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Can Electricity Markets Work Without Capacity Prices?

Fortnightly Magazine - March 15 1998

gas. BPA's spot sales reflect market forces since it is allowed to sell into the wholesale market at prices up to its average costs.

Devotees of monomic prices believe that the two lines shown in Figure 4 will converge in the 25-to-40-mill range. The requirement that average spot rates climb steeply enough to cover the fully allocated cost of new generation completely determines the value for the spot market.

How realistic is this forecasted dramatic shift in spot prices? The primary concept isn't very accurate at all. By assumption, entrepreneurs will forecast the high prices caused by curtailment costs and construct base load resources in response. Wiser entrepreneurs would certainly preempt the activities of the base load entrepreneurs by constructing simple-cycle turbines. Since simple-cycle turbines are a vastly more efficient choice for serving short-duration, high-cost periods (curtailments), the simple-cycle turbines would become the resource option of choice.

Logically, simple-cycle turbines (and other inexpensive peakers) will serve all load growth until the percentage of the time where simple-cycle units were operating on the margin was sufficient to pay for combined-cycle units.

Using standard assumptions, simple-cycle units are less expensive to operate than combined-cycle units for loads that occur as much as 40 percent of the time. (See sidebar, "Energy Prices Don't Tell All.") One absurd result from energy-only pricing would have the variable costs of simple-cycle units define marginal production costs for much of the year. If this were the case, the price might never increase enough to build combined-cycle units.

Several recent "energy only" analyses assume generators are the active parties in the electric markets and consumers are simply passive recipients of market prices. This view suggests that the engineering cabal still retains enormous influence in the electric utility industry. The truth is that consumers' preferences have an enormous impact of market prices and the cost of generation. In a fully deregulated market, consumers always have the choice of finding their own solutions despite the preconceptions of the suppliers.

Risk Aversion (A Factor in Resource Choice)

Figure 5 represents a simple example of what utility planners call a resource scoping curve. These curves are a standard industry tool that identifies the optimal operating range for a particular type of resource. Resources can be plotted with expected operations from zero to 100 percent of the year. The resource with the lowest cost will prove the best choice for loads whose durations match the percentages of curtailment shown along the bottom of the chart.

Compare the cost of curtailment for a low percentage of load with the cost of a peaker unit. Curtailment is clearly always the best choice for loads with annual duration of less than 14 percent. In fact, since the cost line for a peaker unit always starts at its capital cost, it is a mathematical certainty that curtailment is always the best option, no matter cost.

Given this effect, why is it that utilities (and their customers) don't plan for substantial degrees of curtailment? The simplest answer proves also a bit facile: Utilities don't plan for curtailment because rigid operating