It seemed like a good idea at the time. About 10 years ago, large investment banks that had long traded in energy commodities and derivatives, including playing in the wholesale, organized electric markets regulated by the Federal Energy Regulatory Commission (FERC), concluded that it made sense to combine physical assets—power plants, pipelines, and the like—with their financial positions. That gave them the ability to play physical assets off against financial positions in the markets.
Today, those companies are abandoning their physical trading assets in the face of a major move by newly-empowered FERC officials to crack down on what they view as market manipulation. Over the first half of this year, FERC has proposed to fine Barclays Bank $435 million for manipulating western electricity markets, including the California Independent System Operator (CAISO), and pushed JP Morgan Chase into a $410 million settlement of similar charges involving CAISO and the Midcontinent Independent System Operator.
In both cases, FERC said the banks were using physical assets to arbitrage financial markets in ways that benefitted the banks at the expense of consumers. In the Barclays case, FERC said Barclays “built and then flattened substantial monthly physical index positions at four of the then-most liquid trading points in the western United States for the fraudulent purpose of manipulating the index price to benefit Barclays’ financial swap positions.” At JPMorgan, FERC said the bank used “manipulative bidding strategies designed to make profits from power plants that were usually out of the money in the marketplace. In each of them, the company made bids designed to create artificial conditions that forced the ISOs to pay [JPMorgan] outside the market at premium rates.”
Barclays pushed back, refusing to pay the fine and refusing to appeal through FERC’s administrative process, which forces the dispute into federal court. JPMorgan agreed to pay the fine, saying it “admits the facts set forth in the agreement, but neither admits nor denies the violations.” JPMorgan used its physical (wind) assets to make negative real-time bids in the markets, and then reaped windfalls in the next-days day-ahead markets, according to FERC.
An analysis from the Washington law firm of Bracewell & Guiliani noted that under Section 31(d)(3)(A) of the power act, Barclays could either engage in an administrative hearing at FERC or go directly to the federal courts for a complete review. Barclays went directly to the federal district court and has 30 days to pay the FERC fine. “If Barclays fails to pay the penalty,” said the analysis, “FERC must institute an action in Federal District Court to enforce the commission’s penalty assessment. The Federal District Court will then have de novo review over the proceeding.”
The JPMorgan case has been making headlines since March, when The New York Times revealed details of an internal document originated in the FERC enforcement office of Norman Bay, a hot-shot former federal prosecutor from New Mexico with a reputation for aggressive pursuit of alleged wrongdoing. FERC Chairman Jon Wellinghoff hired Bay in 2009 to beef up the FERC enforcement program.
Shortly before the public announcement of the FERC-JPMorgan settlement, JPMorgan announced it was getting out of physical commodities entirely and was putting its assets, including its electricity holdings, on the market. The Wall Street Journal noted that Goldman Sachs and Morgan Stanley have also put “for sale” signs on their physical assets.
The newspaper pointed out the negotiations with FERC and added, “The Federal Reserve, meanwhile, is reviewing a decade-old policy allowing banks to hold physical commodity assets.” The article said, “J.P. Morgan’s decision is the most striking move yet by Wall Street to back away from physical commodities, marking a potential final chapter in a decade-long push by financial firms to seek profits by planting themselves at the center of the global supply chain for industrial materials.”
Investor Craig Pirrong on the financial website Seeking Alpha commented, “No sooner had I written a post that showed the potential comparative advantage that banks had in dealing in physical commodities, did JP Morgan Chase announce that it was throwing in the towel and exiting the business.” Pirrong cited a number of reasons why this may have been the case, including lower profits in the commodity markets and “reputational risk,” also known as public ridicule. (As I commented at ElectricityPolicy.com, “The ever-snarky Daily Show on cable TV linked the physical commodity trading story with the decision by Parker Brothers to eliminate “Jail” from the board of their venerable Monopoly game”).
FERC’s aggressive action on power market manipulations has raised some hackles, including at the Wall Street Journal’s editorial page. In an attack on the nomination of former Colorado regulator Ron Binz to succeed Wellinghoff as FERC chairman, the editorial board said, “President Obama’s rule-makers have amped up major regulators like the Environmental Protection Agency and now they’re turning to more obscure outposts. Take the Federal Energy Regulatory Commission, or FERC, which oversees electric transmission and interstate pipelines. Or used to. Now FERC has deputized itself as a Wall Street regulator.”
—Kennedy Maize is MANAGING POWER’s executive editor