Natural Gas and Electricity Markets: Federal Government Actions to Improve Private Price Indices and Stakeholder Reaction
Published: 2005-12-15T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Since the 1970s, the natural gas and electricity industries have each undergone a shift toward greater competition, referred to as restructuring. This restructuring has moved these industries from regulated monopolies to markets in which competitors vie for market share and wholesale prices are largely determined by supply and demand. Amid this restructuring, private companies have published information about these markets, including reports of market prices in various locations--referred to as price indices. These indices, whether for short-term "spot" or long-term "forward" markets, are developed by surveying selected market participants who voluntarily supply price information. Market participants rely on these price indices to help them make informed decisions about trading these commodities and to evaluate new investments. In recent years, confidence in price indices has been shaken due to misreporting and other abuses. During the energy crisis in the West in 2000-2001, several market participants were found to have purposefully misreported prices in order to manipulate these indices for financial gain. In this context, GAO agreed to answer the following questions: (1) What federal regulatory and statutory efforts have been taken to improve price indices in electricity and natural gas markets? (2) Have federal efforts improved industry stakeholders' confidence in these price indices?
section_title: What GAO Found
paragraphs: Since 2003, the federal government has undertaken a series of regulatory and statutory efforts to improve the availability and accuracy of price information in price indices. First, FERC issued standards on voluntary price reporting and rules of conduct in a July 2003 policy statement. Second, FERC has taken steps to improve its ability to monitor price indices and enforce market rules by (1) reviewing wholesale prices for anomalies that could indicate market problems and (2) collaborating with other entities, such as the Commodity Futures Trading Commission (CFTC), and independent market monitoring units that monitor organized electricity markets to detect market manipulation. Third, the Energy Policy Act--enacted in August 2005--increases the amount and types of civil penalties that FERC may impose on companies that participate in anticompetitive behavior, including knowingly misreporting price information to index developers and gives FERC authority to collect additional transaction information if such information is necessary to ensure price transparency. Fourth, FERC and the CFTC entered into a memorandum of understanding to share and coordinate requests for information, which they say will allow FERC to more readily identify and sanction market manipulation. Many industry stakeholders reported that they now have greater confidence in most price indices, but some expressed concern about price indices for long-term electricity markets. FERC reported that stakeholders are generally satisfied with current price indices and that the quality of information has improved. For example, in a recent survey FERC found that two-thirds of respondents reported their confidence in price indices, on a scale of 1 to 10 (10 being most confident), as a 7 or greater. Further, FERC reported that since 2002 the quality of information has improved because (1) more companies are reporting data to publishers and (2) major publishers are providing more information about the number of transactions and volume of electricity and natural gas trades. GAO's own investigations corroborated what FERC found in its survey. Specifically, natural gas and electricity industry stakeholders reported that, in general, they are reasonably confident in the short-term prices now reported by trade publications and the improved quality of overall information. While stakeholders expressed general satisfaction with most price indices, some reported concerns about price indices in long-term electricity markets. Furthermore, stakeholders are now able to see that some of these markets witness fewer transactions and, as a result, are less developed than others. In the absence of a reliable long-term electricity market and information about prices, market participants noted that they rely on long-term natural gas markets and indices that are more developed. Stakeholders told GAO that, because natural gas is widely used to generate electricity, their prices often move together and, therefore, natural gas forward prices can substitute, to some extent, for electricity futures prices. They also said that the use of these natural gas markets only partly mitigates the lack of robust long-term electricity markets, because electricity and natural gas prices sometime move independently.

section_title: Letter
paragraphs: Since the late 1970s, the natural gas and electricity industries have each  undergone a shift toward greater competition, referred to as restructuring.  This restructuring has moved these industries from ones in which local  monopoly utilities provided services and regulators set prices to ones in  which competitors vie for market share, and wholesale prices are largely  determined by supply and demand. Amid this restructuring, private  companies have routinely published information about these markets,  including reports of market prices in various locations—referred to as  price indices—developed by surveying market participants who voluntarily  supply price information. In some cases, these price indices refer to short- term markets—so called “spot” markets where the electricity or natural gas  is sold for delivery in the near term (e.g., the next hour or the next day). In  other cases, price indices refer to long-term markets, such as “forward”   and other markets—for the purposes of this report, we refer to all of these  as occurring in long-term markets—where the delivery of natural gas or  electricity is expected to occur in the future (e.g., 30 days, 1 year, or  longer). Utility companies and other energy market participants rely on  these price indices to help them make informed decisions about buying and  selling electricity and natural gas and as a guide for potential new  investments. Because price indices play such a pivotal role in the market, it  is vital that energy market participants have confidence that these indices  are robust, transparent, reliable, and accurate. To help ensure that  wholesale market prices are fair and that the information in price indices is  reliable and accurate, the Federal Energy Regulatory Commission (FERC)  has issued regulatory rules supporting competition, routinely monitored  markets for anticompetitive behavior, and enforced and revised market  rules as needed.
In recent years, confidence in price indices had been shaken due to  misreporting and other abuses. Most notably, during the energy crisis in  California and the West in 2000-2001, several market participants were  found to have purposefully misreported prices in order to manipulate these  indices for financial gain. As part of FERC’s efforts to remedy price  manipulation and consumer overcharges that occurred during that  electricity crisis, it has ordered more than $4 billion in refunds. In addition  to concerns about misreporting, some market participants have noted that  the entities that publish price indices often failed to convey information  necessary for them to assess the quality and validity of the indices, such as  information about the volume of transactions represented and the number  of participants trading at various locations. As a result, some stakeholders  raised concerns about the federal government’s ability to adequately  regulate and oversee natural gas and electricity markets and the reliability  and accuracy of prices reported in indices.
In this context, we agreed to answer the following questions: (1) What  federal regulatory and statutory efforts have been taken to improve price  indices in electricity and natural gas markets? (2) Have federal efforts  improved industry stakeholders’ confidence in these price indices?  To  answer these questions, we reviewed federal reports documenting efforts  to improve price transparency and examined literature on price  transparency in the natural gas and electricity markets. In addition, we  interviewed officials at FERC, representatives of relevant trade  associations, and experts. We examined FERC survey data and assessed its  reliability by reviewing existing information about the data, interviewing  agency officials knowledgeable about the data, and examining comments  by the entities surveyed. We conducted our work from June 2005 to  November 2005 in accordance with generally accepted government  auditing standards.
subsections: section_title: Background
paragraphs: The natural gas and electricity industries perform three primary functions  in delivering energy to consumers: (1) producing the basic energy  commodity, (2) transporting the commodity through pipelines or over  power lines, and (3) distributing the commodity to the final consumer.  Historically, many local utilities in the electricity sector built their own  systems of power plants and electricity transmission and distribution lines  to serve the needs of all consumers in their local areas. Similarly, natural  gas companies built networks of pipelines to deliver natural gas from areas  where it was produced to the markets where local distribution companies  served all local customers. These local monopolies were overseen by  regulators, who restricted the entry of new companies and also approved  investments, approved prices paid by customers, and determined profits of  these utilities. However, due to rising electricity prices and technological,  economic, and policy developments beginning in the 1970s, the electricity  and natural gas industries have restructured from a regulated environment  to one that places greater reliance on competition to determine entry,  investment, prices, and profits.  The passage of the Natural Gas Policy Act  of 1978, the Natural Gas Wellhead Decontrol Act of 1989, and subsequent  FERC orders in 1985 and 1992 opened access to pipelines and required  pipeline companies to completely separate transportation, storage, and  sales services, all of which facilitated the shift of natural gas to more  competitive markets. Similarly, the 1978 passage of the Public Utility  Regulatory Policies Act of 1978 and the 1992 passage of the Energy Policy  Act facilitated restructuring in the electricity industry. FERC built upon  these efforts through major regulatory actions in 1996 and 1999 that  required utilities under its jurisdiction to, among other things, provide  nonutility companies that generated electricity with access to the utility’s  interstate transmission lines and encouraged utilities to join in the creation  of independent organizations to operate the transmission system, such as  Independent System Operators (ISO) and Regional Transmission  Organizations (RTO).
Under federal statutes, FERC is the principal federal agency that regulates  the natural gas and electricity industries to ensure that wholesale  electricity and natural gas prices are fair. FERC is responsible for  developing and maintaining the regulatory framework that approves or  otherwise influences the utilities’ terms, conditions, and rates for the sale  or resale and transmission of natural gas and electricity in interstate  commerce. Historically, to ensure that the prices these utilities charged  were just and reasonable, FERC regulated rates by basing the prices on the  utilities’ costs to provide service plus a fair return on investment. Now,  FERC seeks to ensure that wholesale natural gas and electricity prices are  just and reasonable by promoting competitive markets, issuing market  related rules that encourage efficient competition, and enforcing and  correcting market rules as needed.
In the newly restructured markets, many energy market participants rely  on price information obtained from various sources, including price indices  published in trade press because some companies can be reluctant to freely  provide data on purchases and sales. Private companies develop these  price indices by collecting information about market prices from market  participants in a variety of ways, including phone calls to individuals within  energy trading companies. Market participants use these indices to, among  other things, help them make informed decisions about buying and selling  natural gas and electricity. For example, energy market participants use  price indices as a benchmark in reviewing the prudence of gas and  electricity purchases and often reference price indices in the contracts they  develop for gas and electricity purchases. As part of its market oversight  efforts, FERC also monitors these price indices to detect anticompetitive  behavior.
Other federal agencies have roles affecting the electricity and natural gas  markets. The Commodity Futures Trading Commission (CFTC) oversees  markets and transactions related to the sale of commodity and financial  futures and options, while the Federal Trade Commission (FTC) and  Department of Justice police deceptive selling practices. In addition to  these federal agencies, states also oversee aspects of natural gas and  electricity delivery, often through public utility commissions.
section_title: The Federal Government Has Undertaken Multiple Efforts to Improve Price Indices
paragraphs: Since 2003, FERC has undertaken a series of efforts to improve the  availability and accuracy of price information, including specifically  addressing price indices. In 2000 and 2001 during the energy crisis in the  West, some market participants knowingly misreported data to index  providers in order to influence these indices for financial gain. Following  that, FERC convened a series of conferences and workshops that included  regulators, energy market participants, price index publishers, and industry  experts. One of these events included participation by the CFTC and  another included participation by the National Association of Regulatory  Utility Commissioners (NARUC). As a result of these efforts, FERC staff  developed a better understanding of market participants’ desired  characteristics of the price indices and behavior of other market  participants. These conferences and workshops also revealed some  practical short- and long-term solutions to problems such as how market  price indices are developed and why reduced energy trading activity was  occurring.
Using the information that it developed through its conferences and  workshops, FERC developed new standards and rules of conduct for both  market participants submitting trade data and for price index publishers, to  help ensure that price indices were more accurate and reliable and to  strengthen market participants’ confidence in price indices. FERC outlined  the standards that energy market participants and index developers should  follow in a 2003 policy statement. According to FERC, these standards  were designed to encourage standardization in the voluntary reporting of  price and other market information, among other things, and to assure  companies that they will not be subject to administrative penalties for  inadvertent errors in reporting. These standards also encourage energy  market participants to report not only prices but also the volume of the  traded commodity and the date and time of the transaction, and encourage  the entities that publish price indices (e.g., Platts, Natural Gas Intelligence,  and Dow Jones) to also publish this relevant market information. In  addition, FERC standards encourage index publishers to verify the price  data obtained from companies that provide price data, to indicate when a  published price is an estimate made by the publisher rather than data  reflecting only the results of actual trades, and to monitor the data to  identify attempts to manipulate energy price indices. Finally, FERC  standards encourage price index publishers to explain to users how the  index is developed and include the formulas used to calculate the index.
With regard to rules of conduct, FERC issued two orders in November 2003  designed to establish clear guidelines for sellers of wholesale electricity  and natural gas subject to its jurisdiction. These guidelines prohibit  actions that do not have a legitimate business purpose and are capable of  manipulating prices. For example, they prohibit submitting false or  misleading information to FERC or price index publishers.
FERC has also taken steps to improve its ability to monitor price indices  and enforce related market rules. Recently, we reported that FERC had  made significant efforts to revise its oversight approach to better align with  its new role in overseeing restructured markets. In particular, we have  reported that through the establishment of its Office of Market Oversight  and Investigations in 2002, FERC had taken a more proactive approach to  monitoring by reviewing large amounts of data, including wholesale prices,  for anomalies that could lead to potential market problems. In addition,  FERC, which oversees the operators of electricity grids, including ISOs and  RTOs, has worked with these organizations’ market monitoring units— many of which collect substantial amounts of information on prices and  other data to determine, among other things, whether prices are the result  of fair competition or appear to be a result of market manipulation.
Finally, the passage of the 2005 Energy Policy Act included FERC’s  proposed statutory changes to address misconduct of market participants  by increasing civil penalties imposed on companies that participate in  anticompetitive behavior or manipulate the market. These changes  increase FERC’s ability to levy civil penalties under existing laws, raising  potential fines to as much as $1 million per day per violation for as long as  the violation continues. A FERC official said that increasing civil penalties  would allow it to more effectively deter market manipulation and  misconduct that is damaging to competitive markets. Moreover, FERC  officials said that it would lead to greater certainty for market participants,  thereby increasing participation in markets. The Energy Policy Act also  gives FERC authority to collect transaction information if necessary to  ensure price transparency. A FERC official said that this authority would  give FERC additional tools if the current voluntary system of reporting  prices to price index publishers proves inadequate. In addition, in response  to requirements in the Energy Policy Act, FERC and the CFTC entered into  a memorandum of understanding to share and coordinate requests for  information, which they say will allow FERC to more readily identify and  sanction market manipulation.
section_title: Industry Stakeholders Are Reasonably Confident in Most Price Indices
paragraphs: Many industry stakeholders report that they are now reasonably confident  in short-term price indices, although some concerns about the  transparency of long-term electricity markets remain. As part of its effort to  assess its efforts to improve price indices, FERC surveyed industry  participants in March 2004, asking them to rate their confidence in price  indices—with 1 representing no confidence and 10 representing total  confidence that price indices accurately represent market pricing.  Confidence in price indices ranged from an average of 7.5 for gas utilities to  6.7 for marketers, with nearly half reporting a confidence of 8 or greater.  (See fig. 1.)  In addition, in 2004, FERC reported that price index publishers  have submitted information showing that the volume and number of  transactions have increased significantly since 2002 and is influenced by at  least two factors. First, companies that had been reporting transactions  began reporting more transactions to publishers of price indices. Second,  companies that had not been reporting had begun reporting transactions to  publishers of price indices. Furthermore, many of the companies reporting  in 2004 are among the industry’s larger and more active participants.
Consistent with what FERC found, industry trade and research  organizations and others that we interviewed reported to us that their  members have few significant concerns about the short-term, also called  spot, price indices or long-term natural gas indices. They report that,  overall, FERC’s efforts to improve the transparency of spot price indices  achieve sufficient oversight without being heavy-handed. In addition,  industry participants told us that the quality of data being provided to  publishers of price indices has improved since 2002. For example,  according to a major price index publisher, the reporting of price  information has significantly improved in the last 2 years, and, further, the  quality of analysis and reliability of the prices that they report has  improved. Finally, publishers are providing more information about the  market, such as the number of transactions and the amounts of energy  bought and sold at specific trading locations. For example, a major  publisher reported to us that, as of August 2004, it includes volume and  transaction data for each pricing point in the spot market.
Despite their general satisfaction with most price indices, some  stakeholders reported concerns about price indices for long-term  electricity markets. In particular, representatives of one trade organization  told us that while data regarding spot prices and long-term natural gas  prices have improved, they still have concerns about electricity prices  involving long-term purchase arrangements and similar long-term contracts  (e.g., forward and futures markets, where long-term contracts for  electricity and related financial instruments are bought and sold).    Stakeholders are now able to see that these markets witness fewer  transactions and, as a result, are less developed than others. One factor  affecting price transparency in these long-term markets is that the use of  these markets collapsed in 2002 over concerns that prices were  manipulated. This collapse, in turn, has resulted in fewer market  participants and a market that is less developed, making it difficult for  those still wanting to participate in these markets to find a willing trading  partner. In addition, two stakeholders told us that there are not many  options for obtaining data regarding longer term energy market  transactions. Complicating this concern, FERC does not have jurisdiction  for overseeing futures markets and has only a limited direct role in long- term markets. As a result, FERC does not formally collect extensive data  on futures or long-term markets. As a result, one energy market  participant reported that it relies on limited data when developing or  valuing long-term electricity contracts. In the absence of a mature and  reliable long-term electricity market and information about prices, market  participants noted that for now they rely on long-term natural gas markets  and indices, which are more developed. These market participants told us  that because natural gas is used extensively to generate electricity, the  prices often change together. They also said that the availability and use of  these natural gas markets only partly mitigates the lack of robust electricity  markets, because electricity and natural gas prices can, and do, sometimes  move independently.
section_title: Concluding Observations
paragraphs: The move away from regulators setting prices and toward markets where  prices are increasingly a function of competition has raised the importance  of price indices as a mechanism to communicate information to the  market. In recent years, market participants have used these indices in  structuring their transactions and regulators have used them to judge how  the market is performing. As a result, it is important that they accurately  and reliably reflect actual prices.
The federal government has taken a number of steps to encourage  improved availability and accuracy of price indices, which has increased  industry confidence in price and other market information provided in spot  price indices. Although federal efforts appear to have had a positive impact  on short-term (spot) price indices, some concerns remain about price  indices for long-term electricity markets. It does not appear that there is an  easy way to improve reporting on these long-term electricity markets until  the markets themselves mature. Because of the importance of price  indices, it will be important for FERC, Congress, and others to remain  vigilant in their monitoring of existing price indices and attentive for  alternatives to address the remaining issues in longer term markets.
section_title: Agency Comments
paragraphs: We provided a copy of our draft report to FERC for comment. FERC  provided written comments, which are presented in appendix I. In its  comments, FERC generally agreed with our findings and conclusions. In  addition, FERC provided a variety of technical and other comments, which  we incorporated as appropriate.
section_title: Scope and Methodology
paragraphs: To obtain information about efforts FERC has taken to improve natural gas  and electricity price indices, we reviewed reports and other documents  describing federal efforts to improve price transparency and examined  literature on price transparency in the natural gas and electricity markets.  In addition, we interviewed government officials at FERC, representatives  of trade associations, and industry and academic experts in the field. We  assessed the reliability of FERC confidence survey data by reviewing the  survey instrument and methodology used to tabulate results, interviewing  relevant agency officials knowledgeable about the data to understand any  limitations of the data, and corroborating results by interviewing some of  the entities surveyed.
We conducted our work from June 2005 to November 2005 in accordance  with generally accepted government auditing standards.
We are sending copies of this report to the Chairman of FERC as well as  other appropriate congressional committees. We also will make copies  available to others upon request. In addition, the report will be available at  no charge on the GAO Web site at http://www.gao.gov.
If you or your staff  have any questions about this report, please contact me  at (202) 512-3841 or Wellsj@gao.gov. Contact points for our Office of  Congressional Relations and Office of Public Affairs may be found on the  last page of this report. GAO staff who contributed to this report are listed  in appendix II.
section_title: Comments from the Federal Energy Regulatory Commission
section_title: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the individual named above, Jon Ludwigson, Kristen Massey,  Frank Rusco, Barbara Timmerman, Alison O’Neill, Chris Pacheco, and Kim  Wheeler-Raheb made key contributions to this report.