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US electricity markets are anti-consumer

Congress and government regulators need to step in

June 11, 2014 1:30AM ET

Accusations of market manipulation dog the electricity markets from coast to coast, raising questions about the integrity of these secretive entities and whether they can ensure sufficient generating capacity at all times.

Opportunities to drive electricity prices up through misconduct are rampant and sure to grow unless the current rules are reformed and veils of secrecy are pulled back.

The electricity markets, originally designed by Enron, are supposed to benefit consumers by attracting the necessary investment in power plants to meet the demand for juice at all times, especially during peak periods such as hot summer evenings.

Proponents say the current market solution is superior to vertically integrated utilities that generate, transmit and distribute power at prices set by government regulators. It is a remarkable claim, since in areas with electricity markets the reserves — capacity that sits unused or underused but can be called on during high demand — has shriveled.

The price signals that were supposed to spur investment in new capacity have failed to do so, prompting the creation of an added layer of markets called capacity auctions. In these auctions suppliers bid to collect payments just to have power plants standing by in case they are needed. But even the capacity markets have not produced the expected investment, as some of their strongest supporters subtly acknowledge.

In the end, the deregulated electricity markets have repeatedly enabled price gouging and other inefficiencies at the expense of the consumer. Many electricity market rules seem to be based more on hopes and wishes than on evidence of success and realistic appraisals of market dysfunctions.

The small fish problem

Evidence for the inefficiencies of electricity markets abound across the United States.

In Texas a small-fish-swim-free rule exempts small electricity suppliers from anti-manipulation rules on the theory that they lack the heft to move prices.

But a lawsuit filed in April by the trading firms Aspire Commodities and Raiden Commodities alleges that GDF Suez and six small suppliers it owns game the market by withholding power from some power plants to make prices spike, generating artificially high profits for itself and losses for Aspire, Raiden and similar firms.

Surprisingly, GDF Suez, which has said it did nothing wrong, is among those saying that Texas needs to reform its electricity market rules. The real issue here, however, is that what GDF does may be allowed under the rules — further evidence that the markets do not protect customers (or competing operators) from manipulation.

Darren Bush, a professor of antitrust law, has shown that even a small operator with multiple generating plants can exploit flaws in the grid to manipulate prices, raising questions about why this small-fish exemption was created.

In California and the Midwest, JPMorgan Chase last summer paid $285 million in civil penalties and returned $125 million of unjust profits to settle price-gouging accusations.

In New York City, Morgan Stanley paid $4.8 million two years ago to settle price-gouging charges, a penalty that U.S. District Judge William H. Pauley III approved even though he said it was too small to deter future market manipulations.

In PJM, the giant market covering all or parts of 11 states from the mid-Atlantic to Illinois, last month’s capacity auction saw prices double, as I reported last month. 

The Exelon strategy

Since then, UBS Securities and the newsletter RTO Insider, among others, have suggested that Chicago-based energy producer Exelon signaled others about its bidding strategy so skillfully that the ultimate auction price hit the small but very sweet spot that maximized profits.

When owners with fleets of power plants, such as Exelon, bid some of their plants at prices so high that they have no chance that their bids will be accepted, they can maximize profits by reducing their operating costs at plants bid out of the market, while at plants bid into the market they can charge sky-high prices. This mix of lowered costs and higher prices is great for investors but not customers. As RTO Insider put it, Exelon “won by losing.”

Electricity markets are not doing what advocates said they would: efficiently deploy capital to ensure the most efficient mix of power plants so that consumers get lower prices or at least the most efficient prices.

UBS energy analyst Julien Dumoulin-Smith noted that “only a relatively small portion of the fleet is required to be withheld for maximum” profit increases and that Exelon “has more than adequate market power to drive auction results through an aggressive bidding strategy.”

UBS said investors should expect “bidding strategies to drive upside in auction results is likely to only continue in future auctions” as the number of competing plant owners declines. 

Exelon selectively disclosed information — in my view violating principles of stock market disclosure that the Securities and Exchange Commission is supposed to police. Companies must disclose all information that any reasonable investor would need to decide whether to buy, sell, keep or avoid a stock or bond, not just details that encourage bidding up share prices. Exelon revealed that it lost out in bids for three of its plants, saying nothing about others that lost or how many filed winning bids.

That Exelon shares shot up right after the auction only adds to the reasons that the SEC should ask hard questions and send a strong signal to other electricity companies about selective and self-serving disclosure.

Single price auctions

Capacity markets were created in response to a shortcoming in the initial electricity auctions, which rely on a single price, or clearance price. Every owner who bids at or below the clearance price gets that price. So a generator station owner who was willing to sell power for $1 a unit can, in Texas, collect as much as $5,000 per unit and smaller maximum sums in other markets.

Single price markets encourage low bids — which mean modest profits — when the capacity to produce power exceeds demand, but when there is even a tiny shortfall in capacity, then bids soar, and so do profits.

Price spikes, even if they last for only for a few hours or days, are supposed to signal investors to build new generating capacity because profits will be abundant even if new capacity brings prices down a bit. Because it can take years to get a new power plant approved and built, however, the price signal has not been nearly strong enough to encourage investment in the full range of plants that are needed, especially new or replacement base load plants — the ones necessary to satisfy the continuous energy needs of a community. The price signals have been strong enough to encourage investment in small-output, low-cost natural gas turbines that can be installed quickly.

Excess supply creates incentives to shut down existing capacity to jack up prices, as is about to happen in the New England market. 

Paul Joskow, an electricity economist at MIT and a leading proponent of electricity markets, has written of these problems:

Policymakers observe growing electricity demand, shrinking reserve margins and rising prices but little evidence of investment in new generating capacity responding to balance supply and demand … These problems have been exacerbated in the U.S. by instability in the wholesale market designs and market rules.

He recommends even higher prices at peak periods so investors get a strong enough signal to invest in the mix of generating stations needed to supply demand at all times.

Kenneth Rose, a veteran utility economist, showed in 2011 that capacity markets have failed to produce the expected investment in new generating capacity. He concluded that under current rules, what the electricity markets do is drain money from customer pockets into those of existing power plant owners, causing economic damage because of the resulting inefficiency. 

All this means that these markets are not doing what advocates said they would: efficiently deploy capital to ensure the most efficient mix of power plants so that all consumers — individuals, commercial firms and industries — get lower prices or at least the most efficient prices.

Some critics describe the electricity markets as legalized cartels whose real purpose is to jack up prices. I think that goes too far, but no doubt the existing market rules are easily exploited and, as the Morgan Stanley case shows, the penalties for price gouging are too weak to deter misconduct.

A decade ago Margot Lutzenhiser, then a Public Power Council economist, published a detailed analysis in Public Utilities Fortnightly showing that the cost of operating the electricity markets equaled the best official estimates of what they saved consumers.

Unfortunately Lutzenhiser’s finding that the markets are pretenses that fail to produce net savings did not gain traction. Instead, the electricity markets, shrouded in secrecy that supposedly protects consumers, have expanded ever since.

It’s long past time for an outside review of these markets by Congress, state legislatures and the SEC, whose duty is to ensure that companies disclose all the relevant information a prudent investor reasonably needs to know, not selective information that can be used to both rig electric markets and pump up stock prices.

David Cay Johnston, an investigative reporter who won a Pulitzer Prize while at The New York Times, teaches business, tax and property law of the ancient world at the Syracuse University College of Law. He is the best-selling author of “Perfectly Legal,” “Free Lunch” and “The Fine Print” and the editor of the new anthology “Divided: The Perils of Our Growing Inequality.”

The views expressed in this article are the author's own and do not necessarily reflect Al Jazeera America's editorial policy.

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