VAR/FCM Double Recovery Compliance Changes

1. VAR/FCM Double Recovery Compliance Changes Janine Dombrowski 04/28/2010

2. Overview • VAR FCM Double Recovery Compliance • Background on FERC Orders • Summary • Market Rule Revisions • MPUC Proposal • Conclusion

3. Background on FERC Orders • February 28, 2007 FERC Order (ER07-397-000) “(t)he Commission agrees with ISO-NE that transition payments do not compensate resources for their reactive power capabilities since they are below the cost of new entry; however the Commission is concerned that double recovery can occur during the first FCA since the payments equal the cost of new entry. The ISO commits to proposing, for implementation prior to the first FCA commitment year, Tariff provisions to ensure that Resources eligible for CC payments under Schedule 2 for providing reactive supply and voltage control do not receive double compensation. Accordingly, the Commission will require ISO-NE to implement, prior to the commencement of the first FCA commitment year beginning June 1, 2010, tariff provisions to ensure that resources eligible for CC payments under Schedule 2 that provide reactive supply and voltage control do not receive double compensation.

4. Background on FERC Orders • FERC agrees with the ISO’s game theoretic analysis • The ISO game theoretic analysis, filed October 2008 (EL07-38-000), demonstrates the absence of a double recovery issue in a competitive FCA. Under the FCM design, bidders have an incentive to bid a price which reflects the minimum revenue needed to support investment costs net of expected revenue from other markets and from other revenue streams. Bidding at prices above this level would result in resources pricing themselves out of the market. • FERC agrees with the ISO’s game theoretic analysis in the Order denying the MPUC complaint on February 3, 2009. “We find that ISO-NE and its supporting parties have demonstrated to our satisfaction that capacity payments under the FCM settlement agreement (both during the transition and from the Forward Capacity Auctions) and capability payments for reactive service under Schedule 2 do not result in double recovery of capital costs.”

5. Background on FERC Orders (continued) • The Commission further states that, “We agree that sellers in a competitive Forward Capacity Auction will have an incentive to submit bids that take into account revenues from the CC Rate component and, as a result, double recovery is not a concern.” • The first three FCAs were certified as competitive so double recovery is not a concern for the first three Commitment Periods. • The Market Monitor analyzes each FCA and provides an assessment of the competitiveness of the FCA (per Section III.13.8.2).

6. Background on FERC Orders (continued) • If a resource without VAR capability sets the auction clearing price, there is not a concern about double recovery. • In the February 3, 2009 order (EL07-38-000), FERC dismisses the concern of double recovery if a resource without VAR capability sets the FCA auction clearing price. “We acknowledge,…, that if a capacity resource without VAR capability (e.g. a demand response resource) sets the auction clearing price, a new VAR-capable resource would not recover its VAR-related capital costs without the CC Rate component of Schedule 2 and, therefore, would not receive double recovery.”

7. Summary • FERC Orders: • Support ISO’s game theoretic analysis • Agree with the ISO analysis that FCA capacity payments and Schedule 2 capability payments do not result in double recovery of capital costs • Provide that there is no concern about double recovery • During the transition period, or • When the FCA is determined to be competitive (which includes those FCAs conducted to date), or • When the FCA clearing price is less than “true” cost of new entry or • When the FCA clearing price is set by a resource without VAR capability

8. Summary (continued) • January 2010 FERC Order (ER07-397-004) requires the ISO to change tariff language prior to 6/1/2010 to prevent double recovery out of “an abundance of caution.” • This compliance obligation results from an ISO commitment to evaluate double recovery concerns and make tariff revisions. • NEPOOL Markets Committee supports ISO proposal to address double recovery compliance requirement within Market Rule 1 • ISO proposal received a 73.59% vote of support at NEPOOL Markets Committee in April 2010.

9. Market Rule Revisions • Compliance with the FERC order requires that a resource setting the FCA clearing price be prohibited from including anticipated revenues it expects to receive as a Qualified Reactive Resource under Schedule 2. • Existing Resources are prohibited from including such revenues through existing mechanisms and protections. • New Resources are precluded from including such revenues through the new Markets Committee-approved Market Rule 1 language.

10. Market Rule Revisions (continued) • Setting the FCA clearing price • Existing Resources may only set the FCA clearing price through the de-list bid process. • Mechanisms are already in place to ensure that existing resources do not include expected other market revenues in their FCA de-list bids. These expected other market revenues include the expected revenues under Schedule 2. See III.13.1.2.3.2.1.2. Net Risk-Adjusted Going Forward Costs. • The Market Monitor reviews the data submitted in support of the de-list bids as part of the FCA qualification process. • New Resources may set the FCA clearing price so the Market Rule change focuses on New Resources and limits what may be included in an FCA offer from a New Resource.

11. Market Rule Revisions (continued) • Markets Committee Approved Language • III.13.1.1.2.2.3 Offer Information “By submitting a New Capacity Qualification Package, the Project Sponsor certifies that an offer from the New Generating Capacity Resource will not include any anticipated revenues the resource is expected to receive for its capacity cost as a Qualified Reactive Resource pursuant to Schedule 2 of Section II of this Tariff.” This language prohibits a new resource from including anticipated revenues it expects to receive as a Qualified Reactive Resource under Schedule 2 in its FCA offer. This language meets the FERC compliance requirement.

12. MPUC Proposal • MPUC proposal to address the double recovery compliance requirement by modifying Schedule 2 • does not align with a market structure, and • is based on a “faulty notion” about the structure of the FCA and the VAR CC rate.

13. MPUC Proposal (continued) • Why it does not work in the existing market structure: • The FCM isa market with a uniform clearing price which forms the basis of the price paid to resources and is not a unit-by-unit pay-as-bid construct. • In a competitive FCA the resource setting the FCA clearing price will not include any anticipated revenues it expects to receive pursuant to Schedule 2 of Section II of the tariff or from other markets. • The VAR program rate is a negotiated New England-wide proxy rate that is not based on the costs associated with the equipment of a particular generator.

14. MPUC Proposal (continued) • FERC highlights problems with MPUC assumptions • The MPUC proposal is based on a continuing misunderstanding of the market construct of the Forward Capacity Market, which FERC commented on in its February 3, 2009 Order denying the MPUC Complaint (EL07-38-000) “… we previously found that reactive service is a unique service the compensation for which is not covered by capacity payments, whether transition payment or auction revenues. Again, nothing in this complaint has persuaded us to reverse our previous determination that the provision of reactive service requires payment separate from, and in addition, to those received in the Forward Capacity Market.”

15. MPUC Proposal Discussion (continued) • FERC highlights problems with MPUC assumptions (continued) “We agree with ISO-NE that the complaint is “based on a faulty notion that the VAR CC Rate cannot be just and reasonable because of cost overlap judged on a phantom cost-of-service basis.” In other words, neither the FCM payments nor the payments under the CC Rate component arise from a traditional cost-of-service methodology, under which specific costs are allocated to a service class to produce a set rate. On the contrary, both the CC Rate component and the FCM payments (both transition and auction) are not “’cost-of-service’ rates based on the costs of the particular generators providing the two distinct products—VAR service and capacity.” Therefore, treating these two payment methodologies as if they were derived from a cost-of-service basis results in misleading, if not inaccurate, conclusions.” (emphasis added)

16. Conclusion • The ISO continues to support the Market Rule 1 revisions to address the compliance obligation, which: • fully meets the FERC compliance requirement ; • ensures that the resource setting the FCA clearing price -- consistent with competitive market behavior -- does not include compensation for VAR revenue in its FCA offer; • does not require a resource-by-resource cost-of-service accounting of costs and revenues. • The ISO does not support the MPUC proposal.