Market Reform Proposals

1. Market Reform Proposals Pete Fuller NEPOOL Markets Committee March 12, 2013

2. Today’s Discussion • A bit of background • The building blocks: energy, ancillary services, capacity • A cohesive approach to the overall market design • Next steps

3. Qualifier • As currently structured and administered, FCM is deeply flawed: • Mitigation policies should provide the marginal existing resource a reasonable opportunity to recover all of its annual fixed costs • A demand curve that recognizes the incremental value of additional capacity is essential, especially in the absence of a supply curve based on long-run costs • Reliability reviews of existing resource offers (delist bids) should be eliminated; all constraints that are to be enforced through planning or operability criteria should be specified in the auction requirements

4. Background – The Cost of Doing Business Sources: Unit costs: ISO-NE RMR Agreements, http://www.iso-ne.com/genrtion_resrcs/reports/rmr/index.html FCA2-7 prices: ISO-NE website, http://www.iso-ne.com/markets/othrmkts_data/fcm/cal_results/index.html Potential FCA8 prices: UBS, “New England: The Next Bust and Boom,” November 6, 2012. “… beginning with the ‘17/18 auction (held in Feb ‘14), FERC has mandated the floor be removed resulting in a substantial degradation in capacity prices (at best $0.99/kW- mnth), however, given the over-supply, the auction prices could be much lower (closer to spot prices of ~$0.20/kw-mnth of late).”

5. What’s powering New England through the peak? • Look at fuel usage during high electricity demand on the peak of a summer day in 2011. Oil-fired resources produced 14% of electric energy during the peak but produced only 1% of electricity • over the entire year. Background – Fuel Diversity Benefits • At times of peak load – the periods that most influence Loss of Load Probability and ICR – oil and coal continue to be relied upon • on-site fuel storage is an inherent characteristic for these resources Source: ISO New England 2013 Regional Energy Outlook, http://www.iso-ne.com/committees/comm_wkgrps/strategic_planning_discussion/materials/2013_reo.pdf

6. The Building Blocks • Energy • Ancillary Services • Capacity

7. Real-Time Energy – the Foundation • RT Energy prices need to reflect the full cost (and/or value) of meeting demand and reserves at any given moment • This signal is critical to both supply and demand sides of the market • RT price exposure is a primary driver for efficient hedging behavior • DA Energy Market – hedge on a daily basis through a centralized financial mechanism • Standard and customized hedges are also available in the market through bilateral contracts • RT prices discipline behavior of suppliers with DA schedules

8. Ancillary Services • Provide access for ISO to the flexibility and responsiveness needed to balance and manage real-time load dynamics and contingencies • “It is important not to confuse the capacity product with operating reserve products. The capacity product is not an operating reserve product.” (Patton, 2/19/13) • Not all resources need to have high ramp rates, short start times, etc, but it is important that some do • LFRM, augmented by real-time reserves co-optimized with energy (plus regulation) provide the operating flexibility to maintain real-time reliability

9. Capacity • Capacity as a planning mechanism • Capacity requirements (ICR) are based on risk of disconnecting firm load – due to resource deficiency – in all hours, with most risk residing in peak load hours • As a result, the delivery of capacity should be measured in all hours, or a subset of hours reflecting the highest risk of resource deficiency • Capacity as an economic mechanism • Capacity market: the ‘balancing market’ through which resources can seek to recover fixed costs not covered by energy or ancillary service margins • Mitigation policy uses the wrong conceptual benchmark for capacity market offers Capacity price ≤ Total annual costs – (Energy & Ancillary margins) + Risk

10. An Alternative to ISO-NE’s Performance Incentives Proposal • Address energy market pricing problems in the energy market • Increase RCPFs to allow for automated re-dispatch in the event of reserve scarcity • Reflect reliability commitments in energy prices • Eliminate, or put a price on, all ‘unpriced operator actions’ • Real-time prices that reflect the full cost (and/or value) of meeting reserve constraints provide the same incentive as ISO’s proposal for suppliers to be available • Likely to be more efficient than ISO proposal since they will reflect actual conditions rather than a proxy rate

11. An Alternative, continued • The ‘penalty’ for unavailability/non-performance is buying back the DA obligation in real-time • Making scarcity pricing visible to buyers increases efficiency of incentives and hedging • Patton (2/19/13) raises concerns with ISO’s proposal that loads will not bid efficiently DA, DA prices may be suppressed, and there may be inefficient incentives to self-commit gen • Efficient real-time price formation in the energy market avoids these concerns • Additional hedges or options to limit the volatility of energy costs should be commercial products, not regulatory products

12. An Alternative, continued • Make the capacity product a capacity product • Procure enough to meet resource adequacy criterion • Primary obligation is to offer capability to the E&AS markets every day • Measure performance that is within the control of the resource owner, ie, how available is the resource’s full capability in the daily markets? • Focus on high-load hours where most of the resource deficiency risk resides • EFORp: probability that a resource will not be available due to forced outages or forced deratings when there is a demand on the unit to generate during defined peak hour periods

13. An Alternative, continued • Structure the capacity market to reward resources that exceed their target availability and penalize those that under-deliver • Target could be the resource’s long-run average availability, or a class average • Extended forced outages would necessarily result in economic consequences • PJM’s Peak-Hour Period Availability mechanism uses this framework (PJM Manual 18) • “[The Peak-Hour Period Availability] provision establishes a means to assess whether generation resources committed as capacity actually are available at expected levels during peak periods, and credits or charges resources to the extent they exceed or fall short of that expected availability. This will provide generation owners a significant added incentive to ensure that their capacity resources are available when they are most needed, and provide loads greater assurance that their payments for capacity will help maintain peak period reliability.”

14. An Alternative, continued • Eliminate Peak Energy Rent deduction • Viewed as an option, PER has a strike price at a 22,000 heat rate • Current PER is based on real-time delivery & pricing, even though ~90% of the market clears DA and does not see RT pricing • De-couple energy price options from the capacity product • The capacity product is in response to the requirement to have resources at least equal to ICR • Options and other hedges should be pursued in commercial transactions, not regulatory constructs • Appendix A (mitigation) and FERC anti-manipulation rules are more than adequate to address concerns with real-time pricing behavior

15. An Alternative, continued • Capacity market price formation • Investors need a reasonable degree of price/revenue certainty • Prices need to average, over time, the long-run net cost of the marginal resource • Revise mitigation approach • Establish reference prices for existing resources based on long-run average costs • Suppliers may discount their offers in response to actual or perceived competition • A sloped demand curve (recommended by FERC, Patton, etc) would also temper year-to-year price volatility for investors, and enhance reliability

16. Next Steps • Consulting with a number of stakeholders • Significant interest from all segments of NEPOOL and the regulatory community • Plan is to develop sufficient design detail to include in the ISO/Analysis Group evaluation

17. Thanks for your consideration.