Financial Transmission Rights: Design options

1
Financial Transmission Rights Design options

• Presentation to Electricity Commission
• 2 September 2009

2
Background

• Transpower was asked for advice on how to
• Simplify and make 2002 FTR more appealing to
  participants
• Deal with Dr Reads 2002 concerns
• Implement an FTR market

3
Background

• Transpowers advice is a suggested starting point
  for discussion
• Pricing should reflect underlying physics
• FTRs are internally consistent with locational
  marginal pricing
• Regulatory arrangements are different to 2002
• FTR trading platform can be significantly
  simplified without affecting dispatch
• Start simple and evolve with users

4
What is the problem?

• Nodal prices are consistent with physical
  dispatch (i.e. they obey the laws of physics!)
• Locational price differences are caused by
  constraints in the transmission system NOT energy
  availability
• Commercial implications of transmission
  constraints
• Bilateral contracts can only hedge energy costs
• Volatile and unpredictable locational price
  differences must be hedged separately

5
What is the problem?

• There is little ability to hedge locational price
  difference
• Incentive is to vertically integrate and
  regionalise generation and retail
• Consequences
• At best a partial locational price hedge
• Barrier to retail competition
• Significant cost to consumers
• Inefficient use of transmission assets

6
What are the possible solutions?

• Remove locational price differences altogether
• Removes demand side response
• Use rentals to fund a hedge product
• The net amount that needs to be hedged is EXACTLY
  the rentals collected
• Preserves demand side signals

7
Report Structure

• Part 1 what is an FTR? How do they fit into
  integrated market design?
• Part 2 design options
• Part 3 implementation options

8
Markets with locational marginal pricing

• A system for the efficient trading of electricity
  using supply and demand to set price
• Separate contestable and monopoly functions
• Characterised by spot prices that differ by
  location
• Wholesale market competitive trading
• Retail market customer choice

9
Integrated market design
Bid-based, security-constrained, economic
dispatch with nodal prices
10
Physics Kirchoffs law

• This means that . . .
• Every injection into and off-take from the grid
  effects electricity flows on every circuit
• Physical capacity rights cannot be meaningfully
  defined
• Which leads us to constraints and nodal prices .
  . .

11
Commercial risk

• Kirchhoff's law and the occurrence of constraints
  create commercial risk
• Actions of other parties can impact on nodal
  price
• Constraints impact on nodal prices
• Two primary risk management tools
• Bilateral energy contracts referenced against
  price at a node (often internalised by vertical
  integration)
• Hedge to manage locational price risk arising
  from constraints

12
Energy contract example 1
Generator Offered at 2 300 MW dispatched

• Vertically integrated utility generates at A,
  commitment of 300 MW at 2 at B

2
200 MW
Load 300 MW
At limit
Generation Cost to generate at A -600 Gets
paid at A 600
100 MW
2
100 MW
2
Retail Buys 300MW from A -600 Gets paid
for 300MW at B 600
13
Energy contract example 2

• Third party load increases at B

Generator 1 Offered at 2 240 MW dispatched

• Line A B constrained

• Price at B increases to 4

2

• Retailer cant meet obligation of 300MW at its
  generation cost of 2 to load at B (600)

200 MW
Load 1 300 MW
Constrained
40 MW
Load 2 60 MW

• To meet obligation of 300MW at B retailer must
  purchase all 300MW at B for 4 (1200)

4
160 MW
3
Generator 2 Offered at 3 120 MW dispatched

• Additional cost to gentailer is equivalent to the
  rentals of the system (600)

14
From an energy contract perspective

• The transmission price risk between A and B is
  the price difference B - A
• Generation at A cannot offer an energy contract
  referenced at B without taking the transmission
  price risk
• Load at B cannot accept an energy contract
  referenced at A without taking the transmission
  price risk

Generator 1 Offered at 2 240 MW dispatched
2
200 MW
Load 1 300 MW
Constrained
40 MW
Load 2 60 MW
4
160 MW
3
Generator 2 Offered at 3 120 MW dispatched
15
How can A or B manage the transmission price risk?

• Either A or B needs a financial product that
  recompenses the value (PriceB - PriceA)/MW.
• Generation at A can then offer a fixed energy
  price at B, or
• Load at B can accept a fixed energy price hedge
  referenced at A
• The only cash stream correlated with nodal price
  differences is the rentals
• FTRs use this correlation to hedge price
  differences

16
Energy price hedge values differ by location and
over time
17
Features of FTRs trading risk

• Can be matched to an energy contract of a
  specified capacity and duration between two nodes
  near perfect hedge
• Holder receives the rentals between two specified
  points for an agreed capacity and duration
• Protect the holder against extreme price risks
  (constraints, scarcity pricing)
• Can be allocated explicitly and/or through an
  auction
• Traded in secondary auctions or markets
• Only known product that exploits correlation of
  rentals with locational price differences

18
Features of FTRs efficient investment

• Grid could operate with more constraints (more
  efficient)
• Signal the market value of constraints (FTR
  auction value)
• Provide an important economic signal to assist
  with the correct location and timing of new
  transmission investment

19
Rental flows without FTRs

20
Cash flows with FTRs
Auction revenue
FTR rentals premium
FTR rentals

Residual revenue
Rentals premium
21
Design emphasis?

• Merchant new investment?
• Network investment governed by Part F of EGRs
• Merchant investment in connection assets possible
  (probable?)
• Allocation of FTRs to investors not high priority
  in short term
• Locational hedging
• Reduce reliance on physical hedging
• Reduce barriers to new retail entry (increased
  competition)
• Provide means to fully hedge against transmission
  congestion
• High degree of user influence on design
• Start simple and build with experience and need
• WHAT DOES THIS MEAN FOR DESIGN?

22
New Investment

• New investment
• Merchant investment no longer the primary
  mechanism for transmission upgrades
• Allocation of FTRs to investors not high priority
  in short term

Pre-allocation to investors
No pre-allocation
23
Coverage

• Node to node, hubs and nodes, hubs only
• Market power?
• Start simple

High coverage, Complexity
Low coverage, Simplicity
24
Constraints only?

• Losses should be reasonably predictable
• Constraints are not predictable
• FTRs with losses are complicated and confusing

Losses and constraints
Constraints only
25
Revenue adequacy

• Dependent on FTR grid design
• Incorrect grid outage assumptions, unplanned
  outages, emergencies

To FTR market operator/grid owner
To FTR market participants
26
Revenue adequacy

• PJM, CAISO, MISO
• FTR Credits are prorated proportionally
• Payments derated when revenue shortfall occurs
• Excess rentals and auction revenue occurring over
  a month are transferred to a balancing fund
• At end of period balancing fund is used to clear
  unpaid FTRs (pro rata)
• NYISO
• Revenue shortfall is compensated for by imposing
  an uplift charge on transmission owners
• Attempts to link transmission maintenance
  standards with revenue adequacy

27
Revenue adequacy in PJM
28
FTR Duration

• Any duration required
• Start low for accelerated learning
• Change with market requirement

Long duration
Short duration
29
Obligations or options?

• Obligation FTRs can become a cost (obligation
  FTRs are directional)
• Obligation FTRs still hedge price difference even
  when ve
• Option FTRs always cash positive BUT lower
  capacity and computationally different

Options
Obligations
30
Post allocation of residual revenue

• Any allocation possible
• Change results in value transfers
• Simplest approach is to initially make no change

Pre-allocation to investors
No pre-allocation
31
Implementation

• Transpowers system is up and running
• Can assist establishing an FTR market quickly if
  required
• Transitional arrangements could see separation of
  systems from Transpower