April 9-10, 2013 | Westborough, ma

APRIL 9-10, 2013 | WESTBOROUGH, MA

Matthew WhiteSENIOR ECONOMIST

MARKET DEVELOPMENT

A Strategic Planning Initiative

FCM Performance Incentives

Ron Coutu MANAGER,

BUS. TECH. & SOLUTIONS

Parviz AlivandSENIOR ANALYST

MARKET MONITORING

Andrew GillespiePRINCIPAL ANALYST

MARKET DEVELOPMENT

Overview

1. Plan for discussion of related topics

2. Performance Incentives and Bidding Behavior• Explain the impact on the supply curve using three basic cases• Concept is also the foundation for the Impact Analysis• Establish mitigation framework

• The Internal Market Monitor acknowledges and approves the concept presented (i.e., maximizing expected profits)

• This concept is the basis for then evaluating any ‘risk’ premium – that is, a higher price required above this level to avoid any ‘downside’ in exchange for maximum expected profits

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Related Topics

• Further elaboration on the details of this proposal will be the topic of future presentations to the Markets Committee, including but not limited to:– Mitigation ~ April– Balancing ratio & application to zones ~ April/May– Maximum Loss Limit (or stop loss) ~ May– Financial Assurance impacts (w/B&F committee) ~ June– Establishing the Performance Payment Rate ~ June– Bilateral trading ~ July– Reliability rejection of de-list bids ~ July

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The Basics

• All resources (with and without a Capacity Supply Obligation) will be eligible for performance payments to the extent the resource is providing energy or reserves

• A scarcity condition will be any 5-minute interval when the real-time reserve clearing price includes the Reserve Constraint Penalty Factor (RCPF)– Does not include spinning reserve shortages

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FCM PERFORMANCE INCENTIVES Impact on Bidding Behavior

Current Supply Curve

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$/kW

-mo

Resource 1Resource 2

New Resource

RESOURCE 1

Resource 1

• This would be a resource that would remain active even without a Capacity Supply Obligation (CSO)– Currently a ‘price-taker’ that is, zero net risk adjusted going forward

costs (profits from energy and ancillary service revenues)

• The decision for this resource is whether or not to assume a CSO– Which outcome maximizes expected profits over the entire

commitment period – When is the resource better off clearing in the Forward Capacity Auction?

• Let’s look at the two different decision choices– Revenue with a CSO (clears the FCA)– Revenue without a CSO (not cleared in FCA)

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Resource 1: Revenue with a CSO

• Expected revenue if entering (clearing) in the FCA (obtain a CSO for the commitment period)

= Pcapacity + Performance Payments w/CSO + Net Energy & Ancillary Service (E&AS) payments - Fixed Costs

Where:

•Pcapacity = FCA Clearing Price * MW Cleared

•Performance Payments w/CSO = Net expected performance payments

•Net Energy & Ancillary Service (E&AS) payments = Expected Energy and Ancillary Service revenues•Fixed Costs = Total fixed costs

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Resource 1: Revenue without a CSO

• Expected revenue if not entering (not clearing) in the FCA (do not obtain a CSO for the commitment period)

= Pcapacity + Performance Payments w/o CSO + Net Energy & Ancillary Service (E&AS) payments - Fixed Costs

Where:

•Pcapacity = FCA Clearing Price * MW Cleared = 0 (since it did not clear)

•Performance Payments w/o CSO = Expected performance payments (all ‘upside’)•Net Energy & Ancillary Service (E&AS) payments = Expected Energy and Ancillary Service revenues (same as previous case)•Fixed Costs = Total fixed costs (same as previous case)

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Resource 1: Maximize Expected Profits

• Expected Profits will be maximized at a capacity price where expected revenue with a CSO is equal to or exceeds expected revenue without a CSO (this would be the offer ‘threshold’ - i.e., the minimum economic offer price)

• This can be solved for by subtracting the previously defined expected revenue of the resource without a CSO from the expected revenue of the resource with a CSO, and solving for Pcapacity

• At auction clearing prices equal to or greater than Pcapacity (the minimum economic offer price, or expected ‘break-even’ offer price) the resource will maximize expected profits

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Resource 1: Solving for Pcapacity

(Expected Break-Even Offer Price)

Clear in the FCA Pcapacity + Performance Payments w/CSO + Net E&AS payments - Fixed Costs

minus, Not clearing in the FCA 0 + Performance Payments w/o CSO + Net E&AS payments - Fixed Costs

Subtracting the two equations, and solving for Pcapacity

Pcapacity = Performance Payments w/o CSO - Performance Payments w/CSO

Note: ‘Net Energy & Ancillary Service (E&AS) payments’ and ‘Fixed Costs’ terms cancel

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Performance Payments

recall, Performance Payment =

Performance Payment Rate (PPR) x [Actual MW – (Balancing Ratio x CSO)]

Performance Payment Rate (PPR) = $5,000/MWh(The exact value is yet to be determined, but will be constant for the commitment period)

Let: (terms are for entire commitment period)

A = Expected average actual MW (energy and/or reserves)

Br = Expected average balancing ratio

H = Expected total scarcity hours

So,

Performance payments = PPR x [A – (Br x CSO)] x H

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Resource 1: Performance Payments w/o CSO



Performance Payments w/o CSO = PPR x A x H

Because the CSO = 0

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Resource 1: Performance Payments w/CSO



Performance Payments w/CSO = PPR x [A – (Br x CSO)] x H

Let: CSO = 1MW (per unit of capacity)so that this can be rewritten as,

Performance Payments w/CSO = PPR x A x H – PPR x Br x H

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Resource 1: Expected Break-Even Offer Price


Putting the terms together:

Pcapacity = {PPR x A x H} – {PPR x A x H – PPR x Br x H}

Simplified:

Pcapacity = PPR x Br x H

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Resource 1: Expected Break-Even Offer Price (continued)

• The resource will maximize expected profits at capacity prices equal to or greater Pcapacity

• This is the minimum, or expected ‘break-even’ offer price

Pcapacity ≥ PPR x Br x H

Note: ‘ Break-even’ meaning indifferent to having a CSO or not having a CSO, it does not mean the price making the resource profitable overall

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• At this price or greater, the resource will maximize expected profits

• This is not the expected profit, but at this price for capacity the resource can, based on expected performance, maximize profits

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• What about the resource’s performance?– This does not imply performance doesn’t matter – it does!– With or without a CSO, every hour of scarcity is worth the

Performance Payment Rate - $5,000/MWh in this example– Because this resource does not rely on the capacity market to

recover going forward costs (covered by E&AS revenues) it is better off without any CSO when the capacity price is less than Pcapacity

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Resource 1: Example

Pcapacity = PPR x Br x H

Assumptions:PPR = $5,000/MWhBr = 0.75

H = 10 hours

Pcapacity = 5,000 x 0.75 x 10= $37,500/MW-yr, or= $3.125/kW-mo

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This is the participant’s estimate of the average annual balancing ratio during expected scarcity conditions

This is the participant’s estimate of the expected annual total hours of scarcity conditions

Resource 1: Impact on Supply Curve

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$/kW

-mo

Resource A

$3.125

Other Resources Like Resource 1

• Other resources like Resource 1 may not have precisely the same expected values for the balancing ratio and the expected number of scarcity conditions (different Br and H values)

• The ‘flat’ part of the current curve would become upward sloping to some degree

• For instance, for different expected values for H and Br: – H = 11; Br = 0.75; Pcapacity = $3.438– H = 12; Br = 0.70; Pcapacity = $3.500– H = 10; Br = 0.85; Pcapacity = $3.542

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Impact on Supply Curve

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$/kW

-mo

PPR x Br x H

$3.1

25

$3.4

38

$3.5

00

$3.5

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RESOURCE 2


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$/kW

-mo


New Resource

Resource 2

• This would be a resource that would not remain active without a Capacity Supply Obligation (CSO)– Currently this resource relies on the capacity market to contribute to

making up the difference between the resource’s fixed costs and net E&AS revenues (i.e., the going forward costs, GFCs)

• But similarly, the decision for this resource is whether or not to assume a CSO– Which outcome maximizes expected profits over the entire

commitment period – When is the resource better off clearing in the Forward Capacity Auction?

• Again, let’s look at the two different decision choices– Revenue with a CSO (clears the FCA)– Revenue without a CSO (not cleared in FCA)

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Resource 2: Revenue with a CSO (Same as Resource 1)



Where:



•Net Energy & Ancillary Service (E&AS) payments = Expected Energy and Ancillary Service revenues•Fixed Costs = Total fixed costs

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Resource 2: Revenue without a CSO

• Expected revenue if not entering (not clearing) in the FCA (do not obtain a CSO for the commitment period)

= Pcapacity + Performance Payments w/o CSO + Net Energy & Ancillary Service (E&AS) payments - Fixed Costs

Where:

•Pcapacity = FCA Clearing Price * MW Cleared = 0 (since it did not clear)

•Performance Payments w/o CSO = 0 (since it will not operate)

•Net Energy & Ancillary Service (E&AS) payments = 0 (since it will not operate)•Fixed Costs = ‘unavoidable’ fixed costs

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Resource 2: Maximize Expected Profits

• Like Resource 1, expected profits for Resource 2 will be maximized at a capacity price where expected revenue with a CSO is equal to or exceeds expected revenue without a CSO (the offer ‘threshold’ - i.e., the minimum economic offer price)

• Likewise, this can be solved for by subtracting the previously defined expected revenue of the resource without a CSO from the expected revenue of the resource with a CSO, and solving for Pcapacity

• At auction clearing prices equal to or greater than Pcapacity (the minimum economic offer price, or expected ‘break-even’ offer price) the resource will maximize expected profits

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Resource 2: Solving for Pcapacity

(Expected Break-Even Offer Price)

Clear in the FCA Pcapacity + Performance Payments w/CSO + Net E&AS payments - Fixed Costs

minus, Not clearing in the FCA 0 + 0 + 0 – ‘unavoidable’ Fixed Costs

Subtracting the two equations, and solving for Pcapacity

Pcapacity = – Performance Payments w/CSO + (Fixed Costs – ‘unavoidable’ Fixed Costs – Net E&AS payments)

Pcapacity = Going Forward Costs – Performance Payments w/CSO

Note: If there were no expected performance payments, the Pcapacity price would be equal to the resource’s going forward costs

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Resource 2: Pcapacity (Expected Break-Even Offer Price)

Pcapacity = Going Forward Costs - Performance Payments w/CSO




Pcapacity = GFC - [PPR x A x H – PPR x Br x H], or = PPR x Br x H + (GFC – PPR x A x H)

Note: First term is exactly the same as Pcapacity for Resource 1

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Pcapacity ≥ PPR x Br x H + (GFC – PPR x A x H), or≥ GFC – {PPR x [A – (Br x CSO=1)] x H}



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Pcapacity ≥ PPR x Br x H + (GFC – PPR x A x H), or≥ GFC – {PPR x [A – (Br x CSO=1)] x H}

• For resources like Resource 2, the offer price will include the same common component as Resource 1, and may include some or all of the going forward costs– If the going forward costs are offset by the expected performance,

the offer will be no less than the common component (PPR x Br x H)

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Resource 2: Example

Pcapacity = PPR x Br x H + (GFC – PPR x A x H), or= GFC – {PPR x [A – (Br x CSO=1)] x H}

Assumptions:PPR = $5,000/MWhBr = 0.75H = 10 hours GFC = $27,000/MW-yr ($2.25/kW-mo)A = 0.3 (average annual expected performance) Pcapacity = 5,000 x 0.75 x 10 + (27,000 – [5,000 x 0.3 x 10])

= 37,500 + (27,000 – 15,000) = $49,500, or= 3.125 + (2.25 – 1.25) = 4.125/kW-mo

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These are the same system level parameters These are

resource specific parameters

Resource 2: Example (continued)


• In the prior example, the $27,000 ($2.25/kW-mo) of going forward costs were partially offset by the $15,000 ($1.25/kW-mo) of expected performance payments

• If the expected performance (A) was higher, the expected performance payments may completely offset the going forward costs, and the resource would then not need to rely on the base payment to cover going forward costs – these would be covered by expected performance payments alone

• In that case, the resource’s offer to maximize expected profits would then be the same as Resource 1 (PPR x Br x H)

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Resource 2: Example (continued)


• If the expected performance was nil (A=0), there would be no expected performance payments to offset the going forward costs

• In this case, the resource’s offer to maximize expected profits would be the same as Resource 1 (PPR x Br x H) plus the resource’s going forward costs

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Resource 2: Impact on Supply Curve

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$/kW

-mo

Resource 2

$4.125 = $3.125 + $2.25 - $1.25

GFC = $2.25

Other Resources Like Resource 2

• Other resources like Resource B may not have precisely the same expected values for the system level parameters (the balancing ratio and the expected number of scarcity conditions) and will have unique resource specific parameters (going forward costs and expected annual performance)

• The resulting magnitude of each resource’s capacity price will vary and may shift the order of resources in the supply curve

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$/kW

-mo

PPR x Br x H + (GFC – PPR x A x H)

In this example, Resource 2 is now lower in the supply stack

NEW RESOURCE


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$/kW

-mo


New Resource

New Resource

• This would be a resource that would only enter the market with a Capacity Supply Obligation (CSO)

• The decision for this resource is whether or not to assume a CSO (i.e., at what price would it assume a CSO)

• Again, let’s look at the two different decision choices– Revenue with a CSO (clears the FCA)– Revenue without a CSO (not cleared in FCA) – which would be zero

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New Resource: Revenue with a CSO



Where:



•Net Energy & Ancillary Service (E&AS) payments = Expected Energy and Ancillary Service revenues•Fixed Costs = Total Required Entry Costs

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New Resource: Maximize Expected Profits

• The new resource will want to enter the market at a capacity price where expected profits are maximized

• This minimum or ‘break-even’ offer price (Pcapacity ) can be solved for using the same methodology as used for Resource 2

• At auction clearing prices equal to or greater than Pcapacity the resource will maximize expected profits

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New Resource: Solving for Pcapacity

(Expected Break-Even Offer Price)Clear in the FCA Pcapacity + Performance Payments w/CSO + Net E&AS payments - Fixed Costs

Solving for Pcapacity; Pcapacity = - Performance Payments w/CSO + (Fixed Costs - Net E&AS payments)

Currently (no performance incentives), the minimum price a participant would require to proceed with the new resource is the difference between the Total Required Entry Costs (shown above as Fixed Costs) and the expected Net E&AS payments – let’s call this the Minimum Required Price (MRP)

Pcapacity = Minimum Required Price – Performance Payments w/CSO

Note: If there were no expected performance payments, the Pcapacity price would be equal to the resource’s Minimum Required Price

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New Resource: Pcapacity (Expected Break-Even Offer Price)

Pcapacity = Minimum Required Price - Performance Payments w/CSO




Pcapacity = MRP - [PPR x A x H – PPR x Br x H], or = PPR x Br x H + (MRP – PPR x A x H)

Note: First term is similar to Pcapacity for Resource 1

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New Resource: Expected Break-Even Offer Price

Pcapacity ≥ PPR x Br x H + (MRP – PPR x A x H), or≥ MRP – {PPR x [A – (Br x CSO=1)] x H}



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New Resource: Expected Break-Even Offer Price

Pcapacity ≥ PPR x Br x H + (MRP – PPR x A x H), or≥ MRP – {PPR x [A – (Br x CSO=1)] x H}

• For new resources, the offer price will include the same common component as Resource 1, and will include some portion of the minimum required price– Part of the minimum required price is offset by the expected

performance, but the offer will still be no less than the common component (PPR x Br x H), even if all MRP is offset

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New Resource: Example

Pcapacity = PPR x Br x H + (MRP – PPR x A x H), or= MRP – {PPR x [A – (Br x CSO=1)] x H}

Assumptions:PPR = $5,000/MWhBr = 0.75H = 10 hours MRP = $120,000/MW-yr ($10.0/kW-mo)A = 0.9 (average annual expected performance) Pcapacity = 5,000 x 0.75 x 10 + (120,000 – [5,000 x 0.9 x 10])

= 37,500 + (120,000 – 45,000) = $112,500, or= 3.125 + (10.00 – 3.75) = 9.375/kW-mo

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These are the same system level parameters These are

resource specific parameters

New Resource: Example (continued)

Pcapacity = PPR x Br x H + (MRP – PPR x A x H), or= MRP – {PPR x [A – (Br x CSO=1)] x H}

• In the prior example, the $120,000 ($10.00/kW-mo) minimum required price was partially offset by the $45,000 ($3.75/kW-mo) of expected performance payments

• For new resources, the performance (A) may reflect the average expected value over the life of the resource

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$/kW

-mo

New Resource

MRP = $10.00

$9.375 = $3.125 + $10.00 - $3.75

Other New Resources

• Other new resources may not have precisely the same expected values for the system level parameters (the balancing ratio and the expected number of scarcity conditions) and will have unique resource specific parameters (minimum required price and expected annual performance)

• The resulting magnitude of each resource’s capacity price will vary and may shift the order of resources in the supply curve

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$/kW

-mo

PPR x Br x H + (MOP – PPR x A x H)

CONCLUSIONS

Five Key Takeaways

• Capacity Offer-Price Drivers

• FCA Clearing Price Drivers

• Supply Elasticity and Price Stability

• Impact of Performance Incentive

• Resources Clearing the FCA

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Capacity Offer-Price Drivers

• Offer prices will reflect for any resource, system parameters:– Performance Payment Rate (PPR)– Expected annual scarcity hours (H)– Annual average balancing ratio (Br)

• Offer prices for potentially marginal resources(like Resource 2) will also reflect:– Average expected performance (A)– Going forward costs (GFC)

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FCA Clearing Price Drivers

• The FCA Clearing Price will reflect the marginal resource’s:– Going forward costs (GFCs) – like today– Expected net annual performance payments – NEW

(PPR x annual score)

• The expected net performance payments for the marginal capacity resource could be:– Negative if it is expected to perform worse than the expected

annual average balancing ratio (likely if an existing resource)– Positive if it is expected to performs better than the expected

annual average balancing ratio (possible if new entry)

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Supply Elasticity and Price Stability

• One effect of the FCM Performance Incentives is to make the aggregate supply curve more elastic (i.e., flatter)

• This will tend to reduce variability in FCA clearing prices from auction to auction

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$/kW

-mo

New supply curve (red) expected to be more elastic (sloped) compared to current supply curve (green)

Impact of Performance Incentive

• Improving performance is always worth the Performance Payment Rate (PPR) during deficiencies, with or without a CSO ($5,000/MWh in these examples)

• Expected performance impacts FCA offers differently, it depends on what would be done with the resource without a CSO

• Will the resource continue to operate in the energy and ancillary service markets?Yes – Then it is like Resource 1, and expected performance

does not affect the offer priceNo – Then it is like Resource 2 and expected performance

does affect the offer price

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Resources Clearing the FCA

• A resource that clears in the FCA will earn infra-marginal rent (i.e., higher expected profit with a CSO) if:– The resource’s expected average annual performance is

better than the marginal resource setting the FCA price, and/or

– The resource has lower going-forward costs than the marginal resource setting the FCA price

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Logistics & Timing

• ISO Direction: ISO White Paper (October 2012) onFCM Performance Incentives

Also at: http://www.iso-ne.com/spi > Materials

• Timeframes:– Mar-Sep 2013: Markets Committee– Fall 2013: MC & PC votes– Q4 2013: FERC Filing

• Implement: For FCA 9 (FCA held 2015, CCP of 2018/19)

• A major initiative: Impact analysis with MC Q2-Q3 2013

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http://www.iso-ne.com/committees/comm_wkgrps/strategic_planning_discussion/materials/fcm_performance_white_paper.pdf

http://www.iso-ne.com/spi

April 9-10, 2013 | Westborough, ma

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