Enron-style Price Gouging Is Making A Comeback

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The price of electricity would soar under the latest scheme by Wall Street financial engineers to game the electricity markets.

If regulators side with Wall Street — and indications are that they will — expect the cost of electricity to rise from Maine to California as others duplicate this scheme to manipulate the markets, as Enron did on the West Coast 14 years ago, before the electricity-trading company collapsed under allegations of accounting fraud and corruption.

The test case is playing out in New England. Energy Capital Partners, an investment group that uses tax-avoiding offshore investing techniques and has deep ties to Goldman Sachs, paid $650 million last year to acquire three generating plant complexes, including the second largest electric power plant in New England, Brayton Point in Massachusetts.

Five weeks after the deal closed, Energy partners moved to shutter Brayton Point. Why would anyone spend hundreds of millions of dollars to buy the second largest electric power plant in New England and then quickly take steps to shut it down?

Energy partners says in regulatory filings that the plant is so old and prone to breakdowns that it is not worth operating, raising the question of why such sophisticated energy-industry investors bought it.

The real answer is simple: Under the rules of the electricity markets, the best way to earn huge profits is by reducing the supply of power. That creates a shortage during peak demand periods, such as hot summer evenings and cold winter days, causing prices to rise. Under the rules of the electricity markets, even a tiny shortfall between the available supply of electricity and the demand from customers results in enormous price spikes.

With Brayton Point closed, New England consumers and businesses will spend as much as $2.6 billion more per year for electricity, critics of the deal suggest in documents filed with the Federal Energy Regulatory Commission.

That estimate will turn out to be conservative, I expect, based on what Enron traders did to California, Oregon and Washington electricity customers starting in 2000. In California alone the short-term market manipulations cost each resident more than $1,300, a total burden of about $45 billion.

Clearance pricing

Electricity is sold in what are known as clearance price auctions, in which all sellers get the price of the highest winning bid. Imagine 10 suppliers, each owning an identically sized power plant for a total of 10 plants. Now imagine that demand in the next hour will require power from nine of these plants, and that bids range from one penny to $100.

If the plant offering the ninth greatest price — i.e. the second highest price — bids $95, that becomes the clearance price. Under this scenario — and this is the key point with clearance price auctions — every plant that bid $95 or below wins the auction, and each of them gets $95, even if some offered to sell power for a penny and even if the average price was $20.

Electricity market trading records in Texas have shown that under these rules, prices have spiked to more than $3 million per hour above the average price offered. Revenue above the average price is virtually pure profit.

Trading records and experiments conducted by Professor Sarosh Talukdar at Carnegie Mellon University and others show that the electricity auction rules tend to drive prices up, not down, until they approach the level that an unregulated monopolist could charge.

This occurs because suppliers learn to arrange their bids to ensure the highest price, a good example of how competition does not always favor customers or lower prices. While collusion among suppliers is illegal, learning how to jack up prices by studying bidding patterns is perfectly legal.

The original market rules, by the way, were drafted by a massive fraud posing as an electricity trading company named Enron. (I explain those rules, how they came about and how they work against customers in my book “Free Lunch.”)

Just and reasonable?

Energy Capital Partners says it complied with every detail of law. It says regulators “should refuse to entertain baseless allegations of market manipulation.”

Its competitors support the plan. That is not surprising, since they would all share in the profits from artificially inflated prices.

Neither Energy partners nor its competitors argue in their papers that they will be building new power plants to replace Brayton Point, which would mean adequate supply at lower prices.

Whether Energy partners should be allowed to shutter Brayton Point goes to the core principle of utility regulation and electricity markets, a principle designed to balance the desires of customers for low prices with those of investors seeking necessary profits.

The “just and reasonable” principle requires prices that are fair to both customers and sellers, as I teach my Syracuse University College of Law students. Prevailing federal law holds that just $1 of excess profit would be unjust and unreasonable.

The Independent System Operator–New England, which runs the electricity market, asserts in a filing that it has no duty, reason or intent to investigate whether closing Brayton Point constitutes market manipulation. That claim is shocking, because preventing manipulation is the primary reason the market operator exists. The operator gratuitously notes that the shutdown planned by Energy partners “conformed to the governing procedural provisions.”

This clear expression of bias favoring Energy partners’ scheme goes to the heart of how corporate and investor interests have captured the regulatory system, tilting it in favor of firms like Energy partners.

The opposition

Opposition to the plant shutdown comes from Connecticut Attorney General George Jepsen, the consumer advocates at Public Citizen and the Utility Workers Union of America, whose members run Brayton Point. They all say this is market manipulation pure and simple and cannot be allowed even if Energy partners found loopholes in the anti-manipulation rules.

Jepsen further argues that the Independent System Operator’s own reports show it has gone from a surplus of generating capacity to a shortfall. And he points to a baseline price already more than doubling because of inadequate supply.

Public Citizen told the Federal Energy Regulatory Commission, which must approve or block the plan, that Energy partners is engaged in a “capacity withholding scheme in violation of the Commission’s regulations prohibiting unjust and unreasonable rates and the Commission’s Anti-Manipulation Rule.”

Tyson Slocum of Public Citizen characterized the Energy partners explanation for the shutdown as absurd:

In the world of business, a firm announcing that an asset purchased just 5 weeks ago is actually uneconomical to operate would be called incompetent, and such a firm would have difficulty attracting capital and staying in business. But the managing partners of Energy Capital Partners are a highly sophisticated all-star crew of former Wall Street financiers: four of the five managing partners are Goldman Sachs veterans, and the firm’s vice-presidents and principals are alumni of JP Morgan, Morgan Stanley, Bank of America, Credit Suisse and other financial powerhouses. These are not your run-of-the-mill owners and operators of power plants. They are Wall Streeters highly motivated to exploit the intricacies of power markets to make as much money as possible for their Cayman Islands-based affiliates.

The record is clear that artificially reducing supply to jack up prices was the plan of Energy partners from the get-go. The strategy is obvious from auction records, as explained by Robert Clark of the Utility Workers Union of America Local 464.

“Almost immediately after acquiring ownership of the Brayton Point Power Station late last year,” Clark said, “[Energy partners] intentionally withheld all of Brayton Point’s capacity from [auction] for the purpose of reducing capacity supply and intentionally raising the market prices” that Energy partners and its competitors could charge for other New England generating capacity they already owned.

The lesson from the Enron scam should be clear: It needlessly cost electricity customers (and investors) many tens of billions of dollars. Regulators who failed to do their job enabled those crimes. Energy Capital Partners is not a scam, but its proposal to close Brayton Point is.

Unless you want to pay a lot more for electricity, speak up now. Tell your senators and members of Congress to stop this plan to legally steal billions from electricity customers — and make sure it does not pop up in your community.