Benefit of counsel: Standard Market Design— Snake oil or a silver bullet?

Robert P.Knickerbocker Jr.& Kathleen A.Shea
Day, Berry & Howard

Last month, we discussed the Federal Energy Regulatory Commission (FERC) staff’s initial response to Enron’s trading strategies. Another issue is how markets can be reformed to discourage those strategies which took advantage of flaws existing in the California power market. Appendix E to FERC’s July 31, 2002 Notice of Proposed Rulemaking (NOPR) for its Standard Market Design (SMD) explains how SMD should accomplish that purpose.

Many of Enron’s trading strategies exploited flaws in the California power market, such as the fact that California’s day ahead schedule was not financially binding and did not need to be physically feasible in real time. The California Power Exchange (PX) administered the day ahead market, while the real time balancing market was separately administered by the California Independent System Operator (ISO). There were discrete settlement systems for energy and congestion charges, and there was little information exchange between the PX and the ISO. These design flaws created incentives to initiate artificial congestion in the day ahead schedule and receive payment for illusory congestion relief in real time.

Further, “virtual bidding” (e.g., a trader does not control the necessary generation before bidding) was prohibited in California. Therefore, participating in California’s day ahead schedule required actual generation to balance actual load. Certain of Enron’s trading strategies utilized virtual bidding. Because the California ISO presumed Enron’s bids were backed by physical resources, however, Enron has been criticized for “submitting false information” that threatened market reliability.

In Appendix E, FERC states that SMD market rules and a strong market monitoring and mitigation plan will improve market design and prevent future use of Enron’s trading strategies:

“-“Inc’ing” (“Fat Boy”): This strategy circumvented the requirement that balanced day ahead schedules must be based upon actual loads and generation. Because virtual bidding would be permitted under SMD to balance day ahead schedules, Enron’s strategy will be useless and unnecessary generation will not be offered in the real time market. Certain SMD proposed scheduling requirements require disclosure of whether physical resources back energy bids, and SMD would require specific resources to back ancillary services bids.

“-Non-firm Export: This strategy took advantage of a market design flaw permitting payment for congestion relief never provided. SMD’s day ahead schedule would be financially binding, which means that canceling a power flow arrangement in real time would incur resulting costs.

“-“Wheel Out”: Under this strategy, traders exploited the separate and inefficient PX- and ISO-administered markets, allowing scheduling of power over an already-constrained line. SMD as proposed accounts for transmission constraints in the day ahead market and should reject schedules that are physically impossible to wheel. In contrast to the flawed California market, SMD’s congestion management system (CMS) and energy market would be fully integrated, eliminating separate payments for congestion relief. Under SMD, if energy is scheduled a day ahead across a constrained transmission line, market clearing prices would increase in the constrained area and congestion charges would be incurred by the company scheduling those transactions.

“-Export of Power: This practice was designed to benefit from price caps in effect only in part of the Western markets. As proposed, market mitigation procedures would apply consistently to all neighboring regions, eliminating regional price cap discrepancies and reducing incentives to use this strategy. SMD’s proposed resource adequacy requirements are intended to avoid market shortages, which had created the economic incentives for this practice.

“-Load Shift: This tactic exploited California’s zonal CMS (i.e., congestion was managed only between zones and not within zones) and the inefficient separation of the PX and ISO markets. Traders were paid to relieve artificial congestion within a zone in real time without detection. Under the SMD, congestion within a zone could be managed, reducing opportunities to use this strategy.

Only actual experience can determine whether unacceptable Enron trading strategies can be eliminated. As Senator Joseph Lieberman (D-Conn.) recently said about the FERC’s response to Enron, however, “The invisible hand can’t do it all. Markets inherently have no conscience.” SMD may not be able to effectively anticipate and protect against increasingly creative, potentially harmful and yet unknown trading practices that evolve in response to the restructured market.

Knickerbocker is a Partner and Shea is an Associate in Day, Berry & Howard LLP’s Energy Practice Group. They may be reached at 860-275-0100 or at rpknickerbocker@dbh.com and kashea@dbh.com, respectively.

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