EXCERPT 3: THE CALIFORNIA ENERGY CRISIS

In a meeting room down from his Washington office, Alan Greenspan, the Federal Reserve chairman, took a seat at the head of the conference table. To his left sat Lawrence Summers, the Treasury Secretary, and a few staffers. On the right was Gray Davis, the California Governor who had flown in that day, December 26, to discuss his state’s power crisis with the country’s two most influential economists.

“Mr. Chairman, Mr. Secretary, thank you for meeting with me. I’m hoping that we can find some solutions to the troubles facing my state. The thing is, if deregulation fails in California, it will fail in the United States.”

Greenspan placed his hand on a thick briefing book in front of him. He and Summers had met privately minutes before and decided to throw a splash of cold water on Davis. The man needed to understand there were limited answers to California’s problems, all of them unpleasant.

“Truthfully, Governor, California hasn’t deregulated,” Greenspan said. “The state simply replaced one form of regulation with another. It’s become a system of central planning run amok.”

Summers joined in. “You have a fixed price set by the state for selling electricity to the public. But you have a variable, floating price when you buy electricity.”

“That’s not sustainable,” Greenspan said. “The problem is your regulatory system. And there are a very limited number of solutions. But the first step is that prices for consumers are going to have to go up.”

Davis showed no emotion. “I really feel the problem is the energy producers,” he said. “They’re manipulating the markets and forcing up prices.”

“They may be,” Greenspan said. “But that’s beside the point. That’s not causing the problem; that’s making it worse. The real problem is a supply-and-demand imbalance.”

Davis objected. There was plenty evidence, he said, that energy producers were withholding power from the market. Greenspan and Summers didn’t argue the point, stressing that it made economic sense for power to be withheld. The utilities weren’t making good on their bills already. With the utilities now careening toward bankruptcy, it would be folly for power companies to keep pumping electricity into the state without limits. It would just increase their exposure to the likely bankruptcies.

Gently, the two economists suggested that the state government hadn’t helped matters. By attacking power companies, accusing them of crimes and refusing to meet with them, Davis and other politicians had signaled an unwillingness to deal with the structural problems. In a market, perceptions could be as important as reality. Until California took a more realistic approach, power companies would continue to be reluctant to do business with the state.

“Governor,” Summers said, “this is classic supply and demand. The only way to fix this is ultimately by allowing retail prices to go wherever they have to go.”

Davis’s face hardened. He didn’t like being lectured from the ivory tower. “Fine,” he said. “You two live in your world of economics, supply and demand and pricing.”

He leaned in. “Let me tell you about my world,” he said. “About California politics. About referendums, where anybody with enough signatures can take a ballot initiative to the voters and overrule anything that we’re doing.”

Greenspan and Summers listened as Davis laid out his political dilemma. The words made it obvious that the power problems in California would become much worse. Economics and politics were in conflict. And for now, politics would rule.

Two days later, a black sedan pulled to the front of the Ronald Reagan State Office Building in downtown Los Angeles. Ken Lay emerged from the back, followed by Steve Kean, his chief of staff and Enron’s government-relations specialist. They had interrupted their vacations for this quick trip to California to meet with Gray Davis.

Lay and Kean headed to the fifteenth floor and were taken to the Governor’s conference room. After a couple of minutes, Davis came in and walked to Lay, who put out a hand.

“Governor, I’m Ken Lay.”

“Good to meet you, Ken.”

Davis sat at the head of the table, while Lay and Kean took seats on one side, across from a member of the Governor’s staff. “Governor,” Lay began, “as you know, Enron is a major participant in the California market. And clearly the state has some serious problems.”

Lay broached the next subject cautiously. He understood the politics and—Republican though he was—suggested that Davis shift the blame for all the troubles onto his Republican predecessor.

“Governor, you didn’t cause this problem; you inherited it,” he said. “But you can solve it by giving the state true competition and consumer choice.”

The advice he gave could have come out of the mouths of Greenspan and Summers. Supply had to be increased and demand cut, he said. The market had to see the state was serious. Announce plans to build power plants, with temporary waivers from environmental regulations. Allow for pricing models that would result in lower costs during nonpeak hours. Then let the consumers feel the effects of higher prices, in order to change behaviors.

“I can’t do that,” Davis said sharply. “I’m not going to raise rates.”

“Governor,” Lay said, “it’s going to be very difficult to get consumers acting rationally if they’re paying five cents a kilowatt hour for electricity that costs twenty-five cents.”

If Davis took those steps, Lay said, prices would ultimately drop. Then the state could enter into long-term fixed contracts and never face this problem again.

Couldn’t happen, Davis said. And he couldn’t suspend the environmental rules. Voters wouldn’t stand for it.

The conversation dragged on. Davis tossed out a few ideas he was considering—orchestrating state takeovers of power plants, invoking emergency powers. Lay cautioned the market would react terribly to such moves, and again stressed that he had to address supply-and-demand issues. At the meeting’s end, Lay left confident Davis was ready to act decisively, one way or the other.

Cash flow. That was always Enron’s Achilles’ heel.

No matter how much it stitched together in mark-to-market earnings, it simply couldn’t force cash to appear. Sure, it borrowed plenty of money through the complex transactions known as prepays and reported those billions of dollars as cash from operations. But that just pumped up debt without taking care of the real shortfall.

This year, though, would be different. With energy prices in California so high, Enron’s trading partners were forced to put up huge amounts of cash as collateral—some two billion dollars by late December. The cash wasn’t really Enron’s to use; it was more like a security deposit, which the company would probably have to hand back in a few months.

Still, to the untrained eye, the collateral allowed Enron to appear flush. The company reported the two billion dollars as cash flow from operations. If Enron had to return the money when prices dropped, so be it. Its finance team would deal with that later.

Appearing stiff, Gray Davis stood in the Assembly chambers at the state Capitol, delivering his third State of the State address.

“We will regain control over the power that’s generated in California and commit it to the public good,” he said. “Never again can we allow out-of-state profiteers to hold California hostage.”

Davis listed a series of hard-nosed solutions: forbidding generators from conducting unscheduled maintenance, making it illegal to withhold power from the grid, expanding his emergency authority, prosecuting evildoers.

“The remedies I am proposing tonight are reasonable and necessary,” Davis said. “There are other, more drastic measures I am prepared to take if I have to.”

After all the advice from the free-market evangelists, Davis had chosen another path—all-out war.

Rick Causey’s voice was icy.

In Washington, Dick Cheney, the Vice President–elect, was on the telephone with Ken Lay.

Months of uncertainty had followed the November presidential elections, with the Bush and Gore campaigns fighting it out in court over the razor-thin margins of victory in Florida. Now, with Bush declared the victor, the Administration was assembling its Cabinet.

A number of candidates had already been selected—including Don Evans, the campaign’s national finance chairman and an old friend of Lay’s, to serve as Commerce Secretary. Lay himself had interest in one particular job, which was why Cheney was on the phone to Houston this day.

“Ken,” Cheney said, “I’m sure you know, we’ve been seriously considering you for Treasury Secretary.”

Lay could already tell the news wasn’t good.

“The President has decided that with he and Don Evans and I all from Texas, all from the energy business, things were getting too top-heavy. Nominating a fourth person that was in the energy business and from Houston would probably just create too many problems.”

“Well, I certainly understand, Dick,” Lay replied.

Lay wasn’t all that disappointed, though. He didn’t lust for Washington. He was happy staying Enron’s chairman.

Usually, the final weeks of a presidential Administration are like the last days of high school. Nothing much gets accomplished as years of belongings are packed and people prepare for the next stage of life.

So by early January, with George Bush preparing to move into the White House, members of the Clinton Administration might have been expected to be kicking back. Instead, Treasury officials decided to take one last shot at fixing the California electricity mess. They tried to bring everybody together—the energy producers, the Secretary of the Treasury, the governor— for a final bargaining session.

But Davis refused to return to Washington and rejected efforts to meet halfway in Kansas City or St. Louis. Everyone, Davis said, needed to come to California, but the Clinton Administration officials declined.

Instead, this crucial meeting—the last chance for the Democratic governor to obtain help from a Democratic Administration—would be handled by conference call.

On January 13, a series of officials made their way down a hallway deep in the Energy Department. They were all dressed casually, not surprising for a Saturday. Summers, the Treasury Secretary, led the pack, followed by members of his department. Clinton’s National Economic Adviser, Gene Sperling, joined the group, along with an assortment of executives from some of the nation’s leading energy companies.

They arrived in a secure room filled with flashing monitors and high-tech communications devices designed for use in a national energy emergency. The government’s conference call with Gray Davis was about to begin.

About that same time, Ken Lay, Steve Kean, and Rick Shapiro, a company lobbyist, found seats around a conference table in Davis’s Los Angeles office. Lay greeted the other industry executives in the room, including Steve Bergstrom, the president of Dynegy, a top Enron competitor.

The video hookup with Washington was switched on. Larry Summers appeared, sitting at the head of the conference table in the Energy Department’s secure room. They could see Sperling from the White House, as well as the rest of the officials, staffers, and executives.

Everyone on the call was ready to get started, but the sound was left on mute. Governor Davis hadn’t arrived.

Minutes passed. In Washington, Summers fumed. He didn’t want to sacrifice the weekend with family waiting around for Davis to show up. He switched on the sound.

“Do we know where the Governor is?” he asked.

A voice responded. “No, but he’s expected soon.”

Lay watched Summers on the video screen. The answer from the Governor’s aide had clearly annoyed him.

He turned to chat with some of the others at the table, then glanced back at the video screen.

Summers was gone.

After five minutes out of the room, Summers walked back in and switched on the sound. “Okay, anybody know where the Governor is?” he asked.

Again, no real answer.

Back in Los Angeles, Lay leaned toward Steve Bergstrom from Dynegy. “If the Governor doesn’t show up soon,” he said softly, “no matter what we talk about, this isn’t going to be a good meeting.”

After thirty minutes Davis walked into his conference room. Aides scurried to be sure that the sound was on.

“Okay,” Davis said. “Let’s go.”

He offered no apologies or explanations.

Summers kicked things off, reviewing a series of recent recommendations. Long-term electricity prices needed to be stabilized, the market calmed, so California could enter into long-term power contracts. Announcing plans to temporarily suspend the environmental studies required to build a power plant would be a big step forward.

Some analysis had already been conducted, one industry executive said. The companies agreed that long-term prices could be locked in at just under seven cents per kilowatt hour. That was a little more than a penny above the current mandated retail price. A small rate hike, and the utilities could be back in financial health.

Davis looked straight into the monitor.

“That’s all very interesting,” he said. “But as I said in Washington, I cannot agree to any rate increase. And no environmental waivers for the power plants.”

The energy executives spoke up. They had gone as far as they could. Lay suggested that they dig through the numbers to show how closely everything had been shaved.

On the television screen in Los Angeles, Larry Summers looked like he was about to jump out of his skin.

“Governor,” Summers said, fixing his eyes on the screen in front of him, “it appears to me that these guys have done a pretty good job figuring out what the markets will do if the political leaders in California make the tough decisions to get things stabilized.”

The numbers were close, and certainly would help circumvent disaster. “We have to do what’s doable,” he said, “and not just what we want politically.”

Lay watched Davis stiffen. This isn’t working.

“The political reality is that I cannot agree to any rate increase or any environmental waivers,” Davis said. “We’ve got to find some other way to solve the problem.”

The answer should be price caps, Davis said. Just knock down the amount that the energy companies could charge. Some of the other state officials in the room agreed.

Summers’s voice rang through the room. “Price caps are just something temporary while we put together a bigger packet of reforms. It would distort the market.”

The Clinton Administration had allowed California to impose temporary caps, but it would be up to the Bush Administration to decide if those continued. And in the long term, Summers said, they were destructive, because they would push energy producers out of the California market.

The discussion meandered around the table. Neither side would budge. The attitude of some energy-industry executives was almost detached, as if they were indifferent to the prospect of a financial collapse in California.

About thirty minutes had passed. Then, without explanation, Davis abruptly left the room.

With Davis gone, the conversation continued for several minutes. Finally Summers spoke.

“I see the governor hasn’t returned,” he said. “I think we should suspend the conversation until he does.”

Everyone sat in silence for ten minutes. Finally Summers stood, signaling for some of the industry executives to follow him to a nearby anteroom. Sperling from the White House and several Treasury aides followed.

Away from the camera, Summers lectured the energy executives. They couldn’t just shrug the crisis off as California’s problem. They needed to bend over backward to find a way out. Their business was on the line.

“Do you guys understand the political reality?” Summers asked. “If you don’t agree to something that works for California, they are going to come at you with every political and legal gun blazing.”

Sperling agreed. “Without some arrangement, they have to come after you. You may think you’ve done nothing wrong legally. We don’t know. But they have to come after you.”

The executives objected. They had worked hard to make a deal work, they said, but the Governor refused to budge.

“It doesn’t matter!” Summers snapped. “Regardless of whether it’s a bad system, or whether they need a price increase. They are going to dig into your companies, upward, left, and right. You’re going to be the demons.”

In fact, Summers said, if this was handled badly, the prospects for deregulation were going to dim. “The whole trend could go the other way,” he said.

One executive started to argue that California’s system wasn’t real deregulation.

“You’re missing the point!” Summers shot back. “What state legislature is ever going to consider deregulation again if this problem isn’t solved?”

Davis hadn’t returned. Lay caught the eye of Bergstrom from Dynegy and signaled they should head out into the hall. They huddled outside the doorway.

“This is really strange,” Bergstrom said.

Lay agreed. “You can’t make any progress when one of your principals keeps leaving the meeting.”

“I’m not even sure it was worth coming.” Bergstrom shook his head. Maybe Davis just wasn’t serious. There was all this talk about him as a top contender for the Democratic presidential nomination in 2004; maybe he was just setting up a showdown with the Bush Administration.

“Well, one thing’s for sure,” Lay said. “He’s got a better chance of solving this with these guys than he will with the Bush Administration.”

Davis returned about thirty minutes after he had left. Someone told Washington to find Summers, who was still lecturing energy executives off camera. A minute later, Summers returned. He took his seat, furious.

“Governor,” he said sharply, “a lot of us here have given up our Saturday afternoon to make progress on this problem. Some of us have commitments tonight. We’re willing to keep working if we can make some progress.”

He pressed his hands against the table. “But if we can’t make any progress, we really shouldn’t waste time,” he said. “Let’s just decide now we’re not going to get this solved, certainly not in this Administration’s lifetime.”

Davis looked unruffled. “Larry, I really appreciate what everybody’s trying to do,” he said. “But I have made it clear from the beginning that I cannot and will not agree to any solution that increases rates to consumers in California or requires any type of environmental waiver.”

He glanced around the room. “And if all of you think that’s the only way we can solve this, then we might as well go in a different direction,” he said.

The solution was price caps, Davis said again.

In Washington, Summers launched into one final lecture about the evils of price controls. Then he threw in the towel.

“I wonder if, in fact, it’s not best to decide that we are not going to solve this problem today, and let everybody go home to be with their families,” he said.

On the video screen, Davis appeared calm.

“I think that’s right,” he said.

The meeting ended, and the video was shut off. Several officials gathered in the anteroom, frustrated and angry. They complained that Davis was too big a stumbling block, seemingly focused on just saving his political skin.

“So if we get to the 2004 Democratic convention and this guy is a serious contender for President,” one Treasury official said, “which one of us is going to lead the ‘Anybody but Davis’ crowd?”

Excerpted from Conspiracy of Fools by Kurt Eichenwald Copyright © 2004 by Kurt Eichenwald. Excerpted by permission of Broadway, a division of Random House LLC. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.