by Planning Engineer (Russell Schussler)
The unfolding saga around FTX, the cryptocurrency exchange currently in bankruptcy, appears to share some similarities with factors which led to the demise of Enron. Enron and FTX both initially achieved success because they were able to exploit some of the inefficiencies present in a complex system.
While it is a great thing to identify and correct inefficiency, the abilities of those who do so may be greatly overestimated at times. As with Enron, it may have taken a special brilliance for Sam Bankman-Fried to capitalize on some shortcomings in crypto markets. But is the influence he received, the many speaking engagements and the adoring press commensurate with accomplishments and abilities?
You don’t have to be an overall expert in regard to a complex system in order to discover and tinker with particular inefficiencies and shortcomings within that system. In fact, successful exploiters may be grossly ignorant or worse, misinformed about major factors of the complex system. The ability to exploit a system does not mean that the exploiter is capable of redesigning the system, building a system ground up or even maintaining their edge. This post examines the initial success and ultimate failure of Enron’s attempt to transform the energy market before concluding with some thoughts around exploiters and experts.
In the period prior to the emergence of Enron and other power marketers, utilities operated in a more isolated fashion when developing, operating and scheduling their power supply. While there were power sales between utilities which might be triggered by supply and demand imbalances, the concept of short-term sales of energy based on incremental cost differentials was not even on the radar of many within the power industry.
Transmission lines put in to make the system more stable and enable long term sales allowed for such exchanges. However, the mindset of the industry was not there. A common thought was that any energy sales should at least capture incremental as well as the fixed costs of those resources. While economists and utility personnel today can easily see the flaw in such thinking, it was not the case in the 90s. I remember my Vice President in the 1990’s saying, “Why should I sell the output of my plant to my neighbor for less than it costs me?” Now he clearly was an expert on the functioning and economics of the overall power system, but there was a blind spot there. It often took a while and a lot of effort for the argument that “we will best reduce costs when we use every opportunity, we have to make a nickel”, made sense to such experts.
The Power Marketers Emerge
While utilities were very good at economically dispatching their own resources, they were not yet good at working with their neighbors to get overall system costs down. It was common for situations to occur, for example, where one utility would be ramping up a plant with incremental costs of 40 mills/kwh while their neighbor was ramping down a plant with incremental costs of 24 mills/kwh. While the individual systems were efficient on their own, greater efficiencies could be garnered the more their joint operation approximated working together much as a single system would. Great savings can result when margins allow ramping down the more costly plants in an area while increasing generation levels in lower cost plants. There were many challenges in getting multiple utilities to work together. But working together had the potential to provide great benefits to all parties. Enron and other power marketers swept into this environment. Bolstered by better communication technology, good transmission capability and Federal Regulations encouraging efficiency, marketers were able to put together and market deals to richly benefit buyers, sellers and themselves. (For information on Enron lobbying efforts that opened the system to marketers see this.)
Initially the marketers provided a great service. They coordinated numerous useful transactions, many of which might not have occurred in their absence. Cheaper surplus energy replaced more costly energy. They found buyers for temporary and limited capacity surpluses allowing some to defray excess costs and others to reap savings from delaying capacity additions. There were win-win-win situations for buyers, sellers and marketers. The industry underwent a lot of change quickly and at this time many thought that Enron and their ilk were the “smartest guys in the room”. But as it turned out the positive change and impact, they could have upon the system was limited. Their knowledge base lacked breadth and depth.
A Turn for the Worse
As I mentioned earlier, my VP was an expert on power systems despite having a temporary blind spot when it came to recognizing the benefits of potential sales and purchases, and we were slow to act. The power marketers were great at exploiting such shortcomings in the system, but they were not power system experts. Because of their contributions, some gave them credit and deference far beyond what was deserved. They were in an enviable position. They had done great things and they were big and growing, but the situation they were exploiting would not provide for continued unchecked growth. Competitors flooded the markets and utilities gained expertise and confidence in doing such transactions on their own such that potential opportunities to reduce cost differences became scarcer. While many of the power marketers had big goals, they were exploiters not experts and their knowledge and capabilities would not be sufficient to maintain their existing market shares let alone allow for their desired growth.
Financial markets drove great efficiencies in the power markets. Increasing such efficiencies eventually leads to a point of diminishing returns. How did many power marketers respond in this situation given their financial pressures? Often power marketers created deals that were increasingly complex and risky. Eventually many ended up making deals that flew in the face of basic goals and principles of power supply. Some approaches at times crossed over into ethically questionable and occasionally outright morally wrong illegal practices.
An example of an unsound practice concerns the supply of dependable generation capacity for emergency situations such as during unplanned major unit outages or extreme weather. For emergency situations utilities often relied on older plants which were no longer able to run economically. They received costly maintenance just so that they could be ready to supply power in emergency situations. While originally each utility had extra units on hand to provide firm dependable power (usually at a great cost) marketers brought about great benefits through instruments that allowed the sharing of excess capacity, so everyone didn’t need their own exclusive backup units. Initially when contracting for such emergency power there was a physical resource that could be pointed to as available to provide power when needed. Who had priority for each resource under what conditions was well understood by all participants. Those with top priority had “firm power” based on a physical resource on the ground and they could point to it and know when it should be expected to help them out under what conditions. Eventually, power marketers went beyond that and developed an instrument called “financially firm power”. What that meant was that although they did not have an identified resource on the ground, they would “ensure” firm power when needed by the purchaser through their willingness to go into the market and buy energy at whatever price it took. They projected that they would save so much money by not providing actual firm capacity that they could afford to buy it on the spot market in the rare event that they ever needed to actually provide it in an emergency.
While many in the industry were suspicious of such products, overall, the industry bought in to it. In some cases, power supply engineers accepted the new approach; in others they were over-ruled by accountants, rate makers and others who prioritized the benefits from lower costs. Some entities held the line and insisted on products that they could ensure were connected to identifiable physical resources. The short-term financial situation was better for those who trusted the marketers. One reason such instruments could work was because the system was built to be extremely reliable and although these contracts tended to reduce reliability, the system was robust enough it was not observable. While it seemed apparent to many, most did not admit that the system was becoming inherently less robust.
Federal regulations intended to support competitiveness and open access pushed utilities towards more outsourcing of supply side resources. FERC did not like transmission owners allowing their affiliated generators to have a monopoly on power supply or even to get a slight advantage when selecting power supply options. So, marketers would develop power sales contracts which utilities had to compare against self-supply options. Regulation forced utilities to select the options that were “best” in the regulators’ eyes. In addition to products like “financially firm power”, utilities entered long term purchase contracts which may or may not be tied to specific plants, where they hoped anticipated market changes would benefit them down the road. The utility self-generation options were based on in-ground projects that did not allow such leeway to become more competitive (but maybe ultimately more costly). Unlike previous planned resources which a utility could control and see, they were now more dependent on markets and the interactions of many other industry players. Things were fine for a while. Eventually the competitiveness of the market and diminishing returns made it harder and harder for marketers to make money as they had in the past. Some took shortcuts and employed questionable and unethical practices.
While costs were going down, these new arrangements left the power systems without as much redundancy, robustness or resilience as they had had in the past. Previously, although there were not formalized sharing agreements in place, utilities would come to their neighbor’s aid with their excess in times of emergency. But in an efficient market such excess capabilities are increasingly rare and in theory should disappear. At times when emergencies happened, there were not enough resources on the ground to supply the load irrespective of the complex financial arrangements intended to support the system. When multiple parties are committed to provide “financially firm” power and there are insufficient supply sources available, the market price tends to infinity. This causes default or bankruptcy. When market conditions do not jibe with forecasted assumptions of market costs, long term power supply arrangements can force the supplier to default or go bankrupt. When resources are not available the purchasers of such instruments see little relief from their bankruptcy.
Utilities acting on their own had a lot of skin in the game. At the end of the day, they were responsible for keeping the lights on. From my experience they all took this very seriously. Marketers providing efficiency took away a lot of control the individual utilities had in the past. Bad practices, incomplete understanding of power supply and poor market conditions all but guarantee failure. Creative/illegal practices may forestall but will not pre-empt the inevitable crash. Extreme conditions happened, markets did not perform as forecasted, and many marketers went out of business either from the financial or legal impacts of their poor decisions. While it looked like many utilities were saving money along the way, the cost of the failures imposed a crushing financial burden for many.
In California, market prices resulted in utilities seeing incredible price spikes and blackouts. These were blamed on market manipulations. While there were market manipulations and gaming of the system, such problems could emerge without “evil” market participants. The large investor-owned utilities (IOUs) were heavily into the market approach. However, the large municipal entity, the Los Angeles Department of Water and Power (LADWP), perhaps because they were not pressured by regulatory authorities, followed a more traditional planning approach during this period. At the time, I saw the difference as providing a “control” group for the marketing approach. During the electricity crisis LADWP did quite well. They had sufficient energy to serve their needs and made a killing with sales into the market while helping their neighbors mitigate its impacts.
I’ve talked to regulators from California since and read many media accounts, but I don’t know that others have seen the dots as I did, let alone connected them in the same way. Overwhelmingly it seems the consensus is that market manipulation rather than market failures caused the problems. A full examination of the evidence should lead to the conclusion that market manipulations were just exacerbating a bad situation of an already vulnerable system. It seems prudent to ask if market failures and emerging potential disasters “caused” the market manipulations rather than resulting from them. We might be best served by assuming that this type of behavior is inherent and largely unavoidable in failing markets. Such reasoning is not widespread, unfortunately. When the market is responsible for meeting emergency loads, no individual entities have skin in the game. There is a loss here that needs to be reckoned with. Worldwide systems where availability is dependent on markets continue to see problems. However, conventional planning approaches, particularly those with lesser commitments to intermittent resources, continue to do well.
Dangers for Exploiters
While it’s possible to be both an expert and an exploiter, one should be wary of exploiters claiming broad expertise. Initially, exploiting inefficiencies in a system is a good thing. However, exploitation can get out of control and the recipe for failure seen by Enron could apply around innovation in many complex systems:
- Exploiter spots an inefficiency/improvement and use it to make significant profits within the system.
- Initial success leads to greater success, particularly during good times, and that party expands, and others begin to enter that space.
- Success leads the exploiters to over-estimate their capabilities and overestimate their understanding of the overall system.
- Success leads the exploiters to plan for and expect continued growth and expansion.
- Success, money and influence impact policy makers to be overly optimistic such that they make the system more open so such exploitations.
- Eventually opportunities to exploit inefficiencies become less available and exploiters see diminishing returns.
- Pressure for growth, or maintenance of profits, leads to riskier and more questionable decision making.
- The realities of the system come crashing down in times of market stress.
It will be interesting to watch this as more is known about FTX to see if their trajectory followed a similar path.
Exploitation and Innovation in the Energy Arena
In the energy arena the limits of exploitation can be seen on smaller scales as well. The first to capitalize on innovations reap benefits but opportunities often close soon after for existing and new participants. For example, in many circumstances it may be possible to make money by displacing generation which has high variable costs with cheaper intermittent energy. Wind generation and solar applications can be successful. But as more participants enter that space you quickly see diminishing returns. Systems can only accommodate a limited level of displacement from intermittent resources. Furthermore, what worked on a small scale likely will not work when scaled up. (See this posting as to why the continual expansion of intermittent generating resources is inherently limited.)
However, when it comes to wind and solar, we are not as a society recognizing that we are attempting to use these resources at levels far beyond their potential. We have seen some who have made money with intermittent resources seeking to expand their operations, claiming expertise and arguing that the system can absorb their expansion and seeking to impact policy makers and regulators to aid with their expansion. But they are not overall system experts and unfortunately their plans cannot work.
It’s one thing to take apart a system. It takes a lot more ability to put it back together again. Taking apart a system, changing the parts and asking others to put it back together doesn’t take a lot of ability, but the ask is near impossible. Energy “plans” that call for wholesale changes but do not consider how the final overall system might work are not plans but rather only naïve wish lists. “Experts”, be they exploiters, innovators or highly specialized geniuses who call for sweeping change without a broad foundational background, should be meet with a high degree of skepticism. If the plans don’t account for system needs, but rather rely on innovation down the road, the skepticism should be increased further.
Elon Musk has spoken of revolutionizing our energy system, but that is just talk. I appreciate the genius of Elon Musk and he has done an incredible job in developing and manufacturing electric vehicles. He has a strong expertise and presence in the battery market. Kudos for his efforts in rooftop solar even though he may or may not one day reach his early projections there. He may yet help reshape the grid but there is a lot of work that needs to be done before anyone can outline how the grid could be replaced or radically changed. We should be highly skeptical of those with lesser credentials who say they can get us there. The grid is far too complex for wholesale redesign by policymakers. We need to watch our “experiments” with the grid and power supply and be ready and willing to put on the brakes as needed. In formulating energy policy there will be an interplay between old and new types of expertise, but serious respect must be given to proven experience.
Where do policy makers look for expertise? There is risk in looking solely toward the utility industry. As discussed, industry insiders can be to set in their ways and fail to see the benefits that exploiters can realize by eliminating inefficiencies. It’s possible also that industry insiders might be overly skeptical of newer technologies brought about by innovators. On the other hand, ignoring the wisdom of industry insiders also poses a danger as innovator and exploiters likely do not have a great understanding of the broader system. Policy makers should seek broad input from many segments. But care should be taken when evaluating their input. The initial successful track record of Enron and other Power Marketers was not sufficient for entrusting them to transform the energy industry as policy makers did. However, we still see areas of the country that have overly optimistic hopes for the capabilities of markets to provide capacity and energy (See this posting for one example).
On the Ground versus Financial Expertise
Perhaps the biggest problem plaguing Enron (and likely FTX) is that they were too far removed from producing anything of direct value: energy, food, physical resources…. I certainly believe in markets, but they don’t work everywhere. Providing value through financial instruments has great potential to do good. Financial instruments can encourage enhancements while they capitalize on the work and products of others. But those who develop and employ such instruments are not experts in the areas they support. Policy makers, investors, and customers should not place too much faith in their expertise. When we place all our faith in the market and handicap and ignore those who provide the goods, we face a high likelihood of market failure. As may prove out with FTX as well, policy makers coupled with exploiters may be the worst combination for developing policy around a complex system. More importantly, we should not expect policy makers to work solely with exploiters and innovators to transform complex systems. Financial instruments are great, but in the end, you probably need to pay a lot of attention to experts who understand real physical things on the ground.
Thanks to Roger Caiazza for reviewing and providing comments.
via Climate Etc.
November 28, 2022, by curryja