Manipulation of California energy market gives consumers a jolt

The next time your electricity bill prompts you to curse your local utility, here’s another target where you should direct your anger: JPMorgan Chase & Co., which has manipulated the California energy market for its own profit and at a cost to residents and businesses in the state that could be $100 million, $200 million or much more.

That’s the accusation leveled by the California Independent System Operator, which has jurisdiction over 80% of the state’s electrical transmission. The ISO, a nonprofit corporation controlled by the state government, estimates that JPMorgan may have gamed the state’s power market for $57 million in improper payments over six months in 2010 and 2011.

But that could be just the tip of the iceberg: The bank continued its activities past that time frame, according to the ISO. It also says JPMorgan’s alleged manipulation could have helped throw the entire energy market out of whack, imposing what could be incalculable costs on ratepayers.

The Federal Energy Regulatory Commission, the regulator of the ISO and its trading markets, has started a formal investigation into Morgan’s allegedly manipulative energy deals in California and with the Midwest ISO, which covers 11 states from Michigan to Montana.

Forget JPMorgan’s well-publicized multibillion-dollar trading loss in derivatives; this trade turned a handsome profit, and it came directly out of electric customers’ hides. The toll may not have amounted to much for each of the 37 million men, women and children in California. But collectively it’s a massive, illegitimate tax on the entire state.

What’s worse, it shows that we haven’t learned anything from Enron’s bogus energy trading, the disclosure of which helped destroy that firm in 2001 and land several of its executives in jail. To the extent it was designed to exploit loopholes in energy trading rules, experts say, the scheme allegedly perpetrated by JPMorgan Ventures Energy Corp. is cut from the same cloth as Enron’s infamous “fat boy” swindle, which cost the state’s ratepayers an estimated $1.4 billion in 2000.

“There’s nothing really new under the sun,” says Robert McCullough, a Portland, Ore., energy expert who reviewed the ISO complaint at my request. “But it’s a cost you’re paying in your monthly bill.”

Asked for a response to the ISO’s allegations, a JPMorgan spokeswoman referred me to a court brief the bank filed last week stating that its trading involved no misconduct and pointing out that FERC hasn’t found any, to date. FERC says its inquiry is still at an early stage. But given the complexity of the energy market, this may be one of those cases in which the scandal lies not in what’s illegal, but in what’s legal.

One issue raised by this affair is whether government regulators have adequate tools to enforce trading rules. FERC’s investigation could take years, and its maximum penalty is $1 million per day of violation. If the agency hit JPMorgan for even six months of misbehavior, the $180-million bill would be a pittance compared with the $14 billion in revenue collected annually by JPMorgan’s investment banking arm, which houses the energy trading.

The incentive remains for outfits like JPMorgan to stretch the rules to the breaking point — if they get caught, the cost is tolerable; if not, the returns are fabulous. This raises again the age-old question: Can Wall Street be trusted? And it suggests an age-old answer: no.

“You set up these rules,” says Carl Wood, a former Public Utilities Commissioner who served during the California power crisis of 2000-01, “and you have all these very smart people figuring out how to game them.”

Indeed, there are signs that trading scams are rife: FERC in December accused Deutsche Bank of manipulating the California market and in March extracted a $245-million settlement from Baltimore-based Constellation Energy over charges it made manipulative trades in the New York market. (The Deutsche Bank determination is “preliminary” and subject to further investigation.)

These are trades that “don’t create jobs or economic value,” says Tyson Slocum, director of the energy program at the public advocacy organization Public Citizen.

Hints of JPMorgan’s behavior leaked out this month, when FERC went to court to demand unedited versions of emails it had subpoenaed from the bank. News reports generally treated FERC’s demand as little more than a PR embarrassment for Morgan.

But the email dispute is a sideshow. The center ring should belong to the underlying allegations of manipulation. These involve an energy trading unit the bank set up in 2005 as part of a plan to make money via short-term trading in a broad range of commodities with rapidly changing prices, including electricity. JPMorgan doesn’t actually own any plants providing power to California, but holds contracts with generators allowing it to offer their power in trading markets.

The California ISO hasn’t been very forthcoming with details of JPMorgan’s alleged misdeeds. Its public filings don’t even name the bank; it was FERC’s court brief that fingered JPMorgan.

The ISO’s language describing the scheme is impenetrable to a layman. Here’s a piece of its original filing with FERC, untranslated from the original gibberish:

“The use of a particular bidding practice, in conjunction with the application of the metered energy adjustment factor to the calculation of market revenues used to offset bid costs, resulted in overpayment of bid cost recovery amounts to specific resources.”

ISO refused our request to put that in plain English. With the assistance of McCullough and other experts, however, we’ve unwound what JPMorgan is actually accused of doing in the ISO and FERC filings. Be prepared: It’s no less ugly for being diabolically simple.

The alleged scheme involves two related wholesale electricity markets maintained by the ISO. There’s the day-ahead market, in which power plant owners place bids to provide power for the California electricity grid in the future; and the real-time market, an auction market through which ISO buys electricity for immediate distribution to homes and businesses.

To give plant owners an incentive to participate in these auctions, ISO guarantees to cover their costs for starting up or running their plants at a minimal level, even if their bids aren’t accepted. This is known as “bid cost recovery.” ISO rules allow bidders to claim payments of up to twice their real costs.

In simplest terms, JPMorgan submitted bids in the day-ahead market that were so low the firm was certain to be accepted onto ISO’s roster of potential electricity suppliers — in fact, they were negative bids, essentially offering to pay ISO to take their electricity. The bidding is overseen by software, not human beings, and the automated program isn’t smart enough to distinguish a real bid from a potentially fake one. (Implausible as it may seem, there can be legitimate reasons for a power generator to submit a negative bid, but they don’t apply to JPMorgan.) ISO believes that JPMorgan never intended to make that sale, but the beauty of its low bids was that they made it eligible to collect bid cost recovery payments.

The next step was for JPMorgan to make sure that ISO didn’t actually buy its electricity, presumably because the profit margin from the bid cost recovery claim was greater than from actually selling energy. So in the real-time market, it priced its electricity so high that ISO wouldn’t buy it.

The bottom line, the ISO says, is that JPMorgan’s traders never intended to sell it electricity via these bids. The scheme, it says, seems to have been designed purely to capture a bid cost recovery payment the bank didn’t deserve, at a rate that was inflated anyway.

ISO says it first noticed that its auction was being gamed this way in August 2010, when bid cost recovery claims started creeping above the historical range of $3 million to $7 million a month. By February, the monthly bill hit $24 million. More than half the sum, it turned out, was draining out through the bidding loophole.

So in March last year, ISO put through an emergency request to FERC for permission to stamp out the practice by immediately revising its bidding rules. The request was granted, and the problem disappeared … for 10 days.

Then, the ISO found, the same perpetrators discovered another loophole and started squeezing that until it screamed for mercy. As a result, the ISO says, it incurred unnecessary costs of $5.3 million over a period of just five days in April 2011. The new scheme prompted the ISO to ask FERC for a second emergency rule change, also granted.

Through a spokeswoman, Jennifer R. Zuccarelli, JPMorgan disputes that its bids were designed to avoid selling electricity. Its energy trading operation “always stood ready, able and willing to fulfill the bids we made,” she says. The firm observes that bids submitted to the ISO are secret to everyone but the ISO, and therefore its traders have “no way of knowing” whether the ISO will accept or reject its bids. In other words, for all the traders know, they’ll have to deliver power.

Other experts, however, say it’s not so difficult to place a bid you know won’t be accepted. McCullough suggests that the questionable bidding may have been focused on times of year and times of day when electricity demand, and therefore the risk of having to fill a bid, is low.

He also says that the secret bidding is part of the problem. If power generators’ bids were public, they would be subject to more disinfecting sunlight, and any attempt at a swindle might be uncovered much faster.

What the JPMorgan accusations really underscore is that a free market in California electricity, the basis of FERC’s regulatory policies, doesn’t exist. It’s a market vulnerable to anyone who can uncover a loophole in the rules — and it’s so complex that there are almost certain to be more loopholes than electrons in the power grid.

FERC says it has the legal authority to return the state’s wholesale market to a utility model, in which generators would get paid only for their true cost of generation, plus a reasonable financial return. It also has the authority to place trading restrictions on JPMorgan or any other market participant it finds guilty of manipulation, as it did against Enron (though only after that company was already bankrupt). The agency hasn’t indicated whether it might take either step in this case.

What should scare the regulators — and ratepayers — is that there may be many more scams out there, all driving up costs to California consumers. According to ISO documents, JPMorgan’s scheme got discovered only because the firm was collecting so much in excessive payments that it became hard to miss.

“JPMorgan got greedy,” Slocum says. If their take was “25 cents on the dollar, instead of 200%, they never would have been caught.”

Michael Hiltzik’s column appears Sundays and Wednesdays. Reach him at [email protected], read past columns at latimes.com/hiltzik, check out facebook.com/hiltzik and follow @latimeshiltzik on Twitter.