The Federal Energy Regulatory Commission fined JPMorgan $410mm today and you can see why JPMorgan would be okay with that. The details are in this marvelously complicated FERC order and settlement agreement,1 but the outlines of the story are simple. FERC built a terrible box, and the box had some buttons that were labeled “push here for money,” and JPMorgan pushed them and got money. You can understand the category mistake very easily:

  • FERC thought the box was for generating electricity at market prices but with a robust backup system to ensure reliable supply, and
  • JPMorgan thought the box was for dispensing money.

It’s a perfectly understandable mistake to make if you have spent your career building and operating boxes that dispense money, as JPMorgan global commodities head Blythe Masters has. What else could the box be for?

I suppose we should talk about how the box worked, because this is that sort of blog. The settlement agreement details eight strategies, cleverly labeled Strategy A, Strategy B, Strategy C, Strategy D, Strategy E, Strategy F, Strategy G, and Strategy H. Strategy A is a doozy and we should talk about it in the footnotes,2 but really Strategy B, in addition to being much simpler, is a better encapsulation of what is going on here. Here is all of it:

42. Strategy B (January 2011). On January 1, 2011, JPMVEC [JPMorgan Ventures Energy Corporation] took over responsibility for four additional plants. JPMVEC developed a new bidding strategy for two of the plants (AL3&4): for every third hour, submitting an energy self-schedule while submitting prices of between $73/MWh and $98/MWh in the two hours in between. (A self-schedule means that the generator is a price taker, that is, the unit will accept any price set by the market, making a self-schedule more attractive than any price a generator can submit to CAISO [California Independent System Operator, the relevant grid operator].)

43. CAISO gave Day-Ahead awards for the hours in which JPMVEC had submitted self-schedules. JPMVEC’s bids in the intervening hours would typically be out of the money. But CAISO’s software needed to take into account the physical limitations of plants, including the fact that just as cars can only accelerate or brake at a certain rate, a power plant can only increase or decrease its output (i.e., “ramp up” or “ramp down”) at a certain speed, called its “ramp rate.” The CAISO system gave the units large Day Ahead awards every third hour due to the self-schedules and also gave JPMVEC Day Ahead awards in the intervening hours to respect the units’ ramp rates that JPMVEC had registered with CAISO. JPMVEC was paid as bid (via BCR) at the $73/MWh to $98/MWh prices it submitted to CAISO for the intervening hours.

BCR is “bid cost recovery,” the system under which CAISO pays operators non-market bonuses to basically make sure they have their plants on when needed. The strategy is simple enough:

  • The market clearing price for electricity will be, say, $30/MWh.
  • Your inefficient old plants cost about $40/MWh to produce electricity.
  • So you offer to be a price taker every third hour, selling your electricity at $30/MWh.
  • The other two hours you offer $80/MWh, which is way way way above market.
  • The system always lifts the offers of price-takers, so you’re contracted to supply electricity every third hour.
  • But the system, in its infinite wisdom, understands that you can’t just turn a power plant on and off like that.
  • So it tells you to produce energy, at the prices you offered – effectively $80, $80, $30 – for each of those three hours.
  • The system, in its frankly circumscribed wisdom, doesn’t understand (1) that you are fucking with it or (2) that your average price for those three hours is actually $63.
  • So you make a profit of $23/MWh instead of the loss of $10/MWh that you’d have at market rates.

I mean! The only proper response to that is, the first time you do it, CAISO calls you up and tells you to knock it off, and then changes its rules to prevent this sort of obvious gaming. JPMorgan didn’t write in big block letters at the top of its bid that day “HI GUYS WE FOUND A LOOPHOLE AND THIS IS IT” but surely its bid should have had the same effect. We don’t, however, live in the first-best world where CAISO just called them and told them to knock it off, so instead JPMorgan are paying a big fine two and a half years later.3 And they look like villains, and CAISO look like dopes, the two great stock characters of the theater of financial scandal. How you feel about this is almost purely a matter of personal aesthetic preferences; if you’re an electric ratepayer you probably feel Bad and if you’re the inventor of synthetic CDOs you’re like “well of course we did that, we would be nuts not to, it was right there in the rules, they were practically begging us to do it.”

The other strategies are exactly like that in concept4: FERC and the ISOs built a dumb system that rewarded a modicum of perfectly transparent gamesmanship; JPMorgan gamed them in the obvious and perfectly transparent way; JPMorgan made money that it did not, you would have to say, “deserve” to make; and now FERC is mad. The record has a certain amount of JPMorgan maybe lying about its intent and feelings on the matter,5 but there was no lying, or need for lying, about what happened. This is not like Libor, where you had to affirmatively lie. Here JPMorgan just followed the rules, simply and literally, but they followed them to places they were not meant to go.

A generic and important problem with financial scams is one of allocative inefficiency: if you find a scammy way to package mortgages or manipulate interest rates or just Ponzi it up, then money is flowing to mortgages or interest-rate swaps or your Ponzi scheme that in a world of perfect information would be going to more productive uses. That problem is often sort of abstract – telling the average person “well Libor manipulation probably lowered your mortgage rate, but really that money shouldn’t have been going to your mortgage,” tends not to boil his blood – but you can always fall back on a rhetoric of theft: even if it’s hard to see exactly who was hurt by Libor manipulation, the banks’ undeserved profits on it is reason enough to get mad.

Here, sure, JPMorgan made undeserved profits, and those undeserved profits came directly from electricity customers, so you can get mad about the theft if you want. (The fact that the theft was done through utterly transparent manipulation of dumb ISO rules makes me fairly sympathetic, but probably doesn’t do much for the irate ratepayers, who after all didn’t make those rules.)

But it’s also harder to miss the inefficiency. JPMorgan was selling electricity from ’50s and ’60s era steam boiler power plants that produce electricity too inefficiently to compete with modern plants. They ran them anyway, as a frankly incidental component of their box-button-pushing strategy – if they could have done the whole thing synthetically they probably would have. They were just exploiting mistakes in abstract rules by sending around spreadsheets; they didn’t have any particular interest in doing anything in the real world. But as it is, the rules they exploited required them to turn on massive inefficient power plants every day so as to generate overpriced and overpolluting electricity. Rather than generate electricity more efficiently they just found more efficient ways to get overpaid for the electricity they generated. As a metaphor for how financial innovation substitutes for real innovation it’s hard to beat.

FERC, JP Morgan Unit Agree to $410 Million in Penalties, Disgorgement to Ratepayers [FERC]
Order Approving Stipulation and Consent Agreement [FERC]

1. You can always count on an electric regulator for a fancy prose style:

32. JPMVEC’s buyback bids at 120% of Day Ahead prices were intended to be above Real Time LMPs, but only by a small amount. Although Real Time bids at higher prices would have made a dec-down more likely, higher bids could also have reduced JPMVEC’s BCR payments. In response to JPMVEC’s bids, CAISO often dec’ed JPMVEC’s units down to their Pmin in the Real Time Market, resulting in a MEAF of zero.
33. JPMVEC’s bids took into account that, under the BCR formula as then applied, a zero MEAF had two important impacts on payments from CAISO. First, a zero MEAF largely neutralized reductions to BCR that would otherwise have resulted from JPMVEC’s -$30 Day Ahead bids.

Just beautiful stuff.

2. The gist of Strategy A, as I understand it, is roughly that CAISO decided which plants should turn on each day based on the average price they bid for that day in the previous day’s one-day-ahead market, but then actually paid the plants that were turned on based on a two-tier system where their base generation could be at a much higher price than their marginal generation (or the market price). So JPM would effectively bid $90/MWh for its first 91 MWs (its base load, the minimum to turn on the plants) and -$30 (negative $30) for its next 134 MWs, for an average bid of $18ish. They’d get awarded the full 225 MWs at the market price, say $30. Then they’d go into the real-time market the next day and buy back the marginal 134 MWs at slightly above market prices, leaving them with just the base 91 MWs. And through the magic of the pricing system it was able to sell those 91 MWs at the $90/MWh that it had bid. My effort to do the approximate fake math is here.

3. TBF Strategy B only lasted a month so maybe they did catch on quick. The rule change to fix it is obvious: you gotta evaluate the average effective price of the whole award before awarding a ramp-down, instead of just awarding the self-schedule and then the rampdown at whatever price the plant wants.

4. Strategy D is a particular favorite of mine. It’s almost exactly the same as B except it uses the ramp-down trick over the hours before and after midnight: “Because CAISO’s system evaluated only one day’s bids at a time,” and because it knew plants couldn’t turn off on a dime, it’d give JPMorgan an award to generate electricity at market prices (based on a sure-to-be-accepted bid of -$30/MWh) from 11 to midnight, and then at $999/MWh from midnight to 2am. Which is not exactly a peak time! “CAISO paid JPMVEC for those awards at the units’ bid price of $999, even though market prices for the period between midnight and 2 a.m. were about $12/MWh.” Hahahaha I mean how can you not admire that at least a little bit? “Boss, I have found a way to charge 80x the market price for electricity at 1am.” Why invent cold fusion when you can do that? Also, like, imagine the people getting their electric bills and finding out that their 1am porn-surfing cost them $1,000.

5. E.g., and here just kinda let the jargon wash over you:

In phone calls with the CAISO Market Monitor (MMU) in March and April 2011, when asked about the reasons for the company’s bids to CAISO, the Principal Investments personnel who spoke on behalf of JPMVEC stated that their goal was to have the units picked up by CAISO and to respond to the Real Time market. The Principal Investments personnel did not mention BCR or the MEAF as relevant factors.

57 comments (hidden to protect delicate sensibilities)
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Comments (57)

  1. Posted by B. Masters | July 30, 2013 at 11:35 AM

    When you push the buttons on my box, you will get something, but its not money

  2. Posted by beer goggles | July 30, 2013 at 11:37 AM

    i'd throw her a bone, right?

  3. Posted by Guest | July 30, 2013 at 11:50 AM

    FERC me? FERC YOU, pal!

  4. Posted by Guest | July 30, 2013 at 11:52 AM

    I'd swap that TNA for a CDS

  5. Posted by Wooderson | July 30, 2013 at 12:03 PM

    Aerosmith, 2 weeks. Don't forget.

  6. Posted by beer goggles | July 30, 2013 at 12:03 PM

    yeah, but are they synthetic?? enquiring minds want to know!

  7. Posted by bruschettaboy | July 30, 2013 at 12:39 PM

    Wow, how smart. Smartity-smartity-smart! I bet they aced the Applied Smartness paper at the Massachussets Institute of Smart. How dumb do you have to be to know that there's a general rule against manipulation, ten years after Enron? Really smart, that's how dumb.

  8. Posted by Brian Hunter | July 30, 2013 at 12:51 PM

    WTF are you talking about? Meh, never mind, I've got big mouth bass to catch.

  9. Posted by Regina Phalangie | July 30, 2013 at 1:00 PM

    The only thing worse than a hipster is a Texas hipster.

  10. Posted by J. Skilling | July 30, 2013 at 1:10 PM

    *fucking smart

  11. Posted by Lord Humongous | July 30, 2013 at 1:28 PM

    Don't call me pal, chum

  12. Posted by a.s. | July 30, 2013 at 1:29 PM

    Can someone please photoshop that jacket out of the picture?

  13. Posted by D.O.U.G. | July 30, 2013 at 1:51 PM

    Matt —

    Since the inception of CAISO, the abstract, ambiguous and awful rule setting mechanisms have been begging to be LEGALLY exploited. And they were. Sell off all your generation and force the load into the spot markets with the inability to hedge? CAISO. Set up the CDWR to buy insanely priced long term energy contracts at the top of the market? California. Have software that can not handle optimization of min run times on assets across a system wide linear optimization problem? CAISO. Force utilities to purchase 33% RPS standards which force MORE volatility onto a system that is already stretched? California. My personal favorite: "No, we dont need a nuclear plant generating energy this summer, lets form a chant circle, spread pixie dust on ourselves and pray to Obama that the lines between San Diego and the OC don't burn down.: What a joke of a state and an ISO. JPM should run them over again…and again…and again…

    –D.O.U.G

  14. Posted by quant me maybe ... | July 30, 2013 at 1:52 PM

    The outfit says reference librarian. That well defined jaw line says sucking golf balls through 50ft of garden hose poses no real challenge.

    – There, someone had to say what everyone was thinking.

  15. Posted by DDD | July 30, 2013 at 2:03 PM

    The notional value of the synthetic market is 42T while the underlying is only 32B

  16. Posted by M.I.K.E. | July 30, 2013 at 2:28 PM

    Wow, you're surprisingly misinformed.

  17. Posted by Serious Question | July 30, 2013 at 2:29 PM

    Referring to footnote 2, is there some non-intuitive technical reason that a generator would want to sell electricity at a negative marginal price? Assuming that's not Matt's exaggerated assumption, allowing that seems like another major flaw in CAISO's market rules with no purpose except allowing someone to game the system.

  18. Posted by Lazer Blazer | July 30, 2013 at 2:35 PM

    Her tits look fantastic.

    -horny horny hipp0

  19. Posted by Midwestern Fat Guy | July 30, 2013 at 2:37 PM

    So how can I get my money back?

  20. Posted by D.O.U.G. | July 30, 2013 at 2:46 PM

    Yes. Many wind ts will sell at a negative marginal price especially at night. Generally it is down to -$37/MWh or so. Nukes also will sell down to any reasonable level since they do not ramp very well and their startup/shut down costs are very high. The wind is for PTC tax credit, the nukes are for starts.

    D.O.U.G

  21. Posted by Guest | July 30, 2013 at 3:04 PM

    Teach me teach me how to trade power?

  22. Posted by hipster hater | July 30, 2013 at 3:17 PM

    French hipster?

  23. Posted by Guest | July 30, 2013 at 3:26 PM

    Wear a Blythe Masters mask. Show us your tits.

  24. Posted by ILoveLamp | July 30, 2013 at 3:48 PM

    Normal Person reading the FERC Rules: "This can't be right. I don't think we should try to take advantage of these loopholes. It clearly runs against the spirit of the law, and may be an outright violation."

    Wall Streeter reading the FERC Rules: "Those fucking idiots down in D.C. We are going to make a bloody fortune here! What could possibly go wrong?"

  25. Posted by PowerNewb | July 30, 2013 at 4:24 PM

    Wind facilities are getting a $22/MWh tax credit for every MWh they deliver. On a pre-tax basis, that's worth almost $34/MWh, so they will offer down to -$34/MWh before they would consider turning off. Electricity is the only physical commodity that you can't store, so market participants will take a lot of pain overnight to keep their units on in order to be available for the peak daytime market. Even if you can turn on and off efficiently, you run the risk that something can break during startup, which would mean you have to buy back your position in the peak realtime market, which inherently will have a higher clearing price since you've self-created a shortage.

  26. Posted by Turnip Truck | July 30, 2013 at 4:25 PM

    After looking at that blazer, I take back previous comments. I'd rather see that picture of Steve Cohen's smug mug on top of Dealbreaker again.

  27. Posted by GasMaster | July 30, 2013 at 4:30 PM

    The first time I met Blythe, she came to the Bear Energy trade floor in tight black leather pants and matching jacket. Caliente!

  28. Posted by Guestulus | July 30, 2013 at 4:31 PM

    "Also, like, imagine the people getting their electric bills and finding out that their 1am porn-surfing cost them $1,000"

    Anything at 1am usually costs you more than $1,000 anyway, so what's the diff…

  29. Posted by guest | July 30, 2013 at 4:33 PM

    One of the two entities involved here did their job right.

    Hint: It wasn't FERC

  30. Posted by annika | July 30, 2013 at 5:06 PM

    omg – i remember that outfit!v hah!

  31. Posted by Jabba-wakkie | July 30, 2013 at 5:48 PM

    Please, please go post this over on dealbook's article.

  32. Posted by Blythe | July 30, 2013 at 7:00 PM

    I call the style – woodland nymphs' accounting department.

  33. Posted by 007trader | July 30, 2013 at 7:36 PM

    At least JPM uses their real time desk properly, only letting them track PnL. Barclays claims to have let them trade to get to know the markets. Ridiculous!

  34. Posted by Smitty1010 | July 30, 2013 at 9:03 PM

    Loopholes are legal, by definition.

  35. Posted by guest | July 30, 2013 at 9:25 PM

    $410MM says otherwise. but, yeah, stick with that line.

  36. Posted by TOlson | July 31, 2013 at 12:41 AM

    CalISO was told many times about the flaw in Spring 2010 and they said it was the way the market worked.

  37. Posted by A Flower | July 31, 2013 at 12:50 AM

    This case should worry all traders. If you follow the tariff and are open about your actions through your offers and through discussions with the ISO about what you expect to be paid, you can still be accused of manipulation. The lack of notice of what is not acceptable is un-American and FERC and the ISO's actions are not worthy of the attention Wellinhoffer got today.

  38. Posted by Smitty1010 | July 31, 2013 at 7:03 AM

    $410 MM could have come through extortion. JPM owns assets regulated by FERC and has to deal with them in the future.

  39. Posted by Sherlock | July 31, 2013 at 8:15 AM

    Your getting hot

  40. Posted by Guest | July 31, 2013 at 10:23 AM

    Market manipulation isn't, by definition.

  41. Posted by Jim | July 31, 2013 at 10:36 AM

    Uh, no. You are sorely mistaken. These alternating 'must run' sequences are clearly planned to game the market and are some of the most egregious I've ever seen. Much more so than some (emphasis) of the strategies Enron was slammed for during the CA crisis.

    In order for these strategies to work they have to put in a very LOW ramp rate capability for the power plant. I'm betting on 0.5 to 1 MW/min when most are capable of 10 – 30 MW/min or more.

    100% shenanigans. And I'll bet FERC doesn't take that $$ and refund those who overpaid in DA uplift costs.

  42. Posted by Jim | July 31, 2013 at 10:39 AM

    You don't know a lick about energy markets. Clearly. JPM's conduct should result in more severe penalties… these schemes were that egregious.

  43. Posted by 2 cubes over | July 31, 2013 at 11:37 AM

    This would never happen on ERCOT

  44. Posted by 2 cubes over | July 31, 2013 at 11:42 AM

    Is it Sacramento or DC? (CAISO or FERC?)

  45. Posted by blah! | July 31, 2013 at 11:54 AM

    JPM – Let's screw them dam suckers!
    ISO – I think we got a great deal for the rate payer!

  46. Posted by Heater | July 31, 2013 at 1:26 PM

    sucked that we had to walk to happy hour at the four seaons while the JP people took a car

  47. Posted by Smitty1010 | July 31, 2013 at 3:17 PM

    ILoveLamp used the term "loophole" not the term "market manipulation."

  48. Posted by guest | July 31, 2013 at 3:21 PM

    From Barclay's recent "Answer" to FERC:

    =====
    In its Revised Policy Statement on Enforcement, the Commission stated that “we
    emphasize that we are committed to ensuring the fairness of our investigatory process from the
    commencement of an investigation until the time it is completed.” Enforcement of Statutes,
    Regulations and Orders, 123 FERC ¶ 61,156 at P 21 (2008). The Commission also emphasized that its “enforcement procedures are designed to provide due process to those who are the subjects of an investigation or enforcement action.” Id. at P 40.

    These goals have been undermined in this proceeding because OE has failed to respond
    to many of the points and much of the data analysis in Barclays’ submissions, merely asserting
    that it was not persuaded by Barclays’ arguments. Such a failure to address relevant arguments
    and evidence would constitute an arbitrary process if it represented the Commission’s decision.

  49. Posted by Milton | July 31, 2013 at 6:17 PM

    Clearly you are bitter that JPM is smarter than you.

  50. Posted by guest | July 31, 2013 at 6:17 PM

    Barclay's recent response does not make them seem ridiculous. See PDF at the top at:
    http://elibrary.ferc.gov/idmws/file_list.asp?acce

  51. Posted by Rothleder | July 31, 2013 at 8:59 PM

    Uh, yeah. Ramp rates are registered for all ranges for a plant. ISO decides where they place you with full view of your bid and ramps. ISO resettled the entire market for uplift, including what the IOUs made from their units. So no one has any refunds due.

  52. Posted by Peter Jackson | August 4, 2013 at 1:00 PM

    It should worry all traders, as it highlights that FERC is rogue, aggressive and has a warped interpretation of the law. But, the good news is that it does not set precedent of the definition of "market manipulation". That will be done in the courtroom with Barclays, though. And, FERC's record in court isn't impressive — CFTC & Hunter bloodied FERC pretty bad.

  53. Posted by Jacob | August 19, 2013 at 4:33 AM

    I was able to read the whole content, all I can say is this is great! Great post with great ideas with great ideas with a great concept and with such a great writer. A written perfectly and was very much easy to understand.

  54. Posted by Electric radiators | August 20, 2013 at 3:45 AM

    I totally agree with this statement that electricity market rules did not provide a worth opponent for JPMorgan i don't know the reason but i read many times in the newspaper. I am going through this post and thinking of it’s theme and trying to understand what is this post about. At last I can have found something from this post which feels pretty good.So I can not but am writing this comment to express my appreciation.

  55. Posted by Guest | October 31, 2013 at 4:04 PM

    I was part of this team for a short amount of time. During the internal discussions of these strategies, there was a lot of tension and disagreement about the ethical nature of these plays. There were many people involved who did not want to push through with it, but were forced to because of the pressure coming down from the upper management.

  56. Posted by Kevin | March 2, 2014 at 1:07 PM

    Here's a website related to a separate investigation by the Federal Energy Regulatory Commission: http://www.ferclitigation.com. It's packed with information, but the 'overview' video does a nice job providing background information.

  57. Posted by Kevin | March 2, 2014 at 1:18 PM

    and, here's a video:[youtube OxbGRdIFLms http://www.youtube.com/watch?v=OxbGRdIFLms youtube]