FERC's plan to expand into energy market-monitoring faces many challenges.

There are three important challenges FERC's vision of market monitoring face. First, the market consequences of a significant institutional "drag coefficient" when addressing problems of market power or, more generally characterized, market abuse. Second, balancing and modes of mitigation and considering more immediate complementary tools. As well as, third, addressing the relative emphasis on FERC regulation and RTO self-regulation.

In the Federal Energy Regulatory Commission's (FERC) Dec. 17, 2001 paper, , the staff writes that RTOs "need to establish a process for developing periodic reports on prices, volumes, supply, demand, liquidity, and ownership structure and concentration of these markets."¹ FERC staffers go on to say reports should be sent concurrently to FERC and the RTO without the RTO's prior review. FERC's vision is that monitors will work together-and with FERC-to establish common market performance measures. The focus of monitoring would include attention to barriers to entry and whether demand is being satisfied efficiently.

FERC staffers write that monitors would recommend structural and rules changes that would benefit market performance. They argue that rules change proposals should be vetted through a public process in order to promote market transparency. Monitors should be independent of the RTO, but work inside the RTO and be funded by the RTO. There should be an independent reporting relationship to FERC as well as informal reporting to the management of the RTO.

They also assert RTO recommendations regarding rules changes, or more important market mitigation measures that should be applied (rather than ), should be made to FERC. FERC staff indicates that mitigation measures may not be stringent in order to allow for demand responsiveness to essentially "mitigate the mitigation." In conjunction with this focus, FERC staff argues for a standard market power mitigation plan for all RTOs. The logic is that through such means, monitors would be implementing a Commission-approved mitigation plan, "rather than mitigating market power on its own initiative."²

This most recent posture by FERC staff is consistent with the approach that FERC has taken since the start up of ISOs in the United States several years ago. But there are important nuances in the staff paper that indicate a refinement in FERC staff's view of market monitoring.

First, there is clear emphasis on the importance of independence. In particular, the most significant aspect of FERC staff's vision is the specific linkage of the monitoring function to FERC authority. While always a critical pillar in the practice of market monitoring, FERC proposes formalizing the direct reporting relationship to FERC and eliminating any direct reporting line within RTOs. Second, FERC proposes a more explicit emphasis on mitigation in lieu of other methods. Third, there is an emphasis on a lighter-handed response to market power problems if there is evidence of potential new entry or enhanced demand responsiveness.

FERC staff's approach can already be seen in the most recent Midwest ISO order. The basic tenants of the FERC staff's vision paper appear prominently in the Commission's reaction and directions to the MISO market monitor.³

Placing FERC's authority as an umbrella over market monitoring is a well-reasoned advance in the market monitoring state of the art. Given the politicizing of market monitoring in California, stemming from the price excursions of 2000 and the fallout that continues to complicate both the California markets and the Western U.S., FERC staff's vision is a necessary, if not inevitable, shift of emphasis.

Market Abuse & Speed-of-Light Markets: Will FERC Be Fast Enough?

The practical working relationship between market monitors and FERC involves frequent interaction through informal meetings and the submission of reports, as FERC requires. Market monitors also report to ISO and RTO boards and senior managers, providing information about market performance as well as raising issues concerning the efficiency of market operations, including identification of market power related problems.

In cases where evidence of deliberate market abuse by one or more market participants is identified, monitors may take simple steps on their own. For example, sending warning letters or other forms of notice to the alleged violator(s) is one option, or they may refer the problem to FERC or the Department of Justice.

This model of market monitoring fits well within the jurisdictional sphere of FERC's disciplinary powers, such as imposing sanctions or other penalties on market participants, are limited by the Federal Power Act. FERC appropriately emphasizes its authority to use rate making and to define market standards and practices, given its limited powers to sanction and penalize.

Unfortunately, the nature of competitive markets, particularly in organized exchange environments like RTO day-ahead, real-time, ancillary services, and congestion markets, is that they move very quickly and are difficult to control. Current market monitoring methods and processes are far from fleet of foot.

For example, the California electricity crisis began with significant price excursions in May 2000. The California ISO (CAISO) market monitoring staff produced quick reviews of the initial events, but a thorough examination of price excursions did not come out until the middle of August.⁴ The monitor's public report concluded that massive exercise of market power had occurred.

The California Power Exchange's (CalPX) market monitor produced some initial commentary and graphic information to the California Electricity Oversight Board (EOB) in June 2000, but a thorough analysis of price excursions through the summer of 2000 did not come out until late September 2000.⁵ In its report, the CalPX market monitor concluded that there was no basis for allegations of market abuse, because price excursions could be almost entirely explained by fundamental market forces, such as changes in gas prices, power supplies, and other Western wide rare events.

Other investigations, including those conducted by the California Electricity Oversight Board and the state legislature, occurred during the same time period. Most importantly, FERC conducted its own investigation into price excursions in California and produced a report consistent with the CalPX findings, even later in the year than the CalPX report.⁶

With conflicting conclusions amongst monitors, FERC's findings and related orders were vital to regaining order in California markets. But during the period when monitors were doing their analysis and political interests were conducting investigations, market participants were largely unable to assess the risks they ran because no one knew what the outcome was likely to be. During this protracted period the scale of the price excursion problem changed by an order of magnitude-a significant change when the base measure was in the billions of dollars.

The political chaos that occurred during the period for analysis of price excursions should not be overlooked. These policy influential, related perturbations complicated FERC's efforts to understand and craft effective mitigation remedies. The governor of California, the state assembly, various administrative departments, and the attorney general produced reports and conducted investigations that politicized, polarized, and in some cases personalized the effects of market outcomes. Congress was drawn in as the California congressional delegation became involved.

The California case is certainly an extraordinary one, but it illustrates what can happen when the market monitoring system must respond quickly and its mechanisms for response require slow and careful work and extensive process. This "institutional drag coefficient" is a challenge that FERC appears to be addressing by emphasizing market mitigation.

But as the saying goes, "you don't know what you don't know." Therefore, market mitigation is an imperfect method just like all methods. Further, market mitigation will not prevent attempts by market participants to maneuver around whatever design modifications are put in place. One thing that is a universal law in markets is that buyers and sellers find ways to manipulate the rules for their own self interests, including breaking rules, finding loopholes in rules, and exploiting ambiguously defined rules.

In response to this , virtually every other commodity that uses an exchanged-based mechanism for clearing prices from one bidding method or another has established robust market surveillance staffs that carefully monitor trading behavior.

The market surveillance staff in exchanges like the New York Mercantile Exchange (NYMEX) or the Chicago Board of Trade (CBOT) advocates for rule changes where appropriate. But they also investigate abuses, prepare cases, and prosecute alleged rule violations through a well-structured disciplinary process that directly involves participants in the process of policing trading activity. Alleged market abusers are able to defend themselves in a quasi-judicial proceeding. The market surveillance staff makes the case for abuse. A panel of peers judges and brings forward findings. When abuse is found to have occurred, disciplinary standards are applied including various penalties and sanctions for specific types of abuses. Market rules may be changed when the case identifies a flaw in the rules.

Commodity exchanges not only "self-regulate" through well-established judicially oriented internal disciplinary processes, but their surveillance staffs keep in very close contact with the Commodities Futures Trading Commission (CFTC), the federal regulatory body responsible for overseeing the conduct of business by exchanges trading commodities or various financial instruments. The CFTC approves exchange operations, keeps close tabs on their daily activities and is actively involved with surveillance. Where cases of federal law violations are identified surveillance staffs hand over cases to appropriate federal authorities.

The use of disciplinary procedures, as well as market rule changes, enable commodity and financial exchanges to respond quickly to unusual market events. This contributes to minimizing unusual market events in the first place.

A challenge ahead, as market monitoring methods and processes mature, is how FERC will enable market monitors to more quickly respond to market events in a manner that sustains participant confidence and minimizes the kind of out of control politicizing of market activity that occurred in California. After all is said, the question going forward is how can the institutional drag coefficient be reduced? The answer lies in a combination of methods used for monitoring and the relative degrees of "self-regulatory" freedom RTOs are given by FERC.

The Detection Kit: Balancing and Other Modes of Mitigation

The FERC staff's emphasis on mitigation is a well-reasoned approach, especially given the early stage of evolution of electricity markets. Even a standard market design, as FERC is now in the process of creating, will be subject to continuous change. Distinctive regional characteristics will drive some changes. The iron law of manipulation will drive other changes. Refinements in knowledge and experience will drive changes as well.

Since "you don't know what you don't know," real market experience will be a principal source of information and practice that will inform monitors and FERC about flaws and failures in electricity markets. For instance, these outcomes may not be the result of abusive market behavior as much as an ill-conceived incentive structure, poorly thought out assumptions, or just plain bad analysis underlying specific elements of market design. market mitigation, therefore, is an important mode of review and analysis to be encouraged as complementary to any focus.

In fact, and mitigation are two sides of the same coin. For the most part, initiatives stem from analysis of data. The effort is intentionally preemptive. mitigation stems from analysis of data and results in a market rule change or design revision. The obvious main difference is that methods attempt a preemptive strike, while is focused on a reactive correction.

These methodological perspectives would be even more effective if some form of real time monitoring on operating floors were adopted as well. Like trading floors where people interact with each other, operating floors are hubs for voice and data interactions between controllers and market participants. Informal and familiar relationships easily lapse into unintentional passing of sensitive information that may advantage one participant over others. If monitors had a real time presence on the operating floor, some of the potential for unintentional collusive behavior could be spotted and preempted in real time. In doing so, the need for a more prolonged or mitigation might be minimized.

There are other related steps FERC might consider taking. First, review the extent to which trading data must be treated confidentially. Under present market designs, a degree of confidentiality must be preserved to enable free market behaviors. However there are tradeoffs between the benefit of confidentiality and transparency. Transparency has two important components in electricity markets. Transparency of process is essential because it ensures that market participants and stakeholders have a real voice in the evolution of RTO markets. Transparency of data is also essential because it gives all participants the ability to understand market forces and improve the competitiveness of their offerings. This same data may benefit stakeholders by enabling a stronger emphasis on fact-based critiques and recommended market design and market rule changes. And in cases where market abuse is alleged resulting in either an or mitigation, transparency of data is a vital line of defense against inappropriate or overly constraining remedies.

Second, undertake a process of developing disciplinary procedures that RTOs may implement as a first line of defense of their markets. Neither nor mitigation is sufficient for RTOs to ensure that their markets work efficiently with a minimum of abusive behavior. The reason for this is that markets by their nature are fast-paced and inherently unpredictable. Without powers to immediately address a wide range of types of misconduct, RTOs are less able to quickly respond and reduce the risk of significant price excursions, as California experienced in 2000.

The prophylactic benefits of having monitors on the operating floor, as suggested above, should be a part of RTOs establishing a systematic approach to using disciplinary tactics. Disciplinary tactics should be formalized in a process that can be executed quickly. Disciplinary tactics can range from informal warnings and formal notices to cease behavior to formal quasi-judicial proceedings in which alleged misconduct is prosecuted by monitors and defended by the accused before a review body that includes market participant peers. RTOs should specify disciplinary tactics they will use and set forth a schedule of sanctions and penalties tied to specific forms and degrees of misconduct. FERC should support this internal self-regulatory aspect of market monitoring.

RTOs should make their processes, procedures, and associated sanctions and penalties explicit and public for market participants.

As monitoring practices mature the challenge for FERC is to clarify the boundary between what may be acceptable internal RTO disciplinary action and FERC-executed remedies. As presently conceived, FERC's approach is to minimize RTO disciplinary powers. Underlying this approach is the larger question of how FERC balances the emphasis on its regulatory prerogative and RTO self-regulation.

FERC Regulation and RTO Self Regulation: A Symbiotic Relationship

FERC's vision of market monitoring includes internal RTO monitors and/or external RTO or multi-RTO monitors, paid for by the RTO(s) and reporting directly to FERC. FERC staff foresees the commission itself monitoring as well. RTO monitors report and can recommend mitigation measures. Beyond this they do not have other powers. As outlined the vision for market monitoring does not include the scope of the surveillance functions of commodity and financial exchanges but approximates the tight relationship between the self-regulating entity and the regulator consistent with what exchanges enjoy with the CFTC.

RTOs in general are FERC jurisdictional entities operating under approved FERC tariffs that define the scope and methods of operation of the institution. For most operations-related activities RTOs are for all practical purposes self-regulating. Their independent boards provide policy guidance. Associated advisory boards and processes ensure continuous involvement by market participants. The long established institutional means of administrative law and justice available to RTOs and market participants through FERC remains in place, and works. Thus, FERC has done a good job of enabling the growth of largely self-regulating entities in a highly defined regulatory context. Again, this mirrors the sort of relationship that exists between exchanges and the CFTC.

In the case of market monitoring, though, FERC has moved in the opposite direction by reducing the role of RTOs and enhancing its role without taking over the function altogether. While consistent with the CFTC model, the balance between self-regulation and regulator oversight is more skewed toward the regulator in the case of electricity markets. The underlying question to be considered is whether de-emphasizing self-regulation in market monitoring has the unintended consequence of reducing the effectiveness of more generalized self-regulation of the entire RTO.

Meanwhile, such issues as the institutional drag coefficient, best practices in methodology, and the balancing act that involves RTO self-regulation in a FERC regulatory context will persist and influence the maturing of monitoring. Early consideration of these and other issues will help policy-makers to sustain the methodical progress that has been the hallmark of the last decade's restructuring efforts.

1. , by the staff of the Federal Energy Regulatory Commission, December 17, 2001, p. 10.
2. Ibid. p. 10-11.
3. 98 FERC 61, 075 (January 30, 2002).
4. , Department of Market Analysis, August 10, 2000.
5. , September 29, 2000.
6. FERC staff issued a report November 1, 2000 and simultaneously formalized its findings in an order directing changes in the CalPX and the CAISO, including revocation of the CalPX tariff and directions to CAISO to restructure its board to ensure its independence. See, November 1, 2000.

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