Federal energy regulator burns the barn to roast the pig; steep penalty on distributed power provider may have unintended consequences

The Federal Energy Regulatory Commission is wrapping up a banner year in the battle against misconduct and manipulation in energy markets. Over the past year, the FERC assessed nearly one billion dollars in civil penalties against a broad spectrum of participants in the wholesale electric power market, according to the 2013 Report on Enforcement released last week.

The highlights included a civil penalty assessed against JP Morgan Ventures Energy Corporation for $285 million and a record-setting $435 million fine assessed against Barclays BCS +3.49% Bank for alleged market manipulation.

To put the scale of these penalties in perspective, FERC assessed a total of about $274 million in civil penalties for all of the preceding five years combined. Under the Energy Policy Act of 2005, FERC has authority to assign civil penalties of up to $1 million per violation per day to enforce its regulations and federal statutes, including violations of its so-called “anti-manipulation rule.”

The implications of FERC’s escalating crusade against so-called market manipulation suggest that following the rules is not enough to avoid charges for fraud.

What is enough?

Hard to say, but Christopher McEachran, a partner at the McGuire Woods law firm, has made the best attempt I’ve encountered to date at doing so.

To many market participants who come under regulatory scrutiny and to legal observers, ‘market manipulation’ seems to be somewhat of a ‘we know it when we see it’ sort of violation, which can make compliance difficult for even the most well-intentioned market participants . . . While the theories used in each case have their differences, the theme appears to be: market manipulation involves activity that either involves what FERC considers outright misrepresentation or appears to FERC to be traditionally ‘uneconomic’ but that still ends up resulting in profits for your firm, which in some way is viewed by the Commission as manipulative or false — whether or not such activity is permitted by the governing tariff.

Several of FERC’s recent enforcement actions may pose a more serious threat to market efficiency over the long term than the alleged manipulation itself. Take the enforcement action FERC brought recently against a paper mill in Maine for alleged market manipulation.

In March, the FERC assessed a civil penalty of $10 million against the Rumford Paper Company.

The alleged “market manipulation” involved payments Rumford received in 2006 and 2007 as part of the New England Independent System Operator’s (NE-ISO) Day-Ahead Load Response Program (DALRP), which pays customers for reducing the amount of electric power they use from the wholesale electrical grid.

Rumford makes paper products at a large paper mill in Rumford, ME. The mill uses about 95 megawatts (MW) of electricity when fully operational. To supply part or all of this load, Rumford usually operates an on-site power generator with a nameplate capacity of 110 MW. To the extent necessary, Rumford buys additional power or selling excess energy as necessary. During the five-day period when Rumford’s initial baseline load was established, Rumford reduced its internal generation by roughly 30 MW and instead purchased electric from the gird. Once the baseline had been established, Rumford operated its paper mill and generation facilities the same way it had operated them before the baseline period.

“Enforcement concluded that by intentionally ramping down the generator and purchasing energy, instead of producing energy on site, Rumford established a false and inflated baseline,” according to FERC.

The program rules for calculating the customer baseline were ultimately the reason why Rumford’s DALRP strategy proved to be so lucrative. By offering to reduce load every day, the baseline did not change to reflect actual generation or the mill’s energy usage. If the baseline had not remained static, Rumford would not have received the level of compensation it did for its claimed load reduction.

“The Commission determined that this scheme misled ISO-NE, inducing payments to these entities based on the inflated baselines for load reductions that never occurred,” according to the FERC’s Order finding Rumford guilty of fraud and market manipulation.

Rumford’s strategy for maintaining an “inflated” customer baseline was so prevalent that NE-ISO amended the program’s rules. In April 2008, FERC approved those rule changes and cited the scale of the problem as a basis for doing so:

In 2006, total DALRP payments were only $1.74 million, while in 2007, participants in the DALRP received payments totaling $16.81 million. Over half of these payments – about $8.7 million – are associated with static Customer Baselines. Moreover, the proportion of payments associated with static Customer Baselines has grown 68 percent from July 2007 through December 2007, and ISO-NE asserts that other Market Participants could copy this behavior: it would be possible for all 1,700 MW of demand response assets that are currently enrolled in ISO-NE’s Load Response Program to offer into the DALRP at the $50/MWh minimum offer and create static Customer Baselines . . . .

Rumford may have gamed the rules, but it did not break them.

http://www.forbes.com/sites/williampentland/2013/11/29/federal-energy-regulator-burns-the-barn-to-roast-the-pig-steep-penalty-on-distributed-power-provider-may-have-unintended-consequences/?ss=business%3Aenergy