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4.4 PJM congestion instruments
Publication date: 20 Jul 2016
us Utilities guide
Within PJM, congestion creates direct costs to market participants related to transmission congestion charges as well as indirect costs as a result of differences in locational prices when generators are dispatched out of merit order (i.e., in a different sequence than the original schedule) to relieve congestion. Auction Revenue Rights and Financial Transmission Rights are financial instruments used in PJM that provide holders with the opportunity to offset congestion costs. ARRs and FTRs entitle or require the holder to receive payment or pay charges based on price differences at the applicable trading locations.
This section provides an overview of the ARR and FTR process and addresses related accounting issues, including whether the instruments meet the definition of a derivative. UP 4.7 includes the definitions of key terms used throughout this chapter.
4.4.1 Overview of the ARR and FTR process
ARRs and FTRs are financial instruments designed to provide a financial hedge against transmission congestion charges.
• Auction Revenue Rights
ARRs are allocated annually to Firm Transmission Service Customers and entitle holders to the proceeds, or require them to pay the charges, related to the sale of FTRs in an annual FTR Auction (based on price differences between the point of receipt (Source) and the point of delivery (Sink) nodes. The economic value of an ARR can be positive (a benefit) or negative (a liability). ARR holders also have an option to “self-schedule” and convert the ARRs to FTRs (see discussion under Allocation of ARRs below).
• FTR obligations
FTRs are financial instruments that entitle the holder to receive compensation for transmission congestion charges that arise when the transmission grid is congested in the day-ahead market. Each FTR obligation is defined from the Source to the Sink. FTR obligations entitle the holder to receive or require the holder to make payments based on locational price differences experienced in the Day-Ahead Energy Market. FTRs essentially entitle the holder to rebates of congestion charges paid by the Firm Transmission Service Customers.
• FTR options
FTR options are similar to FTR obligations; however, no payment is required from the FTR option holder if the value is negative.
The ARR and FTR process in PJM has the following general timeline:
Allocation of ARRs
The annual ARR allocation is a two-stage process that typically begins in mid-March and concludes in early April. During the first stage of the process, Firm Transmission Service customers may request ARRs along transmission paths for all or any portion of an existing generation resource, up to their individual total network load in a particular Zone. During the Planning Period (June 1 to May 31), ARRs are automatically reallocated on a daily basis based on changes in zonal peak load.
ARR holders have an option to convert the product to an FTR with the same Source and Sink points as the ARR through a process called “self-scheduling” in the first round of the annual FTR Auction. In effect, an ARR provides the holder with a fixed amount of revenue (based on the results of the FTR Auction) compared with an FTR, which provides ongoing offset against transmission congestion charges.
FTR Auction
After the conclusion of the ARR allocation process, PJM conducts a four-round annual FTR Auction, which typically occurs from mid-April to early May of the PJM Planning Period. The FTR Auction conducted by PJM generates revenues by selling FTRs to the highest bidders. Self-scheduled ARRs are included in the FTR Auction and require ARR holders to pay the auction price. Proceeds generated from the annual FTR Auctions are provided to the holders of the ARRs. Additionally, FTRs can be acquired through monthly or long-term FTR Auctions or secondary market trades.
ARRs and FTRs—process
The annual ARR process and cash flows are summarized in Figure 4-7.
Figure 4-7
ARR and FTR process
ARR and FTR process
Incremental ARRs, residual ARRs, and the monthly and long-term FTR Auctions are not included in the flowchart above. In addition, there are no self scheduled ARRs in the monthly or long-term FTR Auctions. Monthly and long-term FTR Auctions include residual FTRs not sold through the annual process. In addition, FTR options are not included in the flowchart. FTR options provide only for payment to the holder based on transmission charges.
In summary, ARR and FTR financial instruments are both designed to provide a hedge against transmission congestion charges. Revenues received by PJM in the FTR Auction process are allocated to the holders of ARRs. Similarly, PJM collects transmission congestion costs from market participants delivering power and paying congestion cost and allocates these proceeds to the holders of the FTRs. In theory, an ARR holder that self-schedules to an FTR (i.e., converts its ARR into an FTR) and uses the underlying transmission to serve customers, should be net income neutral, as it would receive and pay the following cash flows:
• From the ARR—it will receive FTR Auction proceeds
• From the FTR—it will pay FTR Auction charges and receive transmission congestion charges
• As a transmission user—it will pay transmission charges
As a result of these transactions, a transmission customer (i.e., an ARR holder) has the opportunity to obtain FTRs at no net cost along those paths needed to serve its customers. As a user of the transmission, an FTR holder may be required to make congestion payments; however, these payments should be offset by the benefit of holding the FTR. As such, in theory, a Load Serving Entity should not have any net cash inflow/outflow associated with congestion charges required to serve load (although there may be some differences due to shortfalls in amounts received).
The accounting for ARRs and FTRs is discussed in the following section.
4.4.2 Accounting for ARRs
ARRs are allocated to transmission service customers based on their load commitments and underlying firm transmission agreements. As further discussed below, an allocated ARR initially qualifies as a derivative; however, the FTR Auction results in the settlement of the derivative, at which time it is accounted for as a receivable. For calendar year-end companies, the allocation and auction process is completed within the second quarter of the year (i.e., the ARR is a receivable balance at the end of the second quarter). The accounting prior to and subsequent to the FTR Auction is discussed in the following sections.
4.4.2.1 Initial accounting for the ARR
In determining the initial accounting for ARRs, a reporting entity should first consider the accounting for the ARR itself and then consider the accounting for the receipt of the ARR proceeds. As summarized in Figure 4-8, during the period after the ARR allocation and before the FTR Auction, we believe that an ARR generally meets the definition of a derivative.
Figure 4-8
Does an ARR meet the definition of a derivative?
Does an ARR meet the definition of a derivative?
Guidance
|
Evaluation
|
Comments
|
Notional amount and underlying
|
Generally met
|
• Notional (quantity of megawatts) and underlying (settlement is based on locational price differences between the Source and the Sink) are specified.
• If load shifts are significant, the reporting entity may initially conclude that a notional amount cannot be determined.
|
No initial net investment
|
Met
|
• No initial net investment is required.
|
Net settlement
|
Met
|
• Contractual ARRs are settled in cash; therefore, ARRs meet the net settlement criterion in ASC 815-10-15-83(c)(1).
|
The ARR specifies a notional amount (a specific megawatt amount) and is settled based on locational price differences. The ARR settlement amount is determined based on the auction price and the notional amount of the ARR. The settlement proceeds are received in cash. Therefore, we generally conclude that the ARR meets the definition of a derivative. See further discussion in the responses to the following questions.
Question 4-1
Is there an acceptable alternative view that an ARR is not a derivative?
Is there an acceptable alternative view that an ARR is not a derivative?
PwC response
Some believe that ARRs do not meet the definition of a derivative based on the conclusion that an ARR does not have an underlying. The price of an ARR is determined through the auction process, with market participants determining the value by bidding on various paths. As such, the settlement amount is not based on the interaction between the underlying and the notional. Thus, supporters of this view believe that this criterion is not met. Instead, they believe ARRs represent a receivable at the point of initial allocation.
We believe that ARRs should be accounted for as derivatives. However, from a practical perspective, the ARRs are allocated in May and the annual FTR Auctions are completed (and the ARR value is established) before the end of June. As a result, by the end of the second quarter (for calendar year-end companies), the ARR value is fixed and the ARR asset represents a receivable for the proceeds to be received on a monthly basis from the annual FTR Auction. Therefore, for most reporting entities, the question of whether an ARR is a derivative is applicable only for internal reporting purposes. By June 30 of each year, the value of an ARR is established and should be accounted for as a receivable. See UP 4.4.2.2 for discussion of the subsequent accounting.
Question 4-2
Does an ARR qualify for the scope exception available for certain contracts that are not traded on an exchange?
Does an ARR qualify for the scope exception available for certain contracts that are not traded on an exchange?
PwC response
No. ASC 815-10-15-59 provides guidance on certain contracts that are not traded on an exchange as follows:
Excerpt from ASC 815-10-15-59
Contracts that are not exchange-traded are not subject to the requirements of this Subtopic if the underlying on which the settlement is based is any one of the following: . . . (b) The price or value of a nonfinancial asset of one of the parties to the contract provided that the asset is not readily convertible to cash. This scope exception applies only if both of the following are true:
1. The nonfinancial assets are unique.
2. The nonfinancial asset related to the underlying is owned by the party that would not benefit under the contract from an increase in the price or value of the nonfinancial asset.
In accordance with this exception, a contract is not a derivative if it is based on the fair value of a nonfinancial asset of one of the parties to the contract. In certain cases, the ARR holder may have contractual transmission service on a line where it receives ARRs. The value of the ARR is based on the difference in price between the Source and the Sink as determined in the FTR Auction. Therefore, a question arises as to whether the settlement of the ARR is based on the value of a nonfinancial asset of one of the parties to the contract (i.e., the value of the underlying transmission).
However, the transmission revenue (to be received by the transmission holder) and the congestion revenue (to be received by the holder of the FTR) represent two separate payment streams. The value of the transmission contract is the tariff value of the transmission and does not incorporate the separate congestion cash flows. The ARR holder is generally the Load Serving Entity and will receive proceeds from the ARR that are based on the expected value of congestion costs (bid amounts for the FTRs).
As such, we do not believe that the value of the ARR is linked to the value of transmission contracts or underlying transmission owned by the ARR holder. Therefore, the scope exception is not applicable.
Question 4-3
Do ARR reallocations (load shift) change the conclusion that an ARR is a derivative?
Do ARR reallocations (load shift) change the conclusion that an ARR is a derivative?
PwC response
It depends. ARR holders are entitled to self-schedule FTRs equal to the allocated quantity of ARRs in the first round of the annual FTR auction. The notional amount for this right is fixed in the initially allocated ARR. However, the notional amount of the ARR may subsequently change prior to receipt of the cash as a result of load shifts.
ASC 815-10-55-5 through 55-7 provides relevant guidance in addressing notional amounts that may change over the life of a contract in the context of requirements contracts. Although ARRs are not requirements contracts, the overall guidance is helpful in evaluating the impact of potential notional changes.
Excerpt from ASC 815-10-55-7(a)
The determination of a requirements contract’s notional amount must be performed over the life of the contract and could result in the fluctuation of the notional amount if, for instance, the default provisions reference a rolling cumulative average of historical usage. If the notional amount is not determinable, making the quantification of such an amount highly subjective and relatively unreliable . . . such contracts are considered not to contain a notional amount as that term is used in this Subtopic.
In accordance with this guidance, a potential future change in notional amount does not impact the conclusion that the contract has a notional. However, there would be no notional if the determination of the amount is highly subjective and unreliable.
In evaluating an ARR, the notional amount of the contract may change any time from the point it is initially allocated until the reporting entity receives the final cash proceeds. If load shift is minimal, the determination of the notional amount is reliable and, as a result, the contract has a notional. However, if the load shift is significant, the initial determination of the quantity would be unreliable and there would be no notional amount. Reporting entities should evaluate this consideration and make a determination based on their historical experience and future load expectations.
Question 4-4
Does determination of the ARR value based on the results of the auction change the conclusion that the ARR has an underlying and a notional amount?
Does determination of the ARR value based on the results of the auction change the conclusion that the ARR has an underlying and a notional amount?
PwC response
No. The ultimate value of the ARR is determined based on the difference between the locational marginal price at the ARR Sink and the ARR Source as determined in each round of the annual FTR Auction. Although the value is developed through an auction rather than through another mechanism, we believe this represents an interaction between an underlying and a notional amount.
The ARR settlement amount is determined based on the interaction between the prices (as determined through the auction) and the notional amount of the ARR. The incorporation of the auction results does not change the fact that the amount of the payout is determined by the terms of the contract and the interaction of the underlying and notional amount. Therefore, the auction does not impact the conclusion that the contract has an underlying and a notional amount.
Question 4-5
Is an ARR a derivative even though the settlement proceeds may change?
Is an ARR a derivative even though the settlement proceeds may change?
PwC response
Yes. There may be some adjustments to and differences in the actual proceeds due to the PJM allocation process. This may cause some to question whether the settlement truly reflects the interaction between an underlying and a notional amount. However, these adjustments are expected to primarily relate to credit or other shortfalls that occur in the payment process. Any contract may not be fully paid due to issues in settlement. Therefore, the potential settlement adjustments do not impact the conclusion that the contract has an underlying and notional amount.
Question 4-6
Is an ARR a derivative even though the FTR Auction proceeds are received over a 12- month period, instead of immediately?
Is an ARR a derivative even though the FTR Auction proceeds are received over a 12- month period, instead of immediately?
PwC response
Yes. The value of an ARR is determined through the annual FTR auctions and the proceeds are distributed to the ARR holders over the Planning Period (the following 12 months). Whether this constitutes net settlement in accordance with ASC 815-10-15-83(c)(1) should be determined by reference to the guidance in ASC 815-10-15-104 through 15-106, which address settlement through a structured payment.
Excerpt from ASC 815-10-15-104
A contract that provides for such a structured payout of the gain (or loss) resulting from that contract meets the characteristic of net settlement in paragraphs 815-10-15-100 through 15-109 if the fair value of the cash flows to be received (or paid) by the holder under the structured payout are approximately equal to the amount that would have been received (or paid) if the contract had provided for an immediate payout related to settlement of the gain (or loss) under the contract.
In this case, the payments are received over 12 months and there is no interest component. Therefore, the holder of the ARR does not receive the benefit of reinvestment of the proceeds. However, the bidder is also paying for the FTR over a 12-month period; therefore, the bid price presumably incorporates a time-value element.
Furthermore, given the relatively short duration of the payout (less than one year), we conclude that any time value of money would have an inconsequential impact on the fair value of the cash flows to be received over the duration of the payout as compared with those that would be received upon immediate payment. As such, the contract meets the net settlement criterion.
4.4.2.2 Accounting for ARRs subsequent to the FTR Auction
Subsequent to the FTR Auction, an ARR holder has a receivable for its share of the auction proceeds. In assessing the accounting for the ARR, reporting entities should consider the appropriate timing and amount of revenue to be recognized. As noted above, PJM imposes a restriction on the receipt of the ARR revenues, requiring that ARRs be reallocated over the following year on a daily basis based on actual customer load. A reporting entity should consider this obligation to serve future load, a requirement that is substantive and outside of its control. In addition, a reporting entity may have other regulatory requirements associated with its activities. In light of these obligations, reporting entities generally recognize revenue contemporaneously with receipt of the ARR-related cash flows (i.e., when the reporting entity serves the underlying load).
Prior to the recognition of revenue, reporting entities often record no amounts related to the ARR, because the performance obligation would offset any asset recorded. PJM requires explicit net settlement provisions for all transactions between it and its customers. PJM’s operating protocols2 require set-off of ongoing billing amounts as well as amounts owed in the event of default by one of the members. In addition, in accordance with these protocols, PJM has the right of offset for any amounts due to or from a member, arising from any agreement or arrangement. All PJM-related amounts are reported on and settled through combined periodic invoices. PJM requires setoff of all amounts due to and from it, all amounts are billed on one invoice, and only one net payment is made. Therefore, the asset and any related liability would be eligible for net reporting in accordance with the guidance provided by ASC 210, Balance Sheet (ASC 210), in ASC 210-20-45-1.
This requirement is pursuant to the Amended and Restated Operating Agreement of PJM Interconnection,L.L.C., effective July 5, 2012.
4.4.3 Accounting for FTRs
Reporting entities may purchase FTRs through the long-term, annual, or monthly FTR Auctions, as well as through bilateral transactions with other market participants. FTR bilateral transactions may be made through eFTR or directly with other market participants. Transactions completed through eFTR result in a transfer of ownership and are reflected in subsequent PJM invoices. Independent trades are not tracked by PJM and are settled apart from the PJM invoice.
4.4.3.1 Initial accounting for FTRs
An FTR obligation is a financial instrument that results in payment or receipt of funds based on the difference in the day-ahead locational marginal price (LMP) between the Source and the Sink. Similarly, an FTR option is based on differences in the day-ahead LMP; however, the FTR option holder will not be obligated to make a payment if the value is negative. FTR obligations and FTR options are referred to collectively in this section as “FTRs.”
Due to the nature of an FTR, a question arises as to whether it meets the definition of a derivative. As summarized in Figure 4-9, FTRs meet the definition of a derivative as set out in ASC 815-10-15-83.
Figure 4-9
Does an FTR meet the definition of a derivative?
Does an FTR meet the definition of a derivative?
Guidance |
Evaluation |
Comments |
Notional amount and underlying |
Met |
Notional (quantity of megawatts) and underlying (the difference between the price at the Source and the Sink) are specified. |
No initial net investment |
Met |
No initial net investment is required. |
Net settlement |
Met |
FTRs are settled in cash; therefore, FTRs meet the criterion in ASC 815-10-15-83(c)(1). The FTR contract does not require the delivery of electricity across the path that is designated in the FTR. |
An FTR has an underlying and a notional amount specified in the contract. These amounts are not subject to change in the future (i.e., load shift does not impact FTRs). Furthermore, FTRs require no initial net investment and require settlement in cash. As such, FTRs are financial derivatives in accordance with ASC 815.
Question 4-7
Does the auction payment required to acquire the FTR represent an initial net investment in the contract?
Does the auction payment required to acquire the FTR represent an initial net investment in the contract?
PwC response
No. A reporting entity may pay a significant dollar amount for an FTR at the annual, monthly, or long-term auctions, or through bilateral trading. However, these payments represent settlement of the fair value of the contract on the transaction date (not the expected payout when the FTR is later settled). Fair value payments do not represent a significant initial net investment in the contract.
Question 4-8
How should a reporting entity record the initial purchase of FTRs?
How should a reporting entity record the initial purchase of FTRs?
PwC response
A reporting entity may bid for an FTR or obtain an FTR by “self-scheduling” an ARR in the FTR auction. In either case, the reporting entity has a payable to PJM and a derivative with an initial carrying amount equal to the auction price. Therefore, upon purchase, the reporting entity should record the following journal entries with respect to its FTRs (whether self-scheduled or obtained through bid in the auction process):
DR FTR asset |
xx |
||
CR PJM FTR payable |
xx |
||
The payable would be reversed once it is settled with PJM. Similarly, an FTR obtained through a bilateral transaction would result in an FTR asset and a payable to the counterparty. Subsequent changes in the fair value of the FTR would be recognized as gains or losses in the income statement.
Question 4-9
Are there any specific accounting considerations for self-scheduled FTRs?
Are there any specific accounting considerations for self-scheduled FTRs?
PwC response
No. The accounting for a self-scheduled FTR is consistent with the overall model for FTRs described above. The reporting entity has no continuing obligation related to the FTR itself once the FTR is obtained. The FTR will not be adjusted for load shift and a reporting entity can sell the FTR with no future obligation to PJM. Thus, the accounting for self-scheduled FTRs is consistent with FTRs obtained through the auction. The reporting entity should record an FTR asset and related FTR payable after the FTR auction, and subsequent gains and losses related to such FTRs should be recognized in the income statement. In addition, the reporting entity should continue to follow the accounting for the related ARR as discussed in UP 4.4.2.
1 2
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