The Integrated Perspective on Power Market Development in the US: Addressing Market Failures and Responsibilities

1. The Integrated Perspective on Power Market Development in the US:The Issues are as Important as Ever,But Who’s Responsible? Benjamin F. Hobbs Dept. Geography & Environmental Engineering Dept. of Applied Mathematics & Statistics Whiting School of Engineering The Johns Hopkins University Baltimore, MD 21218 USA California ISO Market Surveillance Committee bhobbs@jhu.edu Dublin 31 January 2005

2. Outline • “Old style” vs. “New style” IRP • Old: central planning to address market failures • New: market design to address market failures • Do tradeoffs (environment, costs, renewables, reliability, etc.) no longer matter? • No: Addressed in more appropriate forums • Examples of new planning processes • TEAM: CAISO transmission planning method • Capacity markets • Remaining quandaries • Valuing reliability • Nonlevel “playing field” (market designs) for DSM, renewables

3. Definition of IRP Integrated resources planning

4. Definition of IRP  Integrated, comprehensive consideration of a … … full range of resources (demand, supply, transmission) … …as part of investment planning … considering societal benefits and costs and their distribution (dollar & otherwise) … …considering risks … …in consultation with stakeholders…

5. Generation Planning Gen 1 Gen 2 Gen 3 Gen 4 Transmission Planning System Operation Environmental Planning Demand-Side Planning Central IRP at the Vertically Integrated, Regulated Uility Stake- holders The Planner Consultation Regulator The Plan Prices, DSM, Power Consumers

6. A Classic IRPProcess Source; USAID Office of Energy, Environment & Technology

7. Is such IRP hopelessly dated? www.nps.gov/edis/wrlist.htm

8. Generation Planning Gen 1 Gen 2 Gen 3 Gen 4 Transmission Planning System Operation Environmental Planning Demand-Side Planning Central IRP vs. Decentralized Markets Stake- holders The Planner Regulator Stake- holders Consultation Regulator The Plan Gen 2 Gen 3 Gen 1 Gen 4 Emissions Markets System Operation Demand-Side Planning Transmission Planning Prices, DSM, Power Consumers Consumers

9. Methods • Markets: • Separate consideration of resources by different market parties; coordination by prices • Primary objective (profit), s.t. environmental constraints, emissions allowance costs • Financial risks: Option pricing, financial hedges • Regulators reflect social values in emissions caps, infrastructure (transmission) decisions Old IRP: • Simultaneous consideration of resources; coordination by optimization models • EGEAS, PROVIEW/PROSCREEN, MIDAS • Multiple objective tradeoffs, externality adders • 1 Feb. Dublin workshop • Societal risks: sensitivity analysis, decision trees, physical hedges • Stakeholders express social values • 1 Feb. workshop

10. Dimensions of Economic Efficiency Productive Efficiency Squeeze most you can out of inputs Right mix of inputs Technical innovation

11. Dimensions of Economic Efficiency Productive Efficiency Squeeze most you can out of inputs Right mix of inputs Technical innovation Allocative Efficiency: Motivate consumers to use the “right” amount

12. Purpose of IRP: To Overcome Barriers to Efficiency (“Market Failures”) Productive Efficiency Allocative Efficiency

13. Purpose of IRP: To Overcome Barriers to Efficiency (“Market Failures”) Productive Efficiency Bigger is more efficient ( market power) For instance: Gracie Allen once called a repairman to fix her electric clock. After fiddling with it, the repairman said “There ain’t nothing wrong with the clock, you just didn’t have it plugged in” Gracie: “Well, I don’t want to waste electricity. I only plug it in when I want to know what time it is.” Transaction costs, lack of information (unconsummated deals, too little DSM) Allocative Efficiency

14. Purpose of IRP: To Overcome Barriers to Efficiency (“Market Failures”) Productive Efficiency Can’t buy things you want (e.g., hedges) Bigger is more efficient ( market power) Externalities (e.g., network, environmental) Transaction costs, lack of information (unconsummated deals, too little DSM) No one owns and can sell valued resource (e.g., resource adequacy)  free riders Government sets prices, which don’t reflect marginal cost, value Allocative Efficiency

15. Good Market Design Can Correct Many “Market Failures” Addressed by IRP • Environmental externalities: • Internalized by cap-and-trade systems • Title IV; NOx SIP Call • Floor-and-trade systems for renewables (Renewable portfolio standards, green certificates) • Legislature now makes tradeoffs • For regional or global pollutants, more appropriate forum than individual IRPs • Network externalities: • Internalized in operations by LMP • Market-based transmission: scale economies still a problem

16. Good Market Design Can Correct Many “Market Failures” Addressed by IRP • 3. Free riding on generation adequacy: • Corrected by capacity markets, e.g., “ICAP” (Installed Capacity) Markets • Regulator or ISO makes tradeoffs (how much reserve margin) • In long run: reliability can be priced, and consumers select their preferred level • “ACAP” (Available Capacity Markets) in which ISO cuts off customers lacking contracts if there is shortage (need control equipment, political guts) • Real-time pricing (“economic reliability”) (need meters, consumer acceptance, financial hedges) • 4. DSM • “Market transformation” to overcome information, transaction cost barriers • Real-time pricing could replace load controls (“legacy programs”) • Government or regulated entity subsidize instead of generation company

17. Tradeoffs, Societal Benefits, Resource Substitution Must Still Be Considered by Planning ProcessBut in More Appropriate Forums • Transmission infrastructure planning • Largely centrally planned, considering effects on all market players • Merchant transmission will be niche • Energy efficiency • Government appliance standards; USEPA’s “Green Lights” certification program • Public benefits funds subsidizing DSM • Environmental tradeoffs • Caps on emissions • Renewable portfolio standards More appropriate geographic scope, create level playing field for market players Now generators focus on what they do best: producing efficiently at the right times

18. New Integrated Resource Assessment Process, Case 1: Transmission Planning in the CAISO

19. California ISO:M. Awad, S. Broad, K. Casey, J. Chen A. Geevarghese, K. Johnson, J. Miller, A. Perez, A. Sheffrin, M. Zhang Consultants: E. Toolson, G. Drayton, F. Rahimi CAISO Market Surveillance Committee An integrated economic benefits methodology. Considers: • Savings in resource operation & construction costs • Efficiency gains due to market power mitigation • Improve supplier access to markets  lower bid markups • Less incentive for strategic withholding of inexpensive generation (replaced by higher cost imports/competitive generation) • Transmission-DSM-Generation substitution

20. Then and now: • The economic benefits of transmission to a regulated monopolist were: • Lower reserve margin requirements • Lower production costs • Not as important as reliability • In a market environment, economic benefits include: • Savings in resource operation & construction costs • Efficiency gains due to market power mitigation • Improve supplier access to markets  lower bid markups • Less incentive for strategic withholding of inexpensive generation (replaced by higher cost imports/competitive generation) • Transmission-DSM-Generation substitution • TEAM attempts to calculate these benefits

21. Plan-- But Consider Market Response! • A “multilevel” (Stackelberg) game: • Upper level: planners (& regulator, stakeholders), who anticipate reactions of … • Lower level: market response of consumers, generators • Possible methods: • Multilevel program/math program with equilibrium constraints • Solve iteratively (adjust resources if prices exceed trigger, account for capacity markets)*** Regulator Stake- holders Transmission Planner Gen 2 Gen 3 Gen 1 Gen 4 MARKETS Emissions Markets System Operation Demand-Side Planning Consumers

22. TEAM Principles • Benefits framework: Multiple perspectives • Consumers; Generators; Grid operators; Societal (excluding market power profits?) • No one perspective is “right” • Exclude reliability benefits (hard to monetize) • Full network representation (linearized DC loadflow) • Market-based pricing • Recognize how upgrade might mitigate market power • Recognize uncertainty • Transmission as insurance against extreme events • Different parties have different probability distributions • Resource (supply/DSM) substitution • Simulate market response to changed prices • Account for savings in all resource costs

23. Example TEAM Application: Path 26 Zone Zone Zone

24. Example Effects of ConsideringMarket ResponseandAlternative Scenarios

25. Classic IRP ProductSensitivity, 2013 Benefits

26. A Product of the New IRP:Projected Markups • Ne

27. Case 1: Conclusion • In a market environment, economic analyses of transmission should consider: • Full network model • Multiple scenarios • Market power mitigating effects • Resource substitution • TEAM shows it’s possible! • Market power mitigation benefits crucial

28. New Integrated Resource Assessment Process, Case 2:Planning Markets for Generation Adequacy 3 Keys for Successful Market Design (Steve Stoft) • Three dials can be adjusted (price caps, mitigation rules, …) • Altogether, they should: • Prevent market power abuse • Provide appropriate investment incentives • Ample when generation shortage present or imminent • Absent under surplus conditions Ancillary Services Markets Energy Market Capacity Markets

29. The Energy Market is Incomplete • Unfulfilled: Saint Fred’s (Schweppe) 1978 vision of a market where demand responds to real-time prices • The market does not provide information on the value of reliability at appropriate times. • Height of price spikes reflects: • regulatory decisions • willingness of ISOs and load serving entities to stomach political fallout of curtailment • Least valued uses are not curtailed • Unlikely that the optimal amount of generation will be added under a pure energy market • Would a capacity market improve efficiency?

30. U.S. Policy Change 2003:US FERC “Standard Market Design” “Wholesale Power Market Platform” • FERC has oversight of ISO-based markets and “market based rates” • “Resource Adequacy” was mandated for ISOs by SMD • But under WMP, a state responsibility • A thousand flowers blooming • Two things FERC still insists on: • Market power mitigation must recognize interaction with resource adequacy • Energy, ancillary services markets must include scarcity pricing

31. Alternative Incentives for New Capacity “Price Spike” (Energy Only) Enhance demand-side price response Compensate customers for outages Operating Reserves Mandatory Call Options/ Contracting Installed Capacity 2 Options: ISO declining demand curve Fixed payment from ISO or penalty if capacity inadequate Bidding to ISO PCAP Tradeable ICAP requirements Payments from ISO PCAP Capacity [MW] Capacity [MW]

32. Status of ICAP markets in US Existing/Proposed ISOs Peak ~5GW Load and Capacity

33. Status of ICAP markets in US US market designers deeply & consistently committed to …… ambivalence about whether capacity markets are needed and how they should be designed ISO Demand Curves for ICAP } Mandated Forward Contracts ISO Operating Reserves Markets

34. Challenges for all Capacity Markets • All markets involve political/regulatory decisions about price caps • All markets (except pure price spike) require political/regulatory decisions about desired reliability levels (LOLP) • Without demand-side involvement, the above decisions will be based on non-market valuations (engineering judgment, contingent valuation, regulatory decree, stakeholder processes, etc.) … … Rather than consumer preferences, as revealed by their responses to real-time prices

35. Issues in Designing Capacity Markets • Installed or available capacity? • Incentives to improve performance vs simplicity • Tied to physical assets? • Flexibility vs credit risk • Lead-time and duration of commitment? • 4 yrs PJM, 1 yr ISO-NE • Flexibility vs assurance of adequacy • Geographic distribution? • Markets for different types of capacity? (Flexible vs inflexible; bonus for “green”; supply diversity) • What is the “optimal” penalty for noncompliance? • Creation of opportunities to “game” • Relationship with energy & operating reserves markets • ISO-NE proposal to deduct year-by-year turbine revenues

36. PJM ICAP Demand Curve Proposal:Four Years Ahead ICAP Demand Curve ICAP Supply Curve PICAP QICAP

37. PJM ICAP Demand Curve Proposals How to choose? A multicriteria problem

38. Example Comparison of Five Curves:Tradeoffs between Cost, Reliability, and Overacquisition Source: PJM-JHU dynamic analysis (2005)

39. Conclusions: Remaining IRP Challenges in U.S.:Responsibilities falling through cracks; Uncertain benefits of policies • What should be the economic objective of grid planning? • Motivating efficient investment in transmission infrastructure and controls • “Performance” difficult to measure (avoiding rare events) • Resource adequacy markets: • Remaining controversy over the best designs: physical (ICAP) or financial (contracts)? • Reliability is largely unpriced and consumers can’t choose

40. Conclusions, Cont.Responsibilities falling through cracks; Uncertain benefits of policies • How can we incent efficient load controls in a retail access environment? • Inefficiency of differing resource portfolio standards in different jurisdictions • Hammering of renewables by punitive balancing market designs • Are portfolio standards a cost-effective way to promote technological progress and environmental quality?