l Page 2 January 6, 2016
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From: / Market Development
Date: / January 6, 2016
Subject: / Administrative pricing rules under proposed demand curve design for FCA11
This memo discusses the implications of continuing the administrative pricing rules that have historically applied in the Forward Capacity Market (FCM) for the full (zonal) demand curves design proposed for FCA11. In sum, the ISO-NE proposal eliminates these administrative pricing rules for zones concurrent with the introduction of zonal demand curves, consistent with the decision to eliminate administrative prices at the system level with the introduction of a system demand curve in FCA9. This decision is based on the numerous undesirable properties and design challenges associated with the existing administrative pricing rules whereas other mechanisms can more effectively, comprehensively, and directly address market power concerns.
This memo has five parts. First, it summarizes the objectives of the Inadequate Supply and Insufficient Competition provisions and highlights several concerns with these two-tier pricing schemes. Second, we provide key background on the modifications to the administrative pricing rules proposed or implemented recently, both in the system demand curve package for FCA9 and the ISO’s discussed zonal package for FCA10. The third section explains why the current set of administrative pricing rules are not compatible with the ISO’s proposal for FCA11 and, in fact, undermine the design principles used to derive the sloped curves. Fourth, the memo discusses how other existing and proposed market rules will address the concerns that the administrative pricing provisions were introduced to address. The fifth section concludes by summarizing the ISO’s rationale for proposing to eliminate the existing administrative pricing rules beginning in FCA11.
1. Stated purpose of current administrative pricing rules
Inadequate Supply and Insufficient Competition
The Inadequate Supply (“IS”) and Insufficient Competition (“IC”) administrative pricing rules have been applied to the FCM with the intention of protecting consumers from uncompetitive auction outcomes. Without adequate competition, suppliers could increase clearing prices by withholding capacity or submitting supply offers at inflated prices. The IS and IC provisions aim to address this concern by identifying instances where an auction could fail to produce a competitive outcome and, in these instances, reducing the price paid to existing capacity. The reduced payment rate is intended to “approximate” the price that would be paid in a competitive auction.
Absent the IS and IC rules, a supplier’s financial gain from withholding capacity is largely dependent on the resulting price impact: the gains from withholding increase as the administrative demand curve steepens. The need for the IS and IC rules historically has therefore been largely based on the use of vertical demand curves at both the system and zonal levels, where small changes in capacity offers can have dramatic impacts on the clearing price.
While the IS and IC provisions may help protect consumers against short-run price spikes due to uncompetitive conditions, they have numerous undesirable properties. First, they price discriminate by paying existing capacity a lower price than new entrants when both provide the same capacity product. Second, these two-tiered pricing schemes introduce various gaming opportunities and perverse incentives for capacity suppliers.[1] Third, they increase the risk for existing resources because when triggered, the resource will be paid the administrative price in the auction. However, if the resource must shed its obligation in a reconfiguration auction, it will have to ‘buy out’ of the obligation at the market clearing price, which is likely to be higher. Fourth, the IS and IC provisions require setting subjective trigger conditions (when to price discriminate) and pricing schedules (what prices each type of capacity should be paid). These criteria are difficult to determine and justify using sound market design principles because they lead to wasteful spending and inefficient outcomes.[2]
Furthermore, the IS and IC provisions may actually increase the long-term capacity costs paid by consumers because competitive new entrants will expect to receive lower long-term revenue streams after they become existing resources, whenever these provisions are triggered. This should rationally lead new entrants to submit higher initial supply offers when new, increasing costs to consumers at the outset. Moreover, the added regulatory uncertainty associated with these administrative pricing rules will further increase risk for investors, which can be expected to show up in higher risk premiums and consumer costs, thus undermining their original intent.
Capacity Carry Forward
The Capacity Carry Forward rule was designed to protect suppliers from price drops in import-constrained zones that could occur when a new large generator with excess capacity cleared in the prior year. This concern is greatest with vertical zonal requirements where the price in an import-constrained zone can drop to zero (or the system price) when the existing supply exceeds the requirement by even 1 MW because a lumpy entrant cleared in an earlier auction.
Much like the IS and IC provisions, the Capacity Carry Forward rule requires a trigger condition and payment schedule that is based on subjective criteria. Much like with the IS and IC provisions, these criteria become increasingly difficult to determine and justify using market design principles under a design with sloped zonal demand curves that decreases price volatility relative to the existing vertical requirements.
2. Recent history of administrative pricing rules in the FCM
Prior to FCA 9, the capacity market applied the IS and IC provisions at both the system and zonal levels.
On January 24, 2014, the FERC issued an Order directing the ISO to file sloped demand curves for FCA9 as such a design “will obviate the Inadequate Supply and Insufficient Competition rules and therefore the need for administrative pricing under those provisions” (p. 30).
Due to the short timeframe between this order and key FCA9 dates, the ISO opted to introduce sloped demand curves into the capacity market in two stages. In the first stage, which was completed in the spring of 2014, the ISO filed a system demand curve for FCA9 that eliminated administrative prices at the system level. This change was approved by FERC.
However, this first stage did not modify the IS, IC, or Capacity Carry Forward provisions in import-constrained zones as the ISO indicated that it would address this topic in the second stage when it introduced zonal demand curves.[3] The ISO began discussions on zonal demand curves in the fall of 2014 with the intent of eliminating the IS, IC, and Capacity Carry Forward provisions in import-constrained zones concurrent with the introduction of sloped demand curves in capacity zones. While the ISO ultimately decided not to file its proposal, there was significant discussion with stakeholders about whether the design should retain administrative prices in import-constrained zones.
3. The existing administrative pricing rules under the new proposed demand curve framework
The proposed demand curve framework for FCA11 differs dramatically from the methodology used to derive the system-wide demand curve and the previous candidate zonal demand curves. The continuation of the existing administrative pricing rules does not work well in the context of the new demand curve system.
The basis for the new proposed zonal demand curve framework is a key, logical economic property that will also meet the reliability criteria in the long-run. The economic property requires that the clearing price paid for a MW in each zone is directly proportional to its marginal reliability benefit, in dollar terms. In other words, if an additional unit of capacity in both zones A and B improve reliability equally, the prices should be equivalent in each zone. However, if an additional unit of capacity provides a greater marginal reliability benefit in zone A than in zone B, resources in zone A should be paid a commensurately higher price. This principle, in conjunction with the requirement that the demand curves pay Net CONE on average (to sustain entry and the market over the long term), effectively specifies the structure of the zonal demand curve system (given the zone definitions).
The existing administrative pricing rules contradict this core principle because, when they are triggered, existing resources would no longer get paid proportional to the marginal reliability value their capacity provides. Consider the case where there are two ICCZ’s: A and B, and we retain the IS and IC provisions. Suppose that the IS provision is triggered in zone A due to a shortfall of new and existing capacity. While new resources in zone A will be paid the auction starting price, the IS rule indicates that existing resources in the zone will receive the higher of the Net CONE and the clearing price paid to resources in rest-of-pool.
In zone B, suppose there is an abundance of supply at very high prices and hence, the IS and IC rules are not triggered. The clearing price in zone B may be higher than both Net CONE and the price received by resources in rest-of-pool and is paid to both new and existing resources. In this case, existing MWs that help zone A – which is experiencing a more severe scarcity problem – are paid less than the existing resources in zone B. These are completely incorrect price signals to send to the market about the scarcity and relative value of capacity in each zone.
Furthermore, continuing to employ the existing administrative pricing rules would introduce significant subjectivity into the proposal when the economic framework explicitly attempts to make the zonal design criteria entirely objective. It will therefore be difficult to argue to stakeholders or the FERC that this economic property is central to the design if the proposed design allows it to be violated any time administrative prices are triggered.
4. Other mechanisms more effectively address market concerns
Inadequate Supply and Insufficient Competition
By introducing sloped zonal demand curves that replace the existing fixed requirements, the ISO’s proposal reduces the effective slope of the curve. This change reduces the potential financial gains and price impact associated with withholding capacity or offering it above its competitive price. As a result, the introduction of sloped zonal demand curves will reduce suppliers’ incentives to exercise market power.
While the incentive to bid in an uncompetitive manner is reduced with sloped zonal demand curves, it is not eliminated in all cases. However, the ISO also uses a mitigation process to review delist bids in order to prevent such bidding behavior from driving up costs to consumers. Under this process, the IMM reviews all delist bids submitted by existing suppliers with market power above the Dynamic Delist Bid Threshold Price. If it believes that a delist bid price exceeds the resource’s competitive bid, the IMM modifies this bid to be consistent with its evaluation. Recent market changes have expanded the pool of capacity suppliers that are subject to this treatment to include imports.
Furthermore, on December 17, 2015, the ISO and IMM filed a set of proposals with FERC that targets FCA11 and expands the mitigation process to resource retirements. In particular, this proposal would make it more difficult for participants to increase clearing prices (and therefore capacity market revenues) by retiring an economic resource from their portfolio.
The mitigation process aims to directly prevent anti-competitive outcomes by potentially modifying the supply bids that go into the FCA to reflect their competitive values rather than direct intervention through administrative pricing rules. This approach is more appropriate than the IS and IC rules that may indirectly discourage non-competitive bidding behavior by lowering the price paid to existing suppliers if specific trigger conditions are satisfied. These administrative pricing provisions may introduce both false positives where the trigger conditions are satisfied even though suppliers submitted bids consistent with their true costs, and false negatives where suppliers submit ‘inflated’ supply bids but the trigger conditions are not met. Furthermore, the IS and IC provisions require subjective rules governing the administrative price to be paid, when this lower price is applicable, and which resources receive the administrative price.
Capacity Carry Forward
While a lumpy entrant in an import-constrained zone may depress prices in future years, the magnitude of this impact is dramatically decreased with the introduction of a sloped zonal demand curve because the price does not drop to zero at quantities above the Local Sourcing Requirement. Instead, the decrease in the zonal price is gradual and based on the marginal reliability impact of capacity in the zone. As a result, the use of sloped zonal demand curves obviates the need to continue with the Capacity Carry Forward rule.
5. Conclusion
The existing administrative pricing rules are inherently discriminatory in nature and increase the regulatory risk associated with the market, thereby increasing consumer costs in the long run. Furthermore, they are at odds with the core economic properties behind the proposed zonal demand curves and employ wholly subjective and difficult-to-defend specific trigger conditions in a zonal demand curve context. With increased mitigation provisions and sloped demand curves that limit the price impact of noncompetitive offers, the potential benefits associated with the current administrative pricing rules are dramatically reduced.
Based on these observations, the ISO proposes to discontinue the use of the IS, IC, and Capacity Carry Forward pricing rules concurrent with the introduction of sloped zonal demand curves.
[1] These gaming opportunities can take many forms. For example, existing suppliers have an incentive to withhold capacity in the primary auction to forgo receiving the administrative price, and instead wait to clear until a reconfiguration auction where they will receive the higher market clearing price. Additionally, capacity suppliers may inefficiently replace existing capacity with new in order to receive the higher market clearing price instead of the lower administrative price.
[2] For example, the IC provision is triggered if the existing capacity falls short of the LSR and there is less than 300 MWs of new capacity (III.13.2.8.2). However, it is difficult to use economic fundamentals to argue that the IS provision should be triggered when there are 299 MWs of new capacity offered, but it is not necessary when there are 301 MWs of new capacity.
[3] The Ethier Testimony supporting this filing noted “the ISO will propose sloped demand curves for the capacity zones in a forthcoming filing. Therefore, the capacity zones will retain vertical demand curves for FCA 9, and with them, the need for administrative pricing in import-constrained zones.” (p. 29).