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AAAJ
16,3
446
Received 14 March 2002
Revised 17 August 2002,
3 October 2002
Accepted 14 November
2002
Accounting, Auditing &
Accountability Journal
Vol. 16 No. 3, 2003
pp. 446-466
# MCB UP Limited
0951-3574
DOI 10.1108/09513570310482327
http://www.emeraldinsight.com/0951-3574.htm
Investigating Enron as a public
private partnership
C. Richard Baker
Department of Accounting & Finance, University of Massachusetts
Dartmouth, North Dartmouth, Massachusetts, USA
Keywords Privatization, Partnership, Financing, Balance sheets, USA
Abstract The bankruptcy of Enron Corp. has evolved into a scandal of enormous proportions
involving allegations of fraud, corruption and unethical practices on the part of Enron's corporate
executives, members of its board of directors, external auditors, and high government officials in
the USA. No doubt there will be many articles written about various aspects of the Enron scandal.
The focus of this paper is on the relationships between Enron's business model and the
deregulatory phase of the American economy during the 1980s and 1990s. It is the argument of
this paper that deregulation in the US electricity and natural gas industries fostered the creation
of the Enron business model, and that this model was unsustainable, resulting in the demise of
Enron Corp. Furthermore, while Enron can be viewed as an example of capitalistic excess, the
paper reveals how the Enron business model developed as an American form of a public private
partnership, similar to the types of public private partnerships that have been created in recent
years in the UK. Investigating Enron as a public private partnership may help us to better
understand the role of public private partnerships in contemporary capitalism and shed some light
on the advisability of deregulatory schemes and the unintended consequences that can result from
such schemes.
Introduction
The focus of this paper is on the relationships between the Enron business
model and the deregulatory phase of the American economy during the 1980s
and the 1990s. It is the contention of this paper that deregulation of the
electricity and natural gas industries in the USA prompted the creation of the
Enron business model, and that this model was unsustainable, leading directly
to the demise of Enron Corp. In addition, the paper argues that the Enron
scandal can be better understood as an American form of public private
partnership rather than just another example of the excesses of capitalism. The
paper proceeds as follows. The first section outlines the idea of a public private
partnership, with a focus on how public private partnerships differ in the UK
and the USA. The second section outlines the way in which deregulation in the
electricity industry formed the basis of the Enron business model. The third
section discusses deregulation in the natural gas industry and the creation of
Enron as a company. The fourth section examines how Enron changed its
business strategy from a concentration on becoming the world's largest natural
gas and electricity producer to becoming the world's largest broker of energy
products and other derivative type contracts. The fifth section discusses Enron
as an American form of public private partnership, one which could not have
The author would like to thank Professors Jane Broadbent, Richard Laughlin and an
anonymous reviewer for their helpful comments on this paper. Any remaining errors are those
of the author.
existed without the tacit approval of US federal and state governments. The Investigating
final section speculates about how regulatory frameworks and accounting for Enron
off-balance sheet financing entities may evolve in the USA and what this might
mean for the future public private partnerships.

Public private patnerships

Introduction 447
The concept of a public private partnership can vary both in time and in place
depending on one's conception of the role of the ``state'' in a nation's political
economy (Broadbent and Laughlin, 2002). It is beyond the scope of this paper to
rehearse the debates that have ensued over several hundreds of years
regarding the role of the state in a nation's political economy. Suffice it to say
that during the last two decades there has been a worldwide trend towards
deregulation and privatization, leading to a decline in the level and kind of
services provided by governmental units (Broadbent and Guthrie, 1992). Since
the need for such services does not disappear, an alternative means of
providing the services has been required. In some cases this has led to a process
whereby needed infrastructure is obtained by enticing private sector entities to
provide financing for the infrastructure through state supported incentive
schemes. In these instances, the financing of the infrastructure is typically a
ruse perpetuated jointly by the public sector and by capitalist interests in
which those who pay for the infrastructure (i.e. the taxpayers) are not benefited.
Since the political costs of raising taxes makes it impracticable to finance the
infrastructure otherwise, the ruse is politically acceptable. This type of public
private partnership is exemplified by the Private Finance Initiative (PFI) in the
UK (see Broadbent and Laughlin, 1999; 2002; Hodges and Mellett, 1999; 2002).
Because of its close connection with the PFI, the concept of a public private
partnership (PPP) in the UK has taken on a rather specific meaning since the
initial development of the term in the late 1980s. It is the contention of this
paper, however, that PPPs ought to be considered in somewhat broader terms
in order to obtain a better understanding of the role of PPPs in contemporary
capitalist societies. The following paragraphs develop this argument
analytically by discussing differences between PPPs in the UK and in the USA
as well as differences in the regulatory and deregulatory processes in the two
countries.

PPPs in the UK and the USA

In the UK, a relatively clear distinction is made between certain types of public
services, which were traditionally provided by the public sector during most of
the twentieth century (e.g. electricity generation; water delivery; railroads;
airlines), but which have in many cases been privatized, and other types of
public services (e.g. health care; education), which remain for the most part
under the ownership and control of the central government, even if they have
some private sector involvement. The PFI is an example of this latter type of
PPP, whereby tangible assets, such as buildings, and intangible assets, such as
AAAJ services, are supplied by the private sector, even though the responsibility for
16,3 provision of these services still lies with the public sector.
An important accounting issue has arisen with respect to the latter type of
PPP concerning whether the assets and liabilities of the PPP ought to be
reflected on the balance sheet of the governmental entity that has the primary
responsibility to pay for the facility or the services. The Accounting Standards
448 Board (ASB) of the UK, which is generally averse to off-balance sheet
financing, and also highly influenced by substance over form arguments, has
indicated that if a governmental entity has ownership claims over the asset or
has long-term obligations with respect to the asset or the services, the assets
and liabilities should be reflected on the balance sheet of the governmental
entity. Conversely, in those parts of the public sector that have been privatized,
the responsibility for provision of services has been, in effect, shifted to the
private sector, thus, the same type of accounting issue does not arise.
Nevertheless, there is a perceived need for control to be exercised over the
privatized public services. Consequently, various regulatory bodies (e.g. Office
for Electricity Regulation) have been established to ensure that the private
sector suppliers of essential services are serving the public interest (Broadbent
and Guthrie, 1992).
While both of these responses to changes in the public sector (i.e. provision
of facilities/services under the PFI, or privatization of public services) can be
seen as PPPs, they are nevertheless quite different in nature, leading to
differing issues of control and supervision in order to ensure that the public
interest is protected and enhanced. Much of the previous literature analyzing
PPPs has focused on the non-privatized public sector. It is typically within this
sector that PPPs are considered to be located. However, it is a principal
argument of this paper that both kinds of arrangements (i.e. non-privatized as
well as privatized) should be viewed as PPPs.
One of the primary differences between the UK and the USA with regard to
PPPs relates to a difference in the original ownership of the means for
delivering public services. The scope of the public sector in the USA has
traditionally been much smaller than in the UK in percentage terms, and,
broadly defined, public services, such as electricity and natural gas, have been
supplied by the private sector. This traditional emphasis on provision of utility
type services by the private sector was until recently under the strict control of
government regulatory bodies. This type of regulatory control dated back to
the 1930s, but significant steps were taken during both the Reagan and Clinton
administrations towards deregulation of public services. The business strategy
of Enron Corp. arose during a breakdown in this strict regulatory environment.
The deregulatory phase in the USA economy was similar in many respects
to the privatization of public services that took place in the UK. It is not an easy
matter to explain why there was a movement towards privatization and
deregulation occurring in both the UK and the USA at relatively the same time,
however, Broadbent and Guthrie (1992) suggest that it was part of a worldwide
movement directed towards:
 Changing the character of the discourse and technologies of accounting and auditing to Investigating
promote what is characterized as efficiency, effectiveness, cost savings and streamlining, in
other words, managerialism in the public sector (Broadbent and Guthrie, 1992, p. 3). Enron
While this movement towards managerialism in the public sector was more
pronounced and obvious in the UK than in the USA there have nevertheless
been significant impacts arising from this movement in the US setting. It is the
contention of this paper that Enron Corp. was an American form of public 449
private partnership, in that, Enron could not have developed as it did without
government support provided through favorable legislation and exemptions
from restrictive regulations, many of which were obtained through skillful
lobbying efforts. The business strategy of Enron Corp. was based almost
entirely on obtaining an expert understanding of the regulatory practices in the
natural gas distribution and electricity industries and artfully taking
advantage of opportunities that arose during the deregulatory phase in these
industries during the 1980s and 1990s. It is important to note, for purposes of
this paper, that the America form of PPP differs from the types of PPPs created
under the PFI in the UK. Not the least of these differences is the level of
financial support provided by the central government to the PPPs. In the case
of the PFI, the UK government has provided support for financing schemes via
contracts that are intended to cover the operating and financing costs of the
infrastructure. As discussed previously, the existence of this type of support
has raised questions regarding who it is that actually has ``access to the benefits
of the property and exposure to the associated risks'' (Acounting Standards
Board, 1998, p. 12; Broadbent and Laughlin, 2002, p. 22).
Under the American form of public private partnership, the government
may provide support in the form of long-term contracts to purchase a product
or service (e.g. mail delivery, armaments, aircraft, electricity, natural gas). The
government may also provide favorable tax incentives, direct or indirect
subsidies, and other forms of favorable consideration that are essential to the
creation of the public private partnership. However, in most cases, there has
been a careful attempt to avoid laws and policies that would prevent the
government from directly owning or operating a commercial venture (Baker,
1995). This intentional circumvention is typically successful in avoiding the
question of whether the government's balance sheet is being used to finance the
venture (Broadbent and Laughlin, 2002; Hodges and Mellett, 2002). Moreover,
since US Generally Accepted Accounting Principles do not follow to the
principle of substance over form in a manner similar to UK GAAP, even if the
economic substance of an American form of public private partnership were to
be such that the government had ``access to the benefits of the property and
exposure to the associated risks,'' it would be unlikely that the public private
partnership would be reflected on the balance sheet of the governmental entity
(Baker, 1995).

How PPPs differ in the USA

Because there has never been a period of time in US history when the
government owned or operated a significant portion of the productive capital of
AAAJ the country, the concept of a PPP in America is found among the web of
16,3 contracts, tax incentives and favorable laws passed by federal, state and local
governments regarding functions like transportation of the mails (by horse,
boat, rail or airplane), street lighting (by whale oil, gas or electricity), canals and
toll roads, transcontinental railroads, surface and underground railways,
seaports and airports, and armaments of all types. These contractual
450 arrangements have tended to favor a particular private sector interest to the
detriment of others, or even the general public. Regulated industries, such as
airlines, highway trucking, railroads, ocean shipping, telecommunications,
natural gas distribution and electricity generation, have been allowed to charge
higher rates than would otherwise be the case because it was felt that these
industries were natural monopolies or were essential to the national defense.
The military-industry complex, described by President Dwight Eisenhower[1],
was, and still is, an elaborate form of public private partnership in which
defense contractors are essentially dependent entities of the US federal
government (London, 2002).
Much like the arguments put forth in favor of PPPs in the UK, arguments for
public private partnerships in the USA have often been couched in terms of
recommendations for improving the efficiency and effectiveness of
government. Between 1905 and 1989, there were 11 proposals for
administrative reform of the US federal government (Ingraham, 1992). The idea
of privatizing public services has been one of the more frequently advanced
proposals for governmental reform. Privatization of governmental services is
premised on the idea that civil society would be better off if it relied more on
private sector entities to provide goods and services instead of government. A
reform movement along these lines, which began during the Clinton
administration, was founded on the idea that efficiency and effectiveness in the
public sector could be improved by ``reinventing'' the way federal, state, and
local governments operate, and that privatization might play a role in this
process (London, 2002; Savas, 2000).
Accompanying the move towards privatization of governmental services,
there has been a parallel move to deregulate the regulated sectors of the US
economy, including telecommunications, airline transportation, highway
trucking, natural gas transmission and electricity generation. While
deregulation of the telecommunications industry has generally been seen as a
positive development, the deregulation processes in the natural gas and
electricity industries has been partial and fraught with difficulties. This partial
deregulation process has allowed companies like Enron to take advantage of
loopholes (Broder, 2002). During the summer of 2001, Enron and several other
energy companies were charged with rigging markets for natural gas and
electricity in the state of California to the detriment of electricity consumers.
Since the deregulation process was partial, and because it focused primarily on
the wholesale side of the market, several regulated electric utility companies in
the state of California were forced into bankruptcy in 2001, thus precipitating a
political crisis that has not yet fully subsided (Broder, 2002; Associated Press,
2002).
Deregulation as the basis for the Enron business model Investigating
Similar to the privatization efforts in the UK, steps were taken in the USA Enron
during the 1980s and 1990s to deregulate many formerly regulated
industries[2]. However, while it was recognized in the UK that privatization of
public services involved risks to consumers, and that it was necessary to
establish national regulatory bodies to limit the rates that could be charged to
consumers and to see to it that providers of public services operated in the 451
public interest, the deregulation of previously regulated industries in the USA
developed through a complex set of new laws, as well as the repeal and
modification of old laws and regulations, both at the state and federal levels
(Kahn and Gerth, 2001).
Among the new laws, and modifications to existing laws and regulations,
that facilitated the creation of the Enron business model were the following:
. The Public Utilities Regulatory Policies Act (PURPA), enacted in 1978.
This act forced regulated electric utility companies to purchase
electricity from independent power producers, thereby creating, albeit in
incipient form, the non-regulated electric power industry.
. Federal income tax laws enacted in the early 1980s, which provided tax
incentives for investments in independent power projects.
. US Federal Energy Regulatory Commission (FERC) Order No. 436,
issued in 1985, which allowed natural gas pipelines to become open-
access transporters. Previously, gas distribution companies were
regulated and vertically integrated.
. The Energy Policy Act of 1992 which changed the structure of the
electricity industry by creating a competitive wholesale market for
electricity and granted open access to transmission lines.
. Public Utilities Holding Company Act of 1935. This act prevented
companies from owning more than one electric power plant or operating
in more than one state. Enron obtained an exemption from this act in
1993, allowing it to expand aggressively in the independent power
industry[3].
. Investment Company Act of 1940. This act prevented companies from
owning investments in affiliates or partnerships to an extent greater
than 40 percent of their total assets without registering as an investment
company. Through its lobbying efforts, Enron was able to obtain an
exemption from the Investment Company Act, thereby allowing it to
create multiple off-balance sheet special purpose entities (SPEs) and to
expand overseas using investment partnerships[4].
The manner in which these laws and regulations facilitated the creation of the
Enron business model will be discussed more fully in the following sections.

The regulatory/legal framework of deregulated electricity production

Until recently, the electricity industry in the USA comprised primarily
shareholder owned, regulated electricity companies. This type of industry
AAAJ structure resulted from federal legislation enacted during the 1930s to prevent
16,3 abuses like those that had occurred in the run-up to the Great Depression. In
essence, these laws prevented regulated electricity companies from operating in
more than one state and subjected those companies to rate of return regulation,
whereby prices were established as a function of fixed allowable rates of return
on shareholders' capital. Following the energy ``crises'' of the 1970s, the US
452 Congress passed a number of laws designed to reduce America's dependence
on crude oil from the Middle East, including laws that would partially
deregulate the electricity industry. As the energy crises subsided during the
1980s many of the deregulation initiatives were not fully implemented.
However, the laws did not disappear; instead, individuals who perceived
advantages to be gained from these initiatives continued planning and
lobbying and working towards their goals. Enron was one of the companies
that was created in the wake of the US government's energy initiatives of the
late 1970s and 1980s.
The Public Utility Regulatory Policies Act of 1978 (PURPA) was enacted by
the US Congress to encourage energy conservation and increase electricity
production. Title II of PURPA required the US Federal Energy Regulatory
Commission (FERC) to issue regulations to encourage small power production
(i.e. alternative energy) and cogeneration (i.e. the simultaneous generation of
electricity and useful thermal energy). Congress believed that the development
of small power production and cogeneration would reduce the demand for
imported oil. However, regulated electricity companies also recognized the
potential of PURPA to cause a significant change in the electricity industry.
This was because the law required regulated electricity companies, subject to
certain conditions, to purchase electricity from anyone who could make it
available, thereby leading to a partial deregulation of the generating sector of
the electricity industry. Lawsuits were filed by the regulated companies
challenging the PURPA law as unconstitutional. Much like the PFI in the UK,
these lawsuits delayed the implementation of PURPA by several years.
Ultimately, the United States Supreme Court upheld the essential features of
PURPA in Federal Energy Regulatory Commission v. Mississippi, 456 US 742
(1982) and American Paper Institute, Inc. v. American Electric Power Service
Corporation, 461 US 402 (1983).
Following these court decisions, FERC developed a framework that would
allow state regulatory commissions to implement PURPA. As a part of the
general framework, FERC stipulated that regulated electricity companies had
to purchase power from ``qualified facilities'' (QFs). QFs were defined as ``small
power production facilities'' and ``cogeneration'' facilities. A small power
production facility was defined as a power plant producing less than 80
megawatts of electricity which was fueled by an alternative energy source,
such as water, wind, solar, biomass, wood, municipal waste, other solid waste,
or geothermal energy. A qualified cogeneration facility was defined as a power
plant that produced both electricity and useful thermal energy, such as steam
or heat. A qualified cogeneration facility could be of any size as long as the
percent of thermal energy produced was not less than 5 percent of the total Investigating
energy output (Baker, 1992). Enron
To become a QF, a developer had to file an application with the FERC. The
importance of becoming a QF was obvious in that regulated electricity
companies were not required to purchase electricity from other than QFs, and
in most states the regulated companies would not agree to purchase electricity
unless a project was a QF. Prior to the passage of PURPA there had been some 453
instances of power sales agreements negotiated on an arm's length basis
between industrial companies and regulated electricity companies. This was
common in the Gulf Coast of Texas where there are large petrochemical
facilities fueled by natural gas. Houston Natural Gas Company (the original
name of Enron Corp.) was one of the primary suppliers of natural gas to both
petrochemical and cogeneration facilities in the 1980s (Baker, 1992).

Project financing of independent power projects

Similar to the PFI in the UK, independent power projects were financed
through project financing (Broadbent et al., 2001; Hodges and Mellett, 2002). In
a project financing, the lender looks primarily to the cash flows and the assets
of the project as collateral for the loan. Therefore, it is important that there be a
long-term contract for the sale of the facility's output (i.e. electricity, or in the
case of the PFI, healthcare or other services). The long-term contract had to be
with a creditworthy entity (i.e. a regulated electric company, or the UK
government). Project financing of independent power projects developed
slowly during the initial years after the passage of the PURPA law in 1978. Few
financial institutions took an interest in providing financing for such projects.
There were several reasons for this reluctance, including lack of experience on
the part of developers, unfamiliarity with project financing on the part of
lenders, and the use of new and unproven technologies. As the experience of
both developers and lenders increased, the number of banks and other financial
institutions active in the field of project financing also increased. In the 1980s,
the primary financial institutions providing loans to independent power
projects were banks with experience in project financing in areas such as
mining, pipelines, and oil and gas exploration. Among these banks were
Citibank, Barclays, Morgan Guaranty and Chase Manhattan Bank. These
banks subsequently became the primary lenders to Enron Corp. (Baker, 1992).
At the beginning of the independent power industry, lenders refused to lend
more than 75 percent of the total costs of a project. Since developers of
independent power projects were often thinly capitalized, there was a need for
equity capital or subordinated debt. In the early 1980s, equity capital for
independent power projects was easier to obtain than subsequently because of
the existence of tax incentives provided by the US federal government,
including a 10 percent investment tax credit, five year depreciation write-offs,
and additional tax credits of up to 15 percent for alternative energy. These tax
incentives were a form of public private partnership, in that taxpayers were
subsidizing the creation of the independent power industry. These tax
incentives allowed investments in independent power projects to seem less
AAAJ risky from an investor's perspective. The risk was reduced because most of the
16,3 investment could be deducted as an expense for federal income tax purposes or
taken directly as a credit against federal income taxes. These tax incentives
spawned a large sub-industry of lawyers, investment bankers and accountants
who structured project financing arrangements for independent power projects
(Baker, 1992).
454 By the end of the 1980s all of the tax subsidies for independent power
projects were eliminated by the US Congress because of growing federal
budget deficits. Afterwards, investments in independent power projects had to
be evaluated based on criteria other than the tax subsidies that the investments
produced. This caused a consolidation in the independent power industry
which favored more efficient producers. Since the economics of electricity
generation favor natural gas combustion turbines, developers who controlled
the natural gas supplies were in a position to become dominant players in the
independent power industry. Recognizing the potential to become dominant
players, both Houston Natural Gas Company and Inter-North (the predecessor
companies of Enron Corp.) entered the independent power business in the mid
1980s.

Deregulation of the natural gas industry and the creation of Enron

Kenneth Lay joined Enron Corp. in 1984 when it was still called Houston
Natural Gas Company. Lay had a strategic vision regarding the future of the
natural gas industry focusing on deregulation and growth through mergers,
acquisitions and overseas expansion. This strategy included a move into
independent power production, with natural gas as the cornerstone. In July
1985, Houston Natural Gas Company merged with InterNorth, the parent
company of Northern Natural Gas Company, based in Omaha, Nebraska, to
form Enron Corp. (Enron Corp., 2002). The primary asset of the combined
company was an interstate gas distribution network consisting of
approximately 37,000 miles of pipe. In October 1985, after lobbying efforts by
Ken Lay and others, the US Federal Energy Regulatory Commission (FERC)
issued Order No. 436, allowing natural gas pipelines to become open-access
transporters. Previously, gas distribution companies were regulated and
vertically integrated (Strategic Management Wharton, 2002). The FERC order
deregulated the natural gas industry by separating the production, long-
distance transmission and local distribution functions, leaving each function to
a different set of participants. Ultimately, Enron retained the interstate pipeline
distribution network while phasing out its exploration and local distribution
activities. Kenneth Lay became the Chairman of Enron Corp. in February 1986
(Strategic Management Wharton, 2002).

Transforming the regulated natural gas industry

Between 1986 and 1996 Enron's business strategy was focused on three
primary areas. The first area involved a transformation of the natural gas
pipeline business from a regulated company to an open access, merchant
transporter of natural gas. This transformation allowed Enron to sell natural
gas throughout the USA at unregulated prices. Enron's pipeline network was Investigating
enlarged through acquisitions of other pipeline systems in Florida and the Enron
Pacific Northwest. In 1989, Enron created GasBank, an entity whose purpose
was the wholesale trading of natural gas futures contracts. GasBank allowed
buyers and sellers of natural gas to enter into forward commitments to hedge
the risks of varying spot market prices. As GasBank developed, Enron became
the largest natural gas merchant in North America (Enron Corp., 2002). 455
Investing in independent power production
The second focus of Enron's business strategy was to invest in independent
power production, both by becoming a supplier of natural gas to the projects
and as an equity participant. The US Energy Policy Act of 1992 changed the
structure of the electricity industry by creating a competitive wholesale market
for electricity and granting access to transmission lines similar to the natural
gas industry (Batteles, 1999). However, there was still a barrier to the rapid
expansion of the independent power industry, namely, the Public Utilities
Holding Company Act of 1935. This law was enacted during the Great
Depression to prevent abuses in the electric power industry like those
perpetuated by Samuel Insul. During the 1920s, Insul's Chicago Edison holding
company was a multi-tiered corporate entity with ownership interests in
dozens of electricity companies throughout the USA. After the 1929 stock
market crash, the Insul holding company collapsed, much like Enron did in
2001. However, in 1993, after significant lobbying efforts with the federal
government, Enron was granted an exemption from the Public Utilities
Holding Company Act. This exemption eliminated the remaining barriers to
Enron's rapid expansion in the independent power industry (Labaton, 2002a).
Furthermore, the exemption allowed Enron to acquire an entire electricity
company, an action which would have been prohibited only a few years earlier
(Kahn and Gerth, 2001).
In late 1996, Enron announced that it would acquire Portland General
Electric Company. When this merger was completed in January 1997, it
combined Enron, which by then was the largest marketer of natural gas and
wholesale electricity in North America, with Portland General, a profitable
electric utility located in one of the fastest growing regions of the USA. With
ownership of more than 5,900 megawatts of electricity generating capacity and
more than 37,000 miles of natural gas pipeline, the combined company was
well-positioned to become a dominant player in the deregulated gas and
electricity industries (Enron Corp., 1996). In the following quotation from the
press release which announced the merger, Kenneth Lay explained Enron's
business strategy:
This proposed merger with Portland General represents an outstanding opportunity for us to
create the leading energy company of the future in the North American energy markets. By
combining the natural gas and electricity marketing and risk management expertise of Enron
with the wholesale and retail electricity expertise of Portland General, along with its related
assets and skilled employees, we are uniquely positioned to be the leader in the increasingly
competitive natural gas and electricity marketplace. This strategic merger is expected to be
accretive to Enron's earnings per share beginning in the first year after completion of the
AAAJ merger, and is thus consistent with our long-term compound annual earnings growth target
of at least 15 percent. The deregulation of the electricity market in North America represents
16,3 one of the most significant industry restructurings ever. Just as coal was the primary energy
source of the 19th Century, and oil was the primary fuel of the 20th Century, we believe
natural gas and electricity will converge as the primary sources of energy in North America
and many other markets around the world for the 21st Century. Ten years ago, Enron
successfully embarked on a new strategy to compete in the newly deregulated natural gas
456 market in North America. Customer choice and competition in natural gas, at the wholesale
level and more recently at the retail level, have been a great success for consumers and the
American economy. By applying the experience gained in the natural gas market, Enron has
become, in a very short period of time, the largest independent marketer of wholesale
electricity in North America. As the move toward deregulation in the retail sector proliferates,
Enron is poised to participate as a leader in the evolution toward a converged gas and
electricity market, with more product choices and competitive prices for all customers, large
and small, both wholesale and retail (Enron Corp., 1996).
Despite the enthusiasm surrounding the merger between Enron and Portland
General, within three years, Enron tried to sell Portland General to another
company (Enron Corp., 2001). This was because the Enron business strategy of
becoming the dominant player in the deregulated natural gas and electricity
industries was proving to be not as profitable as Lay had hoped. Consequently,
Enron's deregulation strategy was replaced in the late 1990s with a new
strategy to become the dominant broker in energy related products and other
types of commodities and services, including metals and broadband
communication (Strategic Management Wharton, 2002). This change of
business strategy will be discussed more fully in a later section.

Expansion outside the USA

The third focus of the Enron business strategy was to become a developer of
power plants outside the USA. One of the first overseas projects undertaken by
Enron was the development of a 1,875 megawatt (MW) power plant in
Teesside, UK. Upon its completion in 1993, the Teesside project became the
world's largest natural gas-fired power plant. After the Channel Tunnel,
Teesside was the largest project financing ever completed in the UK (Enron
Corp., 2002). Lord John Wakeham, the former Secretary of State for Energy in
the Conservative Government, played an important role in the development of
the Teesside project. Subsequently, Lord Wakeham became a member of
Enron's Board of Directors. He was a member of the Audit Committee of the
Board at the time of Enron's bankruptcy and was therefore in a position to
know about the business strategies of Enron (BBC, 2002).
Enron's overseas expansion strategy also encompassed the development of a
very large (2,450MW) power project located near Mumbai, India (the Dabhol
project). The first phase of the Dabhol project began in late 1996 and it achieved
commercial operation in May 1999. However, by the beginning of 2002, the
project was not yet complete, and the Indian government was contemplating
terminating the power purchase agreement for the project (The Financial
Express, 2002). In addition, Human Rights Watch charged Enron with
engaging in human rights abuses in connection with the project:
 Human Rights Watch believes that the Dabhol Power Corporation ± and its parent companies Investigating
Enron, General Electric, and Bechtel ± are complicit in human rights violations by the
Maharashtra state government. Human Rights Watch does not take a position on the Enron
persistent and pervasive allegations of corruption that surround Enron's establishment in
Maharashtra and its way of doing business there. But, as described above, Enron's local
entity, the Dabhol Power Corporation, benefited directly from an official policy of
suppressing dissent through misuse of the law, harassment of anti-Enron protest leaders and
prominent environmental activists, and police practices ranging from arbitrary to brutal
(Human Rights Watch, 1999). 457
Other Enron projects included the development of a 790MW gas fired power
plant at Sutton Bridge, UK and the acquisition of Wessex Water Company, also
located in the UK (Enron Corp., 2002). This latter acquisition, along with the
acquisition of a wind energy company, Zond Energy, signaled a diversification
away from Enron's primary focus on natural gas-fired power plants.

A change in Enron's business strategy

When Enron was formed in 1985, its primary business was the operation of
interstate gas pipelines. At that time, regulated gas utility companies were
vertically integrated, controlling the natural gas from wellhead to consumer.
The US government's deregulation process, beginning in the early 1990s,
separated the production, transmission and local distribution functions and
forced the surviving companies to operate in a market environment. This new
environment allowed intermediaries to develop who created contracts for
future delivery of natural gas. Prior to deregulation, large industrial users of
natural gas, including regulated electricity companies, could reliably forecast
their future fuel costs by reference to a regulated tariff. After deregulation,
large users of natural gas had to protect themselves by entering into contracts
for future delivery of gas at agreed upon prices and quantities. Between the
contract date and the delivery date, the price of gas could vary. The supplier of
the natural gas might discover that it had promised to sell at a price that was
lower than the current price, while the purchaser might find that it could buy
gas for less than it had agreed to pay. Consequently, a market for natural gas
derivatives contracts (e.g. options, futures, forwards) began to develop. In the
late 1990s, Enron changed its business strategy to a focus on becoming the
dominant player in the marketplace for energy derivatives. This change in
Enron's business strategy allowed it to continue being the largest seller of
natural gas and electricity in North America without maintaining a large
investment in tangible fixed assets like pipelines and power plants (Strategic
Management Wharton, 2002).

Was Enron's strategy successful?

Even though the price of Enron shares rose steadily from 1996 through 2000,
there was a wide variability in its earnings per share. The annual target
growth rate of 15 per cent for earnings per share set by Ken Lay in 1996 was
not met. As Table I indicates, Enron's diluted earnings per share fell 4 percent
in 1997, rose 16 percent in 1998, rose 26 percent in 1999, and fell 12 percent in
2000. The volatility of Enron's EPS was explained to the financial community
by pointing to non-recurring impairment charges and a cumulative effect of
AAAJ Dollar amounts in millions
16,3 2000 1999 1998 1997 1996

Enron Corp., selected financial information

Net revenues 100,789 40,112 31,260 20,273 13,289
Net income 979 893 703 515 493
Current assets 30,381 7,255 5,933 4,669 3,979
458 Investments and other assets 23,379 15,445 12,760 9,583 5,046
Property, plant and equipment 11,743 10,681 10,657 9,170 7,112
Total assets 65,503 33,381 29,350 23,422 16,137
Current liabilities 28,406 6,759 6,107 4,412 3,708
Long-term liabilities 25,627 17,052 16,195 13,392 8,706
Total liabilities 54,033 23,811 22,302 17,804 12,414
Stockholders' equity 11,470 9,570 7,048 5,618 3,723
Common size balance sheet data
Current assets (%) 46.4 21.7 20.2 19.9 24.7
Investments and other assets (%) 35.7 46.3 43.5 40.9 31.3
Property, plant and equipment (%) 17.9 32.0 36.3 39.2 44.1
Total assets (%) 100.0 100.0 100.0 100.0 100.0
Current liabilities (%) 43.4 20.2 20.8 18.8 23.0
Long-term liabilities (%) 39.1 51.1 55.2 57.2 54.0
Total liabilities (%) 82.5 71.3 76.0 76.0 76.9
Stockholders' equity (%) 17.5 28.7 24.0 24.0 23.1
Ratio analysis
Current assets/current liabilities 1.07 1.07 0.97 1.06 1.07
Total liabilities/stockholders' equity 4.71 2.49 3.16 3.17 3.33
Net profit margin 0.97% 2.23% 2.25% 2.54% 3.71%
Asset turnover 1.54 1.20 1.07 0.87 0.82
Return on assets 1.49% 2.68% 2.40% 2.20% 3.06%
Assets/stockholders' equity 5.71 3.49 4.16 4.17 4.33
Return on stockholders' equity 8.54% 9.33% 9.97% 9.17% 13.24%
Diluted earnings per share $1.12 $1.27 $1.01 $0.87 $0.91
Annual growth in earnings per share ±12% 26% 16% ±4%
Closing share price $83.25 $44.75 $28.53 $20.59 $31.91
Table I. Price/earnings ratio 74.3 35.2 28.2 23.7 35.1
Selected financial
information of Enron Source: Enron Corp. Annual Reports

accounting changes. In the face of a strong bull market, these explanations

were accepted by the financial community, and Enron's price earnings
multiple rose from 23.7 in 1997 to 74.3 in 2000. Enron was counted as one of
America's best companies. The question is whether there were problems
lurking behind the numbers.
As a broker in energy derivatives, Enron had to agree to pay if either party
to the derivative contract defaulted. Without this agreement it would have been
impossible to create a market in energy derivatives. In addition, Enron often
needed to make payments for derivative contracts before receiving payment
from the counter party. Consequently, Enron needed a large amount of liquid
capital to trade energy derivative contracts. In 1996, 44.1 per cent of Enron's Investigating
assets were invested in property, plant and equipment (see Table I). By 2000 Enron
this had changed so that only 17.9 percent of Enron's total assets were invested
in property, plant and equipment. This change was not the result of a decrease
in tangible fixed assets, but was caused instead by a dramatic increase in
current and intangible assets arising from Enron's derivatives trading
activities. The increase in current and intangible assets was financed through 459
increases to both current and long-term liabilities. Shareholders' equity
declined in relation to liabilities, thereby causing a significant increase in
Enron's total debt to equity ratio (2.49 in 1999 versus 4.71 in 2000). One
additional reason that Enron's tangible fixed assets declined as a percentage of
total assets was because Enron's management had begun transferring its
investments in independent power projects to unconsolidated affiliates, along
with the debt related to those projects. This was a conscious practice developed
by Enron's Chief Financial Officer, Andrew Fastow. Fastow was quoted as
saying: ``We transformed finance into a merchant organization . . . essentially,
we would buy and sell risk positions'' (Strategic Management Wharton, 2002).
The idea was to move as many of Enron's assets and liabilities off the balance
sheet as possible. The manner in which this was accomplished was by creating
``special purpose entities.''

Special purpose entities

To shift assets and liabilities off its balance sheet, Enron used an accounting
structure known as a ``special purpose entity'' (SPE). Pursuant to US Generally
Accepted Accounting Principles (GAAP) existing prior to June 2002, a
company could create an SPE and treat it as if it were an independent entity for
accounting purposes if two conditions were met:
(1) an owner independent of the sponsoring company had to make a
substantive equity investment of at least 3 percent of the SPE's total
assets, and that 3 percent had to remain at risk throughout the
transaction; and
(2) the independent owner had to have control of the SPE (i.e. greater than a
50 percent voting interest).
If an SPE met these requirements, a sponsoring company could record gains
and losses on transactions with the SPE, and the assets and liabilities of the
SPE would not be included in the sponsoring company's balance sheet, even
though the sponsoring company and the SPE were closely related.
SPEs were a little known financing vehicle prior to the Enron scandal.
Originally they were intended to be used for specific transactions, such as the
sale of consumer receivables (e.g. credit card loans; car loans; home mortgages)
by a bank to a trust, thereby allowing the securitization of such receivables
(Hartgraves and Benson, 2002). The FASB addressed the issue of SPEs for the
first time in 1984 in Emerging Issues Task Force Issue No. 84-30, which
involved the sale of bank loans to SPEs. Later in 1989, the FASB addressed the
AAAJ issue of non-consolidation of SPEs in EITF Topic D-19. The SEC Observer to
16,3 the EITF indicated that non-consolidation of the SPE and sales recognition by
the sponsor would be allowed if the majority owner of the SPE:
. was an independent third party who made a substantive capital
investment in the SPE;
460 . had control of the SPE; and
. had substantive risks and rewards of ownership in the SPE.
In 1990, the use of SPEs was extended by EITF Issue No. 90-15, with the
consent of the SEC, to leasing transactions in which the sponsor sells an asset,
such as a building, to the SPE and leases it back. It was in this ruling that the
concept arose that an investment equal to 3 percent of the total assets of the
SPE would be considered to be a ``substantive capital investment'' (Hartgraves
and Benson, 2002, p. 252), thus allowing non-consolidation. Ultimately, Enron
took advantage of these EITF pronouncements to create over 3,000 off-balance
sheet SPEs between 1993 and 2000 (Powers et al., 2002).

An example of an Enron SPE: the Chewco transaction

In October 2001, it was disclosed for the first time that Enron had issued
misleading financial statements between 1997 and 2001 because it improperly
failed to consolidate a limited partnership called Chewco Investments LP. A
special investigative report prepared by Enron's Board of Directors stated that
from 1993 through 1996, Enron and the California Public Employees'
Retirement System (CalPERS), one of the largest government pension schemes
in the USA, were partners in a $500 million joint venture partnership called
Joint Energy Development Investment Limited Partnership (JEDI) (Powers
et al., 2002). Because Enron and CalPERS had joint control of the partnership,
Enron did not consolidate JEDI into its consolidated financial statements. The
effects of non-consolidation were significant: Enron recorded its share of gains
and losses from JEDI in its income statement, but it did not show JEDI's assets
or liabilities on its balance sheet (Powers et al., 2002).
In November 1997, Enron wanted to redeem CalPERS's interest in JEDI so
that CalPERS would invest in another, larger partnership. Enron needed to find
a new partner, or else it would have to consolidate JEDI into its financial
statements, which it did not want to do. Andrew Fastow selected one of his
employees, Michael J. Kopper, to purchase CalPERS's interest in JEDI. Kopper
became the owner of the general partner of Chewco LP and also served as its
sole limited partner. Pursuant to the accounting rules for SPEs summarized
above, Enron could only avoid consolidating JEDI into Enron's financial
statements if Chewco had an independent owner with equity capital at risk
equal to 3 percent of the assets of Chewco. Kopper was obviously not
independent from Enron, but Enron could not locate another outside investor.
Eventually Enron seemed to obtain financing for the purchase of the JEDI
interest through an equity investment supplied by Barclay's Bank. However,
Barclays viewed this investment to be a loan, even though Chewco treated it as
equity. The transaction was structured in apparent disregard of the accounting Investigating
requirements for non-consolidation of SPEs. Despite the shortfall in equity Enron
capital, Enron did not consolidate Chewco (or JEDI) into its consolidated
financial statements for the years 1997 through 2000 (Powers et al., 2002).
The results of this failure to follow GAAP were enormous. When the
transaction was reviewed by the SEC in September 2001, it was concluded that
Chewco did not conform to SPE accounting rules, and because JEDI's non- 461
consolidation depended on Chewco's status, neither did JEDI. In November
2001, Enron announced that it would consolidate Chewco and JEDI
retroactively to 1997. This retroactive consolidation resulted in a massive
reduction in Enron's reported net income and a massive increase in its reported
debt, leading directly to Enron's declaration of bankruptcy in December 2001.
A pro forma consolidation of Enron's unconsolidated affiliates indicates that
Enron's return on assets and return on equity would have been reduced
substantially under consolidation (see Table II). For the year 2000, return on
assets would have been reduced from 1.49 percent to 0.98 percent and return on
equity would have been reduced from 8.54 per cent to 3.91 per cent (see Table
II). The growing realization regarding the lack of substance underlying Enron's
financial position led to the decline in Enron's share price from $84 per share in
January 2001 to less than $35 per share in September. However, it was the final
revelation, in October 2001, that Enron had been forced by the SEC to restate its
financial statements for the years 1997 through 2000, and to retroactively
consolidate its unconsolidated affiliates, that ultimately forced Enron into

Dollar amounts in millions

2000 1999 1998 1997 1996

Summary data for unconsolidated affiliates

Revenues 15,903 11,568 8,508 11,183 11,676
Net income 586 1,857 142 336 464
Current assets 5,884 3,168 2,309 3,611 2,587
Total assets 34,155 26,983 22,125 8,851 8,064
Current liabilities 4,739 4,401 3,501 1,089 902
Total liabilities 20,604 15,289 13,138 13,551 11,553
Owners' equity 13,551 11,694 8,987 1,861 2,381
Equity in earnings of affiliates 87 309 97 216 215
Pro forma ratio analysis ± as if consolidated
Current assets/current liabilities 1.09 0.93 0.86 1.51 1.42
Total liabilities/stockholders' equity 2.98 1.84 2.21 4.19 3.93
Net profit margin 0.84% 1.73% 1.77% 1.64% 1.97%
Asset turnover 1.17 0.86 0.77 0.97 1.03
Return on assets 0.98% 1.48% 1.37% 1.60% 2.04% Table II.
Assets/stockholders' equity 3.98 2.84 3.21 4.32 3.96 A pro forma
Return on stockholders' equity 3.91% 4.20% 4.38% 6.89% 8.08% consolidation of
Enron's unconsolidated
Source: Enron Corp. Annual Reports affiliates
AAAJ bankruptcy. These restatements reduced Enron's stockholders' equity by $1.2
16,3 billion.

Evaluating Enron as a public private partnership

Public private partnerships in the USA have typically taken the form of
contractual arrangements, tax incentives, favorable regulation and regulatory
462 exemptions that favor a particular interest to the detriment of others. Enron's
business model depended on a detailed knowledge of the regulatory
environment and knowing how to exploit opportunities that arose during the
deregulatory phases of the electricity and natural gas distribution industries.
The Public Utilities Regulatory Policies Act (PURPA), enacted by the US
Congress in 1978, forced regulated electricity companies to purchase electricity
from developers, thus creating the independent power industry. Federal income
tax laws enacted in the early 1980s provided tax subsidies for investments in
independent power projects. When these subsidies were removed by Congress
in the late 1980s, natural gas companies like Enron, were in a position to
dominate both the natural gas industry and the electricity industry,
particularly after the FERC deregulated the natural gas industry. As Enron
developed its business model, it needed exemptions from other laws and
regulations that impeded its development, including the Public Utilities
Holding Company Act of 1935 and the Investment Company Act of 1940. These
laws had been enacted during the Great Depression to prevent the kinds of
abuses that Enron ultimately engaged in. Enron's continuous involvement in
regulatory affairs required an active participation in politics through
contributions to the election campaigns of public officials. Ken Lay was a
personal friend, and one of the largest financial contributors, to the presidential
campaign of George W. Bush in 2000 (Labaton, 2002b).
The American form of PPP can therefore be seen as a web of interconnected
relationships through which private sector interests influence public sector
interests in ways that benefit particular private sector interests to the detriment
of other interests and even the general public. The traditional role of
governmental regulatory bodies has been to regulate against abuses such as
those perpetuated by Enron. It was the breakdown in the regulatory
environment that allowed Enron to pursue its initial business strategy. This
initial strategy might have succeeded if Enron had not changed its strategy
away from being the largest unregulated supplier of natural gas and electricity
to becoming primarily a broker in energy derivatives. Enron might have
continued taking advantage of the deregulatory processes that had allowed it
to be created in the first place. In a somewhat perverse manner, it was Enron's
change of business strategy that revealed the instability of the deregulatory
process. In effect, the moral of the story may be found in the ways through
which public private partnerships can become dangerous and unstable when
the regulatory framework allows certain practices to become legitimate
activities.
Even though Enron's initial business strategy was not as profitable as
originally intended by Ken Lay in the mid 1980s, it did provide a steady return
on investment. Had Enron continued with this strategy, it probably would not Investigating
have entered bankruptcy and the scandal would not have occurred. In order to Enron
pursue its new business strategy, Enron manipulated complex accounting rules
to move large amounts of tangible fixed assets and long-term liabilities off its
balance sheet. These accounting manipulations were undertaken in the belief
that they would allow Enron to continue to have access to the capital markets
to finance its growing derivatives trading business. Ultimately, however, it was 463
the revelation of Enron's lack of creditworthiness that drove it into bankruptcy.
The sanctioning of off-balance sheet financing vehicles and SPE's by the FASB
and SEC, provided the opportunity for Enron to mislead its creditors and
investors. Without the tacit involvement of the FASB and the SEC, the Enron
scandal could not have occurred.

What may come after Enron?

This section speculates about where events may go after Enron with regard to
legal and regulatory frameworks and accounting for SPEs. Because the Enron
scandal was so prominent and so visible in the USA, a number of legislative
reforms have been proposed and enacted and several changes have been made
to accounting standards in relation to accounting for SPEs and off-balance
sheet financing vehicles. One of the recently enacted laws was the Sarbanes-
Oxley Act of 2002 (Public Law 107-204) signed by the President in July 2002
(New York State Society of Certified Public Accountants (NYSSCPA), 2002).
Among various provisions, the law requires both the Chief Executive Officers
and the Chief Financial Officers of public companies (i.e. those with publicly
traded securities) to certify in every annual report that they have reviewed the
report and that it does not contain any untrue statements or omissions of
material facts. In addition, the Sarbanes-Oxley Act creates a new Public
Company Oversight Board to regulate and oversee audits of public companies.
Auditors of public companies are now prohibited from offering many types of
consulting services to audit clients, and auditors must be engaged by, and
report directly to, the audit committee of the board of directors. It has also
become a criminal offense to fraudulently influence, coerce or mislead the
company's external auditor. Many provisions of the new law seek to restore the
integrity of the audit process and to prevent complicity of auditors in
misleading investors and creditors, as it seems Arthur Andersen did in the
Enron case. In addition, one goal of the new law is to deter the blatant abuse of
accounting standards like those that Enron engaged in. At the same time, it is
unclear the extent to which the new law would have prevented the Enron
scandal. The FASB has belatedly moved to amend the rules for non-
consolidation of SPEs, but only to a limited extent. The independent equity
investment required for non-consolidation of SPEs has been increased from 3
percent to 10 percent. This change might have prevented some of the Enron
SPEs from being treated as being off the balance sheet. However, Emshwiller
(2002) reports that Enron created off-balance sheet SPEs beginning in the early
1990s, and that there was often complicity on the part financial institutions, like
JP Morgan and Barclays Bank, to provide financing that had the appearance of
AAAJ being equity investments, but which were in substance debt. The financial
16,3 institutions treated these investments as debt in their own accounts. It is
therefore doubtful whether this misleading aspect of US GAAP will be
corrected until the FASB begins to adopt a substance over form approach to
standards setting rather than the rule based approach that currently exists. In
sum, there is reason to believe that the Enron scandal will lead to a number of
464 changes in the regulatory framework for corporate governance in the USA, but
most likely it will lead to relatively few changes to the way accounting
standards are established, thus leaving open the question of whether adequate
transparency in financial reporting will be achieved.

Conclusion
The bankruptcy of Enron Corp. has developed into a major scandal involving
accusations of fraud and abuse on the part Enron corporate executives and its
external auditors. There will undoubtedly be many articles written about
Enron. The focus of this paper has been on the relationships between the Enron
business model and the deregulatory phase of the American economy during
the 1980s and the 1990s. The paper has argued that deregulation in the natural
gas distribution and electricity industries allowed the creation of the Enron
business model, and that this model was unsustainable, leading ultimately to
the demise of Enron Corp. In addition, the paper has argued that the Enron
scandal can be better understood as an American form of public private
partnership rather than just another example of capitalism run amok.
The deregulation of previously regulated portions of advanced capitalist
economies has proceeded at a rapid pace not only in the USA but in Europe.
However, it is not clear that there are any real benefits to be gained from this
deregulatory process, and as can be seen from the Enron scandal there are
some real penalties to be paid, not only by the investors and creditors who lost
their investments, but also by the employees of Enron who lost their jobs and
their pension benefits. High level corporate executives benefited through the
creation of off-balance sheet, special purpose entities, while creditors and
investors in Enron were misled into believing that the company was
prospering. This was not only a business failure, it was also an accounting
failure. Accounting standards setters and government regulators must
consider the role they played in the Enron business scandal. As of this writing,
only one Enron executive (Michael J. Kopper) has been convicted of criminal
activity. It may be many years before all of the facts of the Enron scandal are
fully known. In the meantime, as accounting scholars, it is important for us to
be aware of the connection between governmental policies and business
failures. In this sense, Enron should be a warning signal regarding the
unintended consequences of deregulation policy.

Notes
1. ``In the councils of government, we must guard against the acquisition of unwarranted
influence, whether sought or unsought, by the military complex. The potential for the
 disastrous rise of misplaced power exists and will persist'' Public Papers of the Presidents, Investigating
Dwight D. Eisenhower, 1960, pp. 1035-40.
2. As Broadbent and Guthrie (1992) have pointed out, there was a movement throughout the
Enron
English speaking world during the 1980s and 1990s which prompted a dramatic change in
the public sector. This movement centered on promoting efficiency, effectiveness, and cost
savings in government operations. The movement was induced in part by ideologies such
as Thatcherism and Reagonomics.
3. It is unclear whether this exemption ought to be viewed as a failure of regulation or a 465
failure of enforcement. The deregulatory climate of early 1990s was leading in the direction
of repealing the PUHCA (1935). However, it was Enron's lobbying efforts with the Clinton
administration that allowed it to obtain an exemption from the Act.
4. Enron needed an exemption from the Investment Company Act of 1940 because it had so
many SPEs. The FASB rules regarding accounting for SPEs did not hamper Enron's
desires to expand using SPEs because the rules were generally quite liberal and allowed
Enron to treat the SPEs as being off the balance sheet.

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