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Can Electricity Markets Work Without Capacity Prices?

Fortnightly Magazine - March 15 1998

be medical care. Medical care cannot be stored. For example, taking antibiotics when you are not sick is actually bad for you. And it is very difficult to find substitutes for medical care. In the extreme, the curtailment cost of medical shortages is death. While this comparison may seem farfetched, the result of curtailment in either industry is that the lights do go out.

The markets for medical care are similar to those for electricity. Most consumers appear willing to pay a considerable surplus above marginal cost to assure service. While this margin is called capacity in electric markets, it is known as insurance in medical care. An HMO that could not assure you critical care in an emergency would soon be struck off your list, even if the premiums were higher for one that did guarantee to take care of you on a hell-or-high-water basis.

The most likely result is that in a completely open market, some consumers will choose to gamble to receive lower overall prices. Most consumers will pay a margin (em a capacity charge (em to guarantee their costs will never reach curtailment levels, or never have to sit in the dark waiting for their office equipment to power up after the most recent blackout.

What does this mean for price forecasting? The most logical forecast is for spot prices to remain in the same basic relationship to fully allocated costs that they have for many years. Spot prices will continue to reflect variable operating costs, which falls somewhere in the mid-teens for most of the United States and Canada. Prices with a supply and price guarantee, firm prices will converge to the marginal firm resource. At current gas forecasts, this would likely be in the mid-twenties.

Does this mean that merchant plants are a bad idea? Actually, this model of future prices appears far more conducive to merchant plants than the pure energy model. Merchant plants can sell both capacity and energy. The capacity will provide insurance to ultimate consumers against interruption and price volatility. The energy can be sold into the spot markets if the prices are attractive. The economics does not change. The degree of producer and consumer choice does change and with it the efficiency of the market.

Robert McCullough is the managing partner of McCullough Research, an energy consulting firm based in Portland, Ore., which specializes in energy and public policy issues throughout North America. As officer at Portland General Corp., McCullough helped start the nation's first electric brokerage. His work last appeared in Oct. 1, 1996 in the article entitled, "Trading on the Index: Spot Markets and Price Spreads in the Western Interconnection."

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