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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

only rewarded for taking advantage of, perpetuating, and, at best, only incrementally improving the constraint, not for solving or even materially improving the situation.

This market-design flaw is visible in the failure of a variety of otherwise well-conceived projects in constrained market geographies to achieve commercial acceptance and financeability. Perhaps one of the more well-promoted and visible market bellyflops is the Conjunction transmission project. Designed to arbitrage the surplus capacity and energy markets of New York Independent System Operator (NY-ISO) Zone G into the highly constrained downstate Zone J market, the project was well conceived and engineered, and appeared realistic and cost-effective.

The problem was that potential off-takers were worried that it would work too well. Initially sized at between 1,000 and 2,000 MW, the frequently stated concern of open-season bidders was that the project largely would relieve and unconstrain the bottlenecks between the two zones.

One would think this “complaint” should be a good thing, worthy of accolades—but not in a market environment that values the perpetuation, not the elimination, of constraints. Despite the pleas from project sponsors that the market could tolerate that level of incremental capacity infusion without cratering spreads, the project failed to convince bidders. It now resides in the growing waste heap of potentially viable, beneficial projects that languish due to rules that don’t send the right signals and, therefore, don’t achieve optimal outcomes.

Manifestations of the Problem

The lack of forward visibility of capacity values associated with long-dated capital investments makes the financing of any new “merchant” power project more of a gamble than a risk-mitigatable investment. Gambles involve lots of risk, and risky investments may, in certain circumstances, be financeable, but only with lots of expensive equity capital and limited amounts of debt with high embedded spreads. Expensive financing, at best, perpetuates high-cost, risk-laden markets.

But this “at-best” scenario is not playing out, even in the most highly constrained markets. NY-ISO Zones J and K, essentially encompassing New York City, Westchester County, and Long Island, remain constrained despite market-clearing prices in the NY-ISO six-month auction that have been, for years, clearly high enough to cover the capital cost of new generation. Yet, aside from the modest-sized Ravenswood expansion, and despite a number of sited projects, the only material capacity being added is from utility construction (Poletti expansion, East River) or long-term contracts issued in response to utility competitive solicitations (SES Astoria, Neptune).

This summer, the Zone J UCAP clearing price is over $12.00/kW/month. That should be enough to motivate someone to build something, right? Wrong. Market participants have no visible and financeable view of what capacity prices will be when, if, and after their new capacity increment comes on line. As a result, short-term clearing prices for UCAP remain high and would be even higher were it not for the thoughtful actions of the load-serving utilities, Con Edison, LIPA, and NYPA, to address the situation through self-build and long-term contracting.

The situation is similar in California, but compounded by a perplexing and shifting regulatory environment. Again, as in downstate New York, the only limited capacity