Overview of LMP Markets Features of ISOs / RTOs David Withrow Senior Market Economist Fall 2007 Meeting of the NARUC Staff Subcommittee on Accounting and Finance Jackson Hole, Wyoming October 8, 2007

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 2 Independent System Operators / Regional Transmission Organizations in North America (see

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 3 Typical Reliability and Market Components of ISOs / RTOs Day Ahead Market  Schedules for injections and withdrawals  Market Power Mitigation  Optimized Network Model for all Schedules  Locational Marginal Pricing  Commitment of generation for reliability reasons  Financial Transmission Rights  Existing Transmission Contracts Real Time Imbalance Market  Ancillary Services Resource Adequacy

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 4 Background on the California ISO  Began Operations March 31, 1998  Not-for-profit California corporation  Five-member Governing Board appointed by the Governor  Serves peak load in excess of 50,000 MW  Operates over 25,000 circuit miles of transmission, covering over 125,000 sq.miles.  Oversees the dispatch of over 700 generating units  Market re-design to begin March 31, 2008 Mission Operate the grid reliably and efficiently Provide fair and open transmission access Facilitate effective markets and promote infrastructure development

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 5 Core Functions of the California ISO 24 x 7 Grid Operations for Reliable and Non-discriminatory Transmission Service CAISO Operates Markets: -- Transmission (Day Ahead and Hour Ahead) -- Real-time Imbalance Energy Market -- Ancillary Services CAISO performs: -- Day-ahead scheduling -- Congestion management -- Market Oversight / Market Monitoring -- Coordinated Transmission Planning

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 6 Key Market Players in the California ISO Transmission Owners  Pacific Gas &Electric  Southern California Edison  San Diego Gas & Electric  Other entities owning transmission assets operated by the California ISO Generators Load-Serving Entities  Municipally-owned Electric Systems  State Department of Water Resources

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 7 California ISO’s New Day Ahead Process Market Power Mitigation analysis  Analyzes each generator bid to determine market power Integrated Forward Market” – transmission model that optimizes  Energy schedules (bids),  manages transmission congestion,  Procures ancillary services Procurement  Produces: feasible schedules for Real Time LMP prices at each node Residual Unit Commitment  Commits additional capacity, if needed, based on Demand forecast Congestion Revenue Rights (CRRs)  Point-to-point rights to revenues from transmission congestion

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 8 What is LMP? The marginal cost of serving the next increment of Demand at that node consistent with transmission constraints.

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 9 Locational Marginal Pricing LMP determines transparent prices at all price locations on the grid. LMP prices generally consist of three components:  Energy  Congestion  Losses In California, generators are paid the LMP; load pays the averaged LMP in an area  These Load Aggregation Points (LAPs) align with the three major IOUs’ service areas.

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 10 (A) How LMP makes congestion costs transparent

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 11 (B) How LMP makes congestion costs transparent

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 12 Why LMP? LMP manages ALL congestion in the Day Ahead to create physically feasible schedules prior to real-time operations. Locational price patterns indicate areas where additional generation and transmission upgrades are needed. Within the CAISO:  Generation is paid the LMP at the generator node.  Demand pays the average price within each IOU service area.

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 13 Understanding Financial Transmission Rights Different terminology:  PJM/ ISO-NE/ MISO: “Financial Transmission Rights” (FTRs)  NYISO: “Transmission Congestion Contracts” (TCCs)  California ISO: “Congestion Revenue Rights” (CRRs) Definition:  Rights to the hourly congestion revenue between two points – a Source and a Sink. Does not require scheduling energy between any two points Allows hedging of congestion risk under LMP Within CAISO, allocation / auction for terms of one month, one season (four per year) and 10-years.

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 14 Financial Transmission Rights A financial instrument (similar to a forward contract) that entitles the holder to a revenue stream (positive or negative)  Most CRRs are obligations, not options Revenues are based on the difference between the marginal congestion component of the Day-Ahead LMPs at the Source location and Sink location.  The revenue stream is not based on the marginal loss component of the LMP. Provide a hedging mechanism that can be traded separately from transmission service.  FTRs are not necessarily linked to scheduling practices.  FTR markets encompass several hundred million dollars.

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 15 What is it? Convergence (Virtual) Bidding: What is it? Allows market participants to make financial sales (or purchases) for energy in the Day Ahead market, with the explicit requirement to buy back (or sell) that energy in the Real Time market.  Possibly profit from the differences between Day Ahead and Real Time prices.  Virtual bids pressure DA and RT prices to move closer together.  Requires careful credit standards for virtual bidders.

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 16 How is it done? How is it done? Example: Virtual Demand Bid in the Day Ahead Market

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 17 How is it done? How is it done? Example: Virtual Bids are Liquidated as price takers in Real Time Actual RT Price ($55) Actual DA Price ($34)

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 18 Stable prices upon which parties can base contracts -- based on convergence of Day Ahead and Real Time prices. Minimizes incentives to under-schedule in the Day Ahead. Provides mechanism for generators to hedge risk of outages or be guaranteed the Real Time price. Common feature in many ISOs and RTOs.  CAISO will introduce convergence bidding no later than April, Convergence (virtual) bidding: Potential Benefits

Monday, October 8, Fall 2007 Meeting of NARUC Staff Subcommittee on Accounting and Finance 19 Summary Overview of LMP markets, FTRs, virtual bidding and other financial mechanisms. Organized markets permit financial practices within the scheduling and settlement of physical energy. ISOs and RTOs work closely with state regulators in the design and monitoring of markets. CAISO training modules on market processes, CRRs and other features are located at: