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Can Electricity Markets Work Without Capacity Prices?

Fortnightly Magazine - March 15 1998

rules promulgated by regulators don't allow them to. This answer is facile because rules denying curtailment as a resource choice aren't an international law, or even a federal regulation. Operating standards promulgated in Canadian provinces, U.S. cities, rural cooperatives, federal marketing agencies and state regulatory bodies have set operating rules at zero curtailment level.

A more insightful answer would suggest that governments, utilities, cooperatives and regulators have all perceived that customers are not indifferent to risk. Electric customers are highly risk-averse. Estimating risk aversion is never easy. Figure 5 contains a second resource cost line for curtailment, "Actual Curtailment," which reflects the compensation that real customers would demand to curtail load. This line differs from the utility's cost curve for curtailment in that it includes an additional element for the risk incurred by the customer. It shows that the first curtailment in a year marks a real crisis for a customer; risk is greatest at that point. However, the high risk for small levels of curtailment diminishes rapidly as curtailment becomes more frequent. This situation is not as counterintuitive as it seems, at least for a thinking consumer. A completely passive consumer (the price-taker envisioned in monomic pricing) would not respond to additional interruptions. By contrast, a rational customer would quickly determine ways to respond. A utility planning 20-percent curtailments would find that the customers had given themselves emergency backup equipment and alternative fuels, thus lowering risk.

Modeling efforts that ignore the risk aversion of consumers tend to suggest unusual results. They predict short-term periods in which spot prices will rise to curtailment costs of consumers. The electricity market has never experienced such unusual prices for one reason: Customers will take measures to avoid short-duration curtailments.

The level of risk aversion is clearly very high for electricity consumers. One tool of modern economists, "revealed preference," uses customers' actual choices to reveal their degree of risk preference. The choices customers have made over the past 100 years indicate the degree of risk aversion is greater than the cost of a simple-cycle turbine. Their choices have never revealed a preference for curtailment.

Except on an anecdotal basis, we don't have a good idea what these costs are. Analyzing specific industries indicates they are high. A one-minute interruption can destroy the output of an electronic fabrication that has been under way for hours. A one-hour interruption can freeze a continuous caster at a steel mill. A one-day interruption can freeze aluminum to the "pots" and require an enormously expensive repair of the entire facility.

The revealed preference is that consumers are willing to pay insurance (em the price of a simple-cycle turbine (em to avoid the risk of curtailment even if they were willing to pay the cost of curtailment. These numerical exercises reflect the fundamental point that using the history of commodities with dissimilar characteristics as a guide to the future of electricity is inherently risky.

The Capacity Price

(It's Like Medical Insurance)

Given the difficulty of storage and the near impossibility of substitution (gas lights during curtailment periods, anyone?) a better metaphor might