Comments on ISO s Third Revised Straw Proposal for Settlement of Interties in Real-Time

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1 Comments on ISO s Third Revised Straw Proposal for Settlement of Interties in Real-Time Department of Market Monitoring July 26, 2012 Summary The Department of Market Monitoring (DMM) appreciates the opportunity to provide comments on the Settlement of Interties in Real-Time: Third Revised Straw Proposal. 1 DMM has serious concerns about the ISO s proposal which we have expressed to the ISO. DMM s key comments and concerns are summarized below: Virtual bids at the interties provide little or no hedging benefits and little or no liquidity benefits. Concerns over accommodating intertie virtual bids should therefore play, at most, a very minor role in determining the optimal intertie scheduling and settlement structures for maximizing market efficiency and minimizing uplift costs. We support the ISO considering adjustments to intertie settlements that reduce uplift payments and enhance market efficiency. Futhermore, we strongly support the ISO s attempts to estimate the settlement cost impacts of the proposal. 2 However, the ISO s analysis does not lead us to conclude that total uplift would decrease under the ISO s proposal relative to the status quo. FERC s VER order severely limits the amount of time that the ISO s proposal would be utilized in production before ceding to a dispatch and settlement structure with a single 15-minute real-time market. Given: 1. the uncertainty in the proposal s effectiveness in reducing uplift costs, 2. the clear uplift and efficiency benefits of a single real-time market, and 3. the time and resources required to implement the proposal DMM strongly recommends that the ISO consider deferring alteration to intertie bidding and pricing under the current proposal in order to focus its efforts on a dispatch and settlement approach with a single 15-minute real-time market. If the ISO proceeds with the basic elements of the proposal, the ISO needs to more carefully restrict the conditions under which physical import schedules receive makewhole payments. The proposal allows opportunities to receive low-risk profits from import make-whole payments without providing any power. If the ISO determines that make-whole payments are crucial for reliability, we strongly support limiting the make-whole payments system-wide to either imports or exports for any given hour. 1 Settlement of Interties in Real-Time Third Revised Straw Proposal, June 20, 2012, available at 2 Preliminary Results from ISO Settlement Assessment, June 27, 2012, available at IntertiePricingSettlement.pdf DMM/REK 7/26/2012 Page 1 of 8

2 If the ISO proceeds with the basic elements of the proposal, the position limits for intertie virtual bids should be set extremely low and increased only gradually until the ISO can demonstrate that the benefits of intertie virtual bids outweigh their costs. Costs include increasing the import make-whole payments and inefficiencies inherent in any resolution of the Dual Constraint issue. We support allocating the cost of export make-whole payments to deviations from day-ahead schedules that result in incremental real-time energy (positive supply deviations, negative load deviations, and virtual demand). Similarly, the cost of import make-whole payments should be allocated to deviations from day-ahead schedules that result in decremental real-time energy (negative supply deviations, positive load deviations, and virtual supply). We provide additional detail on these comments below. Intertie virtual bids provide little to no value to market efficiency Proponents of intertie virtual bids have argued intertie virtual bids provide benefits to markets in three ways. First, intertie virtual bids allow physical intertie resources to hedge outages. Second, intertie virtual bids allow intermittent intertie resources to hedge their real-time availability. Third, intertie virtual bids provide benefit through increased day-ahead liquidity at the interties. DMM disputes these claims with explanation below. We have explained elsewhere that our analysis of intertie virtual bidding throughout 2011 revealed de minimus use of intertie virtual bids to hedge outages and to hedge intermittent resources. 3 Regardless of the extent to which intertie virtual bids have been, or will be, used to hedge outages and intermittent resources, other available mechanisms can be used to achieve these theoretical hedges. We therefore assert that intertie virtual bids appear to provide no benefit with regard to hedging outages or hedging the availability of intermittent intertie resources. First, consider the use of virtual demand on interties (i.e. virtual exports) to hedge the outage of a physical import. The power marketer will receive the same payments in every scenario by replacing virtual demand with a reduction in its scheduled import quantity. Rather than bidding X MWs of imports and 0.1X MWs of virtual demand to hedge a 10% probability of outage, the power marketer can simply bid 0.9X MWs of physical imports. The net day-ahead payments to the power marketer will be the same using either strategy: receiving payment for 0.9X MWs at the day-ahead price. In realtime, if there is not an outage of the X MWs, the power marketer receives the real-time price for 0.1X MWs using either strategy. Similarly, if there is an outage of the X MWs, the power marketer s net real-time settlement is to buy back 0.9X MWs at the real-time 3 Reply Comments of the California Independent System Operator Corporation and the Department of Market Monitoring and references therein, available at DMM/REK 7/26/2012 Page 2 of 8

3 price under either strategy. Virtual intertie bids therefore do not have value in terms of hedging the outage of a physical resource. Next, consider the use of intertie virtual supply to hedge the availability of intermittent intertie resources. In their comments for the FERC Technical Conference on convergence bidding, 4 Morgan Stanley claims that intertie virtual bids create value by allowing power marketers with intermittent resources to lock in the day-ahead price, but not purchase transmission until hour-ahead when they have a more accurate assessment of their available power. An equivalent way of stating this purported benefit is to say that intertie virtual bids allow power marketers with an uncertain quantity of real-time deliverable capacity to avoid the HASP Reversal Rule when arbitraging an intertie s day-ahead and real-time price. These statements are equivalent because power marketers with an uncertain quantity of deliverable physical energy can schedule their maximum potential physical import quantity in the day-ahead market. Furthermore, they can even lock in this dayahead price while waiting until the hour-ahead market to purchase transmission. Because of the HASP Reversal Rule, the power marketer will simply not be able to profit from buying back any untagged day-ahead quantity at a real-time price that is lower than the locked-in day-ahead price. Instead, the HASP Reversal Rule requires the power marketer to first obtain transmission and e-tag day-ahead schedules in order to profit from those day-ahead schedules not being delivered in real-time. The HASP Reversal Rule creates reliability value by only allowing physically feasible intertie resources to arbitrage day-ahead and real-time intertie prices. The fact that intertie virtual bids allow power marketers to circumvent the HASP Reversal Rule is problematic and is certainly not a market benefit of intertie virtual bids. However, weighing the merits of the HASP Reversal Rule is directly related to what we believe is the central argument of whether or not intertie virtual bids add market value: Is the increased liquidity from allowing potentially physically infeasible schedules to arbitrage day-ahead and real-time intertie prices more beneficial to market efficiency than the costs of allowing intertie virtual bids? Having addressed the questionable potential value of intertie virtual bids as a hedging instrument, we believe the argument over allowing intertie virtual bids should be focused on whether the incremental benefits of the locational day-ahead liquidity provided by virtual bids exceed their costs. In the absence of intertie virtual bids, we have not observed evidence of day-ahead liquidity issues at the interties. Unlike internal nodes where there can be substantial locational market power, the interties are open to competition from a great number of entities and resources. Therefore, the incremental increase in day-ahead liquidity from allowing physically infeasible schedules to arbitrage day-ahead and real-time prices provides very little benefits to market efficiency. 4 Comments of Morgan Stanley Capital Group Inc. under ER , available at DMM/REK 7/26/2012 Page 3 of 8

4 There does not appear to be sufficient benefit to market efficiency from intertie virtual bids (under any proposed two real-time market structure) to outweigh the potential resulting uplift costs and reduction in the liquidity of physically feasible schedules. Intertie virtual bids should not be implemented under a two real-time market structure. Unclear if Proposal will reduce uplift payments Even in the absence of virtual bids at the interties, differences between the HASP and RTD markets can create substantial uplift payments in the form of real-time imbalance energy offset charges. 5 We therefore support the ISO considering adjustments to Intertie settlements that would reduce uplift payments. Futhermore, we strongly support the ISO s attempts to estimate the settlement cost impacts of the proposal. 6 However, the ISO s analysis does not lead us to conclude that total uplift would decrease under the ISO s Proposal relative to the status quo. The ISO s preliminary results show that during the December 2011 to May 2012 period studied, if the same HASP schedules were instead settled under the proposal s settlement structure, there would have been a slight net reduction in total uplift. While such a result is encouraging, the methodology cannot account for how the quantity of incremental HASP schedules would have shifted as a result of market participants responding to intertie resources settling on RTD instead of HASP. In particular, with HASP prices on average below IFM and RTD prices, and with RTD prices on average above IFM and HASP prices, we would expect a significant shift in the quantity of incremental real-time import schedules if those schedules were settled on RTD as opposed to HASP. With real-time intertie schedules settling on HASP, the above pricing relationship between the three markets creates incentives for imports to schedule at the day-ahead price and exports (or decremental imports) to schedule in real-time. However, if intertie resources were settled at the RTD price, there would be price incentives for imports to schedule and settle in real-time instead of day-ahead. As discussed below, we also expect intertie virtual bids would cause an increase in the quantity of net imports scheduling and settling in real-time. The schedule shift towards more incremental real-time imports would increase the makewhole payment relative to estimates made using actual schedules from December 2011 to May Therefore, it is still not clear whether the Proposal would reduce total uplift relative to the status quo. 5 Settlement of Interties in Real-Time Second Revised Straw Proposal, April 23, 2012, pg 7-8, available at 6 Preliminary Results from ISO Settlement Assessment, June 27, 2012, available at IntertiePricingSettlement.pdf DMM/REK 7/26/2012 Page 4 of 8

5 FERC VER Order s impact on Proposal In their comments on the Third Revised Straw Proposal, Powerex accurately characterized the source of many of the market inefficiencies and uplift costs addressed in this stakeholder initiative as being caused by the disparate dispatch and settlement treatment of interties and internal resources in real-time. 7 Furthermore, we agree with Powerex that: The ISO s current proposal, which combines a 3-market-optimization with a 2- market-settlement, is highly problematic; The necessity for make-whole payments underscores the inadequacy of the design; A 2-market-optimization with a 2-market-settlement would resolve the inefficiencies and uplift costs associated with the disparate dispatch and settlement of internal and intertie resources; and FERC s VER order makes this highly preferable dispatch and settlement structure inevitable in the near future. In deciding whether to continue to pursue the proposal in light of FERC s VER Order, we believe the ISO should consider the following four items: The ISO s confidence that the proposal would be an improvement in market efficiency relative to the status quo; The length of time the alleged benefits of the proposal would be realized before ceding to the superior 2-market-optimization, 2-market-settlement structure; The delays in implementing the superior 2-market-optimization, 2-marketsettlement structure that would be caused by diverting resources to design and implement the proposal; and The possibility of being required to reinstate intertie virtual bidding under the current settlement structure. DMM is not confident that the proposed 3-market-optimization, 2-market-settlement structure would reduce total uplift payments relative to the status quo. A 2-marketoptimization and settlement structure would be a vast improvement in terms of market efficiency and uplift costs relative to both the status quo and the proposal. Therefore, DMM recommends the ISO give strong consideration to redirecting effort away from the current proposal in order to focus policy and implementation on a 2-market-optimization and settlement structure. 7 Powerex Comments on Intertie Pricing and Settlement Third Revised Straw Proposal, pg 1-2, available at IntertiePricingSettlementThirdRevisedStrawProposal.pdf. DMM/REK 7/26/2012 Page 5 of 8

6 However, reinstating intertie virtual bids under the current settlement structure would be detrimental in terms of both market efficiency and uplift costs, as was the case during the period that led to the ISO s filing to discontinue intertie virtual bids. 8 Restricting make-whole payments under the proposal If the ISO proceeds with the basic elements of the proposal, the ISO needs to more carefully restrict the conditions under which physical import schedules receive makewhole payments. The proposal allows unacceptable opportunities for marketers to receive low-risk profits from import make-whole payments without providing any power. In particular, as currently proposed, a power marketer could schedule an equal quantity of physical imports and exports in HASP during hours the entity detected patterns of low RTD price troughs. The entity could use a high, price-taking export bid to ensure the export schedule cleared. The entity could use a low enough import bid to ensure the import schedule cleared most hours, but not so low as to eradicate most import makewhole payments. During hours when both import and export schedules cleared, the entity would have no settlement other than: The make-whole payment equal to the amount the import bid exceeded the RTD price; and Fees from the cleared import and export schedules. While persistent fees for cleared intertie schedules could mitigate the profits from this basic strategy and other variants of this basic strategy, the combination of offsetting cleared import and export schedules could drastically reduce the fees. With low fees and/or high expected RTD-HASP price spreads, the above strategy and some of its variants become extremely profitable and low in risk. As a result, DMM strongly opposes a make-whole payment for imports in the absence of a comprehensive set of rules that will eliminate opportunities to exploit the make-whole payment. We recommend the rules be designed to eliminate the make-whole payment for various combinations of offsetting physical and virtual imports and exports in the dayahead and HASP. Furthermore, the rules for applying worse-of pricing to undelivered intertie schedules, transaction fees, the HASP Reversal Rule, and circular schedule rules to offsetting imports and exports should be carefully re-considered and incorporated into the rules for mitigating exploitation of the Proposed make-whole payment. These rules would need to be implemented at the affiliate level in order to adequately mitigate the opportunities for exploiting the make-whole payment. If the ISO determines that make-whole payments (with rules for mitigating its exploitation) are crucial for reliability under the proposal, we strongly support limiting the make-whole payments system-wide to either imports or exports for any given hour. Proposals to clawback the export make-whole payment for entities that earn both import 8 See DMM and CAISO materials submitted for FERC Technical Conference on Convergence Bidding, Docket No. ER DMM/REK 7/26/2012 Page 6 of 8

7 and export make-whole payments in the same hour would be ineffective in mitigating the Amendment 66 concerns because the Amendment 66 strategies do not involve receiving both uplifts concurrently. No intertie virtual bids under the proposal As described above, intertie virtual bids provide little to no value in terms of market efficiency, regardless of the settlement structure. Under the proposal, however, we expect intertie virtual bids to exacerbate the make-whole payment. We expect power marketers with flexible real-time intertie import portfolios would use intertie virtual bids to circumvent the HASP Reversal Rule. In particular, we would expect physical importers to frequently use virtual supply to displace their physical import bids in the day-ahead market. This will allow them to avoid procuring transmission while profiting from buying that power back in real-time when they expect real-time prices to be lower than their day-ahead sale price. However, when real-time prices are expected to be higher than their day-ahead sale price, they can buy transmission and physically import the power through an incremental real-time import in order to obtain the day-ahead price. In the absence of intertie virtual bids, this same strategy would be employed, but the entity would schedule the physical imports in the day-ahead and procure transmission. The entity would schedule to decrement its day-ahead physical schedule in real-time, in order to arbitrage day-ahead and real-time prices. Therefore, we anticipate that implementing intertie virtual bids under the proposal would systematically displace physical imports in the day-ahead market and cause more incremental imports to be economically bid into HASP. As a result, intertie virtual bids would cause total make-whole payments to increase. The costs that intertie virtual bids will impose on those responsible for paying the makewhole will likely exceed the minimal benefits intertie virtual bids may provide to liquidity. Therefore, if the ISO proceeds with the basic elements of the proposal, the position limits for intertie virtual bids should be set extremely low and increased only gradually until the ISO can demonstrate that the benefits of intertie virtual bids outweigh their costs. Costs include increasing the import make-whole payments and inefficiencies inherent in any resolution of the Dual Constraint issue. Cost allocation of make-whole payment under proposal We support applying cost-causation principals to the allocation of make-whole payment costs. We therefore support the ISO s proposal to allocate the cost of export make-whole payments to deviations from day-ahead schedules that result in incremental real-time energy (positive supply deviations, negative load deviations, and virtual demand). Similarly, the cost of import make-whole payments should be allocated to deviations DMM/REK 7/26/2012 Page 7 of 8

8 from day-ahead schedules that result in decremental real-time energy (negative supply deviations, positive load deviations, and virtual supply). DMM/REK 7/26/2012 Page 8 of 8

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