Is an Adequacy Market Necessary

1. Is an Adequacy Market Necessary Roy J. Shanker Electric Power Generation AssociationOctober 16, 2002

2. DISCLAIMER • The material presented here represents my own opinions and is not necessarily representative of those of my clients.

3. Is an Adequacy Market Necessary • Note the use of the politically correct term ADEQUACY instead of capacity • This may make people feel better with the following conclusion • As a matter of both political and economic reality, given the range of potential market designs— • THE ANSWER IS YES

4. Why Capacity Adequacy Markets? • “Energy Only” Markets Work In Theory • Basic Assumptions • Competitive market • Atomistic buyers and sellers • Rational buyers and sellers with knowledge • Elastic demand • Elastic supply, no barriers to entry • TRUE MARGINAL COST PRICING • Functional market design • Absence of market power

5. Why Capacity Adequacy Markets? • In theory, in a market system, when demand exceeds supply the market price would be set by the scarcity costs represented by load bidding in its willingness to be interrupted • The system would clear at prices representing scarcity • Suppliers over time would capture scarcity rents sufficient to attract new capital • There would be no need for capacity requirements • This would be the resolution both short and long term

6. WHY CAPACITY ADEQUACY MARKETS? • We never meet the assumptions of a fully competitive market in electricity—more “workably competitive” • Reasonably concentrated buyers/sellers • Reasonable short term (long term?) barriers to entry • No short term demand elasticity at retail/limited real time information • Limited long term demand elasticity

7. WHY CAPACITY ADEQUACY MARKETS • MOST IMPORTANT--No one would accept the implications of a TRUE pure energy only market • No spin or reserves • Not necessarily power when you throw the switch • No long term adequacy –boom or bust cycles • THE NET RESULT IS SOME FORM OF INTERVENTION TO IMPROVE RELIABILITY AND REMOVE PRICE VOLATILITY • IN TURN THIS ALWAYS RESULTS IN SUPPRESSING SPOT PRICES

8. WHY CAPACITY ADEQUACY MARKETS? • Thus we never meet the revenue expectations of a fully competitive energy only market • Energy markets are never allowed to operate in a fashion that would show scarcity pricing consistent with an energy only market • We always mandate short or long term requirements that depress the spot price of energy • WE WILL NEVER GET SUFFICIENT NEW ENTRY BASED ON ENERGY PRICES ALONE IN A “RELIABLE” MARKET

9. WHY CAPACITY ADEQUACY MARKETS? • Thus there is a simply policy question: • IF YOU ARE GOING TO FORCE THE MARKETS TO BE “LONG”, HOW DO YOU MAKE UP FOR THE “MISSING MONEY” DUE TO SUPRESSING ENERGY PRICES? • CAPACITY ADEQUACY MARKETS ARE THE TOOL TO MAKE UP THAT MISSING MONEY—THEY MUST EXIST IF WE WANT COMPETITIVE NEW ENTRY COUPLED WITH RELIABLE SUPPLY AND RELATIVELY STABLE PRICES • THE TRICK IS TO FIND A DESIGN THAT MEETS THIS FINANCIAL ECONOMIC OBJECTIVE WHILE ALSO SATISFYING THE POLITICAL POLICY OBJECTIVES THAT CREATED THE NEED IN THE FIRST PLACE

10. WHY CAPACITY ADEQUACY MARKETS? • Another way of viewing this problem is that for social and political reasons we are forcing an adequacy requirement on the market, it is a form of mandatory insurance or a tax • The policy questions then need to revolve around what is the most efficient way to pay for the insurance or to collect the tax.

11. THE FERC INITIATIVE—SMD • Ferc has basically recognized this logic in its SMD design • The NOPR identifies three main reasons for having a capacity adequacy requirement of some form : • Spot prices alone don’t send the right signal (or we wont let them) • Mitigation of energy prices may suppress price signals • Like most public goods supported by taxes, there is a “free rider problem” e.g. why pay if you can lean on others-thus some enforcement/mandate is necessary

12. Summary of SMD--Adequacy • To replace ICAP (e.g. a politically correct new name) • RSAC to establish resource adequacy criteria • FERC proposes 12% reserve margin as a “minimum” • ITP functions: • Forecast future demand • Provide technical support to RSAC • Assign each LSE a load ratio share of requirement • Audit LSEs resource plans • Impose penalties on deficient LSEs • Eligible resources: generation , transmission ,demand response • Eligible resources must meet certain standards • “Deliverability” requirement

13. Summary of SMD--Adequacy • Planning horizon • To reflect the time necessary to construct new resources • To be determined by RSAC for each region • Seeks comments on 3-5 year limits • CBM Adjustment—Interaction? • Penalties for deficiencies • All penalties on LSEs who are found deficient • “Very large” penalties for withdrawals from spot markets • Deficient LSEs to be curtailed first in event of shortage • “Very high” penalty for failure to obey curtailment order • ITP Auction? • Is not precluded • FERC appears to prefer bilateral arrangements

14. Benefits/Advantages of Proposal • Strong recognition of need for adequacy • Linkage to historic state/regional adequacy • Forward looking requirement • Need to recognize benefit based on allowing for supply elasticity • Recognition of locational nature of adequacy • Recognition of interaction with CBM • Recognition of need for deliverability

15. Benefits/Advantages of Proposal • Recognition that this is a tax, need for enforcement, not voluntary • All resources recognized, supply, demand, transmission?? • Need for audit/verification • Recognition of potential role for a market based implementation • Linkage to market mitigation • Recognition of need for adequate total compensation

16. Problems/Disadvantages • Misunderstanding of Adequacy Concepts • Mixes Planning Concepts with Operating Concepts • Planning Concept-Statistical--Expectations • Aggregate Reliability, Assumes Generators-Locations • Different Contingency Set from Operating Market • Different Performance Assumptions from Operating Markets • Peak demand • Expected exports • CBM etc. • Expected output • No Necessary Linkage between CRR’s and Adequacy • Penalty Structure Linked to Operating Not Adequacy • Doesn’t Reflect Lessons Learned from Northeast Markets

17. Problems/Disadvantages • Doesn’t work well or at all with retail access • Appears to assume an LSE is like the entire retail load of an IOU-not realistic • Assumes LSE load is divisible-not realistic • Huge barrier to entry to small new entrants • Have to forecast future obligations • Have to take financially binding forward position w/o load? • No provisions to link to rapid load migration

18. Problems/Disadvantages • Mixes Operating/Financial/Adequacy • CRR’s are financial preferences for energy hedges • CRR’s have no necessary relationship to adequacy-they reflect the way in which load or others wish to hedge or speculate on congestion, not overall market adequacy. • Mandating CRR’s for adequacy would tie financial preferences to reliability in an unnecessary fashion

19. Problems/Disadvantages • Mixes Operating/Financial/Adequacy • Adequate markets meet peak load, don’t necessarily assure energy hedges • Deliverability doesn’t necessarily have any relationship to energy hedges in energy markets • Financial hedges don’t necessarily have any relationship to long term adequacy

20. Problems/Disadvantages • Trying to force these linkages through a bilateral market with some sort of CRR requirement: • Doesn’t assure adequacy • Encourages/assures an inefficient market • Penalizes small players • Probably exacerbates the potential for market power

21. Problems/Disadvantages • Penalty Structure is Operating Based-- Does Not Reflect Adequacy • Operating Penalty Much too Low as a Result • LOLP concentrated in about top 40 hours (or less) • At $500 per MWH this is only $20 a kW year • NY is looking at numbers like $225 for new entry, more for penalty—Implies $5000 penalties • When PJM had low per day operating type penalties it encouraged freeriders and it almost sunk the system • Penalty Implementation of Load Shed Not Feasible In a World of Retail Access With Current or Foreseeable Technology

22. Problems/Disadvantages • Penalties are Operational Based—2 • Adequate systems are planned to go short some hours • Adequacy tied to forecast, not actual e.g. why should low actual demand negate the incentive to meet system adequacy • Operational based penalties encourage or worsen the free rider problem, ignore the premise that this is a tax based on expected use

23. Problems/Disadvantages • Penalties are Operationally Based—3 • Could you implement a market the SMD way • It is possible to have adequacy based on a call option structure, e.g. tied to an energy market • However, in such a structure the adequacy requirement would still have to precede the real time market, you still need to link calls with deliverability, and the real time market would simply clear damages NOT remove the obligation to meet adequacy in advance • To be enforceable you would like just shift the asset in the ground requirement to the party selling calls • This would look a lot like the Northeast but with a call mechanism

24. Some of the Lessons Learned • Badly designed adequacy markets are vulnerable to market power • No supply elasticity • No demand elasticity • Barriers to entry by linking obligation to LSE on a one to one basis

25. Lessons Learned • Badly designed adequacy markets are volatile • Tend towards boom bust pricing • Makes unhedged participants vulnerable • Discourages new entry, • Appears inherent with inelastic demand and relatively inelastic demand

26. Lessons Learned • Obligations linked to LSE’s are huge barriers to entry in markets with retail access-particularly where there is poor retail design • Continual chicken and egg problem for new load • Risk of load migration bad for new entrant • Risk of load migration with POLR encourages hoarding • Inherent lack of liquidity at margin exacerbates these problems • Makes changing deliverability or complexity in deliverability a large impediment to small participants, e.g. changing locational requirements

27. Lessons Learned • Deliverability has to be fully integrated in the market design • Multiple ways to handle deliverability, e.g. NY or PJM • But have to have clear rules, procedures and rights up front

28. Lessons Learned • Capacity revenues have to be integrated into overall market design for compensation • Capacity related compensation is mandatory where scarcity is eliminated or capped in energy pricing • Net compensation will be too low to foster new entry

29. Lessons Learned • The Northeast ISO’s have all experienced pieces of these problems • A Joint Capacity Adequacy Group was set up to coordinate efforts • Improve overall market design with respect to these problems • Allow coordination for sales of adequacy products across the region • Long term???– A single adequacy market

30. JCAG-Working Process • The JCAG has come up with several straws that have the advantages of the SMD general approach but may avoid some of the problems just summarized above

31. Range of Proposals • The following represent my integration of what I think has come out of this process that offers a solution • Couple limited scarcity pricing in energy with capacity markets • Add supply elasticity, e.g. forward market • Add demand elasticity, e.g. demand curve • Decouple the one to one LSE requirement, e.g. a central settlement on behalf of load

32. Scarcity Pricing Plus Adequacy • There has to be a mechanism to “pop” to a scarcity energy price above short run marginal costs to reflect true shortage in the market, even when there is demand side bidding • While this recovers some of the needed scarcity rents, adequacy payments must be present as a residual to assure market clearing

33. Add Supply Elasticity • The SMD has this element through future procurement • JCAG proposal was similar but for a shorter lead of two years • Details need to address • Forecast process • Forecast error • Use of market mechanisms, declining auction etc. • Treatment/qualification of demand side • Verification of offers, security requirements

34. Add Supply Elasticity--2 • The RTP would procure ALL adequacy requirements through a central auction ON BEHALF OF ALL LOAD • All parties could still engage in bi lateral agreements through the use of contracts for differences (CFD’s) • Bi laterals through CFD’s would actually be preferred, and it is important not to discourage them

35. Add Supply Elasticity--3 • The JCAG process has made some progress on what a central procurement would look like • Use of central procurement allows flexibility in locational requirements • I have proposed a model that would actually allow simultaneous evaluation of locational requirements such as PJM and NY

36. Procurement on Behalf of Load • ISO/ITP procures on behalf of all LSE’s • Bi laterals welcomed and desirableI • Reduces forecast error issues • Obligations Move with Load • Obligations paid for by Load • Eliminates many market power issues • Eliminates entry barriers for small participants • Can accommodate any complexity of deliverability, including PJM/NY simultaneously

37. Add Demand Elasticity • Initially proposed by NYPSC • General concern about volatility discouraging new entry • Effort to attenuate zero/one volatility of pricing • Should end tendency to price at either deficiency or zero adding stability to pricing • NYISO working on implementation now • Requires a market structure to implement • Major issues • Shape of the curve • Who determines the shape

38. WHAT NEXT? • JCAG PROCESS TO CONTINUE • COMMENTS ETC. TO CONVINCE FERC TO MODIFY ITS NOPR REQUIREMENTS FOR ADEQUACY STANDARDS. • POSSIBLE COORDINATED EFFORTS BY THE NORTHEAST ISO’S