Design Alternatives Sheet (DAS) 18 Physical Bilateral Procurement

Design Alternatives Sheet (DAS) 18 Physical Bilateral Procurement Introduction The subject matter discussed within this document forms part of the process for developing a Capacity Market design for Alberta. The document is intended to prompt discussion and advice on the proposed Physical Bilateral Procurement process. Working definition of Physical Bilateral procurement: Physical Bilateral Procurement is a contractual arrangement between a load market participant and a specific ( named ) capacity resource for physical delivery of all or a portion of the load s capacity needs that must be registered and approved by the ISO. Self-supply is a further specification, limitation, of physical bilateral procurement that restricts the counterparties of the physical bilateral procurement to ones self. The definition of self can take a number of different forms and these options will be discussed as part of the self-supply KDE and design alternative sheet. Physical Bilateral Procurement takes place outside of the centralized capacity market where buyers and sellers find each other (i.e. self-matching) and report their matched commitments to the centralized market (AESO) prior to the capacity auction. Contract prices are not reported to the AESO and remain private information between the buyer and seller. Physical Bilateral Procurement can take one of three forms unlimited physical bilateral, retail exclusion, or self-supply each of which will be reviewed in detail as part 2 of this document. The Physical Bilateral Procurement allows eligible load market participants to take on the capacity obligation themselves rather than having the AESO procure the capacity on loads behalf. The AESO will develop a cost allocation methodology to determine each loads portion of the capacity cost. This allocation methodology will be designed as part of KDE 21. Physical Bilateral Procurement is one mechanism for consumers to hedge their costs. The alternative hedging mechanism is a financial hedge, best illustrated in a contract for differences (CfD) around the capacity market price. In a financial hedge, capacity market participants are still active players in the capacity market and choose financial arrangements with counter-parties to manage costs and payments. Financial hedging requires an index price to build the hedge around, and is done outside the purview of the centralized capacity market. This form of hedge does not require a named capacity resource to backstop the contract. We will discuss financial hedging in more detail when discussing centralized market tools for managing financial hedges, specifically Capacity Market Net Settlement Instructions. The AESO will be responsible for determining the total capacity procurement volume net of the physical bilateral volumes and ensuring that the required volume is procured. The AESO will likely run a centralized auction for volumes not procured through the Physical Bilateral Procurement 1. DAS 3 Reliability Requirements will specify how the Physical Bilateral Procurement will be accounted for (netting off) by the AESO in determining the reliability requirement. 1 We assume the recommendation from DAS 0 - Capacity Procurement Obligation of a centralized market with an option to procure capacity in a physical bilateral manner to be adopted. We have termed this not organised procurement as Physical Bilateral Procurement. Enter Footer Page 1 AESO Internal

Options to the following questions will be assessed: 1. Should the market limit hedging to financial hedges only? If the answer to 1 is no: 2. Should the market allow any form of physical bilateral procurement or apply restrictions to physical bilateral procurement of capacity to qualified BTF self-suppliers only? Design Alternatives Assessment - Part 1 1. Should the capacity market limit hedging to financial hedges only? Using the definition above for physical bilateral procurement. Financial hedges require no named physical capacity resource in order to set up the hedge between buyer and seller. Table 1: Possible definitions for Question 1 Description Advantages Disadvantage s Option 1: Yes, financial only No form of Physical bilateral contracting is permitted. This is similar in design to the existing Energy Market design where all energy must be traded through the power pool. A similar statement would be made that all capacity must be traded through the capacity market. Improved Capacity Market liquidity. Equal treatment for capacity resources and capacity market consumers. Does not required load shed capability in the event the named resource fails to provide capacity during a performance period. No infrastructure changes required to enable the hedge. Does not require individual loads to be allocated a capacity market volume obligation Capacity Resources continued to bear the delivery risk Large numbers of small Loads with a variety of contractual terms and physical bilateral arrangements can make it challenging and time consuming for the system Option 2: No, some form of Physical Bilateral can exist All capacity must be traded through the capacity market except for ISO approved physical bilateral arrangements. Allows load to manage their capacity market volume obligation in multiple ways Load bears the delivery risk for capacity and can choose to shut-off/reduce consumption during performance periods, or pay the performance penalty Allows for situations where the DTS contract is less than the gross load of the site. A physical bilateral contract is not considered a financial derivative which are prohibited in some organizations Negatively impacts size of the centralized market by potentially reducing liquidity, thereby making the market less competitive. Infrastructure costs on those loads to facilitate controlled load shed. In the event Enter Footer Page 2 AESO Internal

Jurisdictional Overview Evaluation Criteria Option 1: Yes, financial only operator to determine whether an individual load has in fact satisfied its capacity obligation. Ireland does not facilitate any form of physical bilateral contract. GB does not facilitate any form of physical bilateral contract. They do not have legacy LSEs and have designated the system operator as the primary procurer of capacity and placed financial obligations on consumers through capacity cost allocation methods. Criteria for Capacity Market The capacity market should be fair, efficient, and openly competitive Option 2: No, some form of Physical Bilateral can exist of true supply shortfall load under physical bilateral contracts must be shed before firm load if the named capacity resource is not available. EMS software changes would also be required to map the load to the named resource. Puts an administrative burden on loads to manage their capacity obligation (e.g. reporting to the AESO, certification, agreements, monitoring, etc.). One approach to implement this option would be to set up LSEs in Alberta which would change or eliminate retail competition and customer choice. The smart grid technology to allow for curtailment by retailer does not exist in Alberta today and would require a large infrastructure investment. All other markets provide some form of physical bilateral contracting, most in the form of self-supply. Self-supply is typically LSEs meeting their capacity obligation with the LSE s own generation. In PJM, only 1 capacity market participant is currently using the self-supply option. 2 In theory, a fair, efficient and openly competitive capacity market can be achieved under either option. Allowing physical bilateral contracts removes the contracted capacity supplier from the capacity market which in turn may affect the overall the competitiveness of the market and market liquidity. Capacity market mechanisms, outcomes and relevant data should be transparent The volumes of Physical Bilateral Procurement arrangements must be fully disclosed prior to any capacity auction (i.e. auction parameters must be updated) to allow for market transparency and for participants to form their bidding strategies. Criteria for Costs and Risk The design should allow consumers to manage the cost of capacity if and where appropriate 2 Based on an informal interview with PJM settlement staff. Enter Footer Page 3 AESO Internal

Option 1: Yes, financial only Option 2: No, some form of Physical Bilateral can exist Financial hedges for all consumers can be achieved through CfDs with capacity suppliers under both options. Option 2 gives participating loads an additional tool for hedging capacity costs. Loads choosing to enter in to physical bilateral agreements will be assigned an obligation to procure their share of required capacity along with the right to negotiate capacity agreements bilaterally, which provides the most flexibility for those loads to manage cost. If Option 2 is chosen then cost allocation (DAS 21) will need to consider this. Criteria for Flexibility Unique aspects of Alberta s electricity system should be considered in the design of the capacity market (high amounts of cogeneration) The combination of a lack of true LSEs, a large share of large industrial load with behind-the-fence generation, and competitive retail are examples of the unique aspects of the Alberta electricity market that should be considered in determining which option to consider. Option 2 provides the most flexibility for Loads but moves more of the reliability risk to load as well. The capacity market should be compatible with other components of the electricity framework Choosing option 2 may require changes to the legislation and may require an assessment with respect to whether physical bilateral procurements are compatible with the existing AUC rules regarding the System Settlement Code for competitive retail. The legislation is currently silent on capacity. Procuring bilaterally in the capacity market does not mean the capacity obligation in the form of energy is exempt from the EUA statement that all electric energy must be exchanged through the power pool. Curtailing load by retailer is currently not possible without the implementation of smart grid technology. Criteria for Timely Development Common practices and lessons learned from other capacity market implementations should be leveraged as much as practicable and applicable. Jurisdictional review is provided in the table above. Simple and straightforward initial implementation should be a priority. Limiting hedging to financial hedges is the simplest model to implement as it requires no work for the ISO. Enter Footer Page 4 AESO Internal

2. Should the market allow any form of physical bilateral procurement or apply restrictions to physical bilateral procurement of capacity to qualified BTF self-suppliers only? There are 3 options, unlimited, excluding retail, or self-supply only. Under all three options described below, Load will satisfy its capacity obligation by using resources it owns or arranges for bilaterally and will not be subject to capacity market charges for load satisfied through Physical Bilateral Procurement. The load in a physical bilateral arrangement will be subject to any performance assessment penalties and incentives of the named capacity resource. The capacity resource used in Physical Bilateral Procurement arrangement will not receive a capacity payment for the contracted volume. Table 1: Possible Options for Question 2 Option 1: Unrestricted Physical Bilateral Description In addition to financial hedging around the capacity market price eligible market participants can choose to cover their forward share of capacity obligation by contracting with any named eligible capacity resource. Loads choosing to procure through a bilateral contract will be netted off the resource adequacy requirement and the named capacity supply resource will not be eligible to participate in the centralized capacity market for the volume and duration of the bilateral arrangement. The capacity obligation lies with the load and as such the load will be subject to a performance penalties/incentives 3. Physical Bilateral Procurement can include all industrial loads that are connected directly to the transmission system (Direct Connect Customers), but it excludes distribution connected retail and commercial load bilaterals because of a lack of technical infrastructure (i.e. smart grid technology) to support self-procurement while maintaining the current retail customer choice model or the formation of Load Serving Entities (LSEs) in Alberta. Self-supply is a form of restricted physical bilateral arrangement, available to participants who have their own eligible capacity resource that can be used to satisfy (fully or partially) their load capacity requirement (load obligation). Self-supply could also be defined as restricting physical bilateral procurement to loads with behind-the-fence (BTF) generation only. DAS13 Self- Supply addresses the various forms of self-supply and will be reviewed if this option is the recommended approach. Advantages Allows loads to manage their own capacity obligation and accept the risks associated not meeting their obligation. Does not require modifying customer choice, implementing LSEs, or smart-grid technology to allow retailers to manage the capacity obligation risk.. Aligns specifically to the needs of co-generation. 3 Exact design of the Performance Assessment program will be discussed in Eligibility design stream. Enter Footer Page 5 AESO Internal

Option 1: Unrestricted Physical Bilateral Does not give retail load ability to physically contract for capacity and the only mechanism left for hedging is Contracts for Difference, or CfDs, (Capacity NSI) around the capacity market price. Like Option 1 this option puts an administrative burden on loads to manage their capacity obligation (e.g. reporting to the AESO, certification, agreements, monitoring, etc.). Disadvantages Impacts size of the centralized market, potentially reducing liquidity, and potentially making the market less competitive. May require changes to the EUA and related regulations. High implementation cost may require province wide smart grid infrastructure to allow retailer participation or set up LSEs in Alberta which would significantly change the way retail competition and customer choice works. Difficult to assess the capacity obligation of retail load under open access. Assigning obligations to some Loads, in particular, retailers will be difficult to implement because the AESO and a retailer will have challenges in accurately forecasting the required capacity due to customer choice and retail switching. Large numbers of small Loads with a variety of contractual terms and physical bilateral arrangements can make it challenging and time consuming for the system operator to determine whether an individual load has in fact satisfied its capacity obligation. The most restrictive option. Jurisdictional Overview There is no example of a jurisdiction with unrestricted bilaterals and a centralized market. CaISO is the closest model to this; however all load is given an obligation to procure rather than choose the option. Through MISO s centralized Planning Resource Auctions (PRAs) each LSE has flexibility to meet this requirement under a combination of bilateral contracting and residual capacity market procurements, unless that LSE is within a state that None of the jurisdictions studied follow this model. Jurisdictions such as GB do not allow self-supply. They do not have legacy LSEs and have designated the system operator as the primary procurer of capacity and placed financial obligations on consumers through appropriately designed capacity cost allocation methods. Generally, regions which have competitive retail have the models where ISOs determine and procure In PJM, the system operator operates a central auction, but each individual LSE may elect instead to use Physical Bilateral Procurement for its entire capacity obligation. PJM is responsible for determining the capacity obligation for load intended to meet the forecast peak load and satisfy the reliability criterion. An LSE may elect the Fixed Resource Requirement ( FRR ) alternative. The FRR alternative allows for Enter Footer Page 6 AESO Internal

Option 1: Unrestricted Physical Bilateral offers retail customer choice. required capacity as the sole buyer. The exception to this rule would be NYISO, however the NYISO model utilize a month-ahead capacity auction model, which significantly mitigates the issue of forecasting error due to customer switching. In MISO, LSEs in retail choice states are not permitted to self-supply. an LSE to submit and, if approved, execute a plan to meet its capacity requirements outside of the RPM market. FRR does not exempt LSEs from their reliability obligation 4, but provides an option for the LSEs to procure capacity resources outside of the RPM. In the ISO-NE obligation model, it is the system operator that procures and settles for capacity. There is no physical obligation placed on LSEs in this market. Loads pay to the system operator their allocated shares of the capacity cost in accordance with the rules or tariff established for this purpose. Evaluation Criteria Criteria for Capacity Market The capacity market should be fair, efficient, and openly competitive In theory, a fair, efficient and openly competitive capacity market can be achieved under each of the three proposed definitions for the Physical Bilateral Procurement definition, although centralized markets are more efficient and openly competitive than bilateral markets. While it may appear unfair to exclude retail from Physical Bilateral Procurement, without the Alberta equivalent of LSEs having relatively stable load to serve (e.g. competitive retail implies no guaranteed stable customer base) implementation of Option 1 may be impractical in Alberta. Assigning the procurement obligation to only loads with BTF generators (Option 3) will allow assigning obligation only to sites that can truly manage their electricity reliability and is a more efficient process. However, Option 3 removes the contracted capacity supplier from the capacity market which in turn may affect the overall the competitiveness of the market and market liquidity. Capacity market mechanisms, outcomes and relevant data should be transparent None of the three options above will be fully transparent to the market as the financial data of bilateral deals are not disclosed. However, the volumes of Physical Bilateral Procurement arrangements must be fully disclosed prior to any capacity auction (i.e. auction parameters must be updated) to allow for market transparency and for participants to form their bidding strategies. 4 PJM s Manual 18, Section 11.1, p. 207, https://www.pjm.com/~/media/documents/manuals/m18.ashx Enter Footer Page 7 AESO Internal

Option 1: Unrestricted Physical Bilateral Criteria for Costs and Risk The design should allow consumers to manage the cost of capacity if and where appropriate Financial hedges for all consumers can be achieved through the negotiation of CfDs (i.e. Capacity NSI) with capacity suppliers. In the Term-sheet 8 Capacity NSI, the mechanism for registering financial hedging arrangements for the purposes of netting the CfDs will be discussed. All options allow both physical and financial hedges. Under Option 1 participating loads will be assigned an obligation to procure their share of required capacity with the right to negotiate capacity agreements bilaterally, which provides the most flexibility for those loads to manage cost. The difficulty arises for variable loads that cannot accurately predict future load and may either over or under procure their volumes. Retail, for example, is subject to customer switching due to competitive pressures that may make it difficult to predict their loads out to the forward period of the capacity market. Rebalancing auctions may give retailers enough ability to adjust their volumes closer to the delivery year; however, the risk of incurring a performance penalty may outweigh the benefit of capacity cost avoidance. The AESO can forecast retail settlement zone loads and reconcile these against the Physical Bilateral Procurement submissions. The issue arises when the sum of the parts does not equal the whole. Under Option 3 the AESO is responsible for procuring a larger share of capacity than under Options 1 and 2 (because fewer participants are able to procure capacity for their share). Accordingly, a larger cost associated with the procurement volume forecast error will be passed on to all capacity consumers except those that choose to self-supply. If Option 1 is chosen then cost allocation (DAS 21) will need to consider this. Criteria for Flexibility Unique aspects of Alberta s electricity system should be considered in the design of the capacity market (high amounts of cogeneration) The combination of a lack of true LSEs, a large share of large industrial load with behind-the-fence generation, and competitive retail are examples of the unique aspects of the Alberta electricity market that should be considered in determining which of the three options is selected. Option 1 provides the most flexibility for Loads but moves more of the reliability risk to load. Limiting the flexibility to those that need it most ensures a more liquid capacity market and a more competitive capacity price. The capacity market should be compatible with other components of the electricity framework Choosing any of the options may require changes to the legislation and may require an assessment with respect to whether such options are compatible with the existing AUC rules and the System Settlement Code for competitive retail. The legislation is currently silent on capacity. Procuring bilaterally in the capacity market does not mean the capacity obligation in the form of energy is exempt from the EUA statement that all electric energy must be exchanged through the power pool. Energy will continue to be paid at the energy pool price. If the procurement obligation cannot be met by the Physical Bilateral Procurement source, the energy market will look to meet that obligation through other available providers and depending on the performance model (DAS 14) those providers may be eligible for a capacity payment. Conversely if the Physical Bilateral Procurement provider can meet its load obligation and has excess energy it may be eligible for an incentive payment. In the event that the bilaterally procuring load cannot meet its obligation and all possible capacity resources have been dispatched the load under Physical Bilateral Procurement would have to be curtailed before other loads. Curtailing load by retailer is currently not possible without the implementation of smart grid technology. If the AESO pursue the path of curtailing load, considerations for the costs of being able to do this Enter Footer Page 8 AESO Internal

Option 1: Unrestricted Physical Bilateral must be considered. Criteria for Timely Development Common practices and lessons learned from other capacity market implementations should be leveraged as much as practicable and applicable. Jurisdictional review is provided in the table above. Simple and straightforward initial implementation should be a priority. Each option presents its own set of complexities. Limiting Physical Bilateral Procurement to only those loads with BTF generation (Option 3) is the simplest to implement as it excludes retail load and the administrative complexity associated with managing unrestricted bilateral contracts. References 1. http://www.brattle.com/system/publications/pdfs/000/005/221/original/enhancing_the_efficiency_of_resource_adequacy_planning_and_procurements_in_the_miso_footprint_newell _Spees_1115.pdf?1448034421, p.10 2. https://www.iso-ne.com/markets-operations/markets/forward-capacity-market/fcm-participation-guide/qualification-process-for-new-generators 3. Designating Resources as Self-Supplied for the Forward Capacity Market https://www.iso-ne.com/static-assets/documents/support/training/courses/fcm/self_supply_downloadable.pdf 4. PJM s Manual 18, https://www.pjm.com/~/media/documents/manuals/m18.ashx Enter Footer Page 9 AESO Internal