<b>Beware the transmission operator that is truly "independent." </b>
Fortnightly Magazine - August 2000


Price Cap Follies

Beware the transmission operator that is truly "independent."

By now you've read all about it: in the dead of night, in a July hotter than hot, how the board of governors of the California Independent System Operator failed by one vote to tighten controls over state-run electricity markets for various back-up power services (real-time ancillary services and intra-zonal congestion management) by forcing the maximum price down to $250 per megawatt-hour, just eight days after it had lowered the price cap from $750 to $500 in what it called emergency action.

But you may have missed the story behind the story--how the ISO proper had opposed the price cap resolutions offered by the various private citizen stakeholders who sit on the board to ensure that the ISO will remain independent of utility control.

A few days after the failed vote, I talked with ISO spokesman Patrick Dorinson, who asked me to "please get the word out" that the governing board makes its own decisions, independent from the ISO proper, and that the two don't always see eye to eye. He sent me a copy of an internal memo that the ISO had circulated to warn that a tougher price cap would make customers worse off, not better.

"Lowering the price caps will increase out-of-market activity necessary by the ISO to maintain reliability within its control area.

"Increased out-of-market activity ... likely will [increase] the number of transactions required in real time ... [and] the likelihood of scheduling errors.

"It may become necessary for the ISO to engage in activity in advance of the PX and ISO day-ahead markets ... thinning the markets and raising prices."

Instead the ISO urged market players to better manage price risk. It asked the regulators and the legislature to remove constraints on hedging opportunities for distribution utilities. But what about those who had already hedged?

On July 10, the Morgan Stanley Capital Group asked the Federal Energy Regulatory Commission to reinstate the old $750 price cap for markets controlled by the California ISO, and to bar any further board attempts to cut the cap. Morgan Stanley called the ISO action "hasty and extreme," prompted by "blatant political pressure." (One press report put the blame for price cap fever on the populist state senator, Steve Peace). But more than that, Morgan decried the losses: "Cal ISO's sudden decision ... disadvantages power marketers such as Morgan Stanley that had hedged and made significant investments in the market in reliance on a $750 price cap."

It added, "This decision unduly favors local utilities or any other entity that has failed to hedge."

BACK EAST, THE FERC FACED ITS OWN CRITICS. The commission was put back on its heels by the Wall Street Journal's page one "Doom and Gloom" story, which saw Energy Secretary Richardson all but promising blackouts this summer. Fearing a hearing in Congress, the FERC quickly asked for advice on how to shore up reliability this summer. The electric industry was only too happy oblige, offering a wide array of ideas.

Perhaps you've seen the press reports about aluminum plants shutting down production and laying off employees in the Pacific Northwest because of high electricity prices. Alcoa Power Generating Inc. acknowledges the problem but sees a possible silver lining in those price spikes. In its comments in the FERC's reliability case, Alcoa attacked the occasional utility practice in power sales contracts of barring the retail customer from reselling the power to third-party customers. As Alcoa sees it, a contract to purchase power is no different than a cogeneration plant. And if qualifying facilities are guaranteed the right to sell power back to the grid, why not everyone? Alcoa explained:

"In economic terms, there is little to distinguish 'inside-the-fence' industrial generation from generation that the industrial user has purchased. In both cases, in times of high demand, it may be economical for the industrial end user to sell power committed to it own use back into the market."

YET LOAD MANAGEMENT CAN'T SOLVE EVERYTHING. Consider the California Department of Water Resources, which runs the pumps that fill the aqueducts to deliver drinking water across the state, and which uses more electric power and transmission resources than any other customer in California. It has water-pumping capability equivalent to 2,600 megawatts of load. Even in off-peak hours, the DWR ordinarily maintains a load of between 1,000 and 1,300 MW. The DWR offers to drop load on an emergency basis as a "non-wires" alternative to transmission expansion, but admits even that plan can go awry.

For instance, Amendment 28 to the California ISO tariff, filed April 14, recognizes that not all loads can turn themselves on and off every 10 minutes in response to ISO dispatch orders. Yet the ISO's proposed Tariff Amendment 29, filed May 2, would do just that. So, for instance, load that had been dropped in one 10-minute interval could be required to be turned back on during the next interval, dropped in the next, and so on, or else be penalized through "no pay" rules.

The DWR says it can drop its pump loads almost instantaneously, but cannot switch them on and off every 10 minutes to respond to ISO instruction. It needs 30 minutes of down time and then five minutes to ramp up for every 100 MW.

RELIABILITY MEANS THAT NOT EVERYBODY WINS. I like the advice from Dynegy vice presidents Kathy Patton and Peter Esposito to rethink the whole ball of wax--including locational marginal pricing and the TLR rules (transmission loading relief)--and to give a second hearing to the FERC's failed notice of proposed rulemaking on capacity reservation tariffs, which would have created firm physical rights to transmission.

As they note in their comments, "Some old NOPRs, like good wine, get better with age."

I also admire Patton and Esposito for daring to question the holy grail of locational marginal pricing. Essentially, they see LMP as a victory for utilities. "Transmission owners and operators clearly win, since ... there is no risk [to them] for costs of congestion." They argue that "power is delivered using a 'blank check' guaranteed by the transmission customers ... those adopting LMP have not seen an erosion in their returns on equity."

"Why," they ask, "does it [LMP] seem to be the congestion management paradigm of regulators and academicians?"

Here Patton and Esposito answer their own question: "The proponents of the centralized market structure fail to recognize the substantial consulting income they derive from setting up such structures, and from adjusting them as time progresses."

Yet it's no answer, either, simply to redispatch assets to get around the bottlenecks--in other words, to accept all transmission schedules and then just "socialize" the cost of congestion. As Patton and Esposito explain, congestion costs went through the roof when they tried that early on in PJM, by scheduling all the low-priced resources and then sparing no expense to redispatch to accommodate the transactions. "

The failure of this early scheme is not difficult to understand. Ask a first grader if she wants to ride her bike uphill or downhill and the answer is quickly obvious."

The Dynegy execs see an unpleasant choice:

"Certainty of delivery with no certainty of price, or certainty of price without certainty of delivery. Either way, reliability, at least as defined in most markets, does not exist."

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