It was a game of bait-and-switch, played by electricity traders at JPMorgan Chase & Co. to gouge California ratepayers out of millions of dollars in excess profit.
Federal regulators, detailing their record $410 million settlement Tuesday with JPMorgan, said the bank's traders employed a variety of deceptive strategies to squeeze excessive cash out of a fleet of Southern California power plants that were old, inefficient and otherwise unprofitable.
Essentially, JPMorgan's traders in Houston would offer to sell power to California at ridiculously low prices, and the state would lock into an obligation to either buy or pay a price for keeping the plants ready to provide power.
The next day, when the juice was actually needed, the firm would jack up its prices. Suddenly, a typical plant in Huntington Beach was transformed from a perpetual loser into a machine spitting out profits of $125,000 a day.
The enterprise came crashing down Tuesday. After a yearlong investigation, the bank agreed to pay the Federal Energy Regulatory Commission a $285 million fine and return $125 million in unjust profits. Some $124 million in profits will be refunded to Californians, and the rest to ratepayers in Michigan.
"We have gotten every penny back that we can attribute to JPMorgan's conduct," said Nancy Saracino, general counsel at the California Independent System Operator.
The ISO runs the power grid, buys last-minute electricity and blew the whistle to federal investigators on JPMorgan's activities.
Besides the refund, JPMorgan agreed not to fight California for $262 million in disputed profits that the state already had recouped or never paid in the first place to the big bank.
All told, Saracino said the settlement represents $386 million worth of value to the state's ratepayers.
The $124 million in disgorged profits will be returned to California customers by their utilities, most likely in the form of lower rates.
The JPMorgan case has aroused fears of a repeat of the 2000-01 energy crisis, when out-of-control Enron Corp. traders plunged the electricity market into chaos.
"It does sort of harken back to some of Enron's trading schemes," said Severin Borenstein, director of the University of California Energy Institute in Berkeley. "In some ways, it was more blatant."
JPMorgan's activities didn't cause nearly as much harm as Enron's, Borenstein said, but the case shows the market "is still vulnerable to some extent."
Regulators, however, said they have ramped up their police powers in recent years – and the JPMorgan case shows the folly of trying to rig the system.
"The cynical interpretation of this is that this is somehow the tip of the iceberg," said Eric Hildebrandt, the ISO's market monitoring manager. In fact, "this is the exception to the rule," he said.
Saracino added: "We're detecting it, we're stopping it and we're punishing . This is really a big deterrent to any future conduct."
Exiting the market
The $410 million settlement is the biggest in FERC's history, and the latest example of the federal agency's recent get-tough approach with power traders.
Earlier this month, FERC hit Barclays Bank with a $453 million fine for manipulating electricity markets in California and other Western states. The London bank is fighting the charges.
JPMorgan accepted the penalty without admitting or denying any wrongdoing.
Because the firm had already set aside money to resolve the case, "this settlement will not have a material impact on earnings," said bank spokesman Brian Marchiony. "We are pleased to put this matter behind us."
The company's stock closed Tuesday at $55.33, down 36 cents, on the New York Stock Exchange.
The settlement culminates a yearlong investigation marked by escalating allegations and multiple subplots.
Last fall, FERC hit JPMorgan with a six-month trading suspension for feeding incorrect information to investigators.
Then state officials charged that JPMorgan was preventing another company from making critically needed upgrades to a pair of Orange County plants; FERC ordered JPMorgan essentially to get out of the way.
The firm abandoned the market in May by selling the rights to market electricity from all of the Southern California plants it controlled to Southern California Edison.
Last week, amid reports that federal banking regulators are increasing their scrutiny of Wall Street's role in trading commodities, JPMorgan said it would try to sell its commodities business.
JPMorgan never owned power plants in California. It plunged into the energy business in the early days of the 2008 financial crisis, when it took over faltering investment bank Bear Stearns.
The deal included contractual rights to trade electricity from several gas-fired plants in Southern California and one in Michigan.
Eventually, JPMorgan controlled more than 4,000 megawatts of California electricity, enough to power about 3 million homes.
Trouble is, the plants were outdated and couldn't compete on price. Hildebrandt said the JPMorgan plants were often "out of the money" – meaning, the company's offers to supply power were rejected because they were too costly.
What's more, JPMorgan had to pay $170 million in annual "rent" to the plants' owner, a generating firm called AES, for the right to market the power.
To turn things around, JPMorgan's traders cooked up a series of "manipulative" strategies, according to FERC documents.
All were designed to exploit the dark shadows of the ISO's complicated market system.
While utilities buy most of their power via long-term contracts, the ISO steps in and buys some electricity on a spot basis, to remedy shortages on the grid.
In some cases, FERC said, JPMorgan was able to sell electricity at "premium rates" by gaming the system. In others, it duped the ISO into paying excessive fees for standing by – running its plants at a low boil, ready to power up if needed.
In one extreme case, covering a three-month stretch in 2011, JPMorgan sold power cheaply to the ISO during late-night hours. But between midnight and 2 a.m., it was able to charge a whopping $999 per megawatt-hour at a time when the market price was $12.
The ISO had to accept the sky-high bids because of the physical realities of power plants; it couldn't force JPMorgan to shut the facilities down so abruptly. A megawatt-hour is enough electricity to power 750 homes for an hour.
Most of the strategies boiled down to a bait-and-switch routine. Federal officials said JPMorgan began offering power at extremely low prices the day before it was needed. The prices were low enough to get the ISO to commit to buying the bank's electricity.
But the next day, JPMorgan would re-submit the bids at much higher prices – higher than prevailing market prices, and higher than JPMorgan's operating costs.
Because its bid had been accepted the day before, JPMorgan was entitled to "bid cost recovery" payments – fees paid by the ISO to compensate a seller for operating an inefficient plant, even if its offering price was above-market.
The idea was to make certain there was enough power to go around in case of a spike in demand. JPMorgan exploited that philosophy.
"They basically created artificially inflated bid cost recovery payments," Hildebrandt said.
FERC fixed most of the blame on four JPMorgan employees: traders Francis Dunleavy, Andrew Kittell and John Bartholomew, and the head of global commodities, Blythe Masters, one of the bank's top executives.
However, the agency didn't take enforcement action against any of them.
Call The Bee's Dale Kasler, (916) 321-1066. Follow him on Twitter @dakasler.