Message-ID: <393029.1075860845223.JavaMail.evans@thyme> Date: Mon, 14 Jan 2002 00:13:45 -0800 (PST) From: william_hogan@harvard.edu Subject: California Market Design Breakthrough Mime-Version: 1.0 Content-Type: text/plain; charset=ANSI_X3.4-1968 Content-Transfer-Encoding: quoted-printable X-From: William Hogan @ENRON X-To: ER:;@ENRON X-cc: X-bcc: X-Folder: \Kenneth_Lay_Mar2002\Lay, Kenneth\Inbox X-Origin: Lay-K X-FileName: klay (Non-Privileged).pst California Market Design Breakthrough William W. Hogan January 13, 2002 A major step forward in California electricity market design appear= s in the proposal offered by the California Independent System Operator (CA= ISO). The CAISO paper is the focus of immediate discussion with its stakeh= olders in anticipation of a market design reform to be filed at the Federal= Energy Regulatory Commission (FERC). This proposal has far-reaching and i= mportant implications. The parallel discussions on standard market design = at FERC must take this CAISO proposal as strong testimony adding support fo= r the Northeast market model that has been shown to work. The Midwest Syst= em Operator should be further encouraged in its market design since it alre= ady incorporates the insights now reported in California. Texans should lo= ok with concern at the Texas wholesale market design that bears a strong re= semblance to the original California model now explained as built on false = premises. The rest of the west should applaud and embrace the simple cando= r of the CAISO and get moving with a standard market design that respects t= he common physics of transmission systems. European regulators and market = participants should save years of agony and expense trying to build a viabl= e electricity market built on the same false premises that California now e= xposes. California's market meltdown starting in June 2000 reverberated aro= und the world. The high prices and market collapse have been cited in many= policy discussions as the reason to reverse course on electricity restruct= uring. As bad as it was, the California market collapse was made much wors= e by factors unique to California in the retail market. And this has distr= acted many from learning the lessons about wholesale market design that hav= e much greater relevance beyond California's borders. California's was the most prominent market design built on the fall= acy that the special characteristics of the electricity transmission grid w= ere just details that could be ignored when designing the market. Built on= a faith that decentralized trading could solve all problems, the original = California wholesale market design embraced a philosophy that emphasized tr= ading and minimized the role of the essential system operator. The key bad ideas have been discussed at length elsewhere (see www = .whogan.com ). Central elements included simplifications supposedly inten= ded to make the market better for traders. In place of the reality of many= locations with important impacts on transmission constraints, the design r= elied on a few large pricing zones. In place of a realistic model of the t= ransmission grid, the design used a so-called commercial network model that= ignored critical features of the grid. In place of point-to-point financi= al transmission rights, the design employed interface rights between zones.= In place of economic dispatch coordinated by the system operator, the des= ign relied on decentralized trading that embraced artificially separated ma= rkets for ancillary services and ad hoc balancing rules for real-time adjus= tments. In place of a coordinated energy spot market, the design imposed a= separate power exchange and balanced scheduling requirements. =20 This flawed wholesale market design did not work. From the very be= ginning, problems appeared and by the end of 1999 the FERC had rejected the= many attempts to fix the superstructure without rebuilding the foundation.= Congestion Management Reform soon became Comprehensive Market Redesign. = Although the reform effort was overtaken by later events, the failure of th= e California wholesale market design should be a warning for every other ma= rket that has embraced its philosophy and adopted its details. Now the CAISO has taken up the serious task of fixing what is broke= n. No longer constrained to be politically correct in defending the ideolo= gical errors that drove the earlier design process, the CAISO reports the s= imple truth. "Upon reexamination of the [Congestion Management Reform] pro= posal ? we find that some of the crucial assumptions underlying the [Locati= onal Pricing Areas] concept break down."(CAISO, p. 13) The assumpt= ions were crucial and flawed. Trying to make the market simpler than is po= ssible turned out not to be possible. "?in reality, the 'simplicity' of the zonal system only appears so becau= se the complexity is assumed away, allowing market participants to ignore i= t in scheduling while the CAISO must manage it through real time adjustment= s and periodic modifications to the rules to mitigate novel gaming strategi= es as they arrive. ... it will be far simpler, and more transparent, to de= sign forward [congestion management] procedures to be as consistent as poss= ible with the real-time operating needs of the grid."(CAISO, p. 14) = Amen. The CAISO paper elaborates on the implications and outlines a new d= irection that is a major break with its past. The same design lesson was l= earned earlier in the Northeast markets including PJM, New York and New Eng= land. Similar insights can be found in well-designed wholesale markets in = other countries, from Chile to New Zealand. Given its prominence in promoting a fallacy, its failure in practic= e, and now its complete reversal on the basic principles, California's turn= around should be a pivotal moment that captures attention in the arcane wor= ld of electricity market design. The changes now proposed for California would be fundamental and sw= eeping. Once reality is acknowledged, the range of possible market designs= narrows substantially. The pieces must fit together. Prices have to refl= ect actual operations. And the system operator must perform certain functi= ons in a way that supports the public interest in an efficient and effectiv= e wholesale market. The centerpiece would be a coordinated spot market org= anized as a bid-based, security-constrained, economic dispatch with nodal p= rices. This can support bilateral transactions with transmission usage cha= rged at the difference in nodal prices. Point-to-point financial transmiss= ion rights would provide the economic equivalent of otherwise unworkable ph= ysical transmission rights. This design works in theory and in practice.= =20 The CAISO proposal is a beginning but still tentative embrace of th= is standard market design along with consistent day-ahead markets and unit = commitment. The CAISO needs to go further, and some of the ideas require c= lose scrutiny. For example, the suggested introduction of an available cap= acity market would be new to California and the concept is not fully develo= ped in the proposal, but this is not much different than the rest of the co= untry where design of capacity markets is problematic. There is much yet t= o be done with the stakeholders and then at FERC. However, the CAISO deserves recognition and support for its candor = and the intelligence of its proposal for the basic elements of the market d= esign. Enlightened market participants and leaders responsible for the pub= lic interest should resist any effort to compromise this essential reform o= r silence the truth. The CAISO has taken a long step in the right directio= n. =20 Everyone interested in the success of electricity restructuring sho= uld hope that Californians complete the journey, soon. We know what to do,= and we can't afford to get it wrong again. The CAISO proposal, "Market Design 2002 Project: Preliminary Draft Comprehe= nsive Design Proposal," January 8, 2002, is available on the web at:http://= www.caiso.com/docs/09003a6080/13/58/09003a6080135879.pdf=20 For further papers on standard market design, see:http://ksgwww.harvard.edu= /hepg/standard_mkt_dsgn.htm=20 William W. Hogan John F. Kennedy School of Government Harvard University 79 John F. Kennedy Street Cambridge, MA 02138 617-495-1317 (o) 617-495-1635 (f) william_hogan@harvard.eduwww.whogan.com =20 orhttp://www.ksg.harvard.edu/whogan