2. NYISO Capacity Markets: Function, Performance, and Future Presented to: Joint Technical Conference on New York Markets & Infrastructure Docket No. AD14-18-000 By David B. Patton, Ph.D. President, Potomac Economics November 5, 2014

3. Together with NYISO’s energy and reserve markets, the capacity market in New York serves a pivotal role in facilitating long-term resource decisions. We have been evaluating the performance of the capacity markets in New York, New England and the Midwest over the past 14 years. This presentation will address the following topics: The Need for Capacity Markets Evaluating the Performance of a Capacity Market Performance of the NYISO Capacity Market Recommendations for Improvements Selected Technical Conference Questions and Issues Overview of Presentation - 2 -

4. Market-based investment in wholesale electricity markets is ultimately facilitated by the markets’ economic signals, including: Energy and ancillary service net revenues during non-shortages; Energy and ancillary service net revenues during shortages; and Capacity market net revenues; Long-run equilibrium is achieved when the combination of these expected revenues covers entry costs of the marginal resource. “Energy-only markets” include the first two revenue streams (because they lack a capacity market). Energy-only markets will sustain some level of resources. However, they will generally not produce sufficient revenues to facilitate the investment/retirement decisions needed to satisfy the RTO’s planning requirements. In other words, there is “missing money”. Capacity markets exist primarily to provide the missing money. The Need for Capacity Markets - 3 -

5. Planning reserve requirements exceed capacity levels that an energy- only market would provide (assuming efficient shortage pricing). Why? First, the “1 day in 10 year” reliability standard implies a value of lost load of $100,000 to $200,000 per MWh. Therefore, additional revenues are needed to prompt the higher level of investment(and slower retirements) needed to satisfy these targets. Second, the higher planning margins result in more supply, which reduces the frequency of shortages (and associated shortage revenues). Third, RTOs take costly reliability actions that tend to reduce real- time prices such that they do not reflect the full value of energy. Lastly, some planning requirements cannot be readily reflected in the real-time market and thus will not be reflected in its shortage pricing. Why is There “Missing Money” in Electricity Markets? - 4 -

6. To most efficiently provide the “missing money”, capacity markets have been developed to allow competition to establish price signals to facilitate the actions necessary to satisfy the planning requirements. The NYISO capacity market is an example of a fundamentally sound RTO capacity market design; Suppliers submit offers to supply capacity for various time periods (e.g., monthly, seasonally). Under competitive conditions, the offers should reflect the minimum payment needed to continue to operate (i.e., “going-forward costs”); A sloped demand curve reflects the marginal value of capacity in providing reliability to the NYISO system. Clearing pricings are established where supply offers intersect the demand curve. A well-functioning market, these clearing prices will facilitate efficient long-term decisions, including new investment, retirement and maintenance decisions. The Role of a Capacity Market - 5 -

7. Capacity market performance should be judged by the outcomes it has facilitated and whether the outcomes have been efficient. What outcomes are expected in a well-functioning capacity market? Capacity enters when and where it is needed. Capacity retires when it is no longer economic or needed. Market power is not exercised. Capacity prices are transparent and predictable over the long-term. The centralized capacity market need not do everything: A well-functioning spot capacity market will facilitate efficient forward contracting by providing an efficient predictable price signal. The centralized capacity need not establish forward contracts. A spot capacity market should not hinder public policy initiatives that address factors not reflected in or priced in the capacity market. Evaluating the Performance of a Capacity Market - 6 -

8. Based on these criteria, the NYISO capacity market has performed relatively well. The outcomes have been consistently competitive with very little capacity withheld from the market. The market has facilitated new investment when and where it has been needed to satisfy NYISO’s planning requirements. – –NYISO has never been short of its planning requirement market- wide or in its load pockets. More than 12,000 MW of new capacity has been developed in New York over the past 14 years, which has included merchant generation, merchant transmission, and investment with forward contracts. Retirement decisions have generally been efficient. However, the delay in defining the Southeast New York capacity zone likely led to some inefficient retirements and hindered investment in that area. Evaluating the Performance of a Capacity Market - 7 -

9. Factors Contributing to the Good Performance of the NYISO Capacity Market - 8 - A sloped demand curve that reflects the reliability value of additional capacity above the minimum requirement, which: Provides efficient spot capacity prices that reflect the prevailing supply. Improves price stability, which facilitates investment by reducing risk. Reduces incentives to withhold capacity by raising the opportunity costs of withholding (foregone revenues) and decreasing its price effects. Locational requirements that reflect the fact that transmission constraints cause RTOs’ planning needs to vary locationally. NYISO’s locational market allows prices to efficiently signal the value of capacity in local areas based on the supply and demand in each area. Market power mitigation measures to ensure that outcomes are competitive. Supply-side: to prevent withholding that would increase prices. Buyer-side: to prevent uneconomic investment intended to lower prices. Transparent spot capacity prices facilitate efficient forward contracting.

10. Although the NYISO capacity market is performing relatively well, we have recommended incremental improvements in two key areas. Refinements in the Mitigation Measures Improvements in the mitigation measures will keep them effective and ensure that they do not hinder efficient investment. Our buyer-side recommendations include: A competitive entry exemption. Modifying key assumptions in the exemption analysis, including the assumed entry date and the status of mothballed units. Improving the offer floor applied to mitigated units. Our supply-side recommendations include: Enhance the pivotal supplier test in NYC so that it matches the rule for the new capacity zone. Recommendations for Improvements - 9 -

11. Dynamic Locational Framework When planning needs arise because of new deliverability constraints, it is highly beneficial for: Capacity prices to immediately reflect these needs; and Capacity prices to not reflect these needs when the deliverability constraints are no longer binding. Locational needs can arise or disappear quickly as resources enter or retire, or as transmission is built. A dynamic framework should facilitate actions by participants in advance of the locational prices emerging based on the expected changes in supply, demand, or the transmission network. A dynamic framework reduces the potential that reliability contracts may be needed in the future to address unpriced reliability needs. Recommendations for Improvements (cont.) - 10 -

12. Should the NYISO capacity market provide a longer revenue certainty period (e.g., 3, 5, or 10 years)? This is not necessary. The NYISO’s spot capacity market facilitates bilateral contracting that can provide revenue certainty. Does the existing NYISO capacity market appropriately incent investment as compared with three-year forward market designs in other capacity markets (e.g., PJM, ISO-NE)? Yes, based on the past results in New York. There is little evidence that awarding a one-year capacity contract three-years ahead would better motivate investment. A “lock-in” provision may motivate investment, but we are concerned that such provisions may raise costs over the long-term. However, the NYISO is studying these issues and we look forward to reviewing their results. Technical Conference Questions: Meeting Reliability Objectives - 11 -

13. Are long-term bilateral contracts a feasible alternative procurement mechanism for New York (e.g., California model)? Bilateral contracts complement the NYISO capacity market, but are not a reasonable substitute. Contracts do not provide transparent price signals and cannot facilitate efficient decisions by suppliers. Bilateral contracts as a substitute for the capacity market would shift substantial risk from suppliers/investors to NYISO’s customers. Are changes to NYISO’s capacity market necessary to better ensure resource performance during peak demand conditions? The primary incentive for good resource performance is NYISO’s real- time pricing (shortage pricing in particular). Resources that are unavailable during peak periods incur tremendous costs or lost profits, particularly when they contribute to a shortage. The NYISO is evaluating whether incremental changes in the capacity market may be beneficial. Technical Conference Questions: Meeting Reliability Objectives - 12 -

14. Why are Reliability Support Services (RSS) agreements needed? Reliability agreements are generally needed when the locational market needs do not fully reflect an RTO’s true reliability needs. RSS contracts have generally been used in New York for relatively narrow local needs that can be addressed by very few suppliers. What is the effect of RSS agreements on the ability of the NYISO capacity market to efficiently meet the intended goal of incentivizing investment in resources and infrastructure? The effect on the market efficiency is are minimal if the agreements are with lowest cost supply option for satisfying the local need. Are there other market and infrastructure impacts of the use of RSS agreements? Markets could be impacted if the use of RSS expands beyond the current isolated local needs. The dynamic local framework we recommend would tend to limit the expanded use of RSS agreements. Technical Conference Questions: Meeting Reliability Objectives - 13 -

15. Are changes to the capacity market needed to account for fuel availability/firmness of fuel, or to differentiate the value of capacity resources based on the “firmness” of fuel arrangements? The real-time energy market should play the primary role in providing these incentives. Efficient shortage pricing greatly rewards: – –Non-gas units that can run during gas shortages; – –Resources with back-up or firm fuel supplies; Hence, RTOs should ensure real-time market efficiently rewards such characteristics before modifying the capacity markets to do so. The proposed changes in NYISO’s real-time shortage pricing will improve these incentives. The NYISO is evaluating whether additional changes in the energy or capacity may be warranted. Technical Conference Questions Meeting Public Policy Objectives - 14 -

16. The NYISO market design has been very effective in facilitating investment and maintaining adequacy. Buyer-side mitigation measures could be improved to ensure that they do not impede economic investment. The locational market framework should be more responsive to changing system conditions. We have not recommended NYISO pursue mandatory forward procurement. Stability in the design and operation of the capacity market is critical. Investors must be able to project capacity revenue over the life of their resources. Instability raises investment risk that will cause investors to require higher prices to enter. Final Thoughts - 15 -