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1 Stakeholder Comments Flexiblee Capacity Procurement Phase I Draft Final Proposal, July 26, 2012 Submitted by Jeffrey Nelson (626) Alex J. Morris (626) Company Southern California Edison Date Submitted August 10, 2012 Southern California Edison (SCE) offers these comments on thee California Independent System Operator s (CAISO) Flexible Capacity Procurement Phase I Draft Final Proposal. SCE provides both conceptual comments and responses to the CAISO s stakeholder comments template. The proposal further develops the CAISO s Flexiblee Capacity Risk of Retirement (FCROR) mechanism intended to provide life support payments to generators at risk of retirement yet deemed needed in two to five years. SCE seeks to ensure FCROR is workably and efficiently designed. 1. The proposal needs multiple key structural enhancementss to be successful. The basic design of the FCROR should ensure its goals are met at the least cost. Four critical FCROR design elements must be established or bolstered to achieve this outcome: Units accepting FCROR designation must be obligated to show up in the year of need unless released from the CAISO s needed designation. The CAISO should have the option to re up FCROR contracts for resources unless released from the needed designation. RA and CPM capability should supersedee FCROR contract terms. The least cost contract path should include a multi year look involving reasonable assumptions. FCROR should not provide profits. Only reasonable butt limited costs should be covered under FCROR so the tool provides "life support yet is less favorable than selling RA. Additional enhancements are still warranted, but these structures promote FCROR goals at reasonable costs and with limited risks to existing capacity contracting structures. 1

2 2. The current proposal has insufficient protections and performance guarantees for electricity customers. While SCE supports the general payment framework of unit specific cost based revenue guarantees net of market revenues, the current proposal inequitably allocates costs and risk reward structures to parties paying for the FCROR. In the proposal, these funders pay for a FCROR resource to receive an option to earn future revenues, to operate with a safety net, to bid capacity with a safety net, and to potentially earn a 10% rate of return. Funders may also absorb potentially significant maintenance or other costs and risks which competitive generators normally bear. For all of this, electricity customers receive inadequate value. They receive no certainty on future availability, no ability to limit the market power of the seller in the year of need, no payback, no opportunity to find an alternative solution, no ability to look across time to determine the least cost approach (between Long term Standby (LTS) or ongoing operations), no chance to question need determination, and no chance to offset current year capacity procurement. While SCE supports the differentiation between must offer Resource Adequacy (RA) or CPM capacity and so understands that FCROR capacity will not offset current year must offer capacity needs, the remaining risk, reward, and cost imbalances need serious justification, SCE requests the CAISO adjust the FCROR design to be more equitable to the electricity customers that ultimately pay the bill. To SCE, the FCROR design should be modified to have more equitable characteristics. 1 First, customers paying to retain a unit should have the full expectation that it will be available in the year of need. The CAISO should thus have the authority to re up a FCROR contract until the CAISO releases the unit because it is longer needed. Second, an external entity should check or balance the CAISO s needsassessment process. SCE suggest the CPUC for this role, as it can evaluate assumptions and also compare reliability risks and Special Protection Scheme (SPS) ramifications against FCROR costs. Third, the chance of a least cost solution should be pursued through both a multi year analysis for the least cost path determination and through the possibility to undercut the proposed FCROR solution by soliciting alternative ideas (including new pseudo ties). Funders should get some form of payback in return for the life support payments given to FCROR resources and the future revenues these payments provide. Funding should never go towards a profit margin for FCROR resources. Lastly, costs should be allocated based on cost causation so parties only pay in proportion to their role in driving need for the tool, especially if Variable Energy Resources (VERs) from other areas, e.g. a Utah VER are sited within the CAISO, exacerbating integration challenges. 3. The LTS path must be maintained. It provides useful options for reducing risks and costs. 1 These equitable design characteristics align well with the CAISO s guiding principles. The CAISO s design, however, may be underemphasizing principles 2 and 7. Principle 2 is that the incentives/compensation provided by any backstop mechanism should be designed in such a way to make a less preferred option when compared to the primary procurement mechanism. Principle 7 is that FCROR must balance the need to ensure needed resources have sufficient capacity revenues to remain viable with the objective of minimizing the use and cost of this backstop. 2

3 LTS status may not only provide a lower nominal cost to retaining capacity at risk of retirement when compared to the ongoing operations approach, but it may also provide real option values. Under LTS, units can defer major maintenance decisions until closer to the time of need when needs are more accurately known and valued. LTS thus provides a hedge against future uncertainty when compared to the ongoing operations status. LTS also delays cash outlays for de mothballing a plant, improving the NPV analysis of the path by allowing more discounting for distant cash flows. Mathematically, these real options can readily fit into the Independent Evaluator s (IE) LTS analysis. SCE expects the IE to have this capability. The potential for an LTS designation also signals to generators that FCROR may not de facto allow ongoing operations with a minimum revenue guarantee safety net. While the LTS path still fairly compensates generators and covers agreed to costs, this outcome encourages generators to continue operations rather than retire with the prospect of FCROR life support. 4. Profit guarantees for FCROR generators are inappropriate, but performance incentives should exist. FCROR is a life support payment and should not provide profits to generators. Generators can expect revenues in the year of need, and should also seek to compete for capacity payments and profits in the intervening years. In line with the CAISO s guiding principles, FCROR should always be less favorable to generators than existing contracting structures. Intra year profit adders should not be allowed. Guarantees of current year profitability via FCROR could adversely affect behaviors in current capacity contracting solicitations. FCROR backstopping should not distort California s capacity contracts. Structures and a commitment to only provide life support and never a profit margin through FCROR will address this concern. Minimum revenue guarantees should also assume reasonable bidding behavior by a FCROR resource. Akin to the Department of Market Monitoring s (DMM) Option 3 2, the CAISO should employ payback calculations that anticipate reasonable market revenues. SCE recommends that the CAISO offset minimum revenue guarantees by back casted pro forma calculations of expected market revenues. This approach guarantees that a FCROR resource recovers authorized costs under reasonable bidding behaviors and also encourages the resources to seek profits, reducing total FCROR costs. This structure differs from a must offer provision for energy and Ancillary Services (AS) because the resource has no requirement to bid. It can always employ different bidding strategies, albeit with risks of different profits. 5. Only resources in the ISO s geographic footprint should be backstopped. Resources physically outside of the CAISO s Balancing Authority should be ineligible for risk ofretirement mitigation, e.g. pseudo ties. If such resources must be included, the CAISO must allow a provision so new flexibility solutions, e.g. new pseudo ties, can compete for the FCROR contract. While 2 Comments on the Final Draft Proposal for Flexible Capacity Procurement, Department of Market Monitoring, August 1, 2012, p Comments FlexibleCapacityProcurementDraftFinalProposal.pdf 3

4 the CAISO should not offer backstop protection to generators potentially throughout the WECC, the CAISO should consider how new pseudo ties can mitigate flexibility needs. 6. Numerous implementation level details should be developed for the proposal to be supported. The nature of the FCROR proposal and its potential implications render many details important. Ultimately, SCE requires resolution on many of these details before finalizing its position on the proposal. The CAISO should also provide a detailed example of how a contract payment to a generator would be determined. It is important that the market clearly understand what costs are eligible for recovery, and what costs are ineligible. SCE requests the CAISO develop a revised Draft Final Proposal in which the above mentioned structures and numerous small details are clarified or addressed. If not already addressed, the CAISO should incorporate, address, or justify excluding the following detailed ideas, some of which overlap with the above structures: Regarding Access to FCROR Designation Pseudo ties should be ineligible, or the CAISO should at least eliminate eligibility of new pseudo ties. Any existing unit in the Western Electricity Coordinating Council (WECC) has the potential to become a pseudo tie in a very short timeframe. The CAISO cannot and should not provide backstop protection for resources throughout the WECC. FCROR candidates must post collateral or alternative means to ensure the resource remains until the time of need (if it accepts FCROR designation). At a minimum, the FCROR contract should require full repayment if the unit is ultimately unavailable in the year of need. Regarding Needs Assessment approaches The needs assessment process should be transparent and involve specific assumptions about the year of need. For instance, the CAISO should not use a study regarding 2021 need to assess needs in An independent check on the needs assessment is needed. A State agency, such as the CPUC, should monitor whether assumptions are prudent and whether reliability risk mitigation costs are appropriate. Regarding the Independent Evaluator (IE) and Recoverable Costs The IE should employ a multi year least cost assessment to determine the best course between LTS and ongoing operations. IE evaluations should include expectations of market revenues in its analysis to ensure the least cost path between LTS and ongoing operation, or between different generators. Before awarding a contract, the CAISO should solicit less expensive solutions, including new pseudoties that could be established before the period of need. SCE refers to this as the undercut option. 4

5 Negotiations for FCROR offers should not be allowed. If the resource declines the IE s FCROR offer, the CAISO will need to find an alternative solution and the resource is not eligible for future negotiations. Major maintenance costs should be verifiable and legitimate. The $2M cap is somewhat arbitrary and contrasts with the unit specific cost based approach for validating major maintenance needs. Accrual accounting (not cash accounting) measures should apply to major maintenance costs calculations to ensure appropriate amortization approaches. Regarding Minimum Revenue Guarantees and payments Eliminate the 10% adder. FCROR resources should anticipate profits via the possibility of future revenues, the safety net, etc. This structure ensures that FCROR designation is unappealing for generators that are currently economic. It also discourages inflation of RA capacity bids. Net market revenue calculations for amounts subtracted from the minimum revenue guarantee should result from back casted calculations of pro forma profits using cost based bids, in line with DMM s Option 2. This approach provides sufficient incentives for resources to bid efficiently yet supports a least cost outcome for funders of the FCROR. Payments should only be made for verifiable costs subject to engineering reviews. Controls are needed to ensure FCROR resources and their affiliates do not exploit FCROR protection by contracting RA at below market costs. Regarding ongoing status for FCROR resources and future payback Once a unit accepts FCROR designation, the CAISO has contractual rights to re up FCROR status unless the CAISO determines the unit is no longer needed. With a find of no need, the CAISO should release the unit from any future obligation. For more immediate needs, CPM designation can supersede FCROR status, but once the CPM expires, the unit must re up the FCROR if instructed to do so by the CAISO. The CAISO should retain collateral for resources under FCROR status until they deliver in the time of need or are released from FCROR. At a minimum, unless released by the CAISO, units that fail to deliver in the year of need should be deemed to have failed to perform and should refund any FCROR payments they received. Once beyond FCROR status (due to CPM status or profitability in the period of need), resources should provide some form of payback. Payback rules could consider cash repayments. 3 A cost based must offer of a resource s capacity (into RA solicitations) for the year of need could also be considered. 3 DACC rules involve a return of monies. groups/task forces/bsstf/ / bsstf rmr business rules.ashx 5

6 Responses to the CAISO s Stakeholder Comments Template 1. The ISO has identified nine principles that will guide the development of the Flexible Capacity Procurement stakeholder initiative. a. Are the guiding principles outlined in the issue paper appropriate? Response: The existing principles are appropriate. b. Are there additional guiding principles the ISO should consider? Please provide any additional guiding principles your organization believes should be included and why your organization believes the additional guiding principles are important. Response: The CAISO should add a new principle that costs, risks, and rewards must be equitably balanced between FCROR recipients and parties that pay for the FCROR allocation. 2. The ISO has proposed using a five year outlook and a one day loss of load in ten years for flexibility needs and applicable NERC reliability criteria local needs to defining the need for Flexible Capacity Procurement Risk of Retirement. Are these the appropriate a) outlook time frame and b) the correct metric to identify a shortage (please specify how you interpret the one in ten metric)? If not, please provide comment regarding what timeframe and metric the ISO should use. Response: The local metrics are logical and supportable. Flexibility needs differ from local needs and require different needs assessment methodologies. The CAISO needs to provide more details on its methodology. SCE recommends a one in two year flexibility need measurement (versus a one in ten). The more stringent look will overstate needs, especially if it involves transient flexibility shortages which can be routine and not indicative of system reliability risk. The CAISO should consider using both several well defined flexibility constraints as well as larger blocky constraints in its resource planning stochastic studies for determining need. A single blocky constraint may indicate more flexibility needs than the needs calculated through several smaller constraints because the blocky constraint can present a more difficult solution for the planning optimization, exacerbating the need. SCE thus recommends comparing need from both approaches and using the lower value. The potential for 15 minute scheduling at the interties should also be measured in meeting ramping needs. 3. Many stakeholders have asked for additional clarity regarding the ISO use of prudent planning assumptions. Please provide comments regarding what your organization believes are considered prudent planning assumptions for use in the ISO s needs assessment. Response: The CAISO should lay out clearer criteria for what constitutes a flexibility shortage. Studies should be specific for a particular year and should include well vetted and accurate assumptions, including assumptions around potential 15 minute scheduling of interties. 6

7 4. Some stakeholders have expressed concerns regarding the ISO s proposed timeline for making Flexible Capacity Risk of Retirement designation. Please provide comments regarding any changes your organization feels are needed to the proposed timeline. Response: SCE supports the CAISO s plan to key in on a post RA period for FCROR designation, e.g. October 31 st. With respect to the timeline of this stakeholder initiative, SCE believes the process needs more time. SCE s support of the FCROR proposal is contingent upon successful resolution of many details. SCE thus requests at least one or likely two more proposals and review windows to finalize the design. As these cycles require approximately one month each, the CAISO should anticipate the need for more time to finalize a design. 5. Some stakeholders have requested the ISO allow a cure period that would allow LSEs to procure a resource prior to the ISO issuing Flexible Capacity Risk of Retirement designation. Is cure period desirable? If so, how long should the ISO allow for a cure period? Response: The CAISO should allow an undercut opportunity. This is different from a cure period. The concept of a cure period is inappropriate because, within given RA contracting horizons, all near term needs have likely been addressed before FCROR related future needs are assessed. The many parties will presumably be in compliance with RA and have nothing to cure. The CAISO s undercut opportunity should involve a solicitation for new and unanticipated flexibility solutions not currently under contract or in development. For instance, the CAISO can solicit new pseudoties for flexible resources. These resources may provide flexibility (or local) needs at lower cost than the potential FCROR resources, especially because FCROR evaluations should mostly assume the resource will be uneconomic until the time of need. The CAISO must ensure this process does not hamper development of anticipated new sources of flexibility. 6. The ISO has proposed that to compensate a resource based on the lesser of costs to place a resource into long standby or going forward costs. However, some parties have expressed concern that compensation based on long term standby costs is not a viable solution. Please provide comments regarding whether your organization believes such compensation mechanism is or is not viable. Why? Response: LTS is a viable and useful option. SCE has significant experience with placing resources on LTS and sees no credibility to claims that LTS is infeasible. While emissions permit or other considerations may make the LTS option less favorable than the ongoing operations option, the IE should have the capability to evaluate these cost aspects, including permitting rules. Moreover, it is entirely possible to estimate costs for LTS, including costs for rehiring trained staff. How else does a new generator estimate the profitability of their enterprise? With potentially millions of dollars in cost accruing across multiple years, the CAISO must approach FCROR with due diligence, and LTS has a key role in this process. 7

8 Additionally, the LTS approach is beneficial in other ways. It provides real options value by delaying major maintenance decisions until needs are more accurately known and by avoiding ongoing operational risks. It also supports guiding principle 2, that FCROR backstop is a less preferred capacity procurement option. 7. The ISO has proposed a cost based minimum revenue guarantee that would claw back all net energy market revenues while the resource is under Flexible Capacity Risk of Retirement designation. Additionally, the DMM has provided additional options compensation mechanisms. Please provide comment regarding the compensation for each of the proposed compensation mechanisms. a. ISO current proposal that covers costs with 10% cost adder and clawback actual net market revenues Response: SCE opposes this 10% adder. Resources on mostly risk free life support do not warrant a return. Any consideration of return has already been factored in by the resource in choosing to accept life support relative to the opportunity cost earned elsewhere by exiting the market. To provide any premium distorts the value of the life support, and threatens to distort the existing capacity contracting structures. The upside for these resources stems from the prospect of current or future market or capacity revenues. SCE supports clawbacks of actual net market revenues. Revenues should be calculated based on a resource s costs, not its bids, in order to ensure clawbacks reflect actual profits. Further, SCE seeks to ensure resources do not recover excessive costs. For instance, the CAISO s current approach proposes to pro rate eligible costs if the resource receives a CPM or other capacity payment for a portion of the FCROR year. These revenues should instead offset FCROR payments dollar for dollar or nearly so, especially if FCROR compensation involves excessive maintenance costs that help a resource to perform under CPM obligations. b. DMM option that covers costs and allows the resource to keep some portion of actual net market revenues Response: SCE opposes this revenue sharing concept. A goal of FCROR is to retain capacity at risk of retirement that is not needed now yet is needed in two to five years at the least cost. Given that resources are guaranteed a sufficient revenue amount, resources do not deserve additional profit while simultaneously on the FCROR safety net, at least until FCROR costs are paid back. All risk, cost, and reward structures should be comprehensively aligned in the FCROR tool. As SCE understands them, DMM s proposals seek to ensure resources bid their costs in to energy and AS markets in order to ensure the resources earn appropriate revenues to offset the FCROR minimum revenue payments. To that end, SCE recommends that the minimum revenue guarantee be reduced by the total amount of market revenues earned in a backwards looking pro forma calculations. This way, a resource always has incentives to bid its costs and is still guaranteed full cost recovery (assuming it bids its costs). 8

9 c. DMM option that does an upfront assessment of expected net market revenues and bases compensation based on costs expected net market revenues Response: This ex ante pro forma calculation should be used by the IE in determining the multi year least cost path for a FCROR candidate resource. For determining end of year payments needed to ensure sufficient revenues for FCROR resources, SCE recommends using a backwards looking pro forma calculation. As discussed above (7b), this approach still guarantees that a resource under ongoing operations status is made whole yet has incentives to bid in a way that lowers the total cost for funding FCROR. 8. Several stakeholders have asked for additional details regarding specific costs that may or may not be covered as part of the minimum revenue guarantee. Please provide specific costs that your organization believes should and should not be covered as part of the minimum revenue guarantee (please expand the table below if more space is needed). Response: SCE maintains that resources should recover agreed to costs. Resources should only recover costs for investments per an accrual accounting system (rather than on a cashflow basis). In reviewing costs, SCE reiterates its views that FCROR should provide minimal payments to keep a resource on life support. The CAISO s list of costs seems fairly comprehensive. The key to an effective, least cost FCROR, however, will be the IE s ability to note which costs are applicable and which are not. Obviously, only reasonable and likely costs should be factored in to the IE review. The IE should not include all costs in the review if they are unlikely. The CAISO should consider a different approach for the $2M major maintenance costs. While SCE supports the use of a prudent cap, SCE wants to further discuss and investigate other approaches, including having the IE use a unit specific assessment of costs, though only if using an accrual accounting system. Given varying generator sizes, the $2M cap may be arbitrary. 4 The LTS option provides a useful approach for retaining the capability of a generator while delaying investment decisions until the need is more certain. Additional Costs that Should be covered In LTS designation, costs for returning the unit to full power operation. Insurance for unplanned maintenance costs. Costs that Should Not Be Covered Excessive deferred maintenance. Costs not actually incurred. 9. The ISO seeks stakeholder input regarding the most appropriate manner to address cost risk that occurs during the year of designation. How should the ISO s proposed compensation include 4 For PJM s DACC, where the resources is needed now but not far in the future, there is little need or incentive to conduct major maintenance. Thus PJM s circumstances may warrant the $2M adder. 9

10 potential unforeseen costs while the resource is under a Flexible Capacity Risk of Retirement designation? Response: FCROR funders should cover agreed to costs. Additional costs should be borne by generators who can earn future market rents. The CAISO should consider requiring FCROR generators to insure resource against these types of unanticipated costs. If generators choose to not pay for these above basic costs, the unit will likely need to retire, and the generator will need to return FCROR payments or forfeit some security deposit for failing to be available in the time of need (see Question 10). LTS provides a useful real option for deferring major maintenance costs and resource use risks. The IE should value these real options when considering the best path for an FCROR designee. 10. The ISO proposes to have a single year designation with no requirements after the designation expires. However, some stakeholders have expressed concern that there is no guarantee that resource would then be there for the year of need. Is it appropriate to limit any requirements to the term of the designation, or should there be some other requirements or obligation to ensure the resource is available during the year of need once a designation has been made. If requirements or obligations should be required, what form should they take? Response: Once under FCROR designation, the CAISO should have the option to re up the FCROR contract, preventing the unit from retiring. Essentially, once the unit goes into a life support structure, it foregoes the ability to retire if the CAISO continues to anticipate a need for the resource. Once released from this designation, it can retire. Because the unit will eventually return to merchant status and is not needed now, it should only receive life support payments and not earn a rate of return or compensation linked with a must offer obligation. Buyers of FCROR need certainty that their payments for FCROR resources are worthwhile and effective in keeping a generator on life support until needed in two to five years at least cost. Without a retention clause and a security deposit, collateral structure, or clawback rule, the buyer has insufficient protections for offering FCROR payments. 11. The ISO proposes to allocate costs of Flexible Capacity Risk of Retirement designations for flexible resources to all load based on a load ratio share and for local resources based on load ratio share to all LSEs that serve the TAC area. Is this the appropriate cost allocation methodology? If not, what alternative might the ISO consider? Response: Costs should be allocated based on cost causation. The CAISO supports this principle. It drives market efficiency. The CAISO should use statistical measure to allocate cost to different categories of market participants. The CAISO s Flexible Ramping Product initiative has leveraged data and statistics to evaluate causation for flexibility needs. The approach includes concepts of regional diversification to fairly quantify the impact of cost allocation to generators, including VERs, in line with allocations to load. FCROR cost allocation could 10

11 adopt this approach. SCE maintains that load should pay for its fair share. A two tier structure may be considered, depending on various factors. The CAISO s next proposal should include a cost allocation structure based on causation. 12. Some parties have expressed concern with potential overlap between the current Flexible Capacity Risk of Retirement proposal and the ISO s existing CPM tariff authority. Please provide comment regarding the ISO s proposed clarification regarding CPM and Flexible Capacity Risk of Retirement provisions. Response: The CAISO has rightly differentiated its CPM tool from the FCROR tool. These tools serve different purposes, address different needs, and as planned have different performance obligations. Once a need is imminent, the use of the CPM makes sense. If the need for a unit at risk of retirement does not exist now but is anticipated in two to five years, the FCROR tool can be used. Concerns about the overlap between the CPM and the FCROR for units in ongoing operations may be unwarranted. The CPM can supercede the FCROR if close enough to the year of need. For units in LTS status, however, the CAISO may consider whether the transition to CPM makes sense if only one year from the year of need. As the CAISO investigates appropriate transition structures between FCROR and CPM, SCE recommends the CAISO also continue to prioritize development of a long term forward flexible capacity procurement mechanism in conjunction with the CPUC and other stakeholders. 13. Please comment on any other issues not previously addressed that your organization feels the ISO must address as part of phase one of this initiative. Response: SCE supports the CAISO s scope for this initiative. Although many structural details need review and address, the scope of the initiative should remain as is. 11