S3E23: Commodities trading expert Matthew Hunter talks about the financial markets for managing – or hedging – energy price risk, and how they and consumers are impacted by extreme events such as California in 2000 and Texas in 2021

Matthew Hunter was a power trader in the Western market in 2000, when California's poorly designed and managed electricity market imploded costing consumers hundreds of millions of dollars. After that, he spent much of his career at the Federal Energy Regulatory Commission and the Commodities Futures Trading Commission. He gives us a deep dive into hedging – futures markets, derivatives and swaps – and how these complex price-risk mechanisms don't necessarily protect consumers in the end.

A leading reason that California's market failed so spectacularly was because state law prohibited the state's Big Three utilities from hedging their price risk. At the height of the resulting energy and financial crisis, California officials rebuffed FERC's recommendations to allow the utilities to hedge their spot-market risk, and instead intervened in the market to purchase long-term power at crisis-inflated costs, saddling the state's consumers with those costs for the last two decades.

Fast-forward to the extreme weather-induced collapse of the Texas market in 2021, and Hunter predicts that, as in California, consumers will be again stuck with the tab. Hedging instruments are generally pegged to a price index for the commodity, and Hunter asserts that, in Texas, unreasonably high natural gas index prices translated to the price indices for electricity, contributing to the dramatic escalation in electricity prices.  Hunter objects to consumers being the backstop for financial losses incurred by speculators in the market.

"If you go from a nominally and totally reasonable . . . gas price to an unreasonable gas price that then transfers itself to an unreasonable power price through contract terms of index-to-index, then it seems perfectly reasonable to roll back the index gas price to roll back the index power price to something that is reasonable," Hunter asserts. "I am not saying that it shouldn't be a scarcity value (but) there's no reason for gas even under scarcity conditions to be twelve hundred dollars per MMBtu or a thousand dollars."

Transcript

EMP S3E23: Commodities trading expert Matthew Hunter
(transcipt edited for clarity)

EMP: Welcome to the Energy Markets Podcast. I'm Bryan Lee, and our guest today is Matthew Hunter, a consultant and expert in commodities trading and regulatory compliance for commodities trading. He spent a good chunk of his career in government both at the Commodity Futures Trading Commission and the Federal Energy Regulatory Commission. Matthew, welcome to the podcast.

MH: Happy to be here, Bryan. 

EMP: So we reached out to you because, with this episode, we'd like to explore the financial markets for energy. They're built around the physical markets for energy or the spot markets for energy. This podcast has markets in its name. We talk a lot on this podcast about the importance of consumers seeing price signals and getting the market design right to allow them to see those price signals and respond to those price signals. But until now, we haven't really delved into the financial markets that overhang these markets, which allow market participants to hedge against price risk in the market. So when we talk about financial markets, Matthew, we're talking about instruments like futures and derivatives, and I guess like the stock market, there are puts and calls and arbitrage. But let's be really basic here. What does it mean to hedge in the marketplace?

MH: That's a great question because I think hedging is greatly misunderstood. Participants push the simplistic views of hedging. So, the largest, most well-capitalized firms that are truly attached to markets have the greatest advantage. They can trade any number of products So if you think about how the world really works – and I guess we're really talking about natural gas and electricity and maybe some in oil – but it is true for everything that the larger participant has the greatest capacity to hedge price risk. Or separately to hedge volumetric risk. Because volumetric risk doesn't hedge price and price doesn’t hedge volumetric. So the tools that can be used to hedge at the greatest level, you can use a derivative structure, something that's benchmarked to some physical product that can be used to hedge price risk, or something that's physical that hedges price risk, or something that is unpriced but hedges volume. And the three elements can combine together to create different synthetic equivalents. The largest firms can trade the most, and they can obviously trade the transportation agreements, they can move physical assets around and hedge derivatively. So they have the greatest advantage. The retail guy has the least ability to hedge. It's very difficult to say that a homeowner can hedge the most basic thing.

EMP: When you mean hedge volumetrically, what do you mean? I know what hedging your price risk means.

MH: Contracts that exist out there, someone will say I want supply for 20 years. Well supply can be hedged volumetrically say, well, how many MMBtus or how many megawatt-hours or whatever the commodity is, I just want an amount. And it can be benchmarked to a physical pricing mechanism. So if you think natural gas, there's something called physical basis. All that is is an amount of gas that will be priced at a future date, but you could do a 20-year gas agreement for delivery based on that future price. And if you chose to hedge derivatively the fixed-price aspect, you can enter in and out of that at will. So you'll see contracts that deliver just gas or deliver just commodity. And so that's the physical side without the fixed-price risk. So there are three elements are together. You can hedge derivative, which has no physical delivery. You can hedge fixed price with physical, or you can hedge the volumetric aspect of it separately. And if you combine them, you synthetically create something else. So if you do a physical at index deal, and then you do a derivative at index – which is fixed-price – what you've created synthetically is a physical fixed-price deal.

EMP: Let's make this a little more basic because I'm envisioning this as more for a general audience than an industry audience. What is a futures contract?

MH: So futures contracts are regulated futures exchange standard products, they can be physically delivered or they can be essentially a derivative. But they all have a fixed-price component and they are regulated by the CFTC in this country. That means that the exchange is regulated and the market participants are therefore regulated.

EMP: So, a futures contract is basically a guarantee that I'll deliver X commodity at X price at this future date and time.

MH: For a physical contract, that is absolutely the case. They get marked-to-market every day. So there's a margining process that occurs every day for changes in price. If you're long and the price goes up, you get credited with money. And if you’re short and the price goes up, you have to pay that money. And it settles quite regularly every day. There'll be a margin – at least one margin call potentially, and that goes through the life of the contract. So, contracts can be listed, you know, take natural gas as example. It could be 12 years, and you could trade it on the very first day that the contract becomes live and you will be marked-to-market every single day right through to delivery. And if you have the ability to make or take delivery, you could theoretically stand or make that delivery.

EMP: And what is a derivative?

MH: Futures, technically, are derivatives, because they're supposed to line up with the physical. And that's a very complicated subject about what is convergence and how the derivative over time – the futures contract – comes to meet essentially the same price as the spot contract at the end of its life. Most derivatives are financial in nature. The evolution of markets has been very robust. And those are benchmark contracts. They draw upon a final settlement based essentially on a physical-pricing mechanism. So in natural gas they tie to natural gas futures contracts, natural gas swaps, for the most part tied to Henry Hub. The final price that is paid at the end, after all of the margining has occurred throughout its life, is ostensibly equal to with very little separation to the physical equivalent that was trading, not in the futures market. And that's the idea anyway.

EMP: You spoke a minute ago about pricing derivatives or futures to an index. Now there are a lot of publishers out there – I used to work for one a long time ago – who essentially go out there and aggregate pricing data and then publish it.

MH: In energy that's the most basic understanding. You see indices everywhere the S&P 500, the S&P 100. If you’re in the stock market, you hear about the Russell or the Dow Jones, those are all indices. In power most of the industry is settled to RTO products, or pricing mechanisms. So there is some place where physical ostensibly is trading in a liquid and transparent manner, that the derivative can settle to draw its final price from there.

EMP: And then we also have kind of financial or derivative products within the RTOs in terms of managing grid congestion. There are financial transmission rights. Do you want to talk a little bit about how that works?

MH: Oh, sure. You think about in gas and power, you have location differences. You have supply being produced in one area and demand in another. In electricity, the ability to move through the system – through the grid – where you are having different pricing mechanisms and processes, right? So you have lots of generation, theoretically, that should be less expensive than where you have less generation but lots of demand. So the energy has to go from the source to where it's ultimately consumed. And in electricity, there are limitations on the line capacity or the transmission line. And, you know, in fact, there are physical constraints. If you have a thousand-megawatt line, as an example, between Point A and Point B inside an RTO, you can't put two thousand megawatts of physical electricity on it because it will burn the line up. So there's something called congestion management, which is all that energy going to the demand from wherever it's being sourced produces two different prices – a low price at the source and a higher price at the sink. And because people have load-serving entities and have to manage risk, there had to be an invention to allow them to hedge the difference between where supply is and where the demand was through transmission. 

EMP: And they're all kind of, for lack of a better word, fictitious entities because you buy this transmission right, but your electrons aren't necessarily following the contract path.

MH: Right. Unless you're scheduling it. Unless you're scheduled, you know, then theoretically, you know, even if we know it's not true electrons go where electrons go and you can't say where's the blue electron that you thought you generated? That's correct. And so, but because, you know, this is a mathematical model, it gives the hedger a great deal of flexibility and confidence in that if they buy electricity at Point A for delivery to Point B, if they buy the congestion between the two, you know, they know how to manage their risk. It's not to say that absolutely that the congestion will be equal or greater than what you purchased. It can actually be the other way around. There can be events to the grid that make congestion go from B to A, though they're pretty rare. So you have an obligation to perform as well financially.

EMP: Financial transmission rights, they assign a price to the congestion. So if you're on the opposite end of the congested path, and you have the ability to kick up a gas generator and send electrons into this in a way that alleviates the congestion you can make money that way.

MH: If you can alleviate congestion, you can make money from trading the physical along with the hedged product. But if you think about it, I'm going to think about it much more simply, which is a load-serving entity may not have generation in the particular area that they have an obligation to serve a load, right, some end-user. And so when they're doing transmission – really transmission and price hedging – they need something that will allow them to not be exposed to extreme congestion. So if you bought congestion of A to B for $5, and there was a major weather event, you know, such as happened in Texas or the polar vortex in PJM several years ago, or an outage, just a simple outage, congestion can go from an expected value of $5 to – I won't say infinite but pretty close to it. And that risk from a load-serving entity perspective is what they want to control and curtail. And so that's why these instruments were originally invented to allow load-serving entities to be able to hedge with production, that they are able to, with these instruments, know what they paid for electricity, know what they sold the electricity for, and know what the cost of the transmission is through the financial transmission right. And that's what they were invented for. And of course, you can speculate with them. And so they’ve become very popular for those firms that model the grid itself to say, oh, we think that Point A to Point B will be greater than $4. So we'll buy it or we think it's going to be less than $4. So we want to sell it, which is independent of how the physical grid will work. 

EMP: So if you have a MMBtu of gas or a megawatt of electricity that closes in the physical market, that has probably been sold and resold and sold again many times in the financial markets. 

MH: Absolutely. 

EMP: Do you want to explain how that works? 

MH: Yeah, I use the MMBtu. I use gas. It’s better because gas trades, I'm going to say, at the retail level far more than electricity does. Electricity in the organized markets, futures markets, swap markets, is traded for the most part by a professional. In natural gas that isn't true. You have lots of different speculative interests. You have hedge funds, you have nonspecialist hedge funds, and you even have small-holder speculators, so CTAs – that's commodity trading advisors – and literally individuals who want to gamble on price differences. So small holders. Small holders are not really in electricity, you know, it's a very complicated, far more complicated market than gas. So it's a better place to talk about how that works. So if you think about it – and I can only talk about it from my background, and I looked at it, you know, let's say several years ago, and every year from while I was at CFTC, and I don't look at it that much anymore – is the turnover rate. Futures are really not meant to go to delivery. And the evidence of that is what goes to delivery. So if you look at the life of a contract – and natural gas has a 12-year lifecycle from when it's first listed to when it dies. That contract can trade millions of times. But what you're going to see in delivery is some number closer to or less than two thousand contracts that go to delivery. And so if it's trading in this great hurly burly, there are so many different interests that are trading. Some are price-risk mitigation, some are speculative, some are related to loan covenants. And so the market is complex, has lots of market participants with lots of different interests, but for the vast majority, they neither have the ability nor the desire to make or take delivery at the end of its life. Even in the physical world, the physical futures contract trades a staggering number of times. And then there are all the pure financial instruments that use the exact same settling instrument mechanism that the physical delivery contract does. And those trade additional millions of times. And so to look at the world and say, how much of it is really about delivery? It's very small. And how much of it is about trading for trading purposes, and that's very large.

EMP: And so what is the benefit of this, all of this speculative trading around this physical commodity? 

MH: That's a fabulous question. Economic theories about the desirability of speculation is that it's a risk-transfer vehicle. Most people will jump to a simplistic view of the economic benefit which is it's a price prediction means. And that doesn't really make sense in the life of a contract that's 12-years long – to say on the first day you're trying to guess the last day’s delivery. It gets better as you get closer to delivery to say, oh, this may be about what you think final delivery price will be. But generally, it's about risk transfer – who wants to accept the risk and who wants to alleviate risk for whatever purpose. So loan covenants on financing agreements for, you know, whether it's production or for a generator, you can see why a bank would say, we want you to hedge to lock in your ability to pay the loan back. And that's very different than guessing what the final price would be about. And the same thing is true for you have high-frequency traders who's stipulate that they're not in the risk-taking business and they trade a lot. They go in and out of the contract a staggering number of times, always saying that they are not in the business of providing true liquidity. And then there are the speculators who take price risk for more than, I'm going say, seconds, minutes, hours. And do it for days, into significant periods of time. So the advantage is there's a diametric opposition of view. Producers theoretically want the highest price possible. And consumers theoretically want the lowest price possible. So at any given moment in time, what is the likelihood that a producer and a consumer are going to meet each other? It's virtually nil, because to get a producer and a consumer to agree at any moment in time, about one is high and one is low, is unrealistic. So who do you have to take that place? And that's what the speculator does. The speculator comes in between producers and consumers and lets those two entities meet across time. Rather than, oh, it's a producer and consumer who are always meeting in real time. That is highly unlikely. So that's the idea behind it. And I'd say from personal perspective, I don't think that it works in every commodity equally. The idea is that speculative endeavors have societal benefits in all instrumentation at all times. But I think overall, as a society, we have made that decision already that markets cure ills. And I would agree in the vast majority of cases that it is a reasonable solution to let producers and consumers and those who wish to bear risk, to accept that risk, to allow producers and consumers to meet each other across time.

EMP: You alluded a moment ago, to the Winter Storm Uri debacle in Texas. We talk about that a lot on this podcast. There's been a lot of misinformation around that. But you know, you get the big headline out of that, that power prices went up to $9,000.

MH: It went up much more than that, actually, if you look at the ancillary services.

EMP: So you know, and separating out from that, you know, whatever missteps the PUC made at that time but you get this big headline of a $9,000 electricity price. But who's actually paying that?

MH: Okay, so that's, that's also an interesting and I would say highly nuanced question. At the end, just the way the California energy crisis had consumers pay it – and they paid for 25 years, right really, you know, effectively.

EMP: They're still paying for it. 

MH: Yeah, it's my understanding that you know, for the most part, it's over, but it was 25 years later. I was a power trader in 2000. I traded California power. This is one of the reasons why I say that not all speculation is useful for all markets. Because you get these funny outcomes. And what I mean by that is the RTOs use the consumer as a backstop for speculative losses to pay speculative gains, rather than holding the speculators who generate those losses accountable. If you and I make a private bet, as an example, and you welch on the bet because you don't have the money. Or I welch on the bet because I don't have the money, you don’t go to somebody else and say you have to pay for it. The stock market doesn't work this way, either. If you can't pay they don't go to the shareholders of the company where the loss was generated, they don't ask them to pony up more money. But in electricity we do. And we say that if a bet between two speculating individuals through an RTO mechanism, and one fails to pay, we'll say the consumers pay. And that was not the idea. If you're going to let speculators play in the market, the backstop should be speculators. And if you can't pay, you don't pay. And the reason that I think this way, is that if the RTO has not managed its margin requirements correctly, or we have an extraordinary event, that doesn't mean that because someone else external to the event has money should be responsible for paying the debt. So I have a, I think, a more extreme view about how this should work. And I am a big believer in if you make a bet, you pay the bet. And if you can't afford to pay the bet, then you don't pay. And if you look at how RTOs manage – or they did, I can't say I've stayed on top of it – so I'll just say that in the past, if there was revenue inadequacy for transmission lines, that would be reflected in payments in FTR values. The RTOs didn't have to. They just said we had revenue inadequacy. So the idea that that they would, in those instances, not go to the end-user to collect. But in a speculative bet on FTR values will go to the end-user, I think is unconscionable.

EMP: That's very interesting. It wasn't where I had anticipated us going when I asked that question. I think what I was trying to get at is that 99.9% of the electricity customers, when you see these big prices, they're not paying that price because their exposure has been hedged through these mechanisms. 

MH: Some of it is hedged. Some is not. We're anticipating, I believe, that consumers in Texas are going to pay for how many years? This event was not purely a financial event that didn't affect them. I also believe that this type of weather event can have a different type of solution that satisfies the scarcity model that we now have and would prevent these extreme prices. It's my understanding that a great deal of the problem of power prices in Texas in this weather event came from index-related gas and index-related power. So if you're buying gas at an index price, and you're selling index power based on it and the index price for gas – and I'm making it up – goes from five dollars to twelve hundred dollars, that's unreasonable. It's an unreasonable price mechanism. And it is because daily gas prices are not supposed to be a scarcity commodity, right? No one views gas as being scarce. And yet the model for scarcity pricing, which applies specifically to electricity, is transferred to gas. And so you have these two index prices. So if you go from a nominally and totally reasonable – to use FERC (terms) – a totally reasonable gas price to an unreasonable gas price that then transfers itself to an unreasonable power price through contract terms of index-to-index, then it seems perfectly reasonable to roll back the index gas price to roll back the index power price to something that is reasonable. And I am not saying that it shouldn't be a scarcity value. There's no reason for gas even under scarcity conditions to be twelve hundred dollars per MMBtu or a thousand dollars. 

EMP: I am a consumer of energy, whether it's natural gas or electricity. And we see all the time – let's take it outside of this Texas event because that was an extraordinary event. But, you know, we'll get into situations where you'll have prolonged hot weather and electricity prices will go up into the triple digits, maybe even quadruple digits. As a consumer I am generally – unless I'm buying from somebody like Griddy, who went bankrupt during the Texas event – I am protected from those price spikes, because of these sorts of mechanisms that allow people to hedge against these sorts of extreme events. Correct?

MH: I'm going to say yes and no, alright? Yes. If everybody was – if someone is hedged, then the provider of liquidity in that hedge would be the one who has to pay. Right? So if we're saying in an ideal world, that that a load-serving entity or a public utility, purchased a hedge for the purpose of locking in prices for its consumers and everything hits perfectly. You had enough of a hedge on that you had. The person didn't go bankrupt that owed you the liquidity, then the hedge worked perfectly. It will be reflected somewhat in the next year's cost. When people lose a lot of money, it generally drives up the cost in the in the next go-round of hedging. But that aside, yes, you're correct, if they were hedged. If they were unhedged at any level, however – so let's say that you thought that your load for a given hour was a hundred megawatts, and you hedged perfectly to the hundred megawatts and it turns out you used a hundred and fifty megawatts. You have to get your PUC to allow you to recover the fifty megawatts that was unhedged. And so in that scenario, where there was a mismatch in hedging, then the consumers ultimately would pay. 

EMP: But that's a regulatory problem and not a market problem. 

MH: Yes, and but it comes from, what's a reasonable amount of hedge? Now I in my career, this is the first thing that I confronted when I traded power. So when deregulation began the very first thing that I had to deal with was my firm was selling the ability to take or not take 3% of the prior years’ power on a given hour on a given day. So if it's going to be hot this year and it wasn't hot last year, I have to guess what my load will be to hedge it in both term and in the short term. And if I get it wrong, I'm the one who eats the difference. And that's perfectly legitimate. However, from a utility’s perspective, it's not legitimate. So they don't want to eat that error, right? And they want to pass it on. And so at some level, they don't have the same financial interest in hitting the hedges as close to perfectly as possible. It's nuanced. It gets complex. What happens when you miss? And you can argue just saying California through its regulatory debacle of deciding early that term-hedging was not allowed, if you recall, all the way back to 2000. That was not allowed by the utilities. And when summer showed up in 2000 after a year – 1999 – when there was no summer load, if you recall 1999 was I forget it was an El Nino or La Nina year, but the weather never showed up. So you had two years’ load growth that shows up for the first time on the Memorial Day weekend. And that gave everyone the idea was oh, it's going to be a difficult row to hoe for that summer if weather shows up. And weather showed up. I think it's highly nuanced. 

EMP: We've talked a bit about this on past episodes where the powers that be that agreed upon this market design, they made a market design that made the utilities – required the utilities – to buy from the spot market. 

MH: Yes.

EMP: They weren't allowed to hedge their price risk in that spot market. And which is crazy when you consider that electricity is one of – if not the most – volatile markets ever created.

MH: Yes. And they didn't understand that then. So when I got into the market, the first thing I was told was that you didn't need credit to buy, but you needed credit to sell. And I said people here don't understand the risk. They think that the risk is I won't be able to pay for what I purchased. And we're talking about at the time, you know, $20 power. You're worried about that it's going to go – effectively, you're not going to be paid – so you're worried about it going to zero. I'm worried about it going to an infinite price, that it goes to the cap or theoretically beyond. And the first test of that was in Cinergy. If you recall, we had $5 and $10,000 prices in the Cinergy market. And when it happened, the powers that be said, it'll never happen again. And my prediction was, no, no, you don't understand trading. This is exactly what's going to happen again, because the market learns. So when you have effectively inflexible demand that crosses the supply at some point, you go, what is the next price? Well, it's infinite. It's what can I get for it? Not there’s reasonable competition to cap it. You have to think about what happens when the generation stack is exhausted. Where's the next megawatt coming from? The scarcity model was built for traders. And if you remember who asked for it, who was asking for this new market in the ‘90s – well, it's Enron first and then behind them it's the major investment banks. Not the commercial banks. They're not in yet, but the investment banks, and they see opportunity. And I said, this is fabulous, you went from a diversified portfolio, which is what you say everybody should have in the stock market, to marginal pricing, which is all stocks should be valued at the highest, least liquid. It makes no sense. And so you gave away all of the – I’ll call it the baseload generation, and if you remember you had stranded-cost recovery and have all these things about, oh, this is going be valueless when it became valuable. The baseload is where the money was. If you think about the fights over nuclear. Nuclear got paid the highest price, it never got paid the highest price before deregulation. So scarcity pricing models replaced the gold-plated regulatory scheme. The idea was that consumers could be paying too much for their power because of abuses within the regulatory framework, as opposed to scarcity. All right, no one had a desire to cure scarcity. And that I think really exists today. You know, the idea of ending scarcity is not good for a model that prices off the marginal megawatt.

EMP: But still, I think that the state, too, expected traders to be good citizens and not arbitrage between the artificially escalated prices in California and what they were able to do outside of California. 

MH: There was abuse. Alright. And that's the other thing about and this is what I've said forever. You’ve got to be really careful with traders, right? You're asking clever people to do clever things and then they're surprised that they're clever. (laughter) So you have to read the rules. I read the rules and remember, I think it was Tim Tim Belden at Enron who got his reputation besmirched in part because he said he read the rules. Yes. And he created what I would consider some illegal scenarios. You know, the Ricochet is clearly against the rules, right? You know, taking power out of California bringing it back in. That that type of thing, but many of the others are not. You have to understand how the rules work. And if you're functioning within the rules, and I don't mean at the edge, and I don't mean that pushing the rails, I mean functioning well within the rules, then that's what you ask people to do. But the scarcity model is not built for – and that's why I was talking about Texas earlier and gas. What do you do when you have – you think about the lowest person on the trading desk in power and gas is the is the hourly/daily, that's the that's the low totem-pole person. Term people are the ones that have the most responsibilities at these firms. And if you have one piece – and a piece being twenty-five or fifty megawatts, or ten thousand MMBtus or five thousand MMBtus – and you get one piece to sell because you're long in a scarcity event, what price should you put up? Well remember all of these firms that they're incented to, to not just from a bonus perspective, but they're incented to deliver the highest value to their shareholders. So you throw the highest price out, not something near or reasonable to where you purchased it, but to what you can get from a scarcity event. And so there's a misalignment of interest in there.

EMP: And I guess that's what regulation is supposed to be there for. But I want to get back to the California event because I feel like there's a lot of misinformation still overhanging that. I mean, there was basically a shortage. The hydropower that California had been counting on was not there because of the drought, which is still with us here 24 years later, it's considered a climate change event now.

MH: And if you'll recall, also that there was going to be a giant shortage of gas in this country and that we were going to have to import LNG and fracking hadn't happened yet.

EMP: There was an actual shortage because there was an explosion at a pipeline that delivered gas to California . . .

MH: Yeah. 

EMP: . . . and so and then, so you had this actual scarcity event . . .

MH: Yes. 

EMP: . . . compounded by utilities not being able to hedge their price risk.

MH: And the large load-serving entities – I think it was San Diego, PG&E and SoCal – were capped at what they could charge retail clients, as well. So you have this perfect, to use the phrase, the cliché, the perfect storm of a series of events that caused prices to go up naturally. A series of regulatory constraints that prevent recovery, right, of value. 

EMP: With all that said, did Enron cause the California energy crisis? 

MH: I wouldn't say they caused it. I know that they did some things that were extremely aggravating. So when they took, it's my understanding that they did this and if I'm wrong in it, then it's my understanding is incorrect, is that they did take some units offline that could have been online to benefit their derivative structures, alright, the physical and derivative structures. So that kind of withholding would have aggravated the pricing. But they didn't cause it. I would say that traders recognize how to exploit scarcity. And so if you tell everybody you have to buy – and I'm not talking about 2001 now, just in the summer of 2000 – you have to buy and it's tough to come by. No one is out there to make things easy for you. You know as to how much can we get long to sell to you because you were unwilling to buy it when it was cheaper. I won't say they caused it but they certainly you know, I would say the entire – look I was trying to maximize value too. You look at the situation and say, what's cheap now and where are you willing to transfer risk to gather greater value later. 

EMP: So they engaged in unscrupulous behavior and practices that may have aggravated things to a certain degree, but by no means did it cause it. And certainly Enron wasn't the only one . . .

MH: That's correct. 

EMP: . . . involved in this. I mean, you had a Reliant trader that was cited in FERC’s post mortem of this, that she was generating computer trades that – was that considered wash trading . . .

MH: Yeah. 

EMP: . . . where now just you just generate these trades over and over again and you artificially push the price up.

MH: You buy and sell, buy and sell, buy and sell and you move the price up.

EMP: We've gone almost an hour here, and I want to get back to price signals. Alright. So, price signals are important not just to the consumer to have them behave properly and adjust their purchasing patterns in response to price signals, but they're also extremely important to this whole huge machine of price risk and financial trading that overhangs this physical market.

MH: Yes. And in that, one thing is that past history informs how future builds – physical builds – will occur. The record, right, of what happened last year, the year before and the year before, with its nuance, whatever outages and new construction, new availability, whatever is in there, informs the decisions about how to build and where to make investments. So if prices are distorted then business development and investment will make bad decisions as well as that consumers can’t budget. I'm going to say the simplest thing, just can't budget. So it’s highly complex and with a significant amount of feedback loops in it with the importance of the ability to hedge, to have liquidity to hedge, for people to take price risk, or be able to exit bad decisions or decisions that turned out to be to be bad, they weren't necessarily bad at the time. Only time and history will tell you whether it was a bad decision.

EMP: How much does regulation interfere with this machinery that we're talking about? 

MH: You know, this is all about some amount of significant hindsight, right, that in 1999, California thought for 2000, the beginning of the year, that 1999 was a model successful year for deregulation. And that's because it didn't understand what actually happened. I don't believe that regulators can anticipate every problem, right, and that you don't know how the rules function. I know when I was at FERC trying to explain the commercial aspects to people who wrote rules but didn't understand what those rules – how they translated to action. If you think about – and I don't want to knock FERC or CFTC. They write a lot of rules, and they're always in the mode of correcting prior rules. Because events happen. The confluence of you know, a weather event that took place and one of the solutions is, well, we should have ordered people to put oils that didn't freeze on their wind turbines, right, as a solution as part of a solution. That didn't recognize that you could have scarcity pricing, and that you don't have a mechanism to prevent that, I'll say, obscene price from transmitting itself through the system. So regulators, my experience with them is they try their hardest to write, and it creates sometimes opportunities for one side while disadvantaging another, and it doesn't recognize that conditions on the ground change. And sometimes the rules are obsolete. 

EMP: And I was thinking more broadly than just CFTC and FERC. I find regulation most problematic at the state level. 

MH: I can say having my CFTC background was international at any number of levels of trying to explain the most simple, manipulative techniques to different government agencies – inside, state level, but also internationally – to understand what data looks like and what data is missing. So that if you're trying to do the simplest job, which to me, is preventing benchmark manipulation. If you don't have the appropriate data, you can't find it. And I would argue it's the simplest of the things to control. You don't need draconian rules to curtail some behaviors where it's just a question of do you have the data to look at?

EMP: And I guess where I'm trying to get to is, you talked about a regulator requiring a turbine operator to have a certain oil that doesn't freeze at a certain temperature. But that's hindsight. With a market, you know, if the operator can anticipate that sort of thing, they'll know that they're going to get great rents during that sort of event and it's going to be to their benefit to buy the more expensive oil so that they're able to produce during that event.

MH: Yes, and then it gets more complicated. Did the wind actually blow? Did it blow at a sufficient volume that it generates sufficient power that caused some amount of congestion that you needed to deal with and all the nonsense that comes with that. There can be too much regulation. And I also think there could be too little regulation or misunderstanding of the proper levels of regulation. Because the world is complex. It's not simple, and just thinking from a derivative perspective, right? Which is, you know, away from the physical side, just to step away and you say, oh, how tough this is. There aren’t regulations on when a new product and/or derivative is invented – something completely new – to come to the regulator and explain how it can be abused, what are you supposed to be looking for? So I'll just use Bitcoin as an example. Bitcoin when it was invented was a minor thing and there aren't any regulations. There's no consideration of it. It is tiny, infinitesimally small, doesn’t present at inception, you know, the fantasies of megawealth and it doesn't need regulation, particularly. But no one explained what growth would look like and how it could be abused. There's no dialogue like that. So the existing regulations had to fit the product as it was invented and developed. And I think that's everywhere. That when something new comes along. And whether it's truly novel or something that's adapted and has novel aspects, that is never brought to the regulator at its inception to say, this is the invention, this is how it is meant to be used and this is how it might be abused. Regulators don't think backwards that way to say this is the regulation this is what it is meant to do, other than what's in the Federal Register. And this is how we anticipate it being used and are we wrong? How can it be abused? So that proper regulation – I'm going to say just pointing at California – if your biggest risk-takers are the ones advocating for deregulation in something, you have to be asking yourself why? Because they're not looking at it to make less money than the utility. They were looking at it as making more money than the utility. And I think that that's important to recognize that the altruistic views of business are rare. 

EMP: You talked about California and all throughout the summer of 2000, where you had these runaway prices, you had California officials pointing at Enron, blaming the Houston cowboys, that's a quote and, you know, calling for FERC to intervene. And FERC time and time again said, well, allow the utilities to hedge and this will calm down. And they didn't do that. And so in the end, they had to purchase all of these very, very expensive long-term contracts.

MH: Worse! I love that, right. So that's January, right after SoCal announces – I don't know if they actually went bankrupt –  they'd just announced they were going to go bankrupt. 

EMP: PG&E had gone bankrupt. 

MH: Okay. It’s January of 2001. Right? So we've had this winter event of 2000 where we had the frozen dam conditions up in the Northwest. And so we had crazy prices in winter because of that event. And then California comes out – the state comes out and says it's going to buy, I forget, it was six thousand, seven thousand, eight thousand megawatts of firm power. One thing you should never do in trading is say what you're going to do before you do it, because the market reacts. 

EMP: It's the same phenomenon if you're going to buy 5,000 acres of property in a certain location, and you've got hundreds of property owners that you're going to buy from, you don't let all of those property owners know that your plan is to buy all that property. You go one-on-one with each of them so that they don't jack up their prices.

MH: Yes, you know, the idea and so transparency in that instance, worked against the state. And if you think about rules like that. So one of the rules that got changed very early was when a nuclear plant went down, they didn't have to tell the market before they themselves – they were given a grace period to be able to re-hedge on their information. Because if they had sold forward, their power and they go down – and I'm not talking about down for a day, I mean down – then all those hedges are buried right instantly. So you should be able to trade on your own information for a period of time. Let that information make its way through the market. So that people recognize it before making an announcement because everybody is just going to withhold if you say, oh, I've lost fifteen hundred megawatts of nuclear capacity for six months. You can bet that as soon as that announcement is out, everything is more expensive. Or rather than saying giving that entity the opportunity to buy something in the market before the market becomes aware of it. Same way with California telling everybody you're going to buy something cost the consumers more money.

EMP: As a former journalist, I really appreciate facts and truth, which are kind of scarce commodities today. And to have people simplistically say, oh, it was that Enron thing, when really it was the state making bad decision after bad decision after bad decision. They made a bad market design. And then they made very bad decisions in responding to the crisis that they created. And then, you know, as politicians will do, they pointed the finger elsewhere to cast blame and to sidestep their accountability. 

MH: I'm not saying that the market wasn't filled with exploiting entities, but not every exploiting entity, quote, exploiting entity, was actually doing anything that was illegal. It was functioning within the rules. At some point, I'll tell you about my experience and what I did when I was trading because I did some fairly unique things to prevent my firm from being caught in the California energy debacle. Because I recognized what was going to come and said we need to protect ourselves from this. And that was an unpopular decision at the firm. And you know, I said, I'm in charge of the Western power trading, I said, you don't know what's coming, and I do. And so I'll give up the money that we think we're going to make today. Because we're not going to get it at the end of the day. And I want to prevent us from having significant money tied up in court for, you know, ten years. And so I don't want those exposures and to give up the opportunity to make money that seemed to be right on the table, and I said you don't understand how the world works. Right. This has happened before. 

EMP: Matthew, thank you very much. Matthew Hunter, an expert in commodities trading, thank you very much.

MH: You're quite welcome.

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