no evidence to the contrary. However, 
we will continue to monitor the markets within our 
jurisdiction, and we will continue to utilize all authorities 
given to us by the Congress to aggressively pursue CEA 
violations. The commission stands ready to work with this 
committee, the Congress, and other regulators to find the 
appropriate responses.
    Thank you, Mr. Chairman, for the invitation to be here, and 
I will be happy to answer any questions at the appropriate 
time.
    [The prepared statement of Mr. Newsome follows:]
  Prepared Statement of James E. Newsome, Chairman, Commodity Futures 
                           Trading Commission
    Thank you, Chairman Bingaman, and members of the Committee. I 
appreciate your having given me the opportunity to testify here today 
on behalf of the Commodity Futures Trading Commission and to contribute 
to the discussion of important issues you have raised.
    I would first like to say--both as a federal financial regulator 
and as a citizen--that I have great sympathy for those who were 
misinformed by incomplete and inaccurate information they may have 
received. I also share the concern that appropriate action be taken to 
ensure that investors, creditors, commercial counter parties, and 
others who rely on the accuracy and completeness of financial 
disclosures by publicly-held companies can continue to do so with the 
fullest confidence. I commend the Securities and Exchange Commission 
for having opened an investigation into these matters.
    I would also like to take a moment to commend Mr. Viola and all the 
people at the New York Mercantile Exchange, as well as their friends 
and colleagues at the New York Board of Trade, for their remarkable 
reactions to the September 11th attacks. Their courage, tenacity, and 
foresight in quickly restoring market operations in the face of 
unprecedented challenges and terrible personal tragedies deserve the 
gratitude of every business, investor, and consumer because these 
markets can play critical roles in the U.S. and world economies. For 
example, the West Texas Intermediate Crude oil contract traded on NYMEX 
is relied upon as a price benchmark around the globe. The fact that 
NYMEX and NYBOT were up and running within only days of the attacks 
helped avert the possibility of economic disruptions across the economy 
and should give us all great confidence in the resilience and strength 
of these institutions.
    With your permission, I would like to tell you a little bit about 
the important role of the futures markets in the U.S. economy and the 
role of the CFTC in overseeing those markets. I will describe how the 
Commission responded to the Enron situation last fall. I will also 
discuss our role with respect to the energy markets and how that role 
changed with passage of the Commodity Futures Modernization Act of 
2000. Finally, I would like to offer some thoughts on how the 
Commission might make a contribution as we move forward.
                               background
    The Commission was created by Congress in 1974 to oversee the 
nation's commodity futures and options markets. The Commission 
perceives its mission to be two-fold: to foster transparent, 
competitive, and financially sound markets, and, to protect market 
users and the public from fraud, manipulation, and abusive practices. 
There are important differences between the futures markets and the 
stock markets. While the stock markets provide a means of capital 
formation, a way for new and existing businesses to raise funds, the 
futures markets provide producers, distributors, and users of 
commodities with a means to manage their exposure to commodity price 
risk. Historically, commodity futures and options were traded on 
agricultural products. And while contracts based on agricultural 
products are traded as actively today as ever, a great many futures 
contracts are now based on non-agricultural physical commodities like 
precious metals or energy products and on financial commodities like 
interest rates, foreign currencies, or stock market indices. Because 
they serve the risk management needs of businesses in virtually every 
sector of the economy, the volume of trading in these financials and 
non-agricultural physicals is now nine times that in agricultural 
contracts. While farmers and ranchers continue to use futures contracts 
to effectively lock in the prices for their crops and herds months 
before they come to market, manufacturers now can also use futures 
contracts to plan their raw material costs and to reduce uncertainty 
over the prices they receive for finished products sold overseas. 
Mutual fund managers can use stock index futures to protect against 
market volatility and effectively put a floor on portfolio losses. And 
electric power generators can use futures contracts to secure stable 
pricing for their coal and natural gas needs.
    These producers, distributors, and users of commodities (whether 
physical or financial) are called hedgers. The futures contract 
positions that hedgers put on are referred to as covered positions. For 
example, a power generator's obligation to purchase natural gas will be 
covered by its ability to use that natural gas in its electricity 
generation. There are other participants in the futures markets who 
take uncovered positions in the hope of making profits rather than 
mitigating risks. These individuals and firms are known as speculators 
and they contribute to the smooth operation of a futures market by 
increasing its liquidity. Because the needs of different hedgers for 
long or short positions may not always be perfectly balanced, the 
presence of speculators increases market effectiveness by better 
ensuring that hedgers will be able to put on positions they need.
    Although I have described the primary purpose of futures markets as 
tools for risk management, it should be noted that many futures markets 
play another important role in the economy, that of price discovery. 
Many businesses and investors that are not direct participants in the 
futures markets nonetheless refer to the quoted prices of futures 
market transactions as reference points or benchmarks for other types 
of transactions and decisions. This is particularly important in many 
agricultural markets where no other means of price discovery exists 
outside of the quoted futures prices but it is also true in other 
sectors, including many energy markets.
                   how the cftc performs its mission
    In seeking to fulfill its mission to foster transparent, 
competitive, and financially sound markets and to protect market users 
and the public from fraud, manipulation, and abusive practices, the 
Commission focuses on issues of integrity. We seek to protect the 
economic integrity of the futures markets so that they may operate free 
from any fraud or manipulation of prices. We seek to protect the 
financial integrity of the futures markets so that the insolvency of a 
single market participant does not become a systemic problem affecting 
other market participants or financial institutions. We seek to protect 
the operational integrity of the futures markets so that transactions 
are executed fairly, so that proper disclosures are made to existing 
and prospective customers, and so that fraudulent sales practices are 
not tolerated.
    The Commission pursues these goals through a multi-pronged approach 
to market oversight. We seek to protect the economic integrity of the 
markets against attempts at manipulation through direct market 
surveillance and through oversight of the surveillance efforts of the 
exchanges themselves. The heart of the Commission's direct market 
surveillance is a large-trader reporting system, under which clearing 
members of exchanges, commodity brokers (called futures commission 
merchants or FCMs), and foreign brokers electronically file daily 
reports with the Commission. These reports contain the futures and 
option positions of traders that hold positions above specific 
reporting levels set by CFTC regulations. Because a trader may carry 
futures positions through more than one FCM and because a customer may 
control more than one account, the Commission routinely collects 
information that enables its surveillance staff to aggregate 
information across FCMs and for related accounts.
    Using these reports, the Commission's surveillance staff closely 
monitor the futures and option market activity of all traders whose 
positions are large enough to potentially impact the orderly operation 
of a market. For contracts which at expiration are settled through 
physical delivery, such as in the energy futures complex, staff 
carefully analyze the adequacy of potential deliverable supply. In 
addition, staff monitor futures and cash markets for unusual movements 
in price relationships, such as cash/futures basis relationships and 
inter-temporal futures spread relationships, which often provide early 
indications of a potential problem.
    The Commissioners and senior staff are kept apprised of significant 
market events and potential problems at weekly market surveillance 
meetings, and on a more frequent basis when needed. At the weekly 
market surveillance meetings, surveillance staff brief the Commission 
on broad economic and financial developments and on specific market 
developments in futures and option markets of particular concern. At 
least one energy product market is usually discussed and officials of 
the Energy Information Administration of the Department of Energy 
periodically attend such meetings.
    If any indications of attempted manipulation are found, the 
Commission's Enforcement Division investigates and prosecutes alleged 
violations of the CEA and Commission regulations. Subject to such 
actions are all individuals that are (or should be) registered with the 
Commission, those who engage in trading on any domestic exchange, and 
those who improperly market commodity futures or option contracts. The 
Commission has available to it a variety of administrative sanctions 
against wrongdoers, including revocation or suspension of registration, 
prohibitions on futures trading, cease and desist orders, civil 
monetary penalties, and restitution orders. The Commission may seek 
federal court injunctions, restraining orders, asset freezes, receiver 
appointments, and disgorgement orders. If evidence of criminal activity 
is found, matters may be referred to state authorities or the Justice 
Department for prosecution of violations of not only the CEA but also 
state or federal criminal statutes, such as mail fraud, wire fraud, and 
conspiracy. Over the years, the Commission has brought numerous 
enforcement actions and imposed sanctions against firms and individual 
traders for attempting to manipulate prices, including the well-
publicized cases against Sumitomo for alleged manipulation of copper 
prices and against the Hunt brothers for manipulation of the silver 
markets.
    In protecting the financial integrity of the futures markets, the 
Commission's two main priorities are to avoid disruptions to the system 
for clearing and settling contract obligations and to protect the funds 
that customers entrust to FCMs. Clearinghouses and FCMs are the 
backbone of the exchange system: together, they protect against the 
financial difficulties of one trader from becoming a systemic problem 
for other traders or the market as a whole. Several aspects of the 
oversight framework help the Commission achieve these goals:

          (1) requiring that market participants post a performance 
        bond, referred to as ``margin,'' to secure their ability to 
        fulfill obligations;
          (2) requiring participants on the losing side of trades to 
        meet their obligations, in cash, through daily (and sometimes 
        intraday) margin calls;
          (3) requiring that FCMs segregate customer funds from their 
        own funds and protect these customer funds from obligations of 
        the FCM; and
          (4) monitoring the capitalization and financial strength of 
        intermediaries, such as FCMs and clearinghouses.

    The Commission works with the exchanges and the National Futures 
Association (NFA) to closely monitor the financial condition of FCMs. 
The Commission, the exchanges, and the NFA receive various monthly, 
quarterly, and annual financial reports from FCMs. The exchanges and 
the NFA also conduct annual audits and daily financial surveillance of 
their respective member FCMs. Part of this financial surveillance 
involves looking at each FCM's exposure to losses from large customer 
positions that it carries and one way in which such positions are 
tracked is through the large trader reporting system. As an oversight 
regulator, the Commission primarily reviews the audit and financial 
surveillance work of the exchanges and the NFA but also monitors the 
health of FCMs directly, as necessary and appropriate. We also 
periodically reviews clearinghouse procedures for monitoring risks and 
protecting customer funds.
    As with attempts at manipulation, the Commission's Enforcement 
Division investigates and prosecutes FCMs that are alleged to have 
violated financial and capitalization requirements or to have committed 
other supervisory and compliance failures in connection with the 
handling of customer business. Such cases can result in substantial 
remedial changes in the supervisory structures and systems of FCMs and 
can influence the way particular firms conduct business. This is an 
important part of the responsibility of the Commission to ensure that 
sound practices are followed by FCMs.
    Protecting the operational integrity of the futures markets is also 
accomplished through the efforts of several divisions within the 
Commission. The Division of Trading and Markets promulgates 
requirements that mandate appropriate disclosure and customer account 
reporting, as well as fair sales and trading practices by registrants. 
Trading and Markets also seeks to maintain appropriate sales practices 
by screening the fitness of industry professionals and by requiring 
proficiency testing, continuing education, and supervision of these 
persons. Extensive recordkeeping of all futures transactions is also 
required. Trading and Markets also monitors compliance with those 
requirements and supervises the work of exchanges and the NFA in 
enforcing the requirements.
    And, as with the Commission's efforts to protect the economic and 
financial integrity of the futures markets, the Division of Enforcement 
also plays an important role in deterring behavior that could 
compromise the operational integrity of the markets. Enforcement 
investigates a variety of trade and sales practice abuses that affect 
customers. For example, the Commission brings actions alleging unlawful 
trade allocations, trading ahead of customer orders, misappropriating 
customer trades, and non-competitive trading. The Commission also takes 
actions against unscrupulous commodity professionals who engage in a 
wide variety of fraudulent sales practices against the public.
        the cftc's role in the energy markets and our response 
                         to the enron situation
    The Commission oversees on-exchange trading of energy-related 
futures and options contracts based on such things as crude oil, 
natural gas, heating oil, propane, gasoline, and coal. Several U.S. 
exchanges are designated to trade energy product futures and options, 
but the overwhelming majority of on-exchange transactions are executed 
on NYMEX, where contracts in each of the products I mentioned are 
actively traded. Please note that the CFTC does not regulate trading of 
energy products on the spot (cash) market or forward market (non-
standardized contracts), which are excluded from our jurisdiction by 
the Commodity Exchange Act (CEA). However, the Commission can, for 
example, look at the spot market under our anti-manipulation oversight 
authority if we believe the spot market in a commodity that underlies a 
futures contract has been manipulated and we want to determine whether 
manipulation of the futures market for that commodity has been 
attempted.
    Because Enron was a large trader of energy-based contracts traded 
on the NYMEX, its on-exchange activity has been monitored by our market 
surveillance over the years. At this time, we have no indication that 
manipulation of any on-exchange futures market was attempted by Enron. 
However, the rapid financial deterioration of Enron last year presented 
an additional concern about the markets: Could its on-exchange futures 
positions be unwound without sudden price volatility or reduced 
liquidity? As it turned out, although Enron had a significant presence 
in these markets, the company was but one of many participants in what 
are very large and liquid markets. When its financial difficulties 
became known and Enron wound down its activities, energy futures price 
showed remarkably little reaction: The markets for energy-related 
futures were not roiled and prices did not spike nor did liquidity dry 
up.
    As would the financial difficulties of any large futures customer, 
Enron's difficulties also raised concerns about the ability of the FCMs 
that carried Enron's on-exchange futures positions to successfully 
close out those positions if Enron were to fail to meet margin calls. 
When Enron's financial troubles became known last fall, staff from our 
Division of Trading and Markets worked closely with the NYMEX 
clearinghouse and the affected FCMs to monitor and to manage the 
winding down of these positions. By appropriately adjusting margin 
requirements, the clearinghouse was able to ensure that adequate Enron 
funds remained on deposit at the FCMs, which both provided additional 
security for the FCMs and their customers and gave Enron a strong 
incentive to reduce its positions as quickly as possible.
    The winding down of Enron's on-exchange positions was accomplished 
quickly and smoothly so that, by the time of Enron's bankruptcy filing, 
the risks to which FCMs were exposed had dropped by 80% from only a 
week earlier. By mid-December, all of Enron's positions on the 
regulated exchanges had been liquidated. (Enron also owned a small 
subsidiary FCM, Enron Trading Services, that carried no positions for 
other customers and only a very small portion of Enron's own on-
exchange positions. At all times, ETS had regulatory capital several 
times the required level. By mid-December, ETS had transferred its 
customers to other FCMs.) I believe that this episode was a success for 
the system of financial controls in the on-exchange futures markets. 
There were no disruptions to the system of clearance and settlement. 
Enron met all its obligations. No customer lost any funds entrusted to 
any FCM.
       how the commodity futures modernization act changed things
    In 1999, the President's Working Group on Financial Markets--which 
is chaired by the Secretary of the Treasury and includes the Chairs of 
the Federal Reserve, Securities and Exchange Commission, and CFTC--
released a report entitled ``Over-the-Counter Derivatives and the 
Commodity Exchange Act.'' The report recommended changes to the CEA to, 
among other things, create legal certainty for off-exchange derivatives 
transactions, such as swaps. Congress considered these recommendations 
and ultimately codified many of them, together with substantial reforms 
of the regulatory regime for domestic exchange-trading of futures and 
options, in the Commodity Futures Modernization Act of 2000 (CFMA).
    With respect to the energy markets, the CFMA exempts two types of 
markets from much of the CFTC's oversight. Such markets are described 
in Section 2(h) of the CEA, as amended by the CFMA. The Act defines 
exempt commodities as, roughly speaking, all commodities except 
agricultural and financial products. This category, which for the most 
part represents futures contracts based on metals and energy products, 
may be traded on the two types of markets covered by Section 2(h). The 
first is bilateral, principal-to-principal trading between two eligible 
contract participants, which include sophisticated entities such as 
regulated banks or insurance companies and well-capitalized companies 
or individuals (for example, those with assets of at least $10 
million), among others. The second is electronic multilateral trading 
among eligible commercial entities, which include, among others, 
eligible contract participants that can also demonstrate an ability to 
either make or take delivery of the underlying commodity and dealers 
that regularly provide hedging services to those with such ability. 
While the Commission does not directly regulate these transactions, we 
do retain anti-fraud and anti-manipulation authority. The public policy 
issues implicated by such trading among sophisticated entities were 
addressed by Congress during passage of this important legislation.
                     suggestions on moving forward
    I would like to first note that the CFTC, as a member of the 
President's Working Group on Financial Markets, is participating in a 
study of corporate disclosure issues relating to auditing and 
accounting which may yield valuable suggestions for how both industry 
and the government may seek to prevent repeats of the Enron situation. 
Within the Commission, we have recently proposed a reorganization of 
the CFTC that will consolidate our market oversight functions into one 
division to help improve what is already an excellent program.
    Mr. Chairman, as a government regulator, I believe that it is 
important to constantly review current policies and procedures, 
especially given today's dynamic marketplaces, to ensure that 
appropriate levels of regulation are maintained. The significance of 
the Enron situation and its ramifications generally deserve study and 
recommendations for improvements. Some of these responses will come 
from the Congress, while others will come from regulators, and still 
others will come from the industry. Having said this, I was a supporter 
of the CFMA because I sincerely believed that a one-size-fits-all 
approach to regulation was outdated, especially with all of the 
business and technological innovations that we have seen in recent 
history.
    Tailoring regulations to the nature of the participant, the 
product, and the facility on which it is traded seemed, in my view, to 
be appropriate concepts on which to define a federal regulatory 
interest. To date, I have seen no evidence to the contrary in my 
agency's initial analysis of the Enron situation. However, we will 
continue to monitor the markets within our jurisdiction, and we will 
continue to utilize all authorities given to us by the Congress to 
aggressively pursue CEA violations.
    The Commission stands ready to work with this Committee, the 
Congress, other regulators, and the industry to find appropriate 
responses. Thank you for the invitation to appear before your 
Committee. I will be happy to answer any questions you may have.

    The Chairman. Thank you very much. Next, let us hear from 
Mr. Vincent Viola, who is the chairman of the New York 
Mercantile Exchange. Thank you for being here.

   STATEMENT OF VINCENT VIOLA, CHAIRMAN, NEW YORK MERCANTILE 
                            EXCHANGE

    Mr. Viola. Thank you. On behalf of the members of the New 
York Mercantile Exchange, Mr. Chairman and members, I 
appreciate the opportunity to participate in this hearing. My 
remarks will briefly summarize our written testimony. I would 
like to make five principal points before the panel this 
morning, if I may.
    NYMEX is, simply put, the largest energy marketplace in the 
world, and it is a federally regulated marketplace where risk 
management is conducted through the expertise of market 
surveillance and open, transparent price discovery. The 
critical component that makes NYMEX unique is its unique 
neutrality to the marketplace. The exchanges market and 
oversight rules identify potential problems that the exposure 
of the unregulated marketplace to Enron's positions may 
possibly have, and stepped in immediately to stabilize the 
marketplace from our perspective, and our marketplace's 
actions.
    Using data and reports from the complete trading year of 
2001 and to date reports for the trading year of 2002, the 
notional value of NYMEX energy trading volume is substantially 
larger than that of Enron and Enron Online. In fact, we are a 
factor of 5 to 1 larger in terms of notional value of the 
volumes traded on our marketplace as compared to Enron Online. 
Transparency is an important component of a truly competitive 
and open marketplace, but rules and procedures which forced a 
true competition are critical to maximizing the benefits of 
transparency.
    While the facts to date do not indicate that the failure of 
Enron was related to rules or the absence of rules governing 
trading in energy contracts, had Congress enacted legislation 
supported by Enron and a number of over-the-counter market 
participants to remove nearly all Federal oversight from the 
energy markets, and platforms would have caused a market 
disruption that could not, I think at this point, be 
contemplated in terms of the end effect upon the consumer.
    In addition to the openness and transparency of its trade 
execution operations, NYMEX's clearinghouse protects all 
participants against counter-party credit risks. It functions 
simply as a central banker for all participants in the energy 
marketplace, and that credit risk really is simply the risk of 
failure of either one of the two parties to a transaction to 
enact that transaction. Over-the-counter or off-exchange 
transactions of the type engaged in by Enron and its counter-
parties do not carry this level of protection.
    Enron Online was, prior to its parent's financial failure, 
a marketplace for the physical delivery of energy products and 
also for unregulated financial instruments called SWAP's, and 
which, as explained earlier, function as over-the-counter 
instruments that look and perform identically to NYMEX-
regulated contracts, with several key exceptions, and I would 
like to point them out distinctly, if I may.
    The counter-parties in an over-the-counter environment bear 
the credit risk of each other in a bilateral capacity. These 
transactions currently are not cleared. NYMEX and other forums 
currently plan to shortly introduce the clearing function and 
the anonymous central counter-party credit mechanism of 
clearing to these products. Pricing is not transparent to the 
public on a system such as Enron Online, because the system is 
geared and participated in by professional traders. The 
transactions simply are not regulated.
    Typically, over-the-counter market participants utilize 
NYMEX as the ultimate source of the most efficient liquidity, 
and liquidity for the purpose of this testimony is simply 
defined as the difference between what someone is willing to 
pay or bid for a set volume of energy and what someone is 
willing to sell that energy for at any given instant. The 
energy marketplace, there is a very substantial interaction 
between NYMEX and the unregulated, physical and over-the-
counter energy markets. The interaction was clearly apparent in 
the case of Enron.
    I would like to share a little bit of the tactical 
perspective of the New York Mercantile Exchange on market 
structure and pricing dynamics as the Enron situation unfolded. 
In the early stages of Enron's difficulties in the fall of 
2001, NYMEX's market surveillance and risk management staff 
alerted the exchange's management of the potential problems, 
and immediately the exchange implemented a number of measures 
that are classically typical of regulated environments.
    Margin requirements on natural gas contracts were 
immediately increased, approval was sought from--and I must 
personally thank the leadership of the CFTC, because we were 
granted immediate approval of the use of an instrument 
described as an exchange of futures for SWAP's, which basically 
this instrument allows for a participant in the cash market to 
migrate the exposure of that position immediately to the 
regulated credit mechanism of our exchange clearinghouse by 
simply choosing to use that instrument, so an over-the-counter 
unregulated instrument immediately becomes regulated, and 
therefore credit-protected.
    The exchange policies to reduce exposure to Enron's credit 
risk by NYMEX traders were implemented. Indeed, as the measures 
were enacted we witnessed a remarkable, what we call flight to 
quality, quality of liquidity as market participants moved to 
the NYMEX, where financial performance is guaranteed as the 
depth and breadth of liquidity from moment to moment can be 
easily identified in the centralized and physical marketplace.
    Based on the information available at this time, it does 
not appear that the failure of Enron was related to rules or 
the absence of rules governing trading in energy contracts. 
Although limited information is available concerning the volume 
done through the Enron system, Enron Online, SEC filings by 
Enron for the first two quarters of 2001 indicate that the 
notional value of trades on Enron Online, the electronic 
marketplace operated by Enron for various over-the-counter 
products, averaged just under $2.8 billion per day notional 
value. The average daily notional value of trades on the New 
York Mercantile Exchange for all of the year 2001 averaged $13 
billion per day, approximately 4.6 times the daily average 
volume reported on Enron Online. These numbers suggest that 
energy companies chose NYMEX over Enron Online for a large 
majority of their business.
    Related to the issue of Federal market oversight, I would 
simply like to point out the perspective of the exchange, the 
New York Mercantile Exchange relative to the Commodity Futures 
Modernization Act of 2000. NYMEX actively expressed concerns 
centered on a provision which appeared in both the House and 
Senate versions of the legislation. This provision was actively 
pushed by Enron, principally by Enron and other prominent 
participants in the over-the-counter market and would have 
exempted energy and metals futures contracts traded on the 
electronic trading platforms from nearly all regulatory 
oversight and thankfully, Mr. Chairman, with your and other 
members of this committee's very distinct efforts, there was a 
recognition of a serious flaw in that sort of policy 
perspective, and extreme deregulation was not really achieved, 
and I think the markets are better for it.
    Quite courageously, this committee challenged Enron and 
others, preventing it from becoming law in its most draconian 
form, and I want to repeat, I think the marketplace, one of the 
reasons the marketplace functioned as efficiently as it did in 
Enron's unraveling was because of the metered and risk 
management perspective of the regulation.
    To this day, we fail to understand the distinction, the 
Mercantile Exchange fails to understand the distinction between 
an exempt exchange doing business electronically and a physical 
exchange doing business in an open trading environment. The 
energy market conditions arising from Enron's bankruptcy could 
have been far different had the unwise proposal to nearly 
completely eliminate regulatory oversight of energy and metals 
futures and options contracts traded on electronic trading 
platforms been adopted as it was originally proposed. As it 
turned out, market participants availed themselves of the 
safety and credit enhancement provided for by the regulated 
marketplace.
    As Congress moves forward in the examination of the complex 
issues arising from the bankruptcy and in consideration of how 
the benefits of transparency and market oversight and enhanced, 
open and fair competition can be extended to the broader energy 
marketplace, including that of electricity, where I think it is 
dearly needed, these lessons should be remembered as future 
legislation is developed and considered.
    Once again, Mr. Chairman, I want to humbly thank you for 
the opportunity to appear, and look forward to answer any 
questions put forward by the panel.
    [The prepared statement of Mr. Viola follows:]
        Prepared Statement of Vincent Viola, Chairman, New York 
                          Mercantile Exchange
    Mr. Chairman, my name is Vincent Viola. I am the Chairman and Chief 
Executive Officer of the New York Mercantile Exchange (``NYMEX'' or the 
``Exchange''), which is the world's largest forum for the trading and 
clearing of energy contracts. NYMEX is a federally chartered 
marketplace, fully regulated by the independent federal regulatory 
agency, the Commodity Futures Trading Commission (``CFTC'' or the 
``Commission''). On behalf of the Exchange, its Board of Directors and 
members, I want to thank you and all the members of the committee for 
the opportunity to participate in today's hearing to study the impact 
of the collapse of Enron on the energy marketplace. As you and the 
members of this committee are painfully aware, the Enron bankruptcy has 
had a far reaching impact on employees, consumers, stockholders, 
regulators, elected officials, and energy market participants. The 
shocking swiftness with which Enron's failure occurred and the lack of 
transparency of the reasons for the failure are necessary topics for 
thorough Congressional review.
    Our comments and observations today will focus primarily on the 
market impact and other issues, including regulatory matters, arising 
from the bankruptcy, and the effect it has had on the marketplace, 
market participants and consumers. Our remarks today will be presented 
in the following order:

   The Energy Marketplace--The Role of NYMEX
   NYMEX is Regulated by the Commodity Futures Trading 
        Commission
   The Marketplace Reacted to the Enron Collapse Swiftly, and 
        Minimal Damage Occurred
   Transparency is a Critical Component of a Competitive 
        Marketplace
   Statutory and Regulatory Issues
               the energy marketplace--the role of nymex
    The New York Mercantile Exchange, Inc., was established in 1872, 
and has grown to become the world's largest exchange for energy and 
precious metals. As a regulated commodity futures and options exchange, 
NYMEX has served as a diverse domestic and international customer base 
by bringing price transparency, competition and efficiency to energy 
markets, and provides businesses with the financial tools to deal with 
market uncertainty.
    Although NYMEX is a marketplace for commercial participants in the 
energy realm to hedge risk and discover prices on large volume 
transactions, the benefits of this marketplace accrue to the consumers 
of energy who receive prices based on open and fair competition. In 
addition to prices being competitively arrived at, the Exchange also 
assures that the prices for all transactions occurring on its floor are 
transparent. They are disseminated world-wide immediately upon 
execution via the market ticker, and are accessible real-time through a 
variety of market data services.
    The transparency of NYMEX prices, and the integrity of its markets, 
makes NYMEX a visible and reliable benchmark for energy pricing which 
is vital to our economy. The visible and highly competitive daily 
transactions of energy futures and options on the exchange provide a 
true world reference price for each of the commodities traded. In the 
aftermath of the collapse of Enron, NYMEX has played a leading role in 
insuring against a broader financial adversity in the energy 
marketplace through its secure liquid market, also served once again in 
its role as a safe haven that we have served during other episodes of 
market uncertainty.
    In addition to price transparency, the Exchange is used and relied 
upon as an open forum for hedging energy price risk. Risk shifting, in 
the secure liquid markets that NYMEX provides, allows commercial 
interests to ``hedge'' the risk of price fluctuations that could affect 
planning of their business operations, and consequently profitability, 
by using futures and options contracts to ``lock in'' energy costs. For 
the commercial participant, the result is a form of risk insurance 
against the financial adversity that can result from volatile energy 
prices. The primary instruments used are futures contracts and options 
contracts:

   A futures contract is a binding obligation to make or take 
        delivery of a specified quantity and quality of a commodity at 
        a specified location and time.
   An options contract is a contract which gives the holder the 
        right, but not the obligation, to purchase or to sell the 
        underlying futures contract at a specified price within a 
        specified period of time in exchange for a one-time premium 
        payment.

    In addition to the openness and transparency of its trade execution 
operations, NYMEX's clearinghouse protects all participants against 
counterparty credit risk, which is simply the risk of failure of either 
one of the two parties to a transaction (the buyer or the seller) to 
pay such funds as they become due to his counterpart as a result of the 
trade. Through a system of cross guaranties among the brokerage firms 
and banks that comprise NYMEX's clearinghouse, credit risk is removed 
from each participant, because financial performance is guaranteed by 
the Exchange and backed by its clearing members. Customer funds are 
held by the Exchange and its clearing members in trust accounts which 
are fully segregated from the exposure and funds of the clearing firm 
or the Exchange itself. Over-the-Counter, or off-Exchange, transactions 
of the type engaged in by Enron and its counterparties do not carry 
this level of protection against credit exposure.
     nymex is regulated by the commodity futures trading commission
    The federal government has long recognized the unique economic 
benefit futures trading provides for price discovery and managing price 
risk. In 1974, Congress created the Commodity Futures Trading 
Commission (``CFTC'' or ``the Commission''), giving it authority to 
regulate commodity futures and related trading in the U.S. A primary 
function of the CFTC is to ensure the economic utility of futures 
markets as hedging and price discovery vehicles--encouraging 
transparency, competitiveness, efficiency, and market and trade 
practice integrity and fairness. Regulated markets must file all terms 
and conditions of contracts, and contract changes, with the CFTC. The 
Commission also oversees registration of firms and individuals who 
either handle customer funds or give trading advice. It conducts and 
monitors rule enforcement at U.S. futures exchanges.
    As part of the federal mandate, NYMEX performs many self regulatory 
functions, and its rule enforcement program is under the jurisdiction 
and watchful scrutiny of the CFTC. NYMEX expends considerable resources 
to maintain a compliance function, including market and financial 
surveillance, as well as a disciplinary process for those who might 
violate any of the Exchange's rules.
Unregulated Physical and Financial Markets Also Provide Risk Management
    Another component of the energy marketplace is comprised of 
exchanges and intermediaries not falling under the jurisdiction of the 
CFTC, which thus are unregulated. These markets are frequently referred 
to as over-the-counter (``OTC'') markets. The trading subsidiary of 
Enron, EnronOnline (``EOL''), was, prior to the parent's financial 
failure, a marketplace for physical delivery of energy products 
(meaning that buyers and sellers actually intended to make or take 
delivery of the commodity bought or sold), and also for unregulated 
financial instruments called ``swaps,'' which are OTC instruments that 
look and function similarly to or identically to NYMEX' contracts with 
several key exceptions:

   The counterparties bear the credit risk of each other--these 
        transactions are not cleared;
   Pricing is not transparent to the public; and
   The transactions are not regulated.

    An over-the-counter or OTC deal is a standardized or customized 
contract usually arranged with an intermediary such as a major bank or 
the trading wing of an energy company, as opposed to a standardized 
contract traded on a futures exchange. A swap is generally defined as 
an agreement whereby a floating price is exchanged for a fixed price 
over a specified period, thus allowing a buyer or seller of energy 
products to ``lock in'' a specific price, and avoid the risk of 
floating prices. The financial purpose of an OTC transaction, 
therefore, is usually the same as the financial purpose of a NYMEX 
transaction. The swap is a financial arrangement which involves no 
transfer of physical energy; both parties settle their contractual 
obligations by means of a transfer of cash. The agreement defines the 
volume, duration and fixed reference price (which for most contracts in 
the U.S. for oil or natural gas is the NYMEX price). Differences are 
settled in cash for specific periods--monthly, quarterly or six-
monthly.
    Typically, OTC market participants utilize NYMEX not only as a 
price reference, but also to hedge their own price exposure resulting 
from the swap agreements or physical contracts that they have entered 
into. Thus, in the energy marketplace, there is a substantial 
interaction between NYMEX and the physical and OTC energy markets.
        the marketplace reacted to the enron collapse swiftly, 
                      and minimal damage occurred
    In the early stages of Enron's difficulties in the fall of 2001, 
some observers feared that Enron's substantial position in the OTC 
marketplace could pose serious problems for a significant number of 
market participants. Although it is still too early to know for sure, 
it appears that these fears did not come to pass, although they were 
well-founded. Enron's counterparties appear to have realized the risk 
in being paired against a company in ever-worsening condition and made 
alternative arrangements, including transferring positions to the 
NYMEX.
    During that same period, NYMEX market surveillance functions, using 
the established tools such as large trader reporting, position limits, 
and position reporting, alerted staff and management to potential 
problems. To address issues arising from the Enron situation, the 
Exchange implemented a number of measures:

   Margin requirements (cash required as a guarantee of 
        fulfillment of a futures contract) on natural gas contracts 
        were increased.
   Approval was sought from, and granted by, the CFTC for the 
        use of EFS (``Exchange of Futures for Swaps'') instruments for 
        natural gas to allow market participants to migrate their 
        positions from the OTC marketplace to NYMEX, where financial 
        performance is guaranteed.
   Exchange policies to reduce exposure to Enron's credit risk 
        by NYMEX traders were implemented.

    Indeed, as the measures were enacted, we witnessed a remarkable 
``flight to quality,'' as market participants moved to the NYMEX where 
financial performance is guaranteed by the safety and soundness of a 
federally overseen clearinghouse.
   transparency is a critical component of a competitive marketplace
    Market transparency has sometimes been defined as ``the ability of 
market participants to observe and obtain information on the trading 
process.'' Transparency has many dimensions because a market has many 
kinds of participants and many types of information. In the case of 
Enron, concerns on transparency have ranged from corporate reports in 
compliance with securities law requirements, disclosure to stockholders 
and employees, and in the nature of the market utilized by the 
company's energy trading arm. We are not inclined to comment on 
securities law related issues, or on corporate governance. We will 
direct our observations to transparency issues related to the 
functioning of the energy marketplace.
    Mr. Chairman, through your legislative efforts and public 
statements, you have promoted the notion that energy markets are in 
need of greater transparency. More than merely paying ``lip service'' 
to the issue, you have translated your opinion into action. 
Specifically, H.R. 2884, the ``Energy Act of 2000'' (Attachment 1) * 
included an important provision which you sponsored, and which directs 
the Secretary of Energy to study how government agencies, consumer 
cooperatives and others can learn about and utilize heating oil futures 
to protect consumers and government budgets from energy price 
uncertainty. Expanding the knowledge and use of market instruments 
directly enhances market transparency.
---------------------------------------------------------------------------
    * The attachments have been retained in committee files.
---------------------------------------------------------------------------
    Even now, the Department of Energy's Energy Information 
Administration (``EIA'') is evaluating comments on their proposal, 
following an initial review by the Office of Management and Budget 
(``OMB''), to provide a weekly report on the volume natural gas in 
storage. This report, which had been done by the American Gas 
Association until the AGA announced that it would cease reporting in 
the spring of 2002, is a critical component of transparency in the 
natural gas marketplace. NYMEX strongly supports the EIA's efforts, but 
we feel it is absolutely critical that the data be released at a time 
when the market is open and has the largest number of participants--we 
have argued for a release time of 10:30 a.m. on the day of release 
(Thursdays). Some comments received during the OMB Review of EIA's 
proposal suggest that the report should be released in the late 
afternoon, or just prior to the weekend, so the data can be 
``digested,'' and would not cause as much volatility in the 
marketplace. While the intentions of those proposing after hours 
release may be chaste, they would have the opposite effect sought. 
Energy markets today trade 24 hours per day. However, the participants 
trading outside of the traditional ``open outcry'' daytime market tend 
to be very large and sophisticated entities. Those large entities would 
have a distinct advantage if the data were to be released when the most 
active market is closed. In essence, they would be in a position to 
utilize information when many market participants could not. While not 
exactly the same issue as ``insider trading,'' the benefits of the 
natural gas survey data in enhancing energy market transparency would 
be greatly diminished if the data is not released during a time when 
the largest number of participants are active.
Transparency Lessons Learned From the California Electricity Disaster
    The most recent, and telling, lessons on market transparency come 
from California. While striving to develop a competitive and 
transparent electricity marketplace to facilitate the implementation of 
California's ``deregulation'' legislation in the mid 1990's, the 
efforts of federal and state agencies overseeing the attempt failed 
miserably. In the name of ``transparency'' a government mandated 
monopoly market, the California Power Exchange (``PX'') was created 
which eliminated competition and forced the market into a ``spot'' or 
day ahead marketplace which is typically the most volatile in energy 
markets. Making things even worse was the fact that the transmission 
system remained, for all intents and purposes, under the monopoly 
control of the utilities, thus stifling yet another avenue for 
competition. The fact that the PX reported prices in the name of 
transparency was of little use in developing a truly competitive 
market. When a monopoly owns a road and controls all access, price 
reporting, or ``transparency'' is of little use to the driver in need 
of that road. In spite of all the benefits of controlling a monopoly 
market, the PX filed for bankruptcy last March.
    The goal of building and enhancing a transparent electricity market 
is a good one. However, without rules and policies which facilitate 
true competition--an environment where many sellers compete with each 
other for buyers, and non-discriminatory access to the transmission 
grid, ``transparency'' will not develop in a manner that maximizes the 
public good. Another potential difficulty lies in the area of committee 
jurisdiction. One agency with expertise and experience in competition 
and transparency is the CFTC. As this committee moves through the 
difficult legislative process, we urge that consideration be given as 
to how the market oversight knowledge of the CFTC might be utilized to 
further the goals of enhanced competition and transparency in the 
electricity markets.
                    statutory and regulatory issues
    Based upon the information available at this time, it does not 
appear that the failure of Enron was related to rules, or the absence 
of rules, governing trading in energy contracts. Until all the facts 
are in, we cannot say with any certainty which of several possible 
causes brought about the bankruptcy, but we do not believe the cause to 
have been the regulation or deregulation of energy trading. Based on 
what we now know, we are not recommending or calling for significant 
changes in the way the over the counter markets are regulated. However, 
as detailed in the following paragraphs, we still do not believe the 
differences in regulatory oversight between energy and metals futures 
contracts traded on electronic platforms, as opposed to those traded on 
an ``open outcry'' manner which resulted from legislation passed in 
2000, are justified on an economic or policy basis.
    Episodes like this one, where a major market participant fails, 
heighten the awareness that the Exchange is a safe haven, and that the 
benefits to doing business on a regulated marketplace hold enormous 
appeal, or should, to any corporation with credit or price exposure to 
energy. We believe that corporate boards and treasury offices should 
become more involved as a matter of their fiduciary obligations to 
their employees and shareholders to learn about the differences between 
regulated and unregulated marketplaces. However, we do not believe that 
business should be compelled to use NYMEX by virtue of a regulatory or 
legislative fiat.
    Although limited information is available concerning the volume of 
business done through the Enron system, SEC filings by Enron for the 
first two quarters of 2001 indicate that the notional value of trades 
on EnronOnline (the electronic marketplace operated by Enron for 
various OTC products) averaged just under $2.8 billion per day. The 
average daily notional value of trades on NYMEX for all of 2001 is $13 
billion, or more than 4.6 times the daily average volume reported for 
EnronOnline. These numbers suggest that energy companies chose NYMEX 
over EnronOnline for a large majority of their business. It was NYMEX, 
not Enron, which represented the largest forum for the trading of 
natural gas, crude oil, and other energy products, by a wide margin, 
notwithstanding (or perhaps because of) the vastly uneven regulatory 
schemes governing our respective conduct. It is worth pointing out that 
NYMEX remains solidly in business.
    Recently, a number of publications have reported that the Exchange 
was ``unhappy'' with the Commodity Futures Modernization Act of 2000 
(the ``CFMA''). Specifically, while we were supportive of, or neutral 
to, much of the legislation, our major concerns centered around a 
provision which appeared in both the House (H.R. 4541) (Attachment 2) 
and Senate (S. 2697) versions of the legislation as introduced in May 
of 2000. This provision was actively pushed by Enron, among others, and 
would have exempted energy and, in the House version, metals futures 
contracts traded on electronic trading platforms from nearly all 
federal regulatory oversight.
    Thankfully, Mr. Chairman, you, Senator Charles Schumer, and 
Senators Richard Lugar and Tom Harkin (Attachment 3) with the Senate 
Agriculture Committee, as well as number of members of congress 
including Congresswoman Carolyn Maloney, Congressmen Peter King, John 
Dingell, and others recognized the serious policy flaws with this 
extreme deregulatory measure, and quite courageously challenged Enron 
and others, preventing it from becoming law in its most draconian form. 
The final version of the legislation passed by Congress in December, 
2000, (H.R. 5660) (Attachment 4), contained a modified version of the 
provision which added the following provisions:

   An exempt electronic exchange would be subject to anti-fraud 
        and anti-manipulation provisions of the Commodity Exchange Act.
   Authority for the Commission to prescribe rules, if 
        necessary to ensure timely dissemination by the electronic 
        trading facility of price, trading volume, and other trading 
        data should the Commission determine that the exchange performs 
        a significant price discovery function.
   Obligate the exchange to maintain records for five years.
   An exempt electronic exchange would have to provide the 
        Commission with access to the facility's trading protocols and 
        electronic access to the facility, and information relating to 
        data entry and transaction details sufficient to enable the 
        Commission to reconstruct trading activity on the facility 
        conducted in reliance on the exemption.

    NYMEX had opposed the exemption from its inception, and had 
supported its elimination from both the Senate and House versions of 
the CFMA. To this day, we fail to understand the distinction between an 
exempt exchange doing business electronically, and one doing business 
on an open-outcry trading floor.
    The risk management/price discovery business has undergone a 
dramatic evolution over the last fifteen years. Many of those changes 
have been both the cause and the effect of legislation passed in 1992. 
Specifically, the growth of the over-the-counter (``OTC'') markets 
whether in financial or commodity swaps, Brent oil forward contracts, 
or other new instruments was the driving force that led to the dramatic 
change in commodity oversight that the 1992 amendments to the Commodity 
Exchange Act embodied. No longer were all futures contracts required to 
be executed on or subject to the rules of a contract market. For the 
first time, the CFTC was granted the authority to exempt from the 
exchange trading requirement, agreements and transactions that may 
otherwise have been subject to the Act. The CFTC exercised that 
exemptive authority shortly after the passage of the 1992 amendments, 
and, as a result, the growth of the over-the-counter markets greatly 
accelerated.
    In many respects, NYMEX, as a marketplace for contracts that 
require physical delivery of a commodity, has been a beneficiary of the 
regulatory flexibility embodied in the 1992 legislation. It has 
fostered the growth of energy price risk management by parties that 
otherwise lack the ability to utilize optimally standardized physical 
delivery contract because they need to manage the price risk in the 
commodity in a more customized manner. Regulatory flexibility has 
enabled these parties to structure transactions with a selected 
counter-party to suit their needs. To the extent that energy price risk 
is transferred to a willing counter-party, that party can protect 
itself through the use of the futures market for the generalized 
commodity price risk and accept the balance of the price risk (for a 
cost the parties agree to) or attempt to otherwise balance it off.
    Congress and the CFTC must provide the flexibility to exchanges to 
innovate--to continue to serve the commercial needs of the community, 
whether oil producers, refiners, farmers, or financial institutions--
free of the regulations which micro-manage, yet within a statutory 
framework that maintains public confidence.
    In testimony presented over the past decade, NYMEX has consistently 
supported and advocated the need for the market oversight (position 
limits, large trader reporting and surveillance) that the centralized 
markets provide. We believe that CFTC oversight is appropriate and 
beneficial in areas that provide oversight and uniform standards aimed 
at protecting the ongoing financial integrity, market integrity and 
trade practice integrity of the marketplace. We believe that correct 
emphasis has been placed on the financial integrity and trade practice 
protections that the self-regulatory structure of this industry has 
always provided. The deepest, most liquid markets--that provide the 
most efficient price discovery and risk shifting--occur on the 
centralized market, i.e. NYMEX, where market and financial integrity 
oversight is a routine part of doing business.
The Energy Marketplace Has Dealt With the Enron Bankruptcy
    Chief among the lessons to be taken from the Enron bankruptcy is 
the value provided by the federally chartered, regulated commodity 
marketplace in supplying market oversight and credit enhancement. The 
ability of market participants to move from largely unregulated trading 
platforms to the Exchange where transparency, liquidity, and market 
oversight are the watchwords, proved to be of critical value in 
avoiding broad ranging disruptions as Enron's problems became known.
    The situation could have been far different had the unwise proposal 
to nearly completely eliminate regulatory oversight of energy and 
metals futures and options contracts traded on electronic trading 
platforms been adopted as originally proposed. As it turned out, market 
participants availed themselves of the safety and credit enhancement 
provided by the regulated marketplace. As Congress moves forward in the 
examination of the complex issues arising from the bankruptcy, and in 
consideration of how the benefits of transparency, market oversight, 
and enhanced competition can be extended to the broader energy 
marketplace, including that of electricity, these lessons should be 
remembered as future legislation is developed and considered.
    Once again, Mr. Chairman, thank you for the opportunity to 
participate in this important discussion.

    The Chairman. Thank you very much for your testimony.
    Mr. Robert McCullough, managing partner of McCullough 
Research in Portland, Oregon.

 STATEMENT OF ROBERT McCULLOUGH, MANAGING PARTNER, McCULLOUGH 
                     RESEARCH, PORTLAND, OR

    Mr. McCullough. Thank you, Mr. Chairman, thank you, members 
of the committee for the opportunity to speak today. Now, I am 
a practitioner, a fact provider and, to be blunt, I am a tiller 
of the fields that are managed and regulated by the fine 
gentlemen who have spoken before. I am going to be very brief. 
The bottom line is that the Enron collapse had tremendous 
impacts throughout the industry. Luckily, it was not spot 
prices.
    He really brought up the central issue, which is 
transparency. That is an economist term, openness, and that 
openness is critical to the working of a competitive market. 
There are three feet to the stool, financial, commercial, 
operational. On the financial side, the issue of blame really 
is not central here. We really do not care at this exact 
moment, in this exact panel, who is at fault, but we care 
critically that the Enron collapse raised the cost of capital.
    For those of you who are conversant with this, it has 
shifted the choice of resources away from renewables towards 
fossil fuels, because renewables are capital-intensive. We will 
live with that choice for many years.
    Now, how did it change the cost of capital? Simply because 
we do not understand the Enron statements. How do you get even 
the most minor understanding of the Enron statements? Well, a 
simple question. Who owned LJM, that led, precipitated the 
collapse? Well, first you need computer resources, you need a 
high-speed Internet connection to the SEC, you need 48 hours to 
download this force generation data base with real-time access, 
and at the end of it what you find is that on November--I am 
sorry, October 20, 2000, Enron stated that LJM was owned in 
part by Credit Suisse and Greenwich Net West.
    Now, the critical issue there is, how can an investor 
possibly invest in these markets without knowing who the 
central owners of these vast enterprises are? This is a logical 
question. Because that information is not available, the 
financial markets are not transparent, the cost of capital will 
be higher. The change will end up in the resources we are 
served by in years to come, and certainly by consumers.
    Next, let us talk about the impact on commercial 
businessmen, trading. A simple fact of the matter is, we have 
very little information on commercial arrangements. Some of the 
new institutions, like the California ISO, are very, very 
secretive. They were lobbied from the beginning by players in 
that market to set commercial data availability rules that were 
very restrictive. You required the intervention of the 
regulatory commissions of all the Western States, the 
Governor's office of many of the major utilities simply to find 
out which resources were running in 2000 and 2001 in 
California.
    We still have very little understanding about who dominates 
many of these hubs. We have very little information about the 
critical long-term forward markets. The chairman of FERC is 
entirely correct, we did not see a lot of spot price changes, 
but we were appalled to find that at the moment of Enron's 
bankruptcy the 2003 and 2004 forward prices in the critical 
hubs in the Pacific Northwest changed, were reduced downward by 
30 percent.
    We cannot explain that coincidence, because the data is not 
available. Moreover, it is not simply a question of one trader 
making money and another trader losing money. Those are prices 
that directly impact consumers.
    The Bonneville Power Administration across this period was 
forced into a major rate increase. They had very unpleasant 
financial results. Preliminary review of what data is available 
in the case that Enron may possibly be the largest single 
commercial partner for the Bonneville Power Administration. 
Again, that will be sorted out in days to come. The bottom line 
is that we need much more commercial information available.
    My firm and my clients have fought efforts at FERC and the 
North American Electric Reliability Council and at the EIA to 
make less information available. That is the wrong path.
    Now let us get to the most important issue. It is actually 
system operations. When all is said and done, we are a wealthy 
country. We can afford the tremendous bills we saw out of the 
California market fiasco. It was not pleasant. Two of our major 
industrial clients went bankrupt, one major utility is 
bankrupt, but reliability is not something you can fix later on 
by moving around money.
    In the winter of 2000, 2001, the lack of system operations 
information from California led to a major policy error. The 
Secretary of Energy, doing the best he could--and this is not 
an error on his part. It is an error on the policymaking part--
decided to direct all of the utilities in the Northwest to draw 
down that scarce storage battery, the Columbia River, to keep 
the lights on in California. I do not think he could have made 
any other decision, but we know from the research done by the 
Northwest Regional Planning Council that he brought us within 
20 percent of long-term interruptions in the Northwest.
    We are not talking an hour a day, we are talking homes and 
stores and churches, factories being without lights for 8, 16 
hours at a time for weeks. The bottom line there is, we needed 
that operational data. We still need it. We still, by the way, 
do not have an easy flow of it.
    Our firm actually receives that data from the Oregon Public 
Utility Commission. It then passes it back to California State 
authorities like the AG's office and the California Public 
Utility Commission. That is how makeshift that information flow 
is.
    The bottom line, gentlemen, is that transparency, openness 
is a far better tool than regulation. If we know what is going 
on, we know what we need to fix. At that point, the excellent 
job of the regulators can focus in on the actual problems. 
Before that, we are trying to operate competitive markets in 
the dark, and unfortunately I am not kidding. We came close, in 
the winter of 2000-01, to actually running the largest single 
integrated electric system in the world in the dark.
    Thank you very much.
    [The prepared statement of Mr. McCullough follows:]
      Prepared Statement of Robert McCullough, Managing Partner, 
                   McCullough Research, Portland, OR
    Mr. Chairman and Members of the Committee:
    Good morning. Thank you for this opportunity to speak on the need 
for transparency in energy markets.
    I would like to start by telling a short historical tale with 
enormous relevance to today's situation. Seventy years ago a pioneering 
electric and natural gas firm collapsed. The bankruptcy, the largest 
one in U.S. history at the time, destroyed the retirement savings of 
millions of Americans. Thankfully, due to the primitive technology of 
the time, interconnections between systems were rare and the collapse 
had few operational implications--the lights stayed on.
    As everyone in this room is aware, I am speaking of the Insull 
Trust. Sam Insull, Edison's secretary, had built a huge empire known 
for its lack of transparency. Even given the weak financial reporting 
standards of the time, Insull's structure was shrouded in secrecy. 
Ownership relationships were so tangled that it took twenty years to 
untangle the web of interlocking directors and pyramided debt and 
equity financings.
    The collapse of the Insull Trust created an enormous public outcry. 
Reforms directly traceable to the collapse are the genesis of our 
current regulatory structure--the SEC, the Federal Energy Regulatory 
Commission, and a variety of other mechanisms like the Public Utilities 
Holding Company Act. Even the North American Electric Reliability 
Council likely owes its existence to the tangled industry structure 
bequeathed to us by Sam Insull.
    Seventy years later we are re-enacting the same drama with Enron. 
Not only are the financial details frighteningly similar, but we are 
realizing that our regulatory framework has failed to protect investors 
and consumers from exactly the same abuses.
    In a sense we are lucky that the two largest collapses in U.S. 
history have occurred in firms that had little operational 
significance. Our situation would have been far worse off if Enron had 
actually achieved the level of hegemony over retail markets that they 
often boasted about. In practice, both failures ended up hurting 
investors more than consumers. We need to recognize that this will not 
always be the case if reforms are not enacted.
    The common theme between these two disasters is transparency. 
Transparency is an academic's name for openness. In everyday English it 
simply means the ability of investors, traders, and operators to 
understand what is going on in the electric and gas industry. Unique in 
the economy, our energy infrastructure is central to the health of 
society on an instantaneous basis. Failures in electricity and gas open 
the specter of the lights actually going out in large areas of North 
America. Transparency allows policy makers, regulators, investors, 
entrepreneurs, and consumers to make intelligent and well founded 
decisions about their energy supply. A refrain we hear often repeated 
is that competitive markets don't operate very well in the dark. If we 
fail to set the right policies, we may actually get to experience this 
first hand.
    Transparency is critical in three different, but closely related, 
arenas.
                         financial transparency
    The first of these is financial. Both Enron and Insull were 
characterized by a bewildering corporate structure and very sketchy 
financial reporting. Insull pioneered abuses in interlocking 
directorates, pyramided securities, and self-dealing. As the weeks pass 
after Enron's Chapter 11, we are hearing exactly the same allegations.
    One of the ironies of the Enron debacle is that if Representative 
Sam Rayburn, one of the authors of the 1935 Public Utilities Holding 
Company Act, had had his way, Enron would have been a registered 
utility holding company. The stringent reporting and regulatory 
requirements would very likely have allowed us to avoid Enron's 
implosion. Every arcane financial transaction would have been on the 
record. Every major decision (and most minor ones) would have been 
subject to SEC review.
    Now we all know that PUHCA is complex, difficult to apply, and 
technologically outmoded. In practice, applying PUHCA has been like 
gardening with a chainsaw--possibly effective but difficult to control. 
I am not proposing that we can easily rehabilitate this tool today. The 
key is that the detailed reporting required under PUHCA would have 
provided the transparency that the investors desperately needed to 
protect themselves from Enron's hidden risks.
    The investor--even those aided by sophisticated Wall Street 
analysts--simply did not have the data to make an informed choice. Our 
detailed dissection of just one of Enron's Special Purpose Entities 
(SPEs) required massive computer resources, many years of experience on 
the ground in the industry, and thousands of hours of professional 
effort.
    Whitewing, the asset holder that supported the investments at Enron 
and Osprey, is now worth no more than $2 billion dollars against a book 
value of $4.7 billion. No matter how creative the bankruptcy court is 
in the unraveling of Enron's Chapter 11, investors will lose $2.7 
billion dollars from just this one SPE.
    The required reforms are straightforward. Off-balance sheet 
financing does not mean stealth financing. Whitewing's income and 
balance sheets needed to be part of the reports available to investors. 
Massive, billion dollar shifts were frequently made in Whitewing's 
structure and only reported with a line or two in Enron's 10Qs and 
10Ks.
    Equally dangerous was Enron's use of mark-to-market revenue and 
earnings accounting. Enron apparently calculated the proceeds from 
multi-year transactions based on values from forward markets that are 
thin at best and non-existent at worst. One industry pundit called 
depending on forward markets in electricity as pricing by rumor. If 
mark-to-market is used, the assumptions behind the calculations must be 
open for review.
                        commercial transparency
    Commercial transparency is also a problem. FERC's previous 
chairman, Curt Hebert, recently appeared before this committee and 
stated that ``In today's competitive markets, however, confidentiality 
of price and customer information can be critical to a utility's 
success.'' One of the lessons of the California market failure and 
Enron's collapse is that he cannot have been more wrong.
    One of the ironies of the California crisis is that the theoretical 
pursuit of transparency through the establishment of centralized 
markets at the California ISO and Power Exchange led to the filing of a 
tariff at FERC that made almost all commercial information secret. The 
logic is that commercial data availability would make gaming the 
centralized markets easier and, therefore, in order to protect the 
competitive process, government must intervene to suppress the 
distribution of market data.
    In practice, the secrecy enforced by the ISO has made their markets 
completely opaque. Another irony is that in the course of the many 
investigations currently under way as well as numerous FERC cases, all 
commercial information is now readily available to market interests. 
Only policy makers, the press, and consumers do not have access to 
market data.
    Restriction of market information weakened the negotiating position 
of consumers and made high prices far more likely in these markets.
    Even today, weak reporting of marketers to FERC and restrictive 
information rules by ISOs make concentration and abuse in market hubs 
difficult to monitor. Enron, for example, doesn't include market hub 
information in their quarterly marketing report to FERC, even though 
many other marketers do. Our only way to know the degree of market 
dominance Enron had achieved at certain hubs is to ``reverse engineer'' 
reports from marketers who do report such data in order to calculate 
Enron's share of transactions. In doing so, we now know that Enron had 
achieved a share of greater than 30% of transactions at the California-
Oregon Border.
    The relevance of such information is critical. On December 3rd, 
Enron went into Chapter 11. At the same time, forward markets on the 
West Coast fell by 30%. No other changes in operations, hydroelectric 
supply, or fossil fuel prices took place at that time. The clear 
implication is that Enron may have been using its market dominance to 
``set'' forward prices.
    The negative impacts of these policies are not only felt by 
consumers. Bonneville Power, an agency of the Energy Department, posted 
$337 million in losses last year--losses that reflect a cost in the 
short term to the U.S. Treasury. One possible reason is the large 
degree of transactions between Enron and Bonneville during this period.
    Transparency, simply put, requires open information for consumers 
and policy makers. In the absence of open information market failures 
are easily disguised and corrective measures are painfully delayed.
                        operational transparency
    The third area where transparency is critical involves system 
operations. Marketers have been lobbying FERC, NERC, and the Energy 
Information Administration to restrict information in the name of 
competition.
    While their arguments seem specious to long time market 
participants such as myself, their energetic advocacy often disguises 
the weakness of their arguments. Where system operations are concerned, 
granting their demands may well be catastrophic.
    NERC and the regional reliability councils were established in 
response to the massive blackout along the eastern seaboard in November 
1965. The idea was to promote reliability by coordinating information 
between parties. All information was open to the public and accessible 
to policy makers.
    Until 2000, the system worked very well. In 2000, the system 
foundered. California emergencies, we now generally believe, had a 
strong component of market failure. In December of 2000, our utility 
clients on the West Coast simply did not know whether that the 
emergencies were true or not.
    When the California crisis started, on May 22nd, 2000, the question 
of whether the high California prices were due to withholding by 
California generators or a real capacity shortage was of critical 
importance to the neighboring systems. Upon investigation, we found 
that the California ISO had effectively classified all of their 
operating information. We were unable to understand why the California 
ISO's official reports to the Western System Coordination Council 
showed a healthy surplus--15%--but they were declaring capacity 
emergencies every few days. A critical issue was whether the major 
thermal units in California were actually being dispatched. The 
California ISO was distributing this information to the WSCC, which in 
turn was making it available to market participants within California. 
Access, even by WSCC members, outside this small group was 
energetically opposed by marketers and the California ISO. When we 
finally raised this issue publicly in October of 2000 and gained access 
for Pacific Northwest utilities, the regulatory Commissions in Oregon 
and California, and a variety of California state agencies such as the 
California Energy Commission and the California Oversight Board, the 
California ISO responded the following day by ceasing to provide this 
information, citing, in part, access to information by Oregon state 
regulators.
    How did commercial transparency create this 180 degree reversal of 
public policy? The answer comes from a lack of understanding about 
competitive markets and the importance of information to consumers. The 
fundamental fact that the ISO overlooked is that freedom of information 
makes markets more efficient. The ISO had no real way of judging 
whether they were actually facing a capacity shortage or a problem in 
their markets once they had forestalled open debate by classifying 
virtually all operational information.
    Today, we know that plant operations in 2000 among the five major 
generators only averaged 50%. Comparable resources--by age, fuel, and 
size--operated at over 90% in surrounding states over the same period. 
In passing, the historical average availability for comparable 
equipment, by age, fuel, and size is 84%.
    As an historical aside, FERC gradually came to understand the 
importance of this data and established a ``must offer'' rule for the 
California generators as part of their repair package at the California 
ISO. This rule, combined with a price ceiling, returned the California 
market to competitive levels. It also appears to have reduced thermal 
plant outages from 50% to 10% in a matter of weeks.
    The lack of reliable operational information brought the system 
very close to disaster. The hydroelectric reservoirs in British 
Columbia, Oregon, and Washington are finite. Water stored in these 
reservoirs are the last insurance policy against system collapse. If 
the California emergencies really reflected a capacity shortage rather 
than a market failure, it would have been critical to maintain this 
insurance policy.
    As it turned out, the Secretary of Energy, on the basis of 
insufficient information, directed the U.S. systems to draw down this 
insurance policy in order to serve everyday loads in California. If 
winter weather in British Columbia, Oregon, and Washington had turned 
harsh, blackouts of substantial duration might well have resulted.
    The fault was not with the Secretary of Energy. The fault was in an 
ISO tariff that restricted the information available to policy makers.
    In the absence of data, we cannot have an informed debate. In the 
absence of an informed debate, we can and often do make the wrong 
decisions.
    The first two forms of transparency discussed above, financial and 
commercial, only affect dollars--losses to investors and overcharges to 
consumers. The loss of transparency in the area of system operations 
was vastly more critical. We came close to shutting off light and heat 
to millions of consumers in January and February 2000--only a year 
ago--because we drew down our reserves several months too early.
    The right policy direction is to guarantee transparency to 
investors, consumers, and operators. The result of the collapse of the 
Insull Trust in 1932 was to make information available to policy makers 
and the public. The implications of the Enron collapse of 2001 is that 
we have allowed the resolve of our parents and grandparents to 
dissipate.
    If we fail, and the evidence from the Enron debacle is that we are 
failing, we may really get the chance to explore competitive markets in 
the dark.
    Thank you.

    The Chairman. Thank you very much.
    Our final witness this morning is Dr. Lawrence Makovich, 
who is the senior director and co-head of the Northern American 
Energy Group in Cambridge, Massachusetts. Dr. Makovich, thank 
you for being here.

 STATEMENT OF DR. LAWRENCE J. MAKOVICH, SENIOR DIRECTOR AND CO-
        HEAD, NORTH AMERICAN ENERGY GROUP, CAMBRIDGE, MA

    Dr. Makovich. Thank you. The collapse of Enron, America's 
largest electricity trader on the heels of the California power 
shortage creates a crisis of confidence in deregulation of 
power markets. Therefore, it is quite important to ask this 
question, what was the impact of this company's collapse on 
power markets across the United States?
    Now, to answer this question we must realize that power 
markets are a set of interconnected markets. There are regional 
spot markets for energy, there are ancillary service markets, 
energy futures markets, forward markets, capacity markets, and 
retail power markets. The impacts of Enron's collapse range 
from negligible to significant across these markets.
    In the spot markets, Enron's collapse had little impact on 
spot markets. An examination of the daily spot market prices 
over the past year show no discernible impacts on electric 
energy prices on critical dates surrounding the Enron collapse, 
including December 2, when they declared bankruptcy. Therefore, 
Enron's collapse did not distort the price signals that 
determine the efficient utilization of powerplants in regional 
markets across the country.
    In ancillary service markets, Enron's collapse did not 
significantly collapse these markets that involve transactions 
for commodities like voltage support, reactive power, and 
spending reserves. Enron's collapse did not close down critical 
energy supply infrastructure, did not threaten electric 
reliability, nor increase the likelihood of brownouts and 
blackouts.
    In futures markets, it is important to realize that the 
spot markets, the volatility we see there is telling us the 
power business is a very risky energy transformation business. 
As a result, it is very important that this business has 
futures and forward markets that are structured to work well to 
provide necessary risk management, and of course the most 
significant impact derives from Enron's position as America's 
largest power trader.
    Enron's bankruptcy forced many power contracts to unravel 
at a significant cost to Enron counter-parties. Similar 
nonperformance problems surfaced during the 1998 defaults by 
bankrupt traders and bankers in the Midwest power markets and 
during the California power crisis that required counter-
parties to write off hundreds of millions of dollars. Such 
write-offs are necessary again in the wake of Enron's collapse. 
Consequently, many Enron counter-parties may suffer value 
declines in capital markets, at least for some period of time.
    However, there is an important caveat. Although Enron's 
collapse forced market players to scramble to replace contracts 
to mitigate risk exposures, the collapse occurred with enough 
warning to avoid a shock to energy futures prices.
    Some of this stability is due to the futures exchanges 
themselves. These exchanges are run by neutral third party 
entities such as the NYMEX that were in a position to intervene 
for Enron's nonperformance and maintain market liquidity.
    Enron's collapse did affect forward power markets. The 
forward power markets involve nonstandardized bilateral 
contracts for power delivery in the future, usually of a longer 
term than the monthly futures contract. However, unlike futures 
markets, no neutral third party entity organizes these markets. 
As a result, Enron filled this void in power markets by being a 
market maker in forward power markets.
    To do this, Enron set up a many-to-one trading platform, 
Enron Online, to facilitate these transactions. To make it 
attractive, Enron provided market liquidity by ensuring 
continuous transactions as an intermediary. This was one of the 
major reasons why Enron operated as a buyer and seller in 
roughly one-quarter of all electric trading activity.
    Enron's collapse suggests that it was a mistake to allow a 
significant market buyer or seller to be the market maker 
without any oversight. As a market maker, Enron created 
information asymmetry by providing all buyers to buy from Enron 
and all sellers to sell from Enron. As a result, even though 
Enron aided the market by providing more price information 
liquidity, Enron was also in a position to be consistently 
among the first to know about most forward market transactions.
    In the extreme, information asymmetry becomes insider 
trading, and such flaw has a potential to destroy confidence in 
the market. However, even well short of that situation, lesser 
information asymmetries can also create potential problems. To 
see this, imagine the temptations facing a market maker/player 
to take large speculative positions in forward markets, 
believing that their information advantage will allow reversal 
of the position ahead of others if the market moves against 
them. Such information asymmetry puts other market players at a 
disadvantage, and even puts investors in a position of being 
the last to know about the speculative position of trading 
companies they own.
    An information advantage market maker/player has the 
potential to create a destabilizing trader collapse if the 
information advantage is not perfect, and eventually results in 
a big, wrong, inescapable bet. Allowing the largest buyer and 
seller in the market to be the market maker without oversight 
is also a mistake, because such conditions create dangerous 
incentives when a market maker also tries to function as the 
objective arbiter of forward power prices.
    This potential problem arises when the market maker/player 
uses mark-to-market accounting for their forward power 
positions and, as a result, they are not indifferent to the 
forward power price. Clearly a dangerous incentive arises, 
because the market maker/player has either a net long or a net 
short position, and has the incentive to shade reported forward 
prices to increase reported earnings. Therefore, oversight is 
essential when a major market player is clearly not indifferent 
to the forward price, and yet fills the role of objective 
arbiter of forward prices.
    Enron's collapse may have a positive impact on capacity 
markets. Capacity markets involve the trading of dispatchable 
megawatts to ensure long-run supply and demand balance in power 
markets. Enron was an influential stakeholder in power market 
design, and an opponent of capacity markets. Enron believed 
that forward markets alone could keep supply and demand in 
balance in power markets over the long run. As a result, 
Enron's demise may help build the consensus that forward power 
markets alone cannot fulfill this function, and capacity 
markets are needed.
    Such capacity markets are a common element in the power 
markets that evolved from tight power pools, the ones that seem 
to be working better right now, and it is part of the reforms 
suggested in the California market design to include these 
going forward.
    In retail markets, Enron's collapse does contribute to a 
crisis of confidence in power market deregulation. That 
significantly impacts State legislation and implementation of 
retail market reform. The well-publicized collapse of Enron on 
the heels of the California crisis is slowing or reversing the 
move from regulation and towards the market by overshadowing 
the positive evidence and lessons from the evolving power 
markets that are working in several regions in the United 
States.
    In conclusion, Enron's collapse had significant impacts on 
some power markets, but does not threaten the U.S. power system 
in the near term. Enron's collapse does create this crisis of 
confidence. Of course, it will take a year or more to find out 
if the problems of lack of oversight, distorted market player/
maker incentives, or asymmetry of information played a role in 
Enron's demise, or whether the collapse was primarily driven by 
quite different factors connected to partnerships and debt. 
Nevertheless, such a daunting investigative task simply 
highlights the need for greater oversight and transparency in 
forward power markets as part of the ongoing structure of power 
markets.
    Thank you.
    [The prepared statement of Mr. Makovich follows:]
  Prepared Statement of Dr. Lawrence J. Makovich, Senior Director and 
          Co-Head, North American Energy Group, Cambridge, MA
         implications for energy markets of the enron collapse
    The collapse of Enron--America's largest electricity trader--on the 
heels of the California power shortage creates a crisis of confidence 
in the deregulation of power markets. The regional power markets across 
the United States are a set of interconnected markets--spot energy 
markets, ancillary service markets, energy futures markets, forward 
power markets, capacity markets, and retail power markets. The impacts 
of Enron's collapse on these evolving power markets ranges from 
negligible to significant. Few impacts are found in the spot, ancillary 
service, futures and capacity markets. Significant impacts are found in 
forward power markets in the short run and retail markets in the long 
run.
Electric Energy Spot Markets
    Enron's collapse had little impact on spot energy markets--the 
trading of megawatt-hours in real time. An examination of daily spot 
market prices over the past year shows no discernable impacts on 
electric energy prices on critical dates surrounding the Enron 
collapse--including around December 2 when Enron declared bankruptcy. 
Therefore, Enron's collapse did not distort the price signals that 
determine the efficient utilization of power plants in regional markets 
across the country.
Power Ancillary Service Markets
    Enron's collapse did not significantly impact ancillary service 
markets that involve transactions for commodities including voltage 
support, reactive power, and spinning reserves. These markets are 
necessary because buyers and sellers of power cannot simply contract 
for power flows without confronting thermal, voltage and stability 
constraints of moving power through a network of high voltage lines. 
Physics dictates that power flows along the path of least resistance 
and not along the contract paths dictated by market transactions. As a 
result, simple bid and offer negotiations cannot determine supply nor 
can they clear fast enough to balance electric supply and demand 
reliably in real time. Thus, power markets involve rules and 
institutions to create markets or contract terms to provide these 
commodities. Enron's collapse did not close down critical energy supply 
infrastructure and thus did not threaten electric reliability nor 
increase the likelihood of brownouts or blackouts.
Power Futures Markets
    The power business is a risky energy transformation business. Thus, 
futures and forward power markets are necessary to provide risk 
management. For example, energy futures markets involve trading of 
standardized power contracts for energy delivery at future dates. Such 
a futures contract allows a buyer to purchase electric energy at a 
fixed price ahead of the delivery date. As such it provides a hedge 
against high spot energy prices in the future. The counterparty to this 
purchase is typically a power supplier who runs the opposite risk of 
low spot energy prices. Power suppliers face this risk because they 
typically commit to multi-month contracts for fuel supply and thus face 
the risk that future power prices may be too low to cover locked in 
fuel costs and quantities. Thus, a futures transaction brings together 
parties with opposite risk exposures to mitigate their risk. The 
futures exchanges are set up around liquid spot trading hubs because 
although few futures contracts involve physical delivery, such physical 
delivery has to be possible in order for the hedging activity to take 
place. A settlement of the futures contract occurs based upon the 
difference between the futures contract price and the actual spot price 
of electricity on the due date.
    The most significant impact derives from Enron's position as 
America's largest power trader. Enron's bankruptcy forced many power 
contracts to unravel--at a significant cost to Enron's counterparties. 
Similar nonperformance problems surfaced during the 1998 defaults by 
bankrupt traders and brokers in the Midwest power markets and during 
the California power crisis that required counterparties to write-offs 
hundreds of millions of dollars. Such write-offs are necessary again in 
the wake of Enron's collapse. Consequently, many Enron counterparties 
may suffer value declines in capital markets, at least for some period 
of time.
    However, there is an important caveat: Although Enron's collapse 
forced market players to scramble to replace contracts to mitigate risk 
exposures, the collapse occurred with enough warning to avoid a shock 
to energy futures prices. Some of this stability is due to the futures 
exchanges themselves. These exchanges are run by neutral third party 
entities such as the NYMEX that were in a position to intervene for 
Enron's nonperformance and maintain market liquidity.
Power Forward Markets
    Enron's collapse affected forward power markets. Forward power 
markets involve non-standardized bi-lateral contracts for power 
delivery in the future usually of a longer term than the monthly 
futures market contract. Such contracts are necessary because the 
standardized contracts of power futures markets are appropriate to 
manage some but not all of the risk in the power business. However, 
unlike futures markets, no neutral third party entity organizes these 
markets. As a result, Enron filled this void in power market by being a 
market maker in forward power markets.
    As a market maker, Enron set up a many-to-one trading platform--
Enron On-line--to facilitate transactions. To make it attractive, Enron 
provided market liquidity by insuring continuous transactions as an 
intermediary. This was one of the major reasons why Enron operated as a 
buyer or seller in roughly one quarter of all electric trading 
activity. Enron's rapid collapse put pressure on forward market players 
to scramble and adjust their contract positions as Enron collapsed. As 
a result, other power traders were able to expand activity and fill the 
void left by Enron's collapse.
    Other traders have filled in for Enron in forward markets. Enron's 
collapse suggests that it was a mistake to allow a significant market 
buyer or seller to be a market maker without oversight. As a market 
maker, Enron created information asymmetry by requiring all buyers to 
buy from Enron and all sellers to sell to Enron. As a result, even 
though Enron aided the market by providing more price information and 
liquidity, Enron was also in a position to consistently be among the 
first to know about most forward power markets transactions. As a 
result, this critical enabling software in forward power markets did 
not maximize market transparency concerning interactions between buyers 
and sellers but instead, Enron-Online may have allowed the company to 
gain an advantaged information position. Of course, this remains to be 
examined as the investigation into Enron goes on, however, such 
information asymmetries can create a serious market flaw.
    In the extreme, information asymmetry becomes insider trading and 
such a flaw has the potential to destroy confidence in a market. 
However, even well short of that situation, lesser information 
asymmetries can also create potential problems. To see this, imagine 
the temptations facing a market maker/player to take large speculative 
positions in forward power markets believing that their information 
advantage will allow reversal of the position ahead of others if the 
market moves against them. Such information asymmetry puts other market 
players at a disadvantage and even puts investors in a position of 
being the last to know about the speculative positions of the trading 
companies they own. An information advantaged market maker/player has 
the potential to create a destabilizing trader collapse if the 
information advantage is not perfect and eventually results in a big, 
wrong, inescapable bet.
    Allowing the largest buyer and seller in a market to be a market 
maker without oversight is also a mistake because such conditions 
creates dangerous incentives when a market maker/player also tries to 
function as an objective arbiter of forward power prices. This 
potential problem arises when the market maker/player uses mark-to-
market accounting for their forward power positions and as a result, 
are not indifferent to forward power prices.
    To see this flaw in allowing a major player to also be the market 
maker without oversight, suppose a market maker/player buys power under 
a ten-year contract from a supplier. The market maker uses this 
transaction, along with other similar transactions that it acts as an 
intermediary for, to establish the forward power price curve at that 
time. This requires the application of some judgment because these 
transactions are not standardized. As time passes, other transactions 
occur that provide the basis for the market maker to reset the forward 
price curve. If the forward price curve increases then the value to the 
power buyer of the ten-year power sales contract at the fixed price 
increases. On the other hand, if the forward price curve decreases then 
the value to the power buyer of the ten-year power purchase contract 
declines.
    Mark-to-market accounting allows the buyer to record this change in 
contract value as current period earnings. Clearly, a dangerous 
incentive arises because the market maker/player that has either a net 
long (purchases exceed sales) or net short position (sales exceed 
purchases) has the incentive to shade reported forward prices to 
increase its own reported earnings. Therefore, oversight is essential 
when a major market player is clearly not indifferent to the forward 
price and yet fills the role of objective arbiter of forward power 
prices.
Power Capacity Markets
    Enron's collapse may have a positive impact on capacity markets. 
Capacity markets involve the trading of dispatchable megawatts to 
insure the long run supply and demand balance in power markets. Enron 
was an influential stakeholder involved in power market design and an 
opponent of capacity markets. Enron believed that forward market 
contracts would keep supply and demand in balance in power markets over 
the long run. As a result, Enron's demise may help build a consensus 
that forward markets cannot fulfill this function and capacity markets 
are needed. Such capacity markets are a common element in the power 
markets that evolved from tight power pools and the reforms in the 
California market design include a plan to create capacity markets.
Retail Power Markets
    Enron's collapse contributes to a crisis in confidence in power 
market deregulation that significantly impacts state legislation and 
implementation of retail energy market reform. The problem is that 
retail markets are linked to wholesale markets and power markets cover 
large multi-state regions. Thus, seven years into power industry 
deregulation, less than half of the electricity customers in the US 
have choice of power suppliers and only a small fraction of demand is 
liked to market price signals. This loss of momentum in power 
deregulation perpetuates a volatile mix of uncoordinated markets and 
regulation into the future.
    The well-publicized collapse of Enron is slowing or reversing the 
move from regulation and toward the market in power industry 
restructuring by overshadowing the positive evidence and lessons from 
evolving power markets that are working in several US regional markets.
                               conclusion
    Enron's collapse had significant impacts on some power markets but 
does not threaten the US power system in the near term. Enron's 
collapse on the heels of the California power crisis does create a 
crisis of confidence that may affect the course of industry 
restructuring in the long run. Of course, it will take a year or more 
to find out if the problems of a lack of oversight, distorted market 
player/maker incentives or asymmetry of information played a role in 
Enron's demise--or whether the collapse was primarily driven by quite 
different factors, connected to partnerships and debt. Nevertheless, 
such a daunting investigative task simply highlights the need for 
greater oversight in forward power markets as part of the ongoing 
structure of power markets.

    The Chairman. Thank you very much. I think all of this 
testimony has been very useful. Let me just start. We will do 
7-minute rounds here.
    Let me just start with the question that occurred during 
your testimony, Dr. Makovich. You indicate that you believe 
that allowing the largest buyer and seller in the market to be 
a market maker without oversight is a mistake. What kind of 
oversight do you think is required, and who should perform that 
oversight, and what, in addition to just oversight, are we 
talking about?
    Dr. Makovich. By the term oversight I am not suggesting 
micro-management of these markets. What I am talking about here 
are the kind of very standard disclosure requirements on 
positions, the kind of transparency in market prices that a 
many-to-many exchange that provides, that provides no one with 
an advantage, advanced information advantage, so this really is 
about transparency and reporting requirements. It does not mean 
that forward contracts have to be public knowledge, but we do 
need some third party entity.
    Now, whether that is NYMEX expanding their business into 
this area, that can analyze these contracts and publish the 
necessary information for these markets to know where they are 
on a real-time basis.
    The Chairman. Let me ask Mr. Newsome, do you agree that the 
additional oversight or openness that both Mr. McCullough and 
Dr. Makovich talks about is required, and if so, how do we get 
to it?
    Mr. Newsome. Well, I think that transparency and disclosure 
are kind of like talking about apple pie and mom. Everyone is 
in favor of that.
    But I think as we look back over the last couple of years, 
there has been a very full debate and airing of the issues. 
When Congress was determining the Commodities Futures 
Modernization Act, that is certainly an area that was looked 
at.
    I think based upon debate that took place during that time 
period, because of the type of trading there, Congress 
certainly did not choose to require at that time that those 
markets disclose, and I think it bears out some difference.
    In the energy exemption there are basically two levels. The 
bilateral level of eligible contract participants, there is no 
requirement there for disclosure,because it is one entity doing 
business with another single entity without any multilateral 
type competition.
    The Chairman. Does anybody else have a point of view on 
this? Mr. McCullough, I gathered from your testimony you 
believed that it was a mistake for Congress to exempt these 
trading activities in energy commodities from these 
requirements for disclosure.
    Mr. McCullough. This has been like a mechanic who just 
pulled his head out from the guts of a car, to say what you 
should do to fix all cars in the future. We do not really have 
very deep and liquid electric markets. We do not really 
understand the price as well. Our only discovery in 2003-04 
electric prices in the largest electric market in the world is 
through surveys conducted by the press. This is a very weak 
tool upon which to base the planning for an entire half of the 
North American continent, and we have even weaker tools in some 
of the other areas.
    The Chairman. Mr. McCullough, just reading from an article 
that was in the Energy Daily this morning--where you are quoted 
or referred to as saying that Enron could have been driven to 
more and larger long-term deals in order to generate increasing 
amounts of market-to-market paper profits needed to hide its 
losses on earlier short-term deals that other money-losing 
operations--the thrust of the article as I understand is your 
suspicion at least, your belief that there is a possible 
manipulation that was taking place on these forward contracts 
that we have not yet become aware of. Is that an accurate 
statement? Would you want to elaborate on that?
    Mr. McCullough. Yes, sir. What we have is such a thin 
market that Enron Online taking a position in these forward 
markets could easily have become the basis for the mark-to-
market accounting. In a sense, the value of Enron's financial 
statement would have become the chicken and the egg.
    Now, we have had some clarification of that hypothesis 
recently in the Tribune, and the Houston Chronicle, I believe, 
where we have traders off the record saying that their deals 
did not seem to pencil out, but they were directed to go on 
ahead. If so, that would be highly consistent with this 
outcome. The problem is more than simply losing the investors 
in Enron money. The problem is that those forward market 
disturbances might become the basis of power purchasing for 
utilities like Seattle City Light, or Governor Gray in 
California, in which case we might be talking about distortions 
that will take years to work out.
    The Chairman. I think my time is up.
    Senator Thomas.
    Senator Thomas. Thank you, Mr. Chairman. I would like my 
statement, along with Senator Domenici's statement, to be put 
in the record.
    The Chairman. We will include that statement in the record.
    [The prepared statements of Senators Thomas and Domenici 
follow:]
   Prepared Statement of Hon. Craig Thomas, U.S. Senator From Wyoming
    Thank you, Mr. Chairman, for holding this hearing. To say the 
demise of Enron was a shock to all of us is an understatement. I was 
deeply disappointed at the collapse of this energy giant and equally 
concerned when the actions of the company's top management came to 
light.
    However, as the Senate Energy Committee, we are not here today to 
discuss the demise of Enron, but whether or not its collapse has had 
affects on the energy market. Ironically, what happened to the company 
is unrelated to Enron's trading business--that is the side of the 
company associated with deregulation. Unfortunately, some will try to 
link what happened to Enron to the electricity restructuring debate, 
the natural gas markets and maybe even the overall energy debate. 
Enron's problems were less about energy and more about poor investments 
and unconventional, for lack of a better term, accounting practices.
    Fortunately, market participants were sophisticated enough to fill 
in the blanks and energy markets have not been significantly affected. 
Both the wholesale electric and natural gas markets continue to 
function smoothly. Sadly, for many shareholders, Enron's collapse has 
had severe implications on the capital markets in this sector. Since 
the company's demise, there was a huge collapse in investor confidence 
and many companies have seen enormous losses with respect to stock 
prices.
    I hope we learn from this hearing that Enron's collapse, though a 
tragedy for the company and its employees, has had no real impact on 
energy markets. The company's failure should not influence the energy 
legislation that this committee or, in our case, this Congress, might 
pass in the future but, should influence the securities legislation we 
might pass down the road. What has happened at Enron should not 
influence the debate regarding energy policy, but make us raise serious 
concerns over corporate accounting and disclosure of corporate 
information.
    I look forward to hearing from the witnesses.
                                 ______
                                 
       Prepared Statement of Hon. Pete V. Domenici, U.S. Senator 
                            From New Mexico
    Mr. Chairman, I understand that this hearing was called, and I 
quote from the briefing memorandum prepared by your staff, to probe the 
``impact of the Enron bankruptcy on energy markets.''
    As more and more details emerge about the demise of Enron, and its 
effects on employees and shareholders, there can be no question that we 
must learn a great deal from this collapse and strengthen our financial 
and reporting policies so this can't happen again. The impact of this 
fiasco on the retirement plans of countless employees is also an 
extremely serious situation, The federal government may need to 
implement new policies to ensure that this kind of debacle can not, 
again, destroy the future plans of so many dedicated employees.
    From the briefing materials prepared by your staff, Mr. Chairman, I 
note the conclusion that the demise of Enron had, and I quote, ``little 
impact on energy markets.'' Analysis of the Republican staff confirms 
the same fact. Testimony from the Chairman of FERC states that ``the 
collapse of Enron has not caused damage to the nation's energy trading 
or energy supplies.''
    So, Mr. Chairman, while we have much to learn from the collapse of 
Enron from regulatory and financial transparency and securities and 
retirement plan perspectives, it appears that the simple answer to your 
goal for this hearing, as stated by your staff, is that the Enron 
collapse had little impact on energy markets.
    Some would argue that the collapse of Enron presents an argument 
against deregulation of electricity markets. I do not agree, any more 
than I would agree that the recent fiasco in the California energy 
markets is an indictment of deregulation.
    I think it's far too early to judge the success of electricity 
deregulation, but it's also far too early to condemn it as a failure. 
The California situation arose from some ridiculous constraints on 
market prices and costs--a rational analysis of their approach to 
deregulation would have easily shown it that it was an over-constrained 
attempt to manipulate the market. It was anything but an attempt to 
apply free market principles to the electricity sector.
    Several states are in the midst of much more successful 
deregulation ventures. We need to give them time to develop their 
approaches and evaluate lessons learned from their experiences. Above 
all, we need to be sure that the federal government does not overly 
constrain the ability of states to deregulate. I think it's safe to bet 
that states, after studying the California problems, will also be 
careful to ensure that a true market economy thrives in their state if 
they choose to pursue deregulation.
    America built its economic engine by providing free and open 
markets, with a transparent financial system to allow evaluation by 
consumers and shareholders. We have prospered tremendously from 
allowing the free market system to work. Deregulation may be a boon for 
consumers, but only if it's done in the context of a free market system 
with full respect for the rights of individual states.
    Before closing, Mr. Chairman, I also want to note that some are 
arguing that Congress should delay action on a comprehensive energy 
bill while all the lessons of the Enron situation are analyzed. I've 
already noted my support for learning all we can from this situation 
and applying those lessons to improved federal controls. But I want to 
state that the Enron situation absolutely should not be used as still 
another excuse to delay action with serious and credible debate on an 
energy bill.
    As President Bush has noted on many occasions, energy security is 
part of national security and it is a vital component of homeland 
defense. Where we can take actions to lessen our dependence on foreign 
energy producers, especially those from unstable parts of the globe, we 
should be doing so.I hope such discussions will be part of a floor 
debate on an energy bill, since the most unfortunate decision was made 
by the Senate leader to strip this Committee from its jurisdiction over 
this bill.
    In closing, in the rush to study the Enron collapse, Congress is 
launching hearing after hearing. Many of those hearings may uncover 
critical new opportunities to improve federal systems, but I don't 
think that will be the outcome of this hearing. Instead, Mr. Chairman, 
I suggest that we allow states to continue to experiment with 
deregulation of electricity markets, while benefiting from the 
experiences of other states.

    Senator Thomas. Let me follow up on your last comment 
there. I guess you said Enron's deals would set the price. I do 
not quite understand that. You have generators, you have a 
price, you know what the price is. If you have transmission to 
move it, why would Enron's deal set the price?
    Mr. McCullough. Mr. Senator, the problem is that we have a 
very deep short-term market. The hourly market is huge. The 
long-term market is bilateral. There are only a few players out 
there. Recently, we put together a long-term deal for a large 
Northwest industrial, a huge smokestack industry. There were 
only four bidders, so Enron simply being a player in that has 
enormous ability to swing those forward markets, and because 
they are not regulated they are in an organized market like 
NYMEX. We only find out what those bids are.
    Senator Thomas. But if you had a regulated market you would 
not be doing that.
    Mr. McCullough. I meant regulated in the sense that we 
would have CFTC or NYMEX oversight, or NYMEX acting as the home 
for that market, and so what happens is, we only find out by a 
survey and, in fact, we are pricing by rumor, and when we 
discovered that plan's energy trader, one of the leading 
journals in the nuts and bolts side of the business, showed 
this major shift in forward prices on the day of their 
bankruptcy, that came as quite a shock to us.
    Senator Thomas. I guess it is a little hard, the 
uncertainty of futures is true in most any commodity, and so 
that is up to the buyer to make that judgment, it seems to me.
    But Mr. Wood, you covered a lot of things. Just in a word 
or two, what would you suggest as a result of this be done by 
the Congress, or by the FERC, or have you gotten to the point 
that you are ready to say?
    Mr. Wood. I think watching this whole event unfold, it is 
clear that there is a lot going on here, other than the issues 
that these bright people--and I am honored to be in their 
midst, quite frankly. I have learned more here than I have in 
probably the last 4 months in my job, just listening to these 
smart guys talk, but there is a lot more going on in this 
story, and I would just suggest, as I mentioned at the end of 
my opening remarks, that there is some wisdom to be had from 
listening, and I know there are a number of other committees 
looking at this. Before you see what the Enron deal can teach 
us, what is interesting is there are some broader stories here, 
and some of which, a lot of which were going on before the 
Enron event happened regarding, I know, the issue on price 
transparency.
    Certainly, I know Commissioner Brownell and I talked about 
that at our confirmation hearing before you all back in May, I 
guess it was. Transparency for markets is critical. The gas 
markets--we have talked a lot about the power markets, but not 
so much about the gas. They have been around about 10 years 
longer. They are much more deep, they are much more liquid. The 
forwards go a lot farther out into the future. They are a lot 
more competitive.
    Enron Online was one-fourth or one-fifth of that market, so 
people felt they were getting a raw deal from Enron Online. 
They have got plenty of other alternatives to go to to do 
forward trading. The power markets are a lot thinner.
    And I am sorry, you asked me to do it in a word or two. I 
guess a word or two, I think steady as she goes on opening up 
the power markets. Congress has been supportive of the 
commission's efforts to do that thoughtfully and do that 
assertively to get the power markets to a health and depth and 
liquidity that the gas markets are.
    Senator Thomas. You have all talked about transparency. The 
question is, how do we do that? Does Congress need to do that, 
or can you do that?
    Mr. Wood. As I mentioned in my testimony, Senator Thomas, 
we have started on that effort at the commission. I think we 
will get--as pointed out here by Dr. Makovich, we will get, I 
guess, the traditional push back from folks that do not want 
certain information to be disclosed into the market. Enron was 
always good about arguing that, about how much they did not 
want out there in the public marketplace for information, and I 
expect that others will fill their shoes and then we will have 
to deal with that.
    Senator Thomas. There has been some increase in generation 
capacity, but that has been one of the problems, is the 
uncertainty, I think, of investment in generation. What do you 
think this Enron thing has as an impact on that, any of you?
    Mr. Wood. Moody's did change after one of the accounting 
issues came up with regard to the Enron story. Moody's did 
really go after, and I believe the others have joined them, go 
after what the reporting requirements are for all of the other 
people who, unlike Enron, are very asset-heavy. But I mentioned 
in my testimony I am a bit worried about the overreaction to 
other people's books that the Enron story precipitated and what 
that might do to the availability of capital in the short run 
with the generators, particularly people building powerplants, 
putting it on the ground, putting cleaner plants in place than 
the ones they are replacing.
    Senator Thomas. What is your reaction, any of you, to 
transmission? It seems to me if you are going to have market 
generators you have to move power, and obviously if you want to 
have a marketplace in the generation area you have to have more 
transmission, do you not?
    Mr. Wood. Amen to that.
    Mr. Nugent. Senator, I think you clearly need more 
transmission to make the market flow and function better. I 
will say that solution seemed to be coming forward. Some have 
not even been presented yet to us, but therefore strengthening 
the capacity over certain routes, seeking some novel new routes 
to markets, and there are some cost pressures that are building 
that may overcome some opposition to transmission in certain 
areas.
    I think particularly of southwest Connecticut, for example, 
where there is a real difficulty in getting power into that 
area. I would say that these are not easy things to solve. They 
balance a lot of issues in the environmental area or in the 
acceptability in neighborhoods. We are working to solve those 
as they come forward.
    Senator Thomas. Would you think that an interstate grid 
with RTO's off of it would be the direction we ought to be 
moving?
    Mr. Nugent. Well, Maine has voiced its support of that, and 
the question is how to get from here to there, but stronger 
ties among that to enable trading are important.
    Senator Thomas. Doctor, I do not know where you are with 
the resistance to doing away with PUHCA, but are there not a 
lot of things that still remain of service in more than one 
State if PUHCA was removed?
    Dr. Makovich. Well, the holding company act is really 
designed to prohibit very large, multi-State ownership in this 
business, and the question of sizing this business today is a 
little bit different. What we do have is large, multi-State 
transmission networks that really define these markets, so the 
real question is, is anybody too big within any one of these 
regional power markets that you are worried about them having 
undue influence?
    It is actually an advantage for companies actually to 
stabilize their earnings. If we do allow them to diversify 
across several of these regional power markets we do not want 
companies that have all their eggs in one basket, so that when 
you get a boom-and-bust cycle in power prices we get tremendous 
variation in their earnings, so the question of size really now 
I think needs to focus on making sure the markets are not 
dominated, these regional markets, and actually it is probably 
a good thing if we have companies that can diversify the risk 
of these power markets across regions.
    Senator Thomas. Thank you, Mr. Chairman.
    The Chairman. Thank you.
    Senator Wyden.
    Senator Wyden. Thank you, Mr. Chairman.
    Mr. Wood, I appreciate you noting that I have been trying 
to lift the cloak of secrecy surrounding energy markets for a 
long time. I think the public ought to be able to obtain basic 
information about what is going on out there, and I want to 
emphasize, we are just talking about basic business 
information. We are talking about transmission capability, 
generating capacity, plant outages. That is what we ought to be 
getting out. That is what is in the bill that I introduced, the 
bipartisan bill with Senator Burns, and we are going to stay 
with this until it gets done.
    Now, the testimony today indicates that following Enron's 
bankruptcy, forward markets, the forward energy markets on the 
west coast dropped by 30 percent. That was testimony, I believe 
from Mr. McCullough. Does that suggest that by keeping secret 
key information, that Enron was able to artificially inflate 
the west coast prices by 30 percent?
    Mr. Wood. Again, I think we have heard the very nonliquid 
markets, there are not many trades that are that far out. You 
remove one guy from it and there is going to be a big change.
    Now, the drop, I am not sure I could drop all the point and 
say that the drop in those prices automatically means there was 
some untoward activity by Enron when there is not that many 
places in the market in the first place, but it certainly is 
worth following up on.
    Senator Wyden. My concern is, there were no other changes 
on the west coast, no changes in hydro supply, fossil fuel 
prices. People were in the dark, and I am not sure that the 
country can conclude that Enron was not manipulating the energy 
markets on the west coast.
    Mr. Wood. The time frame you are talking about, Senator 
Wyden, was when?
    Senator Wyden. Right at the time of the filing on December 
3, Enron went into chapter 11, at the same time, forward 
markets on the west coast fell by 30 percent, no other changes 
occurred, and I want to be clear about that--because you have 
said that it really does not seem to have been any dramatic 
price ramifications as a result of what was going on in Enron 
and, of course, people did not have the information. I am not 
sure that it is possible for the country to conclude that Enron 
was not manipulating the market with their energy trading to 
the detriment of my constituents and Senator Feinstein's 
constituents and others.
    Mr. Wood. I think that is fair. I would like to say that 
what I focused on in my testimony were the markets we do watch, 
which are the physical markets that are the real exchange of 
power, and not these markets that were referred to, the forward 
markets, which are not regulated anywhere, so I wanted to make 
sure my testimony was clear on that.
    Senator Wyden. I think your point is fair as well. I would 
like you to follow that up.
    Mr. Wood. I would be glad to.
    Senator Wyden. Because, given that situation, that 
certainly raises questions about whether Enron was manipulating 
the west coast market, our constituents. You have got three 
west coast members here who have a lot of folks hurting, and I 
would like you to get back to us on that.
    Mr. Wood. I will do that.
    Senator Wyden. Thank you.
    Mr. McCullough, a question for you. In your prepared 
testimony, you said, and I believe you are the first witness 
now to say to the Congress that if the Public Utility Holding 
Company Act had been enforced it could have been used to avoid 
a portion of this horrible debacle for our constituents. How 
did it happen that Enron was not regulated under the Public 
Utility Holding Company Act?
    Mr. McCullough. I can certainly imagine the FEC was 
unwilling to donate massive resources, or even knew how the 
donate the resources in a very changed market, but if we were 
under registered utility rules, every one of those SPE special 
purpose entities would have had to have been reported to the 
SEC. They would have been public. We would have known that 
there were $4.7 billion at risk in White Wing, and certainly 
anyone who lives in Portland knows hundreds of people who have 
lost their life savings, and so it sounds pretty credible to me 
at the moment. that law was written for the Insull Trust 17 
years ago, and I think it is possible the rules and regs could 
be regulated.
    Senator Wyden. Was Enron granted an exemption from the 
Public Utility Holding Company Act?
    Mr. McCullough. Yes, sir.
    Senator Wyden. They were granted an exemption, and when was 
that that they were granted an exemption?
    Mr. McCullough. I am sorry, I do not have that information.
    Senator Wyden. Were there public hearings? I guess I am a 
little incredulous. You told us now that they were actually 
granted an exemption from the Public Utilities Holding 
Companies Act. Were there public hearings, or is there any 
record on this point?
    Mr. McCullough. I am not an expert on SEC activities, but 
it is my understanding that it was a letter as opposed to a 
full hearing.
    Senator Wyden. Mr. Chairman, I would like to insert into 
the record at this point a letter from a number of consumer 
groups raising questions about the exemption that Mr. 
McCullough has talked about, and again, this was the first time 
I had ever heard about this, but I think this is another area 
that when we have a chance to review the documents and to look 
at this, it is important.
    I do not have any further questions, Mr. Chairman.
    The Chairman. Thank you very much. Just to clarify, I am 
informed, and the witnesses can contradict me if I am wrong 
here, but there is a regulation that the Securities and 
Exchange Commission issued sometime ago, 17 CFR 250.2, which 
essentially says that unless otherwise required by the 
commission, a holding company, which is a subsidiary of a 
registered holding company, need file only the initial 
statement, and essentially Enron took advantage of that 
regulation to just file a statement when they acquired the 
Portland utility to say that they were not covered. I believe 
that is the way it occurred.
    Senator Wyden. My understanding is, and this is what I 
would like to have clarified, Mr. Chairman, is apparently there 
are some reports that there was a subsequent March 1997 
exemption--and I guess we will have to take a look whether that 
is the PUHCA statute or the Investment Company Act statute, and 
I think you were talking about them receiving an exemption, is 
that right?
    Mr. McCullough. Yes, sir. I apologize for not being an SEC 
expert, but it is my understanding the SEC did not pursue Enron 
under the PUHCA rules.
    Senator Wyden. Mr. Chairman, I want to be clear. Again, 
this is an area I have heard about for the first time, and I 
think we ought to look very carefully at both the Investment 
Company Act of 1940 and the PUHCA statute and review them both, 
because, given the fact that this has not been talked about, 
and apparently there has been an exemption from one of these 
statutes that might have protected my constituents and people 
on the west coast, I would like us to look at that.
    Senator Thomas. Mr. Chairman, I asked that question a 
little while ago. Based upon the fact that you operate on one 
State, apparently there is an exemption, at least a statutory 
exemption, so that is probably where we need to look.
    The Chairman. We will try to get this clarified. This is a 
good line of inquiry, and we need to understand it better.
    Senator Feinstein.
    Senator Feinstein. Thanks very much, Mr. Chairman.
    Mr. Chairman, earlier I handed you a letter asking that we 
hold a follow-up hearing to learn more about Enron's online 
transactions, and how they affected California and the Western 
energy market from May 2000 to June 2001. I believe, Mr. 
Chairman, that this is a Pandora's Box, and that it must be 
opened.
    I would like to begin my comments with some quotes from 
yesterday's Los Angeles Times, and I quote: ``the entire 
electric restructuring agenda on a national level was an Enron 
agenda,'' said State Senator Steve Peece, who led the 
legislature's effort in 1996, California legislature, to shape 
deregulation. They had such control and influence over Federal 
regulators that in turn put California in a place where we had 
no choice.
    This is sort of a follow-up of what Senator Wyden just made 
very clear. The PUC under pressure set out in 1993 to overhaul 
its 80-year-old system of regulating the monopolies of Pacific 
Gas & Electric, Southern California Edison, and San Diego Gas & 
Electric.
    The fact that Skilling was in PUC meetings was an 
indication of how important we thought this was, said David 
Parquet, an Enron vice president who has been with the company 
in California since 1993. Most of the ones that would later 
come to dominate the California market, Reliant, Duke, and 
Mirant, for example, did not hire lobbyists or begin giving 
campaign contributions until after 1997, when they bought the 
powerplants that PG&E, Edison, and San Diego Gas & Electric 
were forced to auction under deregulation.
    Enron did spend a lot of money on this, said Robert 
Michaels, an economics professor at Cal State Fullerton, who 
has worked as a consultant for the firm. Enron was essentially 
the only company, other than the utilities, that had the 
resources and motivation to send lawyers and experts to 
thousands of working groups and hearings. Enron was very, very 
insistent on what came to be called the market separation rule, 
said Paul Joskow, a Massachusetts Institute of Technology 
economist who worked for Edison as a consultant. Those of us 
who participated warned the commission that there were 
significant potential dangers there.
    Mike Florio, senior attorney with the Utility Reform 
Network and a member of the board that Overseas Cal-ISO, said 
he is convinced that a more integrated approach would have 
spared California the worst of the soaring prices that lasted 
from June 2000 to 2001. With the ISO and the power exchange 
being separate, he said, none of the market monitors could see 
the whole picture, so it was possible for people to play games 
much more easily without being detected.
    Now, this is important, and I want to go now into the 
online aspects of the Enron business, because two companies 
have taken up that online trading with no transparency, and a 
third has taken up that online trading with transparency, 
namely, Intercontinental Exchange with transparency, Dynergy 
and Williams with no transparency.
    Let me make this point. In 1999, the entire cost of 
electricity for the State of California was $7 billion. In 
2000, it was $27 billion, and in 2001, it was $26.7 billion. 
This was a massive transfer of wealth from California's 
investor-owned utilities from consumers to a handful of energy 
companies, and this is just the electricity portion of it.
    Let us take a quick look at spot prices for natural gas, 
which everyone knows drives the price of electricity. This is 
November 2000. The red are spot gas prices in southern 
California, the blue spot gas prices in northern California. It 
goes right up to here, and this narrow black line is the 
benchmark for the rest of the United States.
    Ladies and gentlemen, you clearly see what has happened. We 
are told by analysts that Enron Online may have controlled up 
to 50 to 70 percent of the trading market for natural gas 
deliveries into southern California, 50 to 70 percent. There 
was no price transparency. There was no regulatory oversight 
because Enron's trades were bilateral, and natural gas prices 
drive up electricity prices.
    Keep in mind that many of the generators had gas contracts 
and did not buy on the spot market on the graph, but they used 
spot market prices to justify the higher electricity prices, 
and this is why I think this is so critical, that we look very 
deeply into this.
    On December 12, 2000, the spot price of natural gas 
delivered to the southern California border was $59.12 a 
decatherm. Well, it was $10.12 a decatherm in nearby San Juan, 
New Mexico. Know that it costs less than $1 to deliver the gas 
from San Juan to the California border. On December 12, there 
was $48 a decatherm unaccounted for. As you can see from the 
graph, the problem lasted well into the springtime.
    To keep this in perspective, today's gas price average is 
$1.91 for most of the country, and $2.05 for California, so 
there is a lot of money unaccounted for, while at the same time 
Enron and other energy marketers are announcing record profits 
during that quarter.
    These exorbitant gas prices helped drive up electricity 
prices in California to more than 10 times higher than they 
should have been, and we still do not know why the price of 
natural gas was so much higher in California than in 
neighboring States. Again, Enron Online, I am told, could have 
controlled 50 to 70 percent of the natural gas trades in 
southern California, and all this time, because Enron Online 
was engaged in bilateral trading, nobody except Enron knew the 
prices that were being bid.
    Last January, I introduced legislation to ensure there 
would be at least transparency in the delivery of natural gas. 
I am pleased with Senator Wyden and Senator Bingaman's interest 
in this subject and the fact that there is a transparency in 
the Democratic energy bill introduced by Senator Daschle in 
November. Now that Enron is out of the online energy trading 
business and companies like Dynergy and Williams have stepped 
in to fill the void, there is no transparency, if there was not 
the cap and the intervention, finally, by the FERC, this could 
all happen again.
    I am really starting to believe that Congress needs to 
ensure that a regulatory agency is willing to step up to the 
plate and protect consumers from a repeat crisis. Energy 
deregulation proponents argue that deregulation benefits 
consumers by increasing their choices and lowering their 
prices. You would have a hard time finding a California 
consumer that believes that today, so FERC indeed has a lot of 
work to do, and I want to begin by asking Mr. Wood this 
question.
    The Chairman. Senator Feinstein, you have run out of time. 
Why don't we go ahead to Senator Cantwell.
    Let me just advise we are told there will be a vote here in 
just a few minute, so we will hear from Senator Cantwell, and 
then we may adjourn for a short period to go vote and come back 
and continue.
    Senator Cantwell. Thank you, Mr. Chairman, and I think I 
will enter a longer statement into the record, if I may.
    [The prepared statement of Senator Cantwell follows:]
        Prepared Statement of Hon. Maria Cantwell, U.S. Senator 
                            From Washington
                            i. introduction
    Thank you, Chairman Bingaman, for holding this important hearing on 
the implications of the Enron bankruptcy for our nation's energy 
markets.
    It is our duty as policymakers to take a close look at the factors 
that contributed to this company's collapse.
    We have an obligation to shine a light on what one Enron executive 
last year called a ``regulatory black hole,'' a vortex consisting of 
lax oversight, loophole ridden accounting practices and potentially 
criminal acts on the part of corporate executives. A black hole that 
Enron itself was proud to help create. After all, it was central to 
Enron's business strategy.
    Mr. Chairman, as the Senate prepares to debate an energy bill, I 
must add that I am deeply troubled by the Bush Administration's refusal 
to turn over the records of its energy policy task force to the General 
Accounting Office.
    At a time when Enron's collapse has illustrated in graphic detail 
the need for transparency in our nation's energy policy, the 
Administration's refusal to turn over those records smacks of 
insensitivity toward the many Americans whose lives have been touched 
by this debacle, if not outright obstructionism.
    Enron's bankruptcy has touched the lives of hundreds of thousands 
in our country.
    The effects are being felt most directly and most painfully by the 
families of Enron's rank and file employees--many of whom lost not just 
their jobs but their retirement savings.
                      ii. washington state impacts
    Even the residents of Washington state, who may seem far from the 
epicenter of this scandal, are feeling its impacts.

   Already the Washington Attorney General has filed suit on 
        behalf of the State Investment Board, seeking to recoup more 
        than $100 million in lost shareholder value.
   A 64-year-old construction firm that employs 600 in Bothell, 
        Washington--purchased by Enron in 1997--was left in limbo when 
        its assets were swept into Enron's central cash management 
        system and locked up in the bankruptcy proceeding.
   A Washington-based insurance company has reported a $20 
        million loss--a 10 cents per share earnings hit--as a result of 
        its Enron bond holdings.
   And a number of our utilities--among them Seattle City 
        Light, which has already experienced an almost 50 percent rate 
        increase over the past year due to the Western energy crisis--
        are owed money by Enron.

    Viewed within the sweeping, multi-billion dollar collapse of this 
company, these losses may seem small. But I assure my colleagues that 
they make a difference to Washington state retirees, investors and 
utility ratepayers--many of whom have already been affected by 
recession, the tragic events of September 11 and this past year's chaos 
in Western energy markets.
    For many of my state's residents--who have seen double-digit power 
rate increases over the past year--the first questions that comes to 
mind in view of Enron's collapse is, quite simply: Where did all of our 
money go?
    My initial response to this question might be: down the regulatory 
black hole that Enron helped create, along with the retirement savings 
of many working families and a good deal of investors' confidence in 
the integrity of our financial markets.
    To be sure, this is a question to which the Senate will demand a 
more complete answer during the course of its ongoing investigation 
into the factors that contributed to Enron's downward spiral.
                        iii. market transparency
    And while we are still in the process of unwinding Enron's complex 
web of corporate shell games, I believe a lesson extracted from the 
financial debacle is equally relevant to this Committee's hearing 
today. That is, much as the disintegration has pointed to a need for 
greater coherence and consistency in corporate accounting practices, it 
has underscored the need for transparency in our nation's energy 
markets.
    We will hear testimony today that Enron's collapse has caused 
almost surprisingly little disruption in wholesale energy markets.
    But I believe there remain a number of unanswered questions--
brought into sharp relief for me by the Western energy crisis--that it 
is the duty of this Committee to examine.
    In particular, I think it is a great relief that the collapse of 
such a dominant trader as Enron--which handled up to 25 percent of our 
nation's wholesale energy transactions--had such a small impact on both 
energy supply and price.
    But the question foremost in my mind remains:
    What if Enron's collapse had occurred in the midst of the Western 
power crisis, when chaos in the markets reigned, rolling blackouts had 
become a fact of life in California and appeared imminent in the 
Northwest, due to a drought of historic proportions?
    While energy in the West is now plentiful and prices remain low--
due in part to recession, mild, wet weather and loss of load, not to 
mention jobs in energy intensive industries--how would the market have 
responded when energy ran $3,000 per megawatt and utilities were 
scouring for all possible sources of generation?
    Mr. Chairman, while I'm glad that the impacts to energy consumers 
have been negligible thus far, my fear is that no one really knows the 
answer to this question. And the reason, in my view, is a troubling 
lack of transparency in our nation's energy markets the very same lack 
of transparency that has many energy analysts, regulators and consumers 
scratching their heads over the seemingly incongruous set of factors 
that gave rise to the past year's Western energy crisis.
                             v. conclusion
    As the Senate prepares to consider comprehensive energy 
legislation, I think it is imperative we keep in mind one of our 
primary goals: fostering reliable and efficient markets, which require 
accurate and timely information for participants, regulators and, 
ultimately, the consumers themselves. I again thank you Mr. Chairman 
for holding this important hearing on the lessons we can learn from 
Enron's collapse.

    Senator Cantwell. But Mr. McCullough, I appreciate your 
testimony this morning. Also, I find some of the comments and 
statements very disturbing as to what it means to Northwest 
citizens who were far more concerned about this energy crisis 
before the events in December, because they had actually seen 
the effects of high energy prices, and even though we have 
started to recover from what has been a drought, we still have 
people in the Puget Sound area and various parts of the State 
who are paying 50 percent rate increase in their electricity 
rates, and to think that perhaps, that that 50 percent rise in 
electricity might have been caused by some of these forward 
contracts is a very disturbing concept.
    I am not shooting the messenger. I appreciate your 
comments, but when you say that no other charges in operation 
and hydroelectric supply took place at this time, three is 
clear implication that Enron may have been using its market 
dominance to set forward prices. This, to Northwest consumers, 
seems to be what they have been thinking all along, that where 
there is smoke there is fire, and in this particular case they 
have been gouged.
    My first question is, how do we get more information on the 
forward contracts? How does this committee obtain more 
information on the forward contracts, and what do you think the 
implications are for those forward contracts today, given the 
structure of the bankruptcy? Will some of these entities still 
have to live up to those forward contracts if, in fact, energy 
is delivered?
    Mr. McCullough. Well, the second question is the easiest. 
Yes, Northwest utilities' industrial customers will have to 
live by the deals they made, and they are stuck with these 
higher prices for years to come. We know that each of the 
utilities buys a portfolio. Bonneville, City Light, Portland 
General, Puget Sound Energy, all have had exposure to those 
market changes, and they have all had cost.
    The first question is harder. To the degree that utilities 
really operate in forward markets, this is a very critical 
issue. We have had debates in front of FERC about whether 
markets should be viewed as hourly or daily or monthly. To an 
extent, an hourly market is like the neighborhood bodega. You 
go down once in a while to buy some milk, but most of us 
actually buy our food at Safeway or even Cosco. We buy in the 
future, not simply the present.
    So forward markets are very, very important to us. Our 
industrial and utility clients are far more likely to be in the 
monthly/yearly markets than they are in the hourly markets, and 
so any information the committee can provide, both on the 
current Enron crisis and hopefully through their leadership 
into changing of the rules that will give us transparency in 
those forward markets is going to be absolutely critical.
    It requires an enormous amount of work to discovery that 
Enron had a 30 to 50 percent position in the critical mid-
Columbia market. It is not easy in the moment. The only good 
information we have is from FERC's quarterly marketing reports, 
and thank you, Mr. Chairman, for having those, because that is 
all we have, and we really do need to know who is carrying the 
simple positions so we can judge whether they are far markets 
and fair prices.
    Senator Cantwell. Mr. McCullough, do you believe those 
markets, an entity should have to live by those forward 
markets, if, indeed, Enron is found to have been manipulating 
the market?
    Mr. McCullough. I am an economist rather than a lawyer. 
Contracts are pretty sacred to economists even when they are 
wrongful. Certainly the Attorney General and his fellow 
Attorneys General up and down the coast have been looking into 
that question, and if they find wrongful behavior, I suspect 
then we could find some protection for the customers in the 
coastal States, California through Washington.
    Senator Cantwell. Thank you. Mr. Wood, do you have a 
response to that question? Do you think utilities, if Enron has 
been found to be manipulating the forward contracts, do you 
think that utilities should have to live and be stuck with 
those prices?
    Mr. Wood. I think a court could probably make the call, or 
the State commissions could determine that there are sufficient 
facts to void--in general, it is hard to conclude yes or no, 
but I think that a court is pretty good at saying that is a 
voidable contract and therefore we should not be required to be 
paid. That is what we use courts for.
    I think there is also, depending on the jurisdiction and 
the ability of our commission or State commission to do the 
same.
    Senator Cantwell. Mr. Wood, I have been enthusiastic about 
your appointment to FERC. I think I even told one of the local 
newspapers that this is exactly what the FERC needs, is the new 
energy and smarts of Patrick Wood.
    I have a question, though, because obviously part of this 
going through my constituents' mind and I think the general 
public's is just this right to know, on SEC filings and 
corporate earnings reports, on campaign finance disclosures, on 
even public policy documents, and I guess my question is, since 
FERC is this quasi-judicial entity and there is some sort of 
firewall, you do have communications with the administration, I 
am sure, on their energy policies, and you do have some 
communications, or I would assume--and this is probably 
proceeding prior to you taking over as chairman.
    You do have some communication with, obviously, these 
various entities like Enron. Would FERC make those documents 
available to the public, your communications either between the 
administration on energy policy and your communications, or 
potential communications that may have occurred prior to your 
being the chair of FERC, related to Enron?
    Mr. Wood. I would be glad to, Senator, as I think I have 
been asked for the press for the latter, particularly. I think 
much to everyone's surprise besides mine, because I can tell 
you Enron has not been in to see me or my staff at all since I 
have been here, and plenty of other people have, but that is a 
pretty short list, but I would be glad to give you what we have 
had.
    Senator Cantwell. But your communication with the 
administration, or prior to your taking over, because obviously 
that is new, but the FERC's communication to the administration 
in the early part of the year on energy policy. Again, while my 
constituents were saying, we are getting gouged, and yet there 
was not disclosure. There was not real disclosure on the 
formation of what the energy policy was by the administration. 
Those kinds of communications between FERC and the 
administration on that energy policy, would those 
communications be available?
    Mr. Wood. I would be glad to look into that, if any exist. 
I know from my experience in the State government there was a 
pretty clear definition up front about the distinction between 
an independent agency as opposed to an executive agency, and 
the administration, so I will look into what exists before I 
came, but I do not believe there has been anything since I came 
there.
    Senator Cantwell. Well, we appreciate FERC's willingness to 
make documents public.
    Mr. Wood. We are a public agency, answerable to the 
Congress.
    Thank you.
    The Chairman. With that, we have this vote that has already 
started. Why don't we take a 15-minute break and vote.
    Senator Schumer. Mr. Chairman, I just have one question. 
Can I get that question in?
    The Chairman. We will go ahead and defer to Senator Schumer 
for that question.
    Senator Schumer. Thanks, Mr. Chairman. I would ask my 
statement be read into the record. I know we are trying to get 
over to the vote.
    [The prepared statement of Senator Schumer follows:]
      Prepared Statement of Hon. Charles E. Schumer, U.S. Senator 
                             From New York
    Good morning. I would like to begin by thanking the Chairman for 
holding these hearings, which I feel are part of this committee's 
significant and necessary role in evaluating the performance of post-
Enron energy markets.
    Within the scope of the energy market, the collapse of Enron has 
demonstrated the damage and dysfunction that can result from a lack of 
transparency and oversight, and how a transparent market can be a 
stabilizing and steadying force. In this case, we have a market that 
had been dominated by Enron, in which participants and observers were 
unable to gain a clear and total picture of the markets within which 
they operated, markets that by and large existed outside of adequate 
oversight.
    During the debate regarding the CFMA, I was greatly concerned about 
the similar effects that granting electronic trading facilities an 
exclusion from CFTC oversight would have had on the market, and fought 
hard against such an exclusion. Exempting electronic trading facilities 
from CFTC oversight would have resulted in regulatory arbitrage, 
essentially meaning that all trading commodities would be exempt from 
CFTC oversight. There would have been no anti-market manipulation 
rules, among others, to protect the markets. Those of us who were 
concerned about the ramifications of an ETF exemption fought that 
provision and won.
    Today, as a result of Enron's collapse, what we're seeing is 
exactly the opposite of regulatory arbitrage. We are seeing a flight to 
quality. The stable, transparent markets have absorbed the market share 
that Enron had enjoyed without missing a beat. The fact that the 
largest energy trader in the United States could undergo a rapid 
collapse without disrupting supplies or creating price shocks is a 
testament to the strength of U.S. markets. However, it also 
demonstrates the importance of regulation in ensuring the integrity of 
our markets.
    Although the markets have performed admirably, we cannot afford to 
simply breathe a sigh of relief that in the short term the energy 
markets have been able to move on. We have a responsibility to fully 
evaluate the long-term implications of the Enron collapse on the future 
performance, and on how government fulfills its regulatory role. 
Today's hearing should serve an important role in guiding the Senate as 
we move toward considering comprehensive energy legislation that 
includes significant regulatory reforms.
    Contained in S. 1766 is the repeal of Public Utility Holding 
Company Act. In order to fill the void, a number of the regulatory 
procedures established under PUCHA, including merger authority and 
guaranteed access to books and records are passed to FERC and State 
regulators. We need to explore the question of whether or not these 
transfers or authority are adequate, or whether, and in what fashion 
they need to be augmented. We also need to explore where opportunities 
may exist for state regulators to work in concert with FERC to create a 
safe and stable climate for deregulation.
    In my estimation, the most significant contribution we can make 
toward the long term well-being of America's energy markets, and as a 
result, America's prosperity, is to create a regulatory climate that 
will allow open markets to function with transparency and security for 
all participants.

    Senator Schumer. I would just ask, as some of you know, I 
was particularly interested in the attempt to totally 
deregulate electronic trading facilities, and was heavily 
involved in trying to stop that from happening when it 
happened, and so I guess what I would ask the witnesses, and 
particularly Mr. Newsome and Mr. Viola, who is here along with 
Mr. Seetin, is this.
    Do you think that in general since the Enron problems there 
has been a flight to quality to large and more transparent 
markets in electronic trading, or do we have to worry about the 
fractionalization of the markets, and people going into little 
corners and trading into nontransparent platforms and, related, 
what actions need to be taken to prevent a chain reaction of 
little mini-Enrons if the potential for such--and does the 
potential for such reaction exist?
    I guess Mr. Newsome first, then Mr. Viola.
    Mr. Newsome. Thank you, Senator. As we spoke about a little 
earlier, obviously there was a full airing and debate by 
Congress as they deliberated the Commodity Futures 
Modernization Act. I think that debate was certainly warranted, 
and very useful information, and a proper regulatory regime 
came from that debate.
    As we look at the CFMA, as we look at the flight to quality 
and protection, one of the things that was included in the CFMA 
that has not been discussed here is the allowing of clearing 
four these OTC instruments. That is an area that I know that 
NYMEX is planning to move into, and I certainly think there is 
a lot of positives that can come from that, because when you 
get the credit controls that you currently have on exchange 
offered and utilized off-exchange, that is something that could 
give all of us more comfort, and so I think there are already 
some things in that act that currently are not being utilized, 
that because it is such a new act, it is just being 
implemented. I think market participants are starting to move 
in that direction and will offer some controls.
    Senator Schumer. So you have a little more confidence than 
you would have before the act?
    Mr. Newsome. Yes, sir.
    Senator Schumer. Mr. Viola.
    Mr. Viola. Senator Schumer, I think clearly the last minute 
efforts at sort of not having complete deregulation and 
exemption occur in the CFMA helped greatly in keeping markets 
stable through what would have been a very much more disruptive 
period, and I think that has to be made very clear. The efforts 
on behalf of this committee were instrumental in keeping market 
structure and price dynamics stable in the unraveling of Enron.
    I think a flight to quality is being experienced in the 
regulated environments. The players do not want to 
fractionalize, they want to converge on the central counter-
party risk and anonymous clearing function of the regulated 
exchanges like NYMEX. The point that we at NYMEX want to repeat 
is that the standard for regulation should be the same between 
an electronic platform and open auction outcry public forum 
where the trades are physically executed by traders. That is 
the one point we want to make.
    In the one study that we have done, and observed the one 
migration from a pit environment to an electronic environment--
that was the German bond market that moved to a completely 
electronic environment--we see that beyond the first one or two 
months, the first quarter of trading, the market does 
fractionalize, and it clearly becomes opaque, and it becomes a 
broker-dealer market. There is not that centralized liquidity 
you have in the public forum of a trading pit, and even though 
people may seem to think electronic media creates efficiency 
because it is digitized and quicker, in fact it starts to 
fractionalize liquidity.
    So those are the points I think from an exchange 
standpoint. There is going to be a convergence. There will be 
over-the-counter clearing provided by exchanges like the NYMEX 
and the Intercontinental Exchange, but clearly the standard for 
regulation should be converged to the same.
    Senator Schumer. Thank you, Mr. Chairman. I appreciate 
that.
    The Chairman. You are certainly welcome. We will take a 15-
minute break, and then have a second round.
    [Recess.]
    The Chairman. Let me ask everyone to take their seat. We 
will start the hearing again.
    Let me ask a few additional questions, and I know Senator 
Feinstein has got additional questions. I do not know if other 
members will return or not to ask questions, but we will try to 
do 5-minute rounds at this point just so that we can get 
through as many questions as possible.
    Let me try to paraphrase what I think I am hearing as a 
result of some of the testimony and the questions of Senators 
also, and that is a concern that Enron was the major player in 
many of these forward contracts, or markets for electricity in 
particular, but also natural gas, and that as the major player 
they had the ability to set the price, or substantially impact 
the price that those markets would require people to pay if 
they wanted to enter into those forward contracts.
    And then the implication is that perhaps either individual 
traders or someone in the company might have artificially 
inflated those prices or required higher prices than the market 
otherwise was requiring in order to gain the profit from that, 
presumably, but that the effect of this might have been to 
cause California and some of the other entities that were in 
these long-term markets, these forward markets, to lock 
themselves in at much higher prices than they otherwise would 
have had to.
    Is that a fair paraphrase of what you believe might have 
occurred, or did occur, Mr. McCullough.
    Mr. McCullough. Yes, Senator.
    The Chairman. Is there anybody else who has a point of view 
on whether or not this did occur, or might have occurred, or 
does this sound like an implausible scenario, based upon other 
factors?
    Yes, Dr. Makovich.
    Dr. Makovich. I think what I have testified to is that you 
do not want to put somebody in the position, because the 
forward market is not very liquid and is nonstandardized, you 
do not want to put them in a position where they have to add 
judgment to say, well, here is what the forward price is, and 
also then have that impact their earnings.
    Now, the question about, was there manipulation, for a 
trader, depending upon their position, whether they are in a 
net short or net long position, they can benefit from having 
prices move down as well as having prices move up, so it is not 
clear what Enron's position would have been in the Northwest, 
whether they would have actually benefitted from a drop in 
price.
    What we did see last year across the United States is all 
forward power markets dropped significantly about mid-point in 
the year, and you saw that very clearly in the futures strip, 
which does go out for about a year or so into the future.
    If the forward markets are thin, then it takes a while for 
the forward markets to reflect that as well. The liquidity of 
the futures market is that much greater, and so there was just 
a general downward movement in forward pricing across all power 
markets in the United States last year.
    The Chairman. So what you are basically saying is, you 
think there may not have been an incentive for Enron to 
artificially inflate the price in the forward markets.
    Dr. Makovich. Because of their position and because of 
disclosure. We do not know what their position was. If they are 
short or long, they can benefit by the price going up or down, 
and so the testimony is, we do not want to put people in the 
position of having to have a judgment to say, here is where the 
market is, and that affect the valuation of those positions in 
the future.
    The Chairman. Let me ask one other question. This is about 
the online trading issue.
    Mr. Viola, you have raised this issue, saying that you do 
not think there is a justification for a different standard for 
electronic trading versus trading in the pit. What is the 
current state of law on that, or the current state of law with 
regard to oversight and regulation of online trading, and what 
do you believe that law should be?
    Mr. Viola. Well, I think to reduce my answer to as simple a 
statement as possible, the current state is that the standards 
of compliance and disclosure and position reporting, those 
three principal areas are less onerous for an electronic 
trading platform that is exempt, as applied to the compliance 
disclosure and oversight standard for a pit-traded environment, 
and I think that those two standards need to converge so that 
the liquidity provided in a physical environment can be 
competitive from a structural standpoint, market structure 
standpoint.
    The Chairman. Mr. Newsome, do you have an opinion on that?
    Mr. Newsome. Yes, sir. I think there are some differences, 
and those differences are why the CFMA looked at a different 
regulatory scheme versus regulating both the open outcry and 
the electronic systems exactly the same.
    When you look at different tiers of regulations, it is 
based upon several criteria, and one difference in that 
criteria is real time audit trail that is available to a 
regulator through an electronic system which is not available 
to a regulator through an open outcry system in which you have 
to put together that audit trail through a manual method.
    Another difference was the types of traders who are using 
the system. If you operate in an open outcry system, then 
basically you have access to both sophisticated and retail 
types of traders. Obviously, in a market in which you have 
retail trade, there is a higher need for regulation. If you are 
operating in a market in which there are solely sophisticated 
operators, the intent was felt that there was a less regulatory 
need there than there was with retail participation, and so I 
think there are some reasonings of why there is a difference 
between regulation at the two levels.
    The Chairman. And the assumption that you have there is 
that there will be less sophisticated traders involved in pit 
trading than there will be in online trading?
    Mr. Newsome. No. There is an opportunity to--even if an 
electronic system wanted to open up to a retail customer base, 
then they would have to assume a higher level of regulatory 
responsibility. The exchange in a pit-trader system has an 
opportunity to operate in a less-regulated environment if it 
wants to limit its market base only to those sophisticated 
customers.
    At this point the CFMA, most of the exchange-traded 
contracts had decided to stay at the highest-regulated level 
because of having access to the full customer base, so there is 
a flexibility to the market participants who have different 
levels of regulation, depending upon what customer base that 
they want to operate with and what type of system they want to 
utilize.
    The Chairman. So in your view the key distinction is not 
between being online and being physically trading in the pit. 
The distinction is how sophisticated the people are who have 
access to the market to trade.
    Mr. Newsome. Correct.
    The Chairman. Let me call on Senator Feinstein.
    Senator Feinstein. Thanks very much, Mr. Chairman.
    Mr. McCullough, I mentioned in my statement that analysts 
had told us that Enron controlled about 50 to 70 percent of the 
gas trades that went into California. Would you agree with that 
number?
    Mr. McCullough. Yes, Senator, with the caveat that since we 
have no open discovery on Enron Online, it is purely anecdotal.
    Senator Feinstein. Thank you, and you also say in your 
written remarks that on December 3, when Enron went into 
Chapter 11, at the same time forward markets on the west coast 
fell by 30 percent, and then you say, unlike what Mr. Makovich 
just said, no other changes in operations, hydroelectric supply 
or fossil fuel prices took place at that time. The clear 
implication is that Enron may have been using its market 
dominance to set forward prices.
    Mr. McCullough. Yes, Senator. Let me clarify. I do not 
believe Dr. Makovich and I were disagreeing. We had two major 
west coast shifts. He completely correctly described the mid-
year shift that occurred throughout the markets, but the shift 
I am referring to is actually a December 3 shift, not December 
2, because I remember that was a Sunday, was it not, but 
actually on the trading days we had that dramatic shift, and 
that was in addition to the price shifts that Dr. Makovich was 
describing.
    Senator Feinstein. Thank you, Mr. McCullough. That would 
indicate to me, Mr. Wood, that there was, in fact, a distorted 
market, and I would like to ask you to take a look at 
California's bilateral electricity contracts. If, in fact, 
Enron transactions have distorted that market, and Governor 
Davis signed those contracts, there is a good argument that 
those generators should be forced to renegotiate those 
contracts, so I am making that request of your commission.
    Mr. Wood. Yes, ma'am. We will do that. I think it would 
actually be, we have not--encouraged I guess is a strong word, 
but we have answered when the California commission has 
attempted to kind of get at these issues, that they could 
certainly file at the commission a formal complaint so that we 
can bring the full tools of discovery, and I shared that with 
President Lynch, and I am not sure what their status is on 
doing that.
    Senator Feinstein. Has such a complaint been filed?
    Mr. Wood. Not from California. One has been from Nevada.
    Senator Feinstein. Well, I will see that one gets filed, 
then.
    Let me ask you this question. My understanding is that at 
the break you related to the press that you did not think Enron 
was responsible for California's natural gas spikes. If it was 
not Enron, the only two main suspects would be El Paso and/or 
SEMPRA through southern California gas. I would like to ask 
what went wrong. I would like very much to get your view.
    Mr. Wood. The question that was asked related to the short-
term markets, which I have been kind of differentiating on 
today because we do not have, as was pointed out here today, 
focus on the long-term markets, particularly on gas, which are 
quite competitive, although the fact you raised about the 50 to 
70 percent certainly raised my eyebrows. That is a pretty high 
number for one to assume that it is competitive.
    So with that caveat, which we will look into, because it 
certainly is something we are supposed to look into, there are 
two other players. One of those is certainly subject to the 
pending complaint you and I visited about in this forum before, 
and we did just reopen the record in El Paso and attempt to 
fully flush out the record and understand what happened on 
capacity on that key pipeline going into the State.
    I am not saying they did something right or did something 
wrong, but just making sure we understand fully what the facts 
are there, so I am a little reluctant to opine on that, but I 
would be happy to once we do get a record back from our judge.
    Senator Feinstein. But you are prepared to give me your 
assurance that you are going to look into this?
    Mr. Wood. Yes, ma'am.
    Now, as to December, we have got a jurisdictional issue 
between us and the State. Once the runs get to the State, 
California is not unique, but certainly there are only a very 
few States where the State commission takes over the regulation 
of the natural gas and the physical facilities of a pipeline, 
once it gets to the State borders, and we have visited with you 
all about that before, but there is a bit of--I would call it 
not a dislocation, but a difference as to how regulatory 
treatment of the line that we regulate coming into California 
and the line that the CPUC regulates, which takes over from 
that point to get to the generator plant, or get to the final 
customer.
    That jurisdictional line has been certainly something we 
have worked through informally with the commission to try to 
get around these issues.
    I do know that they took some actions in the recent months 
to change what many have identified as being a tariff problem, 
that people could not buy power all the way through from, say, 
Utah to a point on the coast, and now I think the commission 
has addressed that at the State level, so that should help.
    Senator Feinstein. I do not want to use all my time. I have 
got one very important question.
    Mr. Wood. But certainly on the El Paso one I will answer 
when it is appropriate, and we will find out what we can about 
SEMPRA and talk to you about that.
    Senator Feinstein. Does FERC have the authority to regulate 
online trading presently?
    Mr. Wood. We in September, before this all came up, put out 
revisions to our standards of conduct which are kind of code 
words for, if you have got a regulated company and a 
competitive company under the same umbrella, we want to make 
sure that the regulated company does not do something to 
benefit its competitive cousin to the detriment of somebody 
else out there in the market.
    Senator Feinstein. Is the answer yes?
    Mr. Wood. We asked the question on online, should we go 
forward and treat online as though it were a pipeline company, 
so that is out there. We would not have asked it if we did not 
think we could answer yes, so the answer is yes.
    Senator Feinstein. Very interesting.
    Second question. Do you have the expertise to do it?
    Mr. Wood. Honestly, no. That is why I mentioned a moment 
ago I put out the job announcement for director of this new 
office, and then a number of new people coming on it. The 
Congress was kind enough to give the Commission additional 
funds and positions to use for the enforcement and 
investigation purpose, and I fully intend to utilize those.
    Senator Feinstein. If you went along those lines, since 
energy trades can change hands dozens of times, do you think 
that FERC should be able to regulate all energy trading 
platforms all over the counter, energy trades? How would you 
see that?
    Mr. Wood. If the Congress wants us to do that, Senator, we 
will do that. I would aver that there might be a more expert 
agency to do that, but whatever you all want us to do is what 
we do.
    Senator Feinstein. Well, let me ask, my understanding is 
that the CFTC does not want that responsibility. Is that 
correct?
    Mr. Newsome. Well, I do not think the CFTC has ever made 
that determination of whether they wanted it or did not want 
it.
    Senator Feinstein. Then that is not correct, so are you 
open to it, and would you have the expertise to do it?
    Mr. Newsome. Well, certainly we are open to whatever the 
Congress chooses for us to do. I think if the Congress decides 
that there needs to be more regulatory oversight into that 
area, I think the CFTC would be a proper place to look for that 
regulatory oversight.
    Senator Feinstein. Mr. Wood, how do you feel about that?
    Mr. Wood. I would concur.
    Senator Feinstein. So your preference would be that any 
regulatory authority be vested with the CFTC rather than FERC?
    Mr. Wood. I differentiate between the physical market, 
which is where we have expertise, and then the financial 
trading market, which again is used to handle risk of the 
physical market. If we make sure the physical market works 
well, and that those are transparent and open and known and 
liquid, then the rest of the transactions that Jim and his 
group work with work much more effectively, and I think are 
subject to whatever oversight is appropriate for that activity.
    Senator Feinstein. Thanks very much.
    The Chairman. Senator Cantwell.
    Senator Cantwell. Thanks, Mr. Chairman. I would like to 
follow up on a couple of my earlier points, and the point 
Senator Feinstein has been making, and obviously, Mr. Chairman, 
I think we should think about what information this committee 
does seek to further shed light on these forward contracts, but 
Mr. Wood, I wanted to ask a question.
    I believe that the Supreme Court has previously found that 
FERC has the authority to negate bilateral contracts if it 
finds that the terms or conditions of those contracts are 
unjust or unreasonable, and I know that your comment earlier, 
when I asked the question, was about the court, and I know we 
are talking about what we are going to do moving forward, and 
what is the proper authority, but would you use the authority, 
your authority in this case if we find that these contracts 
signed during the height of this crisis show that they were 
manipulating the forward markets?
    I do not think I have to again emphasize how important this 
is to my State, given the fact that there are many entities--
and again, I am not 100 percent clear, but I think some of the 
contracts that Enron might have had with individual businesses 
might have had an escape clause so they got out of that 
payment, but I do not think the utilities, again the ratepayers 
of those utilities are going to get out of those increases and 
forward contracts.
    Mr. Wood. And I did mention earlier--I am sorry if I 
mumbled it--but that the court or a commission, whether it be 
us or a State commission, would have similar authority, and 
yes, ma'am, we have that under section 206 of the Federal Power 
Act, that authority to look at those contracts.
    I guess my only caution would be if those contracts did 
reflect a true scarcity price that reflected the lack of or the 
reduction of hydropower and relative more expensive fossil 
fuel----
    Senator Cantwell. But I think the point is being made----
    Mr. Wood. If it is market-power related, then I think that 
is a different type of hearing than just one of true scarcity. 
I think that is the only difficult thing I would put out there 
for you to understand before these cases would come to the 
commission, if they do, that that is probably the line of 
inquiry. If it would be as a result of market power, then you 
would go one route. If it is the result of scarcity, then you 
probably would be more uninclined to reform those contracts.
    Senator Cantwell. But again, my constituents are asking who 
is this FERC entity, as they were getting gouged for higher 
prices, and what are they going to do to mitigate this impact, 
and yes we had a drought, but going out and buying on the spot 
market at a time when the partial deregulation caused all sorts 
of problems, now they are hearing maybe these forward contracts 
are unjust, what is FERC gong to do to investigate those 
forward contracts in a manner that will give us some answers 
that I think the public deserves to have.
    Mr. Wood. Well, as you know, as we talked about, I think 
the first time we met, there is a pending complaint about a 
number of contracts under this section 206 before the 
commission. I believe it is finishing up briefing at this 
point, and has had a judge's opinion on it.
    Senator Cantwell. Do you think Mr. McCullough's point that 
things that--I mean, because that investigation started and is 
researching information back to December 1999, and now we are 
talking about isolating--and I have queried FERC before on 
these forward contracts, and whether they should be rolled into 
this investigation, and oftentimes people have responded yes, 
it is of interest, but not a clear commitment that these 
forward contracts should be investigated in the detail that I 
think this morning's hearing is saying that they should.
    Mr. Wood. Are you requesting that the Commission do a 
section 206 investigation in the long-term contracts?
    Senator Cantwell. Yes. I think I would like to know what 
documents you are going to seek that would clarify whether, in 
fact, this 20 or 30 percent increase that happened during this 
time period is because of manipulation by Enron. I think the 
public--again, ratepayers in my State are paying a 50-percent 
increase in our utility rates and want to know.
    Mr. Wood. And we will get them an answer that answers it 
one way or another, and I will commit to doing that for you, 
Senator.
    Senator Cantwell. Thank you.
    Mr. McCullough, do you have any other input on what 
documents we might be seeking, or that FERC should be seeking 
or this committee should be seeking that would help shed light 
on this?
    Mr. McCullough. Yes, Senator. Very clearly, we do need to 
know Enron's position in these markets, as Senator Feinstein 
has said. FERC apparently--and it is anecdotal. When I say 
that, it does not mean it is not true. It means we cannot tell 
for sure if Enron did have a 30 to 50 percent share of these 
markets, which appears to be the current anecdotal evidence, in 
electricity, then they have a tremendous ability to shift those 
prices.
    So I think it is important for these forward positions to 
become public, and it is very important as well in terms of the 
financial investigations to know what these forward positions 
were, because again in market-to-market they were being used as 
the center point of Enron's valuation, so I think throughout 
the entire nexus, we are very interested in this specific 
question.
    Senator Cantwell. Again, Mr. Chairman, obviously Senator 
Feinstein has asked for more hearings and clarification, and I 
support that. I think it is critically important that we 
understand it, and again the difference is between how some 
individual businesses in this bankruptcy may be getting out of 
these forward contracts, and yet utilities, which ratepayers 
are impacted by, may not be.
    The Chairman. Let me ask, to just clarify for my own 
understanding, there is a difference between forward contracts 
and long-term firm power contracts, and the contracts that 
consumers are currently having to pay under, and that utilities 
in California are having to pay under, are these long-term firm 
power contracts, as I understand it.
    Now, the concern here that Mr. McCullough has raised and 
others have raised is that these forward contracts--which are 
unregulated and which are really a hedging device to hedge 
against risk as you go forward into the future--the prices of 
these forward contracts were artificially inflated, and the 
artificial prices there were affecting in adverse ways one of 
the prices that people entered into with long-term power 
contracts. Is that a correct understanding of what we are 
talking about here?
    Mr. McCullough. Yes, Mr. Chairman. If I could describe it 
very simply, we do not have a book, a Bible we can open and see 
the future. When Governor Gray's team made these long-term 
contracts, when my clients or utilities and industries in the 
Northwest make these long-term contracts, they do it by the 
simplest possible way. They pick up the phone and they ask the 
vendors--and Enron was a very important vendor--what the prices 
are in 2003, 2004, 2005, and in Governor Gray's case, all the 
way out to 2010. Then once they have that price discovery, then 
they will actually sit down and sign that long-term contract.
    If the evidence we have from this very narrow test at the 
beginning of December, which was designed to avoid issues on 
hydro or drought, because it was so short that we just saw this 
one event, and we could see the sudden reaction, if those 
affected everyone's perceptions on long-term prices, then we 
might in fact have had a serious distortion that would show up 
all the way through the power prices in Seattle and San 
Francisco and San Diego, even beyond our authorities in 
Edmonton, Alberta, and all the way down to Tijuana. This could 
have affected the markets throughout the entire West Coast for 
long-term contracts.
    The Chairman. So that these forward contracts, those are 
the contracts the price of which dropped 30 percent on 3 
December, the forward contracts.
    Mr. McCullough. Correct.
    The Chairman. And that drop in your view is evidence that 
those forward contracts were artificially high prior to 
December 3, and many of these long-term fixed contracts, power 
contracts that California and others were entering into, may 
well have been artificially high as a result.
    Mr. McCullough. Yes, Mr. Chairman. The Governor Gray 
contracts were higher than the cost of building a new 
powerplant. They were very, very high at the time, but they 
were the only contracts apparently his team were able to 
negotiate. We did not know whether that was scarcity--we do not 
even have the data today to know whether it was scarcity or 
market failure. Most of us presume it was market failure, 
because the crisis has dissipated.
    But where we are now is, we see this sudden single test, 
this experiment with this sudden change, and it really does 
gives us some reason to doubt whether or not that forward 
market was deep enough to get the right economic answers.
    The Chairman. So if, in fact, these forward contracts had 
as big an impact as we are here speculating on the price of 
long-term fixed contracts, then the obvious question is, why 
are forward contracts in this unregulated column on that chart 
that Mr. Seetin put up earlier, why are forward contracts not 
in some way or another regulated so that people have a better 
sense of where they are and how they can be justified.
    Mr. McCullough. Yes, Senator. Now, I am not a person who 
opposes markets. I am a price theory economist, but at the very 
least we need to have discovery. We need to have open pit 
outcry that enables us to check how deep the market is, and we 
need to find out if there is only one person in the pit, if 
there is only one person in the pit that we know to proceed 
with caution. We do not have that information in front of us 
today.
    The Chairman. We are halfway through another vote here. Let 
me just ask Senator Feinstein, Senator Cantwell, did you want 
us to do another round and come back after this vote, or do you 
have a final question we can finish up with?
    Senator Cantwell. I think, Mr. Chairman, we can submit any 
further questions.
    Senator Feinstein. I would like to submit some in writing.
    The Chairman. We will submit some additional questions in 
writing. We thank you all very much. I think it has been a very 
useful hearing, and we will adjourn the hearing.
    [Whereupon, at 12:30 p.m., the hearing was adjourned.]
                               APPENDIXES

                              ----------                              


                               Appendix I

                   Responses to Additional Questions

                              ----------                              

                 U.S. Commodity Futures Trading Commission,
                                  Washington, DC, February 8, 2002.
Hon. Jeff Bingaman,
Chairman, Committee on Energy and Natural Resources, U.S. Senate, 
        Washington, DC.
    Dear Chairman Bingaman: Thank you for the opportunity to appear 
before the Committee on Energy and Natural Resources on January 29. 
Enclosed please find my response to the extra questions supplied by 
Senator Feinstein as a follow-up to the hearing.
            Sincerely,
                                          James E. Newsome,
                                                          Chairman.
             Responses to Questions From Senator Feinstein
    Question. Can you explain why energy transactions, and specifically 
Enron's bilateral energy trades are exempted from CFTC regulation?
    Answer. The Commodity Futures Modernization Act of 2000 (CFMA) was 
signed into law by President Clinton on December 21, 2000. It amended 
the Commodity Exchange Act (the Act or CEA) to, among other things, 
provide legal certainty for over-the-counter (OTC) derivatives 
products. The CFMA added to the CEA a new exemption in Section 2(h)(1) 
for some types of bilateral transactions between sophisticated parties 
in certain non-agricultural and non-financial commodities, including 
energy products. Other types of bilateral energy trades are beyond the 
scope of our regulatory authority under the Act by virtue of the 
statutory exclusions of forward contracts in Section 1a(19) and swap 
transactions in Section 2(g).
    Question. I suspect that Enron On-line didn't just happen to fall 
through the cracks, so what was the rationale for this exemption? Do 
you think this was a mistake?
    Answer. Congress enacted the CFMA after a number of hearings were 
conducted by our House and Senate oversight committees (in the context 
of reauthorizing the CFTC) that covered issues related to evolving 
markets. I believe Congress appropriately recognized that OTC 
derivatives markets, which provide valuable risk management tools to 
commercial counterparties and other sophisticated users throughout the 
economy, do not necessarily require the same level of regulation as 
markets that serve retail participants.
    Question. I understand that the CFTC investigated Enron On-line and 
concluded that there was no market manipulation. Did you have all the 
information you needed to make this determination? How much more 
information would you have had if Enron was performing multi-lateral 
rather than bilateral trading?
    Answer. The Commission has not initiated a formal investigation of 
Enron On-line. However, the CFTC's market surveillance staff regularly 
monitors the regulated futures and options markets, including those for 
exchange-traded energy contracts, to identify activities or price 
relationships that might indicate attempted manipulation or other 
threats to the orderly operation of these markets. We receive daily 
reports of large trader positions. Commissioners and senior staff are 
kept apprised of significant market events or potential problems at 
weekly surveillance meetings. Staff from the Energy Information 
Administration of the Department of Energy are invited to participate 
when energy markets are on the agenda. Thus, because Enron was often a 
large trader of energy-based contracts on the New York Mercantile 
Exchange (NYMEX), its on-exchange trading activities were monitored by 
our market surveillance staff and we have no indication that Enron ever 
attempted to manipulate any on-exchange futures or option market.
    If an electronic trading facility operates multilaterally pursuant 
to Section 2(h)(3) of the CEA,, the CFTC has authority under Section 
2(h)(4) to prescribe rules to ensure the timely dissemination by the 
facility of price, trading volume, and other trading data where the 
CFTC determines that such facility serves a significant price discovery 
function for transactions in the underlying cash market. The Act does 
not provide the CFTC this authority with respect to bilateral 
transactions entered into pursuant to Section 2(h)(1).
    Question. What regulations governed the hedging instruments that 
Enron sold? Some have alleged that Enron sold hedge funds which 
rewarded Enron when gas prices were high and volatile? Can you respond 
to these claims?
    Answer. If by hedging instruments, you refer to futures or options 
traded by Enron on the NYMEX or another regulated exchange--which, like 
other derivative instruments, can serve risk management (hedging) 
purposes--then Enron's positions would be subject to a full range of 
CFTC regulations, including the large trader reporting requirements 
discussed above. If, however, you are referring to transactions which 
may be conducted over-the-counter under the CFMA amendments of the Act, 
then the exemptions and exclusions discussed above would apply.
    Hedge funds, on the other hand, are a form of pooled investment 
vehicle, which typically cater only to sophisticated investors. Some 
hedge funds, if they participate on a regulated futures exchange, must 
register with the CFTC as commodity pool operators. We are not aware of 
Enron having ever marketed interests in any hedge fund, commodity pool, 
or other pooled investment vehicle.
                                 ______
                                 
                      Federal Energy Regulatory Commission,
                                 Washington, DC, February 14, 2002.
Hon. Jeff Bingaman,
Chairman, Committee on Energy and Natural Resources, U.S. Senate, 
        Washington, DC.
    Dear Mr. Chairman: Thank you for your January 31, 2002 letter 
enclosing questions from Senator Richard C. Shelby and Senator Gordon 
H. Smith for the record of your Committee's January 29 hearing on the 
impact of Enron collapse on energy markets.
    I have enclosed my responses to Senator Shelby's and Senator 
Smith's questions. If you need additional information, please do not 
hesitate to let me know.
            Best regards,
                                             Pat Wood, III,
                                                          Chairman.
[Enclosures]
               Responses to Questions From Senator Shelby
    Question 1. Chairman Wood, in your testimony you state that:
    ``Enron appears to have failed because of its questionable non-core 
business investments and the manner in which it reported on its 
financial position to its owner-investors and to the broader business 
community. Based on the facts as they appear now, Enron's actions would 
have led to the same result whether its core business focused on 
energy, grains, metals, or books.''
    This leads me to believe that regardless of the level of regulation 
imposed upon Enron, you believe that they would have failed, is this 
the case?
    Mr. McCullough makes the argument that had Enron been a registered 
holding company all of this may well have been avoided, do you agree 
with this assessment?
    Answer. The full details of Enron's accounting practices are not 
yet clear. Until further information is available, I cannot say whether 
additional regulation, or what types of additional regulation, might 
have prevented Enron's collapse. The excerpt quoted from my testimony 
was intended to mean that Enron's problems did not depend on the fact 
that Enron's core business is in the energy industry. The accounting 
principles at issue appear to apply to all domestic companies, and are 
not unique to the energy industry. In response to Mr. McCullough's 
assertion, I believe that until we have a comprehensive understanding 
of the facts, it would be premature to judge whether Enron's collapse 
may have been averted if Enron had been a registered holding company.
    Question 2. Chairman Wood, in your statement you mention that in 
``December of 2001, the Commission proposed a rulemaking to update the 
accounting and reporting requirements for jurisdictional public 
utilities, natural gas companies and oil pipelines.''
    Could you please explain to the Committee, the current accounting 
and reporting requirements for these entities, and if you could detail 
the differences in those requirements for registered holding companies 
and non-registered holding companies?
    Answer. The Commission's current accounting requirements for 
jurisdictional public utilities, natural gas companies, and oil 
pipelines are encompassed in the Commission's Uniform System of 
Accounts, 18 CFR Parts 101, 201 and 352 (2001). The Uniform System of 
Accounts generally requires these jurisdictional entities to establish 
and maintain a systematic and complete accounting for all of their 
costs. The Uniform System of Accounts is aimed primarily at ensuring 
that the Commission has reliable and comprehensive information to 
verify that cost-based rates are just and reasonable.
    The Commission has established a number of reporting requirements 
for jurisdictional companies. The most important one is that public 
utilities, natural gas companies and oil pipeline companies must file 
an annual report, which generally contains a balance sheet, a statement 
of income, a statement of retained earnings and a statement of cash 
flows--all kept in accordance with the Uniform System of Accounts.
    Marketers typically would be exempt from these accounting and 
reporting requirements, since the requirements are intended to elicit 
cost information and are not relevant to the market-based rates allowed 
for marketers. However, power marketers must file quarterly reports 
concerning their recent power transactions.
    The Commission's accounting and reporting requirements do not vary 
based on whether the company is or is not part of a registered holding 
company. Although the Commission in certain circumstances imposes 
restrictions on public utilities that are part of registered holding 
companies, with respect to pricing for non-power goods and services, 
the basic accounting and reporting requirements applicable to a 
jurisdictional company are not affected by whether or not that company 
is owned by a registered holding company. Public utilities in holding 
companies must abide by the Commission's accounting requirements as 
well as those of the Securities and Exchange Commission.
    Question 3. Chairman Wood, continuing along those lines, it is my 
understanding from the minimal account of information that we now have 
that Enron may have violated the rules of the Financial Accounting 
Standards Board--essentially, they may have violated existing 
accounting rules. In your opinion, would these new accounting and 
reporting requirements that FERC is proposing provide an extra layer of 
protection for consumers and investors?
    Answer. No. The Commission's proposed accounting and reporting 
requirements are intended to make accounting for jurisdictional energy 
companies more consistent with existing accounting requirements for 
non-jurisdictional companies. The Commission's proposal would not have 
prevented Enron's apparent noncompliance with existing accounting 
requirements or standards.
    The proposed accounting and reporting requirements would establish 
uniform accounting requirements and related accounts to recognize 
changes in the fair value of certain security investments, items of 
other comprehensive income, derivative instruments, and hedging 
activities, consistent with certain Financial Accounting Standards 
Board protocols. The new accounting requirements would apply to those 
public utilities, natural gas companies and oil pipelines required to 
comply with the Commission's Uniform System of Accounts. For these 
companies, the proposed rules are intended to improve the accuracy and 
completeness of the accounting information available to the Commission, 
customers and others.
    As noted above, power marketers are not required to comply with the 
Uniform System of Accounts. Thus, the proposed new requirements would 
not apply to power marketers. However, the Commission did ask for 
comments on whether the exemption of power marketers from the existing 
and proposed accounting requirements remains appropriate. These 
comments are due to be filed by March 11, 2002. The Commission will 
evaluate this issue carefully after receiving all of the comments.
            Responses to Questions From Senator Gordon Smith
    Question 1. The Pacific Northwest wholesale generation and 
transmission system provides reliable, low-cost electric service to 
consumers in the region. The predominant cause of transmission 
constraints is not service for regional loads, but marketers and others 
wheeling power out of and through the region. What problems would you 
be solving for electricity consumers in the Northwest by mandating an 
RTO and national market standards?
    Answer. In my view, all uses of the transmission grid are equally 
valid. With most Load Serving Entities (LSEs) dependent on some amount 
of generation remote from their loads, I cannot conclude that regional 
exports rather than native load are the cause of transmission 
constraints. In general, RTOs will achieve greater efficiencies in 
power markets and limit opportunities for discrimination in grid 
operations. They will promote greater competition in regional wholesale 
markets, which will benefit customers by lowering delivered electricity 
rates. RTOs will also conduct regional transmission planning, expedite 
reasonable cost grid expansions, and eliminate transmission rate 
pancaking. A standard market design would help remove barriers to 
regional trade and facilitate regional coordination in performing key 
industry functions.
    I recognize that the electric infrastructure in each region of the 
country has unique operational characteristics and needs. As the 
Commission continues developing RTOs and market design, I will remain 
mindful of the need for balance between the efficiencies of a seamless 
national market and regional flexibility.
    To this end, the Commission has provided a number of opportunities 
for representatives from each region of tire industry to express their 
interests and concerns on these issues, either in writing or in public 
meetings. The Commission will continue its extensive outreach efforts 
as we adopt and implement new policies and requirements on RTOs and 
market design. The Commission is also preparing cost-benefit studies to 
ensure that any actions we may require on these issues are in fact 
likely to benefit customers. I assure you that whatever policies and 
requirements the Commission ultimately adopts will be based on our goal 
of producing additional savings for customers.
    Question 2. Given that FERC still regulates wholesale power and 
transmission, what are the limitations of market-based solutions to 
ensuring adequate power generation and adequate transmission 
infrastructure?
    Answer. Market-based solutions are an important step to ensure the 
adequacy of our electrical infrastructure. Investors will not provide 
the capital needed by the electric industry unless they believe they 
will be compensated adequately compared to other investment 
opportunities. Thus, a good market structure with some assurance of 
sound rulemaking and revenue recovery is essential to assure that new 
generation and transmission are built.
    However, as you suggest, market-based solutions are not sufficient, 
by themselves, to ensure development of needed infrastructure. Siting 
issues often can delay or prevent such development. Of course, we must 
meet our need for energy infrastructure without unduly impairing our 
Nation's environmental assets. However, siting problems are sometimes 
driven by the fact that the benefits of proposed infrastructure would 
go to one state or region while the costs (economic or environmental) 
would go to another. We must find ways to ensure that everyone's 
interests are considered adequately and that the benefits and burdens 
of development are distributed as fairly as possible. The Western 
states, through the Western Governors Association and the Committee on 
Regional Electric Power Cooperation, have recognized the importance of 
sound Western energy infrastructure expansion and are developing 
methods of cooperation to better handle these siting issues across 
states. Here too, having an RTO-led regional planning process would 
help achieve regional infrastructure solutions.
    Question 3. My constituents rely on their long-term Bonneville 
contracts to move federal generation from its source to their loads. 
How are those rights going to be accommodated and protected in an RTO?
    Answer. Bonneville is not a public utility and thus the contracts 
under which it provides service are not subject to the Commission's 
direct jurisdiction under sections 205 and 206 of the Federal Power 
Act. The same concerns you express, however, have been expressed by and 
on behalf of public utilities. In that context, two key issues raised 
in the Commission's rulemaking on market design are: (1) whether an RTO 
transmission tariff should apply to bundled retail transmission; and 
(2) whether existing transmission contracts (e.g., contracts in effect 
before formation of an RTO) should be grandfathered. In the 
Commission's Order No. 888, the Commission did not assert jurisdiction 
over bundled retail transmission. That issue is now pending before the 
U.S. Supreme Court. Also in Order No. 888, and in the formation of 
certain Independent System Operators, the Commission grandfathered 
existing transmission contracts. However, grandfathering existing 
contracts may not be the most efficient approach to RTO formation. We 
have received a number of constructive suggestions on these points in 
our standard market design proceedings and will carefully consider the 
interests of all affected parties before making any decision on the 
these issues in our pending rulemaking.
                              Appendix II

              Additional Material Submitted for the Record

                              ----------                              

                            Consumers for Fair Competition,
                                  Washington, DC, January 25, 2002.
Hon. Jeff Bingaman,
Chairman, Committee on Energy and Natural Resources, Dirksen Senate 
        Office Building, Washington, DC.
    Dear Chairman Bingaman: For years, the Securities and Exchange 
Commission (SEC), private utilities and others have argued that the 
Public Utility Holding Company Act (PUHCA) was a redundant, 
anachronistic law.
    As detailed in the attached paper, the financial collapse of Enron 
underscores the continued importance of regulating the conduct, 
financing and structure of utility companies to facilitate effective 
regulation, protect consumers and investors and support fair 
competition. Absent receipt of an SEC staff ``no action'' letter, Enron 
would have qualified under PUHCA as a registered holding company. Such 
a determination would have resulted in significant restrictions on 
Enron's broadband and foreign utility investments, as well as inter-
affiliate transactions, and required SEC pre-approval of Enron 
securities issuances and direct oversight of books and records.
    Effective administration of PUHCA could have prevented, minimized 
or provided ``early warning'' of the events that precipitated Enron's 
collapse.
    Enron's corporate empire, according to recent reports, includes 
roughly 5,800 affiliates and subsidiaries--including 821 located 
offshore. Simply providing limited access for the Federal Energy 
Regulatory Commission and state utility regulators to review holding 
company books and records, as provided in S. 1766, is clearly 
inadequate to safeguard consumers and investors and prevent the 
corporate and accounting shell-game employed by Enron to disguise the 
true nature of its investments, financial condition and affiliate 
relations. Yet, with repeal of PUHCA, every utility company in the 
country--companies vested with responsibility for provision of an 
essential service--could mimic the corporate structure employed by 
Enron, thereby shielding itself from effective regulatory scrutiny and 
exposing consumers and investors to significant risks.
    Consumer for Fair Competition--an ad hoc coalition of consumer 
representatives, public power organizations, industrial customers and 
small businesses--believe Congress should strengthen, not weaken, the 
nation's laws that protect consumers and investors and promote fair 
competition. We urge you to delete repeal of the Public Utility Holding 
Company Act from your pending legislation unless adequate, additional 
protections are provided.
            Sincerely,
                                              Marty Kanner,
                                             Coalition Coordinator.
   Collapse of Enron Highlights the Need to Strengthen, Not Weaken, 
                     the Nation's Electricity Laws
    The sudden and dramatic financial collapse of Enron, the world's 
largest electricity and natural gas trader, highlights the need to 
strengthen, not weaken, the nation's electricity laws to ensure that 
consumers and investors are protected and fair competition advanced.
    On December 12, 2001, testimony before the House Energy and Air 
Quality Subcommittee, SEC Commissioner Isaac Hunt outlined the abuses 
that led to passage of the Public Utility Holding Company Act of 1935 
(PUHCA): ``inadequate disclosure of the financial position and earning 
power of holding companies, unsound accounting practices, excessive 
debt issuances and abusive affiliate transactions.'' Commissioner Hunt 
asserted that enhanced and expanded regulation by the SEC and the 
states--as well as changes in the accounting profession--rendered the 
protections found in PUHCA ``duplicative and unnecessary.''
    The Enron collapse underscores the failure of the remaining fabric 
of regulatory oversight to uncover the abuses that starkly parallel 
those that led to enactment of PUHCA. Repeal of federal statutes, such 
as PUHCA, removes important tools that could be used to prevent future, 
similar collapses in the energy industry and associated investor and 
consumer harm.
    PUHCA is intended to regulate the structure, financing and 
operations of utility holding companies to prevent complicated 
corporate structures, affiliate transactions and consolidations that 
prevent effective regulation and cause investor or consumer abuse. 
Following is a summary of key provisions of PUHCA and their 
implications in the Enron debacle:
    1. Utility ownership restriction. If a company owns one operating 
utility, it is precluded from purchasing another unless the acquired 
utility can be physically and operationally integrated with the 
original utility. In addition, if the resulting acquisition creates a 
multi-state utility, then the holding company must become a 
``registered'' holding company under PUHCA, with additional 
restrictions on financing and diversification. The effect of this 
restriction was to limit Enron to owning a single operating utility--
Portland General Electric. Had additional, non-integrated utility 
acquisitions been allowed, the consumer impact of Enron's collapse 
could have been significantly magnified. PUHCA repeal would allow a 
small number of companies to acquire a large number of utilities, not 
for reasons of economic and physical integration but for reasons of 
cash flow. This trend toward concentrated utility ownership will 
magnify the harm to energy consumers from the financial failure of any 
one of these companies. Recently, a federal court held that the SEC 
erred in approving a merger between two large utilities because their 
systems were not integrated. This shows the need for more vigorous 
regulatory oversight--not less.
    2. Finance and Accounting. PUHCA requires registered holding 
companies to secure SEC approval prior to the issuance of stock and 
provides for SEC--not just private accounting firm--auditing of company 
books and records. Had Enron been a registered holding company, and 
PUHCA been effectively administered, these requirements could have 
prevented or provided ``early warning'' of Enron's use of stock as 
collateral and payment to a variety of limited partnerships.
    3. Diversification restrictions. PUHCA is supposed to limit each 
registered holding company holdings to a single integrated utility 
system, plus only those businesses that are ``necessary or incidental'' 
to that system. In short, holding companies must stick to their core 
business, and operate it efficiently. One of the primary contributing 
factors in Enron's collapse was its diversification into broadband, 
water utilities and foreign utility investments. Had the SEC 
effectively administered PUHCA, Enron would have been classified as a 
registered holding company \1\ and its investments in broadband would 
have fallen under the 1996 Telecommunications Act restrictions 
requiring prior state commission approval, investment disclosure 
requirements and access to books and records, capitalization, and 
pledging of utility assets.\2\ In addition, Enron's investments in 
foreign ventures would have faced tighter restrictions. Repealing PUHCA 
will remove the restrictions on holding company diversification and 
conditions on holding company investment in telecommunications and 
foreign utility. This action could potentially lead to other utilities 
making risky investments that lead to financial ruin.
---------------------------------------------------------------------------
    \1\ The Federal Energy Regulatory Commission (FERC) determined that 
Enron's electricity trading operations qualified Enron as a ``public 
utility''. As noted in a January 21, 2001, Wall Street Journal article, 
the SEC staff issued a ``no action letter'' in January 1994, 
determining that Enron's energy marketing and brokering activities did 
not constitute ``facilities'' within the mean of an electric or gas 
utility that would require Enron to become a registered holding 
company. Had the SEC staff made the same determination as the FERC, 
Enron would have become a registered holding company under PUHCA with 
the associated restrictions.
    \2\ By restricting the pledging of utility assets, captive 
ratepayers would not be at risk for failed diversification ventures, 
and those ventures could be more limited in scope to do the absence of 
collateral.
---------------------------------------------------------------------------
    4. Affiliate transactions. PUHCA stipulates terms for financial and 
commercial transactions between affiliates that, if properly enforced, 
should prevent corporate shell games that hide the true financial 
condition of a company. PUHCA repeal will remove one check on 
complicated corporate structures that could hide similarly looming 
catastrophes. Because of the increasingly multi-state nature of such 
transactions, additional statutory protections are needed.
    5. Restrictions on consolidation. In the wake of Enron's collapse, 
numerous other ``merchant'' power companies have had their credit 
downgraded and seen stock prices plummet. This financial situation, by 
weakening smaller newcomers, is likely to lead to increased 
consolidation, as healthier incumbent market participants acquire their 
weaker competitors. While such consolidation may be financially 
beneficial to the acquiring and acquired companies--it will certainly 
reduce the number of market participants and reduce competition. PUHCA 
requires that any proposed merger produce economic and operational 
efficiencies and be in the public interest. Rather than utilizing this 
``net benefits'' test, FERC policies call for approval of any merger 
that does not cause obvious harm. Repealing PUHCA will lower the 
standard for utility mergers and acquisitions and lead to increased 
consolidation and reduced competition in the industry.
                                 ______
                                 
   Statement for the Record of the American Public Power Association 
Before the Senate Energy and Natural Resources Committee Hearing on the 
             Impact of the Enron Collapse on Energy Markets
    The American Public Power Association (APPA) is pleased to submit 
testimony to the Committee on the impact the collapse of Enron has had 
upon energy markets and the defects and regulatory deficiencies in 
energy markets that led to the collapse. APPA represents the interests 
of more than 2,000 publicly owned electric utility systems across the 
country, serving approximately 40 million citizens. APPA member 
utilities include state public power agencies and municipal electric 
utilities that serve some of the nation's largest cities. However, the 
vast majority of these publicly owned electric utilities serve small 
and medium-sized communities in 49 states, all but Hawaii. In fact, 75 
percent of our members are located in cities with populations of 10,000 
people or less. Further, most publicly owned utilities are not 
generation self-sufficient but depend on wholesale power purchases to 
meet the retail loads of the communities they serve.
    When Enron filed for Chapter 11 bankruptcy protection on December 
2, 2001, it became the largest bankruptcy in U.S. history. Enron's 
collapse has affected thousands of Enron employees, many of whom lost 
their life savings as well as their jobs. Enron stockholders lost 
countless millions as Enron stock rapidly crumbled from approximately 
$90 a share to less than a dollar per share this year. In Texas, the 
Teachers Retirement System and Employees Retirement System lost a 
combined $59.7 million as a result of investments in Enron stock. In 
addition, banks that loaned Enron money may not be repaid, causing 
instability among lending institutions.
    The collapse of Enron has consequences for energy markets as well. 
Independent power producers nationwide have seen their stock prices 
drop as a result of weakened investor confidence. The negative investor 
sentiment lingering from the Enron debacle has eroded the price of 
Calpine Corporation stock, the country's largest independent power 
producer, to a one-year low.
    Appropriately, the Department of Labor, the Securities and Exchange 
Commission and the Department of Justice have launched investigations 
into Enron's collapse. In addition, numerous congressional committees 
have stated their intent to hold hearings on issues related to Enron.
    We believe it is particularly appropriate for this committee to 
examine Enron's collapse because of the serious implications this event 
has for the electric utility industry and electric industry 
restructuring legislative initiatives. We commend Chairman Bingaman and 
members of the Committee for holding this hearing today. Information 
that comes to light as a result of this hearing, as well as other 
ongoing investigations, could help shape electricity legislation and 
protect consumers, as well as investors, from the questionable 
practices that caused Enron's bankruptcy.
    Unfortunately, the Enron debacle is more than a case of greed and 
accounting failures. The collapse of Enron represents a colossal 
regulatory failure.
    In 1935, the Public Utility Holding Company Act (PUHCA) was enacted 
to regulate the structure, financing and operations of utility holding 
companies to prevent complicated corporate structures, affiliate 
transactions and consolidations that prevent effective regulation and 
cause abuse of investors or consumers. PUHCA directs the Securities and 
Exchange Commission (SEC) to regulate the activities of large, multi-
state electric or gas utility holding companies and to limit their 
diversification into non-utility businesses. In fact, PUHCA was created 
to prevent precisely the kind of utility holding company structure--
with nearly 1,000 affiliates--that Enron became.
    Under PUHCA, the SEC enforces: special accounting requirements; 
limits on utility mergers and expansion; and tough restrictions on 
affiliate relationships. To date, 35 companies are regulated by the SEC 
under PUHCA. It is interesting to note that despite arguments PUHCA is 
perceived by companies as a major problem, the number of companies 
choosing to be regulated under PUHCA by the SEC has doubled over the 
past 10 years.
    Enron was clearly intent on avoiding regulation under PUHCA. In 
1993, Enron obtained a ``no-action letter'' or waiver from the SEC 
exempting their wholesale power-selling unit, Enron Power Marketing 
Inc., from registering under PUHCA. Some have argued that the SEC would 
have been within its authority to require Enron Power Marketing Inc. to 
register under PUHCA and that the SEC issued the waiver without 
addressing the legal issues in the application. Conversely, when faced 
with a similar decision the Federal Energy Regulatory Commission (FERC) 
determined that Enron's electricity trading operations qualified Enron 
as a ``public utility.''
    Had the SEC applied the same criteria, Enron would have become a 
registered holding company under PUHCA with the associated 
restrictions. Restrictions that would have been in place had Enron been 
a registered holding company include: SEC approval prior to the 
issuance of stock; SEC auditing of books and records; limits on 
diversification; and terms for financial and commercial transactions 
between affiliates. The restrictions, had they been appropriately 
administered, could have prevented, or provided ``early warning'' of, 
Enron's collapse. Appropriately, the SEC is now reviewing the 1993 
staff ruling to award the waiver; however, this will provide little 
comfort to the Enron employees and shareholders who suffered great 
personal and financial loss.
    Further evidence of the lengths Enron would go in order to avoid 
PUHCA regulation can be found in Enron's 1997 acquisition of Portland 
General Electric (PGE), a deal specifically structured to avoid placing 
Enron under the strictures of PUHCA. In fact, in a July 1996 article in 
The Electricity Daily Ken Lay, Enron's CEO at the time, stated in 
reference to the PGE deal and their efforts to avoid PUHCA regulation 
``. . . clearly there are (PUHCA) constraints in other deals. We think 
the Act should be repealed.'' Ironically, had these constraints not 
been in place, additional, non-integrated utility acquisitions would 
have been allowed and the consumer impact of Enron's collapse would 
have been significantly magnified.
    Ultimately, the repeal of PUHCA will allow a small number of 
companies to acquire a large number of utilities, not for reasons of 
economic and physical integration but for reasons of cash flow. This 
trend towards concentrated utility ownership will magnify the harm to 
consumers from the financial failure of any one of these companies.
    In addition to the waiver from PUHCA, Enron was able to obtain a 
SEC exemption from the Investment Company Act of 1940. This waiver 
allowed Enron to shift the debt of their foreign operations off their 
books and permitted Enron executives to invest in partnerships 
affiliated with the company.
    Clearly, having regulations in place is not enough--these 
regulations must be strictly enforced in order to be effective. At 
least in terms of PUHCA, a deficiency in SEC enforcement contributed to 
the Enron debacle. This enforcement deficiency may be related to the 
SEC's belief that PUHCA should be repealed or the fact that there are 
currently proposals pending in Congress that would repeal PUHCA.
    Ironically, it was a similar deficiency in enforcement, at FERC in 
this instance, which prolonged and contributed to the energy crisis in 
the West. In California and throughout the West, we believe that FERC 
was so focused on promoting competition that it completely lost sight 
of its obligation under the Federal Power Act to permit only just and 
reasonable wholesale rates and its responsibility to ensure that 
consumers are protected from abuses of market power. Rather than 
relying upon assumed competition to regulate wholesale electricity 
markets, FERC should have taken immediate steps to control electricity 
prices in the West.
    Over the next several months much information will be gleaned and 
many lessons will be learned from the hearings and investigations in 
the Enron collapse. Congress should proceed cautiously on comprehensive 
restructuring legislation until such time that those lessons can be 
assimilated into legislation. Proceeding on comprehensive electricity 
legislation without the benefit of information that comes to light as a 
result these hearings and investigations ultimately is likely to cause 
more harm than good. In order to better protect consumers, shareholders 
and the integrity of energy markets from similar ``Enron'' collapses in 
the future, Congress should undertake an examination of current laws 
and regulations on the books and ensure that those laws and regulations 
are being adequately enforced. Further, Congress should consider, when 
appropriate, strengthening existing law as a means of closing 
potentially exploitable loopholes.