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The Capacity Market Enigma

Why haven’t reliability markets developed?

Fortnightly Magazine - December 2005

is no. On top of the general problem of underinvestment in public goods like reliability, generation developers also would have to contend with numerous financial risks, which would be especially troublesome for peaking and intermediate units that rely on high energy market prices to recover their costs.

First, when price spikes make headlines, it is too tempting politically not to intervene, or threaten to intervene, so as to protect defenseless customers from “selfish generators” who “take advantage of an energy crisis.” One only has to look at the political reaction to high gasoline prices in the wake of Hurricane Katrina to see that political demagoguery is alive and well.

The difficulty, of course, is that high energy market prices may be associated with some form of anticompetitive supplier behavior. Although anticompetitive behavior clearly requires intervention, high prices don’t necessarily mean anticompetitive behavior exists; instead, they may reflect volatile supply-and-demand conditions. The best response to anticompetitive behavior is not to use so blunt a policy instrument as price caps.

As evinced by the California meltdown, it can take regulators years of expensive litigation to determine whether high prices were the result of supply shortages, weather conditions, anticompetitive behavior, or some combination of all of those factors. If generation owners have no other source of market compensation, especially owners of peaking and intermediate units that are dependent on revenues earned over a limited number of hours, they will be less likely to invest.

Taking Your Lumps

Another risk to generators arises from revenue uncertainty caused by the “lumpy” nature of capacity investments, coupled with the lack of demand responsiveness. Financing for generators with high revenue uncertainty simply may be unavailable, even when such investments may be valuable for the system as a whole. Unless the full value of reliability is captured separately, its public good status will lead to under-investment in capacity.

This is particularly true as wholesale energy markets become more focused at the zonal and even individual generator level. Although these focused markets can send more appropriate price signals to investors, one ironic consequence is a higher concentration of suppliers, with the resulting increased potential for market power and greater price volatility. As a result, individual investment decisions, as well as individual operational decisions, will have more profound impacts on wholesale energy prices in these smaller markets.

Consider a transmission-constrained region where new generation investment is valuable from the standpoint of both reliability and energy. Suppose one or more large generating units are in that region, built to exploit economies of scale. If the region is small and transmission constrained, these generating units are likely to have a disproportionate impact on market clearing prices and overall system reliability. These generators may find themselves in an odd position: As long as they operate, energy prices will be set relatively low and the generator will not recover replacement costs. But, if one of the generators suffers a forced outage, market prices may spike and reliability drop, perhaps dangerously so. This is what we call the “endogeneity” problem.

Next, consider the decisions faced by potential