April 1, 2000
Can Electricity Markets Work Without Capacity Prices?
MANY PLAYERS IN THE ELECTRIC INDUSTRY HAVE COME to believe that energy-only prices will soon replace the hundred-year tradition of pricing both energy and capacity.
This idea, sometimes called "monomic" trading, offers a seductive simplicity. Even so, research indicates that it is unlikely to work well.
First, consider some terminology. Traditional electric markets contain prices for both energy and capacity. Energy prices pertain to the actual kilowatt-hours. Capacity prices pertain to the right to take energy. Purchases from a thermal unit usually include prices that will cover fixed costs (capacity) and payments to cover fuel (energy).
Starting from these definitions, the energy-only pricing school then teaches that the volatility of spot prices is an adequate replacement for capacity. They argue that spot markets will implicitly guarantee capacity in two ways: (1) In the short run, energy prices will climb to the point where users will curtail their needs and release capacity for those customers without the ability to curtail their demand, and (2) In the long run, the probability of high-price periods in the spot markets will create an opportunity for entrepreneurs to build new capacity.
In reality, however, the same simplicity that makes this monomic pricing scheme attractive obscures serious operating and economic issues, which could lead to unnaturally high prices. Commodity markets can prove complex. To say simply that monomic pricing remains untested for electricity is to be conservative, at the very least. More importantly, to those with a more extensive understanding of commodity trading, the monomic formulation hides enormous assumptions. Further, experience implies that any theory based on unstated and untested assumptions may fail entirely.
(Seen as a Function of Supply Price)
Modeling of a monomic future critically depends on curtailment charges. These charges reflect the true supply price necessary either to induce a customer to curtail load or to liquidate the damages that the customer would incur from an unexpected outage.
The relationship between frequency of curtailments, curtailment cost and alternative resources is simple. We have reviewed several models that reflect values similar to those in Figure 1. This chart shows that the more an electric supplier has to pay a customer to curtail his load, the less often the supplier will do so. This relationship implies levels of curtailment entirely out of our experience in the electricity industry.
What factors do these curtailment values represent? In the electric utility industry, at least, these factors remain largely hidden.
Simple experience with electricity end users indicates that curtailment is seldom considered a very good option. In fact, although many industries have accepted interruptible rates, most don't really expect interruptions. Recent growth of contracts that include interruptibility has coincided with increasing levels of electric capacity surplus in the U.S. and Canada. The only major use of interruptibility in the last five years led to lawsuits and the elimination of the interruptible clauses in subsequent contracts.
In the short run, curtailment costs strongly reflect the share of electricity in total costs.
Figure 2 shows the energy intensity of different major industries. Each industry will have a different cost for