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FERC staff report alleges trader, funds engaged in fraudulent 'Up to Congestion' transactions in PJM energy markets


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The Federal Energy Regulatory Commission on Dec. 17 issued an order alleging that an individual, Houlian "Alan" Chen, and three funds engaged in fraudulent "Up To Congestion" (UTC) transactions in the PJM Interconnection’s markets. Along with Chen, the order involves HEEP Fund Inc., CU Fund Inc. and Powhatan Energy Fund LLC.

The case presents allegations by the FERC Office of Enforcement (OE) staff of a violation of the commission’s prohibition of energy market manipulation by Chen, HEEP Fund, CU Fund and Powhatan Energy Fund, FERC said in the order.

FERC said that an OE staff report alleges that Chen, trading on behalf of HEEP Fund and Powhatan Energy Fund, "conceived of a fraudulent scheme in connection with the UTC markets operated by PJM; that he communicated the details of that fraudulent scheme to the principals of Powhatan Energy Fund, who knowingly encouraged him to implement it; and that he did implement it on behalf of Powhatan Energy Fund, HEEP Fund, and, later, CU Fund."

FERC noted that "issuance of this order does not indicate Commission adoption or endorsement of the OE staff report."

"This is a matter in which a successful and experienced trader — a man who had profitably traded in the PJM Interconnection (PJM) market for years, consistently pursuing legitimate arbitrage opportunities — decided to cheat," FERC OE staff alleged in the report, which was attached to the FERC order.

"Through his meticulous study of the market, Chen discovered a method to make money ‘almost risk-free’ by, in the words of Kevin Gates, the fund manager who partnered with Chen in this enterprise through Powhatan, ‘moving electricity around in a circle,’" the report alleged.

The report said that Chen’s "manipulation involved a product in PJM called ‘Up-to Congestion’ (UTC), which functions as a swap of the difference or ‘spread’ between the price of electricity at two locations in the day-ahead market and the same two points in the real-time market. Arbitrageurs of UTC can profit when the price spread between those locations moves favorably from the day-ahead to the real-time market, and lose money when the price movement is unfavorable."

According to the report, in late 2009, Chen learned that PJM "had begun to distribute pro rata shares of a pool of funds called the marginal loss surplus allocation (MLSA, sometimes called ‘transmission loss credits’ or ‘TLC’) to UTC trades."
 
The MLSA is a pool of surplus money arising from the fact that PJM charges buyers more for transmission losses than it distributes to sellers. Previously, PJM had distributed MLSA only to market participants trading physical power.

"Soon after he began receiving MLSA, Chen figured out that the amount of MLSA was relatively predictable and that it could, during periods of high load, be greater than the transaction costs of scheduling UTC trades — costs that were themselves predictable," the report alleges.

Chen "then figured out that he could do enormous volumes of wash-like trades and thereby qualify to receive payments of the MLSA, intended for bona fide transactions. In essence, Chen realized he could be paid simply for placing trades — and in particular, trades that cancelled one another out. Instead of contacting PJM, Chen shared this insight with Kevin Gates and the other investors in Powhatan, who, though they knew this opportunity was ‘something that nature shouldn’t allow’ and would be shut down as soon as it was discovered, eagerly endorsed a strategy of gaming the PJM settlement system with a series of non-bona fide wash-type trades designed to collect large amounts of MLSA from sheer trading volume without taking a position in the market," the OE staff report alleged.

The report at a later point alleged that "Chen’s scheme was to execute pairs of large volume UTC trades in identical volumes and hours and in opposite directions on the same paths — paths where Chen had every expectation that the UTC trades would clear."

Like wash trades, "these transactions left Chen with no net position in the market, but created the illusion of bona fide market activity. PJM’s automated settlement software, however, was not programmed to detect this particular scheme, so it awarded these trades MLSA. The scheme was highly profitable, because PJM’s predictable allocations of MLSA were substantially greater than the predictable transaction costs associated with the same transactions," the report said.

"In sum, Chen went into PJM’s UTC marketplace, where market participants are assumed either to be hedging physical transactions or promoting market efficiency by speculating on congestion price movements between the day-ahead and real-time markets, but he did neither of those things. He hedged nothing, provided no good, no service, nor any other benefit to the market, took no meaningful risk and yet came away with over $10 million that should have gone to bona fide market participants, and, ultimately, in large part to ratepayers in PJM," the report alleged.

The report said that Chen is a native of the Zhejing Province in the People’s Republic of China and holds a doctorate in power engineering from Tsinghua University in Beijing.

He came to the United States in 1995 to perform postgraduate work at Drexel University, OE staff said in the report. According to the report, he subsequently worked as an analyst at a succession of companies, including Entergy, Enron and UBS. Chen’s responsibilities included creating and using models to forecast power prices.

"In 2005, Chen left UBS to join Merrill Lynch Commodities, where he gained his first exposure to UTC transactions. After Merrill Lynch decided not to pursue UTC trading, Chen left to create his own firm, HEEP Fund, Inc. He subsequently founded CU Fund in June 2010," the report said.

The FERC order directs Chen, HEEP Fund, CU Fund and Powhatan Energy Fund "to show cause why they should not be found to have violated" a section of the Commission’s regulations and Section 222 of the Federal Power Act "by engaging in fraudulent" UTC transactions in PJM’s energy markets.

They must also show cause why they should not be assessed civil penalties as follows: Powhatan Energy Fund: $16,800,000; CU Fund: $10,080,000; HEEP Fund: $1,920,000; and Chen: $500,000 for trades executed through and on behalf of HEEP Fund and Powhatan and an additional $500,000 for trades executed through and on behalf of CU Fund.

Commissioner Philip Moeller at the agency's monthly meeting on Dec. 18 read from a statement related to the case.

In the statement posted on FERC's website, Moller said "I believe there is a common misperception about one element of our enforcement process. And my statement today is an attempt to clarify that misperception."

In the show-cause order, "the Commission noted that issuance of the staff report does not indicate Commission adoption or endorsement of staff’s findings. This statement reflects the Commission’s long-standing practice not to pre-judge the findings made in staff reports. Instead, the Commission will consider the entire record in this proceeding to determine whether the assessment of civil penalties is appropriate," Moeller said in the statement.

When FERC began its investigation, brothers Kevin and Richard Gates, two of the principal owners of Powhatan, decided to engage in a public fight with FERC over the investigation, including the establishment of a website on which they posted many of the documents from the non-public phase of the investigation, as well as statements of support from economists.—PAUL CIAMPOLI

 
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