Bob Ethier, Ph.D. Manager, Market Monitoring & Mitigation May 10, 2002

1. A Discussion of“An Empirical Assessment of the Competitiveness of The New England Electricity Market”(Bushnell, Saravia 2002) Bob Ethier, Ph.D. Manager, Market Monitoring & Mitigation May 10, 2002

2. Objectives of the Study • To determine the extent to which market power is exercised by developing a “counterfactual” competitive benchmark against which wholesale power prices may be compared.

3. What is the competitive benchmark? • An estimate of the wholesale market price that would exist if no market participant exercised market power. • This estimated market price equals the incremental costs associated with the cheapest unit that is not needed to serve demand in a given hour. • The benchmark is based on the economic principle that a price-taking market participant will produce power from a generating unit as long as the incremental costs incurred do not exceed the revenues from selling that power.

4. What incremental costs comprise Bushnell’s competitive benchmark? • Direct fuel costs reflect spot prices for all fuels except for high-sulfur coal. • Environmental costs are the average traded permit prices for SO2 and NOX. • Variable O&M costs are based on publicly available sources.

5. How is this benchmark price used in measuring market power? • Bushnell compares this benchmark price to 3 different measures of wholesale market prices: • ISO-NE’s reported Energy Clearing Price. • The price at which market demand intersects the aggregate supply curve from all generation units’ price bids. • The price at which market demand served by thermal units intersects the aggregate supply curve from thermal units’ price bids. • An indeterminate range of error exists around benchmark level (e.g., environmentally limited units not explicitly considered, hydro assumed to be perfectly competitive).

6. How are the generating units modeled in computing the benchmark price? • Thermal units: • For a given demand level, marginal costs = the incremental costs associated with the last available unit necessary to meet that demand, given the unavailability of other units due to random forced outages. • Monte Carlo technique used to simulate each unit’s outage probability.

7. How are the generating units modeled in computing the benchmark price? (cont.) • Nuclear, Cogeneration and Small Thermal • Bid price and actual availability are used to proxy the true marginal cost and availability • Hydro and geothermal • Actual observed output is assumed to equal the optimal (least-cost) output expected in a competitive market. • Consequently, in determining the benchmark price, hydro and geothermal production are assumed to be optimal. The marginal costs of meeting the remaining demand by thermal resources are then calculated.

8. Results • Bushnell calculates price-cost margins for the 3 different measures of wholesale prices mentioned above. These margins are expressed as quantity-weighted Lerner indices. • In this report, these Lerner indices measure the percentage of wholesale price over the benchmark at a given time, weighted by power demand at that time. • This is averaged over the period of the study (May 1999-Sept. 2001) • On the following page is a comparison of ISO-NE with PJM and CAISO for May-December 1999 (the only period in which the results of similar market power studies are available).

9. Comparison among US electricity markets: May-Dec 1999

10. Results • For the period May 1999 - September 2001, the 3 measures of wholesale market prices in New England produced the following quantity-weighted Lerner indices: • Energy Clearing Price (ECP) : 12% above benchmark • This includes expected physical dispatch inefficiencies and unit operating constraints. • All-unit aggregate energy bids: 4% above benchmark • “Cleanest” measure of market competitiveness • Major thermal energy bids and quantities supplied: 11% above benchmark. • Ignores bid mitigation due to transmission congestion • These differences reflect various factors such as day-ahead and real-time operations, congestion management, unit operating constraints, and self-scheduled capability.

11. Results (cont.) 1. New England wholesale markets compare favorably with others in the U.S. However, this may change with level of forward contracting and reserve margins. New market rules should help. 2. Further refinements to the benchmark price analysis is desirable. Such refinements include removing simplifying assumptions such as optimal hydro resource bidding and price-insensitive imports. 3. Benchmark analysis is a useful tool for analyzing market performance, but it is not sufficient by itself for determining whether intervention in markets is required (long-run analysis tool not suited to real-time analysis).