1. Day Ahead Market Working Group Meeting May 1, 2003 Market Evolution Program

2. 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.

3. 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

4. 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

5. Public 5 RISK

6. 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

7. 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”)

8. 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 DayDispatch 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 priceReal-time price

9. 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

10. 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

11. Public 11 RETURN

12. 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

13. 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

14. Public 14 Return and...Start-up Costs: How the DAM could be of value: P Q AC MC optimal AC’ 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’ EMP Offer Curve

15. Public 15 Return and...Speed-No-Load Costs: How This Return is Realized in Today’s Market: Possible DAM Design Feature: 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 How the DAM could be of value:

16. Public 16 Return and… “Shut-down” Costs: How This Return is Realized in Today’s Market: Possible DAM Design Feature: “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. How the DAM could be of value:

17. Public 17 Return and…Energy How This Return is Realized in Today’s Market: 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 How the DAM could be of value:

18. Public 18 Return and…Operating Reserve How This Return is Realized in Today’s Market: 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 How the DAM could be of value:

19. 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

20. Public 20 Types of Market Participants and Financial Objectives (6 Examples)

21. Public 21 Risk/Return Strategies Common to Various Types of Market Participants: Type of Market Participant Local Distribution Companies RetailersVirtual DAM Market Participants Examples of Risk Strategies  Hedge a portion of purchases  Minimize real- time market exposure during volatile periods 1) Hedge a portion of purchases 2) Re-sell unused energy to real- time market 3) Minimize real- time market exposure during volatile periods 1) Hedge a portion of purchases 2) Re-sell unused energy to real- time market 3) Speculate on next-day prices 1) Speculate on next-day prices in the real-time market 2) Hedge against next-day prices in the real-time market by securing selling price 3) Secure start- up costs 1) Speculate on next-day prices in the real-time market 2) Hedge against next-day prices in the real-time market Expected Rate of Return N/A (pass through of energy costs under current retail settlement code) 1) N/A for retail customers under Bill 210 2) Enhanced rate of return for larger retail accounts 1) Secure purchase price 2) Lock-in rate of return on bilateral contracts 3) Exposed rate of return for physical energy flows that don’t match DAM positions 1) Secure a selling price 2) Recover start- up and speed- no-load costs 3) Lock-in rate of return on bilateral contracts 4) Exposed rate of return for physical energy flows that don’t match DAM positions 1) Secure a speculative purchase price 2) Secure a speculative selling price 3) Lock-in rate of return on bilateral contracts Depends on regulatory framework Generators and imports Non-LDC Loads and exports

22. 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 3 4 2 5 6 Normal variance between DAM and real-time prices