Transmission Rights for the Texas Nodal Market

1. Transmission Rights for the Texas Nodal Market Shmuel S. OrenUniversity of California at Berkeley Presented at the PUCT Technical Workshop on Transmission Rights Austin, Texas, September 5, 2003

2. Objectives • Understanding the role of property rights in forward energy trading and risk management • Understand the difference between flowgate congestion revenue rights (FG-CRR) and point to point congestion revenue rights (PTP-CRR) as hedging instruments • What type of transmission rights will best serve the Texas Nodal market

3. Tradable Property Rights • Purpose: • Facilitates efficient use of scarce resources (Coase) • Mechanism to reward investment • Enable risk management (hedging, forward markets) • Aspects of Property rights: • Right to financial gain from asset • Right to use asset (weak physical) • Right to exclude others from using the asset (strong physical)

4. Forms of Financial Transmission Rights • PTP CRR (Obligation): • Holder is entitled to or obligated to pay nodal price difference between designated locations per MW denomination • FG CRR (Option) • Holder is entitled to shadow price on congested element in designated direction per MW denomination • PTP CRR Options • Holder is entitled to nodal price difference between designated locations per MW denomination if value is positive but can walk away if it is negative • FG CRR Obligation • A combination of Long FG CRR and Short FG CRR in the opposite direction. Holder is entitled to shadow price on congested element per MW denomination in “Long direction” and is obligated to pay shadow price on congested element per MW denomination if flow is reversed

5. Fundamental Relationship Between Nodal Prices and Flowgate Shadow Prices • Let: • Ni = Energy nodal spot price at bus i • Fj = ATC shadow price at flowgate j (flowgate spot price) Only congested flowgate need to be counted PTDF=Power Transfer Distribution Factor=SHIFT FACTOR

6. Hedging Forward Transactions with PTP and FG CRRs • G1 has a bilateral contract with L3 to deliver 150 MW and wants to hedge congestion charges: PTP approach: Buy 150MW of FTR 1 3 FG approach: Buy 100MW of FGR 1 3 50MW of FGR 1 2 50MW of FGR 2 3 (FGR portfolio emulates the distribution of flow according to the PTDFs published by ERCOT) G1 1 G3 300 2/3 Limits shownX=1 for all lines 100 3 220 1/3 G2 L3 1/3 2

7. Real Time Settlements • Suppose real time dispatch is based on security constrained OPF and the flow constraint on link 2 3 with corresponding shadow price F23 (shadow prices on uncongested links are zero) and nodal prices N1 ,N2, N3 • Nodal pricing based congestion charges paid by the generator for the 150MW transaction from node 1 to 3 are 150*(N3- N1) • Settlement for 150MW PTP CRR 1 3 paid to the generator is 150*(N3- N1) • Settlement for 50MW FG CRR 2 3 is 50* F23.. But N3- N1=1/3* F23 (relation of nodal and shadow prices) • Both the PTP and FG settlements offset the real time congestion charges (full hedging)

8. So What is the Difference? • PTP CRRs guarantee a perfect hedge • Insurance against congestion on flowgates • Insurance against changes in PTDFs • Insurance against changes in ATC on flowgate • Revenue adequacy conditions necessitates limiting the PTP CRR offering • FG CRRs only provides insurance against congestion on flowgates • Holder is responsible to maintain proper mix • PTDF tracking services or insurance against deviation can be offered as a service by private commercial entities

9. Issuing and Trading PTP CRRs • PTP CRRs representing financial property rights to the transmission system must be issued centrally by the ISO (Speculative PTPs “off track betting” can be issued by anyone but have no physical cover) • To insure that congestion revenues can cover PTP settlements, PTPs must meet a “simultaneous feasibility condition” • The virtual “CRR operating point” corresponding to simultaneous bilateral schedules replicating all outstanding PTP CRRs must meet all security and flow constraints. • In an PTP CRR auction (PJM) bidders submit bids for specific PTPs, ISO selects winning bids by treating CRR bids as proposed schedules using a security constraint OPF that maximizes CRR auction revenue

10. Issuing and Trading PTP CRRs (cont’d) • When the RT operating point differs from the CRR operating point, congestion charges will exceed CRR settlements. The difference represents unhedged congestion. • Reconfiguration of simultaneously feasible PTP CRRs to track the operating point must be done centrally (monthly at PJM). • Low liquidity due to large number of CRR types and coordination requirements makes secondary trading impractical. • PTP CRRs must be issued as two sided instruments (that can have negative value) in order to provide adequate hedging capability. • Issuing PTP CRRs as options while meeting simultaneous feasibility severely restricts CRR offering and hedging capability.

11. ® CRR 2 3 B G1 · 320 MW X 2 1 1 ® · · 300 MW A Z · 300 Y · 2 3 ® 100 · C 3 1 3 ® · D 100 MW 220 1 2 ® ® CRR1 3 G2 L3 E · O 2 300 MW 400 MW 20 MW EXAMPLE (nomogram faces correspond Congested flowgates) Changing capacity of line 2 to 3 G3 • Two sided PTP CRRs must stay within the outer nomogram • 2 3 CRR have negative value (must pay) if RT operating point is at D or B. • One sided PTP CRRs (options) must stay within inner nomogram ®

12. CRR 23 B 320 MW X · A 300 MW Z Y C D 100 MW ® E O CRR13 300 MW 400 MW EXAMPLE (cont’d) • Negative valued 2  3 PTP CRRs at D represents a counterflow obligation (needed to offset settlement of extra 1  3 PTP CRRs) • If “CRR operating point” matches RT operating point then PTP CRR settlements equals congestion revenues, ISO breaks even and all transactions can be perfectly hedged. • If Award point is Z and operating point is Y then there are too many 2  3 CRRs and not enough 1  3 CRRs • ISO has excess congestion • revenue • Not all transactions can be hedged • (those that are hedged • have perfect hedges)

13. $/MWh 45 2 MW 100 200 MW 100 MW $/MWh $/MWh 100 MW 220 MW 40 30 300 MW 3 1 MW 500 300 MW MW 400 Congestion and PTP CRRs Settlement (OPF solution = Point D on nomogram) MCPE=$40/MWh • In Real Time • G2 receives $5/MW/h for counterflow • G1 is charged $10/MW/h congestion • And 2 to 3 CRRs must pay $5/MW/h • And 1 to 3 CRRs receives $10/MW/h

14. ® CRR 2 3 B · 320 MW X 2 1 ® · · 300 MW A Z · Y · 2 3 ® · C 1 3 ® · D 100 MW 1 2 ® CRR1 ® 3 E · O 300 MW 400 MW 20 MW Revenue Adequacy CASE 1: Operating Point D is forecasted correctly and bids for PTP CRRs match settlements. Simultaneous feasibility auction also clears at Pt. D, awarding 100 MW 2 to 3 CRRs and 400MW 1 to 3 CRRs at $10/MW/h 1. PTP CRR obligations Congestion rents=400x10-100x5=$3500/h CRR settlement=400x10-100x5=$3500/h ISO breaks even. 2. PTP CRR options Congestion rents=400x10-100x5=$3500/h CRR settlement=400x10=$4000/h ISO is short CASE 2: CRR auction clears at Point B awarding 320MW 2 to 3 PTP CRRs and 20MW 1 to 3 PTP CRRs (Auction revenue may be negative). RT dispatch is still at Point D Congestion rents=400x10-100x5=$3500/h CRR settlement=20x10-320x5= - $1400/h ISO surplus = $4900

15. Issuing and Trading FG CRRs • ISO auctions FG CRRs as financial property rights to the directional flowgates’ physical capacity • Only flowgates likely to be congested need to be included in the auction (but RT congestion rent will be charged on all congested flowgates) • FG CRRs are issued as options since settlement (based on shadow prices) can only be positive or zero • CRR capacity on each flowgate is determined independently of others (no simultaneous feasibility condition) • ISO publishes current PTDFs informing traders of changes in FG CRR mix needed to hedge various point to point transactions • PTP CRRs can be synthesized from FG CRRs. PTP CRR options can be synthesized by buying only FG CRRs with positive PTDFs.

16. Issuing and Trading FGRs (cont’d) • All congestion revenues are paid as settlements of FG CRRs issued by ERCOT or as real time negative congestion payments to counterflow producers • FG CRRs can be traded on secondary markets • Traders or private commercial entities update their FG portfolio to maintain point to point hedges • Producers of counterflow on congestion prone flowgates can sell private FG CRRs (i.e. take short positions covered by their expected real time counterflow revenues from the ISO) on secondary markets (these will command the same prices and settlement as ISO-issued FG CRRs but will be settled privately) • Sellers of counterflow FG CRRs undertake an obligation. Such obligations are necessary to enable full hegdging cover for all transactions • ISO- issued FG CRRs for physical capacity + private FG CRRs for counterflow => All transactions can be fully hedged for any operating point (but it is up to the market to get the FG CRRs into the right hands)

17. ® FTR 2 3 (nomogram faces correspond Congested flowgates) B G1 · 320 MW X 2 1 1 ® · · G3 300 MW A Z · 300 Y · 2 3 ® 100 · C 3 1 3 ® · D 100 MW 220 1 2 ® ® FTR1 3 G2 L3 E · O 2 300 MW 400 MW 20 MW EXAMPLE • ISO can sell FG CRRs covered by physical grid capacity. • 100MW 21 FG CRRs, 100MW 12 FG CRRs, 300MW 13 FG CRRs, 300MW 31 FG CRRs, 220MW 23 FG CRRs, 220MW 32 FG CRRs • FG CRRs covered by wire capacity will only provide hedges for operating points in “light” area. To cover “dark” area of nomogram counterflow producers must undertake counterflow obligations and sell virtual FG CRRs covered by RT counterflow revenue.

18. $/MWh 45 2 MW 100 200 MW 100 MW S.P =$20/MWh $/MWh $/MWh 100 MW 220 MW 40 30 300 MW 3 1 MW 500 300 MW S.P.=$5/MWh MW 400 Congestion and FG CRR Settlement (OPF solution = Point D on nomogram) MCPE=$40/MWh In Real Time FG CRR 1 to 2 receives$20/MW/h FG CRR 1 to 3 receives $5/MW/h All other FG CRRs receive 0 G2 receives net congestion rent $20/3 - $5/3=$5/MW/h G1 pays net congestion rent -$20/3 - $5(2/3)=-$10/MW/h ISO congestion revenue: 400x10-100x5=$3500/h FG CRR settlement: 100x20+300x5=$3500/h ISO always breaks even Regardless of RT operating point

19. Pros and Cons of PTP CRRs • Offers full hedges that account for security constraint dispatch • If RT operating point differs from CRR operating point then not all transactions can be hedged • Centrally managed frequent reconfiguration auctions needed • CRRs must be defined as two sided instruments (otherwise feasibility condition is too strict) • Not conducive to secondary trading

20. Assumptions Underlying Flowgate Approach • Flowgates can be defined • Number of commercially significant flowgates is small and predictable • PTDFs are relatively stable • Flowgate capacities are stable and known

21. Pros and Cons of FG CRRs • Amenable to secondary trading • No simultaneous feasibility required • Requires less central coordination • Small number facilitates liquidity • FGRs can be issued for long periods • Effective property rights for investment or grandfathered rights • All the grid capacity is sold (all congestion charges are distributed as FG CRR settlements) • FG CRRs are one sided instruments (holder has no obligation but issuer does) • Reliance on market to assemble hedges for point to point transactions • Hedges are not perfect unless the cost of PTDF variation is socialized (can create gaming incentives) • Underlying assumptions may not be valid • Traders interested in PTP hedges may have to deal with too many FG CRRs

22. Best of Both Worlds • Real time congestion settlement based on locational marginal prices (nodal for resources and zonal for load) • ISO can offer both PTP and FG CRRs so that combination of CRRs is within the nomogram but remaining capacity on flowgates can also be sold • FG CRRs settled based on flowgates shadow prices. PTP CRRs settled as portfolio of FG CRRs or based on nodal price differences (who underwrites the difference?) • PTP CRR options offered and settled only as portfolios of FG CRRs • Secondary FG CRR markets enable traders to reconfigure their hedges so as to track changes in operating point

23. Other Issues • Derating CRRs • Do we need all PTP CRRs if congestion settlements are based on resource node to load zone? • Limiting CRR ownership to prevent market power • Relaxing the simultaneous feasibility criterion for revenue adequacy

24. (nomogram area reduced by derating line 2 to 3 ® FTR 2 3 B G1 · 320 MW X 2 1 1 ® · · G3 300 MW A Z · H 300 Y · 2 3 110 ® 100 · C 3 1 3 ® · D 100 MW 220 1 2 ® ® FTR1 3 G2 L3 E · O 2 300 MW 400 MW 20 MW Derating 165 MW • If PTP CRRs are awarded based on Pt. D. and RT dispatch • is at Pt. H, then congestion revenues will not cover CRR settlements. • OPTIONS: 1. Full payment to CRR based on nodal prices and uplift of rev. shortfall • 2. Prorate settlement to all PTP CRRs to cover shortfall • 3. Prorate settlement to derated flowgates • Options 1 and 2 socialize cost of derated line (1 to load and 2 to CRR holders) Extreme case when derated line is radial. • Option 3 directly assigns shortfall to the users of derated flowgate.

25. What CRRs are Needed? • Since load imbalances are settled at zonal prices, congestion charges on bilateral transaction must be based on difference of load zonal price minus resource nodal price (to avoid arbitrage) • Hedging needs can be met with node to zone CRRs, which can be settled without publishing price for each load node • In absence of a state estimator nodal prices at load nodes may be imprecise but zonal load price tends to average out the statistical error.

26. Limiting CRR Ownership Dear node Cheap node • Generator with market power at Dear node and dominant CRR holding on line from Dear node to Cheap node benefits twice from high prices at Dear node through local energy sales and through CRR settlement (combined holding amplifies market power). • Excessive CRR holdings increase incentive to exercise market power. • Shares of CRR holdings on congested interfaces must be limited (at least for QSEs with market power in the load pocket). • Hard to impose such limits with PTP CRRs since many different PTP CRRs can be used to control a single FG CRR. • Easy to implement limits for FG CRRs.

27. Relaxing the Simultaneous Feasibility Criterion • Simultaneous feasibility insures revenue adequacy in every operating interval. • Criterion is too stringent, limiting PTP CRR awards and distorting clearing prices. • Not a problem with FG CRRs since all capacity is sold. • Possible relaxation of SF condition may impose revenue adequacy over longer periods or use a value at risk criterion for ISO revenue shortfall.