FCM – And Broader – Market Reforms

1. FCM – And Broader – Market Reforms Pete Fuller NEPOOL Markets/Reliability Committee January 29, 2013

2. Today’s Discussion • Opportunity to offer perspective on ISO’s ‘Performance Incentives’ proposal • Provide additional context for market reform efforts

3. Qualifier • NRG’s position is that, as currently structured and administered, FCM is deeply flawed: • Mitigation of existing resources should provide an opportunity for the marginal capacity resource to recover all of its annual fixed costs • A demand curve that recognizes the incremental value of additional capacity is essential, especially in the absence of a supply curve based on long-run costs • Reliability reviews of existing resource offers (delist bids) should be eliminated; all constraints that are to be enforced through planning or operability criteria should be specified in the auction requirements

4. The Building Blocks • Energy • Ancillary Services • Capacity

5. Real-Time Energy – the Foundation • ISO whitepaper acknowledges the problems with pricing and incentives in the RT Energy market • Mechanisms to reveal scarcity prices are lacking • RT Energy prices need to reflect the full cost of meeting demand and reserves at any given moment • This signal is critical to both supply and demand participants • RT price exposure is the driver for efficient hedging behavior • DA Energy Market – hedge on a daily basis through a centralized financial mechanism • Bilateral contracts also provide a hedging vehicle

6. Ancillary Services • Provide access for ISO to get the flexibility and responsiveness needed to balance and manage load dynamics and contingencies • Not all resources need to have high ramp rates, short start times, etc, but it is important that some do • LFRM, augmented by real-time reserves co-optimized with energy (plus regulation) provide the operating flexibility to maintain real-time reliability • ‘Performance Incentives’ has similar characteristics – is FCM a capacity product or an ancillary service?

7. Capacity • Capacity is supposed to be the ‘swing bus’ through which resources can recover fixed costs not covered by energy or ancillary service margins • Required because energy and AS markets are capped, and price formation is incomplete (as noted in ISO white paper) • Capacity market prices also should be relatively stable year to year to give investors a reasonably reliable expectation of cash flow, coverage ratios, etc – the markets should invite investment • Mitigation policy and the lack of a demand curve frustrate these objectives, and PI will further undercut these goals

8. ISO’s ‘Performance Incentives’ • Whitepaper provides an insightful and accurate critique of current energy markets • But, the whitepaper proposes that the shortcomings of the energy market should be addressed with changes to the capacity market • Issues that PI is intended to address: • Resource Performance and Flexibility (these are energy and AS issues) • Increased Reliance on Natural Gas (PI is a heat rate/start time incentive; link to fuel firmness is not clear) • Integration of Variable Resources (AS issue)

9. Why ‘mimic’ an efficient energy market? • The whitepaper suggests creating a proxy, in the capacity market, for an ‘efficient energy market’ • The penalty aspect of PI has no analog in an efficient energy market • The proposed metric for performance is largely out of the control of suppliers (and may create inefficient incentives to self-schedule) • An efficient energy market has both buyers and sellers; PI would show real-time scarcity prices only to sellers • The place to address shortcomings in the energy market is in the energy market

10. What is the FCM ‘Product’? • Capacity is the capability to produce energy • The primary obligation of a capacity resource is to offer its capability to the E&AS markets every day, to the extent it is physically available • FCM Shortage Events are a randomly-distributed demand for energy and ancillary services • Under the current FCM, fulfilling the offer requirements – under the control of the resource – renders a resource ‘available’ • ‘Scarcity conditions’ under PI are likewise a randomly-distributed demand • But ‘performance’ is largely out of the control of the resource owner

11. The PI ‘Product’ • Under PI, the traditional linkage between capacity and long-run availability is totally severed • Whether explicit or not, the strong incentive in PI is to deliver a very low heat rate or quick-start capability • Incentives for lower heat rates exist in the energy market and in the natural evolution of technology • Incentives, and explicit requirements, for quick-start capability exist in the LFRM and real-time reserve markets • Would FCM with PI effectively replace LFRM? And what would the impact on the energy markets be?

12. A Tangent to Consider LFRM • Consider the characteristics that make LFRM effective: • Voluntary participation • Portfolio obligation • Offer caps; no further mitigation • Penalties can exceed revenues, but risk management is fairly straightforward • Performance obligation (reserve, activate) is entirely within control of resource owner • Cover transactions are available on a daily basis • New audit rules will base ratings on average historic performance

13. An Alternative to PI • Fix the energy market problems in the energy market • Increase RCPFs to allow the system to re-dispatch for reserve scarcity • Reflect reliability commitments in energy prices • Eliminate, or put a price on, all ‘unpriced operator actions’ • Real-time prices that reflect scarcity have the same ‘upside’ effect on suppliers as ISO’s PI proposal • The ‘penalty’ for unavailability/non-performance is buying back the DA obligation in real-time • Making scarcity pricing visible to buyers increases efficiency of incentives

14. An Alternative, continued • Make the capacity product a capacity product • Measure performance that is within the control of the resource owner • Eg, availability of the full capability in the daily markets • Perhaps correlated with focal points of resource adequacy: high load hours (EFORd), or high price hours (EFORp) • Could be constructed to reward resources that exceed a set target or the average performance, and penalize those that under-deliver

15. Thanks for your consideration.