FCM Performance Incentives

1. FCM Performance Incentives Evaluation and RecommendationsRobert Stoddard, Senior Consultant July 11, 2013

2. Disclaimer The conclusions set forth herein are based on independent research and publicly available material. The views expressed herein are the views and opinions of the author and do not reflect or represent the views of Charles River Associates, any of the organizations with which the author is affiliated, or the research sponsor, NextEra Energy Resources. Any opinion expressed herein shall not amount to any form of guarantee that the author or Charles River Associates has determined or predicted future events or circumstances and no such reliance may be inferred or implied. The author and Charles River Associates accept no duty of care or liability of any kind whatsoever to any party, and no responsibility for damages, if any, suffered by any party as a result of decisions made, or not made, or actions taken, or not taken, based on this paper. Detailed information about Charles River Associates, a registered trade name of CRA International, Inc., is available at www.crai.com.

3. Key Goals of Performance Incentives • Incentive for investment • Improve peak availability of existing resources • Primarily by encouraging back-up fuel or firm fuel delivery • Drive new development towards flexible resources with secure fuel supplies • Tilt capacity payments away from low-performing existing resources • Incentive for performance • Mimic incentives that would occur with scarcity LMPs • Reduce likelihood of real-time reliability issues PI seeks to improve reliability both on a planning andoperating horizon; these are good and achievable goals, with some refinements to the PI design.

4. Core Issues with ISO Proposal • Too much unproductive risk to CSO • Focus on ex ante incentives for investment, not ex post punishment • Focus on performance of resources • Need for improved risk management tools • Need for sustained price signal • Challenges for offer price mitigation Improving the quality of risk will improve the ability of the PI to achievecost-effective investment in reliability while lowering consumer costs.

5. Specific Recommendations • Tighter stop-loss provisions • Retain a limited set of excused unavailability • Enhance risk management tools • Implement a capacity demand curve • Improve IMM’s offer review process • Link Performance Payment Rate to IMM mitigation metrics

6. 1. Tighter Stop-Loss Provisions • Stop-Loss linked to FCA Capacity Clearing Prices • Reflects marginal value of incremental resources • Equitably balances risk and reward for resources • Suppliers can incorporate changing risk in Descending Clock Auction • Annual Stop-Loss = greater of • 120% of annual CCP or • $18/kW-year (150% of current $1/kW-month GFC estimate) • Monthly Stop-Loss = retain current 2.5x of monthly CCP • Eliminate daily stop-loss

7. Empirical Impact of Various Monthly Stop-Loss Levels A 2.5x monthly stop-loss eliminates extreme tail events ex post with little impact on ex ante incentive to invest

8. 2. Retain Limited Excused Unavailability • Current standard deemed too lax • But “no excuses / no fault” policy adds unmanageable risk • Retain very limited set of excused unavailability: • Transmission outages • Extreme weather events and other “acts of God” • Units denied self-commitment by ISO • Treatment of units available but not committed by ISO • Encourages resource owners to second-guess ISO commitment • Drives down energy prices • Burns potentially scarce backup fuel needlessly • Consider ramping PPR up during course of scarcity conditions

9. 3. Enhance Risk Management Tools • Improvements to Supplemental Availability Bilaterals • Discussed earlier today • Measure performance on portfolio basis • Hedges against underpayment • Enhance “bulletin board” for SAB trading

10. 4. Implement Capacity Demand Curve • All FCA outcomes to date have been at the floor or ceiling • Floor price in surplus • Ceiling price in scarcity (NEMA/Boston) • Investment requires confidence in long-term prices • Demand curves create tangible benefits for everyone: • Reduced price volatility lowers investment premium required • Surplus committed resources reduces frequency of energy price spikes • Tapered capacity scarcity pricing better manages situations such as the NEMA/Boston price spike in FCA 7 • Sound theory and analytic tools available to optimize demand curve design

11. 5. Improve IMM Offer Review and Mitigation • Recognize full costs of CSO, including foregone scarcity payments and FA costs • Mitigation contingent on structural tests for market power • Substantial deference to supplier’s estimates of key parameters • Inclusion of risk premium • Use of price/quantity pairs reflecting different costs and risks

12. 6. Link Performance Payment Rate to IMM mitigation metrics • In mitigating an offer, IMM replaces the supplier’s business judgment about H (and other key parameters) with its own • Forces suppliers to accept CSO risks at a price below their own valuation of that risk • Asymmetric risk, as potential range of H upwards is much higher than range downward • If mitigation values understate market’s expected values, systematically shifts billions of dollars from capacity suppliers • PPR should scale down as actual value of H approaches and then surpasses mitigation value of H • No change in incentives for suppliers • Marked reduction in risk from over-mitigation of offers

13. Questions?

14. Robert Stoddard Charles River Associates 200 Clarendon St Boston, MA 02116 (617) 331-4373 RStoddard@crai.com