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The Capacity Market Enigma

Why haven’t reliability markets developed?

Fortnightly Magazine - December 2005

investors in new generation, especially those wanting to build peaking or intermediate units. Those investors may look askance at this constrained market, because they may not be able to recover investment costs through high energy prices (which take place only when their units are not operating). It may also be that their profits would be too little to justify building in the region, unless the existing large generators can be “relied on” to fail, and thus drive up the market price of energy during a few, high-priced hours.

ISO-NE is facing this “lumpy” investment problem in load pockets. The overall downward impact on energy prices from large baseload and intermediate units precludes them from recovering investment costs, and has forced increasing numbers of generators to apply for RMR agreements. New generation investment, sized large enough to exploit economies of scale, will drive market prices even lower.

It is possible that the new generator will be efficient enough to operate profitably. But what if the drop in energy market price causes financial distress for the existing generator? If the existing generator shuts down, prices will spike and reliability will drop too far. 5

Thus, short of a guaranteed schedule of sabotage, generation developers likely are to avoid such a constrained region, even though, from a broader market perspective, that is precisely where they ought to build. The answer to this paradox lies in the inability of generators to rely on high energy prices to finance investments. In other words, you cannot rely on a lack of reliability. It is just too risky, because of the inherent volatility of electric markets, the often-occurring phenomena of regulatory and political intervention, as well as other market imperfections.

Reliability Requires Capacity

The remedy for these dilemmas is to provide distinct installed capacity payments to generators. Capacity and energy, while clearly related, are not identical products. Installed capacity provides both short-term and long-term reliability, a public good. And, like other public goods, market forces alone will provide too little reliability. Moreover, if we want to encourage a diverse mix of generating resources—baseload, intermediate, and peakers—investors must expect to earn sufficient revenues to cover their risks for each generation technology. That’s true regardless of whether generation markets are fully deregulated or fully regulated. Ignoring the public good component of installed capacity sooner or later will force system operators to intervene by designating a number of generators as RMR units.

Should we return to fully regulated wholesale energy markets, based strictly on generators’ cost of service, and abandon creating markets for reliability and other ancillary services? FERC does not think so, and, there’s no economic basis to conclude that competitive wholesale energy markets aren’t working well, price caps excepted.

Unlike the market for energy, installed capacity markets always will have an administrative aspect. Just as consumers don’t directly purchase clean air, they don’t directly purchase reliability. And, because reliability, like clean air, is a public good, harnessing the power of market forces to provide reliability requires that a market be established.

Thus, if we are to continue to rely on