California: Nuts & Bolts Lessons from the “School of Hard Knocks”

1. California: Nuts & Bolts Lessons from the “School of Hard Knocks” Susan R. Schneider July 6th, 2014

2. CALIFORNIA EXPERIENCE • California/CAISO market overview • Restructuring motivation & “horsetrading” • How things actually worked • Lessons & reflections • Challenges ahead

3. CALIFORNIA MARKET OVERVIEW

5. CAISO STATISTICS • Combined service areas of PG&E, SCE, SDG&E, and several municipal utilities • Peak demand >50,000 MW • 124,000 square miles • 25,000 circuit-miles (~75% of California grid) • 1,400 power plants (~55,000 MW), more than England and France combined • Serves ~12% of U.S. population (30 million people)

7. TRANSMISSION CONGESTION CONSTRAINS ECONOMIC DISPATCH

8. CAISO FEATURES • Structure: Non-profit “public benefit corporation” (not a state agency) • Funding:Surcharges (Grid Management Charges) on market schedules, transactions, & other grid use(first call on funds) • Governance:5-member independent Board appointed by the California Governor

9. CAISO ACTIVITIES • Forward schedule management: • Day Ahead (10am), Hour Ahead, Fifteen Minute • Congestion management & market optimization (energy, unit commitment, reserves), based on economic bids • Real-time (RT) operations: 15-minute unit commitment, 5-minute economic dispatch • After-the-fact settlements and billing • Transmission/generation outage coordination • Transmission & grid planning • Generation interconnection studies/contracts • Market monitoring

10. MARKET PRICING STRUCTURE • Market-clearing prices for energy: Maximum bid and clearing prices • Zonal pricing structure first • Nodal pricing now (3,300 pricing nodes) • Ancillary Services • Regulation, Spinning Reserve, Non-Spinning Reserve • Includes opportunity costs for energy if not dispatched • Real-time differences from forward schedules billed/paid at RT price

11. OTHER KEY MARKET ENTITIES • Government entities • California Public Utilities Commission: Oversees energy procurement & contracting (IOUs), transmission siting/permitting, retail rates • California Energy Commission: Oversees generation siting & permitting, long-range planning & policy • Other entities • Participating Transmission Owners (3 large IOUs, 13 others) • Scheduling Coordinators (100+) • Load-Serving Entities (LSEs) – Utilities, Community Choice Aggregation, others • Suppliers – Generators & import suppliers/traders

12. EACH LSE & SUPPLIER (generator or import) MUST HAVE A CERTIFIED SC CAISO SC SC GEN LSE SC LSE IMPORT GEN GEN L L LSE L L LSE L LSE L L L L L L L L L L

13. RESTRUCTURING – MOTIVATION & “HORSETRADING”

14. RESTRUCTURING DRIVERS (1980s – Early 1990s) • Trend toward deregulation (“Reagan revolution,” airlines, natural gas (30% of market)) – “Government is part of the problem.” • Utility monopoly under fire (cost overruns, high rates, capacity surplus, modular technology) – perception of utility inefficiency, “Markets can do better.” • Muni pressure for transmission access • Business pressure for retail competition (natural gas deregulation, high costs, bad economy, relocation threats) – competition as a way to “do something” without hurting others.

15. AB1890 – The “Steve Peace Death March” • CPUC examination of open markets in 1993-1995, but legal authority for change not clear • Big battles in California State Legislature between utilities, business/competition advocates, labor/unions, & consumer interests • Grand bargain struck between these interests, and legislation passed both houses of the legislature unanimously in late 1996

16. ORIGINAL BARGAIN – SOMETHING FOR EVERYONE! • Retail customer protection (especially small ones) • All customers get “choice” at the same time (1/1/1998) • 10% rate reduction (bonds), then rates frozen • Consumer protection rules for new retail suppliers & education effort • Independent System Operator (CAISO) • Transmission control – IOUs still own assets (and earn returns) but don’t control them operationally • Open-access system – transparent tariffs & operating procedures (corporate doc on CAISO Web site – www.caiso.com)

17. ORIGINAL BARGAIN (2) • Instant competition, labor protection - multiple suppliers immediately through utility divestiture • 50% of gas capacity required, incentives to divest more • Buyers required to keep existing workforce for 2 years • Cost coverage: Use “headroom” between frozen retail rates & lower market energy costs to: • Recover utility “stranded” & transition costs (including labor severance, retraining, early retirement, and outplacement) and rate-reduction bond payments • Continue “Public Purpose” programs (low-income, conservation/energy efficiency, renewables)

18. SO WHAT COULD GO WRONG?

19. IMPLEMENTATION Implementation was difficult, expensive, and rushed. • Design details took years – not enough time for 1/1/98 “start-from-scratch” effort • Late market start – 4/1/98, just before peak season • Had to use off-the-shelf software, multiple vendors – interface issues, high costs ($200m) • Some elements (e.g., market monitoring) not sufficiently addressed

20. CONSUMER PROTECTION Many consumer protections did not work as expected. • All got 10% discount • Large customers were courted by suppliers • Small customers were mostly not, and only got additional real and sustainable options later • Reliability suffered, and rolling blackouts were called in northern California in winter 2000-2001

21. RECOVERY OF STRANDED & TRANSITION COSTS Insufficient “headroom” – wholesale energy costs exceeded frozen retail rates. • Wholesale energy prices fell initially but then rose: $29/MWh in 1998, $31/MWh in 1999, $110/MWh in 2000 • Generation surplus became shortage • Annual demand growth 1-2% in early 1990s, 3-4% in 1998-9, >5% in 2000 (demand growth also in surrounding import markets) • Lack of new capacity – no entity would sign contracts; utilities stopped building for several years, and no one stepped in right away • Questionable maintenance & forced outages • Market power issues with congestion & market structure – extensive litigation for refunds from private & public suppliers

22. INSTITUTIONAL FAILURES • One of the two largest utilities declared bankruptcy • Utilities couldn’t pay bills – wholesale power exchange failed • Recall of California governor (out went Gray Davis, in came the “Governator”) – energy crisis an important factor

23. EVENTUAL RECOVERY (1) • New resources came on-line • State stepped in to execute long-term contracts for new generation (creditworthy counterparty) • Contracts were expensive, rushed, & not well-negotiated, but they did bring on new capacity • Improved market monitoring & rules, e.g.: • Imposition of bid-price caps, other conduct rules • Establishment of conduct rules, performance metrics • Institution of generation maintenance and outage standards & practices • Settlement of much crisis-era litigation

24. EVENTUAL RECOVERY (2) – LSE Procurement Obligations • LSE “obligation to serve” clarification: Must procure (own/contract) resources for their loads • Resource Adequacy (RA) Requirements • Capacity to serve peak load + Planning Reserve Margin • Specific RA requirements in “load pockets” • Bilateral PPAs with performance incentives & penalties • Must-offer obligations for RA Resources (key feature) • Return of integrated resource planning (CPUC): Procurement separated from transmission functionally but considers transmission “adders”

25. REFLECTIONS & LESSONS LEARNED

26. TRANSITION, TRANSITION! • The journey can be as important as (or more important than) the destination • With multiple complex changes all at once, things will not turn out as expected – flexibility and contingency plans are needed in case problems arise  “Trust, but verify.”(RR) • Market roles & rules must be clear throughout – don’t leave gaps, especially for obligation to serve and conduct rules

27. IMPLEMENTATION MECHANICS • Small details can take a lot of time to address (e.g., meter-data sharing, billing procedures & disputes) • Consider building on existing software, processes • Consider phased implementation (e.g., wholesale before retail, critical changes in stages, large customers before small customers, gradual granularity improvements) • Don’t deploy major changes before peak season • Provide authority/process to reverse or delay changes if problems arise

28. DIVESTITURE REQUIRES CAREFUL CONSIDERATION • Added suppliers but also problems • Quick, low-risk California market entry by buying removed the need for new entrants to build • Divested assets (gas gen) were market-critical • Utilities divested 100% (40% of total nameplate capacity) • “Pairing” of divested plants reduced buyer diversity • Natural gas was the supply “at the margin,” i.e., set market prices and needed for system balance • Plants located in critical areas (load pockets) – that’s why they were sited there in the first place

29. LONG-TERM, SECURE FUNDING CRITICAL FOR NEW INVESTMENT • Short-term markets don’t facilitate long-term investments - financing new plants requires: • Coordinated resource procurement & transmission – requires coordination by multiple oversight entities • Creditworthy counterparties, secure revenue sources • Limitation of long-term market risks to generators • Short-term price signals don’t necessarily incent the “right” new resources, in the “right” place

30. RISK MANAGEMENT BY LSEs – Typical PPA provisions • LSEs & suppliers execute bilateral PPAs • LSE receives all capacity benefits (RA credit) and any renewables credits for project • PPAs provide for: • Payment terms for project output • Availability & production guarantees • Any curtailment provisions • LSE is Scheduling Coordinator for project • Bids project output into CAISO markets, receives revenues • Manages market revenue-PPA difference

31. PRICING STRUCTURE – Short-term Market Clearing Price • Theoretically efficient for dispatch and encourages bidding at marginal cost, but has shortcomings • Bidding prices/practices (and outages) for one plant can affect revenues suppliers receive for others • Inflexible demand can cause price spikes • Other thoughts • Tradeoffs between accuracy and simplicity (80-20 rule) • Negative prices needed for market solutions

32. MARKET MONITORING • Clear market conduct rules & consequences • Transparent & regularly reported metrics – how do you know the market is working well? • Congestion/load pockets and MCP structure require additional monitoring • Diverse monitoring staff is desirable, including personnel with actual market experience

33. ELEMENTS THAT WORKED (1) • Open transmission access: Posted tariffs, operating/interconnection procedures, etc. • Open stakeholder processes • Standard, open decision-making process • Decisions take longer, but all parties have a say, and hopefully the decisions are better

34. ELEMENTS THAT WORKED (2) • Generator interconnection process reform • Private investment & financing requires defined study processes & timelines • Applications may increase greatly – consider cluster studies, diverse cost allocation, up-front upgrade funding • Transparent transmission planning process • Publicly available study plans & study results • Stakeholder meetings & comment opportunities • Recent institution of competitive construction

35. SMALL-CUSTOMER OPTIONS • Significant transaction costs prevented mass-market penetration of third-party energy marketing to individual customers (a la Enron) • Most consumer benefits via other means: • Energy efficiency – appliance & building standards, audits/retrofits, and rebates/tax credits • Community Choice Aggregation: “Opt-out” community-based energy procurement programs, usually offering higher renewable-energy service/options • “Behind-the-meter” applications like rooftop solar (highly subsidized)

36. “UNCONVENTIONAL” RESOURCES CAN HELP • “Intermittent” resources can be predictable and dispatchable with the right data & forecasting tools • Flexible demand can be a viable resource • Can mitigate market power, lower peak supply costs • Works best under same structure as new generation – long-term programs or contracts • Is usually undervalued – credit not given for MCP reduction or infrastructure impacts

37. ARE “WE” BETTER OFF NOW? • Difficult to know – there is no control group or objective standard. • The market is more open, broader, and possibly more efficient – larger operational areas, strong incentives to run plants efficiently, greater procurement planning/oversight • There are more options available in the market • Restructuring is probably not the only way to obtain these benefits (80-20 rule)

38. CHALLENGES AHEAD

39. SELECTED CHALLENGES AHEAD • Integration of renewable resources • Renewable Portfolio Standard: 33% of retail sales must come from specific renewables (wind, solar, geothermal, biomass, biodiesel, small hydro) by 2020 • 40% & 50% RPS under consideration • Flexible RA requirement, new “ramping” product • Storage valuation & deployment • Now expensive but helps energy production follow load, and costs may decline over time • 1,300 MW CPUC-mandated procurement • Pumped-storage proposals

40. THE “TRANSITION” IS NEVER REALLY FINISHED • New generation technologies • New end-use technologies • New societal/market objectives & tradeoffs “The only constant is change.” - Anonymous

41. Susan Schneider • Founder & Principal of Phoenix Consulting, Inc. • Former CAISO VP (at start-up) • Former PG&E executive supervising retail electric & gas market restructuring • Published newsletter on CAISO wholesale market issues for 10 years • Advises generation clients in interconnection process, PPA negotiations, CAISO stakeholder processes