Did Electricity Market Manipulation Cost New York Consumers $157 Million in the Summer of 2006?

The NYISO Capacity Market Price Cap
In papers filed in early 2007 with the Federal Energy Regulatory Commission (FERC), Con Edison asserted that manipulation of a wholesale electricity market cost New York consumers approximately $157 million in the summer of 2006. An association of large electricity users, Multiple Intervenors, also contends that economic withholding by electricity producers has driven up consumer prices by "tens if not hundreds of millions of dollars." The issue was flagged last summer in a Newsday article but at the time the total cost to consumers was not known.

These overcharges would have been possible because of the electric industry “restructuring” of wholesale electricity markets encouraged and facilitated by the New York Public Service Commission (NYPSC). To implement its 1997 “rate/restructuring” agreement with the NYPSC, Con Edison sold most of its power generating plants to three new owners, now KeySpan-Ravenswood, NRG and US Gen. As a result, Con Edison purchases electricity back from these new owners in wholesale markets to meet its customers' needs.

FERC-approved wholesale markets permit sellers of electricity to sell at “market based rates” that are not publicly filed in advance subject to FERC review before taking effect, in contrast to filed cost-based rates which prevailed prior to deregulatory initiatives of FERC. "Market-based rates," if they are actually set by a competitive market, may or may not be less than cost-based rates set under traditional regulation. "Market-based rates", however, have a serious shortcoming not present with cost-based rates - they are susceptible to market manipulation and strategic gaming. In this instance, Con Edison and others argue that certain wholesale "market-based rates" in the Summer of 2006 period were subject to manipulation and that this manipulation cost consumers $157 million. Con Edison passes such wholesale costs on to its retail customers through its monthly "Market Supply Charge."

The "New York Independent System Operator" (NYISO) is a private utility that operates the grid and wholesale electricity markets in New York. NYISO, with FERC approval, created an “installed capacity” (ICAP) auction market to collect payments from “load serving entities,” the largest of which in New York City is Con Edison. The "load serving entities" then pass along the costs of the capacity purchased in the ICAP market to their retail customers.

One of the intended functions of the ICAP market is to create regular payments to owners of existing power generation plants on the theory that this will incent them - or other electric companies - to build more power plants which would also qualify for ICAP payments. As the principal strategy for inducing private investment in new generation facilities, the ICAP mechanism was intended to replace the traditional resource planning processes once conducted by utilities and the state.

Although the NYISO capacity markets have transferred billions of dollars over the past decade to the owners of existing power plants, this has not significantly stimulated construction of new power plants in New York City to meet future needs. Instead, with shortages looming on the horizon, now power plants in the New York City area have been built by Con Edison, or under contract with Con Edison, or by the state-owned New York Power Authority (NYPA), which has built numerous peaker plants and a new 500 MW Poletti baseload plant.

The ICAP auction market pays all sellers the same price. It can make sense for ICAP sellers to withhold capacity (by offering a portion of it at the highest possible price) and thereby constrain supply so as to raise the price of all other segments of their output. The inflated price of the ICAP that is sold can far outweigh the loss from the portion withheld and, therefore, unsold. Mathematical game theory analysis, economics laboratory simulations, and experience demonstrate that this is a common flaw of the NYISO uniform clearing price auctions for energy, capacity, and ancillary services.

Due to the small number of wholesale electricity sellers in the New York City area and concerns about their having market power - the ability to drive prices up above competitive levels - a price cap for this ICAP market of $105/kW year applicable to the three largest owners of divested generation was established by the NYISO, and approved by FERC. With a tight supply situation, the ICAP price was uniformly at the $105 price cap level in auctions held prior to 2006.

Economic Withholding of Capacity in The Summer 2006 ICAP Market
When 1,000 MW of new capacity was added to the New York City area in 2006 (due to the two new 500 MW power plants, one built by NYPA and one by a company under contract with Con Edison) it was expected that the ICAP auction price would fall below the $105 price cap as this should when supply is increased in a competitive market. The Summer 2006 ICAP auction price, however, did not come down at all. Instead, capacity apparently was withheld by sellers, perhaps by demanding extremely high prices so that capacity was only available at the maximum price allowed by the price cap. Auction results indicated that approximately 800 MW of ICAP offered at the capped price of $105/kW year were not purchased. If the three major owners of divested power plants all had offered their capacity as price takers, as auction market theorists believe they should, then the May 2006 auction clearing price would have been much lower than $105/kW-year level.

When the results of the Summer 2006 auction became known, buyers such as Con Edison and NYPSC staff expressed concern to the NYISO that its May 2006 auction outcomes resulted from economic withholding by a pivotal supplier, indicating a problem with the capacity market design that needed to he addressed. The CEO of the NYISO, however, wrote a “Letter to FERC Staff addressing certain issues that have been raised regarding the Installed Capacity market in New York City” in June 2006, stating

neither the [NYISO] tariff nor the Commission's [FERC's]regulations have been violated. We must conclude that the bidding and auction results have been consistent with the market conditions contemplated by the NYPSC and the Commission, and with the price cap approved by the Commission.

This NYISO letter essentially concedes that sellers' withholding of capacity to drive prices up to the maximum price cap is perfectly legal and consistent with existing NYISO market rules, and it further concedes that NYISO has no effective way to prevent withholding of capacity to drive prices up in future ICAP auctions. Under FERC’s market rate system, which consumer advocates are challenging in other cases, there is no way for effective review and revision by FERC of “market based rates” and there is no way for consumers to recover overcharges from the 2006 auction.

In July 2006, the Chairman of the New York State Assembly Energy Committee, Assemblyman Paul Tonko, wrote to the NYPSC, the NYISO and FERC to investigate whether “Enron-like gaming in the New York electricity markets” is occurring.

NYISO's Response to Market Manipulation: Reduce the Price Cap
After vigorously contested internal proceedings, the NYISO decided in a split committee vote to limit the profitability of economic withholding by lowering the maximum price that can be set by the major owners of divested generation. NYISO then filed an application with FERC in December 2006 to approve a tariff change effectively reducing the ICAP market price cap from $105 kW year to $82 kW year. The NYISO’s market advisor submitted an affidavit supporting the price reduction, explaining how ICAP market manipulation can occur and stating

Given the current level of the ICAP requirement and the available supply in New York City, the owners of the generation divested by ConEd in 1998 ("Divested Generation Owners" or "DGOs") were all pivotal suppliers during at least a portion of the two most recent Capability Periods, and one or more of the DGOs was pivotal for all of those Capability Periods. This has been true notwithstanding the recent entry of approximately 1,000 MW of new generation into the Capacity market in New York City. That entry, while significant, was not large enough to render "all of the DGOs no longer pivotal.

I have performed an analysis of the largest DGO's incentives based on the Capacity that it owns, and have determined that it is rational for that DGO to withhold Capacity to raise the Capacity price up to its offer cap level. This is the case because the percentage increase in the market clearing price is larger than the percentage decrease in the quantity of Capacity it sells when it withholds, which results in a greater overall profit. New entry of generation in amounts that would be sufficient to render all of the DGOs no longer pivotal is highly unlikely to ever occur because such investment would not be economically rational. Therefore, one may conclude that the market power issues in the capacity market in New York City will exist for the foreseeable future.

Prior to 2006, nearly all of the ICAP in New York City was scheduled or sold in the NYISO Capacity markets. Beginning in January 2006, more than 1000 MW of new Capacity has been installed in NYC. Given that the marginal cost of selling Capacity is close to zero for most units, the amount of Capacity sold in New York City under the NYC Locality Demand Curve would have increased by this quantity if the market were performing competitively. However, the total ICAP sales actually fell slightly after approximately 500 MW of new capacity at Poletti became available in early 2006. This occurred because one incumbent supplier reduced its sales by approximately the same amount as the new capacity at Poletti. This supplier routinely offered the bulk of this unsold Capacity into the Energy market, which indicates that it could have been sold in the Capacity market with little additional cost. The unsold Capacity quantities increased in May 2006 when an additional 500 MW of Capacity from the SCS/Astoria Energy LLC facility came online. * * * *

I conclude that the ICAP Spot Market Auctions during the 2006 Summer Capability Period have been characterized by economic withholding of Capacity to exercise market power to the maximum extent allowed by the existing offer cap for the DGOs.

The largest DGO in the New York City area, KeySpan-Ravenswood, filed papers opposing the NYISO's proposed price cap reduction, asserting that the existing $105/ kW year DGO price cap is actually too low. In contrast, Con Edison supported reduction of the price ceiling, stating in its papers

the impact on New York State’s consumers of economic withholding during the 2006 Capability Year on was approximately $157 million, of which approximately $119 million impacted New York City consumers alone.

The NYPSC in its comments also agreed that the ICAP market had been manipulated by withholding to make capacity scarce and raise prices:

NYC is a large load pocket that requires about 9,300 MW of local ICAP, while about 5,900 of capacity in NYC is owned by three large DGOs (i.e., KeySpan, USPower Gen, and NRG). Each of these suppliers is pivotal is the sense that supply from each is needed in order to avoid a capacity deficiency. As such, each supplier has the ability to exert market power and to set market prices.

In 2006, approximately 1000 MW of new capacity entered service and was offered into the NYC ICAP market, leading to a reasonable expectation that capacity prices would decline, both in NYC and in the statewide market. However, the NYC ICAP spot market continued to clear at the highest of the DGOs' bid/price caps, despite this recent addition of capacity. The explanation for this result is that there has been a significant increase in economic withholding in the NYC market, impacting both the NYC and statewide capacity markets.

In another proceeding pending at the NYPSC, the City of New York made the following comments regarding price manipulation in New York City electricity markets:

One factor currently impeding the operation of a merchant market in Zone J is the market power of the three major in-City generators. Market power allows those generators to maintain market prices above competitive levels and discourages them from adding capacity that might dilute their market power* * * * [A]ny one of them can set the price above the level that would be the market-clearing price if all capacity were to be bid in at prices intended to clear in a market not subject to distortion. They have every financial incentive to do so * * * *

In the case of KeySpan, its status as a pivotal capacity bidder has also been exacerbated by the company’s use of a contractual arrangement [with Morgan Stanley] to financially purchase 1,800 MW of capacity in the New York City market for a period of three years at a fixed price of $7.57 per kW-month. When coupled with its ownership of the largest in-City generation facility, this gives KeySpan a direct or indirect stake in some 4250 MW of capacity, and a significant interest in higher capacity prices.

FERC Rejects the Price Cap Reduction
On March 6, 2007, FERC issued an order rejecting the NYISO request to reduce its ICAP market price cap, finding that the NYISO had failed to submit "cost support" and "economic justification" for the revised price cap. FERC did not directly mention the apparent withholding and market manipulation. After rejecting the price reduction, FERC stated "[n]evertheless, upon consideration of the pleadings filed in this case and the problems they identify with the current in-city ICAP market rules" it would commence a new case to examine NYISO market rules. FERC also directed commencement of confidential settlement proceedings in the new case, with a refund effective date 60 days hence.

Thus, instead of investigating withholding or on its own motion taking action to correct and refund overcharges due to market manipulation, FERC is examining whether to change the market rules prospectively. This is consistent with FERC's effort to rely on markets without examination of the rates they produce. Indeed, even in cases of egregious manipulation, FERC has opposed subsequent correction of market rates that were set as a result of market power exercise in dysfunctional or non competitive markets it had approved. Recent court decisions, however, have rejected FERC's approach, which is to treat unfiled market rates as if they had been previously filed and approved. These court decisions hold that unreasonable market rates which were not set in a competitive market and which were not subject to review by the public and FERC before they took effect are illegal and correctible. The Court of Appeals for the Ninth Circuit in a December 2006 decision dealing with unreasonable contract rates of sellers with "market-based rates" summarizes FERC's failure to protect customers, which is the primary purpose of the Federal Power Act:

Ultimately, the fatal flaw in FERC’s approach to “oversight” is that it precludes timely consideration of sudden market changes and offers no protection to purchasers victimized by the abuses of sellers or dysfunctional market conditions that FERC itself only notices in hindsight.

As a result,

• FERC has allowed the current NYISO tariff and DGO price cap to remain in effect
• FERC commenced no proceeding to investigate withholding, market manipulation, or to require refunds of unreasonable ICAP market rates charged in the Summer of 2006
• FERC began a new proceeding only to consider tinkering with NYISO market rules that would be prospective in nature.
  
• FERC and the NYISO have no effective curbs on economic withholding by pivotal sellers to drive prices up in future NYISO ICAP auction markets.

Depending on the date the NYISO holds the next ICAP auction, and the results of the new FERC proceeding, it is possible that the ICAP auction market manipulation and overcharges could recur.

A Role for State Action
It its 1996 "vision order" charting the course for its experiment with restructuring, the NYPSC expressed a prescient concern that things might not go as hoped, stating:

In order to ensure that electricity customers are not subject to the abuses of dominant market power, we reserve our authority to protect consumers if a supplier obtains dominant market power.

New York state needs to take action to protect its electricity customers from manipulated prices in NYISO auction markets. In a recent decision, New York’s highest court stated that the NYPSC

maintains ‘light regulation’ over [electric companies that sell only at wholesale] covering ‘matters such as enforcement, investigation, safety, reliability and system improvement. This light regulation also gives the PSC authority to limit . . . power in the market . . . and any actions in contravention of the public interest.’

The NYPSC can and should exercise more fully its powers to correct exercise of market power by sellers in the NYISO markets and to assure that the NYISO and other electric companies act in the public interest in the future. See NYISO Costs Skyrocket, Benefits Questioned.