EMMU Response to Questions on Performance Incentives Proposal

1. EMMU Response to Questions on Performance Incentives Proposal March 12, 2012

2. Patton’s Conclusions on ISO’s Proposal “….we have not identified any fatal flaws in the ISO’s proposal. However, we believe there is substantial additional work needed to fully understand the likely outcomes of the proposal and establish its parameters.” “The proposal advocates vesting most of the incentive to invest in the Performance Payment Rate. This may raise efficiency concerns to the extent that the Performance Payment Rate substantially exceeds the fundamental value of reliability.” “A better approach would be to combine a lower Performance Payment Rate with a sloped capacity demand curve.”

3. Conclusions (Cont’d) • “….because the proposal departs from a more conventional shortage pricing structure, the ISO should evaluate the potential effects of the Performance Incentives Proposal on: • Day-ahead market activity (compared to increasing shortage pricing); • Resource commitments and self-scheduling; and • Imports and exports.” • “We do not believe it is necessary to develop a sloped demand curve before (or simultaneous with) the introduction of the performance incentives. However, we believe this continues to be a high priority that should be developed and discussed with stakeholders as soon as feasible.”

4. Capacity vs. Operating Reserves • “It is important not to confuse the capacity product with operating reserve products.” • “The capacity product is not an operating reserve product.” • “Operating reserves procured by the ISO should be sufficient to respond to potential system contingencies. If they are not, the ISO should review and revise its operating reserve definitions and requirements.” What provides the incentive for resources to be available in the operating horizon to provide energy and operating reserves? • “This incentive is most efficiently provided by the energy and operating reserve prices themselves.”

5. Performance Incentives vs. Higher Shortage Pricing • “A primary difference between shortage pricing and the proposed performance incentives is that the Performance Payment under the performance incentive proposal would not appear in the real-time markets, which means: • Loads would not perceive the incentive in real time; and • Day-ahead market activity would not be affected in the same way as it would if this shortage price appeared in the real-time energy and ancillary services prices.” • “By excluding these payments from the real-time price, the ISO will not be providing incentives to engage in day-ahead activity that will help address the potential shortage.” • “As a result, the day-ahead market will be less effective in coordinating supply commitments.”

6. Capacity Market and Performance Incentives • “If the market is to maintain adequate resources, the following must be true: Capacity Revenue + Energy & AS Shortage Revenue + Energy and AS Non- Shortage Revenue ≥ CONE” • “….the ISO should seek to develop a performance incentive that is based primarily on the value of reliability” • “the ISO could then pursue improvements to the capacity market (e.g., the capacity demand curve) to allow it to efficiently generate the remaining revenue needed to maintain adequate resources in New England.” • “Such improvements would likely include the introduction of a sloped demand curve for capacity.”

7. Mitigation and the Performance Incentives Proposal • “….if the supplier expects 20 hours of shortages in the upcoming year, it should be willing to accept no less than 20 hours times the Performance Payment level.” • “a supplier that is risk-averse may incorporate an additional risk premium in its offer that is based on the expected performance of its unit.” • “A competitive supplier would include both of these values in its FCM offer.” • “In other words, a rational supplier would not be willing to sell capacity at a price less than the value of the embedded option and a rational risk premium.” • “….we believe that reasonable rates can be developed to quantify these values, which will help ensure that mitigation is not applied inappropriately.”

8. NextEra’s Observations • The ISO appropriately desires to drive better supplier performance and promote expanded gas capacity, but its proposal misses the mark • Unlikely to expand gas infrastructure • Likely to require RMR contracts for oil-based units, counter to underlying logic in Devon Power proceeding • Unknowable risk – compounded by unknown mitigation procedures – will be reflected in capacity offers • More appropriate to achieve proper performance incentives through improving real-time shortage pricing • Belongs in the energy market, not capacity, to ensure that all resources can face the same incentive and react • Pair with capacity market changes • Demand Curve