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PennFuture's E-cubed is a commentary biweekly email  publication concerning the current themes and trends in the energy market. 

July 16, 2001
Vol. 3, No. 13
Market Lessons from 2000
 
School's still out for summer, but just as the new and improved  Federal Energy Regulatory Commission (FERC) issued a watershed RTO decision last  week which could lead to substantial expansion of PJM into the Northeast, PJM's  State of the Market Report 2000 contains some interesting information and  lessons for us. 
After the California experience demonized spot electricity  markets, it would surprise many that PJM's 2000 spot energy market was a  bargain. Spot prices in 2000 were below $30.00 per megawatt-hour (MWh), or three  cents per kilowatt-hour (kWh), 70.88 percent of the hours in the year. The  single highest hourly price was $810 per MWh or 81 cents per kWh, but prices  reached or exceeded $200 per MWh during only 13 hours in the entire year  (download charts on our website by typing www.pennfuture.org/items/hourlypricecharts_71601.pdf  in your browser). By contrast, California experienced spot  prices that often exceeded $200 per MWh for most of the last 12 months.
Authored by the PJM Market Monitoring Unit - but likely reviewed  and edited by top PJM management - the Report delivered to FERC concludes that  all of the markets operated by PJM were "reasonably competitive." It cautions,  however, that,
"there are potential threats to competition in the energy,  capacity and regulation markets that require ongoing scrutiny and in some cases  may require action in order to maintain competition. Market participants do  possess some ability to exercise market power under certain conditions in PJM  markets." 
In order to maintain and improve the functioning of the PJM  markets, the Report recommends:

Retention of the $1000/MWh bid cap in the PJM energy market  and investigation of other rule changes to reduce incentives to exercise  market power.
Retention of the $100/mw bid cap in the PJM regulation market.  
Evaluation of additional actions to increase demand-side  responsiveness to price in both energy and capacity markets.
Modification of incentives in the capacity market to require  all Load Serving Entities (LSEs) to meet their obligations to serve load on a  longer-term basis, and require all capacity resources to be offered on a  comparable longer-term basis.

The Report uses several analytical methods to reach these  recommendations and conclusions, including looking at the net revenue for  generation from all sources, the increase in bid amount over marginal cost,  market concentration (as measured using the HHI index), and lastly an analysis  of the resulting prices.
 
See Spot go to market
Perhaps the Report's most intriguing  information on price trends concerns the spot energy market, where average  prices declined by 9.81 percent from 1999 levels. Driven by lower peak prices in  the most expensive 100 hours of the year, the average locational marginal price  (LMP) in 2000 was $30.72 per MWh (3.072 cents per kWh), falling from the 1999  average of $34.06 per MWh (3.406 cents per kWh). This average price decline in  the spot market was more significant because it occurred even though fuel costs  were sharply higher in 2000. Indeed, the average fuel-adjusted LMP in 2000  declined to $24.78 per MWh, or 27.25 percent from the 1999 price of $34.06 per  MWh. 
And when one compares 2000 spot market prices to competitive  future prices for the year 2000 and to 1996 regulated rates for generation, it  becomes clear that spot market prices in 2000 were significantly lower than 2000  future contracts. Even with appropriate price adjustments to facilitate  comparison, they were also much lower than 1996 regulated residential generation  rates for all hours charged by Pennsylvania's six major electric utilities,  which ranged from about $51 dollars to $85 dollars per MWh, or 5.1 to 8.5 cents  per kWh. 
The lesson
Spot market prices, which received so much bad  publicity as a result of the California fiasco, can be a bargain and customers  who are able to manage their demand to reduce or avoid the hours of high spot  prices can reap major savings by purchasing electricity from the spot  market.
In fact, spot market prices in 2000 were below most of  Pennsylvania's shopping credits or "prices to compare." That's saying something,  since the shopping credits in turn are as much as 4.0 cents per kWh less than  the 1996 regulated rate for just generation paid by customers to the monopoly  utilities. 
But?
Since spot market prices in 2000 were well below both  the 1996 generation rate paid to monopolies and the much lower shopping credits,  why were energy suppliers increasingly unable to offer electricity at prices  below the shopping credits? 
ICAP pricing and reliance by electricity suppliers on higher  priced future or forward market contracts supply most of the answer. 
The spot market gives a good indication of what the forward  markets should be under typical circumstances. As the data below indicate, the  average spot market price for all market locations in 2000 was $30.72/MWh,  almost 10 percent less than during 1999, and more than 27 percent lower upon  adjusting for higher year 2000 fuel prices. 
			  PJM Load-Weighted Average LMP ($/MWh) 	
  	  1999 	  2000 	  Change 	
  Average LMP 	  34.06 	  30.72 	  -9.81% 	
  Median LMP 	  19.02 	  20.51 	  7.83% 	
  Standard Deviation 	  91.49 	  28.38 	  -68.98% 	
    	    	    	    	
  Average Fuel Adjusted LMP 	  34.06 	  24.78 	  -27.25% 	
  Median Fuel Adjusted LMP 	  19.02 	  16.80 	  -11.67% 	
  Standard Deviation 	  91.49 	  22.04 	  -75.91% 	

 
While the dramatically lower standard deviation in 2000 indicates  that prices were much less volatile than in 1999, there remained a substantial  gap between average and median prices, indicating that extreme prices during a  small number of hours continued to substantially skew overall average prices.  
Grading on a curve
The PJM 2000 price duration curves,  measuring the percent of time prices were at or below a particular level, tell  an interesting story. As one would expect with higher fuel prices, especially  for natural gas, the general trend was for prices to be slightly higher during  periods where natural gas was the marginal fuel. For approximately 99 percent of  all hours, 2000 energy prices were more expensive than in 1999. Yet, with  relatively low peak demand, the price for the most expensive 1 percent of demand  during 2000 was considerably lower in 2000 than in 1999, accounting for the  entire 9.81 percent average reduction in 2000 prices from 1999. If not  for the reduced prices for the most expensive 1 percent of demand, overall  prices for 2000 likely would have risen approximately 18 percent over 1999, due  largely to higher fuel costs. 
For these reasons, the Report recommendation to "evaluate"  additional actions to increase demand-side responsiveness is SEVERELY  understated. PJM and all consumers have an essential interest in implementing  demand-side response programs to the maximum economic level, with dramatic  implications for saving individual consumers money, improving system  reliability, keeping market prices lower for everyone, and improving market  competitiveness. 
Can everyone say I-C-A-P?
So with the lower wholesale  energy prices and plenty of supply, why did the retail market sputter? 
Installed capacity (ICAP) price increases are a partial  explanation. In addition to energy, the controversial charge for ICAP is the  other significant cost born by electricity consumers within PJM. ICAP represents  a call option on physical generation resources by PJM during system emergencies.  All LSEs are required to purchase an amount of installed capacity equivalent to  their customer's peak load contribution plus an adequate reserve margin,  currently 19 percent. But although it exists for reliability purposes, PJM  curtailed the export of energy outside PJM from PJM-committed installed capacity  on only one day during 2000. 
Logically, the price for installed capacity, like the price of  energy, might have been expected to decrease during 2000. Yet that didn't occur.  As energy prices decreased within PJM, they remained high or continued to  increase in surrounding control areas. Higher prices in the surrounding markets  led some generation owners to de-list their generation committed to PJM in order  to sell out to other control areas without the risk of being curtailed by PJM.  The result was an increase in ICAP prices from an average of $52.86 in 1999 to  $60.55 in 2000. The increase was concentrated over the summer with prices in the  daily markets rising to $177 or more for most of June, July and August. The  increase in ICAP prices raised the cost of supplying many retail customers by  about 1 cent per kWh. The Market Monitoring Unit concluded that the price spikes  over the summer months were a direct result of the opportunity cost associated  with the prices in neighboring control areas.
But the Report's finding that the ICAP market was "reasonably  competitive" seems inconsistent with PJM's conclusion last year that the 2000  ICAP market performed so poorly that it needed a major overhaul. This  inconsistency raises questions about the reasonableness of that portion of the  2000 Report or giving the 2000 ICAP market the PJM seal of approval. 
PJM has invested substantial time and resources since last summer  in an extensive stakeholder process to revise its ICAP rules, especially  concerning the allocation of deficiency revenues and the interval over which  ICAP is purchased. But since the "reformed" ICAP market began operating only  recently on July 1, 2001, it's too soon to know whether it is functioning well  or competitively. We remain skeptical that the PJM prescription cures the  disease, or is merely life support for a dying program.
 
See Spot offer lower prices
Apart from the ICAP market, the  differing prices in forward and spot markets provide substantial explanations  for why electricity suppliers have found it easy to beat the 1996 regulated  generation rate for most utilities but difficult or even impossible to beat the  lower shopping credits. (Shopping credit = 1996 regulated generation rate -  stranded generation cost). Prior to the 2000 summer season, prices in the  forward markets, before anyone knew how mild the weather was going to be,  substantially reflected the high-priced experience of 1999. Because of the high  prices in 1999, energy that was purchased through forward markets - about 82  percent of all energy - was considerably more expensive than the spot prices  turned out to be. Since customers often prefer to lock in a price in advance,  competitive suppliers generally didn't want to provide fixed prices below the  retail shopping credits. If suppliers had relied on the spot market, they could  have offered lower prices. Also, customers who can reduce or shift demand may  well benefit from purchasing more power from the spot market.
 
Recent developments
Both in the East and West coast markets  this week, electricity in daily trading has been near its low for the 52-week  period. Several developments are pushing down the price of wholesale  electricity. Mild weather, falling gas prices, new generation coming online,  increasing demand response and conservation as well as a FERC which understands  that competition must exist prior to price deregulation, are all pushing prices  lower. Moreover, forward market prices for 2002 within PJM are beginning to fall  and are under downward price pressure. 
The new downward trend in forward markets partially results from  moderate prices this summer, even during high demand periods, with prices  generally staying under $150 MWh/$0.15 kWh. A good example of this was July 10,  a relatively hot day with significant demand, which saw prices reach $150 per  MWh for one hour but average $62.78 per MWh for all on-peak hours. 
What's driving forward prices lower?

More efficient generation being installed (below 8000 btu/kWh  as opposed to 11000 btu/kWh).
More ICAP in the market (new capacity estimated at over 4000  MW with load growth at only 1.5 percent or 1000 MW).
More demand-responsive load in the form of 300 additional MW  of Active Load Management.
The addition of PJM West slated for 2002, with lower prices  generally. 
Lower natural gas prices - falling from $4.0561 /mmBtu in July  2000 to $3.29/mmBtu as of July 12, 2001.

This good news, which suggests that retail customers in late 2001  or 2002 may again see retail competitive offers below the Pennsylvania shopping  credits, must be weighed against the troubled ICAP market. ICAP remains an  anachronism. ICAP prices have not returned to competitive levels and remain one  of the significant obstacles to serving retail customers. The forward prices for  ICAP alone have remained above 10 percent of the typical shopping credit. 
Yet even in the world of ICAP there is hope. ICAP prices may be  beginning to soften in the face of a substantial amount of new generation that  is coming online and increased demand response from customers. PJM has  instituted both an emergency and an economic demand-response program, through  which more customers can respond to prices and reduce the price that all  customers pay for electricity. 
Tomorrow's homework
The State of the Market Report contains  plenty of data which confirms that PJM is the country's best-run independent  system operator and best (though still flawed) wholesale market. Prices in the  spot energy market were well below 1996 regulated generation rates, even with  appropriate adjustments. But none of this warrants complacency. Only when PJM  becomes the first market to give consumers the tools they need to change their  demand for electricity, will the wholesale and retail markets within PJM be  FULLY, as opposed to "reasonably," competitive.
A link to download (in .pdf) the PJM MMU Report can be found on  the Internet at: http://www.pjm.com/market_monitoring/reports.html . 

E-cubed is available for reprint in  newspapers and other publications. Authors are available for print or  broadcast.
PennFuture (www.pennfuture.org ), with  offices in Harrisburg, Philadelphia and Pittsburgh, is a statewide public  interest membership organization, which advances policies to protect and improve  the state's environment and economy. PennFuture's activities include litigating  cases before regulatory bodies and in local, state and federal courts,  advocating and advancing
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 - vol3no13_71601.doc