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Special PJM Committee Examining GreenHat Default Proposes New Definitions For "Default", "Material Adverse Change"

Proposes Heightened Scrutiny Of New Market Participants, Background Checks Of Officers Of Non-Public Companies

March 26, 2019

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Reporting by Paul Ring • ring@energychoicematters.com

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PJM has released a report prepared by expert consultants retained by the Special Committee formed by the Board of Managers of PJM Interconnection, LLC to conduct a review of the GreenHat Energy default.

The report recommends new definitions for "default" and "material adverse change", with the report specifically recommending, among other things:

• Amend the tariff to define a default, "as any participant that is unable to meet a monthly variation margin call within two business days."

• Require that the default be declared promptly and without negotiation.

• Amend rules to include within the definition of Material Adverse Change in Attachment Q an inability to meet any PJM margin call within two business days

• Provide rules that give PJM discretion to deal with unanticipated market emergency events. The report notes that a proposed financial markets Risk Oversight Committee, comprising independent directors, "can be the check on any concern of inappropriate use of such authority."

Furthermore, the report recommends heightened scrutiny of new market participants, including background checks

Specifically, the report recommends that PJM:

• Perform outsourced background checks for any member applicant, and should the applicant not be a public company, for the three most senior officers.

• Perform due diligence by confirming that an applicant for membership actually employs the systems and processes for risk management as represented.

• Provide explicit power for the rejection of a membership application should standards of good background and regulatory history not be met.

• Create an internal appeal mechanism in order to address any claims of any undue discrimination swiftly without unnecessarily involving FERC

The report also recommends that PJM assert more its role as a market regulator

The report recommends, "FERC and PJM’s stakeholders should sufficiently empower PJM, and PJM should acknowledge and take ownership of its important duties to provide a fair and orderly market that also protects market participants and other PJM members from risks that they are otherwise unable to manage for themselves. At the same time, we find that PJM should be more assertive in pushing for action needed regarding any critical changes to credit policies, emergency discretion, and the like."

The report notes, "On several occasions, we heard PJM management express serious concerns about being subject to suit and liability from GreenHat should PJM look too closely at GreenHat’s business dealings and thus interfere in its contractual relationships, which would be a tort in normal business dealings. In securities and futures markets, exchanges and their executives are generally given absolute immunity from suit while fulfilling a regulatory function. As the exchange stands in the shoes of the CFTC or SEC in surveillance and enforcement functions, it is given a free hand to work in the public interest and can only be sued when acting as a regulator for acting in bad faith, such as self-dealing."

The report notes, "Like an exchange, PJM has a quasi-regulatory function to make sure that its governing documents are followed, and that markets are fair and free. The Court of Appeals of Texas decided a case closely on point relating to ERCOT’s oversight of its markets and found that ERCOT enjoyed absolute immunity when acting in a regulatory capacity."

The report notes, "There is no way of knowing in advance how a court would rule should PJM or any ISO/RTO claim immunity in a lawsuit for acting in its regulatory capacity in good faith (an error in judgement is not the same as bad faith). However, the strength and lengthy history of the rulings in the exchange space and in ERCOT should provide a significant measure of confidence that PJM can regulate its markets assertively without fearing harsh outcomes of litigation as a result. Clearly, however, PJM would benefit from receipt of a clear mandate from its regulator, FERC, to act in this manner as a market regulator."

The report said that, in summary, the report's authors found that:

• "PJM did not have staff with the necessary training and credentials to successfully manage the financial risks posed by the numerous participants in its FTR markets. For a number of years prior to GreenHat, PJM’s FTR market participants self-regulated their conduct, and the market ran smoothly. GreenHat, however, provided a set of conditions for which the framework that PJM developed over time to manage risk was inadequate."

• "PJM made a decision not to terminate GreenHat’s trading rights when PJM initially understood the potential for a default. Instead PJM chose to manage the situation, which PJM believed could not get worse. As is discussed in detail in this report, PJM did not effectively manage the situation, which grew materially worse."

• "PJM personnel were naive about GreenHat’s assurances of creditworthiness and a future revenue stream pledged to PJM. What is more, they did not appreciate GreenHat’s determined ability to increase its position, and incur additional risk, thus expanding its losses well beyond anything PJM imagined could happen. PJM mistakenly believed it would contain and control GreenHat’s behavior and risk, which in the end it did not. If PJM were better prepared to monitor market participant behavior, and better measure risk, we believe it could have and would have responded more effectively to GreenHat’s empty assurances"

• "PJM was late to recognize GreenHat as a problem. Had PJM declared a default upon first recognizing the GreenHat problem, the amount of the loss would have been substantial but far less than what PJM must deal with today. In any case, we find that even if PJM had made such a default declaration, our recommendations would stand as set forth in this document"

The report also listed the following complications contributing to the GreenHat default:

1. "The PJM Credit Policy Failed to Address Critical Risks A flawed collateral methodology gave GreenHat room to grow without control."

2. "PJM Did Not Take Robust Policy Actions Following Precedent Experience Aggressive action in the past could have implemented relevant policy changes."

3. "PJM Failed to Perform Adequate 'Know Your Customer' Procedures Several opportunities to interrupt GreenHat’s growth were missed."

4. "PJM Management Failed to Develop Robust Participant Risk Management Tools and Procedures Expectations of participant risk management went unfulfilled, giving GreenHat cover."

5. "PJM Surrendered an Early Opportunity to Stop or Restrain GreenHat Once withheld, market access was restored without a sufficiently robust supporting investigation."

6. "PJM’s Management Mistakenly Relied on a GreenHat Pledge Agreement A seductive but problematic pledge by GreenHat fed months of complacency."

7. "PJM Incorrectly Believed That GreenHat Would Not Worsen the Situation An assumption about GreenHat’s intentions dampened awareness."

8. "Qualifications and Training of PJM Staff Were Insufficient Lacking relevant expertise, best practices in risk management were out of reach."

9. "PJM FTR Market Design Flaws Gave GreenHat Room to Develop Lack of transparency gave GreenHat some benefit of the doubt during problem analysis."

10. "An Unwarranted Air of Confidence Facilitated GreenHat’s Ability to Grow PJM personnel did not adequately question convenient internal assumptions."

PJM noted that the report found that PJM did not violate any law, regulation or internal PJM policy

In a letter to stakeholders announcing the release of the report, Susan J. Riley, Chair of Special Committee reviewing the GreenHat default, stated, "The Special Committee fully appreciates the business and regulatory constraints that PJM, as a highly regulated RTO, faces in administering and making rule changes to its financial markets. Further, we recognize that PJM management and its members have already taken significant steps to strengthen its credit policies, and we support the actions that have been undertaken. Nonetheless, the review brought to light certain deficiencies within PJM that the Board takes very seriously."

Riley wrote that, "As such, the Board is taking immediate action, together with PJM management, to address these deficiencies where it can."

"Further, the report sets forth recommendations for best practice improvements to strengthen PJM’s markets, which will be considered by PJM’s management and the Board and will be taken through a stakeholder process for possible Federal Energy Regulatory Commission approval. The Board and PJM management will make consideration of these recommendations a high priority, and we ask that you do as well. Again, while we recognize and appreciate PJM management and our members for proactively undertaking actions that help to strengthen our markets, we have a lot more work to do in this area," Riley wrote

In a statement, PJM President and CEO Andrew. L. Ott said, "PJM management accepts the findings in the report regarding our handling of the GreenHat default."

"We recognize the shortcomings identified in this review," Ott said. "PJM takes the cost of this default very seriously, and we are committed to reforms that better protect market participants in the future."

PJM noted that in 2018, PJM and its members developed a number of credit risk management changes that began to address issues and recommendations that are contained in the report, and work is already underway on a plan to complete these reforms.

In addition, Ott today outlined several areas of his comprehensive action plan that include organizational changes, process improvements and the examination of additional market rule and credit risk management reform. Actions will include, but are not limited to:

• Establishing a new chief risk officer position

• Thoroughly reviewing and revamping processes and procedures in credit risk assessment and monitoring

• Creating a new coordination process for PJM’s Markets, Credit/Finance and Legal areas and its Independent Market Monitor

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