AFTER A FOUR-YEAR DEBATE ON ELECTRICITY REFORM, CALIfornia's powerful industry players have carved out a unique and broad new role for "scheduling coordinators." SCs have the central role in offering fully unbundled generation, transmission and retail-access services. But could these SCs, by controlling the market, also become the new monopolists?

California's highly complex scheme for markets, while said to be laissez faire, maintains several artificial constraints and market protocols that create advantages for SCs. As it is now designed, the California Power Exchange (the spot market, or PX) seems certain to have a limited role and a limited life, further reducing competition and market transparency.

Integral to the California experiment is the SC concept, which so far is unproven. SCs act for generators and consumers to schedule trading on the grid. By submitting bids to the independent system operator (who runs the transmission system), the SCs help the ISO manage line congestion. However, SCs can concentrate generation through contracting or acquisition. In this very complex market, with rules tailored for SCs, concentration of market power appears inevitable, as does market manipulation through gaming behavior.

The Federal Energy Regulatory Commission has allowed California's experiment to begin, but approval remains conditional. %n1%n The FERC will review many matters, most of which involve market protocols governing SC activities. Overall, the FERC appears cognizant of potential problems. However, for the time being it has chosen to monitor market activity and simply "observe" any market-power abuse. Smart gaming strategists will disguise their behavior and avoid regulatory review, much as occurred in England and Wales. A more credible approach might examine each market mechanism and construct counter examples that prove the ability to play inappropriate, discriminatory games.

California's attempt to have SCs "make the market" may have opened a Pandora's box of market power and gaming problems. %n2%n Compared to independent system operators in New York, New England, and Pennsylvania-New Jersey-Maryland, %n3%n with simpler markets and ISOs that resolve congestion, California may have gone too far too fast. Instead, California's scheme makes SCs coordinate all market players and dictate generation dispatch. Congress and other states should take a hard look at California's experiment. California may have created a market-maker role with overwhelming advantage and a market structure that encourages power abuse. That is a future that others should avoid.

Controlling Scheduling and Congestion

Scheduling coordinators offer schedules and bids to the ISO acting as agents for participating generators and loads in three trading markets - day-ahead, hour-ahead and real- time. In each of these three markets, the ISO publishes congestion information, executes trades brokered by the SCs and then redispatches resources, based on SC congestion bids when necessary. In both day-ahead and hour-ahead markets, the ISO accepts schedules and bids from SCs that reflect acceptable dispatch adjustments. The SC's schedule must exactly match the power provided to the grid and power taken off the grid for each hour. In the real-time market, the ISO can use only SC-provided bids to adjust for congestion.

In the day-ahead market, SCs can use an "iterative window" to make trades in response to expected congestion. The SC obtains congestion information from the ISO, examines trading options and adjusts generation and loads, easing trades between its participants or with other SCs. The SC then submits its revised generation and load schedule to the ISO. With these revised schedules, the ISO may determine that SCs have made generation and load adjustments so that congestion no longer exists.

If congestion remains, the ISO can adjust specific generation and load based on voluntarily submitted adjustment bids from SCs. The ISO then sends redispatch instructions to the SC, which the SC must carry out or face economic penalty based on the next incremental bid to meet the ISO's needs. The ISO, however, cannot adjust individual schedules of generators or consumers. %n4%n Only the SC has this authority. The ISO can act autonomously to change generation and load only in extreme emergencies, such as an impending outage.

More Flexibility, Broader Scope

The differences between California's SCs and PX are striking. Though "comparability" serves as the FERC's golden rule - and should have governed the design of the PX and SCs - in California it has taken a back seat.

As market-maker, the SC can negotiate any role it deems appropriate to serve its clients and market participants and can strike any deal that is commercially acceptable between consenting parties. Let the buyer beware; the SC can do any of the following and more:

1. Keep supply portfolio costs "blind" to clients, allowing no price transparency.

2. Ignore the client's specific generation and load costs, allowing SCs to cross-subsidize between clients at will.

3. Discriminate within its portfolio of client-participants (according to inverse price elasticity), such as by differential pricing for customers or groups.

4. Attempt to set prices through strategic or collusive games, using its portfolio of clients' resources and loads.

Smart buyers of SC services may integrate specific contract terms to avoid these pitfalls. Preferred customers with sufficient buying power are expected to benefit most and face less risk by negotiating customized contracts with SCs.

By contrast, the PX is disadvantaged.

The PX is a market maker that accepts day-ahead and hour-ahead energy bids (supply and demand) and loads. The PX must behave in a nondiscriminatory manner with full price transparency. It can only accept generation bids, loads and demand bids. It cannot take a position in the market. The PX will match the lowest incremental generation bid with the highest incremental demand bid, producing uniform market clearing prices (MCPs) for each hour. It then must publish these MCPs, notify its participants of auction results and submit the resulting schedule of generation and load to the ISO.

Meanwhile, an SC can price-discriminate by matching the next highest willingness to pay for demand with a slightly lower generation price. %n5%n Price discrimination merely results in some prices that exceed a uniform MCP and some prices that fall below a uniform MCP. Some SCs even index their prices to the MCP or PX. If PX prices are consistently higher, then SCs can virtually build-in profit margins. The PX, on the other hand, cannot produce prices that are competitive with SCs.

As things stand, an SC can interact and negotiate with its own generators and client loads and with other SCs as well. Even cartel behavior is not prohibited under the ISO Tariff or its protocols. SCs need not disclose any information to client-participants but the resulting schedules. In short, SCs can discriminate at will in any manner within the law.

The PX, which should be able to offer a competitive MCP, remains burdened with protocols limiting its participants and making it an inferior market. California's smaller consumers defined the problems with market protocols, %n6%n some of which are summarized here:

1. PX participants must bid earlier and reveal prices earlier than other SCs. Hence, after the PX has "tied the hands" of its participants, other SCs can submit initial and final, preferred schedules.

2. In the day-ahead market, SC participants can trade to reduce congestion and lower power costs; the PX cannot respond to congestion through bids or trades.

3. Because the PX cannot respond to congestion, generators will shun the PX rather than face an uncertain curtailment to operate.

4. PX participants will trade based on Activity Rules which ensure incentive compatibility (serious binding offers) but SC participants have no such restrictions.

5. The PX cannot take a position in the market (regarding congestion, ancillary services, or transmission contracts) - it is a market maker "without a brain."

And the PX suffers from added burdens. First, it must accept the expensive power from California's investor-owned utilities, while SCs need not. Second, the PX must serve the default customers at each IOU who "choose not to choose." IOUs will not submit demand bids for default loads that do not elect direct access. These customers become pure "price-takers" in the PX, marked by a vertical demand-curve reflecting a presumed willingness to pay an infinite price for electricity. From the experience of England and Wales, we know this situation is a recipe for generators to exercise market power. Third, in comparison to other SCs, the PX effectively requires redundant access costs and transaction costs - though it retains less flexibility than other SCs. %n7%n

In a properly structured environment, a viable PX would create a highly competitive energy market with low transaction costs. This feature would support a more competitive bilateral contracts market and facilitate greater rivalry among all SCs. Hence, the PX would be a transparent substitute for consumers to comparison shop among SCs for better deals. Not surprisingly, SCs have signaled that they don't want a viable competing PX.

Expected Gaming Strategies

Electricity markets in England and Wales revealed many strategic games to increase generation prices and profits, such as generation scheduling and bidding to increase profits and create barriers to market entry. Similar concerns have been raised about gaming in California's markets. %n8%n In sequential and iterative markets similar to those in California, gaming will emerge without uniform pricing or well-designed activity rules. %n9%n

Four simple gaming strategies are briefly explained.

First is gaming by capacity withholding. It has been used with mid-merit or base-load plants to increase prices during peak periods. Events such as "sudden generator unavailability" can reduce supply and increase MCP. The objective is to gain more from the increased peak prices than is lost from having an "infra-marginal" unit operating for more hours. The strategy is successful if generators can target the peak hours to reduce availability and have the power available when peak prices occur.

Second is gaming with "dynamic plant constraints" with plants that are marginal (more expensive). To play this game, the owners of the plant(s) must know the ramp rates - maximum rate of increasing production - of other plants that may operate in a given period. The game then is to get the more expensive unit on line and to "fill" the hours when competing plants would otherwise ramp-up, to ensure that the lower-priced unit is excluded because of dynamic constraints. %n10%n

A third strategy can involve adjustment bids to relieve constraints. Peak-period bidders who otherwise face congestion may eschew the initial energy markets (day-ahead and hour-ahead) and position themselves for the final (constrained) schedule. To succeed in the final schedule, peak-period bidders will: (1) gain information about transmission zone constraints to exercise local market power; (2) bid separate adjustment (incremental or decremental bids) prices to gain transmission access, possibly controlling the constraint point, intending to extract higher commodity or capacity prices; or (3) limit congestion information or restrict price adjustment opportunities. The latter can be achieved most directly through "hardwiring" the protocols or the sequence of bidding and scheduling steps. PX participants face this exact problem because of the market protocols initially accepted by the FERC.

A fourth strategy resembles predatory pricing. Market players may underbid to bar entry and raise overall prices. Through coordinated behavior between a set of generators, which an SC or group of SCs could arrange, market entry can be constrained in the short term, and remaining firms may then increase prices in the longer term. For example, a large portfolio of generators may depress off-peak prices, to restrict entry of base-load plants or assure that such plants face unattractive average prices. This result would disadvantage plants otherwise used in the near term (e.g., qualifying cogeneration facilities that are "put to market").

Gaming strategies also can be combined. For example, generators with market power or the ability to game peak-period prices (the first game above) could repeatedly bid low off-peak prices to bar base-load units (the fourth game). Later, as capacity margins decrease and prices increase, maintaining entry barriers will be more difficult.

Preventing Manipulation

Any previous efforts to address inappropriate gaming in the California market have been left unfinished. Strategic gaming and coordination by SCs to push up prices dominated the California ISO Market Surveillance Division's first workshop on market power. %n11%n The members discussed several market tactics, including market monitoring %n12%n and manipulation by experts to identify where inappropriate gaming could occur, yet neither have been implemented.

Although the FERC appears aware of gaming problems, it has said that such conclusions about potential problems are premature. In the PX approval order, it recommended more study and monitoring. %n13%n FERC's approach is as follows:

1. Ensure FERC jurisdiction by requiring market-related ISO and PX protocols be filed as part of the ISO/PX tariff.

2. Deem the congestion pricing approach preliminary, monitor its ability to send efficient price signals and require more transparent congestion information.

3. Require the PX to file Activity Rules to encourage honest iterative bidding.

4. Require the ISO and PX to conduct studies to assess possible market power abuse.

Regarding the latter, "the studies should pay specific attention to the susceptibility of the auction format to overt and tactical collusion and the potential to exercise market power." %n14%n This is a recurring theme in the FERC's decision.

The FERC also posed approaches to address three of the well-recognized gaming strategies. To address gaming by capacity withholding, the FERC requires that "availability standards" be developed for generators. %n15%n

To concerns about gaming with "dynamic plant constraints," the FERC would have generators file detailed information on marginal cost and unit availability to the ISO and PX, to assist in monitoring. With required plant divestiture, California's IOU generators will compose a small set of the generators that could exercise market coordination and gaming strategies. Monitoring a few plants makes little sense.

To address potential gaming of peak-period bidders and congestion, the FERC requires further study of congestion protocols and market monitoring.

The FERC's ultimate threat is to re-regulate the ISO and PX if market power abuse becomes evident. "We find that, if there is evidence that the Companies have been exercising market power, bid caps may be an appropriate response." This is no idle threat, as the FERC directs "the ISO and PX each to file pro forma bid caps with the Commission under F.P.A. section 205 as soon as practicable."

The need for more market rules, market studies, and even re-regulation is in part a response to the belief that the PX will not provide competitive MCPs. It appears that design has subverted the PX. As California's small and medium consumers have argued, a viable and transparent PX - one not burdened with protocols making it noncompetitive with other SCs - would make gaming and market dominance more difficult. Obviously, this plan would reduce the margins of other SCs, which points to the reason other SCs and large players are so disparaging of a viable PX - that it will affect their bottom line.

Will other interested parties and the FERC have the ability to make this a truly competitive market? The prospects appear dim. Strategic gaming and the capture of monopoly power look destined. Given their momentum, California's major players seem unstoppable. In addition, the ISO is very resistant to FERC's proposed changes, making reform less likely. Other states and Congress should critically assess whether California's head-long rush to laissez faire markets takes two steps forward only to land three steps back.

Eric Charles Woychik, president of Strategy Integration, a consulting firm to industry participants, has worked with energy utilities for more than 20 years. He has been involved in California's electricity market reform since 1985. The author thanks Charles Stalon for clarifying the capture of monopoly power, Michael Shames for his critique, and Michael Florio for the idea of this article. All errors are the author's responsibility.

SC as Gatekeeper

THE SC is a market-maker extraordinaire, a gatekeeper for all

generation and load that seeks access to the ISO grid. Only

SCs can schedule power on the grid. The PX is also considered an SC, but with restricted capabilities. Only SCs can coordinate many generators and loads in a strategic way, influencing the market.

SCs can also:

•  Negotiate generator and load changes with clients.

•  Negotiate bilateral contracts with or between clients.

•  Aggregate contracts between market participants.

•  Act as an Energy Service Provider.

•  Own, contract for, or broker generation.

•  Bundle generation and load.

•  Act as the sole agent to the ISO.

•  Submit schedules and bids for ancillary services.*

* The SC can provide spinning reserves, non-spinning reserves, reservation capacity and regulation (automatic generation control). This set of services differs from the list of ancillary services defined in FERC Order 888. In California, the ISO separately procures voltage (var) support and black-start capability. The ISO also provides balancing energy in the real-time market at market-clearing prices set by the PX.

1 Order Conditionally Authorizing Limited Operation of an ISO and PX, FERC Dockets ec96-19-001, ec96-19-002, et seq., Oct. 30, 1997. (Hereafter, FERC Conditions.)

2 See, e.g., Comments of TURN/UCAN Regarding 15 August Filings of the California ISO Corporation and PX Corporation, Sept. 2, 1997, FERC Dockets ec96-19-003 and er96-1663-003. TURN/UCAN argue "that the instant proposal will result in a discriminatory market which encourages the abuse of market power by large players and will result in major inefficiencies that create large and deleterious impacts on consumers."

3 See, PJM Interconnection, Docket Nos. oa97-261-000 et al., Nov. 25, 1997, 81 FERC ¶ 61,257 (order conditionally accepting open access transmission tariff, power pool agreements and conditionally authorizing ISO).

4 The most expert SCs will in this way attempt to achieve "perfect price discrimination" along the entire demand curve. See, O. Williamson, Economic Organization: Firms, Markets, and Policy Control, 1986.

5 See, Protest of TURN/UCAN Regarding Phase II Filings of the California ISO Corporation and PX Corporation, June 5, 1997, FERC Dockets ec96-19-003 and er96-1663-003.

6 Although some SCs may choose to connect-up to the PX in order to gain more options to arbitrage.

7 See, Comments of TURN/UCAN Regarding the 15 August 1997 Filings of the California ISO Corporation and PX Corporation, Sept. 2, 1997, FERC Dockets ec96-19-003 and er96-1663-003.

8 R. Wilson, Report to the California Trust for Power Industry Restructuring: Bidding Activity Rules for the Power Exchange, March 14, 1997.

9 Start-up and no-load costs for plants that could come on line also factor into this strategy.

10 California ISO, Market Power and Monitoring Workshop, Nov. 18, 1997, Oakland, Calif.

11 Most all generation must be monitored, which is difficult and expensive, and from this data market coordination or gaming must be "observed," which seems subjective at best.

12 For example, the ISO must use incremental bids when load is increased and must use decremental bids when load is decreased, which allows an entity to dump (take) power on the grid and wait for a higher (lower) price to result, making the real-time market unstable. A solution is to use both incremental and decremental bids to set market price regardless of whether load is increasing or decreasing. The ISO is now examining this issue.

13 FERC Conditions, p. 210.

14 "To prevent the Companies from withholding capacity and thereby causing prices to rise, we find unit availability standards to be an appropriate response. We direct the ISO and PX each to file availability standards with the Commission as part of the mitigation proposal as soon as practicable." FERC Conditions, p. 234.

15 FERC Conditions, p. 235.

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