December 11, 2012 | NEPOOL markets committee

1. December 11, 2012 | NEPOOL markets committee Jonathan Lowell Principal analyst | market development Additional Regulation Market Compliance Requirements Stemming from 11-8-12 FERC Order Regulation Market (Order 755) Compliance

2. Background • FERC Order 755 required regulation market design changes to be filed by 4/30/12 to provide • Two Part Bidding – capacity (MW) and service (mileage) • Energy opportunity included in market clearing • Uniform clearing prices and two-part payment • Unfortunately, it is not possible to produce uniform clearing prices that are consistent with economic efficiency (least cost) and incentive compatibility (optimal bidding strategy is to offer true costs) • The ISO filed a “Vickrey Auction” design that provided economically efficient outcomes and incentive compatibility • The ISO proposed to publish “approximate clearing prices” to enhance market transparency

3. FERC Decision • On 11/8/12 FERC issued an order rejecting the ISO’s proposed tariff revisions: • “the instant proposal does not produce uniform clearing prices to all resources that clear during the same settlement period, as required by Order No. 755.” • “Under this market design, the regulation payment for a resource is tied to the system opportunity cost, i.e., the cost savings to the system, which is different for each resource in the auction. As a result, each of the resources that clear during a given settlement period receives a different effective clearing price. This design directly conflicts with Order No. 755’s requirement.” • “the expected payment to a resource is a bundled capacity and mileage payment. … Thus, we find that the proposed tariff revisions do not comply with Order No. 755’s two part payment requirement for both capacity and resource performance.” • “… not convinced that ISO-NE has made a showing that the present market conditions and characteristics warrant a deviation from Order No. 755’s requirements.” • ISO must submit a new compliance filing within 90 days • The rejection did not address efficiency or incentive compatibility issues, but rather was narrowly drawn, based on the specific language of the original order.

4. ISO Perspective and Plan • FERC has clearly signaled uniform clearing prices and two part payments are of primary importance. • ISO intends to meet the 90-day filing deadline (2/6/12) with a proposal that will fulfill all requirements with high confidence • ISO is currently exploring methodologies that will be fully compliant with Order 755, while minimizing potential loss of economic efficiency and incentive compatibility

5. Desirable Design Criteria • Preserve economic efficiency • Select resources based on lowest total cost to the system • This assumes bids are truthful expressions of actual cost • Preserve incentive compatibility • Limited opportunity for “profitable” market manipulation strategies • Clearing prices that are meaningful and consistent • Meaningful: prices bear some resemblance to offers • Consistent: offers of selected resources are profitable, and non-selected are not profitable when evaluated under the clearing prices • Selected resources receive compensation at least equal to their full As-Bid costs plus system opportunity costs • Minimize the need for uplift or make-whole payments

6. Desirable Design Criteria - continued • Meets the reliability and operational needs of system operators • Simple to implement for those who want to participate in the market • Simple (relatively) for the ISO to implement and administer • Computationally feasible

7. Design Options • As mentioned, it is provably not possible to produce two-part uniform clearing prices for inherently bundled commodities that satisfy these criteria! • The ISO has examined several general approaches calculating uniform clearing prices to understand strengths and weaknesses of each. • “Best Fit” pricing over a range of requirements • “Best Fit” pricing for those resources selected as least cost • Several options were considered and quickly rejected as not meeting threshold criteria • Select based on capacity price, dispatch based on mileage price • Highest selected prices • Include opportunity cost in current pricing design

8. Vickrey Auction – Refresher Course • Select lowest cost combination of resources that meet capacity and mileage requirements • Determine Incremental Cost Savings (ICS) - how much system cost increases when each selected resource is excluded • The payment to each resource = as-bid cost of MW + as-bid cost of Miles + ICS • Vickrey design produces efficient outcomes and is incentive compatible, but: • Provides a unique bundled payment to each resource • Does not provide clearing prices

9. Vickrey Example

10. Pricing Concepts • In most electricity markets, prices represent marginal costs (the cost of providing one more, or one less, unit of product) • When the product has a single dimension, price equates to the slope of the supply cost curve

11. Pricing Concepts • When the cost curve is not smooth, we can approximate it with a “best fit” line • The best fit price can then be approximated by the slope of the best fit line

12. Pricing Concepts – Extended to Two Dimensions • With two regulation product dimensions, we can estimate best fit prices by calculating the total cost surface and finding the best fit pricing plane. • Find total cost using Vickrey auction (including ICS) for all combinations of requirements in a region around the actual requirement. • Find the best fit linear prices using least squares regression • The slope of the payment plane along the MW and Miles axes approximate potential uniform clearing prices.

13. Best Fit Pricing Plane – Initial Observations • New prices would be estimated for every selection interval, based on the requirements and available offers for the interval. • Since resources are selected based on least cost, efficiency is largely preserved. • Note that estimated prices could be negative, depending on the local shape of the cost surface. • This is not a problem from a pure economics perspective. Can happen today in the energy market under various patterns of congestion. • In cases where the estimated prices do not fully compensate a resource for its system opportunity costs, an uplift payment would be required. • Since prices are estimated ex ante for offered capacity and (expected) mileage, additional ex post uplift payments may be required when actual mileage differs from the ex ante mileage estimate

14. Best Fit Pricing Plane – Initial Observations cont. • Prices will vary from interval to interval, but averages over time are expected to converge to representative values • Participation in the market is still free of risk to selected resources if they bid their true cost, as long as uplift payments are provided • Without uplift payments, the best fit prices might not fully compensate a selected resource • We note that FERC approved uplift payments for similar purposes in Order 755 designs proposed by other ISOs. • This design may be vulnerable to bid skewing or gaming if payments are based only on prices without any uplift payments

15. Alternative Approaches - Selected Resources “Best Fit” Choice 1: Determine the pricing plane that best fits the as-bid costs of the selected resources, such that: • Cleared resources receive as-bid costs plus uplift as needed to cover their system opportunity costs • Total uplift is minimized • No resource receives negative uplift Choice 2: Determine the pricing plane such that: • All rejected resources are unprofitable at the clearing prices • Cleared resources receive uplift as needed to cover their system opportunity costs • Total uplift is minimized

16. Selected Resources “Best Fit” - Concepts Choice 1: Prices fit to As-Bid Cost of Cleared Resources Cleared Resources: Blue Non-Cleared: Red

17. Selected Resources “Best Fit” – Initial Observations • Supports efficiency by selecting the least cost resources and paying them the correct amount, including system opportunity costs • Initial simulations of Choice 1 indicate the estimated prices are generally, but not always, consistent with resource selections. Choice 2 (not yet simulated) will provide better consistency by definition. • Both approaches appear resistant to gaming since a resource cannot directly affect its payment by small increases in its offer prices • May sometimes result in negative prices • Less computationally intensive

18. Next Steps • Present specific proposal to MC in January • Market rule changes anticipated to be limited and contained in one or two locations • PC review at February 1st meeting • File with FERC on February 6th