Book versus mark-to-market valuation - or - how Enron gave good economic logic a bad name
There is an old saying among economists that the value of something is what someone will pay for it. (There is also an old joke about economists that an economist is someone who knows the price of everything but the value of nothing.) You can see what passes for humor among economists. But if you think about this saying, it flies in the face of all of the accounting principles that we have learned thus far, especially in the last section on depreciation. If you took that section to heart, you would conclude that the economists are wrong and the value of something is its original "book" value minus all of the accrued depreciation.
During the era of regulated utilities (both electricity and natural gas), the value of a capital asset was defined by the remaining book value B(t), which if you think about it makes perfect sense. The utility earns a fixed rate of profit on any capital asset that it constructs, and once an asset is fully depreciated then it can no longer generate any profit for the utility. By this logic, book-valuation is completely sensible. But in the electric utility industry, in particular, as the former investor owned utilities began to sell off their generation assets, they noticed something peculiar. Generation companies were unexpectedly (well, unexpectedly to the utilities, anyway) getting offers to buy power plants at multiple times their book value. In California, in particular, the utilities believed that they had run into a windfall and were basically stealing money from the generation companies. In reality, the generation companies were the cleverer of the two. Electricity prices in California became so high that even at multiple times book value, the prices paid by generation companies for the utility power plants were mere pennies compared to the profits they raked in. (Footnote: because of market manipulation in California's electricity market, many generation companies were later forced to return some of their profits to California ratepayers. Even so, the companies still profited handsomely from the plants.)
The example of electricity deregulation illustrates that the value of an energy asset is not independent of the market in which that asset participates. A power plant owned by a regulated utility that operates in a regulated electricity industry is indeed worth, to its owner, the total sum of its non-depreciated book value. The value of such an asset will inexorably decline over time. But an energy asset that sells its output into a competitive market, with prices set by the machinations of supply and demand, will have a value that is equal to the stream of profits that it will generate to its owner in the future. This value may change from year to year; month to month; day to day; or in some cases, hour to hour.
Here is another example, to which we will return in the assignment for this lesson. The Entergy Corporation purchased the Vermont Yankee power plant in 2002 from its former utility owners. At the time, Entergy paid $180 million for the power plant. The plant had basically been fully depreciated after 30 years of operation, so its value to the utility was very low. Since Entergy paid $180 million for the plant, it must have believed that the plant would have brought in a stream of profits amounting to at least $180 million during Entergy's planned tenure of ownership. At the time that Entergy purchased the plant, electricity prices in the newly-deregulated New England market were around $40 per MWh on average. By 2006, just a few years later, prices in the New England market had increased by 50%. Despite the fact that the Vermont Yankee plant had aged since its purchase by Entergy, the value of the plant likely increased between 2002 and 2006 since the profit it made on each MWh increased. (The cost of operating a nuclear power plant is very low and hasn't changed much in the past 20+ years.) Now, fast forward to 2013. Prices for electricity in the New England market have hit decade-long lows because of cheap natural gas and decreased electricity demand, with no higher prices in sight. The Vermont Yankee power plant faced a difficult political battle to have its operating license renewed. Because its profit margins were being shaved and the costs of continued operation seemed to be rising, Entergy decided to shut down the plant in 2014. So, the value of the plant, which had been sky high just a few years earlier, had declined rapidly. No other group has yet come forward with an offer to purchase the plant and resume operations.
These stories are all examples of mark-to-market valuation. The idea behind mark-to-market valuation is simple enough - that the value of an asset that is traded in the market (or whose output is traded in the market) can change depending on market conditions. The value of the asset on any Balance Sheet should thus change along with market conditions.
The logic behind mark-to-market accounting for appropriately-traded assets is very sound, and is actually required accounting practice in many cases. Mark-to-market accounting would not be appropriate for any asset whose value is set by an authority other than the market, such as a public utility commission. Early on in the process of electricity deregulation, following California's power crisis, mark-to-market accounting got something of a bad name because of how it was used by a company called Enron. One of Enron's claims to fame (infamy?) was figuring out how to manipulate California's newly-deregulated electricity market, but what brought the company to bankruptcy in the end was not its improper trading practices but its improper accounting practices. If you want to learn more about Enron, the book (or movie) The Smartest Guys in the Room has a lot of good discussion. (Full disclosure: Your instructor is quoted in the book.)
The Accountancy Journal has a nice piece that describes what went wrong with Enron and the role of mark-to-market accounting in hiding a lot of Enron's corporate losses. Enron used long-term contracting and derivatives trading (such as futures and options) extensively to make money, so had to mark those contracts to market in its periodic financial statements (i.e., every quarter or so, it had to declare the current market value of all of those contracts and other sorts of deals). Enron's abuse of mark-to-market accounting basically consisted of two related practices. First, Enron would develop opaque numbers for what an energy contract was actually worth (remember from lessons 3 and 4 that natural gas futures prices are only available through NYMEX for a period of several years into the future; so Enron would develop a value for, say, a 20 year natural gas contract that was passed off as being legitimate but was, in fact, nothing more than pure speculation). Second, Enron would record the total expected lifetime value of any given contract or project on its Balance Sheet rather than its value in that particular quarter. These practices had the effect of making Enron appear much more valuable than it, in fact, actually was. In the end, the Enron affair actually had a positive side effect of improving mark-to-market accounting through the development of rules for increasing the transparency of how long-term contracts and other durable assets were valued.