Market Manipulation, Market Power, and the Authority of the Federal Energy Regulatory Commission
Kelliher, Joseph T., Energy Law Journal
"Of the Commission's primary task there is no doubt, however, and that is to guard the consumer from exploitation by non-competitive electric power companies."1
"Give us the tools and we will finish the job."2
For years, the Federal Energy Regulatory Commission (Commission) has promoted competition in wholesale power markets subject to its jurisdiction. It has done so in response to dramatic changes that occurred in the electricity industry over the past twenty-five years. Those changes greatly expanded competition in wholesale power markets, and the Commission made a policy decision to rely increasingly on competition to lower wholesale power prices.
Although the Commission's policy has evolved in response to changes in electricity markets, the goal of Agency policy has remained constant: assuring just and reasonable rates. The Commission has certain legal duties under the Federal Power Act, perhaps the most important of which is assuring that wholesale power rates are just and reasonable. However, the Commission has discretion on what policies it can pursue to assure such rates. The Agency has chosen to rely on competition to achieve that end.
The courts have upheld that approach, in large part, because the Commission has not relied solely on market forces. In fact, the Commission's policies have relied on both competition and regulation to assure just and reasonable rates. The Commission has struggled to find the right balance between competition and regulation.
As the industry has changed, the Commission's role has evolved from setting rates for individual sellers to setting rules of general application that govern electricity markets. Among the most important market rules are those that prevent market manipulation. This article reviews the Commission's authority to prevent market manipulation and finds it wanting.
This article also reviews the Commission's authority to prevent the accumulation and exercise of generation market power3 or horizontal market power. The accumulation of generation market power is a greater concern as the Commission relies on competitive forces to assure just and reasonable prices. Under traditional cost-of-service rate regulation, the accumulation of generation market power is a lesser concern, since the exercise of market power can be controlled by setting individual rates. As the Commission has evolved from setting rates to regulating markets, the accumulation of generation market power is more problematic. This article finds the Commission's authority to prevent accumulation of generation market power to be insufficient.
The Federal Power Act was enacted into law nearly seventy years ago. Much has changed since then. It is unremarkable that the passage of time and the nature of the changes that have swept across the industry created the need for fundamental reforms to the Federal Power Act. This article concludes with a call for legislative action by Congress to bolster the Commission's authority in several key areas in order to strengthen the ability of the Commission to discharge its legal duty to assure just and reasonable rates in the context of competitive wholesale electricity markets.
Part II of this Article reviews the legal duties of the Commission with respect to the regulation of wholesale power sales and disposition of jurisdictional facilities. Part III discusses the dramatic changes that have occurred in the electricity industry over the past twenty-five years and how the Commission's policy evolved in response to these changes. Part IV examines the authority of the Commission to prevent market manipulation and the accumulation of generation market power, concluding that the Commission's current legal authority is insufficient in both areas. Finally, Part V discusses the need for legislative reforms to the Federal Power Act and offers some specific recommendations for such reform.
II. LEGAL DUTIES OF THE FEDERAL ENERGY REGULATORY COMMISSION
A. Prevent Unjust and Unreasonable Rates
The most important legal duties of the Commission with respect to the regulation of wholesale power sales and the transmission of electric energy in interstate commerce are set forth in sections 205 and 206 of the Federal Power Act.4 Under section 205, all rates charged by a public utility in connection with wholesale power sales and transmission of electric energy in interstate commerce must be just and reasonable.5 Under section 206, whenever the Commission finds that a wholesale power or transmission rate charged by a public utility is unjust, unreasonable, unduly discriminatory, or preferential, the Commission is obligated to determine the just and reasonable rate and fix the same by order.6
The courts have determined that an unjust and unreasonable rate is a rate that falls outside the "zone of reasonableness," which is bounded by monopoly rents on the high side and confiscatory prices on the low side.7 Monopoly rents are prices that an unregulated monopoly would charge,8 and confiscatory prices are prices so low that they effectively guarantee an investor will never recover his investment.
The legal duty of the Commission to prevent unjust and unreasonable rates and undue discrimination or preference in the sale of wholesale power or interstate transmission by jurisdictional sellers9 is absolute; the Commission does not have the discretion to ignore them. The Commission does have discretion on how it discharges these legal duties, however.10 Historically, the Commission has discharged its legal duty to prevent unjust and unreasonable rates by directly setting rates for individual sellers, typically setting a cost-based rate that allows for cost recovery plus a regulated return on investment.11 That approach, also known as "profit level regulation," effectively regulates the profit margin of a utility rather than its costs.12 As discussed below, that approach has been changing in recent decades.
B. Review Disposition of Jurisdictional Facilities
Under section 203 of the Federal Power Act, the Commission is charged with reviewing all dispositions of "facilities subject to the jurisdiction of the Commission"13 by public utilities.14 Approval of such dispositions will be granted only if the Commission finds it is "consistent with the public interest."15 In 1996, the Commission issued its Merger Policy Statement, which defined the public interest test it would apply in public utility mergers and dispositions of jurisdictional facilities.16 The Commission later clarified the public interest test it would apply to dispositions in Order No. 642, which sets forth the Commission's filing requirements for section 203 applications.17
Under the Merger Policy Statement and Order No. 642, the Commission generally takes account of three factors in its section 203 analysis: the effect on competition, the effect on rates, and the effect on regulation.1 With respect to the effect on competition, the Commission recognized that effective competition in wholesale power markets can assure just and reasonable rates.1 The Commission also expressed concern about the effect of accumulation of generation market power on competition in wholesale power markets.20 If the Commission finds a proposed disposition has a negative effect on competition, it has broad authority to condition the transaction to mitigate any anticompetitive impact.21
III. EVOLUTION OF FERC POLICY IN RESPONSE TO CHANGES IN WHOLESALE POWER MARKETS
Wholesale power markets have changed dramatically since the Federal Power Act was enacted into law. In 1935, there was relatively little interstate commerce in electricity and limited wholesale sales. The transmission system in most cases did not cross state lines, and few utilities were interconnected. In effect, electricity markets were neatly confined within state boundaries. Virtually all generation was built in load centers, and all segments of the industry-generation, transmission, and local distribution-were presumed to be natural monopolies.22
The industry remained stable for decades.23 Beginning in the late 1960s, however, electric utilities began to significantly expand their interconnections. They did so largely as a response to the 1965 blackout in the Northeast, which resulted in heightened concerns about system reliability. This strengthened interconnection of the transmission grid made possible the later acceleration of competition in wholesale power markets, since a robust transmission grid was a necessary foundation for effective competition.
The next major change was the increase in nonutility generation and the rise of competition in wholesale power markets. Much of the change in the electric power industry since 1978 has resulted from technological change, perhaps the most important of which has been improvements in gas turbine technology.24 In 1978, utilities controlled ninety-seven percent of electric power generation capacity in the United States.25 However, technology spurred development of nonutility generation, destroying the natural monopoly in electric generation, if it ever truly existed.26 The rise of independent power production made more vigorous competition possible. While competition in wholesale power markets has doubtless increased since 1978, it was present beforehand. In fact, federal electricity law envisioned some level of competition in wholesale power markets from the very beginning.27
Competition in wholesale power markets was greatly expanded by enactment of the Public Utility Regulatory Policies Act of 1978 (PURPA). The PURPA promoted competition in wholesale power markets by establishing a mandatory purchase obligation,29 requiring utilities to purchase generation from qualifying facilities that met certain requirements.30 Utilities were barred from owning qualifying facilities, so this new class of generation was reserved for nonutilities.31 The result was a dramatic expansion of electricity generation by independent power producers.32 Ironically, promoting competition was even not one of the purposes of the PURPA.33 The success of the PURPA in this respect must be viewed as fortuitous.
The Energy Policy Act of 1992 advanced competition in wholesale power markets, by further promoting the development of independent power producers.34 This new class of generators, known as "exempt wholesale generators," is exempt from the Public Utility Holding Company Act of 1935.35 Since enactment of the Energy Policy Act, most nonutility generation additions have been exempt wholesale generators.36 These new entrants challenged the utilities by competing for wholesale power sales.37
B. FERC Response to Changed Industry Conditions
In response to these developments in the electricity industry, the Commission instituted fundamental changes in policy, changes that continue to this day. Beginning in the 1980s, the Commission began to rely increasingly on market forces to lower wholesale power prices. To this end, the Commission began to authorize public utilities to charge market-based rates for wholesale power sales, rather than cost-based rates. This marked a fundamental change in Commission policy. The objective of this new policy was clearly to lower wholesale power prices.38 The Commission's authorization of market-based rates was a departure from traditional cost-based ratemaking, which is focused on preventing the exercise of market power by controlling profits rather than fostering efficiency.39 The Commission's policy was intended to create competitive pressures that would improve efficiency and lower wholesale power prices.40
It is important to note that this increased reliance on competitive forces does not mean the Commission made a break with regulation.41 Alfred Kahn perhaps expressed it best thirty years ago:
The two principal institutions of social control in a private enterprise economy are competition and direct regulation. Rarely do we rely on either of these exclusively: no competitive markets are totally unregulated, and no public utilities are free of some elements of rivalry. The proper object of search, in each instance, is the best possible mixture of the two.
That is what the Commission has been working towards: the best possible mixture between regulation and competition, relying more on competition than it did in the past, while retaining significant direct regulation. It has been a struggle to reach an appropriate balance.43
The policy decision to rely increasingly on competitive forces to control wholesale power prices is consistent with the Commission's legal duty to assure just and reasonable rates for the sale of wholesale power by jurisdictional public utilities. The Commission's theory was, and remains, that
[i]n a competitive market, where neither buyer nor seller has significant market power, it is rational to assume that the terms of their voluntary exchange are reasonable, and specifically to infer that price is close to marginal cost, such that the seller makes only a normal return on its investment.
One may question this theory, but it has been upheld by the courts.45 Regardless, there is no doubt the Commission believed its increased reliance on competitive forces was fully consistent with its statutory duty to assure just and reasonable rates.46
One reason the Commission began to rely increasingly on market forces to assure just and reasonable rates was a recognition of the limitations of cost-ofservice regulation.47 Traditional rate regulation does not encourage the regulated utility to be efficient and provide service at a low cost.48 Moreover, cost-ofservice regulation has not proved terribly effective in eliminating excessive costs.49 It was the perceived failure of cost-based regulation that led the Commission to turn to competition.50
It is important to note that the Commission's policy was never intended to deregulate wholesale power markets. Notwithstanding the great debates that have taken place in the United States over deregulation, our economic markets are not truly unregulated in the sense that they are completely free from rules. Virtually all markets are subject to some kind of market rules, either rules laid down by an economic regulatory agency or established under antitrust law.51 The most notable exception is major league baseball, which is not subject to regulation and is exempt from antitrust law.52
As the Commission has relied on competitive forces to assure just and reasonable rates, its role has changed significantly from the one it has played historically. Instead of setting rates for each seller subject to its jurisdiction, the role has changed to one of regulating markets, by setting rules of general applicability. Those rules, in turn, are intended to ensure that wholesale markets are subject to effective competition. The Commission has struggled to develop market rules to govern competition in wholesale power markets in a manner consistent with its legal duties.
The panoply of market rules established by the Commission belies descriptions of the Agency's policy objective as deregulation. When the Commission establishes price caps, as it has in regional transmission organization and independent system operator markets and in the West, it does so in order to prevent wholesale power prices from rising to the level of monopoly rents. When it authorizes capacity payments, the Commission does so to provide generators a reasonable opportunity to make a profit. Both sets of rules are designed to produce rates that are just and reasonable-that fall inside the zone of reasonableness. This effort is most obvious in the organized markets, where spot markets are governed by rules approved by the Commission.54
C. Court Review of the FERC Market-Based Rate Program
The courts have upheld the Commission's decision to rely on market-based rates, and found that doing so is consistent with the Agency's legal duty to assure just and reasonable rates. In Louisiana Energy and Power Authority, the U.S. Court of Appeals for the District of Columbia Circuit explicitly held that:
[t]he Federal Power Act requires that all rates demanded by public utilities for the transmission or sale of electric energy be 'just and reasonable.' Where there is a competitive market, the Federal Energy Regulatory Commission (FERC) may rely on market-based rates in lieu of cost-of-service regulation to ensure that rates satisfy this requirement.
Relying on competitive forces to assure just and reasonable rates has also been upheld by the courts outside the context of federal electricity regulation. In Elizabethtown Gas Co. v. FERC, the U.S. Court of Appeals for the District of Columbia Circuit upheld the Commission's use of market-based rates for certain natural gas sales.56 This has bearing on the use of market-based rates in federal electricity regulation, since the courts have recognized the similarities between the Natural Gas Act and the Federal Power Act and interpreted the laws accordingly.57
The Commission's authority to approve market-based rates and rely on competitive forces to assure just and reasonable rates was recently reaffirmed by the Ninth Circuit in California v. FERC,58 In reviewing the origins of the Commission's market-based rate policy, the court noted that the Commission is obligated to ensure that wholesale power rates are just and reasonable59 and recognized that the Commission's policy decision to rely on market-based rates instead of cost-based rates was intended to achieve that result.60
Significantly, the court, holding that market-based rates do not violate the Federal Power Act,61 also concluded that the Commission cannot rely solely on market forces to assure just and reasonable rates.62 The court distinguished the Commission's market-based rate program from market-based programs developed by the Federal Communications Commission program and Interstate Commerce Commission that had been previously struck down in MCI Telecommunications Corp63 and Maislin Industries.M Those other programs were overturned because the Agencies improperly relied on market forces alone in approving market-based tariffs.65 By contrast, the court found that the Commission did not rely solely on a finding that the applicant for market-based rates lacks market power, but also relied on reporting requirements in order to assure that rates are just and reasonable and not subject to market manipulation.66
D. Recent Improvements to FERC 's Market-Based Rate Program
Under California, the Commission must do more than rely solely on market forces. The market-based rate authorization program, as reviewed by the California court, relied on an ongoing reporting requirement to buttress its ex ante findings with respect to the absence of market power. The Commission relies on much more than that today.
First, the Commission strengthened the reporting requirement that was in effect during the period examined by the court. In April 2002, the Commission issued Order No. 2001, which revised the quarterly filing requirements for public utilities that make wholesale power sales, both cost-based and market-based.67 The Commission also revised the generation market power test that it uses to make ex ante market power findings.68 In addition, the Commission issued the Market Behavior Rules, which amend all electric market-based tariffs to proscribe market manipulation.69 Further, the Commission issued a rule on Standards of Conduct to govern the relationships between natural gas and public utility transmission providers and their affiliates, in order to prevent affiliate abuse.70 In organized markets operated by regional transmission organizations and independent system operators,71 the Commission established a wide range of market rules and provides for market monitoring.72 More recently, the Commission issued a final rule to standardize its reporting requirement for changes in status that implicate the Commission's ex ante findings regarding the absence of market power.73 The Commission recognizes the importance of this proposed rule to the Commission's duty to assure just and reasonable rates.74
IV. LIMITATIONS ON FERC AUTHORITY TO PREVENT MARKET MANIPULATION AND THE ACCUMULATION OF MARKET POWER
A. FERC Authority to Address Market Manipulation
1. General Observations
As discussed above, the Commission's role has changed fundamentally as a result of dynamic changes in the electricity industry. While the Commission's legal duty to prevent unjust and unreasonable rates and prevent undue discrimination or preference has remained constant, the policy means by which the Commission discharges these duties has changed significantly. Instead of setting rates for individual sellers and individual transmitting utilities, the Commission increasingly establishes rules of general application that regulate markets by enforcing market rules.
In a broad sense, the Commission's role has shifted to become more like other federal economic regulatory agencies, such as the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). Those agencies discharge their legal duties by setting rules of general application that regulate the commodity and securities markets, respectively.
This is not to say that the role of the Commission is now identical to those of the CFTC and the SEC. Unlike the Commission, the CFTC and SEC do not have a duty to assure that the price of a commodity or a security is "just and reasonable."75 Instead, their legal duty is to prevent behavior that would pervert the normal operations of commodity and securities markets and result in prices that are higher or lower than would otherwise occur through unmolested market forces. This is demonstrated by the fact that one of the principal charges of the CFTC and SEC in their regulation of commodity and securities markets is to prevent market manipulation.76 Both the Commodity Exchange Act and the Securities Exchange Act of 1934 include express prohibitions of market manipulation that reflect a recognition by the Congress that commodities and securities markets cannot operate properly if subject to market manipulation.77
2. The FERC's Market Behavior Rules
Markets subject to manipulation cannot operate properly. This premise has been recognized in the context of commodities and securities regulation, and Congress has properly granted the CFTC and SEC express authority to prevent market manipulation. Yet, commodities and securities markets are not the only markets susceptible to market manipulation. There have been instances of manipulation of wholesale power markets subject to the Commission's jurisdiction, and manipulation contributed to the western electricity crisis of 2000-01.78 Indeed, the Commission recognizes the urgent need to proscribe manipulation of electricity markets.79 Yet, there is no express prohibition of market manipulation in federal electricity law.80 Of the scores of criminal violations arising out of prosecutions of market manipulation in the electricity industry, there is not one alleged violation of the Federal Power Act, which speaks volumes about the adequacy of current electricity law.81
The Commission has interpreted its existing legal authority in an effort to prevent market manipulation. In November 2003, the Commission issued a rule to proscribe certain forms of market behavior in wholesale power markets.82 The purpose of the rule, known as the Market Behavior Rules Order, is to protect wholesale power customers from market abuses, by (a) providing for effective remedies in the event anticompetitive behavior or other market abuses occur, (b) providing clear rules of the road for wholesale power sellers authorized to sell at market-based rates, and (c) limiting regulatory uncertainty, by defining reasonable bounds within which market activity can be conducted.83 The Market Behavior Rules Order conditions market-based rate authorization on compliance with the behavioral rules. Conduct that runs afoul of the market behavior rules constitutes an electric tariff violation.
The Commission acknowledged that preventing market manipulation is important to its duty to prevent unjust and unreasonable rates. In the Market Behavior Rules Order, the Commission found that existing electric market-based tariffs were unjust and unreasonable and that proscribing anticompetitive behavior was necessary to ensure that rates remain within a zone of reasonableness.84 The Commission also held that its Market Behavior Rules are just and reasonable, and will help assure just and reasonable rates.85 The Commission acknowledged that the Market Behavior Rules, by themselves, will not be adequate to guarantee that rates are just and reasonable.86 As the Commission stated in the Market Behavior Rules Order, "[o]ur prohibition against market manipulation is not the only tool we intend to rely upon to ensure competitive markets. It is, however, a necessary tool. . . ."87
The Market Behavior Rules Order established six behavioral rules. Among them is Market Behavior Rule 2, which prohibits "[a]ctions or transactions that are without [a] legitimate business purpose and that are intended to or foreseeably could manipulate market prices, market conditions, or market rules for electric energy or electricity products . . . ."88 The Commission was very plain that the intent of the Market Behavior Rules Order was to prohibit all forms of market manipulation.89 Although the Federal Power Act does not include an express prohibition of market manipulation, the Commission did just that in the Market Behavior Rules Order.
Market Behavior Rule 2 not only establishes a general prohibition of market manipulation, it also proscribes specific manipulative practices. Rule 2(a) prohibits pre-arranged offsetting trades of the same product among the same parties, which involve no economic risk and no net change in beneficial ownership, otherwise known as wash trades.90 Wash trades have been deemed a manipulative practice in other economic regulatory schemes.91 Rule 2(b) prohibits transactions predicated on submission of false information to transmission providers and other entities responsible for operation of the transmission grid.92 Other regulatory regimes similarly prohibit manipulative practices based on fraud and misrepresentation.93 Rule 2(c) prohibits transactions in which an entity creates artificial congestion and then purports to relieve that congestion.94 Rule 2(d) prohibits collusion with other parties for the purpose of manipulating market prices, market conditions, or market rules.95 Significantly, the specific manipulative practices proscribed by the Market Behavior Rules included those used by Enron.96
A number of parties challenged Market Behavior Rule 2 on the grounds it is unconstitutionally vague and overbroad.97 Parties argued the rule violated due process requirements, by not providing adequate notice of behaviors that were prohibited. 8 Constitutional due process requirements mandate that the Commission's rules and regulations be sufficiently specific to give regulated parties sufficient notice of the conduct it requires or prohibits.99 The Commission noted that "[t]his standard is satisfied '[i]f, by reviewing [our rules] and other public statements issued by the agency, a regulated party acting in good faith would be able to identify, with ascertainable certainty, the standards with which the agency expects parties to conform."100 The Commission concluded it met this due process requirement.101 In particular, the Commission determined that the prohibition against market manipulation in Market Behavior Rule 2 passed constitutional muster.102
The Commission also sought to comply with due process requirements by incorporating an intent standard into the Market Behavior Rules, including Market Behavior Rule 2, which expressly prohibits market manipulation.103 The Commission explicitly declined to adopt a specific intent standard, and intent can be inferred.104
The principal remedy for violation of the Market Behavior Rules is disgorgement of profits.105 Commenters challenged the proposed remedy, arguing that it exceeds the limits of the refund provisions in section 206 of the Federal Power Act.106 section 206 provides that a refund effective date cannot be earlier than 60 days after the filing of a complaint or the initiation of a proceeding by the Commission.107 The Commission distinguished the remedies provided under the Market Behavior Rules Order from refunds ordered under section 206.108 The Market Behavior Rules Order amended all then-existing market-based rate tariffs, and is now applied to new market-based rate tariffs.109 By that device, the Market Behavior Rules are incorporated into electric tariffs, and violations are made subject to disgorgement of profits. Strictly speaking, the "penalty" provided under the Market Behavior Rules is not a refund, but a remedy for violation of a tariff provision prohibiting specific conduct. For that reason, the Commission is not constrained by the time limits in section 206 in setting a tariff penalty charge.
This is consistent with the broad remedial authority recognized by the courts.110 The Commission has authority under sections 205 and 206 of the Federal Power Act to set charges for jurisdictional service, such as wholesale power sales.111 These charges in turn are incorporated into tariffs administered by the Commission, and the Commission has broad authority to redress violation of those tariffs.112
It is interesting to observe what the Commission did not do in the Market Behavior Rules Order. First, the Commission did not amend existing cost-based tariffs to include the Market Behavior Rules. As a result, compliance with the behavioral rules is limited to sales made under market-based tariffs, notwithstanding the recognition by the Commission that cost-based tariffs afford sellers substantial flexibility.113 However, most wholesale sales take place under market-based tariffs.114 Second, the Commission did not find that specific manipulative practices are themselves unjust and unreasonable. Arguably, the Commission could have concluded that market manipulation is inherently unjust and unreasonable, roughly equivalent to per se violations of antitrust law, practices that on their face would always or almost always tend to manipulate markets.115 It did not do so. Instead, the Commission concluded that current market-based tariffs are unjust and unreasonable or may lead to unjust and unreasonable rates without inclusion of the Market Behavior Rules, and relied on its broad discretion to condition a discretionary act, namely authorizing the sale of wholesale power at market-based rates.116
Under the Market Behavior Rules Order, when market manipulation constitutes a tariff violation, the Commission can impose a tough remedy: disgorgement of profits.117 However, that remedy is inadequate. There are three possible outcomes from a manipulative scheme. First, it may fail to affect price. That does not mean there is no reason to sanction the practice. Attempts to manipulate markets undermine the operation of markets, even when unsuccessful, reducing incentives to enter and dampening competition. It is for that reason that the Commodity Exchange Act and Securities Exchange Act of 1934 prohibit attempts to manipulate markets, regardless of their success.118 Under the Market Behavior Rules, however, there is no remedy for unsuccessful attempts to manipulate markets, although such conduct would violate the behavioral rules, since an unsuccessful attempt would not generate profits.
Second, an attempt to manipulate markets may succeed, resulting in economic gain in the form of a foregone loss. A foregone loss is a true economic gain. For example, if a seller would have lost $100, but reduced his or her loss to $10 through market manipulation, he or she realized an economic gain of $90. Under the Commodity Exchange Act and Securities Exchange Act of 1934, successful market manipulation that results in economic gain in the form of a foregone loss can be sanctioned.119 Again, the Market Behavior Rules fall short. The only monetary remedy that can be imposed under the rules is disgorgement of profits, which does not encompass economic gains such as foregone losses.
Third, an attempt to manipulate markets may succeed, resulting in an economic gain in the form of a profit. There is no question that the Commodity Exchange Act and Securities Exchange Act of 1934 provide for sanctioning market manipulation that results in a profit.120 This is the only circumstance where the Commission can impose a remedy, namely where an attempt to manipulate markets is successful and produces a profit rather than a foregone loss.
As noted above, the principal remedy the Commission can impose for violation of the Market Behavior Rules is disgorgement of profits. The Commission can also suspend or revoke market-based rate authorization.121 These remedies may discourage market manipulation to some extent. However, that penalty will prove inadequate in circumstances when the manipulative scheme is unsuccessful, and where it succeeds, but produces an economic gain in the form of a foregone loss rather than a profit. In the latter case, there still is an economic gain, but not one the Commission can sanction. In neither instance will the Commission be able to sanction the prohibited behavior, although it could constitute a violation of the Market Behavior Rules. The Commission has acknowledged that some violations of the Market Behavior Rules would not be subject to the principal penalty provided by the Rules, disgorgement of profits.122
It has been argued the Market Behavior Rules Order approaches the limits of the Commission's legal authority to prevent market manipulation. Others maintain the Commission has actually exceeded its legal authority,123 and the order has been challenged in court.124 It is incontrovertible however, that the Market Behavior Rule represents a very vigorous bid by the Commission to prevent market manipulation. A violation of the Market Behavior Rule is subject to the most severe penalty the Agency can impose: disgorgement of profits. Notwithstanding, in my view the Commission's authority to prevent market manipulation is insufficient.
3. The FERC's Authority to Address Federal Power Act Violations
Unlike other federal economic regulatory agencies, the Commission lacks civil penalty authority for most violations of the Federal Power Act.125 section 316A of the Act limits civil penalties to violations of provisions added or amended by the Energy Policy Act of 1992, namely sections 211, 212, 213, and 214.126 The Commission has no legal authority to impose civil penalties for other violations of the Federal Power Act, most notably sections 205 and 206.
This lack of civil penalty authority is a severe handicap in the Commission's enforcement of market rules. Civil penalties are a principal means by which federal economic regulatory agencies enforce their rules.127 The Commission's civil penalty authority is inadequate, not only with respect to scope, but also the level of penalties. Section 316A limits civil penalties for the specified provisions of the Federal Power Act to not more than $10,000 per day per violation.128 By contrast, the Commodity Exchange Act provides for civil penalties capped at the higher of $100,000 or triple the monetary gain.129 The securities Exchange Act of 1934 provides for civil penalties of up to the greater of $100,000 for an individual or $500,000 for a company, or "the gross amount of pecuniary gain."130
The inadequacy of the Commission's civil penalty authority is clear outside the context of market manipulation. There are other instances where violations of the Federal Power Act go unsanctioned, because the Commission lacks legal authority to impose civil penalties for violations other than the new provisions added by the Energy Policy Act of 1992. For example, section 203 of the Federal Power Act requires that public utilities seek prior authorization from the Commission before entering into a merger.131 However, if public utilities were to merge without Commission authorization, the Agency could not impose civil penalties, since section 203 falls outside the ambit of section 316A. Section 203 also requires prior authorization by the Commission before a public utility disposes of jurisdictional facilities.132 Yet, the Commission could impose no civil penalty if a public utility engaged in an unauthorized disposition. The same is true of section 204 (concerning issuance of securities), section 205 (imposing certain filing requirements), section 301 (providing for rules governing accounts and records), section 304 (directing public utilities to file reports), and section 305 (requiring prior authorization for interlocking directorate positions). For example, the Commission has no authority to impose a civil penalty on parties that make material false statements to the Agency. This stands in contrast with other regulatory statutes.133
The Commission's criminal penalty authority is also inadequate. Under the Federal Power Act, a knowing and willful violation is subject to a maximum penalty of $5000, and imprisonment for up to two years, and an additional $500 per day for a continuing violation.134 This is the amount set by Congress in 1935. By contrast, the Commodity Exchange Act provides for criminal penalties of not more than $1 million and imprisonment for up to five years,13 and the securities Exchange Act of 1934 provides for criminal penalties of not more than $25 million and imprisonment for up to ten years.136 The Commodity Exchange Act and the securities Exchange Act of 1934 have been amended since their enactment to raise the level of criminal penalties.137 The criminal penalties in the Federal Power Act have not changed since 1935.
The inadequacy of the Commission's authority to prevent market manipulation is made plain by a comparison on how various manipulative schemes would be redressed under the Market Behavior Rules Order, the Commodity Exchange Act, and the securities Exchange Act of 1934. As discussed above, there are three possible outcomes from a manipulative scheme: it may fail to affect price, it may succeed; resulting in economic gain in the form of a foregone loss; or it may succeed, resulting in an economic gain in the form of a profit.
In the event of an unsuccessful attempt at market manipulation, the CFTC could impose a civil penalty of up to $100,000,138 the sec could impose a civil penalty of up to $500,000,139 and the Commission could impose no penalty whatsoever. In the event of a successful attempt at market manipulation that results in an economic gain in the form of a foregone loss, the CFTC could impose a civil penalty of up to $100,000 or triple the monetary gain,140 the SEC could impose a civil penalty of up to the greater of $100,000 for an individual or $500,000 for a company, or the "gross amount of pecuniary gain,"141 and, again, the Commission could impose no penalty.
Only in the third instance, a successful attempt at market manipulation that results in an economic gain in the form of a profit, could the Commission impose a penalty, namely disgorgement of profits. It can only do so by virtue of having added the Market Behavior Rules to the tariffs of all jurisdictional power sellers. With the addition of those rules, the Commission can collect a penalty charge, even though it lacks statutory authority to impose civil penalties. By comparison, the CFTC could impose a civil penalty of up to triple the monetary gain,142 and the SEC could impose a civil penalty equal to the gross amount of pecuniary gain.143
The Commission has recognized the need for strong penalties to encourage compliance with the Market Behavior Rules, stating "[wjhere these rules are violated, it is appropriate that the Commission provide a remedy for such conduct. It is important that such conduct be deterred to the extent possible."144 Unfortunately, the penalties provided for in the Market Behavior Rules Order may prove insufficient to prevent market manipulation.
There is a need for legislation to strengthen the Commission's civil penalty authority, both to expand the scope of section 316A to include all violations of Part II of the Federal Power Act, not merely the newer provisions added or amended by the Energy Policy Act of 1992, and to raise the level of civil penalties to levels comparable under other federal economic regulatory regimes. The Commission has acknowledged it would use this additional authority to enforce the prohibition against market manipulation.145 The Commission needs certain tools to prevent market manipulation. There is no valid policy reason why the Commission should not have the same tools that other federal regulatory agencies possess to prevent market manipulation in other industries, no more, no less. If Congress does not grant the Commission strengthened civil penalty authority, it may be difficult to prevent market manipulation in the electricity industry.
B. FERC Authority to Prevent Accumulation of Generation Market Power
In addition to the Commission's authority under sections 205 and 206, discussed above, the Commission has a legal duty under section 203 of the Federal Power Act to review dispositions of jurisdictional facilities. Review under section 203 is subject to two limitations. First, the Commission can review only dispositions by public utilities.146 second, the Commission can review only dispositions of "facilities subject to the jurisdiction of the Commission"147 Facilities that either fall outside the Commission's jurisdiction or dispositions that do not involve public utilities are exempt from this review.
Section 201(b)(1) of the Federal Power Act limits the scope of the Commission's jurisdiction to review dispositions of facilities, providing that the Commission "shall not have jurisdiction, except as specifically provided in this subchapter and subchapter III of this chapter, over facilities used for the generation of electric energy . . . ."148 Section 203 does not in turn "specifically provide" for Commission jurisdiction over generation facilities within the meaning of section 201(b)(1).149 Guided by the plain meaning of section 203, the Commission has consistently disclaimed jurisdiction over generation-only dispositions,150 and the courts have affirmed this limitation on the Commission's authority to review dispositions.151 In a recent case, the U.S. Court of Appeals for the District of Columbia Circuit affirmed a Commission order disclaiming jurisdiction over the potential disposition of generation-only facilities, citing "the Commission's longstanding, reasonable interpretation" of section 203.152
Significantly, the acquisition of a generation-only facility that is not subject to review by the Commission escapes federal review altogether. The antitrust agencies do not review acquisitions of generation-only facilities, and would review such a transaction only if it constituted an "attempt to monopolize" under the Sherman Act.153 By that time, antitrust review may be too late: the public utility would have already accumulated generation market power to the point where it dominated the generation market.
It is true that states would retain authority over these acquisitions, but state review is inadequate. Power markets in the United States are regional in nature and are no longer neatly defined by state boundaries. Review by an individual state of the acquisition of a generation facility by a regulated electric utility in that state could hardly suffice to consider the effects of the transaction on the region. Indeed, state law would likely bar consideration of regional impacts and instead require consideration only of the effect on the individual state. Moreover, state review may focus merely on whether the purchase price was prudent and would likely ignore the effects on competition in wholesale power markets, an area reserved to the exclusive jurisdiction of the Commission.
Section 203 reflects the time when it was written. In 1935, public utility regulation was characterized by cost-of-service rate regulation. That was the means by which the Commission, as well as other federal economic regulatory agencies, prevented unjust and unreasonable rates. As changes in the electricity industry have led the Commission to rely increasingly on competition to assure just and reasonable rates, it may fairly be asked whether there is a need to amend section 203. The limitation on the Commission's authority to review generationonly dispositions reflects an indifference towards the accumulation of generation market power. That indifference may have been appropriate in 1935, when generation market power was restrained by the setting of wholesale power rates for each seller. However, it is no longer sufficient in an era when the Commission relies on competition to assure just and reasonable rates.
In a cost-based regulatory regime, the accumulation of generation market power is arguably not particularly important. The exercise of generation market power can be controlled by setting cost-based rates for wholesale power sales, allowing recovery of costs plus a regulated profit margin. However, the accumulation of generation market power poses more of a threat in a regulatory regime where sellers can charge market-based rates. In that context, a seller may be able to exercise generation market power and charge rates that exceed market levels.
The Commission has taken steps consistent with its existing authority under section 203 to guard against that eventuality. As discussed earlier, the Commission has strengthened its reporting requirements.154 In addition, it has issued a final rule to require jurisdictional public utilities authorized to charge market-based rates to report changes in status, including increases in ownership or control of generation capacity.155 Under the final rule, the reporting requirement is not limited to jurisdictional dispositions, so a public utility would be required to report the purchase of a generation facility that was not reviewed by the Commission under section 203. 56 If a public utility were to acquire a generation facility in a transaction not subject to Commission review, the Commission would have authority to revoke that utility's market-based rate authorization if it determined the acquisition resulted in the accumulation of too much generation market power.
In the event a jurisdictional public utility were to accumulate generation market power through one or more generation-only acquisitions, the Commission may have no choice but to revoke its authorization to charge market-based rates. Otherwise, the public utility would be able to exercise unmitigated generation market power and charge above-market rates. The Commission's duty to prevent unjust and unreasonable rates requires that it not allow that.
There is a perception that the Commission is unalterably opposed to utility acquisitions of generation facilities. That perception is simply incorrect. The Commission recognizes that Congress, in enacting section 203, did not intend the Commission to be hostile to mergers and other dispositions.157 In fact, the Commission has approved all recent utility proposals to acquire generation facilities reviewed under section 203.158 If the Commission were unalterably opposed to these transactions it presumably would have uniformly rejected utility applications to acquire independent generation. It has not done so.
There is potential for accumulation of significant generation market power through transactions that are outside Commission review. Some dispositions have involved large amounts of generation.159 For example, Duke Energy recently sold 5325 megawatts of generating capacity to a new entrant, a disposition that was reviewed and approved by the Commission, largely because the sale was to a new entrant and involved no accumulation of generation market power.160 It is possible, however, the transaction could have been structured to avoid Commission review. If that amount of generation had been transferred to an incumbent public utility, it would have represented a significant accumulation of market power.
Ironically, the limitation on the Commission's authority to review generation-only dispositions may result in more severe restrictions on public utilities that acquire generation facilities through transactions that escape review under section 203. The Commission can condition approval of dispositions under section 203 and has broad discretion to fashion conditions to mitigate accumulation of generation market power resulting from dispositions of jurisdictional facilities.161 In a recent case, the Commission approved the acquisition of a generating facility by an incumbent public utility with relatively modest conditions providing for transmission capacity expansion.162 However, the Commission cannot condition transactions that are not subject to its review. In the event an acquisition that is not subject to the Commission's review under section 203 results in the accumulation of significant generation market power, the Commission may be presented with two choices: allow the seller to exercise unmitigated generation market power or revoke or condition its market-based rate authorization. That is no choice at all. The Commission has a legal duty to prevent the exercise of market power, and does not have the discretion to allow a jurisdictional seller with unmitigated generation market power to charge monopoly rents.
V. NEED FOR LEGISLATIVE ACTION AND OUTLINES OF LEGISLATIVE PROPOSAL
The Federal Power Act is a well-crafted law that has withstood the passage of time. However, any law reflects the circumstances of the period in which it was enacted. Congress does not write a law on a mountaintop; it looks around at the world that surrounds it. In a perfect world, it considers that the world may change, and provides flexibility in that law. While electricity markets and the industry have changed, the Federal Power Act remains largely the same. In my view, the time has come to make fundamental reforms to the statute.
The Federal Power Act reflects certain unspoken assumptions by Congress. One of those assumptions was that there is a natural monopoly in electricity generation. Another was that electricity markets would remain neatly confined within state boundaries. We now know that these assumptions are no longer valid as the natural monopoly theory was disproved over twenty-five years ago and electricity markets in the United States are now regional in nature. In fact, much generation is located remotely from load centers, not even necessarily in the same state.
The Act reflects other assumptions, namely that the transmission grid would also remain largely confined within state lines. If Congress had not relied on this assumption in creating the Act, it might well have provided for federal siting of transmission facilities, in the same manner it provided for federal siting of interstate natural gas pipelines.163
The electricity market has also changed dramatically since 1935. Today, interstate commerce in electricity has exploded; the transmission grid is not only interstate, but international. These dramatic changes that have swept across the industry further highlight the need for reform of federal electricity laws, in the same manner that changes in the telecommunications industry, financial services industry, and commodities industry led Congress to make reforms to the federal laws that govern those industries.164
In my view, the Commission lacks the necessary tools to address these dramatic industry changes, including the threat of market manipulation. A comparison of the Federal Power Act with other federal economic regulatory. laws makes that plain. securities and commodities laws include express prohibitions of market manipulation.165 This is lacking in the Federal Power Act.166 Securities and commodities laws also provide for tough and effective penalties for both attempts to manipulate markets and manipulation itself.167 There is no valid public policy reason why the Commission should not have the same enforcement tools as other federal economic regulatory agencies. A comparison of the Federal Power Act with other federal economic regulatory laws also demonstrates that there is a need for tough civil and criminal penalties. If violations of market rules can go unpunished, they will become more frequent. Again, the Federal Power Act comes up short.
There is recognition in Congress of the need to increase the Commission's enforcement authority. The first step towards expanding the scope and raising the level of the Commission's civil penalty authority took place in 1999, when a Congressional panel approved electricity legislation that expanded the scope of section 316A to Part II of the Federal Power Act.168 The Bush Administration later proposed expanding the scope of the Commission's civil penalty authority, raising the level of monetary penalties, and extending the term for criminal violations.169 The electricity legislation Congress considered during the 107th and 108th Congresses adopted the Administration's proposal with respect to both civil and criminal penalties.170 It should be enacted.
The energy legislation is also intended to strengthen the Commission's ability to prevent market manipulation. The bill specifically prohibits certain manipulative practices, such as transactions based on false information and "round trip trading."171 However, it does not include an express prohibition of market manipulation. There are other legislative proposals to establish an express prohibition of market manipulation, and there is support for these proposals.172
It is unlikely that legislatively prohibiting specific manipulative practices will prove an effective way to prevent market manipulation. The legislative process can be slow and arduous. As a case in point, nearly five years after the electricity crisis in California and the West, not one of the manipulative practices Enron used has been prohibited by law. As Congress struggled to enact legislation, the Commission issued the Market Behavior Rules, establishing a general prohibition of market manipulation and banning a number of specific manipulative practices used by Enron.
Those who engage in market manipulation can have very creative minds. It is unlikely, given the speed of Congressional action, that an approach rooted in enactment of legislation to prohibit specific manipulative practices will be able to keep pace with the creativity of the rogues and scoundrels who stand to earn unjust profits from market manipulation. A better approach would be to establish a general prohibition of market manipulation and authorize the Commission to prohibit specific manipulative practices. As discussed above, that is the approach taken to prohibit market manipulation in securities and commodities laws.
Another necessary change to the Federal Power Act is to amend section 203 and grant the Commission jurisdiction over the disposition of generation facilities. That will enable the Commission to prevent the accumulation of unmitigated generation market power. The Commission could still approve the acquisition of generation facilities, even by jurisdictional public utilities with significant existing generation market power. However, it would have the ability to condition these dispositions to mitigate any market power impact. The Bush Administration proposed providing the Commission authority over generation acquisitions.173
There are other enforcement powers possessed by federal economic regulatory agencies that should be extended to the Commission. For example, the CFTC can issue cease and desist orders, preventing a person from manipulating or attempting to manipulate the market price of a commodity.174 Failure to comply with a cease and desist order is a misdemeanor, subject to monetary penalties and not less than six months nor more than one year in prison.175 The SEC also can issue cease and desist orders not only in the event of past or ongoing violations of the securities Exchange Act of 1934 or SEC rules or regulations, but also future violations.176
There is also a need to strengthen the Commission's ability to collect market information on a routine basis from all market participants, not just public utilities.177 Without the ability to obtain information from all sellers or other entities that have market price information, it is difficult to adequately monitor and understand market developments. Under current law, the Commission can obtain information only from market participants other than public utilities in the course of a specific enforcement investigation,178 or in the preparation of a report to Congress.179 Market participants other than public utilities are also not subject to the Commission's quarterly filing requirements.
As stated earlier, the Commission has a legal duty to prevent unjust and unreasonable prices for wholesale power sales by jurisdictional public utilities. This duty is absolute, and not discretionary, although the Commission has discretion in how it discharges this responsibility. The Commission has chosen to rely increasingly on market forces to assure just and reasonable rates, largely in reaction to the dramatic changes that have taken place in the industry. The courts have upheld that approach.
The Agency has been careful not to rely solely on market forces, and has taken aggressive steps to strengthen its regulatory regime governing the marketbased sales program. An important component of that regulatory regime is the rules the Commission issued to prevent market manipulation: the Market Behavior Rules. However, those rules may be as far as the Agency can go under its existing legal authority. They do not go far enough. The Market Behavior Rules have also been challenged in court.180 If the Commission is reversed, and the behavioral rules are overturned, it may prove difficult for the Commission to prevent manipulation of wholesale power markets. The best way to secure the ability of the Commission to prevent market manipulation is to grant the Agency express statutory authority to do so.
If Congress shares the Commission's concern about preventing market manipulation and preventing the exercise of unmitigated market power, it should enact legislation to establish an express prohibition of market manipulation, authorize the Commission to proscribe specific manipulative practices by rule or order, strengthen the Commission's penalty and enforcement authority, and grant the Commission authority to review all dispositions of generation facilities by jurisdictional public utilities. If Congress does act, and grants the Commission the authority it needs to prevent market manipulation and prevent the exercise of unmitigated generation market power, the Commission will judiciously use this authority to discharge its legal duty to assure just and reasonable rates. If Congress fails to act, it may prove difficult for the Commission to prevent market manipulation and the accumulation of generation market power, a result that can only disserve the public interest.
Hon. Joseph T. Kelliher*
* Commissioner, Federal Energy Regulatory Commission; B.S.F.S., School of Foreign Service, Georgetown University; J.D., Magna Cum Laude, Washington College of Law, American University. This article represents the views of the author, and not necessarily the views of the Federal Energy Regulatory Commission or the United States Government.…
Questia, a part of Gale, Cengage Learning. www.questia.com
Publication information: Article title: Market Manipulation, Market Power, and the Authority of the Federal Energy Regulatory Commission. Contributors: Kelliher, Joseph T. - Author. Journal title: Energy Law Journal. Volume: 26. Issue: 1 Publication date: January 1, 2005. Page number: 1+. © Foundation of the Energy Law Journal 2008. Provided by ProQuest LLC. All Rights Reserved.
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