Financial Transmission Rights In an LMP System

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Financial Transmission RightsIn an LMP System

• Presentation to ERCOT Texas Nodal Team
• By
• John D. Chandley, LECGOctober 22, 2003
• Austin, Texas

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FINANCIAL RIGHTS Overview

• In an LMP system, Transmission Rights are not
  needed to assure physical delivery or to get
  access to the grid. Physical delivery is assured
  through an ISOs bid-based security-constrained
  redispatch. Rights are needed to hedge the
  financial risks of congestion
• Congestion effects are reflected in the nodal
  spot prices.
• Transmission usage charges are defined by nodal
  price differences between the points of receipt
  and delivery.
• Congestion effects on energy and transmission
  prices are not known until the dispatch and the
  RTO defines prices.
• A system of price hedges -- financial
  transmission rights -- is needed to provide
  advance price certainty and to provide tradable
  property rights for the value of a congested grid.

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FINANCIAL RIGHTS Terms

• A common model of financial transmission rights
  has been implemented in PJM, New York and New
  England. The concept is the same, but the
  terminology varies by region
• PJM -- FTRs fixed transmission rights.
• New York -- TCCs transmission congestion
  contracts.
• New England -- FTRs financial transmission
  rights.
• These are all point-to-point rights, not flowgate
  rights (FGRs).
• In PJM, there are both option and obligation
  FTRs.
• In NY and NE, only obligation FTRs/TCCs are
  offered.
• MISO has proposed both FTRs and FGRs, and both in
  options and obligations. MISO will probably
  start with just FTRs, but this is not certain.

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FINANCIAL RIGHTS Why FTRs?

• Financial transmission rights (or FTRs) serve
  multiple functions
• FTRs enable market participants to obtain
  long-term transmission price certainty, analogous
  to physical transmission rights.
• FTRs allow a party access to the price at other
  locations.
• FTRs allow hedging and trading of rights without
  controlling physical operations.
• So they dont restrict or undermine economic
  energy trading or an efficient dispatch.
• FTRs provide a means to value grid upgrade
  investments, because they price the market value
  of avoiding congestion.

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FINANCIAL RIGHTS Financial Instruments

• FTRs are financial hedges, not physical rights.
• Parties do not have to hold FTRs in order to
  schedule use of the system.
• Hoarding FTRs cant preclude others from using
  the grid.
• FTR holders are not required to trade their
  unused FTRs to obtain their value.
• There is no use-it-or-lose-it rule.
• FTR holders receive the market value of their
  rights even if they do not undertake a matching
  energy transaction.

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FINANCIAL RIGHTS Efficient Dispatch

• As financial rights, FTRs function without
  restricting physical operations.
• FTR holders receive the market value of their
  rights even if they do not undertake a matching
  energy transaction.
• FTRs support efficient dispatch, because FTR
  owners receive the economic value of their
  transmission rights regardless of how their
  generation is dispatched.
• FTRs make trading of both transmission rights and
  energy easier and less costly than with exclusive
  physical rights because transmission usage is not
  tied to FTR ownership.

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FINANCIAL RIGHTS Price Certainty

• FTRs enable market participants to lock-in a
  price for transmission prior to the trading day.
• The owner of a FTR is paid the hourly cost of
  congestion (/MWh) between two locations on the
  transmission system. This is the difference in
  nodal prices.
• If the FTR owners net injections and withdrawals
  match the FTR quantities, then the FTR provides a
  financial hedge for the transmission
  congestion/usage charges -- the equivalent of a
  physical transmission right.
• FTRs provide the financial equivalent of firm
  transmission for market participants that use
  their FTRs to support bilateral transactions.

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FINANCIAL RIGHTS Full Hedging

• FTR owners scheduling transactions between the
  delivery and receipt points designated by their
  FTR will be fully hedged against congestion
  costs.
• Suppose Southeast LSE holds 25 FTRs from Bus L to
  Bus V.
• If the LSE scheduled 25 MW of bilateral
  transmission from Bus L to Bus V, it would pay
  12.50/MWh (the difference in locational prices
  between Bus V and Bus L) in transmission
  congestion charges.
• Southeast LSE would then receive 12.50/MWh of
  congestion rents for this hour (the difference in
  locational prices between the points specified in
  its FTR). The net usage charge for its schedule
  would be zero.

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FINANCIAL RIGHTS Not Use-It-or-Lose-It

• FTR holders will realize the value of their
  financial transmission rights regardless of their
  grid use.
• Suppose Southeast LSE holds 50 FTRs from Bus L to
  Bus V, rather than 25 FTRs.
• If Southeast LSE continued to schedule 25 MW of
  transmission from Bus L to Bus V, it would pay
  transmission congestion charges for this
  transaction.
• Southeast LSE would still be paid congestion
  rents for its 50 FTRs. On a net basis, Southeast
  LSE would be paid 12.50/MW for the FTRs not used
  to hedge its actual use of the transmission
  system.

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FINANCIAL RIGHTS Partial Hedging

• FTR owners scheduling transactions between
  delivery and receipt points that differ from
  those designated in the FTR may still be
  partially hedged against congestion costs.
• Suppose that Southeast LSE continued to own 25
  FTRs from Bus L to Bus V, but that it schedules
  25 MW of transmission from Bus A to Bus V to meet
  its load.
• The LSE would pay 15/MWh (the difference in
  locational prices between Bus V and Bus A) in
  transmission congestion charges.
• The LSE would then receive 12.50/MWh of
  transmission congestion rents for this hour (the
  difference in locational prices between the
  points specified in its FTR).
• The net cost of congestion for its transmission
  schedule would be 2.50/MWh.

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FINANCIAL RIGHTS Unpredictable Constraints

• Importantly, FTRs can hedge grid users against
  transmission congestion even when the
  transmission congestion differs from the normal
  pattern.
• In the example above, cheap energy at L and
  higher load at O have dramatically changed the
  pattern of congestion and increased the
  usage/congestion charges between L and V.
• An LSE owning 25 FTR from Bus L to Bus V would
  still incur no net cost for its bilateral
  transmission schedule from Bus L to Bus V.
• Transmission Charge L to V -62.50
• FTR L to V 62.50
• Net 0.00

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FINANCIAL RIGHTS Revenue Adequacy

• An important property of FTRs is revenue
  adequacy. When there is congestion under
  locational pricing, the differences in locational
  prices will cause the ISO to collect congestion
  rents.
• Congestion rents fund payments to FTR holders.
• Revenue adequacy means that the congestion rents
  the ISO collects will be sufficient for it to
  meet its financial obligations to FTR holders,
  regardless of the actual usage of the grid.

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FINANCIAL RIGHTS FTR Obligations

• The revenue adequacy test for FTRs is relatively
  straightforward to implement if FTRs are defined
  as obligations.
• FTR obligations entitle the holder to payments if
  the price differential is positive, but require
  payments to the ISO if the price difference is
  negative.
• A set of FTR obligations is revenue adequate if
  the set of injections and withdrawals
  corresponding to all of the FTRs is
  simultaneously feasible in a contingency
  constrained dispatch.

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FINANCIAL RIGHTS Revenue Adequacy
Any simultaneously feasible set of net injections
and loads can describe a set of revenue-adequate
FTRs. That set of FTRs will remain
revenue-adequate even if actual grid use differs
from the set of injections and loads matching the
FTRs.
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LOAD FLOW UPON WHICH FTR ALLOCATION IS BASED
(bilateral)
0
K
L
5 MW
25 MW
W
C
M
55 MW
87.5 MW
170 MW
A
Y
7.5 MW
22.5 MW
OUT OF SERVICE
IN CONTINGENCY
Z
75 MW
D
X
42.5 MW
100 MW
25 MW
12.5 MW
B
V
N
70 MW
P
O
SYSTEM LOAD 200 MW
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FINANCIAL RIGHTS Revenue Adequacy

• The diagram above illustrates the power flow that
  results if injections and withdrawals
  corresponding to the FTRs shown below are made.
• Since this flow does not violate any of the
  transmission constraints in any contingency, the
  set of FTRs is revenue-adequate.
• As long as the grids transfer capability when
  determining the day-ahead schedule is not
  reduced, the ISO will be able to meet its
  obligations to FTR holders in full.

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FINANCIAL RIGHTS Revenue Adequacy
If the grid use exactly matches the FTRs, the
amount paid for congestion by each grid user will
exactly match the payments to its FTRs. In this
case, the ISO will collect exactly enough
congestion rents to compensate FTR owners.
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FINANCIAL RIGHTS Revenue Adequacy
Even if the system dispatch does not match the
FTRs, the ISO will still collect enough revenues
to compensate FTR owners. In the dispatch
illustrated above, the ISO will collect 15,725
in payments by loads and 312.50 in payments by
transmission-only customers and will disburse
13,087.50 to generators. The ISO retains 2,950
in congestion rents.
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FINANCIAL RIGHTS Revenue Adequacy
The ISOs obligations under the FTRs that have
been sold are computed below.
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FINANCIAL RIGHTS Revenue Adequacy

• The 2,950 in congestion rents collected by the
  ISO are more than the 2,937.50 in congestion
  rents it owes to the holders of FTRs.
• If the dispatch of the system results in net
  injections and withdrawals matching FTR holdings,
  the congestion rents collected by the system
  operator will exactly offset the payments the ISO
  must make to FTRs holders.
• The crux of the revenue adequacy theorem is that,
  even if the dispatch results in net injections
  and withdrawals that do not correspond to the
  outstanding FTRs, the congestion rents collected
  by the ISO will cover and may exceed its
  financial obligations to FTR holders.

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FINANCIAL RIGHTS FTR Obligations

• FTRs defined as obligations can be partitioned
  and reconfigured for trading, with the
  partitioned FTRs perfectly hedged by the original
  FTR.
• A FTR from A to B entitles the holder to the same
  payments as FTRs from A to C and C to B.
• Any FTR from A to B can be partitioned into two
  FTRs A to Hub and Hub to B.
• Any FTR from A to C can be reconfigured into an A
  to B FTR by purchasing a C to B FTR.
• This property does not extend to FTRs defined as
  options.

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FINANCIAL RIGHTS FTR Options

• In principle, it is possible to define both FTR
  obligations and FTR options. FTR options would
  entitle the holder to the difference in
  locational prices if this difference is positive,
  but would not require payment when it is
  negative.
• The principal difficulty in implementing FTR
  options is the complexity of implementing the
  revenue adequacy test.
• Until recently, this difficulty persuaded NY and
  PJM to offer only FTR obligations.
• However, PJM has developed a method to determine
  the simultaneous feasibility of options.
• PJM now offers both options and obligations in
  its FTR auctions.

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FINANCIAL RIGHTS SFT for FTR Options
A set of FTR options is revenue adequate if the
set of injections and withdrawals corresponding
to the FTR options is simultaneously feasible in
a contingency constrained dispatch -- for all
possible levels of every FTR defined as an
option.1 Instead of verifying that a power flow
correspoinding to the set of all outstanding FTRs
is simultaneously feasible (the SFT for
obligations) the ISO must also verify that power
flows corresponding to all possible subsets of
the set of FTRs are simultaneously
feasible. ________________________________ 1Scott
M. Harvey, William W. Hogan, Susan L. Pope,
Transmission Capacity Reservations and
Transmission Congestion Contracts, August 7,
1996, pp. 45-46.
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FINANCIAL RIGHTS Obligations vs Options

• In general, more FTR obligations can be awarded
  than FTR options.
• This is because the obligations may represent
  counterflow that makes other FTRs simultaneously
  feasible, and . . .
• ISO would collect payments from these FTR
  obligation holders, to help maintain revenue
  adequacy.
• But parties may prefer options in some
  situations.
• So options will tend to be more valuable to the
  market
• And with fewer of them, the prices will tend to
  be higher.

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FINANCIAL RIGHTS Obligations vs Options

• Parties may want either obligations or options,
  depending on their expected hedging needs. For
  example
• An obligation might be preferred to hedge fairly
  constant transactions (e.g., from base-load
  plants to loads).
• The congestion charges and FTR credits would
  always offset each other, even if the congestion
  flow/LMP differences were reversed.
• But an option might be preferred for more
  sporadic transactions.
• Because an obligation might result in payments
  when the transaction wasnt scheduled to offset
  them.
• MISO proposes this split to deal with existing
  contracts.

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FINANCIAL RIGHTS Obligations vs Options

• The ISO might also use obligations and options
  differently when awarding FTRs to those who fund
  transmission upgrades.
• Parties funding the upgrade might prefer the
  options . . .
• But if the upgrade had the potential to make
  pre-existing FTRs infeasible, the ISO would also
  need to allocate offsetting obligations to ensure
  simultaneous feasibility and revenue adequacy for
  all outstanding FTRs.
• Some parties might also want to sell counterflow
  forward through the ISO auction, by accepting FTR
  obligations with likely negative prices for a
  price. We see examples of this in PJM.
• Theyre betting that the price they receive now
  for these obligations will be greater than the
  cost of providing counter-flow later.

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FINANCIAL RIGHTS Revenue Adequacy

• The revenue adequacy theorem assures that the ISO
  will collect sufficient congestion charges to pay
  financial rights holders if the full transfer
  capability of the grid assumed in the FTR
  allocation process is available.
• In practice, the transfer capability of the grid
  may be less than that assumed in the FTR
  allocation, due to
• Unplanned transmission outages or
• Unexpected loop flow (higher than assumed).
• In this situation, the ISO may not collect enough
  revenues in congestion charges to fully
  compensate financial rights holders.

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FINANCIAL RIGHTS Revenue Adequacy

• ISOs have adopted different mechanisms to address
  revenue inadequacy due to outages and loop flow.
• PJM -- make up deficit from other hours in the
  month or year if possible, then prorate all FTRs
  in affected hours for residual inadequacy.
• New York -- make up deficit from other hours in
  month if possible. Add any remaining deficit to
  the transmission owners revenue requirements and
  recover in rates.
• NE-ISO -- make up deficit from other hours in
  month, then from accumulated surplus, then
  prorate all FTRs in affected hours.
• NY ISO is also developing a FTR-based rate
  incentives for transmission owners to minimize
  outage costs. The TO would guarantee revenue
  adequacy during line outages over which it had
  control.

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Flowgate Rights
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FLOWGATE RIGHTS

• It would be possible to use a system of financial
  flowgate rights in conjunction with an LMP
  system.
• LMP transmission charges are determined by
  constraint shadow prices.
• So, LMP transmission charges can, in principle,
  be hedged by holding an appropriate mix of
  flowgate rights for those constraints.
• However, issues surrounding how to pick an
  appropriate mix and what happens if you cant,
  provoked a debate among market designers.

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FLOWGATE RIGHTS WITH POINT-TO-POINT FTRS

• Flowgate rights could be used to complement the
  system of point-to-point FTRs.
• For example, MISO has considered a system that
  would offer both FTR obligations and options and
  FGR obligations and options.
• The MISO proposal would have made FGR options and
  obligations available in periodic (monthly)
  auctions.
• In theory, participants could choose the mix of
  FTRs vs FGRs they wanted through a single
  auction.

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FLOWGATE RIGHTS AS OPTIONS OR OBLIGATIONS

• In principle, financial flowgate rights can be
  defined as both options and obligations, just
  like point-to-point FTRs.
• An FGR option entitles the holder to the payment
  of the constraint shadow price for that flowgate,
  if the constraint shadow price is positive.
• An FGR obligation would entitle the holder to the
  payment of the constraint shadow price if the
  shadow price is positive, but would obligate the
  holder to pay the constraint shadow price if it
  is negative.

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THE EARLY ATTRACTION OF FLOWGATE RIGHTS

• The arguments in favor of flowgate rights have
  paralleled the arguments in favor of zonal versus
  nodal pricing.
• A genuine desire to simplify the market to
  enhance trading.
• A concern that point-to-point trading may not be
  easy.
• A belief (or hope) that congestion will be
  limited to a few predictable commercially
  significant flowgates (CSFs) .
• Parties would only need to get FGRs for a few
  CSFs.
• And parties would know which flowgates to
  acquire.
• Congestion costs on non-CSFs would be rare or
  unimportant (so an uplift would be okay).
• A belief/hope that the flows across the small
  number of constraints are predictable stable
  distribution factors.
• So parties could predict how many flowgates to
  acquire for each constraint/CSF, given their
  schedules expected flows and distribution
  factors.

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ARE THE FLOWGATE ASSUMPTIONS VALID?

• The ERCOT experience with zonal pricing mirrors
  findings in other large regions, such as
  California, PJM and New England, and applies to
  flowgates.
• Congestion generally was much greater than
  expected.
• Intra-zonal congestion was greater than expected.
• So a few zones (and CSFs) were not enough.
• For flowgates, this means there can be many
  constraints (and different types) that can have
  commercially significant consequences, and they
  change often.
• Parties may need many FGRs to hedge each
  transaction, and the binding contingency can
  change quickly, changing the needed FGR mix.
• Failure by participants to fully cover congestion
  on CSFs and non-CSFs with FGRs would result in
  incomplete hedges, unless their costs were
  socialized.
• And failing to price any non-CSF constraints
  could lead to
• Significant uplifts from the ISO managing these
  constraints
• Possible gaming opportunities for market
  participants
• I.e., just like zonal pricing.

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EVOLUTION OF FLOWGATE PROPOSALS

• Flowgate rights proposals have evolved over the
  last 2-3 years of debate, as seen in the MISO
  proposals
• Physical FGRs were abandoned early on in favor of
  financial FGRs no use-it-or-lose-it rule.
• Assumptions that there will only be a few CSFs
  were abandoned. Experience and modeling proved
  this wrong.
• Assumptions that the distribution factors would
  remain stable were abandoned. (Grid
  contingencies change them.)
• Hybrid proposals to fix the number of CSFs and/or
  the distribution factors (monthly) and force the
  ISO to manage the rest and socialize the costs
  were eventually abandoned.
• Proposals now accept little/no socialization.
• Each party has to pay full congestions costs via
  LMP and accept the risks of incomplete (or wrong
  mix of) hedges.

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STATUS OF FLOWGATE DEBATE IN THE EAST

• Prevailing current view FGRs may/may not be
  useful, but if FGRs are offered, the risks will
  be borne by the market participants
• To pick the right flowgates to cover with FGRs
• To pick the right number of rights for each
  flowgate
• To bear the congestion costs for uncovered
  flowgates
• ISO will avoid socializing costs of uncovered
  flowgates
• Given these risks, MISO stakeholders agreed that
  FGRs offered by MISO will be short-run, based on
  short-run expectations
• About where congestion is likely
• About the conditions (e.g., planned grid outages)
  likely to affect distribution factors.
• And FGRs not likely to be used for awards to
  those who pay for grid upgrades. PTP FTRs will
  be used for this.

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INFORMATION ON THE FLOWGATE DEBATE

• For further information on the flowgate vs
  point-to-point FTR debate and the evolution of
  flowgate proposals, an excellent source is
• Letter and e-mail exchange between Drs. Shmuel
  Oren and Larry Ruff on flowgate rights systems,
  available on the following website
• http//www.ksg.harvard.edu/hepg/
• And many other articles/papers on flowgates on
  the same site.
• Also see
• W. Hogan, Getting the Prices Right in PJM April
  2, 1999, found at
• http//ksghome.harvard.edu/.whogan.cbg.Ksg/pjm039
  9.pdf
• S. Harvey, MISO Congestion Management System,
  CM Workshop, Dallas, March 14, 2002, available on
  MISO website.