FERC Approves Reforms to PJM Capacity Market

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1 RESEARCH North America Power and Utilities Smart Grid FERC Approves Reforms to PJM Capacity Market FERC Order Facilitates Inclusion of PJM Capacity Performance Reforms Ahead of August Forward Capacity Auction June 22, 2015 Policy Brief Author Erin Carson Chief Policy Strategist Jack Laursen Analyst Contact (212) Key Takeaways: PJM s forced generation capacity outages in the 2013/2014 winter, along with long- term distributed generation trend, prompted PJM to propose capacity market reforms to ensure system reliability After requesting additional information in April, FERC approved PJM s approval, allowing for inclusion in August Forward Capacity Auction Capacity Performance will impose stringent operational requirements and non- performance penalties and cost billions of dollars in the near term Related Research FERC Ruling Contributes to PJM Market Uncertainty PJM Aims for Improved Reliability with Proposed Capacity Market Reforms Entities Mentioned: Federal Energy Regulatory Commission Independent System Operator of New England PJM Interconnection, LLC This report is for industry information only and we make no investment recommendations whatsoever with respect to any of the companies cited, mentioned, or discussed herein. Please refer to the end of this report for analyst certification(s) and other important disclosures.

2 Insight for Industry FERC PJM CP Approval Signals New Era for Power Markets On June 9, 2015, the Federal Energy Regulatory Commission (FERC) conditionally approved PJM Interconnection LLC s (PJM) Capacity Performance (CP) Proposal, recognizing the need for significant reforms to ensure long- term reliability of electricity supply in the PJM Regional Transmission Organization (RTO) region covering 13 states and the District of Columbia. The new CP product Capacity Performance Resource is expected to enhance incentives for resource availability when needed most, alleviate price spikes during emergencies, and diminish the possibility of expensive forced outages. The approval represents a substantial overhaul to the PJM capacity market and gives considerable discretion to PJM. FERC notes that PJM has demonstrated the need for reforms to address weakening resource performance and ongoing changes in the region s resource mix caused by cheap natural gas, new EPA regulations and falling costs of renewable energy. FERC s approval of the PJM proposal is demonstrative of the fundamental transition taking place in power markets, as utilities and regulators adapt to an era of reduced coal consumption and a greater role for distributed generation. Specifically, the approval allows demand response, energy storage, energy efficiency, and intermittent renewable resources to directly participate as a stand- alone CP resource, or aggregate bids for combined capacity within a Locational Delivery Area (LDA). PJM proposed the CP product partly in response to poor generator performance during the January 2014 Polar Vortex when 22 percent of generation was unavailable on the coldest day. The new CP will result in larger capacity payments for over- performing resources and higher penalties for non- performers. The new CP product will replace current capacity products in the PJM region to facilitate sustained, predictable operation through reliable resource availability during emergency conditions. It is likely to result in investments of hundreds of millions across the PJM region to strengthen power plant operations and reduce outages. The reforms pose significant near- term challenges to some power generators due to potentially needed investments in fuel- supply, weatherization, and overall system upgrades to ensure reliability. PJM proposed the new CP plan in part due to the 2014 Polar Vortex 2015 EnerKnol, Inc. All rights reserved. 2

3 Figure 1 - Projected Generation Retirements, Additions and Net Generation Supply Change Through 2016/2017 Delivery Year , MW / / / Addicons Recrements Cumulacve Change in Generacon Source: PJM PJM to Incorporate Capacity Performance in Annual Auction for Delivery Year The June 9 FERC Order enables PJM to incorporate CP into the annual Base Residual Auction (BRA) for the delivery year. The CP proposal modeled in part after ISO- New England s (ISO- NE) pay- for- performance capacity market design reflects the need for stronger incentives within the existing capacity market structure to encourage investment from new and existing resources. Capacity Performance will transition into PJM s existing capacity market construct Reliability Pricing Model (RPM) from the 2016/2017 Delivery Year with full implementation in the 2020/2021 Delivery Year. PJM has utilized its RPM since 2007 to obtain generation capacity or demand reduction commitments three- years ahead to meet peak load projections. The RPM consists of annual competitive BRAs which set long- term market price signals for new capacity and reliability investments. To facilitate transition to CP, PJM s proposal includes an interim capacity product Base Capacity Resource with a lower performance expectation for the and delivery years. PJM will procure at least 80 percent of capacity requirement for those years from CP resources and the remainder from base capacity resources. For the delivery year and beyond, PJM will procure 100 percent capacity requirement in the form of CP. The streamlined transition period allows time for market participants to adapt and lessen cost impacts. Clearly- defined capacity obligations, enhanced incentives, higher auction clearing prices, and higher non- performance penalties can potentially eliminate need to request offer cap relief from FERC in the future. In January, PJM sought 2015 EnerKnol, Inc. All rights reserved. 3

4 temporary relief from the $1,000/MWh cost- based offer cap to address winter price spikes that could cause generators marginal costs to exceed the offer cap. PJM submitted its CP proposal (Docket No. ER ) on December 12, 2014 to ensure that its capacity market provides adequate incentives for resource performance. In a contemporaneous filing (Docket No. EL ), PJM submitted proposed changes to implement the reforms in its energy market. PJM sought an effective date of April 1, ahead of the May 2015 BRA for capacity procurements applicable to the delivery year. On March 31, FERC notified PJM that the CP proposal was deficient and sought additional information to process the filing and on April 10, PJM filed a response to the deficiency letter. On April 24, FERC granted PJM s request to delay the 2015 BRA previously scheduled for May 11-15, 2015 to days after FERC issuance of merits and no later than the week of August 10-14, With the June 9 FERC order, PJM stated that it will make compliance filing within 30 days of the order issuance while preparing for the auction scheduled to begin August 10. FERC requested additional information after PJM announced its CP proposal in December 2014 Existing Penalty Structure Places Risk of Under- Performance on Loads Rather than Resource Providers FERC agreed that PJM s existing capacity market construct does not adequately incentivize resource performance and may adversely impact reliability. Existing capacity market rules compensate a resource based on its real- time performance and increase or decrease total capacity revenue. Resource availability during peak hours is assessed based on its ability to operate in a given hour at expected levels subject to a Peak Hour Assessment Charge, which provides meager incentive to make capital improvements or expand operating expenses to address emergency conditions. PJM stated that the existing penalty structure places most of the risk of under- performance on loads and not on resource owners or operators. A notable disincentive that PJM identified was that the offer cap for existing generators which allows recovery of certain capital costs does not allow inclusion of costs pertinent to natural gas firm transportation arrangements, posing a significant deterrent as additional natural- gas fired resources come line. The Peak- Hour Period Availability Charge applies when a resource s actual availability, during 500 peak hours of the delivery year, is weaker than its five- year average annual outage experience. For the delivery year noted for significant forced outage rates during Polar Vortex days Peak- Hour Period Availability Charges totaled approximately $38.9M, merely 0.6 percent of total capacity revenues. According to PJM, generator equivalent forced outage rates have steadily increased since RPM implementation. The January 2014 Polar Vortex depicted the scope and breadth of reasons for resource unavailability. While natural gas interruptions represented the largest single cause of resource non- performance on a MW basis, approximately 75 percent of the more than 40,000 MW forced outage were attributed to other causes. From , more than 26,000 MW of coal and oil- fired generation has retired or is projected to retire. Currently, natural gas- fired projects account for approximately 82 percent of the projects PJM s interconnection request queue. FERC noted that these reports reasonably demonstrate that resources are inadequately incented to make the investments for reliable performance EnerKnol, Inc. All rights reserved. 4

5 Figure 2 Current Interconnection Queue Capacity MW by Fuel Type (May 2015) Offshore Wind, 50 Nuclear, 2007 Methane, 97 Coal, 1873 Oil, 403 Solar, 1047 Other, 267 Hydro, 249 Wind, 2307 Storage, 32 Wood, 66 Biomass, 137 Natural Gas, Natural Gas Oil Coal Methane Nuclear Offshore Wind Solar Wind Hydro Other Storage Wood Biomass Source: PJM Taking note of improved cold- weather performance after the Polar Vortex outages, FERC stated that it is common for performance to improve after an event and fade out later. Despite successful procurement of commitments three years ahead, PJM s capacity market construct has failed to ensure that resources actually perform when called upon three years in the future. FERC noted that the failure reflects: lack of adequate penalty structure; limited ability to recover costs of necessary investments; and incentive to reduce capital improvement plans and operating budgets. Enhanced CP Market Expands Opportunities for Resource Participation Capacity storage resources, intermittent resources, energy efficiency resources, and demand resources may submit stand- alone CP sell offers in a MW quantity consistent with their average expected output during peak- hour periods. They can aggregate their bids for combined capacity offer provided the aggregation takes place within a LDA. Aggregated offer allowance aims to facilitate CP participation for resources that otherwise may be unable or unwilling to take part on a stand- alone basis due to lack of reasonable investment to mitigate non- performance risk. PJM will establish, on a phased- in basis, an Annual Demand Resource product to replace existing demand resource capacity products, conforming to applicable CP standards. To qualify as a CP Resource, PJM proposed that an offer must include a representation that the seller has made, or will make, necessary investments to ensure that the resource 2015 EnerKnol, Inc. All rights reserved. 5

6 has the capability to provide energy when called upon by PJM and meet applicable operational requirements by the delivery year. FERC rejected PJM s proposed requirement for good- faith representation citing ambiguity and the potential to impede entry of well- performing resources. PJM may reject capacity offers from resources that cannot reasonably be relied upon to meet capacity obligations during emergency conditions, are purely speculative, or would undercut the intent of PJM s CP construct. FERC noted that the scope of PJM s review authority must be appropriately defined and limited. PJM will make the determination based on the Market Monitor s advice and recommendations. External generation capacity resources will be required to obtain an exception to PJM s Capacity Import Limit, including the requirement to be pseudo- tied to PJM by the relevant delivery year. This will ensure that external resources are accountable for their individual performance and PJM has the unit- specific visibility to precisely apply Non- Performance Charges. FERC accepted PJM s requirement, subject to inclusion of a requirement for an external generation capacity resource to demonstrate that it meets or will meet by the start of the delivery year the criteria for an exception to the Capacity Import Limit. FERC also accepted PJM s requirement that resources complete the Facilities Study Agreement to prevent resources that are unlikely to become operational in the relevant delivery year from clearing in a BRA and potentially artificially suppressing regional prices. Market Power Mitigation Provides Revised Offer Cap Methodology PJM s revised Market Power Mitigation rules provide for a default offer cap available to all resources and also allow each resource provider to seek a unit- specific offer cap if it can demonstrate that its costs exceed the default cap. The proposal sets a default offer cap at the product of Net Cost of New Entry (CONE) times the Balancing Ratio and allows resources with high avoidable costs to submit unit- specific offer caps detailing all avoidable cost rate components, including quantifiable risk premium. It reflects the amount that a competitive resource with low avoidable costs (Low ACR Resource) would accept in the capacity market. FERC noted that it is reasonable to set the default cap equal to the competitive estimate for a low ACR resource, as the estimate will be lower than the competitive offer estimate for a High ACR Resource. Offers below the default cap can be considered competitive, and those above that level will be examined to ensure that they are based on legitimate costs and reasonable estimates of unit- specific performance and system parameters. The must- offer requirement aimed to protect against market manipulation allows resources to assess the risk of incurring penalties against the cost of extra investment and reflect the resource provider s balance in the capacity offer. Under PJM s proposal, intermittent resources, capacity storage resources, demand resources, and energy efficiency resources will be categorically exempt from the CP must- offer as their ownership is not concentrated and their physical withholding concerns are not the same as existing generation resources. An individual resource may seek an exception if it demonstrates that it is reasonably expected to be physically unable to meet CP requirements for the delivery year. FERC requires removal of certain provisions, noting that PJM s proposal to exempt Planned Generation Capacity Resources from the capacity market must- offer requirement until they become operational is not convincing EnerKnol, Inc. All rights reserved. 6

7 The FERC accepted PJM s proposal to increase credit requirements corresponding to CP resources increased risk of financial exposure, subject to the condition that revisions recognize LDA- specific Net CONE values in determining a seller s Auction Credit Rate. The FERC also accepted PJM s proposed elimination of existing capacity holdback provision to take effect in the BRA for delivery year. The current market construct reduces capacity procurement amount from BRA by 2.5 percent, requiring the capacity to be procured at a later date through incremental auctions; the requirement was implemented in 2009 to allow short- lead time resources to participate in PJM s capacity market. PJM stated that the holdback restrains demand and suppresses BRA clearing prices. PJM also noted that the longer- lead time associated with its BRA has not hindered participation by short- lead time resources, including demand resources, energy efficiency resources, uprated generation resources, and external resources. Capacity Revenues Closely Tied to Real- Time Delivery of Energy and Reserves PJM s proposed Non- Performance Charge will facilitate closer link between capacity revenues and real- time delivery, thereby incentivizing capacity sellers to invest in and maintain resources. A Non- Performance Charge rate based on Net CONE is more likely to prevent non- performing resources from receiving positive net capacity revenues over the long run and will discourage non- performing resources from taking up capacity obligations as their penalties may fully offset auction revenues in due course. As Net CONE is known ahead of the auction, participants will be aware of the rate prior to submission of offers, providing some extent of certainty before the capacity auction. Though resource providers will not be aware of the quantity and timing of Performance Assessment Hours in the relevant delivery year, they can consider the Non- Performance Charge rate to assess risk, develop investment decisions, and offer strategies. The FERC accepted PJM s proposal to rely on an estimate of 30 hours of Emergency Actions to formulate the Non- Performance Charge rate and requires PJM to make annual informational filings to provide updates on the use of 30 hours for this parameter. PJM must also make annual filings for five delivery years detailing performance and net revenues received from Non- Performance Charges and Performance Bonus Payments. Revisions to Energy Market Rules Broaden Scope of Current Provisions The FERC approved a portion of PJM s proposed revisions to energy market rules. The FERC accepted PJM s revision to the force majeure provisions, recognizing the narrow scope of existing provisions. It also accepted revisions to rules regarding generator outages on grounds current rules hinder PJM s ability to ensure reliability and maintain reserve adequacy at a reasonable cost. The FERC rejected revisions to requirements regarding designating resource capacity as a Maximum Emergency Offer making designated capacity available when PJM declares a Maximum Generation Emergency. PJM proposed to prohibit the designation on a phased- in basis during certain extreme weather alerts or emergencies. Current rules require all generation capacity resources to submit offers for available capacity in the day- ahead market, allowing designation as Maximum Emergency Offer under certain circumstances. The FERC partially accepted PJM s proposed revisions to sellers operating parameters and directed additional modifications. Existing tariff provisions can allow capacity resources to submit energy market offers with inflexible operating parameters that do not reflect actual operating capabilities. Sellers can condition day- ahead energy market offers 2015 EnerKnol, Inc. All rights reserved. 7

8 accepting parameter limitations that extend beyond the operating design characteristics of their specific resources, including economic or budgetary concerns. The FERC deemed PJM s proposed revisions overly restrictive as parameter limits reflect only unit- specific physical constraints, while actual limits would include other constraints, such as contractual limits. For example, physical constraints during peak periods may cause natural gas pipelines to impose contractual provisions such as requiring shippers to take uniform delivery throughout the day. Chairman Bay Dissents Citing CP Design Flaw and Multi- Billion Dollar Costs Chairman Norman Bay dissented to the June 9 Order, stating that the CP product may burden ratepayers with billions of dollars in additional costs without achieving its intended aim. Recognizing the difficulty in conducting a cost- benefit analysis, Chairman Bay emphasized that the CP proposal s potential multi- billion dollar cost and burden for consumers supports the need for an analysis to indicate whether the benefits at least roughly match the costs. In October 2014, PJM estimated that the net incremental cost for the CPP would be $1.4B to 4B. Chairman Bay stated that the RPM has worked tolerably well with marked improvements over the past year. Forced outages dropped from 22 percent in the 2014 winter to 12 percent this winter though both winters were equally cold. He also stated that PJM s capacity market is structurally non- competitive and the CP proposal largely eliminates mitigation, creating a potential mismatch between incentives and penalties. The June 9 Order also weakens the CP design by rejecting PJM s proposal to limit operating parameters to unit- specific physical constraints; requiring resources to be eligible for make- whole payments based on actual constraints creates ambiguity. Though actual constraints would at the very least include fuel delivery arrangements, it is unclear on other constraints, and the provision increases the opacity of make- whole payments. The CP design creates significant incentives to move auction clearing prices up to.85 of Net CONE, as only prices above that level are subject to mitigation in the form of unit specific review. Chairman Bay also stated that the CP incentive structure creates an opportunity to profit non- performance as long the auction clearing price is up to.85 of Net CONE or more and the marginal generator can justify its unit specific costs EnerKnol, Inc. All rights reserved. 8

9 Disclosures Section RESEARCH RISKS Regulatory and Legislative agendas are subject to change. AUTHOR CERTIFICATION By issuing this research report, Erin Carson as author of this research report, certifies that the recommendations and opinions expressed accurately reflect her personal views discussed herein and no part of the author s compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. IMPORTANT DISCLOSURES This report is for industry information only and we make no investment recommendations whatsoever with respect to any of the companies cited, mentioned, or discussed herein. EnerKnol, Inc. is not a broker- dealer or registered investment advisor. Information contained herein has been derived from sources believed to be reliable but is not guaranteed as to accuracy and does not purport to be a complete analysis of the company, industry or security involved in this report. This report is not to be construed as an offer to sell or a solicitation of an offer to buy any security or to engage in or refrain from engaging in any transaction. Opinions expressed are subject to change without notice. The information herein is for persons residing in the United States only and is not intended for any person in any other jurisdiction. This report has been prepared for the general use of the wholesale clients of the EnerKnol, Inc. and must not be copied, either in whole or in part, or distributed to any other person. If you are not the intended recipient you must not use or disclose the information in this report in any way. If you received it in error, please tell us immediately by return e- mail to info@enerknol.com and delete the document. We do not guarantee the integrity of any e- mails or attached files and are not responsible for any changes made to them by any other person. In preparing this report, we did not take into account your investment objectives, financial situation or particular needs. Before making an investment decision on the basis of this (or any) report, you need to consider, with or without the assistance of an adviser, whether the advice is appropriate in light of your particular investment needs, objectives and financial circumstances. We accept no obligation to correct or update the information or opinions in it. No member of EnerKnol Inc. accepts any liability whatsoever for any direct, indirect, consequential or other loss arising from any use of this report and/or further communication in relation to this report. For additional information, please visit enerknol.com or contact management at (212) Copyright EnerKnol, Inc. All rights reserved. No part of this report may be redistributed or copied in any form without the prior written consent of EnerKnol, Inc EnerKnol, Inc. All rights reserved. 9