By Scott DiSavino
July 22 (Reuters) - The California electricity trades thatmay bring JPMorgan Chase & Co a record penalty stem froma "flaw" in the regional trading system, highlighting why powertraders are increasingly anxious about a broad crackdown on themarket.
The Wall Street bank is working to close the book on aninvestigation that dates back more than two years, when theCalifornia Independent System Operator (ISO), the state's gridoperator, noticed that a then-unnamed market participant hadbeen using an "exploitative" trading strategy that hadeffectively forced the grid to pay for a plant to sit idle,ultimately adding to customers' costs.
JPMorgan initially denied the accusations but is nowreportedly in talks with the U.S. Federal Energy RegulatoryCommission (FERC) to settle the complaint for hundreds ofmillions of dollars, a potentially record penalty for theagency.
The case comes amid a series of high-profile investigationsby FERC, which in 2005 was granted by Congress expanded powersto pursue market malfeasance in the wake of the Enron scandaland the 2000-2001 California energy debacle. FERC levied $470million in penalties against Barclays PLC this week formanipulating California power markets.
But unlike traders' brazen efforts to choke off powersupplies and jack up rates for "Grandma Millie" a decade ago,the recent activities stem from far more subtle gambits in whichtraders may benefit whether prices go up or down.
The deeper focus on what appear to be less overt forms ofmanipulation - or what some players would more likely deementrepreneurial trading - has sent shivers through the industry,forcing companies to reassess the risk of participating in the$200 billion U.S. physical power market.
"FERC is trying to convey where it views market activitythat might otherwise be permitted under the letter of the marketregulations to nonetheless be considered unlawful and, in FERC'sview, manipulation," said David Doot, a partner who coversenergy at law firm Day Pitney, told Reuters.
"Clients are revisiting what they are doing to make sure(they) are OK and not skating too close to the line."
During a four-month period from March through June 2011, theoperators of the California and Midwest power grids - theCalifornia ISO and Midwest ISO - made four different filings toFERC to close market loopholes and alert regulators of thebank's "abusive" bidding strategies. (ISOs are nonprofit publicentities responsible for operating power grids and runningcompetitive power markets.)
The ISOs estimated three of the bidding techniques togetherresulted in at least $73 million in improper payments, notincluding "millions of dollars in payments from anothertechnique," according to a FERC lawsuit.
CLOSING LOOPHOLES
In a series of filings over the past two years, theCalifornia ISO described what it called "exploitative biddingpractices" that amounted to bait-and-switch maneuvers.
The ISO said JPMorgan "aggravated the market impact of (a)flaw" of the "bid cost recovery" mechanism, which assuresgenerators will receive compensation for their power plant'sfixed startup and operating costs if the ISO asks their unit torun but it fails to cover its costs from power sales.
The ISO also accused the bank of causing the misuse of"exceptional dispatch," which is a system to activate powerplants on a last-minute basis as necessary to prevent unexpectedemergencies that could threaten grid reliability.
FERC approved each of the ISOs' requests to change theirmarket rules and prevent further abuses.
JPMorgan's trading practices are outlined in the CaliforniaISO's filings with FERC dating to March 2011, when it asked theregulator to modify market rules that had been put in place inApril 2009, when the grid launched a new trading system.
That month the ISO told JPMorgan it was notifying FERC'sOffice of Enforcement of the bank's exploitative biddingpractices. But JPMorgan was not publicly identified as thetrader in question until FERC subpoenaed the bank in July 2012to provide emails related to an investigation into marketmanipulation in California and the Midwest.
FERC closed the bid-cost-recovery loophole in May 2011 andthe exceptional-dispatch loophole in August 2011.
For a time line of FERC's investigation of JPMorgan, see:
FERC's outgoing chairman, Jon Wellinghoff, has said thenewly empowered enforcement team is targeting malfeasance, notWall Street, but traders still fear that its action could reduceliquidity in the market, making prices more volatile.
"FERC likes having financial players in the markets becausethey add capital and liquidity," said Marc Spitzer, a formercommissioner at FERC from 2006-2011 and currently a partner atWashington law firm Steptoe & Johnson.
"But, we don't want them to manipulate an arguable gap inthe law that they managed to find."
HOW THE BANK DID IT
The bank's trading activities in California revolved largelyaround operations at a handful of power plants that JPMorganeffectively operated under "tolling" arrangements. The plantswere owned by AES Corp, but JPMorgan was responsible forfuel-supply and power sales.
Under such agreements, the plant owner (AES) still operatesthe facility, but the third party (JPMorgan) has a significantamount of control over how and when the plant runs, based on itscontract and the profitability of its trades.
According to the California grid, JPMorgan took advantage ofa dynamic that is peculiar to physical power markets, whichoperate on two different time frames: next-day and real-time.
In the so-called day-ahead market, the grid solicits offersto sell electricity for the coming day based on forecast demandand other factors. The California ISO selects which power plantswill run based on competitive bids from generators.
Because capacity needs can vary widely depending on weatherconditions, the day of the week and other factors, the grid alsooperates a real-time market, where spot prices and realconditions require the grid to balance supply and demand on anhourly basis. Prices can fluctuate wildly in this market,spiking three- or fourfold in an hour if the grid is short.
The day-ahead bids include not only the price at which theplant will sell electricity but also the startup costs andminimum load costs it will incur. By selecting a plant to run,the grid agrees to pay those fixed costs if the plant isunderutilized because, for example, electricity demand is lower.
The costs, which include fuel and other expenses, are repaidonly if the plant can't recover them through regular sales. Theyare not disclosed for competitive reasons.
It is this minimum cost that JPMorgan is said to haveexploited to its own advantage. The ISO did not say how much thebank reaped from this kind of trade, but the grid operator hasalready recovered $52 million from power sellers due to suchdeals.
JPMorgan's trading strategy, the ISO said, was to submitbids with high minimum load costs but exceptionally low -sometimes negative - power prices, making them attractive enoughfor the grid to schedule the plant to run the next day.
But in the following day's real-time market, JPMorgan wouldchange its prices, submitting very high bids that discouragedthe grid from "dispatching," or running, the plants.
That would leave the unit running below its minimum level ornot at all, triggering a "minimum load" payment to cover thosecosts.
To cover the previous day's sales, JPMorgan traders wouldsimply buy power supplies in the spot market - potentiallymaking a loss on the electricity trades themselves but more thanmaking up the difference when the grid paid to cover the fixedstartup and minimum load costs.
The ISO said the problem started in December 2010 whenbid-cost-recovery "uplift" charges reached $16 million, up fromprevious monthly payments of $5 million to $11 million. InJanuary 2011 the ISO said uplift amounts surpassed $20 million.
EXCEPTIONAL DISPATCH
The grid also said the bid-cost-recovery strategy increasedpower costs by causing it to call on emergency reservegeneration under the "exceptional dispatch" system because someplants were not meeting their day-ahead commitments.
In the day-ahead market, the ISO selects the units that willproduce energy as well as those that will be held in reserve.Reserve units, which typically represent up to 7 percent offorecast daily demand, stand ready to operate in case of anunexpected shutdown or surge in demand.
By removing its units from the real-time market, JPMorgan'sbidding strategy in some cases also removed units from the poolof reserve capacity, which sometimes forced the ISO to dispatchother units to maintain required reserves at much higher prices.
The ISO said in just five days in April 2011 it paid out$3.6 million in exceptional-dispatch payments related to thebidding strategies. It did not say who profited from thesepayments.
In May, JPMorgan sold the tolling agreements for three AESplants to California power company Southern California Edison, aunit of Edison International.
Barclays (BARC)