By Rory D. Sweeney

Imagine a casino where you could produce $548 million in paper profits — or $100 million in losses — with only $600,000 of collateral. That’s essentially what Andrew Kittell and John Bartholomew saw when they began trading financial transmission rights in PJM in 2014, the beginning of a saga that has now spiraled into the largest default in the history of the RTO’s financial markets.

After the default of Tower Research Capital’s Power Edge hedge fund in 2007, FERC ordered an end to collateral-free trading in Order 741. PJM and other RTOs tightened their credit rules as a result.

But the changes weren’t enough to protect PJM against Kittell and Bartholomew’s GreenHat Energy, which purchased a staggering 890 million MWh of FTRs — the largest FTR portfolio in PJM — before the company defaulted in June.

In hindsight, RTO officials should have been wary of Kittell and Bartholomew, who came to FERC’s attention for their roles in J.P. Morgan Ventures Energy Corp.’s (JPMVEC) scheme to manipulate the CAISO and MISO markets between 2010 and 2012.

The GreenHat debacle has led to proposals for additional changes to PJM’s credit policy and questions about the competence and vigilance of RTO staff involved. PJM’s failure to respond promptly to warnings from other FTR traders allowed GreenHat’s $10 million loss in 2017 to grow — leaving other market participants on the hook for as much as $145 million. [Editor’s Note: FERC issued rulings in two FTR dockets on Sept. 25. See update at bottom.]

Here, based on interviews, PJM records and FERC filings, is how it happened, a cautionary tale of inadequate safeguards, opportunistic traders, foot dragging to patch loopholes and, finally, a botched effort to obtain more collateral that may have netted the RTO nothing. GreenHat’s principals did not respond to requests for comments sent to their attorneys, David Gerger of Houston and John N. Estes III of D.C.

Aggressive Purchases

After becoming a PJM member in 2014, GreenHat began amassing its FTR portfolio in the 2015 long-term FTR auction. The company focused most of its activity on positions in the 2018/2019 planning year, securing the rights to 54 million MWh each month. That accounted for 73% of its portfolio. It held another 18 million MWh (24%) for the 2019/20 planning year and 2 million MWh (3%) for the 2020/21 planning year.

The company stuck mostly to long-term auctions — which are held three times a year and offer positions for the following year and two more beyond that — buying many of the same paths year over year. Between 2015 and December 2017, GreenHat participated in at least five long-term auctions. The positions seemed like good bets at one time: PJM calculates that in the 2015/2016 planning year, GreenHat’s portfolio would have netted $548 million in profits.

How much did GreenHat pay to amass such a large position? Nothing at the time. It bought on credit, having to post only its initial $600,000 in collateral. Yet there were indications that GreenHat was not well capitalized: On one document, it listed its address as 826 Orange Avenue, Suite 565 Coronado, Calif. — a UPS store between a nail salon and a RiteAid.

GreenHat’s positions, had the company held them, would have remained profitable, though less so, in the 2016/17 and 2017/18 planning years.

But the profitability of GreenHat’s positions was falling as transmission upgrades approved in PJM’s Regional Transmission Expansion Plan to alleviate congestion were added to the FTR model. The implied profits of GreenHat’s portfolio, based on the auction clearing price, were $0 from the December 2015 long-term auction, and they generally decreased with each subsequent auction. By the December 2017 auction, the portfolio appeared to be a $45 million loser.

During those years, GreenHat posted no more collateral than the $600,000 it originally provided as a requirement to trade in PJM’s market. FTR auction participants do not pay the purchase price of FTRs until settlement, when the price is combined with or netted against any congestion revenue credit owed to or by the FTR holder. PJM calculates collateral based on a comparison of the purchase price to the “adjusted FTR historical value,” a three-year, weighted average of the day-ahead congestion previously experienced on the FTR’s path.

The comparison calculations are cumulative, so a negative number for one position can help offset a positive number for another. In that way, GreenHat was able to consistently balance out its portfolio so it could continue acquiring positions without owing collateral.

Doubling Down

In April, PJM implemented FERC-approved revisions to its credit policy that factored future transmission upgrades into credit calculations, essentially reducing the expected clearing price on affected paths (ER18-425). The changes would have created a $60 million collateral call for GreenHat’s portfolio, according to PJM, but the rule included a 13-month transition period, which GreenHat would exploit to increase its holdings.

During the transition, GreenHat participated in its only annual FTR auction, for the 2018/2019 planning year, acquiring enough new seemingly winning positions to negate a collateral call. The additional purchases would ultimately add nearly $35 million more in anticipated losses to the company’s portfolio.

“The buying activity in PJM’s PY18/19 auction by [GreenHat] did not appear to be designed to reverse or offset [GreenHat’s losing] positions. Instead, the buying activity was focused on entirely different parts of the PJM network, with a particular focus on buying FTRs with high adjusted FTR historical values (even after accounting for transmission upgrades) relative to their auction clearing prices, which as a result reduced [GreenHat’s] collateral requirements,” DC Energy noted in a FERC complaint seeking immediate changes to PJM’s credit requirements (EL18-170).

Going to Settlement

GreenHat’s positions started going to settlement with the beginning of planning year 2018/19 on June 1, and PJM issued GreenHat a $1.2 million bill for its initial losses on June 5. By the time PJM declared GreenHat in default on June 21 — after a waiting period required by the Tariff — the anticipated losses had ballooned to $110 million.

At a stakeholder meeting in August, Vitol’s Joe Wadsworth said he used recent market results to determine that it could be upward of $145 million and “is getting worse.”

If accurate, the result would be almost triple the $52 million credit default by Power Edge in 2007, which also triggered credit policy revisions following FERC Order 741.

The order noted that FTRs “have unique risks that distinguish them from other wholesale electric markets” with obligations that can run from a month to a year or more, leaving them dependent “on unforeseeable events, including unplanned outages and unanticipated weather conditions.” An outage can switch a profitable prevailing flow FTR to counterflow, resulting in losses. And “because FTR obligations cannot be terminated prior to [their expiration], losses can mount to the point that the FTR holder goes bankrupt,” FERC said.

PJM’s revisions following Power Edge addressed FTR counterflow risks, while GreenHat’s portfolio is predominantly prevailing-flow positions that will be affected by transmission upgrades.

According to DC Energy, all other RTOs/ISOs — CAISO, ISO-NE, MISO, NYISO, SPP and ERCOT — consider the distribution of historical values monthly, daily or hourly and incorporate the low-valued tail of the distribution (e.g., 75th or 95th percentile). CAISO, NYISO and ERCOT also require upfront payments to prevent market participants from defaulting on prevailing-flow portfolios.

Efforts to Intervene

GreenHat’s riskiness didn’t materialize out of nowhere. DC Energy said it approached PJM in April 2016, months after GreenHat had secured its first positions, about tightening up its credit policies. Specifically, DC Energy pushed for a 5-cent/MWh collateral requirement and worked with PJM to shepherd a proposal through the stakeholder process. PJM argues the proposal wasn’t viable because it would have reversed safeguards put in place after the Power Edge default.

Staff removed the collateral requirement from the proposal in September 2016, and the measure failed to receive stakeholder endorsement at the December meeting of the RTO’s Markets and Reliability Committee — around the time GreenHat was securing positions in its second long-term auction that appeared to be a $2 million loss. (See PJM Credit Adder Fails upon Heightened Review.)

DC Energy met with PJM again in February 2017 and made presentations at stakeholder meetings in March, June and November, and again in January 2018. The campaign eventually bore fruit, with FERC approving the change in FTR credit rules effective April 1 that increased credit requirements on paths on which transmission upgrades are expected (ER18-425).

In July, after winning stakeholders’ endorsement, PJM asked for FERC approval of another revision to the credit rules:  imposing a 10-cent/MWh minimum monthly requirement (ER18-2090).

But DC Energy saw that GreenHat’s first bills were coming and attempted to beat the likely default by filing a complaint at FERC on June 4 and requesting it be fast-tracked (EL18-170). DC acknowledged the per-megawatt-hour monthly requirement PJM was likely to file soon, but it said the situation required more expediency and asked FERC to approve its own proposal on credit minimums.

PJM responded on June 25, four days after it declared GreenHat in default, to oppose the proposal and warn that “overly rigid credit requirements can limit market access and constrain competition.” Staff argued that PJM’s new proposals would have imposed a $90 million credit requirement on GreenHat’s portfolio, that GreenHat had always followed PJM’s credit rules and that its purchases seemed like good decisions.

“FTR auction clearing prices when GreenHat acquired the majority of the FTR portfolio on which it has defaulted indicated that GreenHat’s portfolio would be profitable,” staff wrote.

PJM’s Stan Williams said in an affidavit included in the response that staff only became “concerned about” GreenHat’s risk exposure in “early 2017” — despite DC Energy’s claim that it had met with staff to discuss the developing situation roughly a year before.

Vitol, another FTR trader, supported DC Energy’s complaint and blamed PJM staff, saying the RTO “does not appear to have acted in good faith or with any real sense of urgency to address the risk to the market, and may indeed have willfully ignored the mounting risk posed by GreenHat’s market activity or positions.”

Apogee Energy Trading accused RTO staff of being too “focused on trying to prevent ‘another GreenHat’ without addressing the [immediate] GreenHat portfolio problem.”

FTR trader Appian Way criticized PJM in a FERC filing for failing to use “margining” to reflect changes in the market values of FTR portfolios. “Without margining, the moral hazard is that participants double down on losing positions as has been the case with GreenHat Energy.”

Worthless Collateral?

PJM rejected the criticism, citing its efforts to secure additional collateral from GreenHat and the April 2018 rule change shoring up its credit policies. Prior to that, in April 2017, PJM had approached GreenHat to increase its collateral. DC Energy was still promoting its per-megawatt-hour minimum requirements, even though it had failed once to win stakeholder endorsement, and GreenHat had just completed its second long-term auction, where it had appeared successful even though its overall portfolio was running a $2 million loss.

GreenHat offered to sign over the rights to what company representatives said they believed to be $62 million in revenue from selling some of its FTR positions to an undisclosed company in bilateral contracts. PJM agreed to the deal, but it was later told by GreenHat’s counterparty that it had already paid its debts before the company signed the rights over to the RTO.

PJM later admitted that it had not confirmed the amount due prior to accepting the deal. “To avoid a claim of interference with GreenHat’s contractual counterparty and to allow GreenHat the ability to sell down its portfolio, PJM had no choice but to comply with this request,” the RTO said.

GreenHat said it “offered additional collateral when it had no obligation to do so” only because it had no FERC quorum to complain to. The deal was that GreenHat wouldn’t challenge the call, and PJM would make its own evaluation of what the collateral was worth.

However, PJM hasn’t collected anything from the pledge agreement and the RTO now acknowledges “there is now some question whether the pledge agreement will result in monies to PJM.”

DC Energy noted in its complaint that PJM’s Tariff gives staff the “right to ‘require additional collateral as may be deemed reasonably necessary to support current market activity’” and that “such extraordinary measures should be done in unique one-off situations.” PJM staff had referenced that Tariff provision in an email to GreenHat during the collateral call negotiations. But the company said the reforms it proposed were necessary because one-off collateral calls “should not be used to address Tariff deficiencies on a long-term basis.”

But PJM said in a “lessons learned” document presented at the Sept. 17 meeting of its Credit Subcommittee that “there are limited provisions for a discretionary collateral call, and those provisions … are not necessarily applicable in all circumstances.”

It recommended a rule change to allow itself “to issue collateral calls that can clearly be applied broadly to a wider range of potential circumstances and all types of market activity.”

Traders with a Past

This isn’t the first time the people behind GreenHat have exploited market flaws at the expense of other participants. Two of the principals at GreenHat, Kittel and Bartholomew, were identified as lieutenants in the 2013 JPMVEC market-manipulation investigation that resulted in a $235 million fine, which remains FERC’s single-highest penalty paid since its records began in 2007 (IN11-8, IN13-5).

FERC said JPMVEC used 12 different bidding strategies to manipulate the energy markets in MISO and CAISO to ensure dispatch and uplift payments for plants that otherwise were often uneconomic. The company had obtained the tolling rights to most of the gas-fired plants from Bear Stearns, which had fallen apart in the 2008 financial collapse.

Kittell also came from Bear Stearns in the deal. Bartholomew was hired from Southern California Edison after submitting a resume that boasted he had “identified a flaw” in CAISO’s markets that he could exploit for “millions of dollars.”

FERC’s Office of Enforcement said that the company violated the commission’s anti-manipulation rule by “intentionally submitting bids … that falsely appeared economic to … market [operation] software but that were intended to, and in almost all cases did, lead CAISO and MISO to pay JPMVEC at rates far above market prices.”

FERC’s enforcement order came on July 30, 2013, but it noted that by June of that year, JPMVEC had effectively sold its interest in the plants by retolling, or subleasing, them to third parties. As of the enforcement action in 2013, Kittell and Bartholomew were still at JPMVEC but working on “transactional activities.” Though named in FERC’s enforcement order, neither was personally fined, as FERC has sometimes done.

FERC spokesperson Craig Cano said the commission doesn’t comment on investigations and would neither confirm nor deny whether GreenHat is being investigated.

PJM refused to divulge when it learned of the connection between GreenHat and JPMVEC. However, staff acknowledged in the “lessons learned” document that “the current credit application may not include all inquiries that may be relevant for PJM to assess the application.”

The document says “additional information should be required … such as whether an applicant or its owners have been the subject of regulatory investigations in the past, whether an applicant has ever had its market-based rate authority suspended or terminated, whether an applicant has ever had its retail supplier license suspended or terminated, etc.”

Sharing the Pain

Per its Tariff, PJM allocates the losses from defaulted portfolios to every entity that is a member as of the default date. The RTO had 992 members on June 21, and 10% of the final bill will be allocated to them on a per capita basis. Those assessments are capped at $10,000 per incident. The remaining losses will be allocated proportionally according to each member’s gross PJM activity over the three months preceding the default.

PJM has sent bills for $42.5 million for GreenHat’s losses in June through August, representing about 18% of the company’s portfolio, with 33 more months of settlements to go. The losses include both settled positions and money the RTO paid market participants to take on the positions before settlement.

In fact, the bids PJM received to take on GreenHat’s prompt-month positions in August were so far above what they’ve actually settled at that the RTO petitioned FERC for emergency waivers of its Tariff requirements so it can plan a better strategy. The first waiver would allow PJM to only offer the prompt month of GreenHat’s positions — the ones that will settle the following month — into its monthly auctions rather than offering all of the defaulted positions. PJM said it would “maximize the likelihood of liquidation of those positions,” as the Tariff requires (ER18-2068).

The liquidations were costing $775,000 per day, PJM calculated, or $12.4 million for the first 16 days of August.

“By contrast, if PJM had allowed GreenHat’s positions to proceed to settlement, actual losses for those same 16 days in the month of August 2018 would have been approximately $2.3 million, consistently less than $500,000 per day, with some days resulting in $0 in losses or even modest profits when they settled,” PJM’s Tim Horger said in an affidavit filed in the docket.

PJM also argues that markets for the prompt month are far more liquid than those for months and years further out.

After receiving stakeholder approval in August, PJM filed a second waiver request to allow all GreenHat positions to go to settlement through Nov. 30 (ER18-2289). Both requests were intended to buy time for PJM stakeholders and staff to find a resolution.

Some PJM members have also touted the potential for using the FTR market to hedge against the GreenHat losses by taking positions to offset the company’s holdings.

Not all members are pleased with the delay, however. Apogee has opposed both waiver requests, arguing that prompt liquidation is better for the market than attempting to mitigate “undesirable consequences … for certain members over others.” As a financial trader, Apogee’s allocation would be relatively limited compared to members who buy, sell and trade in multiple PJM markets daily.

Apogee argues that waiting could allow traders to “front run” the sale of GreenHat’s portfolio by selling any identical positions they have and then buying them back at a discount when the large volume of the FTRs are sold in the subsequent monthly auctions.

“The additional selling pressure from front-runners also is likely to increase and not mitigate the total loss,” Apogee argued.

In July, PJM filed a third waiver request seeking to hold onto $550,000 in collateral posted by Orange Avenue, another FTR trader also managed by Kittell (ER18-1972). Orange joined PJM in February and posted its collateral but never traded. It sought to withdraw and recover its collateral in June, but PJM asked FERC to allow it to hold the money for a year until it can determine the legitimacy of the $62 million Kittell signed over to PJM on behalf of GreenHat.

Solutions

PJM has held several special sessions of the MRC to discuss the situation with stakeholders and analyze 23 proposals for dealing with GreenHat’s portfolio. The suggestions range from letting all the positions go to settlement to the Monitor’s proposal to cancel them so they don’t settle. Apogee proposed allowing market participants to assume their share of the FTRs from the portfolio instead of paying the allocation. Vitol has suggested a separate sealed-bid auction of the portfolio.

“Our recommendations are so this does not spiral into chaos,” DC Energy’s Bruce Bleiweis said at the Sept. 18 session. Liquidation, he said, is “small bites over a period of time to make it manageable.”

Most financial FTR traders are pushing for liquidation, including Apogee’s Kevin Kelley. “I think there’s a lot of scare in the room based on the August results,” he said at the same meeting.

Staff plan to seek stakeholder endorsement at the Sept. 27 MRC meeting for any of six proposals preferred by stakeholders. If a path forward is approved at the subsequent Members Committee meeting, PJM plans to file it for FERC approval to be effective on Dec. 1. That filing would include a request that, if FERC doesn’t approve the endorsed proposal, it extend the current waiver requests until March 1 to avoid reverting back to the status quo of being required to immediately liquidate the positions. If no proposal is approved, PJM expects stakeholders to direct staff to file the extension request by itself.

PJM also announced it plans to introduce problem statements and issue charges in October for both the Credit Subcommittee and the Market Implementation Committee to implement its “lessons learned.” And a proposal to implement a “mark-to-auction” component into the FTR credit requirement is targeted for endorsement by the MRC and MC at their Dec. 6 meetings.

Staff also met with “experts in energy markets and risk management” during a closed-door FTR Risk Management Workshop on Aug. 14. The session identified at least 18 factors contributing to FTR portfolio volatility and determined that the “highest priority recommendation” is to establish FTR credit requirements based on the highest monthly calculation of three components: (1) path-specific congestion incorporating the projected impacts of transmission system changes (approved by FERC and implemented April 1); (2) a minimum volumetric requirement (implemented Sept. 3 subject to refund); (3) or mark-to-auction determinations (currently before the Credit Subcommittee).

The workshop also identified 11 other potential improvements.

UPDATE

On Sept. 25, the commission approved PJM’s proposal to add a 10-cent/MWh collateral requirement on FTR trades, effective Sept. 3 (ER18-2090), and set DC Energy’s complaint for additional rule changes for a paper hearing (EL18-170).

“We agree that the $0.10/MWh minimum credit requirement for FTRs helps address the specific risks to market participants due to large FTR portfolios that may be under-collateralized,” the commission said in the first order. “As PJM will now apply the higher of the credit requirements based on the FTR historic value or the volumetric credit requirement, this proposal helps address risks associated with large FTR portfolios that may continue to be under-collateralized as a result of prior FTR credit policies in PJM. We agree that the price threshold established in the volumetric credit requirement more reasonably balances the need to remedy credit shortfalls for large FTR portfolios while limiting the impact to market participants in its FTR market.”

The commission noted that no one opposed the proposal, although DC Energy contends it doesn’t go far enough.

“We seek to supplement the record in this proceeding,” FERC said in the DC Energy order, “in order to determine whether the Tariff is unjust and unreasonable even with PJM’s new Tariff revision in place.” It set a refund effective date of June 4.

“We cannot determine whether PJM should be required to implement DC Energy’s proposed mark-to-auction collateral requirement and minimum capitalization proposals or whether other changes to the Tariff may be needed. Therefore, we set the complaint for paper hearing procedures.”

The commission asked for briefing on whether large portfolios create a greater financial risk than smaller portfolios; whether the 10-cent/MWh requirement sufficiently mitigates the risk; whether valuing FTRs based on historical performance fails to reflect their volatility; and whether loopholes continue to exist in PJM’s credit policy.