by Dan Watkiss, Bracewell & Guiliani
The Federal Energy Regulatory Commission (FERC) in a July order endorsed its enforcement staff’s report that rejected allegations of the market monitor for the New York Independent System Operator Inc. (NYISO) that certain “circuitous” wholesale electric energy trades over eight paths in the Northeast and Mid-Atlantic beginning in 2008 amounted to market manipulation or violations of the traders’ wholesale power tariffs.
The NYISO monitor and others had complained that the trades at issue congested the power grid around Lake Erie (attributable in part to a physical phenomenon known as loop flow) resulting in higher costs to power consumers. FERC’s order and the staff report addressing these Lake Erie trades are noteworthy in their articulation of what distinguishes unlawful manipulation from transactions that respond rationally to the price signals from badly designed energy markets. As energy markets expand geographically and the volume of physical and financial trading in energy products grows, this distinction is likely to prove increasingly important to the efficient design of market structures and rules.
Laws and regulations proscribing manipulation of energy markets have proliferated in recent years. Most recently, the Federal Trade Commission (FTC) announced it will put in place in November new rules prohibiting manipulation in wholesale petroleum markets. The FTC’s petroleum regulations, implemented pursuant to the Energy Independence and Security Act of 2007, follow and largely track FERC’s earlier adoption of rules forbidding manipulation of natural gas and wholesale electric power markets. All three sets of anti-manipulation rules are modeled on the Securities and Exchange Commission’s Rule 10b-5 that prohibits any act or omission that results in fraud or deceit in connection with the purchase of a security. The specific anti-manipulation rule in the Lake Erie order and report, similar to Rule 10b-5, makes it a violation of the Federal Power Act to use or employ any device, scheme or artifice to defraud, make an untrue statement of material fact or omit a material fact or engage in any act or practice that operates as a fraud or deceit.
FERC and its staff determined that the circuitously routed Lake Erie trades caused the harms that the NYISO monitor alleged—they contributed to loop flows and power grid congestion, increasing the cost of power to New York consumers—and for that reason FERC authorized the NYISO to prohibit prospectively the scheduling of wholesale power trades over the eight identified circuitous paths. Nevertheless, the agency concluded that these trades were not the product of any fraudulent device, scheme or artifice. Rather, they were induced by what the agency characterized as a “pricing methodology mismatch” among operators of the New York, Ontario, Midwest and Mid-Atlantic grid operators. During periods of grid congestion, that mismatch made it more profitable for a seller to schedule through the four regional markets rather than more directly from source to sink. Contrary to the NYISO monitor, that pricing incentive “simply exposed rather than created a market inefficiency.”
In analyzing the circuitously scheduled transactions, FERC and its staff detailed the profits and losses traders incurred. That the circuitous transactions more often than not were profitable for sellers left the regulator with “no reason to doubt that their motive was simply one of responding to price signals in the market.” And because FERC found no evidence that sellers had attempted to affect price levels artificially or conceal the circuitousness of their schedules—each leg of which was correctly tagged—there was no basis for finding market manipulation or for imposing price mitigations available under the NYISO tariff.
FERC’s message in the Lake Erie order and report is clear: If market structures or rules make profitable and reward power transactions that are arguably inefficient, that inefficiency will not be mistaken as evidence of market manipulation. Rather, it will be received as proof that the market structures or rules are disjointed and in need of reform.
That message shows a more mature, deliberate approach to regulating complex energy markets than characterized earlier periods when any market perturbation was assumed to be the product of manipulation.
Dan Watkiss is a partner with Bracewell & Giuliani in Washington, D.C., representing power companies, exploration and production and midmarket companies, natural gas pipelines, power and liquefied natural gas project developers and lenders, as well as government agencies and regulators. You may reach him at Dan.Watkiss@bgllp.com.