1. Enhancing Capacity Markets to Improve Resource Performance and Investment Pay For Performance: New England’s Capacity Market OPSI 10 TH ANNUAL MEETING | OCTOBER 13-14, 2014 Matthew White CHIEF ECONOMIST

2. New Challenges Require Enhancements to Capacity Market Designs 1.New England faces significant reliability, investment, and resource performance challenges over the coming decade 2.Solution: A two-settlement capacity market design that addresses these challenges 3.Expected benefits: Improved system reliability; cost-effective solutions to region’s investment needs; and a simpler, resource-neutral capacity market design 2

3. Investments for New England’s Future 3 Up to 8,300 MW at risk for retirement by 2020 (28 older oil & coal units) If all retire: ISO estimates a need for 6,300 MW of new or repowered capacity Existing and planned trans- mission projects provide significant flexibility for locating these new resources ISO-NE Retirements Study 2300 MW 1200 MW 1700 MW 850 MW 600 MW 400 MW 550 MW Coal-Fired Resources Oil-Fired Resources At-Risk Capacity Resources in New England Total At-Risk: 8,300 MW Oil-fired Capacity: 6,000 MW Coal-fired Capacity: 2,300 MW 400 M W 270 MW

4. Further Investment and Reliability Challenges – Gas units: “just-in-time” fuel – Coal, oil-steam fleet: 50+ years old – Intermittent resource growth with inherently uncertain output New ‘systemic risk’ to reliability when too many units cannot perform simultaneously 4 ISO New England is increasingly reliant on resources with uncertain performance and availability

5. Challenges: Market Incentives for Investment Many investments could reduce performance risk concerns, at new and existing facilities – New pipelines and non-interruptible gas transport – Dual-fuel, backup LNG, greater liquid fuel storage, and so on… – New flexible generation capacity, more fast-responding DR, etc…. Existing markets provide insufficient incentives for these investments – Many incremental investments are needed only few hours per year – Revenues are insufficient to justify the capital investments 5

6. Principles for NE’s Capacity Market Reforms 1.Reward outputs (power delivered), do not specify inputs – Let suppliers identify least-cost solutions, bearing risks and rewards 2.Redefine performance measures for capacity resources – Delivery of energy and reserves during (reserve) scarcity conditions – Not peak period ‘availability,’ or EFOR-based measures 3.Better align resources’ financial incentives with the value of reliable service during tight system conditions – Mimic the performance incentives of an efficient energy market, with the reduced volatility that a forward market provides 6

7. Paying for Performance: Four Major Elements Capacity Obligations: A Standard Incentive Contract – Base payment set in forward auction, and a performance payment Performance Payment: – Delivery of energy & reserves during (reserve) shortage conditions – May be positive or negative (on top of base payment) – Not based on “availability,” or EFOR-type measures Resource Neutral, No Exemptions – All resources have same base and performance payment rate Who pays what? – Loads pay the base payment set by the forward clearing price – Performance payments are transfers among suppliers 7

8. Product Definition is The Key To Good Markets Traditional capacity ‘product definition’ is… hard to define – One frequent view: Payment (subsidy) for “steel in the ground” Approach: Establish a new, simple, product definition, modifying sellers’ financial obligations to incent performance – Capacity is just a single product: A share of system’s requirements. Standard forward contract structure, based on two concepts: – Two-settlement principle (e.g., like the DA forward energy market) – Scarcity price premium: Real-time incentive in tight system conditions 8

9. Capacity Becomes a Forward-Sold Good Using a Simple, Two-Settlement System Forward-Sold Goods Initial revenue on fwd sale Specifies a forward financial commitment (‘position’) 2 nd Settlement based on deviations at delivery … … at a contract rate, or at replacement (floating) price ISO’s Capacity Reforms Auction-based fwd sale (FCA) Pro-rata share of system requirements (load + reserves) during RT reserve shortages 2 nd settlement for delivery (energy + reserves) deviation from system share At (high) tariff-specified rate (analogous to scarcity pricing) 9

10. Benefits of the Two-Settlement Capacity Market Greater operational-related investments at existing resources to improve resource performance – E.g., secure fuel arrangements and/or backup fuel supplies Efficient resource evolution. Strong incentives for investment in new capacity that is either: (1)Low-cost and highly reliable (nearly always operating); or (2)Highly flexible and highly reliable (gets online quickly and reliably) A more reliable power system at lowest possible cost – Market rewards suppliers that deliver the most cost-effective solutions 10

11. Complementary Energy Market Changes Underway Energy Market Offer Flexibility (2014) – Allows suppliers to update supply offer prices intra-day – Improves generators’ flexibility to incorporate current fuel costs into energy prices during volatile market conditions – Improves incentives to procure fuel to honor ISO dispatch schedules Reserve Market Enhancements (2012/13) – Send stronger, more frequent market price signals when system conditions are likely to be tight – Enhance incentives to procure fuel to honor ISO dispatch instructions and reward resources that perform in stressed system conditions 11

12. For More Information Design and Key FERC Orders ISO White Paper: FCM Performance IncentivesFCM Performance Incentives Stakeholder Process: 16-month process (thru Dec. 2013) FERC Approval: May 30, 2014 and Oct. 2, 2014 OrdersMay 30, 2014Oct. 2, 2014 Implementation:9 th Annual Capacity Auction, Spring 2015 (Delivery year 2018/2019) For more information: www.iso-ne.comwww.iso-ne.com > FCM Performance Incentives Key ProjectFCM Performance Incentives Key Project 12