August 7-9, 2013 | lenox , ma

1. August 7-9, 2013 | lenox, ma Matthew White Senior Economistmarket development A Strategic Planning Initiative FCM Performance Incentives Andrew Gillespie Principal analyst Market development Ron Coutu MANAGER, Bus. Tech. & Solutions

2. Presentation Topics • Overview • Stop-Loss Mechanism and Design Details • Bilateral Trading Design Details • Exemptions – ISO concerns

3. Overview

4. FCM Performance Incentives - Overview • Capacity suppliers with resources that have uncertain performance present a risk to system reliability if too many resources cannot ‘perform’ when needed most – during a capacity deficiency • In this context, ‘perform’ means delivery of either energy or reserves during a capacity deficiency • The current FCM construct provides insufficient incentives for capacity suppliers to make investments to improve resource performance • FCM Performance Incentives provides market signals and investment incentives for capacity suppliers to improve performance i.e., deliver energy or reserves during a capacity deficiency

5. Future Topics (approximate dates) • Elaboration on the details of this proposal will be the topic of future presentations to the Markets Committee, including but not limited to: • Balancing ratio & application to zones ~ May/June • Maximum Loss Limit (or stop loss) ~ May/June/July • Resources with multiple commitment period elections ~ June • Financial Assurance impacts (w/B&F committee) ~ August • Establishing the Performance Payment Rate ~ September • Bilateral trading ~ July/August • Reliability rejection of de-list bids ~ September

6. FCM Performance incentivesQuick Reference Guide

7. FCM PI Reference Guide • A separate document, ‘FCM Performance Incentives Reference Guide’ is posted on the ISO web-site with the other presentation materials for this agenda item • This working document represents the entirety of the design – and will serve as a concise guide for presenting proposed tariff changes

8. STOP-LOSS PROVISIONS

9. Things to Note • Purpose. Provide a liability limit on a capacity supplier’s financial loss exposure for non-performance during the commitment period • Details and Examples. A separate memo, ‘FCM Performance Incentives – Revised Stop Loss Value’, has been posted on the ISO web-site with the other presentation materials for this agenda item • This memo provides additional detail on the various design elements of the ISO’s proposed stop loss

10. Review: Conceptual Approach • The stop-loss is a mutual insurance system among capacity suppliers • A resource with a CSO will be ‘stopped-out’ at a point where the resource’s net capacity payments would exceed the stop-loss limit • All other capacity suppliers each bear (a portion of) this risk: Their total compensation may be reduced if a resource ‘stops-out’ • Key: Maintain performance incentives. A good stop-loss design should minimally distort: • Incentives to perform during scarcity conditions • Incentives to trade-out or replace a non-performing CSO resource

11. Stop-Loss Details – Resource Level • The stop-loss will be applied to individual resources with a Capacity Supply Obligation each Obligation Month • The stop-loss limit ($ amount) will be equal to the product of the CSO amount (kW) and the stop-loss rate ($/kW) • UPDATE: The stop-loss rate will be equal to the FCA Clearing Price minus the FCA Starting Price • The stop-loss limit will apply to the resource’s net monthly capacity payments - the sum of the base payment and performance payments

12. Resource Level - Example • For a resource with a 100MW CSO, the monthly stop-loss limit will be ($1,100,000) = 100,000kW x ($11/kW-mo) • Based on a stop-loss rate of ($11/kW-mo) • FCA Clearing Price = $4/kW-mo. • FCA Starting Price = $15/kW-mo. • Stop-loss rate = $4 - $15 = ($11/kW-mo) • And the limit will be applied to each month’s net capacity payments: • Monthly base payment = $400,000 • Monthly performance payments = ($1,600,000) • Monthly net capacity payments: • Before stop-loss = ($1,200,000) • After stop-loss = ($1,100,000)

13. Why is the rate equal to the difference in prices? • In the third and final annual reconfiguration auction, a resource may be compelled to cover (shed) a CSO at a price up to the starting price of the FCA for that commitment period • This is the maximum value demand places on capacity, and therefore also the highest price at which a supplier would be compelled to cover a CSO (a.k.a., the ‘significant decrease’ provision) • The resource’s net financial position would then be the difference between the FCA Clearing Price paid to the resource and the payment made by the resource to shed the obligation, which may be up to the FCA Starting Price • Using this same difference in setting the stop-loss value provides the same protection against a ‘worst-case’ scenario • Whether that is shedding the CSO at the starting price in the reconfiguration auction or keeping the CSO and being assessed performance charges

14. Why not an annual limit? • The cumulative net financial position of a resource stopped-out every month of the commitment period (in the ‘worst-case’ scenario) would be the same if an annual stop-loss had been used • From the previous examples: • A monthly stop-loss limit of ($1,100,000) would for a year be: • 12 months x ($1,100,000) per month = ($13,200,000) • An annual stop-loss limit using the same rate ($11/kW-mo) would be: • 12 months x ($11/kW-mo) x 100,000kW = ($13,200,000)

15. An annual andmonthly limit don’t work as well as using one or the other • The annual limit becomes superfluous if the ‘worst-case’ scenario using the monthly limit yields the same cumulative financial position as annual limit set using the same rate – prior slide • Setting a monthly limit that yields a cumulative financial position that is less than an equivalent annual limit dilutes incentives to perform • The annual limit would never be reached as the cumulative monthly limit, even if reached every month, would never equal the annual limit – Why then have an annual limit? What good is it doing? • Setting an annual limit that yields a cumulative financial position that is less than an equivalent monthly limit also dilutes incentives to perform • If after a few months of hitting the monthly limit the annual limit is reached, there is little incentive to cover or perform during the remainder of the commitment period – Why then have the monthly limit? What good is it doing?

16. Putting the limits in context • The stop-loss limit, set as the difference between the clearing price and the starting price, is equivalent to limiting net performance charges to ($15/kW-mo.) • Monthly, a $15/kW-mo performance charge is approximately equivalent to completely missing 4 hours of scarcity per month • Worst-case, this equates to missing at least 48 hours of scarcity during the entire commitment period if used as the basis for an annual limit • An annual stop-loss limit of $7.50/kW-mo is equivalent to completely missing 24 hours of scarcity all year • This would equate to missing approximately 2 hours of scarcity per month if used as the basis for a monthly limit • Using both a monthly and annual limit creates inefficiencies if not equivalent, and unnecessary if the two are equivalent

17. Stop-Loss Details – System Level • Potential net surplus. During a scarcity (deficiency), total performance charges exceeds total performance credits. • When a capacity resource is ‘stopped-out’, no additional performance charges (based on the CSO amount) are ‘collected’ from the resource • This can result in the sum of all performance credits exceeding the sum of all performance charges, and would lower the net surplus (possibly making this a net deficit) • The disposition of any net surplus amount, or net deficit, is done pro-rata based on CSOs, accounting for each CSO MWs performance charges not collected (i.e., ‘stopped-out’)

18. Other considerations in the FCM Performance Incentives – Revised Stop Loss Value memo • Consistency – prior slide • Economics. A resource with a CSO should be willing to incur costs during the commitment year —if necessary—that are as high as the ISO’s willingness to pay • Simplicity. The revised stop loss value is mathematically equivalent to limiting a resource’s monthly performance charges to $15 per kw-month (i.e., the FCA Starting Price), regardless of the base payment • Incentives. Setting the stop-loss limit too low undermines the objective to provide financial incentives for resources to undertake incremental investments to improve resource performance • Limited Frequency. A frequently-reached limit creates short-pay risk that will be borne by other capacity suppliers

19. Bilateral trading CSO and Performance Payment Exchanges

20. Bilateral Trading • The current mechanisms for trading CSOs will remain in place (e.g., reconfiguration auctions) • The current Supplemental Availability Bilateral mechanism, with modification, provides an additional means to manage a resource’s performance risk

21. How do Supplemental Availability Bilateral (SAB) transactions work? • These transactions allow the swap of one resource’s ‘availability’ above its CSO to another resource • For on-line resources: amount ≤ (Economic Maximum – CSO) • For off-line resources: amount ≤ (designated reserve amount – CSO) • This does not involve an exchange of CSO: • SABs are effective for shorter periods (less than a month) • The ISO does not settle the bilateral, only the exchanged amount during a shortage event, if any • The bilateral is done between participants ex ante • The settlement, the exchange of availability, is done by the ISO ex post • But, because this is an exchange of ‘availability’ there are zonal checks and limitations

22. Why are there zonal restrictions with SABs? • SABs are an exchange of availability • As such, an exchange of availability may not be a meaningful transaction if the supplementing resource would not actually offset the missing availability of the supplemented resource • Example: The positive availability of supplementing resource in Rest-of-Pool (ROP) may not offset the negative availability of a resource in an import-constrained zone • It is not always the case that the resource in ROP would, even if operating, relieve the deficiency in the import-constrained zone

23. Could something like SABs be done under FCM Pay-for-Performance? • Yes. Under FCM PFP, each resource will have a score during scarcity conditions Score = Actual MW – (Balancing Ratio x CSO) • When the score is positive, the resource is performing above its adjusted CSO amount • This is an actual measurement, but it is analogous to the ‘availability’ of a resource above its CSO amount in SABs • Because this is an actual measurement there is no need to enforce zonal limitations on transactions – more in following slides • Hence, with modifications, the SAB concept could be transformed into a Performance Score Bilateral (PSB)

24. How would a Performance Score Bilateral (PSB) work? • Resource 1 (the supplementing resource) • During a scarcity condition, this resource’s score is positive • Actual MW1 = 1.0 (=EcoMax); Balancing Ratio = 0.5, CSO1 = 1.0 MW (max amount) • Before PSB settlement: Score1 = 0.5 = 1.0 – (0.5 x 1.0)After PSB settlement: Score1 = 0.0 • Resource 2 (the supplemented resource) • During a scarcity condition, this resource’s score is negative • Actual MW2 = 0.0; Balancing Ratio = 0.5, CSO2 = 1.0 MW • Before PSB settlement: Score2 = -0.5 = 0.0 – (0.5 x 1.0) After PSB settlement: Score2 = 0.0 Resource 1 can, via the PSB, transfer its positive score to Resource 2 • After the transaction is settled, both resources would have a score of zero; the performance credit of Resource 1 offsets the performance charge of Resource 2 • These two resources would not be able to do a SAB transaction as the supplementing resource’s EcoMax is the same as the CSO – with PSBs this restriction is immaterial, only delivered amounts are important, and over performance is measured relative to the adjusted CSO

25. These PSB transactions occur ‘automatically’ between resources in the same portfolio • The score of each resource effects the portfolio’s net payment • Assume both resources from the prior example are part of the same portfolio, but that there is no Performance Score Bilateral between the two resources Resource 1 • Score1 = 0.5 MW Performance Payment* = $2,500 Resource 2 • Score2 = -0.5 MW Performance Payment = ($2,500)Net Performance Payments = $0 • The result is the same as in the PSB example * Presuming a Performance Payment Rate of $5,000/MWh

26. No zonal check is needed with a PSB • The score of the supplementing resource can only offset the score of the supplemented resource during the same interval • If there is no scarcity at the supplementing resource’s location, the supplementing resource has a zero score Example: For the same 5-minute interval • Resource 1 (in Rest-of-Pool) • Before PSB settlement: Score1 = 0.0 – because there was no scarcityAfter PSB settlement: Score1 = 0.0 • Resource 2 (in an import-constrained zone) • Before PSB settlement: Score2 = -0.5After PSB settlement: Score2 = -0.5

27. ‘Obsolete’ SAB requirements and limitations when converted to PSB • Eligibility: Under FCM PFP, ANY resource with a positive score can transfer that score – therefore the following is obsolete • SABs are restricted to non-intermittent resources • SABs only allow amounts > the full CSO to be transferred • Designation: Under FCM PFP, ANY resource providing energy or designated as providing reserves has a score – therefore the following is obsolete • SABs require that the transferred amount be offered (available) in the energy market, and hence limited to a single Operating Day

28. exemptions

29. Why are there no exemptions? • (Some) exemptions encourage entry by poor performers • Exempt resources do not need to factor performance risk in FCA bids • Exemptions pay for non-performance • Well-designed market do not pay an “allowance”, they pay for goods delivered. Pay for non-performance undermines incentives. • Exemptions create a cost-shift problem that others bear • ISO must pay the resources that did perform. • Who pays that cost if non-performing resource “A” gets an exemption? • Slippery-slope problem.

30. Logistics & timing

31. Logistics & Timing • ISO Direction: ISO White Paper (October 2012) onFCM Performance Incentives Also at: http://www.iso-ne.com/spi > Materials • Timeframes: • Mar-Sep 2013: Markets Committee • Fall 2013: MC & PC votes • Q4 2013: FERC Filing • Implement: For FCA 9 (FCA held 2015, CCP of 2018/19) • A major initiative: Impact analysis with MC Q2-Q3 2013

32. Andrew Gillespie agillespie@iso-ne.com • Ron Coutu rcoutu@iso-ne.com Matthew White mwhite@iso-ne.com