Enhancing Capacity Markets to Improve Resource Performance and Investment

1. Enhancing Capacity Markets to Improve Resource Performance and Investment Pay For Performance: New England’s Capacity Market OPSI 10th Annual MEETING | October 13-14, 2014 Matthew White chief Economist

2. New Challenges Require Enhancements to Capacity Market Designs • New England faces significant reliability, investment, and resource performance challenges over the coming decade • Solution: A two-settlement capacity market design that addresses these challenges • Expected benefits: Improved system reliability; cost-effective solutions to region’s investment needs; and a simpler, resource-neutral capacity market design

3. Investments for New England’s Future At-Risk Capacity Resources in New England Total At-Risk: 8,300 MW Oil-fired Capacity: 6,000 MW Coal-fired Capacity: 2,300 MW 850 MW Coal-Fired Resources 550MW Oil-Fired Resources 400MW 600MW 270 MW 2300 MW 1700 MW 1200 MW 400MW Up to 8,300 MW at risk for retirement by 2020 (28 older oil & coal units) If all retire: ISO estimates aneed for 6,300 MW of new or repowered capacity Existing and planned trans-mission projects provide significant flexibility for locating these new resources ISO-NE Retirements Study

4. Further Investment and Reliability Challenges • ISO New England is increasingly reliant on resources with uncertain performance and availability • Gas units: “just-in-time” fuel • Coal, oil-steam fleet: 50+ years old • Intermittent resource growth with inherently uncertain output • New ‘systemic risk’ to reliability when too many units cannot perform simultaneously

5. Challenges: Market Incentives for Investment • Many investments couldreduce performance risk concerns, at new and existing facilities • New pipelines and non-interruptible gas transport • Dual-fuel, backup LNG, greater liquid fuel storage, and so on… • New flexible generation capacity, more fast-responding DR, etc…. • Existing markets provide insufficient incentives for these investments • Many incremental investments are needed only few hours per year • Revenues are insufficient to justify the capital investments

6. Principles for NE’s Capacity Market Reforms • Reward outputs (power delivered), do not specify inputs • Let suppliers identify least-cost solutions, bearing risks and rewards • Redefine performance measures for capacity resources • Delivery of energy and reserves during (reserve) scarcity conditions • Not peak period ‘availability,’ or EFOR-based measures • Better align resources’ financial incentives with the value of reliable service during tight system conditions • Mimic the performance incentives of an efficient energy market, with the reduced volatility that a forward market provides

7. Paying for Performance: Four Major Elements • Capacity Obligations: A Standard Incentive Contract • Base payment set in forward auction, and a performance payment • Performance Payment: • Delivery of energy & reserves during (reserve) shortage conditions • May be positive or negative (on top of base payment) • Not based on “availability,” or EFOR-type measures • Resource Neutral, No Exemptions • All resources have same base and performance payment rate • Who pays what? • Loads pay the base payment set by the forward clearing price • Performance payments are transfers among suppliers

8. Product Definition is The Key To Good Markets • Traditional capacity ‘product definition’ is… hard to define • One frequent view: Payment (subsidy) for “steel in the ground” • Approach: Establish a new, simple, product definition, modifying sellers’ financial obligations to incent performance • Capacity is just a single product: A share of system’s requirements. • Standard forward contract structure, based on two concepts: • Two-settlement principle (e.g., like the DA forward energy market) • Scarcity price premium: Real-time incentive in tight system conditions

9. Capacity Becomes a Forward-Sold Good Using a Simple, Two-Settlement System Forward-Sold Goods • Initial revenue on fwd sale • Specifies a forward financial commitment (‘position’) • 2nd Settlement based on deviations at delivery … • … at a contract rate, or at replacement (floating) price ISO’s Capacity Reforms • Auction-based fwd sale (FCA) • Pro-rata share of system requirements (load + reserves) during RT reserve shortages • 2nd settlement for delivery (energy + reserves) deviation from system share • At (high) tariff-specified rate (analogous to scarcity pricing)

10. Benefits of the Two-Settlement Capacity Market • Greater operational-related investments at existing resources to improve resource performance • E.g., secure fuel arrangements and/or backup fuel supplies • Efficient resource evolution. Strong incentives for investment in new capacity that is either: • Low-cost and highly reliable (nearly always operating); or • Highly flexible and highly reliable (gets online quickly and reliably) • A more reliable power system at lowest possible cost • Market rewards suppliers that deliver the most cost-effective solutions

11. Complementary Energy Market Changes Underway • Energy Market Offer Flexibility (2014) • Allows suppliers to update supply offer prices intra-day • Improves generators’ flexibility to incorporate current fuel costs into energy prices during volatile market conditions • Improves incentives to procure fuel to honor ISO dispatch schedules • Reserve Market Enhancements (2012/13) • Send stronger, more frequent market price signals when system conditions are likely to be tight • Enhance incentives to procure fuel to honor ISO dispatch instructions and reward resources that perform in stressed system conditions

12. For More InformationDesign and Key FERC Orders • ISO White Paper: FCM Performance Incentives • Stakeholder Process: 16-month process (thru Dec. 2013) • FERC Approval: May 30, 2014 and Oct. 2, 2014 Orders • Implementation: 9th Annual Capacity Auction, Spring 2015 (Delivery year 2018/2019) • For more information: www.iso-ne.com > FCM Performance Incentives Key Project