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Artifice or Reality:Pricing In the

EasternInterconnection

Robert McCulloughManaging Partner

McCullough ResearchNovember 12, 2001

McCullough ResearchForecasting Philosophy

When Mr. Raccoon wanted to know how longthe winter would last, he went to Mr. HedgeHog. Mr. Hedge Hog explained that hisapproach was very scientific. He checked thecoats on the forest animals and saw whetherthe moss was on the north or the south side ofthe trees. Most of all, he went to the edge ofthe forest to see how large the wood piles thehumans had built.

The Robber Barons

JP Morgan

Samuel Insull

There were a few ups andThere were a few ups anddownsdowns

Roosevelt steps inRoosevelt steps in

Artifice or Reality: Pricing Inthe Eastern Interconnection

• Filtering Market Signals From Social Engineering• Revisiting The Contract Path Fallacy• Loads and Resources• Recent Developments• Prospects and Suspicions

Filtering Market SignalsFrom Social Engineering

• What have we learned from California's mistakes?• How efficient are prices in New England and PJM?• Do prices reflect changes in market conditions?

California's Mistakes

• Since May 2000, we have seen long term pricesfar more sensitive to administrative changes --primarily FERC decisions than fundamentals

• Overall pricing has been very inefficient in thesense that we see major swings unrelated to thesupply demand balance

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 200130,000.00

35,000.00

40,000.00

45,000.00

50,000.00

California ISO Peak Loads

2000 Level

Actual ISO Operations

2/1/2001 3/1/2001 4/1/2001 5/1/2001 6/1/2001 7/1/2001 8/1/2001 9/1/2001 10/1/20010.00

10,000.00

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50,000.00

60,000.00

Operating Resources ISO Reported OutagesSurplus ISO Reported Net Import at Hour 18

COB Futures Markets

4/1/20015/1/2001 6/1/2001 7/1/2001 8/1/2001 9/1/2001 10/1/2001

$/M

Wh

0.00

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Cal 2002 Cal 2003

FERC PriceControls

Derating California

• In 1997, California peak loads were higher andresources were less than in 2000

• Notwithstanding, the ISO believes that it wascapacity constrained in 2000

• The primary reasons turn out to be failures in theISO modeling and dispatch• ISO procedures derate capacity resources by 2,999

MW due to communication problems• ISO transmission dispatch is highly questionable --

Path 15 is often constrained even when the intertie isunloaded

Eastern Interconnection

• We see similar problems with ISO NE and PJM• Contrary to FERC's misconceptions, ISO NE

makes more sense than PJM• Neither market reflects supply information very

efficiently

PJM and ISO NE Pricing

5/11/2001 6/1/2001 7/3/2001 8/1/2001 9/4/2001 10/2/2001 11/1/2001

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ISO NE PJM Henry Hub

October 2001

• In October a major supply decision was made thatcould not have been predicted by the market

• For the past five years, Hydro-Quebec hadpracticed a peculiar experiment in market power:they attempted to set the price of energydevelopment in Quebec and Labrador at $20 U.S.

• This policy effectively ended energy developmentin 30% of the NPCC

October Pricing For 2003

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ISO NE PJM Henry Hub

Revisiting The Contract PathFallacy

• The Contract Path Fallacy• The Congestion Management Fallacy

The Contract Path Fallacy

• Everyone is familiar with the appalling poor fitbetween contract paths and actual transmissionconstraints

• Our traditional approach is to operate the system,make judgments concerning transfer capabilities,and fit contract paths into this limit

• While low tech, the approach had the merit thatactual capabilities were a part of the process

Upping The Ante -- TheCongestion Pricing Fallacy

• The various ISO/RTO implementations haveeffectively reduced the operational basis in favor ofarbitrary models

• We are familiar with the substantial derating of thesystem by the California ISO, but we have a lessprecise understanding of the problems thisapproach may be causing elsewhere

Does Congestion PricingCause Congestion?

• The lesson from California is that it does• Expansion of that lesson to other regions is difficult

without the massive amount of data we now haveon California operations

• The problem is caused by the complexity of thecongestion management process• Adjustment bids in California routinely fail to materialize• Anecdotal evidence indicates that this is the rule rather

than the exception

Loads and Resources

• While NPCC is in good shape, Quebec -- 30% ofthe area -- is facing brownouts if it had continuedon the current path

• Overall, Quebec (and Labrador) has more than20,000 MW of hydro development and 9,000 MWof cogeneration at lower prices than Frame 7

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

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awat

ts

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NPCC (US) Load ResourceBalance

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

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awat

ts

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40,000.00

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42,000.00

Quebec Capacity Balance

Quebec Energy Balance

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Tera

wat

theu

res

170.00

180.00

190.00

200.00

Official Inflows

Actual Inflows

Recent Developments

• NPCC had two major development in the past twomonths• Premier Landry overruled Hydro-Quebec's resource

strategy• ALJ Young's "Business Plan" for the Northwest RTO

was released• Last Wednesday, FERC blinked

NPCC/PJM Map

NPCC/PJM Developments

• FERC had announced a rapid evolution of the NewYork ISO, ISO New England, PJM, and PJM Westinto a single ISO

• As a critical step, all of the stakeholders wereinvited to a mediation with 400 participants

• As a result of the mediation, ALJ Young released aproposed business plan

Northeast Mediation

ALJ Young's Business Plan

New York ISO/Mirant Dialog

• On September 1st, Mirant placed an article in theFortnightly arguing that integrating the four ISOs wouldadd $400 million in efficiency a year• Fixing the "seams" between small ISOs doesn't fix the problems. Only one

Northeast market with central scheduling, governance, market monitoring,planning and reliability rules could generate $400 million annually of regionalefficiencies in energy markets. This estimate is based on looking at flowsbetween New York and PJM and New York and New England from June2000 to December 2000, during periods without binding transmissionconstraints, and "re-dispatching" generation among the regions-still withintransmission limits-to increase imports into the higher cost region. In otherwords, trade patterns are rationalized when ISO rules, not transmissionconstraints, impeded the efficient fore of electricity that could have loweredconsumer electricity bills, especially in New York.

NY ISO's Response

• NY ISO responded: First, the EEA analysis of energy flows between New York and PJM inappropriately compared day-ahead prices toreal-time energy flows. If the EEA methodology is applied to real-time prices and real-time flows between PJM andNew York over the post-ECA-B period, October 11, 2000 to August 31, 2001 (a longer and more recent periodthan that analyzed by EEA), the estimated price impact of implementing interregional real-time dispatch would beto significantly reduce PJM prices, but to either have little effect on or to actually increase New York prices.Moreover, this finding appears to be relatively insensitive to different assumptions about the slope of the New Yorksupply curve.

• Second, it is noteworthy that most of the estimated potential gains from implementing interregionalreal-time dispatch between New York and PJM arise from the elimination of uneconomic flows fromPJM to New York. This is why the price impact gains are concentrated in PJM, as the elimination ofthese flows would lower PJM prices and raise New York prices. It is striking that over the October 11,2000 to August 31, 2001 period, there were net real-time energy flows into New York in over 95percent of the hours in which such flows would have been economic based on the criteria employed byEEA, but there were net real-time energy flows into PJM in only a little over 8 percent of the hours inwhich such flows would have been economic based on the criteria employed by EEA.

Net Flows Versus Price Differential

October Pricing For 2003

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ISO NE PJM Henry Hub

Churchill Falls, Rupert,Great Whale

Last Wednesday FERCBlinked

In recognition of the fact that RTO development is invery different stages in various parts of the country andthat it is not possible for all RTOs to be in operation bythe December 15, 2001 deadline established in Order No.2000, we intend to address in our future orders theestablishment of a progressive, but appropriatelymeasured, timeline for continuing RTO progress in eachgeneral region.

Prospects and Suspicions

• FERC's recent order on November 7th, delays theonrush of events and can be interpreted asallowing more than four RTOs

• FERC clearly continues to prefer PJM to New Yorkor New England

• If we believe a PJM "rampant" future, we shouldexpect lower prices than those in ISO NE

• We should also expect an increased level ofderating and inefficiency

McCullough Research

503-771-5090

robert@mresearch.com