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4.3 PJM capacity market
Publication date: 20 Jul 2016
us Utilities guide
PJM’s capacity market design is known as the Reliability Pricing Model. RPM is designed to ensure the reliability of the electric grid. Capacity Resources are obtained through an auction process for capacity in PJM. Market participants may also engage in bilateral transactions. PJM requires varying levels of participation in the RPM by market participants as summarized in Figure 4-2:
Figure 4-2
Participation in RPM
Participation in RPM
Form of participation |
Type of entity |
Mandatory |
Resource providers with (1) available unforced capacity from existing generation resources located in PJM and (2) bilateral contracts for available unit-specific Capacity Resources located in PJM |
Generally mandatory |
Load Serving Entities (LSEs); however, LSEs can avoid direct participation in RPM auctions by using internally owned Capacity Resources to meet their fixed capacity resource requirement (Fixed Resource Requirement (FRR) alternative) |
Voluntary |
All other resource providers |
Resource providers may alternatively export available capacity outside PJM under certain conditions. The RPM market design and structure as well as related accounting considerations are further discussed in this section. See UP 4.7 for definitions of key terms used throughout this chapter.
4.3.1 RPM auction contracts
The RPM market structure is as follows:
Figure 4-3
RPM auction structure
RPM auction structure
PJM procures resources through the auction process as follows:
- Base Residual Auction—conducted in May three years prior to the start of the Delivery Year. Load Serving Entities pay for the cost of the commitments obtained through this auction through the Locational Reliability Charge.
- First and Third Incremental Auctions—conducted 23 months and 4 months prior to the start of the Delivery Year, respectively. Market participants obtain additional resources when there is a decrease in the expected capacity committed through the Base Residual Auction (due to cancellation, derating, or other issues).
- Second Incremental Auction—conducted 15 months prior to the start of the Delivery Year. Market participants procure incremental Capacity Resources when capacity needs change due to a change in load forecast.
In addition to scheduled RPM auctions, PJM may conduct a conditional incremental auction if necessary. The auction process allows for the procurement of resource commitments to satisfy the region’s capacity requirements. The cost of those resource commitments is allocated among the LSEs through a Locational Reliability Charge. LSEs may partially or totally offset their Locational Reliability Charge obligations by offering and clearing resources in the base residual auction and second incremental auction, or by designating self-supplied resources.
4.3.1.1 Accounting considerations
In accordance with the commodity contract accounting framework (see UP 1), because property is specified, after identifying the deliverables and the unit of accounting, a reporting entity should first determine whether an RPM auction contract contains a lease. If the contract does not contain a lease, a reporting entity should next assess whether it is a derivative in its entirety. A reporting entity should then consider whether the contract contains any embedded derivatives requiring separation from the host contract (unless the contract is a derivative in its entirety). If neither lease nor derivative accounting apply, the reporting entity would account for the RPM contract as an executory contract (i.e., on an accrual basis).
Lease accounting
A contract for the purchase of capacity that is sourced from a specified power plant could technically qualify as a lease. However, because power plants also produce other outputs, such as power and ancillary services, it is generally not expected that the capacity alone would represent 90 percent of the total value of the plant outputs. As such, this type of contract is generally not expected to meet the definition of a lease (see UP 2 for further information). Therefore, the following discussion focuses on whether an RPM auction contract is a derivative.
Derivative accounting
RPM auction contracts generally will not meet the definition of a derivative instrument. Figure 4-4 highlights the derivative evaluation for a typical RPM auction contract; however, each contract should be evaluated based on its individual facts and circumstances.
Figure 4-4
Does an RPM auction contract meet the definition of a derivative?
Does an RPM auction contract meet the definition of a derivative?
Guidance
|
Evaluation
|
Comments
|
Notional amount and underlying
|
Met
|
|
No initial net investment
|
Met
|
|
Net settlement
|
Not met
|
|
In general, we would not expect an RPM auction contract to be accounted for as a derivative because it fails the net settlement criterion.
Net settlement. The contract can be settled net by any of the following means:
- Its terms implicitly or explicitly require or permit net settlement.
- It can readily be settled net by a means outside the contract.
- It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
The following discussion provides information on factors to consider in assessing whether an RPM auction contract has the characteristic of net settlement. See UP 3.2.3 for further information on the overall application of the net settlement criterion.
Net settlement under contract terms
When evaluating whether the net settlement criterion is met, a reporting entity should first consider whether the contract explicitly or implicitly provides for net settlement of the entire contract. RPM auction contracts require the generator to deliver capacity during the Delivery Year equal to the notional amount of capacity that the generator won in the auction. This requirement is for each day of the Delivery Year; and if the capacity is not provided, the generator may incur significant fines and penalties. There are no provisions permitting or requiring net settlement in the contract, either explicitly or implicitly.
Net settlement through a market mechanism
In this form of net settlement, one of the parties is required to deliver an asset, but there would need to be an established market mechanism that facilitates net settlement outside the contract. ASC 815-10-15-110 through 15-116 provides guidance on indicators to consider in assessing whether an established market mechanism exists. A key aspect of a market mechanism is that one of the parties to the agreement can be fully relieved of its rights and obligations under the contract.
In the case of RPM, resource providers that bid into the initial base residual auction have an opportunity to be relieved of their obligations through the first and third incremental auctions. However, this opportunity exists only if there is a physical issue associated with the plant (e.g., it is not available or it is derated) and the auctions occur only twice in a three-year period. Moreover, the incremental auctions do not have the level of activity found in the initial auction because only residual resources are available to participate.
Due to the market design, the incremental auctions are not intended to and do not provide the resource provider with the ability to be relieved of its full rights and obligations under a previously executed contract. Therefore, the auction structure does not create a market mechanism as defined in ASC 815. In addition, the RPM market includes bilateral transactions that are facilitated by PJM through an electronic board (eRPM). As discussed in UP 4.3.2, the eRPM bulletin board currently does not meet the criteria to qualify as a market mechanism.
Net settlement by delivery of an asset that is readily convertible to cash
Whether there is an active spot market for the particular product being sold under the contract is the key factor in assessing whether an asset is readily convertible to cash. Current market conditions should always be considered in this analysis. To be deemed an active spot market, a market must have transactions with sufficient frequency and volume to provide pricing information on an ongoing basis. In addition, quoted prices from that market must be readily available on an ongoing basis. See UP 3.2.3.3 for further information on the determination of whether a market is active.
In the case of the RPM market, we understand that there may be some bilateral spot market activity, with trading among market participants to meet daily obligations. However, there are no quoted prices in the market or transparency into the level of activity, frequency, and volume of transactions. These are indicators that there is not an active spot market for capacity in PJM.
Overall conclusion
We are not aware of a market mechanism or active spot market for RPM capacity contracts and thus we believe that derivative accounting is generally not applicable to these contracts. Instead, the contracts should be accounted for as executory contracts or a legal obligation to the PJM market. However, a reporting entity should evaluate all facts and circumstances in concluding on the appropriate accounting for an RPM contract. In addition, a reporting entity should monitor its conclusion periodically because markets may evolve, potentially rendering this type of contract a derivative. Finally, a reporting entity should evaluate the contract to determine if there are any embedded derivatives that require separation.
Reporting entities may also consider conditionally designating RPM contracts under the normal purchases and normal sales scope exception if physical delivery is probable throughout the life of the contract and the other criteria for application of this exception are met (ASC 815-10-15-22 through 15-51 as applicable). If a conditionally designated normal purchases and normal sales contract meets the definition of a derivative at a later date, the contract would be accounted for as a normal purchases and normal sales contract from the time it becomes a derivative. Absent such a designation, the reporting entity would be required to record the contract at its fair value at the time it becomes a derivative. See UP 3.3.1 for further information on the normal purchases and normal sales scope exception.
4.3.2 Bilateral capacity contracts
The basic transaction structure for bilateral capacity contracts in PJM is as follows:
Figure 4-5
RPM unit-specific bilateral capacity transaction structure
RPM unit-specific bilateral capacity transaction structure
PJM’s bilateral capacity market provides Load Serving Entities with the opportunity to hedge the Locational Reliability Charge. This market also allows resource providers to transact for any auction commitment shortfalls by using unit-specific contracts. The purpose of a unit-specific bilateral contract is to transfer the rights to or control of a specified amount of capacity from the seller to the buyer. Bilateral contracts for unit-specific resources can be offered in the RPM if PJM’s specifications are met.
Unit-specific capacity transactions are posted through PJM’s eRPM, which allows participants to post and view requests to buy and sell capacity. This electronic bulletin board is intended to facilitate bilateral activity. Both parties to a transaction must confirm the transaction in eRPM prior to the start date of the transaction. These transactions may occur before or after the PJM auctions. If the transaction occurs before the auction, capacity obtained through a unit-specific contract may be offered in the auction and the buyer of the capacity will transact with PJM. If the activity occurs after the auction, the PJM auction credit and related resource requirement is transferred from the seller to the buyer.
4.3.2.1 Accounting considerations
The determination of the appropriate accounting for unit-specific bilateral capacity contracts follows an approach similar to the discussion of RPM auction contracts in UP 4.3.1. Consistent with the conclusions reached for RPM auction contracts, generally, we would not expect a unit-specific bilateral capacity contract to meet the definition of a lease. Therefore, this discussion focuses on whether this type of contract meets the definition of a derivative.
Derivative accounting
Unit-specific bilateral capacity contracts generally will not meet the definition of a derivative instrument. Figure 4-6 highlights the derivative evaluation for a typical unit-specific bilateral capacity contract; however, each contract should be evaluated based on its individual facts and circumstances.
Figure 4-6
Does a unit-specific bilateral capacity contract meet the definition of a derivative?
Does a unit-specific bilateral capacity contract meet the definition of a derivative?
Guidance
|
Evaluation
|
Comments
|
Notional amount and underlying
|
Met
|
|
No initial net investment
|
Met
|
|
Net settlement
|
Generally not met
|
|
In evaluating unit-specific bilateral capacity contracts, the key question is whether the contract has the characteristic of net settlement.
Net settlement. The contract can be settled net by any of the following means:
- Its terms implicitly or explicitly require or permit net settlement.
- It can readily be settled net by a means outside the contract.
- It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
Factors to consider in making the net settlement assessment in the context of unit-specific bilateral capacity contracts are discussed in the following paragraphs. See UP 3.2.3 for further information on overall application of the net settlement criterion.
Net settlement under contract terms
When evaluating whether the net settlement criterion is met, a reporting entity should first consider whether the contract explicitly or implicitly provides for net settlement of the entire contract. With respect to unit-specific bilateral capacity contracts, the selling party is required to deliver capacity to the buyer as registered in the eRPM system. Once the contract is executed, the capacity is recognized within the PJM market as the buyer’s capacity. Therefore, the seller is required to deliver capacity to the buyer and we would not expect any provisions for net settlement in this type of contract. However, the reporting entity should review the contract terms to ensure that there are no implicit net settlement terms or liquidating damage provisions that may imply the contract could be net settled.
Net settlement through a market mechanism
In this form of net settlement, one of the parties is required to deliver an asset, but there would need to be an established market mechanism that facilitates net settlement outside the contract. ASC 815-10-15-110 through 15-116 provides guidance on indicators to consider in assessing whether an established market mechanism exists. A key aspect of a market mechanism is that one of the parties to the agreement can be fully relieved of its rights and obligations under the contract.
There are two potential market mechanisms for unit-specific bilateral capacity contracts: (1) the PJM auction process (see evaluation in UP 4.3.1) and (2) the electronic bulletin board structure used to transact unit-specific bilateral contracts. The eRPM structure results in the transfer of all rights and obligations under the contract. Therefore, we specifically evaluated the eRPM structure based on the market mechanism framework. In accordance with ASC 815-10-15-111, the term market mechanism may be interpreted broadly but must have all of the characteristics discussed below (excerpts from ASC 815-10-15-111 are highlighted in italics):
- ASC 815-10-15-111(a)—It is a means to settle a contract that enables one party to readily liquidate its net position under the contract.
The eRPM market structure does not provide the means to net settle a contract. It may enable transactions between individual buyers and sellers; however, the seller under the contract is required to deliver capacity to the buyer and would not be able to net settle a bilateral or auction contract. In addition, there are not multiple counterparties standing by and willing to take on this type of contract. As such, it is not possible for either party to the contract to readily liquidate its net position under the contract.
- ASC 815-10-15-111(b)—It results in one party to the contract becoming fully relieved of its rights and obligations under the contract.
This condition is met. If parties execute a unit-specific bilateral capacity contract involving “cleared capacity,” the seller’s obligation to deliver to PJM under its RPM auction contract is transferred to the buyer.
- ASC 815-10-15-111(c)—Liquidation of the net position does not require significant transaction costs.
Whether this condition is met will depend on the specific facts and circumstances related to the bilateral transactions. Due to the lack of market transparency, reporting entities would need to perform due diligence to determine the level of transaction costs and whether those are customary for bilateral activity.
- ASC 815-10-15-111(d)—Liquidation of the net position under the contract occurs without significant negotiation and due diligence and occurs within a time frame that is customary for settlement of the type of contract.
Factors that would indicate this criterion is met are discussed in ASC 815-10-15- 116 and include: (a) binding prices for the instrument are readily available; (b) transfers of the instrument involve standardized documentation (rather than contracts with entity-specific specifications) and standardized settlement procedures; (c) individual contract sales do not require significant negotiation and unique structuring; and (d) the closing period is not extensive since there is not a need to permit legal consultation and document review.
Reporting entities should assess whether this criterion is met based on current activity in eRPM. However, a lack of transparency in the eRPM market would suggest that a reporting entity’s ability to determine whether this criterion is met is restricted.
The key factor in this evaluation is that there are no quoted market prices and no buyers standing ready to transact via eRPM. We understand there is some level of activity in this market; however, it does not appear that there is sufficient liquidity to support the conclusion that a market mechanism exists.
Net settlement by delivery of an asset that is readily convertible to cash
Whether there is an active spot market for the particular product being sold under the contract is the key factor in assessing whether an asset is readily convertible to cash. Current market conditions should always be considered in this analysis. To be deemed an active market, a market must have transactions with sufficient frequency and volume to provide pricing information on an ongoing basis. In addition, quoted prices from that market must be readily available on an ongoing basis. See UP 3.2.3.3 for further information on the determination of whether a market is active.
Consistent with the discussion of RPM auction contracts (see UP 4.3.1), we understand that there is some bilateral spot market activity as market participants trade to meet daily obligations. However, there are no quoted prices in the market or transparency into the level of activity, frequency, and volume of transactions.
Overall conclusion
We are not aware of a market mechanism or active spot market for RPM unit-specific bilateral contracts, and thus we believe that derivative accounting is generally not applicable to these contracts. Instead, the contracts should be accounted for as executory contracts or a legal obligation. However, a reporting entity should evaluate all facts and circumstances in concluding on the appropriate accounting for RPM unit-specific bilateral contracts. In addition, a reporting entity should monitor its conclusion periodically because markets may evolve, potentially rendering this type of contract a derivative. Finally, a reporting entity should evaluate the contract to determine if there are any embedded derivatives that require separation.
Reporting entities may also consider conditionally designating RPM unit-specific bilateral contracts under the normal purchases and normal sales scope exception if physical delivery is probable throughout the life of the contract and the other criteria for application of this exception are met (ASC 815-10-15-22 through 15-51 as applicable). If a conditionally designated normal purchases and normal sales contract meets the definition of a derivative at a later date, the contract would be accounted for as a normal purchases and normal sales contract from the time it becomes a derivative. Absent such a designation, the reporting entity would be required to record the contract at its fair value at the time it becomes a derivative. See UP 3.3.1 for further information on the normal purchases and normal sales scope exception.
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