Ferc cracks down on power market manipulation

The US Federal Energy Regulatory Commission has declared war on power market abuse, targeting allegations of manipulation by firms including Barclays, Constellation Energy and Deutsche Bank. Further investigations are expected to follow as the agency turns up the heat. By Alexander Osipovich

It was once an obscure government agency, issuing arcane rules on interstate sales of natural gas and electricity. But in the past two years, the US Federal Energy Regulatory Commission (Ferc) has emerged from the shadows with headline-grabbing investigations of possible manipulation in wholesale electricity markets, targeting big-name firms including Barclays, Deutsche Bank, JP Morgan and Baltimore-based Constellation Energy.

The investigations are part of a crackdown by Ferc that could have wide-ranging implications for firms involved in US power markets, say industry observers. And according to Jon Wellinghoff, the agency’s Washington, DC-based chairman, that crackdown is unlikely to end anytime soon.

“Traders should know we have a very sophisticated and very full enforcement division that will not only come after their company, but will come after them [personally] if they’re engaging in activity that constitutes fraud and manipulation,” he says, in an exclusive interview with Energy Risk.

The roots of Ferc’s current stance lie in the Energy Policy Act of 2005 – a law passed after the bankruptcy of Houston-based Enron and the California energy crisis of 2000–2001. The law authorises Ferc to pursue market manipulation and allows it to impose fines of up to $1 million for each day that a company is found to be in violation of the rules governing electricity and natural gas markets. Previously, Ferc was only able to level civil penalties of up to $10,000 per day. The law also increases the maximum fine and imprisonment time that applies to criminal cases.

Since the beginning of 2011, the commission has disclosed more than 10 investigations of power market manipulation, four of which have been resolved through civil penalties, in which the targets of the probes agreed to pay fines or disgorge profits. In March 2012, Ferc reached a $245 million settlement with Constellation Energy to resolve accusations that the company had manipulated the New York and New England power markets.

Traders should know we have a very sophisticated and very full enforcement division that will not only come after their company, but will come after them

More recently, the agency has been turning up the heat on banks. On September 5, Ferc said it was seeking a $1.5 million fine from Deutsche Bank for alleged power market manipulation. Then, on October 31, it announced it was seeking $470 million from Barclays over allegations that former traders at the bank had manipulated power markets in the western US. And on November 14, Ferc ordered the suspension of JP Morgan’s market-based rate authority – a response, it claims, to the firm attempting to mislead the regulator by submitting false evidence as part of another investigation. Barclays and Deutsche Bank both deny the allegations, while JP Morgan says it never intended to mislead the regulator.

Industry observers say the recent flurry of enforcement activity has spooked power traders. “Traders right now are really scared of the liability that could befall them should they be found guilty of manipulation,” says Shaun Ledgerwood, a Washington, DC-based senior consultant with The Brattle Group, who previously worked as an economist in Ferc’s Office of Enforcement.

The case against Barclays stems from behaviour on the bank’s western US power desk that began in November 2006 and lasted intermittently until December 2008. The alleged manipulation was executed by four traders, including Scott Connelly, who was then managing director of North American power, says an October 31 Ferc order that details the allegations.

Opposing positions

The order alleges the Barclays traders entered into a co-ordinated scheme that included executing loss-making trades in next-day fixed-price physical power at four hubs in and around California. According to Ferc, the firm’s trading on the Mid-Columbia, Palo Verde, South Path 15 and North Path 15 hubs had the effect of moving price indexes managed by Atlanta-based exchange operator Ice. By pushing the indexes up or down, Ferc alleges, the Barclays traders profited from opposing positions they held in cash-settled derivatives linked to the Ice indexes. During the months when manipulation is alleged to have occurred, the agency estimates profits on the financial positions totalled $34.9 million, far outweighing a $4.1 million loss on the physical trades.

Emails and instant messages cited in the Ferc order suggest the traders were deliberately seeking to move the indexes. In one such message, Barclays trader Ryan Smith announces his intention to “crap on” the North Path 15 off-peak power market, which shapes electricity prices in northern California.

These activities did not go unnoticed, says Ferc’s order. Unidentified market participants called Ferc’s enforcement hotline, and in July 2007, the commission informed Barclays that it was under investigation. It is unclear who tipped off Ferc, but judging by its order, other market participants had reason to be unhappy about Barclays’ alleged gaming of the indexes. In total, the alleged violations caused $139.3 million in losses for other market participants who used the indexes, the agency estimates.

Ferc wants Barclays to pay a fine of $435 million, as well as $34.9 million, plus interest, in disgorged profits. When that is combined with the proposed fines against the individual traders – $15 million for Connelly and $1 million each for Smith and his two other colleagues – the total bill adds up to nearly half a billion dollars.

On November 29, Barclays and the four traders said in filings they would contest Ferc’s proposed penalty in court. “We believe that our trading was legitimate and in compliance with applicable law,” said a London-based spokeswoman for the bank in an emailed statement. “The [Ferc order] is by its very nature a one-sided document, and does not reflect a balanced and full description of the facts or the applicable legal standard.”

The four individual traders named in the Ferc order declined to comment for this article, either directly or through their lawyers. But a former colleague of Ryan Smith, who spoke to Energy Risk on condition of anonymity, defends the trader as having “high moral character” and expresses surprise at Ferc’s allegations. When asked about the instant messages in which Smith apparently boasted of moving California power markets, the former colleague says: “Ryan has a sarcastic sense of humour. He is a humble guy who says things like that in jest… He says things like, ‘yeah, I pushed the market around’. He knows he doesn’t have the kind of power to make that happen.”

Market observers say the key lesson to be drawn from the Barclays case is the importance Ferc places on uneconomic trading – or executing trades that lose money in one market in order to benefit positions in another market.

Such behaviour is a recurring theme in many of the agency’s recent power market manipulation cases. In the Constellation Energy case, for example, Ferc found Constellation’s traders had routinely taken losses on physical and virtual trades in eastern US power markets to benefit from positions they held in both swaps and financial transmission rights (FTRs) – contracts whose value depends on the level of congestion on the grid. Constellation Energy did not admit to any wrongdoing as part of its settlement with Ferc and a Baltimore-based spokesman for the firm declined to comment for this article.

Likewise, Deutsche Bank stands accused of making unprofitable physical trades involving a small intertie along the California-Nevada border to profit from positions in congestion revenue rights, instruments that are similar to FTRs. Deutsche Bank declined to comment for this article. In a response to Ferc’s allegations filed on November 5, however, the bank strongly denied the allegations, while also pushing back against Ferc’s argument that uneconomic trading constitutes manipulation. “The legal position [Ferc] has taken here is radical,” the bank said. “Essentially, [their] position is that knowingly trading in two related markets is per se unlawful market manipulation, even if the trading is profit-seeking in both markets. Accepting that mistaken contention would mark a sea change in commission precedent.”

Raised eyebrows

Wellinghoff stands by Ferc’s interpretation. Uneconomic trading is a red flag that automatically raises eyebrows at Ferc, he says. Companies “need to make sure that their power traders are not engaging in trades that purposely lose money”, he warns. “That’s a big sign to us and to our analysts. If they have some trade that appears to be losing money for no apparent reason, that immediately flags to us that there’s another side of the trade someplace where they’re gaining a tremendous amount of money.”

Ferc regards uneconomic trading as a form of fraud, since it involves injecting false prices into the marketplace, explains Ledgerwood. “The concept of prosecuting uneconomic trading in commodities markets is relatively new,” he says. “Previously, a lot of traders operated on the belief that it was OK to lose money on a specific position if it benefited their broader portfolio… There are many traders out there who are still under the impression there’s nothing wrong with that. But the fact of the matter is that the world has changed.”

Ironically, Barclays was apparently aware of Ferc’s stance on uneconomic trading when the alleged manipulation took place. Joe Gold, who was then Barclays’ co-head of commodities, told Ferc he had repeatedly warned his traders to avoid uneconomic trades: “The golden rule was always, under no circumstances, lose money on a transaction for the intention of making money on another transaction,” said Gold, according to testimony cited in Ferc’s order.

If that is true, consultants say it underlines the need for trading firms to have effective compliance policies and training programmes in place. “Companies should have a policy, a training programme and engaged enforcement of that policy, not just a document that traders flip through and robo-sign once a year,” says Alan Isemonger, founder of Energy Market Expertise, a California-based consulting firm.

Ferc took more than five years to complete its investigation of Barclays, reflecting the challenges it faced in understanding complex trading data while still growing accustomed to its expanded role. But Wellinghoff promises Ferc will be swifter in the future: “As we get more experience and as we start clearing out some of these older cases, I believe that there is no question that we’ll be able to not only identify issues more quickly, but to move into investigation and potentially enforcement modes,” he says.

Suspension

Unlike Barclays, Ferc has not accused JP Morgan of market manipulation. But the penalty used against the bank, which Wellinghoff admits is “very severe”, is one that will also send shivers down the spines of US power market participants. The order prevents JP Morgan from selling electricity at market-based rates in all Ferc-regulated wholesale power markets for six months beginning in April 2013 – a move that would effectively freeze JP Morgan’s US power trading.

The suspension of the bank’s power trading authority was the result of a months-long feud between Ferc and JP Morgan over the bank’s responses to a power market manipulation probe in California. In July, Ferc said in court filings that JP Morgan was under investigation for a pattern of “abusive” bidding practices spotted by the California Independent System Operator (Caiso) and the Midwest Independent Transmission System Operator (Miso) in early 2011. In March that year, Ferc says it and Caiso began sending a series of questions to the bank about its bidding practices. JP Morgan missed deadlines in responding to those enquiries – and when it finally did respond, it called its responses “completely voluntary”, despite having been told by Ferc that they were mandatory, according to Ferc filings. Eventually, JP Morgan acknowledged it had made “good faith mistakes” in its dealings with the regulator and the ISO.

The bank says it is surprised at the severity of Ferc’s action. “This is a novel use of Ferc’s authority over market-based rates and is unsupported by Ferc’s own regulations – particularly given that the issue in this proceeding was not JP Morgan’s conduct in the market, but rather a dispute over document [submission],” says a New York-based spokeswoman for JP Morgan.

Ferc’s Wellinghoff is unapologetic: “Any market participant’s failure to provide us with accurate data… is a very severe action that warrants a very severe penalty,” he says. He describes JP Morgan’s failure to co-operate with the agency as “a very serious violation that warranted the action that we took”.

The bidding practices Caiso and Ferc were investigating exploited a flaw in Caiso’s bid-cost recovery mechanism. Under this mechanism, if Caiso commits a generator to provide power to the grid, but the generator does not end up selling any power, Caiso reimburses the generator for its start-up and minimum load costs – the idea being to provide generators an incentive to participate in the market. In March 2011, Caiso reported to Ferc that some unnamed market participants had found a way to exploit the mechanism. Specifically, they were placing extremely negatively-priced bids in the day-ahead market to ensure that Caiso would commit their generation resource, before placing much higher, positive bids in the real-time market to ensure that the resource would not actually be dispatched. By doing so, the generators never sold any power, while collecting inflated bid-cost recovery payments. In all, the scheme led to $57 million in improper payments over a period of about six months, Caiso said. In April and May 2011, Miso became aware of a similar practice taking place in the Midwest and also complained to Ferc. The two ISOs never named the perpetrators, but Ferc eventually pointed the finger at JP Morgan.

JP Morgan insists it has done nothing wrong. “We believe we have complied in all respects with the law, as well as Ferc rules and applicable tariffs governing this market,” the spokeswoman says.

“JP Morgan essentially found a way to boost their bid-cost recovery to get back more than their incurred costs,” says Energy Market Expertise’s Isemonger, who previously worked in market design at Caiso. “There’s always a debate about whether this type of thing is manipulation or a design flaw. Often it’s a bit of both, because there will be a weakness somewhere in the system, and someone will figure out a way to take advantage of it.”

Ferc’s action highlights its more aggressive approach to investigations. In the past, it typically commenced cases by sending interrogatories, or written requests for information, to companies suspected of manipulation as a preliminary step. Now, it is bypassing that stage and moving directly and swiftly to depositions, which involve testimony being given under oath, says Wellinghoff. “We’re bringing in the traders involved, bringing in the managers and the other pertinent parties, and subjecting them to direct depositions under oath.”

Perhaps more significantly, Ferc has beefed up its ability to monitor market data and spot potential manipulation without waiting for calls from whistleblowers. In recruiting staff for its Office of Enforcement, Ferc sought individuals with private-sector experience and knowledge of markets, Wellinghoff says. That office is now about 200-strong – and in February it was reorganised to include a new Division of Analytics and Surveillance. Ferc is also casting a wider net in terms of the data it collects and monitors. In April, it amended its regulations to require each regional transmission organisation (RTO) and ISO to electronically deliver market data to the agency on an ongoing basis.

All those developments have made Ferc a better market watchdog, Wellinghoff says. “We do have the capability to internally analyse data and, from that data, have flags that are quickly raised from that analysis that give us specific targets to start an investigation,” he says.

With Ferc’s analysts keeping a close eye on market data, some consultants are advising companies to use in-house tools to monitor their traders and flag potentially manipulative activity before it shows up on the regulator’s radar screens. Sid Jacobson, a Houston-based partner at risk consultancy SunGard Global Services, says that companies have shown increased interest in such trade surveillance technology since Ferc began stepping up its enforcement activities. “Now that the regulators have built up their analytical teams… it is very important for market participants to mature and create internal tools – surveillance cameras, speed bumps, or whatever they are – so they can get ahead of potential issues.”

 

Regulator vs regulator Although the US Federal Energy Regulatory Commission (Ferc) has clearly become a more formidable enforcement agency, it has yet to establish a rock-solid foundation of case law on which to build future cases, say lawyers. Many of its interpretations have yet to be fully tested in the long grind of litigation through the US federal court system, and an unfavourable ruling from a judge could limit the agency’s ability to nab suspected manipulators. The most significant unresolved case involves Brian Hunter – the former natural gas trader at Connecticut-based hedge fund Amaranth who clocked up a $6 billion loss, ultimately leading to the firm’s collapse. Hunter, who is based in Calgary, now stands at the centre of a turf war between Ferc and the Commodity Futures Trading Commission (CFTC). Since July 2007, Ferc has been trying to fine Hunter $30 million for allegedly driving down the settlement price of natural gas futures contracts traded on the New York Mercantile Exchange (Nymex), but Hunter is disputing Ferc’s ability to impose the penalty. The CFTC, which is pursuing its own manipulation case against Hunter, has sided with him in his dispute with Ferc, arguing it has exclusive jurisdiction over the futures market. In response, Ferc points to language in the Energy Policy Act of 2005 that gives it the right to pursue “any entity” engaged in energy market manipulation. It also argues Nymex settlement prices are widely used in physical markets, which it regulates, as well as in futures markets regulated by the CFTC. Hunter denies the allegations and his lawyers did not respond to requests for comment by Energy Risk. The US Court of Appeals for the District of Columbia Circuit is expected to settle the jurisdictional squabble in the coming months. Susan Court, principal of Virginia-based SJC Energy Consultants and a former director at Ferc’s Office of Enforcement, says that if the court rules against Ferc, it would be “a significant constraint” for the agency’s future pursuit of market manipulation cases. Nonetheless, Ferc is confident it has the law on its side. “I believe we are very solid in our legal position,” comments Jon Wellinghoff, its Washington, DC-based chairman.