FERC decision provides guidance to market participants about the enforcement staff's thought process regarding market manipulation.
On September 29, 2008, the Federal Energy Regulatory Commission (FERC) rejected a complaint by DC Energy, LLC, alleging that Hydro Quebec Energy Services (U.S.), Inc., exercised market power to unlawfully affect congestion and energy pricing in the New York Independent System Operator, Inc., (NYISO) energy and Transmission Congestion Credit (TCC) markets. Importantly, it seems that this order is not only a resolution of a specific complaint, but also is intended by FERC to provide guidance to market participants about the FERC enforcement staff's thought process regarding market manipulation.
FERC's decision followed an investigation by FERC's Office of Enforcement into HQ Energy's market practices. The Office of Enforcement determined that HQ Energy did not employ a scheme or artifice to defraud with the requisite scienter, but instead had a legitimate business purpose for conducting its activities in the NYISO markets as it did. The Enforcement Staff Report describing FERC's findings is appended to FERC's order.
In its complaint, DC Energy contended that HQ Energy engaged in a "highly complicated" four-part fraudulent manipulation scheme. First, it asserted that HQ Energy offered energy for sale in NYISO in a manner that minimized congestion at the "HQ Proxy Node," a pricing point for electric energy in the NYISO market. Second, DC Energy claimed that HQ Energy purchased large volumes of TCCs, the prices of which were low because HQ Energy's energy offers had allegedly reduced congestion. TCCs are financial hedging instruments that allow their holder to receive, or obligate their holder to pay, the difference in price between two pricing nodes caused by congestion. Third, DC Energy contended that HQ Energy, after purchasing the TCCs, increased congestion by offering energy into the NYISO energy markets as a "price taker," or at an "opportunity cost" loss. Fourth, DC Energy claimed HQ Energy would recover (or over-recover) the losses incurred in step three through the collection of TCC payments made by DC Energy and others. DC Energy also claimed that HQ Energy engaged in "predatory pricing" by purchasing large amounts of energy off-peak to deliver to Canada from NYISO at prices far higher than the prices at which it sold energy on-peak into NYISO's market during the same time period.
DC Energy argued that HQ Energy's bidding strategy resulted in a "wealth transfer" from suppliers that purchased and resold the energy into the NYISO market to HQ Energy via HQ Energy's TCC position. In so doing, DC Energy believed that HQ Energy defrauded competitors of a fair market price and extracted disproportionately high payments through artificially inflated congestion.
HQ Energy countered that it began buying TCCs in 2006 to hedge against the risk of increased congestion resulting from a rise in the number of imports into New York during the time of the complaint. Having put these hedges in place through the acquisition of TCCs, HQ Energy also modified its bidding strategy to better reflect its hedged position.
In its investigation of HQ Energy, FERC considered several factors, including: (1) whether the actions taken by HQ Energy were explicitly contemplated by FERC; (2) whether HQ Energy's actions served a legitimate business purpose or were economically rational; (3) whether HQ Energy's NYISO energy and TCC market transactions were fraudulent or deceitful; and (4) whether HQ Energy intended to manipulate, or with reckless disregard manipulated, the NYISO energy and TCC markets. FERC determined that the facts supported the legitimacy of HQ Energy's change in business strategy. FERC found that HQ Energy had valid "reasons for using TCCs to hedge against the risk (and cost) of congestion resulting from HQ Energy's increased sales of hydro-generated power into NYISO."
FERC also determined that the claim that HQ Energy engaged in "predatory pricing" by selling power below its "opportunity cost" to increase congestion and thereby maximize the return on its TCCs did not stand scrutiny. FERC found no evidence that HQ Energy was selling its energy below cost. Instead, FERC determined HQ Energy was offering energy at its marginal cost, which can be low for a hydroelectric facility in comparison to the marginal costs of gas or coal facilities. In addition, even if HQ Energy had been selling at below cost, FERC determined that the structure of NYISO's markets and the fact that HQ Energy lacked market power would have made it difficult for HQ Energy to engage in a predatory pricing scheme.
FERC cited two primary reasons that HQ Energy prevailed on the market power claim. First, HQ Energy lacked market power because its actions did not substantially affect the prices New York consumers paid for their energy. Instead, these consumers paid rates determined by the marginal cost of supply in New York. Even as a price taker, HQ Energy would only lessen New York consumer prices since the energy it offered replaced more expensive energy produced within the state. Moreover, the energy HQ Energy produced represented only a small proportion of the overall installed capacity. HQ Energy's actions therefore did not combine market power and trading activity in economically irrational ways because it did not generate losses in one market so as to benefit its position in another by means of manipulating the market price. FERC ultimately accepted HQ Energy's position that it participated in the market as a "price-taker" and traded in TCCs simply to hedge congestion risks in a way that FERC had anticipated. FERC notes that without evidence of intent to defraud, the fact that HQ Energy's price-taker bids in the energy market affected the obligations of holders of TCCs is both known and unsurprising.
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