How financial traders generated profits from California’s power grid
For the past decade, electricity traders and generators have taken advantage of a little-known wrinkle in California’s energy market to extract more than $866 million from the state’s power grid.
Utility ratepayers have absorbed the losses, according to the California Independent System Operator, or ISO, which oversees the sprawling network of power plants, transmission lines and transformers that make up the grid.
Behind it all, wealthy energy traders and generators have been quietly profiting from a collection of arcane financial contracts known as “congestion revenue rights,” a Sacramento Bee review of financial records and interviews shows.
The ISO created the lucrative contracts to help PG&E Corp. and other utilities cushion themselves against spikes in energy costs that occur when portions of the grid get clogged with electricity. The contracts act as a kind of insurance policy, paying cash to offset at least part of the cost of making sure power flows during high-use “congestion” time.
Yet since trading began in 2009, outside investors — mostly a host of boutique commodities trading firms from around the country — have been making sweet profits.
The key to their success: They’ve found contracts covering remote segments of the grid, overlooked by their competitors, and bought them for next to nothing. That’s made the contracts a goldmine.
“We saw financial entities picking off corners of the system on the cheap,” said Perry Servedio, the ISO’s lead market design policy developer.
The profit-taking at the expense of utilities and their ratepayers has largely escaped public notice.
In mid-July one trader, a little-known Houston firm called Vitol Inc., was accused by federal officials last month of trying to fraudulently manipulate the flow of electricity in California to enhance the value of its congestion contracts — but the case was barely mentioned in the media. The firm has denied the allegations.
What occurred isn’t equal in magnitude to the energy crisis of 2000 and 2001, when California was publicly held hostage by blackouts and horrific spikes in electricity costs. Investigators later revealed that rogue traders at Enron, a now-defunct Houston company whose CEO went to prison, and other firms had manipulated energy supplies to swindle billions from California ratepayers.
Nevertheless, the trading in congestion contracts has become another example of how California’s system for delivering electrons has left itself vulnerable to outside forces.
And this time, unlike what happened in the Enron era, the trades are perfectly legal.
“This is not manipulation. It’s a problem with the rules,” said Eric Hildebrandt, director of market monitoring at the ISO. Hildebrandt, who acts as a kind of in-house watchdog at the ISO, has been warning about the problem for years and testified before Congress on the subject in 2017.
The problem got so bad that the ISO has overhauled the system to limit the red ink, effective this year. The losses have been significantly reduced through the first half of 2019, according to Hildebrandt.
Energy traders say the market reforms were a major over-reaction — and ignored the useful role that congestion contracts play in helping utilities manage their electricity flows on the grid.
“We thought it was too drastic a solution,” said Scott Miller of the Western Power Trading Forum, a Sacramento-based association of energy traders and marketers. “The fact that there are winners or losers at any given time is not a problem; it doesn’t mean anyone is manipulating the market.”
His association is asking the ISO to reconsider the changes it’s made.
In the scheme of things, the $866 million in losses over a decade aren’t enormous. The cost of electricity just for California’s three largest utilities is more than $30 billion a year, according to Public Utilities Commission data.
Still, the ISO doesn’t appear likely to back off from the changes it’s implemented to stem the losses on congestion contracts. Servedio said grid managers are watching to see if the reforms take hold for good — or if more tightening of the system is needed.
“The early indications are that (the changes) have been a success,” Servedio said. “If these metrics start to deteriorate, we have no hesitation taking additional action.”
Employees of these energy trading firms seem to inhabit a small, specialized universe. Take, for example, Federico Corteggiano.
Last month, the staff of the Federal Energy Regulatory Commission accused Corteggiano and his employer, Houston-based Vitol, of making illegal energy trades in the California ISO to avoid potential losses on congestion contracts. FERC’s staff wants to fine Vitol about $7.2 million and Corteggiano $800,000.
In its complaint, FERC’s staff said Corteggiano was well aware of the intricacies of the ISO market. While working at a consulting firm in the mid-2000s, he helped create the software the ISO uses to run the congestion contracts. A few years later, FERC said, he was working at Deutsche Bank when the German investment bank was fined $1.5 million for manipulating California’s market, although he wasn’t named in that complaint.
“Corteggiano acquired the knowledge of how to manipulate congestion costs ... in 2010, when he was working at Deutsche Bank,” said the FERC complaint against Vitol and Corteggiano.
Vitol said in a prepared statement that its “conduct was lawful.”
It’s hard to quantify how much the congestion losses have added to the average Californian’s electric bill. The latest available figures from the U.S. Department of Energy show average electricity rates in California rose 24 percent from 2009 to 2017, to 18.31 cents per kilowatt hour.
While the cost per kilowatt is 40 percent above the national average, Californians’ actual monthly bills are about $10 lower than average because the state’s residents use a lot less power.
Enron, blackouts, price spikes
The ISO runs the transmission grid for about three quarters of the state’s electricity network, including the territory served by PG&E, Southern California Edison, San Diego Gas & Electric and many of California’s major public power agencies.
One notable exception is SMUD. The Sacramento Municipal Utility District isn’t a full member of the ISO grid and its ratepayers aren’t absorbing any of the losses incurred on the congestion contracts.
Operating from a sprawling $150 million headquarters near Folsom High School, the ISO is a creature of California’s effort to deregulate its energy markets beginning in 1998.
Attempting to inject market competition into a bloated system, the Legislature ordered PG&E, Edison and SDG&E to sell most of their plants to independent generators and then buy most of their power on a “day ahead” spot market. The ISO was established by the state to run the transmission network and smooth out minor, temporary shortages by purchasing bits of power.
In 2000, however, the market went haywire. Electricity costs went from around $30 per megawatt hour — enough juice to power 750 homes for an hour — to as much as $1,000.
The ISO was thrust into the role of savior and forced to buy enormous volumes of electricity, regardless of price, to keep the lights on. Several days of rolling blackouts hit the grid when purchases fell short. As prices soared, the ISO billed its member utilities for the costs — driving PG&E into bankruptcy. (It emerged from bankruptcy in 2004, only to file for protection again this year because of billions in wildfire liabilities.)
Calm was restored when the state began buying power for the utilities on long-term contracts. That broke the fever in the spot market. When it was later revealed that Enron and its brethren had gamed the system — manipulating supplies to jack up prices with cleverly-named trading schemes like “Death Star,” “Get Shorty” and “megawatt laundering” — state officials began filing legal claims to recoup the losses.
In the years since, the state has recovered more than $7.5 billion for utility ratepayers, representing about 75 percent to 80 percent of the estimated losses.
Nearly 20 years after the crisis, the California energy market is relatively uneventful. The last big trading scandal was settled in 2013, when Wall Street titan JPMorgan Chase & Co. paid $410 million over charges that it used an illegal bait-and-switch scheme to squeeze more dollars from a fleet of Orange County power plants. Morgan didn’t operate the plants but owned the rights to market the juice it generated.
A major reason why peace has been restored is a structural change. Nowadays the utilities buy most of their electricity via long-term contracts; the ISO buys relatively little. But the grid operator still runs a series of markets, populated by utilities, independent generators and traders, in which power is bought and sold, sometimes on an hourly basis, at more than 1,000 locations across the state.
One of the factors that can influence price is transmission congestion. If demand for power soars, or a transmission line fails, it can cause a line to become overloaded with electricity. When that happens, the ISO will direct a generator to kick into gear and deliver juice to customers from a different location. Because ISO markets are designed to buy only the cheapest power available, that backup generator will invariably be more expensive, raising the price of electricity in that sector of the grid.
In other words, congestion costs money.
Clearing up congestion
In 2009, with the blessing of the Federal Energy Regulatory Commission, the ISO and other grid operators around the country introduced “congestion revenue rights,” contracts that would allow the grid to protect itself, or “hedge,” against congestion costs.
Like an insurance policy, the contracts pay the grid cash to offset, or at least partially offset, the congestion costs. Financial traders were allowed to participate in the market because any wager needs a counter-party to put up cash on the opposite side of the bet. “The role of a financial entity ... is to provide the liquidity.”
For financial traders, the contracts are a way of speculating on congestion. If traders bet the right way, their contracts gain value and they collect money from the ISO. If they bet wrong, they pay money to the grid operator.
For the most part, they’ve bet right. Since 2016 Hildebrandt, the director of market monitoring, has been warning leaders of the ISO that the grid was bleeding millions of dollars on congestion contracts. From 2012 to 2015, “the losses to ratepayers” were averaging $130 million a year, he wrote in a report in 2016.
Hildebrandt’s analysis showed independent power generators were making money off congestion contracts, too. But the lion’s share of the profits — more than 85 percent — was going to financial trading firms.
To be fair, Hildebrandt said the problem of congestion contracts is hardly unique to California. In 2017, he testified to the House energy subcommittee that congestion contracts were costing ratepayers around the country $400 million a year.
According to Hildebrandt, the losses were largely the result of a “major market design flaw” — the grid operators’ decision to auction off the contracts en masse.
California’s grid is divided up so finely that, until recently, it was auctioning 1.2 million congestion contracts at a time on its computerized trading platform. That made it easy for savvy traders to find contracts ignored by their competitors and buy them cheaply — often for 50 cents on the dollar or less.
“You had all this bidding behavior spread out over potentially 1.2 million different combinations,” Servedio said. Traders “could get an enormous undervaluation and then make a much larger return. We saw that as a lack of competition.”
Late last year, the ISO attempted to curtail the losses. It put a cap on how much money traders could earn from congestion contracts. And it dramatically reduced the number of contracts up for sale, to about 90,000, according to Servedio.
“We’re able to focus all the bidding behavior and therefore increase the competition,” he said.
The losses totaled $8 million in the first half of 2019, compared to $61 million in the first half of last year.
Problem solved? Hildebrandt, the ISO’s watchdog, isn’t convinced.
While he applauds the organization for making changes — something grid operators in other states haven’t yet undertaken — he said the ISO’s system remains vulnerable.
“It’s still money going out,” he said. “The potential remains for much more significant losses.”