A long-awaited FERC staff report issued Wednesday concluded the wholesale natural gas and electricity markets in California and other western states were significantly manipulated during the critical 2000 and 2001 period. While many had hoped the report and other agency actions on western power refunds and long-term contracts Wednesday would bring some closure for the industry, it appeared the Commission’s investigation of suppliers’ activities was far from over.

FERC issued two show-cause orders against several Enron-affiliated companies, BP Energy and Reliant Energy Services, which are likely to result in more proceedings at the Commission, and additional show-cause hearings involving other energy companies are expected. Thirty-seven companies are suspect, FERC said. Moreover, the Commission plans to carry out a number of actions to implement the recommendations in the staff report.

Pressed about whether the show-cause orders would lead to more uncertainty in the market, Chairman Pat Wood said FERC’s action “significantly narrowed the funnel and that’s what this process has been about since it began.” He noted that FERC sent data requests to “over 200 people” when the agency began its probe of the western energy markets.

“We’re not opening wars on 12 other fronts,” agreed Commissioner Nora M. Brownell. “We are narrowing the scope of the information that we have. We can’t leap to the conclusion that just because we issued show cause orders…that we have automatically assumed guilt.”

The staff report concluded that “markets for natural gas and electricity in California are inextricably linked, and that dysfunctions in each fed off one another during the crisis.” It made 31 recommendations to the full Commission to clean up the industry and prevent another California from recurring in the future.

Wood said FERC would act on the recommendations “in a matter of days and weeks, not months.” Asked if the agency would prioritize the proposals, he said “they’re all important.”

Some of dysfunction of the gas markets was attributed to traders’ manipulation of gas price indexes. Wood also said California’s bad market rules and inadequate energy infrastructure created a “fertile environmental” for energy companies to “twist, turn and perhaps break the rules” in both the gas and power markets.

FERC shared some of the blame as well. Commenting on FERC’s performance during his 10 years on the Commission, Commissioner William Massey said they never should have approved the “severely flawed” California market design. In that case the Commission gave in to pressure from the state to allow the then-popular restructuring plan to go forward. Also, FERC should have intervened sooner and “come to grips with the crisis” when it became clear prices were going out of control.

Questioned by the commissioners, staff agreed that unworkable market rules and inadequacy of supply played a part in the California crisis, but “it is hard to put weight on what affected the market most.” Don Gelinas, primary author of the staff report, said wash trading was a factor. He also noted that one of the California border points, Topock, was an illiquid market with one trader, Reliant Energy, dominating.

“While some portion of these [high gas] price levels reflected legitimate scarcity,” the staff said “we cannot calculate the portion attributable to the scarcity alone.” As a result, staff recommended that FERC use a proxy gas price to compute power refunds for California customers rather than use actual delivered gas prices during that period.

Specifically, it proposed that FERC use producing-area prices plus transportation as the proxy for gas prices in computing the market-clearing prices for electricity in California during the nine-month refund period. Staff estimated this would reduce gas costs in the refund formula by $7.03 in Southern California and $4.18 in northern California, or about $5.60 on average (see separate report).

Many power generators “paid these distorted gas prices,” said staff, who urged that they be made “whole for the spot prices they paid…on a dollar-for-dollar basis.”

Brownell said she wanted to be sure as the individual investigations go forward that the Commission distinguishes between standard arbitrage strategies, which are appropriate for businesses, and illegal attempts to manipulate the market. She noted there appeared to be a relationship between underscheduling in the power market by the California utilities and Enron’s “Fat Boy” strategy of overscheduling. In some cases the strategies may have helped, rather than harmed the market. “Anomaly” doesn’t equal “prohibition,” she said. Going forward, the Commission will listen to comments as to what may or may not be tariff violations.

The “large-volume, rapid-fire trading” of a single company, Houston-based Reliant Energy, was to blame for the “substantially increased” gas prices at the California border during the western crisis period, staff said. “Reliant often bought and sold many times its needs in quick bursts, which significantly [boosted] the price of gas in that market” — an activity that staff called “churning.”

Through its “churning” activity, Reliant was able to “reduce the overall costs of the gas it actually needed,” while profiting by “selling gas at or near the top of the price climb it caused,” the report noted. The energy company was such a “large presence” at the Topock-California border point (between December 2000 and February 2001, it accounted for nearly 50% of the spot gas trades at Topock on EnronOnline) that its trading strategy “moved the entire market,” it said. The EnronOnline trading platform also appeared to have a significant impact on daily gas price indices at the border.

As a result of Reliant’s activities, FERC staff estimated that gas prices were about $8.54/MMBtu higher in December 2000 and about $1.69/MMBtu more over the nine-month period in which refunds are being sought for California power consumers. “These inflated gas prices significantly influenced index prices and the clearing prices paid by most California wholesale buyers for spot power.”

The staff report includes the findings from a year-long investigation by the agency into manipulation of short-term gas and electricity prices in California and other western energy markets. FERC began its probe in February 2002 at the urging of Capitol Hill lawmakers and California officials.

Ironically, Reliant’s existing blanket gas marketing certificate did not bar it from carrying out “churning.” As a future safeguard, staff recommended that the Commission expressly prohibit the gas trading activity in blanket certificates. “We also suggest a generic proceeding to develop appropriate reporting and monitoring requirements for sellers of gas under Commission certificates,” the report said.

It further noted that Enron profited by more than $3 million as a result of a manipulation strategy it used at Henry Hub, where it would drive the price of physical gas upward and then downward. “Although the price change in the physical markets was only about 10 cents/MMBtu, Enron profited due to the effect that this small change in the physical price had on its large financial position.” FERC on Wednesday issued an order for Enron-affiliated companies to show cause why their blanket gas marketing certificates should not be revoked (see related story).

Williams Energy Marketing and Trading was one of the few gas companies to get good news. Staff cleared the company, which is owned by Tulsa, OK-based Williams Cos., of allegations that it cornered the gas market in California in January 2001. Williams bought only a minor amount above what its actual needs were to fuel its power plants, making it hard to make the case that the company was buying and selling to manipulate the market.

Noting that traders’ reported manipulation of gas index prices was partly to blame for the higher prices, staff urged FERC to either order 11 companies to correct their internal processes for reporting trading data to energy newsletters or bar them from selling gas at wholesale. The companies include Dynegy, Aquila, AEP, El Paso Merchant Energy, Williams, Reliant, Duke Energy, Mirant, Coral, CMS Energy and Sempra Energy Trading.

The energy companies must show:

While energy traders believe energy newsletters that publish gas price indexes are able to ferret out fake trading information, staff said it “was unable to confirm that the periodicals could discern fictional trades and eliminate them from the index calculation.” As a result, staff recommended the Commission make a number of changes to the price reporting process, including:

In the wholesale electricity market, “we identify various [companies] that appear to have participated in some Enron price manipulation strategies; entered into profit-sharing arrangements with Enron, which masked Enron’s real-market share; engaged in economic withholding; and raised clearing prices through inflated bidding,” staff said. “We also find evidence of price manipulation of the electric price index at Palo Verde and evidence that the spot power prices in the Pacific Northwest were inflated.”

FERC should order AES/Williams, Dynegy/NRG, Mirant, Reliant, Bonneville Power Administration (BPA), the Los Angeles Department of Water and Power (LADWP), Idaho Power, Powerex Corp. and Enron to show why their prices between May and October 2002 were not the result of economic withholding and inflated bidding — a violation of the anti-gaming provisions of CAISO’s and Cal-PX’s tariff, staff said, adding this would require the companies to return their profits.

It further reported that 37 energy companies, which were cited in a January 2003 CAISO report, violated the anti-gaming and “anomalous market behavior” provisions of the CAISO and Cal-PX tariffs. It urged the Commission to order certain companies to show cause why they should not be required to return revenues for that period or have their market-based rate authority yanked. “This disgorgement would be in addition to the California refund proceeding.”

Some of the companies that were identified in the CAISO report included Sempra/San Diego Gas and Electric, Morgan Stanley Capital Group, Coral Power, Powerex, Enron Power Marketing Inc., Enron Energy Services Inc., Avista Energy Inc., Pacific Gas and Electric, American Electric Power Services Corp., Duke Energy Trading and Marketing, Mirant, Calpine Corp.,Williams Energy Services Corp., and PacifiCorp.

Citing “excessive” power prices in the Pacific Northwest, staff proposed that its findings be remanded to the administrative law judge in that proceeding [EL01-10].

Staff further noted that wash trades were common on EnronOnline (EOL), and “created a false sense of liquidity, which can distort prices.” It called on the Commission to establish regulations that would ban prearranged “wash” trades and the reporting of affiliate trades to published price indexes.

EOL’s trading platform offered no transparency to the energy market, staff noted, but it did provide the Houston company with a “huge information advantage” and large profits. “Enron used the information advantage acquired from its central position in physical markets to earn large speculative profits in financial products — more than $500 million in 2000 and 2001.”

The Commission should require energy sellers with market-based rates and blanket gas certificates to use only those electric platforms with “certain transparency and monitoring attributes,” staff said. Specifically, it recommended that the platforms use “various monitoring tools, such as a churn alarm, to detect a large amount of buying and selling in a short time frame.”

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