1. London Economics International LLC Dr. Serkan Bahçeci Contact: serkan@londoneconomics.com A Comparative Analysis of Actual LMPs and Estimated SRMCs in the PJM Market prepared for Assessing Restructured Electricity Markets: An APPA Symposium Washington, DC February 5, 2007

2. 2 Plan of presentation Introduction Basics – prices, timeframe, market Results of the Study SRMC Modeling Methodology

3. 3 Focus on applied economics with quantitatively rigorous analysis to policy and regulatory issues in the sector Evolved as a result of the infrastructure restructuring in the UK – now headquartered in US, a global economic, financial, and strategic advisory professional services firm specializing in energy and infrastructure LEI has a number of complementary and cross-disciplinary practice areas: l Regulatory economics and market design l Asset valuation, price forecasting and market analysis l Expert testimony and litigation consulting l Strategy advisory LEI’s advisory experiences are complemented by a unique set of tools include network-based simulation models, cost-benefit frameworks, models of strategic bidding behavior, and real options analysis Clients in energy industry include financial institutions, law firms, market institutions, utilities and IPPs LEI has an extensive regulatory advisory background

4. 4 Our assignment is to assess the relationship between energy prices and marginal costs of production Aim to provide insight to the efficiency of market mechanism Aim to provide insight to the efficiency of market mechanism Selected timeframe is from January 2003 to July 2006 Selected timeframe is from January 2003 to July 2006 PJM Classic only (PJM as of January 2003) PJM Classic only (PJM as of January 2003) Collate actual historical LMPs Collate actual historical LMPs l Aggregates of the load zone LMPs – Day Ahead Energy Market Simulate the market-clearing price that would have resulted if generators bid their short-run marginal costs (SRMC) Simulate the market-clearing price that would have resulted if generators bid their short-run marginal costs (SRMC) Compare actual LMPs to simulated SRMC-based prices Compare actual LMPs to simulated SRMC-based prices l Re-created a price-cost markup index for a sample of discrete, hourly trading intervals over the timeframe based on simulated marginal-cost based bidding

5. 5 Plan of presentation Introduction Basics – prices, timeframe, market Results of the study SRMC Modeling Methodology

6. 6 We have focused on the Day-Ahead LMPs in the PJM market, as that is one of longest-lived nodal markets in the US Day-ahead LMPs are financially binding and typically cover 60% of the system load in PJM (2005 average) Day-ahead and real time LMPs are actually converging In PJM, LMP is composed of generation marginal cost + transmission congestion costs (other markets have also included cost of marginal losses, which PJM is also introducing) l l LMPs are equal, when transmission system is unconstrained (ignoring loss component) l l LMPs vary by location, when transmission system is constrained LMP is based on how energy flows – not contract paths l l generators get paid at generation bus LMP l l load zone LMPs used for load settlement In order to encompass many actual conditions, our modeling focused on ‘LMP areas’ rather than individual nodes

7. 7 Selected timeframe is long enough to analyze trends and the selected sample is intended to be representative of each year We sampled days (rather than hours) to capture fluctuations within days We sampled days (rather than hours) to capture fluctuations within days The sample size is 55% The sample size is 55% l 200 days for each full year l 120 days for 2006 Sampling is done using Latin hypercube sampling method, that allows multiple categories and makes sure each category is equally represented in the sample Sampling is done using Latin hypercube sampling method, that allows multiple categories and makes sure each category is equally represented in the sample l months l days of the week l load level l daily load variation 2005 daily load – 365 days 2005 selected sample – 200 days

8. 8 PJM Classic has 10 transmission zones, based on the service territories of the electric distribution companies

9. 9 Primary Fuel Type of Major Generating Assets Map also shows state and county borders and location of the 10 load zones While coal is concentrated in the west, Eastern PJM is dominated by gas-fired resources Source: Energy Velocity

10. 10 … and population density (proxy for load) is higher in the east compared to the west

11. 11 Map is showing: Transmission lines greater than 200 kV Transmission lines greater than 200 kV Generation units greater than 100 MW Generation units greater than 100 MW Transmission interfaces recreated from PJM document titled “GIS Applied to PJM Transmission System”, October 18, 2005. Transmission interfaces recreated from PJM document titled “GIS Applied to PJM Transmission System”, October 18, 2005. Network topology depends on transmission interfaces, which are not perfectly aligned with the boundaries of the load zones Western Interface Central Interface Eastern Interface Source: Energy Velocity

12. 12 Our five region topology is consistent with the differences in zonal LMPs

13. 13 LMPs are consistently lower in the western zones during the study timeframe Source: PJM

14. 14 Plan of presentation Introduction Basics – prices, timeframe, market Results of the Study SRMC Modeling Methodology

15. 15 Short run marginal cost includes fuel costs, environmental costs and variable O&M costs Environmental costs cover SO2 and NOx allowances Environmental costs cover SO2 and NOx allowances Variable O&M costs include Variable O&M costs include l operations supervision l coolants and water expenditures; l pumped storage expenses l equipment expenses l steam expenses from other sources l expenses of transferred steam l electric expenses l miscellaneous steam power expenses l maintenance supervision and engineering l structures maintenance l boiler maintenance l maintenance of reservoirs l maintenance of electric plant l miscellaneous maintenance

16. 16 Fuel is the biggest component in SRMC calculations

17. 17 Average monthly fuel costs have rising trends through the timeframe

18. 18 Price-cost markup index is unit free, allowing comparisons across regions and time Price-cost markup (in dollar terms) is informative but cannot be used for binary comparisons Price-cost markup (in dollar terms) is informative but cannot be used for binary comparisons Price-cost markup index (markup over price) is used by PJM as well as other ISOs, and measures the percentage of the price- cost markup of the actual LMP Price-cost markup index (markup over price) is used by PJM as well as other ISOs, and measures the percentage of the price- cost markup of the actual LMP

19. 19 We simulated the market using POOLMod, our proprietary market simulation software For each hour we used actual historical For each hour we used actual historical l load l transmission flows l imports and exports Daily fuel prices are used for thermal plants Daily fuel prices are used for thermal plants l For gas and oil fired units the closest NG or oil hub (spot) price is used l Coal prices take long-term contracts and transportation costs into account The availability of each thermal plant is determined using EPA’s CEMS database and other sources The availability of each thermal plant is determined using EPA’s CEMS database and other sources l CEMS cover more than 90% of the nameplate capacity For hydro plants we used monthly production data as submitted in EIA Form 906 For hydro plants we used monthly production data as submitted in EIA Form 906

20. 20 POOLMod simulates the actual market conditions to calculate SRMC-based market clearing prices Stage 1-Commitment Is plant available? Stage 2-Dispatch No Not committed for dispatch Review technical capabilities of units Schedule hydro based on optimal duration of operation Competitive bidding assumed Stage 1-Commitment Is plant available? Stage 2-Dispatch No Not committed for dispatch Review technical capabilities of units Schedule hydro based on optimal duration of operation Competitive bidding assumed Stage 1-Commitment Is plant available? Stage 2-Dispatch No Not committed for dispatch Review technical capabilities of units Schedule hydro based on optimal duration of operation Competitive bidding assumed Stage 1-Commitment (daily) Is plant available? Stage 2-Dispatch (hourly) Yes No Not committed for dispatch Review technical capabilities of units and offers Schedule hydro based on optimal duration of operation Resources dispatched based on offer price subject to transmission limits, as well as plant-specific technical constraints SRMC bidding assumed LMPs set equal to the bid of the most expensive dispatched resource Demand duration curve plus reserves for a typical day (MW) Hourly demand (MW)

21. 21 Plan of presentation Introduction Basics – prices, timeframe, market Results of the Study SRMC Modeling Methodology

22. 22 Monthly averages of price-cost markup indices show variation across regions Peak markup index, %

23. 23 … and through time Load-weighted monthly peak and off-peak price-cost markup indices Markup index, %

24. 24 Monthly price-cost markup indices and monthly averages of regional load are not correlated

25. 25 Region P (Penelec) has relatively higher markup indices compared to the other regions

26. 26 Region E (AECO, JCPL, PECO, PSEG) had high markups through 2004 to 2005

27. 27 Region M (PPL and portion of METED) has many statistically insignificant off-peak indices

28. 28 Region B (BGE, PEPCO and remaining METED) has a smaller difference between peak and off- peak indices

29. 29 Region D (Delmarva peninsula) has the highest markup index values in late 2004