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Boom and Bust? Understanding the Power Plant Construction Cycle

Rising energy demand could spur investment in waves, but a fixed capacity charge might flatten the curve.
Fortnightly Magazine - July 15 2000


Rising energy demand could spur investment in waves, but a fixed capacity charge might flatten the curve.

Construction cycles occur in many industries. Examples include automobile manufacturing, metallic commodities, agricultural commodities, and real estate—some of which may differ in fundamental ways from the electric industry. Yet that does not make the power business immune from boom and bust.

The differences that separate these other industries from the power business may arise from their long supply chains or their ability to store products in inventory prior to delivery. The real estate industry, however, appears similar to electricity in many respects. Investors consult market data in deciding whether to construct new buildings, just as a power producer might do. And in real estate, delays in completing construction have given rise to cycles that date all the way back to the early 1800s (See bibliography, Hoyt 1933, DiPasquale 1996, Sterman 2000).

Construction cycles have not been as prominent in the long history of the electric industry—fluctuations in reserve margins have not been as dramatic as changes in inventory in other industries—but that fact may change. When restructuring is completed, electric utilities no longer will be obliged to build the new power plants needed to serve demand. They will consult the market before building the plants that will be needed in the future. Some believe the market will respond in a cyclical manner

This article describes computer simulations to help us understand the key feedback mechanisms that control power plant construction in a restructured electricity market. The model was originally developed for a western utility to help its planners think through strategies to achieve its goals for electric rates and cash flow. The model is used in this article to help us appreciate the potential for construction cycles in the western United States. Summary results are given here; detailed results can be found in an earlier article that I published in Energy Policy, which is listed at the front of the bibliography.

In short, the research in this article suggests that in a restructured market, power plant construction may come in waves, causing alternating periods of over- and under-supply of electricity that may prove severe enough to require operators of spot energy markets to impose artificial price caps. The end result would be major swings in market prices as the industry moves through the phases of a construction cycle.

This research indicates that construction cycles are a potentially serious problem if the western electricity markets follow the example set in California. Under some circumstances, the cycles would take the extreme form of a "limit cycle." In this unfortunate situation, the industry would face repeated periods of under supply, and regulators would be forced to intervene with administrative limits on the price of electricity.

These problems arise from the inherently unstable interactions between the market and investors. But construction cycles are not inevitable. They could be dampened substantially if western markets allow for additional incentives.

This article considers a constant capacity price as a vehicle to deliver the added incentive. Simulation studies have shown that a