The Coming Evolution of Rates in an RTO Market by John Winter

The Coming Evolution of Rates in an RTO Market by John Winter

July 08, 2011

The organized market operated by Midwest Independent Transmission System Operator (MISO) has prompted Southern Minnesota Municipal Power Agency to evaluate its rate structure. Before SMMPA joined MISO in 2006, the joint action agency generated most of its needed power, purchased supplemental supplies and delivered energy to its 18 member municipal utilities. Today, SMMPA sells all of its power into the MISO market and purchases all of its needs from MISO.

SMMPA buys and sells power to and from the MISO market at the locational marginal prices (LMP), the energy price at a specific hour and location in MISO’s transmission grid. Under the auction procedures of its day-ahead market, MISO takes bids from generators for each hour of the following day.  The hourly dispatch schedule for the day-ahead is set according to the lowest cost group of bidders who, together, satisfy market demand for the hour. The high-cost bidder within MISO’s day-ahead dispatch schedule, coupled with adjustments for transmission congestion and energy losses, determines LMPs, which vary by hour and across locations.

In the pre-MISO market, the cost of a megawatt-hour of electricity was based on the actual costs incurred for operating generators and purchasing power, typically under bilateral contracts.  Costs were therefore more predictable on an hour-to-hour basis.  Now, during any given hour, the agency may pay substantially more or less for a megawatt-hour of power than it charges its members.

This mismatch prompted SMMPA to review and possibly restructure its rates.

“The agency’s current rate structure works very well,” said John Winter, SMMPA’s director of finance and accounting. “Our rates provide full recovery of the agency’s revenue requirements, which is their primary purpose. However, since joining the Midwest ISO, we have observed a mismatch between MISO market energy prices and our wholesale rates. There were times during the day and year when MISO’s prices were much higher than SMMPA’s wholesale rate and times when they were much lower.”

SMMPA saw that, through its wholesale tariff, it might be able to provide more efficient and effective price signals to its 18 members and thus provide incentives for load shifts or reduced energy use during high-cost periods. But because the agency’s rates did not reflect MISO’s LMP price patterns, members were unaware of the price fluctuations in the market.

“We also believe there is a potential benefit to better aligning our rates with the costs incurred in the energy market in the form of an improved financial risk management profile,” Winter said. “This benefit would be available to the agency and its members even if energy market pricing signals did not make their way to all, or most of, our members’ retail customers.”

SMMPA hired Navigant Consulting to analyze the MISO-SMMPA price disparities and recommend rate options that might work better in the MISO market.

“We started in the fall of 2009 by talking with SMMPA about its rate policy and assisting the board of directors to develop a set of guiding rate principles,” said Pat Hurley, Navigant’s managing director.  “The guiding rate principles gave the board an opportunity to re-examine the purposes of the agency’s rates.”

“SMMPA’s current rate structure includes a generation demand charge so that seemed like the right place to begin the analysis,” said Hurley.  “The demand charge is based somewhat on the traditional fixed/variable cost approach to designing rates. More recently, the market for regulatory capacity, capacity purchased to satisfy reserve margins as required by regulators, has proved to be lower than the agency’s demand charge.

The evaluation of rate structure provided an opportunity to move the demand charge closer to market as well,” added SMMPA’s Winter. “The demand charge was set at the average of the MISO capacity market and the energy market values.”

With SMMPA’s current rate structure, demand bills are based on each member’s load at the time of the agency’s peak hour in the previous summer season, combined with a ratchet.  This value is then compared to the actual peak demand for the current month. The higher value is used to determine the monthly demand charge for each member. “The downside is the annual/monthly peak approach relies on one peak hour per year.  The annual/monthly peak approach watered down the message on price,” said Hurley.

“The ratchet mechanism has been a source of confusion over the years for some members when they try to explain their power bills to their boards and their retail customers,” Winter said.  Members would like to eliminate the ratchet, he said.

Navigant used the average of the five highest coincident peak loads in the summer as the basis for determining each member’s demand charge, which would apply for the following 12 months.

That analysis supported a move to a structure based less on demand and more on energy so that member power costs better reflected prices in the MISO market, Hurley said.

In the second step of its analysis, Navigant examined prices paid by SMMPA to MISO vs. prices paid by SMMPA members to the agency.

“We found some very interesting LMP patterns in the market,” Hurley said. “Averaging the hourly prices for the 2006-2008 period, MISO had two price peaks per day in the winter and one very distinct and steep price peak in the summer. During those peaks, SMMPA was paying MISO more—at times significantly more—for energy than what it was charging its members.  At other times they were paying significantly less.”

“Although SMMPA had time-of-use (TOU) rates, there was just a small difference between its on-peak and off-peak prices,” Hurley said.  “The agency was paying MISO as much as $50 per MWh more for the peak power than it was charging members.”  At other times, the agency was charging members $20 or more per MWh above what it was paying to MISO for the power.

“SMMPA’s rates don’t have to match MISO’s, but they could better reflect MISO price patterns,” said Hurley.  “There is an opportunity for more variation in the way SMMPA charges for energy to reflect the market ups and downs.”

Based on its analysis, Navigant developed demonstration rates to give SMMPA staff and members a feel for what wholesale power bills would look like if SMMPA prices tracked the time-differentiated costs in the MISO market.

The summer demonstration rates are more in line with MISO’s LMP patterns from June through August, with a peak from 9 a.m. to 8 p.m. and a super peak from 11 a.m. to 5 p.m. The winter demonstration rates are more in line with MISO’s LMP patterns from November through April, with two peaks, one from 6 a.m. to 11 a.m. and the second from 5 p.m. to 9 p.m.

“This is not real-time pricing, where the customer is charged every hour for the LMP,” said Hurley. Rather, it’s seasonal time-of-use, or dynamic, pricing, he said.

SMMPA has fine-tuned its demonstration rate structure using an updated database that includes MISO LMPs for five years. And the agency has begun shadow billing. “All our members get a bill by the 10th of each month,” said Winter. “A few days later, we are sending a second bill based on the shadow rates.  We are also supplementing with some additional comparison reports. The aim is to give members a sense of what their bill would be if the new rate structure were adopted.  We won’t be proposing anything specific for approval by our board until the evaluation is completed.”

The SMMPA board and members have been involved in the process of designing and implementing the new wholesale tariff. “The board supported the project and approved funding,” Winter said. “We frequently discussed progress on the project and, as findings materialized, we presented seasonal and time-of-use rate alternatives they may wish to consider.”

Navigant led a series of workshops for member utilities. Some utilities brought retail customers to the workshops. 

The shadow invoices allow agency members to see the market price patterns that SMMPA experiences for the power that they need to serve their customers, said Winter. “If they choose to do so, and they need not take any action, our members will have the opportunity to incorporate the agency’s improved pricing signals into their retail rates and perhaps make investments in hourly demand metering, providing more effective line-of-sight pricing from the energy market to the end user,” said Winter.

“Some members may choose to make changes and some may not.  Either way they will have better information available to use in working with their customers.”

The impact of the rates will take hold once the price signals reach retail customers. They can make changes in operations, equipment, lighting, and time of use.  Changes at the retail customer level “may result in a more efficient system overall,” Hurley said. 

“If in the future retail customers respond to these pricing signals, it is possible that SMMPA’s system load factor may improve and everyone’s costs may then be lower than what they would have been,” said Winter.  “SMMPA may be able to defer the need for future generation and future energy purchases—and better control future costs.”

Hurley explained the pricing cycle this way: “Market prices drive decisions the agency makes on resources. Resources determine what must be recovered through rates. Rates are determined based on resources needed. Members pay those rates and then members decide what rates to charge their retail customers. The retail customers’ response affects the MISO energy market and thus market prices are affected and the cycle begins again.  There are incentives and disincentives at each point in the cycle,” he said.

“It really is all about price signals and customer response,” said Winter. We have suggested to our board that it consider adopting a rate structure that positions the agency for the future. That future will be market-driven, will include appropriate price signals, and will be consistent with the agency’s guiding rate principles. Under those principles, rates must provide the revenue required for SMMPA to consistently achieve its short-term and long-term financial goals as well as reflect a considered evaluation of the apportionment of revenue requirements among its members,” said Winter.

While SMMPA’s demonstration rate structure isn’t novel, it is cutting edge, said Navigant’s Hurley. “The concepts aren’t new, but doing something about them may be. With the emergence of energy markets like MISO, the rules of power supply have changed,” said Hurley. “But many utilities still have rates—like those of
SMMPA—that even though they work very well from a revenue recovery standpoint could be improved to better reflect price patterns in the market.”

The agency’s current rate structure allows for full revenue recovery and is consistent with most wholesale power providers in the industry.

“Nothing is broken,” said Winter. “However, we believe that adopting rates that better reflect energy market patterns will be valuable to our members because of the better information they will receive and may reduce the risks that can come from a mismatch between agency rates and market prices.”

If the board gives the go-ahead, the new rate structure could be implemented as early as 2012.