Memo INTRODUCTION UNDER-SCHEDULING

Transcription

1 California Independent System Operator Memo To: ISO Board of Governors From: Greg Cook, Senior Policy Analyst/Market Surveillance Committee Liaison CC: ISO Officers Date: September 28, 2000 Re: Management Response to MSC June Price Spikes Opinion INTRODUCTION At the September 8, 2000 board meeting, Frank Wolak, Chair of the Market Surveillance Committee (MSC), presented the findings of MSC s analysis of the June 2000 Price Spikes experienced in the California energy and ancillary services markets. The MSC identified market design flaws that they believe have significantly hindered market performance. The first design flaw outlined by the MSC in their report is that regulatory constraints on forward contracting for energy and ancillary services by utility distribution companies (UDCs), along with the failure of the UDCs to fully utilize the limited authority they had to enter into forward contracts has significantly hindered market performance. The MSC also contends that the lack of a price-responsive final demand and the ISO s policies with respect to the purchase of replacement reserves and the ISO s method for allocating the cost of these purchases also contributed to poor market performance. This memo responds to Chair Smutny-Jones request for a management response to the September 6, 2000 MSC report An Analysis of the June 2000 Price Spikes in the California ISO s Energy and Ancillary Services Markets. The ISO management in large part concurs with the assertions and solutions referenced in the report and has been developing recommendations to address these market issues based on the MSC s recommendations. This memo summarizes the main points of the MSC report and the management response. UNDER-SCHEDULING Since the first summer of operation of the California electricity market, during high load conditions there has been significant under-scheduling of load and generation on a day-ahead and hourahead basis relative to real-time electricity consumption and production. Under these system conditions, substantial amounts of generation and load often do not submit day-ahead or hourahead schedules and instead choose to trade in the ISO s real-time imbalance energy market. Trading a significant amount of load and generation in the real-time market can considerably reduce system reliability. As a result of this concern, in mid-august 1999 the ISO Board GCook Page 1 9/29/00

2 implemented a Replacement Reserve procurement mechanism and cost allocation scheme designed to eliminate the reliability problems caused by large quantities of generation and load showing up in real-time during high load hours. The MSC report describes the replacement reserve cost allocation scheme implemented in August of 1999 and its unintended consequences for the exercise of market power. The MSC previously commented on the proposal in a March 1999 report. The MSC s March 1999 Report noted that the implicit tax on shifting load from the ISO s real-time market to the PX markets may increase prices in both the PX and real-time market. The ISO recognized that the proposal would act as a tax on load that shifted to the real-time market and that it would provide load an incentive to purchase more energy in the PX market at a higher price. This was precisely the intent of the proposal. The ISO agrees with the MSC s most recent conclusion that the current replacement reserve procurement mechanism and cost allocation scheme has increased the expected revenues available to generation unit owners from under-scheduling. The combination of the replacement reserve cost allocation scheme and the June 2000 ISO price caps on adjustment bids and real-time energy also provides Load Serving Entities (LSEs) with an incentive to bid a zero demand into the PX at a price of $750/MWh, adding to the under-scheduling problem. Thus, the ISO agrees with the MSC that there have been possible adverse impacts of the current deviation replacement reserve cost allocation scheme and is evaluating possible alternatives, including the recent MSC recommendations. OUT-OF-MARKET PAYMENT MECHANISM The ISO Tariff permits the ISO to make Out-Of-Market (OOM) purchases when it anticipates the amount of energy available through the real-time market will be insufficient to meet system demand and when there are specific location energy requirements that cannot be met by resources having standing market bids or through the dispatch of RMR units. Prior to January 2000, in-state generators that were called Out-Of-Market were paid the ISO s hourly ex-post prices. In response to complaints from generator owners that the hourly ex-post price did not adequately compensate them for their full operating costs, the ISO developed and alternative payment option. The alternative payment option pays generators called out of market both a capacity component and an energy component as well as verifiable fuel related start-up costs and gas imbalance charges that result from the ISO OOM call. The MSC outlines in their report that the ISO s recently adopted alternative OOM payment scheme has increased the attractiveness to generators of not participating in any of the California energy and ancillary services markets. The MSC recommends that the ISO eliminate the current Out-of-Market (OOM) payment mechanism and replace it with a scheme that makes receipt of OOM calls always less attractive to suppliers than participating in the markets. The ISO would like to clarify that it offered the current alternative OOM payment to generators because there are often times when the ISO needs to call on units OOM for only a few hours of the day. Often, the energy prices during those hours cannot adequately compensate generation unit owners for their running costs. In such cases, the ISO policy has been to make generators whole with respect to their running costs. The ISO does not feel that it could justify ordering generation units to run at a loss. In addition, although the potential GCook Page 2 9/29/00

3 for withholding exists under the current structure, there is no strong evidence that the current OOM mechanism was problematic during the summer of However, the ISO believes that there is merit in discussing the new MSC recommendation further with the MSC to find a solution that would be acceptable to the FERC and would not provide the withholding incentives referenced by the MSC in their report. 10-MINUTE SETTLEMENTS The MSC indicates in their report that there are two potential market power problems associated with the ISO s ten-minute settlement scheme. The first relates to what the ISO calls residual imbalance energy. Under this scheme, the ISO attempts to make the distinction between generators who deviate from their schedules because they responded to the ISO s dispatch instructions in a previous settlement period and those who deviate from their schedules without instructions from the ISO. The MSC indicates that attempts to distinguish between different types of energy supplied within the same time period creates incentives for generation unit owners to have their energy classified as the one that is paid the higher price, often with detrimental impacts on system reliability and spot price volatility. Specifically, under this scheme it is possible for two generators with the same forward schedules and real-time production to be paid differently by the ISO for imbalance energy they supply. The MSC notes that the other problem associated with the ten-minute settlement is the creation of potentially two prices within each ten-minute interval in order for the ISO operator to have the tools to provide the necessary signals to generators to meet the ISO s frequency control requirements. The MSC contends that the reliability problem that led to the creation of two prices within a ten-minute interval can be overcome by setting a single price at a five-minute interval. The ISO agrees with the MSC that attempts to distinguish between different types of energy supplied within the same period creates incentives for generation unit owners to have their energy classified as the one that is paid the higher price. Ten-minute settlements do create incentives for generation unit owners to have their real-time energy receive the highest price. However, the mechanism is designed such that the highest price will always be for instructed energy rather than uninstructed energy. The ISO believes that creating incentives for generators to follow dispatch instructions rather than operate uninstructed improves reliability. The ISO will further analyze the MSC s recommendations regarding 10-minute settlements including looking at a five-minute settlement alternative which the MSC indicates would create stronger incentives for maintaining system reliability. PG&E HYDRO DIVESTITURE In August of this year, the ISO and PG&E entered a market power mitigation agreement regarding the divestiture of PG&E s hydro generation portfolio. The MSC s report indicates that the proposed agreement between the ISO and PG&E does not sufficiently take into account the potentially serious market power implications of the agreement. The MSC contends that the agreement GCook Page 3 9/29/00

4 places too much focus on enhancing system reliability and fails to adequately address market power concerns. The MSC recommends in their report to delay the divestiture of PG&E s hydro generation units and for the ISO to reconsider its proposed hydro market power mitigation agreement with PG&E. The MSC contends that the proposed agreement does not appear to offer any guarantee that wholesale prices will not be adversely impacted by the transfer of PG&E s hydro portfolio from a market participant with an incentive to keep wholesale prices low to a market participant with an incentive to achieve high wholesale prices. The ISO agrees with the MSC that the divestiture of PG&E s hydro portfolio will have a large impact on the energy and ancillary service markets. This is precisely why the ISO developed the market power mitigation agreement with PG&E. The ISO acknowledges that no market power mitigation measure is perfect. Instead, the ISO believes that it is important to balance the need to effectively mitigate market power with the objective of allowing the markets to operate without undue regulatory intervention. Moreover, since the market power mitigation agreement is the product of a negotiation, the agreement reflects and balances the concerns of the parties to the negotiation. Nonetheless, the ISO believes that the ISO-PG&E agreement would reduce the ability of PG&E CalHydro to exert market power while minimizing any reduction in the value of the hydro portfolio. Moreover, the agreement allows the ISO to seek additional protections if circumstances change or if it becomes evident that the agreement is insufficient to address market power. Finally, the ISO has not taken a position on whether or when divestiture should occur; instead the ISO has focussed on ensuring that whatever approach the California Public Utilities Commission adopts for disposing of the hydro units, the approach includes mechanisms to minimize the potential for the exercise of market power. This remains a very high priority for the ISO. FORWARD CONTRACTING The MSC report focuses significant attention on insufficient forward market hedging in California s energy and ancillary services markets. The MSC notes that had California s three UDCs signed forward financial contracts equal to their expected net demand for energy and ancillary services during each hour of the months of May and June of 2000, average prices in the PX and ISO markets during these months would have been significantly lower. Even if the June 2000 price spikes had still occurred, the UDCs would have been largely insulated from this spot market price volatility with forward hedges. The MSC outlined the significant benefits to load serving entities from purchasing forward financial contracts. First, the MSC notes that forward market purchases limit the spot price exposure faced by a load serving entity in that it is subject to spot price risk on its real-time energy requirements only to the extent that they differ from its forward market purchases. The second source of benefits noted by the MSC is that forward market purchases from a generation unit owner limits the incentives the supplier has to exercise market power in the spot market. In addition, forward purchases of energy and capacity would have induced the market participants who sold these contracts to bid more aggressively into the ISO s energy and ancillary services market, thereby reducing their incentive to exercise market power during high load conditions. GCook Page 4 9/29/00

5 The ISO agrees strongly with the MSC that forward contracting by market participants will reduce the risk of price spikes and is an important element of a competitive electric market. The ISO supports the MSC recommendation to eliminate restrictions on how, with whom, and how much forward contracting UDCs can engage in energy and ancillary services. Place Greater Emphasis on Market Power Implications of Reliability Proposals The MSC recommends that the ISO Board and Staff place a greater emphasis on the market power implications of proposals designed to improve reliability. The ISO management agrees that it is very important to consider the market power implications of any proposed market rule changes. Moreover, the ISO has implemented a number of market reforms based on recommendations from the MSC including: - The ISO spent over a year renegotiating its Reliability Must-Run Contracts to address market power concerns raised by the MSC and Department of Market Analysis, - Most of the reforms to the ISO s ancillary service market were based on recommendations from the MSC, and - The MSC has been actively involved in reviewing the ongoing effort to redesign the ISO s Congestion Management Market and has provided significant input on design elements that mitigate market power in the procurement of local reliability services. Staff will continue to strive to consider the market power implications of any proposal designed to improve system reliability. The ISO Staff will continue to work with the MSC to carefully evaluate each of the recommendations in the report and to implement market designs that will not only improve the reliability of the system, but provide the proper incentives to facilitate workably competitive energy and ancillary services markets. GCook Page 5 9/29/00