New York Independent System Operator, Inc., Compliance Filing, Docket Nos. ER , RM , AD

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1 10 Krey Boulevard Rensselaer, NY January 22, 2013 By Electronic Delivery Honorable Kimberly D. Bose, Secretary Federal Energy Regulatory Commission 888 First Street, NE Washington, DC Re: New York Independent System Operator, Inc., Compliance Filing, Docket Nos. ER , RM , AD Dear Ms. Bose: The New York Independent System Operator, Inc. ( NYISO ) hereby submits a compliance filing in this docket to fulfill the Commission s directives in Ordering Paragraph C of the Commission s Order on Compliance Filings. 1 The Commission granted the NYISO an extension to January 22, 2013 for submitting this filing. 2 In this filing, the NYISO addresses the following topics, as directed by the Commission s November Order: i) how resource response rates are used in the selection of resources; 3 ii) temporary adjustments to the Regulation Movement Multiplier; 4 and iii) how opportunity costs are reflected in the Bids and/or settlement of Regulation Service providers. 5 In response to the Commission s rejection of the temporary Regulation Movement Bid Cap, the NYISO is also proposing mitigation measures specific to Regulation Movement that will adequately mitigate any exercise of market power by Generators bidding Regulation Movement FERC 61,105 (2012) ( November Order ). 2 New York Independent System Operator, Inc. Docket No. ER Notice of Extension of Time, November 29, See: November Order See: November Order See: November Order 75, 76

2 Honorable Kimberly D. Bose January 22, 2013 Page 2 I. Documents Submitted 1. This filing letter; 2. Affidavit of Dr. Pallas LeeVanSchaick ( Attachment I ). 3. A clean version of the proposed revisions to the NYISO s Market Administration and Control Area Services Tariff ( Services Tariff ) ( Attachment II ). 4. A blacklined version of the proposed revisions to the NYISO s Services Tariff ( Attachment III ); and II. Communications Communications and correspondence regarding this filing should be directed to: Robert E. Fernandez, General Counsel Ray Stalter, Director of Regulatory Affairs *Mollie Lampi, Assistant General Counsel New York Independent System Operator, Inc. 10 Krey Boulevard Rensselaer, N.Y Tel: (518) Fax: (518) rfernandez@nyiso.com rstalter@nyiso.com mlampi@nyiso.com *Persons designated to receive service III. How Resource Response Rates Are Used in the Selection of Resources A. The proposed term Regulation Movement Response Rate is equivalent to the Regulation Movement a resource can deliver in six seconds. With one caveat, the NYISO confirms the Commission s understanding that the term Regulation Movement Response rate ( RMRR ) is equivalent to the Regulation Movement a resource can deliver in six seconds. 6 The caveat is that the RMRR cannot be less than the six- Tariff. 6 Capitalized terms used but not defined in this filing shall have the meanings given to them in the Services

3 Honorable Kimberly D. Bose January 22, 2013 Page 3 second equivalent of the response a unit can deliver in five minutes (i.e. a unit s Regulation Capacity Response Rate). Should a Regulation Service provider submit a RMRR that is less than the six-second equivalent of its Regulation Capacity Response Rate, the NYISO would not accept it. As the tariff definition indicates, a Regulation Service provider s Regulation Movement Response Rate is: The amount of Regulation Movement a Regulation Service provider is capable of delivering in six seconds which shall not be less than, but can be equal to or greater than, the Regulation Capacity Response Rate equivalent. 7 B. The NYISO uses the RMRR in Dispatching Resources A unit s RMRR is not factored into the commitment of Regulation Resources in the Day- Ahead and Real-Time Markets. 8 These commitment decisions are made as part of the NYISO s co-optimized energy and ancillary services using the sum of each bidder s Regulation Capacity price Bid and the product of its Regulation Movement Bid and the Regulation Movement Multiplier. The Regulation Movement Response Rate is a factor, however, in the NYISO s dispatch of scheduled Regulation Service providers. The NYISO s algorithm for dispatching Regulation Service providers (the Automated Generator Control or AGC dispatch) allocates the megawatts needed (either as increased or decreased generation) over the next six second interval ( necessary dispatch ) on a pro rata basis to scheduled resources weighted by their RMRR. Those with larger RMRRs receive a greater allocation of the ACE correction signal. Thus, the necessary AGC dispatch is allocated to all units, based upon their ability to provide the necessary correction. The amount of the necessary dispatch allocated to Regulation Service Suppliers, ranked by their RMRR is limited, however, by several factors. For Limited Energy Storage Resources ( LESRs ) scheduled to provide Regulation Service in an interval, the allocation of an AGC dispatch is limited by the capacity that is physically remaining as available on the unit in the next six seconds. That is, an LESR that has exhausted its available capacity will not be allocated any portion of the necessary AGC dispatch unless the dispatch directionally enables the unit to refill 7 Services Tariff Section For non-lesr resources a unit s Regulation Capacity Response Rate determines the maximum amount of capacity the unit is eligible to offer the NYISO as Regulation Capacity. For LESR resources the supplier s Upper Operating Limit establishes the maximum amount of Regulation Capacity the unit is eligible to offer as Regulation Capacity. The software tests the accuracy of the number of megawatts offered to verify the unit is not offering more capacity than it can make available in five minutes.

4 Honorable Kimberly D. Bose January 22, 2013 Page 4 its capacity. 9 As well, the allocation of the necessary dispatch to all units is limited by system constraints. Units constrained from responding to the AGC signal by system limits (by sitting on the wrong side of a constraint, for instance) will not be allocated any portion of the required AGC dispatch in that interval. In addition, physical constraints of the resources themselves are considered (lower and upper operating limits) as is the five minute dispatch level. C. Use of a Uniform Regulation Movement Multiplier ( RMM ) Will Not Result in Under-Compensating a Unit That Provides More Regulation Movement Than Assumed by the Uniform RMM As the Commission noted, the NYISO uses the RMM to commit resources and does not use the RMM in dispatch or settlements. As a result, all scheduled units will be dispatched and settled (i.e. compensated) in the same fashion whether their RMRR is the same as, slower, or faster than the uniform RMM. 10 Since the determination of a unit s schedule depends on its price bids for Regulation Capacity and Regulation Movement, a uniform RMM treats each unit s price bid for Regulation Movement on the same, level field. By multiplying a unit s Regulation Movement Bid by a uniform RMM, the scheduling software treats a faster responder as no more expensive for Regulation Service than a slower responder if both have bid the same price for their Regulation Movement and Regulation Capacity. In supporting a uniform RMM, Beacon Power LLC explained why a faster resource may reasonably benefit from a uniform RMM: Furthermore, Beacon Power supports NYISO s use of a uniform RMM. NYISO s proposal to apply the RMM equally, or uniformly, to all resources bidding to provide Regulation Service ensures that each resource s bid is compared on an apples to apples basis by comparing the cost-per-unit of Movement. On the other hand, if NYISO were to use a resource-specific RMM, it would always make slower-ramping resources look artificially less expensive than faster-ramping resources because the slower resources are providing a lower total quantity of Movement than faster-ramping resources, even if their cost-per unit is higher. Thus, Beacon Power supports NYISO s proposal to apply a uniform RMM to all resources since it allows Movement offers to be evaluated on a comparable cost per unit of Movement basis and thus, enables the selection of the least cost set of resources The NYISO s AGC dispatch logic avoids completely exhausting such a Regulation Supplier s limited capacity by reducing the allocated AGC dispatch as such allocations move the unit away from its capacity mid-point (when it can provide its scheduled Regulation Capacity in either direction). 10 November Order New York Independent System Operator, Inc. Docket No. ER , Comments and Protest of Beacon Power LLC 9/7/2012

5 Honorable Kimberly D. Bose January 22, 2013 Page 5 IV. Temporary Adjustments to the Regulation Movement Multiplier The NYISO has reexamined its request for authority to temporarily adjust the RMM in the event that operational or reliability problems require an adjustment over a shorter period of time than would be available if all adjustments were to require a subsequent tariff filing. The RMM value is currently set at ten, a number, as the NYISO explained in its August 17 filing in this docket, that represents the 29 month average ratio of megawatts of Regulation Movement to Regulation Capacity provided each hour over this historic period. In an abundance of caution NYISO had requested the ability to instantly adjust the RMM. After further consideration, it does not appear that specific operational or reliability issues would require an instantly adjusted RMM. Thus the NYISO is including with this compliance filing, revised tariff sections that delete the proposed revision process and that set the RMM value to ten, to be constant over all hours, as approved by the Commission. 12 Any change to the RMM value will be pursued through the NYISO s stakeholder process as a tariff revision. V. How Opportunity Costs Are Reflected In The Bids And/Or Settlement Of Regulation Service Providers The Commission has asked the NYISO to explain how it will account for opportunity costs when committing resources and setting clearing prices in its Regulation Service market. Cross-product opportunity costs in the NYISO s Regulation Market are margins on the sale of Energy or Operating Reserves in the Day-Ahead or real-time markets that a Resource would forego if scheduling it to provide additional Regulation Service would lead to it being scheduled to provide less Energy or Operating Reserves. Cross-product opportunity costs are not expected to be bid by Regulation Service providers. Rather, they are included in the market price by the optimization software as a cost of scheduling the marginal Regulation Service provider. The NYISO s co-optimization of Energy and Ancillary Services reflects cross-product opportunity costs in the Day-Ahead and real-time market prices for Regulation Capacity. The co-optimization software solves for the lowest bid production cost of meeting all the Energy and Ancillary Services required over the optimization period. The Day-Ahead commitment software optimizes over a day, the real-time commitment software optimizes over a two and one-half hour time frame and the real-time dispatch software optimizes over approximately the next hour. 13 When the lowest bid production cost for the necessary Energy 12 See proposed revision to Section 2.18 and the November Order at Services Tariff Section : Each Real-Time Dispatch run will co-optimize to solve simultaneously for Load, Operating Reserves, and Regulation Service and to minimize the total cost of production over its bid optimization horizon (which may be fifty, fifty-five, or sixty minutes long depending on where the run falls in the hour.)

6 Honorable Kimberly D. Bose January 22, 2013 Page 6 and Ancillary Services requires the marginal resource to be scheduled for Operating Reserve or Regulation Service instead of Energy, and such a trade-off results in lost opportunity costs for the marginal resource, these cross-product opportunity costs are reflected in the market price for Regulation Capacity and, in some instances, also in the price of Energy and Operating Reserves. Rate Schedule 3 of the Market Services Tariff explains how the cross-product opportunity cost of the marginal Resource selected to provide Regulation Service is included in the Day-Ahead Shadow Price ( ) of the NYISO s Regulation Service constraint for the given hour, and in the Real-Time Shadow Price ( ) of the Regulation Service constraint for the given RTD interval: Each hourly Day-Ahead Shadow Price shall equal the marginal Bid cost of scheduling Resources to provide additional Regulation Service in that hour, including any impact on the Bid Production Cost of procuring Energy or Operating Reserves that would result from procuring an increment of Regulation Service in that hour, as calculated during the fifth SCUC pass described in Section of Attachment B to this ISO Services Tariff. As a result, the Shadow Price shall include the Day-Ahead Regulation Service Bids of the marginal Resource selected to provide Regulation Service, plus any margins on the sale of Energy or Operating Reserves in the Day-Ahead Market that the Resource would forego if scheduling it to provide additional Regulation Service would lead to it being scheduled to provide less Energy or Operating Reserves Each Real-Time Shadow Price in each RTD interval shall equal the marginal Bid cost of scheduling Resources to provide additional Regulation Service in that interval, including any impact on the Bid Production Cost of procuring Energy or Operating Reserves that would result from procuring an increment of Regulation Service in that interval. As a result, the Shadow Price shall include the Real-Time Regulation Service Bids of the marginal Resource selected to provide Regulation Service, plus any margins on the sale of Energy or Operating Reserves in the Real-Time Market that Resource would forego if scheduling it to provide additional Regulation Service would lead to it being scheduled to provide less Energy or Operating Reserves In addition, as explained in Attachment B of the Market Services Tariff, cross-product opportunity costs are also considered when determining the LBMP. As such, LBMPs will include the cross-product opportunity costs of the marginal Regulation Service provider: LBMPs calculated by SCUC and RTD will incorporate the incremental dispatch costs of Resources that would be scheduled to meet an increment of Load and, to the extent that tradeoffs exist between scheduling providers to produce Energy or reduce demand, and scheduling them to provide Regulation Service or Operating Reserves, LBMPs shall 14 Services Tariff Section (Rate Schedule 3) 15 Services Tariff Section (Rate Schedule 3).

7 Honorable Kimberly D. Bose January 22, 2013 Page 7 reflect the effect of meeting an increment of Load, given those tradeoffs, at each location on the Bid Production Cost associated with those services. As such, those LBMPs may incorporate: (i) Availability Bids for Regulation Service or Operating Reserves Inter-temporal opportunity costs are similarly accounted for in the NYISO s multi-period optimization process which, when making its Energy vs. Ancillary Services trade-off decisions, looks ahead either over the day (in the Day-Ahead Market) or over two and one-half hours in the real-time market. As mentioned, the optimization software represents inter-temporal or lost opportunity costs as a component of the marginal cost of dispatching a resource and thus reflects these costs in the Regulation Capacity clearing price and, in some instances in the LBMP. 17 If a Regulation Service Supplier has inter-temporal costs associated with providing Regulation Service for time periods outside of the optimization horizon (for example, a large storage facility which could fully discharge or charge over a 36 hour period), it is expected that the Supplier would include those costs in its Regulation Capacity and/or Regulation Movement Bids. If such a Resource is the marginal unit, these bid-in costs will be reflected in the Regulation Service clearing price and/or in the LBMP. Moreover, bid costs, including these bidin inter-temporal opportunity costs, will be protected across the day in each Resource s Bid Production Cost Guarantee. 18 The NYISO s Market Monitoring and Analysis group reviews a unit s bid costs when developing reference levels in consultation with a Market Participant pursuant to Section or when developing cost-based reference levels pursuant to Section Factors and adjustments that the NYISO reasonably determines to be appropriate, including appropriate inter-temporal costs, are allowed. VI. Proposed Tariff Revisions to Enhance Existing Market Mitigation Measures for Regulation Movement Bids As the attached affidavit from Dr. Pallas LeeVanSchaick makes clear, the NYISO and its Market Monitoring Unit believe that the rejection of NYISO s proposed temporary Regulation Movement Bid Cap requires an enhancement to the Regulation Movement mitigation measures currently in place. 19 Even with the revisions to Section and that 16 Services Tariff Section 17.1 (Attachment B) 17 See Sections and of the Market Services Tariff: RTC will co-optimize to solve simultaneously for all Load, Operating Reserves and Regulation Service and to minimize the total as-bid production costs over its optimization timeframe. 18 Services Tariff Section , ; see also, November Order The NYISO is assuming, however, that the Commission approved the proposed Bid floor of zero for both Regulation Capacity and Regulation Movement Bids, as described in the revisions proposed for Section Pursuant to the Commission s rejection of the temporary Bid Restriction, the NYISO is deleting the proposed revisions to Section which renders moot the Commission s request in Paragraph 78 for an errata change to this Section.

8 Honorable Kimberly D. Bose January 22, 2013 Page 8 were accepted in the Commission s November Order, existing measures will be insufficient to address concerns about the potential for market power in the Regulation Services market with respect to bidding Regulation Movement. Therefore, in addition to deleting the previously proposed revisions to Section , the Section that had authorized a temporary Regulation Movement Bid Cap, the NYISO is proposing a revision to the manner in which reference levels for Regulation Movement are developed. The proposed changes will ameliorate the concerns expressed by Dr. LeeVanSchaick and better ensure that Loads are protected from the exercise of market power in Regulation Movement bidding behavior. The NYISO s uses conduct and impact assessments to evaluate and mitigate market power. Conduct and impact assessments depend on the development of adequate and appropriate reference levels for each market product being sold. As documented in Services Tariff Section , a reference level based on a Generator s accepted Bids during competitive periods is the preferred calculation method, provided the NYISO has adequate data. 20 As Dr. LeeVanSchaick observes, the preference for Bid-based reference levels is based on the theory that a resource is incented to bid competitively i.e. to bid its marginal costs during competitive periods. 21 Therefore, it can be deterred from exercising market power by comparing its actions during any period to those it takes during competitive periods. The Regulation market design crafted by the NYISO in response to Order 755 creates incentives, even during competitive periods, that are different than those created by the market design for other market products like Operating Reserves and Energy. Because the ISO combines a unit s offer for Regulation Capacity and Regulation Movement for purposes of scheduling, but then pays each scheduled Resource for each MW of Regulation Movement that it provides in response to the NYISO s dispatch, Resource owners, even when they do not have market power (i.e. during competitive periods), have little incentive to offer their marginal Regulation Movement costs. As Dr. David Patton explained in his September 7, 2012 Comments in this proceeding: Any time a market selects the least cost resources using one criteria and then pays them based on a different criteria, firms may have incentives that lead to inefficient market outcomes. 22 Dr. LeeVanSchiack also explained why bid-based references are not likely to accurately represent a unit s marginal cost of Regulation Movement: Fast resources (ie. resources that usually move more than 10 MW per MWh of Regulation Capacity) will have strong incentives to raise their Regulation Movement Bid 20 Services Tariff Sections and MMU Affidavit, Motion To Intervene And Comments Of The New York ISO s Market Monitoring Unit, ER , page

9 Honorable Kimberly D. Bose January 22, 2013 Page 9 in order to be the marginal resource and, thereby, cause the distribution to be favorable towards fast resources. 23 He then provides an example which illustrates that the returns from raising offers above marginal cost can be quite large for fast regulation suppliers. 24 Dr LeeVanSchiack also concludes that the benefits of raising offer prices above marginal cost will be particularly large during regulation shortages. 25 Thus, bid-based references may not be a reliable indicator that a Resource is bidding its Regulation Movement competitively. Therefore, in the absence of a temporary Regulation Movement Bid Cap, the NYISO is proposing to modify the manner in which reference levels for Regulation Movement are to be determined. Pursuant to these proposed revisions, the NYISO will use only the calculation methods described in Sections and and will not use a calculation method based on accepted bids as described in Section Accordingly, the NYISO is proposing to amend Section to indicate that it will not establish real-time or Day-Ahead Reference Levels for Regulation Movement using the provisions found in Section In addition, the NYISO is clarifying Section to indicate that reference levels for Ancillary Services Bids, as well as Energy Bids, are intended to reflect a Generator s marginal costs. The NYISO is also clarifying this Section to indicate that other factors or adjustments as the ISO shall reasonably determine to be appropriate can be included in the Reference levels for for Ancillary Services, as well as Energy, set pursuant to Section or The NYISO is also clarifying that the calculation of the Regulation Capacity Market Price (both Day-Ahead and real-time) as demonstrated in the revisions to Services Tariff Sections and already approved in the Commission s November Order is also the price calculation employed during periods of shortage when the Regulation Service Demand Curve is activated. As these Tariff revisions demonstrate, when the Regulation Service Demand Curve is activated, the Shadow Price for the ISO s Regulation Service constraint for that interval either Day-Ahead or in real-time will be the appropriate Demand Curve price. In addition, these approved revisions demonstrate that the final Day-Ahead and real-time Regulation Capacity Market Price during periods of shortage when the Regulation Service Demand Curve is activated will reflect a subtraction of the marginal Resource s Day-Ahead or real-time Regulation Movement Bid, as appropriate. There are no new proposed tariff revisions being submitted in support of this clarification. 23 MMU Affidavit MMU Affidavit MMU Affidavit See also: MMU Affidavit for an explanation of how these consultations will occur and why they are unlikely to result in over-mitigation.

10 Honorable Kimberly D. Bose January 22, 2013 Page 10 VII. Effective Date The NYISO had developed and tested extensive software changes across a wide variety of its market and settlement systems in relation to the original changes proposed in its 755 response. These changes were ready to be activated, consistent with the original filing at the end of October The revisions to the proposal, described above, require additional software changes. While not as extensive as the initial set of software revisions, these changes likewise require a fully integrated set of testing and regression testing, as they are part of an overall larger integrated software solution. This process allows the NYISO to ensure its market and settlement results are of the highest quality while minimizing errors within these processes. Thus, the NYISO proposes that these changes become effective on or about June 14, 2013, to be designated by a two week notice to FERC and the NYISO s Market Participants. A major software installation, of which the changes in the Regulation Service market design are a part, is currently scheduled for June 12. Schedules are subject to change, however, and if the testing protocols expose flaws, the resolution of which takes additional time, or if the electric grid is exposed to system conditions that make any revisions to the scheduling and dispatch system a risk to reliability, the installation will be delayed. Therefore, the NYISO proposes to provide the FERC and its Market Participants with a two week notice of the effective date for this new Regulation Service redesign which actual effective date is expected to fall between June 12 and June 26, Accordingly, the e-tariff system will show the effective date / year for these proposed revisions as 12/31/9998 in recognition that a two-week notice indicating the precise effective date needs to be filed.

11 Honorable Kimberly D. Bose January 22, 2013 Page 11 VIII. Conclusion Wherefore, for the foregoing reasons, the New York Independent System Operator, Inc. respectfully requests that the Commission accept this compliance filing. Respectfully submitted, /s/ Mollie Lampi Mollie Lampi Assistant General Counsel New York Independent System Operator, Inc. 10 Krey Blvd. Rensselaer, New York (518) cc: Travis Allen Michael A. Bardee Gregory Berson Anna Cochrane Jignasa Gadani Morris Margolis Michael McLaughlin Joseph McClelland Daniel Nowak

12 CERTIFICATE OF SERVICE I hereby certify that I have this day served the foregoing document upon each person designated on the official service list compiled by the Secretary in this proceeding in accordance with the requirements of Rule 2010 of the Rules of Practice and Procedure, 18 C.F.R Dated at Rensselaer, NY this 22nd day of January, /s/ Mohsana Akter Mohsana Akter New York Independent System Operator, Inc. 10 Krey Blvd. Rensselaer, NY (518)

13 Attachment I

14 UNITED STATES OF AMERICA BEFORE THE FEDERAL ENERGY REGULATORY COMMISSION New York Independent System Operator, Inc. Docket Nos. ER , RM , AD AFFIDAVIT OF PALLAS LEEVANSCHAICK, PH.D. I. Qualifications 1. My name is Pallas LeeVanSchaick. I am an economist and vice president at Potomac Economics. Our offices are located at 9990 Fairfax Boulevard, Fairfax, Virginia Potomac Economics is a firm specializing in expert economic analysis and monitoring of wholesale electricity markets, and is the Market Monitoring Unit ( MMU ) for the New York Independent System Operator, Inc. ( NYISO ). Potomac Economics serves in a substantially similar role for ISO New England ( ISO-NE ), the Midwest Independent Transmission System Operator, Inc., and the Electric Reliability Council of Texas ( ERCOT ). 2. As the MMU for the NYISO, Potomac Economics is responsible for assessing the competitive performance of the market, for identifying potential market design flaws and abuses of market power, and for commenting on the NYISO s implementation of the mitigation rules. This has included providing advice on numerous issues related to the determination of generator reference levels. I currently serve as the Director of the MMU for the NYISO. 3. I have worked as an energy economist for over ten years, focusing primarily on wholesale power markets. I have provided advice to Regional Transmission Organizations on transmission pricing, market design, congestion management issues, and market power mitigation. I have co-authored a number of studies evaluating the competitiveness of market outcomes in the NYISO, ISO-NE, and ERCOT. I have provided expert testimony

15 Affidavit of Dr. Pallas LeeVanSchaick Page 2 of 11 before the Federal Energy Regulatory Commission ( Commission ) related to the application of market power mitigation rules and the efficient design of operating reserve markets. 4. I have a Ph.D. in Economics and a M.A. in Economics from George Mason University, and a B.A. in Economics and in Physics from the University of Virginia. II. Purpose and Summary of Affidavit 5. The NYISO plans to comply with the requirements of Order 755 by modifying the regulation market to set distinct clearing prices for Regulation Movement and Regulation Capacity. In the filing to which this affidavit is attached, the NYISO proposes to apply the existing market power mitigation measures for ancillary services to the new offer component for Regulation Movement ( Regulation Movement Bid ). However, the NYISO s proposal includes one significant modification in the application of the mitigation measures to the new Regulation Movement Bid. Specifically, the NYISO proposes not to use the bid-based reference level calculation method for the Regulation Movement Bid reference level. 1 Instead, the NYISO proposes to rely on the other established methods for calculating reference levels. 2 The purpose of this affidavit is to provide my assessment of the NYISO s proposal to rely on reference level calculation methods other than the bidbased method. Unless otherwise specified, capitalized terms used in my affidavit have the same meanings specified in the NYISO Market Services Tariff. 6. The remainder of my affidavit is divided into the following sections. Section III discusses the existing framework for market power mitigation in the energy and ancillary services markets and the principles for setting the reference levels that are used in the implementation of the mitigation measures. Section IVanalyzes the incentives for regulation suppliers under the new regulation market design and explains why these 1 2 Although the bid-based reference level and reference level are not capitalized terms, the bid-based reference level calculation method is described in NYISO MST , and various methods for calculating reference levels are described in NYISO MST The other established methods that the NYISO proposes to use for Regulation Movement are described in NYISO MST and

16 Affidavit of Dr. Pallas LeeVanSchaick Page 3 of 11 incentives make the bid-based reference level calculation method unsuitable for the Regulation Movement Bid reference level. Section V discusses the adequacy of other established methods for calculating reference levels and why the NYISO s proposal is not likely to result in mitigating competitive Regulation Movement Bids. Section VI summarizes my conclusions. III. Market Power Mitigation Measures and the Principles for Setting Reference Levels 7. The NYISO s existing mitigation measures are designed to limit the exercise of market power, while avoiding unnecessary market intervention. This section of the affidavit describes how reference levels are used in the existing mitigation measures and what principles are used in the calculation of reference levels. In particular, this section explains why it is important for the reference level to be an accurate estimate of the marginal cost of a resource. 8. The existing mitigation measures are designed considering that in a wholesale power auction with uniform clearing prices at every location, competitive suppliers generally have an incentive to offer at marginal cost. This is because one clearing price is paid to all suppliers whose offers are accepted in the auction. Therefore, a supplier (that does not possess market power) maximizes its profit by offering at marginal cost, since it will be selected whenever the clearing price is higher than its marginal cost and not be selected whenever the clearing price is lower than its marginal cost. 9. On the other hand, a supplier that possesses market power may benefit from withholding supply (i.e., not selling when its marginal cost is less than the clearing price), since the impact of withholding is to raise the clearing price paid for the supplier s remaining sales sufficient to compensate the supplier for any lost profit on the withheld capacity. The mitigation measures are designed to mitigate offers that are inflated above marginal cost when such offers are likely to raise the clearing price by more than certain clearly established thresholds. 3 Mitigation of an inflated offer is done by replacing the offer with an estimate of the supplier s marginal cost, which is known as the reference level. 3 These thresholds are established in NYISO MST 23.3.

17 Affidavit of Dr. Pallas LeeVanSchaick Page 4 of The reference level of a resource is supposed to approximate its marginal cost. The primary method that has been used to set reference levels for energy and ancillary services is the bid-based reference level method, which sets a resource s reference level based on the resource s accepted offers during competitive conditions over the previous 90 days. 4 This is based on the principle that a resource s accepted offers during competitive conditions over a substantial period of time should reasonably approximate the resource s marginal cost. For a resource that does not have a bid-based reference level, either because the resource did not have accepted offers in the previous 90 days or because the offers were not accepted during competitive conditions, the reference level is calculated using one of the following alternative methods. 11. The first alternative is to base the resource s reference level on an estimate the marginal cost using information received from consultation with the supplier. 5 Another alternative is to estimate the marginal cost using information from similar resources. 6 These alternative methods are used routinely to calculate the reference levels of resources that operate infrequently or in areas with limited competition. 12. For the Regulation Movement Bid, the NYISO is proposing not to use the accepted bidbased reference level method, since this method is not expected to yield a reliable estimate of the marginal cost of movement for resources on regulation. This is because regulation resources will not generally have an incentive to submit Regulation Movement Bids at marginal cost, even under competitive conditions. The following section analyzes the incentives of resources offering regulation and explains why they will not generally have an incentive to submit Regulation Movement Bids at marginal cost. IV. Incentives for Resources Offering Regulation 13. The bid-based reference level calculation method is generally reliable when suppliers have had an incentive to offer at marginal cost during the previous 90 days. However, an See NYISO MST See NYISO MST See NYISO MST

18 Affidavit of Dr. Pallas LeeVanSchaick Page 5 of 11 alternative calculation method should be used when a supplier does not have an incentive to offer at marginal cost. This section discusses the incentives for regulation suppliers under the new regulation market design and explains why regulation suppliers do not generally have an incentive to submit Regulation Movement Bids at marginal cost, making the bid-based reference level calculation method unsuitable for the Regulation Movement Bid parameter. 14. The incentives of suppliers in the new regulation market will depend on how resources are selected and how clearing prices are determined. In the new regulation market, the realtime market will select the regulation resources that have the lowest estimated cost of Regulation Service per MWh of Regulation Capacity, which will equal the sum of: (a) the Regulation Capacity Bid, (b) the opportunity cost of providing regulation rather than energy or operating reserves, and (c) the Regulation Movement Bid times the Regulation Movement Multiplier. The Regulation Movement Multiplier, which will initially be equal to 10 MW of Movement per MWh of Regulation Capacity, approximates the average amount that regulation resources have been moved per MWh of Regulation Capacity in recent years. Although regulation resources will be selected in merit order implicitly assuming they will be moved 10 MW for each MWh of Regulation Capacity scheduled, resources will be paid according to the actual amount they are moved. 15. In real-time market intervals in which the regulation requirement is satisfied, the marginal offer (i.e., the offer with the highest estimated cost of Regulation Service per MWh of Regulation Capacity) is used to set the clearing prices for regulation. The Regulation Movement Market Price is set equal to the Regulation Movement Bid of the marginal resource, and the Regulation Capacity Market Price is set equal to the marginal resource s estimated cost of Regulation Service per MWh of Regulation Capacity minus the marginal resource s Regulation Movement Bid times the Regulation Movement Multiplier. 16. In real-time market intervals in which the regulation requirement is not satisfied, the regulation market clears on the regulation demand curve. In such intervals, the NYISO proposes to set the Regulation Movement Market Price equal to the Regulation Movement Bid of the accepted offer with the highest estimated cost of Regulation Service per MWh of Regulation Capacity and to set the Regulation Capacity Market Price equal to the

19 Affidavit of Dr. Pallas LeeVanSchaick Page 6 of 11 regulation demand curve level minus the Regulation Movement Bid times the Regulation Movement Multiplier. 17. The actual movement of resources is expected to vary considerably by type of resource and operating conditions. Consequently, fast resources will generally move more than is assumed when the real-time market selects regulation resources, which will give them incentives to strategically adjust their offers to take advantage. The remainder of this section describes the two ways in which a fast resource can benefit from raising its Regulation Movement Bid above marginal cost. The first part discusses how a fast resource can benefit from its effect on the prices for regulation movement and capacity. The second part discusses how a fast resource can benefit from raising its Bid Production Cost Guarantee ( BPCG ) payment. A. Incentives to Raise Regulation Movement Market Price 18. Since the Regulation Movement Market Price is based on the offer of the marginal resource, the marginal resource can determine how the overall cost of regulation in the real-time market is distributed into the prices of each component. Fast resources (ie. resources that usually move more than 10 MW per MWh of Regulation Capacity) will have strong incentives to raise their Regulation Movement Bid in order to be the marginal resource and, thereby, cause the distribution to be favorable towards fast resources. The following example illustrates how a fast resource would benefit from being marginal. 19. Suppose that the marginal resource has an estimated cost of $10 per MWh of Regulation Capacity based on a Regulation Capacity Bid of $3 per MWh, a Regulation Movement Bid of $0.20 per MW, and a cross-product opportunity cost of $5 per MWh from not providing energy. 7 This would result in a Regulation Movement Market Price of $0.20 per MW and a Regulation Capacity Market Price of $8 per MWh. In this case, a fast resource that moves an average of 30 MW per MWh 8 of scheduled regulation capacity would expect to 7 8 Note, the cross-product opportunity cost is not a bid-able parameter. Rather, it is determined by the real-time market model when the model determines which product the resource is most economic to provide. This is consistent with the average quantity of movement for some resources in recent months.

20 earn $14 per MWh of Regulation Capacity. 9 Affidavit of Dr. Pallas LeeVanSchaick Page 7 of 11 However, if the fast resource submitted a Regulation Capacity Bid of $0 per MWh and a Regulation Movement Bid of $1.01 per MW, the resource s estimated cost of Regulation Service would rise to $10.10 per MWh, and it would become the marginal resource. Although this would increase the estimated cost of the marginal resource by just 1 percent to $10.10 per MWh, it would shift the distribution of the prices dramatically to $0 per MWh for Regulation Capacity and $1.01 per MW for Regulation Movement. Under this scenario, the fast resource would now expect to earn $30.30 per MWh of capacity, 116 percent higher than if it had not been the marginal resource. 10 This example shows that the returns from raising offers above marginal cost can be quite large for fast regulation suppliers. 20. In any auction with uniform clearing prices, a supplier might benefit from raising its offer price in order to be the marginal resource and thereby set the clearing price at a higher level. However, this is risky because the supplier may lose sales if it raises its offer too much and another supplier is selected instead. This sort of competitive discipline acts as a disincentive for suppliers to raise their offers strategically. However, the previous example shows that the returns from offering strategically would be higher for a fast resource in the regulation market than in the energy market. Furthermore, several aspects of the regulation market will tend to strengthen the incentive for certain suppliers to raise their offers above marginal cost. 21. First, the small size of the regulation market (as compared with the energy market) makes it easier for a supplier to predict how it would need to offer in order to be the marginal resource. For instance, in individual hours in the month of December 2012, an average of 3.6 distinct resources were on margin at some point during each hour in the regulation market, while an average of 9.4 distinct resources were on margin at some point during each hour in the energy market. When the marginal resource changes frequently, it is more difficult for a supplier to gauge the optimal level at which to offer in order to affect the 9 10 $14 per MWh = $8 per MWh Regulation Capacity Market Price + $0.20 per MW Regulation Movement Market Price * 30 MW of Movement per MWh of Capacity. $30.30 per MWh = $0 per MWh Regulation Capacity Market Price + $10.10 per MW Regulation Movement Market Price * 30 MW of Movement per MWh of Capacity.

21 Affidavit of Dr. Pallas LeeVanSchaick Page 8 of 11 clearing price. So, the smaller size of the regulation market makes it easier for supplier to benefit from raising their offers above marginal cost. 22. Second, the benefits of raising offer prices above marginal cost will be particularly large during regulation shortages. During regulation shortages, the accepted resource with the highest estimated cost will set the Regulation Movement Market Price, so a fast resource with no energy opportunity cost could submit a Regulation Movement Bid of $8 per MW and a Regulation Capacity Bid of $0 per MWh, and its estimated cost would be equal to the regulation demand curve level of $80 per MWh. The resource would set the prices at $8 per MW for Regulation Movement and $0 per MWh for Regulation Capacity. In this case, a fast resource that moves an average of 30 MW per MWh of capacity would expect to earn $240 per MWh of capacity from this strategy, three times the demand curve level for regulation of $80 per MWh. B. Incentives to Raise BPCG Payments 23. Although the real-time market model selects the resources with the lowest estimated cost, there is no guarantee that the Regulation Capacity Bids or Regulation Movement Bids of the selected resources will be lower than the respective clearing prices. Consequently, resources selected in merit order may still require BPCG payments to recoup their entire bids. Some suppliers will have strong incentives to raise the Regulation Movement Bids of their inframarginal resources above marginal cost in order to garner larger BPCG payments. 24. For example, suppose that the marginal resource s estimated cost is $10 per MWh and that its Regulation Movement Bid is $0.20 per MW, resulting in a Regulation Capacity Market Price of $8 per MWh and a Regulation Movement Market Price of $0.20 per MW. In this case, a fast resource that moves an average of 30 MW per MWh of capacity would expect to earn $14 per MWh. 11 However, if the fast resource submitted a Regulation Capacity Bid of $0 per MWh and a Regulation Movement Bid of $0.80 per MW, its estimated cost per MWh of Regulation Capacity would still be 20 percent lower than the marginal 11 $14 per MWh = $8 per MWh Regulation Capacity Market Price + $0.20 per MW Regulation Movement Market Price * 30 MW of Movement per MWh of Capacity.

22 Affidavit of Dr. Pallas LeeVanSchaick Page 9 of 11 resource, comfortably within the range necessary to be selected as a regulation resource. 12 This would enable the fast resource to receive a BPCG payment of $10 per MWh of capacity in addition to the market revenue of $14 per MWh. 13 As a matter of fact, any regulation movement offer between $0.47 and $0.99 per MW would enable the fast resource to increase its BPCG payment while still being inframarginal Although suppliers that raise their offer prices above marginal cost are at risk of not being selected when economic to provide regulation, the large size of the range in this example illustrates that many suppliers will benefit from raising their offers above marginal cost with little risk of not being selected. Furthermore, the incentive for suppliers to raise their offers above marginal cost will be present even under very competitive market conditions when there is a large number of suppliers and the supply of regulation is well in excess of the regulation requirement. C. Conclusions Regarding Incentives for Regulation Suppliers 26. The factors discussed in this section will provide some resources with strong incentives to raise their offer prices above marginal cost, even under competitive market conditions where the supply of regulation far exceeds demand. Although the discussion in this section focuses on the particular incentives of very fast resources, the incentives of other resources will also be affected to a lesser degree. Consequently, the accepted bids during competitive periods are not likely to provide a reliable indication of the marginal cost of Regulation The real-time market would estimate the cost of the fast resource as $8 per MWh of Regulation Service = $0 per MWh Regulation Capacity Bid + $0.80 per MW Regulation Movement Bid * Regulation Movement Multiplier of 10 MW per MWh of Capacity. This would be 20 percent lower than the estimated cost of the marginal resource. BPCG payment = {as-offered cost of regulation service} minus {revenue from regulation service} = {$0 per MWh Regulation Capacity Bid + $0.80 per MW Regulation Movement Bid * 30 MW of Movement per MWh of Capacity} minus {$8 per MWh Regulation Capacity Market Price + $0.20 per MW Regulation Movement Market Price * 30 MW of Movement per MWh of Capacity} = {$24 per MWh as-offered cost} minus {$14 per MWh of revenue} = $10 per MWh If the Regulation Movement Bid was $0.47 per MW, the as-offered cost of regulation would be $14.10 per MWh = $0 per MWh Regulation Capacity Bid + $0.47 per MW Regulation Movement Bid * 30 MW of Movement per MWh of Capacity, slightly in excess of the regulation revenue. Each increase of $0.01 per MW in the Regulation Movement Bid would result in a $0.30 per MWh increase in the BPCG payment.

23 Affidavit of Dr. Pallas LeeVanSchaick Page 10 of 11 Movement. Therefore, I support the NYISO s proposal not to calculate reference levels using the accepted bid-based method and, instead, rely on alternative calculation methods. The next section discusses why the alternative methods should provide an adequate basis for implementing the mitigation measures. V. Consultation with Suppliers Regarding Reference Levels 27. The NYISO proposes to calculate reference levels for Regulation Movement using two alternatives to the bid-based method. The first alternative is to base the resource s reference level on an estimate the marginal cost using information received from consultation with the supplier, while the second alternative supplements with information from similar resources. Whenever the NYISO calculates reference levels using one of these alternative methods, there is a possibility for a resource s costs to be under-estimated, so it is important to consider whether this is likely to result in over-mitigation (i.e., mitigation of a competitive offer). However, given the protections for suppliers that are currently built into the mitigation process for Ancillary Services, it is unlikely that the NYISO s proposal will lead to over-mitigation for several reasons. 28. First, the reference level consultation process allows suppliers to request a reference level adjustment to incorporate any type of legitimate cost. So, to the extent that a cost can be foreseen with substantial lead time, a supplier can request that the NYISO reflect the expected cost in its reference level Second, the mitigation measures for Ancillary Services use clearly-defined thresholds for identifying conduct that may warrant mitigation and for assessing the market impact of the conduct. The conduct threshold for Regulation Movement Bids identifies ones that exceed the reference level by at least 300 percent as potentially warranting mitigation. 16 To the extent that a resource s marginal costs fluctuate according to real-time operating conditions, this conduct threshold will provide ample room for most such variations NYISO MST allows the NYISO to calculate a reference level based on consultation with a supplier. The obligations of the NYISO and suppliers in the consultation process are provided in NYISO MST See NYISO MST