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Capacity Markets: A Bridge to Recovery?

A review of the ongoing evolution of market design.

Fortnightly Magazine - May 2005

included modifications to the market-demand curve. By constructing what is referred to as a "sloped" or "curved" demand curve, market designers are attempting to fine-tune the timing of the new build signal and eliminate the binary pricing behavior observed in markets with vertical-demand curves. The sloped-demand curve attempts to add subtlety to the market signals by producing increasingly high levels of compensation for generators when the market moves towards scarcity levels, and by gradually decreasing levels of compensation when resources are adequate.

PJM now is considering taking this a step further, to what can be referred to as "LICAP Plus." If the original PJM structure simply addressed the issue of how much, and the New York/New England LICAP markets add functionality for addressing when and where, the new PJM design also will help determine what type. The scheme under discussion in PJM is designed to address the operational flexibility of the resources that are built. The proposal includes criteria to provide price distinction based on the ability of resources to follow load or provide quick-start functionality. This will help ensure that the generation mix as a whole is diverse enough to provide the full range of resources needed to meet system needs.

So what does all this mean? In terms of market evolution, there is no reason to expect that all of these steps will be followed in order by all markets. As experience builds and historical examples accumulate, it is likely that markets will level-jump from NoCAP to LICAP, for in-stance, as is being considered in California (). Certainly, if a LICAP Plus market appears to work, we may see markets open in the future with that structure used from the beginning. Re-gardless, the current state of the various markets in the United States provides a live example of the progression of thought on how best to ensure resource adequacy in deregulated markets.

The outcome of the discussions under way in PJM will have a significant impact on the future form of capacity markets. PJM has been viewed for some time as a model market, so others likely will continue to follow its lead and adopt similar market structures. In addition, MISO is under order from the Federal Energy Regulatory Commission to produce a system that is consistent with PJM. Given these developments, within several years the Northeast likely will be dominated by LICAP markets, while LICAP Plus could stretch from the Mid-Atlantic to Montana. Developments in California and ERCOT should add additional momentum to the LICAP model in future years.

For market participants, these new structures could have material impacts, at least in the short term. For a generator in Connecticut, for example, the addition of LICAP could mean the difference between less than $1/kW-mo. in capacity compensation or $5 or $6/kW-mo. For a generic 600-MW combined-cycle plant, this could add $40 million per year in revenues. To put this in perspective, an additional $40 million would increase gross margins from 15 to 40 percent for this typical plant, which goes a long way toward covering debt service on struggling