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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

additional incentive to construct power plants, beyond the bare PX energy price. Let's consider a capacity payment as one way to deliver the extra incentive.

Capacity Payments. Capacity payments provide incentives for generators to be available when the system needs generating capacity; they also provide extra revenue to the generator to cover the capital and other fixed costs that are not covered by the energy price. Where capacity markets do exist, they tend to be less formal and provide less price reporting than electric energy markets.2 For example, Rose (1995) predicted that wholesale markets would respond to a tighter supply/demand balance with prices that "develop a hidden premium over marginal fuel costs." He calls the hidden premium a "pure capacity price," and he inferred the size of the pure capacity price "hidden" in energy price data from 1997. Rose asks us to "think of the capacity price as being spread equally over all hours of the year, rather than occurring in certain peak hours, as it does in the real world." He then calculates the pure capacity price at just over 5 mills per kilowatt-hour based on the annual capital cost of a new combustion turbine.

A capacity payment measured in mills per kilowatt-hour is used in the construction cycle because "spreading the payment" over the year corresponds to the average annual operation of the model. Generators now receive the sum of an energy price and a capacity price. The energy price is based on the same rules as before. It's the price needed to bring forth the generation from existing units to meet the demand for energy imposed on the PX. Now, what about the capacity price? Perhaps we should allow the capacity price to vary over time due to variations in the need for generating capacity. But the previous simulations show a highly volatile system if we rely on energy prices alone. The last thing we need is additional volatility from a capacity payment that rises and falls with swings in the construction cycle.3 Investors need additional incentives, not additional volatility. It makes better sense to provide the additional incentive as a capacity payment that remains constant over time and use the simulation model to search for the size of the capacity payment to achieve improved stability. The search (Ford 1999) has shown that capacity payments in the range of 4-8 mills per kilowatt-hour are sufficient to stabilize the system.

Figure 4 shows an example with a 5 mill per kilowatt-hour payment. The simulation shows the stable pattern of construction that we would like to see when demand is growing at a steady rate year after year. Investors begin applying for construction permits around the year 2001, and the capacity begins to grow around 2003. The pattern of growth is smooth and steady because investors fill the "pipeline" by the same amount year after year. The steady growth in new generating capacity allows the energy price to follow a smooth upward trend. The upward trend is caused by a 1 percent per year real escalation in the price of natural