Benefit of counsel: Trading in Enron’s effluent

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

“Death Star,” “Get Shorty” and “Fat Boy.” In the energy industry, references to these and other Enron trading strategies have become commonplace. But what exactly did the Enron traders do? How has Enron’s behavior been viewed by the Federal Energy Regulatory Commission (FERC) staff? What are the consequences for future energy trading?


Robert P. Knickerbocker, Jr.
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On Aug. 13, 2002, FERC staff issued an initial report on Enron’s trading strategies publicly disclosed on May 6, 2002. That report indicated that the investigation is far from over. Although the report repeatedly qualifies its discussion of Enron’s trading strategies as preliminary, it provides some clues as to FERC’s final position once the investigation is complete.


Kathleen A. Shea
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What did the Enron traders do, and was it wrong? In short, a flawed California market design allowed Enron to pursue certain “creative” trading practices that regulators have concluded were based upon misrepresentations and that contributed to both the California energy crisis and the anguish presently being felt in the trad-ing world. These strategies can be categorized in four ways:

“- Taking advantage of price caps, such as by the export and sale of energy at higher prices outside of California contributing to power shortages within California (called “Export of Power”), or by the purchase of power for export at one price cap in order to import it back into California at a higher allowed price cap (nicknamed “Ricochet”);

“- Receiving payment for transmission congestion relief not provided, such as by the scheduling of a counterflow over a constrained line, collecting the relief payment with the knowledge that the ISO will later cancel the counterflow (called “Wheel Out”), or by the scheduling of non-firm power to flow out of the California ISO opposite a constrained line, collecting the relief payment and never delivering the energy (known as “Non-Firm Export”);

“- Creating artificial transmission congestion, such as by claiming fictitious additional load in a congested area and then shifting that load to a lower congested area to collect a payment for reducing load in the congested area (known as “Load Shift”); and

“- Misrepresenting facts, such as overscheduling load with a matching generation schedule to collect the market price for the excess generation needed to balance the real time market (called “Fat Boy” or “Inc’ing”).

Responding to Enron’s trading strategies, FERC’s report proposed new requirements on power marketers. For example, the report suggested that all market-based rate tariffs include a prohibition against the deliberate submission of false information. If adopted, the tariff language would facilitate FERC ordering refunds of any revenues gained from reporting false information. In addition to an enhanced refund authority, the report advocates for the authority to impose civil penalties for prohibited acts.

FERC’s investigative report concluded that each of the trading strategies, as utilized by Enron, were objectionable and that some would be a violation of its proposed new tariff provision. It recognized, however, that there can be legitimate reasons for traders to employ some of the strategies used by Enron, suggesting the need for FERC to employ a case-by-case analysis of how such strategies were employed and their effect on the market.

As for those practices designed to take advantage of price cap differentials, the investigation recognized that such actions may be economically rational. (Those practices generally involve simple arbitrage, where traders seek to take advantage of differences between power markets.) The report, however, objected to Enron’s use of these practices, viewing them as harmful and an exercise of market power, exacerbating California’s energy crisis, putting market reliability at risk, and designed to force the California ISO to purchase Enron power at exorbitant rates.

FERC’s investigation concluded that Enron’s profiting from payments for congestion relief not provided was premised upon imaginary transactions appearing to alleviate constrained paths. As such, the investigative team considered these to be a misrepresentation of facts, and that they would violate FERC’s proposed tariff prohibition against the submission of false information. Similarly, the staff report confirmed that practices designed to create artificial congestion required Enron to deliberately over-schedule load, which had the effect of increasing the value of its transmission rights on the constrained path. The report concluded that such practices were an attempt to manipulate prices, risked market reliability and necessarily involved the submission of false scheduling information.

Finally, although the FERC investigation recognized that there may have been mitigating circumstances surrounding the remaining strategies founded upon misrepresented facts, its response to these strategies was clear: notwithstanding the existence of mitigating factors, any activity involving the deliberate submission of false information or omission of material information should be prohibited.

Over time, with further analysis and input from economists and market design experts, regulators may gain additional insights and a clearer definition of acceptable trading behavior. What is apparent now, however, is that traders’ activities will be carefully scrutinized, and that deliberate misrepresentation of facts for financial gain will be punished. Strategies that exercise market power, risk market efficiency or reliability, or involve any deliberate misrepresentation of fact can lead to swift action by FERC and may expose traders to civil and criminal proceedings as FERC continues to share its findings with the Commodity Futures Trading Commission and the Department of Justice. Any investigation into a trading strategy will undoubtedly prove time-consuming and intrusive to the trader.

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.

Next month Benefit of counsel will examine Appendix E of FERC’s recent Standard Market Design (SMD) Notice of Proposed Rulemaking, and how SMD may eliminate opportunities to use Enron trading strategies to exploit flaws in market design.

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