FERC Report Moves Toward Regulatory Certainty in CA

Market-based electricity neeeded

On March 26 the Federal Energy Regulatory Commission issued its staff report on price manipulation in western wholesale markets. The report, and the likely FERC actions to arise from it, accomplishes some goals that will reduce regulatory uncertainty and improve the investment prospects in this industry, in the rest of the country if not in California.

The FERC report focuses on fact finding and analysis in several related areas, all of which interact to indicate if wholesale prices were “just and reasonable”:

• The interrelatedness of natural gas markets and wholesale electricity markets, and the effects of scarcity-driven and manipulation-driven natural gas price increases on electricity prices

• The interrelatedness of spot electricity prices and forward electricity prices, which further transmitted the natural gas price increases

• Trading strategically and withholding in wholesale electricity markets

• Liquidity issues, including the effects of Enron’s wash trades and Enron’s ability to move illiquid markets

• Enron’s access to information through its proprietary trading platform

The conclusions and recommendations of the report will lead to estimated refunds of $3.3 billion, instead of the $1.2 billion estimated in December and based on actual natural gas market price. Otherwise, the findings largely support FERC Judge Birchman’s preliminary findings in December.

The crux of the analysis addresses natural gas spot prices during Summer 2000 and Winter 2000-2001, finding that repeatedly during that time period, spot prices indicated more than just scarcity in the natural gas market. In tight markets such as the natural gas market in 2000, higher prices are a logical outcome when demand increases and supply cannot respond sufficiently to keep prices lower. The profits that companies earn from supplying into such a tight market are called scarcity rents, and they communicate profit potential from supplying more to that market, either through entry of new competitors or by investment in capacity to be able to supply more. Those forces drive down prices over time.

But the dynamics of the natural gas market in California in 2000 were complicated by the existence of a “soft price cap” in the wholesale electricity markets. Natural gas is the fuel for the marginal generating units in California, and the price cap varied according to the natural gas price. With a price cap that is a function of natural gas prices, an incentive existed to influence natural gas prices and push them higher. The FERC staff report finds that the natural gas price at the Topock node indicates that BP Energy and Reliant followed those incentives. Furthermore, these perverse incentives carried over into the reporting of natural gas prices to trade publications, whose price indices formed the basis of such policy decisions. The false reporting of prices is a serious problem due to the importance of price transparency.

The findings thus suggest that high natural gas prices reflect both scarcity rents and manipulation to raise prices, which would serve to raise the soft price cap on electricity. The FERC staff report contains a careful, thorough analysis to distinguish between scarcity rents and using market power to increase prices at a particular natural gas node. Part of this analysis is a meticulous exploration overseen by Robert Pindyck, an economist who has done extensive research on price movements in commodity markets. The resulting analysis of natural gas price movements and the extent to which they reflected actual scarcity is careful, extensive, thorough and, I think, persuasive. Professor Pindyck and FERC staff also applied similar analytical rigor to exploring the extent to which spot electricity prices influence forward electricity prices, which further enables the transmission of higher natural gas prices. For further reading on the movement of spot and forward energy prices, I recommend Professor Pindyck’s article entitled “The Dynamics of Commodity Spot and Futures Markets: A Primer,” Energy Journal Volume 22 (2001), pp. 1-29.

Most of the finding of direct electricity market manipulation revolves around Enron, particularly Enron’s ability to use its proprietary online trading platform to give it an information advantage. This advantage, which exploited the lack of price transparency across the market, enabled Enron to profit from its trading strategies, from trading in illiquid markets, and from using wash trades to create the appearance of liquidity.

Separating Enron’s widespread perpetration of fraud from the flawed market rules that they could exploit in California has been a challenge. One thing that FERC staff did was analyze such behaviors, by Enron and others, on the basis of rules included in ISO and PX tariffs. Some of these actions did violate rules in the tariffs, and therefore can and should be pursued. Enforcing such rules is one important step in restoring regulatory certainty in wholesale markets. FERC staff recommend that some companies should substantiate the integrity of their bidding. They comprise both private generators and public power companies, including AES/Williams, Dynegy/NRG, Mirant, Reliant, Bonneville Power Association, Los Angeles Department of Water and Power, Idaho Power, Powerex, and Enron. Interestingly, although Enron’s actual California market share was low, its apparent share of the market manipulation that violated existing rules was high.

So what are the major implications of the findings in this report?

Bad rules are still primarily to blame. To quote the Findings at a Glance, “staff concludes that supply-demand imbalance, flawed market design and inconsistent rules made possible significant market manipulation as delineated in final investigation report. Without underlying market dysfunction, attempts to manipulate the market would not be successful.” This finding, importantly, and correctly in my view, recognizes that market manipulation arose from the existence of a flawed design, and firms should not be held responsible for responding to the incentives in that flawed design, but should be held accountable for violations of explicit rules in tariffs.

This thorough analysis can help us move on. The economic limbo and regulatory uncertainty that has hampered this industry is to the detriment of both consumers and the industry. This staff report is so thorough and analytically rigorous that it is unlikely to fall prey to the oft-heard criticism that FERC is not really paying attention to California’s plight. Hopefully this report and subsequent FERC actions will enable California to shift to a forward-looking focus.

The sanctity of contract remains inviolate. Based on these findings, FERC is unlikely to support nullifying the state’s long-term contracts signed in early 2001. This stance is crucial for maintaining a stable legal framework for ongoing activity in this industry. Furthermore, the state has had success at renegotiating the terms of these contracts.

Price above short-run marginal cost signals scarcity and the need for investment in the industry, and refunds should not interfere with that. The care that FERC staff took in establishing a refund rule that preserved the scarcity rent component of prices should indicate the prospect for investment-friendly regulatory certainty. Ex post refunds raise the possibility of expropriation and can stifle investment. The refund rule in this analysis is careful to take that into account as much as possible, and to preserve scarcity rents in tight markets.

Enron aside, the largest magnitude manipulation was in the natural gas input market, not in the electricity market.

• Price transparency, and legal and regulatory simplicity, stability and enforcement, are crucial for the growth of liquid markets that create value for suppliers and consumers.

There are a few more steps in resolving these refunds, but this report and its recommendations are a substantial step toward shifting focus to the future potential value propositions that a market-based electricity environment can deliver to California’s residents and to entrepreneurial firms who could profit from creating that value for them.

Lynne Kiesling is director of economic policy at Reason Foundation and senior lecturer in economics at Northwestern University.