Market Evolution Program

Day Ahead Market Working Group Meeting

May 1, 2003

Market Evolution Program

Public 2

Purpose of These Slides

For discussion purposes only. These slides are meant to support a discussion of the various financial strategies that might be employed by market participants in a Day Ahead Market and their potential implications for design requirements.

The specific design of the Day Ahead Market is an ongoing exercise between the IMO and its stakeholders. In no way are these slides meant to construe any design features of the Day Ahead Market.

Public 3

-y%

Overview

Today’s Topic: Financial Outcomes in the Day Ahead Market

In Three Dimensions:

Risk Return Type of Market Participant

Return

Type of participant

Risk

+x%

0

Generators

Disp. Loads

LDC’s

Virtual Transactions

Imports/Exports

Public 4

Overview

Characteristics of Financial Outcomes:

A “Financial” outcome is derived from:

– The quantity and price each DAM market pariticipant establishes in the DAM for energy, operating reserve, and other costs

– The resulting prices and quantities transacted in the real-time market (where applicable);

– Physical Bilateral Contract Quantities

– Out-of-Market Transactions

– The cost structure of the market participants

…etc. The purpose of these slides is to discuss the influence of DAM design

features thay may directly affect these outcomes.

In-scope for this discussion

Public 5

RISK

Public 6

The Efficient Frontier

•By providing adequate liquidity to the Day Ahead Market, market participants collectively create an “efficient frontier” between the level of returns they are seeking, and the associated level of risk they are willing to take on.

-y%

+x%

0

Risk-free rate of return

Potential Rate of Return

DAM hedging Activity

Partial hedges against real-time price

Speculators

Normal variance between DAM and

real-time prices

Risk

Public 7

Risk Factors

•Market participants should be able to choose an appropriate level of risk depending on their risk/return strategy and the best information available at the time the DAM is open to accept bids and offers each day.

•In the context of the DAM, “risk” should be driven by those events that cannot possibly be known at the time the Day Ahead market position is established.

•Examples of what this risk should NOT include:

• Public information dissemenated by the IMO that is not equally available to all DAM market participants

• Artificial differences between the pricing/scheduling algorithim in the DAM and real-time markets that aren’t truly required to deal with the Day-Ahead context

• Liquidity Risk

• Integrity Risk (ie. “gaming”)

Public 8

Risk Factors

Examples of inappropriate risk factors:

• Incomplete forecasts

• Withholding and other gaming activities

• Late release of outage information

• “Artificial” differences between the day-ahead and real-time dispatch algorithms

Examples of appropriate risk factors:• Sudden weather change

• Changes to real-time bids/offers

• Legitimate constrained on/off events

• Legitimate curtailment of intertie transactions

• Day-ahead differences between the day-ahead and real-time dispatch algorithms

PRICE RISK

Pre-Dispatch Day Dispatch Day

Examples of what every DAM participant should know:• The latest Demand Forecast

• The latest Outage Information

• The latest public information related to any of the algorithm inputs

What every DAM participant should do:

• Formulate a risk/return strategy

• Formulate an expectation of tomorrow’s real-time prices and energy transactions based on the latest information

• Construct an appropriate DAM position

DAM price Real-time price

Public 9

Risk Factors

•Exposure to legitimate risk factors can be controlled by the level to which a DAM transaction is truly:

• a hedge against real-time market exposure - or -

• a speculative position against real-time prices - or -

• some intermediate combination of both.

•These will be further discussed in the context of the examples provided at the end of this presentation

Public 10

Risk Factors and the Implications for DAM Design Requirements

•It is important for market participants to understand the necessary differences in the pricing/scheduling/commitment process between the DAM and the real-time market

•It is important that those differences are indeed necessary in a day-ahead context

•Equal access to information across all DAM participants will be essential

•Uniform timing of the release of information will be essential

•Each source of information feeding into the DAM pricing/scheduling/commitment process will need to be guarded against potential gaming opportunities

•To a practical extent, the DAM should give market participants the choice to allocate their finanical risk between any combination of:

•The DAM

•The Real-time Market

•Physical Bilateral Contracts

Public 11

RETURN

Public 12

Sources of Financial Returns in a DAM context

•The DAM adds new options for constructing a risk/return strategy.

•To most DAM market participants, these new sources of return will add new OPTIONS that they may chose from when constructing their risk/return strategies between the DAM and the real-time market.

•Potential new sources of return could include (subject to the final requirements of the DAM):

• A competitive market for “start-up costs”

• A competitive market for “speed-no-load costs”• A competitive market for “shut-down costs” • A competitive market for buyers and sellers to secure energy prices

• A competitive market for sellers to secure operating reserve prices

•These costs and their implications are the source of the slides that follow in this section

Public 13

Start-up Costs

Return and Start-up Costs:

•Start-up costs are currently recovered as a component of Marginal Costs (MC) offered into the real-time market

•Generators must estimate their expected level of output to arrive at the optimal Marginal Cost curve to offer into the market

•Due to the volatility in the real-time market and the requirement that offer curves must be upward sloping, the optimal output/MC combination may not be achieved

How This Return is Realized in Today’s Market:

Possible DAM Design Feature:

P

Q

AC

MC

•Give Generators the option to offer these costs into the DAM as separate Fixed Cost components

•This would allow generators to choose between the current method of cost recovery and/or recovering a portion of start-up costs as part of their day-ahead position

optimal

Sub-optimal

Target output level

Actual output level

Offer Curve

EMP

Public 14

Return and...Start-up Costs:

How the DAM could be of value:

P

Q

AC

MC

optimalAC’

•The Average Cost (AC) being offered into the DAM or the Real-time market would have a significant portion of the fixed start-up costs removed (i.e. treated separately).

•As a result, the IMO requirement that all offer curves must be upward-sloping would more closely resemble the price-sensitive portion of generator offers being submitted into the market

•Generators are less likely to incur a loss for start-up costs which would be separately compensated under this new arrangement

•Allows the DAM market optimization to efficiently allocate start-up costs over the course of the entire dispatch date.

•Drives generators towards more efficient start-up costs.

MC’

EMPOffer Curve

Public 15

Return and...Speed-No-Load Costs:



• Like start-up costs, speed-no-load costs are currently recovered as a component of Marginal Costs (MC) offered into the real-time market

• The current algorithm gives no consideration to the length of time a generator is held at the minimum loading point incurring costs

• Requires further analysis in the context of Multi-Interval Optimization (MIO)

•Give Generators the option to offer these costs into the DAM as separate Fixed Cost components


Public 16

Return and… “Shut-down” Costs:How This Return is Realized in Today’s Market:


• “Costs” are not recognized in the context of a load bid. Rather, bids are viewed as representing the “…actual benefits of consumption.” (IMO Market Rules, Appendix 7.5 section 2.3.1)

• All bid curves must be downnward-sloping

• If there are any fixed costs to shutting down a load, they must be represented in the bid curve. (i.e. avoided shut-down costs are represented as a benefit of consumption)

• In the case of dispatchable loads: avoiding shut-down costs may also be given the highest possible priorty by bidding a portion of its load at the Maximum Market Clearing Price in order to designate it as non-dispatchable (IMO Market Rules, Chapter 7, section 3.3.18

and associated market manual 4.2)

• Value is prefaced by 2 key questions:1) Should the market now recognize a “cost” associated with shutting-down load?

2) Does today’s market already provide adequate protection against incurring shut-down costs?

•Give loads the option to offer these costs into the DAM as separate Fixed Cost components.


Public 17

Return and…Energy


•Allows market participants to secure an initial rate of return on the pre-dispatch day

•More risk/return options: Allows market participants to use DAM prices as a hedging tool against real-time prices, a speculative tool, or a combination of both

•Both Generators and Loads rewarded for their flexibilty in responding to real-time prices (see examples)

•Overall, more choice for market participants in structuring their activities

•Prices and market schedules are not known until after the dispatch interval

•Pre-dispatch prices and schedules are non-binding and often not an accurate indication of subsequent market conditions

•PBC’s are the only vehicle the IMO recognizes to insulate market participants from real-time energy prices


Public 18

Return and…Operating Reserve


•Allows market participants selling operating reserve to secure an initial rate of return on the pre-dispatch day

•More risk/return options: allows market participants to use DAM prices as a hedging tool against real-time prices, a speculative tool, or a combination of both

•Both Generators and Loads rewarded for their flexibilty in responding to real-time prices (see examples)

•Overall more choice to market participants in structuring their activities

•Prices and market schedules are not known until after the dispatch interval

•Pre-dispatch prices and schedules are non-binding

•PBC’s are not applicable to operating reserve


Public 19

Return and...the possible implications for DAM design requirements

•If the DAM provides separate recognition of Start-up and Speed-no-Load costs there must be a fair and equitable way to recover those costs - which must be at least as accurate or better than today’s cost alocation through energy prices.

•Raises the question whether or not start-up and speed-no-load costs also need to be considered separately in the real-time optimization process

•The allocation of socialized costs from the DAM needs to be considered. This includes:

• operating reserve

• “start-up” costs

• “shut-down” costs

• “speed-no-load” costs

•Ensuring that returns related to energy transactions in the DAM can be secured by using some form of physical bilateral contracts

Public 20

Types of Market Participants and Financial Objectives

(6 Examples)

Public 21

Risk/Return Strategies Common to Various Types of Market Participants:

Type ofMarketParticipant

Local DistributionCompanies

Retailers Virtual DAM MarketParticipants

Examples ofRiskStrategies

Hedge aportion ofpurchases

Minimize real-time marketexposureduring volatileperiods

1) Hedge aportion ofpurchases

2) Re-sell unusedenergy to real-time market

3) Minimize real-time marketexposureduring volatileperiods

1) Hedge aportion ofpurchases

2) Re-sell unusedenergy to real-time market

3) Speculate onnext-day prices

1) Speculate onnext-day pricesin the real-timemarket

2) Hedge againstnext-day pricesin the real-timemarket bysecuringselling price

3) Secure start-up costs

1) Speculate onnext-day pricesin the real-timemarket

2) Hedge againstnext-day pricesin the real-timemarket

ExpectedRate ofReturn

N/A (pass throughof energy costsunder current retailsettlement code)

1) N/A for retailcustomersunder Bill 210

2) Enhanced rateof return forlarger retailaccounts

1) Securepurchase price

2) Lock-in rate ofreturn onbilateralcontracts

3) Exposed rateof return forphysicalenergy flowsthat don’tmatch DAMpositions

1) Secure aselling price

2) Recover start-up and speed-no-load costs


4) Exposed rateof return forphysicalenergy flowsthat don’tmatch DAMpositions

1) Secure aspeculativepurchase price

2) Secure aspeculativeselling price


Depends on regulatory framework

Depends on regulatory framework

Generators and imports

Non-LDC Loads and exports

Public 22

6 Examples

Six examples of varying risk/return stragies:

• Example 1: LDC not participating in DAM (i.e. other than forecasted load being represented for unit commitment purposes)

• Example 2: Disp. Load with no PBC• Example 3: Disp. Generator with no PBC• Example 4: “Virtual” transaction with no PBC• Example 5: Generator with PBC• Example 6: Load with PBC and partial re-sale back into real-time market

-y%

+x%

0

Risk-free rate of return

Risk

Potential Rate of Return

1

34

2

56

Normal variance between DAM and real-time

prices

Documents

Market Evolution Program