1

APPA Business & Finance Conference Austin, Texas

September 25, 2007

WHOLESALE MARKETS in ERCOT: Operations and Pricing

Sharon Mays General Manager

Denton Municipal Electric

2

Wholesale Markets in ERCOT: Operations and Pricing I am pleased to be here today to provide the perspective of a mid-sized municipal utility on the ERCOT wholesale market, both as it exists today and as it is designed to operate beginning on January 1, 2009. Today, I will discuss what I consider to be some of the positive and negative impacts of the two major restructurings which have occurred in ERCOT to date. I will also discuss two aspects of ERCOT’s planned 2009 restructuring to an LMP (Locational Marginal Price) based wholesale market that I find particularly troubling. The foundation for the ERCOT wholesale market which exists today was created in 1995, when the Texas legislature passed a bill providing “Open Access” to the ERCOT transmission system by all market participants. “Open Access” was based on a standard transmission interconnection agreement and a uniform set of transmission tariffs applied to all participants. “Open Access” allowed independent generators to build facilities in Texas and all existing generators, new generators, and power marketers to make power sales to any ERCOT wholesale load. Between 1995 and 1999 the “Open Access” transmission tariffs evolved into a single “postage stamp” $/MW rate based on the total ERCOT wide investment in transmission divided by the ERCOT annual peak load. Load serving entities pay for the ERCOT transmission system based on their load ration share of the ERCOT annual peak load. In the time honored tradition of Texas, ERCOT’s approach to transmission access and tariffs is a “Texas Original”, unlike anything that exists elsewhere in the US electric market.

Generation Additions in ERCOT

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

In Service Year

Sum

mer

Cap

acity

in M

W

Natural Gas Wind Other

The first benefit which occurred as a result of opening up the wholesale market to independent generation resource owners and simplifying transmission access was an explosion of new generation development in ERCOT. Since 1997, more than 26,000 MW of new capacity has been added to the ERCOT electric grid, mostly by independent generation companies. Most of this new capacity is either low heat rate combined cycle natural gas fired generation or wind power. The overall

3

generation efficiency of the ERCOT grid has improved greatly since 1995. Until 2002, this gave retail customers of IOUs, Munis, and Coops access to a broad array of new, more efficient power sources, while the retail customers of the vertically integrated IOU’s still enjoying the benefit of stable pricing provided by the regulatory rate protections. Unfortunately, this benefit was short lived. Once the more efficient new generating units began competing in the ERCOT market, a large number of older plants were either retired or mothballed. Without the capacity of those older plants ERCOT now faces a shortage in reserve capacity in the very near future. Without significant new capacity additions, ERCOT is projected to have a reserve margin below 6% by 2012, even with some of the less efficient mothballed units returned to service.

Load Forecast: 2007 2008 2009 2010 2011 2012

Total Summer Peak Demand, MW 63,794 65,135 66,508 67,955 69,456 70,733 less LAARs Serving as Responsive Reserve, MW 1,125 1,125 1,125 1,125 1,125 1,125 less LAARs Serving as Non-Spinning Reserve, MW 0 0 0 0 0 0 less BULs, MW 0 0 0 0 0 0Firm Load Forecast, MW 62,669 64,010 65,383 66,830 68,331 69,608

Resources: 2007 2008 2009 2010 2011 2012Installed Capacity, MW 61,424 61,424 61,424 61,424 61,424 61,424Capacity from Private Networks, MW 6,513 6,217 6,217 6,217 6,217 6,217Effective Load-Carrying Capability (ELCC) of Wind Generation, MW 298 298 298 298 298 298RMR Units under Contract, MW 169 169 169 169 0 0Operational Generation, MW 68,404 68,108 68,108 68,108 67,939 67,939

50% of Non-Synchronous Ties, MW 553 553 553 553 553 553Switchable Units, MW 2,848 2,848 2,848 2,848 2,848 2,848Available Mothballed Generation , MW 165 510 419 594 558 522Planned Units (not wind) with Signed IA and Air Permit, MW 0 550 550 550 1,300 2,100ELCC of Planned Wind Units with Signed IA, MW 0 171 174 174 174 174Total Resources, MW 71,970 72,740 72,652 72,827 73,372 74,136

less Switchable Units Unavailable to ERCOT, MW 158 317 317 0 0 0less Retiring Units, MW 0 375 375 433 433 433Resources, MW 71,812 72,048 71,960 72,394 72,939 73,703

Reserve Margin 14.6% 12.6% 10.1% 8.3% 6.7% 5.9%(Resources - Firm Load Forecast)/Firm Load Forecast

2007 Report on the Capacity, Demand, and Reserves in the ERCOT RegionSummer Summary

Another benefit of the “Open Access” policy is the open transmission access approach. Moving to a postage stamp transmission rate made the wholesale market in ERCOT much more vibrant. By making all generators in ERCOT economically accessible to all wholesale customers, competition was promoted among generators selling to load serving entities. While the advent of congestion charges for scheduling power flows on commercially significant constraints between defined zones of the ERCOT system added price uncertainty to some transactions, customers in ERCOT still have a greater opportunity to procure wholesale power from many sources than they did before “Open Access”. Another positive aspect of the deregulation process in ERCOT is that the need to address the impacts on the ERCOT transmission system created by “Open Access” and the January 2002 implementation of retail deregulation caused ERCOT to develop a new transmission system planning process. Since the wholesale loads in the service territories of the legacy IOUs, Munis, and Coops are now served

4

by an assortment of generation companies, power marketers, and retail energy providers, it is critical that all of these parties be involved in planning future transmission expansions. To address this need, ERCOT has created a transmission planning process that is transparent and open to all interested parties. Both new wires projects that improve grid reliability and projects that improve economic efficiency are studied. Increasingly, we are seeing generators get more involved in this planning process prior to building new units. The resultbeing better siting decisions and a more efficient transmission grid. This process has led to transmission projects that reduce congestion and improve reliability are being built in ERCOT. However, postage stamp transmission rates and the assumption by load serving entities of responsibility for all costs of interconnection to the grid by new generation has also had some negative impacts. The lack of economic impacts on generation projects resulting from their siting choices has resulted in inefficient siting decisions for some of new generation built in ERCOT. This in turn has led to potentially avoidable increased costs to the wholesale market caused by increased local and zonal congestion resulting from moving energy from remote generation to load centers. It has also limited the options for relieving local congestion problems to construction of transmission solutions. There is no doubt in my mind that , although the processes are not perfect, “Open Access” for generators, postage stamp transmission pricing, and the new ERCOT planning process have made significant improvements to the ERCOT wholesale market. These changes had the potential to reduce the cost paid by consumers for their electric service. Unfortunately, the Texas Legislature decided to break from the Texas tradition of independent thinking and follow the herd of economists stampeding toward retail deregulation in other parts of the US. In 1999, ERCOT was ordered to implement “Retail Choice” in IOU service territories beginning in January 2002. Munis and Coops were given the option to opt in to retail choice, or to remain as “NOIEs” (Non-opt In Entities). The Texas version of “Retail Choice” included making ERCOT responsible for settlement of both the retail and wholesale markets. In order to support settlement of “Retail Choice”, ERCOT replaced its multiple control areas with a single control area operated by ERCOT, centralized scheduling of the transmission system, and created a balancing energy market. One of the most significant adverse impacts of Retail Choice deregulation on the ERCOT wholesale market has been the payment default risk. As a non-profit organization, any revenue shortfall ERCOT experiences as a result of a wholesale market participant failing to pay its obligations must be made up by the load serving entities in ERCOT. That means each retail customer in ERCOT is ultimately at risk for any payment default. In the pre-deregulation world IOU’s served captive loads. This guaranteed customer base combined with regulated cost recovery mechanisms for all aspects of utility service, provided assurance that IOUs would have a stable revenue source, and should be able to remain economically viable. When the IOUs were split into separate operating companies, creating regulated transmission/distribution providers, independent generating companies, and retail electric providers, the situation became much more dynamic. Customers could move from one REP (Retail Energy Provider) to another at will. The stability of future revenue streams from a predictable customer base has been lost. Similarly, generators and power marketers have no guarantee that they will be able to sell their energy for a price sufficient to cover their costs and produce a return on their

5

investment. Thus, an industry that was traditionally considered stable and reliable, both by its customers and investors, is now populated with a number of new companies and entities, many of which do not have investment grade status. In ERCOT today Munis and Coops (NOIEs) are the only parties that consistently have investment grade status. The ERCOT balancing energy and ancillary service markets were created to allow REPs (Retail Energy Providers) and other wholesale market participants to buy both energy and ancillary services directly from ERCOT. This put ERCOT in the position of selling those services to a whole group of new companies, many of which were startups. In order to protect the loads served by ERCOT from default risk, ERCOT initiated credit/collateral requirements for parties trading in the market. Additionally, many generators and power marketers found themselves selling to companies that did not have credit histories, which caused them to increase their credit/collateral requirements. This credit issue has the potential of creating a “death spiral” situation for the ERCOT deregulated market. ERCOT provides services prior to payment, thus, in order to protect the retail customers in ERCOT from the risk of defaults, ERCOT should maintain tight credit/collateral requirements on market participants. However, higher credit/collateral requirements may force out smaller, less well-capitalized participants, leaving only a few larger organizations to serve the market. This is counter to the need to have a robust deregulated wholesale and retail market that consists of a number of players bringing innovation and competition to the consumer. Without a sufficient number of “competitors” the entire premise on which the economic theory behind deregulation collapses. This situation will only be exacerbated when ERCOT moves to a nodal market design. In the current zonal market design, ERCOT-provided balancing energy amounts to approximately 10% of the total energy market. In the new nodal market design, ERCOT will serve as financial clearinghouse for all load and generation, a 10-fold increase in the size of the ERCOT administered market. This will put even greater pressure on ERCOT to ensure market stability and increase credit/collateral pressures on smaller less well-funded market participants. This factor combined with the fact that we have already seen some smaller REPs being bought out by larger companies could ultimately create an oligopoly in the Texas market, both on the retail and wholesale level.

6

Average Price per kWh for All Users

4.00

5.00

6.00

7.00

8.00

9.00

10.00

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Year

Cen

ts p

er k

Wh

TexasUS Avg.OK

Source: Dept. of Energy, Energy Information Administration

I know we are supposed to be here to discuss operations and pricing in the ERCOT wholesale market, but, the real bottom line measure of the success or failure of the wholesale market structure is the cost that retail customers see on their bills. As you can see on this chart of historic electric price data from the Department of Energy, Texas Retail customers have not faired well. Electricity costs in Texas have moved from a price below the national average to a price that, at the end of 2005, was much higher than the national average. While critics of this view will often point to the recent increases in natural gas prices as the reason for the surge in Texas electric prices, I have included average electric prices for Oklahoma which, like Texas, depends heavily on natural gas fueled generation. As gas prices increased, so did prices in Oklahoma, however, they have managed to maintain their price advantage compared to the national average, while Texas prices have increased at a much more rapid rate. The reason behind this trend can be partially explained by the manner in which the Texas PUC implemented the fuel factor adjustment associated with the “Price to Beat” residential rate cap established for the legacy utilities’ REP affiliates. The PUC allowed the “Affiliate REPs” to adjust the price of all energy produced, regardless of fuel source, by the cost increases of natural gas with a de facto upward only ratchet mechanism, because the fuel factor adjustment was not mandated to decrease when natural gas prices declined. The following chart shows the actual PTB fuel factor for an affiliated REP in Texas compared to an estimate of what their traditional regulated fuel factor might have been under a continuation of historic regulated fuel factored rates. While this comparison may not be perfect, it does show the lack of responsiveness to changes in fuel prices over time.

7

PTB Fuel Rate vs. Est. Regulated Fuel Factor

$0.02$0.03

$0.04$0.05

$0.06$0.07

$0.08$0.09

$0.10

Jun-0

1

Dec-01

Jun-0

2

Dec-02

Jun-0

3

Dec-03

Jun-0

4

Dec-04

Jun-0

5

Dec-05

Jun-0

6

Dec-06

Month/Year

$/kW

h

$2$3$4$5$6$7$8$9$10$11$12

Gas

Pric

e ($

/MM

Btu

)

PTB Rate Estimated Regulated FF Gas Price I know that the pure economic theory is that competition ultimately drives prices down. Theory assumes that competitors will all fight to win as much market share as they can get by continuing to lower their prices below those of their competitors until they reach their marginal price. Please excuse this old engineer’s lack of sophistication but that just is not how it works in the real world. First, each competitor’s ability to expand to serve more customers is limited to its ability to raise capital. Therefore, each competitor is seeking to win only the market share they can manage. For example, an ERCOT market participant’s ability to expand will be limited by its ability to provide ERCOT credit collateral. Secondly, participants actually strive to charge the highest price they can charge and still maintain their target market share. They want to maximize the return on their investment, not minimize it to something just barely above their marginal production cost. That is what has happened in ERCOT. REPs have pushed their price as close to the administratively set Price to Beat (with its high fuel factor adjustment) as they can and still maintain their target market share. Wholesale market participants have followed suit, pushing the price of all energy sources as close to the natural gas based prices as they can and still maintain their target market share. Now that the Price to Beat has been eliminated it will be interesting to see how the ERCOT wholesale and retail markets respond. ERCOT has one more major restructuring looming on the horizon, the implementation of a “Nodal” (LMP) based market structure. I want to briefly highlight two concerns with the design of that market;

• The advent of the energy only market design and • The proposed methodology for distributing Congestion Revenue Rights

Capacity based market designs, such as those found in PJM, and NYISO, use capacity payments to generators as incentive to encourage investment in new generation. The energy only approach of the ERCOT Nodal market design relies on occasional, very high market prices to serve as incentive for future investments in generation infrastructure.

8

Energy only markets are reactive in nature, relying on capacity shortages to lead to temporary higher prices which in turn create incentives for generators to build new capacity that will reduce prices. The problem with this market design is that most lower cost generation additions require a significant lead time from the time the need is identified until the new generation is available. Thus, once a capacity shortage is realized, both retail and wholesale consumers, may be subject to volatile and, at times, very high prices until a willing developer can get new generation built and operational. In a LMP market design it will be much more difficult for wholesale customers like Munis to avoid that volatility. Those of us who have the benefit of actually knowing our customers can tell you that retail customers want predictable, stable prices, not volatility. That is true whether they are a grandmother on a fixed income or an industrial customer trying to plan their annual budget and set their product prices. Furthermore, I am not convinced that generation developers, and more importantly their financing agents, will invest funds in new projects that will only serve to drive future market prices down, in response to past excess margins already captured. Frankly, I much prefer a more structured and planned approach to future generation development. While I do not feel that capacity based markets are perfect, I do feel that, if structured correctly, a capacity payment approach could allow the market to have more determination of what type of future generation gets built in the market, where it gets built, and how much is built. My second area of concern for the future involves ERCOT’s proposed mechanism for distributing Congestion Revenue Rights in the new nodal market. Other emerging nodal markets, such as PJM, at least opened the market with their Financial Transmission Rights being allocated to load serving transmission users. This created a certain degree of stability in the market as it adapted to the changes of the nodal market design. ERCOT has chosen to ignore this approach and will sell Congestion Revenue Rights via an open auction mechanism. This will create a commodity market for hedging rights that claims to offer a hedge against congestion costs, albeit imperfect, but the price will be open to manipulation by speculators. As with the energy only nodal market design, ERCOT again opted for a market structure that promotes price volatility and uncertainty, the very opposite of the stable reasonable prices that most public power entities strive for. Summary What concerns me most about the deregulation movement in general is my belief that we are losing sight of the true needs of retail customers. Those customers are not experiments in a test tube. They are real life people who, if we take the time to listen, will make it clear that what they want is stability, predictability, and value in their future energy services. It does not appear to me that deregulation of the electric industry has delivered those items to customers. It is a nuisance when your phone doesn’t work and a real pain when you are stuck in an airport because planes are not flying on schedule, but you can tolerate those inconveniences. But, low cost reliable electric energy is a necessity in the lives of every US citizen and a major building block in the foundation of the US economy. If we forget those simple facts in favor of turning this critical market into a playground for economic theory, the results could be disastrous.