The world's biggest power market has a problem. For over a decade, PJM – the wholesale electricity market that serves 13 eastern US states and the District of Columbia – has allowed market participants to trade financial transmission rights (FTRs), instruments that allow companies to hedge against the costs of congestion on the PJM grid. But in recent years, PJM's mechanism for funding payments to FTR holders has broken down, and that has many market participants upset, including both hedgers and financial traders.
From 2010, when the problem first emerged, to January 2014, firms holding FTRs received roughly $1.1 billion less in FTR revenues than they should have, according to an analysis of data from PJM and Monitoring Analytics, PJM's Pennsylvania-based independent market monitor. Yet the problem shows no signs of going away. Though PJM formed an ‘FTR Task Force' to study the problem, the group failed to agree on a proposed solution to address the market design flaw behind the FTR funding shortfall, due to a deadlock among its members.
Ohio-based utility FirstEnergy grew so exasperated it filed a series of complaints about the problem to the US Federal Energy Regulatory Commission (Ferc). By the end of 2013, the company had suffered a total revenue shortfall of more than $65 million on its FTR portfolio, according to Don Moul, vice-president of commodity operations at FirstEnergy Solutions, a subsidiary of the company that supplies power to around two million customers.
"FTRs are an important tool to help mitigate congestion risk in the PJM energy market," says Moul. "This is particularly true for suppliers that use generation to hedge their retail load obligations. When FTRs are underfunded, this reduces the effectiveness of this risk mitigation tool."
PJM expresses sympathy with FTR holders and says it is trying to find a path forward. The underfunding problem "continues to be a very concerning issue for PJM," says Stu Bresler, Pennsylvania-based vice-president for market operations at PJM. "We continue to do everything we can on a day-to-day basis to make sure that FTRs are funded to the greatest level possible."
The biggest question is, if FTR holders aren’t responsible for real-time congestion, who should be?
The ABCs of FTRs
Like other regional transmission organisations (RTOs) across the US, PJM runs a nodal electricity market. Each of the numerous points in its grid has a different locational marginal price (LMP) for power. The LMP contains both an energy component – a system-wide value that depends on overall supply and demand in the network – and a congestion component, specific to each node, which increases when it becomes more costly to deliver power to that location.
Any FTR contract specifies a path from one node to another, and how much the FTR should pay out depends on the difference in day-ahead LMPs along that path. Typically, FTRs are associated with paths that run from a source to a sink – that is, a point where power is generated to a point where it is consumed – and they make money when the LMP at the sink exceeds the LMP at the source. However, there are also so-called ‘counterflow' FTRs that run in the opposite direction.
PJM holds periodic auctions to sell FTRs of various terms, ranging from one month to three years. Besides generators and power suppliers, which use FTRs to hedge their congestion costs, participants in the auctions include hedge funds and proprietary trading firms. Such players are drawn to FTRs because they are a purely financial instrument, which do not require the ownership of physical assets, and because they lend themselves to quantitative trading strategies.
Whenever PJM auctions off FTRs, it runs an elaborate model to ensure that the revenue it expects to collect from congestion payments will be adequate to cover payouts to FTR holders. Crucially, though, the model focuses on congestion in PJM's day-ahead market, and not in the real-time market, so when unexpected conditions arise in real time, it can scramble PJM's plans and cause underfunding.
Under PJM's current market rules, the pool of money used to pay out FTR holders comes from three sources: surplus revenues from the FTR auctions, day-ahead congestion payments and real-time congestion payments. In past years, that has generally worked well. From July 2006 to February 2010, FTRs were 100% funded, according to PJM data. But starting in 2010, the payout ratio collapsed. In the year from June 2012 to May 2013, it sank as low as 67.8%. Since then, it has recovered somewhat, reaching about 80% in January 2014, according to data from PJM and Monitoring Analytics.
PJM blames the drop-off on real-time congestion, which in recent years has often been a negative number. Positive congestion means PJM is collecting money from market participants for congestion, while negative congestion means PJM is paying money out. The reasons why that number has turned negative revolve around the dramatic changes seen in the US power industry over the past half-decade.
Gone with the wind
One of the key industry shifts that has contributed to the FTR underfunding problem has been the huge build-out of wind generation in the Midwest, within the territory of PJM's neighbouring RTO, the Midcontinent Independent System Operator (Miso). Wind power is intermittent and can create unexpected congestion in the real-time market that is difficult, if not impossible, to model.
Wind power from Miso often manifests itself in PJM in the form of ‘loop flows', with power flowing across the border from Miso into the western parts of PJM, before heading back out into Miso again. That clogs up PJM's transmission lines. "It's really Miso generation to Miso load transfers that are essentially utilising the PJM transmission facilities to get there," says Bresler. "It takes transmission room that PJM market participants can't use, so we can't collect congestion for it."
The shale gas revolution, which has made natural gas a more attractive fuel for power generation than coal, has also contributed to the shift. According to an April 2012 report by PJM on the causes of FTR underfunding, the relative decline in competitiveness of coal-fired power plants in the west of PJM, compared with natural gas-fired plants in the east of PJM, has led to "reduced internal PJM west to east flows" and altered long-established patterns of congestion.
There are other, more mundane reasons, which have fuelled real-time congestion in PJM. According to Bresler, these include a major build-out of new transmission capacity, which has caused construction-related outages; an unusually large number of maintenance outages; and finally, the derating of existing transmission lines, in which grid operators downgrade a line's official capacity.
The ultimate solution to FTR underfunding will be the revamping of PJM's transmission grid to account for all of the changed flows, Bresler believes. "The best fix is going to be once the construction projects are finished and we actually have more transmission system capability," he says. "That's really going to be the end-all, be-all fix."
Market participants acknowledge there are physical reasons behind the FTR underfunding issue, but they argue that PJM must also fix its market design. "PJM's answer fails to address the problem," says FirstEnergy's Moul. "It's not what's happening on the system, or what PJM is doing to address conditions on the system. It's the fact that the tariff requires PJM to pay the money that should go to FTR holders to someone else."
FirstEnergy and a number of other FTR holders support modifying the mechanism PJM uses to fund its FTRs – namely, by removing real-time congestion from the mix, so FTR holders are not on the hook when real-time congestion turns negative. But that has proved contentious, and when market participants have discussed making such a fix, their talks have ended in deadlock.
The difficulty is determining a fair way to allocate the costs of real-time congestion, says Jason Barker, director of wholesale market development at Exelon, the Chicago-based electricity firm.
"The biggest question is, if FTR holders aren't responsible for real-time congestion, who should be?" Barker asks. "In the absence of a known root cause for real-time congestion, it seems to make sense to socialise it across the load base, which would bring FTRs back closer to being fully funded, make them a more effective hedge, and ultimately take [the] risk out of the pricing of the load."
However, when the FTR Task Force presented proposals along those lines to PJM members in December 2011 and December 2012, they went down in defeat. According to Barker, most market participants are simply unwilling to bear any additional costs associated with real-time congestion, so the status quo has remained in place. "There are winners and losers whenever you change the market rules," he says.
FTR holders' main hope right now rests on FirstEnergy's latest complaint to Ferc. Filed on February 15, 2013, the complaint argues that PJM's rules on the funding of FTRs are "unjust and unreasonable" because they unfairly force FTR holders to bear the burden of real-time congestion costs. In an order issued on June 5, 2013, Ferc dismissed the complaint, siding with PJM's argument that 100% revenue adequacy for FTRs was a goal, not a guarantee. Since then, however, a number of major FTR traders and utilities have asked Ferc to reconsider its decision. At the time Energy Risk went to press, it was unclear whether Ferc would grant the FirstEnergy complaint a rehearing.
PJM rejects the claim that its rules are unjust and unreasonable – but it concedes that there are probably more rational ways to allocate the costs of real-time congestion. "We believe that the FirstEnergy proposal would be a beneficial market design change," says Bresler. "Assigning negative balancing congestion to FTR holders probably doesn't make a whole lot of sense anymore."
Living with underfunding
For the time being, FTR holders must wrestle with the possibility that the instruments may not pay out as much as they theoretically should.
Some financial traders have responded by exiting the market altogether. "Our company has pulled out from the PJM FTR market because of the underfunding," says a Pennsylvania-based trader with one proprietary trading firm. "You can't hedge what percentage will actually be paid out. If you can only get 50% of your FTR payment, then there's really no way you can price that into a bid and effectively buy or sell an FTR. It's not worth the risk to do that."
Physical market participants, which use FTRs to hedge against specific congestion risks in PJM, have less choice in the matter. "It's certainly fair to say that FTR underfunding has affected the vitality and the usefulness of FTRs as a congestion hedge, and that obviously we've had to make business decisions that reflect the degraded value of FTR payouts," says Exelon's Barker.
Market sources suggest that one beneficiary of the FTR underfunding problem is Nodal Exchange, the Virginia-based futures exchange that specialises in power. Nodal Exchange offers contracts for energy plus congestion at selected nodes in PJM, a product sometimes described as an ‘FTR lookalike' contract. Such contracts can be used to hedge congestion risks, but without the risk of underfunding, according to Paul Cusenza, chief executive of Nodal Exchange. "There are certain entities that look at [FTR lookalike contracts] as a mechanism to get more certain pricing than would otherwise be available," he says.
Meanwhile, PJM says it is still grappling with FTR underfunding and continues to examine potential market design fixes. "It's not something that we have stopped analysing," says Bresler. "We certainly continue to look at this and see if there are ways we can make it better."