Remarks to the Edison Electric Institute
Chief Executives Conference
Colorado Springs, Colorado
Commissioner Sharon Brown-Hruska
Commodity Futures Trading Commission
September 4, 2003
Good morning. It is my pleasure to address such a prestigious gathering of executives. The past two years have been a particularly tumultuous time for the energy markets and in particular, the electricity markets. Just when it looked like we might turn the corner, the blackout on August 14th demonstrated that there remains work to be done to establish a reliable transmission network for selling and delivering electricity. The good news is that, where there were markets, they not only worked, they worked extremely well.
Thanks to diligent efforts by energy and financial market participants, the integrity of trading and the vital prices coming out of the markets were not compromised by the blackout. This is truly a testament to the strength and resilience of our nation’s markets and industries. As a regulator, I witnessed first-hand the close cooperation between energy and electricity executives, the exchanges, various local and state authorities, and other experts, even as the precise nature of the problem remained unclear.
From my perspective, the blackout illustrated more than ever that markets are the key to spurring innovation and reliability in the energy sector. It is clear that the failure of the electricity grid can at least in part be explained by the lack of a real market for electricity transmission that would send proper investment signals and therefore provide incentives to modernize and bring integrity to the system. With this in mind, I would like to talk today about market mechanisms and the role of derivative contracts in energy markets; the role of the Commodity Futures Trading Commission (CFTC) in regulating derivative markets; actions by the CFTC to help restore integrity to the markets; and the pending energy bill, which I have been closely monitoring.
Everyone in this room is familiar with the drive to deregulate markets for electricity. It has been discussed for years, and although several states have moved to establish competitive markets, progress has been slow. At times deregulation has occurred in a piecemeal fashion, such as in California, with unsatisfactory results. In other cases, such as in Pennsylvania and Texas, the results have been positive. Markets for electricity, including transmission, are complicated by their varying degrees of regulation. Introducing market mechanisms and prices into a model that has for so long been controlled by numerous layers of government is wrought with many hurdles. However, we must continue to push for competitive market solutions. In my view, economic incentives are the only way to push industry toward meaningful innovation that will ultimately provide reliable energy at a lower cost to consumers.
Competition forces producers to search for ways to become more efficient at producing electricity and to more effectively manage costs so that electricity can be offered to customers at the lowest possible price. This is the promise of competition. But competition and competitive markets offer much more than that. To economists, competitive markets are about efficiently allocating scarce resources. For an electricity generator, that means how and to whom it should sell electricity. In a planned economy, the decision is made by politicians, those willing to stand in line the longest, or by lottery. Please note that I did not mention price. That is because prices matter very little in such an economy because there is usually no adjustment in prices to reflect the relative scarcity of a commodity or good.
In most parts of the country, retail electricity is basically sold under this inefficient model. For example, with some exceptions, it does not matter whether a dishwasher is started at 4 p.m. on a 98-degree afternoon, or set to start at 3 a.m. Either way, the electricity costs the same. Certainly the generator would benefit from such a shift in demand to 3 a.m., when loads are less challenged, but what are the incentives to do so? None whatsoever. Even if a consumer is aware of the strain their decision adds to the power grid, this realization is not likely to sway them. As small consumers in a large market, retail customers are unlikely to view their contribution to the problem as being significant. This is what economists call a “free rider” problem.
Slowly, the energy and electricity industries are embracing market principles that would help them solve the “free rider” problem. Some utilities offer variable rates for “non-peak” versus “peak” use hours. In my area of the country in Virginia, utilities often offer retail consumers the opportunity to receive payments or discounts for giving the utility the right to switch off appliances, such as air conditioners, during certain periods of the day. Unfortunately, such programs are the exception rather than the norm.
Transparent tiered pricing can create an allocation scheme that ensures resources flow to those entities or individuals who place the highest value on the commodity while easing congestion in the transmission network. In the dishwasher example, under variable electricity rates, if clean dishes are not needed immediately, consumers can save some money and delay turning it on until later in the night. Otherwise, they can make the choice to wash the dishes now and pay the cost. Meeting and managing demand via price differentiation is well accepted in numerous other industries, and it is time to stop treating electricity like it is a sacred cow.
While market mechanisms will result in more efficient management and allocation of resources, price volatility will occur. Supply usually cannot react quickly enough to offset changes in demand. Demand surges ahead of price changes. In economics parlance, we say prices are “sticky.” This means that commercial participants are unable to adjust prices fast enough or are unable to pass price volatility on to others, either because of contractual constraints, transactions costs, or because they simply would lose business if they shifted prices too often. Volatility can be devastating to buyers and sellers of commodities if they suddenly find themselves having to pay substantially higher prices for goods they consume, or receive lower prices for the goods they sell. These price fluctuations often last for only short periods of time, but the effect they can have on a company’s bottom line may be just enough to put it out of business.
As true competition comes to the electricity market and firms face uncertainty created by price volatility, derivatives will be the financial tool used by producers and consumers to manage price risk and bring stability to the industry. Derivatives, in the form of futures, options and swaps give companies an array of tools for managing price risk. Through these instruments, price risk can be shifted from parties that do not want to hold it, such as a utility, to parties that are willing to hold it in hopes of profiting from it. At the NYMEX, for example, speculators populate the floor of the exchange to provide liquidity by taking on price risk from hedgers wanting to shed it. So while price risk per se can be devastating to a company, derivatives make it manageable. Moreover, the stability that can be achieved through their use will aid firms in attracting more investors and capital to the industry.
On the consumer side, the use of derivatives by local utilities and gas companies make it possible for them to offer customers the benefit of stable and predictable prices. As an example, heating oil companies in my area often offer retail customers the ability to lock in a fixed price during the winter season. The companies are exposed to the risk that the price of oil at the time they deliver it to their customers will be significantly higher than the contract price. So how are they able to offer these deals? One way is by using derivatives. If the company purchases a heating oil futures contract at the time they offer the fixed price, gains on the value of the futures contract if prices rise will cover the loss on the physical oil sold to their customers. The companies lock in their margins and customers benefit from the certainty of fixed prices.
While derivative instruments offer powerful opportunities for companies and individuals to manage risks in a competitive economy, regrettably they have often been much maligned. This is in part because derivatives are perceived to be complex, and therefore a bit scary to the uninitiated. Also, in free markets derivatives are often the first to reveal the reality about the underlying economic fundamentals of scarce resources. Even the widely known investor, Warren Buffet, remarked in recent months that derivatives were “time bombs” and “financial weapons of mass destruction.” But like any good messenger, derivatives should not be shot for the service they provide. Instead of reacting negatively, we need to be forward looking with a clear understanding of how market mechanisms work and the types of financial tools that exist to make them work better.
As Chairman Greenspan has so astutely observed, derivative markets play a significant role in easing the severity of economic downturns. This is partly because banks and other financial institutions have come to rely more on derivative contracts to manage risks. As the saying goes, “what’s good for the goose is good for gander,” and this applies as well to the natural gas and electricity markets as it does to financial markets.
Let me now turn the discussion to some of the recent problems we have experienced in the energy markets and the role of the CFTC in regulating these markets. The CFTC is an independent agency created in 1974 to regulate the futures and options exchanges in the United States. The primary role of the Commission is to assure price integrity in the markets and to protect customers.
Many of you are familiar with recent actions the Commission has taken with respect to price reporting in the natural gas markets. Since December 2002 the Commission has settled 5 administrative actions and assessed $68 million in fines against companies that reported false information on prices and transactions to energy price reporting firms. The Commission continues to investigate numerous companies and individuals to ascertain those who should be prosecuted, and those who are innocent of allegations. Many companies have come forward to report the findings of their own internal investigations and have been cooperative in helping the Commission determine whether wrongdoing occurred. This demonstrates that companies are anxious to put this chapter behind them, and get on with business. For our part, we are working hard to complete the investigations by the end of the year.
Some of you may be asking why the CFTC has an interest in these transactions? After all, the misreported prices were for over-the-counter (OTC) transactions between private counterparties, not futures prices. Very simply, our authorizing statute, the Commodity Exchange Act, recognizes the integral link between the physical and futures markets and the potential for the manipulation of prices in one market to effect prices in the other. As a result, Congress granted the CFTC authority to take action against manipulators of any price of a commodity in interstate commerce. By providing direct and unqualified assurance that criminal and fraudulent behavior by market participants will not be tolerated, we believe we can help restore integrity to the markets and bring legitimate, honest dealing back. The gas and power markets are too important to our economy, and as regulators, we are committed to ensuring that risk management tools offered in the exchange-traded and the over-the-counter markets are liquid and price efficient.
The other area in which the Commission has an interest in the energy markets is in the area of credit risk mitigation. The collapse of Enron highlighted credit risks in OTC energy transactions and virtually dried up those markets overnight.
Before the fall of 2001, no energy company had better credit than Enron. After the collapse, no one was willing to go out on a limb to uncover that they had contracted with the next Enron. As a result, there has been a great reluctance to trade in the OTC markets. The markets in effect lost their financial integrity. Most are concerned that counterparties might default on their obligations, or worse, that a default by one party might spiral out of control into a domino effect capable of taking out one party after another. The reaction has been to either not put oneself in the way of a falling domino or to make sure the domino knocking against you was small enough so as not also to bring you down. Either way, this has made for a smaller, less liquid market in OTC energy products.
One solution explored at the Commission’s joint conference with the Federal Energy Regulatory Commission (FERC) this past spring, is the clearing of OTC trades. Clearing has been a central feature of futures markets since their inception. In futures clearing, the clearinghouse takes the other side of every trade and essentially holds a balanced book. To protect itself against individual defaults, it collects margin from every counterparty to cover short-term changes in the value of a contract, and collects additional margin funds as the market moves against losing positions. In addition, the clearinghouse retains the authority to liquidate any contract of a party that fails to post sufficient margin. Since most futures contracts are traded in liquid markets, the liquidation of a position can be achieved in a fairly expeditious manner. The result is that there has never been a failure of a U.S. clearinghouse and they are extremely good credit risks.
As commercial participants in the energy industry considered clearing of OTC trades, I know many of you are skeptical that an exchange-based clearing model could work in the OTC markets. OTC markets are often not as liquid, contracts not as fungible, and quick settlements put strain on cash flows. Further, there seems to be a belief that clearing provides simply a financial guarantee, while merchant energy companies seek delivery guarantees. If delivery is not made, load severs face severe cost. In power, I understand that securing alternative delivery or taking offline and placing a cracking unit back online at a refinery is extremely costly.
Having thought about this, I believe that innovation of traditional clearing models, whether through the provision of longer settlement periods, price differentials for differences in transmission and delivery characteristics, or specialized delivery requirements and procedures, can address the concerns of the energy industry, while providing an additional means to managing credit risk. Innovative clearing models for OTC energy products are being developed by the New York Mercantile Exchange (NYMEX), the Intercontinental Exchange (ICE), EnergyClear, and others. The Chicago Mercantile Exchange is looking to introduce a truly liquid market in credit derivatives that would allow market participants to hedge against a change in credit rating, to help mitigate credit risk. I believe that we as regulators, including the FERC, the Securities and Exchange Commission (SEC), and the banking regulators, have to encourage such innovation by being flexible and working with firms and exchanges as they develop their products and their models. Helping you manage the entire suite of risks you face will help the industry lower risks and prices for consumers, and will help increase the growth and stability of the economy.
Let me close today by addressing the energy bill passed this year by the U.S. House and Senate, and that Congress will continue to grapple with in the coming weeks. As I pointed out in my recent article in The Energy Daily, the energy bill is important to our markets because proposal that may end up in the bill would have a significant impact on the types or costs of instruments available to firms seeking to manage their risks. Other parts of the bill may play a significant role in determining the market structure within which your firms operate.
Certainly the most relevant part of the bill for this group is the electricity title dealing with the so-called “standard market design” or “SMD.” While the specific design of electricity transmission markets is outside the purview of what we deal with on a day-to-day basis at the Commission, it is nonetheless not that far a field. The debate centers on markets and how to maintain markets that efficiently transmit supply and demand signals between producers and consumers. As you must realize by now, I am an unapologetic supporter of unfettered competition. That is how the markets regulated by the CFTC operate, and they operate well.
One thing that the recent blackout highlighted was weaknesses in our nation’s transmission grid. In a recent radio address, U.S. Senator Charles Schumer of New York attributes the current state of the grid to underinvestment in transmission lines and blames the Bush Administration for a “doctrinal commitment to unfettered deregulation.” While underinvestment in the grid is an issue, underinvestment certainly has nothing to do with unfettered deregulation. Remember that this nation’s power grid was built and has been maintained for the better part of a century under perhaps the strictest regulatory control of any sector of the economy. President Bush has been in office for just over two years. A power grid is not built, or even significantly modified, in two years. Moreover, while there has been some progress in instituting competitive wholesale and retail electricity, transmission markets have lagged behind. If anything, the state of the power grid is an indictment of the effect of over regulation, not deregulation and competition.
The energy bill also contains sections, as well as proposed amendments to it, that more directly affect the CFTC’s oversight responsibilities and our ability to assure that innovative and low cost access to derivative instruments are available to the markets. In the wake of the Enron collapse, just as was the case with the August blackout, there has been a “knee-jerk” call to re-regulate OTC derivatives markets.
As all of you know, Enron was a large promoter and user of derivative contracts. (And I should also mention that the CFTC filed a complaint against Enron in March of this year with respect to the potential manipulation of the natural gas markets). As I previously mentioned, after its collapse, liquidity in many OTC energy products dried up because of concern about the credit risk of industry participants. But widespread defaults on contracts did not occur. In our experience, regulation worked.
Some lawmakers have proposed re-imposing a wide range of regulatory prescriptions on OTC derivative markets that would provide little protective benefit to the markets and its participants, while imposing high costs. The enforcement actions that the CFTC has and continues to take against natural gas traders who have misreported prices and transactions, or attempted to manipulate markets, have been prudent and effective as a deterrence to further abuses. Attempts to layer on additional reporting and disclosure burdens and capital requirements on innocent industry participants seem to be more an effort to demonstrate that lawmakers are “doing something” rather than actually addressing a problem. In addition, certain legislative proposals blur the regulatory jurisdictions of the CFTC and the FERC, thereby potentially resulting in duplicative regulatory oversight. Duplicative regulation or double jeopardy in enforcement actions increases costs and uncertainty for the industry and for the economy.
In summary, prescriptive regulation cannot effectively address problems in the energy sector, and may exacerbate a liquidity shortage by unnecessarily imposing costs on industry participants, and creating regulatory and legal uncertainty. Clearly there must be transparency and integrity in the accounting and financial statements of firms. My concern is that prescriptive regulatory approaches are operationally difficult to implement and could do significant harm to the markets if implemented without regard to market structure. Legislative and regulatory responses to events like those we have seen in the energy markets have to provide a direct hit on actual problems and misdeeds in the markets.
Regulators have been criticized for not moving quickly enough, yet, without good information, or a complete understanding of the markets, quick regulatory action poses a greater risk. “Knee-jerk” responses are not helpful in solving real or perceived problems, but rather tend to create significant costs, not only for the industry, but also for government and taxpayers. Moreover, if the regulatory response is to kill the market, this will deny vital risk management tools to this industry, punish the innocent by curtailing legitimate business activity, and ultimately, the economy will suffer. Please be assured that I will continue to champion competitive markets as we work together to stabilize and strengthen the energy sector.
During the blackout, President Bush quickly reassured our nation that his administration would make every effort not only to investigate the problem, but also work with all interested parties to solve them. It is my sincerest hope that each of you will lend your support to the final passage of the President’s energy plan, ensuring our energy security, as well as continue to assist the task force charged with investigating the blackout.
My sincerest thank you to each of you, as well as the leaders of the Edison Electric Institute, for the opportunity to share my thoughts this morning.