Reed Smith Client Alerts

On June 9, 2015, the Federal Energy Regulatory Commission (“FERC”) issued an order substantially approving PJM Interconnection, LLC’s (“PJM”) proposal, as modified, to make significant changes to its forward capacity market (the “Capacity Performance Proposal”). The capacity market changes – which will be phased-in during a five-year transition period – seek to improve system reliability by providing adequate incentives and penalties for capacity resource performance. The Capacity Performance Proposal was a response in part to the January 2014 polar vortex, during which PJM experienced significant generator performance issues due to a variety of causes, including natural gas interruptions.

The Capacity Performance Proposal includes three core elements:

  1. A New Capacity Product. PJM will introduce a new capacity product – the “Capacity Performance Resource” – which will be subject to heightened performance expectations. Demand resources, energy efficiency resources, capacity storage resources, intermittent resources, and environmentally-limited resources – which in some instances may not be capable of sustained, predictable, year-round operation – will be allowed to combine with each other to offer as an aggregated Capacity Performance Resource.
  2. Increased Penalties and Bonuses. Capacity resources that do not meet their performance obligations during system emergencies will be subject to increased penalties (“Non-Performance Charges”), while resources that exceed performance expectations will be eligible to receive bonus payments.
  3. Net CONE-Based Default Offer Cap. Market power mitigation rules will be revised to allow capacity resources to offer up to a Net CONE-based default offer cap without unit-specific review. Resources will be allowed to offer above the default offer cap if they can demonstrate that such an offer is supported by their costs. PJM asserted that the default offer cap would allow resources to include in their offers costs associated with investments to improve resource performance, and risks associated with non-performance.

FERC found that PJM provided sufficient justification for the Capacity Performance Proposal, presenting evidence that under the current capacity market construct, capacity resources are not sufficiently incented to make the investments required to perform reliably, including during extreme weather conditions. FERC stated that failing to act to address recent generator performance issues and anticipated resource fleet changes could cause reliability issues in the future, at realized cost levels potentially significantly higher to customers in the form of price spikes like those seen in January 2014 and, potentially, in loss of load or other reliability events. FERC approved the Capacity Performance Proposal over the objections of certain load interests and public interest organizations that argued, among other things, that the Capacity Performance Proposal was premature, insufficiently vetted with stakeholders, and a disproportionate and unduly expensive response to the January 2014 polar vortex, and that less extensive measures could be implemented to address performance issues. FERC also accepted in part and rejected in part certain related changes to PJM’s energy market rules.

FERC’s approval of the Capacity Performance Proposal paves the way for PJM to proceed with its annual capacity auction for the 2018/2019 delivery year (i.e., June 1, 2018 – May 31, 2019), which was scheduled to occur in May but was delayed until August 2015 – with FERC’s approval – pending a ruling by FERC on PJM’s Capacity Performance Proposal.

PJM’s Prior Capacity Market Construct Under PJM’s prior capacity market construct, according to PJM, the penalty structure was inadequate and allowed capacity sellers to earn substantial revenues through capacity auctions with little concern of losing significant revenues due to poor performance. PJM noted that for the 2013-2014 delivery year, capacity performance penalties – referred to as “Peak-Hour Period Availability Charges” – totaled approximately $38.9 million, or just 0.6 percent of total capacity revenues. PJM asserted that the existing capacity construct had the potential to jeopardize reliability by failing to provide adequate incentives for resource performance and, therefore, not incentivizing capacity sellers to make capital improvements or to increase operating maintenance to enhance reliability during emergency conditions.

PJM also asserted that the existing capacity market rules – which sought to mitigate the exercise of market power by limiting offers to a resource-specific cost level known as the “Avoidable Cost Rate” – did not allow a capacity market seller the opportunity to recover certain costs associated with improving the performance capability of resources. Specifically, the Avoidable Cost Rate did not take into account costs attributable to natural gas firm transportation arrangements and, according to PJM, failed to allow recovery of capital costs reasonably needed to allow an existing generator to remain in service or improve its peak-hour availability. However, PJM claimed that simply changing the rules to allow inclusion of such costs in capacity supply offers would not be sufficient alone because the inadequate penalty structure would not incent resources to incur such costs. Rather, resources that incurred costs to improve performance would be competing in the capacity market against resources that did not make the same type of investments – the latter, lower-cost resources being more likely to clear in the market and displace resources that made performance-improving investments.

PJM noted that its generator-forced outage rates have increased since its implementation of capacity auctions, including during the January 2014 polar vortex, during which PJM’s forced outrage rate of 22 percent far exceeded its 7 percent historical average. PJM asserted that the deficiencies in its existing rules would have only been exacerbated, if they remained in effect, as additional natural gas-fired resources come online.

Capacity Market Reforms As referenced above, the crux of PJM’s Capacity Performance Proposal, as approved by FERC, involves: (1) the creation of a new capacity product with heightened performance expectations; (2) a recalibration of incentives – through performance bonuses and penalties – to improve capacity resource performance during emergency conditions; and (3) revised market power mitigation rules that allow capacity resources to offer up to a Net CONE-based default offer cap without unit-specific review (and above the default offer cap if a resource can demonstrate such an offer is supported by its costs). These key elements of the Capacity Performance Proposal are summarized below:

New Capacity Product PJM will phase-in a new capacity product – a “Capacity Performance Resource” – that must be capable of sustained, predictable operation that allows the resource to be available to provide energy and reserves whenever PJM determines an emergency condition exists. PJM will have the ability to review and, when appropriate, reject offers from Capacity Performance Resources if such resources:

  1. cannot reasonably be relied on to perform, as required, during emergency conditions;
  2. are purely speculative; or
  3. would otherwise undermine the intent of PJM’s Capacity Performance construct.

PJM’s review will focus on whether a resource can demonstrate that it can reasonably be expected to meet Capacity Performance obligations by the relevant delivery year.

In addition to generation resources, PJM will allow demand resources, energy efficiency resources, capacity storage resources, and intermittent resources capable of meeting Capacity Performance Resource performance requirements to submit offers as Capacity Performance Resources consistent with their average expected output during peak-hour periods. To encourage the participation of such resources – which may not be capable of sustained, predictable operation and may not be able to provide energy during both summer and winter emergency conditions – PJM will allow such resources, along with environmentally-limited resources, to combine with other such resources to submit a Capacity Performance sell offer representing the unforced capacity value of the aggregated resources.

PJM will phase-in its reliance on Capacity Performance Resources during the transition period. For the 2016-2017 and 2017-2018 delivery years, PJM will seek voluntary offers of Capacity Performance Resources to meet the majority of PJM’s reliability requirements. For the 2018-2019 and 2019-2020 delivery years, PJM will procure at least 80 percent of its capacity requirements from Capacity Performance Resources. During this time period, PJM will offer an interim capacity product – the “Base Capacity Resource” – with reduced performance expectations and lower penalty exposure and revenues relative to Capacity Performance Resources. For the 2020-2021 delivery year and beyond, PJM intends to procure all of the region’s capacity requirements from Capacity Performance Resources.

Non-Performance Penalties and Performance Bonus Payments The Capacity Performance Proposal provides for increased penalties for poor performance (“Non-Performance Charges”), along with bonus payments for capacity resources that perform above expectations.

Capacity resources will be subject to Non-Performance Charges modeled after those approved by FERC in ISO New England. The Non-Performance Charges will be based on the expected performance of each capacity resource as compared with its actual performance during an emergency condition. If a capacity resource’s actual performance falls short of its expected performance, the shortfall will be subject to a Non-Performance Charge, absent a valid excuse. Generally speaking, the only valid excuses for poor performance will be performance shortfalls attributable to (1) a planned or a maintenance outage approved by PJM, (2) non-dispatch by PJM, or (3) a reduced-level dispatch by PJM. However, it will not be an acceptable excuse if the resource was not dispatched, or was dispatched down, because of resource parameter limitations specified by the seller, or due to the seller’s submission of a market-based offer in excess of a cost-based offer. Non-Performance Charges will be capped annually through a “stop-loss” limit equal to 1.5 times Net CONE.

Non-Performance Charges will be distributed, as a bonus, to resources that perform above expectations, based on the ratio of the relevant resource’s bonus performance level to the total bonus performance from all resources. Resources that perform well during emergency conditions will be eligible for bonus payments, even if such resources did not have capacity commitments at the time of the system emergency.

Default Offer Cap for Market Power Mitigation The Capacity Performance Proposal provides for the market power mitigation rules for the capacity market to be revised to allow resources to avail themselves of a default offer cap of Net CONE times a Balancing Ratio (a determinant – currently 0.85 – based on the quantity of energy and reserves that a resource must deliver in order to exactly fulfill its capacity obligation within the capacity market design). Capacity supply offers at or below the default offer cap will not be subject to unit-specific review as had previously been the case. PJM asserted – and FERC agreed – that the prior unit-specific review did not take account of the costs of firm transportation of natural gas, and failed to allow recovery of capital costs reasonably needed to allow an existing generator to remain in service or improve its peak-hour availability. FERC agreed with PJM that by allowing capacity sellers to offer capacity at prices up to the default cap (or higher if they can demonstrate that their costs exceed the cap), capacity sellers can submit offers that cover (1) expected new costs of improving resource performance, and (2) the perceived risks of non-performance. FERC found that while continued market power mitigation is necessary due to the structural non-competitiveness of PJM’s capacity market, the default offer cap allows for a simpler mechanism for capacity offer review and mitigation that adequately protects against the exercise of market power.

Chairman Bay’s Dissent Chairman Norman Bay dissented from FERC’s order approving PJM’s Capacity Performance Proposal, arguing that the Capacity Performance Proposal suffers from a serious design flaw and will lead to rates that are not just and reasonable.

Chairman Bay argued that PJM’s current capacity market has worked tolerably well for almost a decade – consistently meeting reserve margins, adding new capacity, and maintaining reliability. Chairman Bay noted that the generator performance issues from the January 2014 polar vortex – which led to $667 million in uplift payments – did not recur in 2015, when generator performance improved substantially due to relatively inexpensive fixes, such as better winterization, additional gas infrastructure, and improved gas-electric coordination.

Chairman Bay took issue with what he characterized as “a serious design flaw” that undermines the goal of providing greater assurance of delivery of energy and reserves during emergency conditions. Chairman Bay argued that the capacity market reforms fail to properly balance the incentives and penalties to ensure resource performance. He observed that the “carrots” – which, due to the default offer cap, include a potential capacity clearing price of Net CONE times the Balancing Ratio (or potentially higher), and performance bonus payments – could be substantially larger than the “stick” (i.e., Non-Performance Charges). Chairman Bay argued that the misalignment of incentives creates an opportunity for capacity resources to profit from non-performance.

Additionally, Chairman Bay argued that the Net CONE-based default offer cap (below which offers are not subject to review) could lead to the exercise of market power due to the structural non-competitiveness of the PJM capacity market. He argued that by removing the mitigation rules that are “usually the safety net,” the Capacity Performance Proposal creates the risk of the unmitigated exercise of market power up to the Net CONE-based default offer cap.

Finally, Chairman Bay took issue with the potential cost of the Capacity Performance Proposal (which PJM estimated would be $1.4 billion to $4 billion), and the failure to determine whether the benefits of the Capacity Performance Proposal outweigh its costs. To that end, Chairman Bay stated that the Capacity Performance Proposal could be viewed as “fix[ing] a several hundred million dollar uplift problem in the energy market with a multi-billion dollar redesign of the capacity market.”

Next Steps As discussed above, PJM, with FERC’s approval, delayed its annual capacity auction for the 2018-2019 delivery year to allow FERC to rule on the merits of PJM’s Capacity Performance Proposal. With FERC having substantially approved of PJM’s capacity market reforms (subject to minor modifications and a required compliance filing), PJM can move forward with its annual capacity auction for the 2018-2019 delivery year. PJM has announced that the annual capacity auction will begin August 10, 2015.

Opponents of the Capacity Performance Proposal can seek rehearing at FERC and, if necessary, appeal FERC’s order in the courts. Although such challenges are unlikely to delay PJM’s implementation of the Capacity Performance Proposal, it may be some time before there is legal certainty.

FERC is also expected to be proactive in overseeing PJM’s implementation of the capacity market reforms and reviewing their effectiveness. To that end, FERC stated in the order that it “can and will actively monitor” implementation of the reforms, and “will act where necessary to modify it to ensure the proper alignment of performance obligations, incentives, and penalties.”


Client Alert 2015-165