“Recent Electricity Auctions”

1. “Recent Electricity Auctions” Dr. David J. Salant Senior Vice President National Economic Research Associates June 2003

2. Agenda • Electricity restructuring, auctions and new markets • New Jersey Basic Generation Service auction • Texas Capacity auctions • CALPX/CAISO • Alberta • FTR auctions • Parallels in other states and other types of electricity markets

3. Auctions and Regulation • Auctions have been used increasingly to replace regulatory processes • Spectrum auctions replaced beauty contests and lotteries • Default Service Auctions • Customers who are not being served by a competitive “third party” supplier must be served by the electricity distribution company at regulated rates • Auctions now have been used for utility energy purchases to serve these consumers • RFPs tend to be followed by bilateral negotiations, providing more scope for regulators to question the results. • Entitlements and PPAs • Utilities required to divest assets • Rather than sell off entire assets, auctions now are used to sell entitlements, strips, PPAs, as in Texas and Alberta

4. New Types of Electricity Auctions • Simultaneous clock auctions • Used for buying or selling multiple units of a few types of lots or products, such as system slices or energy entitlements. • First application for default service procurement was Simultaneous Descending Clock Auction (SDCA) which NERA developed for New Jersey. • Variations of clock auctions have been used to sell energy entitlements in Texas capacity auctions and French VPPs. • Clock auctions are well suit for interconnection capacity. • Simultaneous multiple round auctions has been used on one occasion for selling PPAs in Alberta. • Other, more traditional, auctions such as Yankee auctions and English auctions used for energy entitlements in Alberta and for interconnection in Netherlands did not work well.

5. Auction Design Objectives • Auction design adopted should best match objectives • Simultaneous multiple round/clock auctions are appropriate for efficiently allocating multiple lots, with value interdependencies, such as energy entitlements, capacity and spectrum licenses • Theory suggests that simultaneous auctions will result in economically efficient assignments assuming substitutes and “straightforward” bidding • Simultaneous auctions work adequately when bidders have similar views about complements • Clock auctions are well suited for dividing shares of load. • Simultaneous auctions can create some incentives for bidders to withhold supply, but these incentives can be mitigated with volume adjustments • Simultaneous auctions work less well with strong, overlapping complements

6. The New Jersey BGS Auction 6

7. The New Jersey BGS Auction • Four utilities were under legislative mandate to purchase energy in a competitive bidding process. • NJ EDCs needed to secure one-year forward supplies for approximately 17,000 MW of forecast peak load • Auction was for one year forward contracts. • The auction outome • Prices appeared to be competitive, between 4.87¢ and 5.82 ¢ for entire year. • Over 20 bidders competed to sell and there were 15 winners. • in first ever simultaneous descending price clock auction. • New Jersey Board rendered decision on auction results within 48 hours of the close of the auction

8. New Jersey Winning Bidders 15 9 1 15 5 1 3 20 5 10 2 5 1 5 3 1 15 5 6 9 4 7 3 12 8 BGS Winning Bidders for Year 4 Winning Bidder Number of Tranches Won per EDC territory PSE&G JCP&L Conectiv RECO 5.112 ¢/kWh 4.865 ¢/kWh 5.117 ¢/kWh 5.819 ¢/kWh ALLEGHENY ENERGY SUPPLY AMERADA HESS CORPORATION AQUILA ENERGY MARKETING CONECTIV ENERGY SUPPLY INC CONSOLIDATED EDISON ENERGY DTE ENERGY TRADING INC DUKE ENERGY TRADING FIRSTENERGY SOLUTIONS CORP MIECO NRG ENERGY PPL ENERGY PLUS CORP SELECT ENERGY INC SEMPRA ENERGY TRADING CORP TXU ENERGY TRADING WILLIAMS ENERGY MARKETING & TRADING

9. What was Being Purchased? • Full requirements slices of BGS load of each EDC • Payments will be based on load measured at the PJM interface—no risk of losses • Slices set at roughly 100 MW resulted in • 96 PSE&G tranches • 51 GPUE/JCP&L tranches • 19 Conectiv tranches • 4 RECO tranches • Starting prices set by auction manager/EDCs • Maximum and minimum possible starting prices in the EDC filing • Not capped by shopping credits • Will be based on indicative bids • Will provide adequate risk premiums • Auction manager had discretion to restrict auction volume if competition proves very limited

10. Market Background • NJ EDCs BGS requirements of nearly 17,000 MWs represented over 95% of all NJ energy consumption • Total native capacity of approximately 20,000 MW including some NUGs (although 29,600 MW showed up at the start of the auction) • PS Power controlled 57% of native resources • The top four firm concentration, HH4 = 76% • Limited import capacity from South and West through PJM • Energy prices North and East in NYISO tends to be higher than in NJ • PJM structure facilitated competition in the auction • FTR allocation coordinated with BGS contract • PJM spot market provided options for both buyers and sellers

11. The New Jersey Year 5 BGS Auction 11

12. Changes to the BGS Auction in Y5 • BGS Load Split into two groups: • Hourly Electric Price (CIEP/HEP) for large corporate and industrial customers • Fixed Price (FP) for small and residential customers • Separate but concurrent SDCAs will be held: • HEP Auction is for capacity ($/MW-day) • FP Auction is for all-inclusive price (¢/kWh, same as Y4) • Regulatory approval for each auction’s result is separate. • Winning Bidders sign different contracts; BGS-HEP Supplier Master Agreement and BGS-FP Supplier Master Agreement differ.

13. Design of the New Jersey BGS Auction 13

14. BGS Auction Rules—Overview • The standard Simultaneous Multiple Round (SMR) auction format • Bidding in rounds • Reverse auctions—the sellers bid • Uniform pricing • Form of bids—quantities instead of prices • Total bids cannot increase • Switching—suppliers can switch between EDCs during auction • Ending the auction

15. Sample Results – Start of Auction 96 51 19 4 $63.44 162 1.69 3.44% $62.90 86 1.69 3.43% $63.37 31 1.63 3.16% $60.45 6 1.50 2.50% 285 Round 1 EDC # Bid # Available Ratio Price %Δ PSEG $65.00 142 1.48 2.40% JCP&L $65.00 84 1.65 3.24% Conectiv $70.00 55 2.89 9.47% RECO $62.00 6 1.50 2.50% Totals 287 170 1.6882 Round 2 EDC # Bid # Available Ratio P rice %Δ PSEG 96 JCP&L 51 Conectiv 19 RECO 4 1.6765 Totals 170

16. Sample Results – Near Auction End Round EDC 42 # Bid # Available Ratio Price % Δ PSEG $52.10 102 96 1.06 0.31% JCP&L $53.10 62 51 1.22 1.08% Conectiv $49.50 20 19 1.05 0.26% RECO $56.40 4 4 1.00 0.00% Totals 188 170 1.1059 Round EDC 43 # Bid # Available Ratio Price %Δ PSEG $51.94 100 96 1.04 0.21% JCP&L $52.53 63 51 1.24 1.18% Conectiv $49.37 20 19 1.05 0.26% RECO $56.40 4 4 1.00 0.00% Totals 187 170 1.1

17. Exit Bids 5.2¢ 97 5.175¢ 51 51 5.1¢ 5.1¢ 5.05¢ 19 5.05¢ 19 6.2¢ 4 6.2¢ 4 • The following situation is possible: Round 44 price /kWh Round 45 price /kWh Tranches bid Tranches bid PSE&G (20) 94 JCP&L (12) Conectiv (5) RECO (1)

18. Exit Bids • When bidders reduce their quantity, they can elect to submit an exit price • An exit price is a final price for a slice on which a bidder will no longer be bidding. • Exit prices are • EDC specific • Required to be below the previous round’s going price and above the current round’s price e.g., between 5.2¢ and 5.175¢ • If auction ends, slices would be allocated at the exit price of the slice that just fills the load for the product

19. Other Auction Features • Additional Rules • Size of decrement depended on excess of tranches subscribed over number of tranches available • If an EDC’s tranches are just subscribed or under-subscribed, bidders were not allowed to decrease number of tranches offered • Switching restrictions—switching was not allowed if it would result in under-subscription • Load caps—each EDC imposed a maximum on the number of tranches that a bidder can supply • Pace • Length of rounds were kept as short as possible, but to still allow bidders time to decide on when to reduce eligibility or switch • Bidders allowed limited recesses toward end of auction

20. Auction Closing Rules • As long as there is some excess supply for at least one product (more slices subscribed than available) • Bidding continues • Prices continue to tick down from one round to the next • At a given point in the auction there can be excess supply for one product but not for others • For auction to end • Bidding on all products must have stopped • The offered supply equals the number of available slices for all products • Bidders are paid the closing prices per MWh

21. Starting Prices andAuction Volume Adjustments • Starting prices and auction volume adjustments are two instruments to limit adverse consequences if there is limited competition in the auction • The Auction Manager announced starting prices three days prior to auction • Starting prices were required to be above PJM forward curve by a percentage that was approved by the BPU • Indicative bids were due two weeks prior to the auction will factor into the setting of the starting prices

22. Starting Prices andAuction Volume Adjustments Continued… • Target auction volume could be adjusted based on total interest • If supply, as expressed in the indicative bids is limited, auction volume could have been reduced • Target auction volume was to have been set at no more than a multiple of initial supply • Further auction volume adjustments permitted based on competition

23. Auction Design Issues • Factors affecting expected supplier costs/bidder values • NUG contracts—tranche size depended on existing NUG contracts • Line losses in the distribution system • Capacity obligations • BGS suppliers are required to satisfy the renewable energy (green) standards. Combined rate ranges from 3% in 2002 gradually up to 6.5% in 2012 • Starting prices • Back-up provisions if supply was limited—auction volume adjustments • Minimum stay rules, customer switching, slamming • Implementation—credit, qualification, software

24. The Texas Capacity Auctions 24

25. The Texas Capacity Auctions • The Texas Public Utility Commission (PUC) mandated auctions of capacity by Power Generation Companies (PGCs) beginning August 23, 2001 • All the PGCs (AEP, Reliant and TXU) have been required to sell at least 15% of total capacity • The PUC has imposed specific auction mechanics—including simultaneous auctions of all PGC capacity of a given duration: • Auctions were initially parallel and simultaneous auctions • Activity rules initially were not comparable to usual SMR auction formats • Due to price gaps, PUCT adopted switching rule

26. The Texas Capacity Auctions Continued… • Sellers were provided some latitude in setting starting prices and minimum bid increments • Differences in approaches to starting prices and bid increments drove auction dynamics in some cases

27. Auction Background • Products are 25 MW entitlements defined by • Zone (North, South, West and Houston (except first auction)) • Type (baseload, gas-intermediate, gas-cyclic, gas-peaking) • Seller (AEP, Reliant, TXU) • Term (2-year, 1-year, 1-month) • Timing • Quarterly auctions • At each quarterly auction, there were: • All 2-year contracts were auctioned simultaneously (all types in all zones by all PGCs) • Then, all 1-year contracts were auctioned simultaneously • All 1-month contracts were auctioned simultaneously were auctioned last

28. Implications of Texas Experience for FTR/CRR and Capacity Auctions • FTR auctions in CA and elsewhere do not allow switching between substitute paths • As in Texas, equivalent FTRs can and are likely to sell for much different prices • Lack of switching implies • Bidders need to guess when developing bidding strategy • Allocative inefficiency when higher value bid on one FTR loses to lower value bid on a near or perfect substitute FTR (or CRR) • NYISO, ISO-NE, PJM are also planning to run parallel auctions for each zone

29. Additional Factors in CRR/FTR Auction Design • Kirchoff’s law implies possible non-convexities in set of feasible power transfers • Non-convexities of feasible set will imply that support prices (LMP) will result in corner solutions • Implications for auction is that strong incentives can exist for bidders to strategically under or over report net demands • Package bidding and contingent bidding can be useful in finding optimal allocations • Testing can involve simulation and experiments • Recent developments in package bidding include SAAPB adopted by FCC and Ausubel-Milgrom proxy bidding procedures

30. Alberta PPA Auctions 30

31. Alberta PPA and MAP Auctions • Alberta conducted two sets of auctions • PPA auction for 12 PPAs in late 2000 • MAP auction for strips from unsold PPAs in 2001 • PPAs for energy entitlements of generating units • Auction was a variation SMR auction format used in NJ BGS and developed for FCC spectrum auctions

32. Alberta Power Purchase Arrangement:Auction Results

33. CALPX/CAISO 33

34. California Energy Markets • Three utilities – PGE, SDG&E/Sempra and Southern California Edison • Peak demands of approximately 45K MW in summer months • 18% of supplies from imports • Five main generators controlled nearly half of fossil fuel generation within CA • Summer 2000 crisis began and continued past the close of the CALPX in Feb. 2001 with • Stage 2 emergencies declared on scattered days in May – September 2000 • Stage 3 emergencies in Dec. 2000 (1 day), January 2001 (18 days), February 2001 (16 days), March 2001 (2 days) and May 2001 (2 days). • Average loads of < 33K MW through the latter part of the crisis • AB 1890 mandate IOUs purchase energy through CALPX/CAISO

35. Some Explanations of What Happened? • Strategic withholding of supplies (JK & BBW) and less than perfectly competitive behavior (Puller) • Lack of forward contracts • CALPX had block forward market, • IOUs were permitted to purchase much more block forward than they did and they could hedge with derivatives • Ex post regulatory review of forward/derivative purchases placed all the downside risk with IOU, so this was not a factor • Ability of other WECC buyers to be active in forward markets and inability of CA IOUs placed burden on latter (Allaz and Vila/Salant&Loxley – NJ experience) • Lack of capacity credits/markets or regulation • Nature of equilibrium in CALPX/CAISO SFE type auctions

36. CA 3 large utilities Moderate HHI in generation Capacity and other reserves needed to respond to demand peaks no longer mandated CAISO/WECC – provides links between zones High price spikes CALPX/CPUC did not give utilities much of an out Theoretically unsound Supply Function Auction format NJ 3 large utilities High HHI > 3200 in generation Significant transmission constraints to the remain of PJM Capacity credit market mandates reserve margins Outcome competitive average 5.1¢ for entire year Combination of primary long term contracts and options for spot and short term contracts gave more flexibility for buyers to get a more competitive price Clock auction designed to attenuate market power of the sellers NJ vs. California

37. Example: Price Competition with Capacity Constraints • One buyer who demands D units at any price up to R. • Two sellers. Each seller can produce up to its capacity K at zero marginal cost. • K < D, so neither seller can supply the whole market. • Sellers compete in prices – each seller names a single price at which it will sell up to K units. • Supply is dispatched in order of increasing price, and sellers are paid as bid.

38. No MC Equilibrium Price Demand p2 = R Profmin Supply p1 = 0 Units D K If both set p = MC, then each sells D/2 at price 0, earning a profit of 0 If Seller 2 charged R instead, it would sell D – K earning a profit of Profmin = R(D – K).

39. Applicability of SDCA in Other States 39

40. US Experience with Competition in Generation Services

41. Division of Load and Contract Terms • Many options for dividing up load • Uniform slices of system • Division by customer segment • Firm and non-firm tranches • Metered vs. non-metered customer segments • Contract terms • Wholesale vs. resale • Fixed price service vs. variable (market) price • Seasonal adjustments • Duration • Uniform vs. non-uniform • Length

42. Contract Duration • SDCA can permit contracts of different durations – e.g., Texas capacity auctions • Some longer term contracts can facilitate bidder financing • Some shorter term contracts can allow bidders to adjust portfolios, and can be especially useful for bidders with plants coming on or going off line.

43. CA: Demand and Supply Concentration • As in NJ experience, CA has three main utilities • Supply in California is less concentrated than in NJ • Import capacity comparable in both regions • Affiliation of PS Power with PSEG for approximately 50% of native energy was potential limitation of benefits of the auction • PJM FTR approach facilitated competition in auction for default service load procurement • CAISO only control intra-state transmission, inter-state transmission with rest of WECC could limit competition in an auction

44. Forward vs. Day Ahead Markets • Auction volume adjustments left open possibility of load procurement in day ahead or hour ahead markets • Suppliers apparently wanted to avoid having to sell in what could be a competitive day ahead market, and so had incentives to bid aggressively in BGS auction • Starting prices and process were reviewed and approved by BPU in advance of auction • Auction process required BPU review within 48 hours of auction close • EDC and supplier exposure to risks were both mitigated by prior approval and transparency of process