How to make a noose out of a loophole – JP Morgan’s energy market abuse case

The $400 million package agreed by JP Morgan with the US federal energy regulator to settle its energy market abuse case against the firm at the end of July flags up the legal risks energy firms now run in exploiting loopholes in the frequently complex bidding rules governing energy wholesale markets.

8 August 2013

The $400 million package agreed by JP Morgan with the US federal energy regulator to settle its energy market abuse case against the firm, announced at the end of July, is a great example of the legal risks energy firms now run in exploiting loopholes in the frequently complex bidding rules governing energy wholesale markets.

Firms trading in EU wholesale energy markets need to be extremely careful about engaging in similar manipulative conduct here, given the prohibition on energy market abuse imposed under REMIT (the Regulation on Energy Market Integrity and Transparency) and the potentially unlimited fines (and other civil and criminal sanctions) that may be imposed for breaches.

 Background – Californian Power Market

The Californian market is operated by an organisation known as CAISO which dispatches generators according to a merit order designed to match supply and demand at the lowest cost to consumers.  Generators compete with each other by submitting day-ahead bids to CAISO quoting prices which they will charge if they are dispatched.  The price quoted by the most expensive generator included by CAISO in its merit order ‘stack’ sets the market price paid to all generators in the merit order.

When generators submit bids to CAISO they specify two prices.  First they specify for each month a price for electricity produced at the lowest level of output the plant can reliably sustain (Pmin), which can be up to twice the unit’s estimated actual costs.  Second, they specify an incremental price, which may vary hourly, for additional electricity produced above that minimum level up to the unit’s maximum output level (Pmax).  The market rules permit these incremental prices to vary between -$30 per MWh and $750 (later $1000) per MWh.

Generators not included in the day-ahead merit order because their bids are too high may still need to be dispatched by CAISO for operational reasons.  In that case CAISO will make ‘make whole’ payments to them covering the difference between the market price and their bid price.

In addition to a day-ahead market, CAISO also operates a real-time market on the relevant trading day.  Generators who have not sold all of their output in the day-ahead market are able to sell spare output in the real-time market at a market price set in a similar fashion to the day-ahead market.  Generators may also (and must if required by CAISO) submit bids to buy back their output in the real-time market.  Such generators are remunerated at the real-time market price for buy-backs.

 JP Morgan’s gas fired plant

In 2008 JP Morgan Ventures Energy Corporation (VEC) acquired tolling agreements in relation to several gas-fired power plants in Southern California and Michigan.  Under the California agreements VEC was able to control the output of those power plants.  These plants were less efficient than modern gas-fired plants and the marginal costs (around $45 per MWh) of running them were typically greater than the average ‘day-ahead’ market prices of $30 to $35 per MWh observed in the Californian wholesale market.

The key generating units for present purposes were those at VEC’s Huntington Beach plant, known as HB3&4, and those at its Alamitos plant known as AL3&4.

 Bidding strategies for HB3&4

This involved VEC submitting day-ahead bids for these units of $90 per MWh for output at Pmin.  These were around twice the operating costs of those units ($45 per MWh) and, thus, the highest day-ahead bids it was permitted to submit under the market rules.  At the same time VEC submitted day-ahead bids of -$30 per MWh (the lowest permissible level) for increments above Pmin up to Pmax.  These negative prices were designed to make the average price of VEC’s output low enough to secure its place in the merit order.

On the face of it, this would have meant VEC’s plant being dispatched at market price (i.e. around $30 to $35 per MWh), i.e., below VEC’s operating costs.  However, VEC also generally submitted buy-back bids at around $40 per MWh (slightly above day-ahead market price) for its output above Pmin, thus encouraging CAISO to accept them.  By accepting VEC’s buy-back bids CAISO reduced VEC’s output, often to levels as low as Pmin.  This meant that CAISO was required to pay substantial ‘make whole’ payments to VEC for the difference between market price and the $90 per MWh it had bid for its output up to Pmin.

 Bidding strategies for AL3&4

For these units VEC declared itself a ‘price taker’ (i.e. prepared to run at whatever price the market set) for every third hour in the trading day whilst submitting high priced bids (double the market price or greater) for the intervening two hours.

CAISO awarded VEC a place in the merit order for these low priced hours.  However, because the market rules also require CAISO to dispatch generators for periods during which they need are ‘ramping up’ and ‘ramping down’ on either side of the hours they are needed, CAISO was also obliged to pay VEC ‘make whole’ payments at its (high) bid prices for those intervening hours.

VEC also declared itself a ‘price taker’ for a service required by CAISO called ‘Regulation Down’ which involved running at a level substantially above Pmin and being subject to external control by CAISO during that period.  Knowing that CAISO would be required to pay VEC ‘as bid’ for its output while providing the ‘Regulation Down’ service, VEC submitted high incremental bids (double the market price or greater) for its output during those hours.

 Other bidding strategies

Recognising that CAISO’s system evaluated bids for one day at a time, VEC submitted the lowest possible incremental bids (-$30 per MWh) for the period right at the end of the trading day (midnight) and extremely high bids ($999 per MWh) for the hours between midnight and 2am.  CAISO accepted the low bids but was then also required to dispatch VEC’s units (for ‘ramping down’ purposes) in the first two hours of the next trading day.  This naturally exposed CAISO to very large ‘make whole’ payments.

Finally, VEC offered to provide a further ancillary service (involving running above Pmin) to CAISO for a low price ($1 per MWh) while bidding $999 to provide output above Pmin in the real-time market.  As VEC’s units were out of merit at those high prices CAISO dispatched them down to Pmin levels.  However, CAISO then had to issue ‘exceptional’ dispatches to VEC to bring the units into operation at the required level to provide the ancillary service.  This triggered large ‘as bid’ payments to VEC for output above Pmin.

 CAISO and FERC action

A number of these trading strategies were picked up by CAISO as part of its market monitoring activities, with sanctions being imposed under the applicable market rules in some cases.  In addition, the federal regulator, the FERC, also opened proceedings alleging breach of its ‘Anti-Manipulation Rule’ which forbids, “us[ing] a fraudulent device, scheme or artifice, or mak[ing] a material  misrepresentation […] or engag[ing] in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any entity […] in connection with the purchase or sale of…electric energy”.  VEC agreed to settle the FERC proceedings by paying $285 million as a civil penalty and disgorging a further $125 million in unlawful profits.