Proposed Enhancements to Energy Price Formation

Transcription

1 Proposed Enhancements to Energy Prce Formaton PJM Interconnecton November 15, 2017

2 Ths space s ntentonally left blank. PJM P age

3 Table of Contents Executve Summary... 1 The Problem: Why Are Prce Formaton Reforms Needed?... 1 The Proposed Soluton... 3 The Antcpated Results... 3 Potental Cost Impacts... 4 Shortage Prcng... 4 Part 1: Energy Prce Formaton... 5 Background: Markets n Transon... 5 The Opportuny: Enhance Market Prce Formaton... 8 Concluson: Improved Accuracy, Transparency and Effcency Part 2: Shortage Prcng Background: FERC Order Co-optmzaton and the Operatng Reserve Demand Curve PJM s Shortage Prcng Implementaton Opportunes to Enhance Shortage Prcng Concluson Appendx A: Letter of Support from Dr. Wllam Hogan Appendx B: Integer Relaxaton Model and Examples Integer Relaxaton The Dspatch model The Prcng Model The Settlement Model Examples Appendx C: Current Resource Flexbly Insuffcent Economc Incentve for Flexbly Appendx D: Cost Impacts Summary Energy Market Smulatons Capacy Market Smulatons PJM P age

4 Executve Summary The Problem: Why Are Prce Formaton Reforms Needed? Snce s ncepton, PJM Interconnecton s wholesale energy market has drven effcent resource entry and ex, successfully managed the retrement of a sgnfcant number of coal resources and ther replacement prmarly by natural gas resources, and mantaned a relable grd. The PJM market has also proven adaptable to changes n the ndustry as market rules have evolved to meet new needs. Changes n fuel and technology combned wh a slow-down n demand growth are nfluencng the markets and have revealed an opportuny to enhance energy market prcng so that prces accurately reflect the true ncremental cost of servng load and mnmze the need to recover those costs through out-of-market uplft payments. PJM s proposed enhancements wll ensure prce transparency, provde load-servng entes wh the ably to hedge prce changes and ensure that ncentves support an ncreasngly effcent commment and dspatch soluton. In addon, sendng more-accurate market prce sgnals wll ncent the development of new flexble resource technologes (e.g., batteres and other forms of energy storage) that can nherently follow load and provde more flexbly. In short, whle recognzng the need to ensure that prces reflect the cost of servng load today, PJM proposes to enhance ncentves for followng load and ncreasng flexbly to meet future electrcy needs. Prevously, the upward pressure on prces masked shortcomngs n the energy prcng mechansm. These hgher prces were the result of rsng demand and the hgher costs of margnal uns compared to nflexble uns, 1 whch are not currently elgble to set prce. In the past, hgher-cost flexble uns set prce often enough to ensure that all needed resources could earn suffcent revenues n the energy market, when combned wh capacy revenues, to drve effcent resource nvestments. Today, the contnung penetraton of zero margnal cost resources, declnng natural gas prces, greater generator effcency and reduced generator margns resultng from low energy prces have resulted n a generaton mx that s dfferentated less by cost and more by physcal operatonal attrbutes. 1 Inflexble uns are those wh declnng average costs that are unable to economcally produce power whn a certan range, or that requre an economc mnmum output. Inflexble uns can be of all fuel types, ncludng coal, nuclear and large gas uns, whch are nflexble based on eher ther technology or the way they purchase natural gas. PJM P age

5 As a result, enhancng energy prce formaton so the market sends better prce sgnals has become more promnent and worthy of attenton. 2 The current locatonal margnal prce (LMP) method was chosen because was smple n both concept and mplementaton. There have always been crcumstances under ths method where prces could fal to reflect all elements relevant to sendng the rght market sgnals. As mentoned above, under the current market rules, nflexble uns are not permted to set prce. When the cost of an nflexble un that s needed to serve demand s precluded from settng prce, 3 the LMP does not accurately reflect the true ncremental cost to serve load. Ths LMP lmaton can suppress energy and reserve prces and napproprately ncrease relance on the capacy market. The capacy market ensures the level of resources and avalably necessary for relably but s not desgned to ncent flexbly. Wh capacy performance (CP) enhancements, relably prcng has supplemented energy prcng as an ncreasngly mportant market construct to attract the effcent resource nvestment necessary to meet peak demand needs. However, beyond aggregated resource attrbutes such as maxmum economc generaton and forced outage rates, the CP construct s not ntended to reward the flexbly attrbutes that are essental to effcently meet operatonal needs (e.g., short startng tme, short mnmum runnng tme, low mnmum economc generaton, fast rampng rate). The energy and reserve markets reman the essental core market constructs to send the rght prce sgnals that reflect the ncremental cost of electrcy and ncent the necessary relably attrbutes to mantan a relable grd. All resources that PJM schedules to serve demand should have the opportuny to set prce and earn ther competve returns n the markets. Inaccurate energy market prcng produces prce sgnals that napproprately reduce the energy market revenues earned by relable and economcal resources that are needed to serve load, and as a result, the markets wll not reward useful resource attrbutes and wll not drve effcent resource entry and ex. The rght prce n the energy market should not only reflect the true ncremental costs of resources requred to serve load, but also drve ncentves for provdng the flexbly needed to operate the system, gven the constantly changng nature of s condons. Inaccurate energy market prcng that does not adequately value the relably attrbutes 2 Many of these drvers have been recognzed by the Federal Energy Regulatory Commsson n s naton of a seres of prce formaton natves. MISO Order n FERC Docket No. ER (July 20, 2012): It s also mportant that prces send the correct sgnals to market partcpants about when more supply or demand response s needed. Because the SCED algorhm prevents varous resources from settng the clearng prce, even when those resources represent the last and most costly acton taken by MISO, the SCED algorhm may produce an naccurate prce sgnal. Allowng more resources to set the clearng prce f they are on the margn wll help prevent the market prce from overreactng to transent llusory shortages and from droppng when a block loaded resource s dspatched to address suatons when the system becomes tghter. Thus, the Extended LMP algorhm should enhance market sgnals by allowng prces to better reflect the cost of actons taken to meet system requrements, a result whch we fnd to be just and reasonable. In the near term, MISO s proposal should result n prces that better capture the costs consdered n commtng and dspatchng resources. In the long term, should also send more effectve sgnals about the need for addonal resources n the regon. By producng a clearng prce that better reflects the most expensve acton taken to satsfy demand n the regon, the Extended LMP algorhm should promote more effcent development of supply and demand resources n the future. 3 Some nflexble uns today recover ther costs through uplft payments, and beng elgble to set prce wll not benef these specfc uns. However, allowng these uns to set prces at the margn reduces the prce suppresson effects resultng from ther current nelgbly to set prce and further renforces the ncentves for all uns to offer nto the energy market at ther actual costs. Flexble uns wll benef because energy prces do not currently reflect the resources actually needed to serve load when nflexble uns are on the margn, and flexble uns are therefore seeng lower prces than they otherwse would, and an ncentve to be flexble s ncreased. PJM P age

6 provded by needed resources, regardless of fuel type, s lkely to result n a less-effcent resource mx to mantan a relable grd. Fgure 1 helps explan why the current LMP does not accurately represent the true ncremental cost or send the rght prce sgnals. Gven load at 530 MW, a flexble un at $25/MWh s the margnal un (the most expensve un needed to serve load), and LMP s approprately set at $25/MWh. However, f load drops to 510 MW, and the nflexble uns are nelgble to set prce, then the LMP would drop to zero, and an uplft payment of $10,000 would be requred to make the nflexble uns whole. 4 If the nflexble uns were elgble to set prce, the LMP would be set at $20/MWh by the ncremental cost of the most expensve nflexble un needed to serve load. Fgure 1. Current LMP Does Not Accurately Represent True Incremental Cost The Proposed Soluton PJM proposes to reform LMP to allow all resources selected for dspatch, both flexble and nflexble uns, to set prce and thus provde approprate ncentves to support an ncreasngly effcent commment and dspatch soluton. PJM beleves that expandng the elgbly crera for settng energy market prces to all resources wll produce prces that more accurately reflect the true costs to serve load and wll value flexbly for followng load. These energyprcng enhancements wll also ensure effcent prcng ncentves to mantan requred levels of load-followng capably that s, the ably to adjust output to match changes n load. Gettng prces rght s of growng mportance, antcpatng a contnued ncrease n the penetraton of ntermtent resources. The Antcpated Results Enhancements to energy prce formaton wll mprove market prce sgnals that ncent uns to become more flexble and adjust output when needed to meet dspatch nstructons. LMPs wll more accurately reflect the true ncremental costs to serve load. Whle energy market costs are lkely to go up gven ths change, as wll compensate resources for provdng relably servces that are uncompensated today, market partcpants wll benef from mproved market transparency and effcency n meetng growng flexbly needs. 4 In the example n Fgure 1, the wnd un s dspatchable down. PJM P age

7 Due to the nteracton between the energy and capacy markets, there wll also be a correspondng reducton n capacy market costs, although ths reducton s unlkely to completely offset the ncreased costs n energy market. Recognzng that the evolvng ndustry wh ncreasngly dverse resources could have bgger mpacts beyond the energy market, ths PJM proposal wll also be an essental frst step toward enhanced energy and reserve prce formaton and wll provde long-term benefs, helpng to ensure the rght energy mx s mantaned n the future. Potental Cost Impacts As explaned n Appendx D, PJM has executed smulatons of both the energy and capacy markets to gauge the potental cost mpacts of s proposed prce formaton enhancements. The smulatons resulted n an ncrease n energy market payments that was offset, n part, by reductons n capacy market payments stemmng from the ncrease n net energy market revenues. Overall, the smulatons resulted n a net ncrease n combned energy and capacy market costs of between two and fve percent. Shortage Prcng In PJM, the term shortage prcng s used to refer to the market rules that govern how energy and reserve prces are calculated when there s not enough supply on the system to meet both demand and reserve requrements. Shortage prcng s a crcal component of energy market desgn and presents another mportant market desgn opportuny for PJM to enhance the prce formaton n s energy markets. An effectve shortage prcng model provdes clear, transparent, prcng sgnals to the market to ndcate the current operatng state of the system and ncentvzes market partcpants to act n a way that promotes system relably. Prces that escalate commensurate wh tghtenng condons on the system ncentvze at wll supply such as nterchange, non-capacy generaton resources, and other supply that s not commted to sell energy to PJM, thereby helpng mgate emergency operatng condons. By settng energy and reserve prces to levels that accurately reflect system costs and relably values durng shortage condons, resources that are operatng durng ths perod collect addonal revenues that go drectly towards offsettng gong-forward costs. An effectve shortage prcng mechansm rewards resources that are supplyng energy and other essental grd servces durng emergency condons and, therefore, mnmzes ther relance on the capacy market for revenue suffcency. In order to avod an over-relance on the capacy market for revenue suffcency, s mperatve that an effectve shortage prcng mechansm be n place even wh the exstence of a capacy market. See Part 2: Shortage Prcng for more on PJM s shortage-prcng proposal. PJM P age

8 Part 1: Energy Prce Formaton Background: Markets n Transon For more than 20 years, the PJM wholesale markets have successfully worked to promote competon, produce stable energy prces and attract competve resource nvestments to ensure effcent and relable operatons. However, n recent years, the PJM markets have been undergong a sgnfcant transon. Whle such transons have also occurred elsewhere, each has resulted n a unque fuel mx. Other ndependent system operators (ISOs) have transoned to a fuel mx that contans almost no coal generaton and a preponderance of natural gas-fred combuston turbnes. PJM, on the other hand, has actually become more balanced wh respect to fuel sources, retanng a sgnfcant number of coal resources on the system and seeng those that have retred beng replaced almost exclusvely wh combned-cycle natural gas uns. Shfts n Fuel, Technology, Demand The wholesale markets have seen an unprecedented fuel and technology shft from coal to natural gas resources, drven by the fast growth of low-cost shale gas and the effcency mprovements of combned-cycle gas turbnes. Combned wh the contnued ncrease of renewable energy penetraton from wnd and solar power and decreased electrcy demand growth (caused by both economc condons and the deployment of more energy-effcent applances, lghtng and processes), these developments have resulted n steadly declnng energy market prces. Fgure 2 shows the hstorcally low energy prces PJM experenced n Generally, low prces are desrable and benefcal for consumers provded they contnue to reflect the fundamentals of supply and demand n the market. However, to the extent that prces are suppressed by the analytcal methods of the prce calculaton self, an opportuny exsts to enhance prce formaton by revsng those methods. Fgure 2. Annual Fuel-Adjusted and Load-Weghted LMP ( ) PJM P age

9 Fgure 3 shows that the output of renewable resources measured by the total generaton output has ncreased threefold from 2005 to Wh zero margnal costs, the contnung penetraton of renewable resources effectvely shfts the supply curve to the rght (see Fgure 4). Fgure 3. Renewable Energy Growth n PJM Low Prces, Flattenng Supply Curve, Declnng Net Revenue The Fgure 4 prce shft reflects the competve economcs of combned-cycle gas turbnes asssted by fast-growng, low-cost shale gas, whch, n combnaton wh the ncrease n renewable resources, has led to steadly flattenng supply curves n the energy market. The mpact of ths trend s partcularly strong from 120,000 MW to 150,000 MW of load, the range n whch peak load levels typcally occur n the summer and wnter. As Fgure 4 shows, n 2015 and 2016, the demand crosses the supply curve all the way through ths relatvely flat range, never reachng the pont at whch supply prces begn to ncrease sgnfcantly. Fgure 4. Average Supply Curves (2010, 2011, 2015 and 2016) PJM P age

10 The Capacy Market Is Not a Substute for Energy Market Reforms to Incent Flexbly The capacy market s drven by the resource adequacy requrement to support relably needs when scarcy prcng s unavalable. The capacy market, wh recently mplemented capacy performance (CP) enhancements, strengthens nvestment ncentves to ensure the long-term adequacy of resources necessary to support the relably needs to meet peak demand. The capacy market has supplemented energy prcng as an ncreasngly mportant market construct to attract resource nvestment n order to meet resource adequacy needs effcently. As resource adequacy needs grow, the capacy market not only ensures that new resources are added to the system, but also ncents more effcent new resources to dsplace older, less effcent ncumbent resources. However, beyond the aggregated resource attrbutes such as maxmum economc generaton and forced outage rate, the CP construct s not ntended to reward the flexbly attrbutes that are essental to effcently meet operatonal needs (e.g., short startng tme, short mnmum runnng tme, low mnmum economc generaton, fast rampng rate). Energy market prce formaton has always been and should contnue to be where flexbly s addressed. In the current PJM market construct, whle the energy and capacy markets serve dfferent functons, ther revenues have contrbuted the predomnant share to the recovery of total resource nvestment costs. Due to the changes n the market condons descrbed n prevous paragraphs, PJM has observed dmnshng energy market returns for supply resources. Ths has resulted n a shft to the capacy market for the greater proporton of returns for generatng uns recovery of ther total nvestment costs. As can be seen n Fgure 5, ths trend has been more pronounced snce However, as noted above, the capacy market does not provde the necessary ncentves to ensure suffcent resource flexbly to be able to meet evolvng system needs for dverse resources that provde flexbly attrbutes. Fgure 5. Shft from Energy Market and Ancllary Servces Market to Capacy Market 5 Revenues from the energy and capacy markets were 74.3 percent and 22.9 percent, respectvely, of the total generaton revenue n 2015, and 71.1 percent and 26.6 percent, respectvely, n The total payments for ancllary servces represent 2.8 percent of the total generaton revenue n 2015 and 2.3 percent n PJM P age

11 Questons Rased by Trends A Proposal for Enhancng Energy Prce Formaton The emergng trends of shftng demand and supply condons, ncludng stagnatng energy demand, lower energy prces, flattenng supply curves and the resultng shft to the capacy market for cost recovery, f they persst, could sgnfcantly mpact the effectveness of wholesale energy markets n the future. Ths rases mportant questons concernng energy prce formaton: If the trends above persst, would the current energy and capacy constructs be adequate to attract the effcent mx of resources nvestments to meet growng operatonal needs for flexbly? How can energy and reserve market prces more accurately reflect the scarcy value of electrcy? How can the energy and reserve market prces reflect the value of flexbly and other useful resource attrbutes? How well-algned are energy-market and reserve-market prce formaton when a greater proporton of generatng uns recovery of total costs s shftng to the capacy market? As the supply curve s flattenng and net demand varably s growng, becomes ncreasngly mportant that energy and reserve prces accurately reflect the system ncremental cost, as well as the scarcy value of electrcy, two central aspects of effcent prce formaton. PJM beleves that the reserve markets are a crcal element of market desgn but have not receved the same focus as the energy and capacy markets. Jontly optmzng energy and reserve markets wh scarcy prcng offer a sgnfcant opportuny to enhance the electrcy market prce formaton. Inally, n order to mplement the markets more quckly, reserve markets were gnored and the current energy prcng method was chosen because was smple n both concept and mplementaton. As a result, energy prces could fal to reflect elements relevant to sendng the rght market sgnals under certan crcumstances, and rules for shortage prcng do not accurately reflect the value of energy and reserves durng reserve shortages. To fully address prce formaton ssues, reforms are requred to PJM s shortage prcng approach as well. The Opportuny: Enhance Market Prce Formaton To enhance the long-term sustanable performance of the competve market construct, PJM s evaluatng market desgn opportunes to mprove energy and reserve prcng. Recognzng the value of an ncreasngly dverse resource portfolo wh dstnctve characterstcs, PJM s seekng to ensure that the true cost of servng load s reflected n LMP to the fullest extent possble, uplft s reduced, and ncentves are mantaned. Ths wll ensure that the value of all resources requred to serve demand s accurately and transparently reflected n energy and reserve market prces. Ths proposal follows the prncples of sound market desgn. 6 6 See Appendx A for Letter of Support from Dr. Wllam Hogan. PJM P age

12 PJM beleves that the confluence of the condons descrbed above presents a unque opportuny to enhance energy market prce formaton. 7 PJM s long-term goal s to ensure the rght market prce sgnals, those whch foster effcent resource-nvestment decsons and enable partcpaton of demand reserves, 8 varable energy resources and dstrbuted energy resources. Energy prces should value all of the resources on the system selected to relably serve load wh the greatest possble accuracy and transparency. Enhancng energy market prce formaton represents a benefcal and essental step to strengthen the foundaton of PJM s markets. The 2017 Department of Energy (DOE) Staff Report to the Secretary on Electrcy Markets and Relably 9 provded the followng recommendaton for wholesale markets: 10 FERC should expede s efforts wh states, RTO/ISOs, and other stakeholders to mprove energy prce formaton n centrally-organzed wholesale electrcy markets. After several years of fact fndng and techncal conferences, the record now supports energy prce formaton reform, such as the proposals lad out by PJM 11 and others. Further, negatve offers should be mgated to the broadest extent possble. PJM supports the report fndngs that mproved energy market prce formaton should create prce sgnals that more accurately reflect the true costs of the bulk power supply to meet demand and ensure effcent and relable operatons. 1. In June 2014, the Federal Energy Regulatory Commsson (FERC) nated a prce formaton proceedng to evaluate ssues regardng prce formaton n the energy and ancllary servces markets operated by ndependent system operators (ISOs)/regonal transmsson organzatons (RTOs). In ths proceedng, the FERC establshed that the goals of prce formaton are to: 2. Maxmze market surplus for consumers and supplers 3. Provde correct ncentves for market partcpants to follow commment and dspatch nstructons, make effcent nvestments n facles and equpment, and mantan relably 4. Provde transparency so that market partcpants understand how prces reflect the actual margnal cost of servng load and the operatonal constrants of relably operatng the system 7 Ths entals desgnng new reserve products as needed, streamlnng energy/reserve products n day-ahead and real-tme markets and developng reserve demand functons to enable mproved scarcy prcng. 8 Demand reserves refer to a portfolo of ISO-controlled demand response resources that an ISO could use to meet emergency or loadfollowng needs. Demand reserves could be obtaned through voluntary customer self-selecton from a menu of nterruptble servce optons to be controlled by the ISO n ways that mnmze customer costs of servce nterrupton. 9 U.S. Department of Energy Staff Report to the Secretary on Electrcy Markets and Relably (DOE, August 2017) On Sept. 29, 2017, the DOE ssued a proposal drectng the FERC to requre competve wholesale power markets to ensure that certan relably and reslency attrbutes of electrc generaton resources are fully valued. PJM s proposal, ced by DOE, takes the next step on energy prce formaton to better ensure that market prces transparently value relably attrbutes provdng a superor soluton wh proper prce dscovery of all resources at the true cost n a fuel-neutral manner. 11 Energy Prce Formaton and Valung Flexbly (PJM Interconnecton, June 2017), PJM P age

13 5. Ensure that all supplers have an opportuny to recover ther costs 12 Snce 2014, the FERC has conducted techncal conferences on energy market prce formaton ssues, ncludng the 2016 Fast-Start Prcng Notce of Proposed Rulemakng (NOPR). 13 PJM beleves that the FERC Fast-Start Prcng NOPR promses mportant and benefcal change; however, s scope s focused on fast-start uns. Whle enhancements to the LMP calculaton n these other ISOs/RTOs have focused on fast-start resources, PJM beleves that n the regon PJM serves, the need for enhanced energy prce formaton s related to all resource types. PJM s resource mx s dfferent from other regons. In partcular, natural gas resources n PJM are not lmed to faststart combuston turbnes, but rather are represented by sgnfcant quantes of larger, combned cycle uns. Just over 50 percent of the natural gas fred un megawatts n PJM are combned cycle uns, whle only 35 percent of the natural gas un megawatts are combuston turbnes. The remanders are natural gas-fred steam uns that do not f nto eher category. These resources are competng drectly wh other resource types, and therefore does not serve the regonal needs to lm the prce-settng contrbuton dscussed here to only the fast-start class of uns. Rather, prce formaton n PJM should be neutral to fuel source or resource class so that all uns have the opportuny to compete comparably. Energy Prce Formaton Enhanced energy prcng s an essental, foundatonal step to acheve effcent energy and reserve market prce formaton. Ths step wll ensure that the costs of all resources that are selected to serve the system load are accurately reflected n the energy prcng and wll provde the rght market sgnals that value all useful resource attrbutes. Energy market prcng that adequately values the relably attrbutes provded by needed resources, regardless of fuel type, s necessary to mantan a relable resource mx effcently. The prce sgnals n the energy market need to reflect the costs of resources requred to serve demand and must also drve ncentves for provdng the flexbly needed to operate the system gven the constantly changng nature of s condons. Sendng accurate prce sgnals to support and ncent resource capables needed to operate the system s crcal for relyng on market forces to effcently mantan a relable grd. Other ISOs and RTOs have enhanced ther energy prce formaton mechansms n the relatvely recent past. PJM has not and therefore must evolve n order to ensure that s prce sgnals contnue to meet ther desgn objectves. 12 Prce Formaton n Energy and Ancllary Servces Markets n Regonal Transmsson Organzatons and Independent System Operators (June 2014), Docket No. AD Uplft Cost Allocaton and Transparency n Markets Operated by Regonal Transmsson Organzatons and Independent System Operators (January 19, 2017), FERC Docket No. RM Fast-Start Prcng n Markets Operated by Regonal Transmsson Organzatons and Independent System Operators (FERC, December 2016). PJM P age

14 Margnal Cost Prcng and Convex Condon Energy prce formaton s bult on the foundaton of margnal cost prcng. Margnal cost prcng means that the prce s set equal to the true ncremental cost to produce the last un of output, or equvalently, the potental ncrease n system cost f the last-cleared competve un were unavalable to serve the demand. In prncple, under the assumpton known as the convex condon, effcent prces equal the short-run margnal costs of producton, and margnal cost prcng drves effcent resource nvestments n competve markets. When n the convex condon, the average cost (as well as the ncremental cost) of producton doesn t declne when a generatng un s output ncreases and doesn t rse when a generatng un s output decreases. Under the convex condon, the last-cleared un s always the hghest-rankng un wh the hghest cost n the mer order. Ths property conforms to the prncple of optmaly. The optmal strategy under the convex condon s for each generatng un to bd s true costs and physcal operatng parameters. Ths second property conforms to the prncple of ncentve compatbly. An nflexble generatng un wh a sgnfcant mnmum operatonal lm fals the convex condon because when the output decreases below the mnmum operatonal lm, the cost rses, makng uneconomcal to run the un n that range. 14 Under non-convex condons, uns that are economcally selected to serve load may ncur losses f the prce s set at margnal cost. Fundamentally, n the presence of non-convexy, there may be no market prces that can support competve market solutons whout requrng addonal payments. 15 LMP Prcng Methods The energy market desgn based on LMP n PJM follows the basc prncples of bd-based, secury-constraned, economc dspatch wh locatonal prces, the only known approach that s consstent wh an effcent energy market under the prncples of open-access and non-dscrmnaton. A crucal element of ths model s that the prces and related payments support the effcent dspatch such that market partcpants are ncented to follow the dspatch nstructons and subm bds and offers consstent wh ther actual costs. Under convex condons, the current LMP prcng method supports effcent dspatch. The current prcng method has served the PJM markets well for many years, even though addonal payments have been requred almost daly due to non-convex condons. Most promnent are crcumstances where the problem expands to nclude commment decsons wh start-up costs and assocated constrants such as mnmum output levels and mnmum run-tmes. Under these non-convex condons, locatonal margnal prces alone cannot always be guaranteed to support the effcent outcome whout requrng addonal assocated payments that must be recovered as part of an uplft 14 In electrcy markets, non-convexy arses for other techncal reasons, such as fxed start-up/no-load costs, economes of scale and nflexbles such as mnmum-generaton or block-loadng requrements. 15 The real prce formaton ssue rased by the concern wh nflexbly s non-convexy, as explaned n the body of the paper. Although could be a semantc dffculty, would be more accurate to descrbe the problem as convex vs. non-convex nstead of flexble vs. nflexble, when the latter may cause confuson. The observaton that nelgbly of nflexble uns suppresses prces s vald n some crcumstances, but strctly speakng, s not true n general. For example, ramp constrants can mpose nflexbly, but the constrants are convex and the plants can partcpate n the prcng model wh no specal treatment. Such dstncton could be mportant n a broader polcy forum. PJM P age

15 charge. The shftng resource profles, evolvng external supply condons and reduced nfra-margnal rents descrbed above have brought the lmatons of the current method of LMP calculaton to the forefront whn the PJM regon. In wholesale electrcy markets wh LMP, two dfferent LMP prcng methods have been used to support competve market solutons under the condon of non-convexy: restrcted LMP and extended LMP. Restrcted LMP Method The restrcted LMP method, whch s currently used n PJM, was chosen for the nal mplementaton of the energy markets prmarly because of s smplcy n both concept and mplementaton. The restrcted LMP method gnores the presence of non-convexy n s prce-settng logc and assumes that certan uns, or certan output ranges of uns, are nelgble to set prce when they fal the convex condon. It employs a sngle secury-constraned economc dspatch (SCED) model for both dspatch and prcng purposes. In the SCED model, only flexble uns are elgble to set prce, and the costs for nflexble uns are excluded n the prcng run used to calculate the market clearng prces. As a result, there have always been crcumstances where prces could fal to reflect all elements relevant to sendng the rght market sgnals. When certan nflexble uns that are needed and deemed economcal to be commted and dspatched to serve load, but are nelgble to set prce n the same SCED model (as shown n Fgure 1), the restrcted LMP napproprately lowers energy prces. An uplft payment to the nflexble uns s requred n order to ensure that ther costs are fully recovered. These uplft payments are detrmental to the overall operaton of the market, because market partcpants that must pay these costs are unable to predct or hedge aganst them. In addon, the restrcted LMP method does not assure that the margnal prces are ncreasng when demand ncreases, and a declnng margnal prce curve could create non-transparent arbrage opportunes for vrtual bddng that may potentally ncrease uplft payments n the day-ahead and real-tme markets. Fgure 6 llustrates such a possbly. Assume that the lne ABCD represents the margnal prce curve as the system load ncreases, and that the real-tme load s L1, and equals the day-ahead load forecast. Under these assumptons, the day-ahead and real-tme market would converge n equlbrum to the same prce, P1, whout vrtual bddng. However, the declnng margnal prce curve from B to C gves rse to an arbrage opportuny for vrtual bddng, because vrtual demand, or a DEC bd, could be used to rase the day-ahead load from L1 to L2 and at the same tme, lower the day-ahead prce from P1 to P2. Suppose that the vrtual transacton has no mpacts on the real-tme market outcome; the vrtual bdder wll earn a prof represented by the shaded area. Smlarly, f we assume that the actual real-tme load would be L2, then a tradng strategy usng vrtual supply could be used nstead to gan the same prof. In more realstc suatons wh transmsson constrants, more complcated tradng strateges could be developed usng the up-to-congeston (UTC) devce at farly low rsks. Such vrtual prof would create extra uplft whout benefs In the absence of such arbrage opportuny, vrtual bddng generally enhances prce convergence and benefcal to market effcency. See Hogan, Wllam (2016). Vrtual Bddng and Electrcy Market Desgn. The Electrcy Journal. PJM P age

16 Fgure 6. Arbrage Opportuny wh Vrtual Bddng Uplft payments create, at the margn, a pay-as-bd ncentve for uns to nclude nflexble parameters n ther offers and receve uplft based on those nflexble parameters. 17 As a result, there s an ncentve for the un to offer as nflexbly as possble whle stll gettng commted by PJM n order to maxmze s uplft payments and therefore s profs. Sgnfcant effort has been nvested n mnmzng these uplft costs over tme, ncludng puttng lmatons on the physcal parameters that generatng uns may subm as part of ther offers nto the market. However, effcent dspatch processes can only mnmze the resultng uplft so much. PJM has been requred to create rules to lm physcal parameters over the years due to the ncentves created by the uplft payments. Currently, resource operators have an ncentve to make uns less flexble whle stll beng commted by PJM n order to ncrease the uplft payments they can collect, creatng further prce suppresson effects on the flexble uns. Under the PJM proposal ths ncentve s weakened substantally because, to the extent all uns wll be elgble to set prce and the prce s no longer suppressed, an nflexble un wll gan no fnancal benef from makng uns less flexble to the system whle ncreasng the chance of beng not commted. 17 The 2017 Quarterly State of the Market Report for PJM (January September, Page 206) noted that But when PJM perms a un to nclude nflexble operatng parameters n s offer and pays uplft based on those nflexble parameters, there s an ncentve for the un to reman nflexble. The rules regardng operatng parameters should be mplemented n a way that creates ncentves for flexble operatons rather than nflexble operatons. by Monorng Analytcs, LLC, Independent Market Monor for PJM. PJM P age

17 Extended LMP Method The need for extended LMP arses from non-convex condons where there are no unform prces that reflect the true ncremental cost and support the effcent commment and dspatch soluton. 18 In the extended LMP method, prces that reflect the true ncremental costs are obtaned by relaxng the condons that cause non-convexes, n a procedure known as convex relaxaton. 19 A defnng characterstc of the extended LMP method s that bfurcates the SCED model nto two separate runs: the dspatch run and the prcng run. Whle the dspatch run s the same as n the restrcted LMP method, the prcng run s a convex relaxaton of the SCED dspatch run. In the prcng run, the nflexble generaton uns compete wh the flexble uns and are elgble to set the energy prce when they are needed to meet the demand. Wh approprately desgned uplft payments, extended LMP can support effcent commment and dspatch solutons, snce market partcpants should have no ncentve to devate from the soluton and (to a large extent) have no ncentve to subm offers that dffer from ther real costs. An economcal nflexble un selected to serve load would compete wh a flexble un and be allowed to set prce. When prces reflect the ncremental costs of the margnal uns needed to serve load, all resources wh lower costs benef. Under the restrcted LMP method, an nflexble resource s pad s costs, but a competng, lower-cost flexble resource may be backed down to accommodate that nflexble resource s mnmum generaton. As a result, all flexble resources are pad less for energy and are pad no uplft to cover ther opportuny cost of not generatng because of the nflexble resource s hgh economc mnmum generaton level; the current system penalzes flexble uns whle makng whole nflexble ones. Under the extended LMP method, however, the earnngs of flexble generators would not be suppressed by nflexble uns, n part because of adjustments to the LMP and n part by payments of lost opportuny costs as uplft. As a benef, the extended LMP method effectvely rewards flexbly, reducng relance on the uplft payments wh mproved prce sgnals that ncent resource performance n market operatons. These ncentves wll be necessary n the future, as the PJM system contnues to experence further penetraton of ntermtent resources. The extended LMP prcng method would be compatble wh other reforms that are part of the prce formaton dscusson n PJM. Specfcally, the enhanced prcng model accommodates mproved scarcy prcng, whch should play a promnent role n adaptng to changng market condons wh ncreasng supples of ntermtent or dstrbuted resources. 18 The usual argument for the standard LMP approach avods ths dscusson by assumng that there are no non-convexes that affect the total cost of the dspatch and that the LMP prces are all that s needed to support the dspatch. When ths assumpton s not true, some addonal payment s requred to avod creatng ncentves for market partcpants to devate from the economc dspatch. 19 The theory of extended LMP prcng method s related to what s known as the convex hull relaxaton wh the property of mnmum uplft. However, the mnmum uplft approach s computatonally dffcult to mplement. Of the methods that have been studed, the nteger relaxaton approach provdes a convex relaxaton that results n outcomes very close to the convex hull relaxaton, but ones that avod the hghly challengng operatonal complexes assocated wh convex hull relaxaton. The extended LMP method dscussed here wll nclude nteger relaxaton as the proposed drecton for PJM. PJM P age

18 PJM s Proposed Method: Extended LMP PJM fnds prudent to move forward usng a sound conceptual bass consstent wh fundamental prncples. Further research nto alternatve methods snce the establshment of the energy markets has revealed that the other methods, f computatonally feasble, would yeld results that are more compatble wh the desred ncentves needed to support the effcent commment and dspatch soluton than the restrcted LMP method. PJM s proposng the extended LMP prcng approach to form market prces that more accurately reflect the true costs of all uns and support effcent commment and dspatch solutons. The resultng prces are proposed to be augmented wh soluton support settlements to mprove performance ncentves and drve effcent and relable operatons whle reducng the use of make-whole payments. Leadng energy market economsts have made mportant contrbutons to mprovng on the basc LMP framework to account more fully for the cost of servng load n the energy prce under non-convex condons. Dr. Brendan Rng, later joned by Prof. Wllam Hogan, Dr. Susan Pope and Dr. Paul Grbk, began work on extendng the basc LMP to mnmze uplft payments that create neffcent market ncentves. Ther collectve work, along wh other scholarly contrbutons, lad the foundaton for extended LMP, whch was mplemented n a lmed form by the Mdcontnent Independent System Operator (MISO) n Although the use of locatonal prces s stll n effect, the choce of an extended LMP prcng method has mpacts on the amount of the uplft. PJM beleves that the rght locatonal prces should mnmze the need for uplft payments. The extended LMP method wh convex hull relaxaton represents the deal case that both supports the dspatch and mnmzes the uplft. 21 However, ths approach presents computatonal requrements that would be challengng under the best of crcumstances, and s even more dffcult to apply n the short ntervals requred for the real-tme spot market. The extended LMP method wh nteger relaxaton s a natural approxmaton to the mnmum-uplft method based on convex hull relaxaton. In the dspatch model, the varable representng the commment of the resource has an nteger value of zero or one and the soluton determnes dspatch set ponts for onlne uns. In the prcng model, the nteger varables may be relaxed to a value between zero and one for prce calculatons. After relaxng the complcatng commment constrants present n the dspatch model, the prcng model restores the convex condons to ensure that the margnal prce of the system wll not decrease when demand ncreases See, for example, B. J. Rng, Dspatch Based Prcng n Decentralzed Power Systems, Ph.D. thess, Department of Management, Unversy of Canterbury, Chrstchurch, New Zealand, 1995; W. W. Hogan and B. J. Rng, On Mnmum-Uplft Prcng for Electrcy Markets, March 19, 2003; A. L. Motto and F. D. Galano, Equlbrum of Aucton Markets wh Un Commment: the Need for Augmented Prcng, IEEE Transactons on Power Systems, Vol. 17, No. 3, August 2002, pp ; R. Soshans, R. O Nell, and S. Oren, Economc Consequences of Alternatve Soluton Methods for Centralzed Un Commment n Day-Ahead Electrcy Markets, IEEE Transactons on Power Systems, Vol 23, No. 2, (2008) pp ; and P. R. Grbk, W. W. Hogan, and S. L. Pope, Market-Clearng Electrcy Prces and Energy Uplft, (December 31, 2007, avalable at 21 For the extended LMP method, see Grbk, P. R., W. W. Hogan, and S. L. Pope (2007) Market-Clearng Electrcy Prces and Energy Uplft, John F. Kennedy School of Government, Harvard Unversy. 22 See Appendx B for more on PJM s proposed nteger relaxaton method and examples. PJM P age

19 Physcal generaton uns are nherently lumpy. In other words, they typcally need to be brought onlne at a mnmum output level and are requred to be operated for a mnmum amount of tme before they can be turned off. In the current restrcted LMP calculaton, because of ths lumpness, when a more expensve un s dspatched wh a mnmum output greater than the amount of energy actually needed to serve demand, the extra megawatts from that un can cause prces to fall nstead of ncrease (see Fgure 4), even as the more expensve un s dspatched to serve ncreasng demand. Ths effect prevents prces from reflectng the ncreased system ncremental costs needed to serve the ncreasng demand. The relaxed model PJM proposes offers three notable advantages. Frst, allows PJM to obtan mproved or more accurate LMP usng a prcng model that s relatvely easy to calculate. Second, under certan condons, the prces from the relaxed model would produce the same mnmum-uplft as convex hull relaxaton. In general, the ntegerrelaxaton prces should be close to provdng the mnmum uplft results. Thrd, the enhanced prcng method could be easly extended n practce to accommodate future energy and reserve market desgn and dspatch algorhm enhancements. 23 Sound Prncples of Market Desgn Enhancements to energy prcng should be consstent wh sound prncples of market desgn. Any method that PJM follows needs to meet the followng desgn crera: 1. Effcent commment and dspatch. Gven the true costs and operatng parameters, the market soluton should produce an effcent commment and dspatch. 2. Solutons supported by prces and settlements. Gven the effcent commment and dspatch, the prces and settlements should support the soluton, and gven the prces and payments, the market partcpants should have no ncentve to devate from the dspatch Incentve-compatble condons. To the extent possble, the prce and settlement rules should be ncentve compatble. Bddng the real costs and physcal operatng parameters would earn maxmum prof for the ndvdual market partcpants, and thus they should have no ncentve to subm offers that dffer from ther real costs Mnmzed uplft payments. To the extent possble, the use of uplft payments should be mnmzed. 5. Computatonally feasble. The method must be computatonally feasble. Table 1 provdes a qualatve assessment of alternatve LMP prcng methods based on the above desgn crera. Among the three methods assessed, the extended LMP method wh nteger relaxaton that PJM proposes s close to the deal extended LMP method wh convex hull relaxaton and s computatonally feasble. 23 See Chao, H. (2017) Integer Relaxaton for Electrcy Market Clearng, PJM Interconnecton. 24 The self-scheduled uns are generally not as flexble as the pool-scheduled uns to follow the dspatch nstructons. 25 Today, snce the nflexble uns are not elgble to set prce, they may not update offers as dlgently as the flexble uns to accurately reflect ther real costs and characterstcs. PJM P age

20 Table 1. Qualatve Assessment of Alternatve LMP Prcng Methods Desgn Crera Restrcted LMP Method (Current Method) Extended LMP Method (Integer relaxaton Proposed Method) Extended LMP Method (Convex hull relaxaton) Effcent commment and dspatch Hgh Hgh Hgh Solutons supported by prces and settlements Medum Hgh Hgh Incentve-compatble condons Low Hgh Hgh Mnmzed uplft payments Low Medum Hgh Computatonally feasble Hgh Medum Low Compensatng Flexble Uns for Followng Load The nteger relaxaton approach to the prce-settng algorhm and the resultng ably for some nflexble uns to set energy market prces wll requre soluton support compensaton as uplft to flexble uns that are dspatched to ensure the balance between generaton and load s mantaned. Compensatng flexble resources wll ensure that there s no ncentve to devate from the economc dspatch sgnals such resources receve. In addon to the opton of applyng the extended LMP method to multple perods n a dynamc settng, PJM s evaluatng the need to ncent flexble resources for load-followng servce on the bass of ther opportuny cost of not provdng energy, smlar to other reserve products. 26 PJM beleves that ths credng mechansm could be further developed to be consstent wh a sngle clearng prce product for provdng load-followng servce n ways that would allow resources to compete to provde ths servce, ncludng alternatve resources that would not otherwse follow economc dspatch sgnals, such as demand response and storage. As wh other products n the competve markets, competon to provde ths servce would reduce s cost. As ths would be a new product not currently present n the PJM market, allocaton of s cost would need to be decded. PJM proposes consderng an allocaton of a porton of that cost to nflexble uns, as nflexble uns benef from the flexbly of other resources snce that flexbly allows PJM to dspatch around the nflexble uns. Concluson: Improved Accuracy, Transparency and Effcency PJM beleves that expandng the elgbly crera for settng energy market prces to all resources wll produce prces that more accurately reflect the costs of servng load, mprove performance ncentves, and foster new technologes and emergng desgns wh flexbly attrbutes. Customers wll benef from the mproved market transparency and effcency n meetng growng flexbly needs. Whle the energy cost, net of capacy cred offset, wll lkely ncrease, more accurate prcng wll support effcent nvestment wh dverse resource attrbutes meetng growng operatonal needs for flexbly n the long term. 27 The proposed energy prcng method s not lkely to produce a dramatc change or have as sgnfcant an mpact as 26 See Appendx C for a hstorcal revew of how resource flexbly offered nto the PJM markets has changed over the past three years. 27 See Appendx D for an approxmate estmate of the net mpact of PJM s proposed enhancements of prce formaton. PJM P age

21 mproved shortage prcng. Nonetheless, s a benefcal and essental step toward comprehensve enhancement of energy and reserve prce formaton. PJM recognzes that, as wh any change, there are many ssues to dscuss and constuency concerns to be consdered. PJM wll contnue to seek feedback and nformaton from the Independent Marketng Monor and stakeholders to address these and other ssues. PJM s concerned, however, that whout these changes, the markets wll struggle to contnue ther successful track record of effcently mantanng relably, drvng effcent resource entry and ex, and enhancng the reslence of the bulk power grd. PJM P age

22 Part 2: Shortage Prcng Background: FERC Order 719 In PJM, the term shortage prcng s used to refer to the market rules that govern how energy and reserve prces are calculated when there s not enough supply on the system to meet demand and reserve requrements. PJM s shortage prcng rules were mplemented n 2012 as a result of FERC Order In that order, the FERC requred each ISO/RTO eher to llustrate ther current complance wh the FERC s stated crera for shortage prcng or to amend ther Tarffs and procedures to mplement market rule changes that would be complant wh the FERC s governng prncples. In response to the complance oblgaton set forth n Order 719, PJM fled wh the FERC ndcatng that dd not beleve s current provsons for shortage prcng met the FERC s crera and that planned to engage n dscussons wh s stakeholders to desgn a new shortage prcng mechansm that would be complant. On June 18, 2010, PJM made a complance flng wh the FERC that contaned provsons to mplement a shortage prcng mechansm that conformed to the prncples set forth by the FERC n Order 719. The FERC ssued an order acceptng that flng on Aprl 19, 2012, and PJM mplemented s proposal on October 1, The Importance of Shortage Prcng Shortage prcng s a crcal component of energy market desgn. It provdes a method to escalate energy and reserve prces to levels at or near the values at whch meanngful demand-sde partcpaton can occur eher through the actual curtalment of load or through dstrbuted generaton. An effectve shortage prcng methodology escalates energy prces to ths pont at the most crcal tmes of need, whch s consstent wh the tmes when the ISO/RTO cannot collectvely meet the energy and reserve needs of the system. Absent ths mechansm, s extremely unlkely that the cost of wholesale supply resources would rse to the level requred for demand to partcpate n the market, thus removng any ncentve for demand-sde partcpaton. An effectve shortage prcng model provdes clear, transparent prcng sgnals to the market to ndcate the current operatng state of the system and ncentvzes market partcpants to act n a way that promotes system relably. Prces that escalate commensurate wh tghtenng condons on the system help mgate emergency operatng condons by ncentng at wll supply such as nterchange, non-capacy generaton resources, and other supply that s not commted to sell energy to PJM. Shortage prcng s also crcal to ensurng that competve resources have the opportuny to make suffcent revenues va the markets to cover both ther fxed and varable costs. By settng energy and reserve prces to levels that accurately reflect system condons durng shortage condons, resources that are operatng durng ths perod collect addonal revenues that go drectly towards offsettng gong-forward costs. Ths way, an effectve shortage prcng mechansm rewards resources that are supplyng energy and other essental grd servces durng emergency 28 FERC Order 719, PJM P age