1. 1 California: Nuts & Bolts Lessons from the “School of Hard Knocks” Susan R. Schneider July 6 th, 2014

2. 2 CALIFORNIA EXPERIENCE California/CAISO market overview Restructuring motivation & “horsetrading” How things actually worked Lessons & reflections Challenges ahead

3. CALIFORNIA MARKET OVERVIEW 3

4. 4 CALIFORNIA REGIONAL SYSTEM OPERATORS

5. 5 CAISO STATISTICS Combined service areas of PG&E, SCE, SDG&E, and several municipal utilities Peak demand >50,000 MW 124,000 square miles 25,000 circuit-miles (~75% of California grid) 1,400 power plants (~55,000 MW), more than England and France combined Serves ~12% of U.S. population (30 million people)

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7. TRANSMISSION CONGESTION CONSTRAINS ECONOMIC DISPATCH 7

8. 8 CAISO FEATURES Structure: Non-profit “public benefit corporation” (not a state agency) Funding: Surcharges (Grid Management Charges) on market schedules, transactions, & other grid use (first call on funds) Governance: 5-member independent Board appointed by the California Governor

9. 9 CAISO ACTIVITIES Forward schedule management: Day Ahead (10am), Hour Ahead, Fifteen Minute Congestion management & market optimization (energy, unit commitment, reserves), based on economic bids Real-time (RT) operations: 15-minute unit commitment, 5-minute economic dispatch After-the-fact settlements and billing Transmission/generation outage coordination Transmission & grid planning Generation interconnection studies/contracts Market monitoring

10. MARKET PRICING STRUCTURE Market-clearing prices for energy: Maximum bid and clearing prices Zonal pricing structure first Nodal pricing now (3,300 pricing nodes) Ancillary Services Regulation, Spinning Reserve, Non-Spinning Reserve Includes opportunity costs for energy if not dispatched Real-time differences from forward schedules billed/paid at RT price 10

11. OTHER KEY MARKET ENTITIES Government entities California Public Utilities Commission: Oversees energy procurement & contracting (IOUs), transmission siting/permitting, retail rates California Energy Commission: Oversees generation siting & permitting, long-range planning & policy Other entities Participating Transmission Owners (3 large IOUs, 13 others) Scheduling Coordinators (100+) Load-Serving Entities (LSEs) – Utilities, Community Choice Aggregation, others Suppliers – Generators & import suppliers/traders 11

12. 11/23/201412 L L L EACH LSE & SUPPLIER (generator or import) MUST HAVE A CERTIFIED SC CAISO LSE SC GEN SC L L L L L L L L L L LL LSE GEN LSE SC LSE LSE GEN IMPORT

13. RESTRUCTURING – MOTIVATION & “HORSETRADING” 13

14. 14 RESTRUCTURING DRIVERS (1980s – Early 1990s) Trend toward deregulation (“Reagan revolution,” airlines, natural gas (30% of market)) – “Government is part of the problem.” Utility monopoly under fire (cost overruns, high rates, capacity surplus, modular technology) – perception of utility inefficiency, “Markets can do better.” Muni pressure for transmission access Business pressure for retail competition (natural gas deregulation, high costs, bad economy, relocation threats) – competition as a way to “do something” without hurting others.

15. AB1890 – The “Steve Peace Death March” CPUC examination of open markets in 1993- 1995, but legal authority for change not clear Big battles in California State Legislature between utilities, business/competition advocates, labor/unions, & consumer interests Grand bargain struck between these interests, and legislation passed both houses of the legislature unanimously in late 1996 15

16. ORIGINAL BARGAIN – SOMETHING FOR EVERYONE! Retail customer protection (especially small ones) All customers get “choice” at the same time (1/1/1998) 10% rate reduction (bonds), then rates frozen Consumer protection rules for new retail suppliers & education effort Independent System Operator (CAISO) Transmission control – IOUs still own assets (and earn returns) but don’t control them operationally Open-access system – transparent tariffs & operating procedures (corporate doc on CAISO Web site – www.caiso.com) www.caiso.com 16

17. ORIGINAL BARGAIN (2) Instant competition, labor protection - multiple suppliers immediately through utility divestiture 50% of gas capacity required, incentives to divest more Buyers required to keep existing workforce for 2 years Cost coverage: Use “headroom” between frozen retail rates & lower market energy costs to: Recover utility “stranded” & transition costs (including labor severance, retraining, early retirement, and outplacement) and rate-reduction bond payments Continue “Public Purpose” programs (low-income, conservation/energy efficiency, renewables) 17

18. SO WHAT COULD GO WRONG? 18

19. IMPLEMENTATION Implementation was difficult, expensive, and rushed. Design details took years – not enough time for 1/1/98 “start-from-scratch” effort Late market start – 4/1/98, just before peak season Had to use off-the-shelf software, multiple vendors – interface issues, high costs ($200m) Some elements (e.g., market monitoring) not sufficiently addressed 19

20. CONSUMER PROTECTION Many consumer protections did not work as expected. All got 10% discount Large customers were courted by suppliers Small customers were mostly not, and only got additional real and sustainable options later Reliability suffered, and rolling blackouts were called in northern California in winter 2000-2001 20

21. RECOVERY OF STRANDED & TRANSITION COSTS Insufficient “headroom” – wholesale energy costs exceeded frozen retail rates. Wholesale energy prices fell initially but then rose: $29/MWh in 1998, $31/MWh in 1999, $110/MWh in 2000 Generation surplus became shortage Annual demand growth 1-2% in early 1990s, 3-4% in 1998-9, >5% in 2000 (demand growth also in surrounding import markets) Lack of new capacity – no entity would sign contracts; utilities stopped building for several years, and no one stepped in right away Questionable maintenance & forced outages Market power issues with congestion & market structure – extensive litigation for refunds from private & public suppliers 21

22. INSTITUTIONAL FAILURES One of the two largest utilities declared bankruptcy Utilities couldn’t pay bills – wholesale power exchange failed Recall of California governor (out went Gray Davis, in came the “Governator”) – energy crisis an important factor 22

23. EVENTUAL RECOVERY (1) New resources came on-line State stepped in to execute long-term contracts for new generation (creditworthy counterparty) Contracts were expensive, rushed, & not well-negotiated, but they did bring on new capacity Improved market monitoring & rules, e.g.: Imposition of bid-price caps, other conduct rules Establishment of conduct rules, performance metrics Institution of generation maintenance and outage standards & practices Settlement of much crisis-era litigation 23

24. EVENTUAL RECOVERY (2) – LSE Procurement Obligations LSE “obligation to serve” clarification: Must procure (own/contract) resources for their loads Resource Adequacy (RA) Requirements Capacity to serve peak load + Planning Reserve Margin Specific RA requirements in “load pockets” Bilateral PPAs with performance incentives & penalties Must-offer obligations for RA Resources (key feature) Return of integrated resource planning (CPUC): Procurement separated from transmission functionally but considers transmission “adders” 24

25. REFLECTIONS & LESSONS LEARNED 25

26. TRANSITION, TRANSITION! The journey can be as important as (or more important than) the destination With multiple complex changes all at once, things will not turn out as expected – flexibility and contingency plans are needed in case problems arise  “Trust, but verify.” (RR) Market roles & rules must be clear throughout – don’t leave gaps, especially for obligation to serve and conduct rules 26

27. IMPLEMENTATION MECHANICS Small details can take a lot of time to address (e.g., meter-data sharing, billing procedures & disputes) Consider building on existing software, processes Consider phased implementation (e.g., wholesale before retail, critical changes in stages, large customers before small customers, gradual granularity improvements) Don’t deploy major changes before peak season Provide authority/process to reverse or delay changes if problems arise 27

28. DIVESTITURE REQUIRES CAREFUL CONSIDERATION Added suppliers but also problems Quick, low-risk California market entry by buying removed the need for new entrants to build Divested assets (gas gen) were market-critical Utilities divested 100% (40% of total nameplate capacity) “Pairing” of divested plants reduced buyer diversity Natural gas was the supply “at the margin,” i.e., set market prices and needed for system balance Plants located in critical areas (load pockets) – that’s why they were sited there in the first place 28

29. LONG-TERM, SECURE FUNDING CRITICAL FOR NEW INVESTMENT Short-term markets don’t facilitate long-term investments - financing new plants requires: Coordinated resource procurement & transmission – requires coordination by multiple oversight entities Creditworthy counterparties, secure revenue sources Limitation of long-term market risks to generators Short-term price signals don’t necessarily incent the “right” new resources, in the “right” place 29

30. RISK MANAGEMENT BY LSEs – Typical PPA provisions LSEs & suppliers execute bilateral PPAs LSE receives all capacity benefits (RA credit) and any renewables credits for project PPAs provide for: Payment terms for project output Availability & production guarantees Any curtailment provisions LSE is Scheduling Coordinator for project Bids project output into CAISO markets, receives revenues Manages market revenue-PPA difference 30

31. PRICING STRUCTURE – Short-term Market Clearing Price Theoretically efficient for dispatch and encourages bidding at marginal cost, but has shortcomings Bidding prices/practices (and outages) for one plant can affect revenues suppliers receive for others Inflexible demand can cause price spikes Other thoughts Tradeoffs between accuracy and simplicity (80-20 rule) Negative prices needed for market solutions 31

32. MARKET MONITORING Clear market conduct rules & consequences Transparent & regularly reported metrics – how do you know the market is working well? Congestion/load pockets and MCP structure require additional monitoring Diverse monitoring staff is desirable, including personnel with actual market experience 32

33. ELEMENTS THAT WORKED (1) Open transmission access: Posted tariffs, operating/interconnection procedures, etc. Open stakeholder processes Standard, open decision-making process Decisions take longer, but all parties have a say, and hopefully the decisions are better 33

34. ELEMENTS THAT WORKED (2) Generator interconnection process reform Private investment & financing requires defined study processes & timelines Applications may increase greatly – consider cluster studies, diverse cost allocation, up-front upgrade funding Transparent transmission planning process Publicly available study plans & study results Stakeholder meetings & comment opportunities Recent institution of competitive construction 34

35. SMALL-CUSTOMER OPTIONS Significant transaction costs prevented mass- market penetration of third-party energy marketing to individual customers (a la Enron) Most consumer benefits via other means: Energy efficiency – appliance & building standards, audits/retrofits, and rebates/tax credits Community Choice Aggregation: “Opt-out” community- based energy procurement programs, usually offering higher renewable-energy service/options “Behind-the-meter” applications like rooftop solar (highly subsidized) 35

36. “UNCONVENTIONAL” RESOURCES CAN HELP “Intermittent” resources can be predictable and dispatchable with the right data & forecasting tools Flexible demand can be a viable resource Can mitigate market power, lower peak supply costs Works best under same structure as new generation – long-term programs or contracts Is usually undervalued – credit not given for MCP reduction or infrastructure impacts 36

37. ARE “WE” BETTER OFF NOW? Difficult to know – there is no control group or objective standard. The market is more open, broader, and possibly more efficient – larger operational areas, strong incentives to run plants efficiently, greater procurement planning/oversight There are more options available in the market Restructuring is probably not the only way to obtain these benefits (80-20 rule) 37

38. CHALLENGES AHEAD 38

39. SELECTED CHALLENGES AHEAD Integration of renewable resources Renewable Portfolio Standard: 33% of retail sales must come from specific renewables (wind, solar, geothermal, biomass, biodiesel, small hydro) by 2020 40% & 50% RPS under consideration Flexible RA requirement, new “ramping” product Storage valuation & deployment Now expensive but helps energy production follow load, and costs may decline over time 1,300 MW CPUC-mandated procurement Pumped-storage proposals 39

40. THE “TRANSITION” IS NEVER REALLY FINISHED New generation technologies New end-use technologies New societal/market objectives & tradeoffs “The only constant is change.” - Anonymous 40

41. Susan Schneider Founder & Principal of Phoenix Consulting, Inc. Former CAISO VP (at start-up) Former PG&E executive supervising retail electric & gas market restructuring Published newsletter on CAISO wholesale market issues for 10 years Advises generation clients in interconnection process, PPA negotiations, CAISO stakeholder processes 41