The U.S. government permitted Wall Street firms to expand in the energy industry a decade ago, when the collapse of Enron Corp. and its army of traders left a void in the market. The results aren’t pretty.
JPMorgan Chase & Co. (JPM) settled Federal Energy Regulatory Commission claims this week that employees engaged in 12 bidding schemes to wrest tens of millions of dollars from power-grid operators. A Barclays Plc (BARC) trader stands accused of bragging he “totally fukked” with a Southwest energy market. Deutsche Bank AG workers, faced with losses on a contract, allegedly altered electricity flows to make it profitable instead.
The FERC’s investigations are fueling a debate among lawmakers and the Federal Reserve over whether to reverse more than a decade of policy decisions that let Wall Street banks keep or build units handling commodities and energy. Senators examining the firms’ roles have said they may call bankers and watchdogs to a September hearing amid concern traders are abusing their ability to buy and sell physical products while betting on related financial instruments.
Banks have been seen as “sources of capital investment and market liquidity,” said Marc Spitzer, a partner at law firm Steptoe & Johnson LLP in Washington and a former FERC commissioner. “But the tradition and culture of large banks is different than the conservative and risk-averse culture of regulated utilities.”
JPMorgan, the largest U.S. lender, announced last week that it’s considering ways to exit the physical commodities business, which includes energy trading. The New York-based company, led by Chief Executive Officer Jamie Dimon, 57, will pay a $285 million fine and disgorge $125 million in gains to settle the FERC’s case without admitting or denying wrongdoing.
“We’re pleased to have this matter behind us,” Brian Marchiony, a spokesman for the firm, said as the accord was announced.
“It is up to Congress, and not FERC, to decide if banks should continue to be allowed to participate,” FERC Chairman Jon Wellinghoff said in an e-mailed statement. “We welcome anybody in the markets who wants to play in those markets fairly, whether it be banks, traditional utilities or other traders. We just want to make sure that they play by the rules.”
Details of Enron’s market abuses surfaced in the years after the world’s biggest power trader collapsed in an accounting fraud in 2001. The company, whose actions led to rolling blackouts in California, eventually reached a $1.5 billion settlement with state authorities, while employees pleaded guilty to criminal charges.
To prevent future misconduct, a congressional overhaul of U.S. energy policies gave the FERC additional enforcement powers in 2005, setting the stage for the current jump in cases.
Enron’s fall left a hole in the market. Utilities and companies needed more stable and dependable power brokers for their transactions. Banks, with relatively strong balance sheets and credit ratings, were among companies that saw an opportunity. Congress already had loosened energy-market restrictions in the 1990s, as well as a ban on banks’ involvement in commercial businesses in 1999. Regulators let firms proceed.
UBS AG (UBSN), Switzerland’s largest lender, bought Enron’s energy-trading business in 2002, later shrinking the unit. That same year, Bank of America Corp. also won the FERC’s approval to make electricity transactions. Altogether, more than 50 firms including banks filed applications with the FERC from December 2001 through February 2003 to make trades in that market.
“Banks have assumed a prominent role in energy trading since the collapse of Enron and other energy marketers, in part, because financial institutions generally have significant financial assets to back their trades,” said Richard Drom, a partner at law firm Andrews Kurth LLP who focuses on energy regulation. “Such trading can improve energy markets by promoting market liquidity and energy price transparency.”
JPMorgan’s website credits a predecessor of the bank with helping bring about the advent of electricity by financing Thomas Edison’s research. In 2005, a unit of the company won FERC approval to provide power in wholesale electricity markets, according to the agency. Three years later, the firm inherited U.S. energy holdings and sales arrangements, including power plants in Southern California and Michigan, through its acquisition of failing investment bank Bear Stearns Cos.
The FERC found that J.P. Morgan Ventures Energy Corp., a unit overseen by commodities chief Blythe Masters, engaged in 12 separate bidding strategies from 2010 to 2012. Ten allegedly began while the agency’s probe was in progress.
The bank controlled older power plants that had marginal costs that were typically higher than the market prices of electricity, according to its consent agreement with the FERC. To ensure their profitability, the firm sought to exploit pricing rules, the agency wrote.
JPMorgan used strategies such as offering below-market rates for some hours of energy production, then charging exorbitantly high rates for hours that state bidders agreed to pay for the plants to “ramp” production, according to the FERC.
Masters, 44, was told in an October 2010 document that the firm’s bidding strategies would enable it to produce $1.5 billion to $2 billion in gains through 2018, according to the FERC. She wasn’t accused of wrongdoing. The company’s settlement releases her from any future FERC enforcement actions in the case.
Some JPMorgan bidding tactics were similar to abuses that occurred in the Enron era, FERC Chairman Wellinghoff said in an interview this week.
“That doesn’t mean that they are as widespread or that they are resulting in the level of consumer losses that we saw during that period,” he said.
A recent jump in the watchdog’s cases targeting a variety of companies stems from the additional authority Congress granted its investigators in 2005. Wellinghoff has said that the agency isn’t seeking to single out Wall Street firms.
“We now have a very sophisticated and very deep enforcement team” able to identify and stop market manipulation swiftly, he said in the interview.
The FERC’s case against Barclays and Frankfurt-based Deutsche Bank centered on their alleged abuse of power-market influence to benefit related positions on financial instruments.
At Barclays, the FERC’s investigators found traders made transactions in fixed-price electricity products -- often at a loss -- with the intent of moving an index to benefit the London-based bank’s other bets on swaps. The regulator’s staff estimated that the abuses, spanning 2006 to 2008, caused $139 million “in harm to the market.”
Barclays has said the FERC’s accusations are without basis. The firm has vowed to fight an order that it pay $469.9 million in penalties and forfeited profits. Swaps allow investors to hedge or speculate on changes in underlying assets such as interest rates, currencies or the ability of a borrower to repay debt.
Deutsche Bank agreed to pay the FERC more than $1.6 million in January without admitting or denying wrongdoing. The bank was accused of moving electricity to benefit its position on financial instruments known as congestion revenue rights.
Enron employees targeted by prosecutors took a direct approach: They sought to drive up electricity prices to squeeze more money out of power-starved utilities, businesses and consumers. Wholesale power prices soared and electricity supplies dwindled, leaving millions of Californians to suffer blackouts in 2001. The state’s two largest utilities became insolvent.
The focus on derivatives in some of the bank probes echoes at least one Enron case. In 2004, Enron settled claims brought by the Commodity Futures Trading Commission that employees rapidly bought up natural gas in the spot market, creating “artificial” prices for natural gas futures contracts.
That behavior helped make Enron a repeat topic during a Senate Banking Committee subcommittee hearing on July 23 to examine whether banks are abusing their roles in commodities markets.
“There is at least a very plausible argument that Enron was the pioneer in discovering a business model” that combined the handling of physical commodities and derivatives bets, Saule T. Omarova, a law professor at the University of North Carolina at Chapel Hill, told the Senate panel. “Once that model was discovered, that model was up for the taking.”
The notion that some firms are emulating Enron “suggests that this movie does not end well,” Senator Elizabeth Warren, a Massachusetts Democrat, said at the hearing. It shows “we are now putting more and more risk into this system.”
The cases against banks in the past year have resurrected concerns that traders are disregarding markets and consumers.
Enron workers were caught on audiotapes as they discussed tactics with code names like “Death Star” and “Fat Boy” that could be used to take advantage of consumers, whom they termed “Grandma Millie.” In that case, prosecutors said employees used a variety of strategies, such as creating artificial congestion on transmission lines so that Enron could earn additional fees for relieving the crunch.
One Barclays trader accused of manipulating prices in the U.S. Southwest wrote in an internal message that he had “totally fukked with the Palo mrkt today,” the FERC said in an order this month. Another trader wrote that he was “trying to drive price in fin direction,” referring to transactions he made to benefit derivatives positions, the agency said.
The claims against banks are fueling a regulatory debate that may push those firms back out of certain markets. The Fed said July 19 that it’s reviewing a 2003 decision that physical commodities are “complementary” to banking, allowing lenders such as JPMorgan to operate in both industries. Such a reversal would demonstrate authorities’ growing discomfort with allowing complex trading strategies into markets that ultimately heat people’s homes.
Banks’ and utilities’ interests are fundamentally at odds, with financial firms earning more from volatility and consumers needing stability, said Miki Kolobara, a Phoenix-based attorney who specializes in energy-trading cases. Banks’ hunt for gains will gravitate to derivatives, where profits are theoretically unlimited, rather than in power lines and physical infrastructure, where returns are capped by regulators, he said.
Electricity and natural gas -- the two main commodities under the FERC’s oversight -- are areas in which banks should tread carefully, because the government is wary of practices that hurt people’s ability to meet basic needs.
“Trading in energy requires not just expertise, but also an awareness of a highly complex regulatory structure,” said Harvey Pitt, the SEC chairman during Enron’s collapse. “If traders view energy as just another commodity, then they will find themselves on the wrong side of FERC.’”