EXHIBIT 99.7
CALIFORNIA MARKET STRUCTURE
* California energy "market" is complex
- A progression of forward and spot markets
o Day-ahead (consisting of 24 separate hours)
o Hour-ahead
o Real-time
- Separate markets for different commodities
o Multiple forward energy markets (PX and SCs)
o Forward transmission market (ISO)
- Inter-zonal
- Intra-zonal
o Multiple ancillary services markets (ISO or self-provision)
o Single real-time imbalance energy market (ISO).
* The separate markets interact in complex ways
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WINNING IN CALIFORNIA MARKETS
* What strategies will help you prosper in the California market structure?
* Often heard "folk" wisdom:
- "Bid your true costs and you will maximize your profits."
- How did this folk wisdom arise?
- Is it true?
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UNDERLYING ECONOMIC THEORY
* Each individual market is based on a simple supply/demand economic model
- Operate at intersection of supply and demand curves
o Socially optimal production and use
o Market clearing price
[CHART]
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AUCTION THEORY
* Socially optimal production and efficient prices result if producers &
consumers bid true supply and demand curves
- How do you get parties to bid their true costs?
* Auction theory
- Parties bid true supply and demand curves when
o Each party is small compared to the market
o Market is run once (or infrequently)
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REALITY VS. ECONOMIC THEORY
* Supply and demand curves are not smooth functions
- Start-up costs
- Uncertainty
* Published protocols governing California markets from deviate from theory
and physical reality
- Gaps within a single market
o Some markets will not "clear" and may be unstable
o Constraints that couple the schedule in one hour to the schedule
in the next hour are ignored
- Gaps between markets
* Strategies can affect prices
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REALITY VS. AUCTION THEORY
* Simple auction model ignores important features
- Locational market power due to transmission
o Inter-zonal
o Intra-zonal
- Frequency repeated markets
- Interacting markets
o Energy
o Reserves
- Cooperative behavior among participants
* Parties can bid strategically to take advantage of deviations from theory
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BUSINESS RULES
* Published business rules and processes need more work
- Setting ancillary service requirements
- Interaction with WSCC
- Communicating real-time instructions to resources
- Deciding whether a service has been delivered
o Affects compliance and payments
- Penalties for non-performance
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STRATEGIC DECISIONS IN CALIFORNIA
* Decide which forward energy market to use
- PX or another Scheduling Coordinator
* Decide how to use resources
- Bid capacity in one market and withhold in others
o Energy market vs. reserves markets
o Hour-ahead vs. day-ahead vs. real-time
* Tactical decisions
- Adjust bid prices
- Treat physical constraints skipped in protocols when bidding or ignore
and lean on ISO
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STEPS IN DEVELOPING STRATEGIES
* Expert analysis
- Review of business protocols
- Review of competitor characteristics
- Identify potential strategies based on experience
* Analytical tools
- Test possible strategies against computer
- Test possible strategies against user specified counter strategies
* War gaming
- Red team, blue team competition
- Analytical tools provide playing field
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ANALYSIS OF PROTOCOLS
* Gaps in the protocols provide
- Opportunities for increased profits
- Chance for other players to damage your position
* Analyze protocols
- Find leverage points you can use
- Find ways to protect against actions of others
- Develop potential "raw" strategies
o Prioritize for detailed investigation
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DEVELOPMENT OF PRACTICAL STRATEGIES
* Analysis provides the foundation
- Analysis of protocols
- Analysis of competitors
- Gives start for the development of usable strategies
* Development of practical strategies requires detailed simulation of
market operations
- Impact of your actions
- Impact of competitors' actions
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ANALYTICAL BUSINESS MODEL
* Detailed computational business model of the California markets is
required
- Model protocols and market operation in detail
o Strike a balance among
- modeling detail
- computational resources needed
- available market information
- Game theoretic model with multiple participants
* Must accept a wide range of possible strategies and evaluate the
outcomes
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DEVELOPING STRATEGIES
* Develop strategies that allow you to operate within the protocols and
increase your profits
* Workable strategies
- Do not require unrealizable precision in forecasts
- Position you to take advantage of opportunities to increase profits
when they arise
- Limit losses if conditions differ from expected
* Examine the range of strategies that others may use to increase their
profits
- Develop counter strategies that limit their detrimental impact on you
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CHANGING PROTOCOLS
* ISO/PX will recognize holes as they operate
- Revise protocols and systems to close the gaps
- Time lag between recognizing and closing gaps
o Window of opportunity
- Closing one gap may open others
* Market rules will be fluid for a while
- ISO/PX will be pressured to provide new services and capabilities
o Long-term tradable transmission rights
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ONGOING PROCESS
* Strategy development is not static
- Protocols evolve
- Competitors learn new strategies
* Strategy development is an ongoing effort
- Monitor operation of market
- Monitor actions of competitors
- Revise strategies to keep pace
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EXAMPLE OF A PROTOCOL GAP
* Perot Systems discovered a "hole" in the ISO's protocols for buying,
selling, and pricing imbalance energy
- Allowed strategies that would destablize the market
* Points we will cover in this example
- The way the market would have operated
- A simple example of a strategy to increase profits
- The effects on participants, the PX, and the ISO
- Ways to correct the problem
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MERIT ORDER STACK
[CHART]
* Decremental Supplemental Energy Bids
If ISO must reduce energy output
o Incremental Supplemental Energy Bids and Energy from Reserves
If ISO must increase energy output
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EX POST PRICE WHEN OUTPUT IS INCREASED
[CHART]
* If additional energy (AQ MWh) were needed
- ISO would dispatch the incremental bids and reserves with available
energy in order of increasing bid price
- Ex post price would be the price of the most expensive resource
dispatched
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EX POST PRICE WHEN OUTPUT IS DECREASED
[CHART]
* If reduction of energy (-AQ MWh) were needed
- ISO would dispatch the decremental energy bids with available
reduction in order of decreasing bids price
- Ex post price would be the price of the least expensive resource
dispatched downward
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OUTPUT INCREASES THEN DECREASES IN HOUR
[CHART]
* Increased output of +AQ(1) followed by decrease of -AQ(2) within the hour,
with AQ(1) < AQ(2)
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CONTROLLING THE REAL-TIME MARKET
* The structure of the real-time imbalance energy market would have
permitted strategies by which a participant could have:
- controlled the ex post price
- dumped power on the real time market at a very high ex post
price
- caused wild swings in the ex post price
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SIMPLIFIED EXAMPLE
* Participant P1 has three generation units:
- Unit 1 with operating limits of [100 MW, 2000 MW]
- Unit 2 with operating limits of [100 MW, 2000 MW]
- Unit 3 with operating limits of [50 MW, 100 MW]
* P1 bids to sell 2150 MWh in the forward market (for 1 hour)
- P1 intentionally forgoes the chance to sell an additional
1950 MWh in the forward market
- P1 will use this capacity to control the ex post price and
sell high-priced imbalance energy
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SCHEDULE AND SUPPLEMENTAL BIDS
Schedules from Forward Market
[BAR CHART]
* Supplemental Energy Bids:
- Unit 1: Decremental only
$10,000/MWh for 100 ( < or = to) x ( < or = to) 2000
- Unit 2: No Bid
- Unit 3: Incremental Micro Bids
$ 0/MWh for 50 ( < or = to) x ( < or = to) 55
$10/MWh for 55 ( < or = to) x ( < or = to) 60
*
*
*
* Suppose that Unit 1 submits highest priced decremental bid to ISO
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CASE 1: ISO NEEDS ADDITIONAL ENERGY
[BAR CHART]
* Suppose ISO needs 1,000 MW more
* ISO will use incremental bids (including Unit 3 which gives P1 information)
* P1 starts to increment Unit 2 on its own
* ISO first backs down previously incremental units
* Unit 2 reaches a point at which ISO will have decremented all previously
incremented units and starts reducing the highest priced decremental bid
(Unit 1)
* P1 sells 1,000 MWh in imbalance energy market
* Ex post price set by last unit decremented ($10,000/MWh)
* P1 is paid $10,000,000
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CASE 2: ISO MUST REDUCE OUTPUT
[BAR CHART]
* Suppose ISO must reduce by 1,000 MW
* ISO will use decremental bids and back Unit 1 down by 1000 MW
* P1 would have to pay the ISO $10,000,000 to replace Unit 1's output
* P1 eliminates this risk by simultaneously increasing Unit 2 by 1000 MW
* P1's total real-time output is at scheduled value, so P1's net payment to ISO
is $0
* ISO has problems:
- Imbalance persists
- ISO leans more on regulation
- Regulation capacity requirements increase so ISO must buy more
- Ancillary service costs increase
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EFFECTS ON OTHER PARTICIPANTS
* Suppose that a participant usually experiences appreciable error in
forecasting its real-time load
- It would buy and sell energy on the imbalance energy market due to
forecasting errors
- It could experience extreme peaks in its payments for imbalance
energy if ex-post price can rise very high
- It could insure against these peaks:
o Always schedule more energy in the forward market than it expects
that it will need in real-time
- Usually sells energy on imbalance energy market (or at
least reduce the size of its purchases)
- Additional costs if forward price > ex post price, but
reduces its payment peaks for imbalance energy
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EFFECTS ON PX
* PX participants would be exposed to swings in ex post price
- PX participants could insure themselves against effects
- Grouping participants reduces the amount of extra energy that must be
scheduled and the expected cost
- PX cannot take such a position to insure a group
* Power Marketer (PM) can take a position in a forward market to insure its
participants
- PM takes a position in forward market to sell insurance that PX
cannot sell
- PM attracts participants from the PX
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EFFECTS ON ISO
* Parties could have tried to dump considerable energy on the ISO's
imbalance energy market
- ISO would have needed to decrement energy production more than
anticipated
- Decremental supplemental energy bids are voluntary
o No concept of the ISO buying "negative reserves" to ensure that
it will have enough units that it can decrement
o ISO may have to lean more on regulation
o ISO may have to administratively reduce some generation
- Real-time imbalance energy market may "fail" to set an ex
post price based on decremental energy bids
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ISO's Correction
* The ISO has revised the protocols to make a market that appears to clear:
- Calculate the market clearing price (MCP) that would result if the
ISO were to clear the real-time energy market
- For incremental supplies with price less than MCP, raise the price of
the supply to the MCP
- For decremental bids with price more than MCP, lower the price to the
MCP
* Effect on strategies unclear
- No aware of any strategic studies
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"RE-PRICED" MERIT ORDER STACK
[CHART]
* Decremental Supplemental o Incremental Supplemental
Energy Bids Energy Bids and Energy from
Reserves
If ISO must reduce energy If ISO must increase energy
output output
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ANOTHER PROTOCOL GAP
* Perot Systems discovered a "hole" in the PX's protocols for setting zonal
energy prices when there is congestion.
- Adverse interaction with a hold in the ISO's protocols for setting
congestion usage charges.
* A small participant could control prices in CA and destablize the PX
market.
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SCHEDULES AND ADJUSTMENTS BIDS
* Each SC develops a preferred schedule for its forward market.
- SC's generation equals its demand in each hour.
* ISO combines SCs' schedules and checks for transmission congestion.
- SCs provide adjustment bids that are used to eliminate congestion.
The bids give:
o Cost of increasing output from a resource.
o Savings due to reducing output of a resource.
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EXAMPLE WITH CONGESTION
[CHART]
Transmission limit is violated, so ISO must reschedule to eliminate congestion.
How should the ISO reschedule the resources?
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MARKET SEPARATION
* The ISO runs a transmission market.
- ISO adjusts SC's schedules to maximize value of transmission usage
and eliminate congestion.
- ISO does not become involved in forward energy markets by arranging
trades.
o ISO keeps each SC's generation in balance with its demands
(market separation constraint).
* The SCs' adjustment bids are interpreted as implicit bids to use
transmission capacity.
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EXAMPLE WITH CONGESTION
[CHART]
PX values transmission capacity at $65/MW - $30/MW = $35/MW
SCI values transmission capacity at $35/MW - $10/MW = $25/MW
ISO allocates transmission to most valuable use (PX).
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RESCHEDULE TO RELIEVE CONGESTION
[CHART]
ISO shifts 2 MWh of SC1's generation from G to G
SCI,A SCI,B*
ISO does not arrange trades to lower cost.
Arranging such trades is left to the SCs who run the energy forward markets.
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CONGESTION USAGE CHARGES AND ZONAL MARGINAL COSTS
* Usage charge for sending energy from one zone to another is difference
between zonal marginal costs.
* Zonal marginal costs depend upon SC:
- the SCs' forward energy markets are separate.
* Differences do NOT depend upon the SC.
- Cost of moving a MWh of energy from one zone to another is
independent of SC.
* In the example, usage charge is $25/MWh.
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PX ZONAL ENERGY PRICES
* PX sets zonal energy prices so that:
- Zonal energy price in each zone ( > or = to ) most expensive energy in
each zone
- Differences between zonal energy prices equals ISO's usage charge
between the zones
- Zonal energy prices as low as possible subject to above.
* Zonal energy prices in example:
- Zone A: MC(PX,A)=$40/MWh
- Zone B: MC(PX,B)=$65/MWh.
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CHECK OF MARGINAL COSTS FOR PX
- - To calculate MC(PX,A) increment D(PX,A) by 1 MWh:
o PX increases G(PX,B) 1 MWh @ $65/MWh and sends to A.
o Flow from B to A provides 1 MW of capacity from A to B.
- SC1 increases G(SC1,A) 1 MWh @ $10/MWh.
- SC1 decreases G(SC1,B) 1 MWh @ $35/MWh.
o MC(PX,A) is $65/MWh + $10/MWh - $35/MWh = $40/MWh.
- - To calculate MC(PX,B) increment D(PX,B) by 1 MWh:
o PX increases G(PX,B) 1 MWh@$65/MWh.
o MC(PX,B) is $65/MWh.
- - PX's cost of sending energy from A to B is
MC(PX,B) - MC(PX,A) = $25/MWh.
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HOLE IN PX PROTOCOL
* The PX Protocols required non-negative zonal energy prices.
* If insufficient adjustment bids to alleviate congestion on a path, ISO
would:
- Allocate transmission capacity to SCs pro rata.
- Set a fixed default usage charge on the path.
o ISO was planning to use $250/MWh as the default.
- ISO and PX protocols could interact to destablilize the market.
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GAME ...
* A relatively small PX participant could purposely congest a small
interzonal path.
- Consider Silverpeak intertie (30 MW capacity).
- Gamer could bid 250 MWh in PX auction at $0/MWh
o Assume that he wins and PX UMCP=$25/MWh.
- Gamer wold schedule 50 MWh at Silverpeak intertie and 200 MWh in
California (SP15).
o Silverpeak is congested as a result.
- Gamer would not give a decremental adjustment bid on the 50 MWh he
schedule at Silverpeak.
o ISO will use pro rata allocation and set default usage charge on
Silverpeak intertie=$250/MWh.
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..... GAME ...
[CHART]
* ISO shifts 20 MWh of Gamer's generation from Silverpeak.
* ISO sets default usage charge = $250/MWh on path since it ran out of
adjustment bids to reduce generation at Silverpeak.
* Assume that ISO uses Gamer's adjustment bid in SP15 to replace the 20 MWh
to keep the PX in balance.
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..... GAME
* PX requirements on zonal prices:
- ZMCP (SILVERPEAK,PX) > or = to $0/MWh.
- ZMCP (SP15,PX) > or = to Most expensive energy purchased
in zone (assume that this is $30/MWh).
- Difference in PX zonal prices equals ISO usage charge.
o ZMCP (SP15,PX) - ZMCP (SILVERPEAK,PX) = to $250/MWh.
* Result
- ZMCP (SILVERPEAK,PX) = to $0/MWh
- ZMCP (SP15,PX) = to $250/MWh!
* Gamer was able to increase the price it receives for the 200 MWh it
scheduled in SP15 by $220/MWh.
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CORRECTIONS
* PX removed requirement for non-negative prices
- If a participant does not give a decremental adjustment bid, he is
saying that he will sell the energy at any price.
- This price can be negative -- i.e., he will pay the PX to take the
energy.
* When the ISO runs out of adjustment bids, the ISO sets the default usage
charges based on the adjustment bids that it had received and used.
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