Record fines expose power market flaws

By Dan McSwain

Originally appearing in UT San Diego A key policy lesson of California’s 2000-2001 power crisis was that people who trade in markets for a living are generally smarter than regulators.

The axiom still holds, even though federal regulators recently slapped JPMorgan Chase and Barclays with more than $1 billion in fines. The giant banks were charged with manipulating wholesale electricity markets, chiefly in California; Barclays from 2006 to 2008, and J.P. Morgan in 2010 and 2011.

Regulators didn’t precisely say how badly consumers were thumped by extra costs. To give you a sense of the possibilities, power traders and generators extracted roughly $40 billion in above-normal charges from businesses and consumers during the power crisis, which began in May 2000 and ended in June 2001.

A chief difference is now only about 10 percent of our electricity supply is traded daily, with the rest tied up in long-term contracts. A dozen years ago, 100 percent was traded daily on exchanges, so the potential for gouging was much higher.

Yet California’s electricity market clearly remains a complicated Rube Goldberg device that is prone to manipulation.

And there’s plenty of money to be made. J.P. Morgan thought its profits could grow to $2 billion by 2018, The Washington Post reported last week.

Electricity is by far the world’s most volatile commodity. The price of a megawatt hour can hover close to zero at 3 a.m., and then shoot to $1,500 by 5 p.m. on a hot summer day.

This scares officials, particularly because there are no easy substitutes, and power travels over shared infrastructure. So regulation has been heavy, and grown increasingly complex since California’s 1996 “deregulation.”

But traders like volatility, because they tend to make money on price movements. And they love complexity.

All U.S. markets have regulators somewhere, and this cat-and-mouse dynamic explains the regular news reports of insider trading or antitrust lawsuits. With electricity, the game has more closely resembled Whack-A-Mole.

California’s market restructuring forced regulated utilities to sell their power plants to merchant generators.

Then architects of the new system, led by former Sen. Steve Peace, D-Chula Vista, made a fateful mistake: They killed incentives for utilities to sign long-term contracts. This forced the state’s entire supply into daily auctions on power exchanges.

On May 22, 2000, when a surprise heat wave caused air conditioning use to soar, power prices shot to a cap of $1,500 per megawatt hour from the traditional range of $20 to $40.

State officials eventually realized that traders were exploiting California’s decision to set up two power exchanges. By withholding bids from one market, they could drive up prices in the other.

After prices exploded, newspapers uncovered a secret state database that was allowing traders to see every 15 minutes if a given generator was operating. This allowed traders to exploit breakdowns.

Regulators responded by shutting down the database and lowering price caps. It didn’t work.

Frank Wolak, a Stanford economist who advised state officials, had predicted that traders might evade caps with “megawatt laundering,” a strategy of selling power to buyers in other states, who then resold it back into California — which didn’t cap prices on imports.

By July 2000, megawatt laundering was rampant. Later, as blackouts rolled across the state, federal officials imposed a regionwide price cap.

But this cap allowed generators to recover costs, based on the price of natural gas. So natural gas prices soared, as traders turned their attention to goosing that market.

It took a few years, but regulators eventually found evidence that fraud accompanied outsmarting.

Enron, which filled its trading desk with Ph.D. economists and mathematicians, caught the brunt of enforcement. But Enron certainly wasn’t alone.

California’s market was so poorly designed that traders were practically duty-bound to find flaws. Regulators were overwhelmed by teams of very smart, highly paid people whose full-time jobs were to outmaneuver them.

Although many serious flaws have been patched, the incentives to find loopholes haven’t changed.

According to federal regulators, J.P. Morgan found a way to manipulate clearing prices with a combination of low and high bids.

Barclays, which has vowed to fight in court, is charged with rigging bids to manipulate an index. This is similar to allegations the bank gamed the Libor index that sets worldwide interest rates.

Maybe the sanctions prove that federal regulators have gained the upper hand; a 2005 law expanded their powers. History suggests that any victory is ephemeral.

Once I was hopeful that the advent of smart meters would even the odds for the ultimate buyers.

These gadgets are capable of showing consumers the true price of power every minute or so, instead of once a month. If a trader wanted a crazy price, my neighbor could tell the meter to shut down his pool pump — and so could everybody else, wiping out the seller’s advantage.

But regulators have been afraid to allow market forces to go that far.

So we remain stuck in a netherworld: Regulated utilities install dumbed-down smart meters and other infrastructure at lucrative rates of return, Wall Street controls the generators that feed them, and regulators try to outguess them both.

California’s power market needs a makeover.

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Record fines expose power market flaws

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