FERC has determined that certain market participants were not to blame for unintended electricity flows around Lake Erie.
Concluding a yearlong, nonpublic investigation in response to requests from the New York Independent System Operator (NYISO) Market Monitoring and Performance Department, that arose amid significant political outcry, the Federal Energy Regulatory Commission (FERC) adopted and released the findings of the Office of Enforcement (OE) Staff Report (OE Report), which determined that certain market participants were not to blame for unintended physical electricity flows around Lake Erie (loop flows) from January to July 22, 2008, alleged to have resulted in additional uplift costs to the wholesale electricity market in New York. Rather, FERC concluded that a series of market design and operational decisions by system operators culminated in pricing incentives, which encouraged market participants to undertake economically rational conduct. FERC found that the market participants under investigation did not commit manipulation or violate the applicable tariffs. In analyzing the manipulation claim, FERC’s investigation report provides important guidance with respect to the agency’s recent anti-manipulation authority granted in August 2005.
The OE Report concluded that uplift experienced by NYISO’s customers during the time period was due, in substantial part, to lack of seams coordination between the NYISO and neighboring system operators, economic incentives (proxy price differentials) created by certain NYISO proxy bus pricing changes in 2007 to reflect a change in the phase angle regulator operating protocols in the area (and the failure to monitor this effect), and NYISO’s day-ahead modeling of loop flow, which employed a 90-day rolling average “look back” that was unable to account fully for the loop flow changes. The OE Report also concluded that market participants are not well suited to predict or identify loop flow impacts and, in turn, uplift changes. Indeed, the OE Report reiterated that much of the changes in loop flows and, separately, uplift charges are attributed to operational issues such as line outages, seasonal reliability needs and natural gas cost increases.
The OE Report, as adopted, concluded that market participants did not engage in market manipulation or violate any tariffs by placing circuitous schedules. “The fact that deleterious effects (to NYISO) may have resulted from these pricing incentives suggests not manipulation, but the need for a market redesign.” OE Report, 46. Indeed, FERC also ordered NYISO and its neighboring system operators to submit a report and any tariff revisions within 180 days setting out long-term solutions to the loop flow problem, including addressing interface pricing and congestion management.
On July 16, 2009, FERC released and adopted as its own the results of the OE’s investigation into alleged market manipulation in the scheduling of electricity transmission paths in a counterclockwise direction around Lake Erie. The investigation stemmed from allegations made by NYISO that certain market participants “exploited a seam in the pricing methods used by NYISO, PJM Interconnection, L.L.C. (PJM), the Midwest Independent Transmission System Operator, Inc. (MISO) and Ontario’s Independent Electricity System Operator (IESO).” OE Report, 1. NYISO alleged that the market participants were knowingly scheduling contract paths that “resulted in physical flows substantially at variance from scheduled flows.” Id. NYISO identified two contract paths that allegedly created these market inefficiencies: scheduling from NYISO-IESO-MISO-PJM (so-called Path 1 transactions) and scheduling from PJM-NYISO-IESO-MISO (so-called Path 5 transactions) (also referred to as “circuitous” schedules). NYISO believed that these paths were creating loop flow that, in turn, allegedly resulted in significant increases in uplift costs for market participants and customers in NYISO.
The Anti-Manipulation Rule
FERC’s anti-manipulation rule prohibits electric energy market manipulation. A violation exists “where an entity: (1) uses a fraudulent device, scheme or artifice, or makes a material misrepresentation or a material omission as to which there is a duty to speak under a Commission-filed tariff, Commission order, rule or regulation, or engages in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any entity; (2) with the requisite scienter; (3) in connection with the purchase or sale of natural gas or electric energy or transportation of natural gas or transmission of electric energy subject to the jurisdiction of the Commission.” OE Report, 21. All three elements need to be met for a violation to have occurred. Noting that the third element was “clearly met,” FERC analyzed the first two elements.
Deception and Fraud
NYISO alleged that market participants “might be concealing the true source or sink of their trades.” FERC rejected this claim, finding that there was no deception because “NERC tags clearly show the source, sink and intervening transmission for a schedule.” OE Report, 21-22.
FERC similarly rejected NYISO’s claims that market participants fraudulently took advantage of different pricing methods. FERC staff drew “the opposite conclusion,” noting that “the existence of a pricing incentive is suggestive of the lack of a fraudulent device, scheme or artifice, and is indicative instead of market participants responding to existing prices, rather than artificially affecting them.” OE Report, 22. FERC noted that this is true even though prices “varied from day to day, and individual trades were not always profitable.” OE Report, 23. “The market participants did not act against their economic interests or attempt to artificially affect price, which are hallmarks of market manipulation.” OE Report, 25.
Finding that there was no evidence suggesting intent by the market participants “to obstruct an otherwise well-functioning market,” FERC OE analyzed whether the transactions were conducted with “recklessness” as to the resulting loop flow and uplift. OE Report, 26. FERC OE noted that “[t]he mere scheduling of transactions with the awareness that loop flow will result is not, without more, reckless, since all schedules involve some amount of loop flow. However, it is possible that a conscious disregard of a substantial amount of loop flow, if anticipated to impose significant congestion and uplift costs on customers, might rise to the level of reckless conduct.” OE Report, 27.
FERC’s scienter analysis examined:
- Whether market participants were instructed not to place circuitous schedules resulting in loop flow
- Whether market participants should have known that the schedules would significantly affect loop flow
- Whether market participants should have expected their actions to contribute to uplift
- Whether uplift was primarily caused by the circuitous schedules
FERC OE first concluded that market participants were not advised to refrain from placing circuitous schedules. Regarding whether market participants should have expected loop flow, FERC OE stated that “a market participant cannot predict with any assurance the extent of those loop flows, much less whether such flows might be deemed harmful, because the configuration of any and every element of the electric grid determines the resistance or impedance on that system.” OE Report, 30. This is particularly true because loop flow historically has been predominantly counterclockwise, which had the beneficial effect of reducing congestion on NYISO. FERC OE noted that loop flow “flipped from counterclockwise to clockwise during the last ten days of December 2007, and persisted on the average in a clockwise direction through [July 2008]. Interestingly, this initial change in direction cannot be attributed to the circuitous schedules, as no Path 1 or Path 5 transactions were placed in the last ten days of December 2007. The cause of the initial flip remains a mystery to NYISO.” OE Report, 9.
While FERC noted that the circuitous schedules likely did contribute to uplift, it concluded that “[i]f market participants did not reasonably know whether they were contributing substantially to loop flow, they similarly could not know whether they were contributing to uplift.” OE Report, 34. Uplift charges are even more difficult to determine than loop flow because many additional factors (e.g., transmission outages and fuel costs) contribute to uplift, and because actual uplift charges were based on a 90-day rolling average. “[T]here is no definitive way for a trader, looking forward without the benefit of hindsight, to know whether an arbitrage opportunity reflects true fuel cost and congestion differences, or a market design flaw.” OE Report, 36.
OE staff also reviewed other transactions simultaneously entered into for the same hour with the Path 1 schedules including, for example, an IESO to NYISO trade or a PJM to NYISO trade. These transactions were placed independently from the Path 1 schedules based on the separate economics of each transaction or scheduled as a hedge against congestion and volatility on the Path 1 transaction, and in various hours the transactions may have resulted in losses or profit. The OE Report finds that the overlapping transactions are consistent with an attempt to reduce risk, the core element of a true hedge, and not suggestive of an attempt to affect prices or congestion artificially. OE staff remarked that “[t]aking opposite transactional positions, whether as partial or complete offsets, is not in itself manipulation,” and that hedges can be entirely consistent with legitimate economic decision-making. OE Report, 40.