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The Capacity Market Enigma

Why haven’t reliability markets developed?

Fortnightly Magazine - December 2005

for it themselves. But, in the tradition of public goods, such behavior ultimately will result in a system that is unreliable and harmful to customers.

Since we are not privy to generators’ account books, we cannot determine their financial status. But we can examine the structure of today’s wholesale electric markets, or even an ideal wholesale energy market, to determine whether such markets, by themselves, would provide sufficient incentives to generators to provide sufficient system reliability. They won’t.

Too Little Reliability, Too Late

Today’s wholesale electric markets aren’t fully deregulated. After early prices of $5,000 or more per megawatt-hour (MWh), breaches of contract obligations to supply promised generation, and rolling blackouts, transmission system operators entrusted with overseeing those bid-based wholesale markets and maintaining reliability reacted to regulatory and political pressure to establish price caps in markets. In New England, for example, electric prices today are capped at $1,000/MWh.

Whether or not one argues that $1,000/MWh, or any other binding price cap, is good public policy, the economic effects of price caps are clear: Price caps retard investment and adversely affect the mix of generating resources. 3

Consider peaking units as an example. Peaking units serve a distinct purpose: They trade low capital costs for high operating costs, and thus are designed to run infrequently. Suppose an investor is considering building a new peaking unit. Without any type of separate capacity payment, the owner of a peaking unit must rely on energy market price spikes to recover that capital investment. Now, such price spikes may occur only during a few hours in a year, or may not even happen for several years. Therefore, when the price spikes do occur, they must be high enough for the investor to recover capital cost over time and earn a return on that investment high enough to compensate for the financial risk.

In the presence of price caps, however, a generation developer will be reluctant to invest because the price spikes counted on will be reduced (increasing the financial risk of the project). More important, banks that are asked to finance such investments will be less likely to provide the necessary capital. If they do agree to provide financing, they will charge higher interest rates. As a result, if new peaking units aren’t built at all, overall prices paid by retail customers in the energy market will increase. 4 Moreover, other changes to wholesale market structures can increase uncertainty and retard new investment. That is why regulatory certainty is critical when establishing any new market, whether for generating capacity or air pollution permits. Investors need to know the market rules that will apply and be confident that those rules won’t change in a way that increases their downside financial risk.

The Prospect of Market Intervention

When energy market prices are capped, generation owners need to be compensated for the additional financial risks such caps impose. But what if wholesale energy market prices weren’t capped? Would that obviate the need for a separate long-term installed capacity market, as some claim? For a number of reasons, the answer still