STATE OF MARYLAND
BEFORE THE PUBLIC SERVICE COMMISSION
In the Matter of the
)
Inquiry into Electric Generating
)
Resource Adequacy
)
Case No. 8980
REPLY TESTIMONY OF
JONATHAN WALLACH
ON BEHALF OF
THE MARYLAND OFFICE OF PEOPLE’S COUNSEL
Resource Insight, Inc.
JANUARY 9, 2004
1
I.
Introduction and Summary
2
Q:
Please state your name, occupation, and business address.
3
A:
I am Jonathan F. Wallach. I am vice president of Resource Insight, Inc., 347
Broadway, Cambridge, Massachusetts.
4
5
Q:
Are you the same Jonathan Wallach that filed direct testimony in this
proceeding?
6
7
A:
Yes.
8
Q:
What is the purpose of your reply testimony?
9
A:
The purpose of this reply testimony is to respond to the direct testimony of
10
Michael Swider on behalf of Strategic Energy regarding his general critique of
11
ICAP markets. I also respond to the comments or testimony of Baltimore Gas &
12
Electric (“BGE”), Consolidated Edison Energy, and Mirant Mid-Atlantic
13
regarding consideration of an ICAP demand curve.
14
Q:
Please summarize your findings and conclusions.
15
A:
Mr. Swider inaccurately characterizes the design and performance of the current
16
PJM ICAP market, particularly with regard to the reliability value provided by
17
PJM’s ICAP requirement. In addition, Mr. Swider does not offer reliable or
18
compelling evidence to support his assertion that the ICAP market discourages
19
new entry. Finally, his proposal for a backup adequacy mechanism will
20
effectively transform PJM into an energy-only market, subjecting PJM
21
consumers to excessive levels of energy-price volatility without any appreciable
22
improvement in system reliability or reduction in system costs.
23
A demand curve is ill-suited for the PJM ICAP market, and
24
implementation of a demand curve could result in unjust and unreasonable
Reply Testimony of Jonathan Wallach  Case No. 8980  January 9, 2004
Page 1
1
prices to consumers. The current ICAP market appears to be reasonably
2
competitive, with prices rising or falling to levels that reflect market conditions;
3
it’s unlikely that adoption of a demand curve would markedly improve
4
performance in this regard. Contrary to proponents’ claims, the demand curve
5
would not materially reduce the economic harm from capacity withholding, and
6
in fact could enhance incentives to exercise market power. Finally, the ICAP
7
demand curve may lead to purchases of ICAP in excess of the planning-reserve
8
requirement. Proponents assert that such purchases of excess capacity are
9
justified on the basis of the additional reliability benefits they provide, but fail to
10
provide any evidence of the magnitude of such benefits for PJM or that such
11
benefits exceed the additional costs to consumers.
12
II.
Strategic Energy’s Critique of ICAP Markets
13
Q:
Please summarize Mr. Swider’s direct testimony regarding PJM’s ICAP
market.
14
A:
15
Mr. Swider asserts that the PJM ICAP market is “inherently dysfunctional,”
16
since the market, as currently designed, neither provides reliability value to the
17
system nor provides an incentive for new entry.1 According to Mr. Swider,
18
ICAP procured through PJM’s market provides limited reliability value, since
19
ICAP suppliers “have no financial obligation to inject power, and the generating
20
resources may not even be available.”2 In support of his claim that the ICAP
21
market does not promote new entry, Mr. Swider notes that reserve margins in
1
Direct Testimony of Michael Swider Regarding Generating Resource Adequacy, Case No.
8980, December 5, 2003, p. 4.
2
Id.
Reply Testimony of Jonathan Wallach  Case No. 8980  January 9, 2004
Page 2
1
2003 in regions without ICAP markets were one percentage point higher than in
2
PJM.
3
Q:
Is Mr. Swider’s complaint about the reliability value of ICAP valid?
4
A:
No. Mr. Swider does not accurately characterize the reliability value provided
5
by PJM’s ICAP market. Contrary to Mr. Swider’s assertions, all ICAP resources
6
are required to bid into the day-ahead energy market and assume the financial
7
obligation to serve load when scheduled by PJM on a day-ahead basis.
8
Moreover, even if not scheduled to serve internal load on a day-ahead basis, an
9
ICAP resource is limited to selling to external markets on a non-firm, energy-
10
only basis, with all such sales subject to recall by PJM in real time when needed
11
to meet internal reliability requirements.
12
Q:
margins that an ICAP requirement does not promote new entry?
13
14
Is it reasonable to conclude from Mr. Swider’s comparison of reserve
A:
No. A simplistic comparison of reserve margins across regions bears little
15
relevance to the issue of whether an ICAP requirement promotes new entry.
16
Since most control areas have only recently restructured, the difference in
17
reserve margins between two regions is more likely to be explained by
18
differences in the amount of reserves on each system prior to implementation of
19
wholesale markets, in the amount of new capacity under development at the
20
outset of wholesale competition, and in patterns of load growth since
21
implementation of wholesale competition. For example, even though it has the
22
same type of ICAP requirement and markets as PJM, ISO-New England’s
23
projected reserve margin for the summer of 2003 was about 23%, or four
24
percentage points higher than PJM and three percentage points higher than Mr.
25
Swider’s estimate for East Central Area Reliability (“ECAR”), Electric
26
Reliability Council of Texas (“ERCOT”), and Mid-Continent Area Power Pool
Reply Testimony of Jonathan Wallach  Case No. 8980  January 9, 2004
Page 3
1
(“MAPP”). Clearly, the imposition or absence of an ICAP requirement does not
2
explain these differences between ISO-New England and other regions.
3
Relevance aside, Mr. Swider’s comparison of PJM’s reserve margin to
4
that in ECAR or MAPP is not valid, since it is based on a false premise. Mr.
5
Swider’s assertion that the ECAR and MAPP regions “do not have ICAP
6
requirements” is incorrect.3 In fact, MAPP imposes a 15% planning reserve
7
requirement on its members.4 In addition, although ECAR does not impose such
8
a planning standard, vertically integrated utilities operating as separate control
9
areas within ECAR continue to maintain individual planning-reserve
requirements.5
10
Q:
11
What does Mr. Swider recommend as an alternative to PJM’s ICAP
market?
12
A:
13
For the long term, Mr. Swider recommends widespread implementation of real-
14
time pricing of retail power supply and elimination of the ICAP requirement. In
15
the interim, Mr. Swider recommends a backstop mechanism similar to one
16
currently under consideration in Texas.6 Under this backstop approach, PJM
17
would continue to set a reserve requirement for the control area, but would only
18
procure (and pay for) capacity in an amount sufficient to cover the difference
19
between existing capacity and the total reserve requirement. In other words,
3
Id., p. 5.
4 Mid-Continent Area Power Pool, Regional Reliability Handbook, July, 1999, Section 8.2.1.1.
5 For example, PSI Energy of Indiana utilizes a minimum planning reserve margin of 15%. See
Testimony of Diane L. Jenner, Cause No. 42359 before the Indiana Utility Regulatory
Commission.
6
Mr. Swider does not explain why there is a need to consider such a backstop mechanism for
ERCOT, or why he recommends such an approach for PJM, when he apparently believes that
ERCOT’s energy-only market already provides for reasonable levels of resource adequacy.
Reply Testimony of Jonathan Wallach  Case No. 8980  January 9, 2004
Page 4
1
PJM would procure capacity only in the event that there is inadequate existing
2
capacity to meet peak load plus the required reserve margin. Only new capacity
3
procured to meet this shortfall would receive ICAP payments; existing capacity
4
would no longer be eligible for such payments.
5
Mr. Swider also recommends consideration of the Forward Reserves
6
Market recently implemented by ISO-New England. However, the Forward
7
Reserves Market is a market for operating reserves, not ICAP, and is employed
8
in conjunction with ISO-New England’s ICAP market.
9
Q:
with widespread adoption of real-time pricing?
10
11
Would it be feasible in the long term to eliminate the ICAP requirement
A:
As I discussed in my direct testimony in this proceeding, widespread
12
implementation of real-time pricing is necessary, but not sufficient to allow
13
market forces, rather than the control-area operator, to set the appropriate level
14
of reserves. In addition, the control-area operator would have to have the
15
capability to curtail load of individual market participants. Until both of these
16
conditions hold, market participants will have an incentive to under-invest in
17
reserves and instead lean on other participants’ reliability investments.
18
Q:
alternative to PJM’s ICAP market?
19
20
Is Mr. Swider’s proposal for an interim backstop mechanism a reasonable
A:
No. Mr. Swider’s proposal will effectively transform PJM into an energy-only
21
market, subjecting PJM consumers to the excessive levels of energy-price
22
volatility typically associated with such markets without any appreciable
23
improvement in system reliability or reduction in system costs.
24
As I discussed in my direct testimony, PJM’s ICAP market provides
25
capacity owners a source of revenue separate from the energy market to cover
Reply Testimony of Jonathan Wallach  Case No. 8980  January 9, 2004
Page 5
1
their fixed investment and operating costs and provide for a reasonable return.7
2
Since this separate revenue stream is not available in an energy-only market,
3
capacity owners will bid into an energy-only market at prices that exceed
4
variable cost in order to recover these fixed costs. Such “all-in” bidding leads to
5
extremely volatile energy prices in high-demand hours, since the peaking units
6
that typically run and generate market revenues only in these hours must bid
7
prices that are high enough to recover all their fixed costs during these few
8
hours of operation.8
9
Under Mr. Swider’s backstop proposal, existing capacity will no longer
10
receive ICAP revenues and thus will no longer be able to recover fixed costs
11
through such revenues. Instead, existing capacity will have to engage in the type
12
of all-in bidding associated with energy-only markets in order to recover fixed
13
costs.9 As noted above, the result is likely to be a dramatic increase in energy-
14
price volatility.
15
Mr. Swider’s backstop proposal does not appear to offer any benefits that
16
would offset this increase in price volatility. Implementation of a backstop
17
mechanism will not improve system reliability, since PJM would procure the
18
same amount of reserves under the backstop as under the current ICAP
7
Revenue from the energy market covers variable operating costs and, for infra-marginal
resources, provides a profit margin on variable costs that contributes to coverage of fixed costs.
8
Such all-in bidding may also lead to an inefficient dispatch of generating resources and
consequently higher costs to consumers. In today’s energy market, PJM achieves efficient dispatch
by dispatching resources in order of increasing short-run marginal costs, as represented by the
energy bid. With all-in bidding, PJM will have to dispatch units on the basis of total costs. In this
case, the dispatch may be inefficient when the dispatch order resulting from total-cost ranking
differs from the order that would have resulted from ranking based on short-run marginal costs.
9
Alternatively, existing capacity may simply choose to retire, thereby threatening system
reliability.
Reply Testimony of Jonathan Wallach  Case No. 8980  January 9, 2004
Page 6
1
mechanism. Nor will implementation reduce the cost of ICAP to consumers,
2
since existing capacity will recover any reductions in ICAP payments through
3
increased energy bids.
4
III. Demand Curve Proposal
5
Q:
Please describe the design of the New York ISO’s ICAP market prior to
implementation of the demand curve.
6
A:
7
Prior to adoption of the demand curve, the New York ISO (“NYISO”)
8
administered an ICAP market that was structured similarly to PJM’s, but
9
differed in a few key respects.10 Similar to PJM, the NYISO imposed a fixed
10
planning-reserve requirement on all LSEs in its control area, and established a
11
deficiency penalty in the event that an LSE failed to procure sufficient reserves
12
to meet its capacity obligation. As in PJM, the fixed reserve requirement
13
effectively established a vertical demand curve in the ICAP auctions, with such
14
auctions clearing at the price where the supply curve (i.e., the amalgamation of
15
supply offers) intersected with the vertical demand curve.11 In the event of a
16
supply deficiency – i.e., insufficient supply offers to meet the capacity
17
obligation – the market would clear at the deficiency penalty rate.
10 The NYISO has separate
ICAP requirements and markets for New York City, Long Island,
and the rest of the state (“ROS market”). The description that follows pertains primarily to the ROS
market. The local ICAP markets incorporate unique design elements and exhibit different clearing
dynamics as a result of the fact that these markets are subject to the exercise of market power by
pivotal suppliers.
11
The fixed reserve requirement creates a vertical demand curve in the sense that demand is
fixed at the level of the capacity obligation equal to peak load plus the reserve requirement. With
demand quantity fixed at a specific amount, the ICAP auction clears at the price required by
suppliers to meet that fixed quantity of demand.
Reply Testimony of Jonathan Wallach  Case No. 8980  January 9, 2004
Page 7
1
The NYISO’s ICAP market differed in two respects that are particularly
2
relevant to consideration of the demand curve. First, the deficiency penalty in
3
New York was set at three times the cost of a new combustion turbine (“CT”),
4
as opposed to only one times CT cost in PJM. Setting the deficiency rate at such
5
high levels led to wide price swings from low levels – reflecting the incremental
6
capacity costs of existing generation – when the market was in surplus to three
7
times the cost of new capacity when the market was deficient. In addition, with
8
a deficiency rate three times that of PJM’s, the incentive to withhold capacity,
9
and the economic harm from such withholding, was commensurately greater in
10
New York than in PJM. Second, LSEs in the NYISO were obligated to procure
11
capacity a month at a time, as opposed to seasonal procurement in PJM.12 The
12
relatively short duration of the NYISO’s obligation period further exacerbated
13
price volatility over the course of a year.
14
Q:
Please describe the ICAP demand curve as implemented by the NYISO.
15
A:
The ICAP demand curve replaces the vertical demand curve at the fixed reserve
16
requirement with a sloped demand curve that extends over a range of reserve
17
requirements. As discussed above, with a vertical demand curve, the auction
18
clearing price is determined by the price on the supply curve for a quantity of
19
supply equal to the fixed capacity obligation (i.e., peak load plus the fixed
20
reserve requirement). With a sloped demand curve, both the clearing price and
21
the clearing quantity (i.e., the amount of capacity procured through the auction
22
by the ISO on behalf of LSEs) are determined by the intersection of the
23
(declining) demand and (ascending) supply curves.
12 As I discussed in my direct testimony, PJM has structured the deficiency penalty to create a
strong financial incentive for LSEs to procure on a seasonal basis, even though they are technically
obligated on a daily basis.
Reply Testimony of Jonathan Wallach  Case No. 8980  January 9, 2004
Page 8
1
The slope of the demand curve is defined by specifying: (1) the demand
2
price at the quantity amount equivalent to the fixed capacity obligation; and (2)
3
the quantity amount at which the demand price is equal to zero (i.e., where the
4
demand curve intercepts the quantity axis). In New York, the slope of the
5
demand curve is defined by a price equal to the cost of a new CT at the quantity
6
amount equal to 118% of peak load and an intercept with the quantity axis at
7
132% of peak load.
8
As noted above, the amount of capacity procured through the auction is no
9
longer fixed at the 18% reserve margin when using the sloped demand curve.
10
Instead, both the amount of capacity procured and the price for that capacity are
11
determined by the intersection of the demand and supply curves. If the curves
12
cross at the 118% point, then the NYISO will procure, on behalf of all LSEs, an
13
amount of capacity equal to 118% of peak load at a price equal to the cost of a
14
new CT. If the curves cross at a quantity that exceeds the 18% reserve margin,
15
then the LSEs will be obligated to pay for that amount of capacity (including the
16
excess above 118% of peak load), but at a price below the cost of a new CT.
17
Similarly, if the curves cross at a quantity below the 18% margin, the NYISO
18
will procure that amount of capacity at a price that is higher than the cost of a
19
new CT. However, whenever the auction clears below the 118% capacity
20
obligation, the NYISO will then seek to cover the deficiency by purchasing
21
additional capacity outside of the auction at a price at or below the auction
22
clearing price.13
BGE is thus incorrect when it states that the demand curve “makes the desired reserve
margin more of a mid-point within a zone of reasonableness,” since the NYISO ultimately will
ensure that reserves do not fall below the required reserve margin. See Direct Testimony of William
B. Pino, Case No. 8980, December 5, 2003, p. 10.
13
Reply Testimony of Jonathan Wallach  Case No. 8980  January 9, 2004
Page 9
1
Q:
How has PJM’s ICAP market performed using the vertical demand curve?
2
A:
According to PJM’s Market Monitoring Unit (“MMU”), the ICAP market has
3
produced competitive price levels reflective of market conditions ever since the
4
withholding incident in the beginning of 2001 described in my direct testimony:
5
6
7
8
9
10
Daily capacity credit market prices were quite low during 2002, averaging
$0.59 per MW-day. Prices in the interval, monthly, and multi-monthly
markets declined over the year from $67.20 per MW-day in January to
$12.50 per MW-day in December, averaging $38.21 per MW-day. In both
cases, prices reflected supply-demand fundamentals and were nearer
competitive levels than during 2001.14
Q:
11
Given this competitive performance, why are BGE, CEE, and Mirant
advocating consideration of a demand curve for PJM’s ICAP market?
12
A:
13
In proposing consideration of a sloped demand curve, BGE, CEE, and Mirant
14
appear to have objectives similar to those guiding advocates for the RAM
15
proposal. Specifically, proponents’ objectives appear to be to:
16

Implement a market design that yields appropriate price levels and price
17
stability in order to encourage economically rational capacity investments.
18
Proponents of the sloped demand curve argue that the vertical demand
19
curve yields prices that are too low and too volatile to justify financing and
20
development of new capacity.

21
Revise the structure of the ICAP market in order to reduce opportunities
22
for capacity withholding. Proponents argue that the vertical demand curve
23
encourages pivotal suppliers to withhold capacity and create an artificial
24
shortage, since doing so dramatically increases prices from levels
25
reflecting the incremental costs of existing capacity up to the deficiency
26
rate.
14
PJM Interconnection, 2002 State of the Market, March 5, 2003, p. 69.
Reply Testimony of Jonathan Wallach  Case No. 8980  January 9, 2004
Page 10
1
In addition, echoing arguments made in the NYISO stakeholder process,
2
proponents argue that there is a reliability benefit to purchases of reserves in
3
excess of that required to meet the 1-in-10 LOLP adequacy standard. According
4
to this line of reasoning, the vertical demand curve fails to reflect the additional
5
reliability value of reserves in excess of the required reserve margin, thereby
6
precluding beneficial procurement of excess reserves.
7
Q:
demand curve, is a barrier to efficient entry?
8
9
Do you agree that the current market design, with its reliance on a vertical
A:
No. As I discussed in my direct testimony with respect to the RAM proposal, the
10
current ICAP market appears to be functioning in a competitive fashion,
11
yielding market prices that reasonably reflect the current reserve balance and the
12
amount of new capacity expected in the foreseeable future. In addition, there is
13
no indication at this time that price volatility in the current ICAP market has
14
discouraged development or financing of new construction.15
15
Moreover, even if problems were to develop over time, it would be more
16
appropriate and effective to implement a RAM-like mechanism or alternative
17
mechanism for long-term procurement that directly addresses these barriers.
18
Problems related to price levels or price volatility are symptomatic of
19
underlying problems with the duration of the planning horizon or obligation
20
period, respectively. Replacing the vertical demand curve with a sloped demand
21
curve will not remedy the fundamental problem that gives rise to inefficient or
15 According to a recent filing by Potomac Electric Power Company in Case No. 8796, Phase
II, price volatility in both the daily and monthly ICAP markets has declined substantially over the
last four years. See Potomac Electric Power Company, Report on the Future of Dispatchable
Energy Use Management Programs, Case No. 8796, Phase II, December 22, 2003, pp. 15-16.
Reply Testimony of Jonathan Wallach  Case No. 8980  January 9, 2004
Page 11
1
volatile prices: reliance on spot markets for short-term capacity to encourage
2
efficient investment in long-lived assets.16
Q:
3
Would adoption of a sloped demand curve reduce the incentive for capacity
withholding?
4
A:
5
As I argued in my direct testimony with regard to the RAM proposal, the sloped
6
demand curve does not reduce the economic harm from market manipulation,
7
since it “discourages” withholding by paying suppliers prices on the demand
8
curve that are comparable to those that would prevail if they did withhold.
9
In fact, in PJM, adoption of a sloped demand curve could feasibly increase
10
the profitability of capacity withholding and therefore increase the incentive for
11
pivotal suppliers to exercise market power.
12
As I discussed in my direct testimony, under the current market design,
13
ICAP prices are effectively capped at the deficiency rate and thus cannot rise
14
above this rate when a pivotal supplier forces the market into artificial
15
deficiency through withholding.
16
In contrast, with a sloped demand curve, the price at the required reserve
17
margin will be set at the current deficiency rate of one times the cost of new CT,
18
and rise above that level at lower quantities of reserve. Thus, under the demand
19
curve, the more the capacity withheld and the larger the capacity deficiency, the
20
more the clearing price will rise above the current deficiency rate and the greater
16
In fact, experience in New York, at least for the New York City market, indicates that
application of the demand curve is perversely encouraging market participants to shift capacity
purchases from the 6-month strip auction (which utilizes the vertical curve) to the monthly spot
auction (which applies the sloped curve.) In a complete reversal from results prior to
implementation of the demand curve, the vast bulk of capacity sales in the New York City auctions
for Winter, 2003-04 have been awarded through the monthly spot auction, with only minimal
amounts awarded through the 6-month strip auction.
Reply Testimony of Jonathan Wallach  Case No. 8980  January 9, 2004
Page 12
1
the revenue to non-withheld capacity. Even though a pivotal supplier would
2
need to withhold greater amounts of capacity to increase prices, it wouldn’t
3
necessarily forego revenues on the withheld capacity if, as in the NYISO
4
market, PJM then purchased that withheld capacity out-of-market to cover the
5
artificial deficiency.
6
Q:
withholding?
7
8
How can PJM reduce the incentive and economic harm from capacity
A:
As I argued in my direct testimony, the MMU can employ explicit mitigation
9
measures, such as bid capping, to discourage the exercise of market power. In
10
fact, the MMU recently proposed to implement bid capping for the
11
Commonwealth Edison capacity market.
12
Q:
reserves in excess of the required reserve margin?
13
14
Is there an additional reliability benefit associated with the procurement of
A:
There are two potential reliability benefits associated with the purchase of
15
excess capacity. First, the more reserves, the more reliable the system and the
16
lower the risk of customer outages. Second, the more reserves, the lower the risk
17
of scarcity, and consequently of high scarcity prices, in the energy market.
18
Q:
improve consumer welfare?
19
20
Do purchases of excess capacity using a sloped demand curve therefore
A:
Only to the extent that the additional benefits of such purchases exceed the
21
incremental costs. In this case, there are two sources of additional costs. First,
22
there will be a higher clearing price under the sloped demand curve than under
23
the vertical demand curve. Second, when the market is long, more ICAP will be
24
purchased under the sloped demand curve than under the vertical demand curve.
25
Inexplicably, proponents in this proceeding have not offered any evidence
26
that the additional reliability benefits do in fact exceed the additional costs for
Reply Testimony of Jonathan Wallach  Case No. 8980  January 9, 2004
Page 13
1
the PJM control area. This is particularly troublesome in light of the fact that
2
proponents are effectively arguing that the Commission consider overturning the
3
1-in-10 LOLP standard that has been accepted industry-wide for several decades
4
as providing a reasonable and reasonably cost-effective level of system
5
adequacy.17
6
Q:
Does this conclude your testimony?
7
A:
Yes.
17
It is also ironic that proponents are advocating for the purchase of excess capacity in a
competitive market, when a primary benefit of market restructuring was supposed to be a
reallocation of the risk of excess capacity and associated stranded costs from consumers to
wholesale suppliers.
Reply Testimony of Jonathan Wallach  Case No. 8980  January 9, 2004
Page 14