Economic Planning – Theory and Current Practice Dan Woodfin Director, System Planning Joint PLWG/CMWG Meeting 2/4/2011

2 Goal of this presentation Illustrate concepts Encourage consistent terminology in discussions Provide background on current practice

3 Economic Planning Need and History Need –Historically, vertically-integrated utilities would develop powerflow cases containing the most economic dispatch of their generation fleet –The tradeoff between the cost of the transmission system upgrades and the cost of dispatching higher cost units to resolve any post-contingency overloads in those cases was an internal decision, subject to regulatory oversight –In a deregulated market, where various market participants and consumers may be affected differently by transmission projects, an appropriate mechanism to assess this tradeoff was needed History –ERCOT began to investigate appropriate criteria for the ERCOT nodal market, given the cost recovery/transmission service regime in the Region in late 2004, prepared a White Paper, and proposed criteria during 2005 –TAC and its subcommittees reviewed the criteria options and in Apr 2006 selected the criteria that ERCOT has used since; The TAC Criteria was incorporated into the Planning Charter that was approved by the Board in Jan 2009 PLWG/CMWG

4 Applicability Reliability Projects – Transmission projects that are needed to meet reliability criteria that could not otherwise be met in planning studies by the simultaneously-feasible dispatch of available generation Economic Projects – Transmission projects that allow reliability criteria to be met at a lower total cost than the continued dispatch of higher cost generation, subject to the established economic criteria PLWG/CMWG Economic planning criteria may be used to decide WHICH of several potential projects will be recommended, but they are not used to determine IF a reliability project will be built Economic planning criteria is used to decide both IF a potential economic project will be recommended, and WHICH of several potential projects is preferred

5 Evaluation of Economic Projects (Ideally) Estimate the Net Present Value (NPV) of the cost of transmission project Estimate the NPV of the benefits due to the transmission project over the life of the project –There are several different benefit measures that could be considered (more on this later) If the benefits are greater than the cost of the project, the project is deemed economic

6 Projecting System Dispatch To estimate the benefits from a proposed transmission project, it is necessary to simulate the future hourly dispatch of generation with and without the project ERCOT uses a model that calculates the hourly security- constrained, least-cost unit commitment and economic dispatch of all generation to serve forecasted system load assuming cost-based dispatch of generation The model requires forecasts of hourly load (by bus), fuel prices, generating unit operating and cost parameters, installed generating capacity, and transmission system characteristics and ratings. PLWG/CMWG

7 Practical Considerations From a practical standpoint, it is not possible to forecast the dispatch cost savings over the year life of the transmission project. Instead: –The cost savings are projected over the 1-5 year timeframe for which cases are available –A qualitative assessment is made of whether the savings are reasonably expected to continue –The cost savings are annualized and compared to the annual carrying cost of the transmission project. If the annualized cost savings are greater than the annual carrying cost of the project, the project is deemed economic Due to the uncertainty in many of the inputs, ERCOT typically performs scenario analysis with the inputs having the highest sensitivity on the decision under analysis –RPG participants have input as to what scenarios should be analyzed PLWG/CMWG

8 Estimating Transmission Project Cost Estimated transmission project costs are solicited from the TSP that is expected to build the project –Built-in incentive to provide accurate cost estimate, else the value to the TSP of the RPG Review for its regulatory approval and cost recovery proceedings for the project is diminished Incremental costs are used –Costs of accelerations/delays in other projects should be appropriately considered Annual Carrying Cost –A generic first-year carrying charge rate, based on posted financial assumptions, has been calculated. –The capital cost of a proposed project is multiplied by this rate to get the first year revenue requirement for the project –Based on current financial assumptions, this rate is 16.8% or approximately 1/6. This is the source of the frequently mentioned “6-year payback,” although that is a misnomer PLWG/CMWG

9 The graphic below illustrates the assumed savings and costs based on using the annualized dispatch cost savings compared to the first year project revenue requirement: Costs Over Time 040 Modeled Years Prod. Cost Savings Project Rev. Requirement Year $ Assume Static Costs (e.g. no gas price increase) 1st Year Revenue Requirement is the highest

10 Economic Terminology PLWG/CMWG p S D q P CS PS The economic value, or Societal Surplus (SS), of a product is the sum of the Consumer Surplus (CS) and Producer Surplus (PS). In other words, the economic value is shared by consumers and producers. Producer surplus is due to all producers being paid the market clearing price although some would have been willing to be paid less. Consumer surplus is due to all consumers paying the market clearing price although some would have been willing to pay more. From 4/2006 TAC Meeting

11 Important Equalities Changes in consumer surplus are equal and opposite to changes in producer revenue –In a market with efficient pricing of congestion rights, where the proceeds of the sale of these rights are returned to consumers Changes in societal surplus are equal and opposite to changes in producer costs –For an equal quantity served –An algebraic proof of this is available PLWG/CMWG From 4/2006 TAC Meeting

12 Options Societal Impact Test: the increase in the societal surplus (equal to the reduction in production costs) due to a project must exceed the incremental cost of the project Consumer Impact Test: the increase in consumer surplus (equal to the reduction in generator revenues) due to a project must exceed the incremental cost of the project PLWG/CMWG From 4/2006 TAC Meeting

13 Test Comparison Societal Impact Test: Considers only whether a project has benefit to society as a whole and not whether consumers or producers receive the short-term benefit Since consumers pay all costs in the long term, they ultimately benefit from decisions which increase the societal surplus Individual projects may not immediately benefit consumers (and may cause consumer costs to go up in the short term) May not recommend projects to fix load pockets with high LMPs, but some of this congestion may be solved through generation siting Consumer Impact Test: Consumers pay for all transmission investment, so it seems congruous to fund projects that repay consumers Can justify bad projects, such as removal of transmission capacity Consumer impacts are hard to predict because they are affected by generator bidding behavior and terms of bilateral contracts Transmission projects that pass only the consumer test inefficiently transfer revenue from generators to consumers, with a resulting long-term impact on generation investment. PLWG/CMWG From 4/2006 TAC Meeting

14 TAC Criteria Incorporated into Planning Charter PLWG/CMWG Passes Consumer Test (Generator Revenue Reduction) Passes Societal Test (Production Cost Reduction) Proposed Project Recommend Endorsement by Board Reject YES NO

15 Questions?

16 Appendix 1

17 Appendix 1 Illustrative example using supply curve shift due to transmission project

18 Economic Terminology PLWG/CMWG p S D q P CS PS Same figure, vertical demand curve for ease of illustration

19 Economic Terminology PLWG/CMWG p S D q P CS2 A proposed transmission project allows lower cost generation to be used to serve the load, effectively shifting the supply curve down to S’ The new Consumer Surplus is CS2 The new Producer Surplus is PS2 S’ p’ PS2

20 Economic Terminology PLWG/CMWG D q P CS The change in Consumer Surplus due to the project is the Consumer Surplus with the project minus the Consumer Surplus without the project – illustrated as ΔCS Consumers consume the same amount but pay a lower price S’ p p’ S ΔCS

21 Economic Terminology PLWG/CMWG p S D q P The proposed transmission project also changes the Producer Surplus, illustrated as the difference between the area of PS1 and PS2 It lowers production costs (shifts the supply curve down) but also lowers the prices received S’ p’ PS2 PS1

22 Economic Terminology PLWG/CMWG D q P CS PS The change in the Societal Surplus is the sum of the change in Consumer Surplus and the change in the Producer surplus, illustrated as the area in red. In this case with the vertical demand curve, it is the area between the two supply curves, or the change in production cost. S’ p p’ S ΔSS

23 Appendix 2

24 Appendix 2 Several highly simplistic examples, just to show basic concepts Assumptions: –Two areas with no transmission currently between them –Two generators potentially available in each area, one with a high cost and another with a low cost, constant across output –Proposed transmission line between areas costs and resolves constraints Different Examples are constructed by varying the availability/size of each generator or the load in each area –If generator is not available in a particular example, it is shown with Gen Cap=0 –Changes from reference case inputs highlighted in yellow –Dispatch and related results are shown for two cases “W/O Transmission” and “W/ Transmission” for each Example

25 Example 1

26 Example 2

27 Example 3

28 Example 4

29 Example 5

30 Example 6