EXHIBIT 99.374
February 25, 2000
To: Bob Wilson
From: John Flory
RE: CONSOLIDATING DELIVERY POINTS INTO ONE MAJOR HUB
Bob,
We would like your help on something that is related to an issue we have
discussed before.
BACKGROUND
1. In New England and the Midwest we are in the process of putting a power
exchange on the front end of the ISO markets. One concern we have is
that they will eventually have a high number of zones/nodes. At PJM we
saw that forward trading ground to a halt when the nodal market opened
until someone (do you know who?) got the bright idea to consolidate the
nodes in the Western end of PJM as one major hub.
2. One of the big successes in California has been the concentration of
liquidity in the PX Day Ahead market. FERC's order on ISO amendment 23
threatens that by asking the ISO to look at nodal pricing.
3. One of the selling points for the PX is that market liquidity is
critical - especially as it links to the forward markets and mitigates
market power. Moreover, in the California markets, about 80% of the
price risk is flat price risk, not basis risk. (e.g., 90% of the
variance in SP 15 prices are explained by UMCP and 70% of the variance
in NP15 prices are explained by UMCP.) Since flat price risk is the
biggest risk (and effective forward markets are key to managing that)
we are concerned that FERC's obsession with optimizing transmission
(which maybe accounts for 20% of the price risk) may sub-optimize the
over-all energy market (as happened at PJM until the PJM west hub was
created.)
QUESTION
Can you think of a generic solution that:
a. builds on the lessons learned in California and PJM on the
value of concentrating liquidity (and perhaps at PJM on a
method for linking hub to nodes)
b. we could use wherever we go around the country to create a
major hub (or regional index?) that any ISO (or in some cases
PX) congestion management activities are merely creating the
basis differentials off that hub/index
c. addresses the California Amendment 23 situation in which we
find a way to maintain a key role for a deep liquid PX Day
Ahead market - as either the hub or index - and immune to
whatever ISO action taken in creating more zones?
REFLECTIONS
This is related to our earlier conversation about trying to set our 7am Day
Ahead auction as a binding auction. We were toying with making that an auction
for SP15. Indeed
most traders I talk to about this issue recommend we make SP15 as the dominant
hub for our Day Ahead market and Block Forward market - and everything else
could be a basis differential off that. (And of course there are some concerns
about proper price signals under congestion management in the Day Ahead market
as you and Jim K have discussed.)
On the other hand, I also heard that traders were nervous when they heard that
SP15 was going to get re-defined with the introduction of Zone 26 - and that
hurt trading for a while in both the PX Block Forward Market and the OTC market.
Moreover, a highly plausible outcome of the FERC situation is that SP15 will get
broken up into pieces. This would potentially fragment liquidity - and perhaps
SP15 would no longer be large enough to be the dominant zone/hub.
One solution is that we could always have an SP15 index - in which we would
aggregate all the sub-zones of SP15 (presumably on a volume weighted average
basis) to maintain some stability of a PX index. This seems comparable to what
they are doing in PJM.
Given that approach, maybe we should go ahead and include NP15 (along with the
SP aggregate index) so we have an index that has even greater liquidity. If we
go that far, we are almost back to the point of having our UMCP as the reference
index - and maybe we even get the ISO to add Path 15 (which financially is
almost equivalent to being the delivery point for UMCP today.) Path 15 will have
characteristics similar to COB today. (And indeed in the OTC market, people
trade COB north (to south) and COB south (to north) as two different contract
delivery points just like NP15 and SP15).
The advantage of an aggregate hub/index is that it is less vulnerable to
liquidity moving from one delivery point to another (OTC trading has seen
liquidity move from COB to PV, probably largely because of the dominance of SP15
today). The disadvantage is that most traders prefer to have a delivery point
where there is a lot of capability for physical trading (like SP15 today or PV
or Cinergy).
I strongly believe to protect ourselves (and market liquidity/efficiency) we
need some resolution here that makes our 7 am auction a binding auction in some
way. We are already planning daily block markets at various delivery points so
that people could lock in their basis differentials (off UMCP/Path 15, SP15 or
whatever we want the 7am auction to be) or the full delivered energy price.
You may recall in NordPool that people have a choice between Oslo, Stockholm and
UMCP as the cash market price for liquidating their financial contracts. Most of
them use UMCP because it is deeper. (Of course in Norway, the bids for the UMCP
market are also used for Day Ahead congestion management so that eliminates some
gaming potential created by our separation of the energy and congestion
management markets.)
I suspect that if we have both a main delivery hub market and a basis
differential market in the morning before the ISO congestion management market
resolves at 1pm, people would still have the incentive to use both the PX and
the ISO markets. Moreover, the basis differential market (including a forward
market several months into the future) is a
way to protect against the potential eventual thinning of the ISO inc/dec
congestion management market due to FTRs.
So what solution would you recommend for us - in California and as a prototype
across the country - creating an index of several zones/nodes (like PJM west) or
latching on to one major hub or something else?