The Financial Times reported yesterday that the Staff of the Federal Energy Regulatory Commission (FECR) was investigating a number of electric power marketing affiliates owned by major banks — including JP Morgan Chase, Barclays Deutsche Bank AG, and others, on charges of manipulating electricity prices.  Immediately, reporters starting wondering whether this is like Enron’s antics back in the early 2000s, which ripped off California consumers and decimated California’s flawed electricity markets.  I don’t think it’s the same kind of schemes, but we need more information.

FERC is the federal regulator for electricity markets in the US, with jurisdiction over interstate transmission and the grid operations that include the regional power markets.  The information is sketchy now, but the Staff alleges that the banks’ power traders were manipulating bids and possible generator operations to increase prices in at least two regional US electricity markets, California and the Midwest ISO region.  Reuters, Bloomberg, HuffPo and others then picked up on the story without adding anything on how the allege manipulation worked, so it’s still unclear exactly what they’re alleged to have done.

The question is, what were these bank-affiliated power traders doing?  I’ll get to that in a minute, as it looks like the San Francisco Chronicle picked up a clue, perhaps without knowing it.

It’s not unusual for participants in bid-based, market-clearing electricity markets — like those used to keep your lights on every day in more than half the US — to be suspected of manipulating the markets.   Traders try it all the time, because there are billions of dollars flowing through the electricity market systems every year.  That’s why all of the regional electricity markets, which are operated by Independent System Operators (ISOs) and governed by quasi-public, regulated institutions called Regional Transmission Organizations, have what are called “independent market monitors.”   The monitors are fully independent from the market participants; indeed, the monitors function mostly independent of the ISOs themselves, under the oversight and protection of federal regulators, in this case, FERC.  Even their budgets are set somewhat independently.

The monitor has access to all confidential bidding information, every day, every hour.  For each ISO it closely tracks all bids and offers — quantities of power offered at a price (in $/MWh) submitted to the ISOs.  They verify cost claims, operational characteristics and outage reports (to guard against intentional withholding of plants to exercise market power).  And they track which parties own which trading positions, who controls plant operations, which financial transmission rights they own, and so on.  The electricity markets may well be the most closely monitored “markets” in the United States.  It’s probably the market monitors and their reports to FERC that tipped off FERC staff, but none of the stories report that.

The ISOs keep your lights on by accepting offers/bids from power plant operators and power consumers (like your local distribution utility or your retail “supplier”) for power to be injected or withdrawn the next hour and the next day.  So there are multiple markets:  one for each hour of the day; and one for each hour of tomorrow.   The latter set is called the “day-ahead” market.  The on-the-day hourly markets are called “real time” markets. The ISO schedules the “dispatch” of plants for each hour based on these offers and bids, with the goal of selecting (sorta) the least-costly mix of power plants to exactly match the actual demand on the system at every moment.

The ISO’s goal is that your electricity be supplied at every moment at the lowest cost available to the ISO dispatchers at that moment, given the offers/bids.  And they generally do a great job, while keeping your lights on. (If your lights are off in the east, it’s likely because a tree fell on the local distribution lines outside your house, not because the ISO messed up or there aren’t enough power plants.)

So what is JP Morgan’s power marketing affiliate suspected of doing?   The FT article mentions “bid manipulation” to achieve “excessive prices,” but that could mean lots of things.  With multiple markets, and multiple products like financial transmission rights (which might be called “derivatives”), there are many potential ways to use bids in one market to influence outcomes in another market where the trader may hold a position.  And the affected position may be some financial hedging scheme completely separate from the ISO’s functions.  (Which is why it’s likely a bad idea to have the Wall Street boys engaged in the electricity markets.)  So a trader working for Barclays might be manipulating bids in the day-ahead market in order to influence the values of hedges in some other derivative market.

The only new information about this among the various news reports consists of two words in the SF Chronicle article.  The traders may have been manipulating bids in the day-ahead market to influence “make whole” payments.  Aha. [cont’d]

If that’s correct, it suggests that the alleged scam was a lot more sophisticated than the simple notion of just submitting excessive bids that exceed marginal costs to influence the market clearing price on the day-ahead or real-time markets.  Those simple scams are easy for the market monitors to catch; in fact, they’re automatically flagged in some situations before they’re even allowed.  The “make whole” payments require more explanation.

Recall there are day-ahead markets, which are purely financial.  Power is being bought and sold a day before anything is actually generated or consumed.  And there are the real-time markets, where power is actually generated, injected into the transmission grid, and taken off/consumed by consumers.  The real-time market is thus “physical,” and it keeps your lights on.

The ISOs like day-ahead markets, because what they do is give the ISO a day-ahead look at what power supplies are likely to be available the next day and how much parties are already contracting or scheduling the day ahead to meet the real time needs tomorrow.  So the ISO likes to see most of the power needs it forecasts for tomorrow scheduled a day ahead.  It then compares the amounts being offered and bought day ahead with the demand it forecasts for each hour of the day tomorrow.  The gap between the amounts traded in the day ahead market, and the amounts actually needed in real time, is where the “make whole” payments come in.

For example, if the ISO forecasts demand for hour 11-12 tomorrow to be 100,000 Megawatts (MW), and 95,000 MW clear the day-ahead market (these are typical numbers for the larger ISOs), then the ISO knows there’s a pretty good chance that at least the 95,000 MW will be available in real time.  But when it gets to real time (tomorrow) the ISO must keep the lights on for all 100,000 MW demanded, and also carry operating reserves– extra plants available in case something bad happens — plants malfunction, there’s an unexpected heat surge and everyone runs their air conditioners, etc.  So in the day-ahead market, the ISO will hold a separate bid-based auction for the rest of the power it believes it will need tomorrow — say, another 5,000 MW or more. And it will “commit” those extra units to be available tomorrow, even though their power wasn’t bought/sold in the day-ahead market.

If your plant is committed, you have to incur whatever costs are necessary to make sure you are ready to operate and produce the power you committed to deliver at the moment the ISO calls on you.  If you are then called upon, your plant receives the market-clearing prices for the hours you operate and the energy you provide.  If you are not called upon, you still have to have been ready.  So the “make whole” payments are a guarantee from the ISO that no matter what happens, it will make sure that your revenues, either from clearing prices, or make-whole payments, are enough to cover the costs you were asked to incur by the ISO.

The question is, how were the marketers manipulating the bids for the “commitment” process that can result in excessive make whole payments?  I have some ideas, but that’s the part we don’t know yet.  More later.