Should Seattle City Light join the energy imbalance market?

Since last September, Seattle City Light has been trying to convince the City Council’s Energy and Environment Committee that it should be allowed to join the California Independent Systems Operators (CAISO) Energy Imbalance Market (EIM). On its face, it seems like an easy decision, and if SCL had done a better job on its initial pitch to the Council it might have gone through quickly. But they didn’t, and the Council members asked for more information. As the details have emerged, the case for joining the EIM has become murkier. It’s an interesting case study on the state of the power industry, and it points to some big challenges for Seattle City Light.

Let’s unpack this.

Preface: Robert Cromwell, Director of Regional Affairs and Contracts in Seattle City Light’s Power Management Division, has been very generous with his time and in providing background materials on SCL’s plans and internal analysis related to joining the EIM. He and SCL deserve credit for being open and willing to discuss this issue at length.

Let’s start with some background on the power industry. In the western section of the United States there are dozens of individual utilities and operating companies that are linked together with transmission lines to form a “grid” called the Western Interconnection. The transmission lines allow them to buy and sell power between entities. Those sales are transacted on one of several “markets” overlayed on the grid. A particular market might be used by interconnected providers in a particular region (such as California), and they allow for purchasing a specific amount of power (in megawatts) for a specific period of time such as an hour or a day.  Not all power is bought and sold on bidding markets such as these; for example, Seattle City Light has a long-term contract for large amounts of power (about 40% of SCL’s capacity) from the Bonneville Power Administration, which manages hydro power generation along the Columbia River.  But the value of having trading markets is that they allow for the price of power to fluctuate over time with supply and demand.

There are several sources of power generation in the western grid, including coal, oil, natural gas, nuclear, hydro, solar and wind resources. The cost to generate power varies across each of these sources: coal, oil, gas and nuclear all consume fuel, which is an additional cost on top of the basic machinery, infrastructure and maintenance required for all power sources. But the sources also have different availability: the “thermal” sources have high reliability, meaning that their power is always available. Solar, wind and hydro fluctuate based on the season, the weather, and (for solar and wind) the time of day. And of course the environmental impact also varies across the sources.

A utility such as Seattle City Light needs to provide reliable power to a set of residential, commercial and industrial consumers, which means it needs to acquire a combination of its own generation capacity and contracts for power from other sources that will both cover the needs and “flex” up and down as demand changes. SCL has its large contract with Bonneville; it also has several smaller long-term contracts for power. On top of that, it owns and manages its own set of hydro generation sites on rivers in the Pacific Northwest.

That brings us to the notion of an Energy Imbalance Market.  Here’s the key insight: retail utilities like SCL need to instantly and constantly adjust the total amount of power being supplied into their system to match the total demand from their customers. This is called “balancing.” SCL buys power in increments down to the hour, but they have to fine tune minute-by-minute to balance the load so they modulate their own power generators to even it out. For SCL it’s actually a pretty simple mechanism: they change how much water is flowing through their dams.

Every other utility does the same thing with the power sources under their control in order to balance their load. But while hydro power is very well suited to balancing, the older coal, oil and gas generators are not: they’re either on or off, and it can take up to half a day to “cycle up” or “cycle down” a coal generator (and cycling is particularly rough on the equipment, adding significant wear and tear). To the extent that each utility is independently balancing its own load, the system is very inefficient; utilities without flexible generation capacity are forced to do unnatural acts to satisfy their balancing needs. But an Energy Imbalance Market introduces a new option: trading between utilities for small amounts of power in short time increments (5 or 15 minutes) just for the purposes of balancing. If one utility must cycle up another generator to balance but doesn’t need its full capacity, it can sell its excess on the EIM and another utility can buy that power for the next 5 minutes instead of spinning up its own generator. Everyone wins! With an EIM in place, the decision for a utility is one of cost: is it cheaper to buy the power it needs to balance its load on the EIM than to generate the power itself?

Here’s a great video that explains how this works. It’s from 2014, when there was an effort underway to create an EIM in the Pacific Northwest. That effort fizzled, but the CAISO EIM fared better and is now expanding its reach into our area. Puget Sound Energy has already joined, Portland General Electric is in process, and other western utilities along with SCL are considering it.

SCL has a lot to gain from an effective EIM. A big part of that comes from the fact that it has its own hydro power generation capacity that is cheap to generate (no fuel required), highly desirable green energy (no need to buy carbon offsets), and flexibly controlled.  Equally important: the energy can be stored as water in a reservoir or behind a dam. Power storage is a huge problem in the energy industry, but hydro power handles it elegantly (we’ll come back to this in a minute).

Seattle City Light can benefit financially in four ways from participating in the EIM:

1. It can reduce its balancing costs, by buying power on the market whenever it’s cheaper than generating its own.
2. It can sell excess power into the market — not only excess from its own balancing activities, but other excess capacity it has. During the late spring and early summer when the snowmelt is at its peak, SCL has lots of excess hydro generation capacity.
3. It can arbitrage the EIM market. Arbitrage is commodities trading that takes advantage of structural market inefficiencies to allow you to “buy low and sell high.”
4. It can arbitrage between the EIM market and the hourly and daily markets (often called the “bilateral markets”).

SCL’s cheap and flexible hydro power gives it an enormous advantage in the EIM market and a position as one of the leading sellers. It can choose when to enter the market, and only do so when it’s price competitive — which will be often.

The 600-pound gorilla in the market is solar power from California, of which there is a tremendous amount — but only in the middle of the day. Here’s what the CAISO energy production looked like on May 19th:

But CAISO’s demand curve looks very different; it slowly climbs over the day and spikes during the evening — after the solar power is gone.

That means CAISO needs to dramatically increase its “reliable power” generation, and its market purchases, in the evening.

That is an ideal opportunity for SCL: it can arbitrage the market by buying cheap solar power on the EIM market in the middle of the day, pooling water behind its dams, and selling back cheap green power to California utilities in the evening.  This turns out to be a ridiculously good business opportunity, in part because the tax incentives for solar energy in California mean that solar producers can sell their power at negative prices and still make a profit. And they do, and Seattle City Light buys that power (effectively getting paid to do so).

There are limits to SCL’s ability to exploit this: the rivers need to keep running, so the utility has far less flexibility in the dry season at the end of the summer. It is also at the mercy of the overall climate: its generation capacity looks very different depending on whether there is a large or small snowpack in a given year, and whether runoff is early or late Just look at the difference between 2013 and 2015:

Also, since SCL’s strategic advantage is its flexibility, its ability to profit from that requires market volatility. The more (reasonably predictable) price fluctuation there is in the market, the better SCL does with its arbitrage. Fortunately, the data shows that there is a lot of daily volatility in the EIM: both driven by the huge changes in solar production over the course of the day, and also inherent in the balancing activities.

So in theory this is a great opportunity for SCL, but we need to run the numbers to verify that in practice it’s a money-maker. We start by looking at what it costs to join and actively participate in the EIM. After several iterations of analysis and estimates, SCL has concluded that the upfront costs to join the CAISO EIM is about $12.3 million. In addition, they expect annual costs will run about $2.8 million. They also have an “opportunity cost” in that they will need to utilize some of its allocation of transmission line capacity for the EIM transactions; that’s another $900 thousand per year.  If we project that out for the next 15 years of participating in the EIM, that’s around $55 million of expenses in 2017 dollars.  CAISO potentially has a scheme to trim the upfront costs by $1-2 million by hosting and leasing the IT system that participating utilities need rather than forcing them to buy it themselves, but that’s just nibbling around the edges; the upfront costs will still be at least $10 million.

And that brings us to the big question: will joining the EIM generate enough revenues to make a profit? That’s where this gets messy, and quite frankly, where SCL’s business case analysis falls short. Of the four financial opportunities the EIM provides (listed above), SCL decided to include only one of them in their revenue projections: arbitrage within the EIM market. They hired a consultant to run a few dozen scenarios, and they came up with this:

If you are having trouble making sense of this, you’re in good company; the City Council members couldn’t either, and SCL couldn’t explain it in English. There are some important insights jammed in there, but in order to tease them out, we need to step back and discuss a few concepts.

We’ve already established that market volatility is critical to SCL’s ability to make a profit arbitraging the EIM. There are two additional factors of equal importance:

• SCL’s reach: how much of its power capacity can it make available on the EIM;
• The market depth: how much of SCL’s power the other participants in the EIM market are capable of using.

In other words: SCL needs to be able to buy and sell at a profit, but it also needs to have a large volume of sales since the profit on any individual transaction is small.

SCL’s analysis says that they have at least 300 megawatts of reach that they can make available in the market.

That’s actually very conservative; in fact, they could make their entire hydro generation capacity available on the EIM and just buy more long-term power contracts to backfill if they thought they could make more money doing so.

But is there 300 MW of market depth? As of earlier this year, the answer is no; SCL’s analysis found there was reliably about 80 MW, and it rarely got as high as 200 MW.  However, more utilities are scheduled to join the EIM, and those tend to be heavy on fossil-fuel-based generators. As they join, the market depth will grow. On the other hand, having more market participants will tend to decrease volatility. The market giveth, the market taketh away.

But let’s look at that analysis chart again:

Here’s what they did: they ran revenue projections assuming a market depth of 100, 150, 200, or 300 megawatts. Given the upfront and ongoing costs, SCL would need about $4.5 million in annual revenues to break even. There will be a lot of fluctuation year-to-year, for all the reasons already discussed, but we have many years for that to average out so we really only care about the average revenues. And we can see from the chart that at a market depth of 150 MW, the average revenues fall short. It only starts to become feasible close to 200 MW of market depth — which we know rarely occurs today.

There are lots of holes you can poke in this analysis. It’s based upon historical pricing data for power, but the modeling wasn’t a particularly good approximation of how it might play out in 5 or 15 minute transactions. It also assumed “perfect foresight,” i.e. it can optimize transactions knowing what the future price will be — a completely unrealistic assumption. So SCL’s internal Risk Oversight Group took another shot at it, applying the dynamics of the hourly bilateral market — a closer approximation to 5 and 15 minute intervals. Their revised projections are only slightly changed, and the conclusion is still the same: below 200 MW it doesn’t pan out.

That said, this is still a lousy model. They didn’t address the biggest weakness, the “perfect foresight” assumption. When pressed on that point by City council staff, SCL responded by reducing all their revenue forecasts by 20% — a not-at-all-scientific approach.  The strange part about this is that there is a tried-and-true approach for modeling this very situation: Monte Carlo simulations. It’s unclear why SCL chose not to do a Monte Carlo simulation analysis, since it has the data it needs to do one; in fact, it used that data to make the volatility graph we looked at earlier:

To summarize their revenue projections: they only modeled one out of four financial opportunities, they did that one poorly, and the result says that it’s unlikely to be profitable under current market conditions.

And yet, there are (at least) four reasons why SCL should join the EIM anyway. First, as described above the revenue projections are extremely conservative; the other three revenue opportunities are real and could be susbtantial. Second, the EIM is poised to grow significantly, which will improve the revenues.

Third, Seattle City Light is a business going through a major transition, as demonstrated by these charts on its retail residential and commercial/industrial consumption.

Retail consumption is dropping, even as its customer base grows. SCL has been using wholesale power sales to subsidize the retail business and keep rates down. But wholesale power prices have also dropped over the past few years. The utility needs new markets in order to stabilize its business. Because the EIM arbitrage business is focused on intra-day price fluctuations, it is largely insensitive to long-term pricing trends. That’s a great complementary business to its existing wholesale and retail businesses.

Fourth, it’s good for the environment. Since many West coast utilities must pay carbon offsets for greenhouse gases emitted by their fossil-fuel power production, there is a strong environmental and financial incentive for buying SCL’s clean hydro power. To the extent that it displaces dirty power generation, it could reduce CO2 emissions by 32,000 to 65,000 tons each year. Here’s a deeper analysis on the impact on greenhouse gas emissions. There is a robust ongoing debate about the cost of a ton of CO2 emissions, but the financial impact is considerable.

There are risks to entering the EIM that also need to be weighed. The required market depth may not appear, though at this point that doesn’t seem likely. The chance of an Enron-style market meltdown is almost nil, because of strict requirements for market participation: utilities must prove that they have sufficient power capacity to cover their own load, so that no one is dependent on the EIM for essential power needs and can withdraw at any time. A more pressing concern is whether hydro power will continue to have unique value long-term since a viable power storage solution, combined with high-volume solar and wind generation, would undercut the value of hydro.

But the most pressing concern is whether SCL is really up to the task. It knows it’s sliding down a fiscal hill, with the wholesale market in the tank and retail consumption dropping, leaving it no choice but to continue to raise retail rates to try to stay afloat. That is unsustainable. It needs to articulate a new path forward for the business. Joining the CAISO EIM is its most forward-thinking proposal to-date, and yet it delivered a nearly incoherent pitch that left the City Council unconvinced.  SCL also mishandled its huge IT project with Seattle Public Utilities to create their new NCIS billing system, and recently it was reported that its new AMI digital meter program is over budget (and SCL wasn’t forthright in making that fact known).

Joining the Energy Imbalance Market alone won’t solve Seattle City Light’s fiscal woes, but it is a reasonable step to incrementally improve its competitiveness in a rapidly evolving industry. On the other hand, with SCL struggling to manage its business today, one has to wonder how it will handle the much bigger challenges waiting around the corner. Eventually the City Council should let the utility join the EIM, but first SCL needs to be able to give a clear explanation of what will happen when it does.  SCL’s leadership also needs to articulate a clear plan for taking the business forward and demonstrate that it is capable of executing on that plan.

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