By Rory D. Sweeney

Fighting a PJM proposal to impose uplift costs on up-to-congestion trades, the Financial Marketers Coalition last week enlisted one of the intellectual pioneers of electricity markets in its defense.

Presenting the conclusions from his white paper on virtual trading, Harvard economist William Hogan told the Energy Market Uplift Senior Task Force that PJM should eliminate uplift costs from all financial transactions rather than extending them to UTCs.

UTC volumes have withered since September 2014 after PJM Traders Continue to Shun UTCs on Uplift Fears.)

Hogan said PJM’s October 2015 paper, which recommended charging UTCs, was too narrowly focused and failed to acknowledge some of virtual transactions’ benefits, including countering market power, improving market efficiency and hedging real-time market risks.

“Uplift can arise for many reasons. … The focus on deviations, which are used for allocating uplift costs, do not go hand in hand with added uplift costs,” said Hogan, the Raymond Plank Professor of Global Energy Policy at Harvard’s John F. Kennedy School of Government. “We want to be careful about using [deviations] as a measure of failure of the system and then using that to allocate a subcategory of the costs.”

He suggested exempting virtual trading from uplift charges and allocating the costs instead to the “real-time gluttons” — consumers who won’t respond to even the most extreme price signals.

It’s “foolish,” he said, to think that the costs could be allocated anywhere other than consumers. “In the end, in equilibrium, the load’s gotta pay,” he said. “Aggregate efficiency should be the standard.”

‘Reversal of the Conventional Wisdom’

Hogan’s stature — Public Utilities Fortnightly has called him “the chief architect of wholesale electric market design in the United States” — makes him a valuable ally. Among his other clients have been numerous utilities, MISO, ISO-NE and the Electric Power Supply Association, which enlisted him in its unsuccessful bid to eliminate FERC oversight of demand response. He was also among the experts who defended Richard and Kevin Gates’ Powhatan Energy Fund in their high profile campaign against FERC market manipulation charges.

Hogan conceded that his position on virtual trading represents a “reversal of the conventional wisdom.” He rejected arguments by those who contend that virtual bidding provides no significant benefits and thus extracts money via what a 2015 paper by Massachusetts Institute of Technology economist John E. Parsons and three FERC analysts termed “parasitic” profits.

He highlighted two studies — one focused on California and the other on ISO-NE — that concluded virtual transactions increased price convergence between the day-ahead and real-time markets and reduced dispatch costs. While “not a dramatic number — a single-digit percentage of improvement” — the studies showed how virtual transactions help smooth out the “lumpiness” of unit commitment costs, Hogan said.

“The inclusion of the convergence bidding and the virtual bidding made the whole system operate more efficiently,” he said. “Neither of these studies go all the way, but they are very suggestive.”

Hogan also took on PJM Independent Market Monitor Joe Bowring, who contends that UTC transactions are increasing shortfalls in FTR funding and that PJM should consider NYISO’s model, which limits virtual transactions to zones or hubs. (See PJM Ponders Changes to Virtual Trades, DA Market.)

Hogan said new recommendations contained in Bowring’s 2015 State of the Market report would result in the “undoing [of] financial transmission rights.”

“Forgetting … the larger context linking the market design economics to engineering principles can result in analyses and recommendations that can neglect the requirements of efficient electricity market design and recreate problems already solved,” Hogan wrote. (See “Financial Transmission Rights,” Bowring Urges Return to ‘Fundamentals’.)

Hogan was more conciliatory toward PJM’s 2015 paper, which he credited as “generally supportive of the contribution of virtual transactions as improving overall market performance” despite being issued “in a context where virtual bidding is under attack.” (See PJM Suggests Changes to Virtual Transactions.)

But he said the examples cited in PJM’s report “do not provide a framework for evaluating the overall cost and benefits of virtual transactions,” a task he acknowledged “is not easy.”

“The limited available analyses from other regions indicate that the benefits are material and outweigh the costs, but no available studies cover all the relevant issues.”

Focus on Deviations

PJM’s uplift charges totaled $314.2 million in 2015, down from $960.5 million in 2014, when costs spiked as a result of the polar vortex.

Because LMPs do not cover all production costs, uplift payments — or “residual” charges — are required to make generators whole. The biggest component of PJM’s uplift charges is the balancing operating reserve (BOR), the costs of which are allocated based on real-time deviations from day-ahead schedules.

Hogan said allocating uplift costs according to the deviations is inappropriate and “particularly problematic for virtual transactions, which by design involve a 100% deviation.”

He also said PJM’s cost allocation “does not arise from any fundamental model … [implying] that the allocation method is more an administrative compromise than the product of a principled analysis.”

Some deviations are expected and inevitable, Hogan said, citing the “lumpiness” of unit commitment costs. As an example, he described a generator being priced too high to clear the day-ahead market but clearing during the later reliability run.

Because uplift is a result of residual costs, attempting to figure out the cost causation “is a fool’s errand,” Hogan said.

“The important question is the aggregate net benefit of virtual transactions, not the residual cost. If virtual transactions increase the net benefits in the market, then there is no incentive-based reason to assign additional costs to virtual transactions.

“Allocating the uplift costs to network connection charges would be better than adding to a so-called ‘uplift’ charge on load billed per megawatt-hour,” he continued. “If an uplift charge is necessary, it should be allocated to the least price-responsive loads. If a nondiscriminatory uplift charge is required, it should be spread across the widest possible base of loads that cannot bypass or avoid the charge.”

Hogan said the “principal problem” PJM identified with virtual transactions is a “computational burden that would be only indirectly affected by uplift allocations and could be addressed through other means with fewer negative consequences for the broader market design, such as by continuation of bidding budgets that allowed flexibility in the choice of virtual transactions.”

Recommendations, FERC Action

In addition to calling for an end to uplift charges, Hogan identified two other recommendations that differed from PJM’s:

• Analyze the impact of virtual trading on unit-commitment decisions rather than assume differences between day-ahead and real-time conditions. “The PJM analysis refers to the importance of commitment decisions throughout the report but does no explicit analysis of those commitment decisions,” Hogan said. “The absence of the analysis undermines the PJM conclusions.”
• Increase the number of locations at which virtual transactions may be placed.

FERC is long overdue to issue a ruling in its Section 206 inquiry. In opening the docket, FERC said it would rule within five months after it receives comments following a technical conference. The conference was held in January 2015 with follow-up comments due at the end of May.

However, the commission may be delaying action to see what emerges from PJM’s stakeholder process. The task force, which has been discussing the issues since July 2013, is scheduled to meet next on Sept. 1.