Remarks to the Energy Bar Association
Luncheon Speaker, Mid-Year Meeting
Commissioner Sharon Brown-Hruska
Commodity Futures Trading Commission
December 4, 2003
It is my pleasure to address you today. When I was asked by Chairman James Newsome of the CFTC to focus my attention on energy policy and legislation in the spring of this year, I agreed, knowing that the task would be something like my first year teaching finance courses to MBA students. Since the students were already in their second year of graduate business school, and I was a freshly-minted economics PhD, I felt the students would know substantially more than I did about both the foundations of finance and more exciting topics like stock market performance. However, after mountains of study and preparation time, plenty of Zantac, and a willingness to learn from those I was charged with teaching, I was able to make a meaningful contribution to their knowledge primarily because I brought a different perspective.
Today seems the culmination of a similar set of circumstances, since I am addressing you, who are clearly well versed in the energy markets, and from whom I can and have learned a great deal. My understanding of and views on the importance of markets were formulated early in my economics training, but my hands-on experience derives from working with financial markets, intermediaries, and investors as a scholar, and now as a regulator. The financial market perspective can inform us on market structure issues, management of credit and other risks, and capital formation – just a few of the topics that are of particular interest to the energy sector.
The energy markets are different from the financial asset markets, but not all that different. The need to encourage the development of viable and liquid markets and market structures in energy is as important to our economy as the need for such markets in stocks and bonds. Finding the appropriate level of regulation, one that encourages trading and innovation while deterring manipulation and fraud, is no less important.
We are now approaching the end of 2003, a year in which we witnessed a blackout that highlighted problems in the electricity grid, a war in Iraq that bounced around supply and crude oil prices, and low levels of production and storage of natural gas that caused price spikes in February and October. And, despite what I regard as heroic efforts by Vice President Cheney and the Bush Administration to put forth a coherent energy policy and to pass energy legislation that would promote needed reform, the Energy Bill that emerged from conference has been ostensibly tabled by the Senate, leaving us to wonder what challenges next year will bring.
From my perspective, the challenges of 2003 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 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 ensure the integrity of the system. The vacuum left by the collapse of Enron and the exit of many merchant energy firms from trading have left the markets wanting for liquidity and increased capital inflows.
Markets for electricity, including transmission, are complicated by 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 enable the industry to encourage innovation that is critical to providing reliable energy at a lower cost to consumers.
As greater competition comes to the energy markets and firms face uncertainty created by price volatility associated with competitive markets, derivatives will be the financial tools 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 the exposure, such as a utility, to parties that are willing to assume the exposure in hopes of profiting from it. At the New York Mercantile Exchange (NYMEX), for example, speculators populate the floor of the exchange to provide liquidity by assuming price risk from hedgers wanting to shed it. So while price movement is a feature of competitive markets, derivatives make it manageable. Moreover, the stability that can be achieved through derivatives will aid firms in attracting more investors and capital to the industry.
The increased use of energy derivative instruments, such as those traded on exchanges such as NYMEX and those traded over-the-counter, I hope will answer the question you may have as to why a CFTC Commissioner is here to address you in the first place. NYMEX trades numerous energy products, including crude oil, natural gas, and electricity. The CFTC has exclusive jurisdiction to regulate futures and options exchanges, like NYMEX, and others that trade derivatives contracts on a number of products that run the gamut from energy to securities to pork bellies. As a result, we find ourselves frequently working with other agencies, including the Securities and Exchange Commission, the Federal Reserve Board, the Department of Agriculture, and the Federal Energy Regulatory Commission, among others, since our jurisdiction is over derivatives that span numerous underlying assets, rates, and commodities.
In our authorizing statute, the Commodity Exchange Act, Congress recognized the integral link between the physical and futures markets and the potential for the manipulation of prices in one market to influence prices in the other. In short, fraud and manipulation compromise a market’s ability to perform the vital functions of price discovery and risk management. As a result, Congress granted the CFTC authority to take action against manipulators of any price of a commodity in interstate commerce. By implication, our mission is affirmative as well, in that, performing our duties effectively, we provide the necessary assurance to market participants, investors, and consumers that the markets are competitive and fair.
As I am sure you are aware, federal and state authorities, led by the CFTC, have initiated a number of investigations and enforcement actions against companies and traders that focus on allegations of manipulative activities in the energy markets. We have initiated or are currently investigating 32 companies (including employees of those companies) to determine whether violations of the Commodity Exchange Act occurred including wash trading, manipulation, and false reporting.
I recently discussed market manipulation in the energy markets in a talk I gave to the Cornerstone Research group and that appears in the Futures & Derivatives Law Report. A few points of relevance are worth noting both with respect to our law and in the cases we have brought. In addition to proving that a manipulative act occurred that created artificial prices, the CFTC’s Division of Enforcement must be shown that the respondent intended to create that result -- a showing of “specific intent.” Yet, even as this element raises difficult issues of proof, in my view, the intent requirement is the safe harbor that legitimate users of markets can and should be able to rely upon when they trade in the markets. In nascent markets, in liquidity-challenged markets, and in markets that have been characterized by fairly large players -- circumstances that have typified the energy markets -- it is not unusual to see prices move as a result of one market participant’s trading.
In my two terms at the CFTC, one as a staff economist and now as a Commissioner, I have noticed that a correlation exists between price levels and the call for regulatory or legislative action. Usually when prices move significantly, we hear that prices are being manipulated and regulation should be implemented to prevent this. While we are quick to investigate the circumstances that may have given rise to such price moves, particularly with an eye toward economic conditions, extreme price movement by itself does not constitute a prima facie case for manipulation. In my view, we must be vigilant not to equate unpopular price moves with manipulative behavior, and, therefore, throttle the market’s ability to serve its national public interest of providing a means for managing price risks, discovering prices, and disseminating pricing information.
Many have raised concerns that the legal definition of manipulation is too limiting and the requirements for proof of manipulation under the law are too extensive to prosecute, much less deter illicit behavior. They instead propose numerous remedies, from extensive disclosure and transparency requirements, to wholesale legislative solutions to discourage market “strategies” that are alleged to be manipulative. Before I discuss the proposed remedies, let me again suggest that our laws must protect those engaging in legitimate business activity from frivolous regulatory or legal action.
As part of our affirmative obligation to regulate these markets, we must provide assurances that we will follow due process in our investigations of alleged wrongdoing in the markets. To this end, I believe that we should not rush to make public pronouncements or release staff studies that allege manipulation when we do not yet have sufficient evidence or a viable case to support it. As we investigate, we are also bound by our statute in Section 8 of the Commodity Exchange Act to protect proprietary or sensitive information that we acquire in our investigations. We have worked hard to establish relationships with other regulatory agencies to try to avoid subjecting respondents to unnecessary and duplicative regulatory scrutiny or double jeopardy.
There have been a series of proposals put forth on Capital Hill that could, however, create a circumstance where firms face additional costs as a result of duplicative and ambiguous regulatory structures. Senator Feinstein has put forth proposals to revise the CFTC’s jurisdiction to more broadly and prescriptively regulate the over-the-counter energy markets. Senator Cantwell proposed an amendment that is billed as prohibiting Enron-type manipulation strategies, but is similarly overbroad, lacking specific parameters on what constitutes manipulation and creating potential overlap of authority between the CFTC and the FERC.
In my view, duplicative and prescriptive regulation is neither necessary nor well-suited to address the problems being experienced by the energy sector, and instead may exacerbate a liquidity shortage in the energy complex by unnecessarily imposing costs on industry participants, and creating regulatory and legal uncertainty. As a result, in our effort to squelch illegal behavior, we may end up unwittingly nurturing it by encouraging noncompetitive, illiquid markets. The true enemy of manipulation and market power is competition and liquid markets.
The energy bill worked out in conference and passed by the U.S. House, but which stalled in the Senate, contained several provisions that directly affect the CFTC’s oversight responsibilities. Changes proposed to Section 4b of the Commodity Exchange Act seek to make it clear that the Commission has the authority to bring anti-fraud actions in off-exchange principal-to-principal futures transactions. The reason this shows up in the energy bill is that it enables the CFTC to go after illegal conduct that may occur in an Enron-Online type environment, where transactions are not intermediated but where fraud may be present. The conferenced Energy Bill also contained savings clauses to confirm the Commission’s exclusive jurisdiction with respect to futures and options on energy commodities, a provision to reaffirm the Commission’s CEA Section 9 civil authority, a provision to respond to the initial Valencia decision involving false reporting under Section 9(a)(2), and a provision affirming that these changes to CEA Section 9 restate existing law and continue to apply to acts or omissions that occurred prior to enactment.
Overall, these provisions are of the order of clarifications that do not substantively affect the cash markets. Frankly, given some of the earlier proposals and language I had seen, including language in the original House-passed bill, I was relieved to see that the CFTC was not drafted into regulating a wider swath of territory that would expand our jurisdiction beyond the fraud and manipulation authority we already have. In my view, FERC has jurisdiction over the cash markets, and the best thing that we can do, and that we should do, is to share our expertise and resources with FERC with regards to markets and market structure matters, in enforcement, and surveillance activities.
In the wake of the Enron collapse, just as was the case with the August blackout, there has been a “knee-jerk” call to increase the CFTC’s regulatory authority. As all of you know, Enron was a large promoter and user of derivative contracts. I would note, however, that the CFTC filed a complaint against Enron in March of this year with respect to the potential manipulation of the natural gas markets. 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. With regard to the financial integrity of the markets we regulate, regulation worked.
Some lawmakers have proposed re-imposing a wide range of regulatory prescriptions on OTC 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.
A case in point that went virtually unnoticed in the conference report that I found especially problematic from both a conceptual and regulatory perspective were the provisions regarding market transparency in both electricity and natural gas. When I read the conference report I felt a little like Mr. Smith goes to Washington in that it illustrated how compromise can result in some really scary legislation. And even though I applaud both Chairmen Dominici and Tauzin’s efforts here to satisfy those who supported the market transparency provisions, I believe there never was a more ambiguous solution to a problem that did not need a solution than in this case.
Proposals for increased market transparency have always been held out as a solution to all manner of market ill. In separate sections of the conference report, one in the Electricity Title and the other in the Oil and Gas title, FERC is required within 180 days following enactment of the legislation to establish a reporting system that would facilitate price transparency. In electricity, FERC is directed to issue rules “establishing an electronic information system” to provide itself and the public with information about the availability and market price of wholesale electric energy and transmission. With respect to natural gas, mandatory disclosure is not only required to FERC who then may make it public, but it is also required that entities report their transaction prices to price publishers. The mandate is then made illusory for the FERC as it is then forbidden from competing with a price publisher and prohibited from regulating price publishers or imposing any requirements on the publishers of such information.
I usually give a general disclaimer at the beginning of my speech that the views I express in my remarks are my own, and do not necessarily reflect those of the CFTC Commissioners or staff, but lacking a convenient place to put it early on, let me state it now, since I am getting ready to opine somewhat. Prior to coming to the CFTC, I did research on the market for information in the securities and futures area, and I became a proponent of the law and economics view regarding the property rights associated with information generated in trade as well as the protections and limitations associated with commercial speech, in general.
The problem with the transparency proposals is that they will interfere with the markets for information, which the legislation seems not to realize exist. The law and economics of information is an area of public policy that has engaged many in academia and industry for years. Information inherent in transaction prices and trade is the product of investment and expertise that is part of the price discovery process. The rewards to developing that information not only help counterparties ensure that they get a fair deal but also contribute to the overall efficiency of the market. A requirement that information be surrendered to a government agency for dissemination to the public, or to a publisher in the business of profiting from the sale of that information, runs perilously close to a taking or expropriation of that information from those who engage in price discovery. In addition, this provision could endanger energy price efficiency while costing the U.S. taxpayers dearly. In short, why have a government regulator perform a service that can be performed in the private sector in a more efficient and reliable manner?
Certainly, false price reporting by traders in the natural gas market was pervasive. Since December of last year, the CFTC has entered into eight settlements with a number of prominent energy companies and power merchants, collecting a total of $130 million in civil money penalties for attempting to manipulate prices reported on energy indices. In all of these matters, the Commission has alleged that the firms knowingly delivered false or misleading or knowingly inaccurate and, in effect, artificial trade prices and volumes in an attempt to skew those indices for their financial benefit. In early October, the CFTC announced the filing of a complaint in federal district court against another major power company for attempting to manipulate natural gas prices in a similar manner.
The FERC and the CFTC, working together and separately, have pushed hard to solve the problems of false price reporting. Two technical conferences on price formation sponsored jointly by the FERC and the CFTC were widely attended and much was learned about the circumstances of the energy industry that gave rise to the conduct of false price reporting. For their part, the industry, including groups like the Committee of Chief Risk Officers, has made great strides toward developing standards for price reporting, but also for restructuring the function of price reporting, moving it from the traders to the back office, and incorporating internal controls to ensure prices reported are legitimate trade prices. In addition, companies whose employees provided false information have been cooperative with both FERC and the CFTC investigations, seeking not only to quell any concerns that misreporting was condoned at the corporate level, but also to illustrate to shareholders and the public that it will not be tolerated in the future.
A hidden cost of making a government agency become a price reporter is that performing the price reporting function would inevitably take away resources from other areas of regulatory responsibility for which the agency is responsible, including the vital functions of surveillance and enforcement. Rather than engaging in the rote activities of compiling and publishing price information, a regulatory agency would prefer to spend time analyzing the information to ensure that market problems and illegal activity are adequately evaluated and investigated
On this front, there is a basis for changes to ensure that FERC has routine access to information produced by market participants and publishers regarding the markets they regulate. At the CFTC, we have long had the availability of futures exchange data, including price and position data, so that we could properly police our markets and enforce our statute. We have also acquired real time information and data from publishers and data vendors. Most importantly, as I mentioned earlier, we are compelled via statute to protect the proprietary nature of contractual and counterparty information and not to divulge that information to the public.
The best reason not to put government in the business of price reporting is that there already is a market for information and it is competitive. Currently, there are many publishers who publish gas and power price information, including Platt’s, a subsidiary of McGraw Hill and the Energy Intelligence Unit, to name a few. As a result of the stain on their indices created by false reporting by traders, these firms have invested substantially in improving their procedures to ensure that the information they cull is accurate and that they no longer get duped by traders making false or inaccurate reports. Most powerful are the market incentives that those in the business have to ensure that the information they report is accurate and not fabricated. It is called reputational capital, and in the information business, if you don’t have it, you’re out of business.
Even more importantly, the cases the CFTC has pursued in this area demonstrate not only that we have significant authority to punish false price reporting and manipulation in the energy sector, but also that we are prepared to exercise that authority. In my view, proposals that would give additional authority in the price reporting space to the CFTC or the FERC rest on the premise that somehow we are powerless to stop the false price reporting. Or, that the industry is indifferent. Nothing could be further from the case. The strong action the CFTC has taken in these markets and the proactive steps taken by FERC illustrate that the problem is already well on its way to being a piece of history.
I want to thank you again for inviting me to speak to you and share my thoughts. I welcome any questions you may have and look forward to seeing you in the future.