Discussion with the RCM Working Group 27 March 2012 RCM discussion - - PDF document

Discussion with the RCM Working Group

27 March 2012

RCM discussion with the RCM Working Group

• WHAT CAUSES EXCESS RESERVE CAPACITY
• THE RCM AS AN ADMINISTRATIVE MECHANISM

EVALUATING CHANGES TO THE RCM AGAINST THE MARKET OBJECTIVES

• EVALUATING CHANGES TO THE RCM AGAINST THE MARKET OBJECTIVES
• THE EXCESS RESERVE CAPACITY PROBLEM
• THE RECENT DOWNWARD REVISION TO THE MRCP
• THE LINKAGE BETWEEN THE MRCP AND AN EFFECTIVE RCM

The Lantau Group 1

Options for discussion

• ADJUST THE SENSITIVITY OF THE RCP TO EXCESS RESERVE CAPACITY
• INSTITUTE A QUANTITY-BASED CONTROL MECHANISM

ENHANCE BILATERAL MARKET SUPPORT

• ENHANCE BILATERAL MARKET SUPPORT

The Lantau Group 2

Stepping Back

• What is the purpose of the RCM?

– Incentivise timely addition of capacity – Signal when no further investment is needed – Be compatible with the Market Objectives in the broader context of the WEM

• What is the value of reserve capacity?

– Administrative value vs economic value – What happens if these two values are not the same?

• Who provides capacity?

– What “is” capacity?

The Lantau Group

• Putting the RCM in context

– Short-term signals versus longer term value management – The RCM as part of the overall WEM context

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Why do we have excess reserve capacity?

• On the supply side, investors continuously adjust their

investment plans based on their expectations of future

• conditions. The amount of excess reserve capacity in the WEM

is also the product of legacy conditions (such as the pre-global

Expectations Legacy programmes

is also the product of legacy conditions (such as the pre global financial crisis economic boom), as well as historical programmes (no longer in force), such as the Displacement Mechanism in the original Vesting Contract and the earlier Schedule 7 requirements that required Western Power Corporation to tender for new capacity; and

• On the demand side, current and projected demand will

generally not be the same as the level that was previously expected or projected. Market conditions change all the time. The global financial crisis and subsequent global economic

RCM Changing market conditions Global Financial Crisis

The Lantau Group

The global financial crisis and subsequent global economic slowdown exemplify disruptive forces that caused demand to be much lower than previously forecast.

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The reasons for excess reserve capacity are complex

Shift towards more energy efficiency and distributed generation

The WEM: small, lumpy market – easy to forecast, difficult to get right….

The Lantau Group 5

The economic value of incremental reserve capacity in the WEM

6000

Example from 2009/10 Capacity Year (from appendix to TLG RCMWG paper)

2000 3000 4000 5000 MW Capacity Credits Actual Load Load Scaled to 10 Percent POE Forecast

Note:

• - Large excess
• - Steep LDC

The Lantau Group 6

1000 1000 2000 3000 4000 5000 6000 7000 8000 Cumulative Hours

LOLP: Based on 2009/2010 Actual Loads

0 0014% 0.0002% 0.0004% 0.0006% 0.0008% 0.0010% 0.0012% 0.0014%

LOLP (percent)

LoLP w/ DSM LoLP w/o DSM

Note:

• - Few relevant hours
• - Low LOLP

The Lantau Group 7

0.0000% 4 8 12 16 20 24 28 32 36 40 44 48

Hours Ranked by Load

Capacity Value based on Actual 2009/2010 Loads

0 18 0 02 0.04 0.06 0.08 0.10 0.12 0.14 0.16 0.18

Capacity Value ($/MW)

Capacity Value w/ DSM Capacity Value w/o DSM

Note:

• - Low value
• - Few hours

The Lantau Group 8

0.00 0.02 10 20 30 40 50 60

Hours Ranked by Load

LOLP: Based on the 10 Percent POE forecast for the 2009/10 capacity year

1 4% 0.2% 0.4% 0.6% 0.8% 1.0% 1.2% 1.4%

LOLP (percent)

LoLP w/ DSM LoLP w/o DSM

Note:

• - Same story

The Lantau Group 9

0.0% 4 8 12 16 20 24 28 32 36 40 44 48

Hours Ranked by Load

Capacity Value: 10 percent POE forecast for the 2009/10 capacity year

160 20 40 60 80 100 120 140 160

Capacity Value ($/MW)

Capacity Value w/ DSM Capacity Value w/o DSM

Note:

• - Same story
• - Fewer than 50 hrs

The Lantau Group 10

20 10 20 30 40 50 60

Hours Ranked by Load

Observation 1: the RCM over‐values incremental reserve capacity relative to its economic value

• “…the value of incremental reserve capacity over the year is AUD

253/MW with DSM or AUD 780/MW without it. These values are 253/MW with DSM or AUD 780/MW without it. These values are still much lower than the actual cost of reserve capacity in the RCM.” (p. 20)

• The difference between the administrative value and the economic

value of capacity credits is extremely high making any transition a value of capacity credits is extremely high, making any transition a cause for potential celebration or alarm – inherently partisan

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Observation 2: Demand Resource (MWs) by class Capacity Year 24‐48hr (Class 4) 48‐72hr (Class 3) 72‐96hr (Class 2) 96‐all (Class 1) Capacity Year (Class 4) (Class 3) (Class 2) (Class 1) 2010/11 116.5 20 17 2011/12 152.1 108 2012/13 414.5 40

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As of mid 2011 Note: all of the demand resources are in classes that (currently) align with the number of hours that a resource needs to be available to contribute materially to the provision of valuable reserve capacity

The number of capacity credits is not linked to the actual reserve requirement

• Under the RCM, any resource that can establish itself as “committed” and declares itself as

intending to trade bilaterally can secure Capacity Credits.

• The RCM does not require facilities that have declared their intent to trade bilaterally to actually

do so.

• By stating an intention to trade bilaterally and becoming a committed facility, a new entrant can

enter the WEM and earn the administered RCP without ever entering into a bilateral contract, or necessarily intending to operate at all.

• As a result, the number of Capacity Credits can decouple (as it has) from the actual reserve

requirement.

The Lantau Group

This is not an inherent flaw of capacity markets – investors are supposed to take risks, including the risk that they have entered a market that is prone to oversupply

Trend in excess reserve capacity

14 6% 14.6%

The Lantau Group 14

The trend is concerning

Trend in “uncontracted” capacity credits

50% 60% 10% 20% 30% 40% 50%

Note:

• - Recent reduction

in investment

• activity. Why?
• - RCM review?
• - MRCP revision?
• - Perception of risk?
• - Impact contracting

behaviour?

The Lantau Group 15

0% Sep 2006 Nov 2006 Jan 2007 Mar 2007 May 2007 Jul 2007 Sep 2007 Nov 2007 Jan 2008 Mar 2008 May 2008 Jul 2008 Sep 2008 Nov 2008 Jan 2009 Mar 2009 May 2009 Jul 2009 Sep 2009 Nov 2009 Jan 2010 Mar 2010 May 2010 Jul 2010 Sep 2010 Nov 2010 Jan 2011 Mar 2011 May 2011 Jul 2011 Sep 2011 Nov 2011

1-%RCR contracted

Why?

behaviour?

Why the trend in uncontracted capacity credits?

• The upward trend in the uncontracted reserve

capacity requirement suggests that

– generators prefer to contract with the IMO or

50% 60%

Uncontracted Capacity Credits – that retailers prefer not to contract with generators.

• Is it easier to deal with the IMO (e.g., lower

transactions costs) or is there a disconnect in the market (e.g., the IMO sets a floor price when the actual economic value of credits is lower)?

0% 10% 20% 30% 40% p 2006 v 2006 n 2007 ar 2007 y 2007 ul 2007 p 2007 v 2007 n 2008 ar 2008 y 2008 ul 2008 p 2008 v 2008 n 2009 ar 2009 y 2009 ul 2009 p 2009 v 2009 n 2010 ar 2010 y 2010 ul 2010 p 2010 v 2010 n 2011 ar 2011 y 2011 ul 2011 p 2011 v 2011

The Lantau Group 16

This is the most concerning evidence of an administrative cause to the mismatch between supply and demand

Se No Ja Ma Ma Ju Se No Ja Ma Ma Ju Se No Ja Ma Ma Ju Se No Ja Ma Ma Ju Se No Ja Ma Ma Ju Se No

1-%RCR contracted

MRCP review

• The RCP is a function of the MRCP, which is, in turn, based on the estimated cost of connecting

a 160MW gas turbine to the WEM.

• The recent changes to the MRCP included significant methodological and definitional

adjustments:

– The basis for the estimate of transmission connection costs was changed; and – The specification of the generation technology was altered to incorporate inlet cooling.

• Together these specific changes reduced the MRCP by over 20%

The Lantau Group 17

The significant reduction in the MRCP due to methodological or definitional changes is a crucial factor to consider when evaluating the RCM

Economic implications of the MRCP revision

• The MRCP is a hard cap to the value of a capacity credit in the WEM

– The value of a capacity credit can be lower than the MRCP, but not higher

• The expected value of a capacity credit is therefore below the MRCP

The expected value of a capacity credit is therefore below the MRCP

The Lantau Group 18

Is this a problem-in-waiting?

What next?

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Market Objectives

• promote the economically efficient, safe and reliable production and supply of

electricity and electricity related services in the South West interconnected system;

• encourage competition among generators and retailers in the South West

encourage competition among generators and retailers in the South West interconnected system, including by facilitating efficient entry of new competitors;

• avoid discrimination in that market against particular energy options and technologies,

including sustainable energy options and technologies such as those that make use

• f renewable resources or that reduce overall greenhouse gas emissions;
• minimise the long-term cost of electricity supplied to customers from the South West

interconnected system; and

The Lantau Group

• encourage the taking of measures to manage the amount of electricity used and when

it is used.

Evaluating a specific change to the RCM (or even its current performance) against the Market Objectives involves balancing a number of countervailing forces.

RCM Process Diagram

There has always been enough capacity. But an effectiveness review

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But an effectiveness review has to consider the possibility

• f how the RCM deals with a

case of too little capacity being presented.

Comparison of the RCM to other “Capacity Markets”

• The RCM is not a capacity market – it is a mechanism

– There is no reason to expect the RCM to “get it right” necessarily given that it is not a particularly dynamic

• r market-sensitive mechanism
• The problem with the RCM is that the administered value of capacity credits can depart

significantly from the economic value of capacity credits

– In part this creates a value management (wealth transfer) issue (too much money flows to capacity) – In part this creates a possibility of incentives for uneconomic investment in the WEM – The MRCP review has highlighted a previously “hidden” aspect of this issue

• The RCM could be replaced with a formal capacity market, or it could be adjusted in ways that

make it more consistent with market-based outcomes

The Lantau Group

– The former is a significant task, with ample room for error and very significant impacts on value expectations that would likely require transition mechanisms to facilitate – The latter enhances the option of evolving towards a market-based mechanism over time

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Adjust the Sensitivity of the RCP to Excess Reserve Capacity

Simple approach

The Lantau Group 23

A steeper slope would create a much sharper incentive against excess reserve capacity

Amount of Excess Reserve Capacity Based on “‐1 slope” Based on “‐3 slope” 0% 85.0% 85.0% 5% 81.0% 73.9% 10% 77.3% 65.4% 15% (~current) 73.9% 58.6% 20% 70.8% 53.1% 25% 68.0% 48.6% 30% 65.4% 44.7% 35% 63.0% 41.5% 40% 60.7% 38.6% 45% 58.6% 36.2% 50% 56.7% 34.0%

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Would the steeper slope “stop” investors from adding to excess reserve capacity until the market clears? If so, it would achieve a near-equivalent “impact” on behaviour as would a move to an economic capacity price A floor value could be considered as a stop loss arrangement, but why?

The steeper “incentive” can be maintained but the starting point adjusted (=100% MRCP rather than 85% MRCP)

80% 90% 100%

Current excess reserve capacity level

20% 30% 40% 50% 60% 70% 80% RCP relative to MRCP RCP Adjustment (slope = -1) from 85% MRCP 0% 10% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Percentage of Excess Reserve Capacity RCP adjustment (slope = -3) from 100% MRCP

Evaluating a specific change to the RCM (or even its current performance) against the Market Objectives involves balancing a number of countervailing forces.

Steeper incentive but with MRCP as starting point

Amount of Excess Reserve Capacity Based on “-1 slope” starting at 85 percent Based on “-3 slope” starting at 100 percent starting at 85 percent

• f the MRCP

starting at 100 percent

• f the MRCP

0.0% 85.0% 100.0% 5.0% 81.0% 87.0% 10.0% 77.3% 76.9% 15.0% (~current) 73.9% 69.0% 20.0% 70.8% 62.5% 25.0% 68.0% 57.1%

The Lantau Group

30.0% 65.4% 52.6% 35.0% 63.0% 48.8% 40.0% 60.7% 45.5% 45.0% 58.6% 42.6% 50.0% 56.7% 40.0%

Possible transition mechanisms

• Initiate the steeper slope immediately, but transition via a “floor” price that starts at just five

percent below what the current RCP methodology would produce and then reduce the floor price by five percent each year for three years before dropping the floor altogether; or

• Introducing the steeper slope in a stepwise manner, with the slope moving from -1 to -1.5 in year
• ne; to -2.0 in year two, and to -2.5 in year three and -3.0 in year four; or
• Introduce the refinements as of a projected date such that participants have time to make

changes, if appropriate, in anticipation of the future implementation.

The Lantau Group 27

Investments that are justifiable primarily on the basis of an administrative mechanism rather than an underlying source of fundamental value invariably bear risk associated with eventual regulatory reform.

Institute a Quantity-Based Control Mechanism

• Credit certification “gatekeeper” (Spigot Control: do not certify or issue credits if excess exists)

– What happens as conditions change, as they can quite quickly in the lumpy and relatively small WEM? – If there are multiple projects queuing up for certification, perhaps each with varying degrees of bilateral contract commitments, how should the IMO choose? – Currently commitment status is partly determined on the basis of irrevocable commitments. Why would facilities enter into irrevocable commitments if becoming “committed” did not assure access to Capacity Credits? – Would a facility not be declared committed even if it had negotiated a bilateral contract covering all of its potential Capacity Credits?

The Lantau Group 28

IMO?

Link quantity mores strongly to loads

• IMO could sell credits to short retailers at a punitively high price while offering to buy from long

generators at a very much lower prices

The Lantau Group 29

Rely more extensively on auction processes

• Instead of an IMO “buy/sell” price (set by the RCM via the RCP adjustments), an auction is used

to determine the value of all uncontracted capacity credits

• Uncontracted retailers would procure from auction rather than from IMO. If credits do not clear,

they do not clear (price goes quickly to zero).

• What happens if market “tightens” – can the same process incentives and support new

investment in a timely manner?

The Lantau Group 30

Should the MRCP always be a hard cap?

90% 110%

100% MRCP 105% MRCP The expected value of a CC needs to be sufficient to support investment. If the MRCP is set “exactly” at the best estimate of the expected cost of new

30% 50% 70% 90% RCP relative to MRCP

expected cost of new capacity, then the RCP will tend to be < MRCP setting up a longer term problem Note: In the event of an auction, the auction winner has access to a 10-year assured price (up to MRCP)

The Lantau Group 31

• 10%

10% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Percentage of Excess Reserve Capacity

Matrix

Administrative RCM (Value of CC set by formula) Economic RCM (Value of CC set by market ( A i )) process (eg. Auction)) Active exposure (new capacity does or does not enters WEM due to RCM settings) May induce/support investment that should not have occurred – depending on settings May not support investment at all, even if needed Likely to introduce significantly greater value volatility to capacity market, and introduce significant implementation challenge Would require significant changes

The Lantau Group

Passive exposure (new capacity enters WEM due to policies or programmes) Potential protection to investors in the event of non- market-based interventions Drives value of CC down to zero, whether or not stakeholders responded correctly to economic value

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Comment

• Currently, the RCP is adjusted downward in proportion to the amount of excess reserve capacity

that exists.

• A straightforward change would focus on sharpening the administrative price adjustment

mechanism to be more responsive to the amount of excess reserve capacity in the WEM.

• An alternative of “spigot control” would go against market-based provision of capacity by new

investors, though it would help protect existing generation investors from further potential reductions in CC value

• Consequently, we favour a price-based adjustment either driven by more use of auctions

(complex implementation and more volatile value impacts), or a sharpened RCP price adjustment formula Th i k t b id d i i hi h th dj t t t th RCP ffi i tl d

The Lantau Group

• The risk to be avoided is one in which the adjustments to the RCP are so sufficiently and

consistently downward without any chance of an offsetting upward adjustment that the expected value of a Capacity Credit over the life of a capacity investment is not sufficient to support that investment commercially.

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