Amendment to Improve Transparency, Strengthen Enforcement, and Prevent Manipulation In Energy Markets

Recently highly negative events in our energy markets show there is an urgent need to prevent price manipulation in those markets, improve the transparency of energy markets, and to strengthen the ability of state and federal agencies to enforce the rules governing the operation of those markets. Widespread price manipulation and falsification of price information in the electricity and natural gas markets in the past few years have inflicted billions of dollars in extra costs on energy consumers and businesses, and were a severe blow to our economy. The corruption and manipulation of these markets by Enron and other companies has fueled the collapse of the some energy markets in the United States, the bankruptcy of some energy companies, and a huge decline in investment and trading in the energy markets.

The bipartisan amendment of Senator Feinstein, Senator Lugar, myself and others would close the "Enron loopholes" in the law that Enron and other companies used to manipulate energy markets at the public's expense, strengthen prohibitions on fraud and manipulation, and give both the Federal Energy Regulatory Commission – or FERC – and the Commodity Futures Trading Commission – or CFTC – the necessary tools to monitor the energy markets to prevent manipulation and ensure prices are fairly and competitively arrived at.

This legislation is needed because large companies like Enron are now permitted to trade large amounts of energy in virtually unregulated markets, making those unregulated markets – and the resulting price of energy we use – vulnerable to fraud and manipulation.

FERC's recent report on manipulation in the western energy markets provides some stunning examples of how the energy markets can be manipulated. FERC found Enron, through its unregulated electronic trading center, called Enron On-Line, "manipulated the price of physical gas upward, then downward," earning millions of dollars in illegal profits. FERC determined that Enron often "invited counterparties to wash trades, and these trades created a false sense of liquidity, which can distort prices. Enron also manipulated prices on EOL by having affiliates on both sides of certain wash-like trades. This created artificial price volatility and raised prices."

The Report concluded that "large-volume, rapid-fire trading by [Enron] . . . substantially increased natural gas prices in California." FERC found "significant market manipulation" in the "inextricably linked" natural gas and electricity markets, and that "dysfunctions in each fed off one another" during the energy crisis in California. According to FERC:

"Spot gas prices rose to extraordinary levels, facilitating the unprecedented price increase in the electricity market. Dysfunctions in the natural gas market appear to stem, at least in part, from efforts to manipulate price indices compiled by trade publications. Reporting of false data and wash trading are examples of efforts to manipulate published price indices."

The Report found "many traders acknowledged that false reporting was done openly in the industry. . . . The widespread false reporting led Staff to conclude that reported prices did not reliably reflect market activity."

I'd like to give one specific example of how in a single day – January 31, 2002 – Enron used an unregulated, non-transparent internet trading system to manipulate the natural gas market in California. In August 2002, the FERC staff issued an investigatory report finding that out of a total of 227 trades on that day, 174 - or more than two-thirds of the trades that day - involved Enron and a single unnamed party. Most of these trades took place during the last hour of trading, with two parties buying huge amounts of natural gas from each other in numerous transactions. FERC determined that the trades took place at "higher prices" than other trades that day and resulted in a steep price increase over the last hour of trading. FERC described this trading activity as "difficult to rationalize as a normal or standard business practice" and noted:

"[O]nly Enron and possibly the counter party could have known that so much of the trading was going on between themselves, because parties looking at EOL's screens could only see the bid and ask prices; they could not know who the counter party was on any particular trade."

The FERC report indicated that Enron Online's prices were routinely used to prepare published reports on natural gas prices, which meant that the Enron price data was not just affecting Enron trades, but also causing higher natural gas prices industrywide. The report concluded that Enron had "significant ability and incentive to manipulate the price data published by the reporting firms."

This spring, FERC issued a number of recommendations to fix the problems in the energy markets. FERC recommended new policies and procedures for the oversight of commodity trades and prices, and a system of market surveillance to detect and prevent manipulation.

In March of this year, following a year-long investigation, I released a Permanent Subcommittee on Investigations staff report into the operation of the crude oil markets. The Report describes the regulated and unregulated markets for buying and selling crude oil, and explains how crude oil prices are set and how they affect the price of critical oil commodities, such as gasoline, home heating fuel, jet fuel, and diesel fuel. The Report describes the vulnerability of unregulated commodity markets to price manipulation, and the need for and beneficial effects of U.S. commodity regulation. The Report also explains how the over-the-counter markets are virtually unregulated and therefore vulnerable to manipulation.

The Report concludes, "The lack of information on prices and large positions in OTC markets often makes it impossible to determine whether traders have manipulated crude oil prices." The Report recommends that traders in OTC markets be required to "provide the CFTC with routine information on large positions in crude oil and energy contracts and derivatives, as well as other information that would aid the CFTC in detecting, preventing, and halting commodity market manipulation."

So we have two reports reaching the same conclusions about the need for more market transparency and strengthened oversight to detect and prevent fraud and manipulation in energy markets.

How did we get to this position today where companies like Enron are permitted to manipulate prices in our energy markets?

The answer lies in how the energy markets and the federal regulations have evolved over the past twenty years. Billions of dollars worth of contracts for the future delivery of energy are now traded every day. These contracts are called "energy derivatives," because they derive their price from the price of the energy commodity in the contract.

There are two basic types of energy derivatives. Energy derivatives that are traded on futures exchanges are called "futures contracts." The trading of futures contracts on futures exchanges is regulated by the Commodity Futures Trading Commission under the Commodity Exchange Act.

The other type of energy derivatives, which are not traded on futures exchanges, are called "over-the-counter" energy derivatives. These derivatives may be traded by fax, by phone, in face-to-face meetings, or over the internet. The trading of these derivatives is virtually unregulated.

Both the futures markets and the over-the-counter markets perform identical economic functions. Both markets enable traders to buy and sell commodities at fixed prices, disseminate information about commodity prices, and provide a way for buyers and sellers to "hedge" against changes in the price of these commodities. Commodity traders routinely use both the futures markets and the over-the-counter markets for price discovery and hedging.

Today, the types of contracts traded in the futures and over-the-counter markets are virtually identical. As an indication of how indistinguishable these contracts really are, the NYMEX even calls some of the contracts it offers on its over-the-counter electronic market "futures contracts." The largest over-the-counter electronic trading facility, the Intercontinental Exchange – known as "ICE" – trades contracts that it calls "futures look-alikes."

Although both markets perform identical economic functions, only the futures markets are regulated to prevent price manipulation. This lack of regulation in the over-the-counter markets attracts traders who seek to avoid the disclosure required on the regulated futures exchanges and leaves the over-the-counter markets vulnerable to manipulation.

All commodity trading on the futures exchanges is extensively regulated under the Commodity Exchange Act (CEA) in order to ensure that prices reflect legitimate market forces and are not artificially manipulated. This regulation and transparency has bolstered the confidence of traders in the integrity of these markets and helped propel the United States into the leading marketplace for many commodities. For example, the New York Mercantile Exchange – or NYMEX – is the world's leading exchange for futures contracts for energy products, such as natural gas, crude oil, gasoline, and home heating oil.

The CEA makes it a felony to manipulate the price of any commodity, and contains a number of provisions to enable the futures exchanges and the CFTC to detect and prevent price manipulation. The CEA requires the regulated futures exchanges to ensure trading is orderly and to detect and prevent price manipulation. The CEA directs the CFTC to oversee the operations of the futures exchanges and to itself perform market oversight and ensure trading is orderly. According to a former CFTC Chairman, "The job of preventing price distortion is performed today by regulatory and self-regulatory rules operating before the fact and by threats of private lawsuits and disciplinary proceedings after the fact. Both elements are essential."

"The heart of the Commission's direct market surveillance," according to the CFTC, "is a large-trader reporting system, under which [the futures exchanges and brokers] electronically file daily reports with the Commission. These reports contain the futures and option positions of traders that hold positions above specific reporting levels set by CFTC regulations."

There are no protections against manipulation in the over-the-counter markets. Unlike the futures markets, OTC markets are not required to monitor trading to detect and deter fraud and price manipulation. Information that is routinely reported to the futures exchanges and the CFTC is not available to the over-the-counter exchanges or to the CFTC. Traders do not have to report large trades, and there are no position limits or daily price limits. The OTC markets lack all of the critical features of an effective program to detect and prevent price manipulation.

Over-the-counter energy derivatives are unregulated because of a provision that was added to a conference report at the last minute on an amendment to the Commodity Exchange Act that was tacked onto an omnibus appropriation bill at the end of the Congress in 2000. The Commodity Futures Modernization Act of 2000 (CFMA) was intended to clarify the regulation of financial instruments. Most of the provisions in the CFMA were based upon the recommendations contained in the Report of The President's Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act, which was jointly issued in November 1999 by the Department of the Treasury, the Federal Reserve, the SEC, and the CFTC.

The Working Group recommended that financial derivatives be excluded from regulation under the CEA, but that derivatives involving non-financial commodities with a limited supply, such as energy commodities, not be excluded. The Working Group stated: "Due to the characteristics of markets for non-financial commodities with finite supplies, however, the Working Group is unanimously recommending that the exclusion not be extended to agreements involving such commodities."

The House and Senate bills leading up to the CFMA did not contain any exemptions for energy derivatives. The exemptions in current law for trades in over-the-counter energy derivatives – sometimes called "the Enron exemption" – was inserted into the CFMA at the eleventh hour during the House-Senate conference. This exemption was never considered by any committee; it was never discussed in any hearing; it was never commented on by interested parties; it was simply inserted in the conference at the last minute. And it's one of the reasons for the Enron mess we've had to clean up after.

Exempting energy commodity trades from the CEA didn't make sense when it happened in 2000. It would be irresponsible to continue it now, especially after we have seen how it facilitated the market fraud and manipulation by Enron and others.

I have joined my colleagues to develop an amendment that would return the commodities law to the way it was for decades prior to the passage of the Enron exemption. It would ensure that fraud and price manipulation would be a felony, and it would remove "the Enron exemption" as a shield from prosecution. It would also authorize the CFTC to establish recordkeeping requirements to enforce the anti-fraud and anti-manipulation prohibitions in the CEA.

This amendment also contains important provisions to improve FERC's ability to ensure the transparency and integrity of wholesale energy prices. It would direct FERC to establish an electronic price reporting system, strengthen the penalties for violations of the Federal Power Act and the Natural Gas Act, prohibit wash trading and other collusive and manipulative practices in wholesale energy markets, and clarify FERC's authority to fashion appropriate remedies in cases of wholesale price manipulation.

I'd like to mention some of the letters we have received in support of this legislation.

Governor Jennifer Granholm, of my home state of Michigan, states that, in the aftermath of the massive electricity blackouts that struck Michigan and large areas of the midwest and northeast this past summer, "all necessary steps should be taken to bolster business and consumer confidence in the nation's energy markets and promote additional investment in reliable energy delivery at a fair price." Governor Granholm says our language "would improve energy price transparency in wholesale electricity markets, greatly increase criminal and civil penalties for trading violations, prohibit market manipulation and fraud in all energy market sectors, and strengthen day-to-day energy market oversight, including over-the-counter market transactions that significantly affect energy prices."

The American Public Gas Association supports the amendment because "it will improve market transparency and provide the essential regulatory oversight to detect and prevent manipulation and improve the efficiency of energy markets."

Attorney General Eliot Sptizer, from the State of New York, urges swift adoption of the amendment, writing that "the amendment closes loopholes used to manipulate energy markets, improves the ability to detect fraud and other manipulation, and deters manipulation by establishing substantive penalties."

The North American Securities Administrators Association, the association representing the securities administrators of the 50 states, supports this amendment because it "would provide more transparency to the wholesale electricity markets, supply the CFTC with the authority to detect fraud and manipulation, and help to deter wrongdoing by significantly increasing the penalties for violations of the Federal Power Act."

Consumers Union, the Consumer Federation of American, Public Citizen, and the U.S. Public Interest Research Group support this amendment. They state it "would go a long way towards addressing the serious problems plaguing the nation's energy markets."

The Derivatives Study Center comments that "this important legislation will assure that [energy commodities] will be covered by federal prohibitions on fraud and manipulation. . . . It will subject [energy] derivatives to some of the same regulations that apply to securities, banking, exchange-traded futures and options and other sectors of U.S. financial markets."

The National Association of State Utility Consumer Advocates writes that this legislation "will help fix broken energy markets and give regulators the tools needed to protect consumers from market manipulators."

One hundred and fifty years of history of our commodity markets demonstrates that market integrity and investor confidence will not magically spring up in markets that have been tainted by manipulation. That same history shows that fair and efficient markets do not emerge by themselves. Rather, regulation and oversight are necessary to ensure that markets are fair and efficient. Without fair and efficient – and that means transparent – energy markets consumers will pay higher prices for energy products, capital will be misallocated, and our national economy and security will be harmed.

This history also shows that a legal prohibition against commodity market manipulation, without more, does not deter or prevent manipulation. Continuous market disclosure and oversight are essential to halt manipulation before economic damage is inflicted upon the market and the public. This is why a major portion of the CFTC's budget and resources is devoted to oversight of the futures markets.

Although some enforcement actions have been brought following the manipulation of the western markets, these enforcement actions will do little to make whole the consumers and businesses that suffered billions of dollars in losses from those misdeeds. It would be far better to ensure that such abuses do not occur in the first place, rather than rely on the hope that a few of the manipulators are caught years after the fact.

We cannot afford to have more Enrons, more manipulations, more frauds, and more flight of capital in the energy sector. It is imperative that we restore the integrity and credibility of our energy markets.

I hope my colleagues will join us in our ongoing bipartisan effort to create fair and transparent energy markets that investors can trust.