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Perspective

Proper authority and market monitoring and mitigation could make the system work.

 

In the last few years we have watched appalled as the western U.S. electricity markets collapsed, taking with them the solvency and viability of several very large participants, including the California Power Exchange (PX).

In August, we watched in disbelief as blackouts spread almost instantaneously through New York, Canada, and the Midwest, leaving millions stranded without electricity for hours and days. There is a common thread. Today the Federal Energy Regulatory Commission (FERC) lacks clear statutory authority under the Federal Power Act (FPA) to do the tasks most policy-makers expect it to do: (1) regulate markets (though it has authority to regulate prices);

(2) ensure the reliability of the electric transmission system; and (3) ensure the adequacy of the nation's supply of generation. Moreover, the combination of the physical development of the system on a multi-state regional basis, and constitutional limitations, make it impracticable to assume states can effectively provide that authority.

Technology and economics have moved the industry far beyond the point where the state/federal division of 1935 can work. When there is less-than-robust demand response and unequal bargaining power between buyers and sellers, market behavior rules are required, but regulators need to have the right authority to craft effective rules. That authority does not currently exist for FERC in the Federal Power Act (FPA), and the issue of federal pre-emption makes it impracticable to assume states can effectively provide that authority.

The FPA is also ill-suited to being the legal cornerstone for reliability of the industry. Without clearer authority, FERC will have to continue its "carrot and stick" approach-coaxing transmission owning utilities to join regional transmission organizations (RTOs) and fashioning contractual, rather than statutory, obligations to maintain resource adequacy and transmission system reliability. The process has not worked well. Without changes that give regulators the right tools, the next power crisis could be right around the corner.

To get the tools (and the rules) right in a market economy, products and markets can be regulated either by price (on a cost-of-service basis for essential services) or by regulation of behavior of market participants. The consequences of the several forms of regulation are different, as are the methods used to regulate.1 In price-regulated markets, all sellers selling above a certain price point may have to pay refunds to all buyers who bought from them, regardless of whether the seller did anything wrong, or even if it sold below its own cost. But price-regulated sellers often benefit from limited liability for other damages if selling under an approved tariff.2

Surely a lesson from the California crisis is that in deregulated markets, the rules need to focus on behavior-ensuring (by incentive or fiat) competitive behavior. This approach is not particularly well-suited for an agency with a price-regulated market statute, but, fortunately, models for behavior regulation exist. The Commodity Exchange Act,3 and the Securities Exchange Act of 1934,4 authorize the operation of organized markets under the supervision of federal agencies and clearly forbid certain manipulative actions as defined by the agency.5 In Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) regulated markets, the violators of the rules can be made to pay for all damages incurred by other participants in the markets-criminal and civil penalties and liability under civil suits brought by those harmed. Those innocent of market rule violations who were induced to sell by high market prices may rely on the finality of transaction.

Regulators Need the Right Tools

Given the differences in approaches and outcomes between price and behavior regulation, what should regulators and policy-makers do? Notwithstanding the various efforts to retard or stop completely the march of FERC's standard market design, the consensus of Congress, as well as FERC, appears to remain that competition is a more effective mode of regulation than price setting. Thus, from a federal perspective, if the market is to be the primary regulator for an essential commodity highly susceptible to price manipulation, the natural path is to move promptly to regulation under a scheme analogous to that which has worked reasonably well to regulate financial and commodity futures markets.

Moreover, it seems unlikely that states will be able to forestall for long the move to competitive markets, given the rapid regionalization of the industry. In short, the current industry structure and need for regulation is increasingly more like that of securities and commodities sales and their exchanges rather than rate-of-return regulation.

The analogies to more traditional commodities and securities are not, however, without flaws. In particular, both the CFTC and SEC rely substantially on self regulating organizations, or "SROs"-the National Association of Securities Dealers (NASD) for securities and the National Futures Association (NFA) for commodities. No statutory authority for SROs exists under the FPA. Moreover, while RTOs, independent system operators (ISOs), and their organized markets are, in effect, exchanges, stock or commodity exchanges are different. In particular, those organized markets comprise members that are regularly both buyers and sellers. When exchanges establish rules and enforce them, there exists within each participant and the collective whole a vested interest in making the rules balanced and enforceable because anything one gives, one can easily get in the next transaction. The participants themselves have every reason, therefore, to write reasonable rules and, in general, to honor the Golden Rule.6

Electricity markets today lack the ingredients needed for the Golden Rule to be meaningful. The ultimate buyers of electricity (and their wholesale middlemen) need electricity in real-time. Suppliers have similar limitations on the ability to produce electricity in highly variable amounts or to store it. Most buyers are not also equally sellers, and vice versa. In fact, functional unbundling (and, in some states, mandatory corporate unbundling) has made this even less true than in the past. This means that regulators (FERC and the states) will have a more difficult job in the early years of commodity/security-type regulation-because they will have to ensure that the rules emulate ones that truly equal exchange participants would have written. Most importantly, regulators (and legislators) will need to resist the urge, when the conditions for market-based rates fail, to revert to retroactive price regulation.

Can Market Monitors Do the Job?

Increasingly, FERC "gets it" on the need to craft behavioral rules. This is most evident in the not-so-subtle shift in the role of market monitoring and mitigation within RTOs and ISOs. In fact, as FERC continues its quest for true independence in RTOs, the RTO/ISO looks more and more like a regional SRO. Market monitoring and mitigation units (MMUs) are evolving into on-the-ground investigators, enforcers, and, potentially, independent proponents of market rules. The question is whether the MMUs can do the job. Properly designed, it appears that they can and, at least in some locations, already do much of it.

What do MMUs do that well-crafted rules and FERC and the states cannot? First and foremost, they have access to all of the bid and offer data by each participant on a real-time basis, and to the control room personnel who are often critical to understanding whether system conditions explain a questionable bid-tasks achievable only by personnel "on the ground" at the RTO/ISO. Existing MMUs have this access and FERC has made it clear that it expects this sort of access for MMUs in new RTOs. Even the California ISO (Cal-ISO) MMU, without independent sanctioning authority, was able to alert regulators to intentional under-scheduling of load in the day-ahead market, a reliability problem, very early in the life of the Cal-ISO. The problem was first identified by Cal-ISO staff in the summer of 1998, and rules were modified thereafter.7 Likewise, the ISO filed an emergency tariff change in July 1999 to shut down a "dec game" whereby a generator, knowing it was the only likely source to relieve local congestion, submitted "strategic bids" that were $750,000 per day.8

What is sometimes lacking, however, is political consensus on rewriting rules to eliminate the games. This can be well-recognized, such as the growing inability of the Cal-ISO stakeholder board to deal effectively with the market meltdown, leading FERC to order its dissolution in 2001. A less well-known but equally important example is the history of efforts within California to give utilities the ability to hedge with longer-term purchases. The Cal-ISO board raised caps from $250 to $750 in 1999, but it provided for reducing the caps if, among other things, "practicable demand side options" were not in place by the next summer.9 The California Public Utilities Commission (CPUC) authorized some hedging but limited forward purchases to one-third of the utility's historical minimum hourly load by month, which "unnecessarily restrict[ed] the ability of utility distribution companies to forward-purchase electricity and therefore to mitigate the potential exercise of market power."10 Even the legislature got involved, using a budget bill to block implementation of a June 2000 CPUC compromise order that had set the stage for utilities to purchase from "other qualified exchanges" rather than just the PX.11 Even in the Eastern ISOs, with independent boards and authority within the ISO to propose rules without stakeholder consensus, there remains substantial disagreement over the market monitoring and mitigation rules that have been implemented, with energetic protests to each new filing on mitigation rules.

In short, the information as to who was doing what in the West Coast markets was there and available, at least to the Cal-ISO markets, which had a functioning MMU.12 A regional RTO would have had access to even more data. The crisis continued and worsened, when it should have been contained. A substantial prophylactic would have been authority vested in the Cal-ISO MMU to monitor and mitigate coupled with a "must-offer" obligation, at least on sellers whose business is to profit-maximize, to balance the "must-buy" situation of buyers. Both of these are rules authorized for ISO-New England and the New York ISO. If, in addition, FERC had the authority to judge participants' actions based on whether they had "employ[ed] any device, scheme, or artifice to defraud"13 rather than whether there was an enforceable (unambiguous) contract that had been violated, one can imagine that the procedural morass of the California refund cases would have been substantially averted.

What Next for Markets?

The electricity market cannot be expected to self-regulate in the public interest in this area unless and until the table is filled with buyers and sellers of equal bargaining power, none of which can skew the market profitably-a condition unlikely to be met in this decade, if ever. That need not, however, justify abandoning markets. Congress recognized essentially the same issue for securities markets in the '30s when it enacted the various securities and exchange laws and, within a few years, SROs. Getting the rules right for protections from fraud and manipulation falls first to the regulators and, where they deem it appropriate, to their delegates. This mission requires, however, clear statutory authority for enforcement and sanctions and power to delegate.

The FPA is not adequate as it stands. Without clear, unambiguous description of prohibited conduct, the authority to sanction is left in doubt.14 Moreover, there needs to be a consistent approach to defining what acceptable ranges of behavior should be. Currently, the definitions are inconsistent among the various MMUs. For example, some view departure from the short-run marginal cost (SRMC) bidding envisioned by second price auction theory to be a violation. The reports of the California Market Surveillance Committee to FERC, for example, relied upon variations from the market clearing price that would have occurred based on SRMC bidding to be an indication of exercise of market power, and FERC is now proceeding on an extraordinary attempt to reconstruct the California markets based essentially on this principle. In other regions, the acceptable range of bidding is well above the short-run marginal cost, with mitigation reference levels set to catch only several hundred percent above that level.15

Both approaches cannot simultaneously be right. FERC must rationalize the various approaches if the broad regional markets needed for efficiency are not to be destroyed. Even the second price theory is under attack, internationally, with Britain and Wales having switched to the "pay as bid" model. FERC will have to deal with the arguments for that model as well.

FERC and Congress are thus faced with an important (and urgent) task-deciding what they want the industry to be. If the generation part of the industry is to be subject to market discipline, then Congress must explicitly give FERC the tools to make market discipline work. In addition, Congress must clarify the jurisdiction of FERC as opposed to the CFTC.16 At least the recent Senate Commerce Committee version of S.14 contained language suggesting that the CFTC had exclusive jurisdiction over electricity and natural gas as commodities under the CEA. If an RTO must operate a day-ahead market, an hour-ahead market, and a balancing market, which of these are futures markets, and which are physical? Thus far FERC has required these markets in a certain form. If these are futures markets, does the CFTC have exclusive jurisdiction? Does it have concurrent jurisdiction? Just as Enron appears to have designed many of its trading strategies to avoid violations of the CEA, we can expect others to plan their operations so as to find the gaps in regulation between the CFTC and FERC. There are significant differences between the two agencies, and having both in charge of this industry is a recipe for disaster.

What Next for Reliability?

The original theory in 1935-that the states would regulate most of the business of electric public utilities with FERC (then the FPC) handling the relatively minor transactions at wholesale -has become less and less workable over the years as more and more of the power business occurs at wholesale. While the Public Utility Holding Company Act of 193517 (PUHCA) gave the states some ability to continue regulating as the holding companies grew, the continuation of the merger trend and the looming repeal of PUHCA will continue to erode state power. In many ways, the development of very large conglomerates has limited the ability of the states to saying no from time to time where the state has siting authority. Since many of these projects are likely needed to strengthen the interstate transmission grid but have less clear local benefits, we run a risk akin to the Cold War standoff between superpowers-regulation by mutually assured destruction-but very little potential for regulation in the traditional sense. We have seen what results from that partially regulated model in terms of blackouts, and it is not a good public policy choice.

Surely the recent blackout presents an almost irresistible mandate to Congress to do something to prevent future widespread service interruptions. Many utilities have thought for some time that a federal siting mechanism for transmission lines that mirrors that for gas pipelines in the Natural Gas Act18 would make sense, and would break what they perceive to be the logjam (and logrolling) in state certification. Granting such authority to FERC would seem a logical response, given the focus in at least the early press reports on the underinvestment in transmission and its likely contribution to the transmission grid meltdown in August.

The stage has been set for a conference committee grant of such power to FERC, based on the House version of the Energy Act this year.19 The current provision would permit FERC to act only if states have failed to certify generation for a significant period of time. If inadequate transmission facilities turn out to have been a factor in the recent blackout, as many believe likely, one might expect the conferees to tilt toward even greater FERC siting authority. This would be easier to swallow than a grant to FERC of power to ensure "resource adequacy"-an area more seen as within the exclusive purview of the states.

In any event, with both the unpleasant memories of the West Coast meltdown in 2000 and the Eastern Blackout of 2003 in the minds of conferees returning to hash out an energy bill, the time may have come for significant electricity industry legislative reforms. Those most likely to emerge may well be reforms that build on successes in other industries, such as enforcement powers already in place for commodities and securities markets, and federal eminent domain for interstate energy delivery facilities.


  1. Here and elsewhere, we simplify somewhat because of space limitations.
  2. Under the "filed rate doctrine," courts cannot examine a rate that FERC has approved or permitted to be in effect. Cf., Montana-Dakota Utilities Co. v. Northwestern Public Service Co., 341 U.S. 246 (1951). Thus there is no relief other than that which the commission can provide in such a regulatory regime. It is not clear whether this doctrine is or should be still valid in a market rate structure. The potential of having to pay all damages suffered by all parties who lost as a result of market manipulation is an effective death sentence to most market participants, and a more serious disincentive to manipulation.
  3. 7 U.S.C. 1, et. seq. ("the CEA").
  4. 15 U.S.C. 78a, et. seq. (the "'34 Act").
  5. See, e.g., 15 U.S.C. 78j and SEC rule 10(b)(5).
  6. Even so, of course, there has been enough litigation under each act to make clear that there will always be market participants who see an opportunity for profit large enough so that the golden rule is abandoned in favor of the golden calf. Regulation of conduct is still required. And the experience in the electric markets in which one of the prevalent market models was the "one to many" market of the sort operated by Enron On Line left some of the market traders with very heavy positions, which in turn made it highly profitable to engage in wash trades or other shenanigans to move the market, given the "mark to market" accounting in use.
  7. There are a series of memoranda on the issue, beginning Aug. 4, 1998, and continuing through the fall. These are available on the Cal-ISO Web site in the archived documents of the Stakeholder Board, http://www.caiso.com/pubinfo/BOG/documents/other/archives.html, including reports on the ISO's tariff compliance project. This under-scheduling laid the groundwork for the Enron "Fat Boy" bidding strategy response by the generators.
  8. The Cal-ISO identified this "flaw in one of the market rules," providing the opportunity for "strategic bidding" in a 1999 Transmittal Letter, Docket No. ER99-33-000 (June 18, 1999) at 1, 3. available at www.caiso.com/docs/1999/06/18/199906181638404506.pdf.
  9. The Cal-ISO resolution provided for a reduction in the caps if by March 2000 it determined the markets not "workably competitive" or there were not "practicable demand side options." See minutes of Aug. 26, 1999, Board at http://www.caiso.com/pubinfo/BOG/minutes/docs/Minutes990826BOARDOFGOVERNORS.pdf.
  10. March 2000 Report on Competitiveness, Market Surveillance Committee, at http://www.caiso.com/docs/09003a6080/04/30/09003a60800430ed.pdf.
  11. The California legislature added the following provision to its 2000-2001 budget bill: "The Public Utilities Commission may investigate issues associated with multiple qualified exchanges. If the commission determines that allowing electrical corporations to purchase from multiple qualified exchanges is in the public interest, the commission shall submit its findings and recommendations to the Legislature on June 1, 2001. Prior to June 1, 2001, the commission shall not enact any decisions authorizing electrical corporations to purchase from exchanges other than the Power Exchange, as defined in Section 355 of the Public Utilities Code. Any decisions authorizing electrical corporation purchases from qualified exchanges enacted prior to the effective date of this section, but after June 1, 2000, shall not be enforced."
  12. The lack of data on systems outside of the Cal-ISO control area hampered investigations, however, since some games involved out-of-control area buyers and sellers, for which the Cal-ISO's information was limited, because its right to data (established by "contract" in the tariff) did not extend to other control areas.
  13. SEC Rule 10b-5, 13 FR 8183, Dec. 22, 1948, as amended at 16 FR 7928, Aug. 11, 1951.
  14. FERC is, essentially, relegated to enforcement through contract rights. It must design tariffs for public utilities to file that give FERC authority not clearly resident in the statute. Then, if it can induce market participants to join in the tariff, it has only a contract-based right to approve sanctions on behavior. While an ingenious attempt to reach a rational result, this is a Rube Goldberg approach to regulation. FERC needs greater authority for its own police and regulatory powers, and added authority to delegate it to MMUs. Finally, MMUs need to abide by the dictates of due process, if they are to be effective SROs.
  15. See New York Independent System Operator, 99 F.E.R.C. 61,246 (2002); see also Comments of David B. Patton dated Nov. 15, 2002, in Docket No. RM01-12-000.
  16. The CFTC has asserted jurisdiction over sales of electricity and natural gas as commodities, at least in the futures markets, having recently investigated some of the transactions that have turned up in the West Coast investigations as violations of the CEA.
  17. 15 U.S.C. 79a, et. seq. (PUHCA).
  18. 15 U.S.C. 717, et. seq.
  19. H.R. 6.

History Repeating Itself

The key to not repeating history is to learn from it. The necessary ingredients to averting the next California crisis, wherever it might occur, are:

 

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