Hedging bets on electricity

Zen and the art of making utility customers pay for trading losses

January 09, 2008|By JAY HANCOCK

The New York offices of hedge fund Tower Research Capital are decorated with Buddha statues, "ornate lamps, oriental rugs, pottery, sofas, tables and plenty of plants," says Alternative Investment News. More plants and statues are on the terrace, "creating a Zen garden feel."

It's easy to be mellow when you can force hapless electricity customers to cover your losses.

A Tower affiliate just lost what grid managers estimate to be an $80 million bet on electricity hedges that now must be covered by Baltimore Gas and Electric households and other Mid-Atlantic consumers.

The default by Power Edge LLC, disclosed Dec. 26, is another, particularly ugly demonstration of how flawed wholesale power markets - enabled by Washington - help drive up prices for everybody now that electricity has been deregulated.

Last year PJM Interconnection, which manages the grid from New Jersey to North Carolina, pleaded with Washington for protection from Tower and other Wall Street cowboys.

PJM urged the Federal Energy Regulatory Commission to require ample collateral from financial speculators, so users wouldn't be left holding the bag in case something goes wrong. On Oct. 26 FERC refused, saying that, while it recognized the potential risk, there was no reason to hurry with strict new rules.

A few weeks later Power Edge lost badly on electricity trades and defaulted on payments to PJM. Because Power Edge is a limited liability corporation, PJM has little recourse and must spread losses among members such as BGE and other utilities, generation companies and power sellers.

"This default would not have happened" if FERC hadn't rejected the request, says David M. Kleppinger, a lawyer who represents industrial electricity customers.

Until now Tower founder Mark Gorton, an electrical engineer and Harvard MBA, was more famous for launching LimeWire, the popular music- and video-sharing Web software. But Gorton makes his money other ways, notably by hiring Ivy League math types and turning them loose on the markets.

"Hack Wall Street" says Tower's recruiting come-on. The firm employs "rigorous statistical methodology to identify non-random patterns in the behavior of markets," says its Web site. "Exploiting these inefficiencies allows the firm to earn exceptional returns with very little risk for its clients."

Especially when it can stick others with the losses.

Power Edge is one of several Tower affiliates set up to speculate on electricity, according to a piece last year in Power Markets Week. The entities buy "financial transmission rights," which are bets on whether or not congestion will increase costs on certain parts of the grid at certain times.

Making money in PJM's illiquid and inefficient FTR market was probably kindergarten for these guys. But while the geniuses got the trading algorithms just right, they apparently forgot to check the maintenance schedule on PJM's Web site. A planned transmission outage in New Jersey caused the Power Edge position to go badly wrong, leading to the default.

When the bet went bust, the company owed other grid participants an estimated $80 million that it couldn't pay because it didn't post enough collateral. Under PJM rules, when one member defaults, everybody else covers the shortfall.

"We're not commenting on this," said Nick Underwood, Tower's director of investor relations.

PJM is again asking FERC for permission to toughen collateral requirements. The nonprofit grid manager, based in Norristown, Pa., is also "assessing the appropriate legal steps" related to the Power Edge blowup and another, much smaller default by another player, spokesman Terry Williamson says.

Asked whether FERC made the right decision in October, an agency spokeswoman referred me to an order stating that PJM didn't demonstrate an urgent need for new rules because, "with the passage of the summer congestion period, the credit risk identified by PJM for this year has essentially passed."

Oops. Power Edge defaulted in November.

Because financial players such as Tower suck millions from wholesale electricity markets that will never be invested in a single generation plant or transmission line, some users claim they hurt the system even when their bets are successful.

"For every dollar in profits that a financial arbitrageur extracts from the market, that's one less dollar in savings that's going to go to customers," says Kevin Murray, an engineer who works on energy issues for the McNees, Wallace & Nurick law firm in Columbus, Ohio. "It ends up being basically a wealth transfer from one segment of the population to another."

On the Midwestern grid, investors in financial transmission rights with no stake in electricity hardware have taken about $100 million a year from the system for the last three years, estimates Mike Stuart, senior vice president of policy at Wisconsin Public Power.

So you, the electricity customer, lose when Tower loses. And you lose when Tower wins.

Spread across the grid, the $80 million Power Edge default would come to pennies per BGE customer if the utility decided to pass along the cost. But it's part of a troubling pattern that has driven kilowatt prices higher than what can be explained by more-expensive oil, natural gas and other generation fuel.

Allegations of Enron-style manipulation by power-generation companies continue to crop up in wholesale markets across the country. PJM's own market monitor has found evidence of "excess" profits by generators, which FERC has disregarded. And the whole thing is opaque. We don't know what positions Tower may have taken in other trading vehicles still in business.

Gorton, who already has an enemy in the Recording Industry Association of America because of the file sharing enabled by LimeWire, has earned new hostility with this stunt. But save some blame for the Washington bureaucrats, deep in their own Zen trance of denial.

jay.hancock@baltsun.com

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