INDEX

TESTIMONY OF

ROBERT W. ANDERSON, ROBERT J. PETTY, AUDREY PERINO, AND JEFF KING

Witnesses for Bonneville Power Administration

**SUBJECT: Marginal Cost Analysis Study**

**Page**

Section 1. Introduction and Purpose of Testimony 1

Section 2. Definition of Marginal Cost 1

Section 3. Uses in the Rate Case 2

Section 4. Estimation Methodology 3

Section 5. MCA Development Process 4

TESTIMONY OF

ROBERT W. ANDERSON, ROBERT J. PETTY, AUDREY PERINO, AND JEFF KING

Witnesses for Bonneville Power Administration

**SUBJECT:** **MARGINAL COST ANALYSIS STUDY**

**Section  1: Introduction and Purpose of Testimony**

*Q. Please state your name(s) and qualifications.*

A. My name is Robert Anderson and my qualifications are contained in
WP-02-E-BPA-01.

A. My name is Robert Petty and my qualifications are contained in
WP-02-E-BPA-58.

A. My name is Audrey Perino and my qualifications are contained in
WP-02-E-BPA-57.

A.  My name is Jeff King and my qualifications are contained in
    WP-02-E-BPA-35.

*Q. What is the purpose of your testimony?*

A. The purpose of this testimony is to sponsor the Marginal Cost
Analysis (MCA) Study included in BPA's 2002 Initial Rate Proposal.

*Q. How is your testimony organized?*

A. This testimony contains five sections including this introductory
section. Section 2 defines marginal cost and describes its relevance to
BPA. Section 3 explains how and why the MCA is used in the rate case.
Section 4 describes the methodology used to estimate marginal costs.
Section 5 reviews the public process that BPA participated in to develop
the marginal cost estimates.

**Section 2: Definition of Marginal Cost**

*Q. What is marginal cost?*

A. Marginal cost is defined as the additional cost of producing or
acquiring an extra unit of a product or service. In economic theory,
when supply and demand are in equilibrium the market price will equal
the variable cost of the marginal unit of production. This is because
producers will find it in their interest to add production as long as
the price they can receive exceeds the marginal cost of production. For
the electric energy market, this definition translates to the variable
cost of the marginal generating unit, where the marginal generating unit
is the last unit dispatched in least cost order to meet energy demand.

*Q. Please define the specific quantities that you use to represent the
marginal costs.*

A. The marginal cost in the MCA is equal to the hourly variable cost of
the marginal resource for energy available at the Mid-Columbia trading
hub. Equivalently, this value may also be referred to as the "market
clearing price."

# Q. Why is the market clearing price relevant to BPA?

A. The marginal cost is used as an indication of a market clearing price
for hourly bulk energy transactions. Therefore, it is related to the
cost that BPA could experience to acquire additional energy, or the
price that BPA could realize in selling surplus bulk energy. The actual
cost BPA experiences for bulk power transactions may not be exactly
equal to the hourly market clearing price because BPA may buy or sell a
different product than what is traded in an hourly market. In addition,
BPA bulk energy transactions may occur at a price not exactly set by the
marginal resource in a particular hour. In either case, the hourly
marginal cost is related to the market clearing price for bulk energy
and is therefore used as a starting point for the price that BPA will
experience for hourly bulk energy transactions.

**Section  3: Uses in the Rate Case**

# Q. How is the MCA used in the rate case analysis?

A. The MCA is used for two purposes in the rate case. First, it is used
to inform, but not to directly set, the price level at which BPA buys
and sells in the bulk power market. For a complete description of BPA's
bulk revenue forecast, see BPA's Risk Study, WP-02-E-BPA-03. Second, the
MCA provides a basis for sending price signals through BPA's rate
design. For example, marginal costs are used as a starting point in
deriving the relative levels of the monthly energy rates, and also in
deriving the relative levels of heavy load hour energy rates versus
light load hour energy rates in a given month. Marginal costs are
important in setting the relative levels of rates so that BPA's rates
send an appropriate price signal. For a complete discussion of how the
marginal costs are used in BPA's rate design, see the Wholesale Power
Rate Development Study, WP-02-E-BPA-05.

*Q. Why is it important to send price signals?*

A. Overall economic efficiency is most likely to be achieved when
consumers face a set of prices for alternative products and services
that are generally priced at their marginal cost. For example, when the
consumer is facing the decision to purchase more or less electrical
energy versus more or less conservation it is important that both price
signals reflect the marginal cost of providing an additional unit of
each. If they do not, then the consumer may make a decision that
minimizes his or her individual costs but does not reflect the cost of
the resources that are used to satisfy that decision. In order to make
appropriate decisions, prices should reflect the marginal costs of
obtaining or disposing of one additional unit of any good or service.
The specific importance of marginal costs to BPA's rates is described in
the testimony of Burns, *et al.,* WP-02-E-BPA-08).

**Section 4: Estimation Methodology**

*Q. What technique has BPA used to forecast marginal costs?*

A. BPA uses an electric market model called AURORA.

*Q. Please briefly describe the theory behind AURORA's modeling
technique.*

A. AURORA is an economic fundamentals based approach that models
wholesale energy transactions in a competitive pricing system. AURORA
uses a demand forecast and supply cost information to find an hourly
market clearing price, or equivalently, the marginal cost. To determine
price in a given hour, AURORA models the dispatch of electric generating
resources in a least cost order to meet the load (demand) forecast. The
price in the given hour is equal to the variable cost of the marginal
resource. Over time, AURORA will add new resources and retire old
resources based on the net present value of the resource. In this way,
AURORA models the functioning of competitive economic market system.

*Q. Is this technique fundamentally different from the way BPA estimated
marginal costs in BPA's 1996 rate case?*

A. No. BPA used a production costing model (PMDAM) in BPAs' 1996 rate
case. PMDAM followed the same fundamental theory. The theory is that
price is determined by the variable cost of the marginal resource and
the resource portfolio adjusts over time as determined by the net
present value of resources.

**Section 5 MCA Development Process**

*Q. What process did BPA use to select AURORA?*

A. BPA reviewed several models and consulted with the public on the
selection of the appropriate model for the MCA. This public consultation
was conducted in open workshops. First, BPA issued a request for
proposals to a broad range of organizations to provide a tool for use in
the MCA. From the responses to this request, three models were selected
as possibly adequate for the task that were reasonably priced: PMDAM --
owned by New Energy Associates; IREMM - owned by Resource Data
International; and AURORA -- owned by EPIS. BPA facilitated the public
review of these models by having representatives for each model make
presentations on their models in a public workshop. BPA also reviewed
the results of preliminary price forecasts from each of these models and
shared these results with the public.

*Q. Why did BPA choose AURORA?*

A. Public participants in the workshops noted several strengths of
AURORA and BPA agreed with these comments. AURORA is the most accessible
model to review and operate, while at the same time providing a good
level of accuracy. A local company owns AURORA, and this allows for
quicker and better user support. AURORA had been recently used by the
Northwest Power Planning Council (NWPPC) and was reviewed and tested by
the NWPPC and energy experts assisting in this analysis.

*Q. Has AURORA been used for a similar purpose before?*

A. Yes. AURORA is commercially available and is used by several other
organizations. The most relevant previous application was by the
Northwest Power Planning Council (NWPPC) in the study, "Analysis of the
Bonneville Power Administration's Potential Future Costs and Revenues."
The NWPPC used AURORA to forecast long-term market clearing prices. This
analysis was conducted with oversight by both a technical work group and
a policy work group. As stated in the introduction to the NWPPC's study,
"\[E\]ach group was made up of respected representatives of key interest
groups. The purpose of these groups was to allow access to their
expertise and perspectives and to ensure that there was broad
understanding of the methods and assumptions driving the results."

*Q. Have interested participants in the rate case had an opportunity
review BPA's use of AURORA?*

A. Yes. In order to facilitate public review, BPA paid for a 'blanket'
usage agreement with EPIS. Under this agreement, BPA paid EPIS to make
AURORA available to interested rate case participants at a reduced cost.
In addition, as part of this agreement EPIS has conducted three training
workshops to work through the theory and operational details of AURORA.
BPA has also made the data and assumptions used in the MCA available to
the public.

# Q. Did the public participants offer comments on BPA's use of AURORA?

A. Yes. Public participants reviewed the original data base in detail.
After this review, the participants offered several very useful
suggestions for the data base.

*Q. Please describe these suggestions.*

A. Several resources were identified that should be added or deleted
from the original AURORA data base based on current information. In the
original AURORA data base, the amount of capacity for each resource was
derived from the nameplate rating. It was suggested to change this to
the available capacity as given by the WSCC. Participants also suggested
that BPA should add and delete resources so that the data base is
consistent with the WSCC geographic boundary. In the original AURORA
data base, all nonutility generation was defined as a generic gas fired
resource with a heat rate approximately equal to 10,000 Btu/kWh. It was
suggested that the data base should account for the individual
characteristics of these generating resources and include any updates on
additions or retirements to be consistent with current WSCC data.
Participants suggested that BPA review and improve, if possible, the
minimum generation percentages used in the unit commitment logic.
Updates on the amount of transmission capacity and wheeling rates were
offered. Workshop participants suggested that curtailment prices should
be constant in real dollar terms. It was also suggested that BPA change
the definitions of AURORA areas from a state-based definition to one
that more clearly matched transmission areas.

*Q. How did BPA respond to these suggestions?*

A. BPA reviewed these comments and concluded that many were appropriate.
BPA set priorities for how best to incorporate these comments within the
rate case time lines. BPA incorporated the highest priority comments
that were feasible within our timeframe for the initial proposal.

BPA added and deleted resources to use more current information. BPA
changed the capacity definition from nameplate to available capacity.
BPA added and deleted generating resources to be consistent with the
WSCC geographic definition. BPA included data for unit-specific
nonutility generation instead of a simple generic gas fired resource and
updated the resources to be consistent with current WSCC data. BPA
researched minimum generation levels for the unit commitment logic and
updated this data. BPA updated transmission capacities and wheeling
rates. BPA changed the curtailment escalation rate so that curtailment
prices remained constant in real dollar terms. BPA was not able to
incorporate a change in the definition of AURORA areas within the
schedule for preparing BPA's initial proposal. This change would not
result in a change in the level of loads or resources in the WSCC. BPA
will continue to review changes to AURORA for inclusion in further
analysis.

*Q. Does this conclude your testimony?*

A. Yes.