DECISION GRANTING APPEAL IN PART AND DENYING APPEAL IN PART

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1 Robert C. Arnold Robert I. Hanfling Jack G. Lotis, Vice Chair Joseph H. Petrowski, Chair Jay S. Siegel N E P O O L B O A R D OF R E V I E W In the Matter of the Appeal in: September 19, 2001 Case No. 05-NE-BD-2001 (Sithe New England Holdings LLC, Duke Energy North America LLC, Mirant New England, Inc. NRG Power Marketing Inc., and PG&E National Energy Group) DECISION GRANTING APPEAL IN PART AND DENYING APPEAL IN PART Procedural Background By letter dated May 21, 2001 Sithe New England Holdings LLC ( Sithe ) seeks review of the decision of the Participants Committee ( PC ) at its May 9, 2001 meeting to reject proposed changes in NEPOOL s Operating Reserve Markets ( Reserve Markets ). 1 Sithe is joined in this appeal by Duke Energy North America LLC ( Duke ), Mirant New England Inc. ( Mirant ), NRG Power Marketing Inc. ( NRG ), and PG&E National Energy Group ( PG&E ). National Grid USA ( National Grid ), TransCanada Power Marketing ( TransCanada ) and ISO New England ( ISO ) filed timely notices of intervention. On June 15, 2001 the Board of Review ( Board ) granted The NSTAR Companies 2 ( NSTAR ) late request for intervention. The Board found no opposition to the request or prejudice to the other parties by permitting NSTAR s late intervention. The Appellants (jointly), ISO, National Grid, TransCanada, and NSTAR filed statement of positions. The PC filed copies of the minutes of the committee meetings at which the subject matter of the appeal was discussed as well as related materials. By notice issued July 2, 2001 the Board scheduled a technical conference for July 18, to consider the issues raised by this appeal. The Notice of technical conference was issued prior to the receipt of statements of position to enable the Board to consider and rule upon the appeal in a timely manner. 1 The Reserve Markets include the markets for Ten Minute Spinning Reserves ( TMSR ), Ten Minute Non-Spinning Reserves ( TMNSR ) and Thirty Minute Operating Reserves ( TMOR ). 2 Boston Edison Company, Cambridge Electric Light Company, Canal Electric Company, and Commonwealth Electric Company.

2 In its statement of position TransCanada requests the Board to defer considering the merits of the Appellants case until the Board could compare the Appellants reserve market proposal to ISO s forthcoming reserve market proposal. TransCanada states that ISO notified the Federal Energy Regulatory Commission ( FERC ) on June 4, 2001 of ISO s intention to file its reserve market proposal with the FERC. TransCanada states that it was ISO s intention to place its proposal before the NEPOOL Market Committee meeting of July 17 and 18 and include it on the agenda for the PC meeting of August 3. Similarly, National Grid, in its statement of position, requests that the Board deny the appeal without prejudice, and subject to, the Appellants ability to appeal any PC decision with respect to ISO s currently pending reserve market proposal. NSTAR s statement of position also relies upon the anticipated ISO s reserve market reform proposals in urging the Board to reject the appeal, or in the alternative, to delay action on the appeal to allow time for the NEPOOL committees to complete their review of ISO s proposals. In its statement of position ISO states that it expects its final reserve market proposal to be on the PC agenda at its August meeting and that [if approved] it would be promptly filed with the FERC. By Notice issued July 13, the Board, upon consideration of the parties statement of positions, rescheduled the technical conference for August 17. Anticipating the possibility that ISO s reserve market proposals would be included as an agenda item at the PC s August 3 meeting, the Board concluded that a brief postponement of the technical conference was justified. If action on ISO s proposal were taken at the August 3 meeting, it would avoid possibly duplicative proceedings on the same issues. At the same time it would allow the Board the opportunity to consider the issues in a more comprehensive manner. In the July 13 Notice, the Board also made provision for the PC to send ISO s proposal to the Board and for the parties comments on that proposal, all to be received prior to the August 17 technical conference. The Board also required the Appellants to file a statement in response to ISO s statement of position and critique of the Appellants technical white paper. 3 In a July 18 letter to the Board the Appellants state that they continue to suffer real, immediate and ongoing economic harm in both the reserve markets and the energy market from the design flaws addressed in this Appeal. The Appellants urge that the Board permit no further delay in this proceeding. By submission dated August 9 the Secretary of NEPOOL advised the Board that ISO had abandoned its administrative pricing proposal for the reserve markets and that the issue had not been discussed at the August 3 PC meeting. On August 10 Appellants responded to ISO s statement of position and critique of the Appellants white paper. 3 The white paper entitled Problems, Issues, and Solutions for Near-Term Reform of the NEPOOL Reserve Markets dated June 18, 2001 was prepared for the Appellants by a consultant, John G. Farr of Lexecon Inc. It was submitted as part of the Appellants statement of position. 2

3 The technical conference was held on August 17 as scheduled. Representatives of the Appellants attended the conference. There was no one in attendance representing the Intervenors. In its August 14 submission ISO explained that it had no one available for the technical conference because of its engagement in the FERC ordered Northeast RTO mediation process. Position of the Parties The Appellants oppose the PC s decision at its May 9, 2001 meeting to reject proposed changes to the Reserve Markets. The Appellants assert that the Reserve Markets have suffered from several long-standing fundamental market design flaws since their inception. The Appellants request that the Board direct the PC to adopt four proposals to reform the Reserve Markets. These proposals and the parties positions with respect to each are discussed below. Appellants Proposal No.1: Increase the aggregate market requirement for operating reserves to recognize the quantity of reserves actually scheduled under ISO unit commitment practices. Appellants argue that this proposal would require ISO to pay for all of the reserve services that it uses. According to the Appellants, ISO has been scheduling more capacity for TMOR than it has been paying for, resulting in greatly depressed reserve clearing prices and biasing the energy clearing price lower. Appellant states that under current NEPOOL rules, the market requirement for the sum of the TMSR and TMNSR is equal to the largest resource contingency in NEPOOL, and the TMOR market requirement is onehalf of the second largest contingency. Appellants maintain that, in practice, however, ISO has been scheduling units to provide the currently required level of ten-minute reserves plus TMOR, plus additional reserves, which ISO labels replacement reserves, sufficient to replace all ten-minute reserves in the event of a second contingency. The Appellants are not disputing ISO s scheduling practice with respect to replacement reserves. What it is requesting is that ISO s unit commitment practice be captured in NEPOOL s market rules by expanding the TMOR market requirements to include replacement reserves. Appellants assert that in this way, generators will be compensated for all the reserve services that ISO is scheduling. The ISO makes these arguments: (1) under current rules replacement reserves are guaranteed compensation for their start-up, no-load and energy bids that are accepted and run in the energy market, (2) once scheduled, these units are also eligible to be selected by the dispatch software to provide either spinning or non-spinning reserves for levels above their low operating limit ( LOL ) depending on their reserve bids, (3) there is no reason, a priori, to assume that the bids of such units for non-spinning reserves would be higher or lower on average than those of other available units, (4) some units that would otherwise be designated as reserves may be displaced by the additional units, (5) the non-spinning reserve price is depressed principally because, as non-spinning reserve is defined, participants incentives are to reduce their bids to zero, (6) an increase in the TMOR would not be an accurate reflection of ISO s requirement for replacement reserves, (7) it would artificially increase the risk of a capacity shortage, (8) it is unlikely to have a 3

4 substantial effect on reserve price or the aggregate payment to generators, and (9) to increase the likelihood of a capacity shortage is to increase the likelihood of noncompetitive results in both the reserve and energy markets. Appellants Proposal No. 2: Correct the cascading of reserve markets to include the cascading of reserve prices by using the clearing price for lower-quality reserves to establish the minimum clearing price for higher-quality reserves in all hours. Appellants argue that pursuant to a FERC order 4 NEPOOL market rules now require ISO to purchase higher-quality reserves (e.g., TMSR) rather than lower-quality reserves (e.g., TMNSR) to meet lower quality reserve requirements up to the point that the higher quality reserves become more expensive than the lower quality reserves. Appellants refer to this as product cascading. They claim that NEPOOL neglected to implement the second part of FERC s cascading directive: i.e., to ensure that the clearing price in each market will reflect the quality of service, the clearing price for TMSR will be at least as great as that for TMNSR, which will be at least as great as that for TMOR. Appellants refer to this as price cascading. According to Appellants, NEPOOL s implementation of product cascading without price cascading has resulted in unintended consequences, market distortions and perverse incentives. Appellants maintain that this incomplete cascading of the Reserve Markets had routinely resulted in price inversions where the price paid for lower-quality reserves is actually higher than the price paid for higher quality reserves. They assert that this sends perverse economic incentives to generators to provide lower quality reserves to the system, and penalize those who provide higher quality reserves. The ISO s opposition to the Appellants price cascading proposal follows these lines: (1) this is a direct attempt to increase price, (2) it would place a floor under the auction-based price in the ten minute reserve markets on the occasions when the TMOR price is higher (and in the spinning reserve market when the non-spinning markets are higher), (3) FERC did not order this result, (4) FERC sought to reduce the cost of lowerquality reserves not the reverse, (5) in a sound market structure more valuable products would cost more and have higher bids than lower-quality products and therefore as products cascade from more valuable products to less valuable products, prices would fall as well, (6) the current markets are not sound and so experience price inversion, and (7) this proposal has nothing to do with the actual flaws in the reserve market. Appellants Proposal No. 3: Set the minimum price for TMNSR and TMOR in any hour based on the highest lost opportunity cost (i.e., the energy clearing price minus the energy bid) for generation capacity that is in-merit in the energy market but is instead dispatched to a lower output by the ISO to provide TMNSR and TMOR. Appellants argue that under current NEPOOL rules, there is no minimum clearing price for TMSR and TMOR but ISO, nevertheless, can and does schedule generating 4 New England Power Pool, 85 FERC 61,379 (1998); see also, ISO New England, Inc., 89 FERC 61,209 (1999). 4

5 capacity that is in-merit 5 for the energy market as TMNSR or TMOR. As a result, the Appellants assert, a generating unit that could earn the difference between its bid price and the energy clearing price must instead serve as reserves and forgo earnings on generation in return for a typically miniscule TMNSR or TMOR reserves payment. Appellants claim that the amount lost by the generating unit as a result of the ISO s scheduling decision (i.e., the energy clearing price minus the energy bid) is a very real lost opportunity cost for that unit. Appellants believe that its proposal will (1) provide a more efficient price signal to the market as to the value of reserves on the system, (2) further strengthen incentives for resources to bid flexibly providing ISO with the most robust mix of resources to meet the region s energy and reserve requirements by making generators indifferent between providing energy or non-spinning reserves, and (3) permit the same opportunity cost methodology used to set the minimum clearing price for TMSR to be extended to apply to TMNSR and TMOR. The ISO s arguments against the Appellants proposal are these: (1) this is merely another attempt to increase prices and is not addressed to any flaw in the market, (2) ISO does not schedule generating capacity that is in-merit for the energy market as TMNSR or TMOR, (3) ISO is only permitted to schedule in-merit units as reserves during a capacity shortage (which occurs only a few days a year) when it undertakes the steps required by Operating Procedure 4 to preserve reserve margins, (4) when a unit is scheduled in this fashion, the unit is said to be postured to preserve reliability, and is compensated under special rules that provide payment for lost opportunity, and (5) postured units (such as pumped storage units) are chosen for their particular abilities to respond in an emergency when the market is not competitive and their compensation is not an appropriate measure of compensation for other reserve units. Appellants Proposal No. 4: Provide prospective information to market participants on ISO s full reserve requirements and commitment targets on a daily basis, and retrospective information on the actual level of each category of reserves available on the system on an hourly basis at the end of each month. Appellants state that on a prospective basis, ISO currently provides daily information on aggregate capacity availability and reserve requirements, but does not include replacement reserves and, that currently, ISO provides no retrospective information regarding the actual availability and commitment of reserves on the system. Appellants assert that the efficient operation of the reserve markets require that market participants have access to timely information regarding the operation of markets. Appellants request that this information be made available to market participants, properly aggregated or otherwise masked to protect confidentiality. The ISO states that it has no strong objection to this proposal, but notes that providing additional regular reporting requires extensive staff effort to collate this information by hand or software revisions to allow it to be generated automatically. The 5 In merit means that the energy bid price for a generating unit is below the energy clearing price, and hence the unit would be dispatched and compensated in the energy market, unless the ISO chooses to instead schedule it as reserves. 5

6 ISO says that if this proposal were presented to the PC in another context, the PC might conclude that the cost is worth the result. Discussion This appeal appears to be a classic case of the pursuit of a better answer preventing the accomplishment of any improvements. All parties appear to agree that there are serious problems with the structure of the operating reserve markets and that compensation for those reserves are too low. However, in the two plus years that NEPOOL has been struggling with the issue no significant progress has been made in resolving the underlying issues. Indeed, with the changes in ICAP markets which, as recognized by NSTAR, are inextricably linked to reserve markets, there has arguable been a deterioration in the operating reserve market structure. The Board believes that correct market structures require compensation for all services that are provided. Further, if possible and practicable, compensation should be determined by competition for providing the services. In the case before us, the record indicates that neither of those two objectives is being met. Appellants Proposal No. 1 The Board understands ISO s objection to increasing the requirement for TMOR by adding to TMOR the amount of replacement reserves it currently commits. It appears that the scheduling of replacement reserves is a long-standing practice within NEPOOL. Presumably, it relates to the particular make-up of NEPOOL loads and resources since it is over and above the reserve requirements established by the industry to assure regional reliability. The variations in markets (i. e., demand and supply characteristics) among regions may explain the differing practices in providing reserves to assure reliability. Although the target amount of replacement reserves appears to be specified, it also appears that the amount of replacement reserves actually put in place by ISO on any given day is subject to its discretion. The Board has no reluctance to endorse a continuation of the practice. No party challenges the primacy of ISO to set operating reserve levels, including replacement reserves. However, all such reserves are a provided service and entitled to compensation. For these reasons, the Board recommends that the market rules be revised to create replacement reserves as a separate market product and that providers of the service be notified of their selection. By making changes in the market rules, ISO does not need to change its stated reliability criteria or increase the amount of TMOR that it schedules. Replacement reserves should be a fourth category of operating reserves procured in the competitive market. The revised market rules should continue to permit ISO to exercise its discretion in the amount, if any, and make-up of the replacement reserves. It is also important that the procurement protocol supports providing this service at as competitive a price as possible and enabling ISO to make its commitments as economical as possible. To this end, the protocol must recognize that ISO is a monopsony purchaser of this product and the amount available in the market may be close to the target established by ISO even during average conditions. 6

7 The new category will be a lower priority service than TMOR although product cascading protocols may have the needs met in any given day by resources that meet higher priority service requirements. The Board recommends as a first choice that replacement reserves be procured through an auction similar to the auction held for other reserve services. Such an auction should permit bids that are derivatives of other products; e.g., a percentage of the clearing price for TMOR. Because the scheduling of replacement reserves may push the limit of available capacity with the desirable operating characteristics, the Board recognizes that it may be necessary to put in place an administrative cap on compensation for replacement reserves to protect the market from gaming. One approach that might accomplish this is to cap the replacement reserves at the clearing price for TMOR. Another approach that would not necessarily include an auction would be to reestablish a meaningful ICAP deficiency payment to promote a viable bilateral market for operating reserve service. The Board recognizes that the record does not cover all the considerations in establishing a new product market but is confident that NEPOOL can find workable solutions if it remains committed to the objectives of the NEPOOL Agreement. The Board makes no predictions as to how the change will affect prices for operating reserves or other market products. And, as noted, the Board accepts that there may need to be administrative limits on compensation for some products. Such limits, if necessary, must be to protect the market from manipulation and exercise of market power. Prices related to scarcity must be revealed or there cannot be a proper functioning of the market. If, as may be the case, NEPOOL already faces a scarcity of the desired type of reserves, improving the market design is the preferred way to correct the problem and any necessary administrative controls in the interim must be kept to a minimum in terms of both scope and duration. Recognizing the complexity of the problems, the Board would not be opposed to significant changes being put in place for a trial period to guard against unintended consequences being locked in place. The physical assets available to ISO to reliably provide the energy and reserves needed to meet load are not reduced by this change. Hence, the Board does not expect the change will lead to an increase in the risk of capacity shortages or the attendant problems such shortages would cause. To the contrary, improving the market structure for operating reserves, even if the revisions don t solve all the problems in the reserve markets, will encourage the providing of additional reserves and reserve options. The concern of the Board is proper competitive market design. The goal is to have all products and services compensated based upon their value in the market place. In this setting, it is reasonable and acceptable for suppliers to try to maximize their profits and for purchasers to try to minimize their costs. Only in those circumstances where market power can be exercised (and in theory this can happen on the demand side as well as the supply side) or the market manipulated, should administrative controls be imposed. Actual or potential, high or low prices are not in and of themselves the basis for administrative controls. Such controls are only justified when the market cannot adequately assure competitive prices. When such controls are necessary, the parties should agree on the necessary corrective measures and, hopefully, an action plan for implementing those measures. 7

8 According to its statement of position, ISO expected to include in its reform proposal that was subsequently abandoned, the provision that Non-quick-start units that are not scheduled day ahead could be released and permitted to self-schedule for external sales. While not a part of this appeal, the Board would strongly encourage movement in that direction. For the reasons stated above, Appellants Proposal No.1 is rejected as to the request to include replacement reserves in TMSR and is granted with respect to ISO identifying and compensating replacement reserves. Appellants Proposal No. 2 The Appellants and ISO have diametrically opposite views on whether the FERC intended ISO to cascade both product and price when procuring ancillary services. Appellants referenced New England Power Pool, 85 FERC 61,379 (1998), in which the FERC states in part: Under a cascading approach suggested by Crampton and Wilson, the ISO can move bids from one market to another, allowing it to procure ancillary bids services more efficiently and at lower cost. We direct NEPOOL to propose revised market rules which will permit this flexibility and to file those rules within 60 days of the date of the issuance of this order. The FERC goes on to describe an alternative approach for optimizing ancillary services procurement and appears to give ISO the leeway to use either the Crampton and Wilson approach, the described alternative approach, or a mix of the two. The ISO appears to agree that the FERC ordered ISO to adopt the Crampton and Wilson cascading approach. Citing ISO New England, Inc., 89 FERC 61,209 (1999) ISO states that the FERC required the cascading that NEPOOL subsequently adopted and approved it as filed. However, ISO contends that the FERC did not intend to require price cascading. Presumably, ISO reasons that if FERC intended to require price cascading it would have commented on the matter and ordered that it be implemented when FERC approved NEPOOL s cascading proposal. Although it is true that the current market rules have been ordered by the FERC, its intent in this matter is open to interpretation. Crampton and Wilson, who are cited by the FERC in New England Power Pool, 85 FERC 61,379 appear to recommend what Appellants refer to as price cascading. Otherwise, contrary to their recommendation, the lower quality products could be priced higher than higher quality products. As explained by Crampton and Wilson 6 : In general, each superior-quality service should be allowed to substitute for inferior qualities whenever it is cheaper. In this way, the clearing price in each market will reflect the quality of service: the clearing price for TMSR will be at 6 Extracts from A Review of ISO New England s Proposed Market Rules dated September 9, (Tr.59). 8

9 least as great as that for TMNSR, which will be at least as great as that for TMOR. And, In particular, the ISO should select the percentages of spin, non-spin, and operating reserves optimally to take advantage of the offered bids. In this way prices decrease in the sequence of reserves, reflecting the quality of reserves. Absent administrative intervention, the pricing result forecast by Crampton and Wilson prevails only if there is more supply of each product available (other than the lowest quality product) than is committed by ISO. If the offers for any one product are fully committed (again, other than the lowest quality product), the price relationships are likely to have price inversions. The FERC did not comment on the price relationship aspect of the Crampton and Wilson recommendation. However, the FERC approved a pricing protocol for the New York power pool that is consistent with the recommendations of Crampton and Wilson. New York Independent System Operator Technical Bulletin #54, Subject: Reserve Clearing Prices for Day-Ahead and Real-Time Markets dated June 5, 2000, p. 3, (Tr. 61) states: Normally, the clearing price for a higher priority reserve service is higher than the clearing price for a lower priority reserve service in a given market (DAM or Real-Time Market). If a lower priority reserve market clears at a higher price than a higher priority reserve service, however, then the lower priority reserve service clearing price will set the clearing price for the higher-priority service. Both the FERC and Crampton and Wilson were advocating that ISO have the flexibility to minimize the total cost of ancillary services. The issue revolves around which market clearing price protocol provides the most efficient market. Typically, a properly designed market will have higher quality products priced higher than lower quality products if the market is in balance. However, there are price inversions even in properly designed markets when there are imbalances between product supply and demand. An inversion does not of itself reveal whether the higher quality product is in over supply or the lower quality product is in short supply. Indeed, even in properly designed markets, price inversions may be persist if, as is the case in reserve markets, the supply is inelastic, barriers to entry and exit are high, and capital investments are of a long duration. If the higher quality product is in a condition of over supply, raising its price will be counterproductive to restoring the balance. If the lower quality product is in short supply, raising the price of the higher quality product will do little if anything to increase supply of the lower quality product. Even without price cascading, sellers of higher quality products are likely to raise their prices to capture the higher clearing price of the inferior product when there is product cascading. Over time, the market can be expected to align itself to give the product price relationships advocated by Crampton and Wilson, particularly if suppliers are free to offer their product in whichever market best benefits them. The Board finds no justification in the record for mandating that relationship. 9

10 Accordingly, the Appellants Proposal No. 2 is rejected without prejudice to the Board s future consideration and ruling on any appeal which can demonstrate that price cascading in the reserve markets results in a more efficient market design. Appellants Proposal No. 3 There is a discrepancy in the positions of the Appellants and ISO on this issue for which the record does not provide resolution. The Appellants claim that units that are inmerit for providing energy are withheld from the energy market to provide TMNSR or TMOR and thus lose valuable revenues because of the improper setting of operating reserve payments. The ISO flatly denies that it schedules capacity in that manner except during the implementation of Operating Procedure 4. If the Appellants are correct in their assertion, there is a significant problem with the compensation for resources that are inmerit for the energy market but withheld to meet operating reserve requirements including, potentially, replacement reserves. If ISO is correct, then the issue is moot. Unfortunately, the Appellants in their August 10 filing did not respond to ISO s direct contradiction of the predicate upon which this proposal rests. The Board agrees with the concept of using lost opportunity costs to set a floor on compensation for providing reserves (or any other service or product for that matter) provided ISO can independently determine, or at least independently verify, the value of the lost opportunity. Lost opportunity costs are the most objective measurement available of the value of an alternative use of a resource. However, the Appellants have not established on the record that the procedures being used by ISO do in fact result in withholding TMNSR and TMOR from the energy market when those resources are inmerit in the energy market. Absent such circumstances, changing the market rules would appear to have no practical implications and would be an unnecessary effort on the part of the PC and ISO. For the reasons set forth above, the Board rejects Appellants Proposal No. 3. Appellants Proposal No. 4 The Board recognizes that proper information flow is an important factor in efficient market design. However, the Board sees no benefit in requiring a monopsony buyer to have to disclose to the supply market its requirements in real time or even retrospectively in the near term. A strong argument can be made that providing this information could be counterproductive to the development of a healthy wholesale market. In a regulated pricing structure, complete transparency and full disclosure of intentions is critical for administering a cost based system. In a competitive market, the situation is reversed because the market sets the price. Hence, it is quite common in a competitive market for participants to spend a great deal of time and money to try to project, infer, and deduce the intentions of counterparties. It is also common for buyers and sellers to hold this information close to the vest in a justifiable and reasonable attempt to avoid gaming and other forms of price distortion. In the procurement of ancillary services on behalf of market participants, ISO should not be required to provide the degree of transparency requested by the Appellants. 10

11 Conclusion Accordingly, Appellants Proposal No. 4 is rejected. For the reasons set forth above the appeal is granted in part and denied in part. The Board recommends that the PC proceed to implement the recommendations contained herein. NEPOOL BOARD OF REVIEW /s/ Joseph H. Petrowski, Chairman /s/ Robert C. Arnold /s/ Robert I. Hanfling /s/ Jon G. Lotis /s/ Jay S. Siegel 11