Power Markets: Hate the Players, Not the Game

on July 22, 2013 at 12:00 PM

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Early indications of the direction the newly activist Federal Energy Regulatory Commission are deeply worrying, not just for the power industry but for the entire economy, as well as for the future of the agency’s own necessary and important work in overseeing the evolving US electricity sector.

Not many people cry for banks when regulators issue enormous fines, and financial institutions have become accustomed to the back door taxation on their activities that the fines represent. In the past few days FERC, which is finally emerging from more than a decade of learning its new role as a proper market regulator as it cleaned up from the collapse of Enron following partial deregulation, has generated headlines by issuing nearly a billion dollars in proposed fines against banks involved in trading on power markets.

The Commission is not only within its rights to fine JP Morgan and Barclays for their alleged market manipulation at these levels, it is a strategically clever move. FERC now has the power to actually get attention-generating amounts of money from traders, and it needs that “big stick” to guarantee it is listened to and its rules have weight in the market. The Wall Street Journal notes that the Barclays fine alone would far outweigh the cumulative fines issued in the preceding five years of the Commission’s operations.

Unfortunately, early reporting pertaining to at least one of the massive fines indicate that FERC itself may be in the process of setting back its own agenda by decades and in the process further undermining already shaky confidence in the power sector in the US. Bringing poorly structured cases to court tempts judicial messing around in business models that investors rely on to fund new infrastructure, and while the details around the murky alleged activities in both of the big cases FERC has filed are still emerging, a mistakenly activist commission that prompts further regulatory uncertainty is arguably worse than a toothless one.

Early discussions of the cases FERC is bringing focus on the “make whole” payments FERC has allowed in power markets. The California Independent System Operator has, like traditional public utility commissions before it, erred on the side of excess generation to guarantee reliability by encouraging power delivery companies to compensate power generators if they use less of their electricity than was originally agreed. That “make whole” premium doesn’t cover the full amount of the lost sales but it does encourage power generators to continue to create slightly more electricity than the market probably needs. Everyone would rather pay a little more than have the lights go out, the argument goes, and while that speaks to the underlying flaws in treating the power system like other commodities markets, it is also probably correct and mostly workable.

Of course, markets and capitalist systems rely on companies finding the flaws in markets and exploiting them. The idea, for those who have forgotten their economics courses, is that the profits generated by exploiting those flaws will be substantial enough to create competition and thereby innovation that lessens the profits and over time solves the flaw in the most efficient way.

Unfortunately in the current environment, that also means that bank trading desks can make a lot of money. In the alleged activity behind recent fines, FERC says that traders underbid the market ahead of time to guarantee purchases of excess power by delivery firms, then raised those bids to restrict delivery in the same day market, collecting enough of a make-whole payment on the shortfall in resulting real purchases to guarantee a profit. That isn’t very nice of them, but it is also hard to see it as anything but good business. If they were unable to make delivery when they’d contracted to, they’d have been in trouble and rightfully so. But the flaw in the system is self-evidently in the make-whole payment, not necessarily in the bidding process.

The New York Times reported that some of JP Morgan’s executives may be under scrutiny for having misled the federal government during its investigation of the trades, in which case they’d join the great tradition of getting in bigger trouble for the coverup than for the original alleged infraction. Even if they lied (and a new story in the Times since walks back from that implication), that doesn’t absolve FERC from appearing to want to have its cake and eat it too.

Attempting to dictate outcomes is a fast road for regulators to generate a command economy. In the case of the traditional power sector, an overpriced command electricity market that guaranteed returns to overproduction of energy at centralized stations for delivery to disparate locations was worth the cost. The sector attracted investment to its guaranteed returns and created cheap power that fueled economic growth.

But the inexorable power of markets and technology is slowly cracking the old system open. Distributed generation, smart grid monitoring, fuel shifts and the prospect of improved storage are building into a tidal wave of change for the industry that means a more efficient future, but one that has to be paid for with new investment models. Those investment models might make some people very rich, and not always in a way that makes everybody happy.

Guaranteeing the right balance between innovative business, sufficient reliability and social responsibility requires a strong regulator; a hamstrung FERC does nobody any good in the long run. The federal power regulator increasingly needs to be strong and activist, but it also needs to be careful and smart. If FERC’s first major indictments out of the gate are struck down, or if it inadvertently opens its own market designs to judicial review through filing incompletely thought-out cases, the vast sums that FERC itself says are needed in power infrastructure will be delayed or will go elsewhere.

The US needs a strong power sector, and it needs a strong power sector regulator: Nobody said it would be easy, but FERC should be careful not to make its own job harder than it needs to be.