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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

in the rate of growth of demand, and hydro generation is the same, year after year. With these factors held constant throughout the simulation, we know the oscillations come from the interactions inside the system.

High-Growth Scenario. The pattern in Figure 2 represents only one of several patterns of cyclical behavior. If the demand growth rate is lowered to 0.5 percent per year, for example, the simulation shows a gradual growth in the PX price over time. It is not until the very end of the simulation that the PX price would interest investors. The model shows no signs of a construction cycle under such low growth conditions. But a more volatile simulation is shown in Figure 3, where demand is assumed to grow at 2.5 percent per year.

In Figure 3 all other assumptions are the same as before, but the simulation indicates that the PX price will follow an entirely different trajectory. It grows rapidly during the early years of the simulation, reaching the cost of a CCCT in just five years. It then "shoots past" the cost of a CCCT hitting an administrative limit by the year 2004. The circuit breaker is imposed because the region is short of energy. This price cap remains in effect for over a year before sufficient capacity comes on line to eliminate the shortage. The new capacity then causes the price to fall rapidly, reaching a low of around $22 per megawatt-hour around the year 2006.

Figure 3 shows the same pattern recurring after 2006. Continued growth in electricity demand causes the PX price to return to an upward trend, and the trend accelerates around 2010. Administrative limits are imposed again around 2012, and the price is capped until another wave of construction eliminates the shortage of energy.

The oscillation in Figure 3 is known as a "limit cycle." Limit cycles are common in natural systems. They appear when a system prone to growing oscillations encounters a natural limit. Once the system reaches its natural limit, the cycle can repeat itself in an amazingly stable manner (as in the beating of the human heart). But the limit cycle in Figure 3 is not particularly "natural" since the price caps are imposed administratively on a market that has failed to stimulate the needed investment in a timely manner. It is highly doubtful that the industry could survive this pattern of behavior. It is important that we understand the factors contributing to the unstable behavior, and that we design policies to stabilize the system.

Adding a Capacity Incentive: A More Stable Market

The simulations shown so far envision an electric industry based on the premise that investors must rely only on the energy price in a competitive spot market in order to recover the full cost of a new CCCT. They reveal a market plagued by boom and bust. These cycles could prove particularly troublesome if a new CCCT should lose some of its competitive advantage, for example, because of an increase in construction costs. (See Ford, 1999.)

These results suggest that investors need an