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Complaint: Flawed FTR forfeiture rule threatens market liquidity, hedging in PJM

Changes to PJM Interconnection's implementation of a rule requiring the forfeiture of profits from financial transmission rights under certain circumstances are forcing market participants to choose between transacting in FTRs or in the virtual market, XO Energy charged in a complaint filed with the Federal Energy Regulatory Commission.

That choice threatens liquidity and competition in PJM's markets and has already seen XO, along with Exelon Corp. and Nextera Energy Marketing LLC, cease virtual trading, the complaint contended. Further, the situation has penalized and thus deterred the use of virtual transactions as a tool for hedging physical assets.

Virtual transactions are bids and offers submitted in the day-ahead market without the intent of delivering or consuming physical power in the real-time market. FTRs are financial instruments used to offset market participants' transmission congestion costs in the day-ahead market.

After PJM noticed that some market participants were using virtual transactions to create congestion and profit off FTRs on transmission paths that were never congested, the grid operator created rules requiring participants to forfeit unfairly acquired FTR profits. However, FERC in January 2017 found that those rules needed to be revised because they failed to consider the net impact of a market participant's overall portfolio of virtual transactions.

In an April 2017 compliance filing, PJM proposed certain revisions, despite those revisions being opposed by power trading firms. However, PJM implemented those changes without a FERC order because the commission's January 2017 order established a Jan. 19, 2017, effective date for the compliance filing.

XO's April 8 complaint alleged that PJM's rules are so broad that it "captures competitive market conduct and leads to less efficient-market outcomes."

Noting that "quantification of financial harm from the FTR forfeiture rule is difficult to calculate fully," XO said it has forfeited nearly $4.6 million between January 2018 and December 2019, compared with $1.9 million in gross FTR revenue over the same period, resulting in a net FTR loss of $2.7 million.

"The cumulative impact of the rule, however, is more alarming," XO said. "Virtual transactions, which are essential to a well-functioning and efficient market, will diminish as participants continue to decrease due to the flawed implementation of the rule."

The PJM's independent market monitor's 2019 State of the Market report put total FTR forfeitures from January 19, 2017 the effective date of the rule changes through December 31, 2019, at $20.1 million.

The complaint contended that PJM's rule has created market inefficiencies for participants in both the virtual and physical realms. The rule penalizes "financial market participants whose virtual activity is profitable," while also creating conditions under which "market participants with physical positions are unable to hedge their physical load or generation," the complaint asserted.

Ruta Skucas, a partner at law firm Pierce Atwood who is representing XO in this matter, said in an interview, "If we are going to have these products in the market available for entities to take advantage of for a variety of reasons, including hedging and liquidity, we need to make them accessible. They need to be tools in the toolbox, and this particular rule limits which tool you can use."

Among the rule's flaws is that "it fails to consider whether a market participant has financial leverage" or assess intent, according to the complaint.

"There is no such thing as a properly designed automatic forfeiture rule; any forfeiture rule should only relinquish profits from conduct that, if combined with sufficient credible evidence of intent, would constitute a potential violation," XO argued.

According to XO, PJM ignores this critical component of demonstrating sufficient evidence of intent to manipulate the market and based profit forfeiture "simply on the fact that a market participant holds both FTR and virtual portfolios." As such, XO urged FERC to reject PJM's compliance filing and advocated for replacing or significantly revising the FTR forfeiture rule.

The company said the rule should be replaced with a structured market monitoring approach. But if the commission opts to revise the rule, revisions should include a test for financial leverage and development of "a structured market monitoring function that is capable of assessing a participant's behavior for sufficient credible evidence of intent in order to determine whether a potential violation occurred." (FERC docket EL20-41)

Jasmin Melvin is a reporter with S&P Global Platts. S&P Global Market Intelligence and S&P Global Platts are owned by S&P Global Inc.