State of New Jersey
Board of Public Utilities

In the Matter the Provision of Basic Generation Service Pursuant to the Electric Discount and Energy Competition Act.

Docket No. BPU EX01050303
Certification of Paul L. Chernick

 INTRODUCTION

1.            I am the President of Resource Insight, Inc., having a business address of 347 Broadway, Cambridge, Massachusetts 02139.

2.            I have been professionally involved in utility ratemaking and power-supply planning issues for more than 23 years. I have testified in more than 180 utility regulatory proceedings before more than 25 state, provincial, Federal and other regulatory agencies. Much of my work has addressed the valuation of utility power plants and the estimation of market prices for power; these are the subjects of this certification.

3.            I testified on behalf of the New Jersey Division of the Ratepayer Advocate earlier in this proceeding.

4.            Since the filing of comments in this proceeding, two important events have occurred. First, the largest power marketer in the country, Enron, has filed for bankruptcy. Second, the Federal Energy Regulatory Commission (FERC) has issued new guidelines for determining whether a competitive market exists.

ENRON BANKRUPTCY

5.            The Enron bankruptcy has important implications for the BGS auction proposed by the utilities, due to Enron’s role not only as a power marketer, but also as a gas marketer, market maker, and key player in the entire range of energy-related financial markets.  Although it is not clear at this time whether the Enron collapse will result in any fundamental, long-term damage to the Nation’s energy markets, it is causing a number of short-term disruptions that have serious implications for the proposed auction of some18,000 MW of BGS load.

6.            The effects of the Enron bankruptcy on the proposed New Jersey BGS auction go far beyond the loss of the country’s largest marketer as a bidder.  These other effects include the following:

§        The loss of Enron as a supplier of electricity and natural gas to other participants in the auction;

§        The loss of Enron as a dominant provider of a wide variety of financial services used as hedging tools by market participants;

§        The diversion of human resources needed for participation in the auction as potential auction participants work to resolve the many disruptions arising from the Enron collapse and related litigation; and

§        Potential difficulties in securing credit from financial institutions, which will likely become more cautious as a result of their exposure to large Enron-related losses.

7.            The effects of the Enron collapse are likely to be more serious for the near-term acquisition of supply for 18,000 MW of load in a single auction than for procurement of supply in smaller increments of 2,000 or 4,000 MW. In order for a statewide auction to succeed, it is essential that it attract the broadest participation possible. As I explained in my earlier testimony, even before the Enron collapse, the tight generation market in New Jersey made it questionable whether marketers would be able to obtain the commitments needed to produce vigorous competition for the entire 18,000 MW statewide BGS load in a single auction. The many disruptions caused by the Enron collapse will make this an even more difficult process.

Energy Marketing

8.            One impact of the Enron collapse is the loss of Enron as a participant in the auction. Enron was far and away the country’s largest marketer of electricity. Its marketing affiliates were responsible for about 186,000 GWh of electricity purchases in the fourth quarter of 2000, the latest period for which FERC has data posted. This was roughly three times the value for the next-largest marketers, Duke, Reliant, and Aquila, and 26% of total purchases for all utility-affiliated and independent power marketers. “Fourth Quarter 2000 Transactions for AF and PM,” http://www.ferc.gov/electric/ PwrMkt/2000-4pmrevised.htm (attached as Appendix A).

9.            The loss of this large electric marketer as both a direct participant in the auction and a supplier to other participants may reduce the liquidity of the market and make it more expensive and riskier for marketers to put together the package of services that would be needed to participate in the proposed New Jersey BGS auction.

10.       Given the reliance of many generation owners on natural gas as a fuel, the auction will also be affected by the loss of Enron as a natural gas marketer.  Enron was one of the largest gas marketers in the country. According to the Houston Chronicle, Enron Wholesale Services sold 28.3 Bcf, or 26%, of the 108 Bcf sold by “marketers with major trading operations in Houston” (So far as I am aware, all major gas marketers have major trading operations in Houston.) Enron was the largest marketer by far; second-place Duke sold only 11.9 Bcf. “Top Natural Gas Marketers,” May 17, 2001, http://www.chron.com/content/ chronicle/special/01/100/charts/gas.html (attached as Appendix B).

11.       Any difficulties in arranging gas supplies and hedging is likely to increase the costs of gas-fired power plants, and hence the prices at which the generation owners are willing to commit energy to the marketers who would be bidding in the BGS auction. Those higher energy costs would increase the minimum prices bidders would accept in the auction, resulting in higher consumer costs.

Energy Trading and Financial Services

12.       Perhaps even more important than the loss of the country’s dominant energy marketer is the loss of Enron as a provider of energy trading and financial services. In addition to its role as an energy marketer, Enron was the dominant trader in energy-related contracts, including, in addition to contracts for delivery of natural gas and electricity, a variety of financial derivatives. “Bankrupt,” Economist.com, Dec. 3, 2001 (attached as Appendix C).  Indeed, Enron was described by one source as  “hedge fund with a gas pipeline on the side.”  “Upended,” Economist.com, Dec. 1, 2001 (attached as Appendix D).

13.       Enron was not a broker; it acted as a counterparty to all of these transactions, many of which were offered though the Enron’s Internet trading platform, EnronOnline. “Year-Old Energy Exchange Gets Boost as Enron Struggles,” Dow Jones Newswires, Nov. 29, 2001 (attached as Appendix E).  The scope of Enron’s energy trading operations was enormous.  A recent article noted that, “before concerns about Enron’s creditworthiness mounted last month, analysts said Enron was the counterparty in roughly 25% of all North American gas and power trades.” Id.  “Utility Rivals Benefit from Enron’s Fall,” Atlanta Journal-Constitution, Nov. 30, 2001 (attached as Appendix F).

14.       In the wake of its bankruptcy filing, Enron is now attempting to revive its energy trading business. “Energy Traders Continue to Prowl the Floor That Enron Helped Build,” NYT, Dec. 6, 2001 (attached as Appendix G). However, given Enron’s current financial problems, market participants are likely to remain wary of entering into transactions with Enron. 

15.       While other firms are moving to fill the void left by the loss of EnronOnline, there will be a period of adjustment. Intercontinental Exchange (ICE) formerly, an electronic energy marketplace which was formerly a “distant second” to Enron, is struggling to accommodate a wave of traders seeking an alternative to EnronOnline. “Year-Old Energy Exchange Gets Boost as Enron Struggles,” Dow Jones Newswires, Nov. 29, 2001, p. 2 (attached as Appendix E); “Enron’s Woes Touch Firms Around the World,” Wall Street Journal (WSJ), Nov. 30, 2001 (attached as Appendix H). Other energy firms are also “scrambling” to provide the energy trading services formerly offered by Enron. “Enron’s Collapse to Spark Scramble for Market Share,” WSJ, Dec. 3, 2001 (attached as Appendix I).

16.       The current loss of Enron’s huge trading operation will tend to reduce liquidity and increase transaction costs in the electric and gas markets, at least until other firms, and possibly a revived Enron, fully expand to replace Enron’s former operations. With the loss of a key player in the market for financial derivatives and other hedging tools, marketers’ ability to hedge their risks will be adversely affected. Risk management tools are likely to be more difficult to obtain, and more expensive, at least for the short term.

Diversion of Resources Needed for Auction

17.            Aside from the loss of Enron’s participation in the auction, and the loss of the services it would have provided to generators and to marketer-bidders, the failure of Enron may have other adverse effects on the auction, due to Enron-related developments which will drain the resources of marketers and their traders and lawyers. Resources that are committed to unraveling the Enron collapse cannot be used in preparing for and participating in a New Jersey BGS auction.

18.            First, as Enron loses the ability to serve its existing customers, other retail marketers will be busy bidding for their business. Enron’s large commercial and industrial customers, including manufacturers, technology firms, hotel chains, and universities are reportedly “scrambling to line up alternative suppliers in case the collapsed energy company isn’t able to supply power or meet other obligations under its long-term contracts.” “Enron Customers Seek Backup Suppliers,” WSJ, Dec. 3, 2001 (attached as Appendix J).  To meet this need, retail marketers, including those expected to participate in the proposed New Jersey BGS auction, will need to devote time and effort to acquiring supporting resources, including gas supply for generation, power purchases, swaps and hedges. Many of these supporting services are among the services that Enron previously provided, and may be temporarily in short supply.

19.            Second, major marketers, including Duke Energy, Williams, Reliant Resources, Dynergy, and Mirant, relied on Enron for some of the resources needed to supply their customers. “Energy Firms Tally Cost of Enron’s Woes,” WSJ, Nov. 30, 2001 (attached as Appendix K).  These marketers will need to acquire replacement resources, including electricity, gas, and hedges. As noted above, many of these same firms are also moving to fill the void left by the loss of Enron’s trading operation.

20.            Third, the large number of market participants with open trading positions or other commitments from Enron may be involved in litigation over recovery of their losses, which will use a large amount of legal, financial and economic talent and may also require the traders’ expertise in determining the magnitude of the losses. The extreme examples of this phenomenon are the efforts of Dynergy to assume ownership of Enron’s Northern Natural Gas pipeline and fend off a $10 billion lawsuit by Enron. “Enron Corp. Files Largest U.S. Claim for Bankruptcy,” NYT, Dec. 3, 2001 (attached as Appendix L). Dynergy was the third-largest gas marketer in the Houston Chronicle survey. “Top Natural Gas Marketers,” May 17, 2001, http://www.chron.com/content/ chronicle/special/01/100/charts/gas.html (attached as Appendix B). Other examples include:

·        Williams Companies, a major energy trader, with something under $100 million in net exposure to Enron, “Enron Fall to Cost Tulsa, Okla.-Based Rival Millions,” Tulsa World, Nov. 30, 2001 (attached as Appendix M);

·        Reliant Resources, with about $80 million of exposure to Enron Corp., largely from power and gas sales, “Reliant Resources Sees Enron Exposure $80 Mln,” Reuters, Nov. 29, 2001 (attached as Appendix N);

·        Mirant, with about $50 million of exposure, “Rivals Benefit from Enron’s Fall; Mirant Gains in Energy Trading Sector, But is Owed More Than $50 Million,” Atlanta Journal-Constitution, Nov. 30, 2001 (attached as Appendix O); and

·        Duke Energy, with about $100 million in non-collateralized exposure    “Duke Says Has $100 Million in Exposure to Enron,” Reuters,” Nov. 29, 2001 (attached as Appendix P).

21.            The efforts required to resolve these issues is likely to be substantial.  The Enron bankruptcy filing is the largest ever, and complicated by questions about the company’s accounting methods and substantial undisclosed liabilities. “Enron Corp. Files Largest U.S. Claim for Bankruptcy,” NYT, Dec. 3, 2001 (attached as Appendix L); “Path to Settling Claims Will be a Long One, Experts Say,” NYT, Dec. 3, 2001 (attached as Appendix Q).  The Enron bankruptcy is widely expected to be “one of the messiest, most complex bankruptcy cases ever.”  “Enron’s Woes May Ripple Out to Others,” WSJ, Nov. 29, 2001 (attached as Appendix R).

22.            An essential separate problem is that for some months, until the bankruptcy court resolves the issues, two sets of generation assets may be obligated to some other PJM loads: one existing set that may be withdrawn due to Enron’s failure, and a second set that is committed to replace the Enron supply. One example would be the portion of the PECo equivalent of BGS that is served by New Power, which has relied on Enron for energy supply and risk management services. “ The New Power Company Pushes Forward With Retail Agenda, Despite Financial Challenges,” Scientech IssueAlert, Nov. 30, 2001(attached as Appendix S). The resources that Enron contracted to serve the New Power load are still committed, but PECo must confront the possibility that it will need to resume service to this load in the near future. Thus, neither the generators currently serving the load nor PECo can commit to provide power to bidders in the New Jersey BGS auction. Similarly, may of Enron’s large commercial and industrial customers are seeking alternative supplies, while remaining under contractual commitments to Enron. “Enron Customers Seek Backup Suppliers,” WSJ, Dec. 3, 2001 (attached as Appendix J).

23.            Financial companies are important in providing the financial guarantees and liquidity (letters of credit, surety bonds) necessary for the operation of marketers, including the BGS bidders. Banks and insurance companies may be somewhat reluctant to commit large new sums in support of the BGS auction, immediately after writing off millions of dollars due to the Enron failure and prior to development of new guidelines for these commitments. For example:

·  Citicorp, J.P. Morgan Chase, and Bank of America have been reported as having credit exposures of $700 to 800 million, $500 million, and $200 to 300 million, respectively. “Could Have Been Much Worse,” The Desk, Nov. 30, 2001 (attached as Appendix T).

·  Bear Stearns Cos. Inc. said it had $69 million in exposures to Enron, including $44 million in net unsecured exposure, including loans, letters of credit and derivative transactions. “Bear Stearns Has $69 Mln Exposure to Enron,” Reuters, Nov. 30, 2001 (attached as Appendix U).

·  Chubb Corp. said it has $220 million in maximum pre-tax exposure to surety bonds relating to Enron Corp. “Chubb Says Has $220 Million in Enron-Related Exposure,” Reuters, Nov. 30, 2001 (attached as Appendix V).

·  Dutch financial services group ING put its total unsecured exposure to Enron at about $195 million “ING Says Total Enron Exposure $195 Million,” Reuters, Nov. 30, 2001 (attached as Appendix W).

·  The Canadian Imperial Bank of Commerce estimated a credit exposure of $215 million to Enron Corp., including about $115 million in senior unsecured loans, letters of credit and derivatives. “CIBC Details Enron Exposure, Other Canada Banks Shy,” Reuters, Nov. 29, 2001(attached as Appendix X).

24.            These problems listed above will be sorted out over time. Most of the affected companies are large enough that their financial viability is not likely to be impaired by the Enron failure. Existing capabilities are likely to be expanded, and issues are likely to be resolved. Yet these uncertainties and distractions may not be resolved quickly enough to support a full-scale auction in next couple of months. Even in this transition period, some entity is likely to offer marketers the various disrupted services (energy, risk management, financial services), but the costs may be higher. Marketers may put together bids, but at prices high enough to reflect their higher costs and risks, and the opportunity cost of pursuing the BGS auction rather than other opportunities.

New FERC Market Power Screen

25.            Another development with important implications for the New Jersey BGS auction is the FERC’s adoption of a new interim market power screen and mitigation policy for use in connection with applications for authorization to sell power at market-based rates. The new standard was adopted by FERC in a November 20, 2001decision issued upon consideration of the triennial market power updates submitted to AEP Power Marketing and several other generation owners.  AEP Power Marketing, Inc., et al., FERC Docket Nos. ER96-2495-015 et al., Order on Triennial Market Power Updates and Announcing New, Interim Generation Market Power Screen and Mitigation Policy (Nov. 20, 2001) (attached as Appendix Y). 

26.       Under the previous standard, the FERC focused on the applicant’s market share of installed and uncommitted generation in a particular market. An applicant with a market share of 20% or less was presumed not to have undue market power. Id., p. 6-7. The Commission has concluded that, as a result of continuing significant structural changes and corporate realignments, this test no longer adequately protects consumers. Id. P. 7.The FERC has therefore adopted a “Supply Margin Assessment” or “SMA” screen, pending completion of a generic rulemaking proceeding. Id.

27.       The SMA screen focuses on whether a the applicant is “pivotal” in the market, that is, “whether at least some of the applicant’s capacity must be used to meet the market’s peak demand.” In other words, any applicant holding more capacity than the surplus above peak demand in the relevant market is presumed to create market power concerns. Id.

28.       The FERC Order provides that “[a]ll sales, including bilateral sales, into an ISO or RTO with Commission-approved market monitoring and mitigation will be exempt from the SMA and, instead, will be governed by the specific thresholds and mitigation provisions approved for the particular markets.” Id., p. 8. While this exemption appears to apply to sales within PJM, it does not appear to apply to the proposed BGS auction, as the outcome of the auction, as I understand it, would not be subject to review and possible mitigation by PJM’s market monitoring unit. In any event, regardless of the direct applicability of the SMA screen, it provides the Board with important guidance in determining whether the proposed BGS auction raises market power concerns.

29.       Applying the concept of the SMA screen, both PSEG Power and Reliant Resources control enough generation so that at least some of the capacity they control must be used to supply New Jersey’s BGS load. As I explained at page 10 of my prefiled direct testimony in this matter, PJM expects about 64,000 MW of generation to be available in the summer of 2002. This is only about 2,000 MW above the required 62,000 MW. PSEG Power controls 10,770 MW within PJM, well above the 2,000 MW peak day surplus. While some of this capacity may be committed to special contract customers and other obligations, the vast majority will be available for the BGS auction.

30.        Reliant Energy controls 6,843 MW. MAAC Response to 20001 NERC Data Request, Section 3.3 (Apr. 1, 2001) (excerpt attached as Appendix Z). Some of Reliant Energy’s generating capacity will not be available for participation in the proposed auction due to its commitments to provide power to GPU’s Pennsylvania affiliates. Based on the ratio of GPU’s JCP&L load to total GPU load, as shown in the 1994 Edition of the PUR Analysis of Investor-Owned Utilities (920,666 Gwh/49,410 Gwh, or 41%), I estimate that GPU will have approximately 3,000 MW of uncommitted capacity available for the proposed New Jersey auction.

31.       The above discussion confirms the serious concerns about market power that were explained in my previous written and oral testimony. Both PSEG Power and Reliant, knowing that the capacity they control is “pivotal” in the BGS auction, will be in a position to exercise market power by withdrawing capacity from the auction or pricing it above competitive levels. The standards recently promulgated by FERC must be considered in any decision on the proposed BGS auction.

 I hereby certify that the foregoing statements made by me are true. I am aware that if any of the foregoing statements made by me are willfully false, I am subject to punishment.

__________________________
Paul L. Chernick


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