FERC Filings
Comments of EPSA, Colorado Independent Energy Association, Independent Energy Producers of California, IPPNY and WPTF re: Public Utility Market-Based Rate Authorizations
Market Behavioral Rules Must Provide Certainty Without Eliminating Innovation and Risk Management
1. Introduction and Overview
Competitive Suppliers concur with the Commission’s goal of clearly defining acceptable and unacceptable behavior so the market-based sellers, and their employees, are on notice as to what behavior is unacceptable. Such notice is imperative, as there are appropriate arbitrage activities that occur in competitive markets that are allowable and justifiable, as pointed out in a recent FERC show cause order issued to the California market participants.
Competitive Suppliers appreciate, however, that it may be difficult to write a definitive description of unacceptable market behavior without unnecessarily constraining innovation, risk management and market development. Markets are dynamic, and therefore it is inevitable that new and creative ideas, as well as responses to ever-changing market conditions, will arise that have not yet been considered. However, to avoid an open-ended game of “gotcha,” wherein market participants are at constant risk that seemingly appropriate behaviors will, particularly in a politicized context, be found after-the-fact to be unacceptable, certain language in the Commission’s proposed Market Behavior Rules must be modified or clarified.
To assist in that process, Competitive Suppliers have attached a red-lined and clean versions of the Commission’s proposed Market Behavior Rules, suggesting specific word changes and setting forth the basis for Competitive suppliers proposals. In many cases, however, Competitive Suppliers’ suggestions are more generic and address more than one proposed Market Behavioral Rule. For that reason, Competitive Suppliers’ comments below address certain aspects of the proposed Rules.
2. Behavior rules must include an intent requirement
The Federal Power Act requires that wholesale rates be just and reasonable. To that end, the Commission has the authority to approve market-based rates in the first instance and to act under Section 206 to modify its approval of market-based rates. The proposed behavior rules focus on ensuring that market participants do not “lie, cheat or steal,” or, stated another way, do not engage in misconduct under their market based rate authorizations. Other regulated commodities, such as securities transactions and commodity future trading, have rules similar to the proposed Market Behavior Rules. Many decades of litigation spawned by those laws and regulations have clearly established that intent is an express element of many security and commodity laws, regulations and rules. This body of case law has helped to clarify the circumstances and behaviors that would be legally sufficient to find a violation of various aspects of the Securities Exchange Act and the Commodities Exchange Act.
For example, for manipulation to be established under the Commodities Exchange Act, it must first be specifically proven that the defendant intended to improperly manipulate price. In addition, each of the following elements must also be proven: (1) the defendant possessed the ability to influence prices; (2) an artificial price existed; and (3) the defendant caused the artificial price. Frey v. Commodity Futures Trading Commission, 931 F.2d 1171, at 1177-78 (7th Cir. 1991); In re Soybean Futures Litigation, 892 F. Supp. 1045; In re Cox, [1986-87 Transfer Binder] Comm.Fut.L.Rep. (CCH) 23,786 at 34,063 (July 15, 1987).
With regard to the intent element, the CFTC has ruled that “specific intent” must be proved to sustain a charge of manipulation. In re Indiana Farm Bureau Cooperative Association, Inc., 1982 WL 30249 (CFTC December 17, 1982). Thus, “it must be proven that the accused acted (or failed to act) with the purpose or conscious object of causing or effecting a price or price trend in the market that did not reflect the legitimate forces of supply and demand influencing prices in the particular market at the time of the alleged manipulative activity.” Id. at *6. In order to establish intent, “there must be a purpose to create prices not responsive to the forces of supply and demand; the conduct must be ‘calculated to produce a price distortion.’” Id. at *7 (citation omitted).
Similarly, Rule 10-b of the regulations of the Securities and Exchange Commission requires a finding of intent to violate this section. For example, churning, i.e. entering into transactions and managing a client’s account for the purpose of generating commissions and in disregard of the client’s interests, is classified as a “device, scheme or artifice to defraud” under the regulation. Yet, longstanding case law has made clear that churning not only requires an intent to defraud, but also a willful and reckless disregard for the investor’s interests. Miley v Oppenheimer & Co., 637 F.2d 318 (5th Cir. 1981)
Some litigation testing and challenging the Commission’s rules is inevitable; however, building on well-established case-law and providing clarity that intent is a required element of the Commission’s rules should help provide greater certainty and circumvent unnecessary litigation. While it is clear the years of litigation over the Commission’s proposals are likely to produce a similar result, that process will be expensive, time consuming and, while it unfolds and until the rules are defined as specifically as possible, will contribute to greater uncertainty in the wholesale markets.
Moreover, adoption of an intent standard would be consistent with the statutory scheme under the Federal Power Act. The Commission’s responsibility under the FPA is to ensure just and reasonable rates. Under that responsibility, the Commission can approve market-based rates of individual sellers and the rules of the individual power markets in the first instance under Section 205, and can change those individual market-based rates and rules under Section 206. Market participants, however, are entitled to the protections that Congress afforded under Section 206. Those protections include a prohibition on ordering refunds prior to a statutory required refund effective date.
In this proceeding, the Commission is proposing to condition market-based rate authority so that it could order retroactive refunds upon a finding that a market participant violated a particular condition. To the extent that these rules become effective, the Commission must punish only intentional misconduct. Fundamental fairness and the protections in the Federal Power Act dictate that the Commission should not punish behavior that is consistent with the operation of the market rules approved by the Commission.
Market participants should not be put in the position of having to predict the Commission’s response to their participation in markets under rules approved by the Commission, and specifically (a) whether their conduct was consistent with the operation of a competitive market, or (b) whether competitive forces in conjunction with their conduct in approved RTO/ISO markets produced just and reasonable rates “consistent with legitimate forces of supply and demand.” This is particularly the case when the Commission has promulgated so few rules on the subject. If the Commission believes that a market rule is not contributing to just and reasonable rates, or that a market seller is not charging just and reasonable rates, then it is incumbent upon the Commission to change the market rule or the authorization of the individual seller on a going-forward basis consistent with the protection Congress afforded under Section 206. The Commission cannot use these proposed rules to achieve, on a retroactive basis, a just and reasonable rate no matter how laudable such a goal. For that reason, the Commission should only act under these rules on the basis of intentional misconduct.
3. Applicability of behavior rules to organized and bilateral markets must be clarified
There are three aspects of the applicability of the proposed rules that Competitive Suppliers believe the Commission must clarify. First, to the extent that these rules are intended to reinforce existing rules in RTO and ISO markets, the Commission needs to clarify the interplay between those rules and these proposed rules. Second, the impact of regional differences must be considered when Commission-approved RTOs/ISOs develop behavior rules specific to their region. Third, the applicability of these rules to bilateral transactions needs to be clarified.
On the first issue, the proposed Market Behavior Rule #1 appears to require sellers to comply with the rules of the applicable power market. First, the Commission should clarify that these are the Commission-approved rules of independent RTOs and ISOs. Moreover, when various market rules were approved, the full impact of those rules, and the risks associated with potentially losing market-based rate authority for failure to comply with those rules, were not fully appreciated by any parties. For example, presumably, current market rules preclude the RTOs and ISOs from requiring sellers to act in ways that put public health and safety, or their generating facilities, at risk. If not, then in some cases existing RTO and ISO market rules may need to be refined or modified, and the Commission needs to be sensitive to that fact.
However, in some instances, the proposed Market Behavior Rules suggest that they may preclude behavior that is acceptable under the rules of certain power markets. For example, the actions prohibited under Market Behavior Rule #2 (B) and (C) would appear to preclude practices, such as virtual bidding, which are expressly permitted under Commission-approved tariffs in certain organized RTO/ISO markets. While the Commission addresses this issue in footnote 18, the priority for specific Commission-approved RTO/ISO rules over the more general Market Behavior Rules should be clearly spelled out in the rules themselves.
Additionally, the Commission should consider the impact of profound regional differences in behavior rules on both market certainty and seamless markets. While regional differences may be appropriate on various discrete matters, many of the proposed Market Behavior Rules address generic issues and should be the same for each market in the country. If market participants, particularly those engaged in multiple markets, need to understand and comply with behavior rules that vary from region to region, the risk of inadvertent mistakes increases and the time needed to provide regulatory certainty, as rules are tested through various regulatory proceedings, increases as well.
The third issue implicated here is the intended impact of these Market Behavior Rules on bilateral markets. The Commission has established an appropriate high bar for disturbing existing contracts. It is unclear whether the application of these rules to bilateral contracts entered into between sophisticated commercial counterparties will set a new standard whereby unhappy buyers can seek to set aside contracts under different standards than those contained in their contracts. The Commission has taken significant steps recently to reaffirm the sanctity of FERC-jurisdictional contracts. In many instances, these proposed behavior rules simply are not applicable to transactions outside organized markets. Thus, the Commission should clarify that these rules will not be a basis for modifying rates otherwise agreed to under bilateral contracts and that many of these rules are simply not applicable to bilateral transactions.
4. The concept of prices resulting from “legitimate forces of supply and demand” is currently controversial in the electric industry
In several instances, the proposed Market Behavior Rules suggest that violations occur when prices vary from what would be expected from “legitimate forces of supply and demand.” While Competitive Suppliers have been a strong supporter of the development of competitive wholesale markets and the customer benefits associated with competitive markets, in every organized market today pervasive mitigation interferes with price formation that might otherwise occur if the forces of supply and demand could freely interact. Without using this proceeding to reargue the pros and cons of market intervention, it is fair to say that there is very little consensus as to what price might result from the unfettered interplay of the legitimate forces of supply and demand. This issue may have greater clarity in the securities and commodities markets, given the years of litigation in those fields. In electricity markets today, however, how to value scarcity, how supply and demand interact to set prices, when to allow reserves and/or demand response to set the market clearing price, what the proper components of marginal cost are, and when mitigation is appropriate are all the subject of great dispute and disagreement.
Even in today’s organized markets, there is a wide range of approaches to mitigation, ranging from rate caps, to automated mitigation procedures, to RMR-contracts, to marginal cost plus ten percent. The Commission has recognized this fact and indicated that a staff review of various mitigation approaches from region to region is appropriate. In fact, in her concurring statement accompanying the issues of this Order, Commissioner Brownell noted:
I appreciate the need to balance these goals but have a fundamental concern that we have allowed markets to form without a full appreciation of what constitutes a market, let alone the market dynamics that foster a truly competitive market. For example, what defines a competitive market and what constitutes scarcity price? These questions remain largely unanswered.
Without a clearer consensus on the proper approach to price formation, the proposed language will result in a great deal of controversy and expensive litigation to address issues that will be better resolved in other forums.
In addition, any after-the-fact analysis of real-time conditions is, as the Commission has learned from California, extraordinarily difficult. Any attempt to reconstruct the legitimate business expectations of a wide range of market participants in a complex market in which the interaction of the parties affects the outcome is virtually impossible. Doing so when some of those parties are disappointed by the outcome is fraught with political danger.