Excerpt for the Executive Summary The electric power industry is transforming rapidly due to low natural gas prices, technological changes, dramatic cost reductions in renewable generation, and increasingly ambitious environmental policy goals and consumer preferences. The Environmental Protection Agency’s (EPA’s) Clean Power Plan (CPP) is perhaps the most visible and heavily-debated regulatory mandate in this trend toward an environmentally-constrained electricity industry. Much of the industry’s discussion about CPP and related environmental objectives has focused on energy efficiency, reducing coal-fired generation, and adding more renewable generation. This whitepaper complements those discussions by showing how a well-planned transmission system can help meet environmental objectives at lower overall costs, saving customers tens of billions of dollars compared to a system that is primarily planned to focus on more immediate needs to meet reliability requirements. The current uncertainties over CPP implementation are not likely to change the ongoing trend toward a clean power future, given that both market forces and policy preferences for cleaner energy sources are pushing in the same direction: natural gas prices currently are projected to remain relatively low for the foreseeable future, the costs of various renewable energy technologies continue to decrease, and customer preferences are evolving toward having more control over the their energy usage, including the energy source. Furthermore, many states, towns, corporations, and consumers are pursuing their goal of reducing emissions from electricity generation, independently of federal and state regulations. Such trends will invariably shift the country’s generation mix from coal to natural gas and renewable resources, with necessary upgrades to the nation’s transmission grid.
Organized wholesale electricity markets were created to address burgeoning costs of new power generation under the traditional regulatory scheme and to encourage innovation through free-enterprise competition. The discipline of the marketplace promised lower costs and greater efficiencies. Two decades of experience and numerous studies have demonstrated competitive wholesale markets in PJM and elsewhere bring increased operational efficiency and innovation, resulting from transparent market prices and the benefits of single, independent dispatch across a broad region. These benefits are realized through economies of scale that permit optimization of a large and diverse set of resources and load. The resulting efficiencies are measured in reduced heat rates and increased capacity factors.
However, as a host of organic and external factors change the power supply landscape, some have questioned the efficacy of competitive wholesale markets at promoting the most efficient entry and exit of resources – especially compared to traditional utility regulation with administrative planning and direction, such as under a state-integrated resource plan. Various forces, including federal and state public policies, low-priced domestic natural gas and static or declining levels of wholesale electricity consumption, have challenged incumbent or “legacy” generation resources by increasing operating costs, creating capital investment needs and reducing revenues realized in PJM’s energy, capacity and ancillary service markets. For the least efficient of these resources – older, small coal units, single-unit nuclear stations and older, high-heat-rate natural gas and oil-fired generation – these cost and revenue pressures have threatened their ongoing viability and not unexpectedly have led to retirements in many cases.
Consequently, some observers have questioned whether wholesale markets have forced premature retirements of viable legacy generating resources and whether markets can be relied upon to ensure adequate power supplies in light of the retirements. The questions raised with regard to decisions and outcomes related to the changing nature of the supply portfolio in PJM can be summarized as:
Can we rely on PJM’s organized wholesale electricity market to efficiently and reliably manage the entry and exit of supply resources as external forces create tremendous uncertainty and potential industry transformation?
The goal of this paper is to answer this question. In doing so, this paper does not present itself as an exhaustive or scientific analysis of what are complex issues characterized by numerous variables. In some cases, the value proposition brought to the generation investment decision by competitive markets can be shown with a high degree of confidence. In other cases, the relative advantage of a competitive versus a regulated paradigm in efficiently bringing in new generation and exiting inefficient generation is more arguable. Finally, certain challenges and difficult outcomes necessarily result from the operation of PJM markets in driving investment decisions – challenges and difficulties involving choices between often-competing social and political interests. In contrast, when investment decisions are driven by utilities and their regulators, a trade-off between diverging policy interests can be made directly and explicitly, though not necessarily from a well-informed understanding of the trade-off.
Summary Efficient electricity day-ahead market designs include virtual transactions. These are financial contracts awarded at day-ahead prices and settled at real-time prices. In PJM these virtual transactions include incremental offers (INCs) that are like generation offers, decremental bids (DECs) that are like demand bids, and up-to-congestion bids (UTCs) that are like transmission price spread bids. Virtual transactions offer potential benefits to improve the efficiency of electricity markets, mitigate market power, enhance price formation, hedge real-time market risks, and price those risk hedging benefits.
The role and performance of virtual transactions has been a subject of controversy. A report by PJM addresses some of these controversies, identifies possible problems in the present implementation of virtual transactions with the associated settlement rules, and makes recommendations for changes in the treatment of virtual transactions. The PJM report is generally supportive of the contribution of virtual transactions as improving overall market performance. Illustrative examples in the report highlight these contributions and add to the general understanding of the benefits and some of the problems with its current rules for treating virtual transaction.
Although these examples help in explaining the mechanics of virtual transactions, and the interactions with the underlying physical market, the examples do not provide a framework for evaluating the overall cost and benefits of virtual transactions. The PJM analysis is not alone in this regard, because the evaluation task is not easy. There is no readily available template waiting to be applied to the PJM case. The limited available analyses from other regions indicate that the benefits are material and outweigh the costs, but no available studies cover all the relevant issues. However, going beyond examples of particular outcomes to consider, the broader context is important. Looking to the broader framework can change both the diagnosis of the symptoms and the prescriptions for the cures.
Under the current PJM market rules, there is an asymmetry in the settlement treatment of different types of virtual transactions, applying residual uplift charges to INCs and DECs but not to UTCs. One of the PJM recommendations is to eliminate this asymmetry by extending the same uplift treatment to UTCs. The argument is based on allocation of uplift costs according to the deviations between real-time quantity and day-ahead schedules. This approach is particularly problematic for virtual transactions, which by design involve a 100% deviation.
There is no simple connection between deviations, uplift costs and market efficiency. Under a broader equilibrium analysis there can be conditions where there is no relationship between any of these components. Furthermore, the allocation of properly defined residual costs according to a cost causation argument can in itself be a contradiction. More importantly, the focus on uplift cost causation is misplaced. The important question is the aggregate net benefit of virtual transactions, not the residual cost. If virtual transactions increase the net benefits in the market, then there is no incentive-based reason to assign additional costs to virtual transactions. The iii criterion for assigning residual costs would then turn to doing the least damage to the performance of the market.
A better symmetric solution is to avoid any uplift allocation to virtual transactions. The residual cost allocation would then apply to real load; liquidity and entry in financial day-ahead virtual transactions would be enhanced; market power would be reduced; accurate price formation would be supported; and the efficiency of the overall PJM electricity market system should be improved. This reversal of the conventional wisdom follows from a broader framework than that applied by PJM for consideration of the costs and benefits of virtual transactions.
This broader framework builds directly on the basic principles of efficient electricity market design. Stepping back to consider first principles makes it easier to see the connections among the components of market design, in order to consider the function and benefits of virtual transactions from the perspective of aggregate market performance. PJM’s own analysis provides many examples of the contributions and effects of virtual bidding, but does not connect the examples to the broader framework of electricity market design principles. Furthermore, going beyond the uplift allocations, the PJM recommendations restricting the use of virtual transactions do not follow necessarily even from a narrower evaluation perspective. The principal problem PJM identifies with virtual transactions is a computational burden that would be only indirectly affected by uplift allocations, and could be addressed through other means with fewer negative consequences for the broader market design, such as by continuation of bidding budgets that allowed flexibility in the choice of virtual transactions.
Restricting explicit virtual bidding, as PJM proposes, creates market power for those who can make implicit virtual bids. Explicit virtual bidding mitigates or eliminates this market power, provides liquidity, improves price formation, allows hedging, connects naturally with longer term financial transmission rights, helps reveal defects in market design, and on average should improve system operations.
The PJM report appears in a context where virtual bidding is under attack. While a complete cost benefit analysis is not available, the PJM analysis can be expanded to enhance both the understanding of the role of virtual bidding and the policies that support overall electricity market efficiency.
Excerpt from the Executive Summary: This white paper (paper) describes the design of a new, distribution level market for energy and related electric products from Distributed Energy Resources (DER) and of a statewide digital Platform to animate and facilitate the financial transactions in that market. Tabors Caramanis Rudkevich (TCR) has prepared this paper as an input to the Reforming the Energy Vision (REV) proceedings of the New York State Public Service Commission (the Commission). The paper presents the rationale for establishing this new market structure, explains how the establishment of a digital platform would support the operation of the market, and describes the steps required to implement the Platform and Platform Market.
Intorduction: In one of the first laws establishing regulation of the electric utility industry, the Federal Power Act of 1920 (FPA) there was a recognition that there were two types of transactions commonly entered into in the industry that would be subject to regulation - with a different regulatory regime for each. Retail sales, or sales directly to customers who consumed the power themselves were deemed to be intra-state sales to be regulated by the states. But any sale for resale, i.e. a sale from any generating entity to a second entity that resold the power, was deemed to be an inter-state sale subject to regulation by the Federal Energy Regulatory Commission (FERC). This paper deals with the latter type of electric sale – wholesale sales regulated by the federal government. Up until the mid-1990’s, most wholesale sales were between vertically-integrated and state-franchised utilities, either short-term to take advantage of one utility having cheaper power at a moment in time than another utility, or longer term to provide needed capacity to the purchasing utility. Both of these types of transactions were mostly conducted under bilateral contracts between the buyer and the seller – the contracts being submitted to FERC for approval according to the statutory framework of the FPA.1 Until the mid-1990’s, short-term transactions were typically conducted on a split-savings basis, meaning the savings resulting from the transaction were evenly split between the buyer and seller. Longer-term transactions were typically cost-based, with the seller allowed to earn a regulated return on the sale.
For a variety of reasons beginning in the mid-1990’s there was a development of a new type of market, made possible by the deregulation or restructuring process which for the first time allowed retail customers in some states to choose their electric supplier. It was thought at the time that effective retail competition required utilities to divest all or some of their power plants to third parties. At the same time, changes in Federal law and regulation were making it considerably easier for third parties to enter generation markets and have guaranteed access to utility transmission systems. Thus new wholesale markets began to be developed in many regions of the country
Because of concerns about fairness, these new markets formed around independent system operators or regional transmission organizations independent of the transmission and generation owners in their regions. These regional operators also adopted a new form of wholesale market for their regions, a centralized market based on bids submitted to the market operator from individual generators. These bid-based centralized markets utilized locational marginal pricing (“LMP”), whereby generators bid at their location into a centralized market and bids are accepted or rejected based on projected electricity needs for the relevant period. While
generators are dispatched from lowest-cost bid to highest-cost bid up until the point that expected demand plus a reasonable margin is satisfied (and reliability constraints are recognized,) all successful bidders receive the highest priced successful bid at their location.
Another feature of these new LMP markets is that rather than charging for transmission service based on a contract path, users of the transmission system were to pay congestion charges based on the difference in locational prices between the point of injection and the point of receipt (i.e., the location of the seller and the location of the buyer). Market participants were either allocated, or had to buy through auctions, so called financial transmission rights (“FTRs”) which give them rights to use the transmission system without paying congestion charges. In this way, market participants could hedge their transactions by owning FTRs.
The theoretical basis of LMP markets is that individual generators bid into the market at their marginal cost (the cost of producing their next kilowatt-hour) because to bid less would result in their losing money if they were to win the bid and have to generate and to bid more might mean that they don’t get dispatched even though the transaction would be profitable to them. The market operator (RTO or ISO) chooses winning bidders based on the lowest cost combination of bids that can be dispatched in real time within reliability constraints. Thus, in theory, generators presumably will have incentives to operate as efficiently as possible, because only the lowest cost generators get paid, and their profitability depends on getting dispatched and having costs below the LMP. Profits are simply the difference between the LMP paid to all generators at a given location and the generators actual cost for the period for which its bid was submitted. These bid-based LMP markets are most often referred to as “organized” wholesale markets or “centralized” wholesale markets. This paper refers to centralized markets, as the term “organized’ gives a false impression that other markets types are not organized.
Executive Summary Renewable Portfolio Standards (RPS) have been fundamental to jump-starting the renewable energy (RE) industry, accounting for over 60% of the growth in RE generation since 2000. However, the simple MWhbased approach used by traditional RPS policies does not differentiate between each renewable MWh based on its value to the grid or for reducing fuel consumption. Already some states are experiencing challenges as renewable energy production during certain times is beginning to provide diminished value in terms of reduced fuel consumption or capacity contribution. As states continue to achieve their RPS goals and reach increasingly higher levels of RE penetration, new approaches will likely be needed to guard against diminishing returns of a simple MWh based approach.
Vogelsang, Ingo. The Convergence of Simple Regulatory Incentive Mechanisms for Electricity Transmission Pricing / Investment." Presentation to the CIDE Electricity Policy Group. Mexico City, April 14, 2016."