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The Capacity Market Enigma

Why haven’t reliability markets developed?

Fortnightly Magazine - December 2005

(ISO-NE), the region’s regional transmission organization. 1 Regardless of whether this capacity market is established—and there are strong proponents and opponents of such a market—ISO-NE almost surely will continue to establish reliability targets and operating standards. Reliability targets establish the levels of installed capacity ISO-NE deems necessary to ensure enough generation is available to meet consumers’ electric demand at any time. Operating standards ensure that generators do not operate in ways that compromise the safety and integrity of the transmission system. ISO-NE also will continue to require utilities and other wholesale customers to own or purchase their “fair” share of capacity requirements, to prevent them from “free riding” on everyone else’s generation capacity.

Thus, the controversy is less over the need for reliability standards (although how much reliability is enough has been a subtext of the debate) and the associated need for market intervention to eliminate free riders, as it is about whether those obligations can be met by establishing a separate, long-term market in which the price of installed capacity is set by supply-and-demand conditions. Finally, and more fundamentally, there is debate as to whether having a well-functioning energy market would ensure sufficient capacity in the long-run, eliminating the need for any separate long-run installed capacity market. 2

Is Today’s System Broken?

Opponents of establishing an installed capacity market, or paying generators anything for the inherent resource adequacy they provide, argue that an installed capacity market only will provide a windfall for generators at the expense of utilities and their customers, without providing a more reliable system. Generators, not surprisingly, have very different views, arguing that, in the current energy market, with its price caps and availability rules, many generators needed for reliability are hemorrhaging dollars.

Currently, power pools designate a number of generators as reliability-must-run (RMR) units. Such a designation prevents individual generation owners from shutting down units needed to maintain the integrity— i.e., the reliability—of the entire regional power grid, and ensures they are adequately compensated for providing that regional benefit. Rather than being compensated based on the dictates of supply and demand, however, the prices paid to generators under RMR agreements are based on cost-of-service, in much the same way as regulated local utilities’ cost-of-service filings are made with their state regulators. FERC has sought to replace such cost-based arrangements with market-based ones whenever possible, believing that market solutions can provide resource adequacy and security more efficiently than can traditional, cost-of-service arrangements. However, some opponents of long-term installed capacity markets have argued against even these cost-based arrangements as being unnecessary and overly compensating generators at the expense of customers.

Opponents of installed capacity markets have adopted two conflicting positions. Some opponents argue there is no need for separate capacity markets, because a well-functioning energy market will provide all the capacity needed. Others argue that separate capacity markets only provide “windfalls” to generators, and have no impact on energy markets. Taken together, these arguments represent a classic free-rider response: Capacity market opponents want to “rely on” others’ generation investments to provide system reliability, and not have to pay