Phew, that was close! (2)

In an earlier post by the same title, I described the near default event in the PJM electricity market in 2008 that occasioned new regulatory action by the Federal Energy Regulatory Commission (FERC). The FERC’s actions are designed to reduce systemic risk in the electricity marketplace. Of course, systemic risk is a hot topic these days, and the focus is on banks and derivatives markets. The example of FERC and the electricity market is another interesting case that can be used to illuminate the economic issues that ought to be central to shaping policy.

Can regulation reduce systemic risk? If so, how?

In the case of the electricity market, the main objective is to maintain the regular day-to-day functioning of the market in the face of default or bankruptcy by this or that company that trades in the electricity market. The objective cannot be to prevent a company’s default or bankruptcy. But when default arises, there are better and worse ways to handle it. This is a major economic principle behind bankruptcy laws. If every creditor is rushing to protect its own interests, the collective interests of the creditors can be sacrificed. A good bankruptcy procedure imposes a process that maximizes the value of the defaulted company so that the payout to the creditors is maximized. There are other objectives, too, and many subtleties I can’t get into, but this is one key issue.

In the electricity market reform, the objective is accomplished, in part, by setting limits on the amount of unsecured credit granted through trades in the wholesale marketplace. Payments owed for the purchase and sale of electricity must be settled quickly so that the outstanding debt cannot grow too big. Direct limits on unsecured credit through trades are established. Companies are still free to negotiate unsecured lines of credit with their banks, and they can use the cash to trade on the exchange. But if bankruptcy arises, the creditor is the bank, and not a counterparty to the trades on the wholesale electricity market. So the reform doesn’t directly force a company to reduce its credit exposure and its probability of default. It just reduces the amount of a company’s exposure directly tied to trades within the marketplace, and thereby pulls the marketplace itself out of the center of whatever bankruptcy mess arises. If a company goes bankrupt, this should not be a major event as far as the wholesale marketplace is concerned.

Rules designed to protect the collective interests of creditors in default do not directly address how the company found itself in default and need not look back to directly limit the amount of debt the company can take on. These rules can make clear how priority of claims are enforced ex post, so that potential creditors and the company can decide ex ante what type and amount of credit they are willing to negotiate. But it is not typically the role of the bankruptcy regulations to proscribe foolishness ex ante.

Other parts of the reform attempt to simply reduce the potential mess that can arise in the event of default whenever rights and obligations have not been clearly defined. Ambiguity sometimes paralyzes the authorities in taking the type of resolute action necessary to minimize the damage from a default and bankruptcy. Clarifying the legal status of debts incurred through purchases and sales in the wholesale electricity market is a good precaution. Only with clarity can the ex post optimal management of the defaulting company be chosen.

What are the limitations of the regulatory reform?

Neither FERC nor the wholesale market organizations can directly assure the sound financial management of companies involved in the production, distribution and use of electricity. Nor would anyone want them to try. It is not the goal of the reform to directly change the financial riskiness of companies buying and selling in the market. The decisions about what are prudent risks are between the companies and their creditors. If mistakes are made, the consequences will be between them, too. The only goal of the regulatory reform is to protect the ongoing integrity and operation of the electricity marketplace itself from damage when mistakes are made by individual companies and their creditors. The task is to limit the collateral damage. This is an appropriate goal of regulation.

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