ENERGY MARKETS:

Experts see more opportunities for abuse in gas-electric alignment

Natural gas and electric power markets may need to be closely aligned to assure reliable grid operations as gas-fired generation expands. But that could also add to the already complex challenges facing regulators trying to prevent energy market manipulation, according to some economists and attorneys in the energy sector.

The prospect of interlinked gas and power markets was raised by experts from the Brattle Group consulting firm, in their response to a request for comments from the Federal Energy Regulatory Commission. FERC's query focuses on potential grid reliability threats as new gas supplies from shale deposits accelerate gas-fired generation.

If the Northeast and other regions are headed toward a significantly greater dependence on gas-fired electric power, the two industries need to get together on how their markets run, how new pipelines will be funded and how electricity reliability will be assured, FERC commissioners say.

The creation of new markets for natural gas that were coordinated with the daily and hourly trading of electricity in organized power markets could, in principle, provide price signals that prompt pipeline shippers and customers to shift gas deliveries to generators when power demand abruptly peaks, the Brattle team said.

But another result would likely be an expansion of complex trading strategies for "virtual" deliveries of electricity and gas, and for financial derivatives tied to energy trades, at a time when federal regulatory oversight of these trades is still unsettled, some experts say.

"As markets get more complex, in physical and financial dimensions, there is more opportunity for perverse incentives," said a regulator not authorized to comment on the record. "The more complex people's portfolios get, the more cover they may think they have."

Rice University business school professor Vincent Kaminski quoted the British writer G.K. Chesterton's aphorism about where a wise man would hide a leaf: in a forest. If he had no forest, he would plant one.

"If you are dishonest and have a more complex system, that creates more opportunities for you. But still, the fact that someone can misuse the system doesn't mean you should try to improve it," Kaminski said.

The linkage of energy trades and financial derivatives was at the center of last month's record settlement of FERC's anti-manipulation case against Constellation Energy. The settlement, just before Exelon Corp. completed its acquisition of Constellation, required Constellation to pay $245 million in penalties and disgorged profits. Although the case centered on trading for power, not gas, it is an example of complex trading that challenges regulators.

Despite FERC's "win" in that case, its mandate to pursue allegations of unjust pricing in financial derivative markets still faces a day in court, in a pivotal case before the U.S. Court of Appeals for the District of Columbia Circuit. If FERC loses, the regulatory oversight of gas and electricity markets will become even more clouded, energy attorneys say.

Gas and power alignment face hurdles

In the analysis it filed with FERC last month, the Brattle authors noted both the potential gains and obstacles to close ties between gas and power trading.

"There would be high prices for gas on extremely tight gas days" and, for example, a factory might agree to give up its guaranteed gas delivery right and sell the gas to a generator with a pressing short-term need for more fuel. Or generators that can run either on gas or oil might switch to the oil option, taking the high payment in releasing more gas to other customers.

Spot wholesale electricity prices would presumably spike upward, as well, producing large profits for generators that had paid to lock in gas supplies. That could be the incentive for generators to join in paying for new pipelines, the Brattle analysts said.

But they added, "in practice, it is doubtful that this ideal of strong reliance on very flexible intraday pricing can be achieved. One weak link in the chain is the assumption that it would be politically acceptable to let prices spike high enough to do their job. Experience in the electric industry indicates we are often uncomfortable with prices that reflect the true value of scarcity (or we cannot readily distinguish them from market power abuses)."

The Brattle analysts made no reference to the Constellation Energy investigation. Constellation CEO Mayo Shattuck III said last month that the company's actions were lawful portfolio risk management transactions. "The company admits to no wrongdoing in this case," he said in a statement. However, in the consent agreement, the company stipulated that FERC's description of its actions was "true and correct."

FERC Chairman Jon Wellinghoff said the Constellation investigation illustrated the opportunities for abuse that complex energy markets present, and the need for surveillance. "There are going to be some people to test the limits and others who will go beyond the limits and actually engage in fraud, manipulation and abuse," he told Reuters.

Market complexity

Constellation Energy traders were operating in two different arenas. One was the "virtual" energy market for the hourly supply and purchase of electricity run by grid operators in New York and New England.

In the virtual market, traders can execute "sell" contracts to supply power for the following day -- the "day ahead" energy market that guides actual power plant and grid operations in that following day. Or they could enter "buy" contracts to take power the next day. The market is virtual because the parties don't intend to deliver or take power.

The contracts are wound up the following day in the "real time" market when traders who committed to sell or buy close the transaction with a contract in the opposite direction. Last-minute shifts in the weather, availability of power plants or power line congestion can affect the difference between the day-ahead and real-time markets. Traders are betting that they'll guess right about the price movements.

Grid officials say the virtual trading has proved its value because the interactions of many buyers and sellers leads to more accurate forecasts of market needs and supply and more competitive energy prices.

Constellation's second arena involved the trading of derivative financial instruments called "contracts for differences," or CFD swaps.

The CFD swaps are commodity transactions that are outside the virtual markets, over which the Commodity Futures Trading Commission says it -- not FERC -- has jurisdiction. But the value of the CFD swaps is tied to final energy prices set in the virtual market.

The linkage between the two markets creates opportunities for manipulation, investigators say. Suppose traders sought to move the day-ahead market price higher. They could enter a "buy" order in the virtual market, in effect telling the market that there was more demand for power coming the next day than would otherwise be so. That would open the door for additional -- and more expensive -- generators to run that next day. As a result, the day-ahead price would rise.

The resulting higher prices could cause those traders to lose money in the virtual market. But they could more than make up for that if the higher virtual market prices benefited their much larger positions in the unregulated CFD swaps market, where there is no regulatory limit on the amount of positions that can be taken (unlike in the FERC-regulated virtual market).

Constellation violated FERC's anti-manipulation statute because its traders repeatedly lost money in the virtual market in order to make greater profits speculating on much-larger trading positions in the swaps market, the commission said.

The Constellation trading pattern apparently was quickly spotted within months after it began in 2007. However, the settlement was not hammered out until more than four years later, according to the timetable in FERC's order -- just before Constellation concluded its hoped-for merger with Exelon.

Contested regulatory authority

Regulation of trades in financial derivative products like CFDs is still unsettled, four years after the 2008 market crisis triggered by unregulated derivatives.

FERC's authority to regulate trades in commodity markets is being tested in a pending case before the U.S. Court of Appeals in the District, brought by Brian Hunter, the former head trader of the Amaranth Advisors hedge fund. Hunter, who was fined $30 million in a market manipulation case, said FERC does not have jurisdiction to prosecute him. The CFTC agrees with him.

"The two agencies have different views on where their jurisdictional boundaries lie," said Ray Wuslich, an energy partner with the Winton & Strawn firm, which represented Amaranth.

Wuslich said he doubted that linking gas and power markets would open new opportunities for abuse. "The markets are already complex. Smart people are always looking for smart, clever ways to make money, and sometimes they cross the lines.

"The real uncertainty is that the rules aren't clear about what the regulators think is manipulation. A regulatory agency and a regulated community need to know where the lines are," he said. Otherwise, market efficiency -- and consumers -- suffer, he said.

Industry agreement elusive

Although alignment of gas and power markets is headed for a lot more scrutiny, agreement between the two industries doesn't appear to be around the corner, based on leaders' statements.

Donald Santa, chief executive of the Interstate Natural Gas Association of America, said his industry agrees on the need to assess the gas-power issues, but cites fundamental differences with the power sector. "Pipelines do not build in response to a market forecast or some type of regional plan; it's in response to customers who are willing to sign up for firm contracts that will underpin that [investment]," he said in an interview.

"In the pipeline mindset, they want an assured deal, and that's not what happens in our industry," said John Shelk, president of the Electric Power Supply Organization, which represents merchant electric power companies. "Our guys are bidding on power, sometimes in hours, sometimes in minutes. That just doesn't lend itself to the predictability that the pipelines want," he said.

"Neither one of them really feel that this is their problem," said Frank Graves, one of the authors of the Brattle Group report. "The pipes don't care if the generator guys run out of gas. And the electric guys don't want to provide finance indemnification for the gas guys. They want short-term bursts" of gas supply when they need it. "Neither is being bad-spirited about it," Graves said. They just live in different worlds.

"You have two industries that are critically dependent on each other," Kaminski said. "They operate according to a different clock, so they should be synchronized.

"The fact that the system will be more complicated is a price we have to pay. "

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