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Energy Regulators Battle The Post-Enron Syndrome

Politics / Market Regulation Aug 04, 2013 - 06:59 PM GMT

By: Andrew_McKillop


The EU probe into potential rigging of oil prices in Europe and outside Europe, launched in early July is comparable by its scope, possible impact and potential fines levied against wrongdoers, to the precedent set by the Libor rigging scandal. European regulators' scrutiny of Libor (the London interbank offered rate) interest rate benchmarks finally led, in 2011, to the Royal Bank of Scotland Group (RBS), UBS, and Barclays being fined a total of about $2.5 billion.

On July 17, the US Federal Energy Regulatory Commission (FERC) upheld fines of $453 million imposed on Barclays and four of its power traders, for manipulation electricity markets in California and three other States. On July 30,  the FERC approved an agreement with JPMorgan Chase's energy trading subsidiary (JPMVEC) under which it will pay a civil penalty of $285 million to the US Treasury and 'disgorge' $125 million in unjust profits, for electricity market manipulation in California and the Midwest.

To be sure, cynics remarked after these record fines – which for the FERC and other regulators like the Commodity Futures Trading Commission (CFTC), and financial sector watchdog Securities and Exchange Commission (SEC) are victories -  were “only a fraction” of the probable illicit profits the scams generated.

Europe's oil price-fixing probe notably focuses Platts, a division of New York-based McGraw Hill Financial which publishes the Dated Brent benchmark. This benchmark helps set pricing for more than half the world’s traded oil, covering transactions that total at least $600 billion-a-year. With derived and related petroleum products and financial instruments, total turnover value concerned can exceed $3.5 trillion-a-year. As of present European regulators, who have already been joined by US regulators in this probe with worldwide scope, have not said the period of time that price-fixing may have operated.

Both in Europe and the US, price-rigging and market-fixing in the energy and commodities sector was enabled by successive waves of de-regulation and liberalisation. In the case of the US, Federal and State governments permitted Wall Street firms to expand into the energy industry more than a decade ago, when the collapse of Enron Corp. and its army of traders left a void in the market. It was believed at the time that “a new page had turned”, but the results are an uncomfortable proof that unregulated financial markets invite crime.

Lawmakers and regulators hoped that the Enron debacles would not occur a second time. Lawyers close to the US FERC say that banks were at first seen as sources of capital investment, for example in power infrastructures such as grid links, as well as providers of market liquidity. This benign viewpoint has given way to a better appreciation of the post-2000 operating culture and morality of banks and brokers, symbolized by the terms “banksters and crony capitalism”. Particularly in the power sector, regulators soon found there was a culture clash of “crony bankers” with the power companies. These have a tradition of regulatory oversight and public service, and a risk-averse culture. When the two cultures clash, and the banksters win, the clearest result on the ground is high and volatile energy prices, and in extreme cases rolling blackouts and power cuts, in the US forever associated in the public mind with the Enron scandal.

In the JPMorgan case, the USA's largest bank settled FERC charges that employees engaged in 12 illicit power bidding schemes to wrest illicit profits of tens of millions of dollars on a regular basis from power-grid operators in at least four States for more than two years. In the proceedings, a trader working for one of JPMorgan's associate bankers, Barclays Plc, was accused by the FERC of “colorfully bragging” that he “totally fucked” a Southwestern energy market. Other associated traders, from Deutsche Bank, faced with losses on a power contract, allegedly went so far as to falsify the direction of electricity flows across several US States to make the contract profitable.

Both in Europe and the US, regulatory investigations are fueling a rising debate about allowing “rogue finance” to take the dominant role in operating commodity and energy markets, and setting prices on these markets. In the US,  Federal and State lawmakers and the Federal Reserve are revising their conclusions on more than a decade of post-Enron policy decisions which opened the door to Wall Street bankers and brokers, to build heavily-staffed divisions handling commodities and energy.

US Senators, who have already formally called for US participation in the European oil price-fixing probe have said, following the Barclays and JPMorgan cases, they may call bankers and the regulatory watchdogs to a September hearing which will focus the clear signs of abuse reported on an almost daily basis. The most critical abuses consist in these purely financial trading divisions being able to buy and sell physical commodities and energy, while also creating and betting on related financial instruments which for “performance” need rapid and large changes of prices for the linked physical asset.

The rapidity and low execution cost of setting up and operating the tradable instruments, which are collateral-free bets, also favours “rogue finance” abuse in physical commodity markets.

JPMorgan, which had expected fines and charges considerably above those finally won by the FERC,  announced last week that it was making a corporate strategic review, and considering ways to exit the physical commodities business, including energy trading. Its official spokespersons openly said the bank is happy to have the present market-rigging case behind it. Other often-cited major banks and brokers implicated in, or suspected of energy and commodity market manipulation,  especially Barclays and Goldman Sachs have however said they have no intention of retreating from these markets, Deutsche Bank has engaged a process of capital restructuring that may include a withdrawal from high risk / high-reward operations, typified by energy and commodity markets. UBS of Switzerland may also be considering a retreat from “aggressive”participation in these markets.

The FERC Chairman Jon Wellinghoff  has said that “It is up to Congress, and not FERC, to decide if banks should continue to be allowed to participate”, adding that he “welcomed anybody” who wants to play in those markets fairly, whether banks, traditional utility and energy companies, brokers or traders. The main problem is to ensure “they play by the rules.” For the banksters, this runs diametrically against their real operating strategy in energy and commodity markets. In US energy markets unlike Europe, the already-twelve-year history of high level market abuse, symbolized by the 2001 collapse of Enron, has left an enduring suspicion in the minds of the public. Enron, then the world’s biggest power trader, collapsed in a complex accounting and tax evasion fraud. Its market rigging actions led to repeated and rolling blackouts in California, and a final $1.5 billion settlement with State authorities. Several Enron directors pleaded guilty to criminal charges and were jailed in a series of trials stretching more than 6 years.

Due to the Enron scandal, the US FERC was given large additional enforcement powers, in 2005, including the power to set fines as high as $1 million-a-day. Despite these radically increased powers however, the FERC shares common weaknesses with other regulatory agencies concerned by the interaction of commodities trading and finance. These include the CFTC and SEC. All suffer from a still-critical understaffing of analysts and experts able to fully understand complex trading instruments, as exemplified in the very recent SEC case against the Goldman Sachs algorithm-based CDO expert Fabrice Tourre, involving fraud of at least $1 billion.

Enron’s fall left a hole in the market. Again unlike Europe with its tradition of national-based power markets with little interconnection, US power companies need stable and dependable power brokers for their often multi-State power exchange transactions. Banks which at the time often had strong balance sheets, high credit ratings and a good public image saw an opportunity, aided by Congress already having loosened energy-market restrictions in the 1990s, preceding the Enron affair, and had canceled the ban on banks becoming involved in commercial energy businesses in 1999.

Helping explain the stance of UBS today, which may follow JPMorgan in a “strategic retreat” from energy and commodities trading, Switzerland’s largest lender had purchased Enron’s energy-trading business in 2002, before being forced to shrink the division when Enron finally collapsed. Also in 2002, Bank of America won the FERC’s approval to operate electricity market transactions. In total more than 50 finance sector firms,  including national and foreign banking groups, filed applications with the FERC by February 2003 to operate in US energy markets.

For the FERC in the early 2000's, the rapidly increasing role of banks in energy trading following Enron's collapse was welcomed because these financial institutions generally had significant financial assets to back their trades. Assuring market liquidity was assumed able to prevent or limit market abuse, through the creation of large and liquid markets, leading to “energy price transparency.” In fact the exact opposite is all too often the result.

 JPMorgan’s website credits a predecessor of the bank with helping bring about the advent of electricity by financing Thomas Edison’s research. On the ground in the real world of today, however, bankster involvement in energy trading, especially electricity, features the purchase or operation of outdated and inefficient plant. In 2008, JPMorgan inherited US energy holdings and sales arrangements including older power plants in Southern California and Michigan, through its acquisition of failed investment bank and broker Bear Stearns Companies, which like Lehman Bros had fallen victim to the 2007-2008 financial crisis.

JPMorgan therefore controlled older power plants that had marginal costs typically higher than the market prices of electricity. According to the FERC, it sought to exploit pricing rules, notably by offering below-market rates for some hours of energy production, then charging exorbitantly high rates for hours of the day during which state power bidders agreed to pay high unit prices for the plants to “ramp up” production. The bank was therefore financially advantaged by maintaining older and inefficient power plants under its control.

JPMorgan's power strategy, according to an October 2010 document held by the FERC was believed able to produce $1.5 billion to $2 billion in gains in the 8 years to end-2018. To ensure this, JPMorgan used bidding tactics similar to abuses that occurred in the Enron era, FERC Chairman Wellinghoff said.
As the FERC case against JPMorgan showed, Barclays and Deutsche Bank operated very similar abuse of their power-market influence to enable profitmaking from outdated and inefficient power production facilities.

In all three cases, the banks were prepared to make transactions in fixed-price electricity products -- at a loss – in order to move benchmark power prices, notably day-ahead prices, one way or the other, and to thus make profits on other related but purely financial bets on swaps. Their corporate interest in either providing electricity, or operating modern, efficient or low-emissions power plants was either zero or close to zero.

Barclays has to be sure vowed to fight the FERC order of July that it pay a total of more than $480 million in penalties and forfeited profits on illicit power trading operations in the US. Deutsche Bank agreed to pay the FERC $1.6 million in January 2013 without admitting or denying wrongdoing. The bank was accused of moving electricity prices to benefit its position on complex electricity-related financial instruments called “congestion revenue rights”.

While Enron employees sought to “simply” drive up electricity prices to squeeze more money out of power-starved power distributors, utilities, businesses and consumers, today's “bankster” strategy in power and energy market manipulation crosses sectoral demarcation lines much more easily. In 2004, the post-bankrupt, restructured Enron settled claims brought by the CFTC (Commodity Futures Trading Commission) that employees elevated natural gas prices in the spot market, creating artificially high  prices for natural gas futures contracts. After the electric power debacle that had caused its first corporate bankruptcy, Enron had downsized, restructured, and sought to gouge natural gas prices.

At the time, before the advent of the “fracking” boom natural gas was a prized commodity in the US. The ideal conditions for market rigging existed – the perception of shortage - offering easy pickings for banksters seeking to emulate Enron. Their strategy features far more “sophisticated” or complex financial instruments linked with the “underlying asset” - electricity or other commodities – and does not automatically require constant high prices for the “underlying asset”.

Comment on US and European regulators' investigations of energy market rigging and price fixing has inevitably included the conclusion that rogue finance operators have merely taken the Enron “model” and perfected it, by making it more complex and wider ranging. The US senate commission hearing testimony on the JPMorgan, Barclays and Deutsche Bank power market rigging exploit was told by several experts that Enron “was the pioneer in discovering a business model”, because more than 10 years ago it had bundled physical commodities trading with bets on financial derivatives. The role of physical shortage, exemplified by Enron's natural gas price rigging which was favoured by the perception of gas shortage, has been globally replaced by adding risk – price risk and supply risk.

The conclusion is simple. The bankster energy trading scam adds risk, rather than removing it.

So-called financialisation or commoditization of energy and commodities production and supply inevitably ignores “humdrum details” like operating efficiency, physical infrastructures, national energy policy goals, and the cost of energy delivered to final consumers – which in fine and in almost all cases are raised by financialisation, sometimes extremely. In the Enron trials lasting 6 years from 2001, employees were caught on audiotapes discussing trading tactics using code names like “Death Star” and “Fat Boy” to take advantage of “Jack and Jill Sixpack” consumers, also called “Grandma” .

Any strategy able to hike prices was par for the game, such as artificially congesting power grids so that Enron could gouge additional fees for relieving the crunch. Today's banksters prefer to trade complex financial products whose profitability rises as the “underlying asset's” price become more volatile – as well as higher!

The previous “radical” argument, becoming mainstream, is that the basic interests of banks and energy companies are fundamentally opposed. Financial “players” earn more from volatility and exploiting consumers' needs for stable supplies of lifeline commodities, including energy. Banksters therefore hunt gains through financial derivatives, where profits are theoretically unlimited, but which for high performance need volatile, constantly changing prices of the basic necessities, which for banksters are merely “underlying assets”.

The US Enron scandal was certainly a watershed event, in the same way as recent FERC victories against the banksters. As Harvey Pitt, the SEC chairman during Enron’s collapse said: “If traders view energy as just another commodity, then they will find themselves on the wrong side of the FERC.”

By Andrew McKillop


Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2013 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisor.

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