CORPORATE AFTERSHOCK 1 PHẦN 9 pot

Aspects of elec-tricity trading are subject to the overlapping jurisdiction of both the FERC and the Commodity Futures Trading Commission CFTC, with both agencies currently investigating

1 0 6

5

R EGUL AT ION OF

W HOLESA LE ELEC TR ICI T Y

TR A DING AF TER ENRON

ANDREA S KRAMER , PAUL J PANTANO JR., AND

DORON F EZICKSON

As explained in Chapters 1 and 4, Enron Corporation did not fail

because of its participation in wholesale and retail electricity

mar-kets But as Neves also noted in Chapter 4, electricity markets are

typically viewed as special because of the reliability issues that surround

the provision of wholesale power to public utilities and municipalities with an obligation to serve retail customers as well as to sell power rectly to retail customer through a hodgepodge of state restructuring, di-rect access, and f ixed retail price regulatory efforts Not surprisingly, with the disclosure of questionable wholesale electricity trading practices

by Enron, regulatory and legislative investigations and litigation have in-tensified, focusing on the propriety of wholesale electricity prices in Cal-ifornia and the western United States in 2000 and 2001

At this same time, the Federal Energy Regulatory Commission (FERC) and Congress are also considering reforms to the operation and oversight

of wholesale electricity markets While anticompetitive conduct must be investigated and penalized, we believe that the continued regulatory un-certainty caused by inconsistent legal standards governing wholesale trad-ing practices poses a substantial risk to the viability of the developtrad-ing wholesale and retail competitive electricity markets in the United States Regulatory reform efforts must have as a primary goal the clarification of Copyright © 2002 Andrea S Kramer, Paul J Pantano Jr., and Doron F Ezickson All rights reserved.

the legal standards by which wholesale electricity trading conduct will be judged While the recent FERC staff investigation report into Enron’s trading conduct suggests that the FERC is trying to establish clearer stan-dards, more definitive steps must be taken to restore regulatory certainty

to the competitive electricity markets

We also fear that the recent Committee on Governmental Affairs ma-jority staff memorandum criticizing FERC for its oversight of Enron may inappropriately pressure and immobilize FERC, slowing down common-place and routine filings and further damaging the competitive electric-ity markets.1

Clear trading rules are a critical component of an eff icient com-modity market Today, electricity market participants face a dizzying array of existing and proposed regulatory requirements Aspects of elec-tricity trading are subject to the overlapping jurisdiction of both the FERC and the Commodity Futures Trading Commission (CFTC), with both agencies currently investigating allegations of market manipulation

in the western markets Yet, the jurisdiction of each agency and the legal standards governing their reviews differ in material respects

Moreover, a multitude of pending lawsuits, alleging manipulation of the electricity markets, seek to apply state competition laws to the same conduct being investigated by the FERC and the CFTC In addition, FERC

is conducting refund proceedings that may result in the recalculation or unwinding of hundreds of thousands of spot electricity transactions While declaring its recognition of the sanctity of contracts, FERC has nev-ertheless allowed private parties to forward contracts to proceed to trial

on their attempt to renege on those long-term contracts on which they are alleged to have lost money.2 The FERC is also investigating wash trades, without the benefit of any market rules with respect to buy and sell transactions Finally, FERC is considering a number of reporting and fundamental design and operational changes to the wholesale electricity markets that will take years to implement This lack of regulatory au-thority and clarity makes it increasingly difficult for market participants

to prudently manage the regulatory and legal risks associated with whole-sale electricity trading

We focus on the federal regulation of the wholesale electricity trad-ing because the viability of wholesale tradtrad-ing drives the success of whole-sale and retail competitive markets We maintain that future regulatory reform must resist additional, burdensome regulatory requirements and must be focused instead on establishing clear and enforceable standards The lack of clarity is, in and of itself, harmful to competition because it deters market entry and raises transaction costs Future regulatory changes must, therefore, honor one of the fundamental principles of

competition: transparency and predictability of market rules Regulatory changes must not be driven by political pressure to find a scapegoat for Enron’s failure

To illustrate the complexity and inefficiency of the current regula-tory regime, we first describe the physical and derivative products used by those market participants engaged in active commodity markets Second,

we brief ly describe the current competitive wholesale power market in the United States Third, we set out the different jurisdictional mandates

of the FERC and the CFTC, with respect to trading electricity products Fourth, we examine the jurisdictional interplay between the FERC and CFTC, reviewing their pending investigations in the West Finally, we rec-ommend steps to begin to restore some regulatory certainty to the whole-sale electric markets

TH E P OW E R M A R K ET

Historically, the wholesale electricity market was not an active trading mar-ket.3Rather, electricity was generated for use by the customers of the reg-ulated utility that had generated the power If a utility had any excess generation capacity, it would typically sell its excess electricity to neigh-boring utilities Trading was hampered by limitations in the electricity transmission system Trading also was hampered and shaped by state reg-ulation of retail markets, including limitations on the use of wholesale for-ward contracts by public utilities to supply retail load, state commission prudence reviews of generation planning and purchasing decisions, re-quired purchasing from qualifying facilities (QFs) under Public Utility Reg-ulatory Policies Act of 1978 (PURPA) at the public utility’s marginal costs

as fixed by the state commissions, and the public utility’s traditional retail obligation to serve With the start of federal deregulation efforts in the wholesale electricity markets, however, the power markets have been de-veloping into active physical and derivative trading markets In the past six

or seven years, an entirely new business has developed for the purchase and sale of physical electricity and for entering into derivative contracts with values determined by reference to electricity prices.4

As Neves explains in more detail in Chapter 4, the physical power mar-ket primarily consists of spot and forward contract transactions Parties to forward contracts generally contemplate that the delivery of the underlying commodity will occur at a future date In practice, however, the majority

of electricity-forward contracts are settled by book-outs, an agreement be-tween forward contract parties to settle their respective obligations with a cash payment of the difference between the contract and reference (mar-ket) prices, as opposed to making and taking physical delivery A book-out may occur when two parties have agreed to deliver the same commodity to

each other or the participants form a string (many participants trading the same contract, allowing the first seller to deliver to the last buyer) or circle

(a transaction beginning and ending with the same participant) Any party

in a string or a circle can choose not to book-out the transaction and, in-stead, take delivery of the underlying commodity

The derivatives power market is presently an OTC market with finan-cially settled options, swaps, caps, and f loors entered into between the par-ties to the transactions Futures contracts on electricity (and options on those futures contracts) had traded on the New York Mercantile Exchange (N Y MEX) from March 29, 1996, until February 15, 2002 On February 15,

2002, however, N Y MEX delisted its electricity futures contracts and op-tions because of insufficient contract liquidity Low trading volume was at-tributed to limitations in the electricity transmission system Low volumes also were attributed to variations in state deregulation efforts.5For exam-ple, states throughout the country were in various stages of (1) “un-bundling” commodity costs from regulated transmission, distribution, and billing/metering services; (2) “stranded cost” recovery for generation and power purchase agreements rendered uneconomical through deregulation; (3) setting a viable “price to compare” for competitive retail market entry; and (4) establishing fair business and operations rules for retail power mar-keters This hodgepodge between state deregulatory efforts and the varying success of deregulation and competitive access within the states and spe-cific public utility distribution systems resulted in only a small percentage

of residential and commercial customers switching to competitive retail providers Retail power marketers were not able, and did not have the in-centive, to serve retail customers This reduced competitive opportunities and thus liquidity in both the wholesale and retail markets

In an effort to compete with electronic trading platforms, N Y MEX announced in May 2002 that it would offer clearing services for OTC en-ergy contracts beginning on May 31, 2002.6In October 2002, N Y MEX announced that it was planning to relaunch its PJM (Pennsylvania, New Jersey, and Maryland hub) electricity futures contract sometime in early

2003.7This relisted contract would have different terms and conditions than the previous PJM futures contracts that were delisted in 2002 Addi-tionally, the new contract would be traded on the NY MEX ACCESS® elec-tronic platform as well as through its open-outcry system.8

Cur rent Regulat or y Framework

Both the FERC and the CFTC have regulatory authority over certain as-pects of the electricity market, with jurisdiction depending on the elec-tricity product in question FERC has exclusive jurisdiction over physical sales of wholesale electricity, including spot and forward sales The CFTC,

on the other hand, has exclusive jurisdiction over futures contracts and commodity options Although the CFTC does not have regulatory juris-diction over physical sales of electricity, it has jurisjuris-diction to investigate and punish manipulation and attempted manipulation in the price of commodities, including physical transactions Thus, in practice, two dis-tinct federal agencies have jurisdiction that sometimes overlaps in regu-lating the wholesale electricity market.9

FERC Jur isdict ion ove r Physical Transact ions

The FERC, an agency under the Department of Energy,10 receives its ju-risdictional mandate under the Federal Power Act (FPA) over the inter-state “sale of electric energy at wholesale.”11 Wholesale electricity sales include spot and forward sales The FERC is charged with ensuring that rates charged for wholesale electricity are “just and reasonable.”12 The FPA also grants the FERC jurisdiction over the transmission of power, which includes both physical and f inancial transmission rights.13The FERC’s jurisdictional grant does not apply to financially settled (physical

or derivative) transactions of any kind

In addition, the 50 states and the District of Columbia are vested with jurisdiction over retail power sales to end users, whether provided by the regulated public utility distribution company or by a licensed or registered competitive retail service provider The state commissions also set public utility retail rates and returns on capital and equity, review the prudence

of public utility generation and wholesale power purchasing decisions, and,

in some cases, establish or approve integrated resource plans governing a public utility’s addition of new generation and wholesale purchase-power resources and demand-side management and retail load response pro-grams In some states, public utilities bid out to wholesale power suppliers the wholesale supply component of their retail standard offer, default, or basic generation service obligations to customers that remain on the reg-ulated supply and distribution utility service State regulation often af-fects the type of wholesale power and demand/load response products required by public utilities serving retail load

FERC’s jurisdictional mandate is confused further by inconsistent de-finitions of covered transactions Although the FERC has jurisdiction over wholesale spot transactions, it does not have a consistent definition of a spot transaction For instance, the FERC has stated that a spot transaction

is a sale for delivery in “24 hours or less and that [is] entered into the day

of or day prior to delivery,”14and that the spot electricity market is “a mar-ket where goods are traded for immediate delivery.”15Yet, in a FERC pro-ceeding in 2001, an administrative law judge found that “spot power transactions” included sales for up to one month in length.16Although this

definition is inconsistent with industry practice, the FERC has not indi-cated whether it will accept or modify this conclusion This inconsistency creates substantial uncertainty as to those transactions subject to FERC ju-risdiction

Market-Based Rates Wholesale sellers must obtain the FERC’s ap-proval to sell wholesale power at market-based rates (MBR) The FERC grants MBR authority if the wholesale seller (and its affiliates) lack mar-ket power with respect to the ownership or control of generation or trans-mission assets and the seller cannot otherwise erect barriers to market entry Once the FERC authorizes an applicant to sell power at MBRs, the seller’s rates are presumed to be “just and reasonable.” FERC’s regula-tion of MBRs seeks to ensure that wholesale sellers do not subsequently obtain “market power.” This is because, absent a change in circumstances (that is, a seller subsequently obtains market power), the seller is pre-sumed to be unable to manipulate prices

As a general rule, a wholesale seller has market power if a portion of its capacity must be used to meet pool peak demand and its capacity ex-ceeds the market’s supply margin The FERC has found that before such

a seller can sell power at MBRs, it must mitigate its market power by of-fering to sell, in the relevant market, its uncommitted capacity in spot market sales at cost-based rates.17

MBR Reporting Requirements Once the FERC approves a whole-sale seller’s MBR, the seller is subject to three reporting requirements First, it must advise the FERC about any material changes in its status Second, it must file quarterly and annual transaction reports The FERC has recently adopted new quarterly transaction reporting requirements, under which sellers must electronically file and post on the FERC’s Web site transaction information, including an index of customers, a sum-mary of contractual terms, and short- and long-term transaction details Third, the seller must file a triennial update to its initial market power analysis

Although it is the CFTC that regulates derivative transactions, the FERC proposed in December 2001 that wholesale sellers report informa-tion with respect to their financially settled derivatives transacinforma-tions to the FERC This proposed rulemaking would require wholesale sellers to fol-low the Uniform System of Accounts, which currently applies to utilities that sell power at cost-based rates.18

On May 31, 2002, the FERC rejected the claim by the California at-torney general that power marketers had failed to properly file their MBRs,

as required by the FPA, because the FERC did not require the power mar-keters to provide the details of the rates of their transactions before the

dates the rates were used.19The FERC rejected these claims, finding that the FPA does not dictate the rate-making methodology to be followed or the elements that must be included in a lawful tariff.20 The FERC deter-mined that its current filing procedures satisfy the “filed rate doctrine as required by the FPA.”21

Courts have also affirmed that the FERC’s reporting requirements for MBRs satisfy the provisions of the FPA This affirmation is based on the fact that the FERC requires such sellers to lack, or mitigate, market power before allowing such sellers to sell electricity at MBRs, and the FERC re-quires quarterly informational filings to ensure that marketers are not ex-ercising market power.22

FERC’s Enforcement of MBRs Under the FPA, MBRs must be “just and reasonable” to be lawful.23If FERC f inds that a market is not func-tioning properly—or that a wholesale seller has market power (even if only

in a niche market)—the FERC can take steps to ensure that rates are just and reasonable.24

If the FERC finds specific wholesale power transactions to be unjust and unreasonable, the FERC has various remedies available to it First, FERC can initiate an action on its own, or a private party can file a com-plaint with FERC, requesting the FERC to determine that the rates, charges,

or classifications are unjust and unreasonable and that a refund is appro-priate.25Second, FERC can alter the market structure, implement addi-tional reporting requirements (with respect to transaction-specific price data), impose price caps, institute mandatory sale requirements, or revoke

a seller’s right to sell power at MBRs On a going-forward basis, FERC can also require a seller to change its MBR tariff (including numeric, formula,

or capped rates).26

While FERC has exclusive jurisdiction over wholesale rates, the FPA does not provide guidelines as to how FERC should determine whether wholesale rates are just and reasonable In addition, the courts have found that FERC is not “bound to the use of any single formula or combination

of formulae in determining rates.”27As a result, there is “no precise legal formulation for setting a just and reasonable rate and no precise bright-line for when a rate becomes unjust and unreasonable.” With such a lack

of statutorily mandated guidelines, FERC has taken the position that “if over time rates do not behave as expected in a competitive market, [FERC] must step in to correct the situation.”28If FERC determines that rates are unjust and unreasonable, it will set rates that it considers to be

“just and reasonable,” issuing an order imposing those rates on the par-ties to any affected transactions Recently, in the context of its broad in-vestigation of Enron and the western power markets, the FERC staff stated

it intends to apply the CFTC’s market manipulation standard to ques-tioned transactions.29

Allegations of unjust and unreasonable prices have included claims of market manipulation and electricity shortages and criticisms of power trading practices In the past, the FERC has proposed a wide range of re-sponses The FERC proposed in August 2002 to condition a grant of MBR tariff authority on the requirement that the seller not exercise market power or act in an anticompetitive manner (including physical or eco-nomic withholding of capacity) and that the MBR transactions could be subject to refunds or “other” retroactive remedies.30The FERC staff also recommended in August 2002 conditioning market participation on an agreement not to misstate or omit information while trading.31 In addi-tion, the FERC issued a paper on March 1, 2002, discussing proposed rules

to govern withholding power from the market, evaluation of market price, appropriate penalties, due process concerns, and potential tariff modifi-cations.32In its investigation of western markets, the FERC is conducting refund proceedings concerning various spot and forward market transac-tions, and it is conducting a coordinated investigation of manipulation al-legations with the CFTC, Department of Justice (DOJ), and SEC.33In July

2002, the FERC released a 600 -page proposal on electricity market design that proposed a standard market design to apply across all wholesale elec-tricity markets.34

Private Litigation of MBRs In addition to the FERC’s ongoing reg-ulation of wholesale electricity rates, a number of private class action suits are pending in California These lawsuits allege that certain wholesale electricity sellers engaged in unfair business practices, price fixing, and withholding of electricity.35These lawsuits clearly challenge the FERC’s exclusive jurisdiction of wholesale electricity rates Any court decisions would result in de facto regulation of wholesale market activities In this regard, a long line of Supreme Court cases acknowledge the FERC’s ex-clusive jurisdiction and support preemption of private plaintiffs’ claims.36

Despite the FERC’s unquestionable jurisdictional mandate, however, the FERC has not currently asserted its jurisdiction before these courts or made efforts to have these cases dismissed

CF TC Jur isdict ion ove r Commodit y Transact ions

CFTC jurisdiction, established under the Commodity Exchange Act (CEA), is premised on a commodity’s involvement in the transaction or

activity at issue The CEA defines a commodity to include 24 specified

agri-cultural products, “all other goods and articles, except onions,”37and “all

services, rights, and interests” in which futures contracts are “presently or

in the future dealt in.”38The CFTC has exclusive jurisdiction over futures contract transactions in a commodity.39The CFTC also has exclusive ju-risdiction over option contracts on a commodity,40as well as options on futures contracts for a commodity.41Participants in these derivatives mar-kets are regulated by the CFTC

In what amounts to a jurisdictional power grab, the FERC recently amended its rules to require wholesale sellers to start reporting to the FERC their booked-out power transactions in addition to contracts that actually result in physical delivery of power.42Interestingly, in Order No 2001-A, the FERC clarif ied that wash trades are a subset of book-out transactions that must be reported quarterly by power marketers because

“collecting and disclosing these data will promote confidence in the integrity of markets and will be helpful for market monitoring purposes

to detect improper conduct.”43The CEA, however, expressly prohibits wash sales.44The FERC is considering whether, and to what extent, it should also require wholesale sellers to report their power derivatives transactions on an annual basis The FERC recently issued a notice of proposed rulemaking (NOPR) to require wholesale sellers to disclose power derivative transactions.45

Congress has generally exempted from CFTC regulation commercial merchandising transactions in physical commodities, whether delivery is

in the spot market or in the forward market for deferred delivery.46As to spot and forward transactions, the CFTC’s authority is generally limited

to enforcement actions for the manipulation of commodity prices.47

The CFTC views cash market or spot transactions as “transactions for

the immediate sale and delivery of a commodity.”48Industry practice sup-ports the view that the spot market is the immediate sale and delivery of

a spot commodity.49In general, cash market or spot transactions are lim-ited to transactions in which a commodity is delivered against payment on

or within two days of the trade date.50

Transactions Subject to CFTC Jurisdiction CFTC jurisdiction de-pends on the commodity transaction at issue being of a type subject to the CFTC’s jurisdiction For example, a futures contract for “sale of a com-modity for future delivery” is subject to the CFTC’s exclusive jurisdic-tion.51 A forward contract for the deferred sale of a commodity (“for delayed shipment or delivery”) is exempt from CFTC jurisdiction, except with respect to the CFTC’s authority over price manipulation or attempted manipulation

Under the CEA, the CFTC has exclusive jurisdiction over “accounts, agreements including any transaction that is of the character of or com-monly known as an option, and transactions involving contracts of sale of

a commodity for future delivery.”52Although the CEA does not explicitly

define future delivery, the CEA says that future delivery “does not include

any sale of any cash commodity for deferred shipment or delivery.”53As a result, spot power transactions (for immediate delivery) and forward power transactions (for deferred delivery) are not subject to the CFTC’s jurisdiction except with respect to allegations of price manipulation.54

Because of the implications of the CFTC’s precisely defined jurisdic-tion, with futures contracts subject to exclusive CFTC jurisdiction and forwards exempt except for allegations of manipulation, there has been considerable debate over how to draw the line between a futures contract and a forward contract The CEA does not explicitly define what consti-tutes either a futures or a forward contract As a result, the elements of these products have developed through judicial interpretations, CFTC in-terpretations, and CFTC policy statements.55

Before enactment of the Commodity Futures Modernization Act of

2000 (CFMA)56in December 2000, the distinction between futures and

for-wards was critical, not just because of the CFTC’s exclusive jurisdiction over

futures, but also because futures contracts were required to be traded on

an exchange that was designated by the CFTC as a “contract market.”57

With the CFMA, however, the distinction between futures contracts and forwards has become less important for energy products because the CFMA established several exclusions and exemptions from the CEA that are available to energy products.58Among other things, broad safe harbors now apply to transactions in so-called exempt commodities, which include electricity and natural gas, if certain requirements are met For electricity and natural gas transactions to qualify as exempt commodities, the con-tracts must be entered into between eligible contract participants (ECPs).59

In addition, for those entered into on a “trading facility,”60 both parties must qualify as eligible commercial entities (ECEs).61Transactions in ex-empt commodities continue to remain subject to the CFTC’s jurisdiction over manipulation and attempted manipulation.62

Book-Out Transactions As in some commodity markets, many electricity-forward contracts are “booked-out,” which means the contracts are financially settled between the parties without the actual delivery of power.63The CFTC has affirmed that the forward contract exclusion to CFTC jurisdiction is available to such forward contracts, provided that delivery “routinely” occurs.64Financial settlement does not change a for-ward contract into a futures contract if three requirements are met:

1 A forward contract is not viewed as a futures contract if the origi-nal forward contract is entered into between commercial partici-pants in connection with their businesses