ISO-NE submits proposal to strengthen performance incentives in New England’s Forward Capacity Market

Resource performance concerns driving FCM redesign

ISO New England submitted a proposal to the Federal Energy Regulatory Commission (FERC) on Friday, January 17, 2014, that provides stronger incentives for resources to undertake investments that ensure they can perform when the power grid is stressed. These changes to key elements of the Forward Capacity Market (FCM) are needed to address significant risks to the continued reliability of the region’s power grid. These risks, identified through the Strategic Planning Initiative, include poor resource performance; New England’s dependence on natural gas as a fuel to generate a large portion of its electricity; impending retirements of aging resources; and integration of increasing levels of renewable resources.

What is FCM? Each year, ISO New England holds an auction to purchase the amount of capacity (both generation and demand-side resources) that will be needed to satisfy demand for electricity for a one year commitment period three years into the future. FCM uses a descending auction approach where resources compete to satisfy the predetermined capacity requirement. During each auction round the price drops and, as the price lowers, individual resources remove themselves from the auction when the price drops below the point at which they are willing to commit to a capacity supply obligation. Auction prices continue to drop until the capacity requirement is reached. Resources that take on capacity supply obligations in the FCM are taking on the commitment to be available to produce power when called on by the ISO. The central purpose of the capacity market is to provide resource owners with financial incentives to promote investment in new and existing generation and demand-side resources to be available in future years, ensuring the region has the capacity needed to meet peak demand for electricity.

History of FCM in New England

The current FCM in New England grew out of a 2006 settlement agreement among the six New England states, industry stakeholders, and ISO New England. Circumstances on the power grid then were very different than they are today: oil and coal units operated regularly; natural gas prices were rising; renewable resources were just starting to come online; and resource performance had been improving since industry restructuring in the late 1990s. However, the power industry in New England has changed radically since the compromise agreement was reached. After several years of real-world experience with the FCM, it has become clear that the design requires fundamental change because it is not achieving its most basic objective: ensuring grid reliability in a cost-effective manner.

Shortcomings of current FCM design, escalating resource performance concerns

As the industry landscape has changed, the need to revamp the FCM has become more urgent. While generators and demand-response resources that participate in the FCM take on an obligation to be available and receive monthly capacity payments in exchange for that commitment, these capacity payments are poorly linked to resource performance. In fact, under the current design, average resource performance has been declining and the poorest performing resources continue to be paid. This weak linkage between capacity payments and performance means there is little incentive for owners to invest in their resources to ensure that they are capable of providing energy and reserves when needed. As a result, the region is seeing lagging investment in existing resources, a pronounced decline in resource performance, and some near misses when it comes to reliability.

From just this past year, the five-day heat wave in the summer of 2013, the cold spell in January and Winter Storm Nemo in February serve as examples.  Because of the predicted heat and anticipated heavy demand for electricity in July, the ISO alerted all resources well in advance to be available and ready to perform. Nevertheless, several generators were unavailable when they were needed most. Earlier in the year, during last winter’s cold spell and then Winter Storm Nemo, ISO system operators managed through extremely challenging operating conditions although a high number of natural gas and oil generators were unavailable because of inadequate fuel arrangements. To read more about deteriorating performance and its effect on grid operations see the testimony of Peter Brandien, ISO New England’s vice president of system operations, included in the filing as Attachment I-1b, beginning on page 86.

ISO New England’s Pay-for-Performance proposal

To address these lapses in performance that can threaten reliability, ISO New England’s proposal would make significant changes to the incentive structure in FCM by closely linking each resource’s capacity payments to its actual performance during times when the grid is stressed and has a deficiency in operating reserves. Put simply, resources that perform well will be paid more, and resources that perform poorly will be paid less.

The new “Pay-for-Performance” (PFP) proposal means the FCM will now have a two-settlement design—similar to the structure of the ISO’s energy markets and many other forward contracts used throughout the economy. Each supplier that takes on a forward obligation in the Forward Capacity Auction will have a second settlement, during the delivery year, based on its actual performance during scarcity conditions. Under this design, resources that perform poorly cover their forward obligations through purchases from other suppliers in the pool that perform well. The absence of a two-settlement system is one of the major design flaws of the original FCM rules from the settlement agreement.

This approach shares the same key benefit of other two-settlement systems:  it results in payments from under-performing to over-performing resources, rewarding suppliers that make cost-effective investments to improve system performance during stressed conditions. Consumers will continue to pay only the base forward capacity price, determined by a competitive capacity auction three years in advance.

PFP will benefit the region

If the PFP mechanism is implemented, it will likely stimulate important changes:

• Operation investments: Strong performance incentives will provide resource owners with the economic motivation and financial ability to undertake investments that help ensure their resources can perform when needed. This might include investment in dual-fuel capability, so a resource can switch to another fuel when one is not available; more reliable fuel supply arrangements, such as LNG supply contracts; shorter planned outages; and other improvements.
• Cost-effective solutions: Markets motivate suppliers to deliver services in the most cost-effective ways. Under PFP, each resource owner will be able to develop and select the solutions that work best for the technologies and features of their resources. This approach rewards suppliers that pursue the most cost-effective means to improve performance and reliability.
• Efficient resource evolution: Over time, stronger incentives will lead to a shift in the resource mix that directly improves system reliability at the lowest cost. Resources that are unreliable and have high operating costs may submit higher offers in future capacity auctions, based on their expectation that they may perform poorly, which will result in reductions in their capacity payments. At higher prices, these resources will be less likely to clear the auction. By contrast, the compensation provided for strong performance will enable highly efficient or highly flexible resources to profitably make lower offers, and they will therefore be more likely to clear future capacity auctions.

Recent stakeholder correspondence On January 10, 2014, some stakeholders submitted a letter to the ISO requesting that the ISO not submit its PFP proposal. After careful discussion and consideration, the ISO made the decision to move forward with its PFP filing. In a response letter, the ISO explained why it is critical that the region act now to address the fast-changing circumstances taking place on the New England power grid. The region will need new capacity resources in the coming years and only with a well-defined capacity product and market that sends clear price signals based on actual performance will New England garner the investments needed for reliability.

Stakeholder process, alternative NEPOOL proposal

Over the past fourteen months, ISO New England has held numerous meetings with the New England Power Pool (NEPOOL), state regulators, and other industry stakeholders regarding the need to redesign the FCM to address the strategic risks facing the region. During the stakeholder process, the ISO adjusted its proposal based on stakeholder input. At the conclusion of the NEPOOL process, NEPOOL did not support the ISO’s PFP proposal, and instead favored a proposal to make modifications mainly to the region’s energy markets. The ISO considered but did not support NEPOOL’s proposal because it would not materially improve suppliers’ incentives for resource performance and investment, and would unnecessarily increase price volatility in the marketplace. As required by the ISO’s tariff, the filing submitted to FERC on January 17 includes both the ISO’s PFP proposal and NEPOOL’s alternative proposal. You can also view the NEPOOL materials separately.

Next steps

The ISO and NEPOOL have asked FERC to issue a determination on the filing by May 14, 2014. The ISO and NEPOOL have also requested that the majority of market rule revisions become effective on June 1, 2018, which is the start of the capacity commitment period associated with the ninth Forward Capacity Auction (FCA #9). In addition, both the ISO and NEPOOL are asking FERC to approve a smaller set of mitigation-related revisions to become effective on June 1, 2014, after the eighth Forward Capacity Auction is run this February and before the qualification deadline for existing resources to participate in FCA #9 on June 2, 2014.