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Can Electricity Markets Work Without Capacity Prices?

Fortnightly Magazine - March 15 1998

curtailment of electric service, based on a variety of factors, including its storage capability and the impact of loss of power on processing. For example, actual curtailment costs for metals can be relatively low at 90 mills per kilowatt-hour. Curtailment costs for food and lumber climb to 1,000 mills. For the vast majority of other industries, curtailment costs range from 3,000 to 5,000 mills per kilowatt-hour.

Why are curtailment-based prices so high when other commodity industries do not experience price ranges that vary by a factor of 100? The major reason is the availability of storage and substitutes. One commodity-based industry that is closely linked to electricity is aluminum. Aluminum is a pure commodity where approximately 30 percent of its cost is energy. Aluminum prices range from $0.40 to $1.20 per pound. When aluminum is scarce, prices increase until the stockpiles have been consumed and consumers (em primarily packaging and structural metals (em turn to alternative metals. At no point in the aluminum price cycle do we actually see beer go unconsumed or airplanes uncompleted for lack of inputs. Inventory is an important component. Since metal prices do vary, maintaining a stockpile of aluminum against periods when the price is high is economically efficient for producers and speculators. A simple calculation proves that aluminum purchased at $0.40 against market peaks eventually can be sold at $1.20 even if years pass between lows and highs in the market.

Electricity is very different. Electricity has no real storage capability. Although some hydroelectric systems theoretically can hold water for future generations, practical considerations (often environmental) preclude filling the reservoirs against future high prices. Electricity also doesn't have many substitutes. Computers cannot operate with natural gas. Some industries can shift between fuels for process heat, but that marks the exception rather than the rule.

Can knowing the level of curtailment costs prove useful in understanding how markets behave?

The credibility of curtailment-driven markets depends on the curtailment's depth and its frequency. Figure 3 shows the scale of curtailment (percentage of the market curtailed) for North America's West Coast for 1996, if the regions started with load and resources in balance.

One Department of Energy study argues passionately for the future of energy-only markets and used 85 mills for the curtailment penalty. This study would predict curtailments of 10 percent of total load during high peak periods, such as August.

Spot Prices

(A Window on Supply Costs)

By definition, if the only incentive to build base load generation comes from electric spot markets, the spot price must quickly increase to the fully allocated cost of a combustion turbine and stay at that level (on an annual average basis) in perpetuity.

By comparison, however, historical spot market prices for electricity have never approximated the level of fully allocated costs of new resources. The Bonneville Power Administration, one of the continent's largest utilities, maintains data on both spot sales revenues and the fully allocated costs of new resources (see Figure 4).

The falling level of fully allocated costs reflects the shift from nuclear generation to units fired by natural