ASM Phase II LFRM Offer Cap

1. ASM Phase IILFRM Offer Cap NEPOOL Markets Committee 25 May 2005 Marc D. Montalvo ISO-NE Markets Development

2. LFRM Offer Cap Outline • Proposed Cap • Derivation of Cap • Questions

3. Proposed LFRM Offer Cap • Single Offer Cap for all Zones • Hard price cap set equal to the offer cap • Cap equals $17,000 MW-month

4. Offer Cap: Background Issues • All LFRM resources are also LICAP resources. • An LFRM resource is distinguished from a LICAP resource by the delivery requirements and penalty structure of the LFRM service. • A supplier would not logically take on an incremental LFRM obligation without the reasonable expectation of incremental compensation. • In any location the LFRM clearing price should be at least as great as the LICAP auction clearing price.

5. Need for the Offer Cap • Prices should be allowed to rise to a level indicative of the need for additional resources. • This price is greater than or equal to the carrying cost of a new entrant at long run equilibrium. • Under shortage conditions there is no competitive discipline on prices. • An administratively imposed cap constrains the price to protect buyers from otherwise unchecked prices while providing proper price signals to potential suppliers.

6. Constructing the Offer Cap • GOAL: Estimate the costs that an Increment of LFRM Supply would have to Recover to be willing to enter the market. • A supply offer in the LFRM market is composed of the following: • expected foregone energy revenues • expected foregone commitment costs • expected penalties • incremental O&M and/or capital investment • expected LICAP clearing prices • risk premium

7. Foregone Energy Revenues • The expected foregone energy revenues are a function of: • Incremental variable cost • LMP • LFRM threshold price. • The foregone energy revenues for an aero-derivative CT were estimated using historical data. • 2004 daily natural gas index prices at NE City Gate from Platts/Argus • Heat Rate = 10,500 Btu/kWh • 2004 LMPs • Strike Price = Gas Price x 14,500 Btu/kWh Heat Rate

8. Foregone Energy Revenues • Using the historical data, the foregone energy revenues for an aero-derivative CT offering into the LFRM market would have been on the order of $0.10 to $0.20 per kW-month. • Let the foregone energy revenues be $0.15/kW-month.

9. Foregone Commitment Costs • An aero-derivative CT does not have to be on-line to supply its reserve capability. • The expected foregone commitment costs (startup and no-load) for an off-line resource are zero. • The foregone commitment costs are $0.0/kW-month.

10. Penalty Exposure • The expected penalties for a new aero-derivative CT should be low given the expected high availability and startup performance. • Given the performance penalties proposal and assuming an EFORd of 5.0% and a failure to start rate of 5.0%, the expected penalties are estimated to be on the order of $0.60 to $0.70 per kW-month. • Assume that the value of expected penalties is $0.65/kW-month.

11. LICAP Clearing Prices • According to the LICAP demand curve, the LICAP clearing price will not exceed 2xEBCC or approximately $16/kW-month. • This price means that there is a general capacity shortage in the location. • If this were the case, the market would be calling for incremental capacity of any type. • If the incremental LICAP resource was able and chose to offer its supply into the LFRM market, it would incur no incremental capital costs to provide the LFRM service. • All of the costs associated with carrying the incremental capital investment could be recovered through the LICAP market.

12. Estimating the Cost of LFRM Incremental Supply • Let the benchmark LFRM technology be an aero-derivative CT. • The aero-derivative CT can provide either the ten or thirty minute LFRM service. • Modularity and available range of sizes (low granularity relative to local requirements) make these resources well suited to providing incremental supply. • From the LICAP case, an aero-derivative CT has an annual carrying cost in the $10 to $13/kW-month range. • If the LFRM clearing price exceeds the carrying cost of an aero-derivative CT plus the expected incremental cost of providing the LFRM service, an investor should be willing to build an aero-CT to meet the LFRM demand.

13. Incremental O&M and/or Investment • The incremental capital investment required to meet the LFRM obligation with a new aero-derivative CT is the annual carrying cost of the machine. • The incremental capital investment is $13/kW-month. • If the LICAP price were expected to be less than $13/kW-month, say $10/kW-month, the LFRM supply offer would reflect an Incremental Investment Component of $13 - $10 = $3/kW-month. • Assuming a LICAP price of $16/kW-month and an annual carrying cost of $13/kW-month, the expected LICAP Price recovers the entire annual carrying cost of the investment. • The incremental investment component to be recovered from LFRM is $0/kW-month.

14. Risk premium • The value of foregone energy revenues and penalties are estimates of the expected value. • The risk premium is an amount that the supplier would add to his offer to cover the probability that his expected value estimates are incorrect, i.e., underforecasted. • For the sake of this discussion, assume that the risk premium is equal to 10% of the expected value of foregone energy revenues and penalties, or $0.08/kW-month.

15. Summary of Offer Cap Derivation Foregone energy revenues $0.15/kW-month Foregone commitment costs $0 Expected penalties $0.65 Incremental O&M and Investment $0.0 LICAP clearing price $16.0 Risk premium $0.08 $16.88/kW-month Approximately $17/kW-month

16. Questions