Proposal: Modify FRM Offer Cap & Forward Capacity Auction Price Netting Rules

1. August 11-13, 2015 | NEPOOL MARKETS COMMITTEE Christopher Parent CPARENT@ISO-NE.COM | 413.540.4599 Proposal to modify the FRM offer cap and Forward Capacity Auction price netting rules Forward Reserve Market Offer Cap

2. Contents • Problem summary slide 3 • Recommended modifications slide 12 • Summary and schedule slide 22

3. Problem Summary Recap of concerns discussed at April 2014 MC

4. Current FRM offer cap is $14/kW-month was set in 2006 The Forward Reserve Market (FRM) clearing price is reduced by the Forward Capacity Auction (FCA) clearing price to set the FRM payment rate (i.e., the “price netting rules”) Thus, the effective FRM offer cap is: $14/kW-mo minus the FCA clearing price (capped at zero) FCA clearing prices for 2016/17 (CCP7), 2017/18, 2018/19 have approached or exceeded $14/kW-mo Suppliers will not participate if the effective FRM offer cap does not allow the incremental costs of providing forward reserves to be reflected in their offers The effective FRM offer cap is likely too low in upcoming FRM auctions to attract sufficient supply

5. FRM price netting rules can produce inappropriate market outcomes when there is FCA price separation • Higher-cost reserve suppliers may be selected in the FRM auction instead of lower-cost reserve suppliers when the FCA clearing price associated with the location of the higher-cost reserve supplier is lower • FRM payment rate may be lower for constrained reserve zones than for rest-of-system when constrained reserve zones have a higher FCA clearing price • FRM may pay a ‘premium’ in some reserve zones when marginal supplier for meeting system requirements has a FCA clearing price that is higher than the FCA clearing price associated with other reserve zone

6. Examples Stylized demonstrations of problems with current FRM offer cap and price netting rules

7. The price netting rules can result in the Forward Reserve Payment Rate being $0.00/kW-month when the FCA clearing price exceeds the FRM offer cap When the FCA clearing price exceeds the FRM offer cap, there is no market incentive for suppliers to offer into the FRM because there is no incremental value in clearing (the Forward Reserve Payment Rate will be zero) Example 1A. Suppliers may not offerinto the FRM when the FCA clearing price exceeds the FRM offer cap

8. Participant C would likely not offer into the FRM as the maximum potential monthly FRM payment rate would be $7.00 which is below their incremental FRM cost of $8.00 FRM auction offers cannot exceed the FRM offer cap of $14.00 The maximum FRM clearing price is the FRM offer cap Under conditions in which FCA clearing price approaches the FRM offer cap, there is an increased likelihood that suppliers would choose not to offer into the FRM because they are unable to offer and recover their incremental FRM costs Example 1B. Suppliers may not offer into the FRM if their costs exceed the effective FRM offer cap

9. Assuming that the NEMA reserve constraint is not bindingand the offer from either Participant A or B would meet the system requirement, the FRM would clear the offer from Participant B The FRM clearing price would be $7.00 for the system and NEMA Participant B would be paid $4.00 to provide forward reserves However, Participant A’s offer (that did not clear) would have been a less costly option (only $2.00) to meet the reserve requirement Example 2. Higher incremental FRM cost offers may clear instead of lower incremental FRM cost offers

10. Assuming that the NEMA reserve constraint is not binding and the offers from Participant A and B are both required to meet the system requirements, the FRM clearing price would be $9.00 The NEMA FRM payment rate is $2.00 Participant A is compensated at their incremental FRM costs The system FRM payment rate is $6.00 (which is higher than the NEMA FRM payment rate ) Participant B receives a premium of $4.00 (difference between the NEMA and system FCA clearing prices) to meet the same requirement Example 3A. Suppliers may receive a ‘premium’ if a constrained zone offer is marginal to meet the system requirement

11. Assuming that the NEMA reserve constraint is binding and the offers from Participant A and B are marginal to meet the respective requirements, the FRM clearing price would be $9.00 for NEMA and $7.00 for system The NEMA FRM payment rate is $2.00 and the system FRM payment rate is $4.00 The system FRM payment rate exceeds the NEMA FRM payment rate even though the requirement for the constrained NEMA zone was binding Example 3B. System FRM Payment Rate can be higher than the zonal FRM Payment Rate

12. RECOMMENDED MODIFICATIONS Revising FRM offer cap and removing FCA price netting

13. FRM is intended to provide compensation for the sale of forward reserves • Even under the current design, in competitive auctions the FRM offer cap is irrelevant since the auction clears at the incremental cost of providing forward reserves • Assuming the effective FRM offer cap is sufficiently high for suppliers to reflect incremental costs • In non-competitive conditions (including insufficient supply to meet requirements), there is a potential for ‘double recovery’ of capacity costs with the current FRM offer cap • This was the primary driver for including the price netting rules

14. ISO recommends modifying the FRM offer cap to eliminate the need for price netting rules • FRM offer cap will be set reflecting the estimated cost to meet an FRM obligation considering foregone real-time payments, non-performance penalties, and reasonable risk premiums • The cap will not be set including assumptions of costs required for a new aero CT, but rather on the incremental cost of providing the forward reserves – thus removing concerns of ‘double payment’ • Modifying how the FRM offer cap is established allows for the price netting rules to be eliminated • FRM offers should reflect only incremental costs of taking the FRM obligation • Removing the price netting rules will address the potential inappropriate market outcomes identified earlier

15. Examples - REVISITED Demonstrating how problems are addressed by revising the FRM offer cap and eliminating price netting rules

16. Previously (slide 7) we observed that when the FCA clearing price exceeds the FRM offer cap it would inhibit FRM offers from suppliers with non-zero incremental FRM costs Eliminating the price netting rules will prevent FCM prices from inhibiting supply participation in the FRM Example 1A. Suppliers may not offerinto the FRM when the FCA clearing price exceeds the FRM offer cap

17. Previously (slide 8) we observed that Participant C is unlikely to offer into the FRM because their incremental FRM costs ($8.00) exceed the maximum possible FRM payment rate ($7.00) Eliminating the price netting rules will prevent FCM prices from inhibiting supply participation in the FRM Setting the FRM offer cap sufficiently high (without price netting rules) will allow the FRM to provide adequate compensation for the sale of forward reserves Example 1B. Suppliers may not offer into the FRM if their costs exceed the effective FRM offer cap FRM Offer

18. Previously (slide 9) we observed the FRM would clear Participant B (with higher incremental FRM costs but a lower total FRM offer) if only one of these offers were needed. The cost of forward reserves would be $4.00 Assuming that the NEMA reserve constraint is not bindingand the offer from either Participant A or B would meet the system requirement Eliminating the price netting rules will allow suppliers to bid only their incremental FRM costs Participant A with lower costs would be selected instead of Participant B to provide forward reserves at a cost of $2.00 Example 2. Higher incremental FRM cost offers may clear instead of lower incremental FRM cost offers FRM Offer

19. Previously (slide 10) we observed the FRM would clear both offers with a single clearing price of $9.00, but payment rates of $2.00 for NEMA and $6.00 for system (a ‘premium’ for system suppliers) Assuming that the NEMA reserve constraint is not binding and the offers from Participant A and B are both needed for the system requirement Eliminating the price netting rules will allow suppliers to bid only their incremental FRM costs Participant B would instead set the clearing price at $4.00 and all suppliers meeting the requirement receive this price Example 3A. Suppliers may receive a ‘premium’ if a constrained zone offer is marginal to meet the system requirement FRM Offer

20. Previously (slide 11) we observed the FRM would clear both offers to meet their respective requirements and set a clearing price of $9.00 for NEMA and $7.00 for system. However, after netting the FCA price, the FRM payments rate is $2.00 for NEMA and $4.00 for system Assuming that the NEMA reserve constraint is binding and the offers from Participant A and B are marginal to meet the respective requirements Eliminating the price netting rules will allow suppliers to bid only their incremental FRM costs The lower-cost NEMA offer (Participant A, $2.00) would clear first, the NEMA constraint would not bind, and the clearing price for both zones would be set at $4.00 by the system offer from Participant B Assuming the Participant A offer is sufficient MW to meet the NEMA requirement, but not the total system requirement Example 3B. System FRM Payment Rate can be higher than the zonal FRM Payment Rate FRM Offer

21. Summary and Schedule Recap and next steps

22. Summary and Schedule • FRM offer cap will be set based upon the incremental costs of providing forward reserves allowing for the price netting rules to be eliminated • Proposed changes will be in place for the summer 2016 FRM delivery period