1. Competitive Wholesale Power Market: Capacity Market
By Raj Addepalli, Ph.D., CFA
Presented at
USEA-USAID Executive Business Meeting
Bogota, Colombia
July, 2006

2. New York Action Regulatory Restructuring – Flexibility
Divesture of utility generation assets to eliminate vertical market power concerns
Creation of the New York ISO Mid 1999
Wholesale and Retail Competition in the State
Presently over 40% of customer load is supplied by competitive suppliers; remaining load is still supplied by host utilities as default service providers
Utilities use a supply portfolio approach - includes certain long-term legacy contracts with divested generators, short-term purchases from generators and wholesale suppliers through bilateral contracts, purchases from the NYISO spot market, and financial derivatives to mitigate risk

3. The NYISO Control Area New York State: 19,157,532 people
Peak Load Forecast of 33,295 MW
38, 340 MW Native Generation
Over 335 generating units modeled
Required Installed Capacity 39,288 MW
1700 MW in Demand Response
10,775 miles of High Voltage Transmission

4. 2006 Capacity (MW) by Fuel Type

7. New York Market 91% Merchant Generation
Regulated and Merchant Transmission
Regulated Monopoly Distribution
Competitive Retail Sales

8. New York Wholesale Markets
Energy - Day-Ahead and Real Time Markets
Installed Capacity Market
Ancillary Services Markets
Market based:
Reserves (10 min spinning, 10 min non-spin and 30 minute reserves)
Regulation
Cost based:
Voltage Support
Blackstart
Scheduling
Demand Response
Virtual Markets
Transmission Congestion Contracts

9. New York Wholesale Markets- Energy Central Dispatch System
Bilateral
(forward)
Contracts
50%
NYISO
Day-Ahead Market
45 – 50%
Real
Time
<5%
Bilateral Contracts outside the NYISO %
NYISO Day-Ahead Market %
NYISO Real-Time Market <5%
100%

10. Why Capacity Market?
There is a continuing debate regarding whether there is a need for a separate capacity market or competitive markets should rely solely on energy markets to provide sufficient inducement for new entry.
If reliability is not a criterion that needs to be satisfied, or if there is sufficient demand price elasticity, or if there is sufficient tolerance for very high energy prices, then perhaps one could consider reliance solely on energy markets - BUT we are not there yet.

11. ICAP Market Purpose
Capacity markets were created to insure that a sufficient supply reserve margin would exist to assure the reliability of the electric system.
A combination of bid/price cap energy market mitigation measures and the desired capacity reserve margin result in energy revenues that are insufficient, by themselves, to support new entry.
Capacity market revenues provide the additional revenue stream that is needed to facilitate new entry.

12. Installed Capacity Market
Reliability criterion of a one day in ten years loss of load expectation is established by the NERC’s Northeast Power Coordinating Council (NPCC). To meet the reliability rules, utilities and other load serving entities in New York are required to purchase capacity to meet forecast peak load plus 18% reserve margin
Three Capacity Markets in NY
New York City
Long Island
Rest Of State
Six month strip auctions (summer and winter), monthly auctions and spot auctions are conducted by the NYISO
The six-month and monthly auctions are voluntary
Spot auction (deficiency auction) is mandatory
If loads do not have sufficient bilateral capacity contracts, they are assigned the capacity cost based on the spot auction results

13. Original ICAP Market Design
Demand Curve was vertical in nature
Loads were required to purchase Minimum Requirement- bilateral or through NYISO market
Deficiencies charged a high penalty
Market proved dysfunctional
Erratic ICAP prices
When capacity is tight, ICAP prices spike
When capacity levels exceed the minimum requirement, however, ICAP prices plunge
Loads had no incentive to purchase ICAP above minimum
Excess capacity beyond minimum not valued although it may help reliability
Susceptible to market power abuse
Suppliers had incentive to withhold to create deficiency

14. ICAP Demand Curve Original design used “vertical” demand curve
Fixed minimum requirement
Fixed deficiency charge
New design uses “sloped” demand curve
Price decreases gradually as supply increases
Loads buy excess supply cleared in the auction
Market function improved
Prices less erratic
Prices vary predictably with ICAP supply

15. Demand Curve Original ICAP Market Design vs. Sloped Demand Curve 5 105 10 15 20 25 96 98
100
102
104
106
108
110
112
% of Minimum Requirement
$ per kW-month
Original market design
Sloped Demand
Curve

18. Sloped Demand Curve
The purposes of the sloped demand curve include (compared to a vertical one):
stabilize revenue streams for generators
reduce potential market power of generators
provide for more predictable prices for sellers and buyers
value capacity beyond the minimum level as having reliability value

19. Derivation of the Sloped Demand Curve
The Sloped Demand Curve is specified in the tariff, and approved by FERC. The parameters are updated every three years.
DC is a simple straight line defined by two points. The reference point is (X1,Y1)
X1: The installed capacity requirement: 118% of peak load
Y1: The cost of new entry for a peaker less anticipated energy and ancillary service market revenues
X2: The capacity level where its value is zero: 132% of peak; Y2=0
The maximum price is capped at 1.5x the cost of new entry

20. Reference Point
The analysis to help determine the reference point update last year was performed by a consultant, Levitan Associates, with the help of market participants.
Key Assumptions include:
Installed cost of a new peaker- Frame 7FA gas turbine for the ROS market
Equipment (Power Island, Balance of Plant, Spare Parts
Construction
Owner’s costs (Development, Engineering during construction etc)
Startup and Testing

21. Key Assumptions (contd)
Size, Heat Rate
Debt/Equity ratio: 50%/50%
Cost of Money: 20 year interest rate, equity (after
Fixed O&M (property taxes, site lease, contract services, staffing, insurance, general and administrative costs)
Depreciation life, Income Tax Rate etc
From the above, compute annualized carrying cost of peaker

22. Key Assumptions (contd)
Expected Energy Revenues
Apriori Estimation
Historic Based
Expectations
Deterministic
Stochastic
OR Post-fact hypothetical peaker based estimate
Expected AS Revenues
The annualized reference value is then adjusted for summer/winter periods

23. Items Debated Is there a need for introducing a sloped demand curve?
Will the change induce new merchant entry - the ability to generate cash flows to cover cost of new entry over long-term
Will it help keep needed existing economicgeneration from retirement?
Should there be a forward market (beyond one year) component to the capacity market?
What are the customer impacts - including quantity of ICAP to be purchased and the new market clearing price?
Is there authority for NYISO or regulators to impose such a purchase obligation on the loads?
How does regulatory uncertainty affect investor risk assessment?

24. Items Debated What should be the frequency for updating parameters?
Derivation of each element in the reference price Y1
Levels of X1 and X2: should X1 be exactly at the minimum requirement or somewhat to the right of it?
What should be the price to the left of X1?
The slope of the demand curve
stability vs volatility of prices
customer impact
impact on generator market power
Monopsony power - the ability of large loads to enter into contracts ‘out of market’ with new suppliers to suppress market clearing prices

25. Resource Planning ISO Reliability Planning Process
Pre restructuring, vertically integrated utilities built (or contracted for) needed resources to ensure reliability of the system
In a restructured market, it is envisioned the market should address resource needs to ensure reliability
Planning process is primarily designed to provide information to the market participants
While market is expected to address resource needs, there could be instances of “market failure” and the market may not satisfy the resource needs
In that case, there is a need for a back-stop solution to procure adequate resources to ensure reliability

26. Resource Planning Annual Comprehensive Reliability Plan
NYISO does a 5-10 year Reliability Needs Assessment annually as a first step and identifies reliability based resource needs
It seeks market based responses (transmission, generation, demand response) to meet the needs
In addition, it seeks from the responsible utilities a “backstop regulated solution” in case market solutions do not materialize in a timely fashion; other entities can also offer an “alternate regulated solution”
NYISO certifies projects that would technically meet the identified need without identifying a preferred solution
Cost Allocation based on beneficiaries-pay methodology

27. Resource Planning “Economic” Planning process:
Primarily intended to address congestion
NYISO posts information on a historical basis on several quantitative metrics of congestion - to assist the market place
Under what conditions should regulatory solutions be considered to alleviate congestion? Work in progress

28. Checklist
Any time we consider changing the market design, we try to address the following:
What is the affect on existing wholesale or retail competitive markets?
Would it provide sufficient incentives for new generators to enter the market - lead to the entry of appropriate techonology and size generators?
Would it provide sufficient incentives for existing generators to stay in the market, if economically appopriate?
Will it lead to cost minimization to customers?
Will it work as intended?
Is it simple to implement?
Is it a minor change or major change?
What are the risks of implementing? Will it have unitended consequences?
How are potential market power concerns addressed?
Will it be transparent and clear to market participants and accepted by them?
Is it easy to police and to ensure there is no abuse by market participants?
Would it receive regulatory support?