Liquidated Damages Contracts May Qualify for Utility Supply

Regulators will be advised on how to resolve one of resource adequacy?s thorniest issues?whether an energy contract mechanism known as firm liquidated damages should be allowed to count toward utilities? resource-adequacy, or supply, obligations?by a California Public Utilities Commission staff report expected next month. Late last year, the commission required utilities to have a 15 to 17 percent cushion of extra supplies over what is expected to be needed, but how to calculate those supplies has been the subject of technical workshops since that decision. The commission will likely release a proposed decision in July. Resource-adequacy requirements are set to go into force in June 2006. Southern California Edison and other parties?including suppliers and energy service providers such as Strategic Energy and Arizona Public Service?want firm liquidated damages contracts to be counted toward the resource-adequacy requirements of utilities and other load-serving entities. The California Independent System Operator strongly opposes allowing liquidated damages contracts?known as ?firm LD? or ?LD contracts??to qualify as capacity for utilities and other load-serving entities to meet their resource-adequacy requirements. ?We agree generally that there is a role for liquidated damages contracts in the energy market to meet the responsibilities that load-serving entities have,? said Phil Pettingill, CAISO?s manager of policy development. ?The problem in the resource-adequacy requirements is the issue of not knowing what resources are intended to run under that contract.? Pettingill calls firm liquidated damages contracts ?implied capacity.? He said Edison and others have claimed that these contracts have been upheld. ?That may be true, and that makes it an appropriate financial hedge to protect them in terms of energy costs,? Pettingill said. ?But it doesn?t allow us to check and test and validate that there are enough resources to serve the CAISO load. There?s no way to add them up.? Born in the mid-1990s with electricity market restructuring, firm liquidated damages is a contract mechanism that allows a seller of electricity to pay cash instead of supplying the power promised for a particular time period, with the payment amount determined by the buyer?s cost to procure the equivalent energy elsewhere. These trading agreements are in widespread use in California. ?It is probably the predominant form of energy contract,? said Doug Parker, an Edison energy supply manager. ?The second most common would be unit-contingent contracts,? which pledge the output of specific generating units. Because they are not tied to a specific power source, firm liquidated damages contracts allow sellers to shop the market and buy electricity at the lowest costs available, a factor that provides vital leverage in hedging electricity prices, according to Parker. ?The seller has a portfolio of resources that they either own or have under contract,? he added. ?They can also substitute from the market if the market has a cheaper source.? Because the cost of executing a liquidated damages clause is so unpredictable and potentially high, sellers almost never choose to substitute cash for electrons, according to Parker. A situation in which ?somebody decided not to deliver power because they had a better deal somewhere else is virtually unheard of,? Parker said, noting that Edison has never experienced this, even during the 2000-01 electricity crisis. In fact, Parker says, firm liquidated damages contracts are ?far and away? more reliable than unit-contingent contracts, in which supply obligations are tied to a particular generating unit?s performance. As part of the CPUC?s resource-adequacy process, CAISO is in the early stages of a systemwide deliverability analysis that is looking at regional transmission congestion and other factors that can restrict power plants? actual capacity significantly below their rated capacity. Throwing liquidated damages contracts into the mix could impair the accuracy of this critical forecast, according to Pettingill. ?Are some of these generators committing their resources to sell outside, maybe to Arizona or Nevada?? he said. A related concern is double-counting: ?Because a liquidated damages contract does not identify the resource, a load-serving entity can?t tell if the supplier that sold it that liquidated damages contract is relying on the same set of generators that the [utility] specifies in the capacity portion of its resource-adequacy portfolio,? Pettingill said. Edison?s Parker thinks CAISO has the analytical chops to factor liquidated damages contracts into its analysis of deliverable capacity. ?It?s our opinion that CAISO can evaluate the specific resources inside their footprint and look at the combined import capabilities of the transmission system,? he said. But Parker acknowledges that double-counting generating capacity is a legitimate concern. ?When CAISO takes all these year-ahead and month-ahead showings that are supposed to add up to 115 percent of their forecast load, how do they make sure that a resource hasn?t effectively been counted twice?? he asked. In the resource-adequacy workshops, ?people have leapt to the immediate conclusion that this is an unsolvable problem so we have to get rid of liquidated damages contracts,? Parker said. He believes that there are a number of possible solutions, including special accounting methods under which suppliers would warrant that their total contracted power sales do not exceed their physical generation capacity. One thing Edison and CAISO appear to agree on is that firm liquidated damages contracts should not be part of a future capacity market that is envisioned by the CPUC to encourage investment in power plant construction. ?The difference of opinion we have with CAISO is over the use of these contracts for a specific purpose in what we?ll call the transition period,? Parker said. That period is the time between when resource adequacy becomes effective and when a solid framework for administering capacity payments takes shape. ?Before you have this capacity market [with] a brand-new accounting mechanism for physical capacity, you have to meet your resource-adequacy requirements with what I?ll call conventional products that exist in the marketplace today, which include these liquidated damages contracts,? Parker concluded.

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