WASHINGTON – On March 14, 2011, Blythe Masters, head of JPMorgan Chase’s global commodities group, asked one of her top deputies why California power officials were making ominous inquiries into the bank’s arcane and lucrative business of selling electricity. Five months earlier, Masters had been given a spreadsheet predicting that this line of business would generate profits of $1.5 billion to $2 billion by 2018.
Francis Dunleavy, the Houston-based executive in charge, replied in an email that he would handle the matter, but added that “it may not be pretty.”
On Tuesday, JPMorgan Chase agreed to a record $410 million settlement of accusations by government regulators of manipulating electricity prices in California and the Midwest.
The Federal Energy Regulatory Commission (FERC) said the bank’s subsidiary, J.P. Morgan Ventures Energy Corp., had charged electricity grids in those regions as much as 80 times the prevailing power prices at certain hours of the day through “manipulative bidding strategies” between September 2010 and June 2011.
Under the agreement, JPMorgan will pay a civil penalty of $285 million to the U.S. Treasury and will return $125 million in what regulators described as “unjust profits.” The first $124 million of returned profits will go to rate payers in California, and the other $1 million will go to rate payers in the Midwest, FERC said in a news release. In addition, JPMorgan dropped claims that California’s electricity grid owed the bank $250 million. JPMorgan reported a profit of $21.3 billion last year.
Nancy Saracino, general counsel of the regional grid known as the California Independent System Operator (Caiso), said: “This is a historic settlement. California got back every penny. We’re very, very pleased.”
“We are pleased to put this matter behind us,” said JPMorgan spokesman Brian Marchiony. He said the settlement would not have a material impact on earnings because the bank had already set aside reserves for it.
The settlement comes amid a debate over whether the federal government should bar or limit banks’ abilities to engage in the commodities business, and JPMorgan itself said last Friday that it would exit the physical commodities business. Lawmakers have been investigating the influence of Goldman Sachs in aluminum markets, Barclays is fighting a FERC penalty for alleged market manipulation, and longtime commodities traders have complained that banks have an advantage because of their ability to borrow money at preferential rates from the Federal Reserve.
On Tuesday, FERC Chairman Jon Wellinghoff said that whether banks such as JPMorgan should stay in the commodities business was up to Congress. “We just believe that whoever is engaged in markets should play by the rules,” said Wellinghoff, “and if not, then our enforcement division will come after them.”
FERC’s enforcement power was enhanced in the Energy Policy Act of 2005, a response to the California electricity crisis of 2000 when rolling blackouts and sharp rate spikes followed drought, supply shortages and manipulation, most notably by Enron, which had urged states to deregulate electricity markets. FERC now has about 200 people in its bulked-up enforcement division, although some traders say its power is too great.
JPMorgan said the settlement was linked to the energy business it bought in 2008 as part of its Bear Stearns acquisition, which was encouraged by federal regulators in the midst of the financial crisis. The bank owned the natural gas that went into and the electricity that came out of three Southern California power plants owned by Arlington, Virginia-based AES.
Electricity markets act differently from others. Regional grid operators weigh sealed buy-and-sell bids from a relatively small number of utilities, power generators and middlemen. Caiso covers 80 percent of the state of California, and about 10 percent of its power purchases are made either the day before or the day of the power being delivered. Because electricity is hard to store, some prices are set hour to hour.
JPMorgan was able to game the system, FERC said. It bid very low (or even negative) prices one day, then jacked up rates extremely high and was reimbursed under rules that compensate power generators for the time it takes to ramp up or ramp down facilities as needed. People familiar with JPMorgan’s negotiations said the bank believed there was nothing wrong with that and that Caiso’s rules even set a bidding range from minus $30 per megawatt hour to $1,000 per megawatt hour.
“Power markets have gotten massively more complex, even relative to the days of Enron,” said James Bushnell, an associate professor of economics at the University of California, Davis. “The goal of all this complexity was to improve efficiency. However, the complexity also occasionally creates opportunities for traders to take advantage of idiosyncratic behavior of the market rules.”
Bushnell said that “firms like JPMorgan can periodically twist the spirit of a market rule” and turn it “into an opportunity for profits way beyond what those rules intended.”