FINANCIAL PERFORMANCE OBLIGATION Markets Committee Meeting February 7-8, 2012

1. FINANCIAL PERFORMANCE OBLIGATIONMarkets Committee Meeting February 7-8, 2012 Donald J. Sipe

2. Financial Performance Obligation • Requires every unit with a capacity obligation to financially guarantee the delivery of energy: • a) At or below a specified strike price • b) In any dispatch interval • c) Up to an amount equal to its capacity obligation • Financial in nature • Does not Require Physical delivery in any hour • A unit may fulfill its obligation by either • a) Physically providing energy or; • b) Purchasing replacement energy at the real time or day ahead price Donald J. Sipe

3. Objectives and Principles 1) Create a stronger link between capacity and energy market revenue streams. 2) Enable increased use of scarcity pricing while minimizing market power concerns. 3) Improve incentives for performance based on well established economic principles of “loss aversion”. 4) Provide a true hedge for load in return for capacity payments 5) Lower risk premiums by placing risk of performance on those who can hedge it best. 6) Dampen bimodal swings in Capacity pricing by using the “option risk” of the FPO to: a) Create a rational basis for existing capacity resources to bid higher than “0” and b) Create a rational basis for existing units to delist at prices in excess of current “going forward costs”; and c) Rationalize supply by “encouraging” exit (at least from the capacity market) of high cost, inefficient units Donald J. Sipe

4. The FPO Would Replace the Current PER • FPO is a unit specific, precisely accurate, PER adjustment mechanism that assures: • a) ratepayers never pay twice for capacity (e.g. once through a capacity payment and then again through scarcity pricing), and • b) Suppliers are neither rewarded nor penalized for anything but their own performance • A unit that performs according to ISO dispatch instructions at or below the strike price never has its capacity payment adjusted • a) a unit never gets a deduction based on real time or day ahead energy prices it did not receive • b) a unit can receive scarcity rents from the market (without a capacity deduction) if it provides additional service to cover non- performing capacity assets. • c) a unit that does not receive a CSO can do the same • The FPO is compatible with either a LICAP type curve or an FCM construct. Donald J. Sipe

5. How It Works • Establish a strike price for entry. • Based on operating cost of CONE unit • Indexed to fuel • Other ideas for setting strike price can be discussed • Load pays the lesser of the strike price or clearing price in any hour. • Amounts collected from load are paid to suppliers per their load ratio share of ICR in any hour. • Suppliers are also charged or paid the clearing price for any deviation from their load ratio share of ICR based on actual performance in the hour. • In any hour where the clearing price is equal to or less than the strike price and a generator does not perform, this is a wash. • In any hour where the clearing price is above the strike price and a generator fails to perform, the result is the generator pays the difference between the clearing price and the strike price for the deviation. Donald J. Sipe

6. Example • Simple system: two generators (A&B) each 200 MW. System load 200 MW. • Each generator has a CSO for 100MW and has 100 MW uncommitted capacity. • Strike Price $10.00. • Load hits 200MW with clearing price of $11.00. • Generator B has an outage and can’t deliver on his 100MWCSO. • Generator A is dispatched at 200 MW (100 MW above its CSO). Donald J. Sipe

7. Example cont. • Generator A has a positive deviation of 100MW from its load ratio share of ICR (its full CSO in this instance). • Generator B has a 100 MW negative deviation. • Load pays the lesser of the strike price or the clearing price x 200MW=$10x200=$2,000. • Both Generator A and B are paid 100MWx$10=$1,000. • Generator B is charged for the negative deviation at the clearing price. • Generator A is paid for the positive deviation at the clearing price. Donald J. Sipe

8. Example cont. Donald J. Sipe

9. Scarcity Pricing Under the FPO. • Scarcity pricing is used by generators to allocate the risk of dispatch. • A supplier can always protect itself by bidding its CSO at or below the strike price and performing. • Suppliers can hedge the financial risk of non-performance bilaterally • Because load is hedged, scarcity pricing does not run the risk of market power or market manipulation since other suppliers are incented to hedge such prices directly through operation or bilaterally. • Loads committed as DR capacity would not be hedged by the FPO from scarcity prices. • DR that failed to perform (provide load reductions) would pay full scarcity prices for all deviations. Donald J. Sipe

10. Further Points • LMPs not constrained by strike price. • FPO does not alter: • Need or requirement to physically back capacity commitment; • Requirement for availability adjustments or penalties based on performance. • All the FPO does is replace the PER with a true hedge. For further discussion of questions, theory and examples, See Financial Performance Obligation (whitepaper) prepared on behalf of AF&PA in Docket No. AD08-4-000. For very similar concepts, see The Convergence of Market Designs for Adequate Generating Capacity with Special Attention to the CAISO’s Resource Adequacy Problem, A White Paper for the Electricity Oversight Board by Peter Cramton and Steven Stoft (April 25, 2006). Donald J. Sipe