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Energy Trading Review Wash Trades and Western Market Trading Practices

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Energy Trading Review Wash Trades and Western Market Trading Practices

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    1. Energy Trading Review Wash Trades and Western Market Trading Practices Pankaj Sahay, PhD Scott Greene, PhD Tim Schutt Contacts: Tim Schutt (314) 206-8612; tim.schutt@us.pwcglobal.com Pankaj Sahay (213) 236-3563; pankaj.sahay@us.pwcglobal.com Financial Risk Management

    2. Objectives Wash Trades Details of Wash Trades in energy markets Motivation behind these trades Investigation into these deals Legal implications Other trading tactics employed in California Fat Boy Load Shift Death Star Ricochet Get Shorty

    3. Timeline Summer 00-01 California declares electricity shortages on over two dozen occasions June 18, 2001 The FERC imposes a price cap in 10 Western states after prices rise ten-fold from year ago prices. Feb 13, 2002 The FERC orders a nationwide investigation into wholesale power and natural gas markets on whether manipulation by Enron or other energy traders caused soaring prices in the West a year ago. May 6, 2002 FERC releases Enron documents detailing trading strategies to drive up power prices in California. Companies volunteer information on round trip trades. May 8, 2002 SEC launches broad investigation of wash trades at selected companies May 8, 2002 FERC orders energy firms to say whether they employed Enron-like trading strategies in California market. May 21, 2002 FERC issues orders to about 150 energy marketers to “admit or deny” whether they used wash trades in West US as a part of ongoing investigation into California prices.

    4. What are “Wash Trades”?

    5. Possible Motivations Energy firms defend entering into wash trades for legitimate business reasons Verification of prices to use for “mark-to-market” valuation Companies may enter into these roundtrip transactions to establish visible forward price curves in illiquid markets. These curves are used for “mark-to-market” valuation. Rectification of incorrect transactions A reverse transaction may be entered to negate an erroneous transaction that has been entered in the system “Bragging rights” in industry surveys Operation size

    6. Possible Motivations Regulators and the stock markets view additional motivations for entering into wash trades Inflate trading volumes Increasing revenues can mislead investors about the company’s fiscal health. Large volumes demonstrated their ability to deliver on contracts. High volumes create a façade of liquidity in the energy markets. Market Power Wash trades can be used to move prices in a direction to distort true value. Price data from these trades may have been reported in industry publications. Market making for “mark-to-market” valuation Companies may enter into these roundtrip transactions to establish forward price curves favorable for “mark-to-market” valuation of long term contracts.

    7. Immediate Impact Wash trades have added to the current problems for the energy trading industry Loss of confidence in the investor community has led to depressed stock prices for companies engaged in energy marketing and trading. Companies in the industry have suffered deterioration in credit quality. Lower liquidity in energy markets Due to the downgrades in credit rating for most players in the industry, bilateral deals have been reported to be slow, especially in the far-forward market. Energy marketers have been downsizing their trading operations in a bid to restore investor confidence in their stock, shrinking the pool of players. The crisis has restricted industry’s access to capital further affecting business. Overall loss of confidence in the energy trading has forced energy traders to rethink their operations Trend towards smaller trading operations Asset sales Reorganization of top management at several energy firms.

    8. Immediate Impact Greater scrutiny from market participants Board-level and audit committees at companies have increased the level of scrutiny for transactions of their trading groups Controls review of risk management infrastructure Regulators are expected to increase examination of the energy trading firms. Regulators may deal severely with the companies engaged in these trades if they find evidence of market manipulation. FERC Chairman Pat Wood has expressed the opinion that some of these trades may be legitimate. SEC inquiry

    9. Investigations Federal Energy Regulatory Commission FERC is investigating wash trades in WSCC and Texas for electricity and natural gas activities to ascertain whether there was any price manipulation Energy Marketers: FERC requested following information from all energy marketers in WSCC for power and natural gas in a bid to understand the extent of use of these transactions and the impact on prices in energy markets: “Admit or Deny” use of wash trades Methods and rationale to arrive at value and compensation for these transactions. Whether the transaction was reported to organizations such as Platt’s, Bloomberg, that report prices or forward indices. Identity of traders entering into these transactions. Platform for executing each transaction, e.g. telephone, brokers, electronic media. Trading Data Reporting Agencies: FERC requested the following information from organizations that report trading data on energy markets: Description of process for gathering and posting price information, especially with respect to use of prices from Enron Online. History of posted prices for different locations.

    10. Response to FERC Investigations Energy firms have adopted a multi-step process to respond to the FERC query Define the universe of transactions to be examined Define the screening criteria for wash trades and filter the initial list of transactions that need further review Review the screened transactions to ascertain whether they were executed simultaneously and discuss with commercial staff for intent Provide the documentation to FERC along with underlying caveats and assumptions

    11. Investigations Securities and Exchange Commission SEC is investigating the financial accounting and earnings statement reporting Companies reported wash trades on the revenue and cost lines. Even though these entries did not have any impact on net earnings or cash flow, the revenue was inflated. Traders could have entered into these trades to create a visible price in a illiquid market for “marking-to-market” their long-term deals at a profit.

    12. Implications for the industry Impact of including wash transactions in market price surveys and therefore mark-to market values. Reporting revenues based on net trading margins rather than those based on gross trading dollars. Increased risk management and internal audit oversight.

    13. What happened? April 1998 – California market starts operations June 2000 – June 2001 dramatic price increases, rolling black outs, insolvency, the “California Energy Crisis” February 2002 FERC orders investigation to determine whether any entity manipulated short term prices for electricity or natural gas. March 2002 FERC issues information request to all jurisdictional and non-jurisdictional wholesale sellers in WSCC May 2002 Memos turned over to commission in response to data request. Memos outline trading practices. The memos Disclosed to FERC, SEC, Department of Justice, and California Attorney General. Waived all claims of attorney-client privilege Two versions – minor differences, third undated memo reviews previous Outlines two main principles Congestion relief and “inc-ing” Describes nine or ten practices in detail Summarizes ISO Tariff issues regarding “gaming” and “anomalous market behavior”

    14. What was “Fat Boy”? Background: Scheduling Coordinators are required to submit balanced schedules. When actual load in real time exceeds the scheduled load, generation deviations receive the clearing price. Tactic: By scheduling generation balanced to fictitious load in the forward markets, in real time that generation will appear as a deviation. Result: Generation outside California receives the imbalance market payments. (Note that internal generation can simply over generate in real time without need to forward schedule load.) Risk: Tactic only profitable if in the aggregate all SCs have under scheduled load and there is a real time shortage of generation. Trade must run counter to trend. Imbalance clearing price can be positive or negative. Potential use of this tactic identified by ISO prior to start of market. Tactic also known as “Inc-ing”. Mitigation strategy imposes explicit penalties for uninstructed deviations. This tactic was profitable when the market needed the generation due to systematic or erroneous forward scheduling of load, and thus this practice may have increased reliability and benefited the market.

    15. What was “Load Shift”? Background: FTRs are both scheduling and financial rights that permit holders to receive congestion payments and submit schedules using the paths connecting zones. A simplified hub and spoke arrangement represents the actual transmission network. Tactic: Load is over scheduled in one zone and under scheduled in another zone to create congestion in the forward market on a path in which the FTRs are held. Result: In the forward market, congestion revenue is received for the unused FTRs, in the imbalance market payments are received when the actual load and generation does not cause congestion and appears to relieve congestion. Risk: Shift may not congest the path. Gaming scenario identified by ISO during design of the FTR auction. Mitigation involves position limits on FTR holders and increased monitoring.

    16. What was “Death Star”? Background: The California grid is interconnected to the Western States, power flows through and around California. Transmission reservations do not reflect actual power flows. Tactic: Power is scheduled between two peripheral zones within California counter to prevailing congestion. An equivalent amount of power is scheduled outside of California between the same two zones only with source and sink reversed. Result: The schedule through California receives congestion revenue for relieving congestion but no actual power flows since the net power injected at each zone is zero. Risk: The congestion revenues may not compensate for the transaction costs. ISO still investigating. Stated concern is that schedules not backed by physical resources. Exploits seams between markets. Mitigation involves better inter-regional coordination.

    17. What was “Ricochet”?

    18. What was “Get Shorty”?

    19. Two main themes for the trading tactics Arbitrage day-ahead and imbalance market, or CA and West Takes advantage of systematic under-scheduling of load Takes advantage of “balanced” schedule requirement Examples : Fat Boy, Ricochet, Wheel-out Creating and then relieving Congestion, or exploiting defect in Congestion Management rules Takes advantage of physical scheduling characteristic of FTR Takes advantage of separation of grid management from market Dependent upon trade structuring, who gets paid the congestion price Examples : Death Star, Load Shift, Wheel-out Other schemes Ancillary Service Game: Get Shorty, Non-firm as firm

    20. More Tactics Wheel out: Power is scheduled on a downed inter-tie. Schedule still receives congestion payment if counter to congested direction even if path is unavailable. Export to avoid price caps: Power is bought inside California and sold outside California when external prices exceed California price caps. Congestion relief: (1)Non-firm power is scheduled in forward market to create counter flow and receive congestion payments. The schedule is cut prior to real time so no power is actually sent. (2) Power is scheduled counter to congestion, receives the congestion payment but is never physically delivered and assessed the increment ex-post price. However, the congestion rent exceeds the deviation payment. This is especially effective under the price cap. Non-firm as firm: Imports are scheduled as firm (A/S provided) but in fact are not firm. Results in payment for A/S that are not provided.

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