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Mending Our Broken Capacity Markets

The ability to provide reliable capacity is becoming both riskier and more costly to society and investors alike.

Fortnightly Magazine - June 2006

at high cost to the firm and, as a result, to customers. The resulting high cost of power fully reflected the economic exposure of this risky investment.

Needed: Clearly Defined Responsibilities

Our industrial ancestors a century ago perhaps can be forgiven for the lack of clearly defined load-serving responsibilities and a well-defined marketplace in which capacity investments could be made with relative revenue certainty and thus relatively low cost to society. After all, back then, electricity wasn’t perceived as a societal need but as a luxury. For the better part of the past century, industrial and regulatory evolutions have provided a sound platform upon which the commercial act of providing reliable power is no longer a “you bet your business” gamble. Assigning clear and unambiguous responsibility for reliable grid service and, in return, providing reasonable assurance of a fair, authorized return on investment—classically know as the “regulatory bargain”—worked well to meet the huge growth of the American grid. Supplemented by the Public Utilities Regulatory Policy Act of 1978 and the Energy Policy Act of 1992, the ability of new entrants to compete effectively with established utilities on the basis of capital and operating efficiency in the generation space, still under the watchful eye of regulated, clearly defined utility planning responsibilities, enhanced the options available for ensuring reliable, low-cost capacity.

Devolution

Over the past decade, the American grid has been devolving into an environment where the ability to provide reliable capacity is becoming both riskier and more costly to society and investors alike.

The reason for this devolution? Poor designs of capacity markets, or, in some cases, lack of any design at all. The three-fold objective of capacity markets should be to:

1. Ensure reliability of the electric grid;

2. Provide this reliability at lowest cost to society; and

3. Supply this reliable capacity with a mix of resources that, in aggregate, are efficient, environmentally acceptable, low-cost producers of energy.

In several regions in this country, we have lost sight of the importance of these three objectives, and have allowed a combination of embedded constituencies and brilliant economic minds to design market structures that do not necessarily portend a healthy future for the industry.

The reason for this negative outlook is that the classically defined responsibilities for providing adequate capacity supplies have been replaced with either overly complex or unduly simplistic market-pricing signals designed to motivate appropriate capital-deployment decisions. This has replaced singular responsibility for taking thoughtful action, under the watchful eye of state and federal economic regulation, with the proverbial “invisible hand of the market.”

The market’s invisible hand only can operate effectively if it is wired into a well-functioning market nervous system and brain. The organized markets of North America have manifested suboptimal structures for motivating efficient capacity decisions by attempting to guide long-term capital decisions via much shorter duration price signals. In the energy market, things work rather well because pricing signals are provided in-time units—day-ahead and hour-ahead—that are consistent with unit-dispatch decision making. The energy market gives us signals in the same temporal space as our decisions are made