The threat of after-the-fact rules, prosecutions and penalties has become so great that the rule-of-thumb on many trading floors is, “If you can make money at it, don’t do it,” industry witnesses told a Federal Energy Regulatory Commission technical conference on standards of conduct and market behavior rules for the natural gas and electric markets in Chicago Friday.

That comment came from Mirant attorney Debra Raggio Bolton, who said it has gotten to the point where any creative or innovative behavior is automatically labeled as bad because it is impossible to know what trading practices will retroactively be found to be illegal. In a competitive market the object is to maximize profits, but in the California crisis of several years ago, companies that made money were later penalized when it was determined after-the-fact that certain processes were illegal.

“Making a profit in a competitive market is not a dirty word. You shouldn’t assume that bids above short-run marginal costs are wrong,” Bolton said. A competitive market can’t function efficiently if trading is restricted because of the fear that later political pressure will cause regulatory agencies to rule actions are illegal, she added.

Bolton recently advised Mirant traders not to do transactions known as “hockey stick bidding,” because it might appear to be an attempt to manipulate the market, but that type of maneuver was later approved for the PJM Interconnection market.

The lost opportunities for marketers translate into losses for consumers, said Jim Allison, regional risk manager for ConocoPhillips. Fewer trades and traders add up to less liquidity, wider bid/ask spreads and in some cases, a lack of matching bids or offers. This means higher transaction costs that ultimately impact consumers. “Self-imposed reductions in activity distort price signals,” Allison said, both in the short and long term.

Those making decisions on whether to invest in projects that won’t go into service for several years will be trying to forecast what prices will be, but they don’t know if they will be able to collect any upside. “If prices are attractive, how likely is it they will be able to keep the upside? We know we’ll get the downside, but we don’t know if we’ll get the upside.” This reduces investment in new generation and transmission.

Since there are considerable gray areas in trading, companies need to establish guidelines for their traders and procedures for going through channels within the company to determine if a particular practice will later be determined to be legal, said Mark Perlis, an attorney with Dickstein Shapiro Morin and Oshinksy LLP. Companies need to articulate and monitor their trading policies, then with mechanisms in place that can be reviewed, they will have a due diligence defense if practices are later questioned.

That is still a trading deterrent, Bolton said. By the time a particular trading idea is run through channels, the opportunity is gone. Several witnesses in the day-long conference recommended a process for filing a “no action letter” with FERC similar to a procedure before the Commodity Futures Trading Commission (CFTC), wherein a practice is vetted with the agency ahead of time.

Any action that makes a profit could conceivably be ruled later as an attempt to manipulate the market, the witnesses said. FERC staff, however, pointed out that the rules state that an action is defensible if it has a “legitimate business purpose.” This is a definition accepted by other regulatory agencies.

Director William Hederman of FERC’s Office of Market Oversight and Investigation (OMOI) had opened the conference saying Commission’s efforts are directed at restoring integrity and the public perception of integrity to energy markets. “We want to help you do it; this is not a command and control from the Commission type of thing.” The efforts, including the technical conference, are directed at how to make compliance with reasonable business practices work. Staff made forms available at the meeting so that anyone could contribute their input on the subject.

Perlis pointed out that at the time the so-called “Enron practices” occurred the management and supervisors of trading probably didn’t know all of the activities that were going on. That has changed. With the whole new atmosphere, including the Sarbanes-Oxley law, companies are striving to be good public citizens. “They don’t want their employees getting in trouble for bad behavior. This is bad for morale and bad for business.” Most are working much harder setting up behavioral rules and monitoring employee activities, Perlis said.

Allison said in today’s market, “everybody on the trading floor understands what everybody else is doing. They’ve seen all the different ways things can blow up and they don’t want it to happen again.” Employees effectively monitor each other. “Within a company everything is out in the open; positions are knowable by everybody, and transactions are properly captured in the record to facilitate price reporting.”

FERC staff also reviewed its new auditing process for standards of conduct where it is looking first at 10 companies, eight electric and two gas, and discussed the elements they are looking for. The commission has doubled its audit staff in the past six months.

FERC plans a second round of company audits, and, depending on how the audits turn out, could do more. The key is having an active compliance officer, clear company guidelines and training and continued monitoring of the standards set out in Order 2004, including the rules for meetings between transmission employees and merchant employees, separation of facilities and access to operations.

As part of the compliance effort, the Commission has reviewed websites for 190 companies to determine if they meet all the posting requirements. In the first review only 31% met all the requirements. Now almost all do. In some cases, FERC found management had told their staff “don’t worry about it; FERC will never get to us,” Demtra Anas, managing counsel for Enforcement in OMOI, said. Obviously, they were wrong.

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